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Chapter 10:

Market Power: Ability of a seller or buyer to affect the price of a good (below marginal cost or above
marginal value of a good)
1. Monopoly: Market with only one seller
Average revenue = Demand Curve (downward sloping; Marginal revenue decreases as Q increases)
Marginal Revenue = Double the slope of Demand Curve
D: P = a bQ
MR = a 2bQ
Profit maximization: MR = MC

Q* is the profit maximized output level (MR = MC). If the firm produces smaller output => lose some profit
because extra revenue can be earned. If the firm produces more output would reduce profit because the
additional cost would exceed additional revenue.
Market power measure: Markup over marginal cost as a percentage of price
Market power is inversely related to price elasticity of demand faced by firm.
As |Ed| get closer to 1 (more elastic), market power increases.
With perfect competition, firm has no market power as demand is perfectly inelastic thus P = MC
Compute Price: P =
1+( )

Exercise #3: A monopolist firms faces a demand E d = -2. Constant MC = $20 per unit. If MC increases by 25%,
would the price charged also rise by 25%?
Since P =
: P = MC / (1 ) = MC/0.5 = 2MC = 2($20) = $40
1+( )
If MC increases by 25%, P will also increase 25% (directly proportional relationship according to the formula)
Exercise #7: A profit-maximizing monopolist is producing Q = 800; P = $40
If Ed = -2; (40 MC)/40 = => 40 MC = 20 => MC = $20 per unit.
Percentage markup = 0.5; or 50% of the price.
Suppose AC = $15, FC = $2000. Find the firms profit:
TR = 800($40) = $32,000

TC = AC*Q = 800($15) = $12,000

Profit = TR TC = $20,000

***Shift in Demand:
A monopolistic market has NO supply curve. There is no one-to-one relationship between price and the
quantity produced.
An increase in the demand for a monopolists product doesnt always result in a higher price (Price elasticity
of demand => Market power). An increase in the supply facing a monopsonist doesnt always result in a
lower price.
(a) Monopoly case:

Case a: Demand curve shifts from D1 to D2. But the new marginal revenue curve intersect MC at the same
point => Same output, but lower price.
Case b: Demand curve shifts from D1 to D2; demand becomes more elastic. The new marginal revenue
curve intersects MC at a higher level of output. But because demand is now more elastic, price remains the
(b) Monopsony case:
ME1 intersects with MV curve at Q1, result in price P (where Q1 intersects AE1).
Suppose Supply curve shifts from AE1 to AE2. Therefore Marginal expenditure curve also shifts from
ME1 to ME2, which intersects MV at a new output. This new level of output results in the same price
(Q2 intersects with AE2).

The effect of a tax:

A tax on output can have different effect on a monopolist than on a competitive firm.
MR = MC + t
Exercise #4:
Average Revenue Curve, or Demand: P = 120 0.02 Q
Cost Function: C = 60Q + 25,000
a. Level of production, price, and total profit:
Demand: P = 120 0.02Q
Marginal Revenue: MR = 120 0.04Q
MC = 60
Profit maximization: MR = MC => 120 0.04Q = 60 => Q = 1500
P = 120 0.02(1500) = 90
Profit = TR TC = (90)(1500) [(60)(1500) + 25,000] = 20,000 cents => $200
b. Levy a tax of 14 cents per unit:
Demand: P* + t = 120 0.02Q (P* is the price received by suppliers)
Marginal Revenue: MR = 120 0.04Q t (t = 14 = lost revenue per unit)
Profit maximization: MR = MC => 120 0.04Q 14 = 60 => Q = 1150
Price: P* = 120 0.02Q t = 83
Profit: TR TC = (83)(1150) [(60)(1150) + 25,000] = 1450 or $14.50


MR = 120 0.04Q
MC + t = 60 + 14 = 74
MR = MC => 120 0.04Q = 74 => Q = 1150
Demand: P* + t = 120 0.02Q (P* is the price received by suppliers)
Price: P* = 120 0.02Q t = 83
It does not matter who sends the tax payment to the government. The burden of the tax is shared by
consumers and the monopolist in exactly the same way.
Sources of monopoly power:
The elasticity of market demand
Number of firms in the market
Interaction among firms
2. Social Costs of Monopoly Power:

When moving from a competitive price and

output (Pc and Qc) to a monopoly price and
quantity (Pm and Qm):
- Consumer lose A + B
- DWL = B + C
***Important note:
PS: Above MC and below monopoly price
CS: above monopoly price and below
demand curve
DWL: between 2 quantity; below demand
curve and above MC

