lOMoARcPSD|58994964

H1 ECON10004 Summary Notes

Introductory Microeconomics (University of Melbourne)

Scan to open on Studocu

Studocu is not sponsored or endorsed by any college or university

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])
 lOMoARcPSD|58994964

ECON10004 SUMMARY NOTES

DECISION THEORY AND COSTS:
- Rational decision makers undertake a decision that maximises their net benefit
where net benefit = total benefits less total costs
- There are direct and indirect costs, which make up the opportunity cost
o Costs are measured in terms of resources including resources that are no
longer available for alternative uses (including time)
o The direct cost is the cost of resources that will be used in the chosen
alternative
o The indirect cost is the cost of the next best alternative; as you are using
up time undertaking one action and can no longer undertake this
alternative
o Must exclude sunk costs from decision making- which are resources used
before making the decision as they are no longer relevant
- Absolute advantage- the ability to produce a good using fewer inputs than another
producer
- Comparative advantage- the ability to produce a good at a lower opportunity cost
than another producer. It is not possible for a party to have a strict comparative
advantage in both goods
- Marginal benefit is the increment in total benefits by taking an action or increasing
the level of activity by one unit
o Is the derivative of the total benefit function
- Marginal cost is the increment in total costs by taking an action or by increasing the
level of activity by one unit
o Is the derivative of the total cost function
- To maximise net benefit, one would take an action/increase the level of activity as
long as MB exceeds MC. If MC exceeds MB it is no longer worthwhile to continue as
net benefit would be decreasing
o The optimal level of activity occurs when MB = MC or when the derivative
of the net benefit function equals zero

PERFECTLY COMPETITIVE MARKETS- Supply and

Demand
- There are multiple buyers and sellers who are price takers, with no market power
- No product differentiation (homogenous goods or services)

Demand curves
- Perfectly competitive markets face downward sloping demand curves. This is
because as price increases, less people demand the product (less quantity traded)
- Law of demand: price and quantity are inversely related
- When a price changes, we see movement along the demand curve and a change in
quantity of demand
- When another factor changes that affects demand, there is a shift in the demand
curve

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

o Increasing demand- demand curve shifts to the right (or up)

o Decreasing demand- demand curve shifts to the left (or down)
Supply curves
- Perfectly competitive markets face upward sloping supply curves. This is because as
price increases, sellers are more willing to supply (increase quantity)
- Law of supply: price and quantity are positively related
- When price changes, there is movement along the supply curve and a change in
quantity supplied
- When another factor changes that affects supply, there is shift in the supply curve
o Increasing supply- supply curve shifts right (downwards)
o Decreasing supply- supply curve shifts left (upwards)

Types of goods and products

- Normal goods- income and demand are positively related (as income increases,
demand increases)
- Inferior goods- income and demand are inversely related (as income decreases,
demand increases) e.g. public transport tickets
- Substitutes- the price of one good is positively related to the demand of another
good. One substitute replaces the other e.g. uber and public transport
o As the demand of one good increases, the demand of the other good
decreases
- Complements- the price of one good is inversely related to the demand of another
good. The two complements are typically consumed together e.g. video games
o Demand of both goods increase and decrease simultaneously

Market equilibrium
- Occurs when demand and supply have been brought into balance
- The quantity demanded is the same as the quantity supplied
- No excess or shortage of goods
- Occurs where the supply and demand curve intersect
- Market will always clear at equilibrium
- When P does not equal P* (market price is not the equilibrium price), the
competitive process will drive the price to converge to P*
o If the price is higher than the equilibrium price, the quantity supplied
would be greater than the quantity demanded (excess supply). Therefore,
suppliers will discount goods to P* in order to sell them. Note some
suppliers may be rationed out of the market as they would like to sell for
P but can’t
o If the price is lower than the equilibrium price, the quantity demanded
would exceed quantity supplied, meaning there is a shortage. Therefore,
buyers will bid up (be willing to pay for higher) prices. Note some buyers
will be rationed out of the market as they are not willing to increase their
price

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Demand shocks
- Occur when there is a change in demand (at every price, Q D increases or decreases)
due to an external change
- Positive demand shock- causes buyers to demand a greater quantity at every given
price, leads to an increase in demand (demand curve shifts right)
o Increase in P* and Q*
o Immediate effect- excess demand, however there is upward pressure to
increase price so there is no excess in the long run
- Negative demand shock- causes buyers to demand a lesser quantity at every given
price, leads to a decrease in demand (demand curve shifts left)
o Decrease P* and Q*
o Immediate effect- excess supply, however downward pressure on the
equilibrium price restores equilibrium = no excess in the long run

Supply shocks
- Occur when there is a change in supply (at every price, QS increases or decreases)
due to an external change
- Positive supply shock- causes suppliers to want to supply more quantity at every
given price, leads to an increase in supply (supply curve shifts right)
o Decrease in P*, increase in Q*
o Immediate effect- excess supply, however downward pressure on P*
causes equilibrium to be re-established
- Negative supply shock- causes suppliers to want to supply less quantity at every
given price, leads to a decrease in supply (suppler curve shifts left)
o Increase in P* and decrease in Q*
o Immediate effect- excess demand, however, is resolved by buyers willing
to bid up the price (upward pressure on price) and equilibrium re-
established

When there is a combination of supply and demand shocks, draw the diagrams. Some may
affects on price and quantity may be ambiguous if the size of the shock is unknown

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

ELASTICITY
- Elasticity measures the responsiveness of quantity demanded (or supplied) to their
determinants. Is a unit free measure
- Allows us to analyse the magnitude of changes and provide more precise statements
to ambiguous supply and demand shocks

Price elasticity of demand

- Measures the responsiveness of quantity demanded to a change in price
ε D=
|d QD P
∙
dP Q D |
Types of elasticity:
o Perfectly inelastic: ε D =0
o Inelastic: 0< ε D <1
o Unit elastic: ε D =1
o Elastic: 1<ε D < ∞
o Perfectly elastic: ε D =∞

