ECON 111 – Microeconomic Principles

Lecture 1 – Introduction & PPF

Economics – Micro and Macro
Economics is how people use scarce resources to satisfy unlimited wants i.e. the choices they make.
Microeconomics is the study of the economic behaviour in particular markets – specific areas of the economy.
It looks at the individual agents economic choices and how markets coordinate the choices of economic
decision makers.
Macroeconomics is the study of the economic behaviour of entire economies
Resources, and Goods & Services
Resources are inputs or factors of production i.e. they are used to produce goods and services. Goods and
services are scarce because resources are scarce.
 Labour – Physical and Mental Effort  Payment is wages.
 Capital  Payment is interest

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o Physical Capital – Buildings and Machinery used to produces G&S
o Human Capital – Knowledge and Skill used to increase productivity
 Natural Resources Payment is rent m
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o Renewable
o Non-Renewable
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 Entrepreneurial Ability – Imagination to develop a new product/process  Payment is profit

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A good is a tangible product used to satisfy human wants whereas a service is an activity, or intangible product,
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used to satisfy human wants.

Decision Makers and Markets
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Households – Consumers demand G&S and Resource Owners supply resources

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Firms, Govt., World – Demand resources and produce G&S

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A market is a set of arrangements by which buyers and sellers carry out exchange at mutually agreeable terms.
Product market is for G&S and Resource Market is for resources.
Individuals and Marginal Analysis
Individuals are rational – They make the best choice with the available information to maximise expected
benefit and minimise the expected cost. Marginal analysis is the comparison between expected benefit and
expected cost.
Choice and Opportunity Cost
To make a choice is to pass up another opportunity. Thus an opportunity cost is the value of the best
alternative forgone when something is chosen.
Ceteris Paribus – Other variables remain unchanged.
Economic Model - Production Possibilities Frontier (PPF)
An economic model is a simplification of economic reality, assumptions are made to build model and the
model is used to make predictions.
Assumptions of PPF:
 Two products
 Given time frame, e.g. 1 year
 Fixed resources (quantity, quality)
 Fixed technology (quantity, quality)
 Fixed ‘rules of the game’
The PPF is a curve showing alternative combinations of goods
that can be produced when available resources are used
efficiently. Efficiency is getting the most from the available
resources. Inefficient combinations are inside the PPF,
unattainable ones are outside. The most efficient
combinations are on the PPF.

Movement along PPF – Give up some of the good on the y-axis to get more of the good on the x-axis.
Slope of PPF - Opportunity cost of 1 unit of the good on the x-axis
Law of increasing opportunity costs - To produce more of one good, a successively larger amount of the other

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good must be sacrificed

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The PPF is primarily shifted outward by economic growth due to the increased ability to produce goods and
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services, but there are other factors.
 Changes in resource availability
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 Increases in capital stock

 Technological change
 Improvements in the rules of the game
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Lecture 2
Cost and Profit
Explicit Costs - Opportunity cost of resources employed by a firm. They have an actual payment and are on
the accounting statement.
Implicit Costs - A firm’s opportunity cost of using its own resources or those provided by its owners. They do
not have an actual payment and aren’t listed on an accounting statement.
Accounting Profit – Total revenue minus explicit costs.
Economic Profit (a.k.a. Supernormal Profit) – Total revenue minus all costs (implicit and explicit)
Can be considered as the opportunity cost of all resources.
Normal Profit – The minimum profit required by the entrepreneur i.e. the break-even point.
 Total revenue is equal to all costs
 Therefore equal to the opportunity cost of the entrepreneurship.
Production in the short-run and other Terminology
Variable Resources – Can be varied in the short run to an increase or decrease in production
Fixed Resources – Cannot be varied in the short run
Short Run – At least one resource is fixed
Long Run – No resource is fixed

