Microeconomics

Supply and Demand

A Consumer's Constrained Choice
Demand
Consumer Welfare and Policy Analysis
Firms and Production
Perfect Competition
Oligopoly Models
Market Failure
Monopoly and Monopsony
Problem Solutions:
Week 2
Week 3
Week 4
Week 5 - Firms: Competition and Monopoly
Week 6 - Imperfect Competition
Week 7
Week 9 - Further Consumer Theory
Collection
Prelim 2013
Prelim 2011
Prelim 2010
Long 2008
Essay Plans

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Supply and Demand

The supply and demand model describes how consumers and suppliers interact to determines the
quantity of a good or service sold on the market and the price at which it is sold.
Demand
The amount of a good that consumers are willing to buy at a given price during a specified time
period, holding constant other factors that influence purchases, is the quantity demanded.
Consumers decide how much of a good or service to buy on the basis of its price and many other
factors, including tastes, information, income, the prices of other goods and government actions.
Substitutes - a product that you view as similar or identical to the one you are considering
purchasing. If the price of a substitute is lower, you might consider switching to the substitute.
Complements - a good that you like to consume at the same time as the one you are considering
buying. If the price of a complement is higher, you are less likely to buy both goods.
The Demand Function
The demand function shows the correspondence between the quantity demanded, price, and other
factors that influence prices. For example, the demand function might be:
= (, , , ).
Usually, we're primarily interested in the relationship between the quantity demanded and the price
of a good - i.e. we hold the other factors constant.
A demand curve is a plot of the demand function that shows the quantity demanded at each
possible price, holding the other factors constant.

A change in the product's price causes a movement along the demand curve.
Law of Demand: consumers demand more of a good the lower its price, holding constant tastes, the
prices of other goods and other factors that influence demand. This law means that the demand
curve always slopes downward:

< 0.

A change in other prices causes the demand curve to shift.

Summing Demand Functions
Suppose there are two consumers with demand functions:
= () and = ().
Total demand of both consumers is the sum of the quantities each demands separately:
= + = () + ().
Supply
The quantity supplied is the amount of a good that firms want to sell during a given time period at a
given price holding constant other factors that influence firms' supply decisions, such as costs and
government actions.
Production costs affect how much of a good the firms want to sell. As a firm's cost rises, it is willing
to supply less of the good.
The Supply Function
The supply function shows the correspondence between the quantity supplied, price, and other
factors that influence the number of unites offered for sale. Written generally:
= , (where ph is the price of inputs).
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 = (, ) (where ph is the price of inputs).

Market Equilibrium
When all traders are able to buy or sell as much as they want, we say that the market is in
equilibrium - a situation where no participant wants to change their behaviour. In the market, there
is an equilibrium price and quantity.
Finding the market equilibrium

Forces that drive a market to equilibrium

If the market is not at equilibrium, consumers or firms would have an incentive to change their
behaviour.
If the price were initially lower than the equilibrium price, consumers would want to buy more than
suppliers would want to sell. There would be excess demand. Some consumers would be able to buy
the good, whereas others would not be able to find a supplier. Some frustrated consumers might
offer to pay suppliers more than the established price. Alternatively, suppliers who notice the
disappointed customers, might raise their prices.
If the price were above the equilibrium, there would be excess supply. Not all firms would be able to
sell their goods. Rather than incur storage costs, firms would lower the price to attract additional
customers.
The equilibrium price is called the market clearing price because it removes all frustrated buyers and
sellers from the market.
Elasticities
Demand Elasticity
The Price Elasticity of Demand is the percentage change in the quantity demanded in response to a
given percentage change in the price at a particular point on the demand curve. PED is given by:

= = = .

The elasticity of demand is always negative, because of the law of demand.

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The elasticity of demand varies along most demand curves. On downward sloping linear demand
curves, the higher the price, the more negative the elasticity of demand.

Demand curves with constant elasticities have the exponential form:

=
The demand curve is horizontal if consumers view the good as identical to another good and do not
care which one they buy.
Demand curves are vertical for essential goods - people will pay anything to get them.
We can measure how sensitive the quantity demanded at a given price is to income by using the
income elasticity of demand:
%
= = .
%

Goods that consumers view as necessities have income elasticities near 0.
Luxuries have income elasticities greater than 1.
The cross price elasticity of demand measures the responsiveness of demand for one good relative
to the price of another good:
%

= = .
%

Complements have a cross price elasticity that is negative.

Substitutes have a positive cross price elasticity.
Supply Elasticities
The price elasticity of supply is the responsiveness of quantity supplied to the price. PES is:
%
= = = .
%

Supply is:
Perfectly inelastic when PES is 0.
Inelastic when 0 < PES < 1
Elastic when PES > 1
Perfectly elastic when PES is infinite.

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Constant elasticity of supply functions are of the form:

=
Perishable goods might have a vertical supply curve (perfectly inelastic) since the seller will accept
any market price for the good in order to get rid of it.
Long Run versus Short Run
Demand elasticities might be lower in the short run, since in the long run, consumers can switch ti
substitute products.
Similarly, in the short run, firms are limited by the size of their plants, or number of machines, so
elasticity is likely to lower in the short run, compared to the long run, when the firm can build more
plants and buy more equipment to increase output.
Effects of a Sales Tax
Equilibrium Effects of a Specific Tax
The specific tax causes the equilibrium price consumers pay to rise, and the equilibrium quantity to
fall.
If the consumer pays p for a good, and the government takes , then the seller receives .

How Specific Tax Effects Depend on Elasticities

In the new equilibrium, the price that consumers pay is determined by the equality between the
demand function and the after tax supply function:
() = ( ).
Thus, the equilibrium price is an implicit function of the specific tax:
= ()
() = (() )
To determine the effect a small tax has on the price, we differentiate this with respect to :
(() )
= = 1 .

Rearranging terms, if follows that the change in price consumers pay with respect to the tax is:

=
.


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= .

By multiplying by p/Q, we can express this in terms of elasticities:

= .

For a given supply elasticity, the more elastic the demand, the less the equilibrium price rises when
the tax is imposed.
For a given demand elasticity, the smaller the supply elasticity, the smaller the increase in the
equilibrium price consumers pay.
The same equilibrium no matter who is taxed
Suppose that the tax is collected from consumers instead of producers.
Quantity supplied need not equal quantity demanded

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A Consumer's Constrained Choice

Model of consumer behaviour is based on the following premises:
- Individual tasters or preferences determine the amount of pleasure people derive from the
goods and services they consume.
- Consumers face constraints or limits on their choices (both budget and legal constraints).
- Consumers maximise their well-being or pleasure from consumption, subject to the
constraints they face.
Preferences
Consumers must allocate their money to buy a bundle (market basket or combination) of goods.
Consumers could choose bundles of goods randomly, blindly choosing one good over another
without any thought. However, consumers appear to make systematic choices. To explain this
behaviour, economists assume that consumers have a set of tastes of preferences that they use to
guide them in choosing between goods.
Properties of Consumer Preferences
There are five assumptions about the properties of consumers' preferences.
1. Completeness - when facing a choice between any two bundles of goods, a consumer can rank
them so that one and only one of the following relationships is true:
The consumer prefers the first bundle to the second
The consumer prefers the second bundle to the first
The consumer is indifferent between the two bundles
There is no possibility that the consume cannot decide which bundle is preferable.
2. Transitivity - a consumer's preference over bundles is consistent. If the consumer prefers
Bundle Z to Bundle Y, and prefers Bundle Y to Bundle X, the consumer also prefers Bundle Z to
Bundle X.
3. More Is Better (non-satiation) - more of a commodity is better than less of it. A good is defined
as a commodity for which more is preferred to less, whereas a bad is something for which less
is preferred to more.
4. Continuity - if a consumer prefers Bundle A to Bundle B, then the consumer prefers Bundle C
to Bundle B if C is very close to A.
5. Strict Convexity - consumers prefer averages to extremes.
Indifference Curves
Indifference curves are the set of all bundles of goods that the consumer views as being equally
desirable.
Preferences are summarised in an indifference map (or preference map), which is a complete set of
indifference curves that summarise a consumers tastes.
Given the assumptions about preferences, the indifference curves must have the following
properties
1. Bundles on indifference curves farther from the origin are preferred to those on indifference
curves closer to the origin. This is due to the 'more is better property'.
2. There is an indifference curve through every possible bundle. This is due to completeness.
3. Indifference curves cannot cross. If they did cross, this would violate the transitivity/'more is
better'.
4. Indifference curves slope downward. This is because of 'more is better'.
5. Indifference curves cannot be thick - because of 'more is better'.
Utility
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Utility
Ordinal Preferences
If we only know the consumers' relative rankings of bundles, our measure Is ordinal rather than
cardinal. Because utility is an ordinal measure, we should not put any weight on the absolute
differences between the utility number associated with one bundle and that associated with
another - we only care about the relative utility ranking of the two bundles.
Utility and Indifference curves
Indifference curves are a 2D representation of a 3D plot of utility. An indifference curve consists of
all those bundles that correspond to a particular utility measure. If the utility function is ( , ),

then the expression for one of her indifference curves is = ( , ). This expression determines

all those bundles of q1 and q2 that give her utils of pleasure.

Willingness to substitute between goods
It is useful to know the slope of an indifference curve at a particular bundle of goods. The slope at a
point of the indifference curve is called the Marginal Rate of Substitution, because it is the maximum
amount of one good that a consumer will sacrifice (trade) to obtain one more unit of another good.
The MRS depends on how much extra utility the consumer gets from more of each good. The extra
utility they get from consuming the last unit of a good is the Marginal Utility.
Given a utility function ( , ), the marginal utility of q1 = = .
The marginal utility of q2 = = .

We determine the MRS by finding out the changes in q1 and q2 that leave utility unchanged, and

keep the consumer on the same indifference curve = ( , ). ( ) is an implicit function

which tells us how much of q2 is consumers given q1. We want to know how much q2 must change if
we increase q1, given utility is constant.

First, differentiate = , ( ) with respect to q1:

, ( )
, ( )

= 0 = + = + .

Rearranging the terms, we find that:

= = =

Curvature of indifference curves

Since indifference curves are convex to the origin, as we mot to the right along the indifference
curve, the MRS becomes smaller in absolute value . As you move to the right, the consumer will give
up fewer of q2 to obtain one of q1. This willingness to trade fewer as you move right reflects a
diminishing marginal rate of substitution: the MRS approaches zero as we move down and to the
right.
Indifference curves are usually convex. When consumers have a lot of one good, they are willing to
give up a relatively large amount of it to get a good of which they have relatively little. However,
after that first trade, they are willing to give up less of the first good to get the same amount more of
the second good.
It is hard to imagine indifference curves that are concave to the origin - this way the consumer is
willing to give up more of one good the less of it they have, to get the other.
Extreme cases of convex indifference curves are:
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Extreme cases of convex indifference curves are:

Perfect substitutes - the consumer is completely indifferent as to which good to consume.
(, ) = +

, =

Perfect complements - goods that a consumer is interested in consuming only in fixed proportions.
(, ) = min(, )
Indifference curves are right angle 'L's. The only condition where there isn't an excess of either
good is where = or = . So only bundles where the goods are in the right proportions
are chosen.

Budget Constraint
If we cannot save and borrow, our budget constraint is the income we receive in a given period. If a
consumer spends all their income on only two goods, then their budget constraint is + =
.
This is the budget line/budget constraint - the bundles of goods that can be bought if the entire
budget is spent on those goods at given prices.
We can rewrite the budget constraint as:

= ,

Which makes it easier to sketch.

The budget constraint line is constant, which could suggest that the consumer can buy fractional
numbers of the two goods. However, it actually implies that the consumer can buy these goods at a
rate of one half per time period (for example). If the consumer buys one of a good every other week,
then they buy on average half of it each week. This makes fractional amounts of any good plausible.
The slope of the budget line is the Marginal Rate of Transformation (MRT): the trade-off the market
imposes on the consumer in terms of the amount of one good the consumer must give up to obtain
more of the other good.
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more of the other good.

= = .

Constrained Consumer Choice

Were it not for the budget constrain, consumers who prefer more to less would consume unlimited
amounts of some goods. Instead, consumers maximise their well-being subject to budget
constraints.
The Consumer's Optimal Bundle
We want to determine the bundle within the opportunity set that gives the consumer the highest
level of utility.
The optimal bundle lies on an indifference curve that touches the budget constraint at only one
point.
The optimal bundle must be on the budget constraint. Bundles that lie on indifference curves
above the constraint are not in the opportunity set. Budgets inside the budget constraint are
not maxima, since more is better than less.
Bundles that lie on indifference curves that cross the budget constraint are less desirable than
certain other bundles on the constraint (i.e. averages preferred to extremes, so the points on
the constraint within the two crossing points are on a higher indifference curve than the
bundles where the constraint and indifference curve cross).
The optimal bundle must lie on the budget constrain and be on an indifference curve that does not
cross it. Such a bundle is the consumer's optimum.
Interior solution - the optimal has positive quantities of both goods. For the indifference curve to
touch the budget constraint but not cross it, it must be tangent to the budget constraint. The two
curves have the same slope at the point where they touch.

= = =

Rearranging gives:

= .

Utility is maximised if the last dollar spent on one good gets the consumer as much extra utility as
the last dollar spent on the other good.
If the last dollar spent on one good gave the consumer more utility than the last dollar spent on the
other, the consumer could increase their utility by spending more on the first good and less on the
second.
Corner solution - if the indifference curves are flatter, then the optimum bundle lies on an
indifference curve that touches the budget line only once, on one of the axes. (NB the indifference
curve and budget constraint are not tangent here.)
Maximising Subject to a Constraint Using Calculus
Lagrangian Method:
max = ( , ) + ( )

= = = 0

= = 0

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= = 0

= = 0.

At optimal levels of q1, q2: = , = .

= = .

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Demand
Deriving Demand Curves
Cobb Douglas - the demand for each good is dependent on the consumer's income and each good's
own price, but not the price of the other good.
( , ) =

= = = =
(1 )

(1 ) =
= + =
(1 ) = ()

(1 )
=

Graphical Interpretation

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If we increase the price of a product while holding other prices, the consumer's tastes, and income,
constant, we cause the consumer's budget constraint to rotate, prompting the consumer to choose
a new optimal bundle.
Effects of an Increase in Income
An increase in income causes a parallel shift of the budget constraint away from the origin,
prompting a consumer to choose a new optimal bundle.
How Income Shifts Demand Curves

Consumer Theory and Income Elasticities

Inferior goods: elasticity < 0
Normal goods: elasticity > 0
Luxury goods: elasticity > 1
The shape of the income-consumption curve for two goods tells us the sign of their income
elasticities.

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It is impossible for all goods to be inferior. When income goes up, the budget constraint shifts
outward, so either both goods are normal, or one is normal and one is inferior.
If both goods were inferior, the consumer would buy less of both goods as his income rises, which
doesn't make sense.
A good may be normal at some income levels, and inferior at others.

