Tran Ly

Microeconomics Notes & Practices

Advent 2014
Chapter 1: Introduction
Microeconomics: Branch of economics that deals with behavior of individual economic units consumers,
firms, workers, and investors as well as the markets that these units comprise.
Describe how prices are determined through the government and interaction between consumers, worker,
and firms
Positive analysis: Describing relationships of cause and effect
Normative analysis: Examining questions of what ought to be
Market: collection of buyers and sellers that, through their actual or potential interactions, determine the
price of a product.
Arbitrage: practice of buying at a low price at one location and selling at a higher price in another
Perfectly competitive market: many buyers and sellers; no single agent has a significant impact on price
Nominal price: absolute price of a good; unadjusted for inflation
Real price: price of a good relative to an aggregate measure of price; price adjusted for inflation
CHAPTER 2: The Basis of Supply and Demand
1. Supply and Demand:
a. The Supply Curve: Relationship between the quantity of a good that producers are willing to sell and
the price of the good.
Law of supply: The higher the price, the more firms are able and willing to produce and sell.
Upward sloping curve
Variables that affect supply:
Price of the goods
Production costs (Land, Labor, Capital,
Wages, Interest charges, Raw materials)
Technology
Information (future expectation, price
increases => supply decreases)
When production cost decrease, output
increase => S shifts right

b. The Demand Curve: Relationship between the quantity of a good that consumers are willing to buy and
the price of the good.
Law of Demand: the lower the price, the more consumers will want to purchase a good.
Shifting the Demand Curve: Change in income:
Normal good: As Income increase, quantity demand for normal good increase, D shifts to the right.
Inferior good: As Income increase, quantity demand for inferior good decrease, D shifts to the left.
OR change in price of substitutes or complements:
1. Substitutes: two goods for which an increase in the price of one lead to an increase in the quantity
demanded of the other.
2. Complements: two goods for which an increase in the price of one leads to a decrease in the quantity
demanded of the other.
1

OR Taste & preference; Taxes and Subsidies; Information

2. The Market Mechanism:
a. Equilibrium: A situation in which each individual is doing his/her best given the decisions of
the other individuals
Equilibrium (or market clearing) price: Price that equates the quantity supplied to the quantity demanded.
Market mechanism: Tendency in a free market for price to change until the market clears.

Surplus: Situation in which

the quantity supplied exceeds
the quantity demanded
(Excess supply: pressure to
lower price)
Shortage: Situation in which
the quantity demanded
exceeds the quantity supplied
(Excess demand: pressure to
increase price)
Assumptions:
1. At any given price, a given quantity will be produced and sold.
2. Represents what goes on in a perfectly competitive market: Many sellers and buyers; No barrier of entry;
Homogenous products; Full information =>Firms and Consumers are price takers.
* No individual can influence the price with their actions.
3. Changes in market equilibrium:
(Graph Shift of supply and demand curves over time as market conditions change)

Example 2.1.a. Market for Eggs.

The supply curve for eggs shifted right as
production costs fell; the demand curve shifted
to the left as consumer preferences changed. As
a result, the real price of eggs fell sharply and
egg consumption rose.

Example 2.1.b. Market for College Education.

The supply curve for a college education shifted
right as the costs of equipment, maintenance,
and staffing rose. The demand curve shifted to
the right as a growing number of high school
graduates desired a college education. Both
price and enrollments rose sharply.

4. Elasticity of Supply and Demand:

Elasticity: Percentage change in one variable resulting from a 1-percent increase in another.
Price Elasticity of Demand: Percentage change in quantity demanded of a good resulting from a 1%
increase in its price.

