1 Consumer Theory

1.1 Lecture 1: Introduction to Microeconomics

1.1.1 What is microeconomics?
• Microeconomics is the study of how individuals and frms maximize their
well-being in a world of scarcity.
• The core of microeconomics is the study of constrained optimization
and assessing tradeofs.

• The key concept behind tradeofs is opportunity cost: every action or

inaction has a cost in terms of what could have been done instead.

1.1.2 Modeling in microeconomics

• A model is any description of the relationship between two or more eco-
nomic variables.

• Economic models are simplifed representations of relationships between

variables.

Supply and Demand Model:

• Demand curve is downward-sloping. It shows the relationship between

price and quantity demanded. It measures the willingness of consumers
to buy a certain good.

• Supply curve is upward-slowing. It shows the relationship between price

and quantity supplied. It measures the willingness of producers to sell.

• The intersection of supply and demand curve is the market equilibrium.

Each point on the demand curve shows how much consumers will demand
at a given price. Each point on the supply curve shows how much pro-
ducers will supply at a given price. At the equilibrium price, suppliers are
willing to supply as much as demanders will demand.

1.1.3 Positive vs. normative economics

• Positive analysis is the study of the way things are (e.g. eBay auctions).
• Normative analysis is the study of the way that things should be (e.g.
should organ sales be legal?).

1.1.4 Market economy

• Capitalistic economy: individuals and frms decide what to produce
and consume, subject to limited restrictions by the government (similar
to laissez-faire).

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 • Command economy: government in control with production and allo-
cation (e.g. inefciency and corruption of Soviet Union).

• Invisible hand: Adam Smith’s concept, self-regulating nature of markets

and self-interest

1.1.5 TO KNOW – Conceptual Understanding

• Microeconomics studies how individuals and frms make optimal choices
under scarcity, focusing on trade-ofs and opportunity cost

• Models are simplifed tools to understand behavior; positive economics

explains what is, while normative economics debates what should be

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1.2 Lecture 2: Preferences and Utility Functions
1.2.1 Consumer preferences
• Consumer choices are based on preferences and budget constraints
• To model consumer preferences, there are three assumptions:
– Completeness: when comparing two bundles of goods, you either
prefer one, prefer the other, or are indiferent
– Transitivity: If consumer prefers bundle x to bundle y, and bundle
y to bundle z, then must prefer bundle x to bundle z
– Non-Satiation: More of a good is always better, consumers never
get satiated

1.2.2 Indiference curves

• We use indiference curves as the basic graphical tool of consumer the-
ory. There are four important properties of indiference curves:
– Consumers prefer higher indiference curves
– Indiference curves are downward-sloping
– Indiference curves never cross
– There is one indiference curve through each possible consumption
bundle

1.2.3 Utility
• Utility is a way of mapping preferences. We use utility to get ordinal
ranking, not cardinal ranking
• Utility function translates consumer utility from diferent consumption
bundles into units, that can then be compared.
• Marginal utility is the derivative of utility with respect to good. It
measures how utility changes as consumers consume more of a good. The
important principle of diminishing marginal utility states that con-
sumers receive less utility from each unit of a good they consume.
• The slope of the indiference curve is called the marginal rate of sub-
stitution (MRS).
– marginal rate of substitution (M RS) = rate at which consumers are
willing to trade Y axis for X axis
–
M Ux δU/δx
M RS = − =−
M Uy δU/δy
– M RS is the ratio of marginal utilities
– M RS is diminishing as you move along the indiference curve

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1.2.4 TO KNOW – Graphical and Math Understanding
• Prove that indiference curves never cross using a fgure

• Prove that indiference curves are downward sloping using a fgure

• Draw indiference curves corresponding to perfect complements and per-

fect substitutes

• Know how to sketch an indiference curve given a verbal description of a

consumer’s preferences

• Calculate marginal utilities given a utility function

• Calculate marginal rate of substitution given a utility function

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1.3 Lecture 3: Budget Constraints
1.3.1 Budget constraint
• Consumers have limited resources: their budget constraint. One sim-
plifying assumption is that budget is equal to income (I). Budget over
two goods X and Y is defned to be

I = p X X + pY Y

• The slope of budget constraint is defned as marginal rate of trans-

formation (MRT): rate at which you can transform one good into the
other in the marketplace
pX
M RT = −
pY
Intuitively, with a fxed budget, by choosing one thing you are by defnition
reducing the money you have to spend on other things.
• Shifts in price and income alter the position and slope of the budget con-
straint.
– For example, if the price of good X increases, the budget constraint
fattens.
– If the income decreases, the budget constraint shifts inwards.

1.3.2 Constrained optimization

• The goal of constrained choice is to maximize utility subject to the budget
constraint. Preferences are represented by indiference curves.
• The optimal bundle that a consumer can choose is defned by the point
where indiference curve is tangent to the budget constraint:
M UX δU/δX pX
M RS = − =− =− = M RT
M UY δU/δY pY
At this point, slope of indiference curve = slope of budget constraint.
This is equivalent to equating the marginal cost and beneft of consuming
each good.
• The above equation defnes an interior solution (in which the consumer
consumes some of each good); if indiference curves are fat, there can also
be corner solutions in which the consumer only consumes one good

1.3.3 TO KNOW – Graphical and Math Understanding

• Know how to write down a budget constraint given prices and income
• Show graphically how to fnd the bundle that maximizes the consumer’s
utility subject to the budget constraint

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• Solve for the optimal bundle mathematically for a consumer given a utility
function, prices of the two goods, and income; be sure to check for corner
solutions

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2 Demand
2.1 Lecture 4: Demand Curves
2.1.1 Deriving demand curve
• Demand curve shows the relationship between price and quantity de-
manded. Often we connect consumer choice theory to demand curves by
varying prices while holding income constant.