- If the demand of a good is price elastic, increasing the price of the good will cause
the quantity demanded to fall by a larger magnitude than the price increase,
resulting in an overall decrease in total revenue
o The consumer will be responsive to changes in price
o Luxury goods are thus more price elastic
o The demand curve will be flat
- If the demand of a good is price inelastic, increasing the price of the good will cause
the quantity demanded to fall by a smaller magnitude than the increase in price,
resulting in an overall increase in revenue
o The consumer will not be as responsive to changes in prices
o Essential goods are thus more price inelastic
o The demand curve will be steep
- Revenue is maximised at unit elasticity

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Price elasticity of supply

- Measures the responsiveness of quantity supplied to a change in price ε s= | d Qs P
∙
dP Q s |
Types of elasticity:
o Perfectly inelastic: ε s=0
o Inelastic: 0<ε s <1
o Unit elastic: ε s=1
o Elastic: 1<ε s <∞
o Perfectly elastic: ε s=∞

- If the supply of a good is price elastic, increasing the price of the good will cause the
quantity supplied to increase by a larger magnitude than the price increase
o Suppliers are responsive to changes in price
o Supply curve is flatter
- If the supply of a good is price inelastic, increasing the price of the good will cause
the quantity supplied to increase by a smaller magnitude than the price increase
o Suppliers are not very responsive to changes in price
o Supply curve is steeper

Income elasticity of demand

- ε γ measures the responsiveness of quantity demanded to a change in income
- Is expressed as a percentage change in quantity demanded per percentage change in
income
- Normal goods have ε γ > 0 as the demand increases as the income of the consumer
increases
- Inferior goods have ε γ < 0 as the demand increases as the income of the consumer
decreases
- Necessary goods typically have 0<ε γ <1 (relatively inelastic) because these goods are
necessary despite the price they are sold at
- Luxury goods typically have ε γ >1 (relatively elastic) because the purchase of these
goods can be deferred until income levels are great enough

Cross price elasticity of demand

- ε AB measures the responsiveness of quantity demanded of one good to a change in
price of another good
- Substitutable goods have ε AB> 0
o As the price of the substitute good (good B) increases, the consumption of
good A increases (as A’s price decreases). Two increases = positive
elasticity
- Complementary goods have ε AB< 0
o As the price of good B increases, there is a smaller consumption of good A
(as its price also increases), leading to negative elasticity

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

WELFARE IN PERFECTLY COMPETITIVE MARKETS

- Total welfare or total economic surplus = consumer surplus + producer surplus

Consumer surplus (CS)

- Measures the buyer’s willingness to pay, net of the amount they actually pay
- Buyers whose willingness to pay exceeds P* receive a consumer surplus as such:

Producer surplus (PS)

- Measures the amount sellers receive, net of their willingness to sell
- Sellers who sell for a higher price than their willingness to sell (usually their total
opportunity cost) receive a producer surplus

Efficiency
- An allocation is said to be efficient when the total surplus is maximised and there is
no deadweight loss
- A deadweight loss represents the decrease in total surplus relative to the efficient
benchmark
o Represents the imbalance between the marginal cost of suppliers and the
marginal benefit of buyers
o When we deviate away from Q*, we see either the absence of mutually
beneficial trades or the engagement in mutually harmful trades, which
are inefficient

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

GOVERNMENT INTERVENTION
- Indirect interventions (on demand or supply) include taxes and subsidies
- Direct controls (on price or quantity) include price floors, price ceilings and quotas

Taxes
- A payment to the government on each unit of a good transacted
- Are used by governments to generate revenue
- Can be imposed on the buyer or the seller – both will bear a part of the tax burden
o The tax burden is more heavily experienced by the more inelastic party
- Creates a tax wedge between the price paid by buyers and the price received by
sellers t = PD – PS
o If imposed on the seller, shifts the supply curve left by the tax amount
(right)
o If imposed on the buyer, shifts the demand curve left by the tax amount
(left)

Solving for the equilibrium (for taxes and subsidies)

o Write an equation for PS where Ps = PD – t (or PS = PD + s for subsidies)
o Substitute this equation into the supply curve for P so it is in terms of P D
o Equate this supply curve with the demand curve and solve for PD
o Find PS with the first equation
o Find Q* by subbing PD into the demand equation

Creates a deadweight loss and is thus inefficient:

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Subsidies
- A payment from the government, to consumers or producers, for each unit of good
transacted
- Are used by the government to encourage consumption or production
- Can be thought of as a negative tax that creates a subsidy wedge: s = P S – PD
- The subsidy is financed by taxing market participants. This tax is equal to P S – PD and
generates tax revenue which exceeds these additional surpluses:

Creates a deadweight loss and is thus not efficient:

Price Controls: Price Floors and Ceilings

- A price floor imposes a minimum price for trade (left)
o Only has effect if the current equilibrium price is below the price floor
o If so, the equilibrium price will become this minimum value (at P )
o Will cause excess supply as QS > QD
- A price ceiling imposes a maximum price for trade (right
o Only has effect if the current equilibrium price is above the price floor
o If so, the equilibrium price will become this maximum value (at P)
o Will cause a shortage (excess demand)

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

X marks the deadweight loss

Quotas:
- Quotas impose a maximum quantity traded
- Cannot trade more than that quantity, regardless if it is above or below equilibrium
- Creates a kinked supply curve, where supply becomes vertical at the quota quantity
- A deadweight loss forms in the crossed areas

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

INTERNATIONAL TRADE
- Countries have different resource endowments leading to different capabilities in
producing goods
- A country with a lower opportunity cost in the production of a good is said to have a
comparative advantage
- Autarky is when there is no international trade
- International trade creates more consumption opportunities compared to autarky
- Countries produce less goods which they have a comparative disadvantage in.
Instead they import these goods and export goods that they have a comparative
advantage in
- Advantages of international trade are an increase in overall welfare, reduction in
poverty and inequality, increase variety of goods/services and strong growth in
countries that have great integration in the world market
- Disadvantages of international trade are that some groups are worse off, that there’s
an asymmetric reduction in trade barriers and potential national security issues
(which makes some economies vulnerable)

- To examine the benefits of trade we compare a domestic perfectly competitive

market with no international trade to one with trade and compare surpluses
- Consider a world market with a predetermined world price (PW), where most
countries contribution to this market is small, meaning they are price takers and
operating like a perfectly competitive market