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The weighted sum of a consumer's income elasticities equals one.

The total budget constraint is:
+ + + =
Differentiating with respect to income:

+ + + = 1

Multiplying and dividing each term by , we can rewrite this equation as:


+ + + = 1



If we define the budget share of Good I as: = / and note that the income elasticities are
= / (/ ), we can rewrite this expression to show that the weighted some of the income
elasticities equals one:
+ + + = 1.
Effects of a Price Increase
An increase in a price of a good has two effects on individual's demand.

One is the substitution effect: the change in the quantity of a good that a consumer demands when
the good's price rises, holding the other prices and the consumer's utility constant.
The other is the income effect: the change in the quantity demanded because of a change in income,
holding prices constant. An increase in price reduces a consumer's buying power, effectively
reducing the consumers income or opportunity set and causing the consumer to buy less of at least
some goods.
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some goods.
When the price of a product rises, the total change in quantity purchased is the sum of the
substitution effect and the income effect.
Income and Substitution Effects with a Normal Good

Because indifference curves are convex to the origin, the substitution effect is unambiguous: less of
a good is consumed when its price rises.
The direction of the income effect depends on the income elasticity.
Income and Substitution Effects with an Inferior Good
If a good is inferior, the income effect and the substitution effect move in opposite directions. For
most inferior goods, the income effect is smaller than the substitution effect. As a result, the total
effect moves in the same direction as the substitution effect, but the total effect is smaller.
For a Giffen good, the income effect more than offsets the substitution effect.
Compensated Demand Curve
The demand curves so far have allowed a consumer's utility to vary as the price of the good
increases. Consequently, the consumer's demand curve reflects both the substitution and the
income effects as the price of the product changes.
The Marshallian/uncompensated demand curve allows utility to vary.
The Hicksian/compensated demand curve shows how the quantity demanded changes as the price
rises, holding utility constant, so that the change in the quantity demanded reflects only the pure
substitution effect from a price change.
It's called the compensated demand curve because we would have to compensate the consumer as
the price rises so as to hold the consumer's utility constant.
The compensated demand curve for the first good is:

= , , .
Because the compensated demand curve reflects only substitution effects, the Law of Demand must
hold: price increases cause the compensated demand for a good to fall.
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hold: price increases cause the compensated demand for a good to fall.

The compensated and uncompensated demand curves must cross at the original price and
consumption level.
The compensated demand curve is steeper than the uncompensated demand curve at the common
point. This is because the compensated demand curve reflects only the substitution effect, unlike
the uncompensated demand curve, which includes the income effect which reinforces the
substitution effect since the good is a normal good.
Slutsky Equation

Total effect = substitution effect + income effect

For a normal good (price increase)
Negative = Negative - Positive
For an inferior good (price increase)
? = Negative - Negative

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Consumer Welfare and Policy Analysis

Consumer Welfare
Since we rarely know individuals' utility functions, and have no way to compare measures of
individual utility, we measure consumer welfare in terms of dollars.
Consumer surplus is the most widely used measure of consumer welfare. Consumer surplus is
relatively easy to calculate using the uncompensated demand curve.

Willingness to pay
The inverse demand curve reflects a consumer's marginal willingness to pay: the maximum amount
a consumer will spend for an extra unit. The consumer's marginal willingness to pay for a good is the
marginal value the consumer places on buying one more unit.
Consumer surplus is the monetary difference between the maximum amount that a consumer is
willing to pay for the quantity of the good purchased and what the good actually costs. Consumer
surplus us a dollar-value measure of the extra pleasure the consumer receives from the transaction
beyond its price.
An individual's consumer surplus is:
- The extra value that a consumer gets from buying the desired number of units of a good in
excess of the amount paid
- The amount that a consumer would be willing to pay for the right to buy as many units as
desired at the specific price
- The area under the consumer's inverse demand curve and above the market price up to the
quantity of the product the consumer buys
If the price of a good rises, purchasers of that good lose consumer surplus.

Expenditure Function and Consumer Welfare

Consumer surplus is the income that we would need to give a consumer to offset the harm of a price
increase. However, the consumer surplus method, which uses the uncompensated demand curve, is
inexact, since it does not hold a consumer's utility constant as the price changes.
If we have an estimate of the compensated demand curve, we can calculate the pure income effect
measured.
Along a compensated demand curve, as the price rises, the change in the quantity demanded by the
consumer reflects a pure substitution effect. The corresponding amount of income compensation is
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consumer reflects a pure substitution effect. The corresponding amount of income compensation is
the measure we seek.
The expenditure function (the minimum expenditure necessary to achieve a specific utility level)
contains the same information as the compensated demand curve. The compensated demand curve
is the partial derivative of the expenditure function with respect to p1.
We can calculate the consumer welfare loss of a price increase as the difference between the
expenditure at the two prices:

= , , , , .

To use this approach we have to decide which level of utility to use. We can use the level of utility
corresponding to the original indifference curve or the level on the indifference curve of the optimal
bundle after the price change.
Compensating Variation: the amount of money one would have to give the consumer to keep them
on the original indifference curve.

Equivalent variation: the amount of money one would have to take from a consumer to move the
consumer to the new, lower indifference curve.
Indifference Curve Analysis

Comparing the Three Welfare Measures

For a price increase:
If the good is normal, then:
|| > || > ||.
If the good is inferior, then:
|| < || < ||.

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Market Consumer Surplus

As the price of a good increases, consumer surplus falls more:
1. The greater the initial revenue spent on the good
2. The less elastic the demand curve at the equilibrium
Measurements of Inflation: The Cost of Living Index
Cost of living indices measure the difference in the economic cost of changing prices holding the
utility level fixed.
Example: the price of good 1 has quadrupled. How much would it cost to maintain a fixed standard
of living under the final prices relative to the initial prices?
The 'fixed standard of living' refers to a reference indifference curve - we can either choose the
initial indifferent curve, or the final indifference curve.
The cost of living index associated with the initial indifference curve is calculated in the same way as
the Compensating Variation, just expressed as a ratio.
The initial expenditure was 100, and the cost of remaining on the initial indifference curve with final
prices is 200. Therefore:
200
= = 2.
100

The cost of living index associated with the final indifference curve is calculated in the same way as
the Equivalent Variation. We already know the final expenditure was 100, and the cost of reaching
the final indifference curve at initial prices was 50. Therefore:
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the final indifference curve at initial prices was 50. Therefore:

100
= = 2.
50
The economic costs of inflation are heterogeneous. To come up with a headline rate, we have to
average over the household population. To do this, we have to weight households whose
expenditure is relatively large by more than those who spend less.
These 'plutocratic' indexes, like CPI, give a biased estimate of the true mean rate of inflation. The
bias is in the direction of whatever the rate of inflation is for the rich.
Substitution Bias
Another source of bias is known as substitution bias. Since we often don't know the indifference
curve map, we fix a reference basket of goods instead.
Laspeyres Index
If we hold the basket of goods fixed at the initial level, we can calculate the expenditure required at
the final prices:
4 50 + 1 50 = 250.
Using the fixed basket gives the Laspeyres index:
250
= = 2.5.
100

This is an over-estimate compared to the cost-of-living index, since the CoL index allows for a
behavioural response, whereas the fixed basket method doesn't. The relative price of good 1 has
gone up, so the consumer will substitute away from it. But the fixed basket method doesn't allow for
this, so consumers are exposed to too much price change.
Paasche Index
If we hold the basket of goods fixed at the final level, we can calculate the expenditure required at
the initial prices, and work out the Paasche index:
100
= = 1.38.
72.5

We have an under estimate - since, again, there is no allowance for a behavioural response. The cost
of buying the fixed basket is higher than the cost of maintaining the same utility. But now the
overestimate is on the denominator, so the index is biased downward.
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Effects of Government Policies on Consumer Welfare
Quotas
Consumers' welfare is reduced if they cannot buy as many units of a good as they want.

Food Stamps
Poor people who receive cash have more choices than those who receive a comparable amount of
food stamps. As a result, a cash grant increases a recipient's opportunity set by more than food
stamps of the same value do.

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Policy makers object to giving cash nevertheless, because they fear that cash might be spent on
goods like alcohol or drugs, or will not spend enough on food. Economists argue that households are
the best judge of how to spend their scarce resources.
This is a question is normative - whether or not it is desirable to let poor people choose what to
consume - so economics cannot answer it.
Subsidies vs Cash
Many countries provide subsidies for goods like childcare to poor parents.

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Deriving Labour Supply Curves

Labour - Leisure Choice
People choose between working to earn a wage, and leisure - all their time spent not working for
pay. Nonwork (N) includes all the time spent not at work.
A consumer's utility depends on how many goods, and how much leisure they consume:
= (, ).
Households face an hours worker constraint and an income constraint - the number of hours worked
per day equals 24 minus the amount of time spent in leisure:
= 24 .
Total income equals earned income and unearned income, such as income from inheritance or gifts:
= + .
The price of leisure is foregone earnings - the higher your wage, the more an hour of leisure costs
you.

The consumer sets their marginal rate of substitution of income for leisure equal to their marginal
rate of transformation of income for leisure in the market:

=
= = .

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= = = .

The supply curve for hours worked is the mirror image of the demand curve for leisure.
Income and Substitution Effects
For a wage increase:
The substitution effect must be negative for leisure. A compensating wage increase causes the
consumer to consumer fewer hours of leisure and to work more hours.
As wage rises, if the consumer works the same number of hours as before, they have a higher
income.
The income effect is positive if the consumer views leisure as a normal good.

When leisure is a normal good, the substitution and income effects work in opposite directions. If
the overall effect is that the consumer consumes more leisure when their wages rise, then they must
work fewer hours. There is therefore a backward bending section of the supply curve.
If the consumer viewed leisure as an inferior good, both the substitution effect and income effect
would work in the same direction, so that an increase in wages would cause the hours of leisure
consumed to fall and work hours to rise.
Shape of the labour supply curve
Whether the labour supply curve slopes upward, bends backward, or has sections with both
properties depends on the income elasticity of leisure.

If a worker views leisure as an inferior good at low wages and a normal good at high wages, as the
wage increases, the demand for leisure first falls and then rises, and thus the hours supplied to the
market first rise and then fall.

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Micro Page 26

Firms and Production

Production
A firm uses a technology or production process to transform inputs or factors or production into
outputs. Firms use three kinds of input:
1. Capital services (K) : use of long lived inputs such as land, buildings and equipment
2. Labour services (L): hours of work provided by managers and workers
3. Materials (M): natural resources and raw goods that are typically consumed in producing or
incorporated into making the final product
Production Functions
The production function is the relationship between the quantities of inputs used and the maximum
quantity of output that can be produced given the current level of knowledge about technology and
organisation. The production function for a firm that uses only labour and capital is:
= (, ).
Time and Variability of Inputs
The short run is a period of time so brief that at least one factor of production cannot be varied. A
factor that cannot be varied in the short run is a fixed input. Factors that can be varied are variable
inputs. The long run is a long enough period of time that all inputs can be varied.
Short Run Production: One Variable and One Fixed Input
In the short run, we assume that capital is fixed and labour is variable. In the short run, the firm's
production function is:

= , .
The marginal product of labour is the change in total output resulting from using an extra unit of
labour, holding other factors constant. The MPL is the partial derivative of the production function
with respect to labour:
(, )
= = .

The average product of labour is the ratio of output to the number of workers sued to produce that
output:

= .

In most production processes, the average product of labour first rises, and then falls as labour
increases. It initially rises because it helps to have more than two hands when assembling the goods.
Output may initially rise more than proportionally because of greater specialisation of activities.
However, as the number of workers rises further, output may not increase by as much because
workers have to wait to use a particular piece of equipment or because they get in each other's way.

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Law of Diminishing Marginal Returns

If a firm keeps increasing an input, holding all other inputs and technology constant, the
corresponding increases in output will eventually become smaller.
Long Run Production: Two Variable Inputs
Isoquants
The equation for an isoquant where output is held constant is:

= (, ).
Isoquants have the same properties as indifference curves, the only difference being that isoquants
hold quantity constant while indifference curves hold utility constant.
The farther an isoquant is from the origin, the greater the level of output - the more inputs a firm
uses, the more output it gets if it produces efficiently.
Isoquants do not cross - this would contradict the assumption that firms always produce efficiently.
Isoquants slope downward - if an isoquant sloped upward, the firm could produce the same level of
output with fewer inputs, which would suggest an inefficiency.
Micro Page 28

output with fewer inputs, which would suggest an inefficiency.

Isoquants must be thin - same reasoning as sloping downward.
The curvature of an isoquant shows how readily a firm can substitute one input for another.
If the inputs are perfect substitutes, then each isoquant is a straight line. The production is of the
form:
= + .
Sometimes, it is impossible t to substitute one input for another - inputs must be used in fixed
proportions, and they are perfect complements. The production function is of the form:
= min(, )

Substituting Inputs
The slope of an isoquant shows the ability of a firm to replace one input with another while holding
output constant. The slope of an isoquant is called the Marginal Rate of Technical Substitution:

= .

Because all isoquants slope downward, the MRTS is negative. To determine the slope at a point on
the isoquant, we totally differentiate the isoquant,
= (, ) with respect to L and K.
Differentiation with respect to labour, and realsiing that outut does not change along the isoquant,
we have:

= 0 = + = + .

As we move down and to the right of the isoquant, we increase the amount of labour slightly, so
must decrease the amount of capital to stay on the same isoquant. A little extra labour produces
amount of extra output, and similarly for capital. The change in output due to the drop in
capital in response to the increase in labour is . If we are to stay on the same isoquant,
these two effects must offset each other:

=
.

Micro Page 29


= .

Rearranging, we find that:

= = .

Diminishing Marginal Rates of Technical Substitution

As we move down and to the right along a curve isoquant, the slope becomes flatter. This reflects
diminishing MRTS: the more labour the firm has, the harder it is to replace the remaining capital
with labour, so the MRTS falls.
Returns to Scale
If all inputs are increased by a certain percentage, and output increases by that same percentage,
then the production function is said to exhibit Constant Returns to Scale.
For example, if a firm builds a second identical plant, then:
= (2, 2) = 2(, ).
If the output rises more than in proportion to an equal percentage increase in all inputs, then the
production function exhibits Increasing Returns to Scale.
IRS might arise from increase specialisation of labour or capital in one larger plant.
If output rises less than in proportion to an equal percentage increase in all inputs, then the function
exhibits Decreasing Returns to Scale.
DRS might arise from difficult in organising, coordinating and integrating activities within the firm as
it increases in size.
Varying Returns to Scale
Many production functions have IRS for small amounts of output, CRS for moderate amounts, and
DRS for large outputs.