Total Product (TP) – A firm’s total output

Production function – Relationship between amounts of resources employed and total product
Marginal Product (MP) – Change in total product from an additional unit of resource with other things
constant
Marginal Returns
Increasing marginal returns is when the marginal
product increases whereas diminishing marginal
returns is when marginal product decreases.
Law of diminishing marginal returns – as the
number of new resources increases, the marginal

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product of an additional resource will at some
point be less than the marginal product of the
previous resource. m
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Costs in the Short-Run

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Average Costs in the Short Run
Average Variable Cost, AVC = TVC/Q
 Variable cost divided by output
Average Fixed Cost, AFC = TFC/Q
 Fixed cost divided by quantity
Average Total Cost, ATC = TC/Q
 Total cost divided by output
 ATC = AFC + AVC
When MC < Average Cost, the marginal pulls down the
average. When MC > Average Cost, it pulls the average
up.
The U-shape of average cost curves, is the law of diminishing marginal returns. Therefore, MC intersects AVC
and ATC at their minimum points.
Costs in the Long Run
Economies of Scale – Forces that reduce a firm’s average cost as the scale of operation increases in the long

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Diseconomies of scale – Forces that may eventually increase a firm’s average cost as the scale of operation
increases in the long run
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Long run average cost (LRAC) curve – Indicates the lowest average cost of production at each rate of output
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when the scale of the firm varies
 If there is a constant LRAC, the LRAC neither increases nor decreases with changes in firm size. Also,
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there would be no economies of scale and no diseconomies of scale

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Lecture 3
Market Structure
The market structure depends on
 Number of suppliers
 Product’s degree of uniformity
 Ease of entry into the market
 Forms of competition among forms
The four types of Market Structures are:
1. Perfect Competition (Lec 3)
2. Monopolistic Competition (Lec 5)
3. Oligopoly (Lec 12)
4. Monopoly (Lec 6)

The market structure that a firm is in affects its

decisions in regards to how much to produce; what
price to charge.
Perfectly Competitive Market
Characteristics of a Perfectly Competitive Market:
 Many buyers and sellers
 Commodity; or very standardized product
 Fully informed buyers and sellers
 No barriers to entry
In a perfectly competitive market, the
individual buyer or seller has no control
over the price thus making them price
takers. The market price is determined by
demand and supply. To be a price taker,
means that the quantity supplied or bought
will have no effect on the price.
Short run profit maximization
To maximise economic profit, a firm must

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produce a quantity where total revenue (TR) exceeds total cost (TC). Then they must increase production as

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long as each additional unit adds more to TR than TC.
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Marginal Revenue (MR) = P = Average Revenue (AR) = Horizontal line of demand curve.
Short run profit maximisation is based on the concept of marginal analysis. Therefore, a firm must expand out
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if MR > MC (Marginal Cost) but stop it before MC > MR. Profit maximisation occurs when MR = MC.
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Minimising short run losses

Short Run Supply Curve
Firms Market
How much firms supply in the short run Quantity supplied by industry at each price in
SR
Upward sloping portion of firms MC curve Horizontal sum of all firms short-run supply
Above minimum AVC curve curve

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Perfect Competition in the Long Run m
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Economic or Supernormal profit in the short run disappears as new firms enter the market in the long run and
the market supply increases. When there is an increase in firms selling identical products, the market price
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decreases. Thus is the long run, firms in a perfectly competitive market break even.
Similarly with economic losses in the short run, firms exit market, market supply decreases, price increases
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and firms break even.