The demand is price elastic when ED < -1 or |ED| > 1

The demand is price inelastic when ED > -1 or |ED| < 1
a. Linear Demand Curve: Demand curve that is a straight line: Q = a bP

EPD depends not only on the

slope of the demand curve but
also on the price and quantity.
The elasticity varies along the
curve as price and quantity
change. Slope is constant for
linear demand curve.
Near the top, price is high and
quantity is small => EP get

closed to
(More
elastic).
The
|elasticity|
becomes
smaller as we move down the

1. Infinitely Elastic Demand:

(a) For a horizontal demand curve, Q/ P
is infinite. A tiny change in price leads to an

enormous change in demand. Demand is

perfectly elastic: ED =
1. Completely Inelastic Demand:
3

(b) For a vertical demand curve, Q/ P is

0. Because the quantity demanded is the same

no matter what the price, the elasticity of

demand is zero: ED = 0
(c)

(d)
b. Other Demand Elasticities:
2. Income Elasticity of demand: Percentage change in the quantity demanded resulting from a 1-percent
increase in income.
(e)
(f)
EI > 0 => Normal good
(g)
EI < 0 => Inferior good
3. Cross-price Elasticity of demand: Percentage change in the quantity demanded of one good resulting from
a 1-percent increase in the price of another.

(h)
(i)

EPoD > 0: substitutes; EPoD < 0: complements

5. Short-run Vs. Long-run elasticities:

Demand:
4. Gasoline: Long-run is more elastic than
short-run

In the short run, an increase in price has only a

small effect on the quantity of gasoline
demanded. Motorists may drive less, but they
will not change the kinds of cars they are
driving over night.
In the long run, because they will shift to
smaller and more fuel-efficient cars, i.e.
electricity cars, the effect of the price increase

will be larger. Demand, therefore, is MORE

elastic in the long run than in the short run.
5. Automobiles => Durable Goods. Durability:
Long-run is LESS elastic than short-run.
If price increases, consumers initially defer
buying new cars, thus annual quantity
demanded falls sharply.
In the longer run, old cars wear out and must be
replaced; thus annual quantity demanded picks
4

up. Demand, therefore, is less elastic in the long

run than in the short run.

6.
7.
8.
9.
10. Income Elasticities:
For most goods and services foods, beverages, fuel, entertainment, etc. income elasticity of demand is
larger in the long run than in the short run.
For a DURABLE good, the short-run income elasticity of demand will be much larger than the long-run
elasticity.
Supply:
11. Supply and Durability: If the price increases, there is greater incentive to convert scrap copper into new
supply. Secondary supply (supply from scrap) increases sharply. Later, as the stock of scrap decreases,
secondary supply decreases. Long-run secondary supply is LESS elastic in the short run.
Supply and Demand:
S&D for Coffee: A freeze or drought in Brazil causes the supply curve to shift to the left.
12. Short-run:
1. In the short run,
supply is completely
inelastic; only a
fixed number of
coffee beans can be
harvested.
Demand is also relatively
inelastic; consumers change
their habits slowly.

As a result => the initial

effect = SHARP increase in
price.
13. Intermediate run:

14. Both supply and demand

are more elastic; price falls
part of the way back.
15.
16.

17.
18.
19.
20. Long-run:
21. Supply is extremely
elastic; because new coffee
trees will have had time to
mature, the effect of the
freeze/drought will have
disappeared. Price returns to
P0.

6. Understanding and Predicting the effects of changing market condition:

Demand: QD = a bP
Supply: QS = c + dP
Elasticity: Demand: ED = b(P*/Q*)
Supply: ES = d(P*/Q*)
a = Q* + bP*
Q = a bP + fI

7. Government Intervention Price controls:

Taxes and Subsidies
Quality controls: quotas, bans
Price controls:
1. Price ceiling: Maximum legal price for a good
or service
Non-biding => No effect and market stays the
same.
Price ceiling < Equilibrium price
a. => Biding, market price drop.

2. Price floor: Minimum legal price for a good or

service. E.g. minimum wage.
Non-binding, no effect on the market
Price floor > Equilibrium prick
b. => Binding market price goes up.
c. (Graph)

d.
3. Taxation (graph draw):
Specific tax: an absolute amount of tax: t
e.
PC = Price consumers pay
f.
PS = Price suppliers pay
Without tax specific: PC = PS
g.
With a specific tax: PC = PS + t; QD at Pc = QS at PS
h.
i.
t = wedge
j.
Burden of Taxation
k.
For consumers Pc P
l.
For suppliers: Ps - P
Ad valoren tax: %
Ps = (1 )PC
m.
n.