2.1.2 Elasticity
• Price elasticity of demand is defned to be

δQ/Q
ϵ=
δP/P

For example, if quantity demanded falls by 2% for each 1% increase in

price, ϵ = −2.

• Perfectly inelastic demand: demand does not change regardless of

what happens to price, ϵ = 0. When there is no plausible substitute,
demand is likely to be perfectly inelastic.

• Perfectly elastic demand: demand will drop to zero if price moves at

all, ϵ = −∞. When there are perfect substitutes, demand is likely to be
perfectly elastic.

• The elasticity afects consumers’ response to a shift in price: if the elas-

ticity is between 0 and −1, then frms can raise revenues by raising the
price (since consumers will still buy the good in signifcant quantities); if
ϵ < −1, then raising the price results in a decline in frm revenue.

• Accurately estimating an elasticity requires a shift along the supply curve

(e.g., a tax on suppliers would shift the supply curve up, causing the
equilibrium price to rise and quantity to fall, from where we can calculate
the price elasticity of demand).

2.1.3 Shifts in demand curve

• To trace out a demand curve, we change prices holding income constant.
To shift a demand curve, we change income holding prices constant.
• The “Engel Curve” shows the direct relationship between income and
consumption.

• The income elasticity of demand shows what happens to consumption

as income changes.
δQ/Q
γ=
δY /Y

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 – Most goods are normal goods: they have a positive income elastic-
ity. Consumption of normal goods increases as income rises.
– Inferior goods have a negative income elasticity. Consumption of
inferior goods falls as income rises.
– Necessities are goods with γ < 1. You spend a smaller share of
your income on necessities as income rises.
– Luxuries are goods with γ > 1. You spend a larger share of your
income on necessities as income rises.

2.1.4 Income and substitution efect

• An increase in price has two efects: income efect and Substitution
efect.
• substitution efect is the change in quantity of good demanded when
good’s price changes, holding utility constant.

– When one good gets relatively expensive, the substitution efect is

the extent to which you shift away from that good.
• Income efect is the change in quantity of a good demanded because of
a change in income, holding prices constant.
– Rise in price efectively lowers the consumer’s income, and this has
a distinct efect on demand.

• Income efect reinforces substitution for normal goods, as both have a

negative efect on the quantity demanded as income rises. But income
efect works against it for inferior goods. Therefore, substitution efect is
always negative, but income efect can be positive.

• Accordingly, the overall efect of a price increase on consumption of a good

can be negative (for a normal good), or positive, it is an inferior good. And
the income efect is larger than the substitution efect.

price change substitution efect income efect total efect

normal good price rises ≤0 ≤0 ≤0
normal good price falls ≥0 ≥0 ≥0
inferior good price rises ≤0 ≥0 uncertain
inferior good price falls ≥0 ≤0 uncertain

• Gifen good is a good with a positive own-price elasticity.

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2.1.5 TO KNOW – Conceptual Understanding
• Explain the diference between a movement along the demand curve and
a shift of the demand curve
• Explain what the elasticity of demand/supply imply about changes in
equilibrium

• Explain what quantities observed after price changes imply about the
income and substitution efects

2.1.6 TO KNOW – Graphical and Math Understanding

• Given an algebraic expression for demand, calculate the price elasticity of
demand at any point along the curve

• Graph budget constraint lines and show how the line shifts or rotates when
a price of a good changes or the agent’s income changes

• Derive a demand curve mathematically given a utility function, the price

of one of the goods, and an income level
• Derive an Engel curve mathematically given a utility function and the
price of both goods

• Show and calculate the efect of a price change in a graph showing a con-
sumer’s optimal bundle; decompose the efect graphically into the income
and substitution efect

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3 Production and Costs
3.1 Lecture 5: Production
3.1.1 Production function
• The goal of frms is to maximize profts by minimizing costs, given tech-
nological constraints.
• Production functions describe what is technologically feasible for frms
to produce. Firm converts inputs (or factors of production) into outputs
through a production process. Here outputs are the goods and services
produced by the frm, and inputs are capital and labor.

q = f (L, K),

where q is output, L is labor, and K is capital.

• In the short run, at least one input is fxed. In the long run, all inputs
are variables.

3.1.2 Short run production

• Recall that in the short run, at least one input is fxed. Suppose we have
fxed capital and variable labor. Marginal product of labor is the
change in the total output resulting from using an extra unit of labor,
holding other inputs constant.
δq
M PL =
δL
Generally, we assume diminishing marginal products: the next worker
increases output more than the previous one.
• Marginal product of capital is the additional output gained from one
extra unit of an capital, holding the other inputs constant.
δq
M PK =
δK

3.1.3 Long run production

• Isoquants are curves showing all (L, K) combinations producing the same
output. The shape of isoquants is determined by the degree of substi-
tutability between inputs.
• The slope of isoquant is the marginal rate of technical substitution
(MRTS). M RT S varies along the isoquant. M RT S falls as labor in-
creases. Isoquants exhibit diminishing marginal rates of technical substi-
tution.
δK M PL
M RT S = =−
δL M PK

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3.1.4 Returns to scale
There are three cases when you increase all inputs proportionally:

• Constant returns to scale: input increases proportionally, and output

increases proportionally. For example, f (2L, 2K) = 2f (L, K).