Rent Seeking: spending of resources in any socially unproductive activities in order to acquire, maintain, or
exercise monopoly power (market power). Firms can invest as much as monopoly profit into rent seeking
Property rights (patents): monopoly right => create monopoly power. Bring innovation and promotes
research and development that otherwise would not take place => Increase social welfare.
Price regulations: most often used for natural monopolies, such as local utility companies.
Natural monopoly: Firm that produces the entire output of market at a cost lower than what it would be if
there were several firms. If a firm is a natural monopoly, it is more efficient to let it serve the entire market
rather than have several firms compete.
Regulating the price of a natural monopoly:
A firm is a natural monopoly because it has economies of scale (declining average and marginal costs) over
its entire output range.
If price were regulated to be P c (competitive price; MC cross D) the firm would lose money and go out of
business. Setting the price at Pr yields the largest possible output consistent with the firms remaining in
business; excess profit is zero.

3. Monopsony: Market with one buyer

Monopsony power: Buyers ability to affect the price of a good.
Marginal value: Additional benefit derived from purchasing one more unit of a good.
Average expenditure = Supply Curve
Marginal Expenditure: Double the slop of supply curve
Profit maximization: Output @ ME = MV; Price @ MV (Demand curve) intersects AE (Supply curve).

Sources of monopsony power:

Elasticity of market supply
Number of buyers
Interaction among buyers
4. Social Costs of Monopsony Power:
(a) Monopoly:
(b) Produce where MR = MC
(c) AR (Demand) > MR so P > MC
(e) Monopsony:
(f) Produce where ME = MV
(g) AE (Supply) < ME so P < MV

When moving from a competitive price and

output (Pc and Qc) to a monopsony price
and quantity (Pm and Qm):
- Increase in consumer surplus A B
- Producer surplus falls by A + C
- DWL = B + C

(n) Chapter 18: Negative Externality and Public Goods
1. Negative Externalities:
Externality: action by either a producer or a consumer which affects other producers or consumers, but is
not directly accounted for in the market price
(o) Example: A firm emits noxious fumes that affect residents of a community. The noxious fumes impose
costs on the residents, and the residents have no control over the quantity of the fumes. Costs may include
health problems, foul-smelling air, reduce property values and house price. The firm do not have to pay to
emit the fumes => this external cost is not reflected in the price of their products => Negative Externality.
Externality Missing market: Others are not compensated
Marginal external cost MEC: increase in cost imposed externally as one or more firms increase output by
one unit.
Marginal social cost: MSC = MEC + MC





Welfare Analysis


Equilibrium Output:
(ak) A + B + F + G
(an) C + D + E
(ar)D + E + F + G + H

(ai) Efficient Output: Q*

(aj) CS
(al) A
(am) PS
(ao) B + C + D + F
(ap) Externality
(aq) (between
MSC and MC)
(at) TS
(au) A + B + C - H
(av) A + B + C
(aw) DWL = H; The market produces too much => Market failure; Missing market for pollution
A monopolist who produces under the presence of either positive or negative externality do not always lead
to greater misallocation of resources

(a) Negative externality: a competitive market produces too much output (the cost was underestimated)
compared to the socially optimal account. A monopolist restricts output => produce closer to optimal point.
(b) Positive externality: a competitive market produces too little output. A monopolist further restricts output =>
produce even less goods => Greater misallocation of resources.
2. Positive Externality:
Marginal social benefit MSB = MEB + MB
Example: Money spent on R&D. If a firm designs a new product, and if that design can be patented => earn
a large profit. But if the new design can be imitated by other firms, those firms can appropriate some of the
developing firms profit => Little reward for R&D.
Positive externality:
MSB > MB (Demand curve)
The difference is MEB
A self-interested homeowner invest in q1
in repairs @ MC = D (MB)
Efficient level of repair is q* (higher) @

3. Ways of correcting Market Failure:
Targeting the emission:
Tax emissions
Regulate emissions (standards)
Target the market for paper: Tax the market for paper
(ba) The optimal tax is set to the value of MEC (NOT marginal private cost) at Qefficient
(bb) Exercise #6
QD = 160,000 2000P => P = 80 0.0005QD
QS = 40,000 + 2000P => P = (QS 40,000)/2,000 = 0.0005QS 20
MEC = 0.0006QS
a. Produced under competitive conditions:
Equilibrium price: QD = QS => 160,000 2000P = 40,000 + 2000P
(bg) P = $30
(bh) Q = 100,000
b. Socially efficient price and output:
(bi)MSC = MEC + MC = 0.0006QS + 0.0005QS 20 = 0.00011QS 20
(bj)Set this equal to Demand: 0.00011Q 20 = 80 0.0005Q
(bk) Q = 62,500
(bl)P = $48,75
c. The optimal tax is set to the value of MEC at Qoptimal
(bm) t = MEC at Q = 62,500