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Lecture 4
Demand
Ceteris Paribus, demand is the quantity consumers are willing and able to buy at each possible price during a
given time period. The Law of Demand is that quantity demanded varies inversely with price.
 Substitution effect of a price change – When the price of a good falls, it becomes relatively cheaper
compared to other goods. Thus consumers substitute it.
 Income effect of a price change - A fall in the price of a good increases consumers’ real income thus
consumers able to purchase more goods.
Movement along the demand curve occurs due to a change in quantity demanded or by a change in price.
The curve shifts to the right for ↑ demand and to the left for ↓ demand. Shifts of the demand curve occur for
multiple reasons:
  Changes in consumer income. ↑ Income means ↑ Demand.
o Normal Good - Demand increases as income increases
o Inferior Good - Demand decreases as income increases
 Changes in prices of other goods.
o Substitute - ↑ in price of good A leads to ↑ demand for good B
o Complements - ↑ in price of good A leads to ↓ demand for good B
 Changes in consumer expectations.
o Income expectations – Income ↑ therefore demand ↑
o Price expectations – Future price ↑ therefore demand now ↑
Thus a shift in the demand curve results from a change in one of the factors of demand except for the price
of the good
Supply
How much producers are willing and able to offer for sale per period at each possible price, other things
constant. The Law of Supply is that quantity supplied is directly related to its price.
Movement along the supply curve occurs due to a change in quantity supplied or by a change in price.

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The curve shifts to the right for ↑ supply and to the left for ↓ supply. Shifts of the supply curve occur for
multiple reasons:
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 Changes in technology. Production costs decrease/ increased quantity at each price therefore supply
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↑
 Changes in prices of factors of production – production costs ↓ thus supply ↑
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 Changes in Producer Expectations - ↑ future prices lead to ↓ current supply

 Changes in number of producers.
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o Market supply - ↑ producers means ↑ supply.

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Thus a shift in the supply curve results from a change in one of the factors of supply except for the price of
the good.
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Market Equilibrium
Surplus – Excess quantity supplied (S > D)
Leads to lower prices, decreased production and increasing demand.
Shortage - Excess quantity demanded (D > S)
Leads to higher prices, increased production and decreasing demand.
Market Equilibrium is where S = D at equilibrium point, quantity and price. No pressure on price.
Lecture 5
A Monopoly is a sole supplier of a product with no close substitutes. It is therefore a price maker.
Barriers to Entry
Legal Restrictions
 Patents and Invention Incentives - Exclusive right to sell a product for 20 years from the date the
patent application is filed.
 Licences - Government awarding an individual firm the exclusive right to supply a particular good or
service
Economies of Scale
 Natural Monopoly
 Downward-sloping long-run average cost curve - One firm can supply market demand at a lower
average cost per unit than could two firms
Control of essential resources
 Firms in a monopoly generally have control over some resource critical to production.
Revenue

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As a monopoly would supply the market demand, to sell more they would have to lower the price on all units
sold.
Total Revenue = P x Q m
Average Revenue = TR/Q  However for monopolist AR = P
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The demand curve is the average revenue curve.
Marginal revenue MR = ∆TR / ∆Q  for a monopolist, MR < P
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The MR curve is downward sloping and below the demand curve

Costs and Profit Maximisation
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Since a monopolist is a Price Maker, it would require a firm with a decent amount of market power to set the
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price.
Profit Maximisation
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 A monopoly must supply the quantity where total revenue exceeds total cost by the greatest amount
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 Where Marginal Revenue equals Marginal Cost (MR = MC)

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Short and Long Run

If P > ATC then a monopoly would have economic profit in the short run
If ATC > P > AVC then a monopoly would have economic losses in the short run
If P < AVC then a monopoly should shut down in the short run (AVC is above the demand curve)

Short run profit does not guarantee long-run profit. If the industry has high barriers that block new entry then
that results in economic profit. However if experiencing long run losses, firm should exit the market.
Price Discrimination
The concept of charging different groups of consumers different prices for the same product to increase
profits. Conditions for price discrimination are:
 Downward sloping demand curve
 At least two groups of consumers with different price elasticity of demand
 Ability to charge different prices at low cost
 Prevent reselling of the product
A model of price discrimination with two different consumer groups.