• Increasing returns to scale: input increases proportionally, and output

increases more than proportionally. For example, f (2L, 2K) > 2f (L, K).

• Decreasing returns to scale: input increases proportionally, and out-

put increases less than proportionally. For example, f (2L, 2K) < 2f (L, K).

3.1.5 TO KNOW – Conceptual Understanding

• Understand the inputs and outputs of production function
• Identify the diferences between short run and long run production

• Identify diferent cases of returns to scale: constant, increasing, decreasing

3.1.6 TO KNOW – Graphical and Math Understanding

• Calculate the marginal product of labor, marginal product of capital

• Graph isoquants, and see how its slope is the marginal rate of technical
substitution. Calculate M RT S given production function

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3.2 Lecture 6: From Production to Costs
3.2.1 Short run costs
• Fixed costs are the costs of inputs that can’t be varied in the short run.
– In this course, we usually assign capital as fxed costs.
• Variable costs are the costs of inputs that can be varied in the short
run.
– In this course, we usually assign labor as variable costs.
• Total costs are the sum of fxed and variable cost: C = F + V C.
• Marginal costs are the change in costs for another unit of output:
∆C
MC = .
∆q
In the short run, marginal cost is just the change in variable costs.
• Average costs are the average cost of production per unit produced.
C
AC =
q
VC
AV C =
q
FC
AF C =
q
• Graphically, marginal cost is constant upward slope, average fxed cost
is steadily declining, average variable cost is rising but more slowly than
marginal cost, average total cost is frst declining then rising. Note that
where the average costs are at a minimum is where they cross the marginal
cost curve.
• Sunk costs are costs that cannot be recovered through any change in
production patterns. Sunk costs cannot be recovered and should not afect
future production decisions.

3.2.2 Long run costs

• Recall that in the long run, all input costs are variable. So choice is over
input mix to maximizes production efciency, or minimizes costs.
• Isocost line is the combination of capital and labor that yield the same
total level of costs. Total costs is

C = rK + wL.

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 • Firms choose economically efcient combination of inputs for a given level
of output.

• Cost minimization is achieved when isoquant f (L, K) is tangent to isocost

C = wL + rK:
M PL w M PL M PK
= ⇒ = .
M PK r w r
Economically efcient point is where the last dollar spent on labor adds
as much to output as the last dollar spent on capital.
• Expansion path traces cost-minimizing (K, L) combinations for all out-
put levels.

3.2.3 Economic and accounting profts

• Accounting profts measure only cash infows of revenues and outfows
of costs

• Economic proft also accounts for opportunity costs that aren’t neces-
sarily paid in cash

3.2.4 TO KNOW – Conceptual Understanding

• Identify the defnition of fxed costs, variable costs, and sunk costs
• Know the diference between short run and long run production. In the
short run, at least one input (capital) is fxed. In the long run, all inputs
are variable

• Explain why average costs are at a minimum when they cross the marginal
cost curve
• Firms choose input combinations to produce a given output at lowest cost

3.2.5 TO KNOW – Graphical and Math Understanding

• Derive diferent cost functions: total costs, fxed costs, variable costs,
marginal costs, average costs
• Know the shape characteristics of AF C, AV C, M C in a graph

• Show graphically in the isoquant–isocost diagram how to yield the cost-

minimizing (L, K)

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3.3 Lecture 7: Competition I
3.3.1 Perfect competition
• Firms in the market are price takers, on both the output and input sides.
Conditions for perfect competition are:
– Firms sell identical products
– Consumers know prices charged by all frms in market
– There are very low transaction costs in searching across possible pur-
chase opportunities

3.3.2 Short run proft maximization

In the short run, we assume no frm entry or exit.
• Firms choose output q to maximize π(q) = R(q) − C(q), where R(q) is
the total revenues the frm receives from selling output q, and C(q) is the
total cost
max π(q) = R(q) − C(q)
∂π(q) ∂R(q) ∂C(q)
= − =0
∂q ∂q ∂q
∂R(q) ∂C(q)
=
∂q ∂q
MR = MC

• In perfect competition, marginal revenue M R equals the market price p.

Therefore, frms produce until M R = M C = p.

• In the short run, competitive frm faces a perfectly elastic demand curve
M R = p. Hence, for a perfectly competitive frm, P = M C.

• Shutdown decisions: frms continue producing in the short run as long as

it covers its variable costs. Firms shut down only if P < min AV C.

3.3.3 Short run and long run supply

• A frm’s short-run supply is its M C curve above the minimum AV C
• A frm’s long-run supply is its M C curve above AT C

• Market supply is the horizontal sum of individual frms’ supply curves

• Short run equilibrium happens at the intersection of market demand with

market supply determines the equilibrium price; each frm then produces
where M C = p.