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Exports
¿
If PW > P :
- Each seller who was originally in the domestic market will make more money if they
sell in the international market. Causes the domestic price to rise to P W and sellers
are indifferent between selling at home or abroad
- QD(PW) will be sold domestically and excess supply (QS(PW) - QD(PW)) will be sold
internationally (exported)
- Domestic consumer surplus decreases (buyers are losers), however the producer
surplus will increase by proportionately more (producers are winners) causing an
overall increase in total welfare
- This producer has a comparative advantage in producing this good

Imports
¿
If PW < P :
- Buyers are better off purchasing from international sellers as they offer a lower
price. Therefore, the domestic price must fall to PW and buyers become indifferent
between buying domestic goods or foreign goods
- QS(PW) will be purchased domestically and excess demand (QD(PW) – QS(PW)) will be
imported from international suppliers
- Domestic producer surplus decreases (sellers are losers), however the domestic
consumer surplus increases by proportionately more (consumers are winners),
causing an overall improvement in total welfare

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Government Intervention in International Trade

Import Tariffs
- Imports become subject to a price increase from P W to PW + t to move the market
¿
closer to the autarky equilibrium when PW < P
- Attempts to ‘protect’ domestic sellers by penalising foreign sellers
- Causes quantity supplied by domestic sellers to increase, and quantity demanded by
domestic buyers to decrease
- Imports are now QD(PW + t) – QS(PW + t)
- Leads to an increase in domestic producer surplus (sellers are winners) and a
decrease in domestic consumer surplus (buyers are losers); however overall welfare
(total surplus) decreases and a deadweight loss arises
- The government benefits from tariff revenue

Import Quotas
¿
- Import quotas restrict foreign imports to a certain quantity (Q ) when PW < P
- Causes the supply curve to kink PW until Q and then run parallel to the domestic
supply curve
- Domestic consumer surplus decreases (buyers are losers) however the domestic
producer surplus increases (sellers are winners) and total welfare overall decreases
(see below)
- Quota owners also make up a part of the total surplus as shown below

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

EXTERNALITIES
- Market failure can also occur in perfectly competitive markets leading to inefficient
outcome which generates lower wellbeing for society than the efficient level
- A negative externality arises when a decision-maker’s action causes costs for others
that is not borne by the decision-maker (e.g. smoking, not socially distancing)
- A positive externality arises when a decision-maker’s action causes benefits for
others that is not received by the decision-maker (e.g. education, vaccinations)
- Because the decision maker does not bear the costs or receive the benefits, they do
not consider these spill-over consequences for others and only consider their private
marginal benefits (PMB) and private marginal costs (PMC) (the original supply and
demand curves). Therefore, the market equilibrium equates PMB and PMC to
maximise private net benefits (at Q*)
- However when there are externalities and wider implications are considered, the
society has a different perspective with social marginal benefits (SMB) and social
marginal costs (SMC) that generate a socially optimal outcome (at Q**)
- If PMB = SMB and PMC = SMC the market equilibrium is socially efficient, however
this is not the case in the presence of externalities (and deadweight losses occur)
- Privately optimal outcome occurs when PMB = PMC
- Socially optimal outcome occurs when SMC = SMB

Positive externality in production

- Occurs when SMC< PMC
- E.g. A beekeeper’s presence of bees helps the orchardist produce flowers
-

Negative externality in production

- Occurs when SMC> PMC
- E.g. A factory pollutes the river and harms the boat businesses downstream
- Privately optimal outcome (left) and socially optimal outcome (right)
- C in the privately optimal outcome (left) represents the inefficiency in the free
market or the deadweight loss when the privately optimal outcome is achieved
rather than the socially optimal outcome

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Positive externality in consumption

- Occurs when SMB> PMB
- E.g. Vaccinations help prevent other people from getting ill, even those who don’t
take the vaccine
- Privately optimal outcome (left) and socially optimal outcome (right)
- D on the privately optimal outcome graph (left) represents the inefficiency in the
free market or the deadweight loss associated when the privately optimal outcome
is achieved rather than the socially optimal outcome

Negative externality in consumption

- Occurs when SMB< PMB
- E.g. Smoking in public causes others to breath in smoke which is harmful to them

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Government intervention:
- In order to get the market to achieve the efficient outcome, we can compel relevant
decision makers to ‘internalise’ the externality by getting them to take into account
these social costs and benefits through messages (e.g. government messages about
social distancing);
- Or, governments can directly intervein through Pigouvian taxes and subsidies, direct
regulation or coasian bargaining
- To make the privately optimal outcome equal to the socially optimal outcome,
consider moving the private curve to meet the social curve and whether that is done
via tax or subsidy

Pigouvian taxes
- Pigouvian taxes realign the private and social curves to achieve an efficient market
outcome
- This tax is exactly the difference between the private and social curves
- The below examples show the effect of a Pigouvian tax on a negative production
externality
o The green rectangle shows the tax revenue, the upper blue rectangle
shows the consumer surplus and the lower blue rectangle shows the
producer surplus after the tax has been incorporated
o The yellow intersection shows the market outcome before the tax
(privately optimal outcome) and the pink intersection shows the market
outcome after the tax (socially optimal outcome)
o Resolves the deadweight loss by gaining area E
o In this case the tax is equal to SMC – PMC and tax revenue is this tax
multiplied by the equilibrium quantity of the socially optimal outcome

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Pigouvian subsidies
- Pigouvian subsidies realign the private and social curves to achieve the efficient
market outcome
- The subsidy is the difference between the relevant private and social curves
- The below example shows the effect of a Pigouvian subsidy on a positive externality
in consumption
o Pay consumers a subsidy to raise their PMB so it is aligned with SMB
o The subsidy paid to each consumer is equal to SMB – PMB and the total
subsidy this subsidy multiplied by the socially efficient quantity traded
o Resolves the deadweight loss by gaining K and I
o The yellow intersection shows the market outcome before the tax
(privately optimal outcome) and the pink intersection shows the market
outcome after the tax (socially optimal outcome)