Perfect Price Discrimination

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Monopolist who charges a different price for each unit sold – the monopolists dream.
Demand curve becomes MR curve  Allocative efficiency: No deadweight loss
Deadweight loss of monopoly
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When a firm with market power restricts output and increases the price; ends up a net loss to society.
 Deadweight lower – Substantial economies of scale and keeps price below profit maximising value to
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prevent attracting competition.

 Deadweight higher - Secure and maintain a monopoly, inefficient, lack innovation.
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Lecture 6
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Monopolistic Competition Characteristics:

 Very Many Firms
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 No barriers to entry or exit

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 Product differentiation
o Physical differences – Appearance; quality
o Location
o Services
o Product image – Promotion; advertising
Short Run Profit or Loss
Demand curve slopes downward, MR Curve is downward sloping and below demand.
Same as monopoly but flatter because products are similar not identical.

Maximise Profit: MR = MC
If P > ATC then economic profit
If ATC > P > AVC then economic losses
If P < AVC shut down
(AVC is above the demand curve)
Long Run
If short-run economic profit If short-run economic loss
New firms enter the market Some firms exit the market
Draw customers away from other firms Their customers switch to other firms
Reduce demand facing other firms Increases the demand for the remaining firms
Demand Curves of existing firms shift to the left Demand Curves for firms shift to the right
Profit disappears in long run Loss is erased in long run
ZERO ECONOMIC PROFIT IN LONG RUN (P = ATC in long run)

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Lecture 7
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Price Elasticity of Demand

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A measure of the responsiveness of the quantity demanded of a good to a change in its price when all other
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influences on buying plans remain the same.

Calculated by

The formula will give a negative value because price and quantity are inverse: P↑ → Q↓
However, since we are measuring the magnitude, the negative sign is omitted.

Two ways of calculating elasticity:

 Point Formula (Left) – Calculating at a point
 Mid-Point Formula (Right) – Over a range

Point formula is dependent on the direction (rise or fall) of the price change. It gives us the exact
responsiveness.
Mid-point formula uses the average price and quantity and we get the same elasticity value regardless of
direction. It is an approximate responsiveness.
Demand Elasticity
Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity.
If the

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percentage change in the quantity demanded is smaller than the percentage change in price, the price
elasticity of demand is less than 1 and the good has inelastic demand.
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If the percentage change in the quantity demanded is greater than the percentage change in price, the price
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elasticity of demand is greater than 1 and the good has elastic demand
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Total Revenue and Elasticity

The change in total revenue due to a change in price depends on the elasticity of demand:
 Elastic Demand – a 1% price cut makes Q↑ by more than 1% thus TR ↑
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o If a price cut increases total revenue, demand is elastic.

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 Inelastic Demand – a 1% price cut makes Q↑ by less than 1% thus TR ↓

o If a price cut decreases total revenue, demand is inelastic.
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 Unit Elastic Demand – a 1% price cut makes Q↑ by exactly 1% thus TR is unchanged.

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o If a price cut leaves total revenue unchanged, demand is unit elastic.

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(Total Revenue Test is underneath each condition)

Factors influencing Elasticity
Closeness of Substitutes:
 Closer the substitute, the more elastic the demand for the G&S
o Necessities, such as food or housing, generally have inelastic demand.
o Luxuries, such as exotic vacations, generally have elastic demand.
 Proportion of Income Spent
o The greater the proportion of income spent, the greater the elasticity.
 Time Elapsed since price change
o The more time consumers have to adjust, the greater the elasticity.
Cross Elasticity
The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change in the
price of a substitute or a complement, other things remaining the same. Cross elasticity for a substitute is
positive and for a complement, it’s negative.
∆% 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
Calculated: ∆% 𝑖𝑛 𝑃 𝑜𝑓 𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑
Income Elasticity
The income elasticity of demand (IED) measures how the quantity demanded of a good responds to a change
in income, other things remaining the same.
 IED > 1, demand is income elastic, good is a normal good
 1 > IED > 0, demand is income inelastic, good is a normal good
 IED < 0, good is an inferior good
∆% 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
Calculated: ∆% 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒

