ECO201 StudyGuide PDF

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Chia, W. M. (2020). ECO201 Managerial economics (study guide). Singapore: Singapore
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Table of Contents

Table of Contents
Course Guide
1. Welcome.................................................................................................................. CG-2
2. Course Description and Aims............................................................................ CG-3
3. Learning Outcomes.............................................................................................. CG-5
4. Learning Material................................................................................................. CG-6
5. Assessment Overview.......................................................................................... CG-7
6. Course Schedule.................................................................................................. CG-10
7. Learning Mode.................................................................................................... CG-11
Study Unit 1: Demand and Supply Analysis

Learning Outcomes................................................................................................. SU1-2
Chapter 1: Introduction to Managerial Economics............................................. SU1-4
Chapter 2: Demand Analysis and Supply Analysis........................................... SU1-9
Chapter 3: Elasticity............................................................................................... SU1-22
Summary................................................................................................................. SU1-36
References............................................................................................................... SU1-54
Study Unit 2: Market Equilibrium and Economic Efficiency

Chapter 1: Market Equilibrium............................................................................. SU2-4
Chapter 2: Economic Efficiency........................................................................... SU2-13
i
Table of Contents
Summary................................................................................................................. SU2-29
References............................................................................................................... SU2-44
Study Unit 3: The Cost Side of the Market

Chapter 1: Cost of Production in the Short Run................................................. SU3-3
Chapter 2: Cost of Production in the Long Run............................................... SU3-16
Summary................................................................................................................. SU3-24
References............................................................................................................... SU3-33
Study Unit 4: Competitive Markets and Monopoly

Chapter 1: Competitive Markets and Economic Profit...................................... SU4-4
Chapter 2: Perfect Competition............................................................................. SU4-9
Chapter 3: Monopoly............................................................................................. SU4-20
Summary................................................................................................................. SU4-36
References............................................................................................................... SU4-54
Study Unit 5: Strategic Thinking and Oligopoly

Chapter 1: Strategic Thinking and Game Theory............................................... SU5-4
Chapter 2: Oligopoly............................................................................................. SU5-17
Summary................................................................................................................. SU5-35
References............................................................................................................... SU5-51
ii
Table of Contents
Study Unit 6: Managerial Decisions in Imperfect Markets

Chapter 1: Externalities........................................................................................... SU6-4
Chapter 2: Asymmetric Information................................................................... SU6-16
Chapter 3: Incentives and Organisation............................................................. SU6-28
Chapter 4: Regulation............................................................................................ SU6-42
Summary................................................................................................................. SU6-54
References............................................................................................................... SU6-84
iii
Table of Contents
iv
List of Tables
List of Tables
Table 1.1 Kate’s Demand Schedule for Pizzas....................................................... SU1-10
Table 1.2 Seller’s Supply Schedule for Pizzas........................................................ SU1-15
Table 1.3 The Relationship between Price Elasticity and Total

Expenditure.................................................................................................................. SU1-27
Table 1.4 Summary of Income Elasticity of Demand............................................ SU1-29
Table 1.5 Summary of Cross Price Elasticity of Demand..................................... SU1-29
Table 2.1 Cindy’s Total Utility from Chocolate Consumption............................. SU2-16
Table 3.1 Total Product, Average Product and Marginal Product......................... SU3-6
Table 3.2 Fixed Cost, Variable Cost and Total Cost................................................. SU3-7
Table 3.3 Average Fixed Cost, Average Variable Cost and Average Cost............. SU3-8
Table 3.4 The Long Run Average Cost of Production........................................... SU3-16
Table 4.1 Monopoly Revenue, Cost and Profit...................................................... SU4-22
v
List of Tables
vi
List of Figures
List of Figures
Figure 1.1 The Difference between Accounting Profit and Economic

Profit................................................................................................................................ SU1-5
Figure 1.2 Change in Quantity Demanded – Movement along the Demand

Curve............................................................................................................................. SU1-10
Figure 1.3 Change in Demand – Shift in Demand................................................ SU1-11
Figure 1.4 An Increase in Demand – Rightward Shift.......................................... SU1-12
Figure 1.5 A Decrease in Demand – Leftward Shift.............................................. SU1-13
Figure 1.6 Change in Quantity Supplied – Movement along the Supply

Curve............................................................................................................................. SU1-15
Figure 1.7 Change in Supply – Shift in Supply..................................................... SU1-16
Figure 1.8 An Increase in Supply – Rightward Shift............................................. SU1-17
Figure 1.9 A Decrease in Supply – Leftward Shift................................................ SU1-17
Figure 1.10 Calculating Price Elasticity of Demand.............................................. SU1-24
Figure 1.11 Calculating Price Elasticity of Demand.............................................. SU1-25
Figure 1.12 Perfectly Elastic and Perfectly Inelastic Demand Curves................ SU1-25
Figure 1.13 Decrease in Price will result in a Fall in Total Expenditure (Total

Revenue) when Demand is Inelastic....................................................................... SU1-27
Figure 1.14 Decrease in Price will result in a Rise in Total Expenditure (Total

Revenue) when Demand is Elastic.......................................................................... SU1-27
Figure 2.1 Market Equilibrium................................................................................... SU2-5
vii
List of Figures
Figure 2.2 Excess Demand and Excess Supply in the Market............................... SU2-6
Figure 2.3 Four Rules governing the Effects of Supply and Demand

Shifts................................................................................................................................ SU2-7
Figure 2.4 Increase in Supply..................................................................................... SU2-8
Figure 2.5 Increase in Demand................................................................................... SU2-8
Figure 2.6 Responses to Profit.................................................................................. SU2-14
Figure 2.7 Responses to Loss.................................................................................... SU2-15
Figure 2.8 Cindy’s Total Utility from Chocolate Bar Consumption.................... SU2-17
Figure 2.9 Individual and Market Demand Curves for Chocolate Bars............. SU2-19
Figure 2.10 Economic Surplus.................................................................................. SU2-21
Figure 2.11 Market Equilibrium and Welfare......................................................... SU2-22
Figure 2.12 Deadweight Loss.................................................................................... SU2-23
Figure 2.13 Incidence of Tax..................................................................................... SU2-24
Figure 3.1 AVC, AC and MC...................................................................................... SU3-9
Figure 3.2 Profit Maximising Output, P = MC...................................................... SU3-10
Figure 3.3 Profit Maximizing Output, P = MC...................................................... SU3-11
Figure 3.4 Long Run Average Cost Curve.............................................................. SU3-17
Figure 4.1 Demand Curve for the Representative Competitive Firm................. SU4-10
Figure 4.2 Output Choice for a Competitive Firm................................................ SU4-12
Figure 4.3 A Competitive Firm’s Short-Run Supply Curve................................. SU4-13
Figure 4.4 Market Supply Curve for the Competitive Industry.......................... SU4-14
viii
List of Figures
Figure 4.5 Long-Run Competitive Equilibrium - Profits...................................... SU4-15
Figure 4.6 Long-Run Competitive Equilibrium - Losses...................................... SU4-15
Figure 4.7 Marginal Revenue.................................................................................... SU4-23
Figure 4.8 Monopolist’s Output Decision............................................................... SU4-25
Figure 4.9 Changes in Demand................................................................................ SU4-27
Figure 4.10 Changes in Marginal Cost.................................................................... SU4-28
Figure 4.11 Perfect Competition and Monopoly.................................................... SU4-29
Figure 4.12 Monopsony Purchasing........................................................................ SU4-31
Figure 5.1 A Single-Period Quantity Setting Game................................................ SU5-5
Figure 5.2 A Battle of Sexes Game............................................................................. SU5-7
Figure 5.3 Matching Pennies....................................................................................... SU5-9
Figure 5.4 Product Choice Game in Extensive Form............................................ SU5-11
Figure 5.5 Price Competition with Identical Products.......................................... SU5-19
Figure 5.6 Price Competition with Differentiated Products................................. SU5-20
Figure 5.7 Profit-Maximising Output: Monopoly vs Duopoly............................ SU5-22
Figure 5.8 Best Response Quantities Curves.......................................................... SU5-22
Figure 5.9 Effect of a Government Subsidy on a Cournot Equilibrium.............. SU5-25
Figure 5.10 Stackelberg Equilibrium........................................................................ SU5-27
Figure 5.11 Competition versus Cartel.................................................................... SU5-29
Figure 6.1 Positive Externality.................................................................................... SU6-6
Figure 6.2 Negative Externality.................................................................................. SU6-7
ix
List of Figures
Figure 6.3 Efficient Public Good Provision............................................................. SU6-11
Figure 6.4 Markets for Lemons and Good Cars.................................................... SU6-19
Figure 6.5 Economically Inefficient Effort.............................................................. SU6-29
Figure 6.6 Fixed-Fee Rental Contract...................................................................... SU6-32
Figure 6.7 Profit-Sharing Contract........................................................................... SU6-33
Figure 6.8 Natural Monopoly Price Regulations................................................... SU6-44
Figure 6.9 The Efficient Level of Emissions........................................................... SU6-47
Figure 6.10 Standards and Fees................................................................................ SU6-48
x
List of Lesson Recordings
Introduction to Managerial Economics..................................................................... SU1-6
Demand Supply and Market Equilibrium.............................................................. SU1-19
Elasticity....................................................................................................................... SU1-31
Market Equilibrium...................................................................................................... SU2-9
Economic Efficiency.................................................................................................... SU2-25
Cost of Production in the Short Run....................................................................... SU3-12
Cost of Production in the Long Run....................................................................... SU3-21
Competitive Markets and Economic Profit.............................................................. SU4-7
Perfect Competition.................................................................................................... SU4-16
Monopoly..................................................................................................................... SU4-33
Strategic Thinking and Game Theory..................................................................... SU5-14
Oligopoly...................................................................................................................... SU5-31
Externalities.................................................................................................................. SU6-12
Asymmetric Information........................................................................................... SU6-24
Incentives and Organization..................................................................................... SU6-38
Regulation.................................................................................................................... SU6-50
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Course
Guide
Managerial Economics
ECO201 Course Guide
1. Welcome
Presenter: Dr Ding Ding
This streaming video requires Internet connection. Access it via Wi-Fi to

avoid incurring data charges on your personal mobile plan.
Click here to watch the video. i
Welcome to the course ECO201 Managerial Economics, a 5 credit unit (CU) course.
This Study Guide will be your personal learning resource to take you through the course
learning journey. The guide is divided into two main sections – the Course Guide and
Study Units.
The Course Guide describes the structure for the entire course and provides you with an
overview of the Study Units. It serves as a roadmap of the different learning components
within the course. This Course Guide contains important information regarding the
course learning outcomes, learning materials and resources, assessment breakdown and
additional course information.
i
https://d2jifwt31jjehd.cloudfront.net/ECO201/IntroVideo/ECO201_Intro_Video.mp4
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ECO201 Course Guide
2. Course Description and Aims
This course provides you with fundamental knowledge from managerial economics that
practicing managers can and do use. Managerial Economics is the science of directing
scarce resources in management of a business or other organization. The course is
organized in three parts. Following the introduction, the first part presents the basic
starting point of managerial economics and the framework of perfectly competitive
markets. The second part broadens the perspective to situations of market power while
the third part focuses on issues of management in imperfect markets.
Course Structure
This course is a 5-credit unit course presented over 6 weeks.
There are six Study Units in this course. The following provides an overview of each Study
Unit.
Study Unit 1 – Demand and Supply Analysis
This unit helps you understand the basic starting point of managerial economics,
including demand, supply, market equilibrium and the concept of elasticity.
Study Unit 2 – Market Equilibrium and Economic Efficiency
This unit will put together the theory of demand and theory of supply to analyse market
equilibrium. It develops the concept of efficiency and explores why many tasks are best
left up to the market. It also presents the concept of economic surplus and looks at how
unregulated markets can generate the largest possible economic surplus.
Study Unit 3 – The Cost Side of the Market
The aim of this unit is to analyze cost in the short run and cost in the long run.
Understanding the differences between short run and long run help to explain firm’s shut-
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ECO201 Course Guide
down condition in the short run and break-even condition in the long run. It also discusses
the differences between economies of scale and economies of scope
Study Unit 4 – Competitive Markets and Monopoly
This unit will cover competitive markets, the concept of economic profit, perfect
competition and monopoly.
Study Unit 5 – Strategic Thinking and Oligopoly
This unit describes markets where there is interdependency among the firms/sellers. Such
imperfectly competitive markets are in between the perfect competition and monopoly
and are called oligopoly.
Study Unit 6 – Managerial Decisions in Imperfect Markets
This unit covers issues of management in imperfect markets. It discusses various types of
market failures including externalities, public goods, asymmetric information, incentives
and organisations. It also focusses on the solutions to these market failures and in
particular the role of government regulations in imperfect markets.
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ECO201 Course Guide
3. Learning Outcomes
Knowledge & Understanding (Theory Component)
By the end of this course, you should be able to:
• Explain the scope of managerial economics and its logical fit in the business decision
making process.
• Debate how market equilibrium is established using demand and supply curves
and the factors that affect demand and supply curve.
• Determine price, income, and cross-price elasticities of demand and explain the
relationship between total revenue of a firm and the price elasticity of demand for
its product.
• Compute total fixed cost, total variable cost, total cost, marginal cost, average total
cost, average fixed cost, and average variable cost and construct the cost curves.
• Examine the characteristics of perfect competition.
• Analyse the characteristics of imperfect competition: monopoly, oligopoly and
monopolistic competition.
• Compare the decision making process involving multiple plants, multiple pricing,
multiple products and entry barriers.
Key Skills (Practical Component)
By the end of this course, you should be able to:
• Demonstrate the essential knowledge and interpersonal skills to work effectively

in a team.
• Show well developed written proficiency.
• Give presentations in class or by video recording in areas related to Managerial
Economics.
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ECO201 Course Guide
4. Learning Material
The following is a list of the required learning materials to complete this course.
Required Textbook(s)
Png, I. (2016). Managerial economics (5th ed.). Routledge.
Other recommended study material (Optional)

Bernheim, B. D., & Whinston, M. D. (2014). Microeconomics (2nd ed.). McGraw-Hill
Higher Education.
Frank, R. H., & Bernanke, B. (2013). Principles of economics (e ed.). McGraw-Hill Higher
Education.
Perloff, J. M. (2016). Microeconomics (7th ed.). Pearson Education.
Pindyck, R. S., Rubinfeld, D. L., & Koh, W. T. H. (2006). Microeconomics: An Asian
perspective. Prentice Hall.
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ECO201 Course Guide
5. Assessment Overview
The overall assessment weighting for this course for the Evening Cohort is as follows:
Assessment Description Weight Allocation
Pre-Course Quiz 1 2%
Assignment 1 Pre-Class Quiz 1 2%
Pre-Class Quiz 2 2%
Assignment 2 Group-Based Assignment 38%
Class Participation Participation during seminars 6%
Examination Written Examination 50%
TOTAL 100%
The overall assessment weighting for this course for the Day-time Cohort is as follows:
Assignment 1 Pre-Course Quiz 02 2%
Assignment 2 Group-based Assignment 1 38%
Class Participation Participation during seminars 6%
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ECO201 Course Guide
Exam Written Examination 50%
TOTAL 100%
The following section provides important information regarding Assessments.
SUSS’s assessment strategy consists of two components, Overall Continuous Assessment

(OCAS) and Overall Examinable Component (OES) that make up the overall course
assessment score.
For SBiz courses, both components will be equally weighted: 50% OCAS and 50% OES.
(a) OCAS: In total, this continuous assessment will constitute 50 percent of overall
student assessment for this course. The sub-components are reflected in the table above
and are different for the day-time and evening cohort. The continuous assignments
are compulsory and are non-substitutable. It is imperative that you read through
your Assignment questions and submission instructions before embarking on your
Assignment.
(b) OES: The Examination/End-of-Course Assessment is 100% of this component.
To be sure of a pass result, you need to achieve scores of at least 40% in each component.
Your overall rank score is the weighted average of both components.
Examination:
The final (2-hour) written exam will constitute the other 50 percent of overall student
assessment and will test the ability to relate and apply concepts and theories. All topics
covered in the course outline will be examinable. To prepare for the exam, you are advised
to review Specimen or Past Year Exam Papers available on Learning Management System.
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ECO201 Course Guide
Passing Mark:
To successfully pass the course, you must obtain at least a mark of 40 percent for the
combined assessments (i.e. Quizzes, GBA and class participation) and also at least a mark
of 40 percent for the final exam. For detailed information on the Course grading policy,
please refer to The Student Handbook (‘Award of Grades’ section under Assessment and
Examination Regulations). The Student Handbook is available from the Student Portal.
Non-graded Learning Activities:
Activities for the purpose of self-learning are present in each study unit. These learning
activities are meant to enable you to assess your understanding and achievement of the
learning outcomes. The type of activities can be in the form of Quiz, Review Questions,
Application-Based Questions or similar. You are expected to complete the suggested
activities either independently and/or in groups.
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ECO201 Course Guide
6. Course Schedule
To help monitor your study progress, you should pay special attention to your
Course Schedule. It contains study unit related activities including Assignments, Self-
assessments, and Examinations. Please refer to the Course Timetable in the Student Portal
for the updated Course Schedule.
Note: You should always make it a point to check the Student Portal for any
announcements and latest updates.
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ECO201 Course Guide
7. Learning Mode
The learning process for this course is structured along the following lines of learning:
a. Self-study guided by the study guide units. Independent study will require at
least 3 hours per week.
b. Working on assignments, either individually or in groups.
c. Classroom Seminar sessions (3 hours each session, 3 sessions).
iStudyGuide
You may be viewing the iStudyGuide version, which is the mobile version of the
Study Guide. The iStudyGuide is developed to enhance your learning experience with
interactive learning activities and engaging multimedia. Depending on the reader you are
using to view the iStudyGuide, you will be able to personalise your learning with digital
bookmarks, note-taking and highlight sections of the guide.
Interaction with Instructor and Fellow Students
Although flexible learning – learning at your own pace, space and time – is a hallmark
at SUSS, you are encouraged to engage your instructor and fellow students in online
discussion forums. Sharing of ideas through meaningful debates will help broaden your
learning and crystallise your thinking.
Academic Integrity
As a student of SUSS, it is expected that you adhere to the academic standards stipulated
in The Student Handbook, which contains important information regarding academic
policies, academic integrity and course administration. It is necessary that you read and
understand the information stipulated in the Student Handbook, prior to embarking on
the course.
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ECO201 Course Guide
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1
Study
Unit
Demand and Supply Analysis

ECO201 Demand and Supply Analysis
Learning Outcomes
This study unit consists of 3 chapters with Chapter 1 as an introduction chapter, Chapter
2 focussing on demand, supply and market equilibrium and Chapter 3 looking into the
concept of elasticity.
Key concepts covered in Chapter 1 include:
1. Accounting profit
2. Economic profit
1. Supply and demand model

2. Change in demand versus change in quantity demanded
3. Change in supply versus change in quantity supplied
1. Elasticity of demand
2. Elasticity of supply
3. Total expenditure
4. Total revenue
By the end of this unit, you should be able to:
1. Describe the distinction between accounting profit and economic profit

2. Discuss the variables that influence demand
3. Discuss the variables that influence supply
4. Define the price elasticity of demand and explain what determine the elasticity
of demand
5. Calculate the price elasticity of demand based on information from a demand
curve
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6. Discuss how changes in the price of a good affect total expenditure and total
revenue depending on the price of elasticity of demand for the good
7. Explain the cross-price elasticity of demand and income elasticity of demand
8. Define the price elasticity of supply and explain what determine the elasticity
of supply
9. Calculate the price elasticity of supply based on information from a supply curve
SU1-3
Chapter 1: Introduction to Managerial Economics
1.1 Introduction
Managerial Economics or Economics for Managers is a subject that applies microeconomic
theory – the study of the behaviour of individual economic agents – to business problems
in order to teach business decision makers how to use economic analysis to make decisions
that will achieve the firm’s goal of profit maximisation. Economic theories are used as
they help managers to approach practical business problems by simplifying assumptions
to filter out irrelevant ideas and information and present complex problems in relatively
manageable terms.
Successful managers understand how market forces create both opportunities and
constraints for profitable decision making. Such managers understand the way markets
work, and they are able to predict prices and production levels of the goods, resources
and services that are relevant to their businesses. Hence, we begin the study with market
analysis involving demand, supply and market equilibrium.
1.2 Accounting Profit vs. Economic Profit

In economic theory, we first assume that the firm’s goal is to maximise its profit. There are
basically two types of profit: accounting profit and economic profit. The way economists
understand profit is different from accountants. To accountants, profit is defined as the
difference between the revenue it takes in the year and its explicit costs for that year.
Explicit costs are defined as the actual payments a firm makes to its factors of production
and other suppliers. Accounting profit can then be defined as:
Accounting profit = Total revenue – Explicit costs
On the contrary, economists define economic profit somewhat differently. To them, profit
is defined as the difference between the firm’s total revenue and not just its explicit
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costs, but also its implicit costs. Implicit costs are defined as the opportunity costs of the
resources supplied by the firm’s owners. Economic profit is thus defined as:
Economic profit = Total revenue – Explicit costs – Implicit costs
Figure 1.1 The Difference between Accounting Profit and Economic Profit
Figure 1.1 illustrates the difference between accounting profit and economic profit.
Accounting profit as shown in (b) is the difference between total revenue and explicit costs
whereas normal profit as shown in (c) is the opportunity cost of all resources supplied by
a firm’s owner. Therefore, economic profit as shown in (c) is the difference between total
revenue a firm earned and all costs, including both explicit and implicit costs.
Take for instance, consider a firm with $4 million in total annual revenue whose only
explicit costs are salaries to workers, totalling $2.5 million per year. The owner of this firm
has supplied machines and other equipment with a total resale value of $10 million.
Accounting profit: We can easily calculate the firm’s accounting profit as the difference
between total revenue and total explicit costs. Therefore, the firm’s accounting profit is
$1.5 million i.e. $4 million minus $2.5 million.
Economic profit: The calculation of economic profit is less straight forward. To calculate
the firm’s economic profit, we must first calculate the opportunity cost of the resources
supplied by the firm’s owner. Suppose the current annual interest rate on savings accounts
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is 10%. Had the owner not invested in machines and other equipment, the owner could
have earned an additional $1 million per year by depositing $10 million in a saving
account. So, the firm’s economic profit is $0.5 million i.e. $4 million minus $2.5 million
minus $1 million.
It is noted that the economic profit calculated is less than the accounting profit by
exactly the amount of the firm’s implicit costs of $1 million. This difference between the
accounting profit and the economic profit is also known as normal profit which is simply
the opportunity cost of the resources supplied to a business by its owner.
Read
You should now read Ivan Png (2016), Chapter 1, pp. 3-4 and Chapter 7, pp. 139-141,
Managerial Economics, 5th Edition.
Lesson Recording
Introduction to Managerial Economics
Activity 1
Question 1
Liza owns a café in Singapore whose monthly revenue is S$50,000. Her annual
expenses to run the café are as follows:
Salary to workers S$20,000
Food and drink S$5,000
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Electricity S$1,000
Vehicle lease S$1,500
Rental S$5,000
Interest on loan for equipment S$10,000
1. Calculate Liza’s monthly accounting profit.
2. Liza could earn $10,000 per month as an accountant. However, she prefers to run
the café. In fact, she would be willing to pay up to S$2,750 per month to run the
café rather than to work as an accountant. Is the café making an economic profit?
Should Liza stay in the café business? Explain.
Formative Assessment
1. Which of the following is the difference between accounting profit and economic
profit?
a. accounting profit considers all costs
b. economic profit considers only implicit costs.
c. normal profit
d. equal to excess profit
2. If accounting profit is less than normal profit, then the firm is earning
a. a loss
b. an economic profit
c. an excess profit
d. negative accounting profit
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3. Assume you own your own business and your explicit costs are $10,000/year. You
could earn $1,000 in your next best alternative job. Your revenue is $12,000/year. What
is your accounting profit?
a. 1000
b. 2000
c. 11000
d. 12000
is your economic profit?
a. 1000
b. 2000
c. 11000
d. 12000
5. If firms in an industry earn less than a normal profit,

a. Firms will exit
b. The price of resources in the industry will fall
c. The opportunity cost of resources in the industry will fall
d. All of the above.
SU1-8
Chapter 2: Demand Analysis and Supply Analysis
2.1 Introduction
This chapter introduces the most foundational model in market economics: demand
(Section 2.2) and supply (Section 2.3) with the demand curve summarising the behaviour
of buyers and the supply curve summarising the behaviour of the sellers in the market
place.
2.2 Demand
A product’s demand curve shows how much consumers of the product want to buy
at each possible price, holding other factors constant. Quantity demanded is defined as
the quantity of a good or service that a consumer is willing and able to purchase at a
given price. Table 1.1 shows Kate’s demand schedule for pizzas and Figure 1.2 shows
Kate’s demand curve for pizzas. When the price of pizzas falls, Kate tends to buy more
pizzas, and when the price of pizzas rises, she tends to buy less. In other words, when
the price falls, quantity demanded increases and when the price rises, quantity demanded
decreases. This suggests that the relationship between price and quantity demanded is
negatively related.
2.2.1 Change in Quantity Demanded

When the price of pizzas falls, Kate’s quantity demanded for pizzas increases. Hence, the
demand curve depicted has a negative slope. When price alone rises or falls, Kate can
be thought of as moving along the demand curve, buying more of the good when price
falls and less of the good when price rises. This negative relationship between the price
of a product and the quantity of the product demanded is known as the law of demand.
The law of demand suggests that, holding everything else constant, when the price of a
product falls, the quantity demanded of the product will increase, and when the price of
a product rises, the quantity demanded of the product will decrease.
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Table 1.1 Kate’s Demand Schedule for Pizzas
Price Quantity
(Dollar per Pizza) (Number of Pizzas)
S$4.00 8
S$3.00 12
S$2.00 16
Figure 1.2 Change in Quantity Demanded – Movement along the Demand Curve
The demand curve is downward sloping for two reasons:
a. The substitution effect causes buyers to switch to substitutes when the price
changes.
b. The income effect causes a change in quantity demanded when a change in price
changes the buyer’s purchasing power.
c. Buyers’ reservation prices, the most they are willing to pay for a good differ.
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2.2.2 Change in Demand

Other than the price of the product itself, a demand curve holds all factors that can affect
the demand constant. However, a decision to buy some good like pizzas is driven by
many factors in addition to its price. Among them might be consumer incomes, prices
of goods that complement that good, and prices of goods that can be substituted for
that good, consumer tastes and in some cases, government regulations in terms of tax and
subsidy. Consider the demand for pizzas. If a new recipe that suited the taste of a large
proportion of consumers is introduced, consumers’ desire for pizzas will increase and
they will purchase more at any given price. A change in this factor will cause the entire
demand curve to shift with an increase in demand shifting the demand curve to the right
and a decrease in demand shifting the curve to the left. Figure 1.3 below shows the shift
in the demand curve for pizzas, holding the price of pizzas constant.
Figure 1.3 Change in Demand – Shift in Demand
1. Consider pizzas and coke and assume that they are complements . All else
being equal including the price of pizzas, an increase in the price of coke causes
consumers to buy less of pizzas, shifting the demand curve for pizzas to the left.
Similarly, consider pizzas and hamburger and assume that they are substitutes
. All else being equal including the price of pizzas, an increase in the price of
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hamburger causes consumers to buy more of pizzas, shifting the demand curve
for pizzas to the right. Therefore, we can conclude that an increase in the price of
complements will cause a decrease in the demand for the product and an increase
in the price of substitutes will cause an increase in the demand for the product.
2. A normal good is a good that consumers will buy more when their income
increases and buy less when their income decreases. If pizza is a normal good,
then an increase in the income of consumers will increase the demand for pizzas,
shifting the curve to the right and a decrease in the income of consumers will
decrease the demand for pizzas, shifting the curve to the left. On the other hand,
an inferior good is a good that consumers will buy less when their income
increases and buy more when their income decreases. If pizza is an inferior good,
an increase in the income of consumers will decrease the demand for pizzas,
shifting the curve to the left whereas a decrease in the income of consumers will
increase the demand for pizzas, shifting the curve to the right.
An increase in demand shifts the

demand curve to the right.
An increase in
• Income and the good is a normal
good
• The price of substitute goods
Figure 1.4 An Increase in Demand – • The taste of consumers towards the

Rightward Shift good
• Population
• Expected future price of the good
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A decrease in demand shifts the demand

curve to the left.
An increase in
• Income and the good is an inferior
good
• The price of complement goods
Figure 1.5 A Decrease in Demand –

Leftward Shift
Movement along the demand curve vs the shift in the demand curve: A change in the price
of a product causes a change in the quantity demanded (movement along its demand
curve) and a change in factors other than the price of the product itself, such as consumer
taste or income and price of other related products, causes a change in the demand (shift
in demand with an increase in demand shifting the curve to the right and decrease in
demand shifting the curve to the left).
Read
You should now read Ivan Png (2016), Chapter 2, pp. 21-31, Managerial Economics, 5th
Edition.
Recap:
1. Quantity demanded refers to an individual point on the demand curve.

2. A change in quantity demanded occurs when the price of a good changes and
one moves along the demand curve.
3. A change in demand occurs when the entire demand schedule or demand curve
shifts.
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4. When the price of the product falls, the quantity demanded for the product
increases, vice versa. As a result, we see a movement along the demand curve .
Therefore, we can conclude that a change in the price of the product will lead
to a change in quantity demanded .
5. The inverse relationship between the price of the product and the quantity
demanded for the product suggests that the demand curve is downward sloping.
6. When the price of the product is held constant, a change in factors other than the
price of the product itself, such as consumer taste or income and price of other
related products, causes a shift in the demand curve. Therefore, we can conclude
that a change in factors other than the price of the product itself will lead to
a change in demand , with an increase in demand shifting the curve to the right
and a decrease in demand shifting the curve to the left.
2.3 Supply
After discussing demand, we now turn to its counterpart, supply. As with demand, this is a
behavioural relationship. But this time it represents the ability and willingness of suppliers
to offer a good or service for sale. The relationship can be represented by a supply curve. A
product’s supply curve shows how much sellers want to sell at each possible price, holding
constant all other factors that affect supply. Table 1.2 shows the seller’s supply schedule
of pizzas and Figure 1.6 shows the supply curve for pizzas. Note that the supply curve is
upward sloping suggesting that the relationship between price and quantity supplied is
positively related.
2.3.1 Change in Quantity Supplied

When the price of pizzas falls, seller’s quantity supplied for pizzas increases. Hence, the
supply curve depicted has a positive slope. When price alone rises or falls, seller is moving
along the supply curve, selling more of the good when price rises and less of the good
when price falls. This positive relationship between the price of a product and the quantity
of the product supplied is known as the law of supply. The law of supply suggests that,
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holding everything else constant, when the price of a product falls, the quantity supplied
of the product will decrease, and when the price of a product rises, the quantity supplied
of the product will increase.
Table 1.2 Seller’s Supply Schedule for Pizzas
Price Quantity
(Dollar per Pizza) (Number of Pizzas)
S$4.00 16
S$3.00 12
S$2.00 8
Figure 1.6 Change in Quantity Supplied – Movement along the Supply Curve
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2.3.2 Change in Supply

Other than the price of the product itself, a supply curve holds all factors that can affect
the supply constant. Many other factors, however, can also affect the supply of a product,
for instance, technology, the price of factor inputs, the prices of other possible outputs,
and in some cases, government regulations. Consider the supply of pizzas. When the cost
of flour is lower, sellers can now produce more pizzas at a lower cost making pizzas more
attractive to produce and sell at any given price. A change in this factor will cause the
entire supply curve to shift with an increase in supply shifting the supply curve to the
right and a decrease in supply shifting the curve to the left. Figures 1.7, 1.8 and 1.9 below
show the shift in the supply curve for pizzas, holding the price of pizzas constant.
Figure 1.7 Change in Supply – Shift in Supply
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An increase in supply shifts the supply

curve to the right.
An increase in
• Number of firms
• Productivity
Figure 1.8 An Increase in Supply –

Rightward Shift
A decrease in supply shifts the supply

curve to the left.
An increase in
• The prices of inputs

• The price of a substitute in
production
Figure 1.9 A Decrease in Supply – Leftward • The expected future price of the
Shift
product
Movement along the supply curve vs the shift in the supply curve: A change in the price of
a product causes a change in the quantity supplied (movement along its supply curve) and
a change in factors other than the price of the product itself, such as consumer technology,
the price of factor inputs, the prices of other possible outputs, causes a change in the
supply (shift in supply with an increase in supply shifting the curve to the right and
decrease in supply shifting the curve to the left).
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Read
Edition.
Recap
1. Quantity supplied refers to an individual point on the supply curve.

2. A change in quantity supplied occurs when the price of a good changes and one
moves along the supply curve.
3. A change in supply occurs when the entire supply schedule or supply curve
shifts.
4. When the price of the product rises, the quantity supplied for the product
increases, vice versa. As a result, we see a movement along the supply curve.
Therefore, we can conclude that a change in the price of the product will lead to
a change in quantity supplied.
5. The direct relationship between the price of the product and the quantity
supplied for the product suggests that the supply curve is upward sloping.
When the price of the product is held constant, a change in factors other than the price
of the product itself, such as consumer technology, the price of factor inputs, the prices
of other possible outputs, causes a shift in the supply curve. Therefore, we can conclude
that a change in factors other than the price of the product itself will lead to a change in
supply, with an increase in supply shifting the curve to the right and a decrease in supply
shifting the curve to the left.
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Lesson Recording
Demand Supply and Market Equilibrium
Activity 2
Question 1
Consider the market for minivans. For each of the events listed below, identify
which of the determinants of demand or supply are affected. Also indicate whether
supply or demand increases or decreases.
1. People decide to have more children.
2. A strike by steelworkers raises steel prices.
3. A release of new automated machinery for the production of minivans.
4. There is a rise in the price of sport utility vehicles.
5. There is a reduction in peoples' wealth caused by a stock-market crash.
1. Quantity demanded falls as the price rises and rises as the price falls, so we say that
a. quantity demanded is determined by quantity supplied.
b. price is determined by quantity demanded.
c. quantity demanded is a function of demand.
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d. quantity demanded is negatively related to the price.
2. Which of the following would not affect an individual's demand curve?

a. expectations
b. income
c. prices of related goods
d. the number of buyers
3. Nancy likes pasta today more than she did yesterday. This fact leads us to conclude
that
a. Nancy must now consider pasta a luxury.
b. Nancy must have experienced an increase in her income.
c. Nancy is now willing to pay more than before for pasta at each relevant price
of pasta.
d. the supply of pasta must have increased and stimulated Nancy’s enhanced
taste for pasta.
4. Wheat is the main input in the production of flour. If the price of wheat decreases, all
else equal, we would expect the
a. demand for flour to increase.
b. demand for flour to decrease.
c. supply of flour to increase.
d. supply of flour to decrease.
5. Which of the following sets of events would most likely cause an increase in the price
of a new house?
a. higher wages for carpenters, higher wood prices, increases in consumer
incomes, higher apartment rents, increases in population, and expectations of
higher house prices in the future
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b. lower wages for carpenters, lower wood prices, increases in consumer

incomes, higher apartment rents, increases in population and expectations of
c. lower wages for carpenters, higher wood prices, decreases in consumer
incomes, higher apartment rents, decreases in population and expectations of
d. higher wages for carpenters, lower wood prices, decreases in consumer
incomes, lower apartment rents, decreases in population and expectations of
lower house prices in the future.
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Chapter 3: Elasticity
3.1 Introduction
In this chapter, we explore the concept of elasticity, which describes the responsiveness
of demand and supply to change in price and other economic factors. Specifically for
the responsiveness of demand, some of these factors include income and prices of other
related goods. At the end of this chapter, you should notice that changes in market
equilibrium depend very much on the slope of demand and supply i.e. the elasticities of
demand and supply.
3.2 Price Elasticity of Demand

When the price of a good rises, based on the law of demand, the quantity demanded falls.
However, to predict the effect of the price increase on total expenditure, one also needs to
know by how much quantity falls. The quantity demanded of some goods, such as rice, is
not very responsive to changes in price. For other goods, however, the quantity demanded
is extremely responsive to changes in price, car for example.
3.2.1 Definition of Price Elasticity

The price elasticity of demand for a good measures the responsiveness of the quantity
demanded of that good to changes in its own price. This can be shown by dividing the
percentage change in the quantity demanded of a product by the percentage change in
the product’s price. Formally, the price elasticity of demand is:
For example, if the price of pizzas falls by 1 percent and the quantity demanded rises
by 2 percent, then the price elasticity of demand for pizzas has a value of -2. Strictly
speaking, the price elasticity of demand will always be negative (or zero) because changes
in quantity demanded and price are always moving in opposite direction. However, for
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convenience, we usually drop the negative sign and focus only on the absolute value of
the price elasticity of demand.
The demand for a good is said to be:
1. Elastic: Demand is elastic when the percentage change in quantity demanded is

greater than the percentage change in price, so the price elasticity is greater than
1 in absolute value, εx > 1 .
2. Inelastic: Demand is inelastic when the percentage change in quantity
demanded is less than the percentage change in price, so the price elasticity is less
than 1 in absolute value, εx< 1 .
3. Unit-elastic: Demand is unit-elastic when the percentage change in quantity
demanded is equal to the percentage change in price, εx= 1 .
3.2.2 Determinants of Price Elasticity of Demand

There are four main determinants of the price elasticity of demand for a product.
1. The availability of close substitutes: The more substitutes for a product, the
greater the price elasticity of demand.
2. The passage of time: Demand becomes more elastic as more time passes.
3. Luxuries versus necessities: The demand curve for a luxury is more elastic than
the demand curve for a necessity.
4. Share of the good or services in the consumer’s budget: The smaller the share
of the good or service in the consumer’s budget, the more inelastic the demand
for that good or service will be.
3.3 A Graphical Interpretation of Price Elasticity

For small changes in price, price elasticity of demand is the proportion by which quantity
demanded changes divided by the corresponding proportion by which price changes. The
formula for price elasticity of demand can be written as:
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This formula has a straightforward graphical interpretation as follows:
Figure 1.10 Calculating Price Elasticity of

Demand
The slope of this demand curve is 8/2 = 4. So, 1/slope of demand for x is 1/4. The ratio of
P/Q at point A is 8/3. As a result, the price elasticity at point A is equal to (8/3) × (1/4)
= 2/3. This means that when the price of the good is 8, a 3 percent reduction in price will
lead to a 2 percent increase in quantity demanded.
It is noted that for a straight-line demand curve, demand is elastic on the top half, unit-
elastic at the midpoint, and inelastic on the bottom half.
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Figure 1.11 Calculating Price Elasticity of

Demand
There are two important exceptions to the general rule that elasticity declines along
straight-line demand curves. First, a horizontal demand curve is perfectly elastic, at every
point as the slope of the demand curve is zero and the reciprocal of its slope is infinite.
Price elasticity of demand is thus infinite at every point. Such demand curves are said to
be perfectly elastic. Second, a vertical demand curve is perfectly inelastic at every point
as the slope of the demand curve is infinite.
Figure 1.12 Perfectly Elastic and Perfectly Inelastic Demand Curves
3.4 The Midpoint Elasticity Formula