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

ASYMMETRIC INFORMATION
- Asymmetric information is where one economic actor knows more than another
- As the quality and characteristics of a good are not always observable to the buyer
or seller, goods of different quality may be traded within the same market which
leads to a market failure (products in the market are no longer homogenous)
- Where a buyer or seller does not know the quality of the good, they will calculate its
value (their willingness to pay/sell) using an expected value as they are risk neutral
- Where there is full information or no information for both buyers and sellers, there
is no market inefficiency

Types of goods:
- Search goods: a product or service with features and characteristics that are easily
evaluated before purchase. Usually standardised goods such as groceries, toys
- Experience goods: a product or service where important features or characteristics
are not observable at the time of purchase, but the purchaser learns about the
quality over time. Examples include used cards, travel, advice, haircuts
o Seller usually has more information than the buyer
o As buyers cannot differentiate quality, sellers with low quality goods may
be keen to sell their products whereas sellers with high quality goods will
want to hold onto their goods
- Credence goods: a producer or service where the quality of the good is difficult to
ascertain at the time of purchase and continued to be difficult to measure after
consumption. There is no clear sense of benefit, such as with vitamins, car repairs,
plumbing and education

Adverse selection
- A situation where there is asymmetric information and where an offer by the
informed party reveals negative information about the product being offered
- The buyer usually has less information than the seller, so the buyer calculates their
willingness to pay using an expected value whilst the seller knows their exact
willingness to sell for their particular good/service
- As the buyer needs to consider all quality goods in their calculation, their willingness
to pay will likely be less than a high-quality seller’s willingness to sell. As they will not
be able to sell for their WTS, they will exit the market. Buyer’s will then realise that
they no longer have access to high quality goods, hence revaluating their expected
value downwards. This may lead to more seller’s exiting the market as the buyer’s
new WTP is less than their WTS, causing them to leave the market. This ‘unwind’ in
the market causes only really poor-quality goods to remain in the market
o This leads to large negative impacts on the efficiency of markets via
allocation inefficiency whereby goods are not allocated to the people who
value them the most, and a market collapse where the market goes into a
death spiral as described and only low-quality goods are traded
- The negative impacts of adverse selection have led to the formation of various
institutions, such as legal systems that protect buyers from faulty products, quality
inspections and certificates, reputation systems (online ratings and reviews) and
other signals such as warranties

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Adverse selection and Insurance

- In this case, buyers have more information than sellers as they know more
information about themselves. For example, car insurance, drivers know how
recklessly/safely they will drive but insurers do not
- For drivers that are ‘safe’, the average risk of any driver is above their risk; meaning
the premium that they are charged is too high for them, meaning they won’t take
out insurance. This means that premiums will rise, as only risky drivers will take out
insurance, meaning only the riskiest drivers will be covered.
- To help mitigate this adverse selection, accident insurance is mandatory in Australia
and many other countries
- This is similar to health insurance where only those who have a 100% chance of
getting sick are covered and many other people who are less likely to fall sick are
uninsured. Even if the likelihood of each customer in getting sick is known, not
everyone will be covered
- This led to the creation of private insurance markets (alongside the universal health
care system) in attempt to stop this unwinding
o In Australia, Medicare attempts to help the unwinding by taxing high
earning individuals who do not get private insurance. This tax is usually
greater than the insurance premium, incentivising people to take out
private health insurance. This encourages propitious selection where
buying insurance signals lower likelihood of sickness

Moral hazard
- Moral hazard is where one party engages in risky behaviour as they know that the
other party will bear the consequence of the action
- People may change their behaviour and become ‘riskier’ when they are covered;
resulting in asymmetric information after a contract (such as an insurance or
warranty contract) is signed. The seller cannot control how the buyer acts
Example: warranties in the car market
o A car dealer may want to signal the high quality of their car by offering a
warranty if the car breaks
o Suppose the buyer can decide to drive either recklessly or safely
o If this warranty is in place, the driver will decide to drive recklessly as they
know they will be covered; and the cost of the warranty is not worth it if
they drive safely
o To fix this, the car company may offer partial insurance meaning some of
the cost will be covered by the warranty and the other will have to be
paid out of pocket to replace the car. If this out of pocket value is above
the ‘value’ of reckless driving, the driver will choose to drive safely
o This transfer/share of risk in the contract induces better or ‘safer’
behaviour by getting the buyer to partially ‘internalise’ the risks involved
with their actions. The seller needs to try to align interests
o Other example of this include performance related pay for high earning
staff and having a grading system in schools and universities (so students
try)

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

COST FUNCTIONS AND PROFIT MAXIMISATION

Production functions
- Firms who are on the supply side of the market have the purpose of turning inputs
into outputs. Types of inputs include labour (L) (employees and staff), capital (K)
(machinery, factories, vehicles) and raw materials (don’t focus on raw materials)
- Technology describes how inputs are turned into outputs
- Production functions can be used to determine the highest output (Q) that a firm can
produce for a specified combination of inputs
- In the short run we assume only 1/2 inputs are variable (usually labour) and the
other is fixed (usually capital), as in this time horizon the firm is typically only able to
change one input
- However, in the long run we consider both labour and capital to be variable as the
firm is able to adjust all of its inputs
For productivity, we consider:
- The total product (TP) which describes the total quantity of outputs given the level of
inputs
- The marginal product (MP) which describes the increase in an output from an
additional unit of input
o To find the marginal product of labour, we hold capital fixed at K and
consider what happens when we increase labour by a small amount
o To find the marginal product of capital, we hold labour fixed at L and
consider what happens when we increase capital by a small amount
- The law of diminishing returns states that as the use of an input increases in equal
increments (with all other inputs fixed), a point will eventually be reaches where the
resulting additions result in a decrease in output

Example: Bob’s Production function

- Can see the maximum output with 1 machine is 36. Each individual employee after 6
does not add extra benefit
- Assume that inputs are efficient here, usually output diminishes as workers increases
above the maximum due to overcrowding (law of diminishing returns)
- Continues below in green points

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Profit maximisation
- A firm’s profit is equal to its total revenue (what it receives for the sale of its outputs)
minus its total cost (what it pays for its inputs) and we assume firms are profit
maximisers
- Firms therefore aim to maximise profit(Q) = TR(Q) – TC(Q) where TR(Q) is the total
revenue function and TC(Q) is the total cost function in terms of quantity