Elasticity of Supply
The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a
good when all other influences on selling plans remain the same.
∆% 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑
Calculated: ∆% 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

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Factors affecting Elasticity of Supply

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Resource Substitution Possibilities

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 The easier it is to substitute among the resources used to produce a good or service, the greater is its
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elasticity of supply.
Time Frame for Supply Decision
 The more time that passes after a price change, the greater is the elasticity of supply
o Momentary supply is perfectly inelastic. The quantity supplied immediately following a price
change is constant.
o Short-run supply is somewhat elastic.
o Long-run supply is the most elastic.
Lecture 8
Welfare economics is the study of how the allocation of resources affects economic wellbeing.
Willingness to pay is the maximum amount that a buyer will pay for a good.
Consumer Surplus is a buyer’s willingness and ability to pay minus the amount the buyer actually pays.
 Value to buyers – Amount paid by buyers
Producer Surplus is the amount a seller is paid for a good minus the seller’s cost.
 Amount received by sellers – Costs of sellers
Total surplus = Value to buyers – Costs of sellers
Demand Curve = Marginal Benefit Supply Curve = Marginal Cost
Graph

Deadweight Loss is the reduction in total surplus that results from a market distortion that results in either
overproduction or underproduction.

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Market Structures and Efficiency
Productive Efficiency – Minimum point on the LRAC Curve
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Allocative Efficiency – Produce output that consumers value most, MB = MC, no deadweight loss
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Perfect Competition – Said to be allocative and productively efficient.
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 Consumer surplus – Consumers pay less than they are willing to pay
 Producer surplus – Producers are willing to accept less than what they are receiving.
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Monopoly and Monopolistic Competition – Allocative inefficient due to deadweight loss. Also productively
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inefficient due to not minimising ATC in the long run.

Externalities.
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Market Failure – Where the quantity of a product demanded by consumers does not equate to the quantity
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supplied by suppliers. Thus intervention may be required to prevent market failure from occurring.
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Externality – an uncompensated impact of one person’s actions on the wellbeing of a bystander

 Positive – Makes the bystander better off
o Production – Social Costs moves supply curve to the right (S↑)
o Consumption – Social Value moves demand curve to the right (D↑)
 Negative – Makes the bystander worse off
o Production – Social Costs moves supply curve to the left (S↓)
o Consumption – Social Value moves demand curve to the left (D↓)
Solutions to Externalities
Coase Theorem – if trade in an externality is possible then bargaining will lead to an efficient outcome
regardless of the initial allocation of property.
 No Externalities Involved – All parties take them into account
 Outcome is independent of who has property rights.
 Transaction costs are low
Regulation - The government can remedy an externality by either requiring or forbidding certain activities.
Regulators may set a maximum level for certain externalities as well (pollution).
 E.G. it is a crime to dump poisonous chemicals into the water supply.

Governments can use market-based policies that provide incentives to take externalities into account.
Market-based Solutions via Price – Corrective taxes and subsidies.
 Tax the negative externalities. Ideally equals the external cost.
 Subsidise the positive externalities. Ideally equals the external benefit.
Market-based Solutions via Quantity – Tradable Pollution Permits
 Each permit allows a firm to emit a unit of pollution
 A market to trade these permits will develop and that market will be governed by the forces of supply
and demand.

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Lecture 9
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Price Ceiling
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A price ceiling is a legal maximum on the price at which a good

can be sold.
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 Binding price ceiling – placed under equilibrium

 Non-Binding price ceiling – place above equilibrium
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Binding price ceilings create shortages and thus, to manage the

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shortage, some mechanism to ration the good will develop.

Price Floor
A price floor is a legal minimum on the price at which a good
can be sold.
 Binding price floor – placed under equilibrium
 Non-Binding price floor – place above equilibrium
Binding price floors create surpluses and thus, to manage the
surplus, some mechanism to ration the buyers will develop.