Micro Page 30

Perfect Competition
Firms decide how much they should produce. To pick a level of output that maximises its profit, a
firm must consider its cost function and how much it can sell at a given price. Under a competitive
market structure:
- There are many firms producing identical products
- Firms can easily enter and exit the market
- Each firm is a price taker (the firm cannot raise its price above the market price)
- A competitive firm can ignore the specific behaviour of individual rivals in deciding how much
to produce
Competition
Price Taking
A market is competitive if each firm in the market is a price taker: a firm that cannot significantly
affect the market price for its output or the prices at which it buys its inputs. The firm is a price taker
if it faces a demand curve that is horizontal at the market price - the firm can sell as much as it wants
at that price, so it has no incentive to lower its price. The firm cannot increase the price at which it
sells by restricting its output because it faces an infinitely elastic demand - a small increase in price
results in its demand falling to zero.
Why a Firm's Demand Curve is Horizontal
Firms are likely to be price takers in markets that have some or all of four properties:
- The market contains a large number of firms
No one can raise or lower the market price
The more firms in the market, the less any one firm's output affects the market output,
and thus price
- Firms sell identical products
There is no branding or differentiation
- Buyers and sellers have perfect information about the prices charged by all firms
If firms try to charge a higher price, consumers switch to a different firm
- Transaction costs are low
It is easy for a customer to buy from a rival firm if the usual supplier raises its prices
- Firms can freely enter and exit the market
Other firms can quickly enter and erode profits
Some markets contain firms that are, for all intents and purposes, price takers, even if the market
does no exhibit all the characteristics of perfect competition.
Derivation of a Competitive Firm's Demand Curve
An individual firm faces a residual demand curve: the market demand that is not met by other sellers
at any given price. The firm only sells to people who have not already purchased the good from
another seller.
We can determine how much demand is left for a particular firm at each price using the market
demand curve and the supply curve for all other firms in the market:
The quantity the market demands is a function of the price:
= ()
The supply curve of the other firms is:
()
The residual demand function equals the market demand function minus the supply function of all
other firms:
() = () ()

Micro Page 31

At prices so high that the amount supplied by other firms is greater than the quantity demanded,
residual quantity demanded is 0.

The residual demand curve is much flatter than the market demand curve, so the elasticity of the
residual demand curve is much higher than the market elasticity.
If there are n identical firms in the market, the elasticity of demand facing one firm is:
= ( 1) .
A firm's residual demand curve is more elastic:
- The more firms (n) are in the market
- The more elastic the market demand ()
- The larger the elasticity of supply of other firms ( )
Why Perfect Competition is Important
1. Many markets can be described as competitive (e.g. agriculture, commodities, stock
exchanges).
2. A perfectly competitive market has many desirable properties, against which economists
compare real world markets.
Profit Maximisation
We assume that all businesses want to maximise profits, since a firm that does not maximise profits
is likely to lose money and be driven out of the business
Profit
Profit is the difference between a firm's revenues and costs:
=
Costs are the opportunity cost/economic cost - the value of the next best alternative use of any
input the firm employs. Economic profit is different to business profit.
E.g. a small business owner takes home 20,000 per year. If instead of running the business, the
owner could have earned 25,000 a year, then the economic profit is -5,000.
Maximising Profit
The profit function varies with output:
() = () ()
To maximise profit, a firm must answer two question:
1. What output level q* maximises its profit or minimises its losses
2. Is it more profitable to produce at q* or to shut down and product no output?

Micro Page 32

Output Rules:
The firm sets its output where profit is maximised:
- If the firm knows its entire profit curve, it can immediately set its output to maximise its profit
The firms sets output where marginal profit is zero:
The first order condition for profit maximisation is:
( )
= 0.

q* needs to be set such that the firm's marginal profit with respect to quantity equals zero.
The second order condition also needs to hold:
( )
< 0.

Since the firm's profit function is a function of revenue and costs, we can write the first order
condition as:
( ) ( )
= ( ) ( ) = 0.

A firm sets its output where its marginal revenue equals its marginal cost:
( ) = ( ).
The second order condition must hold:
( ) ( ) ( ) ( )
= < 0

(The slope of the marginal revenue curve must be less than the slop of the marginal cost curve.)
Shutdown Rule
The firm shuts down only if it can reduce its loss by doing so:
Fixed costs that are sunk costs cannot be avoided by stopping operations. The sunk cost is irrelevant
to the shutdown decision - by shutting down, the firm stops receiving revenue and stops paying
avoidable costs, but it is still stuck with its fixed costs. It only pays for a firm to shut down if its
revenue is less than its avoidable costs.
In the long run, all costs are avoidable, because the firm can eliminate them all by shutting down.
Thus in the long run, it pays to shut down if the firm is making any loss at all:
In the long run, the firm shuts down only if its revenue is less than its avoidable cost.
Competition in the Short Run

Micro Page 33

Short run competitive profit maximisation

Because competitive firms face a horizontal demand curve, a competitive firm can sell as many units
of output as it wants at the market price p.
So a competitive firms revenue increases by p if it sells one more unit of output, so its marginal
revenue equals the market price:
= .
A competitive fir maximises profit by choosing output such that:
( ) = 0:
= ( ).
The second order condition must hold:
( )
< 0.

Since p does not vary with q, dp/dq = 0. So:

( )
> 0.

i.e. the marginal cost curve must be upward sloping at q*.

Short run shutdown decision

The firm can only gain from shutting down if its revenue is less than it's short run variable cost:
< ()
We can write this as:
()
< = .

Micro Page 34

A competitive firm shuts down if the market price is less than the minimum of its short run average
variable cost curve.

Short run firm supply curve

As price increases, the equilibrium production point is determined by the intersection of the relevant
demand curve (market price line) and the firm's marginal cost curve.
If the price falls below the firms AVC, the firm shuts down. Thus, the firm's short run supply curve is
its marginal cost curve above its minimum average variable cost.

An increase in factor prices causes the production costs of a firm to rise, shifting the firm's supply
curve to the left.

Micro Page 35

Short Run Market Supply Curve

The market supply curve is the horizontal sum of the supply curves of all the individual firms in the
market. In the short run, the number of firms in the market is fixed at n. If all firms are identical,
each firm's supply curve is identical, so the market supply at any price is n times the supply of an
individual firm.

The market supply curve flattens as the number of firms increases. The more identical firms
producing at a given price, the flatter (more elastic) the short run market supply curve at that price.
If the firms have different minimum average variable costs, not all firms produce at every price.

Micro Page 36

As with identical firms, when both firms produce, the market supply curve is flatter. Because the
second firm does not produce at as low a price as the first firm, the supply curve has a steeper slope
at lower prices.
Short Run Competitive Equilibrium

Competition in the Long Run

In the long run, the output decision is the same as the short run - to maximise profit.
Since all costs are variable in the long run, the long run shutdown point is when revenue is less than
costs (i.e. the firm makes any economic loss).
Long Run Firm Supply Curve
A firm's long run supply curve is its long run marginal cost curve above the minimum of its long run
average cost curve. The LRAC curve differs from SRAC curve since the firm is free to choose its
capital in the long run.

Micro Page 37

Long Run Market Supply Curve

In the long run, firms can enter or leave the market. Thus, we need to determine how many firms
are in the market at each possible price to obtain the LR market supply curve.
The long run market supply curve is flat at the minimum long run average cost if firms can freely
enter and exit the market an unlimited number of firms have identical costs, and input prices are
constant.

If the number of firms in a market is limited in the long run, then the market supply curve slopes
upward. The only way to increase market output is for existing firms to produce more. Because
individual firm's supply curves slope upward, the long run market supply curve is also upward
sloping.
Because firms with relatively low minimum long run average costs are willing to enter the market at
lower prices than others, the market supply curve is upward sloping.
In markets where factor prices rise or fall when output increases, the long run supply curve slopes
even if firms have identical costs and can freely enter or exit.

Micro Page 38

Long Run Competitive Equilibrium

Micro Page 39

Oligopoly Models
Nash Equilibrium
A Nash Equilibrium is a situation such that no player has an incentive to change their strategy given
what the other player is doing.
When we are interested in understanding what kind of behaviour will emerge in an interaction
between fully informed, rational players, the Nash concept helps us narrow down the list of possible
outcomes.
Duopoly Models
In oligopoly markets, one firm's best course of action depends crucially on what the other firm(s) will
do. We can solve these problems using the Nash equilibrium concept.
The environment:
- A homogenous product
- Two firms (more can be added as long as there are few enough for each to affect the market
price)
- Perfect and symmetric information
- No uncertainty
Producers choose strategies, which specify how a firm will act in every possible distinguishable
circumstance whether or not that situation actually arises. Each firm's payoff depends on the
strategies adopted by both themselves and their opponent.
The Firms' problem - to choose a strategy is optimal. This will depend on what strategies each firm
thinks the other firm will adopt.
The Cournot Model
- The two firms set quantities simultaneously.
- Each firm has to forecast what the other will do to set its output to be profit maximising.
- A firm's strategy is a contingent plan specifying their levels of production given various levels
of production by the other firm.
Firm 1 thinks that firm 2 will produce units of output. Conjectured industry production will be:
= + .
Given conjectured output, we can read the price consumers are willing to pay from the inverse
market demand curve:
().
Given its conjecture about firm 2, firm 1 will maximise profits. The point where this occurs is still:
= .
(In the competitive case, the firm's MR was just the price. Now we need to add to this a term to
reflect the fact that in a duopoly, the firm is large enough to influence the price itself.)
Firm 1's revenue is:
= () .
Marginal revenue (using the chain rule) is:
= () + () .

The point of profit maximisation for firm 1 is therefore to produce an amount such that:
() + () = .
By varying its conjecture for firm 2, firm 1 can, for every possible compute its optimal response.
This set of { , } pairs represents firm 1's reaction function and describes its strategy. We can thus
Micro Page 40

This set of { , } pairs represents firm 1's reaction function and describes its strategy. We can thus
rearrange the profit maximisation function as:
= ( ).
We can do exactly the same process for firm 2, to get a similar reaction function.
The reaction functions describe the firms' strategies - they are descriptions of plans of action which
are contingent on whatever the other firms might do. Note that the strategies describe plans in all
possible eventualities - even those which are never played.
The Nash equilibrium is a situation in which each firm's strategy is a best response to the chosen
strategy of the other firm. In the current context, the Nash equilibrium must be a combination of
outputs such that:
- The optimal output for firm 1 is , assuming that firm 2 produces
- The optimal output for firm 2 is , assuming that firm 1 produces
= ( )
= ( )
This is an equilibrium since both players are playing best responses - any deviation would not be
profit maximising.
This equilibrium is the point where the two reaction functions cross.
Example
Market Inverse Demand Curve: = 30
Total output: = +
Identical, constant returns to scale firms: = = 3
Firm 1 Revenue:
= ()
= (30 )
= (30 )

Marginal Revenue:
= () + ()
(30 ) + (1)
= 30 2 .
Firm 1 must set = :
30 2 = 3
This is the reaction function, but we can write it more explicitly as = ( ):
27 1
= .
2 2
Because the firms have identical technologies, the reaction function for firm 2 is identical in form:
27 1
= .
2 2

Micro Page 41

At the Nash equilibrium, total industry output is:

= + = 18
= 30 = 12.
Ignoring fixed costs, each firm will make profits of:
= = 12(9) 3(9) = 81.
The Cournot Model - Asymmetric
If one firm has a cost advantage (its marginal cost of production is lower than its rival's), we can
derive the answer formally using just what we know already. Intuitively, the answer is that the firm
would do better than its opponent - it will have greater market share and make greater profits.
Example
Suppose that everything is the same as before, but = 0. Firm 1's reaction function is:
30 2 = 0.
This rearranges to:
30 1
= .
2 2
(Firm 2's reaction function is unchanged.)

At the Nash equilibrium, total industry output and price are:

= + = 11 + 8 = 19
= 30 = 30 19 = 11
Profits for firm 1 are:
= 11(11) = 121
Profits for firm 2 are:
= 11(8) 3(8) = 64
Industry output has gone up. This is because production costs have gone down in this industry on
average which means that it is economic for more units to be offered for sale at any given price
Micro Page 42

average which means that it is economic for more units to be offered for sale at any given price
(there are more units for which WTA is less than the price). Since sales have increased, the WTP
must have fallen, so equilibrium price falls as well.
Aggregate profits go up thanks to the average reduction in production costs, but the firm with the
cost advantage takes a higher proportion of the total profits.
Cournot with Many Firms
A rearrangement of the = reaction function condition gives the equation:

= .
||

Where is the market share for firm 1, and || is the absolute value of the elasticity of market
demand.
The LHS is the firm's mark up of price over marginal cost of production.
- As MC falls, the firm's market share rises.
- As demand becomes more elastic, the firm's mark-up falls (since you sell fewer units, even
though you make more money on each unit sold).
In an industry in which both firms have the same technology:


= = .

As more and more technologically similar firms enter the industry, 0 and (the market
moves towards a competitive equilibrium).
The Bertrand Model (homogenous products)
- Firms choose prices simultaneously.
- Apart from that, the setup is the same as the Cournot model.
- The Nash equilibrium is a matter of finding a pair of pricing strategies such that each price is
the best response for each firm and such that these choices are all consistent.
The Nash equilibrium is price = marginal cost.
This is a market for a homogenous product - if there are two firms in the market and the market is in
equilibrium, then they must be charging the same price. No price above marginal cost can be a
stable equilibrium (the firm would lose its sales and thus have an incentive to cut their price again).
No price below can be profit maximising.
Example
Reconsidering the two original firms:
= = 3 = 3
= 27.

Output is higher than the Cournot case, price would be lower, and both firms would make zero
economic profit.
The Bertrand Model (differentiated products)
Many economists believe price setting models are more plausible than quantity setting models,
since the firms set prices and then consumers determine quantities. If a firm sets quantity, it is not
clear how the prices of goods are determined in the market.
For differentiated goods, a firm can charge more than another without losing all its sales. If
consumers view the goods as perfect substitutes, a small drop in the rival's price causes this firm to
lose all its sales. Therefore, differentiation leafs to higher equilibrium prices and profits in the
Bertrand model.
The demand function for the firms are:
Micro Page 43

The demand function for the firms are:

= ( , ); = ( , ).
We assume the firms have constant marginal costs m, and no fixed costs.
Firm 1's objective is to maximise profits:
max = ( , ) ( , )

( , )
( , )
= ( , ) + = 0.

This contains the information in fir m1's best response function:

= ( ).
We can derive firm 2's response function in the same way.

The Bertrand best response curves slope upward, indicating that a firm charges a higher price the
higher the price the firm expects its rival to charge. The intersection of the best response functions
determines the Nash equilibrium.
Example
Firm 1 demand curve:
= 58 4 + 2
( ) = = ( )(58 4 + 2 ).

= 58 8 + 2 + 4 = 0

29 1
1
= + + .
4 4
2
If coke's marginal cost of production is 5 per unit:
39 1
= + .
4 4

Firm 2 demand curve:

= 63.2 4 + 1.6
( ) = = ( )(63.2 4 + 1.6 ).