4. Subsidy (graph draw):

Specific subsidy: an absolute amount of subsidy: sub
o.
PC = Price consumers pay
p.
PS = Price suppliers pay
Without subsidy specific: PC = PS
q.
With a specific subsidy: PC + sub = PS; QD at Pc = QS at PS
r.
s.
Burden of Taxation
t.
For consumers Pc P
u.
For suppliers: Ps - P
Ad valoren subsidy: %
Pc(1 + ) = PS
v.
w. ***TAXATION AND PRICE ELASTICITY***
x. (2 graphs)
y.
z.
aa.
ab.
ac.
ad.
ae.
af.
7

ag.
ah.
ai.
aj. D1 elastic
ak. S1 inelastic
al. Suppliers face the largest burden of taxation
am.D2 inelastic

an. S2 elastic
ao. Consumers face the largest burden of
taxation

The burden of taxation is heavier on the more inelastic side.

ap. ***Incidence of an increase in a specific tax
Es
t
aq. Pc=
EsE D
ar.
If ED = 0; Demand is perfectly inelastic; Pc= t
as.
If ES = 0; Supply is perfectly inelastic; Pc=0
at. ***Price Elasticity of Demand and Sales:
au.
When demand is inelastic, increase P will increase sales.
av.
When demand is elastic, increase P will decrease sales.
aw. (Graph)
ax.
ay.
az.
ba.
bb.
bc.
bd.
be.
bf.
bg.
bh.
bi. Application: Illegal Drug Market
bj.

bk.
bl. CHAPTER 3: CONSUMER THEORY
bm.
3 aspects:
Consumers have rational preference
Individuals face budget constraints
Individuals make choices that yield the highest satisfaction/happiness utility
1. Consumer Preferences:

Preferences are expressed over 2

goods or services
Consumption set: combination of
the 2 goods that can be chosen in
the absence of any constraint.
Bundle: list with specific quantities
of one or more goods.

bn.

Basic Assumptions:
bo. Completeness: Any 2 bundles can always be compared
bp. Transitivity: Preferences are transitive. If a consumer prefer bundle A to bundle B and bundle B to bundle
C, then the consumer also prefers A to C.
bq. Monotonicity More is better: Increasing the quantity of at least one of the goods in a given bundle is
always preferred.
Indifference curves:

br.

Curve representing all combinations of

market baskets that provide a consumer
with the same level of satisfaction.
An indifference curve pass through a
bundle X is a set of bundles for which the
individual is indifferent with X.
Preference map: Set of indifferent curves.

bs. ***Shape of an indifference curve:

Downward sloping by monotonicity
2 indifferences dont cross
Marginal Rate of Substitution:
Maximum amount of Good 1 that a consumer is willing to give up in order to obtain one additional unit of
Good 2.
Law of diminishing MRS: As X1 increases along a given indifference curve, the absolute value of MRS
decreases.
Convexity: the decline in the MRS reflects a diminishing marginal rate of substitution. When the MRS
diminishes along an indifference curve, the curve is convex.
X1
MRS = Slope of indifference curve =
X2
bt. (Graph)
bu.
bv.
bw.
bx.
by.
bz.
ca.
10

cb.

Another way to interpret this assumption: Consider a bundle that is a mix of X and Y. Specifically lets mix
of X and of Y. The mixed bundle has 7 of X 1 and 7 of X2. The mixed bundle is preferred to X and Y. =>
Individual prefer mixes to extremes.
Perfect Substitutes and Perfect Complements:
1. Perfect substitutes: Two goods for which
the marginal rate of substitution of one for
the other is a constant.
2.
MRS = -1
3.
Law of diminishing MRS does not
apply

4. Perfect complements: Two goods for which

the MRS is zero or infinite, the indifference
curves are shaped as L-shaped right angles
5. (elaborate more on graph)
6.

7.
8.
9. Bad: Good for which LESS is preferred rather than more (Graph):
10.
11.
12.
13.
14.