Price Controls
Although floors and ceilings may regulate the market, often
they can hurt those that they are trying to help.
 A price ceiling on rent keeps prices low, but
discourages maintenance and makes housing hard to
find.
 A price floor on minimum wage may raise incomes for workers, but leaves other workers out.
Tax Incidence
A study of who bears the burden of taxation. E.g.: when government levies a tax on a good, the tax incidence
determines the degree to which buyers and sellers will be worse off.

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Taxes discourage market activity. When a good is taxed, the quantity of the good that is bought and sold is
smaller in the new equilibrium. Buyers and sellers share the burden of taxes. In the new equilibrium, buyers
pay more for the good and sellers receive less. It does not matter whether the tax is levied on buyers or sellers.
The effects on the market, and the tax incidence, are identical.
Elasticity and Tax Incidence

Subsidy
A subsidy is a payment from government, to consumers or sellers, for each unit of a good that is bought or
sold. Can be regarded as negative taxes.

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The market outcomes are identical no
matter who it’s paid to (Buyers or Sellers).
Subsidies encourage market activity:
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 The quantity bought and sold rises
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as a result of the subsidy

First Home Owners Grant

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 Subsidy paid to buyers when they

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purchase their first residence.

 Offset the effects of GST. $7000
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given to first-time home buyers.

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 Benefits
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o With supply of housing being inelastic and demand being relatively elastic, the price buyers
pay does not fall much, so buyers gain a small benefit. In contrast, the price sellers receive
rises substantially, indicating that sellers gain most of the benefit.

Lecture 10 (same topic as lecture 9)

Effects of a Tax
A tax on a good reduces the quantity that is bought and sold. Both buyers and sellers are worse off when a
good is taxed; a tax raises the price buyers pay and lowers the price sellers receive. The tax creates a wedge
between the price paid by buyers, and the price received by sellers.
 Consumer Surplus ↓ - tax makes buyers purchase ↓Q at ↑ P
 Producer Surplus ↓ - tax makes sellers sell ↓Q at ↓ P

Governments raise revenue from this tax. The revenue comes from the wedge created:
 Tax Revenue = Size of tax times Quantity
Deadweight Loss of Tax
Sections B & D are the tax revenue
Sections C & E are the deadweight loss of taxation
i.e. the reduction in total surplus.
 Exists because the revenue raised by the tax
is less than the loss of consumer and
producer surplus due to the tax.

Determinants of the Deadweight Loss:

 Inelastic Supply – Small Loss
 Relatively Elastic Supply – Large Loss
 Inelastic Demand – Small Loss
 Relatively Elastic Demand – Large Loss
The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks,
and the greater the deadweight loss.

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Effects of a subsidy

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A subsidy for a good increases the quantity that is bought and sold. Both buyers and sellers are better off
when a good is subsidised; a subsidy lowers the price buyers pay and raises the price sellers receive.
 Consumer Surplus ↑ - Buyers purchase ↑Q at a ↓P
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 Producer Surplus ↑ - Sellers sell ↑Q at a ↑P
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Since subsidised can be referred to a negative tax, the cost of the subsidy subtracts from government revenue.
 Cost of Subsidy = Size of Subsidy times Quantity.
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Lecture 11
Consumption Possibilities
A household’s consumption choices are constrained by its income and the prices of the goods and services
available. The budget line describes the limits to the household’s consumption choices. E.g.:
 Lisa has $40 to spend. The price of a movie is $8 and
the price of soft drink is $4 a case.
 All points on the BL and inside it are affordable.
 The BL can be thought of as opportunity cost.
The budget equation states that: Expenditure = Income
 Budget equation for Lisa is:
o PS.QS + PM.QM = Y
A household’s real income is the income expressed as a
quantity of goods the household can afford to buy.
 Lisa’s real income in terms of soft drinks is where BL
meets y-axis. In terms of movies, it’s where BL meets

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x-axis.