The midpoint elasticity formula results in a unique value when calculating the elasticity of
demand. A demand curve drawn as a vertical line represents a perfectly inelastic demand
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curve. A perfectly elastic demand curve is drawn as a horizontal line. The midpoint
formula can be written as:
where and
Example: Calculating the Price Elasticity of Demand
Calculate the price elasticity of demand for wheat using the midpoint formula and verify
that the price elasticity of demand is –0.103.
Year Price Quantity

(per bushel) (billions of bushels)
2013 S$3.00 3
2014 S$6.00 2.8
3.5 Elasticity and Total Expenditure

Changes in price and quantity demanded result in changes in the total expenditure. Total
expenditure is simply the number of units bought times the price for which it sells. The
market demand curve for a good tells us the quantity that will be sold at each price.
We can thus use this information to calculate total expenditure and show how the total
amount spent will vary with its price. Changes in total expenditure are related to the price
elasticity of demand. If demand is elastic, change in price (increase or decrease) will result
in changes in total expenditure in the opposite direction. If demand is inelastic, changes in
price (increase or decrease) will result in changes in total expenditure in the same direction
as the change in price. When demand is unit-elastic, changes in price (increase or decrease)
will result in no change in total expenditure.
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Figure 1.13 Decrease in Price will result in

a Fall in Total Expenditure (Total Revenue)
when Demand is Inelastic
Figure 1.14 Decrease in Price will result in

a Rise in Total Expenditure (Total Revenue)
when Demand is Elastic
Table 1.3 below summarises the relationship between price elasticity and total expenditure
(total revenue).
Table 1.3 The Relationship between Price Elasticity and Total Expenditure
If demand is Then Because
Elastic An increase in price The decrease in quantity demanded is

reduces revenue proportionally greater than the increase
in price.
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If demand is Then Because
Elastic A decrease in price The increase in quantity demanded is

increases revenue proportionally greater than the decrease
in price.
Inelastic An increase in price The decrease in quantity demanded is

increases revenue proportionally smaller than the increase
in price.
Inelastic A decrease in price The increase in quantity demanded is

reduces revenue proportionally smaller than the decrease
in price.
Unit-elastic An increase in price The decrease in quantity demanded is

does not affect revenue proportionally the same as the increase in
price.
Unit-elastic A decrease in price The increase in quantity demanded is

does not affect revenue proportionally the same as the decrease in
price.
Read
Edition.
3.6 Income Elasticity of Demand

The income elasticity of demand for a good measures the responsiveness of quantity
demanded to changes in income. Mathematically, the income elasticity of demand can be
measured by dividing the percentage change in quantity demanded by the percentage
change in income.
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Table 1.4 Summary of Income Elasticity of Demand
If the income elasticity of demand is Then the good is Example
Positive, but less than 1 Normal and a necessity Milk
Positive and greater than 1 Normal and a luxury Caviar
Negative Inferior High-fat meat
3.7 Cross Price Elasticity of Demand

The elasticity of demand for a good measures the responsiveness of quantity demanded
to changes in the prices of its related goods. Mathematically, the cross price elasticity of
demand can be measured by dividing the percentage change in quantity demanded of
good x by the percentage change in the price of good y.
Table 1.5 Summary of Cross Price Elasticity of Demand
If the two goods are Then the good is Example
Substitutes Positive Two brands of printers
Complements Negative Printers and toner cartridges
Unrelated Zero Printers and peanut butter
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Read
Edition.
3.8 Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of the quantity supplied to a change
in price. Mathematically, this can be calculated by dividing the percentage change in the
quantity supplied of a good by the percentage change in the good’s price. Formally, the
price elasticity of demand is:
The mathematical formula for price elasticity of supply at any point is the same as the
corresponding expression for price elasticity of demand. Because of the law of supply, this
elasticity normally will have a positive numerical value.
3.8.1 Determinants of Price Elasticity of Supply

There are three main determinants of the price elasticity of supply for a product.
1. Flexibility and mobility of inputs: Production that requires less skilful labour
is likely to be more elastic in terms of its supply. For example, coffee production
requires labour with only minimal skills means that a large pool of labour can be
shifted from other productions to coffee production making the supply of coffee
more elastic.
2. Availability of production capacity: Supply becomes more elastic if sellers are
able to increase production quickly even with only a small change in price
because of excess capacity.
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3. Adjustment time: Because it takes time for producers to switch from one activity
to another and because it takes time to train workers, buy new machines and
build new factories, the price elasticity of supply will be higher in the long run
than in the short run.
Lesson Recording
Elasticity
Activity 3
Question 1
For each pair of items below, determine which product would have the higher price
elasticity of demand in absolute value.
1. Blood pressure medicine for someone who has high blood pressure and the
purchase of Clairol hair colouring product.
2. A new BMW or a tank of gas for your current car.
3. Seiko watch or watches in general.
Question 2
The schedule below shows the number of packs of cigarettes bought in Singapore
each day at a variety of prices.
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Price of cigarettes Number of packs purchase per day
6 0
5 3,000
4 6,000
3 9,000
2 12,000
1 15,000
0 18,000
1. Graph the daily demand curve for packs of cigarettes in Singapore.
2. Calculate the price elasticity of demand at the point on the demand curve at which
the price of cigarettes is $3 per pack.
3. If the price of cigarettes increases from $3 per pack to $4 per pack, what would
happen to total revenues?
4. Calculate the price elasticity of demand at a point on the demand curve where
the price is $2 per pack.
5. If the price of cigarettes increases from $2 per pack to $3 per pack, what would
happen to total revenues?
1. The percentage change in quantity demanded that results from the percentage change
in price is known as the
a. price elasticity of supply
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b. price elasticity of demand

c. income elasticity of demand
d. cross-price elasticity of demand
2. If the price of good increases by 20% and that lead to a decrease in quantity demanded
by 60%, what is the price elasticity of demand for that good?
a. 30
b. 3
c. 1/3
d. 2/6
3. If the price elasticity of demand for a good is greater than one, then the demand for
that good, with respect to price, is
a. elastic
b. inelastic
c. unitary elastic
d. perfectly elastic
4. When the price of hot dog is $1.50 each, 500 hot dogs are sold every day. After
lowering the price to $1.35 each, 510 hot dogs are sold every day. At the original price,
what is the price elasticity of demand for hot dog?
a. 66.67
b. 5
c. 1
d. 0.2
5. If the consumers cannot switch to a close substitute when the price of a good increases,
price elasticity of demand for that good is likely to be
a. elastic
b. inelastic
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c. unitary elastic
6. Low budget items such as soap have ______ price elasticity of demand than big-ticket
items such as DVD player.
a. higher
b. lower
c. very high
d. unitary
7. Assume the price of gasoline doubles tonight and remains at that price the next two
years. The price elasticity of demand for gasoline measured tomorrow will be ______
when compared with the price elasticity of demand for gasoline measured two years
from now.
a. more elastic
b. larger in absolute value.
c. the same.
d. more inelastic.
8. A price elasticity of demand of 0.3 means a

a. 10 percent increase in the price results in a 3 percent increase in quantity
demanded.
b. 3 percent increase in the price results in a 3 percent decrease in quantity
demanded.
c. 10 percent increase in the price results in a 3 percent decrease in demand.
d. 10 percent increase in the price results in a 3 percent decrease in quantity
demanded.
9. If the slope of the demand curve is -0.167, price is $8 and quantity demanded is 12
units, then demand for this good is
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a. perfectly elastic.
b. elastic.
c. unit elastic.
d. inelastic.
10. During recessions, when workers lose their jobs and experience reduced incomes,
sales of durable goods (goods with a life expectancy of 3 years or more) decline.
Apparently, durables are
a. substitutes.
b. normal goods.
c. complements.
d. inferior goods.
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Summary
In this study unit, we start with an introduction to managerial economics in Chapter

1, followed by demand and supply analysis in Chapter 2 and last but not least a
detailed investigation on the concept of elasticity. Understanding the differences between
accounting and economic profit is very important.
The supply and demand models are the foundations of managerial economics. A demand
curve shows the quantity demanded as a function of price, other things equal. Generally,
the demand curve slopes downward. Changes in price are represented by movements
along the demand curve; changes in other factors, such as income, the prices of related
products and advertising, are represented by shifts of the entire demand curve. The supply
curve shows the quantity supplied as a function of price, other things equal. The effect of
a change in price is represented by a movement along the supply curve to a new quantity.
Changes in other factors such as wages and the prices other inputs are represented by
shifts of the entire supply curve.
The elasticity of demand measures the responsiveness of demand to changes in a factor

that affects demand. Elasticities can be estimated for price, income and prices of related
products. The own-price elasticity if the ratio of the percentage change in quantity
demanded to the percentage change in price. Demand is price elastic if a 1% increase in
price leads to more than a 1% drop in quantity demanded, and inelastic if it leads to less
than 1% drop in quantity demanded.
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Solutions or Suggested Answers
SU1-Chapter 1 Activity 1
1. Calculate Liza’s monthly accounting profit.
Liza's accounting profit is her revenue minus her explicit costs, or $7,500 per month.
2. Liza could earn $10,000 per month as an accountant. However, she prefers to run the
café. In fact, she would be willing to pay up to S$2,750 per month to run the café
rather than to work as an accountant. Is the café making an economic profit? Should
Liza stay in the café business? Explain.
The opportunity cost of her labour to run the café is S$10,000 - S$2,750 = S$7,250
per month. Adding this implicit cost to the explicit costs implies that the café is
making an economic profit of S$250 per month. Since S$250 > 0, Liza should stay
in business.
Chapter 1 Formative Assessment
1. Which of the following is the difference between accounting profit and economic
profit?
a. accounting profit considers all costs
Incorrect. Accounting profit is the difference between total revenue and
explicit costs.
b. economic profit considers only implicit costs.

Incorrect. Economic profit is the difference between total revenue a firm
earned and all costs, including both explicit and implicit costs
c. normal profit
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Correct. The difference between the accounting profit and the economic
profit is known as normal profit which is simply the opportunity cost of
the resources supplied to a business by its owner.
d. equal to excess profit

Incorrect. Excess profit is the level of profit that is higher than a level regarded
as normal.
2. If accounting profit is less than normal profit, then the firm is earning
a. a loss
Correct. The difference between the accounting profit and the economic
profit is known as normal profit.
b. an economic profit
earned and all costs, including both explicit and implicit costs.
c. an excess profit
Incorrect. Excess profit is the level of profit that is higher than a level regarded
as normal.
d. negative accounting profit

explicit costs. Given the information, we cannot tell whether accounting
profit is positive or negative.
is your accounting profit?
a. 1000
explicit costs. $12,000-$10,000 = $2,000.
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b. 2000
Correct. Accounting profit is the difference between total revenue and
explicit costs.
c. 11000
explicit costs. $12,000-$10,000 = $2,000.
d. 12000
explicit costs. $12,000-$10,000 = $2,000.
is your economic profit?
a. 1000
Correct. Economic profit is the difference between total revenue a firm
earned and all costs, including both explicit and implicit costs. $12,000-
$10,000-$1,000= $1,000.
b. 2000
$10,000-$1,000= $1,000.
c. 11000
$10,000-$1,000= $1,000.
d. 12000
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$10,000-$1,000= $1,000.
5. If firms in an industry earn less than a normal profit,

a. Firms will exit
Incorrect. Normal profit is the difference between the accounting profit and
the economic profit, which is simply the opportunity cost of the resources
supplied to a business by its owner. When a firm earns less than normal
profit, then the firm should exit the industry. This answer is correct but
incomplete.
b. The price of resources in the industry will fall

profit, then the price of resources in the industry will fall. This answer is
correct but incomplete.
c. The opportunity cost of resources in the industry will fall

profit, then the opportunity cost of resources in the industry will fall. This
answer is correct but incomplete.

Correct. Normal profit is the difference between the accounting profit and
supplied to a business by its owner. This answer is complete.
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If people decide to have more children, they will want larger vehicles for hauling
their kids around, so the demand for minivans will increase. Supply will not be
affected.

If a strike by steelworkers raises steel prices, the cost of producing a minivan rises
and the supply of minivans decreases. Demand will not be affected.

The development of new automated machinery for the production of minivans
is an improvement in technology. This reduction in firms' costs will result in an
increase in supply. Demand is not affected.

The rise in the price of sport utility vehicles affects minivan demand because sport
utility vehicles are substitutes for minivans. The result is an increase in demand
for minivans. Supply is not affected.

The reduction in peoples' wealth caused by a stock-market crash reduces their
income, leading to a reduction in the demand for minivans, because minivans are
likely a normal good. Supply is not affected.
1. Quantity demanded falls as the price rises and rises as the price falls, so we say that
a. quantity demanded is determined by quantity supplied.
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Incorrect. Quantity demanded is defined as the quantity of a good or service

that a consumer is willing and able to purchase at a given price.
b. price is determined by quantity demanded.

c. quantity demanded is a function of demand.

d. quantity demanded is negatively related to the price.

Correct. When the price falls, quantity demanded increases and when
the price rises, quantity demanded decreases. This suggests that the
relationship between price and quantity demanded is negatively related.
2. Which of the following would not affect an individual's demand curve?

a. expectations
Incorrect. An increase in expected future price of the good shifts the demand
curve to the right.
b. income
Incorrect. An increase in income (and the good is a normal good) shifts the
demand curve to the right.
c. prices of related goods

Incorrect. An increase in the price of substitute goods shifts the demand curve
to the right. An increase in the price of complement goods shifts the demand
curve to the left.
d. the number of buyers
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Correct. Changes in the number of buyers will not affect an individual’s

demand curve. For factors affecting an individual’s demand curve.
3. Nancy likes pasta today more than she did yesterday. This fact leads us to conclude
that
a. Nancy must now consider pasta a luxury.
Incorrect. This cannot be inferred from the context. It is about change in
demand.
b. Nancy must have experienced an increase in her income.

Incorrect. This may not necessarily be true. It is about change in demand.
c. Nancy is now willing to pay more than before for pasta at each relevant price
of pasta.
Correct. It is about change in demand.
d. the supply of pasta must have increased and stimulated Nancy’s enhanced
taste for pasta.
Incorrect. It is about change in demand and has nothing to do with the supply.
4. Wheat is the main input in the production of flour. If the price of wheat decreases, all
else equal, we would expect the
a. demand for flour to increase.
Incorrect. We cannot tell about the demand of flour from the context
b. demand for flour to decrease.

Incorrect. We cannot tell about the demand of flour from the context.
c. supply of flour to increase.

Correct. A decrease in the price of inputs shifts the supply curve to the
right.
d. supply of flour to decrease.
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Incorrect. A decrease in the price of inputs shifts the supply curve to the right.
5. Which of the following sets of events would most likely cause an increase in the price
of a new house?
a. higher wages for carpenters, higher wood prices, increases in consumer
incomes, higher apartment rents, increases in population, and expectations
of higher house prices in the future
Correct. Higher wages for carpenters and higher wood prices are examples
of increases in the prices of inputs, which shift the supply curve to the left
and therefore increase the house prices. Increases in consumer incomes,
higher apartment rents, increases in population, and expectations of higher
house prices in the future are factors which shift the demand curve to the
right and therefore increase the house prices.
b. lower wages for carpenters, lower wood prices, increases in consumer

incomes, higher apartment rents, increases in population and expectations of
Incorrect. Lower wages for carpenters and ower wood prices are examples
of decreases in the prices of inputs, which shift the supply curve to the right
and therefore decrease the house prices.
c. lower wages for carpenters, higher wood prices, decreases in consumer

incomes, higher apartment rents, decreases in population and expectations
of higher house prices in the future
Incorrect. Lower wages for carpenters shifts the supply curve to the right and
decreases the house prices. Decreases in consumer incomes shift the demand
curve to the left and decreases the house prices.
d. higher wages for carpenters, lower wood prices, decreases in consumer

incomes, lower apartment rents, decreases in population and expectations of
lower house prices in the future.
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Incorrect. Lower wood prices shifts the supply curve to the right and
decreases the house prices. Decreases in consumer incomes, lower apartment
rents, decreases in population and expectations of lower house prices in the
future shift the demand curve to the left and decreases the house prices.
1. Blood pressure medicine for someone who has high blood pressure and the purchase
of Clairol hair colouring product.
The demand for the hair product is more price elastic than that of blood pressure
medicine. The latter is required for survival and has virtually no substitutes while
substitutes are around for the former and it is not a necessity.
2. A new BMW or a tank of gas for your current car.

The demand for a new car is more price elastic than the demand for a tank of gas.
The former is a luxury good while the latter is essentially for transportation at
present.
3. Seiko watch or watches in general.

The demand for Seiko watches is more price elastic than the demand for watches
in general. Narrowly defined markets such as the Seiko watch market have more
substitutes.
1. Graph the daily demand curve for packs of cigarettes in Singapore.
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2. Calculate the price elasticity of demand at the point on the demand curve at which
the price of cigarettes is $3 per pack.
Use the formula: elasticity = (P/Q) (1/slope). When P = 3, Q = 9 and 1/slope is 3. So
elasticity = 3(3/9) = 1.0.
3. If the price of cigarettes increases from $3 per pack to $4 per pack, what would happen
to total revenues?
If the price increases from $3 to $4, revenue will fall from $27,000 to $24,000.
4. Calculate the price elasticity of demand at a point on the demand curve where the
price is $2 per pack.
Using the same formula as in (b), elasticity = (2/12) × (3) = 0.5.
5. If the price of cigarettes increases from $2 per pack to $3 per pack, what would happen
to total revenues?
If the price increases from $2 to $3, revenue will rise from $24,000 to $27,000.
1. The percentage change in quantity demanded that results from the percentage change
in price is known as the
a. price elasticity of supply
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Incorrect. Price elasticity of supply measures the responsiveness of the

quantity supplied to a change in price.
b. price elasticity of demand

Correct. The price elasticity of demand for a good measures the
responsiveness of the quantity demanded of that goods to changes in its
own price.
c. income elasticity of demand

Incorrect. The income elasticity of demand for a good measures the
responsiveness of quantity demanded to changes in income. Mathematically,
the income elasticity of demand can be measured by dividing the percentage
change in quantity demanded by the percentage change in income.
d. cross-price elasticity of demand

Incorrect. The cross price elasticity of demand for a good measures the
responsiveness of quantity demanded to changes in the prices of its related
goods.
2. If the price of good increases by 20% and that lead to a decrease in quantity demanded
by 60%, what is the price elasticity of demand for that good?
a. 30
Incorrect. The price elasticity of demand for a good can be shown by
dividing the percentage change in the quantity demanded of a product by
the percentage change in the product’s price. 60%/20%=3.
b. 3
Correct. The price elasticity of demand for a good can be shown by
c. 1/3
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d. 2/6
3. If the price elasticity of demand for a good is greater than one, then the demand for
that good, with respect to price, is
a. elastic
Correct. Demand is elastic when the percentage change in quantity
demanded is greater than the percentage change in price, so the price
elasticity is greater than 1 in absolute value.
b. inelastic
Incorrect. Demand is inelastic when the percentage change in quantity
demanded is less than the percentage change in price, so the price elasticity
is less than 1 in absolute value.
c. unitary elastic
Incorrect. Demand is unit-elastic when the percentage change in quantity
demanded is equal to the percentage change in price.
Incorrect. A horizontal demand curve is perfectly elastic, at every point as
the slope of the demand curve is zero and the reciprocal of its slope is infinite.
Price elasticity of demand is thus infinite at every point.
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4. When the price of hot dog is $1.50 each, 500 hot dogs are sold every day. After
lowering the price to $1.35 each, 510 hot dogs are sold every day. At the original price,
what is the price elasticity of demand for hot dog?
a. 66.67
Incorrect. Apply the formula for price elasticity of demand, we have
((510-500)/500) / ((1.35-1.50)/1.50) = 0.2.
b. 5
((510-500)/500) / ((1.35-1.50)/1.50) = 0.2.
c. 1
((510-500)/500) / ((1.35-1.50)/1.50) = 0.2.
d. 0.2
Correct. Apply the formula for price elasticity of demand, we have
((510-500)/500) / ((1.35-1.50)/1.50) = 0.2.
5. If the consumers cannot switch to a close substitute when the price of a good increases,
price elasticity of demand for that good is likely to be
a. elastic
Incorrect. Demand is elastic when the percentage change in quantity
demanded is greater than the percentage change in price, so the price
elasticity is greater than 1 in absolute value.
b. inelastic
Correct. Demand is inelastic when the percentage change in quantity
demanded is less than the percentage change in price, so the price elasticity
is less than 1 in absolute value.
c. unitary elastic
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Incorrect. Demand is unit-elastic when the percentage change in quantity

demanded is equal to the percentage change in price.
Incorrect. A horizontal demand curve is perfectly elastic, at every point as
the slope of the demand curve is zero and the reciprocal of its slope is infinite.
Price elasticity of demand is thus infinite at every point.
6. Low budget items such as soap have ______ price elasticity of demand than big-ticket
items such as DVD player.
a. higher
Incorrect. The price elasticity of demand for a good measures the
responsiveness of the quantity demanded of that goods to changes in its own
price. When the price changes, the changes in the quantity demanded of low
budget items are smaller.
b. lower
own price. When the price changes, the changes in the quantity demanded
of low budget items are smaller.
c. very high
d. unitary
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7. Assume the price of gasoline doubles tonight and remains at that price the next two
years. The price elasticity of demand for gasoline measured tomorrow will be ______
when compared with the price elasticity of demand for gasoline measured two years
from now.
a. more elastic
Incorrect. For two years from now, there will be more substitutes for gasoline,
therefore the price elasticity of demand will be greater.
b. larger in absolute value.

c. the same.
d. more inelastic.
Correct. For two years from now, there will be more substitutes for
gasoline, therefore the price elasticity of demand will be greater.
8. A price elasticity of demand of 0.3 means a

a. 10 percent increase in the price results in a 3 percent increase in quantity
demanded.
price. This can be shown by dividing the percentage change in the quantity
demanded of a product by the percentage change in the product’s price.
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b. 3 percent increase in the price results in a 3 percent decrease in quantity

demanded.
c. 10 percent increase in the price results in a 3 percent decrease in demand.

d. 10 percent increase in the price results in a 3 percent decrease in quantity

demanded.
own price. This can be shown by dividing the percentage change in the
quantity demanded of a product by the percentage change in the product’s
price.
9. If the slope of the demand curve is -0.167, price is $8 and quantity demanded is 12
units, then demand for this good is
a. perfectly elastic.
Incorrect. The elasticity can be calculated as 8/12 * (1/0.167) >1. Therefore,
the demand for this good is elastic.
b. elastic.
Correct. The elasticity can be calculated as 8/12 * (1/0.167) >1. Therefore,
c. unit elastic.
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d. inelastic.
10. During recessions, when workers lose their jobs and experience reduced incomes,
sales of durable goods (goods with a life expectancy of 3 years or more) decline.
Apparently, durables are
a. substitutes.
Incorrect. The concept of substitutes is about two or more goods and is
reflected in cross price elasticity of demand.
b. normal goods.
Correct. For normal goods, the income elasticity of demand is positive.
c. complements.
Incorrect. The concept of complements is about two or more goods and is
reflected in cross price elasticity of demand.
d. inferior goods.
Incorrect. For inferior goods, the income elasticity of demand is negative.
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References
Higher Education.
Education.
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2
Study
Unit
Market Equilibrium and Economic

Efficiency
ECO201 Market Equilibrium and Economic Efficiency
Learning Outcomes
This study unit consists of 2 chapters with Chapter 1 putting together the theory of
demand and theory of supply learned in Study Unit 1 to analyse market equilibrium.
Chapter 2 develops the concept of efficiency and explores why many tasks are best left up
to the market. It presents the concept of economic surplus and looks at how unregulated
markets can generate the largest possible economic surplus. The chapter also discusses
why intervention in the market can lead to undesired or unintended consequences.
Finally, the chapter discusses how intervention in a market can lead to increased economic
surplus.
1. Excess demand
2. Excess supply
3. Market equilibrium
1. Consumer surplus
2. Producer surplus
3. Technical efficiency
4. Market system
5. Marginal utility and the rational spending rule
6. Incidence of taxes
1. Use a graph to illustrate market equilibrium

2. Use demand and supply graphs to predict changes in prices and quantities
3. Explain how price elasticities of demand and supply can affect the changes in
prices and quantity
4. Apply the rational spending rule to find the optimal levels of consumption
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5. Explain the conditions for economic efficiency and the effects of taxes on market
equilibrium
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Chapter 1: Market Equilibrium
1.1 Introduction
Now that we have explored the behaviour of both buyers and sellers in isolation, we need
to look at the interaction of the two groups to achieve an equilibrium price . We found
from our demand curve that an increase in price causes buyers to want to buy less of the
good, while it causes our sellers to want to supply more of the good. A decrease in price
causes buyers to want to buy more but sellers to sell less. At any given price, it may be that
buyers would like to buy more of a good than sellers are willing to sell, or the reverse. This
is where it is very important to understand that prices adjust to equate quantity supplied
with quantity demanded.
1.2 Market Equilibrium

Market equilibrium is a situation in which quantity demanded equals quantity supplied.
Figure 2.1 shows the market equilibrium of pizzas which occurs at the intersection of
demand and supply of pizzas.
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Figure 2.1 Market Equilibrium
If prices are high, sellers might like to sell a lot of the good, but buyers are unwilling to
buy it creating an excess supply or surplus in the market. In this case, prices tend to
fall so sellers can encourage buyers to purchase more. Alternatively, if price is very low,
buyers might like to purchase much of the good, but sellers are reluctant to offer it creating
an excess demand or shortage in the market. In this case, buyers bid up the price to a
higher level. When price reaches that level at which the quantity demanded by buyers is
just equal to quantity supplied by sellers, we say the market has reached its equilibrium.
Graphically, equilibrium occurs where both the supply relation and the demand relation
are satisfied simultaneously. That’s where the two curves cross.
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Figure 2.2 Excess Demand and Excess Supply in the Market
Here is a very good exercise for you: change, one at a time, the values for each of the
“other” variables in the demand and supply functions and re-solve for equilibrium. You
should plot out new curves for each case, as well. Become familiar with how each of these
alterations shifts its respective demand or supply curve and the effects on equilibrium
price and quantity. This is an essential exercise for understanding the market model.
Read
You should now read Ivan Png (2016), Chapter 5, pp. 96-102 , Managerial Economics,
5th Edition.
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1.3 Predicting the Effects of Change in Demand and Supply

Figure 2.3 summarises the effects of change in demand and supply. The diagrams hold for
supply or demand shifts of any magnitude, provided the curves have their conventional
slope. The four rules governing the effects of supply and demand shifts are as follows:
Figure 2.3 Four Rules governing the Effects of Supply and Demand Shifts
Click here for the PDF.
1.4 Using Price Elasticity of Demand to Predict Changes in Price

An increase in supply will lead to a decrease in equilibrium price and an increase in
equilibrium quantity. However, the extent of the decrease in price and increase in quantity
depends very much on the elasticities of supply and demand. Figure 2.4 shows that when
demand is elastic i.e. when the demand curve is flatter, an increase in supply that shifts the
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supply curve to the right will increase equilibrium quantity by a larger amount compared
to the case when demand is more inelastic.
Figure 2.4 Increase in Supply
1.5 Using Price Elasticity of Supply to Predict Changes in Price

An increase in demand will lead to an increase in equilibrium price and an increase
in equilibrium quantity. Figure 2.5 shows that an increase in demand leads to a larger
increase in quantity and a smaller increase in price when the supply curve is more elastic
i.e. when the supply curve is flatter.
Figure 2.5 Increase in Demand
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Read
You should now read Ivan Png (2016), Chapter 1, pp. 103-108, Managerial Economics,
5th Edition.
Lesson Recording
Market Equilibrium
Activity 1
Question 1
We continue with Question 1 in Study Unit 1 Chapter 2. Consider the market for
minivans. For each of the events listed below, identify which of the determinants of
demand or supply are affected. Also indicate whether supply or demand increases
or decreases. Draw a diagram to show the effect on the price and quantity of
minivans.
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Question 2
1. Use the information in the graph below to find price elasticity of supply at point
A.
2. Based on the elasticity of supply in part (a), if price increases by 10%, by how
much will the quantity supplied change?
3. What will happen to the price elasticity of supply in each of the following cases
(becomes more inelastic, more elastic, or does not change)?
i. Inputs become easier to transport
ii. New inputs into production of the good are found
iii. The firm moves from the short-run to the long-run
1. Which of the four graphs represents the market for peanut butter after a major
hurricane hits the peanut-growing south?
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a. A
b. B
c. C
d. D
2. New oak tables are normal goods. What would happen to the equilibrium price and
quantity in the market for oak tables if the price of maple tables rises, the price of
oak wood rises, more buyers enter the market for oak tables, and the price of wood
saws increased?
a. Price will fall and the effect on quantity is ambiguous.
b. Price will rise and the effect on quantity is ambiguous.
c. Quantity will fall and the effect on price is ambiguous.
d. Quantity will rise and the effect on price is ambiguous.
3. During the last few decades in the United States, health officials have argued that
eating too much beef might be harmful to human health. As a result, there has been
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a significant decrease in the amount of beef produced. Which of the following best
explains the decrease in production?
a. Beef producers, concerned about the health of their customers, decided to
produce relatively less beef.
b. Government officials, concerned about consumer health, ordered beef
producers to produce relatively less beef.
c. Individual consumers, concerned about their own health, decreased their
demand for beef, which lowered the equilibrium price of beef, making it less
attractive to produce.
d. Anti-beef protesters have made it difficult for both buyers and sellers of beef
to meet in the marketplace.
4. Consider the market for new DVDs. If DVD players became cheaper, buyers
expected DVD prices to fall next year, used DVDs became more expensive, and DVD
production technology improved, then we could safely conclude that the equilibrium
price of a new DVD would
a. rise.
b. fall.
c. stay the same.
d. We couldn't be sure what it might do.
5. New cars are normal goods. What will happen to the equilibrium price of new cars
if the price of gasoline rises, the price of steel falls, public transportation becomes
cheaper and more comfortable, auto-workers accept lower wages, and automobile
insurance becomes more expensive?
a. Price will rise.
b. Price will fall.
c. Price will stay exactly the same.
d. The price change will be ambiguous.
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Chapter 2: Economic Efficiency
2.1 Introduction
Chapter 2 develops the concept of efficiency and explores why many tasks are best left up
to the market. It presents the concept of economic surplus and looks at how unregulated
markets can generate the largest possible economic surplus. The chapter also discusses
why intervention in the market can lead to undesired or unintended consequences.
Finally, the chapter discusses how intervention in a market can lead to increased economic
surplus.
2.2 Two Functions of Price

In a free market system, market prices serve two functions:
1. To redistribute scarce goods among potential claimants so that those who get
them are those who value them most, and
2. To direct productive resources to different sectors of the economy.
To understand how markets are likely to lead to an efficient allocation of society’s

resources, we begin with the concept of perfectly competitive markets, when both buyers
and sellers are price takers. That is, they have no control over the prices at which they buy
and sell. This is a reasonable assumption when three conditions hold:
1. There are negligible transactions costs, which means that buyers know where to
find goods and can compare prices easily among all the sellers.
2. Goods are homogeneous, meaning that products are undifferentiated, so there is
effectively no difference between a product sold by one seller and the next.
3. There are a large number of sellers, such that no one seller is an appreciable
fraction of the total market.
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2.3 Sellers
2.3.1 Responses to Profits

Figure 2.6 shows the marginal and average cost curves for a representative firm. The
equilibrium price is P0 when both the supply and demand curves intersect. Given the
equilibrium price of P0, the representative firm chooses to produce at the point where P
= MC. q0 is produced. At output of q0, P = P0 and AC = AC0. Since P0 > AC0, the firm is
making economic profit or supernormal profit (shaded area). In the long run, supernormal
profit attracts new firms to enter driving up supply and shifting the supply curve to the
right as market with firms earning economic profit will attract resources. With higher
supply, equilibrium price falls. Firms will continue to enter into the market so long as P
is above AC. This process will stop when a new equilibrium is restored at P = P1 = min of
AC.
Figure 2.6 Responses to Profit
2.3.2 Responses to Losses

Figure 2.7 shows the marginal and average cost curves for a representative firm. The
equilibrium price is P0 when both the supply and demand curves intersect. Given the
equilibrium price of P0, the representative firm chooses to produce at the point where P
= MC. q0 is produced. At output of q0, P = P0 and AC = AC0. Since P0 < AC0, the firm is
making economic loss (shaded area). In the long run, firms making economic loss leave
reducing supply and shifting the supply curve to the left. With lower supply, equilibrium
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price rises. Firms will continue to exit from the market so long as P is below AC. This
process will stop when a new equilibrium is restored at P = P1 = min of AC.
Figure 2.7 Responses to Loss
Therefore, in the long run, all firms in a competitive market will tend to earn zero economic
profit. Zero economic profit is the consequence of price movements caused by the entry
and exit of firms trying to maximise economic profit.
Read
5th Edition.
2.4 Buyers
The task of this section is to explore the demand side of the market in greater depth than
what was introduced in Study Unit 1. There we only asked you to accept the claim that
the quantity demanded of a good rises as its price falls. This relationship is known as the
law of demand. In this section, we develop the idea of utility maximisation and the model
of consumer choice behind the demand curve. It also presents the Rational Spending
Rule. We will also see how a market demand curve is derived by adding horizontally the
demand curves for individual buyers.
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2.4.1 The Concepts of Total Utility and Marginal Utility

The concept of utility is generally used in economics to represent the satisfaction people
derive from their consumption activities. Here, we assume that consumers act in a rational
way when they make decisions. They spend their income so that they can maximise their
satisfaction. This goal is commonly known as utility maximisation. The marginal utility
a consumer receives from consuming an additional unit of good will diminish as more is
consumed in a given period of time. Consumers maximise their utility when the marginal
utility per dollar for each good consumed is equal.
To illustrate this further, we will make use of a simple example. Table 2.1 shows the
relationship between the total number of chocolate bars Cindy eats per hour and the total
utility, measured in utils per hour, she derives from them.
Table 2.1 Cindy’s Total Utility from Chocolate Consumption
Quantity Total utility Marginal utility

(bars per hour) (utils per hour) (utils per bar)
0 0 -
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10
6 140 -10
We can show the utility information in Table 2.1 graphically, as in Figure 2.8. It is noted
that when more bars per hour Cindy eats, the more utils she gets. However, this is only
true up to the fifth bar. Once she continues beyond five bars, the total utility begins to
decline.
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Figure 2.8 Cindy’s Total Utility from Chocolate Bar Consumption
It is also interesting to note that her utility rises at a diminishing rate with additional
consumption. This is usually true for most goods. The marginal utility a person receives
from consuming an additional unit of a good will diminish as more is consumed in a
given period of time. The term marginal utility denotes the additional utility gained from
consuming an additional unit of one good and the concept that marginal utility diminishes
as more is consumed in a given period of time is known as the law of diminishing
marginal utility. Mathematically, marginal utility can be calculated as
For example, the marginal utility of moving from one to two bars per hour is 40 utils per
bar. This is calculated as
In the textbook (pp. 19), marginal utility is being translated into monetary terms and is
known as marginal benefit. The marginal benefit is then defined as the benefit provided
by an additional unit of item consumed.
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2.4.2 The Rational Spending Rule

Most of the time, we face more complicated purchase decisions as we generally must make
decisions about many goods and not just a single one like chocolate bar. To illustrate, we
assume now that there are two goods, chocolate bar and ice cream cone. We use MUC to
denote marginal utility for chocolate bars and PC to denote price of chocolate bar. Then,
the ratio MUC⁄PC is the marginal utility per dollar spent on chocolate bar. Similarly, we
let MUi to denote marginal utility for ice cream cones and Pi to denote price of ice cream
cone. Then, the ratio MUi⁄Pi is the marginal utility per dollar spent on ice cream cones.
The rational spending rule suggests that when Cindy’s utility is maximised, the marginal
utility per dollar will be exactly the same for the two types of goods. That is:
Therefore, when
1.
, then marginal utility per dollar spent on chocolate bars is larger
than marginal utility per dollar spent on ice cream cones. Cindy could always
increase her total utility by buying one more unit of chocolate bar and one less
unit of ice cream cone (since income is fixed). When more chocolate bars and
less ice cream cones are consumed, the law of diminishing marginal utility sets
in lowering MUC and increasing MUi . She will continue to consume more
chocolate bars so long as the inequality holds. Her total utility is optimal only
when .
2.
, then marginal utility per dollar spent on chocolate bars is lower
than marginal utility per dollar spent on ice cream cones. Cindy could always
increase her total utility by buying one more unit of ice cream cone and one less
unit of chocolate bar (since income is fixed). When more ice cream cones and
less chocolate bars are consumed, the law of diminishing marginal utility sets
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in increasing MUC and reducing MUi . She will continue to consume more ice
cream cones so long as the inequality holds. Her total utility is optimal only when
The rational spending rule has an important implication. Suppose and price
of ice cream cones increases. Other things being equal, . This will induce a
consumer, like Cindy, to switch her consumption from ice cream cones to chocolate bars
and hence lowering the quantity demanded for ice cream cones. This implies that the
demand curve for ice cream cones is indeed downward sloping.
2.4.3 Individual and Market Demand Curves

Suppose that there are only two buyers, Cindy and John, in the market for chocolate bars
and that their demand curves are shown in Figure 2.9. To construct the market demand
curve for chocolate bars, we simply add the individual quantities demanded at each price.
The process of adding up individual demand curves to obtain the market demand curve
is known as horizontal summation.
Figure 2.9 Individual and Market Demand Curves for Chocolate

Bars
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Read
You should now read Ivan Png (2016), Chapter 2, pp. 36-37 and pp. 41-42, Managerial
Economics, 5th Edition.
2.5 Market Equilibrium and Efficiency

In a perfectly competitive market, firms will supply all those goods that provide
consumers with a marginal benefit at least as great as the marginal cost of producing them.
1. The price of a good represents the marginal benefit consumers receive from
consuming the last unit of the good sold.
2. Perfectly competitive firms produce up to the point where the price of the good
equals the marginal cost of producing the last unit.
3. Therefore, firms produce up to the point where the last unit provides a marginal
benefit to consumers equal to the marginal cost of producing it.
Market equilibrium is the combination of quantity and price such that the quantity
willingly demanded is just equal to the quantity willingly supplied. This is just the
intersection of the market supply and demand curves, or the unique combination of
price and quantity that simultaneously satisfies both the market demand function and the
market supply function.
Figure 2.10 shows that:
1. If P = $1 then Qs = 2. At quantity of 2 the consumer is willing to pay $2. If the buyer

pays $1.25 for an extra unit, producer is $0.25 better off, and the consumer is $0.75
better off, or economic surplus increases by $1.00. Therefore, we can conclude
that at $1, the market is not efficient.
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2. If P = $2 then Qd = 2. Additional output costs only $1. This is $1 less than a buyer
would pay. If the buyer pays the seller $1.75, the buyer gains an economic surplus
of $0.25 then the seller gains an economic surplus of $0.75. Therefore, we can
conclude that at $2, the market is not efficient.
Figure 2.10 Economic Surplus
An allocation of resources is economically efficient if no re-allocation of resources can

make one person better off without making another person worse-off.
An allocation of resources is economically efficient if:
1. All users achieve the same marginal benefit,