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3.3.4 TO KNOW – Conceptual Understanding
• Explain/know the condition when a frm will shut down (1) in the short
run and (2) in the long run
• Explain when frms will enter/exit in the long run

• Know why M R = M C = p in the short run for a frm in a perfectly

competitive market

3.3.5 TO KNOW – Graphical and Math Understanding

• Calculate M R and M C given production function and cost function
• In a perfectly competitive market, given a short run cost curve, fnd the
short run supply curve for a frm
• In a perfectly competitive market, show graphically how aggregate market
supply changes as there are more frms

• In a perfectly competitive market in the short-run, given cost curves for

frms, demand, and the number of frms, fnd the equilibrium price, what
each frm produces, and the total quantity

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3.4 Lecture 8: Competition II
3.4.1 Long run competition
• In the long run, there will be entry and exit in a perfectly competitive
market until all frms make zero proft.
• Free entry/exit with identical frms implies the long-run supply price
equals the minimum of the long-run average cost curve.

• Long run supply curve is only fat under very restrictive conditions. It is
fat only when frms are identical and input prices constant. It is upward-
sloping if

– Barriers to entry exist

– Firms difer in efciency
– Input prices rise with industry expansion

Long run supply curve is fatter than the short run supply curve due to
the potential for entry and exit.

3.4.2 Agent problem

• Separation of ownership and control: ead managers to pursue personal
perks over cost-minimization

3.4.3 TO KNOW – Graphical and Math Understanding

• Know the condition for long run equilibrium

• Show graphically that fat LR supply curve at min AT C, and LR supply

is upward-sloping if input prices rise or frms difer

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4 Welfare Economics
4.1 Lecture 9: Supply and Demand, Consumer and Pro-
ducer Surplus
4.1.1 Demand and supply
• Demand curve measures the willingness of consumers to buy the good

• Supply curve measures the willingness of suppliers to supply the good

• Supply and demand curves can shift when there are

– changes in the ability of producers to supply (driven by cost of an

input or technology)
– changes in consumer tastes or preferences
– changes in income
– changes to the price of complement or substitute goods. A rise in the
price of a substitute good for good X raises the demand for X.

For example, suppose that tastes change so that folks want to drive big
cars. Gas guzzling cars are a complement for gas, because as people want
more of gas guzzling cars, they want more gas. This will shift out the
demand for gas.
Now suppose that there is a war in the middle east and we suddenly it is
harder to get as much gas. This makes it more expensive to get gas, so
for each quantity of gas the suppliers need to charge more, which causes
an upward shift in the supply curve.

• Case of perfectly elastic demand: demand will drop to zero if price moves
at all from the original equilibrium

4.1.2 Consumer surplus

• Consumer surplus is the area under the demand curve and above the
price since the demand curve represents the marginal willingness to pay
for a good.
• Consumer surplus is inversely related to elasticity of demand.

4.1.3 Producer surplus

• Producer surplus is the area above the supply curve and below the price
since the supply curve represents the marginal cost of producing the good.

• In the long run, producer surplus is the proft.

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4.1.4 Total welfare
• Social welfare is the sum of producer and consumer surplus.

• In competitive equilibrium, where supply equals to demand maximizes

total welfare.

4.1.5 Deadweight loss

• Deadweight loss is the loss in welfare that is a result of moving away
from the perfectly competitive equilibrium.

• Deadweight loss can be caused by monopolies, government taxation.

4.1.6 TO KNOW – Conceptual Understanding

• Describe factors that shift supply and demand curves

• Explain how consumer surplus depends on the elasticity of the demand

curve

• Explain what deadweight loss is intuitively

• Explain why competition maximizes total surplus

4.1.7 TO KNOW – Graphical and Math Understanding

• Know how to calculate consumer surplus, producer surplus, and dead-
weight loss from various government policies (quantity restriction, price
ceiling, price foor, tax, etc.)

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4.2 Lecture 10: Welfare Economics
4.2.1 Government interventions
• Interventions in market can also lead to disequilibrium. For example,
imposing a minimum wage means that more people will want to work than
employers want to hire at the minimum wage. This creates unemployment.
The cost of these interventions is found in reduced efciency (trades that
are not made); there may be benefts in greater equity.
– Price ceiling is a legal maximum price that for a good or service. A
valid price ceiling is usually before the equilibrium price. With price
ceiling, at equilibrium, quantity demanded is greater than quantity
supplied.
– Price foor is a legal maximum price that for a good or service. With
price foor, at equilibrium, quantity demanded is less than quantity
supplied.

• These restrictions generate deadweight loss and efciency loss.

4.2.2 TO KNOW – Conceptual Understanding

• Know what price ceiling and price foor are, and identify their efects in
the market

• Know “what’s wrong” with excess supply or excess demand

4.2.3 TO KNOW – Graphical and Math Understanding

• Analyze the efect of a price ceiling in a graph

• Analyze the efect of a price foor in a graph

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5 Monopoly
5.1 Lecture 11: Monopoly I
5.1.1 Monopoly proft maximization
• Monopoly is a market with only one frm. Firms are price makers, not
price takers.
• Total revenue is
T R = P (Q) · Q

• Average revenue is given by the demand curve

AR = P (Q)

• Marginal revenue is additional revenue from selling one more unit

∂T R
MR =
∂Q

• Monopoly faces downward sloping demand curve and therefore

∂T R ∂P (Q) · Q ∂P
MR = = = P (Q) + Q
∂Q ∂Q ∂Q
And because
∂P
M R = P (Q) + Q < P (Q)
∂Q
Monopolist has to decrease price on all units sold in order to sell one
additional unit. This is not the case with a perfectly competitive frm,
which cannot infuence the price at which it sells. Therefore, M R curve
for monopolist is below AR curve (the demand curve).
• A monopoly never produces at the inelastic part of the demand curve
∂P 1
M R = P (Q) + Q = P (1 + )
∂Q ϵD
for |ϵD | < 1, M R < 0.
• To maximize proft in a monopoly, frms produce at M R = M C.
1
M R = P (1 + ) = MC
ϵD
P − MC 1
=−
P ϵD
is the markup, or measure of monopoly power, which depends on the
elasticity of demand. Higher markup means demand is more inelastic.