Utility and Utility Functions:

15. Utility: numerical score representing the satisfaction that a consumer gets from a given market basket.
16. Utility function: Formula that assigns a level of utility to individual market baskets.
17. Bundle (X1, X2) => Utility U(X1, X2)
18. Consider 2 bundles: X with U(X1, X2) and Y with U(Y1, Y2).
19. X is preferred to Y if and only if U(X1, X2) > U(Y1, Y2)
Ordinal utility function: Generate the ranking of bundles in order of most to least preferred.
11

Convecting: the concept of utility with indifference curve. Along an indifference curve, utility remains
constant.
20. 2. Budget Constraints:
21.

Budget constraints: Constraints that

consumers face as a result of limited
incomes.
Budget line: All combinations of
goods for which the total amount of
money spent is equal to income.
Describe the combinations of goods
that can be purchased given the
consumers income and the prices of
the goods.
Spending = Income:

I = P1X1 + P2X2
Slope - Marginal Rate of
Transformation: MRT =

P 1
P2

22. 3.Consumer Choice:

Individuals are maximizing their utility subject to a budget constraint
The maximizing bundle must satisfy two conditions:
- Located on the budget line
- Give the consumer the most preferred combination of goods and services (highest U)
Satisfaction is maximized (given the budget constraint) at the point where MRS = MRT
(a) Marginal benefit: benefit from the consumption of one additional unit of a good => |MRS|
(b) Marginal cost: Cost of one additional unit of a good => |MRT|
(c) Satisfaction is maximized when MB = MC.
23. (Ex: Chapter 3, question 6 and Dr. Pierres graph)

12

24.
25.
26.
27.
28.
29.
30.
31.
32.
33.
34.
35.
36.

Objective: Individuals are maximizing their

utility subject to a budget constraint
I = 100; P1 = 5; P2 = 10
(1) How much income is spent?
More is better. Individuals spend all
their incomes. The optimal choice is
on the budget line
(2) Optimal choice is found where MRS =
MRT (tangency)

37. At A, |MRS| is larger than |MRT| (MRS is steeper than budget line)
38. Suppose |MRS| = 2 (willing to pay 2 units of good 2 for 1 more unit of good 1). MRT = -P 1/P2 = -, I
only have to give up unit of good 2 for 1 more unit of good 1. A is not optimal because I could
increase my utility by purchasing 1 more unit of good 1 => Move from A to C.
39. ***Corner Solution: Situation in which the MRS for one good in a chosen bundle is not equal to MRT.
When a corner solution arises, the consumer maximizes satisfaction by consuming only one of the two
goods.
40. (Graph + Chapter 3 Exercise 14)
41.
42.
43.
44.
45.
46.
47.
48. Principles for Maximization of Utility
(1) Optimal choice sits on the budget line
(2) MRS = MRT
49. |MRS| = benefit of consuming of one more unit of X
50. |MRT| = cost of consuming of one more unit of X = P1/P2

51. Marginal Utility

Marginal Utility of X1: Additional amount of utility generated from increasing X1 by 1 unit
Marginal Utility of X2: Additional amount of utility generated from increasing X2 by 1 unit
Overall, as consumption of good 1 increases, MU1 decreases. In general, MU1 and MU2 are both decreasing
Principle of diminishing returns
13

52.
53. Connecting MRS and MUs
54. Graph
55.

Law of diminishing MRS:

When |MRS| is high (at A), there are lots of X2
while few of X1. MU2 is small; MU1 is big.
When |MRS| is low (at B), there are lots of X1
while few of X2. MU1 is small; MU2 is big.

56.
57.

From A to B, utility increases as X1 increases;

utility decreases as X2

58.
59.
60.

MRS = MU1/MU2

61. Examples of Utility Function

(1) Perfect Substitutes:
62.
63.
64.
65.
66.
67.
68.
69.
70.
(2) Perfect Complements:
71.
72.
73.
74.
75.
76.
77.
78.
79.
80.
(3) Cobb-Douglass:
81.
82.
83.
84.

14

85. Chapter 4: Individual and Market Demand

1. Demand Curve:
Relationship between optimal choice X1 and P1 holding all else the same: that is I and P2 are held constant.