Total cost function (long run)

- Can be used to find the cheapest way of producing a certain amount of output
- For the above example with Bob (in the long term), if we wanted to produce 72 units
and if the cost of labour is $40,000 per unit and the rental cost for machinery is
$50,000 per unit we have the options and costs of:
o 2 machines, 12 workers = $580,000
o 3 machines, 9 workers = $510,000
o 4 machines, 8 workers = $520,000
- The cheapest combination is therefore chosen, so 3 machines and 9 workers will be
used and TC(72) = $510,000
- This can be seen on the continuous graph as such for outputs of 24 and 36, which
builds a TC(Q) function by connecting the two cheapest ways of producing such
levels of output (as marked by the dots). Note that this TC(Q) = LRTC(Q) (long run
total cost function) as both inputs are considered variable

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Short run costs

- As in the short run one input is considered fixed and the other is variable, our short
run total cost function can be expressed as SRTC(Q) = FC + VC(Q)
o Fixed costs do not vary with the level of output
o Variable costs do vary with the level of output
- Considering the Bob example in the short term, if Bob decided to rent 2 machines on
a yearly contract (and the contract can be reversed by shutting down (i.e. not a sunk
cost), and the number of machines cannot be easily adjusted), capital is fixed and
labour is therefore variable (Bob can change the level of labour as he pleases)
o Now we consider the 2nd column of the previous table (circled in blue)
o Can develop a production function (total product) that depicts the
relationship between quantity of output and quantity of input (left);
o As well as a total cost curve which depicts the relationship between the
total cost (which depends on the quantity of inputs) and the quantity of
output)
o The shape of these graphs depicts diminishing marginal returns. On the
right graph this is shown by the decreasing slope as L increases, as each
additional worker contributes less and less quantity/output. On the left
graph this is shown at the kink (maximal output) as hiring more workers
will not increase the output, but increase costs, and due to the increasing
slope and shape of the graph
o Both graphs represent the firms underlying technology- both really show
the same thing

- Diminishing marginal product is where each worker will deliver successively lower
marginal product. Consequently, we need an increasing quantity of workers to
produce an extra one unit of output

Comparing Short Run Costs and Long Run Costs

- The long run total cost function will
always lie below the short run total cost
function because the LRTC function
represents the lowest cost for all possible
combination of outputs
- They will only coincide when it is efficient
to use exactly two units of capital in the
production function

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Other Cost Functions:

Cost measure Name How to derive
The cheapest way to produce an amount Q
Long-Run Total Cost * LRTC(Q) using the best combination of inputs and
technology

LRTC (Q)
Long-Run Average Total Cost LRATC(Q) ¿
Q

Costs that do not vary with the level of

output in the short run as these inputs
Fixed Cost * FC
cannot be changed (but can be recovered by
shutting down and aren’t sunk)
The portion of short run costs that vary with
Variable Cost * VC(Q) Q and can be changed in this time horizon.
Typically labour/material costs

Short-Run Total Cost * SRTC(Q) ¿ FC +VC (Q)

dSRTC (Q) dVC (Q)

Short-Run Marginal Cost ** SRMC(Q) ¿ =
dQ dQ

FC
Average Fixed Costs AFC(Q) ¿
Q

VC (Q)
Average Variable Costs AVC(Q) ¿
Q

SRTC (Q)
Short-Run Average Total Cost SRATC(Q) ¿ = AFC (Q )+VC (Q)
Q

* read above for more information

- Short run marginal costs describe the increase in short run total cost in order to
produce one additional unit of output (formula is given above)
- Short run average total cost is often used to get cost in per unit terms
o As FC is a constant, average fixed costs decrease as Q increases
o When short run marginal costs are strictly increasing, average variable
costs must increase throughout
o The shape of SRATC(Q) is thus typically U-shaped as at low Q, AFC are high
and then decrease as Q increases (as fixed costs are spread across more
units). Then when variable costs begin to increase, SRATC(Q) increases
again giving it a U-shape

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

o The shape varies with the size of the sized costs and the extent which
marginal costs increase with quantity
-

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Example: Car Washing Business

- There are two methods for washing cars as such:
1. Bucket and hose, no large physical capital required but capacity constraint
associated with labour affects the marginal product
o Low fixed cost
o Diminishing marginal product of labour
o SRMC(Q) and AVC(Q) are rising over
output due to diminishing marginal
product of labour
o SRATC(Q) is U-shaped because at low
output AFC is higher, but decreasing;
and at high output, VC(Q) and AVC(Q)
are increasing
o AVC(Q) and SRMC(Q) intersect at
Q=1

o SRMC(Q) must intersect with AVC(Q) and SRATC(Q) at their minimum

values because when MC < SRATC (or AVC), the next unit (marginal cost)
costs less to produce than the average, lowering ATC. Conversely, when
MC > SRATC (or AVC), the next unit (marginal cost) costs more to produce
than the average. Therefore, they are the same (intersect) when AVC(Q)
and SRATC(Q) are at their minimum

2. Automation, large investment in machinery (that is easy to maintain) and

constant marginal product
o High fixed cost
o Constant marginal product of electricity
o SRMC(Q) and AVC(Q) are
constant over Q due to
constant marginal product
o AFC(Q) is declining throughout
as fixed costs become more
dispersed as Q increases
o As AVC(Q) is constant and
AFC(Q) is decreasing, SRATC
(the addition of them) is
decreasing
Continued below signalled in green

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Long-Run Average Total Cost and Short-Run Average Total Cost

- As all costs become variable in the long-run, firms can select any-short run
production method. Since these costs differ for different production methods and
levels of output, firms should always choose the cheapest production method
- Hence the production level Q for LRATC should reflect the ATC of the production
method with the minimum SRATC(Q)
- For the Car Wash example, the bucket and hose is cheaper for a lower production
level whereas the automated method is cheaper for higher production levels.
- Therefore graphically, LRATC(Q) should envelope all SRATC(Q), meaning
LRATC (Q) ≤ SRATC(Q) (left)