= 63.2 8 + 1.6 + 4 = 0

Micro Page 44

(Firm 2 has same marginal costs)

52
= + 0.2
5
Finding the intersection points:
39 1 52
= + + 0.2
4 4 5
= 13; = 13.
Collusion
In both models, firms have a clear incentive to collude:
- In the Cournot model they can behave like monopolists and maximise joint profits, then divide
up the profits.
- In the Bertrand model for homogenous goods they can agree to charge the same price but set
it above marginal costs.
But in one period interactions, collusion is not a Nash equilibrium, since in each case there is an
incentive to defect:
- In the Cournot case each firm could increase their own profits if it independently raised its
output above the collusive level.
- In the Bertrand model each firm can increase profits by independently dropping their price
below the collusive level.
In dynamic games (where firms interact repeatedly) collusion can occur. If the firms interact
repeatedly, then the firm has to think about what the other will do if it breaks the collusive
agreement - the other firm is likely to retaliate in the next period.
Firms have a range of available carrot and stick strategies, which need to be credible. If the strategy
goes against the firm's own interest, the threat is not credible.

Micro Page 45

Market Failure
Previous analysis has focused on economic behaviour in benign and special circumstances:
- There are no externalities: there are no direct interactions between firms and consumers. The
only way they can interact is indirectly through the price mechanism.
- There is perfect information: price differences for homogenous goods cannot persist for long
before they are arbitraged away, and consumers know the value of the products they are
buying.
- There is no market power: firms are price takers in both input and output markets.
These kinds of perfect markets work:
1. They allocate resources to those who value them the most (and can afford them).
2. All gains from trade are exploited.
3. Firms operate at minimum cost.
The markets are technically and allocatively efficient, as well as Pareto efficient.
But the conditions for perfect markets rarely hold in the real world. We can look at behaviour when
these conditions fail:
- Market power: monopoly and monopsony behaviour
- Externalities: public goods and public bads
- Imperfect information
Externalities and Market Failure
Interdependence in behaviour is a key feature of the economy in the real world - what other agents
do will affect what the optimal choice/strategy is in any situation. Oligopoly models show
interdependence which is mediated by the market price, but no real interdependence.
The benefit of having interdependencies mediated by the agent's effect on the market price is that it
simplifies the agents in our models. It means that an agent does not have to think about what
everyone else in the market is doing - they simply look at the market price and this summarises
everything they need to know about the choice. The cost of this simplification is that it is not a good
approximation to what happens in the real world.
Externalities - when the actions of one economic agent affect another other than through the price
mechanism/market transaction, we say there is an externality. Externalities can be positive (when
they have beneficial external effects) or negative (when they are harmful to others).
E.g. Second hand smoke: smoker gets nicotine, cigarette company gets money, but we suffer
without compensation
E.g. A neighbour who maintains their house may increase the value of yours
Externalities cause competitive markets to behave inefficiently, in the absence of a mechanism to
involve all the affected parties:
- The neighbour will under invest in their house since they have no reason to take account of
your preferences.
- The smoker will smoke too much since they have no reason to care about you.
Public Goods
Public goods involve externalities which are non-rivalrous and non-excludable.
E.g. National Defence, lighthouses, clean air - different people cannot consume different amounts so
they have to come to a collective decision on how much to have.
Suppose we have two people who have preferences over a private good x and a good g given by:
( , ) and ( , ).
A good like g is such that whatever one consumes, the other consumes.
Person 1 has to choose a bundle to consume. But person 1's utility depends on x1 and g, where =
+ .
Micro Page 46

 + .
If 2 chooses more of good g, 1 gets the benefit. If 2 is expected to provide enough to satisfy 1, then 1
will free ride.
Individual optimisation:
1's optimisation problem is:
max( , ) . . + = ; + = .
,

max( , + ) . . + = .

Use the chain rule:

= = .

Because = + :

= 1.

So we get:

= .

Setting this equal to the ratio of prices, we get:

= =

This outcome is known as the Cournot-Nash outcome, as it is similar to the problem of the supply of
a homogenous good in an oligopolistic market.
Suppose that the prices are 1 each, so the relative prices are 1 and that the MRS's = 1/1
This says that both individuals are willing to accept 1 worth of the public good in return for a loss of
1 worth of the private good. If we reduce the amount of the private good available and offer to
compensate them, can we do this in a way which makes them better off? If so, we're not at a Pareto
optimum.
Suppose we cut back their spending on the private good by 1 each: we save 2 x 1 = 2.
To compensate the two people, we need to raise expenditure on the public good for each of them
by 1 each. But this only costs 1, because what one gets, the other gets too. They are just as happy
(they're on the same indifference curve) but there is 1 left over. This money could have been
shared out, thereby improving the situation for both, while making no one worse off (there is a
Pareto improvement).
The Pareto efficient thing to do is to (hypothetically) merge the entities. Merging two agents
internalises the externality. They act in a jointly optimal way and that tells us what efficiency looks
like.
We want to maximise social welfare:
( , ), ( , ) .
The social/Pareto optimum is found by solving:
max ( , ), ( , ) . . ( + ) + = + .
The maths is slightly more complicated, since there are three variables, but optimising in the
usual way gives us:
Micro Page 47

usual way gives us:

, + , = .
The socially optimal provision of the public and private goods would result in the sum of the MRS's
equalling the relative prices. This is known as the Samuelson condition.
Suppose that the prices are 1 each so the relative prices are 1, and that the MRS's do not add to 1.
For example:
1
1
, = , , = .
4
2
Person 1's MRS tells us that he would accept 0.25 worth of the private good in return for a loss of
1 worth of the public good. Similarly, Person 2 would accept 0.50 worth of the private good in
return for losing 1 worth of the public good.
Cutting back spending on the public good by 1, we save a pound and to compensate the two
people we can give them 0.25 and 0.50. They are just as happy, and we've got 0.25 left over.
Clearly we are at a Pareto improvable position when the sum of the MRS's does not equal the
relative prices.
Missing Markets
The market based problem is that there is no market for these externalities - there is a missing
market. For example, there is no market for CO2 emissions, since in the absence of international
agreements, there are no rules to confer property rights on anyone. It is the absence of these
property rights which causes the problem. If we can set up a framework which confers these rights,
then the parties can trade and the market can solve the problem of finding a Pareto efficient
outcome.
The Coase Theorem - when trade in an externality is possible and there are no transaction costs,
bargaining will lead to an efficient outcome regardless of the initial allocation of property rights.
Production Externalities and Pollution
A production externality is a situation in which the production function of a firm is affected by the
actions of another party.
A steel mill produces two outputs: steel and pollution (, ) and has the cost function (, ).
The marginal cost of producing steel is positive.
The marginal cost of producing pollution is negative (abatement activities cost money).
A fishery downstream has cost function (, ).
The marginal cost of producing fish is positive.
The marginal cost of pollution is positive (pollution in the river raises costs).
The firms' profit maximisation problems are:
max (, )
max (, ) .
First order conditions are:
(, )
= 0

(, )
= 0

(, )
= 0.

All of these conditions say that price equals marginal costs (because we have assumed a perfectly
Micro Page 48

All of these conditions say that price equals marginal costs (because we have assumed a perfectly
competitive situation in the steel and fish markets). But there is no market for pollution - the price is
zero and the optimal production of pollution for the steel mill is to produce it until the marginal cost
is zero.
To work out the Pareto efficient situation, we hypothetically merge the firms. The new profit
maximisation problem is:
max + (, ) (, ).
FOCs:
(, )
= 0

(, ) (, )
= 0

(, )
= 0.

The interesting condition is:

(, )
(, )
= .

This condition says that the merged firm should equate the marginal cost of pollution abatement to
the marginal benefit of a reduction in pollution to the fishery. Since the marginal cost of pollution to
the fisher is positive, there will be less pollution. But there will not be zero pollution (unless the
above condition holds at x = 0).

Permits & Property Rights

One solution to this problem is to pass a law conferring property rights on either party and let them
trade (tradable permits).
Suppose we confer property rights on the fishery for a clean river, but allow the fishery to sell the
right to pollute. Let q be the unit price of pollution.
Micro Page 49

right to pollute. Let q be the unit price of pollution.

The cost of buying pollution permits is added to the mill's costs, so the steel mill's optimisation
problem is:
max (, ).
The fishery has permits as a secondary source of income:
max + (, )
The FOCs are:
(, )
(, )
= ; =

(, )
(, )
= ; =

Note that the price of pollution is equal to the social cost of pollution and that equating the two
figures for the price gives us the identical solution as when we merged the two firms.
Giving the property rights to the steel mill gets us to the same Pareto optimal point, although the
division of profits will not be the same. It obviously matters a lot to the parties involved who gets the
permits. As such, permits are often auctioned.
The advantage of the permit system is that it creates the opportunity for efficient exchange.
Furthermore, environmental groups can buy permits and then not exercise them, as a way of
cleaning the air. The purchase of permits creates a major positive externality on the rest of society.

Permits are also easy to monitor and adjust by setting the number of permits to match current
pollution and then gradually reduce the quantity to reduce the effects of the pollution. The price of
the permits gives a good indication of the appropriate time to reduce the quota - low prices suggests
the quantity is too large and should be reduced.
Permits schemes do have some problems - they require international agreements, which take a long
time and are open to manipulation. There is also no guarantee that the optimal level of pollution will
be low.
Pigouvian Taxes
Another solution to the problem is to make sure that the polluter faces the correct social cost of its
actions. One way to do this is to place a tax on the pollution generated by the steel firm. Suppose
that we put a tax of t per unit of pollution generated by the steel firm. The profit maximisation
problem becomes:
max (, ) .
FOCs:
(, )
= 0

(, )
= .

This is setting the tax equal to the Pareto efficient outcome price.

Micro Page 50

The problem with Pigouvian taxes is that they require us to know the socially optimal level of
pollution in advance.
Imperfect Information
The price mechanism relies on information. A consumer needs to know only the prices of the goods
and their own personal preferences in order to make a sensible choice of purchases. Manufacturers
need only need to know the prices of goods in order to decide what to produce.
However, there are circumstances where the prices are not the only necessary information required
for firms and consumers to make good decisions. In such situations, information can lead to market
failures.
Lemons
Akerlof showed that in a situation where sellers are better informed than the buyers, the market for
used cars may collapse. The information possessed by the sellers of the used cars destroys the
market.
Suppose that the quality of used cars lies on a 0 to 1 scale and that the population of used cars is
uniformly distributed o the interval [0,1]. Let the quality represent the value a seller places on the
car.
Now suppose that there are also buyers and that buyers like cars more than sellers - the average
buyer puts a value on a car which is 50% higher than the value the seller places on it.
Trade would clearly be a good thing: the buyers' WTP exceeds the sellers' WTA on average by 50%,
so trade would reallocate the cars to those who value them most and would be a Pareto
improvement.
At a price p, any seller with will be willing to trade.
The expected average quality of the cars offered at this price will be 0.5. Buyer's WTP for cars
whose quality is expected to be 0.5 is 0.75, so < .

Micro Page 51

Thus, the buyer is not willing to pay the price p for the average car offered at price p. The effect of
the informed seller, and uninformed buyer, produces a lemons problem. At any given price, all the
lemons and only a few good cars are offered, and the buyer- not knowing the quality of the car - isn't
willing to pay as much as the actual value of a high value car offered for sale. This causes the market
to collapse
Adverse Selection
The Lemons model is an example of adverse selection.
Adverse selection - there is hidden information so that an information asymmetry arises, and as a
result low quality items crowd out high quality items.

One of the classical examples of adverse selection threatening markets concerns healthcare.
Individuals know more about their health risks than insurance companies, and so there is hidden
information, and an incentive for bad risks to sign up.
Private information in insurance markets leads insurance companies to expect hidden problems with
individuals that have the highest demand for insurance (because individuals expect that they will
need a lot of insurance in the future). If insurance companies do not observe type, it may not be
possible to base an insurance contract on the average type; low risk types may not find it in their
interest to purchases that type of insurance.

Micro Page 52

Monopoly and Monopsony

Monopoly and Market Failure
The first order condition for a profit maximising monopolist is:
() = 0
() + () = ()
= .
The first term of marginal revenue is just the price. The second involves the slope of the inverse
demand function (this reflects the fact that marginal changes in output decisions will affect the WTP
in the market).
Since () < 0:
() < ()
The competitive firm is a special case in which () = 0.

MR falls twice as fast as AR in the linear case because the revenue function is quadratic.
We can rearrange the MR = MC condition:
() + () = ()

Recall the definition of the elasticity of demand:

()
() = ()

Since the demand curve slopes downward, we know that the slope of the demand curve and
the slop of the inverse demand curve are just inverses of each other:
1
() =
()
1 ()
() =
()
1 ()
() =
()
Substitute this into the MR = MC condition:
1 ()
() + = ()
()
1
() 1 + = ()
()
Or more simply:
1
1
= ()
| |
Micro Page 53

1
1 = ()
|()|
This says that the monopolist will charge a price which is above marginal cost because it will always
operate on a part of the demand curve where demand is elastic
|()| > 1
Rearranging the first order condition as:
()
1
=
|()|

(the proportional mark-up of price over marginal cost.)

> () and the monopolist prices above the marginal cost, but their ability to do thi is limited
by the demand curve. When elasticity is low, the mark up is at its biggest.
Compared to the competitive outcome, the monopolist charges more and produces less.

A is the consumer surplus which is transferred across to the monopolist. The area B is lost consumer
surplus, and C is lost producer surplus.
Sources of Monopoly power
1. Being granted a monopoly by the government - through patents, copyright laws or
government franchises (e.g. local rail franchises, new drugs)
2. Economies of scale which are large relative to the size of demand - if the AC when a single firm
serves the entire market is lower than when two or more enter, a monopoly can be the result
(e.g. telecoms, electricity distribution)
3. Control of an essential or sufficiently valuable input - technology that confers a cost advantage
(e.g. software)
Monopolies and Taxes
In markets served by a monopolist, more than 100% of a tax can be passed on to the consumer.

A specific duty of t shifts the marginal cost up by a fixed amount, as the firm has to remit t on every
unit sold. When demand is linear, the price has increased by less than the size of the tax.
Micro Page 54

unit sold. When demand is linear, the price has increased by less than the size of the tax.
But when the demand curve is convex to the origin, the amount by which the price changes exceeds
the amount of the tax.

Price Discrimination
The monopolist is producing where > .
This means that there is a consumer who would be willing to pay a price of for a
marginal unit of the good beyond who is not buying any at the moment.
If the firm sold a unit to this person for p, then it would still be the case that price exceeded marginal
cost - so it's worth doing. This means that both the firm and the buyer would be better off - a Pareto
improvement. This is true for all sales between and .
Monopolies would like to sell at a lower price to marginal consumers, whilst continuing to charge a
high price to everyone else. The key is finding a mechanism to prevent arbitrage, and identifying
marginal consumers.
3rd Degree Price Discrimination
This occurs when a firm can identify different groups of consumers and sell to each of them at
different prices.
The total profit for the firm is:
( ) + + ( ) ( + + ).