(bn) t = 0.0006(62,500) = $37.5

(bo) Pc = 80 0.0005(62500) = $48.75
(bp) Ps = 0.0005(62500) 20 = $11.25
(bq) (Difference of t = $37.5)
The market should face the real cost: P represents MSC. To obtain efficiency, the price needs to
reflect MSC.

Exercise #7
(bw) Demand: P = 100 Q
(bx) MC = 10 + Q
(by) MEC = Q
a. Competitive conditions:
(bz) Set P = MC (supply curve):
(ca) 100 Q = 10 + Q
(cb) Q = 45
(cc) P = $55
b. Socially efficient price and output:
(cd) MSC = MEC + MC = 10 + 2Q
(ce) Set this equals to Demand: 100 Q = 10 + 2Q
(cf)Q = 30
(cg) P = $70
c. The optimal tax is set to the value of MC at Q optimal:
(ch) t = MEC = Q = 30
(ci) Pc = 100 30 = $70
(cj) Ps = 10 + Q = $40
d. Monopolistic conditions:
(ck) MR = 100 2Q (double the slope of Demand curve)
(cl) Profit maximization: MR = MC => 100 2Q = 10 + Q
(cm) Q = 30
(cn) P = $70
(co) This coincides with the socially efficient level.
e. Tax for monopoly would be 0 because the monopolist is already producing at the socially efficient
output in this case.
(cp) SolutionstoSecondhandSmoke:
a. Abillisproposedthatwouldlowertarandnicotinelevelsinallcigarettes.
(cq) Some smokers might actually smoke more in an effort to maintain a constant level of
b. Ataxisleviedoneachpackofcigarettes.
c. Ataxisleviedoneachpackofcigarettessold.

(cu) Smokingpermitseffectivelytransferpropertyrightstocleanairfromsmokerstononsmokers.A

4. Public Goods:
Public good: Nonexclusive and non-rival good:
Non-rival: when the marginal cost of providing the good to an additional consumer is 0.
Ex: Highway without congestion, TV signal => can be exclusive
Non-exclusive: when people cant be excluded from consuming a good
Ex: Lake, ocean => but fishing is rival
Example of public goods: national defense
Private good: Exclusive and rival
Market failure: free riders Consumer or producer who does not pay for a nonexclusive good in the
expectation that others will. Problem: its difficult to exclude people from consuming a nonexclusive
commodity. E.g.: Public TV, security in a mall
Wikipedia but dont have to pay for it, there are positive externalities. There may also be negative
externalities to the extent that the information provided by Wikipedia makes it easier for students to

Example: Three stores Demand for security:

(cy) Store 1: P = 80 10Q
(cz) Store 2: P = 40 5Q
(da) Store 3: P = 40 5Q
(db) MC = $60/hour (Constant => horizontal MC curve)
a. Market outcome (equilibrium):
(dc) 80 10Q = 60
(dd) Q = 2
b. Efficient provision of security: Add all willingness to pay:
(de) P = 160 2Q = 60
Exercise #10: Three groups in a community:
(dh) Demand curves for public TV in hours of programing T are:
W1 = $200 T
W2 = $240 2T
(dk) W3 = $320 2T
MC = $200/hour
a. Efficient number of hours of public TV:
(dm) Add all willingness to pay: W = $760 5T
(dn) Set this equal to MC = $200
(do) T = 112 hours
b. How much public TV Would a competitive private market provide:
(dp) Assume TV is not a public good, and it costs $200 to produce each hour for each group.
(dq) Group 1: W1 = 200 T = 200 => T = 0

Group 2: W2 = 240 2T = 200 => T = 20
(ds) Group 3: W3 = 320 2T = 200 => T = 60
(dt)Total number of hours demanded are 80 hours.