2. All suppliers operate at the same marginal cost, and
3. Marginal benefit equals marginal cost.
Technical efficiency, on the other hand, means providing an item at the lowest possible
cost. Technical efficiency and economic efficiency are two different types of concepts that
differ from one another in a few ways. The main key differences are highlighted below.
1. Technical efficiency happens where there is not possible to increase the output
without increasing the input.
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2. Economic efficiency happens when the production cost of an output is as low

as possible.
3. Technical efficiency is a pre-requisite for economic efficiency i.e. in order to
achieve economic efficiency, one should first achieve technical efficiency.
4. Economic efficiency happens when every resource is made use of to serve each
person in the very best ways while minimising waste.
5. Once there is economic efficiency, any change that is made is likely to harm
others.
Therefore, a market in equilibrium is said to be efficient meaning that no re-allocation is

possible that will benefit some people without harming others.
Figure 2.11 shows the consumer surplus and producer surplus in a market. Consumer
surplus is the difference between the consumer’s willingness to pay and the total amount
that must be paid to consume the good. Producer surplus is the difference between the
total revenue from selling the good and the firm’s total cost. Aggregate surplus is the sum
of producer and consumer surplus. Maximising aggregate surplus is the same thing as
maximising consumer plus producer surplus.
Figure 2.11 Market Equilibrium and Welfare
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Any deviation from the quantity that achieves that maximum surplus creates a
deadweight loss.
Figure 2.12 Deadweight Loss
Total economic surplus in a market is maximised when exchange occurs at the equilibrium
price. However, it should be noted that an equilibrium is efficient does not imply that it is
good or even fair. All markets can be in equilibrium, yet many people may lack sufficient
income to buy even basic goods and services.
Read
5th Edition.
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2.6 Taxes
We make use of Figure 2.13 below to analyse the incidence of tax. Initially, the market is
at its equilibrium at point A where equilibrium price is S$3.00 and equilibrium quantity
is 3 units. Before a tax is imposed on the product,
Price paid by consumers=Price received by suppliers
Suppose now a tax of S$1.00 is imposed, equilibrium quantity drops to 2.5 units.
Price paid by consumers-Price received by suppliers=Tax
As a result, price paid by consumer is S$3.50 whereas price received by the supplier is S
$2.50. The wedge is the amount of tax per unit. The total amount of tax revenue earned
by the government is S$1.00 × 2.5 units.
Figure 2.13 Incidence of Tax
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Read
5th Edition.
Lesson Recording
Economic Efficiency
Activity 2
1. Suppose that milk initially sells for S$1.00 per litre. Describe a transaction that
will create additional economic surplus for both buyer and seller without causing
harm to anyone else.
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2. You are having lunch at an all-you-can-eat buffet. If you are rational, what should
be your marginal utility from the last morsel of food you swallow?
3. Martha’s current marginal utility from consuming orange juice is 75 utils per glass
and her marginal utility from consuming coffee is 50 utils per cup. If orange juice
costs $2.50 per glass and coffee costs $2.00 per cup, is Martha maximising her total
utility from the two beverages? If so, explain how you know. If not, how should
she rearrange her spending?
4. For the demand curve shown, find the total amount of consumer surplus that
results in the gasoline market if gasoline sells for $2.00 per gallon.
5. Suppose the government requires beer drinkers to pay a $2 tax on each case of
beer purchased.
a. Draw a supply-and-demand diagram of the market for beer without the
tax. Show the price paid by consumers, the price received by producers,
and the quantity of beer sold. What is the difference between the price
paid by consumers and price received by producers?
b. Now draw a supply-and-demand diagram for the beer market with tax.
Show the price paid by consumers, the price received by producers, and
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the quantity of beer sold. What is the difference between the price paid
by consumers and price received by producers? Has the quantity of beer
sold increased or decreased?
1. Market equilibrium is considered efficient because

a. quantity supplied equals quantity demanded.
b. the price consumers pay equals the amount producers receive.
c. no more trades remain that benefit some without harming others.
d. excess supply is zero.
2. In the town of SoccerBorough, the equilibrium price for soccer balls is $12 each and
the quantity exchanged at that price is 200 balls. If the price is $10 each, the quantity
exchanged in the market of SoccerBrough will be
a. more than 200 balls
b. exactly 200 balls
c. less than 200 balls
d. about 240 balls
3. Total economic surplus is

a. the sum of all the individual economic surpluses gained by buyers and sellers
in a market.
b. the sum of producer and consumer surplus in a market.
c. maximized at market equilibrium.
d. all of the above
4. If a market is not in equilibrium, which of the following is always true?

a. The quantity exchanged is below equilibrium quantity.
b. The quantity exchanged is above equilibrium quantity.
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c. The price is above the equilibrium price.

d. The price is below the equilibrium price.
5. A situation is efficient if
a. no change can help some people without hurting others.
b. the gain for some people offsets the loss for others.
c. the gain for some people more than offsets the loss to others.
d. consumer surplus is maximized.
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Summary
In this study unit, we put together the theory of demand and theory of supply learned
in Study Unit 1 to analyze market equilibrium in Chapter 1. In Chapter 2, we study the
concept of economy efficiency and explore why many tasks are best left up to the market.
To understand the complete effect of a shift in demand or supply, it is necessary to consider

both sides of the market. Generally, the effect of any change in demand or supply depends
on the elasticities of both demand and supply.
Consumer surplus is the difference between a buyer’s total benefit from some quantity
of purchases and his or her own expenditure. Changes in price affect consumer surplus
through the price changes themselves as well as through changes in the quantity
demanded. Producer surplus is the difference between revenue from some production
rate and the minimum amount necessary to induce the seller to produce the quantity.
Free-market competition will ensure that the allocation of resources is economically

efficient. Although the buyers and sellers act selfishly, the net outcome is as good as the
best efforts of the most enlightened and well-informed central planner.
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If people decide to have more children, they will want larger vehicles for hauling
their kids around, so the demand for minivans will increase. Supply will not be
affected. The result is a rise in both the price and the quantity sold, as the figure
below shows.

If a strike by steelworkers raises steel prices, the cost of producing a minivan rises
and the supply of minivans decreases. Demand will not be affected. The result is a
rise in the price of minivans and a decline in the quantity sold, as the figure below
shows.
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The development of new automated machinery for the production of minivans
is an improvement in technology. This reduction in firms' costs will result in an
increase in supply. Demand is not affected. The result is a decline in the price of
minivans and an increase in the quantity sold, as the figure below shows.

The rise in the price of sport utility vehicles affects minivan demand because sport
utility vehicles are substitutes for minivans. The result is an increase in demand for
minivans. Supply is not affected. The equilibrium price and quantity of minivans
both rise.
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The reduction in peoples' wealth caused by a stock-market crash reduces their
income, leading to a reduction in the demand for minivans, because minivans are
likely a normal good. Supply is not affected. As a result, both the equilibrium price
and the equilibrium quantity decline.
1. Use the information in the graph below to find price elasticity of supply at point A.
4/20 (1/.1) = .2 (10) = 2
2. Based on the elasticity of supply in part (a), if price increases by 10%, by how much
will the quantity supplied change?
For every 1% change in price, quantity supplied changes by 2%, so a 10% increase
in price leads to a 20% increase in quantity supplied.
3. What will happen to the price elasticity of supply in each of the following cases
(becomes more inelastic, more elastic, or does not change)?
i. Inputs become easier to transport
ii. New inputs into production of the good are found
iii. The firm moves from the short-run to the long-run
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In each case, the change increases price elasticity of supply (makes supply more
elastic).
1. Which of the four graphs represents the market for peanut butter after a major
hurricane hits the peanut-growing south?
a. A
Incorrect. The demand is not affected by the hurricane. The supply shifts to
the left because of the hurricane.
b. B
c. C
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d. D
Correct. The demand is not affected by the hurricane. The supply shifts to
the left because of the hurricane..
2. New oak tables are normal goods. What would happen to the equilibrium price and
quantity in the market for oak tables if the price of maple tables rises, the price of
oak wood rises, more buyers enter the market for oak tables, and the price of wood
saws increased?
a. Price will fall and the effect on quantity is ambiguous.
Incorrect. The demand curve shift to the right and the supply curve shift to
the left. The price will rise while the effect on quantity is ambiguous.
b. Price will rise and the effect on quantity is ambiguous.

Correct. When the price of maple tables rises, the demand for oak tables
will shift to the right since they are substitutes. When the price of oak wood
rises, the supply for oak tables will shift to the left. With more buyers, the
demand will shift to the right. When the price of wood saws increase, the
supply will shift to the left. Therefore, the demand curve shift to the right
and the supply curve shift to the left. The price will rise while the effect
on quantity is ambiguous.
c. Quantity will fall and the effect on price is ambiguous.

d. Quantity will rise and the effect on price is ambiguous.

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3. During the last few decades in the United States, health officials have argued that
eating too much beef might be harmful to human health. As a result, there has been
a significant decrease in the amount of beef produced. Which of the following best
explains the decrease in production?
a. Beef producers, concerned about the health of their customers, decided to
produce relatively less beef.
Incorrect. The demand curve shifts to the left. The equilibrium price and
quantity decrease.
b. Government officials, concerned about consumer health, ordered beef

producers to produce relatively less beef.
quantity decrease.
c. Individual consumers, concerned about their own health, decreased their

demand for beef, which lowered the equilibrium price of beef, making it less
attractive to produce.
Correct. The demand curve shifts to the left. The equilibrium price and
quantity decrease.
d. Anti-beef protesters have made it difficult for both buyers and sellers of beef
to meet in the marketplace.
quantity decrease.
4. Consider the market for new DVDs. If DVD players became cheaper, buyers
expected DVD prices to fall next year, used DVDs became more expensive, and DVD
production technology improved, then we could safely conclude that the equilibrium
price of a new DVD would
a. rise.
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Incorrect. We cannot tell the direction of shift of the demand curve. Therefore,
we cannot tell the movement of equilibrium price.
b. fall.
c. stay the same.

d. We couldn't be sure what it might do.

Correct. If DVD players became cheaper, the demand curve for DVD
would shift to the right. If buyers expected DVD prices to fall next year, the
demand curve for DVD would shift to the left. If used DVDs became more
expensive, the demand curve for DVD would shift to the right, If DVD
production technology improved, the supply for DVD would shift to the
left. We cannot tell the direction of shift of the demand curve. Therefore,
5. New cars are normal goods. What will happen to the equilibrium price of new cars
if the price of gasoline rises, the price of steel falls, public transportation becomes
cheaper and more comfortable, auto-workers accept lower wages, and automobile
insurance becomes more expensive?
a. Price will rise.
Incorrect. The demand curve shifts to the left and the supply curve shifts to
the right. The price of new cars will fall.
b. Price will fall.

Correct. If the price of gasoline rises, the demand for new cars will shift
to the left. If the price of steel falls, the supply of new cars will shift to
the right. If public transportation becomes cheaper and more comfortable,
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the demand for new cars will shift to the left. If auto-workers accept
lower wages, the supply of new cars will shift to the right. If automobile
insurance becomes more expensive, the demand for new cars will shift to
the left. Therefore, the demand curve shifts to the left and the supply curve
shifts to the right. The price of new cars will fall.
c. Price will stay exactly the same.

d. The price change will be ambiguous.

1. Suppose that milk initially sells for S$1.00 per litre. Describe a transaction that will
create additional economic surplus for both buyer and seller without causing harm
to anyone else.
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At the price of S$1.00, there is excess demand of 4,000 litre per day. Suppose a seller
produces an extra litre of milk at marginal cost of S$1.00 and sells it to the buyer
who values it most at S$6.00 for price of S$3.00. Both buyer and seller will gain
additional economic surplus and no other buyers or sellers will be hurt by the
transaction.
2. You are having lunch at an all-you-can-eat buffet. If you are rational, what should be
your marginal utility from the last morsel of food you swallow?
Since the marginal cost of an additional morsel of food is zero, a rational person
will continue eating until the marginal benefit of the last morsel (its marginal
utility) falls to zero.
3. Martha’s current marginal utility from consuming orange juice is 75 utils per glass
and her marginal utility from consuming coffee is 50 utils per cup. If orange juice
costs $2.50 per glass and coffee costs $2.00 per cup, is Martha maximising her total
utility from the two beverages? If so, explain how you know. If not, how should she
rearrange her spending?
Martha is currently receiving 75 utils/$2.50 = 30 utils per dollar from her last dollar
spent on orange juice, but only 50 utils/$2.00 = 25 utils per dollar from her last dollar
spent on coffee. Since the two are not equal, she is not maximising her utility. She
should spend more on orange juice and less on coffee.
4. For the demand curve shown, find the total amount of consumer surplus that results
in the gasoline market if gasoline sells for $2.00 per gallon.
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Consumer surplus = (1/2) × base × height = (1/2) × (80,000 gal/yr) × ($8/gal)=

$320,000/yr.
5. Suppose the government requires beer drinkers to pay a $2 tax on each case of beer
purchased.
a. Draw a supply-and-demand diagram of the market for beer without the tax.
the quantity of beer sold. What is the difference between the price paid by
consumers and price received by producers?
b. Now draw a supply-and-demand diagram for the beer market with tax.
the quantity of beer sold. What is the difference between the price paid by
consumers and price received by producers? Has the quantity of beer sold
increased or decreased?
a. The figure on the left shows the market for beer without the tax. The
equilibrium price is P1 and the equilibrium quantity is Q1. The price paid
by consumers is the same as the price received by producers.
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b. When the tax is imposed, it drives a wedge of $2 between supply and

demand, as shown in the figure on the right. The price paid by consumers
is P2, while the price received by producers is P2 - $2. The quantity of beer
sold declines to Q2.
1. Market equilibrium is considered efficient because
a. quantity supplied equals quantity demanded.
Incorrect. An allocation of resources is economically efficient if no re-
allocation of resources can make one person better off without making
another person worse-off.
b. the price consumers pay equals the amount producers receive.

c. no more trades remain that benefit some without harming others.

Correct. An allocation of resources is economically efficient if no re-
d. excess supply is zero.
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2. In the town of SoccerBorough, the equilibrium price for soccer balls is $12 each and
the quantity exchanged at that price is 200 balls. If the price is $10 each, the quantity
exchanged in the market of SoccerBrough will be
a. more than 200 balls
Incorrect. When the price is below the equilibrium price, there is excessive
demand. Less than the equilibrium quantity will be supplied.
b. exactly 200 balls

c. less than 200 balls

Correct. When the price is below the equilibrium price, there is excessive
d. about 240 balls

3. Total economic surplus is

a. the sum of all the individual economic surpluses gained by buyers and sellers
in a market.
Incorrect. This is correct but incomplete.
b. the sum of producer and consumer surplus in a market.

c. maximized at market equilibrium.
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d. all of the above

Correct. This is the complete answer.
4. If a market is not in equilibrium, which of the following is always true?

a. The quantity exchanged is below equilibrium quantity.
Correct. When the market is not in equilibrium, there is either excess
supply or excess demand. With excess supply, the quantity exchanged
is according to the demand curve. With excess demand, the quantity
exchanged is according to the supply curve. In both cases, it is below
equilibrium quantity.
b. The quantity exchanged is above equilibrium quantity.

Incorrect. When the market is not in equilibrium, there is either excess supply
or excess demand. With excess supply, the quantity exchanged is according to
the demand curve. With excess demand, the quantity exchanged is according
to the supply curve. In both cases, it is below equilibrium quantity.
c. The price is above the equilibrium price.

Incorrect. When the market is not in equilibrium, the price can be either above
or below equilibrium price.
d. The price is below the equilibrium price.

Incorrect. When the market is not in equilibrium, the price can be either above
or below equilibrium price.
5. A situation is efficient if
a. no change can help some people without hurting others.
Correct. An allocation of resources is economically efficient if no re-
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b. the gain for some people offsets the loss for others.
c. the gain for some people more than offsets the loss to others.
d. consumer surplus is maximized.

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References
Higher Education.
Education.
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3
Study
Unit
The Cost Side of the Market

ECO201 The Cost Side of the Market
Learning Outcomes
This study unit consists of 2 chapters with Chapter 1 focussing on cost in the short run
and Chapter 2 focussing on cost in the long run.
1. Short run vs. long run

2. Different cost concepts including total cost, total fixed cost, total variable cost
and their respective average cost and also marginal cost
3. Profit maximising condition
4. Shut-down condition in the short run
1. Economies of scale vs. economies of scope

2. Break-even condition in the long run
1. Describe the distinction between short run and long run

2. Describe various cost concepts
3. Discuss the relationship between different cost curves
4. Explain firm’s profit maximising condition
5. Explain firm’s shut-down condition in the short run and break-even condition
in the long run
6. Discuss the differences between economies of scale and economies of scope
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Chapter 1: Cost of Production in the Short Run
1.1 Introduction
This chapter looks into the concept of supply in more detail and introduces average
variable and average total cost curves. This allows for graphical representation of the
firm’s shut down rule, profits and losses. The chapter also provides deeper discussion on
the origins of the supply curve and considers how firm decides how much to produce.
1.2 Opportunity Cost

Opportunity cost is the value of the next-best alternative that must be forgone to undertake
an activity. The principle of opportunity cost involves the notion of scarcity i.e. no matter
what we do, there is always a trade-off. This concept is applicable not only to individual’s
daily decision making but also to firm’s decision making. We must trade off one thing
for another because resources available are limited and can be used in different ways. By
acquiring something, we use up resources and have less available to acquire something
else. The principle of opportunity cost allows us to measure such trade-off. Our discussion
of the firm’s cost is based on economic cost and the computation of economic cost is based
on the principle of opportunity cost. A firm’s economic cost is defined as the opportunity
cost of production including both explicit and implicit costs as discussed in Study Unit 1. A
firm’s explicit cost is defined as its actual cash payments for inputs. For example, if a firm
were to spend a total of S$30,000 per month on workers, material, rental and machinery, its
explicit cost is S$30,000. This is an opportunity cost because money spent on these inputs
cannot be used for something else. The firm’s implicit cost is defined as the opportunity
cost of non-purchased inputs such as the entrepreneur’s time or money. For example, if
the entrepreneur could earn S$20,000 per month in another job, the opportunity cost of
his time is S$30,000. Besides, many entrepreneurs also use their own funds to set up and
run their business. If an entrepreneur starts a business with money withdrawn from his
saving account, the opportunity cost of using these funds is the interest the funds could
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have earned. Suppose that the interest earned is S$10,000 per month. The opportunity cost
using these funds is S$10,000. The economic cost in this example is S$30,000 + S$20,000 +
S$10,000 = S$60,000.
Read
5thEdition.
1.3 Sunk Cost

It is important to note a difference between opportunity cost and sunk cost. Sunk cost to a
firm is a cost that the firm has already paid or has agreed to pay some time in the future.
It is an expenditure that has already been made and cannot be recovered. Once the firm
incurs this cost, it cannot be avoided by shutting down the business. Therefore, the firm
should ignore the cost of the facility in most of their business decision. What matters is
the costs that depend on what we do and not the costs that we can do nothing about.
Read
5thEdition.
1.4 Short Run and Long Run

Technology is the process a firm uses to turn inputs into outputs of goods and services
and technological change is the change in the ability of a firm to produce a given level of
output with a given quantity of inputs.
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1. Positive technological change results from rearranging the layout of a store,

faster or more reliable machinery, among others. The result is more output from
the same inputs or the same output from fewer inputs.
2. Negative technological change may result from hiring less-skilled workers,
damage to buildings due to inclement weather, for instance. The result is a
decline in quantity of output that can be produced from a given quantity of
inputs.
When we refer to the short run, we mean a period of time during which at least one of the
firm’s factors of production is fixed and cannot be varied. For example, for a photocopying
market, we can assume that the number of workers can be varied on short notice but the
capacity of its photocopying machine can only be changed with significant delay. For this
photocopying firm, the short run is simply the period of which the firm cannot change the
capacity of its photocopying machine. By contrast, when we speak of long run, we refer
to a period of time of sufficient length that all the firm’s factors of production are variable.
Here, the variable factor is worker and the fixed factor is the photocopying machine.
Read
5thEdition.
1.5 Short-run Production and Diminishing Returns

Suppose that you have decided to start a small company making bottles. To keep thing
simple, suppose that the silica required for making bottles is available free of charge
and that the only costs incurred by the firm are the wages you pay your employees and
the lease payments on your bottle-making machine. Before we can discuss the cost of
production, we need information on the production process.
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Table 3.1 below shows how the output produced varies with the number of workers, using
only one bottle-machine in the beginning. It is the firm’s short-run production function.
Table 3.1 Total Product, Average Product and Marginal Product
Workers Total Product Average Product Marginal Product
0 0 0
1 10 10 10
2 50 25 40
3 80 27 30
4 100 25 20
5 110 22 10
6 115 19 5
The firm’s total product shows how the output varies with the number of workers
employed. The average product is the total product divided by the number of workers
employed. The marginal product is the change in total product from one additional unit
of worker. It is noted that marginal product first increases with the number of workers
employed. When a firm increases its workforce, individual workers can specialise in
particular production tasks. Productivity increases. A two-worker operation produces
more than twice as many bottles as a one-worker operation. However, starting with the
third worker, the production process is subject to diminishing returns. This is a situation
at which as one input increases while the other inputs are held fixed, output increases at
a decreasing rate.
1.6 Fixed Cost and Variable Cost

Total cost is the cost of all the inputs a firm uses in production. Variable costs are costs that
change as output changes. Fixed costs are costs that remain constant as output changes.
Accordingly, we have
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Total cost (TC) = Fixed cost (TFC) + Variable cost (TVC)
When a firm spends, it incurs an explicit cost. When a firm incurs monetary costs, these are
explicit or accounting costs. As discussed in Study Unit 1, implicit costs are nom-monetary
opportunity costs. Economic costs usually include both accounting and implicit costs.
The firm’s production function is the relationship between the inputs employed by the
firm and the maximum output it can produce with those inputs. The production function
is short run if the time period is too short to vary at least one of the inputs. The firm’s
average cost (AC) equals the total cost divided by the quantity of output produced.
Average fixed cost (AFC) equals TFC divided by total output. Average variable cost (AVC)
equals TVC divided by total output. AC can be expressed as
Marginal cost (MC) is the change in total cost from producing one more unit of output
which can be expressed as
To gain a better understanding on the relationships between these costs of production, it

is helpful to consider a perfectly competitive firm confronting the decision of how much
to produce. The firm in question is a very small company that makes plastic bottles. Table
3.2 shows how the firm’s costs of production vary with its bottle production.
Table 3.2 Fixed Cost, Variable Cost and Total Cost
Bottles Fixed cost Variable cost Total cost Marginal cost

per day (S$/day) (S$/day) (S$/day) (S$/bottle)
0 40 0 40
80 40 12 52 0.15
200 40 24 64 0.10
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Bottles Fixed cost Variable cost Total cost Marginal cost

per day (S$/day) (S$/day) (S$/day) (S$/bottle)
260 40 36 76 0.20
300 40 48 88 0.30
330 40 60 100 0.40
350 40 72 112 0.60
362 40 84 124 1.00
Accordingly, we can calculate the AFC, AVC and AC of the firm and summarise our
calculations as follows:
Table 3.3 Average Fixed Cost, Average Variable Cost and Average Cost
Bottles per day Average fixed cost Average variable Average cost
cost
80 0.5 0.15 0.65
200 0.2 0.12 0.32
260 0.15 0.14 0.29
300 0.13 0.16 0.29
330 0.12 0.18 0.30
350 0.11 0.21 0.32
362 0.11 0.23 0.34
Figure 3.1 reveals that
1. MC must intersect AC at its minimum point.

2. When MC < AC, AC is falling.
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3. When MC > AC, AC is rising.

4. The same relationships hold true between MC and AVC.
Figure 3.1 AVC, AC and MC
Read
Edition.
1.7 Short-run Individual Supply

Costs are one aspect of the firm decisions on (1) whether to continue in operation and (2)
how much to produce. The other aspect to these decisions is revenue. We now turn to the
revenue aspect of a firm.
For a perfectly competitive firm, the maximum-profit condition is that price must be equal
to marginal cost i.e. P = MC. The firm should continue to expand as long as price is at
least as great as marginal cost. In Figure 3.2, we see that if the firm follows the rule of P =
MC, at price of S$0.20, it will produce 260 units per day. Why? First, suppose that the firm
sells 200 units at a price of S$0.20 instead, then we notice that it benefits from expanding
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output by one unit as the price of selling an additional unit is S$0.20 but the additional
cost incurred to produce this additional unit is S$0.10. So, by selling the 201st bottle for
additional 20 cents and producing it for an extra cost of 10 cents, the firm will increase its
profit by 20 – 10 =10 cents. In this way, we can show that for any quantity with P > MC,
the firm can increase profit by expanding production. Conversely, suppose that the firm
sells 300 units at a price of S$0.20 instead, we see that marginal cost is S$0.33 per bottle.
If the firm then reduces its output by one bottle, it would cut its cost by 33 cents while
losing only 20 cents of revenue. As a result, its profit would grow by 13 cents. Again, we
can show that for any quantity with P < MC, the firm can increase profit by contracting
production. It follows that at a market price of 20 cents per bottle, the firm maximises its
profit by selling 260 units, the quantity for which P = MC.
Figure 3.2 Profit Maximising Output, P = MC
From the graphical method, we are able to calculate the firm’s profit. Based on the previous
example, if price is S$0.20 per bottle, daily profit is simply the difference between price
and average cost times the number of units sold. In this case, P = 0.20 and AC = 0.12, profit
per unit is (P – AC) = 0.08 and total profit is 0.08 × 260 units = S$20.80. This can be shown
by the rectangle in Figure 3.3.
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Figure 3.3 Profit Maximizing Output, P = MC
1.8 The Firm’s Short-run Shutdown Condition

Should the business continue in operation? To make this decision, a firm needs to compare
the profit from continuing in production with the profit from shutting down. We will
illustrate this using an example. Imagine an ice cream seller selling ice cream at Tioman
Island which is an island off the east coast of Peninsular Malaysia. High season at the
island peaks between May and August when the weather generally displays the least
rainfall. Low season occurs when the monsoon winds begin to blow from October,
bringing heavy rain and strong waves till January. During this low season, the ice cream
seller at the beach will have to make decision between continuing business and shutting
down temporary.
Suppose the seller decides to continue and yet suffers a loss. (Note: we have no issue with
the seller making a profit as he will definitely continue to operate.) Let the total revenue
be TR while the total fixed cost from rental is TFC and the total variable cost is TVC. Then,
the loss associated with this operation is
Loss (Continue operating) = TFC + TVC - TR
On the other hand, the seller decides to shut down temporary; he makes no revenue but
at the same time incurs no TVC. The seller, however, has to continue paying rental to keep
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his booth. Otherwise, his booth will be taken away. Therefore, the loss associated with this
shutting down is
Loss (Shut down) = TFC
The seller should continue selling ice cream during this low season if the loss from
operating is at least as low as the loss from shutting down i.e.
Loss (Continue operating) ≤ Loss (Shut down)
This means that
TFC + TVC - TR ≤ TFC
which can be simplified to
TR ≥ TVC
Since TR = P × Q and TVC = AVC × Q, the condition can be further reduced to
P ≥ AVC
Therefore, profit-maximising rule together with this shut-down rule imply that firm’s
short run supply curve is simply the portion of MC that lies above AVC. More discussion
on this can be found from Study Unit 4.
Read
Edition.
Lesson Recording
Cost of Production in the Short Run
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Activity 1
Question 1
Paducah Slugger Company makes baseball bats out of lumber supplied to it by

Acme Sporting Goods which pays Paducah $10 for each finished bat. Paducah’s
only factors of production are lathe operators and a small building with a lathe.
The number of bats it produces per day depends on the number of employee-hours
per day, as shown in the table below.
Q Number of employee-
(bats/day) hours per day
0 0
5 1
10 2
15 4
20 7
25 11
30 16
35 22
1. What is Paducah’s profit maximising level of output?
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2. What would Paducah’s profit maximising level of output be if the government

provide a lump sum subsidy of $30?
Question 2
In Question 1 above, how would Paducah’s profit maximising level of output be

affected if the government imposed a tax of $10 per day on the company?

imposed a tax of $2 per bat?
2. Why do these two taxes have such different effects?
1. Which of the following best explains why wages in service industries have increased
along with wages in manufacturing industries, even though service industry
productivity has not increased as much? Because
a. the opportunity cost of working in the service industry is the wage in the
manufacturing industry.
b. the opportunity cost of working in the manufacturing industry is the wage in
the service industry.
c. the service and manufacturing industry are complements.
d. working in the service industry yields much more utility.
2. A firm's profit is equal to which of the following?

a. the value of its sales
b. marginal revenue minus marginal cost
c. total sales minus wages
d. total revenue minus total cost
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3. When the quantity of an input can be altered in the short-run, the input is
a. fixed.
b. variable.
c. implicit.
d. explicit.
4. A firm will shut down when

a. it is not earning a profit.
b. price does not equal marginal cost.
c. price is less than average cost.
d. revenue is less than variable costs.
5. The difference between a firm’s average total cost and its average variable cost is its
a. profit.
b. marginal revenue.
c. average fixed cost.
d. producer surplus
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Chapter 2: Cost of Production in the Long Run
2.1 Introduction
Last chapter focusses on short-run cost curves which show the cost of producing different
quantities of output in a given production facility. We now turn next to long-run cost
curves which show production costs in facilities of different sizes. As discussed earlier,
the long run is defined as a planning horizon during which a firm is perfectly flexible in
its choice of all inputs. For example, in the long run, a firm can build a new production
facility including factory and office.
2.2 Long Run Average Cost vs. Long Run Marginal Cost
Long run total cost (LRTC) is the total cost of production in the long run when a firm is
perfectly flexible in its choice of all inputs and can choose a production facility of any size.
We illustrate this concept using an example from Table 3.4 below. Long run average cost
curve (LRAC) is negatively sloped up to a certain point. This is mostly due to the effect of
labour specialisation. If the firm replicates the operation, LRAC will be horizontal beyond.
Table 3.4 The Long Run Average Cost of Production
Labour Output Labour Cost Capital Long-run Long-run

(S$/day) Cost Total Cost Average
(S$/day) (S$/day) Cost
(S$/day)
3 5 150 100 250 50
4 10 200 100 300 30
8 20 400 200 600 30
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Labour Output Labour Cost Capital Long-run Long-run

(S$/day) Cost Total Cost Average
(S$/day) (S$/day) Cost
(S$/day)
12 30 600 300 900 30
Table 3.4 shows the LRTC for different quantities of 5, 10, 20 and 30 units per day. The
replication process means that the LRTC increases proportionately with the quantity
produced per day. Since LRTC is proportional to the quantity produced, the LRAC does
not change as output increases.
Figure 3.4 Long Run Average Cost Curve
A firm’s long run marginal cost (LRMC) is the change in long-run cost as a result of
producing an additional unit of output. Unlike the short run, in the long run, firm is
perfectly flexible in choosing its inputs. Therefore, the LRMC is the increase in cost when
the firm can change its production facility besides workforce.
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Read
5th Edition.
2.3 Economies of Scale

A firm is experiencing economies of scale when its long run average cost curve is
negatively sloped as shown by Figure 3.4. One way to quantify the extent of economies of
scale in production is to determine the minimum efficient scale for producing the good.
Minimum efficient scale is the output at which economies of scale are exhausted and
the long run average cost curve becomes horizontal. There are two types of economies
of scale: internal and external. Internal economies of scale are due to cost savings of
a firm regardless of the industry or market in which the firm operates. It may come
about in a number of areas. For instance, large firms find themselves easier to carry the
overheads of advanced research and development (R&D). In some industries, R&D is
particularly crucial, say, pharmaceuticals industry for example. Pharmaceuticals industry
in general has huge cost of discovering the next blockbuster drug. Many mergers between
pharmaceuticals companies have been largely driven by the desire of the companies to
spread their R&D expenditure. External economies of scale, on the other hand, are due to
benefit a firm gets because of the way in which its industry is organised.
If a firm’s long run average cost is positively sloped, the firm is experiencing diseconomies
of scale. This means that when the firm increases its output, its long run average cost of
production increases. Usually, firm experiences diseconomies of scale for two reasons:
1. Coordination problem: When a firm becomes larger, it requires several layers of

management to coordinate activities of the different parts of the organisation.
2. Increasing input costs: When a firm increases its output, it will demand more of
its inputs and may be forced to pay higher prices for some of these inputs.
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In the long run, all costs are variable.
1. Many firms experience economies of scale which means long run AC falls as
output increases.
2. Constant returns to scale occur when long run AC is unchanged as output
increases.
3. Diseconomies of scale exist when long run AC rises as output increases.
Read
5th Edition.
2.4 Economies of Scope

Economies of scope are conceptually similar to economies of scale. Economies of scope
occur when the total cost of production is lower with joint than separate production.
In other words, firm finds it cheaper to produce a range of products together than to
produce each one of them on its own. Such economies of scope induce businesses to have
centralised functions including finance or marketing.
Economies of scope occur when there are cost savings from by products in the production
process. Besides, a firm that sells many products or in many countries or both will find
it less risky in the sense that if one of its product lines becomes unfashionable or one
of its market destinations has an economic slowdown, the firm will be able to continue
operation and trading. The desire to benefit from economies of scope was one of the
reasons for vast international conglomerates built up in the 1970s and 1980s.
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Read
5th Edition.
2.5 Long-run Individual Supply

As discussed in Section 1.4 of this Study Unit, in the long run, all factors are variable
factors. How should then a seller make its two key decisions (1) whether to continue in
operation and (2) how much to produce?
2.6 Long-run Break-even Condition

In the long run, a seller should continue in production if he is making at least zero
economic profit or what is commonly known as normal profit. Suppose that profit of the
seller is
π = TR - TC
Then, the seller should continue if
TR - TC ≥ 0
This imply that
TR ≥ TC
Since TR = P × Q and TC = AC × Q, the condition can be further reduced to
P ≥ AC
Therefore, profit-maximising rule together with this break-even rule imply that firm’s long
run supply curve is simply the portion of MC that lies above AC.
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Read
Edition.
Lesson Recording
Cost of Production in the Long Run
Activity 2
1. You want to know the short run marginal cost of producing a Honda Accord.
Comment on the following statement from an analyst in the production
department: The marginal cost of an Accord, given our current volume, is $25,000.
Of course, the actual marginal cost depends on the number of cars produced. The
larger the number produced, the lower the unit cost because we will spread out
our design and tooling costs over more cars.
2. Shuttle Express wants to compute the cost of adding a third daily bus between
Singapore and Kulai in Johore, Malaysia. Comment on the following statement
of Abacus Ang, the company accountant: If we add the third bus, our total cost
would increase from $700 to $780. Therefore, the marginal cost of the third bus
is $260 ($780/3).
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1. Which statement regarding short- and long-run cost is not correct?

a. The long-run average cost curve is the envelope of the short-run average cost
curves.
b. The short-run cost is everywhere equal to or greater than the long-run cost.
c. The long-run marginal cost curve is the envelope of all short-run marginal cost
curves.
d. A negatively-sloped long-run average cost curve implies economies of scale.
2. At the current level of output of 100 units, the average variable cost is $15, the average
cost is $20, and marginal cost is $18. Which statement(s) is (are) correct, if any?
I. Average cost must be falling with increased output.
II. Fixed cost equals $500.
III. Average variable cost must be rising with increased output.
a. I only is correct.
b. II only is correct.
c. I, II, and III only are correct.
d. I and II only are correct.
3. Economies of scale exist when

a. constant returns to scale are present.
b. input prices are falling.
c. average costs fall as the scale of production grows.
d. a 10% increase in all inputs causes a 9% increase in output.
4. Rhonda recently quit her job as a tax preparer, where she earned $4,000 per month, to
open her own flower shop. She already owned a garage that she rented out for $1,500
per month before she decided to use it for her shop. Her utilities total $200 per month,
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and her flowers and supplies total $2,000 per month. Rhonda’s total economic costs
per month are _______
a. $1,500
b. $2,000
c. $3,700
d. $4,000
5. A mining company is required to fill in its open pit and landscape it in twenty years
when the ore it’s currently mining becomes exhausted. The cost will be twenty million
dollars. This cost should _______
a. be considered as a variable cost.
b. not be considered to be a sunk cost until it actually has to be paid.
c. be considered as an avoidable cost.
d. be considered to be a sunk cost now.
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Summary
In this study unit, we analyze the cost side of the market in the short run and the long run.
Conventional accounting statement s do not always provide all the information on costs
necessary for effective business decisions. Managers should use the principals presented
in this study unit to develop accurate information about costs.
Economies of scale arise from either significant fixed costs or variable costs that diminish
with the scale of production. An industry where businesses exhibit scale economies will
tend to be concentrated. Economies of scope arise from significant joint costs across the
production of two or more items. Scope economies drive business to supply multiple
products. The experience curve shows how average costs decline with cumulative
production.
Opportunity cost is the net revenue from the best alternative course of action. Sunk
costs are costs that have been committed and cannot be avoided. For effective business
decisions, managers should consider opportunities and ignore sunk costs.
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1. What is Paducah’s profit maximising level of output?
As indicated by the entries in the last column of the table below, the profit-
maximising quantity of bats for Paducah is 20/day, which yields daily profit of $35.

provide a lump sum subsidy of $30?
Same quantity as in part a, but now profit is $65, or $30 more than before.
Q Total Total Total cost Profit

(bats/day) Revenue labour cost ($/day) ($/day)
($/day) ($/day)
0 0 0 60 -60
5 50 15 75 -25
10 100 30 90 10
15 150 60 120 30
20 200 105 165 35
25 250 165 225 25
30 300 240 300 0
35 350 330 390 -40
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imposed a tax of $2 per bat?
A tax of $10 per day would decrease Paducah’s profit by $10 per day at every level
of output. But the company would still maximise its profit by producing 20 bats
per day. A tax that is independent of output does not change marginal cost, and
hence does not change the profit-maximising level of output.
2. Why do these two taxes have such different effects?

But a tax of $2 per bat has exactly the same effect as any other $2 increase in the
marginal cost of making each bat. As we see in the last column of the table below,
the company’s profit-maximising level of output now falls to 15 bats per day. At
that level it earns exactly 0 profit, but at any other level of output it would sustain
a loss.
Q Total Total Total cost Profit

(bats/day) Revenue labour cost ($/day) ($/day)
($/day) ($/day)
0 0 0 60 -60
5 50 15 85 -35
10 100 30 110 -10
15 150 60 150 0
20 200 105 205 -5
25 250 165 275 -25
30 300 240 360 -60
35 350 330 460 -110
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1. Which of the following best explains why wages in service industries have increased
along with wages in manufacturing industries, even though service industry
productivity has not increased as much? Because
a. the opportunity cost of working in the service industry is the wage in the
manufacturing industry.
Correct. The concept of opportunity cost applies here.
b. the opportunity cost of working in the manufacturing industry is the wage

in the service industry.
Incorrect. This explains the other way round.
c. the service and manufacturing industry are complements.