Economies and Diseconomies of Scale

- Economies of scale describe the output range over which long-run average total
costs are falling (higher capital realisation)
- Diseconomies of scale describe the output range over which long-run average total
costs are rising (constraints arise when becoming too big and complicated)
- The minimum efficient scale is the lowest level of production that minimises long-run
average total costs

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Profit Maximisation in Perfectly Competitive Markets

- Firms will only want to operate in cases where their economic profit is greater than
or equal to zero; and want to produce the quantity that maximises this profit
- Economic profit = PQ – FC – VC(Q) = Q[P – ATC(Q)] (includes opportunity costs but
not sunk costs)
- Accounting profit = PQ – SC – FC – VC(Q) (includes sunk costs and excludes some
opportunity costs e.g. indirect opportunity costs associated with time)
- Individual firms in perfectly competitive markets face a constant (perfectly elastic)
demand curve that is equal to the market price P* (horizontal), which is also equal to
its marginal revenue and average revenue curve:
o TR ( Q )=P¿ × Q
dTR (Q)
o MR ( Q ) = =P¿
dQ
TR (Q)
o AR ( Q )= =P¿
Q
- The point of profit maximisation occurs when the marginal revenue and marginal
cost curves intersect. This is because if MC(Q) < MR(Q), the firm could increase
production to increase profits, however if MC(Q) > MR(Q), producing more units is
more costly than beneficial. This is also the point where the total cost function is
most distant away from the total revenue function
- A firm should therefore produce Q* such that MR(Q*) = P* = MC(Q*)
- The profit the firm produces is given by the equation π (Q )=Q [ P− ATC ( Q ) ] or the
blue square

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Short-Run: Perfectly Competitive Markets

- To continue operation in the short run: TR(Q)≥TC (Q) noting that some total costs
¿
may be sunk; and P ≥ SRATC (Q)
- The firm’s short-run supply curve can therefore be derived from a part of the
marginal cost curve that lies above the short-run average total cost curve; as the firm
will shut down when the marginal cost curve is below the SRATC curve

- The short-run industry supply curve is the sum of all the individual firm’s short-run
supply curves, as long as price exceeds average variable cost. This will also be
upward sloping. Even firms that may prefer to shut down in the long run may stay as
many of their costs may be sunk
- In the short run we assume the number of firms in the market is fixed, and no firms
may enter
n
The market quantity supplied is therefore QS ( P )=∑ Qi ∙ P where each firm is
¿ ¿ ¿
-
i
supplying their respective profit-maximising quantity
o The industry supply graph is vertical until the minimum price a firm will
sell at, becoming horizontal there
o It then increases again at the price where the next firm begins supplying
o Curve begins going upwards again at QS(P*), by adding up the supply of
Q1(P*) and Q2(P*)

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Long-Run: Perfectly Competitive Markets

- To continue operation in the long run: TR(Q)≥TC ( Q ) noting that total costs may be
¿
greater as they are not sunk; and P ≥ LRATC (Q)
- In the long run however, there is free entry and exit into and out of the market and
firms can adjust all of their technologies
- Firms will enter the market in the long run until economic profits are equal to zero.
o This is because if firms are earning profit in the short run, more firms will
enter in the long run, which will increase the industry supply and decrease
P*, which will happen until the last firm is making zero economic profit.
o Similarly, if firms are making negative accounting profits in the short run,
some firms may exit until the least profitable firm in the market is earning
zero economic profit
- Therefore, firms will enter and exit the market which will induce price adjustments
until there is ‘an equilibrium number of firms’ and there is no more entry and exit
n
The total quantity supplied ( QS ( P )=∑ Qi ∙ P ) will match the total quantity
¿ ¿ ¿
-
i
demanded
- The long-run market supply curve when firms have access to identical technologies
will be a horizontal at the long-run average total cost

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Demand shock
- If there was a positive demand shock, in the short run, as the number of firms is
fixed, prices will rise and each firm will make a positive profit (image b)
- Then, in the long run, more firms will enter due to this positive short run profit. This
will then cause the equilibrium price to decrease and total quantity supplied to rise,
until there is zero economic profit for the last firm again (image c)
o If new and incumbent firms have the same cost structure, prices should
fall back to the same level as the additional long run but with an increased
quantity supplied
o Long-run industry supply will therefore be perfectly elastic and horizontal
if the firms have the same cost structure

- However, if new firms have a higher LRATC than incumbent firms, prices will not fall back to
the initial level and long-run industry supply will be upwards sloping (increasing cost case)
(top image)
- On the other hand, if new firms have a lower LRATC than incumbent firms, the long-run
industry supply will be downwards sloping (decreasing cost case) (bottom image)

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

MONOLPOLIES

Market Power
- Market power refers to the ability of a firm to raise prices above the level that would
exist in a perfectly competitive market
- Monopolies have complete market power, oligopolies have some market power, and
perfectly competitive markets have no market power. Markets with lots of firms with
differentiated goods are said to have monopolistic competition (some power)
- Market power usually comes from barriers to entry (constraints that preclude other
firms from entering as it is highly expensive or due to some policy or regulation, or
from product differentiation, where firms gain market power if their consumers are
not willing to switch to another product
- Market power is inversely related to the degree of competition in the market

- As firms with market power face a downward sloping demand curve TR(Q) = P(Q)*Q
o ‘Hump’ shaped due to downward sloping demand curve. TR is low at the
start as Q is low but increases as with Q as P is still quite high. Eventually
TR decreases as the firm will have to reduce prices to sell high quantity
- Market power can be represented by rearranging the demand curve in terms of P(Q)
which represents the maximum price a firm could sell at for Q units (price curve)
- This curve is also equal to the average revenue curve as TC(Q)/Q = Q*P(Q) / Q = P(Q)
- As the demand curve is downward sloping, the marginal revenue curve will no longer
be constant and be a downward sloping curve that lies below the demand curve

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Profit-Maximisation for Monopolies