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5.1.2 Welfare efects of monopoly
• Monopolists produce less than the competitive quantity, reducing total
surplus and producing deadweight loss.
• Social welfare can be maximized under perfect price discrimination.

5.1.3 TO KNOW – Conceptual Understanding

• Explain why marginal revenue is less than average revenue for a monopolist
but not for a competitive frm

• Know why both a monopolist and perfectly competitive frm want to set
MR = MC

• Explain why a monopolist’s market power depends on the elasticity of

demand
• Explain why there is deadweight loss (DW L) when a monopolist cannot
price discriminate

• Explain why there is no deadweight loss (DW L) when a monopolist can

price discriminate

5.1.4 TO KNOW – Graphical and Math Understanding

• Given a cost function and a demand curve, solve for the price and quantity
in a market with a monopolist; be sure to check whether the monopolist
will want to shut down

• Derive an equation relating the monopolist markup to the elasticity of

demand

• Graphically, identify the producer surplus, consumer surplus, and DW L

of monopoly in the uniform price case

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5.2 Lecture 12: Monopoly II
5.2.1 Origins of monopoly
• Natural monopoly occurs when when a single frm’s average cost con-
tinuously declines over the relevant output range, due to very high fxed
costs and low marginal costs.

• Government-created monopolies include state provision (postal services,

utilities) and patents.

5.2.2 Addressing monopolies

• Mandating p = M C eliminates monopoly power and deadweight loss but
requires knowing the true competitive price

• Setting p too low can shrink output below even monopoly levels, reducing
total welfare

5.2.3 TO KNOW – Conceptual Understanding

• Know reasons monopoly may rise

• Discuss the pros and cons of patents

5.2.4 TO KNOW – Graphical and Math Understanding

• Graphically show the welfare impact of patents
• Graphically show the welfare efects of government regulation of monop-
olies

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6 Other Market Structures
6.1 Lecture 13: Oligopoly
6.1.1 Oligopoly overview
• Oligopoly is a small group of frms in a market with substantial barriers
to entry by additional frms
• In an oligopoly, frms can behave cooperatively or noncooperatively. If
they behavior cooperatively, they can form a cartel. If they act nonco-
operatively, they can move back towards the competitive outcome, with
lower profts.
• A market with two frms is called a duopoly.

6.1.2 Game theory

• Two key points of game theory are:
– Each frm will produce a strategy, which will be dependent on what
it thinks the other frms are doing, and these set of strategies taken
together will jointly determine the outcome
– Game will end when the market is in equilibrium
• The Nash Equilibrium: o frm wants to change its strategy given what
other frms are doing
• Prisoner’s dilemma: a simple example of game theory. We illustrate
the problem with a payof matrix.
• Dominant strategy: the best thing to do no matter what the other guy
does

6.1.3 Cournot Model of Noncooperative Equilibrium

• Cournot equilibrium: the set of quantities for each frm such that,
holding the quantities of all other frms constant, no frm can obtain a
higher proft by choosing a diferent quantity
• Reaction curve: relationship between frm’s proft maximizing output
and output it thinks its competitor will produce. Cournot equilibrium is
where the reaction curves intersect.
• Math to calculate the Cournot equilibrium:
– Calculate residual demand for a given frm (in other words, the de-
mand for a frm’s product subtracting out other frm’ output deci-
sions)
– Create a total revenues function

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 – From the total revenues function, derive marginal revenues
– Solve its proft maximization problem (M R = M C). This will give
you a frm’s best response function to other frms’ output decisions.
– Solution is a set of quantities (one for each frm) that solves the
system of equations in 4.

6.1.4 TO KNOW – Conceptual Understanding

• Explain the “prisoner’s dilemma”

• Understand why cooperation can be sustained in a infnitely repeated

game but not in a game with fnite periods
• Explain why cartels are unstable

6.1.5 TO KNOW – Graphical and Math Understanding

• Find the Nash equilibrium of a game, given a payof matrix

• Solve for quantities and prices when two frms compete in Cournot equi-
librium

• Solve for a cartel equilibrium with n frms

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6.2 Lecture 14: Oligopoly Continued
6.2.1 Cartels
• Cartels are fundamentally unstable (incentive to “cheat” and raise own
production) and because they are illegal (antitrust laws).
• Each member has an incentive to cheat on a cartel, and they can get away
with it, because their additional production is fairly small relative to the
total. If one frm cheats, it gets all of the beneft of selling more quantity,
but only a part of the poisoning efect – that gets shared with all other
frms in the market.

6.2.2 Many frms

• Noncooperative equilibrium leads to less output and more profts than
does the competitive market case
• In terms of welfare, usually perfect competition > oligopoly > monopoly
• Quantity as an indicator of social welfare. Deadweight loss in welfare
analysis comes from trades that aren’t made.
• As the number of frms get large, the Cournot equilibrium approaches
perfect competition – as the number gets small, it approaches monopoly.

6.2.3 Price competition

• Bertrand competition: frms set prices (instead of quantities) at the
same time
• Two frms may be enough to remove market power if products are identical
• To avoid Bertrand competition, frms can product diferentiate. Identical
Bertrand duopolists drive price down to marginal cost. In other words,
frms will set their prices at marginal cost.