The optimisation occurs when the first order conditions are applied to each group:
+ = () for each g group.
The firm should set marginal revenue equal across all groups.
Using the expression we derived earlier, we can rewrite = as:
1
1 = .

For any pair of markets, the two Lerner expressions must be equal. This means that:
| ( )| > < .

Micro Page 55

Market 1 is less price elastic, so consumers get charged a higher price.

If firms could identify all individuals' WTP and prevent arbitrage, then they could in principle practice
perfect price discrimination by charging every individual a personalised price. This is perfectly Pareto
efficient - the firm is extracting all of the consumer surplus and transferring it to itself (there is no
DWL).
Monopolies and Mergers
Horizontal mergers are considered to be bad for consumers. This intuition comes from the Cournot
oligopoly version of the mark-up equation:

= ,
||

Which shows that as the market share grows so does the mark up.

Vertical mergers can be beneficial for consumers especially when the two firms involved already
enjoy a degree of market power within their own markets.
Monopsony
In a monopsony a sole buyer exploits its position to influence the market price of its inputs. The
profit maximisation problem faced by the monopsonist is to choose its input:
max () ()
(when the firm is a price taker in the market for its output.)
The first order condition is just MR = MC again:
() = () + ().
(This condition just says that the firm should hire workers until the extra revenue generated by
the last worker just balances the cost of hiring that worker.)
The term () measures the revenue generated by using a marginal unit of the input . This is
termed the maginal revenue product. Under CRS it is flat, with DRS it is downward sloping.
In a competitive factor market, the supply curve the firm faces is flat - it can hire as much labour as it
likes at the going wage rate. But when the firm is the only buyer of labour in the market, it faces an
upward sloping supply curve: if it wants more labour, it will need to pay more and so drive the wage
up.
Using the definition of the supply elasticity gives:
1
= () 1 +
|()|
This implies that the marginal cost of labour at the profit maximising optimum will be higher than
the market wage:
() > () i.e the marginal cost curve lies above the supply curve.
The firm wants to hire labour at the level which () = () which is at . At this point the
wage can be read off the supply curve ( ).

Micro Page 56

If the firm was buying labour competitively, its MC(x) would just be the inverse supply curve. It
would hire more workers and pay them more. As it is, the firm exploits workers by not even paying
them their marginal revenue product
Once again, the first order condition can be rearranged to give a mark-up (really mark-down)
equation:
()
1
= .
|()|
()
When bargaining power is weak due to a low elasticity of supply, workers are more likely to be
exploited.
In monopsony markets, minimum wages can correct DWL, rather than creating it.

Micro Page 57

Problem Solutions

Micro Page 58

Week 2
1.
a)
b)
c)

Explain the nature of the opportunity costs of the following activities:

Attending a lecture
Spending time on a train
Extracting oil from underground

a) The leisure time which the student could have had if he didn't attend the lecture
b) The time one the train has the opportunity cost of whatever activity the person couldn't do. The money could have been
spent on another form of transport (e.g. bus)
c) Could sell the extraction machinery (if the costs aren't sunk costs).
Local community: employment, environmental factors, real estate value (up or down)
Government: nationalised industry, other energy sources, national oil sustainability
2. Assume that the domestic supply curve for beef is upward sloping and that the domestic demand curve is downward
sloping. Illustrate the market equilibrium on a diagram. Suppose now that the government decides to allow imports
of foreign beef. Assume that the country faces perfectly elastic foreign supply at a lower than current domestic price,
and that consumers do not care whether they eat domestic or foreign beef (i.e. domestic and foreign supplies are
perfect substitutes). Use measures of consumers and producers surpluses to evaluate who gains and who loses from
this policy. Is free trade benecial for society?
Consumer surplus increases
Original CS: A
New CS: A+B+C+D
Consumers benefit since the introduction of foreign firms reduces the market price, causing consumer surplus to rise.
Domestic producer surplus falls
Original PS: E+B
New PS: E
Producer for the surplus for domestic producers falls since the foreign firms drive down the price of beef.
Foreign supplier welfare increases
We assume foreign supplier profit goes up, since they have entered a new market
But: Domestic workers might not find another job, so long term welfare could be negative
Industrialisation at the expense of the lost agriculture: pollution, structural unemployment (Occupational
immobility/Insider-Outsider Theory)
Assuming the price mechanism is efficient: externalities/food miles
3. (From Katz and Rosen) An article about the market for marijuana made the following three observations:
a) In 1991, the price was $80 an ounce; several years earlier the price was $30 an ounce.
b) By 1991, marijuana smoking was no longer in vogue: health concerns...have risen above the desire to get giddy.
c) Relentless police pressure had turned marijuana into a scarce commodity.
Draw a set of supply and demand curves that are capable of illustrating these observations.

4. The demand curve for a good is given by QD = 28P.

a) What is the total consumers surplus if the quantity sold is 16?
b) What is the price elasticity of demand at this quantity?
a) 16 = 28 - P1
P1 = 12
CS = 1/2(16 x (28-12)) = 128
b) PED = Q/P x P/Q
= -1 x 12/16 = -0.75

Micro Page 59

Week 3
1. Suppose that random access memory (RAM) costs 50 per gigabyte. The value to you, measured in terms of
your willingness to pay, of an additional gigabyte of memory is400 for the rst gigabyte, and then falls by onehalf for each additional gigabyte. Draw a graph of marginal cost and marginal benet. How many gigabytes of
memory should you purchase?
PMB (q) = 400(0.5q-1)
PMC(q) = 50
Equilibrium at MC = MB, since if MB > MC: next unit provides more benefit than cost, so consumer benefits from buying
another unit. If MC > MB: consuming an extra unit will provide less benefit than the cost, so the consumer will not go
beyond MC = MB.
At equilibrium:
400(0.5q-1) = 50
Q=4
1. Suppose that the market for chicken meat (where XS is the quantity of meat supplied and XD the amount
consumed) can be described by the linear demand and supply curves
xD =abP, xS =c+dP
where b and d are coecients, a and c are constants, and P is the market price for chicken meat. Assume that b
and d are both greater than 0.
a) Would you expect a to be positive or negative? Why?
Expect a to be positive. a/b is the reservation price. We would expect there to be a price at which all consumers are
either unwilling or unable to pay for the good. So quantity demanded is zero at this positive price. Since b>0, in order for
a/b >0, a must be positive.

b) Would you expect c to be positive or negative? Why?

We would expect c to be negative. If the supply curve intercepts the Price axis at a positive value (i.e. -c/d > 0), c must be
negative, since d > 0. If c is positive, the supply curve crosses the Price axis at a negative value, meaning that for low
quantities, the firms would be willing to supply the good for free. This doesn't seem likely since we assume firms have
some costs, and want to maximise profits. If they supply the good for free, they are definitely making a loss.
c) Sketch the demand and supply curves, identifying intercepts and the slopes of the curves. Show the market
equilibrium on your diagram.

d) Find an expression for the price elasticity of supply and demand. What economic factors are likely to determine
the price elasticities of demand and supply for chicken products?

=

=


=

=
+

Factors affecting PED:

Factors affecting PES:
e) Find the equilibrium market price and output
At equilibrium: xD = xS= Q
= +
( + ) =

=
+
xS = c + dP
= +

+
Micro Page 60


= +
+
( + ) +
=
+
+
=
+
f) Assume that, in the short run, the market supply of chicken is perfectly inelastic, and represented by the
equation xS =cSR+dSRP. What does this imply about the values of cSR and dSR? Why is this not likely to be the case
in the long run? Find the market equilibrium.
cSR = Q*
dSR = 0 (since the supply curve is a vertical line)
In the long run, increases in price are likely to encourage suppliers to produce more, or more suppliers might enter the
market in response to higher prices, resulting in an upward sloping (more elastic) supply curve.
At equilibrium: xD = xS(SR)
=

Q = cSR
g) By how much does the equilibrium market price change when a increases by 1 unit in the short run and the long
run? By how much does the equilibrium market output change? Explain the economic intuition behind these
results.
Short run
Initial equilibrium:

= , = 0
+
New equilibrium:
( + 1)
1
1
= = + = +
+
+ +

Price changes increases by 1/b, output stays constant since supply is perfectly inelastic.
Long run
Initial equilibrium:

+
= , =
+
+
New equilibrium:
+1
( + 1) + + +
= , = =
+
+
+
Price increases by 1/(b+d), Output increases by d/(b+d)
In the LR, the price increases is smaller, because the increase in demand is partly offset by higher supply, so price is not
forced upward by as much. Output increases because supply is more elastic, so some of the extra demand at the original
price can be met by new suppliers.
h) Suppose that there is a health scare about swine flu. How would you model this change? Graphically illustrate
the short run and long run effects. Comment on these effects.
Demand for chicken increases. Demand shifts out.
See g).
Suppose the government introduces a tax on chicken meat of t for every unit of chicken meat sold.
i) Why does it make no difference to the economic incidence of the tax whether chicken suppliers or chicken
consumers are forced to pay?
The economic incidence of tax is upon the entity which bears the economic cost.
The tax means that: pD = ps + T
If the supplier pays, consumers pay price pD, and suppliers receive pD-T.
This shifts the supplier curve up by T.
If consumers pay, suppliers charge ps, and consumers pay ps + T.
This shifts the demand curve down by T.
j) Find the new equilibrium price for consumers and producers. How is the economic incidence of the tax related
to the elasticities of demand and supply? What is the economic intuition behind this result?
pD = ps + T
D(pD) = S(pD-T)
=
Micro Page 61

 =
= +
( ) = + ( )
+ = +
+
=
+
=
+
=
+
+ ( + )
=
+

=
+
If demand is more inelastic relative to supply, the incidence of tax will be greater on consumers. This is because the
increase in price will reduce quantity demanded by as much, and so consumers will pay most of the tax.

Micro Page 62

Week 4
1. A company producing bicycles has two plants, A and B. The number of bikes produced per month in the two
plants are: YA = 40LA1/2 and YB = 210LB2/3. Suppose that 400 workers are currently employed in plant A, and 1000 in
plant B. Find: Total output, output per worker, the marginal product of labour in each plan. Should the company
consider moving workers from one plant to another?
= 40 400 = 800
= 210 1000 = 2100
Total output = 2900

800
= = 2

400

2100
= = 2.1

1000

= ( ) = 20

= ( ) = 70

= 20 400

= 70 1000

=1

= 0.7

Should switch workers from B to A, since MPLA > MPLB. This would increase output in A more than output is reduced in B.
The firm should keep shifting workers until the marginal products are equal.
2. A firm has production function = where alpha is between 0 and 1. The rental price of capital is r and
the wage rate is w. The market price of a loaf of bread is fixed at p.
a) Derive an expression for the marginal product of labour.

= = (1 )

b) Sketch the relationship between B and L for K = 1, 2, 3

c) Provide an intuitive explanation for the sketches you made in part b

More capital means that for a given level of labour, output is higher. Once there are many workers, however, there are
not enough machines for the workers to use, so there are diminishing marginal returns to adding extra workers to a fixed
amount of capital.
d) Derive the short run profit function when labour can be varied, but capital is fixed at 1. Find the level of labour
which maximises short run profits.
SR Revenue = =

SR Costs = r(1) + w(L)

Micro Page 63

 =
( + )
=

= (1 )
Max profit when = 0:

(1 )

(1 )
=

(+ Check second order condition)

e) Derive the long run profit function. Find the long run profit maximising capital labour ratio. How would you
graphically depict this optimum? Comment on your solution.

LR Revenue = =
LR Costs = rK + wL

= (1 )

At max: = 0, = 0

(1 ) = 0

= ()

(1 )

=0

=

Sub in (*)

=
(1 )
Choice of production technique depends on w/r (relative prices) and (the relative coefficients from the production
function).
The gradient of the isocost curve is -w/r
(

The MRTS =
At tangency these are equal, which gives us the same equality as the profit maximising method.

3. Consider the production function Y=KL.

a) Under what conditions does this production function exhibit constant, increasing and decreasing returns to scale?
= () ()
=
=

Constant returns to scale if a + b = 1
Micro Page 64

Constant returns to scale if a + b = 1

Increasing if > 1
Decreasing if < 1

b) Is it possible to have decreasing marginal products for every input and yet increasing returns to scale? If so, give
an example; if not, prove it.
Decreasing MPL if < 0
( 1)()
( 1) < 0

<0

0<<1
Same for .
So it is possible: e.g. = 0.6, = 0.6
Now suppose that =1/2 and the firm exhibits constant returns to scale. Let capital be a fixed constant in the short run:
KSR= K. The firm is a price-taker with respect to the output price p.Let the unit wage be w and the unit cost of capital be
r.
c) What is the firm's optimal choice of labour LSR, given an arbitrary level of output Y, in the short run? Hence, what
is the marginal cost curve? How much will the industry supply in the short run?
1

= =
2

d) Suppose the price of output changes from p to p + p. Draw a graph to show the increase in producer surplus.
(e)*Nowconsiderthelong-runresponseofthesector.Showthatthecostcurveisa
linearfunctionofY.Drawagraphtoshowtheincreaseinproducersurplus

Micro Page 65

Week 5 - Firms: Competition and Monopoly

1.
a)
b)
c)
d)

True or False?
Average total costs always exceed variable costs
Short run average costs exceed long run average costs
A competitive firm will not operate where marginal cost is less than average cost
A competitive firm operating at a point of decreasing returns to scale must be making a
profit
e) The average cost function is conventionally drawn to be U-shaped
a) False
Average total costs = average variable costs + average fixed costs. Although in the short run,
the presence of fixed costs means that average total costs will always exceed variables costs,
in the long run all factors of production are variable. This means that there are no fixed costs
in the long run, and so average total costs = average variable costs.

b) True
In the long run, all factors of production are variable, so a firm can optimise on two factors
instead of one. It can choose how much capital it uses for a given output. In the short run,
since there are fixed costs, average costs are higher, and the firm might not be producing as
efficiently as it can. So LRAC forms an envelope which contains the difference SRAC curves,
which corresponds to the different fixed costs/scales of production.

c) False
In the short run, a competitive firm might operate where MC < AC if it is still covering AVC. The
short run shutdown point is MC < AVC, whereas in the long run the shutdown point is MC < AC
(since there are no fixed costs). In the short run, if a firm can make a contribution towards
fixed costs, which have to be paid regardless of output, it will continue to produce, since the
total loss will be smaller than if the firm shut down.
d) True
If there are decreasing to scale, average costs are rising, with output. This means that MC >
AC. So if the firm produces at p = MC, p > AC, so the firm will definitely make a profit.

e) True
Micro Page 66

e) True
The U shape of the AC curve represents the difference components. Average fixed costs fall as
output increases, and approaches zero as output gets larger, since the fixed cost is spread over
many units of output. Average variable costs fall and then rise, because of increasing and then
diminishing marginal returns, when adding a variable factor to a fixed factor. Since AC = AVC +
AFC, at low output, the falls in fixed costs dominate, and AC is falling. At higher outputs, when
AFC are nearly zero, rising AVC mean that average costs rise again.
2. A perfectly competitive industry is composed of 60 firms. The industry demand curve is
given by = , where P is the price and QD is the total market demand. Firms

have identical costs given by the function = + +
, where q is the firms' output.

a) What is the market price and level of each firms output in the short run?
b) How much profit does each firm make? Comment.
c) How many firms will operate in the long run? How much profit will they make?
d) The government imposes a per-unit sales tax of 5. What happens to each firm's output in the
short run? How many firms will survive in the long run?
e) Comment on the welfare impact of the tax.
50
1
a) = + 5 + .