- Monopolies choose a quantity that maximises their total revenue curve (at
maximum point of curve on previous page)
- This point is also the point where the revenue from the infra marginal customer (pre-
existing customers) (inframarginal loss) equals the additional revenue from the
marginal customer (marginal gain)
- Monopolies also want to maximise profit and do so by equating MR(Q) and MC(Q).
dP(Q)
Note that MC (Q )=P ( Q )+ Q∙ which can be rearranged to
dQ
dP(Q)
P ( Q )−MC ( Q )=−Q ∙
dQ
- Marginal gain is the profit obtained from gaining an additional cost: P(Q) – MC(Q)
dP(Q)
- Inframarginal loss is the reduction in price for selling additional quantity: Q ∙
dQ
- Profit maximisation therefore occurs at the quantity in which marginal loss is equal
to the marginal gain, which is also where TC and TR curves of maximal distance apart

Linking to Price Elasticity of Demand:

Starting from the above equation:
dP(Q)
P ( Q )−MC ( Q )=−Q ∙
dQ
Dividing by P(Q) gives
P ( Q ) −MC ( Q ) −dP ( Q ) Q 1
= ∙ =
P (Q) dQ P ( Q ) −dQ( P) P(Q)
∙
dP Q
Notice the denominator is the price elasticity of demand, therefore:
P ( Q ) −MC ( Q ) 1
=
P (Q) εD

- The left-hand side is a measure of the mark-up (the percentage amount that the firm
raises prices over its marginal cost. This is a standard measure of market power and
is know as the ‘Lerner Index’
- The right-hand side is the reciprocal of price elasticity of demand. Note that the
negative disappears as price elasticity of demand is negative (without taking the
absolute value)
- Despite having the freedom to choose any price, the monopolies best action is fully
pinned down by the price elasticity of demand, and hence the consumer’s tastes
- There is no supply curve when analysing a monopoly problem

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

- Monopolists always choose a price where the elasticity of demand is at least 1

(elastic). If it is less than 1 (inelastic) than they will increase price.
Monopolies and Market Failure
- Monopolies create an inefficiency as monopolies want to maximise their own
economic profit. By raising the price over the marginal cost, the quantity they choose
will be lower than the economically efficient quantity and a deadweight loss is
created
- The efficient outcome occurs where P(Q) = MC(Q), however the monopoly outcome
occurs where MR(Q) = MC(Q), and as MR(Q) lies below P(Q) (the demand curve),
QM < Q* and P(QM) > P(Q*)

Addressing this market failure:

- This market failure can be addressed by:
o Pro-competition policy: promotes competition in the industry via
associations such as the ACCC (Competition and Consumer Commission)
o Direct regulation: constrain the behaviour of the monopolist
o Public ownership: convert monopolies into public enterprises

Example: Pharmaceutical Benefits Scheme (PBS)

- Patents are given to firms who create new pharmaceutical drugs in Australia,
allowing the company to act as a monopoly in this market
- As these drugs are important and expensive to create, this incentivises firms to
create new drugs as they will have access to monopoly profits
- However, PBS applies a direct regulation on the pricing on these drugs to mitigate
these associated inefficiencies by setting a producer price that is below the
monopoly price, but above the consumer price and by paying a subsidy to make up
for the difference between the producer and consumer price
- For example, for a drug with a constant MC and no FC, the monopoly manufacturer
will set a price PM above MC and create a deadweight loss. However, by listing the
drug on PBS they will have a large increase in sales (as doctors are more likely to
prescribe these drugs); so, they will list
their drug on the PBS and settle for a lower
(regulated) price, although still being
compensated by the government for their
loss in monopoly profit
- The government sets a consumer price PC
to be equal to MC to achieve the efficient
quantity Q* and sets a producer price PA

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

(so PC < PA < PM)and the drug manufacturer will still make exactly the monopoly profit
therefore being willing to join the PBS

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

PRICE DISCRIMINATION
- Price discrimination increases profits when firms have market power to set prices
and therefore charge different customers different prices based on their willingness
to pay
- Can increase welfare but generally erodes consumer surplus

First-Degree (perfect) Price Discrimination

- Where the monopolist knows the exact willingness-to-pay of all customers and can
prevent arbitrage (resale)
- Each unit of the product is sold to the consumer who values it the most, at the
maximum price they are willing to pay
- The producer surplus takes over the entire consumer surplus, and there is no
deadweight loss (efficient quantity is achieved)
- Is generally not possible and unrealistic in today’s society as we don’t have enough
information about consumers to do so

Example in Lecture 15 slides 9-18 on drugs vs vaccines for perfect

price discrimination

Second-Degree Price Discrimination (refer to Lecture 16 slides for

graphs)
- Where the monopolist has no observable signals to segregate customers based on
their willingness-to-pay, but by selecting a product that is best for them, the
consumer reveals their type. The price of the product therefore depends on its
quality/quantity
- Use a menu of goods/prices to help determine types of customers
- For example, pricing different sizes of milk reveals the consumers willingness to pay,
as well as pricing different quality products (e.g. iPhones) at different prices
- However, some consumers pretend to be different types, so, the monopolist distorts
some characteristics of low-quality products (have really poor quality/basic features)
to make this product undesirable for them so they choose the high-quality one
o This is why economy class on planes is so poor and basic
- Buyers with low WTP will receive no surplus from trade whereas buyers with high
WTP will receive information rents (surplus)
- Second degree price discrimination is an example of adverse selection or a screening
model as it’s designed to make customers self-select the quality and price for them.
This is often referred to as the revelation principle (decision reveals the type of
buyer)

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

- When high WTP customers pretend to be low WTP customers, they receive positive
information rents since the monopolist has to ‘bribe’ them to reveal their private
information about their type (by making the low quality product really poor)
- Firms can also extract information with loyalty cards and through browser scraping
Third-Degree Price Discrimination
- The monopolist identifies different groups of consumers based on observable
differences in demand and sells the same product to different groups at different
prices. They must be able to prevent arbitrage (resale from the low-price market to
the high-price market)
- For example, the age, gender, social group, socioeconomic status and location of the
consumer
Example: Movie Tickets for adults and students
- Suppose for the two markets the demand curves are: (and MC = 20 per unit)
o Q Adults = 100 – P (more disposable income than students, less steep)
o Q Students = 160 – 2P
Profit and Outcome for Adults with price discrimination:
o Profit = Q(P)P – Q(P) * 20 = (100 – P)(P- 20)
o 100 - 2P + 20 = 0 (taking the derivative and setting it 0 for maximum)
o Solving gives P = 60 and Q = 40
Profit and Outcome for Students with price discrimination
o Profit = (160 – 2P)(P – 20)
o 160 – 4P + 40 = 0 (taking the derivative and setting it 0 for maximum)
o Solving gives P = 50 and Q = 60