86.
87.
88. Example 1: Perfect complements
89.
90.
91.
92.
93.
94.
95.
96.
97.
98.
99.
100.
101.
102.
103.
15

104.
105.
Example 2: Perfect substitutes (Chapter 4 #2)
106.
107.
108.
109.
110.
111.
112.
113.
114.
115.
116.
117.
118.
119.
120.
121.
2. Income and Substitution Effect:
122.
A fall in price good 1 has two effects:
(1) Substitution effect: Consumers will tend to buy more of good 1, which has become cheaper and less of
good 2 that is now relatively more expensive.
(2) Income effect: Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing
power.
Normal good:

16

123.

Consumer is initially at A on
budget line RS.
When price of food falls,
consumer moves from A to B;
consumption of food increase
from F1 to F2.
Imaginary budget line RT
Substitution effect:
F1E
(move from A to D)
Changes the relative prices food
and clothing but keeps real
income constant.
Income effect: EF2
(move from D to B)
Keeps relative prices constant but
increases purchasing power.
Total effect:

124.
Change in food from A to D: Substitution effect X1D X1A > 0
125.
Change in food from D to B: Income effect X1B X1D > 0 (normal good)
126.
Change in food from A to B: Total effect: X1B X1A > 0
127.
Remarks:
128.
Substitution effect < 0 when price increases
129.
Substitution effect > 0 when price decreases
130.
If income effect < 0 when price increase (less income, less purchasing power): normal
good
131.
Inferior Good:

17

132.

The consumer is initially at A on the

budget line RS.
Price of food decrease, consumers
move to B.
Substitution effect: F1E
(move from A to D)
Income effect: F2E
(move from D to B)
In this case, food is an inferior good
because the income effect is
negative.
However, because substitution
effect > income effect, the decrease
in price leads to increase in quantity
demanded.

Giffen Good: Good whose demand curve slopes upward because the (negative) income effect is
larger than the substitution effect.

18

133.

When food is an inferior good,

and when the income effect is
large enough to dominate the
substitution effect, the demand
curve will be upward sloping.
The consumer is initially at A.
After price of food falls,
consumer moves to B to
consume less food.
Income effect EF2 >
Substitution effect F1E, the
decrease in price of food leads
to lower quantity demanded.

Exercise 1: Perfect complements X1 and X2

134.

135.

136.

137.

138.

139.

140.

141.

Exercise 2: Perfect substitutes X1 and X2

19

142.

Chapter 6: Production

(1) Production Decisions of a Firm:

143.
144.
145.
146.

Inputs
Raw materials,
land, labor,
physical capital

FIRM
(use technology)

Outputs

Typically, focus on 2 types of inputs: labor (L) and capital (K); focus on a single output q.

1. Production Technology: A practical way of describing how inputs can be transformed into outputs.
2. Cost Constraints: Firms must take into account the prices of labor, capital, and other inputs.
3. Input choices: Given its production technology and prices, the firm must choose how much of each input
to use in producing its output.
147. Production function: relationship between output q and input L, K: q = f (K, L)
148. Short-run vs. Long-run:
Short-run: fixed input, K is fixed: q = f (K fixed, L)
Long-run: all inputs are variable and adjustable
(1) Short-run:
q = f (K fixed, L)
Properties of the short-run production function: Marginal product of labor (MPL) Amount of output that is
produced from the addition of an extra unit of labor

20

Slope = MPL =

q
L

q
L
Law of diminishing marginal product:
MPL decreases eventually as L increases;
MPL usually increases as L increases for
low values of L.
Average product of labor: APL =

Law of diminishing marginal returns:

Principle that as the use of an input
increases with other inputs fixed, the
resulting additions to output will
149.

(2) Long-run: Both K and L are variables: q = f (K, L)

Isoquant: All combinations of L and K that allows to produce a specific level of output.
Assumption: more inputs => more outputs

21

Isoquant map: graph combining a

number of isoquants, used to
describe a production function.

150.