Incorrect. This is not a valid statement.
d. working in the service industry yields much more utility.

working in the service industry yields much more utility.
2. A firm's profit is equal to which of the following?

a. the value of its sales
Incorrect. This is the revenue.
b. marginal revenue minus marginal cost

Incorrect. This is the marginal profit.
c. total sales minus wages

Incorrect. There can be other costs than wages.
d. total revenue minus total cost

Correct. This is the profit.
3. When the quantity of an input can be altered in the short-run, the input is
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a. fixed.
Incorrect. When we refer to the short run, we mean a period of time during
which at least one of the firm’s factors of production is fixed and cannot be
varied.
b. variable.
Correct. When we refer to the short run, we mean a period of time during
which at least one of the firm’s factors of production is fixed and cannot
be varied.
c. implicit.
Incorrect. This is not related to short run or long run. We have discussed the
concept of implicit costs.
d. explicit.
Incorrect. This is not related to short run or long run. We have discussed the
concept of explicit costs.
4. A firm will shut down when

a. it is not earning a profit.
Incorrect. A firm should continue operating in the short run as long as
revenue is larger than total variable cost. The profit may be negative.
b. price does not equal marginal cost.

Incorrect. A firm should continue operating in the short run as long as
revenue is larger than total variable cost. It is not necessary that price equals
marginal cost.
c. price is less than average cost.

Incorrect. A firm should continue operating in the short run as long as price
is larger than average variable cost.
d. revenue is less than variable costs.
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Correct. A firm should continue operating in the short run as long as

revenue is larger than total variable cost.
5. The difference between a firm’s average total cost and its average variable cost is its
a. profit.
Incorrect. It is the average fixed cost.
b. marginal revenue.
c. average fixed cost.

Correct. It is the average fixed cost.
d. producer surplus
1. You want to know the short run marginal cost of producing a Honda Accord.
Comment on the following statement from an analyst in the production department:
The marginal cost of an Accord, given our current volume, is $25,000. Of course, the
actual marginal cost depends on the number of cars produced. The larger the number
produced, the lower the unit cost because we will spread out our design and tooling
costs over more cars.
The $25,000 figure includes some of the fixed cost of production (design and
tooling costs) so it is an average cost, not a marginal cost.
2. Shuttle Express wants to compute the cost of adding a third daily bus between
Singapore and Kulai in Johore, Malaysia. Comment on the following statement of
Abacus Ang, the company accountant: If we add the third bus, our total cost would
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increase from $700 to $780. Therefore, the marginal cost of the third bus is $260
($780/3).
The $260 calculated is the average cost and not marginal cost. The marginal cost
is $80 ($780-$700).
1. Which statement regarding short- and long-run cost is not correct?
a. The long-run average cost curve is the envelope of the short-run average cost
curves.
Incorrect. This statement is correct.
b. The short-run cost is everywhere equal to or greater than the long-run cost.
c. The long-run marginal cost curve is the envelope of all short-run marginal
cost curves.
Correct. The long-run average cost curve is the envelope of the short-run
average cost curves.
d. A negatively-sloped long-run average cost curve implies economies of scale.

2. At the current level of output of 100 units, the average variable cost is $15, the average
cost is $20, and marginal cost is $18. Which statement(s) is (are) correct, if any?
I. Average cost must be falling with increased output.
II. Fixed cost equals $500.
III. Average variable cost must be rising with increased output.
Incorrect. Since marginal cost is smaller than average cost, average cost must
be falling with increased output. But this is not the only correct statement.
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Incorrect. Fixed cost = 100 *(20-15) = $500. But this is not the only correct
statement.
c. I, II, and III only are correct.

Correct. Since marginal cost is smaller than average cost, average cost must
be falling with increased output. But this is not the only correct statement.
Fixed cost = 100 *(20-15) = $500. But this is not the only correct statement.
Since marginal cost is larger than average variable cost, average variable
cost must be rising with increased output.

Incorrect. They are not the only correct statements. III is also correct.
3. Economies of scale exist when

a. constant returns to scale are present.
Incorrect. A firm is experiencing economies of scale when its long run
average cost curve is negatively sloped.
b. input prices are falling.

c. average costs fall as the scale of production grows.

Correct. A firm is experiencing economies of scale when its long run
d. a 10% increase in all inputs causes a 9% increase in output.

4. Rhonda recently quit her job as a tax preparer, where she earned $4,000 per month, to
open her own flower shop. She already owned a garage that she rented out for $1,500
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per month before she decided to use it for her shop. Her utilities total $200 per month,
and her flowers and supplies total $2,000 per month. Rhonda’s total economic costs
per month are _______
a. $1,500
Incorrect. Total economic costs = $1,500 + $200 + $2,000 = $3,700.
b. $2,000
c. $3,700
Correct. Total economic costs = $1,500 + $200 + $2,000 = $3,700.
d. $4,000
5. A mining company is required to fill in its open pit and landscape it in twenty years
when the ore it’s currently mining becomes exhausted. The cost will be twenty million
dollars. This cost should _______
a. be considered as a variable cost.
Incorrect. Variable cost can be changed in the short run.
b. not be considered to be a sunk cost until it actually has to be paid.

Incorrect. It is a suck cost now.
c. be considered as an avoidable cost.

Incorrect. It is a suck cost now.
d. be considered to be a sunk cost now.

Correct. It is a suck cost now. A sunk cost is a retrospective (past) cost that
has already been incurred and cannot be recovered.
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References
Higher Education.
Education.
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4
Study
Unit
Competitive Markets and

Monopoly
ECO201 Competitive Markets and Monopoly
Learning Outcomes
This study unit consists of 3 chapters with Chapters 1 and 2 focusing on the competitive
markets, the concept of economic profit and perfect competition. Chapter 3 looks into
monopoly.
1. Competitive markets
2. Zero economic profit
1. Perfect competition
1. Market power
2. Monopoly
3. Monopsony
4. Contribution margin
5. Lerner’s index
1. Appraise the main characteristics of competitive markets

2. Discuss the zero economic profit in competitive markets
3. Explain the entry and exit in competitive markets in the short run and the
conditions that define perfect competition
4. Explain and compare the short run and long run equilibrium in perfect
competition
5. Locate the sources of market power
6. Identify the profit maximising price and quantity for a monopoly
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7. Explain how a monopoly should respond to changes in demand and costs,

the effects of advertising and R&D on a monopoly, and the optimal level of
advertising and R&D
8. Compare the market structure of perfect competition and monopoly
9. Describe the optimal purchasing decisions of monopsony
SU4-3
Chapter 1: Competitive Markets and Economic Profit
1.1 Introduction
In managerial economics, we study three main types of market structures namely perfect
competition, monopoly and oligopoly. Perfect competition and monopoly are at the two
extreme ends of the market structures. The main differences between these three markets
are (1) the number of producers and (2) whether there is free entry and exit. Perfect
competition is characterised by many producers and free entry while monopoly has
only one producer and no free entry. Oligopoly lies in between perfect competition and
monopoly with limited number of producers and no free entry.
Understanding the different market structures helps the managers to make the right
decisions about production levels of the goods, resource allocations and entry/exit.
Therefore, they can have better strategic moves based on the different market structures.
This chapter introduces the competitive markets and the following chapter looks into
perfect competition in more detail. The last chapter in this study unit focuses on monopoly.
Oligopoly is discussed in the next study unit. Hence, we begin the study with competitive
markets and economic profit in this chapter.
1.2 Competitive Markets

The model of competitive markets is the basic start point of managerial economics and
can be used to study a variety of markets. Competitive markets involve many buyers and
sellers. Buyers are the demand side and sellers are the supply side. What we have seen in
the previous study units are the basic elements of the competitive markets – the demand
and supply analyses and the market equilibrium.
The three main characteristics of competitive markets are:
• Price taking
• Product homogeneity
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• Free entry and exit
Price taking means each buyer and seller take the market price as given. In competitive
markets, there are many sellers (or firms). Each individual firm sells a very small share
of the total market output, and therefore cannot influence the market price. Competitive
markets are characterised by many buyers (or consumers) as well. Each individual
consumer buys too small a share of the total market output to have any impact on the
market price.
Product homogeneity means that firms produce and sell identical or nearly identical
products. This means that the products of all of the firms are perfectly substitutable with
one another. No firm can raise the price of its product above the price of other firms
without losing most or all of its business. Homogeneity ensures that there is a single
market price. Oil, certain raw materials, and agricultural commodities are examples of
homogeneous products.
Free entry and exit means that suppliers can easily enter or exit a market, and buyers
can easily switch from one supplier to another. The assumption of free entry and exit is
important to ensure that firms can freely enter industries if they see a profit opportunity
and exit if they are suffering loses. For example, pharmaceutical companies are not
competitive because of the large costs of R&D required. The banking industry is not
competitive either since you cannot start a bank even when you are very rich.
1.3 Economic Profit

The concept of economic profit has been discussed in Study Unit 1 Chapter 1 Section 1.2.
To recall the definition, economic profit is the difference between the firm’s total revenue
and both explicit and implicit costs:
Economic profit = Total revenue – Explicit costs – Implicit costs
In competitive markets, each individual firm and consumer is a price taker. The market
price and output are determined from the total market demand and supply. Given the
market price, to maximise profit, each firm produces up to the amount where the marginal
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cost equals the marginal revenue, which is equal to the price in competitive markets.
On the demand side, each consumer buys up to the quantity such that his/her marginal
benefit equals his/her marginal cost, which is exactly the price.
To summarise, in the competitive market equilibrium, we have the following:
• The marginal benefits of the buyers are equal.

• The marginal costs of the sellers are equal.
• The marginal benefit and marginal cost are equal (to the price).
Therefore, a perfectly competitive market satisfies all three requirements for economic
efficiency, even though each buyer and seller makes choices independently and selfishly.
Given that marginal revenue equals marginal price equals price at the competitive
equilibrium, each firm earns zero economic profit. Zero economic profit means the firm
is satisfied in existing business and no new firms will enter the industry as there is
no economic profit to be made. Because of the free entry and exit characteristic of
a competitive market, short run profits will attract new firms into the market. More
producers increase total supply which lowers the market price. This continues until there
are no more economic profits to be gained in the market, therefore, there is zero economic
profit at the equilibrium.
Read
You should now read Ivan Png (2016), Chapter 1, pp. 12-13, and Chapter 6, pp. 122-123,
Managerial Economics, 5th Edition.
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Lesson Recording
Competitive Markets and Economic Profit
1. The demand curve faced by a firm that is a “price taker” is

a. P = A; where A is the market-determined price
b. Q = A; where A is the market-determined quantity
c. P = Q
d. P = 0
2. If a firm is earning zero economic profits

a. its revenues are sufficient to pay explicit costs, but not implicit costs.
b. the owner will not be able to pay himself or herself a salary.
c. it will shut down in the long run, but will continue to operate in the short run.
d. the owners are earning a return on their time and investment that is equal to
the opportunity costs of that time and investment.
3. If economic profits are positive, then

a. firms will be exiting the industry.
b. accounting profits can be either negative, zero, or positive.
c. the firm is receiving exactly a normal profit.
d. accounting profits must be positive.
4. In the perfectly competitive industry, economic profits

a. include only explicit costs.
b. are always greater than accounting profits.
c. have no relationship to accounting profits.
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d. serve to motivate entry or exit.
5. Suppose all firms in a perfectly competitive industry are experiencing economic

profits. One can hypothesise that
a. market supply will decrease.
b. market price will rise.
c. the number of firms will rise.
d. market demand will increase.
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Chapter 2: Perfect Competition
2.1 Introduction
Perfect competition is an extreme form of competitive markets. In real life, many markets
are highly competitive while few markets are perfectly competitive. Many markets face
relatively low entry and exit costs as well as highly elastic demand curves. Even if a market
is not perfectly competitive, comparing that market to the perfectly competitive case can
be useful for many managerial implications.
2.2 Perfect Competition

Perfect competition has desirable properties in terms of efficiency and welfare, which
are used as benchmarks in comparing different market structures. Perfect competition is
usually identified by the following characteristics:
• Sellers and buyers are price takers

• Homogeneous and divisible output
• No transactions costs
• No externalities
• Perfect information (price, quality, market conditions)
• Free entry and exit for both buyers and sellers
Even if some of the above conditions do not hold in real life, a market can still come close
to achieving these desirable properties. Next, we are going to look at the characteristics in
detail.
2.2.1 Buyers and Sellers

In perfect competition, there are many buyers and sellers. Each buyer demands a small
quantity of the total market output and each seller supplies a small portion of the total
market output. Therefore, each individual buyer and seller has no market power to
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influence the market price. Instead, they take the market price, which is determined by
the total demand and total supply, as given and fixed. Therefore, they are known as price
takers. While the demand curve faced by whole market is downward sloping, the demand
curve faced by an individual seller is a horizontal line (see Figure 4.1) since an individual
seller has no impact on market price.
Figure 4.1 Demand Curve for the Representative Competitive Firm
2.2.2 Products and Transactions

The products in perfect competition are homogeneous, which are perfect substitutes.
There are no transaction costs associated with buying or selling. As a consequence, if a
seller tries to charge a slightly higher price than his competitors, he will definitely lose
all his customers. His customers can easily go to another seller in the market with no
additional transaction costs.
In general, the degree of products homogeneity in a market is directly related to the level
of competition among the sellers. If sellers can differentiate their products from each other
in terms of quality or any other aspects, then the competition is relatively weaker and they
can sell at different prices.
There is no externality in perfect competition. That is, the marginal benefits to the buyers
are independent with each other. Similarly, the marginal revenue and marginal costs of
the sellers are independent. No buyer (seller) can influence another buyer (seller) through
his own purchases (sales) of the product.
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2.2.3 Information Structure

Perfect competition assumes perfect information. Buyers and sellers have symmetric
information about the prices of the products, production technology, available substitutes
in the market etc. As a consequence, no one has secret information which could give him
an advantage in the market. This type of information structure makes the competition
intense in the market.
2.2.4 Entry and Exit

Buyers and sellers in perfect competition can enter and exit the markets freely without
any legal, regulatory or technological barriers. This ensures that in the long run market
equilibrium, the seller’s average cost of production is equal to the price level. If price is
higher than average cost, the positive economic profit in the market attracts new sellers
into the market. Market supply goes up and the price will be driven down until it equals
to the average cost where there is zero economic profit.
The ease of entry and exit is also an important determinant of the degree of competition in
the market. If some market has a higher entry and/or exit cost, the potential new sellers are
less likely to enter the markets since they need to take these extra costs into consideration
when making decisions on whether to enter the market. Therefore, the existing sellers are
able to make positive economic profits with these barriers to entry and exit. The market
is hence less competitive.
2.3 Competitive Equilibrium

Market equilibrium is the combination of quantity and price such that the quantity
willingly demanded is just equal to the quantity willingly supplied. This is just the
intersection of the market supply and demand curves, or the unique combination of
price and quantity that simultaneously satisfies both the market demand function and the
market supply function. How to find the market demand and supply?
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To see how to aggregate individual consumers’ demand curves to yield the market
demand curve, we just add them up horizontally. We then do it for each possible price,
and we have market demand. If consumers’ demand curves are different in the long run
than in the short run, then the market demand will reflect that difference.
To find market supply, we need to see how much each firm is willing to offer at each
price and then sum those quantities for all prices. So we need to find the individual firm’s
supply curve first. To decide an individual firm’s supply curve, we analyse the output
decision of a competitive firm. The competitive firm’s demand is a horizontal line since the
market price is determined by market supply and market demand. Individual producer
sells all units for the market price regardless of that producer’s level of output. With the
horizontal demand curve, we have MR = P. Therefore, for a perfectly competitive firm,
profit maximising output occurs when MR = MC = P, as shown in Figure 4.2.
Figure 4.2 Output Choice for a Competitive Firm
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Figure 4.3 A Competitive Firm’s Short-Run Supply Curve
Supply curve tells how much output will be produced at different prices. Competitive
firms determine quantity to produce where P = MC. Firm shuts down when P < AVC
(average variable cost). This is because by shutting down, the firm will lose all the fixed
costs. So the firm will continue producing in the short run as long as the loss is smaller than
the total fixed cost. Therefore, a competitive firm’s supply curve is portion of the marginal
cost curve above the AVC curve, as shown in Figure 4.3. With the individual firms’ supply
curves, we can now derive the market supply curve as the horizontal summation of
individual firms’ supply curves, as shown in Figure 4.4.
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Figure 4.4 Market Supply Curve for the Competitive Industry
In perfect competition, we need to distinguish between the short run and long run market
equilibrium. In the short run, a limited number of firms have technology and access to
inputs to supply. In the long run, potentially any firm has access to technology, resulting
in free entry of firms. Therefore, in the long run, firms will enter as long as price is at least
as great as ACmin (the minimum average cost), resulting in a horizontal long-run market
supply curve.
If there are positive economic profits in the short run, the long-run response to short-
run profits is to increase output as illustrated in Figure 4.5. Short run profits will attract
other producers. More producers increase industry supply from S1 to S2, which lowers the
market price from P1 to P2. This continues until there are no more profits to be gained in the
market – zero economic profits, which is exactly at S2 and P2. On the other hand, if there
are negative economic profits in the short run (i.e. short run losses), the long-run response
to short-run losses is to decrease output as illustrated in Figure 4.6. Short run losses will
cause some inefficient producers to leave the industry, shifting the market supply to the
left from S1 to S2, which increases the market price from P1 to P2. This continues until there
are no more economic losses in the market, which is exactly at S2 and P2.
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Figure 4.5 Long-Run Competitive Equilibrium - Profits
Figure 4.6 Long-Run Competitive Equilibrium - Losses
In summary, the long-run competitive equilibrium with free entry has three properties:
1. All firms in industry are maximising profits: MR = MC.

2. No firm has incentive to enter or exit industry: Earning zero economic profits.
3. Price is at minimum point of average cost.
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Read
Edition.
Lesson Recording
Perfect Competition
1. Assume all firms in a particular perfectly competitive industry are earning economic
profits. This will cause firms to ______ the industry, which will continue until ______.
a. exit; economic losses occur
b. exit; economic profits are zero
c. enter; economic profits are zero
d. enter; economic profits are negative
2. If a single firm, belonging to a perfectly competitive industry in long run equilibrium,

discovers a significant cost saving methodology, then?
a. all firms will enjoy economic profits for a short period of time.
b. the rest of the industry will quickly adopt the new methodology.
c. the firm will enjoy economic profits forever.
d. their firm will lower price to drive the rest of the industry out of business.
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3. Suppose several United States software design companies compete with each other
in a perfectly competitive environment. If one company decides to move some of its
offices to a low-wage country in order to reduce operating costs
a. the other companies will still be able to remain profitable while operating
solely in the United States.
b. the company that moves to the lower-wage country will earn positive
economic profits in the long run because it will keep a cost advantage.
c. the other companies will also move to the low wage country in order to remain
in the industry.
d. the other companies will charge higher prices than the company that moved.
4. Use the following to answer questions 4-8:
Suppose lettuce farmers in California initially have production cost per harvesting
period (including a normal profit) of $35,000. Charlie, a farmer with experience in
production management, develops a delivery system that shortens the time between
harvesting the lettuce and displaying on the shelves of a grocery store. As a result,
Charlie saves $5,000 per harvesting period.
In the short run, Charlie's reduction in cost will ______ the market price of lettuce.
a. decrease
b. have no impact on
c. increase
d. first increase then decrease
5. In the short run, Charlie's total revenue will _______ and total cost will ________.
a. increase; decrease
b. decrease; increase
c. be the same as before; be the same as before
d. be the same as before; decrease
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6. In the short run, Charlie's economic profit will be _________ per harvesting period.
a. $0
b. $5,000
c. $30,000
d. $35,000
7. The long run supply curve for the industry will shift _____ by ______ per harvesting
period.
a. downward; $5,000
b. upward; $40,000
c. upward; $5,000
d. ambiguous; $0
8. In the long run, each farmer will be earning a(n) ______.

a. economic profit of $5,000
b. accounting profit of $0
c. accounting profit of $5,000
d. economic profit of $0
9. One assumption of the perfectly competitive model is that there are no barriers to
entry. This assumption most directly leads to the implication that
a. firms will spend significant amounts of money on advertising.
b. positive economic profits will only be possible for a fairly short period of time.
c. fixed costs will be relatively high.
d. firms will compete on the basis of better service and amenities rather than
price.
10. If you were to open a business in an industry that is approximately perfectly

competitive, you would expect that
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a. you would earn little to no profit in the short run, but higher profits eventually.
b. your competition would respond to your entry into the industry by
aggressively advertising.
c. you would earn zero economic profits in the short run, and zero accounting
profits in the long run.
d. in the long run you would earn zero economic profits and positive accounting
profits.
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Chapter 3: Monopoly
3.1 Introduction
In the previous chapter, we have learnt about perfect competition where no single buyer
or seller can influence the market. The ability of a buyer or seller to influence the market
supply or demand is called market power. In this chapter and the next study unit, we
will study the markets with market power, which include monopoly and oligopoly. In this
chapter, we focus on two extreme cases of market power − monopoly and monopsony. In
a monopoly, there is only one seller who has market power and thus can influence market
supply. In a monopoly, there is only one buyer who has market power and can influence
market demand.
We first look at the sources of market power. Following this, we analyse how a monopoly
maximises profit to decide the price and production level. Then we discuss the responses
to demand and cost changes, as well as the effects of advertising and R&D for a monopoly.
We conclude with a discussion on monopsony.
3.2 Sources of Market Power

Since we have known that buyers and sellers in a perfect competition have no market
power, it is natural to come up that the sources of market power are the negations/
opposites of the conditions of perfect competition. Two key ingredients to market power
are barriers to enter and elasticity of demand and supply. The sources of market for buyers
and sellers are almost symmetric. So we focus on the market power of sellers here. There
are four main sources of market power to the sellers.
1. Product differentiation can increase demand and reduce price elasticity of

demand of the buyers. Product differentiation can come directly in terms of the
quality, design, function and brand. It can also be built up through advertising
and promotion.
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2. Intellectual property encourages innovation and therefore establishes product

differentiation. Intellectual property, including patents, copyright, trademarks
and trade secrecy, ensures a period of exclusive use of certain innovation and
therefore is able to exclude competitors and create market power.
3. Economies of scale, scope and experience provide an incumbent seller a cost
advantage in producing the goods over the potential competitors. Hence, this
advantage deters new entry and creates market power. With economies of scale, a
producer with large scale has cost advantage over smaller-scale producers. With
economies of scope, a producer who combines the production of multiple goods
has cost advantage over competitors with fewer products. With economies of
experience, a more experienced producer with a larger accumulated aggregate
production has cost advantage over competitors who have less production and
less experience.
4. Regulations are sometimes imposed by the government to limit competition for
economic or social reasons. Producers who have the government licences are
protected from the competition and therefore gain market power.
3.3 Profit Maximisation of Monopoly

Monopoly is characterised by one seller and many buyers, and one product with no good
substitutes. There are barriers to entry and therefore the monopoly seller is price setter in
the market. Market power implies a downward sloping demand curve. As a monopoly,
the seller faces the market demand curve. Unlike a seller in perfection competition who
has no influence on the market price, the monopoly seller’s decision on productions and
sales will affect the market price.
To analyse the profit-maximising sales, we first look at the revenue and then the cost of
the monopoly seller. In particular, we will base the discussions on the following example
in Table 4-1, which shows the monopoly revenue, cost and profit.
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Table 4.1 Monopoly Revenue, Cost and Profit
Price Sales Total Marginal Total Marginal Profit

(P) $ (Q) Revenue (TR) Revenue (MR) Cost (TC) Cost (MC)
6 0 0 - 1 1 -1
5 1 5 5 2 1 3
4 2 8 3 3 1 5
3 3 9 1 4 1 5
2 4 8 -1 5 1 3
1 5 5 -3 6 1 -1
3.3.1 Marginal Revenue

First, let’s focus on the first four columns, which present the relationship among price,
sales, and revenue. The second column shows that for every $1 reduction in price, the
sales increases by 1 unit. The first and second columns are essentially the demand curve.
Using this information, we can calculate the total revenue for every price, which is price
multiplied by sales as shown in the third column. For the total revenue, we can calculate
the marginal revenue, which is the extra revenue from selling one more unit, as in the
fourth column. For example, to increase sales from 2 units to 3 units, the seller must reduce
the price from $4 to $3. Hence, the seller will gain revenue of $3 × 1 = $3 on the additional
unit, but lose $(4 - 3) × 2 = $2 on the 2 units sold other than the marginal unit, that he could
have sold at $4. Thus, the revenue for the additional 1 unit is $3 - $2 = $1, which means
that the marginal revenue is $1.
Because the marginal revenue is the price of the marginal unit minus the loss of revenue on
the units sold other than the marginal unit, the marginal revenue in general is lower than
the price as shown in Figure 4.7. In the above example, MR = $1 < P = $3. It is possible that
the marginal revenue can be negative as shown in the above Table 4.1. The price elasticity
of demand determines the difference between the marginal revenue and the price. When
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the demand is very inelastic, then the seller must reduce the price substantially to increase
sales. So the marginal revenue will be much lower than the price. When the demand is
very elastic, the seller need not reduce the price very much to increase the sales. Hence,
the marginal revenue will be close to the price.
Figure 4.7 Marginal Revenue
3.3.2 Profit Maximisation

To maximise profit, we need to consider the cost in addition to the revenue. In Table 4.1,
we can see that there is a fixed cost of $1 since the total cost with Q = 0 is $1. The marginal
cost in the 6th column measures the change in total cost arising from an additional unit
production. For simplicity, the marginal cost is constant in this example.
With the information on revenue and cost, now we are ready to calculate the profit for
each price and quantity, as shown in the last column in Table 4.1. We notice that the
maximum profit is $5 with a price of $3 and sales of 3 units. The general rule to identify
the profit maximising sales and price is that a seller should produce at the quantity where
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the marginal revenue equals the marginal cost i.e. MR = MC. This rule is applicable to any
seller, not only a monopoly. This can be reasoned as follows. At output levels below MR
= MC (MR > MC), the decrease in revenue is greater than the decrease in cost compared
to the level where MR = MC. At output levels above MR = MC (MR < MC), the increase
in cost is greater than the decrease in revenue (MR < MC).
Next, we illustrate the profit maximising price and output for a monopoly in Figure
4.8. The demand curve shows the quantity that the customers will buy for each price.
Equivalently, it shows the maximum price the customers will pay for each quantity. It
hence indicates the average revenue (AR) for each quantity. As we have discussed above,
the marginal revenue is smaller than price for each quantity and hence the marginal
revenue curve is below the demand curve. The marginal cost is now upward sloping
instead of constant, indicating that the total cost increases with the scale of production. The
intersection of the marginal revenue and marginal cost curve gives the profit maximising
quantity Q*. Once the output is determined, the price is set according to the demand curve.
Quantity demanded is therefore always equal to the quantity supplied (output level). We
notice that the output level and price are determined together.
To further understand why a monopoly has maximum profit at Q* where MR = MC,

suppose that the monopoly produces Q1 < Q*, where MC < MR. Then if he increases
production to Q*, the revenue will increase by more than its cost and hence the profit will
increase by the shaded area (green). By contrast, if the monopoly produces Q2 > Q*, where
MC > MR, then if he decreases production to Q*, the revenue will fall by less than its cost
and hence the profit will increase by the shaded area (blue).
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Figure 4.8 Monopolist’s Output Decision
Recall that the demand curve indicates the marginal benefit for each quantity of purchases.
We see that in the above profit maximising production level Q*, the marginal benefit
exceeds the marginal cost to the buyers. This means that some buyers are willing to pay
more than the marginal cost for the good but he cannot get it since there is no more supply.
Therefore, this leads to economic inefficiency.
3.3.3 Demand and Cost Changes

In the following, we are going to answer the following question. How should a monopoly
respond to changes in demand and costs? In general, the price and quantity should be
adjusted to the level where the (new) marginal revenue equals the (new) marginal cost.
First, we look at changes in demand. Unlike the competitive markets, shifts in demand
no longer trace out price and quantity changes corresponding to a supply curve. This is
because there is no supply curve for monopoly and the output is instead determined by
marginal cost and the shape of the demand curve. In general, changes in demand can lead
to one of the following:
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a. Changes in price with no change in output (see Figure 4.9(a))

b. Changes in output with no change in price (see Figure 4.9(b))
c. Changes in both price and quantity (see Figure 4.9(c))
(a)
(b)
(c)
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Figure 4.9 Changes in Demand
While the first two cases are possible, changes in demand usually cause a change in both
price and quantity. Generally, when the demand changes, we need to first identify the new
marginal revenue curve and then adjust the production scale to the level where the new
marginal revenue equals the original marginal cost.
Next, we look at changes in costs. We should be careful about the type of cost that is
changing. If only fixed cost changes, then the production quantity and price will not be
affected since the profit maximising price and sales depend on the marginal revenue and
marginal cost only. Changes in fixed costs will not change the marginal cost and therefore
will not affect the price and quantity. However, if changes in fixed costs are extremely
large such that the total cost becomes larger than the total revenue, then the monopoly
will operate at a loss and should therefore shut down.
If the marginal cost changes, then the production level and price should be adjusted such
that the original marginal revenue equals the new marginal cost, as illustrated in Figure
4.10.
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Figure 4.10 Changes in Marginal Cost
3.3.4 Advertising
Unlike perfect competition, any seller with market power (including monopoly) can
influence the market demand through advertising and many other promotion activities
such as sales promotion and public relations. Advertising can increase the demand by
shifting the demand curve upwards as well as causing it to be less elastic. The marginal
revenue curve will shift upwards and the sales will increase as a result. The change in
contribution margin, which is defined as the total revenue less variable cost, is the benefit
of advertising. Then the net benefit of advertising is the change in the contribution margin
less the advertising cost.
How to maximise profit with advertising? The monopoly should advertise up to the
point where the marginal benefit of advertising equals the marginal cost of advertising.
Equivalently, it is the point where the increase in the contribution margin from an
additional dollar of advertising is exactly $1. Suppose it is larger than $1, then the
monopoly will increase profit if he spends an additional dollar on advertising. On the
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contrary, if it is smaller than $1, the monopoly can increase profit by cutting the advertising
cost.
3.3.5 Research and Development

Another way for a monopoly (or any seller with market power) to influence its demand
is to invest in research and development (R&D), which can create product differentiation
and new products. Similar to advertising, R&D shifts the demand curve upwards and
makes it less elastic. The sales and contribution margin will be increased as a consequence.
Therefore, the monopoly should invest in R&D to the point where the increase in the
contribution margin from an additional dollar of R&D expenditure is exactly $1.
3.4 Market Structure

The perfect competition and monopoly that we have learnt so far are two extreme cases of
market structure. In perfect competition, there are numerous sellers who have no market
power while in monopoly there is only one seller who has a lot of market power. These
two market structures lead to different prices and production levels as shown in Figure
4.11. Under perfect competition, the price will be determined by aggregate market supply
and aggregate market demand. Given the determined price, a perfectly competitive firm
will produce at the quantity where MC = P. On the contrast, monopoly produces where
MR = MC and then sets the price according to the demand curve. Therefore, monopoly
power results in higher prices and low quantities compared with perfect competition.
Figure 4.11 Perfect Competition and Monopoly
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Among monopolies, some have more monopoly power and some have less monopoly
power. Monopoly power could be measured by the extent to which price is greater than
MC for each firm. Lerner’s Index of monopoly power compares monopoly power among
monopolies. It is defined as L = (P - MC)/P, which is simply the incremental margin
percent. The larger the value of L (between 0 and 1) the greater the monopoly power. In
perfect competition, P = MC and hence L = 0. By contrast, in monopoly P > MC, hence L
> 0. The index is widely used to compare monopoly power among a few big firms in the
same industry.
3.5 Monopsony
Markets where buyers have market power are almost parallel to the cases where sellers
have market power. An extreme case is that there is only one buyer but many sellers, and
it is called a monopsony. Each seller is too small to affect the market and hence the supply
side is perfectly competitive. The only buyer makes decisions about the quantity to buy.
The net benefit from purchasing the product to the buyer can be measured by the benefit
generated less the expenditure. To maximise the net benefit, the monopsony buyer will
purchase the quantity at which the marginal benefit equals the marginal expenditure, as
illustrated in Figure 4.12.
Suppose that the marginal benefit decreases with the quantity of purchases. The supply
curve shows the quantity that competitive sellers are willing to provide for each
price level. In other words, it indicates the average expenditure of the monopsony
corresponding to each quantity of purchase. The marginal expenditure is similar to the
concept of marginal revenue. It measures the change in expenditure from an additional
unit of purchase. The marginal expenditure curve is upward sloping and more steep than
the upward sloping average expenditure curve.
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Figure 4.12 Monopsony Purchasing
In the following, we explain why a monopsony purchases the quantity at which the
marginal benefit equals the marginal expenditure. If a monopsony purchases a quantity
at which marginal benefit exceeds marginal expenditure (i.e. to the left of Q*), then he can
obtain a larger net benefit by purchasing more since the benefit will increase more than the
expenditure. By contrast, if he purchases more than Q* where the marginal expenditure
is larger than the marginal benefit, reducing purchases would increase his net benefit
since the benefit will drop by less than the expenditure. Therefore, the monopsony will
exactly maximise his net benefit when purchasing Q* where marginal expenditure equals
marginal benefit.
With the optimal quantity Q*, the price P* can be determined along the competitive supply
curve. We notice that the price is smaller than the marginal benefit. If there are many
buyers instead which form a competitive demand side, then the marginal benefit curve
represents the market demand. The equilibrium price and quantity will then be Pc and Qc.
The price then equals the marginal benefit. In general, a monopsony restricts his purchases
to get a lower price and enjoy a net benefit which is larger than the competitive level.
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Activity 1
The figure below reflects the cost and revenue structure for a monopoly that has
been in business for a very long time. D is the average cost curve. Use this figure
to answer the following questions.
1. Identify the curves labelled A, B and C.
2. What is the profit maximising quantity and what price will the monopolist
charge?
3. What is the area that represents total revenue at the profit maximising output
level?
4. What is the area that represents total cost at the profit maximising output level?
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5. What is the area that represents profit?
6. What is the profit on a typical unit sold (average profit) for a profit maximising
monopoly?
7. If this industry was organised as a competitive industry, what is the profit

maximising price and how many units will be produced?
Read
5th Edition.
Lesson Recording
Monopoly
1. Suppose a competitive firm and a monopolist are both charging $5 for their respective
outputs. One can infer that
a. marginal revenue is $5 for both firms.
b. marginal revenue is $5 for the competitive firm and less than $5 for the
monopolist.
c. marginal revenue is less than $5 for both firms.
d. the competitive firm is charging too much and the monopolist too little.
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2. A downward sloping demand function

a. is characteristic of both a perfectly competitive firm and a monopolistic firm.
b. is required for profit maximisation for a firm regardless of its industry type.
c. is true only of firms in a perfectly competitive industry.
d. necessarily implies that the firm's marginal revenue will be less than price.
3. Market power measures the firm's ability to

a. under cut its competitors.
b. resist union wage demands.
c. raise its price without losing all of its sales.
d. influence the price its competitors charge.
4. A firm might have a monopoly in a market because

a. its average total cost function is increasing over the entire relevant range of
output.
b. the market is geographically isolated from other sellers.
c. the firm's technology is obsolete.
d. it is not making a profit, and therefore no other firms wish to enter.
5. Both the perfectly competitive firm and the monopolist find that,
a. price and marginal revenue are the same.
b. they can sell all they want to at the market price.
c. it is best to expand production until the benefits and costs of the last unit .
d. price is less than marginal revenue.
6. When the firm lowers price from $8 to $7, marginal revenue is less than $7 because
a. marginal cost is greater than $3.
b. the consumer only pays $4 for the fourth unit.
c. the firm is charging $1 less for each of the first three units of output.
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d. demand is perfectly elastic.
7. If a firm's demand function shifts, in general,

a. its marginal revenue function and profit maximising output will also change.
b. its cost functions will also change.
c. its total cost functions will change, but its variable cost functions will be the
same.
d. the level of output that maximises profit will not change.
8. If the market price is $7 and a perfect competitor increases output from 150 units to
200 units, the firm will collect __________ additional dollars in revenue.
a. $7
b. $50
c. $350
d. $1,050
9. If a monopolist finds that its marginal revenue exceeds its marginal costs at the
current level of output, it should,
a. do nothing; it has maximised profits.
b. contract production until the difference between marginal revenues and
marginal costs is larger.
c. expand output until marginal revenue equals marginal costs.
d. expand output until price equals marginal costs.
10. If a monopolist were to discover that at its current output level, marginal revenues
are $13 and marginal costs are $20, then it
a. must be earning a loss.
b. needs to lower price.
c. needs to increase output.
d. needs to decrease output.
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Summary
In this study unit, we focus on two extreme cases of market structures, which are
perfect competition and monopoly. We start with an introduction to the competitive
markets in general in Chapter 1, followed by the more detailed discussion on the perfect
competition in Chapter 2 and last but not least a detailed investigation on the monopoly.
Understanding the key differences of the perfect competition and monopoly is very
important, especially how the equilibrium price and quantity is established. After we learn
more market structures in the future, you should be able to differentiate all these market
structures.
Perfect competition is characterized by many buyers and many sellers with no market
power. The price is determined by the market supply and demand. Each competitive firm
takes the price as given and then sets its output. An individual firm is a price taker and
hence faces a horizontal demand curve. Due to free entry and exit, competitive firms earn
zero economic profit in the long run.
Monopoly has market power and can restrain sales to raise the market price above the
competitive level, extracting higher profits. It maximizes profit by operating at a scale
where marginal revenue equals marginal cost. The extent to which a monopoly should
adjust the price and quantity in response to changes in demand or costs depends on the
shapes of both marginal cost and marginal revenue curves. Advertising and R&D are two
ways to increase demand for a monopoly. The optimal level of advertising and R&D are
determined such that the marginal benefit from them equals the marginal cost on them.
Monopsony is a single buyer with market power. He can restrain purchase to depress the
price below the competitive level and hence increase the net benefit.
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1. The demand curve faced by a firm that is a “price taker” is
a. P = A; where A is the market-determined price
Correct. Price taking means each buyer and seller take the market price as
given.
b. Q = A; where A is the market-determined quantity

Incorrect. Price taking means each buyer and seller take the market price as
given, therefore the demand curve should be P=A, where A is the market-
determined price.
c. P=Q
determined price.
d. P=0
determined price.
2. If a firm is earning zero economic profits

a. its revenues are sufficient to pay explicit costs, but not implicit costs.
Incorrect. Economic profit is the difference between the firm’s total revenue
and both explicit and implicit costs. Therefore, with zero economic profits,
total revenue should be able to cover implicit costs as well.
b. the owner will not be able to pay himself or herself a salary.
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total revenue should be able to pay himself or herself a salary.
c. it will shut down in the long run, but will continue to operate in the short run.
Incorrect. Zero economic profit means the firm is satisfied in existing business
and no new firms will enter the industry as there is no economic profit to be
made. It will not shut down in the long run.
d. the owners are earning a return on their time and investment that is equal to
the opportunity costs of that time and investment.
Correct. Economic profit is the difference between the firm’s total revenue
the owners are earning a return on their time and investment that is equal
to the opportunity costs of that time and investment.
3. If economic profits are positive, then

a. firms will be exiting the industry.
Incorrect. Because of the free entry and exit characteristic of a competitive
market, positive economic profits will attract new firms into the market.
b. accounting profits can be either negative, zero, or positive.