- If there was no price discrimination in this case, and prices were above $80, the
student market would shut down. Therefore, the aggregate demand curve is:

{
Q ( P )= 100−P if P ≥80
260−3 P if P ≤80
(100 – P + 160 – 2P = 260 – 3P)
- Since both prices are below 80, we can just use the second equation
- Therefore, the profit in the combined market is
π ( P )=(260−3 P)P−20(260−3 P)
260−6 P+ 60=0 (setting the derivative equal to zero to maximise profit)
Solving gives P = 53.333 and Q = 100
- Comparing to the case with price discrimination, the student market has a lower
price and the adult market has a higher price. Therefore, the student surplus
increases, the adult surplus decreases and the firm’s profit increases with price
discrimination. The price of the more inelastic (price insensitive) market goes up

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

(losers) and the price of the more elastic (price sensitive) market goes down
(winners).
- The net effect depends on the shape of the demand curves. If one group would not
be served without price discrimination, then allowing price discrimination increases
overall welfare unambiguously. If the total quantity with discrimination decreases or
stays the same, social welfare unambiguously decreases

GAME THEORY (and Oligopoly)

- Game theory is the study of decision-making in strategic situations
- In strategic games, decisions players make have cross-effects on other players and
players will respond to the actions of others
- Cooperative game theory is used in understanding bargaining and matching
- Non-cooperative game theory is used more in economics and assumes each agent is
doing what is best for them (focus for microeconomics)
- Can split the economic problem into three parts: environment (what influences the
agent’s decisions, what they know/want), market mechanism (the rules of the game)
and strategic action (how they respond to one another)
- Simultaneous games are static situations where all individuals make their decision
once at the beginning of the game without observing any other actions (e.g. rock
paper scissors)
- Sequential games are dynamic situations where games have a sequence of moves
with new information being transmitted about past actions (e.g. chess)
- A player is a decision-maker in a strategic situation
- A move can be either simultaneous (decision at the same time) or sequential (one
player decides, then the other)
- A payoff is the outcome for a player, given the set of actions. The result of a decision.
- A strategy is a complete set of decisions in response to the other player’s decisions in
every contingency (a strategy for a whole game of chess, rather than one move). Can
be pure (chooses each action with certainty) or mixed (with randomness)
- Equilibrium is when each player chooses a strategy that is a ‘best response’ to the
strategies of the other plays
- An action corresponds to a single decision in the game. NOT the same as a strategy
unless there is only one action in exactly one state of the game (rock paper scissors)
- Nash equilibrium looks for strategy profiles for all individuals such that no individual
has an incentive to change any of their actions given the strategies of others
- A strictly dominant strategy is one that provides the player with a strictly higher
payoff than all other strategies
- A strictly dominated strategy is one that will never provide the player with the best
payoff, no matter what the other player chooses

Finding Nash Equilibrium in Simultaneous Games

- Three techniques to do so: cell-by-cell inspection, iterated elimination of dominated
strategies and best-response analysis
- In best-response analysis, we use the game table and first look at player 1, holding
player 2’s action fixed and highlighting which outcome is best for player 1. Then we
do the same for player 2. Any cell with payoffs for player 1 and 2 highlighted will be
the Nash Equilibrium

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

- In Nash Equilibrium the player chooses actions that maximise their payoffs based on
the actions of others. They will never choose a strictly dominated strategy and take
into account that their opponents will not play strictly dominated strategies
- The Nash Equilibrium is the predicted equilibrium
- Can have multiple Nash Equilibria. To determine which one is the most likely
outcome, we would need to consider psychology

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Oligopolies
- Oligopolistic markets compromise of just a few firms
- They are better off when they cooperate and act like a monopolist, however, in the
absence of a binding agreement, firms face incentives to deviate from cooperation
Example: Airbus vs Boeing
- Suppose Airbus and Boeing are the only two firms in the passenger jet industry
(duopoly) i.e. QS = QA + QB
- If both firms have zero fixed costs and MC = $100 million, inverse demand is
P = 800 – QD, if the cartels decide to collude and act as a monopoly:
Determining market outcomes:
TR ( Q )=P ×Q=800 Q−Q2
MR ( Q ) =800−2 Q
MR ( Q ) =MC ( Q ) ∴ 800−2Q=100∴ Q M =350 , P M =450
π=350 ( 450−100 ) =122,500 for both Airbus and Boeing
Q
If they perfectly collude: Q A =QB = M =175 and π A =π B=61,250
2

- Suppose Boeing behaves to the cartel agreement. If the ‘game’ is played one time,
should Airbus also stick to the collusive agreement?
TR A =Q A ( 800−Q A −QB ) =800 Q A−Q 2A−Q B ∙ Q A
MR A=800−2 Q A−Q B
MR A=MC ∴ 800−2Q A −Q B=100
QB
Q A ( Q B )=350− (Airbus’s best response strategy to Boeing)
2
175
If Boeing supplies 175, Airbus’ best response is Q A =350− =262.5
2
Hence Airbus would be incentivised to not follow the agreement (and supply more),
and so will Boeing (they both have same best response strategy due to identical
costs)
The Nash Equilibrium will thus be at the at the intersection of the two best response
700
strategies (middle image) at Q= .
3
Left image shows outcome if agreement is followed and not followed (right image)

- This shows strategic substitutes as when one firm increases the quantity the others
decrease their quantity, implying that if you commit to a quantity, you can take
advantage of the other person’s response

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

- If we add more firms and assume there are N identical firms that are symmetric,
each firm will find their best response function by holding the other firms fixed:
- As more firms exist in the oligopoly, the total quantity produced will increase, but
the quantity produced by each individual firm will decrease

EXTERNALITIES (COASIAN BARGAINING)

- Coase Therom: if property rights

PUBLIC GOODS

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])

 lOMoARcPSD|58994964

Downloaded by Gilbird Beilschmidt (lujoyce803@[Link])