2
= 5 +
Firms maximise profit at MR = MC:
=5+ =5
(SoC: = 0 1 = 1 < 0.)

= 60

= 60 300.

At equilibrium: = :
60 300 = 1100 4
100 = 1400
= 14.

= 5 = 14 5 = 9.
b) = 9 14 = 126
1
= 50 + 5(9) + (81) = 135.5
2
= = 126 135.5 = 9.5
Since firms are making a loss, in the long run, firms will exit the market.
1
50
c) = + + 5
2

1 50
=

2
Minimum AC when AC' = 0:
1 50
= 0
2
= 10.
100
100
: = = = 0.1 > 0.

1000
In the long run, firms will leave the market until all abnormal profit is gone, and all remaining
firms are operating at the minimum average cost.
1
50
= (10) + + 5 = 15
2
10
Market demand = 1100 40 = 1100 40(15) = 500.
Micro Page 67

= 500,

= 10 50 firms in the market, making 0 economic profit.

d) Short run

= 1100 40;
= 60( 5) 300
At equilibrium: =
1100 40 = 60 600
100 = 1700
= 17 = 1100 40(17) = 420.

= 420. Number of firms = 60

=7

Long Run
Add 5 to the LRAC function (since the unit tax adds a cost of 5 for every unit produced).
50
1
= + 10 +

2
Want to find the minimum LRAC, to find the long run equilibrium price:
1 50
= = 0

2
50
1
= 10 = + 10 + (10) = 20.
10
2
In the long run, p = 20.
Long run market demand = 1100 40(20) = 300.

= 300;
= 10 30 firms in the market in the long run.
e) Short Run

17
= = 40 = 1.61

1100 40(17)

17
= = 60 = 2.42

60 600
Since supply is more elastic relative to demand, in the short run, consumer welfare is reduced
more heavily.
In the long run, the entire tax is passed on to consumers, as well as a further price rise since
firms leave the market.
3. Consider a perfectly competitive industry. What are the short-run and long run effects on
price and industry supply of:
a) A change in preferences which leads to an inward shift of the industry demand curve
b) Technological progress which reduces each firm's marginal costs
c) The introduction of a fixed annual charge which firms must pay in order to trade

Micro Page 68

a) SR: The shift in demand (D1 => D2) causes industry price and quantity supplied to fall (p1 => p2;
Q1 => Q2). This means that marginal revenue falls, so the profit maximising quantity (where p =
MC) falls.
LR: since firms are making a loss, some will exit the market. This causes supply to shift in (S1 =>
S2). So market price returns to p1, but quantity supplied falls (Q2 => Q3).

a) SR: falling MC means AC also falls. Firms still produce where MC = MR, so quantity per firm
increases. This means the firm makes a supernormal profit.
LR: profits attract more firms to the industry, and since there are no barriers to entry, new
firms can enter the market. Industry supply shifts out, so p falls until firms make zero
economic profit.

c) SR: the annual charge is a fixed cost, so only AC shifts up. In the SR, firms make a loss.
LR: losses will cause some firms to leave the market (since there are no exit barriers). This will
cause supply to shift in, and the market price will increase.

Micro Page 69

4. Give brief but complete answers to the following questions:

a) For a monopolist, why does the marginal revenue curve lie below the demand curve?
b) What is the relationship between the price elasticity of demand and the divergence between
price and marginal revenue?
c) Will the monopolist produce at minimum average cost
d) What is meant by the deadweight loss of monopoly?
e) If the demand curve is = . and the monopolist's total cost function is () =
, what output would a profit maximising monopolist choose? What is the price elasticity
of demand at this output?
a) The inverse demand curve is given by: = ().
= ()

= = () + ().

For a monopoly, the demand curve is downward sloping, since it has price setting power
() < 0
() + () < () since the second term is negative.

b) = +

= = .

Sub into MR equation:

1
= + = 1 +

So as the elasticity of demand approaches infinity, marginal revenue tends toward the price
level.
c) No necessarily - if the MR happens to cross MC at the minimum point of the AC, then the firm
will produce at this point. However, more likely, the monopolist will make economic profit,
and will not operate at the minimum AC.
d) The deadweight loss of monopoly is the lost consumer and producer surplus in a monopoly
compared to if the market was competitive (firms produced where price = marginal cost).

The lost consumer surplus is the B, and the lost producer surplus is C.
e) = 100 0.5 = 200 2; () = = 2
= = 200 2
= 200 4
max = :
200 4 = 2
= 33.3
(: = 4 2 = 6 < 0)
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200 2
= = 0.5 = 2.

5. A monopolist has two plans, A and B, whose outputs of the same product are qA and qB, and
whose total costs are = + + and = + + . Total demand for
the product is = . What is the profit maximising price and division of output
between the two plants? Comment on your answer.
The firm produces where the marginal costs are equal, because if they were not equal, the
firm could reduce total costs by producing one more unit at the plant with lower MC, and one
less at the one with higher MC.
=
8 = 2 = 22 + 2
=7+

Produce where MR = MC:

= :
100 4 = 22 + 2
100 4 4 = 22 + 2
100 4(7 + ) 4 = 22 + 2
= 5 = 12.
(: = 4 4 2 = 10 < 0)
= 100 2 = 100 2(5 + 12) = 66
Production is higher in the firm with lower costs.

. There are two markets for this

6. A monopolist has total costs given by = + +

good, X and Y, with demand given by = and = .

a) If the monopolist can third degree price discriminate, how much will it sell to market X? How
much will it sell to market Y? What are profits?
b) If the monopolist must charge the same price in both markets, how much will it produce?
Now how much profit is made? Comment.
c) What happens if fixed costs double?
a) Set MC = MR in both markets:

= 10 + = =
3
=
110 2 = 50
= 2 60
=

+
110 2 = 10 + = 10 +
3
3
330 6 = 30 + + = 30 + + 2 60
9 = 360
= 40 = 20
= 70; = 40.
60
= 40(70) + 20(40) 100 + 10(60) + = 2300
6
: = 2

1
1
< 0; = 1 < 0
3
3
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1
1
: = 2 < 0; = 1 < 0
3
3

b) At prices below 50, the demand curve is the horizontal sum of the two market demands, and
the prices are the same:

= + = 110 + 100 2 = 70
3
2
= 70
3
Set MR = MC:
2

70 = 10 +
3
3
= 60 = 50

2 1
: = < 0
3 3

60
= 60(50) 100 + 10(60) + = 1700.
6
The monopoly's profits fall when it is not allowed to price discriminate. The price when the
monopoly cannot discriminate lies in between the two prices when it can.
c) Changes in fixed costs would not cause the monopoly to change its output, since marginal
costs remain unchanged. The only difference would be that for each market, the monopoly
would make less profit.

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Week 6 - Imperfect Competition

1. Consider two firms, 1 and 2, locked in a Bertrand duopoly game. Firm I faces the following
demand for its product:

= + (, = , ; ).

a) Identify the property of the demand function that allows us to interpret the firms as
producing partly differentiated product.
b) Suppose the firms have the same constant average and marginal cost = 20. Write down the
profit equations for each firm and hence find the equations of their reaction curves. Find the
Bertrand equilibrium of this duopoly game. What are the market prices at equilibrium?
What are profits?
c) Referring back to the reaction curves, give a qualitative description of how the equilibrium
will be affected by a change in the marginal costs from 20 to 25.
3
1
2
1
a) = 180 + ; = 180 + .
2
2
3
2
If the goods are differentiated, one firm can charge more than the other without losing all its
sales, and the goods will be viewed as imperfect substitutes.

1
=

2
Cross Price Elasticity of demand = .
Since must be positive (since both terms are positive), the overall cross price elasticity is
positive. Therefore, the goods are imperfect substitutes.
3
1
b) = 20 = ( 20) 180 +
2
2

1
= 180 3 + + 30 = 0

2
1
= 70 +
6

: = 3 < 0

1
= 70 +
6
Bertrand equilibrium at the point where both firms reaction functions cross. This is the Nash
equilibrium since at this point, both firm's strategies are the best response to the chosen
strategy of the other firm.
Sub p2 into equation for p1:
1
1
= 70 + 70 +
6
6
= 84 =

3
1
= 180 (84) + (84) = 96 =
2
2
= = 84(96) 20(96) = 6144
c)

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The increase in marginal costs causes the reaction functions of both firms to shift outwards
along their respective axes. This will cause both firms to raise their prices, and equilibrium
output will fall.
2. Reconsider the same two firms as above. However, not they are behaving as Cournot
duopolists (they set quantity instead of price).
a) Show that the firms' demand functions may be rewritten as:

= (, = , ; )

b) Suppose the firms have the same constant marginal cost = 20. Write down the profit
equations for each firm and find the equations of their reaction curves. Find the Cournot
equilibrium. What are the marketed quantities at equilibrium? What are profits?
c) Referring back to the reaction curves, give a qualitative description of how the equilibrium
will be affected by a rise in marginal costs.
d) In light of your results, discuss the following proposition: Differentiated products tend to
mute the difference between the two different types of competition'.
3
1
3
1
a) = 180 + ; = 180 +
2
2
2
2
2
1
2
1
= 120 + ; = 120 +
3
3
3
3
Sub in p2 into the equation for p1:
2
1
2
1
= 120 + 120 +
3
3
3
3
2
2
1
= 120 + 40 +
3
9
9
8
2
2
= 160
9
3
9
3
1
= 180 .
4
4
b) = 20

3
1
= 180 20 = 0

2
4
3
1
= 160
2
4
Micro Page 74

320 1
=
3
6
320 1
=
3
6
320 1 320 1
=
3
6 3
6
640
= =
7

Micro Page 75

Week 7

1. A student has 2 to spend on beer and orange juice. Initially the orange juice costs 0.50 a pint and beer costs
1 a pint.
a) Draw the students budget line.

0.5 + 2
b) Suppose that, following a college subsidy, OJ costs 0.25 for the first 10 pints, and 0.50 a pint thereafter. Draw
the students budget line.

0.25 + 2
c) Repeat the exercise, but assume that the student has 4 to spend on drinks.
i) 0.5 + 4
ii) ( 10): 0.25 + 4
( 10): 0.5( 10) + + 2.5 4

2. Draw indifference curves to illustrate each of the following statements, commenting on the nature of
preferences and on the MRS in each case
a) I like Coke and Pepsi, and I don't care which I drink - I can't tell them apart
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a) I like Coke and Pepsi, and I don't care which I drink - I can't tell them apart

The goods are perfect substitutes, so MRS = -1. The consumer doesn't prefer either good, so is happy to trade one for
another and stay on the same indifference curve.
b) I love Coke but hate Pepsi.

Pepsi is a 'bad' so has negative utility. To keep utility constant, more coke has to be added for each Pepsi. MRS is
positive.
c) I love Pepsi, but have not feelings one way or the other about Coke

The consumer is indifferent about Coke. So for a given level of Pepsi, adding more Coke does nothing to change utility.
MRS = 0
Micro Page 77

d) I always have milk in my coffee, but I do not drink milk alone

The goods are perfect complements. Outside a certain ratio, adding more of one or the other does nothing for utility.
MRS = 0 or -infinity depending on which of the goods is in excess.
e) I like tea and coffee, but too much of either stops me sleeping

There is a fixed satiation point where utility is maximised. At points above this, the 'goods' become 'bads' and so utility
falls as you add more of each product. MRS is negative below the satiation point, and positive above it.
3. For each of the following utility functions derive the equation for an indifference curve, draw the indifference
curve map for three indifference curves, find the MRS and explain what each map might imply about consumer
behaviour in response to price and budget changes.

a) (, ) =

2
=
3

1
; =
3

= 2
=

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= 2
=

b) = {, }

= 0 when 2
= when 2
(Perfect complements)
c) = +
=
1
= ; = 1
2

1
=
2
(Quasi-linear preferences)
d) = +
=
= 1
(Perfect substitutes)
4. Alice consumes only food and clothing. The marginal utility of the last pound she spends on food is 8, and the
marginal utility of the last pound she spends on clothing is 7. The price of food is 1.60 per unit, and the price of
clothing is 3.50 per unit. Is Alice maximising her utility?
8

16
= =
7

35
So she is not maximising her utility.

5. Max is a utility maximiser. His income is 100, which he can spend on canteen meals and on notebooks. Each
meal costs 5 and each notebook costs 2. At these prices, Max chooses to buy 16 canteen meals and 10
notebooks. Now the price of notebooks falls to 1. At the same time, his income falls to 90. Do these changes
allow him to get onto a higher indifference curve?
Since Max is a utility maximiser, at 10 books x 16 meals, the MRS of his indifference curve must be -2/5 (equal to the
relative prices). After the change, he can still afford this bundle of goods. However, the relative prices are now -1/5. So
his budget line is shallower. If we assume he has a well behaved utility function, this will allow him to get onto a higher
indifference curve.

Micro Page 79

indifference curve.

6. A student has 1000 to spend on books (20) and luxuries (10). The students utility function is (, ) =
a) Find the marginal utilities, and the MRS of luxuries for books. Is this a well behaved utility function?

= = 2 ; = = 3

3
=
2
Yes - MRS is always negative and it's convex.
b) The student chooses his consumption of books and luxuries to maximise his utility. Will he spend all his income?
Yes - because the marginal utility is always positive for both goods, so increasing the amount spent on each (and thus
the amount consumed) will always increase utility.
c) Using the condition MRS = -p1/p2, find how many books and luxuries he will buy.
: 20 + 10 = 1000
3
1
=
2
2
3 =
20 + 10(3) = 1000
= 20; = 60
d) Now consider the more general problem when disposable income is I and the price of books and luxuries are p B
and pL. Repeat the analysis to find the demand function for books as a function of prices and income. What
special properties does this demand function have?
3

=
2

3
=
2
+
3
+ =
2
2
=
5
Special: Cross price elasticity = 0
Income elasticity = 1
e) Are these luxuries in the economic sense?