6.2.4 TO KNOW – Conceptual Understanding

• Explain why cartels are unstable
• Compare welfare from diferent forms of competition (monopoly, oligopoly,
perfect competition)
• Know the diference between quantity (Cournot) and price (Bertrand)
competition

6.2.5 TO KNOW – Graphical and Math Understanding

• Solve for price and quantity when frms compete in a model of Bertrand
price competition

25
7 Labor Market
7.1 Lecture 15: Input Markets I: Labor
7.1.1 Factor demand
• Factor markets is the markets for labor and capital that determine input
prices. Factor demand is the general model for labor and capital.
• We are interested in the marginal beneft and cost of adding an additional
unit of labor.

• Marginal revenue product (M RP ) is the value to the frm of another

unit of labor:
M RPL = M R · M PL
– The marginal cost of another unit of labor in a competitive labor
market is wage w.
– If the market is perfectly competitive, M R = p. The equation above
becomes M RPL = w = p · M PL . Firms hire until the wage equals
the value of what that worker is producing.

7.1.2 Capital demand

• Similarly, Marginal revenue product of capital(M RPK ) is the value
to the frm of another unit of capital:

M RPK = M R · M PK ,

where M PK is the increment in output from one extra unit of capital,

holding labor fxed. Firms purchase additional capital until rental rate
= M RPK .

7.1.3 Labor supply

• Deriving labor supply is essentially exploring utility over consumption
and leisure. We treat leisure as a good and consumption as its comple-
ment. Wage rate is the opportunity cost of leisure.

• The slope of the budget line, the rate at which you can trade of goods
for leisure, is wage rate. The wage rate is the price of leisure in terms of
goods, and is also the opportunity cost of leisure.

• We discuss labor supply using income and substitution efect. Income

efect works against substitution efect if leisure is a normal good.

• When wage increases, the “price” of leisure rises. But higher wage also
increases real income.

26
7.1.4 TO KNOW – Conceptual Understanding
• Derive factor demand in frms, explain marginal revenue product, marginal
revenue product of labor, and marginal revenue product of capital
• Individuals choose between leisure and work

• When the wage rises, leisure becomes more expensive (substitution efect):
people tend to work more. Simultaneously, a higher wage increases real
income (income efect).

7.1.5 TO KNOW – Graphical and Math Understanding

• Plot the graph that refects individual trade-of between leisure and con-
sumption

• Illustrate the income and substitution efect in the leisure vs. consumption
graph

• The intersection of aggregate labor-demand and labor-supply curves is the

equilibrium wage and employment level

27
7.2 Lecture 16: Input Markets II: Labor and Capital
7.2.1 Labor market equilibrium
• Firms demand for labor is driven by the additional revenue generated by
hiring an extra unit of labor, which is the value of marginal product.
• The supply of labor refects the trade-of between income and leisure for
workers.
• Equilibrium wage and employment is where aggregate labor demand equals
aggregate labor supply.

7.2.2 Minimum wage efect

• A legally imposed wage foor (minimum wage) above the equilibrium wage
creates a gap between the quantity of labor supplied and demanded.
• Employers reduce hiring when faced with a higher mandated wage, while
more workers are willing to work at that wage, resulting in a surplus of
labor (unemployment).

7.2.3 Monopsony
• A monopsonistic employer faces an upward-sloping labor supply curve,
meaning that hiring additional workers requires raising wages for all em-
ployees.
• The marginal cost of labor exceeds the wage paid, leading the monopsonist
to hire fewer workers and pay a lower wage compared to a competitive
market.
• Introducing a moderate minimum wage can counteract monopsony power
by setting a wage that aligns with a competitive market.

7.2.4 Capital supply

• Capital is all the machines, land, and other physical inputs
• Price of capital is the interest rate. The interest rate functions as the cost
of borrowing and the reward for saving.
• Firms demand for capital depends on the expected return from investing
in productive assets relative to the interest rate.
• Households decide how much to save based on intertemporal prefer-
ences – tastes for consumption today vs. consumption in the future
• Wage rate is the price of forgoing productive work to take leisure, the
interest rate provides the price of forgoing productive savings to take con-
sumption.

28
 • Interest rate on savings operate in exactly the same way as changes in the
wage rate on labor.

7.2.5 TO KNOW – Conceptual Understanding

• A wage foor set above the market equilibrium reduces the quantity of
labor demanded and increases the quantity supplied, thus creating unem-
ployment

• A monopsonistic employer faces an upward-sloping labor supply curve,

so hiring additional workers requires raising wages for all, making the
marginal cost of labor exceed the wage

• Households allocate consumption across periods by weighing the benefts

of consuming now against consuming later, constrained by the interest
rate which determines the trade-of

29
7.3 Lecture 17: Making Choices Over Time
7.3.1 Present value
• Key insight for thinking about capital markets: a dollar tomorrow is worth
less than a dollar today.
• Money available today is more valuable than the same amount in the
future because it can be invested or used immediately.

• Comparing sums across time requires adjusting future amounts to their

present-day equivalent.

• The rule of making choices over time is to pick the option with the highest
present value.

7.3.2 Infation and real interest rate

• Infation erodes purchasing power over time, so nominal returns must be
adjusted to refect real gains in buying power.

• real interest rate = nominal interest rate − infation rate

• What matters to individuals is real interest rate when making decisions.