Incorrect. Accounting profit = Total revenue – Explicit costs. Economic profit
= Total revenue – Explicit costs – Implicit costs. If economic profits are
positive, then accounting profits must be positive.
c. the firm is receiving exactly a normal profit.

Incorrect. The difference between the accounting profit and the economic
profit is known as normal profit which is simply the opportunity cost of the
resources supplied to a business by its owner. Positive economic profit means
the firm is receiving more than a normal profit.
d. accounting profits must be positive.
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Correct. Accounting profit = Total revenue – Explicit costs. Economic profit

= Total revenue – Explicit costs – Implicit costs. If economic profits are
positive, then accounting profits must be positive.
4. In the perfectly competitive industry, economic profits

a. include only explicit costs.
and both explicit and implicit costs.
b. are always greater than accounting profits.

= Total revenue – Explicit costs – Implicit costs. Economic profit are always
smaller than accounting profits.
c. have no relationship to accounting profits.

= Total revenue – Explicit costs – Implicit costs. Economic profit are always
smaller than accounting profits.
d. serve to motivate entry or exit.

Correct. Zero economic profit means the firm is satisfied in existing
business and no new firms will enter the industry as there is no economic
profit to be made. Because of the free entry and exit characteristic of
a competitive market, short run profits will attract new firms into the
market.
5. Suppose all firms in a perfectly competitive industry are experiencing economic

profits. One can hypothesise that
a. market supply will decrease.
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market, short run profits will attract new firms into the market. Market
supply will increase.
b. market price will rise.

supply will increase and market price will fall.
c. the number of firms will rise.

Correct. Because of the free entry and exit characteristic of a competitive
market, short run profits will attract new firms into the market.
d. market demand will increase.

demand will not be affected.
1. Assume all firms in a particular perfectly competitive industry are earning economic
profits. This will cause firms to ______ the industry, which will continue until ______.
a. exit; economic losses occur
Incorrect. Positive economic profit in the market attracts new sellers into the
market. Market supply goes up and the price will be driven down until it
equals to the average cost where there is zero economic profit.
b. exit; economic profits are zero

c. enter; economic profits are zero
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Correct. Positive economic profit in the market attracts new sellers into the
d. enter; economic profits are negative

2. If a single firm, belonging to a perfectly competitive industry in long run equilibrium,

discovers a significant cost saving methodology, then?
a. all firms will enjoy economic profits for a short period of time.
b. the rest of the industry will quickly adopt the new methodology.
Correct. Perfect competition assumes perfect information. Sellers
have symmetric information about the production technology. As a
consequence, no one has secret information which could give him an
advantage in the market.
c. the firm will enjoy economic profits forever.

d. their firm will lower price to drive the rest of the industry out of business.
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3. Suppose several United States software design companies compete with each other
in a perfectly competitive environment. If one company decides to move some of its
offices to a low-wage country in order to reduce operating costs
a. the other companies will still be able to remain profitable while operating
solely in the United States.
Incorrect. Positive economic profit in the market attracts new sellers into
the market. Market supply goes up and the price will be driven down until
it equals to the average cost where there is zero economic profit. If other
companies do not move to the low wage country, they will suffer from
economic losses and exit the industry.
b. the company that moves to the lower-wage country will earn positive
economic profits in the long run because it will keep a cost advantage.
Incorrect. Perfect competition assumes perfect information. Sellers have
symmetric information about lower-wage information. As a consequence, no
one has secret information which could give him an advantage in the market.
Positive economic profit in the market attracts new sellers into the market.
Market supply goes up and the price will be driven down until it equals to
the average cost where there is zero economic profit.
c. the other companies will also move to the low wage country in order to
remain in the industry.
Correct. Perfect competition assumes perfect information. Sellers have
symmetric information about lower-wage information. As a consequence,
no one has secret information which could give him an advantage in the
market.
d. the other companies will charge higher prices than the company that moved.
Incorrect. In perfect competition, sellers are price takers and therefore cannot
charge a higher price than other firms in the industry.
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Suppose lettuce farmers in California initially have production cost per harvesting
period (including a normal profit) of $35,000. Charlie, a farmer with experience in
production management, develops a delivery system that shortens the time between
harvesting the lettuce and displaying on the shelves of a grocery store. As a result,
Charlie saves $5,000 per harvesting period.
In the short run, Charlie's reduction in cost will ______ the market price of lettuce.
a. decrease
Incorrect. In the short run, there is no entry and exit.
b. have no impact on
Correct. In the short run, there is no entry and exit.
c. increase
d. first increase then decrease

5. In the short run, Charlie's total revenue will _______ and total cost will ________.
a. increase; decrease
Incorrect. Revenue is not affected by the new delivery system, but the cost
is reduced.
b. decrease; increase
is reduced.
c. be the same as before; be the same as before

is reduced.
d. be the same as before; decrease
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Correct. Revenue is not affected by the new delivery system, but the cost
is reduced.
6. In the short run, Charlie's economic profit will be _________ per harvesting period.
a. $0
Incorrect. Short run economic profit will equal to the cost saving, which is
$5,000.
b. $5,000
Correct. Short run economic profit will equal to the cost saving, which is
$5,000.
c. $30,000
$5,000.
d. $35,000
$5,000.
7. The long run supply curve for the industry will shift _____ by ______ per harvesting
period.
a. downward; $5,000
Correct. Positive economic profit in the market attracts new sellers into
the market. Market supply shifts to downward by $5,000, which is the cost
saving.
b. upward; $40,000
saving.
c. upward; $5,000
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saving.
d. ambiguous; $0
saving.
8. In the long run, each farmer will be earning a(n) ______.

a. economic profit of $5,000
b. accounting profit of $0
c. accounting profit of $5,000

d. economic profit of $0
9. One assumption of the perfectly competitive model is that there are no barriers to
entry. This assumption most directly leads to the implication that
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a. firms will spend significant amounts of money on advertising.

Incorrect. Advertising is not useful in perfect competition since the products
are homogeneous.
b. positive economic profits will only be possible for a fairly short period of
time.
c. fixed costs will be relatively high.

Incorrect. We cannot draw any conclusion on the fixed costs for perfectly
competitive markets.
d. firms will compete on the basis of better service and amenities rather than
price.
Incorrect. Products are homogenous in perfectly competitive markets.
10. If you were to open a business in an industry that is approximately perfectly

competitive, you would expect that
a. you would earn little to no profit in the short run, but higher profits
eventually.
b. your competition would respond to your entry into the industry by

aggressively advertising.
Incorrect. Advertising is not useful in perfect competition since the products
are homogeneous. There is free entry in perfect competition.
c. you would earn zero economic profits in the short run, and zero accounting
profits in the long run.
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equals to the average cost where there is zero economic profit. In the long
run, you would earn zero economic profits.
d. in the long run you would earn zero economic profits and positive
accounting profits.
equals to the average cost where there is zero economic profit. In the long
run, you would earn zero economic profits and positive accounting profits
1. Identify the curves labelled A, B and C.
A = Demand curve; B = Marginal Revenue curve; C = Marginal Cost curve.
2. What is the profit maximising quantity and what price will the monopolist charge?
Quantity = Q2 units; Price = P3
3. What is the area that represents total revenue at the profit maximising output level?
the rectangle P3 × Q2
4. What is the area that represents total cost at the profit maximising output level?
the rectangle P0 × Q2
5. What is the area that represents profit?

the rectangle (P3 - P0 )× Q2
6. What is the profit on a typical unit sold (average profit) for a profit maximising
monopoly?
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average profit = P3 - P0
7. If this industry was organised as a competitive industry, what is the profit maximising
price and how many units will be produced?
Quantity = Q4 and Price = P2
1. Suppose a competitive firm and a monopolist are both charging $5 for their respective
outputs. One can infer that
a. marginal revenue is $5 for both firms.
Incorrect. For a competitive firm, it faces a horizontal demand curve.
Therefore, the marginal revenue equals price. For a monopolist, the demand
curve is downward sloping and marginal revenue curve lies below the
demand curve. Therefore, marginal revenue is smaller than price.
b. marginal revenue is $5 for the competitive firm and less than $5 for the
monopolist.
Correct. For a competitive firm, it faces a horizontal demand curve.
Therefore, the marginal revenue equals price. For a monopolist, the
demand curve is downward sloping and marginal revenue curve lies
below the demand curve. Therefore, marginal revenue is smaller than
price.
c. marginal revenue is less than $5 for both firms.

Incorrect. For a competitive firm, it faces a horizontal demand curve.
Therefore, the marginal revenue equals price. For a monopolist, the demand
curve is downward sloping and marginal revenue curve lies below the
demand curve. Therefore, marginal revenue is smaller than price.
d. the competitive firm is charging too much and the monopolist too little.
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Incorrect. We cannot draw conclusion on this for the given context.
2. A downward sloping demand function

a. is characteristic of both a perfectly competitive firm and a monopolistic firm.
Incorrect. A perfectly competitive firm faces a horizontal demand curve.
b. is required for profit maximisation for a firm regardless of its industry type.
c. is true only of firms in a perfectly competitive industry.

Incorrect. Any perfectly elastic demand has a horizontal demand curve.
d. necessarily implies that the firm's marginal revenue will be less than price.
Correct. Because the marginal revenue is the price of the marginal unit
minus the loss of revenue on the units solder other than the marginal unit,
the marginal revenue in general is lower than the price.
3. Market power measures the firm's ability to

a. under cut its competitors.
Incorrect. The ability of a buyer or seller to influence the market supply or
demand is called market power.
b. resist union wage demands.

c. raise its price without losing all of its sales.

Correct. The ability of a buyer or seller to influence the market supply or
d. influence the price its competitors charge.
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4. A firm might have a monopoly in a market because

a. its average total cost function is increasing over the entire relevant range of
output.
Incorrect. Economies of scale, scope and experience provide an incumbent
seller a cost advantage in producing the goods over the potential competitors.
Hence, this advantage deters new entry and creates market power.
b. the market is geographically isolated from other sellers.

Correct. This makes the firm the only seller in the region.
c. the firm's technology is obsolete.

Incorrect. When a firm’s technology is new, it may have market power.
d. it is not making a profit, and therefore no other firms wish to enter.

Incorrect. Firms with market power can make excess profit.
5. Both the perfectly competitive firm and the monopolist find that,
a. price and marginal revenue are the same.
Incorrect. This is true for perfectly competitive firm only since it faces a
horizontal demand curve.
b. they can sell all they want to at the market price.

Incorrect. This is true for perfectly competitive firm only since it faces a
horizontal demand curve.
c. it is best to expand production until the benefits and costs of the last unit .
Correct. This is the profit maximization condition for any firm.
d. price is less than marginal revenue.
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Incorrect. For perfectly competitive, price is equal to marginal revenue. For

a monopolist, price is larger than marginal revenue.
6. When the firm lowers price from $8 to $7, marginal revenue is less than $7 because
a. marginal cost is greater than $3.
Incorrect. Because the marginal revenue is the price of the marginal unit
b. the consumer only pays $4 for the fourth unit.

c. the firm is charging $1 less for each of the first three units of output.
Correct. Because the marginal revenue is the price of the marginal unit
d. demand is perfectly elastic.

7. If a firm's demand function shifts, in general,

a. its marginal revenue function and profit maximising output will also change.
Correct. Generally, when the demand changes, we need to first identity the
new marginal revenue curve and then adjust the production scale to the
level where the new marginal revenue equals to the original marginal cost.
b. its cost functions will also change.

Incorrect. The cost function is not affected by the demand in general.
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c. its total cost functions will change, but its variable cost functions will be the
same.
Incorrect. The cost function is not affected by the demand in general.
d. the level of output that maximises profit will not change.

Incorrect. Generally, when the demand changes, we need to first identity the
new marginal revenue curve and then adjust the production scale to the level
where the new marginal revenue equals to the original marginal cost.
8. If the market price is $7 and a perfect competitor increases output from 150 units to
200 units, the firm will collect __________ additional dollars in revenue.
a. $7
Therefore, the additional revenue is $7 * (200-150) = $350.
b. $50
c. $350
Correct. A perfectly competitive firm faces a horizontal demand curve.
d. $1,050
9. If a monopolist finds that its marginal revenue exceeds its marginal costs at the
current level of output, it should,
a. do nothing; it has maximised profits.
Incorrect. It should expand output until MC=MR.
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b. contract production until the difference between marginal revenues and

marginal costs is larger.
c. expand output until marginal revenue equals marginal costs.

Correct. Suppose that the monopoly produces at the quantity where MC
< MR. Then if he increases production, the revenue will increase by more
than its cost and hence the profit will increase.
d. expand output until price equals marginal costs.

10. If a monopolist were to discover that at its current output level, marginal revenues
are $13 and marginal costs are $20, then it
a. must be earning a loss.
Incorrect. We cannot tell whether the firm is earning a loss since there is not
enough information.
b. needs to lower price.

Incorrect. Since MC>MR, if he decreases production, the revenue will fall
by less than its cost and hence the profit will increase. As a result, the
equilibrium price will increase.
c. needs to increase output.

Incorrect. Since MC>MR, if he decreases production, the revenue will fall by
less than its cost and hence the profit will increase.
d. needs to decrease output.

Correct. Since MC>MR, if he decreases production, the revenue will fall
by less than its cost and hence the profit will increase.
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References
Higher Education.
Education.
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5
Study
Unit
Strategic Thinking and Oligopoly

ECO201 Strategic Thinking and Oligopoly
Learning Outcomes
This study unit looks at markets where there is interdependency among the firms/
sellers. Such imperfectly competitive markets are in between the perfect competition and
monopoly and are called oligopoly. We begin with discussions on strategy thinking and
basic game theory in Chapter 1, which involve decision making in situations where the
payoff to actions depends not only on the person or firm undertaking the action, but
also on how it relates to the actions taken by others. In Chapter 2, we discuss how firms
in oligopoly market structure must weigh the likely responses of rivals when making
business decisions.
1. Nash equilibrium in pure strategies vs. Mixed strategies

2. Dominant strategies vs. Dominated strategies
3. Zero-sum game vs. Positive-sum game
1. Oligopoly
2. Residual demand
3. Best response function/curve
4. Bertrand model vs. Cournot model vs Stackelberg model
5. Strategic complements vs. Strategic substitutes
1. Describe the basic elements of a game and solve an equilibrium for a game
2. Identify and explain the Prisoners’ Dilemma and how it applies to real-world
situations
3. Appraise one-stage and multiple-stage games
4. Demonstrate how games in which timing matters differ from games in which it
does not
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5. Compare the price competition on homogenous and heterogeneous goods

6. Differentiate the price competition oligopoly and the quantity competition
oligopoly, and discuss how to set the profit maximising price and quantity
7. Appraise that prices can be strategic complements while quantities can be
strategic substitutes
8. Appraise how capacity leadership creates first-mover advantage
9. Discuss how to limit competition
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Chapter 1: Strategic Thinking and Game Theory
1.1 Introduction
In real life, we often encounter situations in which two or more parties make decisions
and all have an interest in the decisions of the others. Such situations involving strategic
thinking are called strategic situations or games. The parties involved are called players
in the game. A strategy is a set of responses for each player to each possible set of
responses of all other players. The ideas and principles of game theory provide an effective
guide to strategic decision-making in many businesses. Corporate financiers apply game
theory in takeover contests. Telecommunications and media providers apply it in bidding
for licences. Game theory is also very useful to sellers with market power in choosing
competitive strategy.
In this chapter, we consider how to organise thinking about strategic decisions, choose
among alternative strategies, and make better strategic decisions. In particular, we look
at two models of games. The first one models situations where players make decisions
simultaneously and is called strategic form game. This model applies to the price
competition in markets with few sellers (i.e. oligopoly, to be discussed in next chapter).
The second one models sequential decision-makings and is called extensive form game.
This applies to strategic moves planning, including commitments and threats.
1.2 Nash Equilibrium

We look at a single-period quantity setting game of two firms. The two firms Alpha and
Beta are the only producers of some good and they simultaneously decide the output level.
Each of them has two strategies: high output q = 6 and low output q = 4. Each firm’s profit
depends on its own output level as well as the output level of the opponent. Their profits
are shown in Figure 5-1.
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Figure 5.1 A Single-Period Quantity Setting Game
We can interpret Figure 5.1 as follows. The rows display the alternative strategies for
Alpha and the columns display the alternative strategies for Beta. Each firm has two
strategies and hence there are four possible outcomes. The four cells represent one of the
four possible outcomes. In each cell, the first entry represents the profit for Alpha and the
second entry represents the profit for Beta. For example, when Alpha chooses q = 4 and
Beta chooses q = 6, the outcome is the lower left cell, where Alpha’s profit is $38 and Beta’s
profit is $51. Other cells can be interpreted in a similar way.
A one-stage game can be described by identifying the players, their entire set of possible
strategies, and the payoffs (profits) for each possible set of strategies by all players. A
payoff table or payoff matrix similar to that of Figure 5.1 typically can identify all the
essential elements of a single-stage game. Such figures depict a game in strategic form and
are used to model games where two players make decisions simultaneously. In general,
we use rows to describe the strategies of one player, the columns to describe the strategies
of the other player and the corresponding cells to indicate the outcomes/consequences of
the game.
Given the game in strategic form, next we ask the following question: what is Alpha’s
best response? We need to consider the possible choices of Beta in order to determine
Alpha’s best response. If Beta chooses high-output strategy, Alpha should choose high-
output since $41 > $38. If Beta chooses low-output, Alpha should choose high-output
again since $51 > $46. Thus Alpha always chooses high-output regardless of the choice of
Beta. We say that high output is Alpha’s dominant strategy and the strategy of low output
is dominated by the strategy of high output. In general, a dominant strategy is one that is
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the best response to all possible actions of the other player. On the contrary, a strategy is
dominated if another strategy leads to a preferred outcome in all circumstances.
Beta’s problem is exactly the same and it also has a dominant strategy (high-output).
Therefore, (high-output, high-output) is called a Nash equilibrium. A set of strategies
among players constitutes a Nash equilibrium in a single-stage game if, when the other
players’ strategies are revealed, no player would then choose a different strategy. In a Nash
Equilibrium, no player wants to change its strategy because each player is using its best
response − the strategy that maximises its profit/payoff, given its beliefs about its rivals’
strategies. Nash equilibria are self-enforcing, since a prior agreement among players to
choose their Nash-equilibrium strategy would not be violated by any player.
Notice that in the above example if they had both chosen the low-output strategy,
they could have made more profits ($46 each). They do not maximise profits. This is
a prisoners’ dilemma game − playing dominant strategies gives an inferior outcome to
playing dominated strategies. If all players’ dominant strategies lead them to a result that
is jointly worse for them than some other set of strategies, a Prisoners’ Dilemma exists.
Prisoners’ Dilemma happens because of lack of trust/binding agreement.
1.2.1 Solving Equilibrium

We next discuss how to solve a Nash equilibrium for a game in strategic form. The first
step is to eliminate dominated strategies since there is another strategy leading to better
outcome in all situations. Next we check all the remaining strategies, one at a time. In
the above quantity setting game, after ruling out the dominated strategies (low output
for Alpha and low output for Beta), there is only one strategy left and this is the Nash
equilibrium. We look at a more complicated example, which is the Battle of Sexes game.
Ross and Rachel are deciding whether to go to a football game or a ballet performance on
Saturday evening. Their payoff matrix is represented in Figure 5.2.
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Figure 5.2 A Battle of Sexes Game
There is no dominated strategy for either Ross or Rachel. So we need to analyse all the
strategies in this case. Without loss of generality, we can start from Rachel. If Ross chooses
football, then Rachel would choose football (since 1 > 0). If Ross chooses ballet, then
Rachel would choose ballet (since 2 > 0). Next we look at Ross, if Rachel chooses football,
then Ross would choose football (since 2 > 0). If Rachel chooses ballet, then Ross would
choose ballet (since 1 > 0). Therefore, both (football, football) and (ballet, ballet) are Nash
equilibria since given that the other player chooses football (ballet), the player prefers to
choose football (ballet). The Battle of the Sexes shows that a Nash equilibrium can occur
even in the absence of dominant or dominated strategies.
To see why (ballet, football) and (football, ballet) are not Nash equilibria, we show that
one player will find it better to deviate from the current strategy. If Ross chooses ballet and
Rachel chooses football, then Ross can benefit by changing to football (assuming Rachel
remains to choose football); Rachel can benefit by deviating to ballet (assuming Ross
remains to choose ballet). Therefore, (ballet, football) is not a Nash equilibrium. Similarly,
we can check that (football, ballet) is not a Nash equilibrium. In general, if some player
does not follow its Nash equilibrium strategy, then the other player may find it better to
deviate from their respective Nash equilibrium strategies.
We can see that it is reasonable to expect people who have full knowledge of the possible
strategies and payoffs to end up in a Nash equilibrium if one exists. The reasons for this
expectation have to do with rational people being able to make accurate guesses about
each other’s choices.
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1.3 Randomised Strategies

So far, we have looked at games in which players choose one strategy or another. We
call them pure strategies in that case, because they are not mixed up, where the player
sometimes chooses one and sometimes chooses another. In this Battle of Sexes game, there
are two Nash equilibria in pure strategies. Some games do not have a Nash equilibrium in
pure strategies. These games will have an equilibrium in randomised/mixed strategies,
where each player chooses a probability of choosing each respective strategy such that
the expected payoff to the other player is independent of her strategy choice. The set of
all players’ probabilities so calculated constitutes a Nash equilibrium in mixed strategies.
Randomisation is very useful in the context of competition since it makes the actions and
outcomes unpredictable.
In the Matching Pennies game illustrated in Figure 5.3, there is no Nash equilibrium in
pure strategies. If Tom chooses heads, then Jerry would choose heads. If Jerry chooses
heads, then Tom would choose tails. If Tom chooses tails, then Jerry would choose tails. If
Jerry chooses tails, then Tom would choose heads. This goes into a cycle, and hence one
player will always deviate in any of the four possible outcomes. It seems that in this game,
each player should make sure that the other player doesn’t know his move. How could
one player be sure that the other doesn’t know his next move? One way would be for the
player himself not to know for sure, and that could be accomplished by randomising his
actions.
Mixed strategy reveals uncertainty about rival player’s strategic choice. Player 1’s mixed
strategy represents player 2’s uncertainty about what player 1 would do. Given the
uncertainty concerned, player likes to be indifferent between her strategic choices. In the
Matching Pennies game, suppose Tom adopts the following randomised strategy: choose
heads with probability ½ and choose tails with probability ½. Given this randomised
strategy of Tom, how should Jerry act? We can calculate the expected payoff for Jerry from
choosing heads. Jerry’s payoff would be 1 if Tom chooses heads, and -1 if Tom chooses
tails. Hence, Jerry’s expected payoff from choosing heads is (1 × 1/2) + (-1 × 1/2) = 0.
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Similarly, we can calculate that Jerry’s expected payoff from choosing tails would be (-1 ×
1/2) + (1 × 1/2) = 0. Jerry gets the same expected payoff from his two pure strategies and
hence he is indifferent between the two. Accordingly, he would be willing to randomise
between them.
Figure 5.3 Matching Pennies
Next, suppose Jerry chooses heads with probability ½. How will Tom act? If Tom chooses
heads, his expected profit would be (-1 × 1/2) + (1 × 1/2) = 0. Similarly, if Tom chooses tails,
his expected profit would be (1 × 1/2) + (-1 × 1/2) = 0. Therefore, given Jerry’s strategy,
Tom is indifferent between choosing heads or tails.
A Nash equilibrium in mixed/randomised strategies is similar to a Nash equilibrium in

pure strategies: given that the other player chooses his Nash equilibrium strategies, the
player’s best response is his own Nash equilibrium strategy. In the Matching Pennies
game, the following randomised strategies constitute a Nash equilibrium: Tom chooses
heads with probability ½ and Jerry chooses heads with probability ½. While a Nash
equilibrium in pure strategies does not always exist, there is always a Nash equilibrium
in mixed strategies (consider the pure strategy as a special case of mixed strategy).
1.4 Competition or Coordination

We can classify strategic situations by the outcomes as either zero-sum games or positive-
sum games. The key criterion to distinguish these two types of games is based on whether
one player can be better off without another being made worse off. If yes, then it is a
positive-sum game. Otherwise, it is a zero-sum game. We can identify the zero-sum game
and positive-sum game by the summations of the outcome for the players in every cell
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of the game in strategic form. If the sum is a constant number (whether positive, zero or
negative), then one player can become better off only if the other is made worse off and
hence it is a zero-sum game. Note the zero-sum game does not mean that the sum is zero. If
the sum is not a constant, then one player may be better off without hurting another player
and hence it is a positive-sum game. Zero-sum games are extreme cases of competition
while positive-sum games allow for at least some coordination.
For the examples discussed so far, the Matching Pennies game is a zero-sum game and
one player can be better off only if the other is worse off. The Battle of Sexes game and
the quantity setting game are positive-sum games. Both Alpha and Beta could agree that
both choose low output is better than both choose high output (the Nash equilibrium).
However, the challenge for them is to enforce the agreement. If they act independently,
each firm would choose high output. In Battle of Sexes game, the better outcome is
that both choose the same thing (either football or ballet). The problem is that if both
choose football, Ross would benefit more than Rachel; and if both choose ballet, Rachel
would benefit more than Ross. Therefore, this situation involves both competition and
coordination.
1.5 Extensive Form Games: Sequencing

What we have discussed so far are strategic games where players move simultaneously.
Now we turn to extensive form games (also called multi-stage games), ones in which the
players make their strategic choices sequentially: first one player moves, then the other,
and then possibly more rounds follow in turn. In games with perfect information, a player
knows all the previous moves of the other player, as in tic-tac-toe. Multi-stage games of
perfect information can be described with the use of a tree diagram which shows both
players, their sequence of play, their respective possible choices, and the ultimate payoffs
for each player for each possible sequence of all the players’ moves.
We look at an example of the Product Choice game illustrated with a game tree in Figure
5.4. Two breakfast cereal makers, Alpha and Beta, face a market with two new varieties
of cereal (“crispy” and “sweet”). There is a market for a new “crispy” cereal and a new
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“sweet” cereal but each firm has the resources to introduce only one new product. In the
game tree, a node represents a point where a firm must choose a move, while the branches
leading from a node represent the possible choices at the node. Suppose Alpha moves first.
At the first node A, Alpha must choose between crispy (the upper branch) and sweet (the
lower branch). After Alpha had made the choice, Beta makes the next move. Beta’s node
depends on Alpha’s choice. If Alpha has chosen crispy, then Beta will be at node B and
must decide between two branches crispy and sweet. If Alpha has chosen sweet, then Beta
will be at node C and must decide between crispy and sweet. The profits (payoffs) for the
two firms are indicated at the end of each branch, respectively. The first number indicates
the profit for the first mover, Alpha, and the second number is the profit for Beta.
Figure 5.4 Product Choice Game in Extensive Form
Given the game in extensive form, what are the best strategies for the two firms? We
use backward induction to solve such games, starting from the final node and reasoning
backwards towards the initial node. There are two final nodes: B and C. At node B, Beta
can choose crispy, which yields -5, or sweet which yields 20. Clearly, at node B, Beta would
choose sweet and we can cross out crispy. Now consider node C. If Beta chooses crispy,
he gets 10. If Beta chooses sweet, he gets -5. So it will choose crispy at node C and cancel
the sweet branch. Having determined how Beta will act at each of its two possible nodes,
B and C, we next work back to consider the initial node A. At node A, if Alpha chooses
crispy, it can foresee that Beta will choose sweet, so Alpha will get 10. On the other hand,
if Alpha chooses sweet, it can foresee that Beta will choose crispy, so Alpha will get 20.
Therefore, Alpha will choose sweet first and then Beta should choose crispy.
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In general, in a game with perfect information, the first player should reason backwards.
In multi-stage games, a Nash equilibrium is a pair of strategies such that, knowing the
other person’s strategy, each player would not choose a different strategy. In other words,
it is the sequence of best responses, with each response decided at the corresponding node.
In the above example, (sweet, crispy) is a Nash equilibrium.
In the product choice game, the first mover Alpha has a larger profit. This is called a first
mover advantage since a player gains advantage by moving before others. First mover
advantage does not always exist in strategic situations. Sometimes, first mover may even
have a disadvantage since it needs to advertise and promote a lot to get the new products
known and accepted by the consumers.
In some cases, there is no perfect information. We still analyse the game in extensive form
with backward induction using all available information. For example, if the first mover
only knows the probabilities with which the other player will choose between alternative
strategies, he will use this information to calculate his expected profit under alternative
strategies and choose the one which maximises his expected profit.
1.6 Strategic Move

A very important ingredient in a strategic situation is reputation, which is the picture of
an individual held in other people’s minds, usually painted by observing the actual past
actions of that individual. Often, we use a person’s reputation to predict his actions in
the future, based on our observations of his past behaviour in similar circumstances. We
always need to be mindful that when others intentionally reveal something of themselves,
they might be “gaming” us in an attempt to influence our actions towards them.
The actions that one player takes to influence other players’ beliefs or actions in a way
which benefits himself is called a strategic move. A strategic move should be credible to
the other players in order to be effective. Conditional strategic moves are actions taken
under specific conditions to influence the beliefs or actions of other players in a favourable
way. Conditional strategic moves usually come in as promises or threats. Bank deposit
insurance is an example of promise, where the government pays in the case that the
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bank cannot repay. This promise can effectively prevent bank runs when the banks are in
difficulties.
The preventing entry game is a typical example of threat. In the first stage, the incumbent
firm (gas station) decides whether to pay ($b) the landlord of the rest area for the exclusive
rights to be the only gas station there. This is a threat to deter entry. If it pays, no entry,
incumbent makes (monopoly profits – b), entrant makes 0. If it does not pay, entry occurs,
both firms share the market and each firm makes profits ($Πd). For the incumbent, it pays
to deter entry only if (monopoly profits - b) is more than Πd. Otherwise, the threat to deter
entry is not credible and will not work out.
1.7 Repetition
We have so far considered games which take place only once. Many games in life (like two
airlines setting the fares on a competitive route each week) are played again and again, so
we need to examine repeated games. In repeated games, the same players face the same
set of strategies and payoffs over and over again in succession.
In repeated games with a Prisoners’ Dilemma, a cooperative strategy might result if each
player vows to match the previous move of the other player. Cooperation may allow the
players to circumvent the bad result of a single-stage Prisoners’ Dilemma. If both players
begin cooperating, this strategy perpetuates that result and maximises their joint reward.
But it is still true that any player who unilaterally violates the agreement on a given move
will gain an advantage over a cooperative move.
Activity 1
You are deciding whether to open your own fruit stand in your hometown this
summer or just hang around your parents’ house. The returns to your decision
depend on whether someone else also opens a fruit stand. The payoff matrix for
your decision shows your summer earnings and is given below.
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You
Produce Don't Produce
Someone else Produce -100, -100 1000, 0
Don't Produce 0, 1000 0, 0
1. Identify two possible equilibrium outcomes in this game.
2. Suppose your parents decide to subsidise you with a $200 payment if you open
your fruit stand. Revise the payoff matrix to account for the subsidy.
3. What is the new equilibrium with the subsidy?
Read
5th Edition.
Lesson Recording
Strategic Thinking and Game Theory
1. Which of the following statement is true? (Assume there are two players in each
game.)
a. in a one-stage game each participant makes his choice without knowing the
choice of the other participant
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b. in a multi-stage game, no participant has information about the other player’s

choice before he makes his choice.
c. in a multi-stage game, each participant have information about the other
player’s choice before he finalizes his choice.
d. in a one-stage game, only one participant is permitted to make a choice.
2. A strategy is dominant if
a. it is that player’s best response, regardless of the other players’ choices.
b. it will permit that player to dominate the game and knock the other player
completely out of the game.
c. it maximizes the expected value of that player’s payoff.
d. it permits the player to dominate the game by exaggerating his power (within
the game) through bluffing.
3. Which of the following is a prisoner’s dilemma? Bonnie and Clyde simultaneously

make decisions on whether to confess about a crime. (The numbers in each cell
represent years of prison time. The first number in each cell represents Clyde’s
sentence; the second number represents Bonnie’s sentence.) Note that small numbers are
preferred over large numbers. Hint: begin by checking each game to determine whether
Bonnie has a dominant strategy. Then check whether Clyde has a dominant strategy.
Check the intersection of the two dominant strategies. Is there a different cell (no pun
intended) that is preferred by both Bonnie AND Clyde?
a. Bonnie
confess Remain silent
Clyde confess 30,30 2,40
Remain silent 4,2 7,5
b. Bonnie
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c. Bonnie
d. Bonnie
4. In a two-player single-stage game, which of the following statements provide correct

information about a Nash Equilibrium?
a. Player A’s decision is the best possible decision given Player B’s choice and
Player B’s decision is the best possible decision given Player A’s choice.
b. The solution to a prisoner’s dilemma is a Nash Equilibrium
c. A Nash equilibrium is stable and self-enforcing because each player believes
he made an optimal choice when he sees his opponent’s choice.
d. All of the above
5. In Rock-Paper-Scissors game, what strategy dominates the strategy of always

choosing “rock”?
a. mixed strategy
b. pure strategy
c. always choose “paper”
d. none of the above
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Chapter 2: Oligopoly
2.1 Introduction
This chapter focusses on strategic interaction among oligopolists. An oligopoly contains a
small number of sellers whose actions are interdependent. It is a market structure which
lies between the two extremes of perfect competition and monopoly. Some examples
of oligopoly markets are automobiles, steel, aluminium, petrochemicals and electrical
equipment. Oligopoly usually presents management challenges. It can involve strategic
actions to deter entry, such as threaten to decrease price against new competitors by
keeping excess capacity. It also involves rival behaviour, because there are only a few firms
and hence each firm must consider how its actions will affect its rivals and in turn how its
rivals will react. Game theory is apt at describing much of oligopoly because it lays out
the strategies and payoffs.
We first study the pricing competition of oligopolists (short run analysis), and then the
quantity/capacity competition (long run analysis). Finally, we look at the ways to restrain
competition in an oligopoly and the benefits of such restraints.
2.2 Price Competition

Price competition in oligopoly depends on whether the product is homogeneous or
differentiated. For simplicity, we will focus on duopoly, in which only two firms compete.
2.2.1 Homogeneous Product

Assume here that the firms compete with price, not quantity. Firms produce homogeneous
(identical products) goods and consumers will buy from lowest priced seller. If firms
charge different prices, consumers buy from lowest priced firm only. If firms charge same
price, consumers are indifferent whom they buy from. How should the firms set the price
strategically? Such price-setting competition models for homogeneous products are called
Bertrand Competition. Bertrand equilibrium is a Nash Equilibrium in prices.
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We illustrate the price setting strategies for Bertrand competition with best response
curves in Figure 5.5. Best responses curves depict a seller’s best action as a function
of competing sellers’ actions. Suppose two firms simultaneously set prices on identical
goods. With identical products and constant marginal and average costs of $5, Firm 1’s
best-response curve starts at $5 and then lies slightly above the 45° line. That is, Firm 1
undercuts its rival’s price as long as its price remains above $5. For example, if Firm 2’s
price is $10, then Firm 1 can attract all the buyers by cutting the price to $9.99. Similarly,
Firm 2’s best-response curve starts at $5 and then lies slightly below the 45° line. The
best-response curves intersect at e, the Bertrand or Nash equilibrium, where both firms
charge $5. At the equilibrium, price equals marginal cost, which is the same as the perfect
competition equilibrium.
In general, as long as price is above marginal cost, each firm would be better off slightly
undercutting the other’s price. If price were equal to marginal cost, the best response is to
match that price. Nash equilibrium in homogeneous Bertrand duopoly is identical to the
competitive equilibrium, because firms have incentives to cut prices until the price is equal
to marginal cost and they earn zero profit. We note that although we discuss the case with
two firms, Bertrand price does not depend on number of firms in general. Although the
idea of price-setting is appealing, only a few firms can still bid the price down to marginal
cost like competitive firms.
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Figure 5.5 Price Competition with Identical Products
2.2.2 Differentiated Product

With differentiated products, if one seller undercuts the competitor’s price, it would take
away only part of the competitor’s demand. We look at an example of Coke and Pepsi,
which are differentiated products. If Pepsi were to cut price a little, some loyal Coke
consumers will not switch to Pepsi. So in such cases, there is no need to match rival’s price
cut exactly.
Price-setting duopolists with differentiated products face residual demand functions that
depend on own price and the difference between rival’s price and own price. Residual
demand is the market demand less the quantities supplied by other sellers, which is the
part of market demand that is not being met by the competitors. Each firm can solve for
its best response function by maximising the profit. Best-response curves slope upwards,
showing that a firm charges a higher price the higher the rival’s price is. Nash equilibrium
is intersection of rivals’ best response functions.
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Figure 5.6 Price Competition with Differentiated

Products
Figure 5.6 illustrates the price-setting equilibrium of Coke and Pepsi. If both firms have
a constant marginal cost of $5, the best-response curves of Coke and Pepsi intersect at e1,
where each sets a price of $13 per unit. If Coke’s marginal cost rises to $14.50, its best-
response function shifts upwards. In the new equilibrium, e2, Coke charges a higher price,
$18, than Pepsi, $14. Note that the price of Pepsi also increases even though its marginal
cost does not change. This is because of the strategic interactions in oligopoly. In general,
in price competition with differentiated products, if a seller incurs higher marginal cost,
the competitors absorb part of the impact by raising their prices. The seller with higher
cost loses customers and profit, but the loss is reduced to the extent that its competitors
respond with higher prices.
The competing products can differentiate in many aspects, such as location, taste and
design. In general, the greater is the degree of differentiation, the less price elastic will
be each seller’s residual demand, and therefore the higher are Nash equilibrium prices.
Therefore, sellers can mitigate competition by differentiating their products.
Referring to the best response curves of Coke and Pepsi, if Coke were to raise price, then
Pepsi should raise its price as well. On the other hand, if Coke were to cut its price, then
Pepsi should also cut its price. Intuitively, if Coke raises its price, the marginal consumer
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who used to be almost indifferent between Coke and Pepsi would now prefer Pepsi.
Hence, Pepsi’s demand would become relatively inelastic, and so Pepsi would raise price.
Here we call the prices strategic complements since an adjustment by one firm leads the
other firm to adjust in the same direction. In the Bertrand models of price competition,
prices are also strategic complements.
In the two models of price competition discussed so far, we have assumed the competitors
set prices simultaneously. If one seller acts before others, this might create first mover
advantage as we have previously analysed in games of extensive form. In price
competition games, the leader can sometimes set sufficiently low price that it takes away
so much demand that a potential competitor cannot break even. Thus no other producer
would enter the market. This strategy is called limit pricing and is mostly applicable to
production involving a substantial fixed cost. The leader’s price should be credible in
order for the limit pricing strategy to make sense.
2.3 Quantity Competition

While the short run competition is price for oligopolists, the long run competition lies
in production quantity/capacity. Oligopoly models in which firms produce identical
products and face a residual demand function that depends on the quantities set by rivals
firms are called Cournot models. In the Cournot model of oligopoly, each firm treats the
output of competitors as fixed, and all firms decide simultaneously how much to produce.
Firm will adjust its output based on what it thinks the other firm will produce.
We look at an example of two airline companies, United Airlines and American Airlines,
competing on the quantity (in terms of the number of passengers to serve). Each airline
must take into account the other airline’s behaviour when choosing its profit-maximising
quantity. Let’s first look at how American Airlines decides on its profit-maximising
quantity, as shown in Figure 5.7. If American Airlines is a monopoly (left side of Figure
5.7), it picks its profit-maximising output, qA =96 units (thousand passengers) per quarter,
so that its marginal revenue, MR, equals its marginal cost, MC. In the case of a duopoly
(right side of Figure 5.7), American Airlines will use its residual demand curve (the part of
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market demand that is not being met by United Airlines) to decide the profit-maximising
output. If American Airlines believes that United Airlines will fly qU = 64 units per quarter,
its residual demand curve, Dr , is the market demand curve, D, minus qU . American
maximises its profit at qA = 64, where its marginal revenue, MRr , equals MC.
Figure 5.7 Profit-Maximising Output: Monopoly vs

Duopoly
(Source: Perloff (2016))
Figure 5.8 Best Response Quantities Curves
To find the Cournot equilibrium (Nash equilibrium) quantity of American Airlines and
United Airlines, we need to find the best response/reaction curves, which are depicted
in Figure 5.8. The best-response curves show the output each firm picks to maximise
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its profit, given its belief about its rival’s output. A firm’s profit-maximising output is a
decreasing schedule of the expected output of its competitors. Therefore, the best response
curves are downward sloping. The Cournot equilibrium occurs at the intersection of the
best-response curves, where each firm will set a quantity of 64.
Next, we demonstrate how to solve for the Cournot equilibrium above using some simple
algebraic equations. Suppose that we are given that the total market demand as Q =
339 - p and the constant marginal cost which equals the average cost is 147. Given this
information, we are ready to calculate American Airlines’ residual demand as:
qA = Q(p) – qU = (339 - p) - qU
We can then rearrange the above equation to get the inverse demand:
p = 339 - qA - qU
American Airlines’ total revenue is:
πA = p × qA = (339 - qA - qU ) qA
So the marginal revenue for American Airlines is (taking first-order derivative of πA with
respect to qA):
MRA = 339 - 2qA - qU
To maximise profit, American Airlines will set marginal revenue to be equal to marginal
cost, such that:
339 - 2qA - q U = 147
Therefore, American Airlines’ best response curve is:
Similarly, we can derive the best response curve for United Airlines as:
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Solve for intersection point of the best response curves will give: qA=qU= 64 , Q=128 and
p=$211. The algebraic solutions are consistent with the graphic solutions.
In general, in Cournot models, firms set quantities simultaneously to maximise profit.