(du) Chapter 16: General Equilibrium and Economic Efficiency

1. General Equilibrium Analysis:
Partial equilibrium: focusing on one market, all else the same, independent of effects from other markets.
Ignoring feedback effects can lead to inaccurate forecasts of the full effect of changes in one market.
General equilibrium: Looking at simultaneous equilibrium in all relevant markets, taking feedbacks effects
into account.
A partial equilibrium analysis will stop at the initial shift whereas a general equilibrium analysis will
continue on and on, incorporating possible shifts in demand in related markets and ensuing feedback effects
on the first market.
(dv) Example 1: Good 1 and Good 2 are substitutes
QD1 = 10 2P1 + P2
QD2 = 10 2P2 + P1
QS1 = 5
QS2 = 5
a. Partial Equilibrium: Analysis of market for good 1: Suppose P1 = P2 = $5
(ea) Q1 = 5; P1 = $5
(eb) Suppose QS1 increase to 10
(ec) QD1 = 10 2P1 + 5 = 15 2P1 = 10
(ed) P1 = $2.5
b. General Equilibrium Analysis:
(ee) Initial equilibrium: P1 = 5; Q1 = 5; P2 = 5; Q2 = 5
(ef)Suppose QS1 increase to 10
(eg) Final equilibrium:
(eh) 10 2P1 + P2 = 10
(ei) 10 2P2 + P1 = 5
(ej) P1 = 5/3
(ek) P2 = 10/3
(em) Exercise #1: Gold and Silver are subtitutes
(en) Pg = 975 Qg + 0.5Ps; Qg = 75
(eo) Ps = 600 Qs + 0.5Pg; Qs = 300
a. Equilibrium prices:
(ep) Pg = 975 75 + 0.5Ps = 900 + 0.5Ps
(eq) Ps = 600 300 + 0.5Pg = 300 + 0.5Pg
(er)Ps = 300 + 0.5(900 + 0.5Ps) = 750 + 0.25Ps => 0.75Ps = 750; Ps = $1,000
Similarly, Pg = $1400
b. Qg = 150:
(et) Plug in new numbers:
(eu) Pg = $1300
(ev) Ps = $950
2. Efficiency in Exchange:
Exchange economy: no production take place; individuals own endowments; two or more consumers trade
two goods among themselves
Pareto efficient allocation: allocation of goods in which no one can be made better off unless someone else
is made worse off
Contract curve: Curve showing all efficient allocations of goods between two consumers, or of two inputs
between two production functions

Pareto efficient implies MRSA = MRSB

Starting at A, any trade that moved the allocation outside the shaded area would make the
consumers worse off.
At B, the trade is mutually beneficial, but not yet efficient (because UJ and UK did not intersect)
Even if a trade from an inefficient allocation makes both people better off, the new allocation is
NOT necessarily efficient.
(fa)At C, the two indifference curves intersect => MRS of two people are identical => Pareto efficient.
D is also Pareto efficient. This allocation would leave Karen no worse off (the point is on the
initial indifference curve) but would make James much better off (his indifference curve shifts right).
Pareto Efficient allocations are not all equally desirable from a social point of view. Society also
cares about equity (whether the allocation is fair).

3. Trade in a Competitive Market:
Consumers are price takers
Market prices of the two goods determine the terms of exchange among consumers.
Income = Market value of endowment

A is initial allocation.
Price line PP represents the ratio of prices
(fi) Competitive market will lead to an equilibrium at C, the point of tangency of both indifference curves
and the price line.
(fj) Example:
Jens MRS of orange juice for coffee is 1 (willing to trade 1 coffee for 1 orange juice)
(fl) Drews MRS of orange juice for coffee is 3 (willing to trade 3 coffee for 1 orange juice)
Porange = $2; Pcoffee = $3 => possible to trade 2/3 coffee for 1 orange juice
Since both are willing to trade more than what they have to pay, there is an excess demand for
orange juice and excess supply of coffee. Thus, price of coffee will decrease, price of orange juice will
The allocation in a competitive equilibrium is Pareto efficient
If everyone trades in the competitive marketplace, all mutually beneficial trades will be completed and the
resulting equilibrium allocation will be Pareto efficient.
4. Equity and Efficiency:
The Utility Possibilities Frontier: Curve showing all efficient allocations of resources measured in terms of
the utility levels of two individuals


Any point on the frontier are Pareto efficient

Any point below the frontier are inefficient
From H to F: James gains utility while Karen
doesnt lose anything
- From H to E: Karen gains utility while James
doesnt lose anything
- L is not attainable (not enough of both goods)
One Pareto efficient allocation of resources
may be more equitable than another.