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Relative price is the price of one good divided by the price of another. Relative price is the magnitude of the
slope of the budget line
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If there is a change in income, with all things remaining the same:
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 Slope of BL doesn’t change at all

 BL shifts parallel left (for ↓Y) or right (for ↓Y)
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Preferences and Indifference Curves

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Indifference Curves – A line that shows combinations of goods among which a consumer is indifferent.
All of these possible combinations of goods can be sorted
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into three groups: preferred, not preferred, and just as good

 All points above the indifference curve are preferred
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to all the points on the indifference curve.

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 All the points on the indifference curve are preferred

to all the points below the indifference curve.

A preference map is a series of indifference curves which

describe a person’s preferences for all combinations of
goods. The further away from the origin the IC, the higher
level of satisfaction.
Indifferent curves cannot intersect.

Marginal Rate of Substitution (MRS)

Measures the rate at which a person is willing to give up good y to get an additional unit of good x while at the
same time remaining indifferent. Essentially the gradient of the slope at a point
∆𝑦
Calculated: 𝑀𝑅𝑆 = ∆𝑥
 If indifference curve is relatively steep, the MRS is high
 If indifference curve is relatively flat, the MRS is low
Diminishing Marginal Rate of Substitution.
A general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at
the same time remain indifferent as the quantity of good x increases.
Degree of Substitutability: The shape of the
indifference curves reveals the degree of
substitutability between two goods

Predicting Consumer Choices

Best Affordable Choice (BAC) is:
 On the BL
 On the highest attainable indifference curve
At the BAC, MRS = relative price of the two goods.

Changes in price move the BL on an axis.

There is movement along the demand curve

A ↑ in income moves BL outward (right)

A ↓ in income moves BL inward (left)
The demand curve will shift left or right appropriately.

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en
Substitution effect: due to a change in the relative price as
the price of one good change. m
cu
 P falls: SE moves from left to right
 P rises: SE moves from right to left
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Income effect: due to a change in the real income as the price of one good changes
 P falls (relative income increases): YE moves from left to right
p

 P rises (relative income falls): YE moves from right to left

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o IE and SE only move in the same direction for normal goods.

o For Inferior Goods: when income ↑, quantity bought ↓
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in
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Lecture 12
Oligopoly Characteristics
 A few firms
 Barriers to entry
o Legal Barriers
o Economies of Scale (Natural Barrier)
o Control of Resources
 Therefore, firms are interdependent
 Products may be identical or differentiated
Game Theory
Game theory is the study of how people behave in strategic situations. This tool helps us analyse the
interdependency of firms that is a unique feature of oligopoly.
A dominant strategy is a strategy that is best for a player in a game regardless of the strategies chosen by the
other players. A Nash Equilibrium is when all the actors choose the best strategy form themselves given the
strategies of the other actors.

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Rules of a Game:

en
 There are 2 players
 Per turn, each player has 2 choices
 Players cannot communicate with each other
m
cu
 Each player tries to maximise their benefit, given the other player’s choice.
Do

 Within one game, each player has more than one turn – “An Iterated Game”.
If a completed game can be played more than once, then it’s called a repeated game
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Prisoners Dilemma
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A particular ‘game’ between two captured prisoners that illustrates why cooperation is difficult to maintain
even when it is mutually beneficial.
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Oligopolies in this scenario

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This game shows the profits earned by

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Jack and Jill as they depend on the one

and other’s production decisions.
 If Jill makes 40L, Jack should
make 40L because he makes
$1600 instead of $1500
 Both have dominant strategies
in this case

Lecture 13
Trade
Comparative Advantage – person can produce a good at a lower opportunity cost compared to the others
 Comparing opportunity costs
Absolute Advantage – person is more productive than others
 Comparing productivity
Terms of trade  Op. Cost Good A < Terms of Trade < Op. Cost Good B

When trading, each country aims to reach a point outside the PPF thus being able to consume outside the PPF.