Each firm’s best response function gives its profit-maximising quantity, given the quantity
of its rivals. Equilibrium occurs at the simultaneous solution of the firms’ best response
functions. Cournot equilibrium is a Nash equilibrium. Because it is a set of quantities
sold by firms such that, holding the quantity of the other firm constant, no firm
can obtain a higher profit by choosing a different quantity. Nash equilibrium in the
homogeneous Cournot case results in price above competitive equilibrium and below
collusive monopoly level. Equilibrium quantity is below the competitive level and above
monopoly level. Firms enjoy positive profits which are in total less than joint monopoly
profit. As the number of firms increases, Cournot Nash equilibrium quantity approaches
competitive quantity, and price approaches efficient competitive level. When there are
N identical firms, Cournot oligopoly quantity equals to N/(N+1) fraction of competitive
equilibrium quantity.
The next natural question is: how will Cournot oligopolists respond to changes in demand
and cost? When there is an increase in market demand, the residual demand would shift
to the right and so the residual marginal revenue would shift to the right. The profit-
maximising quantity would be larger and hence the best response curve would be higher.
Thus, in the new equilibrium each firm would choose a larger quantity.
How about changes in cost? In the American-United game, suppose that United Airlines
gets a $48-per-passenger subsidy, reducing its marginal cost to $99. American Airlines’
marginal cost remains $147 as before. The two airlines play Cournot game. United
Airline’s marginal revenue is not affected but because its marginal cost is lower, it
produces more output for any given American Airlines’ output level, as shown in Figure
5.9. United Airlines’ best-response curve shifts outwards. A government subsidy that
lowers United’s marginal cost from MC1 = $147 to MC2 =$99 causes United Airlines’ best
response output to American Airlines’ qA = 64 to rise from qU = 64 to 88. If both airlines’
marginal costs are $147, the Cournot equilibrium is e1 . If United Airlines’ marginal cost
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falls to $99, its best-response function shifts outwards. It now sells more tickets in response
to any given American Airlines’ output than previously. At the new Cournot equilibrium,
e2 , United Airlines sells qU = 96, while American Airlines sells only qA= 48.
Figure 5.9 Effect of a Government Subsidy on a Cournot

Equilibrium
You may have noted that in Cournot models the best response curves are downward
sloping. The larger the quantity one firm chooses, the smaller the quantity the other firm
will choose. This is different from the best response curves in price competition, which
are upward sloping. In quantity competition, the downward sloping best responses are
called strategic substitutes, since an adjustment by one party leads other parties to adjust
in the opposite direction. Knowing whether business choices are strategic complements
or strategic substitutes is important for managers to respond to competitors actions.
2.4 Capacity Leadership

Oligopoly models in which one firm (the leader) sets its output before other firm (the
follower) does are called Stackelberg models of oligopoly. The leader realises that once it
sets its output, the follower will use its own Cournot best-response function to set its (the
follower’s) output. So the leader will substitute rival’s best response function into own
residual demand function. The leader can manipulate the follower, by predicting what the
follower will do before the follower acts.
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In the airlines Cournot model, suppose American Airlines plays first. American Airlines’
residual demand is market demand minus United Airlines’ best-response function:
We can next find American Airlines’ profit-max output by setting MR = MC and get qA =
96. We then substitute qA = 96 into United Airlines’ best-response function, to get qu =
48. So the total market quantity is Q =144, and p = $195. This Stackelberg Equilibrium is
illustrated in Figure 5.10. The residual demand the Stackelberg leader faces is the market
demand minus the quantity produced by the follower, qu , given the leader’s quantity, qA .
The leader chooses qA = 96 so that its marginal revenue, MRr , equals its marginal cost. The
total output, Q = 144, is the sum of the output of the two firms. The quantity the follower
produces is its best response to the leader’s output, as given by its Cournot best-response
curve.
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Figure 5.10 Stackelberg Equilibrium
With the above example, we see that going first gives American Airlines the advantage.
Leader’s output is twice as large as follower’s. Leader’s profit is twice as large as
follower’s. Going first allows American Airlines to produce a large quantity. United
Airlines must take that into account and produce less. We have used a game tree to analyse
why moving first is important in the previous chapter. The first-mover has an advantage
in deterring new entrants through commitment to high level of output making potential
rival’s post-entry profit less than entry cost. The entry deterrence, however, must be a
credible threat.
2.5 Restraining Competition

We have seen that due to differences in market power, a monopoly is in general
more profitable than an oligopoly, which is more profitable than perfect competition.
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An implication from this general result is that firms can restrain competition among
themselves in order to achieve the profit of a monopoly. In this section, we discuss some
ways of restraining competition.
The first one is called a cartel, which is an agreement to restrain competition. A cartel
can be either seller cartel or a buyer cartel: sellers can restrain competition in supply and
buyers can restrain competition in demand. We illustrate a seller cartel here and a buyer
cartel is similar. Members of a seller cartel believe they can raise profits by acting together.
We know that a competitive firm faces an (almost) flat demand curve because it is so
small relative to the market, and it ignores the effect of a change in its output level on the
profits of other firms. If all the firms lower their output, there will be a noticeable effect
on the price. A cartel recognises the effect of collective action, and restricts output below
the competitive level (and raises price above marginal cost). Cartel reduces output until
MR=MC, and produces the monopoly output and earns (collective) monopoly profits. To
achieve the cartel output, each firm must lower its output to qm = Q/n.
A comparison of a cartel and perfect competition is illustrated in Figure 5.11. The marginal
cost and average cost of one of the n firms in the market are shown. A competitive firm
produces qc units of output, whereas a cartel member produces qm< qc . The competitive
equilibrium, ec , has more output and a lower price than the cartel equilibrium, em . At
the cartel price, pm , each cartel member has an incentive to cheat, wants to raise output,
but wants all other members to abide by the agreement and stick to the cartel output. The
cheating member would like to produce q* where its MC equals pm. If too many firms do
this, the cartel will fail. Therefore, for a cartel to succeed, it must have some way to compel
each member to abide by its quota. Another reason for a cartel to fail is that the positive
economic profit can attract new entrants into the market. Therefore, a cartel should also
be able to restrain new competitors in order to succeed.
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Figure 5.11 Competition versus Cartel
Labour union is an explicit form of seller cartel. It negotiates with the employers to gain
higher wages which workers could obtain through individual negotiation. In order for
such a cartel to succeed, it must restrict employment so as to raise wages above the
competitive level.
In some countries, cartels are not legal and thus can only be achieved by private
enforcement. In order for a private enforcement to be effective, several conditions should
be met. First, the number of sellers should be relatively small. Second, sellers are operating
near capacity so that they have little incentive to expand. Third, the sunk costs are
relatively small so that the sellers are unlikely to behave like competitive sellers who
are more willing to cut price and exceed their quota. Fourth, there are barriers to entry
and exit. Finally, the nature of the product can also influence the effectiveness of a cartel.
However, the direction of influence is ambiguous. Because if the product is homogeneous,
a seller can easily sell more than its quota, but the cartel can also easily monitor the various
sellers.
An alternative for competing sellers to restrain competition without using private

enforcement is through integration. Two sellers with market power in the same or
similar businesses can combine together to form a common ownership, which is called
a horizontal integration. The combination can then set price and quantity at monopoly
in a legal way. This will lead to a reduction in the quantity supplied and hence raise the
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market price and increase profits. The two sellers therefore benefit from such a horizontal
integration.
Activity 2
1. Lea and Gayle are duopolists each owning a tourist guide service in a popular
scenic town. The market demand function is Qd = 42,000 – 350P, where P is the
price of tours around the town’s main attractions and Qd is the number of tours
demanded per year. The marginal cost is $75 per tour. Competition in the market
is described by the Cournot model. What are Lea’s and Gayle’s equilibrium
outputs? What is the price? What do they each earn in profits? How does the price
compare to marginal cost? How do these profits compare to the monopoly price
and profit?
2. The market demand function for tourist guide services is ,
where P is the price of tour around the town’s main attractions and is the
number of tours demanded per year. The marginal cost is $75 per tour. Suppose
Lea enters this market first and chooses her output. How much larger is her profit
compared to the situation in Question 1 described by the Cournot model. How
do Gayle’s profits in the two cases compare?
Read
5th Edition.
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Lesson Recording
Oligopoly
1. If both Macy and Gimble charge a high price, they each earn $200. If they both charge a
low price, they each earn $100. If one charges a low price and the other a high price, the
one who charges a low price will capture much of the market and earn $300, leaving
the other with only $75. Which statement(s) is(are) correct regarding this situation?
I. Charging a high price is a dominant strategy for both.
II. This is a prisoners’ dilemma in which both will end up earning less than
they could if they successfully cooperated.
III. For maximum profit, these two sellers should cooperate, one charging a high
price and the other charging a low price.
c. III only is correct.
2. Two producers, A and B, of a homogeneous product face a market demand function

given by Q = 3000 -100 P. Both have zero marginal cost and act as Cournot duopolists,
setting quantity simultaneously. Which of the following expressions gives firm A’s
best response function?
a. PA = 30 - 0.01 QA
b. PA= 30 - 0.02 QA
c. QA= 1500 – 0.5 QB
d. QA = 3000 – 2 QB
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3. Two non-cooperative firms engage in a homogeneous Bertrand duopoly. Market

inverse demand is given by P = 300 – 0.05 Q. Each firm has constant MC = $100. What
will be the Nash equilibrium price charged by each firm?
a. $100
b. $150
c. $200
d. $250
4. In the Bertrand model, the Nash Equilibrium occurs when

a. both firms charge the monopoly price and split the monopoly quantity equally
between them.
b. one firm drives its rival out of the market, and then sets the monopoly price.
c. both firms set price equal to marginal cost.
5. The Cournot model

a. is useful when firms make capacity or inventory decisions that determine the
quantity available for sale.
b. implies that price will exceed marginal cost.
c. has a Nash Equilibrium.
d. all of the above
6. Cartels would be more stable if

a. firms that cheat on the agreement could be legally punished.
b. firms that cheat on the agreement were better informed about the value of
agreement.
c. many firms of different sizes were involved.
d. demand for the output was more variable.
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Suppose Firm M and Firm N produce and sell identical product with zero marginal
cost. Following is the market demand curve for the product.
The profit-maximizing price for a monopolist with this demand curve is _____.
a. $1
b. $2
c. $3
d. $5
8. If firm M and N decide to collude and work as a pure monopolist such that each firm
will produce half the quantity demanded by the market, what will be the economic
profit for firm M?
a. $0
b. $50
c. $100
d. $150
9. Suppose firm M cheats on firm N and reduces its price to $1.00/ each. How many
units would firm M sell?
a. 50
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b. 100
c. 150
d. 200
10. Suppose firm M cheats on firm N and reduces its price to $1.00/ each. What will be
the economic profit for firm M?
a. $75
b. $100
c. $150
d. $200
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Summary
In this study unit, we focus on markets with interdependency. We firs discuss strategy
thinking and basic game theory in Chapter 1. Then we look into the oligopoly market
structure in Chapter 2.
In strategic situations, when the parties move simultaneously, there are several useful
principals to follow: avoid using dominated strategies, focus on Nash equilibrium
strategies, and consider randomizing. When the parties move sequentially, a strategy
should be worked out by looking forward to the final nodes and reasoning back to the
initial node. Through conditional or unconditional strategic moves, it may be possible
to influence the beliefs or actions of other parties. In some settings, the first mover has
the advantage. In others, the first mover is at a disadvantage. Finally, it is important to
consider whether the situation will be played just once or repeated.
Prices are strategic complements. In an oligopoly, where sellers compete on price, if one
seller raises or lowers its price, then others will adjust prices in the same direction. Sellers
can dampen price competition by differentiating their products. Production capacities are
strategic substitutes. In an oligopoly, where the sellers compete on production capacity,
if one seller raises or lowers capacity, then others will adjust capacities in the opposite
direction. If a seller can commit to its capacity before others, then it will gain a first mover
advantage. If the leader commits to sufficient production capacity, it can even exclude
potential entrants.
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1. Identify two possible equilibrium outcomes in this game.
The equilibria are:
1. you produce, someone else doesn't
2. someone else produces, you do not.
2. Suppose your parents decide to subsidise you with a $200 payment if you open your
fruit stand. Revise the payoff matrix to account for the subsidy.
The payoffs when you produce will be increased by $200 in each case.
You
Produce Don't Produce
Someone else Produce -100, 200 1000, 0
Don't Produce 0, 1200 0, 0
3. What is the new equilibrium with the subsidy?

Your new equilibrium is to produce (someone else does not produce).
1. Which of the following statement is true? (Assume there are two players in each
game.)
a. in a one-stage game each participant makes his choice without knowing the
choice of the other participant
Correct. Players make decisions without knowing the decisions of other
players.
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b. in a multi-stage game, no participant has information about the other

player’s choice before he makes his choice.
Incorrect. In games with perfect information, a player knows all the previous
moves of the other player.
c. in a multi-stage game, each participant have information about the other

player’s choice before he finalizes his choice.
Incorrect. In games with perfect information, a player knows all the previous
moves of the other player, but not the current move.
d. in a one-stage game, only one participant is permitted to make a choice.
2. A strategy is dominant if
a. it is that player’s best response, regardless of the other players’ choices.
Correct. In general, a dominant strategy is one that is the best response to
all possible actions of the other player.
b. it will permit that player to dominate the game and knock the other player
completely out of the game.
Incorrect. In general, a dominant strategy is one that is the best response to all
possible actions of the other player. It does not give any player an advantage.
c. it maximizes the expected value of that player’s payoff.

Incorrect. In general, a dominant strategy is one that is the best response to
all possible actions of the other player. It has nothing to do with the expected
payoff.
d. it permits the player to dominate the game by exaggerating his power (within
the game) through bluffing.
Incorrect. In general, a dominant strategy is one that is the best response to all
possible actions of the other player. It does not give any player an advantage.
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3. Which of the following is a prisoner’s dilemma? Bonnie and Clyde simultaneously

make decisions on whether to confess about a crime. (The numbers in each cell
represent years of prison time. The first number in each cell represents Clyde’s
sentence; the second number represents Bonnie’s sentence.) Note that small numbers are
preferred over large numbers. Hint: begin by checking each game to determine whether
Bonnie has a dominant strategy. Then check whether Clyde has a dominant strategy.
Check the intersection of the two dominant strategies. Is there a different cell (no pun
intended) that is preferred by both Bonnie AND Clyde?
a. Bonnie
Incorrect. If Clyde confesses, Bonnie will confess. If Clyde remains silent,

Bonnie will confess. Confess is a dominant strategy for Bonnie. If Bonnie
confesses, Clyde will remain silent. If Bonnie remains silent, Bonnie will
confess. Clyde has no dominant strategy. (confess, confess) is a Nash
equilibrium. It is not a prisoner’s dilemma since confess is not a dominant
strategy for Clyde.
b. Bonnie

confesses, Clyde will confess. If Bonnie remains silent, Bonnie will confess.
Confess is a dominant strategy for Clyde. (confess, confess) is a Nash
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equilibrium. It is not a prisoner’s dilemma since the outcome is not inferior

to (remain silent, remain silent).
c. Bonnie
Correct. If Clyde confesses, Bonnie will confess. If Clyde remains silent,

confesses, Clyde will confess. If Bonnie remains silent, Bonnie will
confess. Confess is a dominant strategy for Clyde. (confess, confess) is a
Nash equilibrium. It is a prisoner’s dilemma since the outcome is inferior
to (remain silent, remain silent). If all players’ dominant strategies lead
them to a result that is jointly worse for them than some other set of
strategies, a Prisoners’ Dilemma exists.
d. Bonnie

confesses, Clyde will remain silent. If Bonnie remains silent, Bonnie will
remain silent. Remain silent is a dominant strategy for Clyde. (Remain silent,
confess) is a Nash equilibrium. It is not a prisoner’s dilemma since the
outcome is not inferior to (confess, remain silent).
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4. In a two-player single-stage game, which of the following statements provide correct

information about a Nash Equilibrium?
a. Player A’s decision is the best possible decision given Player B’s choice and
Player B’s decision is the best possible decision given Player A’s choice.
Incorrect. The statement is correct but it is not complete answer.
b. The solution to a prisoner’s dilemma is a Nash Equilibrium

c. A Nash equilibrium is stable and self-enforcing because each player believes

he made an optimal choice when he sees his opponent’s choice.
d. All of the above

Correct. This is the complete answer.
5. In Rock-Paper-Scissors game, what strategy dominates the strategy of always

choosing “rock”?
a. mixed strategy
Correct. There is no pure-strategy Nash equilibrium in this game.
b. pure strategy
Incorrect. There is no pure-strategy Nash equilibrium in this game.
c. always choose “paper”

Incorrect. There is no pure-strategy Nash equilibrium in this game.

Incorrect. There is no pure-strategy Nash equilibrium in this game, but there
is a mixed strategy one.
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1. Lea and Gayle are duopolists each owning a tourist guide service in a popular scenic
town. The market demand function is Qd = 42,000 – 350P, where P is the price of
tours around the town’s main attractions and Qd is the number of tours demanded
per year. The marginal cost is $75 per tour. Competition in the market is described
by the Cournot model. What are Lea’s and Gayle’s equilibrium outputs? What is the
price? What do they each earn in profits? How does the price compare to marginal
cost? How do these profits compare to the monopoly price and profit?
First note that inverse demand is . Given Lea’s (L) and Gayle’s (G)
outputs, and the price is
The residual demand is,
To find the Nash equilibrium:
Find Lea’s best response function by deriving her marginal revenue, then set up
profit maximising conditions.
Set MR = MC:
By the symmetrical nature of the problem we can deduce without calculation that
Gayle’s best-response function is . Thus the Nash equilibrium
is:
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Substituting Gayle’s output into Lea’s best-response function, we find that Lea’s
output is also 5000. Using this information we can recover the market price:
per tour. Both Lea and Gayle will each earn a profit of
per year.
Note that P = $90 is higher than the perfectly competitive price of $75. To find what
the price would be if there was a monopoly in this market, use the same inverse
demand curve without partitioning it into residual demand curves, then find the
marginal revenue and set up the profit-maximising condition:
and set MR = MC:
Substituting this quantity we find that P = $97.5 and profit for the monopoly firm
is $168,750 per year.
2. The market demand function for tourist guide services is , where
P is the price of tour around the town’s main attractions and is the number of
tours demanded per year. The marginal cost is $75 per tour. Suppose Lea enters this
market first and chooses her output. How much larger is her profit compared to the
situation in Question 1 described by the Cournot model. How do Gayle’s profits in
the two cases compare?
Recall Lea’s residual demand curve from problem (1).
Recall also, Gayle’s best-response function: . By substituting
Gayle’s best-response into Lea’s inverse residual demand function, we get a

formula characterising the price Lea receives at any output she might produce,
while taking into account Gayle’s response to her choice:
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Now derive Lea’s marginal revenue:
To maximise her profit, Lea will set MR = MC.
Gayle’s best response is . At a total market output of
11,250 the market price is . This price implies that

Lea’s profit is $84,375 per year, while Gayle’s profit is $42,187.50. Lea makes $9,375
more, and Gayle made $32,812.50 less, than in the case characterised by the Cournot
model.
1. If both Macy and Gimble charge a high price, they each earn $200. If they both charge a
low price, they each earn $100. If one charges a low price and the other a high price, the
one who charges a low price will capture much of the market and earn $300, leaving
the other with only $75. Which statement(s) is(are) correct regarding this situation?
I. Charging a high price is a dominant strategy for both.
II. This is a prisoners’ dilemma in which both will end up earning less than
they could if they successfully cooperated.
III. For maximum profit, these two sellers should cooperate, one charging a high
price and the other charging a low price.
Incorrect. Charging a low price is a dominant strategy for both.
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Correct. Charging a low price is a dominant strategy for both and this leads
to an inferior outcome than both charging a high price.

Incorrect. For maximum profit, these two sellers should cooperate, both
charging a high price.

Incorrect. I only is incorrect. Charging a low price is a dominant strategy for
both.
2. Two producers, A and B, of a homogeneous product face a market demand function

given by Q = 3000 -100 P. Both have zero marginal cost and act as Cournot duopolists,
setting quantity simultaneously. Which of the following expressions gives firm A’s
best response function?
a. PA = 30 - 0.01 QA
Incorrect. Firm A’s residual demand is QA =3000-100P-QB. Firm’s A’s
profit is QA*P = QA*(3000-QB-QA)/100. To maximize profit, Firm A’s best
response is QA= 1500 – 0.5 QB.
b. PA= 30 - 0.02 QA
Incorrect. Firm A’s residual demand is QA =3000-100P-QB. Firm’s A’s
c. QA= 1500 – 0.5 QB

Correct. Firm A’s residual demand is QA =3000-100P-QB. Firm’s A’s profit
is QA*P = QA*(3000-QB-QA)/100. To maximize profit, Firm A’s best
d. QA = 3000 – 2 QB
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@ Incorrect. Firm A’s residual demand is QA =3000-100P-QB. Firm’s A’s

3. Two non-cooperative firms engage in a homogeneous Bertrand duopoly. Market

inverse demand is given by P = 300 – 0.05 Q. Each firm has constant MC = $100. What
will be the Nash equilibrium price charged by each firm?
a. $100
Correct. In a homogeneous Bertrand duopoly, firms have incentives to cut
prices until the price is equal to marginal cost and they earn zero profit.
b. $150
Incorrect. In a homogeneous Bertrand duopoly, firms have incentives to cut
c. $200
d. $250
4. In the Bertrand model, the Nash Equilibrium occurs when

a. both firms charge the monopoly price and split the monopoly quantity
equally between them.
b. one firm drives its rival out of the market, and then sets the monopoly price.
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c. both firms set price equal to marginal cost.

Correct. In a homogeneous Bertrand duopoly, firms have incentives to cut

Incorrect. In a homogeneous Bertrand duopoly, firms have incentives to
cut prices until the price is equal to marginal cost and they earn zero profit.
5. The Cournot model

a. is useful when firms make capacity or inventory decisions that determine the
quantity available for sale.
Incorrect. The statement is correct but the answer is incomplete.
b. implies that price will exceed marginal cost.

c. has a Nash Equilibrium.

d. all of the above

Correct. The statement is complete.
6. Cartels would be more stable if

a. firms that cheat on the agreement could be legally punished.
Correct. Cartels would be more stable if firms that cheat on the agreement
could be legally punished.
b. firms that cheat on the agreement were better informed about the value of
agreement.
Incorrect. Cartels would be more stable if every member is equally informed
about the value of agreement.
c. many firms of different sizes were involved.
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Incorrect. Cartels would be more stable if smaller number of firms of similar

sizes are involved.
d. demand for the output was more variable.

Incorrect. Cartels would be more stable if demand for the output was more
stable.
Suppose Firm M and Firm N produce and sell identical product with zero marginal
cost. Following is the market demand curve for the product.
The profit-maximizing price for a monopolist with this demand curve is _____.
a. $1
Incorrect. For a monopoly, profit maximizing output is where MC=MR,
which is 100 units. And the corresponding price is $2.
b. $2
Correct. For a monopoly, profit maximizing output is where MC=MR,
c. $3
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d. $5
8. If firm M and N decide to collude and work as a pure monopolist such that each firm
will produce half the quantity demanded by the market, what will be the economic
profit for firm M?
a. $0
Incorrect. If firm M and N decide to collude and work as a pure monopolist,
profit maximizing output is where MC=MR, which is 100 units. And the
corresponding price is $2. Each firm produces 50 units. The economic profit
for firm M is 50*$2=$100.
b. $50
c. $100
Correct. If firm M and N decide to collude and work as a pure monopolist,
d. $150
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9. Suppose firm M cheats on firm N and reduces its price to $1.00/ each. How many
units would firm M sell?
a. 50
Incorrect. From the demand curve, then price is $1, demand is 150 units. Firm
M will capture all the demand.
b. 100
c. 150
Correct. From the demand curve, then price is $1, demand is 150 units. Firm
d. 200
10. Suppose firm M cheats on firm N and reduces its price to $1.00/ each. What will be
the economic profit for firm M?
a. $75
M will capture all the demand. Its economic profit will be $1*150=$150.
b. $100
c. $150
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Correct. From the demand curve, then price is $1, demand is 150 units. Firm
d. $200
SU5-50
References
Higher Education.
Education.
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6
Study
Unit
Managerial Decisions in Imperfect

Markets
ECO201 Managerial Decisions in Imperfect Markets
Learning Outcomes
This study unit focusses on issues of management in imperfect markets and consists of
four chapters. The first three chapters discuss various types of market failures and the last
chapter focusses on the solutions to these market failures. Chapter 1 discusses externalities
and public goods. Chapter 2 looks into asymmetric information. In Chapter 3, we discuss
incentives and organisations. Chapter 4 looks into the role of government regulations in
imperfect markets.
1. Externalities
2. External benefit/cost
3. Free rider
4. Network externality
5. Public goods
1. Asymmetric information
2. Adverse selection
3. Risk-neutral and risk-averse
4. Appraisal
5. Screening
6. Signalling
7. Contingent contact
8. Winner’s curse
1. Organisational architecture
2. Moral hazard
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3. Holdup
4. Residual income
5. Vertical integration
1. Natural monopoly
2. Marginal/Average cost pricing
3. Potentially competitive market
4. Structural regulation
1. Describe externalities and discuss why private markets may misallocate

resources in the presence of externalities
2. Explain how the effects of externalities can be remedied
3. Appraise asymmetric information and discuss how it leads to the lemons
problem and adverse selection
4. Discuss how to resolve information asymmetries through appraisal, screening,
signalling and contingent contracts
5. Appraise moral hazard and discuss how monitoring and incentives can resolve
moral hazard
6. Appraise holdup and the application of detailed contracts
7. Explain and implement organisational architecture
8. Appraise the conditions for a natural monopoly vs potentially competitive
market and how governments should regulate a natural monopoly vs foster
competition
9. Appraise how governments should regulate markets with asymmetric
information and externalities
10. Discuss how to provide public goods
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Chapter 1: Externalities
1.1 Introduction
This chapter investigates two general areas in which markets are not able to function
efficiently on their own: externalities and public goods. Externalities occur whenever
someone is affected by another person’s consumption or production decision without
being part of a corresponding market transaction. Public goods are ones such that non-
payers cannot be excluded from their consumption.
We first introduce the concept of externalities. We define positive and negative

externalities and discuss how they affect resources allocation and present graphical
treatments of external costs and benefits. The ways of correcting market failure arising
from externalities are also presented. This chapter also introduces network externalities,
which arise when a party directly conveys benefit or cost to everyone else in the same
network. We discuss briefly how the demand and competition in markets with network
externalities differ from the conventional markets in several important aspects. Finally,
public goods are discussed, including the economically efficient level and the ways to
achieve this level.
1.2 Externalities
Externalities arise between producers, between consumers or between producers and
consumers. Externalities are the effects of production and consumption activities not
directly reflected in the market. An externality occurs if someone’s consumption or
production helps or hurts others outside the market. Some examples of externalities
include pollution, fire extinguishers in every apartment and vaccinations. They can be
negative or positive. If the externality harms others, it is a negative externality or external
cost. If the externality benefits others, it is a positive externality or external benefit.
Sometimes, a single activity may hurt some and benefit others, for example, smell of pipe
smoke, perfume, and wind chimes.
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1.2.1 Positive Externality

Positive externalities occur when a decision bestows a benefit on a third party who
is not involved in the market transaction, for example, neighbourhood beautification
and education. Existence of positive externalities means that external benefits are not
considered by market decision makers. As a result, too little of the good gets produced
and consumed in competitive markets and hence they are sources of inefficiency.
To show how positive externalities can result in too little production, we look at an
example of home repair and landscaping in Figure 6.1. Homeowner repairs and plants
a beautiful garden where all the neighbours benefit from it. However, homeowner does
not take their benefits into account when deciding the repair level. The demand curve
D depicts the individual marginal benefits to the homeowner who spends money on
home repairing. Repairs generate external benefits to the neighbours, which is shown
by the marginal external benefit curve (MEB). When there are positive externalities (the
benefits of repairs to neighbours), marginal social benefits (MSB) are higher than marginal
benefits D. The MSB curve is the vertical sum of the MEB curve and the individual benefits
presented by demand curve. Here, there is a disconnection between the private marginal
value (represented by market demand) and social marginal value of each additional unit
consumed. The difference is called the external benefit, and it is disregarded by private
decision makers, so they produce and consume too little. A self-interested homeowner
invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1
discourages repair. Therefore, the individual’s optimal point is A while the society’s
optimal point is B.
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Figure 6.1 Positive Externality
1.2.2 Negative Externality

A negative externality occurs when third parties are harmed by the consumption or
production of a good or service without being part of the market transaction, for example,
pollution (air, water and noise). Negative externalities represent the part of social costs that
are not fully recognised as part of private costs, and therefore not adequately accounted
for in making decisions. For example, even if a firm’s plant dumps waste in a river
which affects those people living downstream, the firm has no incentive to account for
the external costs that it imposes on those downstream. When there is a disconnect
between private costs − on which firms make decisions − and social costs − which reflect
society’s lost opportunities − then those private decisions will likely be socially inefficient.
Existence of negative externalities means external costs are not considered by market
decision makers. As a result, too much of the good gets produced and consumed in
competitive markets and hence leading to economic inefficiency.
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Figure 6.2 Negative Externality
To illustrate the negative externalities and inefficiency, we consider a scenario of steel plant
dumping waste in Figure 6.2. Marginal external cost (MEC) is the increase in cost imposed
on fishermen downstream for each level of production. As firm output increases, external
cost on fishermen downstream increases measured by the marginal external cost curve.
Marginal social cost (MSC) is the vertical sum of individual MC and MEC, and it is the
true cost of production. Assume the firm has a fixed proportions production function and
cannot alter its input combinations. The only way to reduce waste is to reduce output.
Price of steel and quantity of steel initially produced are at the intersection of supply and
demand. The MC curve for the firm is the marginal costs of production. Firm maximises
profit by producing where MC = P1 in a competitive market. Firm’s output is q1 and
socially optimum output is q* (the intersection of MSC and P1). From a social point of view,
the firm produces too much output.
1.2.3 Externalities in General

In the two examples above, positive externalities and negative externalities are discussed
separately. There can be cases where both positive externalities and negative externalities
are present. In such cases, the socially optimal solution is at the point where the marginal
social benefit equals the marginal social cost, which we can also say that an externality is
resolved at the economically efficient level.
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If the source and recipients of the externalities are in the same group, then the group
decision making can solve the externalities. Otherwise, some intermediaries can solve the
externalities. Consider a positive externality, the production level is too low compared
to the socially optimal level. An intermediary can collect fees from the recipients of the
externalities (neighbours in the home repairs example) to pay the source (homeowner in
the home repairs example) to increase the externality (repair level) up to the point where
marginal social benefit equals the marginal cost. And hence the positive externality is
solved. Similarly, a negative externality can be solved through an intermediary who pays
the source to reduce the activity generating the externality to the economically efficient
level.
1.3 Resolving Externalities

The economically efficient level, where the marginal social costs equal the marginal social
benefits, is called the benchmark for an externality. To achieve the benchmark, or in
other words, to solve the externality, there are in general two practical ways: (1) common
ownership of the source and recipient and (2) agreement between the source and recipient.
If the source and the recipient of the externality are combined under common ownership,
the common owner can then choose the economically efficient level of output. In the home
repair example, if the neighbourhood forms a community, then the community takes into
account all the benefits and costs of home repair and will invest in the socially optimal
repair level. Another way to resolve externalities is by agreement. The source and recipient
of the externality negotiate and agree on how to solve the externality.
However, there are two common obstacles to the resolution of externalities: the
assignment of rights and free riding. If the rights are not clearly assigned, then it would
be difficult for the parties involved to agree on common ownership or the level of the
externality. For example, in the above negatively externality example, if the fishermen
downstream owned the river (clean water) and thus have property rights over it, then it
would be much easier for them to control the upstream emissions. A free rider contributes
less than its marginal benefit to the resolution of an externality. In the extreme, the free
rider avoids all the contribution. The incentive to take a free ride arises when it is costly
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to exclude particular individuals from receiving the benefits from an externality. For
example, in the home repair example, after a community has formed, each family in the
neighbourhood should contribute. But if one single family contributes less or does not
join the community, then it is free riding the nice neighbourhood environment. Free riding
leads to the result that markets will not provide efficient level of the good because there
is no way to ensure the provider will be paid for it.
1.4 Network Externalities

When a benefit or cost increases with the size of the network, there is a network effect. An
example of network effect is the telephone service. The benefit to one subscriber depends
on the total number of other subscribers. With the network effects, the marginal benefit
and demand for an item will depend on the total number of other users. A network
externality arises when a benefit or cost directly conveyed to others increases with the
number of users i.e. the size of the network. The presence of network effects or network
externalities makes the demand and competition differ from the conventional markets in
several important aspects.
In markets with network effects or network externalities, the demand is zero unless the
number of users exceed some critical mass, which is defined as the number of users at
which the quantity demand becomes positive. For example, the demand for telephone
would be zero if the number of users is very small since there is no one to call. Due to this
feature in demand, user expectations for a new technology are important and can create
two equilibria. The role of user expectation is the second important feature of markets with
network effects. With optimistic expectations (expect the demand to exceed the critical
mass), everyone will adopt the technology and the demand exceeds the critical mass. On
the other hand, if expectations are pessimistic (expect less than critical mass demand),
then no one will adopt the technology and the demand will be zero. In either case, the
users’ expectations are self-fulfilling. The third important feature of markets with network
effects concerns the character of competition. When there are several competitors, each
with demand close to critical mass, then if one of them can take a small initial lead to
increase its user base by a small amount, the market demand will shift to that competitor
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and the others would fail. This is called tipping. The fourth important feature of markets
with network effects concerns the price elasticity. When the demand is smaller than critical
mass, the product demand is extremely price inelastic as the demand will be zero. When
the demand is around the critical mass, the demand would be very price elastic. The
product demand is price elastic only when the demand exceeds the critical mass. Network
effects in general cause the market demand to be more price elastic because of the feedback
effects in the network.
1.5 Public Goods

Public goods are goods/services whose consumption by one person does not preclude
others from also consuming them. Public goods are non-rival and non-excludable. Non-
rival means one more person can consume the good without reducing the ability of others
to consume it. For any given level of production the marginal cost of providing it to an
additional consumer is zero. Non-excludable goods means goods that people cannot be
excluded from consuming, so that it is difficult or impossible to charge for their use. Some
examples of public goods include fireworks, national defence and the use of lighthouse
by a ship.
Efficient level of private good is where marginal benefit equals marginal cost. For a public
good, the value of each person must be considered. Therefore, we must equate the sum
of these marginal benefits to the marginal cost of production to drive the efficient level of
public good. Because everyone consumes at the same amount of a public good, we need to
add up all the marginal values of society’s members for each level of the public good. That
means vertical summation of individuals’ demand (marginal benefit) curves. Marginal
social benefit of a public good is the vertical summation of all citizens’ marginal private
benefit curves. Efficient level of public goods equates marginal social cost to marginal
social benefit.
We illustrate the efficient public good provision in Figure 6.3. Suppose there are two
consumers. D1 is demand for consumer 1 and D2 is demand for consumer 2. D is total
demand for all consumers by vertically adding D1 and D2. The efficient output occurs
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where marginal cost equals total marginal benefit, which gives 2 units of output. The
marginal social benefit is therefore $1.50 + $4.00 or $5.50.
Figure 6.3 Efficient Public Good Provision
Pure public goods present a problem for market efficiency. Because of their non-
excludability, it is possible, once they are produced, for someone to free ride. Consumers
do not have the incentive to pay what the item is worth to them. Free riders will understate
the value of a good or service so that they can enjoy its benefit without paying for it.
At best, public goods will be provided insufficiently, if at all in a competitive market
environment, making them another example of market failure.
Some public policies to correct market failure in public goods include: Government can
produce the good directly for free with the tax revenue; Government can give incentives
for private producers through subsidies or buy the good in private markets and provide
it. Governments also try to reduce free riding by using social pressure, compulsion or
privatisation.
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Read
5th Edition.
Lesson Recording
Externalities
1. Which of the following would not be considered to involve an externality?