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=

2

=
5

2
2
= = = 1
2
5
5
5
Not strictly a luxury since YED isn't greater than 1.
f) How does the analysis change if books have a second hand value of 5?
Budget constraint shifts outwards since the student gets income from selling the books.

Micro Page 81

Week 9 - Further Consumer Theory

1. Write down and explain the Slutsky equation in terms of partial derivatives.

The Slutsky equation calculates a change in demand for a good in response to a change in its
price.
The first partial derivative is the substitution effect. This measures the change in demand for a
good keeping utility constant, in response to the change in relative prices.
The second part is the income effect. This is the change in demand for x ad a result of the fall
in the real income/purchasing power of the consumer, as a result of the price change.
2. A consumer has well behaved preferences for current and future consumption, c1 and c2. He
has current income y1 and future income y2, and can borrow or save at the market rate of
interest. Write down his lifetime budget constraint. Suppose that at the initial budget
constraint he is a saver. If the market interest rate falls, explain how his current
consumption will change, paying close attention to the income and substitution effects. Is it
possible that he is better off after the fall in the interest rate?
r is the interest rate.
= + ( )(1 + )
= + (1 + ) (1 + )
If the saver stays a saver:

The saver is unambiguously worse off. The new utility curve has to be lower than the old one,
if consumer has well behaved preferences. Substitution effect = A => B. Income effect = B=> C.
If the saver becomes a borrower:
The effect is ambiguous. Depending on the shape of their indifference curves, they might be
better off or they might be worse off.
(Show diagrammatically.)
3. Explain the relationship between CV, EV and CS. Under what circumstances will they be
identical?
CV is the amount you would have to compensate a consumer after a price rise to keep them
on the same indifference curve.
EV is the amount you have to take away from a consumer to replicate the loss of utility from
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EV is the amount you have to take away from a consumer to replicate the loss of utility from
the price rise (and put them on the same lower indifference curve).
CS is the aggregate welfare from the price which consumers pay being below the price they
are willing to pay for a good.
We can observe these three welfare measures using compensated and uncompensated
demand curves. The uncompensated demand curve (Marshallian) is the standard demand
curve, which contains both income and substitution effects. The compensated (Hicksian)
demand curve just shows the substitution effect of a price rise on demand for a good (shows
the effect of a price rise holding utility constant).
For normal goods:
The compensated demand curve for a good is steeper than the uncompensated demand
curve. This is because for a given price rise, the income effect acts in the same direction as the
substitution effect, so the change in total demand is larger on the uncompensated demand
curve for a given price rise.
We can see that || > || > ||
For inferior goods:
The compensate demand curve is shallower than the uncompensated demand curve. For a
given price rise, the total change in the uncompensated demand curve is smaller because the
income effect acts in the opposite direction as the substitution effect.
|| < || < ||
For these three measures to be equal, we need the uncompensated and compensated
demand curves to be identical. This only occurs when there are no substitution effects i.e. the
consumer has quasi-linear preferences.

4. Consider the utility function =

Part A
a) Derive an expression for the consumer's marginal rate of substitution between good 1 and
good 2:

= =

= (1 )

= =
(1 )

b) Solve the consumer's optimisation problem and derive the consumer's Marshallian demands
for good 1 and good 2
At the optimum point of consumption, MRS = relative prices, since this is the point of tangency
between the budget constraint and the utility curve. We know this is a maximum utility points
because the consumer has well behaved (Cobb-Douglas), convex preferences.

=
1

Micro Page 83

Collection
units of free electricity per year. Switch
1. Free electricity scheme - households originally get
to a cash benefit under which eligible households receive a Free Electricity Allowance equal

to euros per year. Allowance set such that it was precisely equal to the cost of buying
units of electricity.
Denote electricity consumption by e, other consumption by x, the prices of electricity and
consumption by pe and px, respectively, and household income by m.
a) Consider a household's choices over electricity and other consumption.
i) On a single diagram with x on the vertical axis, draw and fully label the budget constraints
for an eligible household under both the old and the new schemes.
ii) Write down the two budget constraints algebraically.
a)
units: =
.
i) The cash benefit is equal to the cost of buying units

For the original scheme, the first units are free, so the budet constraint is flat up to this point
(the houshehold can maintain a constan level of consumption of other goods, since electricty
has no cost). After this, the budget constraint is downward sloping.
For the new scheme, the allowance is added to total income.

, . The first scheme goes through this point

Both schemes must go through the point
since this is where electricity stops being free. The second one must go through this point
since the cash benefit exactly matches the cost of buying this much electricity, which is added
to other income.

ii) Scheme 2: + = +
+
= +

Scheme 1:
>
: = + (
)
<
: =
b) Consider a third policy under which the Irish government abolishes both the free electricity
scheme and the allowance scheme, and instead offers a cash grant g such that g < f, as well
as lowering the price of electricity for all households. Suppose that this scheme is designed
such that the number of free units under the free electricity scheme is exactly affordable for
eligible households.

i) On a single diagram, draw the budget constrains for all three policies for an eligible
Micro Page 84

i) On a single diagram, draw the budget constrains for all three policies for an eligible
household.
ii) A household that was not eligible for the free electricity scheme has to pay the standard
price for electricity. Draw on a single diagram the budget constraints that such a household
faces before and after the introduction of the price subsidy scheme.
i) < ; < .

ii) Non eligible households do not get any units of free electricity, nor do they get the cash
grants. They can benefit from the subsidy, however.

c) Analyse the likely behavioural and distributional effects of the FEA and price subsidy scheme
compared to the original free electricity units scheme.

Both new schemes benefit households who previously received the free electricity. Scheme 2
benefits them more than Scheme 3. We dont know the distributional effects, since there is no
indication as how the subsidy/grant money will be raised.
d) The Irish government wants to know which policy it should pursue. Advise.
Scheme 2 and Scheme 3 completely dominate Scheme 1: consumers above the free electricity
level are on higher indifference curves, and consumers who were previously below are better
Micro Page 85

level are on higher indifference curves, and consumers who were previously below are better
off.
are
Between Scheme 2 and 3, there is an ambiguous effect. Consumers who were above
unambiguously better off (we can see this from the diagram from b) ii).)
In a switch from 2 to 3, consumers who stay below the free level are worse off. For Consumers
, the effect is ambiguous.
who switch sides, and start to consume more than

2. You have been given the following information concerning UK sales of the Sun newspaper:
Daily circulation 2.5m
Price

0.5

Price elasticity

-0.5

a) Assuming that the demand curve is linear, derive the inverse demand for The Sun

0.5
= 0.5 =

2.5

= 0.4

= 0.4
= 0.5 + 0.4(2.5) = 1.5
= 1.5 + 0.4
b) Assuming that the price in the table represents the equilibrium price, that the supply curve
for The Sun is linear and that if the price were zero the paper would be closed, derive an
expression for the inverse supply curve.
= +
=0
0.5
= = 0.2
2.5
= 0.2

c) At the equilibrium price:

i. Calculate the consumer surplus and explain what it measures
ii. Calculate the producer surplus and explain what it measures
iii. Draw and fully label a diagram to illustrate your calculations
c)
i. CS is the difference between what consumers are willing to pay for a good and the price which
they actually pay. It is the benefit which consumers derive from paying for a good at a price
below their willingness to pay.
1
= (1.5 0.5)(2.5) = 1.25
2
ii. PS is the difference between the price suppliers are willing to supply at and the price which
they actually supply at. It is the benefit which producers derive from selling a good at a price
above their willingness to accept.
1
= (2.5)(0.5) = 0.625
2
iii.

Micro Page 86

iii.

The government is considering putting standard rate VAT (20%) on newspapers

d)
i.
ii.
iii.

For The Sun newspaper

Calculate the deadweight loss of the tax and explain what it measures
Calculate the amount of Government revenue the tax would raise
Draw and fully label a diagram to illustrate your calculations.

d)
i. = (1.2)(0.2 ) = 0.24
At equilibrium:
0.24 = 1.5 0.4
1.5
= = 2.34375
0.64
= 0.24(2.34275) = 0.5625
= 0.2(2.34275) = 0.46875
1
= ( )(2.5 ) = 0.00732
2
DWL measures the social cost of the tax, which results from the reduction in output. It
measures the lost consumer and producer surplus which is not captured as tax revenue

ii. = ( )( ) = 0.220
iii.

e) Explain what your results indicate about the effective incidence of the tax.
Micro Page 87

e) Explain what your results indicate about the effective incidence of the tax.
The effective incidence of the tax refers to the economic agent (consumers or producers) who
end up actually bearing the cost of the tax. This is different to the formal incidence, which is
simply the agent who actually remits the money to the government.
The tax will fall more heavily on consumers if their elasticity of demand is inelastic compared
to the elasticity of supply.
= 0.5

1
0.5
= = = 1

0.2 2.5
Since supply is more elastic, the incidence falls more heavily on consumers. We can see this,
since the consumers pay an extra 0.0625/unit whereas producers only lose 0.03125/unit.

f) In general, what determines the effective incidence of a tax on a product? What is the
economic intuition for this?
The effective incidence of tax is determined by the relative elasticities of supply and demand.
Whichever is more inelastic will face more of the incidence.
When demand is inelastic, producers have bargaining power. Consumers can't change their
quantity demanded by as much for a price rise, so producers can pass on more of the tax
without significantly reducing output.
g) Give a brief critical discussion of your analysis of the efficiency implications of this policy.
- We have assumed that demand is linear: a curved demand curve would lead to a lower
DWL
- Partial equilibrium vs general equilibrium: we don't know what the government plans to
do with the revenue
- Externalities: if there are negative externalities associated with the production of the
good, the tax would be justified
- We have assumed perfect competition: could be a monopoly.

3. A firm uses labour and capital in its production process. The prices for these two inputs are
determined in competitive markets and the firm cannot affect them. The wage is w and the
rental cost of capital is r.

a) How does the average cost of production vary with the quantity of output when returns to
scale are constant, increasing or decreasing?
Returns to scale returns to the increase in output resulting from increasing all factors of
production by a fixed proportion .
Constant returns to scale: Constant average cost
Decreasing returns to scale: Rising average cost
Increasing returns to scale: Falling average costs
b) Assume now that in the long run, returns to scale are constant. In the short run, only labour
can be varied; the capital stock is fixed. Does the short run production process have constant
returns to scale? How does the cost of producing an extra unit in the short run compare to
the cost of producing an extra unit in the long run
In the short run, the presence of a fixed capital stock means that there are decreasing returns
to scale. Increasing labour by a certain amount will not result in an as large increase in output,
since the optimal amount of capital cannot be selected.

Micro Page 88

4. All firms in a perfectly competitive industry have the same U shaped average cost function.
Factor prices and technology are fixed. The demand function for the industry's product is
downward sloping. In the short run, the number of firms in the industry is fixed. In the long
run, firms are free to enter or leave the industry
a) Explain the relationship between average cost and marginal cost for this type of cost
function.
When marginal cost is less than average cost, average cost is falling. This is because each extra
unit added costs less than the average cost of producing the previous units, so this brings the
average down. When marginal costs are greater than average costs, each added unit costs
more than the previous average, which brings the average up. So average costs are rising.

We can prove that when marginal costs are equal to average costs, this is point of the
minimum average cost.
()
= ; = ()

To find the minimum AC, we differentiate and set equal to 0:

() ()
= = 0 () () = 0

()
() = = .

b) Explain how a firm decides how much to produce. What is the equilibrium price in the long
run?
Given the assumption that firms maximise profits, firms will produce at the point where MR =
MC.
Proof:
= = () ()

= () + () () = 0

Competitive firms are price takers, since if they try to charge a price above the market rate,
consumers will buy elsewhere (due to perfect information about the prices of competitors). As
such, the MR is flat, and its slope is 0.
This means that:
() = ()
So firms produce at the point where price = marginal cost (= marginal revenue).

The long run equilibrium price is equal to the minimum average cost. Firms cannot make any
economic profit in the long run, since there is free entry and exit to the market. If firms make a
profit, this attracts new entrants, who shift the supply curve out, and reduce the market price,
until firms make only normal profits.
c) Suppose the demand function for the product shifts outwards, so that at each price there is
higher demand. What happens to the market price, the quantity produced by each firm and
the total quantity bought and sold, in both the short and long run?
Short Run

Micro Page 89

At the initial equilibrium, all firms make no economic profit. The shift in market demand
means that the market price increases and the total quantity bought/produced increases. The
MR curve for the firms shifts up, so each firm increases its output, since we assume firms
operate at the profit maximising point (where p = MR = MC).

Long Run

In the long run, supernormal profits attract new firms to the industry, and since there are no
entry barriers, they can enter quickly and easily. Supply shifts out. So the market price returns
to its original level, but industry output is higher. Individual firm output returns to its original
level.

d) Now suppose that the government is keen to promote small businesses and it offers a lump
sum subsidy to each firm in the industry. What will happen to the market price in the short
run and the long run? What is the long run effect on the size of each firm.
Short Run

The subsidy is a lump sum, so it acts as a reduction in fixed costs. AC shifts downward,
marginal costs stay the same. Since MC is unchanged, firms produce at the same level.
However, they now make some economic profit.

Long Run
Micro Page 90

Long Run

In the long run, firms making an economic profit attracts new firms to the industry, so supply
shits outward. This
reduces the price, until all firms are making only normal profits again. Each firm is producing at
a lower output than it was before.