7.3.3 Investment decisions

• When making investment decisions, we invest if net present value > 0.
• Firms evaluate their decisions by weighing up front costs against expected
future payofs under present values.

• Consumers think about long-run gains when making decisions about whether
or not to incur expenses today.

7.3.4 TO KNOW – Conceptual Understanding

• A dollar today is worth more than a dollar tomorrow because it can be
used or invested immediately
• Rising prices reduce the purchasing power of money over time

• When evaluating future sums, individuals and frms think in terms of what
those dollars will actually buy, not just their face value

30
8 International Trade
8.1 Lecture 18: International Trade
8.1.1 What is international trade?
• The extent to which countries participate in international trade can be
described by two quantities: exports (or the value of the goods a country
sells to the rest of the world) and imports (or the value of the goods a
country buys from the rest of the world)

8.1.2 Production possibilities frontier

• Production possibilities frontier shows the maximum combination of
outputs that can be produced from a given set of inputs.

• An economy of scope: it is more efcient to produce goods jointly

than separately. Graphically, it is represented by a convex production
possibilities frontier.

8.1.3 Comparative advantage and gains from trade

• We say a country has a comparative advantage in the production of a
good when the opportunity cost of producing a particular good is lower
in any one country.

• Diferences in opportunity costs lead to comparative advantage in diferent

goods.

• Even when countries have an absolute advantage in producing a good,

there can be comparative be a comparative advantage.

• When countries have diferent comparative advantages in production of

diferent goods, there are potential gains from trade through specializa-
tion – each country produces what it has a comparative advantage in
producing.

• Comparative advantages can come from:

– Diferences in factor endowments (for example, Canada is a major

exporter of lumber & paper products since so much of that country
is forested — this gives them a comparative advantage in that area)
– Diferences in technology (for example, Japan is a major exporter
of autos despite no natural factor endowment advantage)

8.1.4 TO KNOW – Conceptual Understanding

• Distinguish between comparative advantage and absolute advantage

31
8.1.5 TO KNOW – Graphical and Math Understanding
• Given costs of production for two nations, determine, for each good, which
country has an absolute and/or comparative advantage
• In diagrams and math, show the welfare impact of imports and exports in
US markets

32
8.2 Lecture 19: International Trade: Welfare and Policy
8.2.1 Welfare impacts of international trade
• International trade produces efciency gains from specialization. Interna-
tional trade also unambiguously raises social welfare.
• In competitive model, opening to trade unambiguously increases total
welfare but usually at the expense of either consumers or producers

8.2.2 Trade policy

• Import tarifs are taxes levied only on imports.

• Some people oppose free trade because they believe free trade is not good
enough at compensating the losers, and that it could be socially damaging
routes to comparative advantage.

• The same set of principles about trade in goods applies also to the free
fow of workers – immigration.

8.2.3 TO KNOW – Conceptual Understanding

• Explain why international trade unambiguously raises social welfare

• Give arguments for and against free trade

8.2.4 TO KNOW – Graphical and Math Understanding

• Analyze the welfare impact of an import tarif

33
9 Uncertainty
9.1 Lecture 20: Uncertainty
9.1.1 Expected utility and expected value
• Expected value is equal to the probability of each outcome times the
value of that outcome.
– If a random variable X can take the values x1 , x2 , · · · , xk and each
value occurs with probability p1 , p2 , · · · , pk . Then the expected value
of X is
E[X] = x1 · p1 + x2 · p2 + · · · + xk · pk .

– A fair gamble means zero expected value.

• Expected utility is the probability weighted average of utility.

EU [X] = u(x1 ) · p1 + u(x2 ) · p2 + · · · + u(xk ) · pk .

– In a coin fipping game,

EU [X] = P r(lose)U (lose) + P r(win)U (win).

– Diferent than utility of expected value, since utility functions usually

concave (due to diminishing marginal utility of income). Diminishing
marginal utility of income means that the next dollar is worth less
to you than the last one was in terms of happiness you gain.

9.1.2 Risk preferences

• Risk averse: concave utility, diminishing marginal utility income
√
– For example, U (C) = C.

• Risk neutral: linear utility, constant marginal utility income, when an

agent only cares about expected value

– For example, U (C) = C.

• Risk loving: convex utility, increasing marginal utility income

– For example, U (C) = C 2 .

9.1.3 Applications
• Insurance

– Risk averse people will pay money to turn a gamble into a certain
payof since they get higher utility from certain income than from a
gamble with the same expected value.

34
 – Maximum amount they’re willing to pay for this is their risk pre-
mium. The risk premium rises as the size of the loss rises (holding
other variables constant). The risk premium falls as income rises
(because loss is closer to linear).
– Lottery behavior is a puzzle – maybe risk averse at low incomes and
risk loving at high incomes.

9.1.4 TO KNOW – Conceptual Understanding

• Explain why there is less risk aversion for small gambles

9.1.5 TO KNOW – Graphical and Math Understanding

• Given a utility function, be able to determine whether the agent is risk
neutral, risk averse, or risk loving

• Calculate the expected value and expected utility from a gamble, given a
utility function and a description of the gamble

• Calculate the risk premium for insurance, given a utility function and a
description of the relevant risks

35
9.2 Lecture 21: Asymmetric Information and Social In-
surance
9.2.1 Social insurance
• In the insurance market, there is information asymmetry. The purchasers
of insurance may know more about their insurable risks than the seller
(insurer) does.