a. Driving one’s automobile onto a crowded freeway at rush hour.
b. Mowing one’s lawn with an exhaust-emitting power lawnmower.
c. A firm’s purchasing enough of an input to drive up its price to the firm’s
competitors, thus increasing their costs.
d. A university locating in a region, thus increasing property values of all the
adjoining landowners in the region.
2. Which statement(s) is (are) true regarding the provision of goods with externalities?
I. Otherwise-competitive markets provide less than the efficient level of a
good with negative externalities.
II. Otherwise-competitive markets provide more than the efficient level of a
good with positive externalities.
III. Imperfectly competitive markets might provide the efficient level of a good
with negative externalities, but not necessarily.
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3. An appropriate policy to remedy a negative externality in production would be

a. to charge an emissions fee equal to the marginal social cost of production.
b. to charge an emissions fee equal to the marginal private cost of production.
c. to charge an emissions fee equal to the difference between the marginal social
cost and the marginal private cost of production.
d. to impose the same emissions standard on each firm in the industry, regardless
of it abatement cost efficiency.
4. Which statement is correct concerning positive externalities?

a. If a consumer would have paid more than she did pay for a competitively-
priced good, she received a positive externality.
b. Positive externalities are spillover benefits bestowed on parties not directly
involved in a related market transaction.
c. A monopolist might end up producing the efficient amount of a good with
positive externalities.
d. Competitive markets tend to produce too much of a good with positive
externalities.
5. Herb runs an egg ranch next door to Sally’s auto body shop. Sally’s shop makes a lot
of noise that could be eliminated if she incurred $6,000 per year in noise- abatement
procedures. As it is, she earns $50,000 per year in profit. Herb’s chickens don’t lay as
many eggs when it’s noisy. With all the noise next door, he earns $120,000 a year, but
if it were quiet, his profit would be $124,000. Which statement is correct?
a. Since both Herb and Sally operate in competitive markets, efficiency is
probably about as high as it’s likely to get.
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b. Without a law that requires silent auto body operation, Herb is destined to put
up with the noise and earn lower profit.
c. If a law ensured Herb the right to silence for his hens, Sally would just have
to pay the abatement cost, resulting in lower total profit for both producers
together.
d. If a law ensured Herb the right to silence for his hens, Sally could possibly
negotiate to pay Herb for the right to make noise in her shop, leading to a more
efficient outcome.
6. Where inefficiencies exist owing to negative externalities, ______

a. frictionless negotiation and well defined property rights will result in the same
distribution of wealth, regardless of how the property rights are assigned.
b. it is always more efficient to eliminate the source of the negative externality
through strict enforcement anti-pollution laws.
c. there is an opportunity to increase overall wealth through elimination of the
externality.
d. negotiation will result in a different ultimate allocation of resources, depending
upon how the property rights are assigned.
7. The efficient level of air pollution _______

a. is the level that minimizes damage done from air pollution.
b. is the level that equates the marginal cost of abatement to the marginal social
benefit from air pollution.
c. is always zero.
d. is the level that equates the marginal cost of abatement to the marginal social
cost of air pollution.
8. A good is said to be non-excludable if _____

a. one more person can consume it without reducing the amount other people
can consume.
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b. anyone can buy it without meeting restrictions such as residency or age.

c. once it is produced, even people who do not pay for it cannot be prevented
from consuming it.
d. you must pay for it in order to be able to consume it.
9. Which of the following activities is non-rival but not non-excludable?

a. watching a baseball game in a stadium that is not filled to capacity.
b. national defense.
c. fishing in the ocean.
d. viewing a spectacular sunset.
10. When dealing with pure public goods,

a. the government must always provide them.
b. private firms will always provide them.
c. the government frequently provides them although private firms provide
some.
d. the government must legally compel private firms to provide them.
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Chapter 2: Asymmetric Information
2.1 Introduction
We have so far assumed that consumers and producers had complete information about
the relevant economic variables. In many real life business situations, one party to a
transaction tends to know more than the other. In such cases, we have asymmetric
information. Here are a few examples of asymmetric information: seller of product knows
more about its quality than the buyer does; workers know their skills and abilities better
than employers; business managers know more about their firms’ costs, competitive
position etc than the shareholders.
Asymmetric information explains many institutional arrangements: it is the reason why

auto companies offer warranties on parts and service for new cars or why firms and
employers sign contracts that include incentives and rewards. The better informed party
may exploit the less informed one (“opportunistic behaviour” or “opportunism”), leading
to market failures (low-quality goods are sold, price is above marginal cost). For example,
if consumers do not know the quality of the good, some firms may try to sell them low-
quality goods. Knowing this the consumers will be unwilling to pay much, even for high-
quality goods (they can’t tell which is which). Producers of high-quality goods can’t sell
their products and consumers end up with low-quality goods. Bad goods drive good ones
out of the market.
Market failures can be reduced or eliminated if consumers can learn about quality or
prices of goods in an inexpensive manner or if the seller can signal quality by giving
warranties or money-back guarantees. In this chapter, we focus on business practices
that resolve asymmetric information, which include appraisal, screening, signalling and
contingent contracts. They play a major role in credit, labour, insurance and other markets
characterised by asymmetric information. We can apply the concept of information
asymmetry and techniques to resolve asymmetries very broadly.
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2.2 Imperfect Information

Imperfect information is the absence of certain knowledge. It can be the knowledge about
the present or past.
2.2.1 Imperfect vs. Asymmetric Information

Imperfect information can be about a single person. For example, you do not know
precisely whether it will rain or not next Monday. Asymmetric information involves
two or more parties, one of whom has less information. So the less informed party in
asymmetric information definitely has imperfect information. Imperfect information does
not necessarily imply asymmetric information. For example, in a perfectly competitive
market for umbrellas, both buyers and sellers don’t know precisely about the weather
conditions, but they are equally informed about the weather forecasts. They have
imperfect but symmetric information. Therefore, the perfectly competitive market still
works efficiently. However, if the information is asymmetric between the buyers and
sellers, then the perfectly competitive market will fail to work. As we have discussed in
Study Unit 4, perfect information is an important condition for perfect competition.
2.2.2 Risk and Risk Aversion

A direct consequence of imperfect information is risk, which is the uncertainty about costs
or benefits. For example, if you play a coin flip game, which you win $1 for heads and lose
$1 for tails. You have imperfect information about the results of coin flips and therefore
you face risks when play this game.
A risk-neutral person is indifferent between a certain amount and risky amounts with
the same expected value. A risk-averse person prefers a certain amount to risky amounts
with the same expected value. For example, in the coin flip game, the expected value from
flipping a fair coin is 0.5 × $1 + 0.5 × (-$1) = $0. It is a fair gamble since the expected gain
from playing the game is the same as not playing. A risk-averse person will refuse any
fair gamble, while a risk-neutral person will accept any gamble that is fair or better.
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A risk averse will pay to avoid risk and this creates the business of insurance. Insurance
takes certain payment in exchange for eliminating risk. The more risk averse a person, the
more he/she is willing to pay for insurance.
2.3 Adverse Selection

Adverse selection is opportunism by the informed person in such a way that he/
she benefits from transacting with an uninformed person who does know about an
unobserved characteristic of the informed person. For example, since unhealthy people
are more likely to buy insurance, the proportion of unhealthy people in the pool of
insured people increases. This forces insurance companies to raise the price of insurance,
until more and more healthy people decide not to buy insurance, while more and more
unhealthy people do. To see another example, if a company offers generous maternity
benefits, a disproportionate number of women who are planning to become mothers
would apply for a job there. Governments can help eliminate adverse selection by setting
out maternity benefits for all companies, by providing medical insurance for all people
over 65 years of age (they may not buy insurance regardless of their health because it is
too expensive) and so on.
2.3.1 Market for Lemons

We look at the market for used-cars to illustrate the inefficiencies of adverse selection. This
is also called the Akerlof’s Market for Lemons, where bad quality cars are referred to as
the “lemons” and the good quality cars are referred to as the “peaches”. Owners of lemons
are more likely to sell their cars, leading to adverse selection. Buyers cannot tell by looking
at the car if it is a lemon or a peach, but the seller does know. So this creates asymmetric
information. Suppose the maximum a buyer is willing to pay for a lemon is $1000 (DL in
Figure 6.4 panel a) and for a peach is $2000 (DG in Figure 6.4 panel b). The reservation
price of the owners of lemons – the lowest price they will accept – is $750. The supply
curve for lemons (SL in Figure 6.4 panel a) is horizontal at $750 up to a 1000 cars, where
it becomes vertical (no more cars for sale at any price). The reservation price of owners of
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good cars is v, which is less than $2000. Figure 6.4 (panel b) shows two possible supply
curves: one for v=$1250 (S1) and one for v=$1750 (S2).
With symmetric information, if both sellers and buyers know quality prior to sale, the
equilibrium in the lemons market is e (1,000 cars sold for $1,000 each), and the equilibrium
in the good-car market is E (1,000 cars sold for $2,000 each). All cars are sold, with good
cars selling at a higher price than bad ones at a lower price. This market is efficient because
goods go to those who value them most.
With symmetric information, if no one (neither buyers nor sellers) can tell if the car is a
good one or a bad one, a risk-neutral buyer (one who maximises expected value) would
pay the expected value on a car of unknown quality. The expected value is (½*1000) + (½
* 2000) = $1500. Risk-neutral sellers place an expected value of (½ * 750) + ½ v = 375 +
½ v which is smaller than $1375, since v is smaller than $2000. So in this case all cars are
sold as well. But sellers of good cars get a lower price because of the presence of lemons.
The market is efficient as well because cars go to people who value them more than their
original owners.
Figure 6.4 Markets for Lemons and Good Cars
With asymmetric information, sellers know quality but buyers do not. If buyers can’t tell
quality before buying but assume that equal numbers of the two types of cars are for sale,
their demand in both markets is D*, which is horizontal at $1,500. There are two possible
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equilibria: all cars sell at the average price or only lemons sell for a price equal to the
value that buyers place on lemons. In the first case, sellers of good cars value their cars
at v= $1250 which is less than the buyers expected value of $1500. The supply curve for
good cars is S1. So equilibrium in the good-car market is at point F and in the lemons
market at point f. This is efficient but not equitable, because sellers of lemons benefit while
sellers of peaches suffer. Consumers with lemons are unhappy. This creates an adverse
selection since the party with relatively poor information (buyers) draws a selection with
less attractive characteristics (lemons). In the second case, sellers of good cars value their
cars at v= $1750, and so are unwilling to sell them for $1500. The supply curve for good
cars is S2. Buyers cannot buy anything except lemons. So lemons drive good cars out of
the market. In equilibrium, no good cars are sold and 1000 lemons sell for the actual and
expected price of $1000 (point e). This is inefficient because good cars stay with seller who
values them less than buyers. Buyers cannot get a good car.
To avoid the lemons problem, we can establish laws to prevent opportunism such as
product liability laws to protect consumers from nonfunctional, defective or dangerous
products. Consumers can also screen the products personally if it is not too expensive to
do so. For example, a buyer can get a mechanic to check a used car before buying it or
just buy from firms with good reputations. Other ways to resolve the lemons problem
include third-party comparisons via consumer reports or organisations, standards and
certifications, licensing, signalling by firms-brand names, reputation, guarantees and
warranties.
2.3.2 Lending and Insurance

In some markets, the sellers have more information than buyers. In other markets, the
buyers can have more information than sellers as well. An example is the market for
lending, the borrowers (buyers) have better information than the lenders about their
personal willingness to default i.e. to stop paying the interest and principal. Because of
this asymmetric information, the lenders will draw an adverse selection of borrowers. The
lender will ask for a higher interest rate and fewer good borrowers (those who are unlikely
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to default) will borrow, resulting in more bad borrowers (those who are likely to default)
in the market.
Asymmetric information problems are particularly severe in the market for insurance as
well. Buyers of insurance policies will always know more about the likelihood of the event
being insured against happening than will insurance companies. To reduce the problem
of adverse selection, insurance companies gather as much information as they can on
people applying for policies. People applying for individual health insurance policies
or life insurance policies usually need to submit their medical records to the insurance
company.
2.4 Resolving Information Asymmetries

We have seen that asymmetric information gives rise to economic inefficiency and
market failure. A direct way to solve problems from information asymmetries is through
appraisal. Besides, there are three indirect ways to resolve information asymmetries,
which are screening, signalling and contingent contracts. We present them one by one in
the following subsections.
2.4.1 Appraisal
Appraisal is to obtain the information directly and is a direct way to solve problems
from information asymmetries. In the used-cars market, a buyer can engage experts to
appraise the cars. If such appraisals are available, then there will be a separate market
for good cars, in which buyers and sellers have equal information. Therefore, the market
will be efficient. For appraisals to work, the asymmetric information must be objectively
verifiable. The appraisers should be able to distinguish the good cars and bad cars, and
different appraisers should give the same opinions. Since appraisal often involves costs,
the potential gain from resolving the asymmetries should cover the cost of appraisal as
well.
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2.4.2 Screening
Screening involves an action taken by the uninformed person to determine the
information provided by the informed person, for example, test-drive several used cars
before buying one, or trying out a second-hand piano, insurance companies requiring
medical exams by their own doctors before selling health insurance, asking if they
scuba-dive, drive race cars etc. The less informed party can elicit another party’s
characteristics indirectly through screening. Screening does not directly determine the
unknown information, but instead elicit some characteristics which can indirectly reveal
the unknown information. For screening to work, the less informed party should be able
to control some variables to which the better informed parties are differently sensitive.
The most effective screening may involve a combination of differentiating variables.
Sometimes, the information asymmetries can involve more than one characteristic. In such
cases, the less informed party in general need as many differentiating variables as there
are characteristics to resolve.
2.4.3 Signalling
Signalling is an action taken by an informed person to send information to the uninformed
one. For instance, the seller of a used good may give a reason for the sale, or give
guarantees and warranties. Firms use reputation and standardisation to signal quality.
Potential employees use education as a signal of productivity, dress well at interviews
and highlight their achievements. The key is that the signals must be credible. The parties
with different characteristics choose different signalling policies. Signalling indirectly and
credibly communicates the characteristics of the better informed party without revealing
the unknown information. To be credible, a signal must induce self-selection among the
better informed parties. In particular, the cost of signalling must be sufficiently lower for
parties with better characteristics than for the inferior ones such that only the good ones
will give the signal.
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2.4.4 Contingent Contracts

A contingent contract specifies actions under particular situations. Usually, it involves
a contingent payment, which is a payment made if a specific event occurs. Contingent
payments can be used to screen as well as signal. For example, an employer can offer
a fixed wage or contingent wage which depends on the employee’s productivity. The
choice between fixed and contingent wage can screen workers of different productivity.
A worker can send a signal to the employer that he/she is highly productive if choosing
the contingent wage.
2.5 Auctions
Information problems can occur in auctions. In some auctions, neither the bidder not the
seller has complete information about what is being auctioned. One possible outcome of
auctions, the winner’s curse, occurs when the winning bidder overestimates the value of
the item and ends up worse off than the losers. The winner’s curse is more severe in the
following three circumstances: (1) there are more bidders; (2) the true value of the item is
more uncertain; and (3) in a sealed-bid compared with an open auction. Therefore bidders
should be more conservative in these situations.
Activity 1
1. Consider the market for loans for the purpose of capital investments. Suppose
lenders cannot price discriminate (i.e. vary interest rates) between good and
bad borrowers in loan contracts because the lenders are not able to observe the
riskiness of the investment project. What is the nature of the adverse selection
problem in this market? What is likely to happen to the lender's profit?
2. In the following situations, explain why there is asymmetric information, and

identify the consequence of asymmetric information.
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a. the sale of life insurance

b. the sale of used computers
Read
5th Edition.
Lesson Recording
Asymmetric Information
1. People are risk neutral if

a. they will accept any gamble.
b. they will accept a gamble only if it is better-than-fair.
c. they will accept a fair or better gamble.
d. they will not accept an unfair gamble.
2. If you will refuse any fair gamble you are

a. risk loving.
b. risk neutral.
c. risk averse.
d. risk avoiding
3. When buyers and sellers are not equally well informed about a good, there is
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a. unfairness.
b. asymmetric information.
c. symmetric information.
d. risk aversion.
4. The Lemons Model explains how

a. asymmetric information decreases the average quality of goods for sale.
b. people with lower quality goods are more likely to sell them.
c. reservation prices for used goods are lower.
d. all of the above
5. In some situations, parties to a transaction have the same pieces of information or,
put another way, there is no differential information between the two parties. In other
cases, one party may have more information than the other. Consider the following
two scenarios:
i. Alex purchases from Jerry a ticket for an outdoor concert some months away.
Neither Alex nor Jerry know what the weather will actually be on the day
of the concert.
ii. Sven offers to sell Frank his 14-year old BMW. Sven is familiar with the car's
maintenance records and accident history but Frank is not.
Which of the following statements is true?

a. Both transactions involve the existence of asymmetric information.
b. Scenario (ii) involves the existence of asymmetric information while scenario
(i) does not.
c. Scenario (i) involves the existence of asymmetric information while scenario
(ii) does not.
d. Neither transaction involves the existence of asymmetric information.
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6. There are 1,000 houses in Ardmore Park. Each house costs $300,000 and 1 percent of
the houses are likely to be wiped out by floods and landslides. Residents do not know
with certainty which homes will be wiped out. Scott Klein, an enterprising college
graduate is considering starting an insurance agency to offer flood insurance policies.
The policy will pay the purchase price of $300,000 if a homeowner's house is wiped
out. What is the maximum annual premium that a homeowner will be willing to pay
for a policy?
a. $1,000
b. $3,000
c. $30,000
d. $300,000
7. Auto insurance companies reward those have had no moving violations for several
years with "good driver" discounts. What is the incentive for insurance firms to do
this?
a. It reduces the potential inefficiency caused by adverse selection because the
discount ensures that only good drivers will purchase auto insurance.
b. It is a way of making bad drivers subsidize good drivers
c. It reduces the potential inefficiency caused by adverse selection because some
safe drivers will also be insured instead of just attracting reckless drivers.
8. Suppose that in a market for used cars, there are good used cars and bad used cars
(lemons). Consumers are willing to pay as much as $6,000 for a good used car but only
$1,000 for a lemon. Sellers of good used cars ask $5,000 per car and sellers of lemons
ask $800. Buyers cannot tell if a used car is reliable or is a lemon. It has been estimated
that 30% of all used cars in the market are lemons. Based on this information, what
is the likely outcome in the market for used cars?
a. Only lemons will sell, for $800 each.
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b. Only lemons will sell, for $4,500 each.

c. Both good used cars and lemons will sell for $4,500 each.
d. Both good used cars and lemons will sell for $1,000 each.
9. Many consumer items, such as cars and home entertainment systems, come with
some form of warranty. Why do firms offer warranties?
a. If firms do not offer warranties, no one will buy high priced consumer goods.
b. Firms want to encourage repeat customers.
c. Warranties serve as a form of consumer insurance.
d. A warranty is essentially a form of price discrimination where the firm charges
a higher price to some consumers without discouraging others.
10. Which of the following is an example of adverse selection?

a. The odds of a fire rise after the building is insured because the person with fire
insurance is likely to pay less attention to fire hazards.
b. People prefer to buy new cars rather than used cars.
c. Someone whose building is more likely to burn down is likely to buy to
insurance.
d. Someone with auto insurance drives more recklessly than someone without
auto insurance.
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Chapter 3: Incentives and Organisation
3.1 Introduction
We analyse organisational architecture in this chapter, which comprises the distribution
of ownership, incentive schemes and monitoring system. In the internal management of
an organisation, four common issues are moral hazard, holdup, monopoly power and
economies of scale and scope. Moral hazard arises when one party’s actions affect but
are not observed by another party. It is a result of asymmetric information. Holdup is an
action to exploit the dependence of another party. The degree of moral hazard and the
potential for holdup depend on the organisational architecture and in particular vertical
integration. Besides moral hazard and holdup, the architecture of an organisation also
influences the internal monopoly power and economies of scale and scope. All these can
determine the efficiency of an organisation.
3.2 Moral Hazard

Moral hazard is a result of asymmetric information. It is opportunism characterised by the
informed person’s taking advantage of the less-informed person through an unobserved
action. In other words, the informed person cannot be accurately monitored by the other
party. For example, someone who has full auto insurance may drive less carefully; and
employee may be lazy and shirk his duties; firms that have full coverage against fire may
not install fire prevention systems; and someone with life insurance may smoke, drink or
sky-dive.
A well-known example of moral hazard is the Principal-Agent problem. The agent

is the person who acts and the principal is the party whom the action affects. An
agency relationship exists whenever there is an arrangement in which one person’s
(the principal’s) welfare depends on what the other person (the agent) does. Some
examples are: owners of companies (stockholders) have only limited and imperfect control
over the managers’ behaviours; dentists, doctors, plumbers, mechanics recommending
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procedures/repairs that you don’t need to make money; workers shirking on the job when
not monitored; sharecroppers putting in too little effort (they bear the full marginal cost
of working an extra hour), but get only a fraction of the benefit; hired farm labour shirks
but owners work the hardest.
Figure 6.5 Economically Inefficient Effort
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Let’s next look at an example of the Principal-Agent model, where the principal (P) hires
agent (A) to do duck carvings job. The profit depends on the number of duck carvings
per day. As shown in Figure 6.5, the joint profit π is maximised at 12 carvings, where
marginal revenue equals marginal cost which equals 12 at equilibrium point e. The joint
profit reaches a maximum of $72 at E, where they sell 12 carvings per day. If they use a
revenue-sharing contract, their joint profit will not be maximised as reasoned below. For
example, if A gets three-quarters of the revenue and P gets the rest, A maximises his profit
by selling 8 carvings, where his new marginal revenue curve MR* = 3/4MR equals his
marginal cost at point e*. If they split the revenue, A sells 8 ducks per day and gets $24 at
E*, and P receives the residual, $40 (= $64 – $24). The joint profit is $64, which is smaller
than $72. Therefore, this is not economically efficient. We need to solve the moral hazard
between the principal and agent.
We can measure the degree of moral hazard by the difference between the economically
efficient action and the action chosen by the party subject to moral hazard. The larger the
difference, the greater is the degree of moral hazard. In the above example, if the agent
gets a lower portion of the total revenue, the lower will be the effort that the agent chooses
relative to the economically efficient level, and hence the larger the degree of moral hazard.
3.3 Incentives
We have seen that when you contract with people whose actions you cannot monitor,
they may take advantage of you. Generally, there are two complementary ways to resolve
inefficiencies from moral hazard. One is to directly monitor the actions of the party subject
to moral hazard. In the principal-agent model, the principal can invest in monitoring,
surveillance and other methods to collect information about the agent. The other way
is to design contracts that align the incentives of the party subject to moral hazard
with the other parties. Monitoring systems and incentive schemes are two elements of
organisational architecture. Let us next look at how to design efficient contracts to align
the incentives of the principal and the agent.
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3.3.1 Incentive Schemes

Efficient contract is an agreement with provisions that ensure that no party can be made
better off without harming the other party. This leads to efficiency in production and
efficiency in risk bearing. Efficiency in production requires that the P’s and A’s combined
profits are maximised (prevent moral hazard). Efficiency in risk bearing requires that risk
sharing is optimal in that the person who least minds facing the risk (the risk-neutral or
less risk-averse person) bears most of the risk.
One way to solve the moral hazard presented in the principal-agent problem is through a
fixed-fee rental contract. The agent pays a fixed rent to the principal and gets the residual
profit. We illustrate how it can maximise joint profit when the agent gets the residual profit
in Figure 6.6. If the agent gets all the joint profit, π, he maximises his profit by selling 12
carvings at e, where the marginal revenue curve intersects his marginal cost curve: MR
= MC = 12. The joint profit at 12 carvings is $72, point E. If the agent pays the principal
a fixed rent of $48, he maximises his profit by selling 12 carvings. Note that a fixed rent
does not affect either his marginal revenue or his marginal cost. If A pays a rent of $48 to P,
A’s profit is π – $48. By selling 12 carvings and maximising joint profit, A also maximises
his profit. Therefore, the fixed-fee rental contract resolves the moral hazard problem and
leads to the economically efficient outcome.
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Figure 6.6 Fixed-Fee Rental Contract
Another way to solve the moral hazard presented in the principal-agent problem is
through a profit-sharing contract. P and A can use a contingent contract where they divide
their profit. We illustrate why profit sharing is efficient in Figure 6.7. If the agent gets a
third of the joint profit, he maximises his profit, 1/3π, by maximising joint profit, π. A
chooses output of 12, which is the joint-profit-maximising level.
Other incentive schemes to resolve moral hazard link compensation to some measure of
performance. One common incentive scheme is performance scheme, which bases pay on
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some measure of performance. Another one is a performance quota, which is a minimum

standard of performance, below which penalties apply. For example, the principal can
set the performance quota exactly at 12 units of output such that the outcome will be
economically efficient.
Figure 6.7 Profit-Sharing Contract
3.3.2 Risk and Multiple Responsibilities

We have seen that incentive schemes can help to resolve moral hazard, but it has
two serious side effects. One is risk and the other is worse performance on other
responsibilities.
Since incentive schemes link compensation to some observable measure of the

unobservable action, other factors that affect the observable measure can bring up risks to
the party subject to moral hazard. For example, a raincoat salesman’s commission is based
on monthly sales revenue. In addition to the salesman’s effort, the actual sales depend on
the weather conditions, competition and some other factors. The salesman is uncertain of
these other factors and therefore the commission scheme imposes risk on him. Risk will
arise if the party subject to moral hazard is uncertain about his compensation. The cost of
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risk usually depends on the impact of extraneous factors, risk aversion and the strength of
incentive schemes. In general, the weaker the extraneous factors and the less risk averse
the party subject to moral hazard, the stronger the incentive schemes. To reduce these
risks, we can use relative performance incentive schemes, which cancel out the effect of
extraneous factors to the extent that they affect all the agents equally.
The party subject to moral hazard can have multiple responsibilities. In the duck carvings
example, the agent may be responsible for the quantity as well as the quality of duck
carvings per day. It is difficult to balance the multiple responsibilities since performance
on some responsibilities are more difficult to measure. When the incentive schemes focus
on just one responsibility, it will result in side effects of aggravating the moral hazard
with regard to other responsibilities. It is easy to measure the quantity of duck carvings,
but it is difficult to measure the quality. If the principal adopts a strong incentive scheme
for output, the agents would tend to focus on output and quality would fall. To achieve
a balance among multiple responsibilities, the principal needs to use a weaker incentive
scheme.
3.4 Holdup
A related managerial issue to moral hazard is holdup, which is an action to exploit
another party’s dependence. While information asymmetry is a necessary condition in
moral hazard, it is not so in holdup. For example, some restaurants may charge additional
fees on public holidays since the demand is higher. These restaurants disclose this
information on their menus and the customers can clearly observe it. So there is no
information asymmetry. In general, when there is potential for holdup, other parties will
take precautions to avoid dependence, which either increases costs or reduces benefits.
Therefore, the overall economic efficiency is reduced.
The specificity of an investment in an asset is the percentage that will be lost if the asset is
switched to another use. Reducing specific investments is a particular type of precaution
against holdup since it reduces dependence.
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The scope of holdup also depends on the completeness of the contract between parties.
A complete contract specifies the actions of all parties under every possible contingency.
In practice, all contracts are deliberately incomplete since it is extremely costly to prepare
and agree on a complete contact. A contract should be more detailed if potential benefits
and costs are larger or possible contingencies are more serious.
3.4.1 Ownership
Holdup can be resolved by changing the ownership of relevant assets. Ownership means
the rights to residual control, which are rights that have not been contracted away. A
transfer of ownership means shifting the rights of residual control to another party. The
owner of an asset has the right to receive the residual income from the asset, which is
the income remaining after payment to all other claims. Therefore, the owner has the full
incentive to maximise the value of the asset while other parties would not. The other
parties may hold up and exploit the owner’s dependence in this case.
Vertical integration is the combination of assets for two successive stages of production
under a common ownership. With separate ownership, the owner of each asset maximises
the value of its own asset separately, which usually is at the cost of other owners of other
assets. With common ownership, the owner will maximise the value of the combined asset.
Vertical integration changes the ownership of assets and thus changes the distribution of
the rights to residual control and residual income, which in turn affect the degree of moral
hazard and the potential for holdup.
3.5 Organisational Architecture

Organisational architecture consists of the distribution of ownership, incentive schemes
and monitoring systems. In managerial economics, the design of organisational
architecture depends on a balance among four issues – holdup, moral hazard, internal
market power, and economies of scale, scope and experience – and the mechanisms by
which these issues may be resolved. We next discuss how ownership will affect the four
issues respectively.
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Holdup Vertical integration can mitigate the potential for holdup. An external contractor
owns the asset and residual control of an asset includes the right to withhold its service.
Hence, an external contactor has the power to withhold the services of its assets. An
employee can engage in holdup as well, for example strikes, but it is less likely to happen
and has lower costs even if it happened. This is due to the fact that an employee has much
less power since the assets belong to the employer.
Moral Hazard Vertical integration changes ownership and increases the degree of moral
hazard since an employee is subject to relatively greater moral hazard than an owner.
This is because a worker’s marginal compensation is in general less than the employer’s
marginal profit contribution, and hence the worker chooses less than the economically
efficient level of effort. On the contrary, if the worker owns a share of the business, then the
worker receives residual income and hence will choose the economically efficient level of
effort. Many firms pay senior managers through shares and stock options such that they
have a share of ownership, and therefore reduces the degree of moral hazard.
Internal Market Power Vertical integration creates an internal monopoly because of the
preference for an internal service provider. An internal provider with market power may
raise its price above the external contactors and this high cost is borne by the organisation.
Outsourcing is a way to resolve an internal monopoly by purchasing services from cheaper
external sources. Similarly, an internal monopsony can arise from vertical integration. To
resolve the internal monopsony power, the business can establish a policy to sell externally
whenever the external price is higher.
Economies of Scale, Scope and Experience Typically, an internal provider will operate at
a smaller scale than an external contractor. Therefore, an internal provider will charge a
higher price and it is less efficient. Similarly, an internal provider expects a low cumulative
volume and would be high up on the experience curve. It is therefore less efficient than a
specialised provider who can push down the experience curve and have lower costs. For
an individual organisation, if it already produces one item out of the two products where
there are economies of scope, then it can reduce total cost by producing the other one as
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well. However, if it does not already produce either item, then economies of scope imply
that it should outsource both.
3.5.1 Balance
A good organisational architecture depends on a balance of the four issues and on other
ways to resolve these issues. Holdup can be resolved through more detailed contracts.
Moral hazard can be resolved through monitoring and incentives. Internal market power
can be solved through outsourcing and external sales. In general, we need a mix of
all policies to get an economically efficient solution. When an organisation considers
its vertical boundaries, the key factors in favour of vertical integration are holdup and
economies of scope, while factors in favour of outsourcing are moral hazard, internal
market power, and economies of scale, scope and experience. When an organisation
considers its horizontal boundaries, the key factor in favour of integration is economies
of scope, while the factor against it is moral hazard.
Activity 2
1. Kenny has just been hired as the manager of The Fennel Grill. The restaurant
enjoys a good reputation for its food and service. Currently, the wait staff (servers)
are not required to share their tips with the kitchen staff (cooks, dishwashers).
Kenny feels that this is an unfair system and would like to eliminate tipping
and in its place implement a standard 15 percent service charge which will be
shared equally among non-management restaurant staff. How will this affect the
productivity of the wait staff? Will this scheme require less monitoring or more
monitoring of the wait staff?
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2. Explain why there is asymmetric information in the following situation and

identify the consequence of asymmetric information: hiring a property manager
to manage the condominiums you own.
Read
5th Edition.
Lesson Recording
Incentives and Organization
1. All of the following are ways to reduce moral hazard by ensuring that the incentives
of the agent match that of the principal except
a. McDonald's requires that franchisees must put up 40 percent of the investment
required to start up the restaurant themselves.
b. requiring that all firms that issue stock to the public have their statements
audited by an independent accounting firm.
c. venture capitalists provide capital to start-up firms and then ensure that the
equity in the firm is not marketable to anyone but them.
d. giving the chief executive officer of a large corporation the right to make
financial decisions independently.
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2. Dynasty Corp. is run by a team of managers who have been elected by the firm's
board of directors. Dynasty, a private corporation owned by 400 stockholders, is
a manufacturer of security systems. Which of the following statements is true? A
principal-agent relationship exists between
a. Dynasty's board of directors and the firm's employees where the board of
directors is the principal and employees are the agents.
b. Dynasty's stockholders and customers where the stockholders are the
principals and customers are the agents.
c. Dynasty's board of directors and the management team where the board is the
principal and managers are the agents.
d. Dynasty Corp. and its customers where Dynasty Corp. is the principal and its
customers are the agents.
3. ________ occurs when actions taken by one party to a transaction are different than
what the other party expected at the time of the transaction.
a. Fraud
b. Moral hazard
c. Adverse selection
d. Risk aversion
4. If a fire insurance company requires firms buying fire insurance to install automatic
sprinkler systems, the insurance company is trying to reduce:
a. adverse selection problems.
c. moral hazard problems.
d. sunk costs.
5. Management can give workers incentive to work harder by:

a. paying an efficiency wage.
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b. having a seniority system.

c. having a profit sharing system among employees.
d. all of the above.
6. Management can encourage workers to work as hard as they can by:

a. monitoring workers closely.
b. hiring only hard workers.
c. assuming that workers are motivated on their own.
d. assigning numerical quotas of what each worker should produce each day.
7. If workers cannot be monitored closely, management can give workers incentive to

work hard by:
a. giving them awards for meeting production quotas.
b. fining them for every low quality product they produce.
c. hiring only hard workers.
d. increasing the value of the job to them, relative to other jobs they could hold.
8. The most uncertain work incentive system is:

a. use of a market wage.
b. use of an efficiency wage.
c. use of a profit sharing program with employees.
d. use of a seniority system.
9. An example of a moral hazard problem in labor markets is:

a. employees may steal from the firm.
b. workers may work too hard and cost other potential workers jobs.
c. workers may fake injuries to get medical awards.
d. workers may put forth as little effort as possible on the job.
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10. When people who buy insurance change their behavior because they are protected
from loss by the insurance, the insurance market exhibits:
a. economic irrationality.
c. moral hazard.
d. adverse selection.
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Chapter 4: Regulation
4.1 Introduction
In this chapter, we look at situations where buyers and sellers act independently and
selfishly such that the resource allocation is not economically efficient. We will address
the role of the government regulations in such situations. Government regulations try to
resolve the divergence between marginal benefit and marginal cost and hence increase the
social welfare.
We consider various sources of economic inefficiency, which include market power,

externalities and asymmetric information. We have discussed these inefficiencies in
previous chapters. In this chapter, our foci are the conditions under which the government
should intervene and the appropriate forms of regulation. When a business faces
significant economies of scale or scope, it may be economically efficient for the
government to award a monopoly franchise and then regulate the monopoly’s exercise
of market power. Besides, we also discuss how the government can resolve externalities
through standards and user fees, and resolve asymmetric information through regulation
of disclosure, conduct and business structure.
4.2 Natural Monopoly

A market has a natural monopoly if it is cheaper to have only one firm producing the
entire output, rather than several firms. In other words, the average cost of production is
minimised with a single supplier. For example, the market for public utilities (electricity,
water, gas) is usually a natural monopoly. A common feature of these markets is that
economies of scale or scope are large relative to the market demand. In a natural monopoly,
average cost strictly declines and therefore the marginal cost curve lies below the average
cost curve.
In a natural monopoly, the government should prohibit competition and allow a single
supplier so as to produce at the lowest average cost. However, the monopoly can
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exploit this exclusive right to raise the price, which makes the consumers worse off.
The government must control the natural monopoly to ensure market efficiency. There
are usually two ways to do this. One is for the government to own the business
itself and operate at the economically efficient level. However, in practice, government-
owned enterprises tend to be relatively inefficient, because they are prone to be coopted
by employees and they may not be able to secure the economically efficient level of
investment when competing with other priorities for a budget allocation. The other way,
which is used more often in practice, is to award a monopoly franchise to a commercial
enterprise and then regulate it.
We next look at an example of natural monopoly of telephone utility awarded to a

commercial enterprise and the corresponding price regulations in Figure 6.8. We see that
this natural monopoly has a strictly declining average cost curve. If the phone utility is
an unregulated, profit-maximising monopoly, the market equilibrium is at point e1. It
provides 31,000 telephone lines at $710 each annually and makes a profit of $14,322,000,
equal to area A. We see that the output is too low to take advantage of the declining cost
curve, therefore the government wants to regulate the natural monopoly. The government
may regulate the price so that the utility breaks even at point e2, where the average cost
curve intersects with the demand curve. This practice of setting the price equal to the
average cost and supplying the quantity demanded is called the average cost pricing.
Alternatively, the government may regulate the utility to behave like a price taker at
point e3, where the marginal cost curve intersects with the demand curve. This practice
of setting the price equal to the marginal cost and supplying the quantity demanded is
called the marginal cost pricing. If so, the government must subsidise the utility by area B
= $2,583,000 to keep it from shutting down. Therefore, under monopoly pricing the firm
makes profits; and under average cost pricing the firm breaks even; while under marginal
cost pricing the firm makes losses.
Under marginal cost pricing, the marginal benefit equals marginal cost and therefore
it is economically efficient. However, there are two challenges to implement it. One is
the government subsidy as discussed above. The other is the cost information since the
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franchise holder tends to over-report its costs to achieve a higher price under regulations.
This inefficiency is indeed a result of asymmetric information.
Figure 6.8 Natural Monopoly Price Regulations
An alternative to price regulation is through rate-of-return regulation, which avoids the

issue of cost and instead focusses on the profit. Specifically, the franchise holder is allowed
to set prices freely, but it cannot exceed the maximum allowed profit. However, the rate-of-
return regulation is also subject to several challenges. One is to determine the appropriate
rate of return, given that there are few comparable businesses. Another is to determine
the return base, which is the assets or equity on which the franchise holder may earn the
allowed return. Besides, the franchise holder tends to over invest beyond the economically
efficient level to enlarge the rate base so as to increase the profit.
4.3 Potentially Competitive Market

A potentially competitive market has relatively small economies of scale and scope.
Allowing two or more suppliers in the market will not increase the average cost. Therefore,
the government should promote competition in a potentially competitive market to
achieve economic efficiency.
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Competitive laws, also called antitrust laws, are rules and regulations designed to
promote a competitive economy by prohibiting actions that restrain or are likely to
restrain competition and restricting the forms of allowable market structures. Monopoly
power can arise in a number of ways, each of which is covered by the antitrust laws.
Specifically, competition laws prohibit competitors from colluding on price or other
aspects of purchases or sales; businesses with market power from abusing their market
power; mergers or acquisitions that would create substantial market power; and specific
business practices such as control over resale prices and exclusive agreements.
Laws against anti-competitive mergers take effect in Singapore in 2007. A business merger
is to take advantage of business synergy among related firms but merger can create
monopoly in certain industries. For example, there are three firms in this industry. If these
three firms merge to become one big firm, it is now a monopoly. Under the proposed
competition law, the merger is illegal.
In some circumstances, one market is a natural monopoly while the related upstream
or downstream markets are not. For example, the distribution of water may be a
natural monopoly while its production is potentially competitive. In these markets, the
government faces challenges when the monopoly franchise holder also participates in
the potentially competitive market. The government should consider how to preserve
monopoly in one market and at the same time promote competition in another. One
solution is to separate the natural monopoly from the potentially competitive market
through structural regulations, which stipulate conditions for a business to produce
vertically related goods and services.
4.4 Asymmetric Information