Micro Page 91

Prelim 2013
1. Consider a competitive industry with a large number of potential firms with access to the
same technology and of equal efficiency. In the short run, the number of firms is fixed. In the
long run, there is free entry and exit
i) Explain how the short and long run supply curves of the industry are determined
In the short run, the industry supply curve is upward sloping. It is an aggregate of all the
individual firm supply curves in the industry. For competitive firms, since they produce where
P = MC, their supply curve is just the marginal cost curve above Average Variable Costs (since P
= AVC is the short run shut down point for firms in the short run). When price rises in the short
run, all the firms in the market raise their output, so industry output increases.
In the long run, the industry supply curve is horzinontal at P = min(AC). If firms make a profit in
the short run, then new firms will enter the market (since there is perfect information, new
firms can know about profits right away, and since there is free entry, they face no barriers to
entry). The increase in the number of firms causes prices to fall, until all firms are making zero
economic profit. There is a similar process if firms make a loss in the short run, with firms
leaving the market.
ii. Discuss how equilibrium output, the price level, consumer surplus and profit would be
affected in the short and long run by:
a) An increase in fixed operating costs for firm
b) The imposition of a sales tax
a)

Short run
The increase in fixed costs shifts average costs upward (AC1 => AC2), without affecting marginal
costs, since fixed costs do not depend on output. In the short run, firms do not change their
output, but they make a loss (Area A). The price level is unchanged in the short run.
Long Run
In the long run, since firms are making a loss, some will exit the market (they can do this since
there are no barriers to exit). This will shift market supply inward (S1 => S2). Firms will leave the
market and supply will shift in until price is equal to the minimum average cost, and all firms
make no economic profit. The industry price has increased (P1 => P2), and industry quantity has
fallen (Q1 => Q2). For individual firms, output has risen (q1 => q2). Consumer surplus has fallen
by Area B, and is now equal to Area C.
b)

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Short run
The sales tax (assumed to be a unit tax here) causes firms' average costs and marginal costs to
shift upward (AC1 => AC2; MC1 => MC2) by the size of the unit tax. The firm reduces its output
in the short run, and the supply function shifts inward, causing the price to rise (p1 => p2), but
not by the full amount of the tax. Equilibrium output is lower (q1 => q2). Consumer surplus is
reduced by the Area (A+B), and there is an area of DWL (B+C). Firms make a loss (Area D).
Long Run
In the long run, firms will leave the market, causing supply to shift in by even more, until the
price level has increased by the full amount of the unit tax (p2 => p3), and this is also the point
of minimum average cost, so firms make no economic profit. Industry output is lower (Q2 =>
Q3), but individual firm output returns to q1. Consumer surplus is reduced by even more. The
tax is fully passed on to consumers because the long run industry supply curve is horizontal, so
is perfectly elastic, compared to consumers who have relatively inelastic demand in
comparison.
iii. How would your answer to part ii) be affected if firms differed in efficiency?
If firms differed in efficiency, they would have different marginal and average costs. Therefore,
the effects of the changes would differ from firm to firm. Some might continue to make a
profit while others made a loss, and so more/less firms might exit the market.
iv. Suppose that the inverse demand curve for the industry is = and firms have cost
function () = +
a) Find the long run equilibrium price, quantity, and number of firms in the industry
b) Suppose the government imposes a sales tax of 3 per unit. Find the change in consumer and
producer prices, and the tax revenue raised, in the short and long run. Comment on the
welfare implications of the tax.
a) () = + 4
() = () = 2
4
() = +

Minimum AC where MC = AC:

4
2 = +

2 = + 4
= 4 = 2.
In the long run, P = min (AC)
4
= (2) = 2 + = 4
2
Plug p = 4 into the marked demand equation:

= 30 4 = 26
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Each firm produces 2, and market output is 26

26
= = 13.
2
b) Short run
SR supply = 13 x firm supply curve.

: = = 2 =
2
13

:
= 13
=
2
2
=
13
Unit tax shifts supply curve up by 3:
2
= + 3
13
At equilibrium: supply = demand
2
+ 3 = 30
13

= 23.4
= 30 23.4 = 6.6
= 6.6 3 = 3.6
23.4
= = 1.8
13

= 3 23.4 = 70.2
Long run

4
= + + 3

= 2 + 3
Min AC where MC = AC:
4
+ + 3 = 2 + 3

=2
New market price is: 2 + + 3 = 7

= 23
Number of firms = 23/2
In the LR, consumers pay the whole of the tax. An area of DWL is created, since output is
restricted.
3.
i. Define the price elasticity of demand. Explain intuitively how the elasticity affects the
behaviour of a monopolist
PED is the responsiveness of the amount of demand to a change in the price level.
%

= =
%

If demand is more inelastic, monopolists can restrict output and charge a higher price, since
consumers still demand a high quantity even at higher prices. If demand were elastic, raising
prices would reduce demand by more, so revenues and profits would fall.

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The price a monopolist charges can be modelled by

1
=

||
This shows that as the elasticity of demand becomes inelastic, the monopolies mark-up
becomes greater, so price is higher.
Output

Price

Elasticity -2
Costs

Assume the firm has a linear demand curve = +

ii. Use the information in the table to show that the demand curve is = and find the
inverse demand curve and marginal revenue curve. Hence estimate the firm's current
marginal cost explaining your reasoning

4
= 2 =

2

= 1 = 1

2 = + (1)(4)
=6
=6 =6
= 6 2
A profit maximising monopolist produces at the point where MC = MC. So:
= = 6 2(2) = 2
iii. Assuming the firm has negligible fixed costs and constant returns to scale, draw a single
accurate diagram showing:
Inverse demand curve, MR, MC, output and price, competitive output and price.

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iv. By calculating CS and profits, and comparing with the competitive outcome, assess the
welfare implications of monopoly in this industry. Use a diagram to illustrate your analysis.
1
= (6 4)(2) = 2
2
= (4 2)(2) = 4
+ = 6
Under perfect competition:
=0
1
= (6 2)(4) = 8
2
There is an area of DWL associated with monopoly - area A - associated with the restricted
output imposed by the monopolist, and prices above marginal costs. In perfect competition, P
= MC, and output is higher.
v. Without doing any further calculations, describe how you think your findings about this firm
would have been altered if your estimate of the elasticity of demand had been higher.
Explain your reasoning.
If elasticity were higher, the monopolist would not be able to charge as high a price, since this
would cause a larger fall in consumer demand. Output would be higher, since MR would
become more 'elastic' as well (become less steep) and so the area of DWL would be smaller.

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Prelim 2011
3. A hairdresser is a monopolist in the local market. Currently, the hairdresser only cuts
women's hair. It is considering expanding into men's haircuts, charging different prices for
men and women.
i) If it is optimal for the monopolist to charge a lower price for men than for women, what can
you conclude about the demand for men's and women's haircuts? Explain, stating any
assumptions you make about costs.
Monopolists price according to:
1

1 = =
1
||
1
||
If it is optimal to charge men a lower price, this must mean that men's demand for haircuts is
more elastic than women's, since this makes smaller, which makes the denominator of the
overall fraction larger.
Intuitively this makes sense, since if demand is more elastic, the monopolist cannot charge as
high a price, since this will result in a more than proportional fall in demand, which will reduce
revenue and thus profits.
This assumes that the costs of cutting women's and men's hair are identical, which might not
be the case in reality.
Assume that the total cost of carrying out y haircuts, regardless of how many are for
men/women is given by:

() = + +

And the inverse demand curves for women's and men's haircuts respectively are:

= ; =

ii) When the hairdresser only cuts women's hair, calculate the profit maximising quantity, and
the corresponding price, and the resulting profits.
= = ( )

= 55 50 5
8
8

= 55 5 = 0

4
4

= 50
2
= 100
: = < 0
100
= 55 = 42.5
8
= 2450
iii) When the hairdresser cuts both men's and women's hair, and can charge different prices,
what is the total profit as a function of the quantities of haircuts for women and men?
Find the profit maximising quantities, the corresponding prices, and profits. How do the
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Find the profit maximising quantities, the corresponding prices, and profits. How do the
quantity and price of women's haircuts compare to ii)? Explain.
( + )

= 55 + 40 50 5 5
8
16
8

+
= 55 5 = 0

4
4
= 200 2

+
= 40 5 = 0

8
4
3 = 280 2
(1) (2): 3(200 2 ) = 280 2
= 80 = 45
= 40 = 37.5

= 0.5
= 0.375
= 0.25
< 0,
<0
= (0.5)(0.375) (0.25) = 0.125 > 0
So the point is a maximum.
= 2650
The quantity of women's haircuts is lower, and the price is higher. This is because since
marginal costs are higher in the individual women's market, since output is higher as a result
of the firm providing for the men (for a given level of men's output, women's costs are higher
since total output is higher).
If the price discrimination were not allowed, the hairdresser would find it more profitable to
cut women's hair only.
iv) Show that consumer surplus is lower when price discrimination is allowed than when it is
banned, but total welfare (including profits) is higher. Comment on how general these
conclusions are.
PD is banned: (MC = 30)

1
= (55 42.5) 100 = 625
2

1
= 625 + (42.5 30)(100) + (100)(30) = 3375
2
PD is allowed: (MC = 35)
1
1
= (55 45)(80) + (40 37.5)(40) = 450
2
2
1
1
= 450 + (45 35)(80) + (35)(80) + (37.5 35)(40) + (35)(40)
2
2
= 3450

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Prelim 2010
2. Firms in a competitive industry sell output at price p = 10 and use labour as their only input.
One unit of labour is required to produce one unit of output. The supply curve of labour is L
=w-1
a) Find the equilibrium wage, the profits of firms, and the surplus enjoyed by workers.
In a competitive market, firms produce where P = MC.
MC is the cost of producing one extra unit, which is the cost of hiring one extra worker = w.
So the equilibrium condition is: P = MC = w = L +1
10 = L +1
L=9
W = 10
Firms make zero economic profits.
The surplus of workers is:
1
81
(9 9) = = 40.5
2
2
b) If the government taxes wages at a rate of 50%. Find how your answers to part a) change,
and find the revenue raised by the government.
L = 0.5w -1
w=2L + 2
10 = 2L + 2
L=4
W = 10
Worker surplus =
1
(4 4) = 8
2
Government revenue =
5 4 = 20
Suppose that instead there is a single firm which acts as a monopsonist.
c) Find how your answers to a) and b) change
With no tax
Marginal expenditure = () +
+ 1 + (1) = 2 + 1
10=2L+1
L = 4.5
W= L + 1 = 5.5
Profits = 4.5*4.5 = 20.25

Surplus:
1
4.5 4.5 = 10.125
2
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1
(4.5 4.5) = 10.125
2
With tax
W = 2L + 2
ME = 2L + 2 + L(2) = 4L + 2
L=2
W(government) = 6
W (worker) = 3
Profits = (10-6)2 = 8
GR = 3 x 2 = 6 6
Surplus = 1/2*2*2=2
d) Suppose that the government introduces a minimum wage 6. Find the equilibrium profits of
the firm and the surplus enjoyed by the workers, assuming there's no tax.
W = L +1 = 1 6
L=5

Profits = (10-6)*5=20
Surplus = 1/2*5*5=12.5
e)
3. An industry consists of two firms. Firm 1 has total costs of 2A, firm 2 has total costs of 3B.
The markets for goods a and b are interdependent, and the inverse demand curves are given
by:
=
=
a) Are the two goods substitutes or complements?
Cross price elasticity is responsiveness of one good's demand to a change in the price of the
other good.
If positive: goods are substitutes
If negative: goods are complements

(, ) =

= 1

= 20 2 (rearrange the A demand curve)

= 20 2(20 2 )
= 20 40 + 4 + 2

= 1 + 4 = 3

3
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1
=
3
Since XED is positive, the goods are substitutes.
b) Suppose that the two firms are engaged in Cournot competition.
i. Find the equilibrium supply of each good
ii. Find the market price of each good
i. = = (20 2 ) 2

= 20 4 2 = 0

9
=
2 4

: = 4

= = (20 2) 3

= 20 4 3 = 0

17
=
4
4

: = 4

At Cournot Equilibrium: A is the best response to B's quantity, and B is the best response to A's
quantity.
17

9
4
4
=
2
4
17
4 = 18 +
4
4
15 = 55
11
= = 3.67
3
10
= = 3.33
3
11
10 28
ii. = 20 2 = =
3
3
3
11
10
29
= 20 2 =
3
3
3
c) If the two firms were instead engaged in Bertrand competition: would we expect the
equilibrium price to be equal to the marginal cost of producing the good? If so why? If not,
why not?

We would not - for Bertrand competition, price only equals marginal cost if the two goods are
homogenous. In this situation, if one firm tries to charge more than the other firm, then all the
consumers who used to buy from that firm would switch to the other firm. This leads firms to
undercut each other until they both charge only the marginal cost for the good, and make no
economic profit. Any attempt to charge above this price results in demand falling to zero.
Micro Page 101

However, in this case, since the goods are imperfect substitutes, the firms can charge different
prices, and only some of the consumers will switch.
d) Suppose firms 1 and 2 merge. How much of each of the goods will be supplied? Compare
your answer with the supply when the markets are served by two firms engaged in Cournot
competition.
= 20 2 + 20 2 2 3

9
= 20 4 2 = 0 =

2 2

17
= + 20 4 3 = 0 =

4
2

= 4 < 0
= 4 < 0
= 2

= (4)(4) (2) = 20 > 0

17

9
4
2
=
2
2
19
= = 3.17
6
8
= = 2.67
3
Supply is restricted.

Micro Page 102

Long 2008
2. A firm uses an input, x, to produce an output y. It sells y and buys x at given market prices.
i) Explain what a production function (with one input and output) is.
The production function gives the mathematical relationship between inputs and outputs. It
models how much of the input x is needed to produce a given amount of y.

ii) Suppose that the firm's production function exhibits positive but diminishing marginal
productivity. Using a diagram, explain how the profit-maximising choice of the input is
determined.

The production function has diminishing marginal productivity, which means that it is upward
sloping, but the slope gets shallower. As output increases, a higher quantity of input is
required to produce one extra unit of output.
The marginal revenue curve is therefore downward sloping.
The Marginal Revenue Product curve is just the marginal revenue curve multiplied by the price
of x (a positive constant) so this is also downward sloping.
The firm will buy output and expand production until the extra revenue from using one more
unit of input and producing an extra unit output, is equal to the marginal cost of producing
that unit (the cost of buying the input). Thus, the firm produces at the point where the
marginal revenue product is equal to the cost of the input.
The firm's use of x causes damage to its neighbours. The marginal damage is increasing in x.
iii) Show, using a diagram, that a tax on x will induce the firm to reduce its use of x, and explain
the effect on the firm's profit of the imposition of the tax.
Private Marginal Cost of the firm is lower than the total social cost, since this is the firm's costs
Micro Page 103

Private Marginal Cost of the firm is lower than the total social cost, since this is the firm's costs
plus the cost of the externality to the neighbours. Thus the Social Marginal Cost curve is
upward sloping, and above the Private Marginal Cost Curve. The tax will shift Marginal Costs
inward, causing the firm to reduces its output. Since x is the only input, this will cause the firm
to reduce its demand for x.
The tax reduces firms profits, since the firm does not produce at the optimum level, and the
government takes revenue away.
iv) Show, using a diagram, what determines the Pareto efficient level of x, and how the tax
should be set to achieve this.
The Pareto efficient level is where the marginal social cost = demand

Micro Page 104

Essay Plans
If all markets were perfectly competitive, there would be no need for government intervention
- Externalities
Tax producers of externalities
Assign property rights
Coase theorem: property rights and no transaction costs
- Minimum wage
- Maximum price
- Tariffs + quotas
- Missing markets
Austerity with weak output?
- Classical model:
Increased government spending can't affect output
No effect on output
Really unrealistic
- Keynesian multiplier is larger than 1
- Ricardian equivalence
Doesn't matter
But: government doesn't borrow at same rate
Consumers aren't rational
Past: budgets haven't balanced
- Bond rates
World markets think we're spending too much
Bond rates too high
But bond rates are low
- Weak output strengthens the case for fiscal expansion

What is NRU, why does it change/vary between countries

- No voluntary employment
All resources used efficiently
In equilibrium, finders = separators
- Finding rate
Training
Information
- Separation
Union
Labour laws

Micro Page 105