• In this case, the insurer will be reluctant to sell insurance, since he will
be worried that only those with the insured-against problems will demand
insurance.

• Moral hazard is a central feature of insurance markets:

– If families buy fre insurance for their homes, they may be less likely
to keep fre extinguishers handy
– If people have health insurance, they may be less likely to take pre-
cautions against getting ill
– If workers have unemployment insurance, they may be less likely to
search hard for a new job
• Moral hazard is a problem because it

– lowers efciency by removing productive trades

– causes revenue raising

9.2.2 Social insurance in the U.S.

• These programs share the following features:

– Insure you against some adverse event: retirement, illness, injury, job
loss
– Financed by universal payroll taxes: all workers pay in as a function
of their earnings
– Key programs are
∗ Social Security insures against loss of earnings due to retirement,
disability, and longevity risk.
∗ Medicare provides health coverage to the elderly.
∗ Disability Insurance, Workers’ Compensation, and Unemploy-
ment Insurance each protect against specifc labor-market con-
tingencies.

36
9.2.3 TO KNOW – Conceptual Understanding
• Insurance markets face adverse selection: when individuals know their own
risk but insurers cannot, high-risk individuals disproportionately enroll,
driving up premiums and potentially collapsing the market

• Moral hazard arises once insured: protection against losses reduces pre-
cautionary efort, leading to overuse of benefts or riskier behavior that
imposes additional cost

• Government intervention (mandates, subsidies, or public provision) can

solve adverse selection by pooling risk across a broad population, but
must balance against increased moral hazard

37
10 Efciency and Equity
10.1 Lecture 22: Efciency and Equity
10.1.1 Choosing the socially optimal allocation
• Social welfare function (SWF) can be thought of as a utility function
for society taking individual utilities as inputs

SW F = f (U1 , U2 , · · ·)

• Isowelfare curve shows distributions of utility across which society is

indiferent

– Utilitarian SWF: SW F = U1 + U2 + · · ·
– Rawlsian SWF: SW F = min(U1 , U2 , · · ·)

10.1.2 Inequality in the US and around the world

• The rate of absolute deprivation matters, and we measure that by poverty
line.

10.1.3 Sources of Leakage

• Transfer programs lead to decrease in labor supply especially among those
who qualify or are originally near the cutof to receive the subsidy.

• Distortionary taxation leads to DWL–this is the cost of redistribution.

10.1.4 TO KNOW – Conceptual Understanding

• Explain what diferent social welfare functions imply about optimal allo-
cations

• Intuitively describe the efciency cost of redistribution

10.1.5 TO KNOW – Graphical and Math Understanding

• Show in a consumption-leisure graph how taxes on labor income could af-
fect labor supply; then in a labor market graph, show the DWL of putting
taxes on labor income

• Do simple calculations to determine welfare under diferent SWF

38
11 Taxation and Redistribution
11.1 Lecture 23: Taxation and Redistribution
11.1.1 Taxation in the U.S.
• Diferent types of taxes in the U.S. are:

– Income tax (progressive, main tax in the U.S.)

– Payroll tax ( fat)
– Consumption tax (regressive, paid on spending rather than earnings)
– Property tax (tax on wealth)
– Corporate tax (tax on businesses, small share of total tax revenue)

11.1.2 Taxation in the U.S.

• Importance of targeting assistance programs

• Earned Income Tax Credit (EITC) is a wage subsidy program that bal-
ances targeting and efciency

11.1.3 TO KNOW – Conceptual Understanding

• Identify whether a particular tax is progressive, fat, or regressive

39
11.2 Lecture 24: Externalities
11.2.1 Externality theory
• An externality occurs whenever the actions of one party make another
party worse or better of, yet the frst party neither bears the costs nor
receives the benefts of doing so.

• Negative externality: negative impacts on society which the individual

does not pay for. Must abide by two conditions:

– Costs on others, not self

– Costs that the individual doesn’t pay for
– For example: smoking, drinking
– Individuals tend to overconsume these as they do not bear all of the
costs
• Society wants individuals to internalize the externality – price of the good
includes the cost of the good to society.

11.2.2 Government solution

• Government has its regulation: if the government knows what the socially
optimal outcome is, the government can just impose it.

• Government can impose a corrective tax of the magnitude of this external-

ity. As a result, the tax efectively internalizes the externality and leads
to the socially optimal outcome.

11.2.3 TO KNOW – Conceptual Understanding

• Describe what externality is, describe examples and impacts of negative
externality
• Describe ways how government deals with externality

40
12 Behavioral Economics
12.1 Lecture 25: Behavioral Economics
12.1.1 Introduction of behavioral economics
• Key of behavioral economics is bringing psychological insights into our
models to enrich them.
• Time inconsistency or self-control model: individuals are unable to carry
out their optimal consumption plans.

• Exponential discounting:
T
X
U = u(C1 ) + u(Ci ) · δ i
i=2

• Hyperbolic discounting:
T
X
U = u(C1 ) + β u(Ci ) · δ i
i=2

• In response, policies include information, taxation, regulation, supply,

“nudges”.

12.1.2 TO KNOW – Conceptual Understanding

• Write out (1) exponential discounting model and (2) the hyperbolic dis-
counting model; contrast the models
• Explain what behavioral economics study and some important models

• Explain how corrective taxes can address time-inconsistency

41
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14.01 Principles of Microeconomics

Fall 2023

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