5. Social Welfare Functions:

Measure describing the well-being of society as a whole in terms of the utilities of individual members
(fr) Every competitive equilibrium allocation is Pareto efficient
(ft) Any Pareto efficient point/allocation can be sustained as a competitive equilibrium if the endowment can
be redistributed (refer to Utility Possibilities Frontier)
If individual preferences are convex, then every Pareto efficient allocation (every point on the contract
curve) is a competitive equilibrium for some initial allocation of goods.
6. Efficiency in Production:
Results about efficiency also extend to economies where production is possible
3 notions of Efficiency:
(a) Input Efficiency:
The output of good 1 and good 2 is allocated on the Production Possibilities Frontier
Every producers marginal rate of technical substitution (MRTS) of labor for capital is equal in the
production of both goods

Technical efficient: MRTS = w/r
(b) Output efficiency:
The combination of outputs that best matches the preferences of individuals
MRS = MRT (= Px/Py) for all consumers

(c) Exchange efficiency:
The outputs are traded until MRSs are equalized for everyone: MRS = Px/Py

7. Market Failure: When the market equilibrium is not Pareto efficient:

Market power (Monopoly, monopsony)
Missing market:
Incomplete information
Public goods
Question 1:
a. The First Welfare Theorem: Every competitive equilibrium is Pareto efficient.
b. The endowment: A: C =2 W =1; B C = 3 W = 2; MRS = -W/C
(gb) Point e is not Pareto efficient because MRSA is not equal to MRSB

c. The allocation that is the competitive equilibrium is:
Consume all the goods in the endowment (not 1)
MRSA = MRSB (not 2)
3 => Point W
At W, MRSA = MRSB = -3/5 (= Price ratio). Price ratio is Pc/Pw = 3/5
(ge) Question 2:
Q = 50,000 P => P = 50,000 - Q
(gg) MC = $1000/oz
(gh) MEC = 1,000 + Q
a. Competitive equilibrium quantity and price:
(gi)Set P = MC
(gj)50,000 Q = 1,000
Q = 49,000oz
(gl)P = $1,000
b. Efficient production level:
MSC = MC + MEC = 2000 + Q
50,000 Q = 2000 + Q
Q* = 24,000oz
P* = $26,000
c. Dead Weight Loss: between MSC and MC, between two quantities:
(49,000 24,000)(51,000 1,000)/2 = 25,0002
d. Specific tax on gold:
t = MEC = 1000 + Q* = 1000 + 24,000 = $25,000 per oz
Pc = $26,000

(gt)Ps = $1,000

Question 3:
a. Define:
Non-rivalry: when the marginal cost of producing a good to an additional consumer is 0
Non-exclusivity: when it is impossible to exclude people from consuming one good
b. Competitive markets fail to provide the efficient quantity of a public good:
(gw) The positive externality presents in the provision of a public good. When individuals demand a
public good, they look at their willingness to pay and compare it with the price of the public good.
No one has the incentive to consider the impact of their decision on the well-being of others. But
when someone decides to purchase a public good, everybody else benefit => Positive externality.
Therefore, if a public good were provided via markets, there would be under provision of it. In some
cases, market completely fails to provide a public good so its best for the government to provide it.
Example: national defense.
(gy) Question 4:
a. Rent seeking: when firms invest resources into unproductive activities to acquire, maintain, or bargain
to gain monopoly power. E.g.: Lobbying, bribing, anti-competitive practices, etc. Rent seeking makes
monopoly power even less efficient than what the DWL suggests, because firms can invest as much as
monopoly profit into rent seeking efforts.
b. Partial equilibrium: focusing on one market, all else the same, independent of effects from other
markets. Ignoring feedback effects can lead to inaccurate forecasts of the full effect of changes in one
(gz) General equilibrium: Looking at simultaneous equilibrium in all relevant markets, taking
feedbacks effects into account.
(ha) A partial equilibrium analysis will stop at the initial shift whereas a general equilibrium analysis
will continue on and on, incorporating possible shifts in demand in related markets and ensuing
feedback effects on the first market.
c. Monopoly power is a market failure because monopolists create dead weight loss by setting the price
above marginal cost (price does not reflect the true cost). The output is too low compared to optimal
point, which corresponds to output inefficiency. Other considerations can be mentions such as rent
seeking, and/or the presence of other market failure (negative externality can make monopoly power less
damaging, while positive externality make monopoly power more damaging).


Edgeworth Box Special Cases:


Case 2: Both have perfect substitutes preferences (but with difference MRS)


Case 1: A has perfect complement utility, B has convex preference (convex indifference curve):

(hj)Note that if both of the agents have the same MRS in this case, ALL POINTS in the Edgeworth box
are Pareto efficient (same indifference curves).