We have seen that asymmetric information can lead to market inefficiencies, in particular,
adverse selection and moral hazard, in Chapters 2 and 3 of this study unit. To resolve
the information asymmetry, the regulators can regulate the disclosure of information by
the better-informed party, and the conduct and business structure of the better-informed
party.
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Disclosure by the better-informed party is the most obvious way to resolve asymmetric
information, but it works only if the information can be objectively verified. The regulator
can also regulate the conduct of the better-informed party so as to limit the extent to
which it can exploit informational advantage. Another way of regulation is to regulate
the structure of the industry by enforcing separation of different businesses. On the other
hand, an industry organisation can use self-regulations, such as entry and exit, business
structure, investment, production, products, pricing and advertising, to forestall direct
government regulations. However, an issue here is that some organisations may use self-
regulation as a cover to limit competition.
4.5 Externalities
In Chapter 1 of this study unit, we have seen that externalities can lead to market
inefficiency. Since the benefit or cost passes directly from source to recipient instead of
through a market, the market mechanisms cannot work in these situations. Suppose
the market failure is pollution. There is no market for pollution. Output decision and
emissions decision are independent. Firm has chosen its profit-maximising output level.
Marginal social cost (MSC) of emissions is upward-sloping because of substantially
increasing harm as pollution increases, as shown in Figure 6.9. Marginal cost of abating
emissions (MCA) is the additional cost to firm of controlling pollution. It is downward-
sloping because there are economies of scale in reducing emissions. As shown in Figure
6.9, if the firm does not consider abatement, its profit maximising level is 26 units of
emissions, which is the level where MCA is zero. The socially efficient level of emissions
is 12 where the MSC equals the MCA.
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Figure 6.9 The Efficient Level of Emissions
4.5.1 Regulation of Externalities

Since there is no market for emissions, government regulations are necessary to resolve
the externality. Firms can be encouraged to reduce emissions to the efficient level in three
ways:
1. Emissions standards
2. Emissions fees/taxes
3. Transferable emissions permits
We next discuss some options for reducing emissions to E* in the above example using
Figure 6.10. From the society’s point of view, the equilibrium point is S. Hence, optimum
level of emissions is 12. For the firm, the equilibrium point is B as there is no cost of
emissions. An emission standard can set a legal limit on emissions at E* (12). It should
be enforced by monetary and criminal penalties. A potential issue of emission standard
is that it increases the cost of production and the threshold price to enter the industry.
Another way is to impose emissions fees or taxes, which are charges levied on each unit
of emission. In Figure 6.10, what if we impose $3 per unit of emissions? At the 8th unit
of emissions, marginal cost of not reducing emissions is greater than the fees; hence, the
firm continues to pollute. The firm will stop only when marginal cost of not reducing
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emissions is equal to the fees of $3 per unit. The firm will then choose S which is the
society’s equilibrium point too.
Figure 6.10 Standards and Fees
In our example, standards and fees produce the same results. But it may not be so if we
have more than one firm and their cost structure is different. In these situations, fees are
better than standards and permit is the best way to deal with emissions. Since we do not
need to know the cost structures, with emissions permits, market forces will decide the
most efficient way to reduce pollution. It also allows private citizens to participate since
private citizens can raise the value of the permit by bidding.
Congestion is another example of negative externality. It is an externality that varies over

time because it is more likely to occur during peak hours, while outside of peak hours,
the facilities such as highways and tunnels provide non-rival use. As a consequence,
the marginal cost varies with the time of the day and hence the user fees should
change accordingly as well to ensure the economically efficient level of usage. Similarly,
externalities can vary geographically and the appropriate user fees/taxes should vary
accordingly.
Another class of externalities are probabilistic, such as accidents. Government typically

assigns rights which then establish the basis for the relevant parties to resolve the
externality. Specifically, the law specifies the conditions under which one party must
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pay damages for causing harm to another, which are called the liability of the parties to
an accident. This is essentially an implicit price for failing to take care and causing an
accident.
4.6 Public Goods

We have seen in previous chapters that public goods have two characteristics. One is non-
rival, which means that for any given level of production the marginal cost of providing it
to an additional consumer is zero. This imposes a challenge to achieve economic efficiency
in the provision and consumption of public goods. The other is non-excludability, which
means people who do not pay cannot be excluded from consuming the good. This leads
to an issue for the provider to collect revenue.
To resolve these issues, the government can provide the public goods for free, for example,
national defence. Charities can also provide some public goods for free, for example,
open-source software. Some private enterprises and non-profit organisations can provide
the public good with government subsidies as well, such as scientific research and
development.
Activity 3
1. What are emissions standards? Why might both sides (both polluter and pollutee)
have an incentive to exaggerate their costs?
2. Answer the following questions about natural monopoly.

a. What is the defining characteristic of a natural monopoly?
b. Should a natural monopoly be made competitive?
c. Suppose the government wants to ensure that some of the benefits of
declining average cost are passed on to consumers. To achieve this goal,
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it requires that the natural monopoly sets price equal to marginal cost.
Is this a feasible goal? Explain.
d. What is an alternative to marginal cost pricing that ensures that
consumers reap some of the benefits of declining average cost?
Read
5th Edition.
Lesson Recording
Regulation
1. A synthetic “Chemical X” is the secret ingredient in many plastics that are designed
to be visually appealing. Chemical X has been in production for over 30 years, yet is
produced by only one firm. The most likely explanation for their monopoly is
a. a patent.
b. a government franchise.
c. a copyright.
d. economies of scale.
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The firm illustrated in the graph is a(n)

a. oligopolist.
b. natural monopolist.
c. monopolistic competitor.
d. insufficient information to classify.
3. To profit maximize, the firm will choose to produce __________ units and charge a
price of __________.
a. 3.5; $33.50
b. 7; $19.30
c. 3.5; $5
d. 3.5; $22.50
4. The socially efficient price and output combination is

a. $5 and 7.
b. $22.50 and 3.5.
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c. $5 and 3.5.
d. $33.50 and 3.5.
5. At the point of profit maximization, the monopolist earns

a. a profit of $38.50.
b. a loss of $38.50.
c. a loss of $11.20.
d. a loss of $61.25.
6. At the socially efficient level of output, the monopolist would earn

b. a profit of $50.05.
c. a loss of $100.10.
7. The __________ at the socially efficient level of output will be __________ at the profit
maximizing level of output.
a. loss; smaller than
b. profit; larger than
c. profit; smaller than
d. loss; larger than
8. The EPA has proposed strict controls on the amount of sulfur diesel fuel contains.
The effect of the regulation is estimated to increase the equilibrium price of a gallon
of diesel fuel by 10 cents. Assuming the supply of diesel fuel has positive slope and
demand has negative slope, one can infer that
a. the external benefits of diesel fuel is less than 10 cents.
b. the external cost of diesel fuel is greater than 10 cents.
c. the external cost of diesel fuel is less than 10 cents.
d. the external benefit of diesel fuel is greater than 10 cents.
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9. Which one of the following government actions is intended to generate positive

externalities?
a. Free speech laws.
b. Speed limits on the highways.
c. Public service ads discouraging smoking.
d. Subsidies for planting trees on hillsides.

some.
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Summary
In this study unit, we look at issues of management in imperfect markets. We first discuss
various types of marker failures in the first three chapters and then in the last chapter we
focus on the solutions to these market failures.
An externality arises then one party directly conveys a benefit or cost to others. An item is a
public good if one person’s increase in consumption does not reduce the quantity available
to others. The benchmark for externalities and public good is economic efficiency. At that
point, all parties maximize their net benefits. Externalities can be resolved through merger
or joint ownership, but resolutions may be hampered by differences in information and
free riding. Similarly, the commercial provision of a public good depends on being able to
exclude free riders. Excludability depends on law and technology.
In situations of asymmetric information, the allocations of resources will not be

economically efficient. The asymmetry can be resolved directly through appraisal or
indirectly through screening, signaling or contingent payments.
The architecture of an organization comprises the distribution of ownership, incentive

schemes and monitoring systems. An efficient organizational architecture resolves four
international issues – holdup, moral hazard, monopoly power, economies of scale and
scope, and how these can be resolved.
The marginal benefit of an item may diverge from the marginal cost for three basic
reasons: market power, asymmetric information and externalities and public goods. The
divergence results in economic inefficiency. Government regulation may help where
private action fails to resolve the economic inefficiency.
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1. Which of the following would not be considered to involve an externality?
a. Driving one’s automobile onto a crowded freeway at rush hour.
Incorrect. This involves a negative externality.
b. Mowing one’s lawn with an exhaust-emitting power lawnmower.

Incorrect. This involves a negative externality.
c. A firm’s purchasing enough of an input to drive up its price to the firm’s

competitors, thus increasing their costs.
Correct. Externalities are the effects of production and consumption
activities not directly reflected in the market. There is no externality.
d. A university locating in a region, thus increasing property values of all the

adjoining landowners in the region.
Incorrect. This involves a positive externality.
2. Which statement(s) is (are) true regarding the provision of goods with externalities?
I. Otherwise-competitive markets provide less than the efficient level of a
good with negative externalities.
II. Otherwise-competitive markets provide more than the efficient level of a
good with positive externalities.
III. Imperfectly competitive markets might provide the efficient level of a good
with negative externalities, but not necessarily.
Incorrect. Otherwise-competitive markets provide more than the efficient
level of a good with negative externalities.
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Incorrect. Otherwise-competitive markets provide less than the efficient level

of a good with positive externalities.

Correct. Imperfectly competitive markets might provide the efficient level
of a good with negative externalities, but not necessarily.

Incorrect. Otherwise-competitive markets provide more than the efficient
level of a good with negative externalities. Otherwise-competitive markets
provide less than the efficient level of a good with positive externalities.
3. An appropriate policy to remedy a negative externality in production would be

a. to charge an emissions fee equal to the marginal social cost of production.
Incorrect. The firm will stop only when marginal cost of not reducing
emissions is equal to the emission fees.
b. to charge an emissions fee equal to the marginal private cost of production.

c. to charge an emissions fee equal to the difference between the marginal social
cost and the marginal private cost of production.
Correct. The firm will stop only when marginal cost of not reducing
d. to impose the same emissions standard on each firm in the industry,

regardless of it abatement cost efficiency.
4. Which statement is correct concerning positive externalities?
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a. If a consumer would have paid more than she did pay for a competitively-
priced good, she received a positive externality.
Incorrect. This is a negative externality.
b. Positive externalities are spillover benefits bestowed on parties not directly

involved in a related market transaction.
Correct. Positive externalities occur when a decision bestows a benefit on
a third party who is not involved in the market transaction.
c. A monopolist might end up producing the efficient amount of a good with

positive externalities.
Incorrect. Existence of positive externalities means that external benefits are
not considered by market decision makers. As a results, too little of the good
gets produced and consumed in competitive markets and hence they are
sources of inefficiency.
d. Competitive markets tend to produce too much of a good with positive

externalities.
Incorrect. Existence of positive externalities means that external benefits are
not considered by market decision makers. As a results, too little of the good
gets produced and consumed in competitive markets and hence they are
sources of inefficiency.
5. Herb runs an egg ranch next door to Sally’s auto body shop. Sally’s shop makes a lot
of noise that could be eliminated if she incurred $6,000 per year in noise- abatement
procedures. As it is, she earns $50,000 per year in profit. Herb’s chickens don’t lay as
many eggs when it’s noisy. With all the noise next door, he earns $120,000 a year, but
if it were quiet, his profit would be $124,000. Which statement is correct?
a. Since both Herb and Sally operate in competitive markets, efficiency is
probably about as high as it’s likely to get.
Incorrect. There is a negative externality.
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b. Without a law that requires silent auto body operation, Herb is destined to
put up with the noise and earn lower profit.
Incorrect. Externalities can be resolved in other ways than law.
c. If a law ensured Herb the right to silence for his hens, Sally would just have
to pay the abatement cost, resulting in lower total profit for both producers
together.
Incorrect. If a law ensured Herb the right to silence for his hens, Sally could
possibly negotiate to pay Herb for the right to make noise in her shop, leading
to a more efficient outcome.
d. If a law ensured Herb the right to silence for his hens, Sally could possibly
negotiate to pay Herb for the right to make noise in her shop, leading to a
more efficient outcome.
Correct. This is way to resolve externality.
6. Where inefficiencies exist owing to negative externalities, ______

a. frictionless negotiation and well defined property rights will result in the
same distribution of wealth, regardless of how the property rights are
assigned.
Incorrect. This depends on how the property rights are assigned.
b. it is always more efficient to eliminate the source of the negative externality

through strict enforcement anti-pollution laws.
Incorrect. This may not always be efficient.
c. there is an opportunity to increase overall wealth through elimination of the

externality.
Correct. Elimination of the externality can improve efficiency.
d. negotiation will result in a different ultimate allocation of resources,

depending upon how the property rights are assigned.
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Incorrect. Efficient outcome is always the same.
7. The efficient level of air pollution _______

a. is the level that minimizes damage done from air pollution.
Incorrect. The efficient level of air pollution is the level that equates the
marginal cost of abatement to the marginal social cost of air pollution.
b. is the level that equates the marginal cost of abatement to the marginal social
benefit from air pollution.
Incorrect. The efficient level of air pollution is the level that equates the
c. is always zero.
Incorrect. It may not be zero if the cost of abatement is big.
d. is the level that equates the marginal cost of abatement to the marginal social
cost of air pollution.
Correct. The efficient level of air pollution is the level that equates the
8. A good is said to be non-excludable if _____

a. one more person can consume it without reducing the amount other people
can consume.
Incorrect. This is called non-rival.
b. anyone can buy it without meeting restrictions such as residency or age.

Incorrect. This is not related to non-excludability.
c. once it is produced, even people who do not pay for it cannot be prevented
from consuming it.
Correct. The definition of non-excludable goods.
d. you must pay for it in order to be able to consume it.
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Incorrect. This is not related to non-excludability.
9. Which of the following activities is non-rival but not non-excludable?

a. watching a baseball game in a stadium that is not filled to capacity.
Correct. This is excludable and non-rival.
b. national defense.
Incorrect. This is non-excludable and non-rival.
c. fishing in the ocean.

d. viewing a spectacular sunset.


Incorrect. Private firms may provide them.

Incorrect. The government may provide them.

some.
Correct. This is about the provision of public goods.

Incorrect. The government frequently provides them although private firms
provide some.
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1. Consider the market for loans for the purpose of capital investments. Suppose lenders
cannot price discriminate (i.e. vary interest rates) between good and bad borrowers
in loan contracts because the lenders are not able to observe the riskiness of the
investment project. What is the nature of the adverse selection problem in this
market? What is likely to happen to the lender's profit?
Adverse selection occurs when the potential borrowers who are the most likely to
produce an undesirable (adverse) outcome, the bad credit risks, are the ones who
most actively seek out a loan and are thus most likely to be selected. The lender's
profit is likely to fall because the incidence of default is likely to be high.
2. In the following situations, explain why there is asymmetric information, and identify
the consequence of asymmetric information.
a. the sale of life insurance
b. the sale of used computers
2a. Individuals know more about the risk of their life-styles than do insurance
companies. The consequence of this is adverse selection: people with more risk of
death are those most likely to buy life insurance.
2b. Owners of used computers know more about the characteristics of their
computers than do potential buyers. The consequence is adverse selection: buyers
fear buying defective computers which means that owners of reliable used
computers will not be able to sell their product at their required price, thus
causing them to drop out of the market. Also buyers interested in buying reliable
computers avoid the used-computer market.
1. People are risk neutral if
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a. they will accept any gamble.

Incorrect. A risk neutral person is indifferent between a certain amount and
risky amounts with the same expected value. A risk averse person prefers a
certain amount to risky amounts with the same expected value.
b. they will accept a gamble only if it is better-than-fair.

Incorrect. A risk neutral person is indifferent between a certain amount and
risky amounts with the same expected value. A risk averse person prefers a
certain amount to risky amounts with the same expected value.
c. they will accept a fair or better gamble.

Correct. A risk neutral person is indifferent between a certain amount and
risky amounts with the same expected value. A risk averse person prefers
a certain amount to risky amounts with the same expected value. A risk-
averse person will refuse any fair gamble, while a risk-neutral person will
accept any gamble that is fair or better.
d. they will not accept an unfair gamble.

Incorrect. A risk-averse person will refuse any fair gamble, while a risk-
neutral person will accept any gamble that is fair or better.
2. If you will refuse any fair gamble you are

a. risk loving.
b. risk neutral.
c. risk averse.
SU6-62
Correct. A risk-averse person will refuse any fair gamble, while a risk-
d. risk avoiding
3. When buyers and sellers are not equally well informed about a good, there is
a. unfairness.
Incorrect. With asymmetric information, party to a transaction tends to know
more than the other.
Correct. With asymmetric information, party to a transaction tends to know
more than the other.
c. symmetric information.
Incorrect. With symmetric information, all the parties to a transaction are
equally informed.
d. risk aversion.
Incorrect. A risk averse will pay to avoid risk and this creates the business
of insurance.
4. The Lemons Model explains how

a. asymmetric information decreases the average quality of goods for sale.
Incorrect. This statement is correct but not complete.
b. people with lower quality goods are more likely to sell them.
c. reservation prices for used goods are lower.

SU6-63
d. all of the above

Correct.
5. In some situations, parties to a transaction have the same pieces of information or,
put another way, there is no differential information between the two parties. In other
cases, one party may have more information than the other. Consider the following
two scenarios:
i. Alex purchases from Jerry a ticket for an outdoor concert some months away.
Neither Alex nor Jerry know what the weather will actually be on the day
of the concert.
ii. Sven offers to sell Frank his 14-year old BMW. Sven is familiar with the car's
maintenance records and accident history but Frank is not.
Which of the following statements is true?
a. Both transactions involve the existence of asymmetric information.

Incorrect. Scenario (ii) involves the existence of asymmetric information
while scenario (i) does not.
b. Scenario (ii) involves the existence of asymmetric information while scenario

(i) does not.
Correct. In scenario (i), both parties are equally uninformed. In scenario
(ii), Sven has more information than Frank about the car.
c. Scenario (i) involves the existence of asymmetric information while scenario

(ii) does not.
d. Neither transaction involves the existence of asymmetric information.
SU6-64

6. There are 1,000 houses in Ardmore Park. Each house costs $300,000 and 1 percent of
the houses are likely to be wiped out by floods and landslides. Residents do not know
with certainty which homes will be wiped out. Scott Klein, an enterprising college
graduate is considering starting an insurance agency to offer flood insurance policies.
The policy will pay the purchase price of $300,000 if a homeowner's house is wiped
out. What is the maximum annual premium that a homeowner will be willing to pay
for a policy?
a. $1,000
Incorrect. The expected loss for a homeowner is $300,000*1%=$3,000. The
insurance pays the amount of the value of each house. Therefore, the
maximum annual premium that a homeowner will be willing to pay is $3,000.
b. $3,000
Correct. The expected loss for a homeowner is $300,000*1%=$3,000. The
maximum annual premium that a homeowner will be willing to pay is
$3,000.
c. $30,000
d. $300,000
SU6-65
7. Auto insurance companies reward those have had no moving violations for several
years with "good driver" discounts. What is the incentive for insurance firms to do
this?
a. It reduces the potential inefficiency caused by adverse selection because the
discount ensures that only good drivers will purchase auto insurance.
Incorrect. The discount reduces reckless driving behavior, but cannot ensure
that only good drivers will purchase auto insurance.
b. It is a way of making bad drivers subsidize good drivers

Incorrect. Bad drivers are not subsidizing good drivers.
c. It reduces the potential inefficiency caused by adverse selection because

some safe drivers will also be insured instead of just attracting reckless
drivers.
Correct. Adverse selection is opportunism by the informed person in
such a way that he/she benefits from transacting with an uninformed
person who does know about an unobserved characteristic of the informed
person.

Incorrect. A and B are not correct. The discount reduces reckless driving
behavior, but cannot ensure that only good drivers will purchase auto
insurance. Bad drivers are not subsidizing good drivers.
8. Suppose that in a market for used cars, there are good used cars and bad used cars
(lemons). Consumers are willing to pay as much as $6,000 for a good used car but only
$1,000 for a lemon. Sellers of good used cars ask $5,000 per car and sellers of lemons
ask $800. Buyers cannot tell if a used car is reliable or is a lemon. It has been estimated
that 30% of all used cars in the market are lemons. Based on this information, what
is the likely outcome in the market for used cars?
a. Only lemons will sell, for $800 each.
SU6-66
Incorrect. Seller’s expected value for a car in the market is 70%*$6,000

+30%*1,000=$4,500. This is the amount they are willing to pay, which is larger
than the amount asked by the sellers of good cars. Therefore, only lemons
will sell for $4,500.
b. Only lemons will sell, for $4,500 each.

Correct. Seller’s expected value for a car in the market is 70%*$6,000
+30%*1,000=$4,500. This is the amount they are willing to pay, which is
larger than the amount asked by the sellers of good cars. Therefore, only
lemons will sell for $4,500.
c. Both good used cars and lemons will sell for $4,500 each.
d. Both good used cars and lemons will sell for $1,000 each.
9. Many consumer items, such as cars and home entertainment systems, come with
some form of warranty. Why do firms offer warranties?
a. If firms do not offer warranties, no one will buy high priced consumer goods.
Incorrect. Without warranties, some people may still buy high priced
consumer goods.
b. Firms want to encourage repeat customers.

Incorrect. Warranties serve as a form of consumer insurance.
c. Warranties serve as a form of consumer insurance.
SU6-67
Correct. Warranties serve as a form of consumer insurance to prevent the

lemons problem.
d. A warranty is essentially a form of price discrimination where the firm

charges a higher price to some consumers without discouraging others.
Incorrect. Warranties serve as a form of consumer insurance to prevent the
lemons problem.
10. Which of the following is an example of adverse selection?

a. The odds of a fire rise after the building is insured because the person with
fire insurance is likely to pay less attention to fire hazards.
Incorrect. This is an example of moral hazard Moral hazard is a
result of asymmetric information. It is opportunism characterized by the
informed person’s taking advantage of the less-informed person through an
unobserved action. In other words, the informed person cannot be accurately
monitored by the other party.
b. People prefer to buy new cars rather than used cars.

Incorrect. Adverse selection is opportunism by the informed person in such
a way that he/she benefits from transacting with an uninformed person who
does know about an unobserved characteristic of the informed person.
c. Someone whose building is more likely to burn down is likely to buy to

insurance.
Correct. Adverse selection is opportunism by the informed person in
such a way that he/she benefits from transacting with an uninformed
person who does know about an unobserved characteristic of the informed
person.
d. Someone with auto insurance drives more recklessly than someone without
auto insurance.
SU6-68
Incorrect. This is an example of moral hazard Moral hazard is a

result of asymmetric information. It is opportunism characterized by the
informed person’s taking advantage of the less-informed person through an
unobserved action. In other words, the informed person cannot be accurately
monitored by the other party.
1. Kenny has just been hired as the manager of The Fennel Grill. The restaurant enjoys
a good reputation for its food and service. Currently, the wait staff (servers) are not
required to share their tips with the kitchen staff (cooks, dishwashers). Kenny feels
that this is an unfair system and would like to eliminate tipping and in its place
implement a standard 15 percent service charge which will be shared equally among
non-management restaurant staff. How will this affect the productivity of the wait
staff? Will this scheme require less monitoring or more monitoring of the wait staff?
Tipping gives servers an incentive to provide good service. If tipping was
eliminated and replaced by a standard 15 percent service charge, the wages of
servers are likely to fall and service is likely to be shoddy. This scheme is likely to
require more monitoring if the same quality of service is to be rendered.
2. Explain why there is asymmetric information in the following situation and identify
the consequence of asymmetric information: hiring a property manager to manage
the condominiums you own.
The property manager acts as your "agent," since he is performing some task
on your behalf. Because you (the principal) cannot perfectly monitor the agent's
behaviour, the agent has an incentive to undertake less effort than you consider
desirable. The consequence of this asymmetric information is moral hazard: risk
of dishonest, or otherwise, inappropriate behaviour by the agent.
SU6-69
1. All of the following are ways to reduce moral hazard by ensuring that the incentives
of the agent match that of the principal except
a. McDonald's requires that franchisees must put up 40 percent of the
investment required to start up the restaurant themselves.
Incorrect. This is a way to reduce moral hazard through incentive schemes.
b. requiring that all firms that issue stock to the public have their statements
audited by an independent accounting firm.
Incorrect. This is a way to reduce moral hazard through monitoring.
c. venture capitalists provide capital to start-up firms and then ensure that the
equity in the firm is not marketable to anyone but them.
Incorrect. This is a way to reduce moral hazard through incentive schemes.
d. giving the chief executive officer of a large corporation the right to make
financial decisions independently.
Correct. To reduce moral hazard, we should not give the chief executive
officer of a large corporation the right to make financial decisions
independently.
2. Dynasty Corp. is run by a team of managers who have been elected by the firm's
board of directors. Dynasty, a private corporation owned by 400 stockholders, is
a manufacturer of security systems. Which of the following statements is true? A
principal-agent relationship exists between
a. Dynasty's board of directors and the firm's employees where the board of
directors is the principal and employees are the agents.
Incorrect. Dynasty's board of directors and the management team where the
board is the principal and managers are the agents.
SU6-70
b. Dynasty's stockholders and customers where the stockholders are the

principals and customers are the agents.
c. Dynasty's board of directors and the management team where the board is
the principal and managers are the agents.
Correct. The agent is the person who acts and the principal is the party
whom the action affects. An agency relationship exists whenever there is
an arrangement in which one person’s (the principal’s) welfare depends on
what the other person (the agent) does
d. Dynasty Corp. and its customers where Dynasty Corp. is the principal and
its customers are the agents.
3. ________ occurs when actions taken by one party to a transaction are different than
what the other party expected at the time of the transaction.
a. Fraud
Incorrect. Moral hazard is a result of asymmetric information. It is
opportunism characterized by the informed person’s taking advantage of
the less-informed person through an unobserved action. In other words, the
informed person cannot be accurately monitored by the other party.
b. Moral hazard
Correct. Moral hazard is a result of asymmetric information. It is
the less-informed person through an unobserved action. In other words,
the informed person cannot be accurately monitored by the other party.
c. Adverse selection
SU6-71

d. Risk aversion
Incorrect. A risk averse person prefers a certain amount to risky amounts
with the same expected value.
4. If a fire insurance company requires firms buying fire insurance to install automatic
sprinkler systems, the insurance company is trying to reduce:
a. adverse selection problems.
Incorrect. Asymmetric information occurs when one party to a transaction
tends to know more than the other.
c. moral hazard problems.

d. sunk costs.
Incorrect. A sunk cost is a cost that has already been incurred and thus cannot
be recovered.
5. Management can give workers incentive to work harder by:

a. paying an efficiency wage.
SU6-72
Incorrect. This can give workers incentive to work harder, but it is an

incomplete answer.
b. having a seniority system.

incomplete answer.
c. having a profit sharing system among employees.

incomplete answer.
d. all of the above.

Correct. All the above can give workers incentive to work harder.
6. Management can encourage workers to work as hard as they can by:

a. monitoring workers closely.
Correct. Monitoring is a way to reduce the moral hazard problem.
b. hiring only hard workers.

Incorrect. This cannot reduce the moral hazard problem.
c. assuming that workers are motivated on their own.

d. assigning numerical quotas of what each worker should produce each day.
Incorrect. This cannot reduce the moral hazard problem since quality cannot
be monitored.
7. If workers cannot be monitored closely, management can give workers incentive to

work hard by:
a. giving them awards for meeting production quotas.
be monitored.
SU6-73
b. fining them for every low quality product they produce.

be monitored.
c. hiring only hard workers.

d. increasing the value of the job to them, relative to other jobs they could hold.
Correct. This is a way to reduce the moral hazard problem.
8. The most uncertain work incentive system is:

a. use of a market wage.
b. use of an efficiency wage.

c. use of a profit sharing program with employees.

Correct. This is a way to reduce the moral hazard problem.
d. use of a seniority system.

9. An example of a moral hazard problem in labor markets is:

a. employees may steal from the firm.
b. workers may work too hard and cost other potential workers jobs.
SU6-74

c. workers may fake injuries to get medical awards.

d. workers may put forth as little effort as possible on the job.

10. When people who buy insurance change their behavior because they are protected
from loss by the insurance, the insurance market exhibits:
a. economic irrationality.
Incorrect. Asymmetric information occurs when one party to a transaction
tends to know more than the other.
c. moral hazard.
SU6-75
d. adverse selection.
1. What are emissions standards? Why might both sides (both polluter and pollutee)
have an incentive to exaggerate their costs?
An emission standard is a legal limit on the amount of pollution that a person or
entity can produce from a particular activity. In order for the government to set
an efficient emission standard, it needs to know precisely the polluter’s cost of
abatement and the social costs. Thus, both sides have an incentive to overestimate
the costs. On the one hand, the polluter will overestimate their cost of abatement
so that the government places higher emission standards. The pollutee has the
incentive to overestimate the social cost of emissions so that the government sets
a lower emission standard.
2. Answer the following questions about natural monopoly.

a. What is the defining characteristic of a natural monopoly?
b. Should a natural monopoly be made competitive?
c. Suppose the government wants to ensure that some of the benefits of
declining average cost are passed on to consumers. To achieve this goal, it
requires that the natural monopoly sets price equal to marginal cost. Is this
a feasible goal? Explain.
d. What is an alternative to marginal cost pricing that ensures that consumers
reap some of the benefits of declining average cost?
SU6-76
2a. The defining characteristic is the presence of significant economies of scale such
that average cost of production declines over the relevant range of market demand.
2b. No, given the importance of economies of scale, society is better off with one
big firm producing the output rather than several small firms.
2c. Setting price equal to marginal cost is not feasible because the natural
monopoly will incur persistent losses and therefore will not continue to produce
in the long run.
2d. An alternative solution is to require average total cost pricing, that is, where
price is set equal to average cost of production (where the average cost includes the
opportunity cost of funds invested). This will allow the monopolist to earn normal
profit which means that the monopolist can stay in business.
1. A synthetic “Chemical X” is the secret ingredient in many plastics that are designed
to be visually appealing. Chemical X has been in production for over 30 years, yet is
produced by only one firm. The most likely explanation for their monopoly is
a. a patent.
Incorrect. This is an example of natural monopoly. A common feature of these
markets is that economies of scale or scope are large relative to the market
demand. In a natural monopoly, average cost strictly declines and therefore
the marginal cost curve lies below the average cost curve.
b. a government franchise.
SU6-77
c. a copyright.
d. economies of scale.
Correct. This is an example of natural monopoly. A common feature of
these markets is that economies of scale or scope are large relative to the
market demand. In a natural monopoly, average cost strictly declines and
therefore the marginal cost curve lies below the average cost curve.
The firm illustrated in the graph is a(n)
a. oligopolist.
SU6-78
Incorrect. In a natural monopoly, average cost strictly declines and therefore

b. natural monopolist.
Correct. In a natural monopoly, average cost strictly declines and therefore
c. monopolistic competitor.
d. insufficient information to classify.

3. To profit maximize, the firm will choose to produce __________ units and charge a
price of __________.
a. 3.5; $33.50
Incorrect. To profit maximize, the firm will produce at MR=MC with 3.5 units.
The corresponding price according to the demand curve is $22.50.
b. 7; $19.30
c. 3.5; $5
d. 3.5; $22.50
Correct. To profit maximize, the firm will produce at MR=MC with 3.5
units. The corresponding price according to the demand curve is $22.50.
SU6-79
4. The socially efficient price and output combination is

a. $5 and 7.
Correct. The socially efficient price and output combination is where the
demand curve intersects the MC. That is, price is $5 and quantity is 7.
b. $22.50 and 3.5.

Incorrect. The socially efficient price and output combination is where the
c. $5 and 3.5.
d. $33.50 and 3.5.

5. At the point of profit maximization, the monopolist earns

Incorrect. At the point of profit maximization, the price is $22.50 and quantity
is 3.5. Therefore, the net profit is ($22.50-$33.50)*3.5=-$38.50. It is a loss of
$38.50.
b. a loss of $38.50.
Correct. At the point of profit maximization, the price is $22.50 and
quantity is 3.5. Therefore, the net profit is ($22.50-$33.50)*3.5=-$38.50. It is
a loss of $38.50.
c. a loss of $11.20.
$38.50.
SU6-80
$38.50.
6. At the socially efficient level of output, the monopolist would earn

Incorrect. At the socially efficient level of output, the price is $5 and quantity
is 7. Therefore, the net profit is ($5-$19.3)*7=-$100.10. It is a loss of $100.10.
b. a profit of $50.05.
c. a loss of $100.10.
Correct. At the socially efficient level of output, the price is $5 and quantity
7. The __________ at the socially efficient level of output will be __________ at the profit
maximizing level of output.
a. loss; smaller than
Incorrect. Based on Q5 and Q6, the loss at the socially efficient level of output
will be larger than at the profit maximizing level of output.
b. profit; larger than

Incorrect. Based on Q5 and Q6, the loss at the socially efficient level of output
c. profit; smaller than
SU6-81
Incorrect. Based on Q5 and Q6, the loss at the socially efficient level of
output will be larger than at the profit maximizing level of output.
d. loss; larger than

Correct. Based on Q5 and Q6, the loss at the socially efficient level of output
8. The EPA has proposed strict controls on the amount of sulfur diesel fuel contains.
The effect of the regulation is estimated to increase the equilibrium price of a gallon
of diesel fuel by 10 cents. Assuming the supply of diesel fuel has positive slope and
demand has negative slope, one can infer that
a. the external benefits of diesel fuel is less than 10 cents.
Incorrect. Diesel fuel has external costs instead of external benefits.
b. the external cost of diesel fuel is greater than 10 cents.

Correct. The external cost of diesel fuel is greater than the increase in the
equilibrium price of a gallon of diesel fuel.
c. the external cost of diesel fuel is less than 10 cents.

Incorrect. The external cost of diesel fuel is greater than the increase in the
equilibrium price of a gallon of diesel fuel.
d. the external benefit of diesel fuel is greater than 10 cents.

Incorrect. Diesel fuel has external costs instead of external benefits.
9. Which one of the following government actions is intended to generate positive

externalities?
a. Free speech laws.
Incorrect. Positive externalities occur when a decision bestows a benefit on a
third party who is not involved in the market transaction.
b. Speed limits on the highways.
SU6-82
Incorrect. This is to correct negative externality.
c. Public service ads discouraging smoking.

Incorrect. This is to correct negative externality.
d. Subsidies for planting trees on hillsides.

Correct. Positive externalities occur when a decision bestows a benefit on
a third party who is not involved in the market transaction.

Incorrect. The government frequently provides pure public goods although
private firms provide some.


some.
Correct. The government frequently provides pure public goods although

SU6-83
References
Higher Education.
Education.
SU6-84

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Course Development Team

Head of Programme : Assoc Prof Huong Ha

© 2020 Singapore University of Social Sciences. All rights reserved.

Educational Technology & Production

How to cite this Study Guide (APA):

University of Social Sciences.

Build S1.0.5, T1.5.21

2. Course Description and Aims............................................................................ CG-3

3. Learning Outcomes.............................................................................................. CG-5

4. Learning Material................................................................................................. CG-6

5. Assessment Overview.......................................................................................... CG-7

7. Learning Mode.................................................................................................... CG-11

Study Unit 1: Demand and Supply Analysis

Chapter 1: Introduction to Managerial Economics............................................. SU1-4

Chapter 2: Demand Analysis and Supply Analysis........................................... SU1-9

Study Unit 2: Market Equilibrium and Economic Efficiency

Chapter 1: Market Equilibrium............................................................................. SU2-4

Chapter 2: Economic Efficiency........................................................................... SU2-13

Study Unit 3: The Cost Side of the Market

Chapter 1: Cost of Production in the Short Run................................................. SU3-3

Chapter 2: Cost of Production in the Long Run............................................... SU3-16

Study Unit 4: Competitive Markets and Monopoly

Chapter 1: Competitive Markets and Economic Profit...................................... SU4-4

Chapter 2: Perfect Competition............................................................................. SU4-9

Study Unit 5: Strategic Thinking and Oligopoly

Chapter 1: Strategic Thinking and Game Theory............................................... SU5-4

Study Unit 6: Managerial Decisions in Imperfect Markets

Chapter 3: Incentives and Organisation............................................................. SU6-28

Table 1.1 Kate’s Demand Schedule for Pizzas....................................................... SU1-10

Table 1.2 Seller’s Supply Schedule for Pizzas........................................................ SU1-15

Table 1.3 The Relationship between Price Elasticity and Total

Table 1.4 Summary of Income Elasticity of Demand............................................ SU1-29

Table 1.5 Summary of Cross Price Elasticity of Demand..................................... SU1-29

Table 2.1 Cindy’s Total Utility from Chocolate Consumption............................. SU2-16

Table 3.1 Total Product, Average Product and Marginal Product......................... SU3-6

Table 3.2 Fixed Cost, Variable Cost and Total Cost................................................. SU3-7

Table 3.4 The Long Run Average Cost of Production........................................... SU3-16

Table 4.1 Monopoly Revenue, Cost and Profit...................................................... SU4-22

Figure 1.1 The Difference between Accounting Profit and Economic

Figure 1.2 Change in Quantity Demanded – Movement along the Demand

Figure 1.3 Change in Demand – Shift in Demand................................................ SU1-11

Figure 1.4 An Increase in Demand – Rightward Shift.......................................... SU1-12

Figure 1.5 A Decrease in Demand – Leftward Shift.............................................. SU1-13

Figure 1.6 Change in Quantity Supplied – Movement along the Supply

Figure 1.7 Change in Supply – Shift in Supply..................................................... SU1-16

Figure 1.8 An Increase in Supply – Rightward Shift............................................. SU1-17

Figure 1.9 A Decrease in Supply – Leftward Shift................................................ SU1-17

Figure 1.10 Calculating Price Elasticity of Demand.............................................. SU1-24

Figure 1.11 Calculating Price Elasticity of Demand.............................................. SU1-25

Figure 1.12 Perfectly Elastic and Perfectly Inelastic Demand Curves................ SU1-25

Figure 1.13 Decrease in Price will result in a Fall in Total Expenditure (Total

Figure 1.14 Decrease in Price will result in a Rise in Total Expenditure (Total

Figure 2.1 Market Equilibrium................................................................................... SU2-5

Figure 2.2 Excess Demand and Excess Supply in the Market............................... SU2-6

Figure 2.3 Four Rules governing the Effects of Supply and Demand

Figure 2.4 Increase in Supply..................................................................................... SU2-8

Figure 2.5 Increase in Demand................................................................................... SU2-8

Figure 2.6 Responses to Profit.................................................................................. SU2-14

Figure 2.7 Responses to Loss.................................................................................... SU2-15

Figure 2.8 Cindy’s Total Utility from Chocolate Bar Consumption.................... SU2-17

Figure 2.10 Economic Surplus.................................................................................. SU2-21

Figure 2.11 Market Equilibrium and Welfare......................................................... SU2-22

Figure 2.12 Deadweight Loss.................................................................................... SU2-23