Input increases as move from q1 to

q2.
Slope of Isoquant = MRTS
(marginal rate of technical
substitution): Amount by which
the quantity of one input can be
reduced when one extra unit of
another input is used, so that output
remains constant.

151.

Example of Isoquants:

1. Perfect substitutes:
K & L are perfect substitutes in the production
process.
MRTS = -1; q = K + L

2. Fixed proportions (Perfect complements):

K & L are used in fixed proportion in the
production process; q = min (K, L)

22

3. Typical Isoquant: Cobb-Douglass production function:

Cobb-Douglass
q = ALaKb
a
MRTS =
b

K
L

A: technology; the larger A the

better firm is at transferring
inputs into outputs.
K
L
Along an isoquant q
MPL
MRTS =
MPK
MRTS =

(2) Returns to Scale:

Rate at which output increases as inputs are increased proportionately
(1) Increasing returns to scale: when all inputs double, q more than doubles.
(2) Constant returns to scale: when all inputs double, q doubles.
23

=0

(3) Decreasing returns to scale: when all inputs double, q less than doubles.
Chapter 7: Cost of Production
Economic Cost vs. Accounting Cost:
(1) Economic cost: Cost to a firm of utilizing economic resources in production
(2) Accounting cost: Actual expenses plus depreciation charges for capital equipment
Opportunity cost: value of the best forgone alternative
Sunk cost: expenditure that cant be recovered
Costs:
FC Fixed cost: cost that doesnt depend on the level of output q
VC Variable cost: cost that increases a q increases
TC Total cost = FC + VC
MC Marginal cost: cost to produce an additional unit of the output q
FC
AFC =
q
VC
AVC =
q
TC
ATC =
q
Economically efficient: When a firm minimizes its cost of production
Technologically efficient: When a firm cant produce a given level of output using fewer inputs

Short-run Cost:
Short-run cost minimization: what is the least costly way to produce a given level of output q?
In the short run, economically efficient and technology efficient are equivalent.

24

MC crosses ATC at
minimum value of
ATC
MC crosses AVC
at minimum value
of AVC

Cost in the Long Run:

The isocost line: graph showing all possible combinations of labor and capital that can be purchased for a
given total cost.

C = wL + rK
In the typical case, to be economically
efficient in the long run means:
The input choice is technologically
efficient *on the isoquant
Slope of isocost = Slope of
w
isoquant or MRTS =
r
B is not economically efficient
w
because MRTS
r
Suppose |MRTS| = 2, 1 unit of L can
replace 2 units of K to produce q.
Slope of isocost = 1, 1 unit of L cost
only 1unit K.
25

Cobb-Douglass: q = K1/2Q1/2; a = ; b =
Suppose w = 10, r = 20
Slope of isocost line = -1/2
A is economically efficient:
a
K
At A, MRTS = -1/2 =
b
L

Substitute into production function: q = K1/2Q1/2

K = L
Now, suppose w increases to w = 20
Slope of new isocost line = -1
B is economically efficient
K=L

20 2 q
Slope of cost function = Marginal cost
MC = 20 2
ATC = 20 2

L=
K=

2 q
q
2

So C(q) = wL + rK = 10

2q + 20

q
; C(q) =
2

Constant return of scale whenever a + b = 1

Cost Function for Perfect Substitutes (MRTS is not diminishing):
- w > r: only employ K; L = 0; K = q; C(q) = rK = rq
- w < r: only employ L; L = q; K = 0; C(q) = wL = wK
- w = r: All technological efficient choices are economically efficient; any L and K as long as q = L + K
C(q) = wL + rK = wq or rq
Economies and Diseconomies of Scale
Economies of scale: situation in which output can be doubled for less than a doubling of cost
Diseconomies of scale: situation in which a doubling of output requires more than doubling of cost
No economies of scale: constant LRAC because of constant return to scale
Relationship between Short-Run and Long-Run Cost

26

LR cost is always lower than SR cost

The LAC is the
envelope of the SRAC
SAC1, SAC2, and SAC3.
With economies and
diseconomies of scale,
the minimum points of
the SRAC do not lie on
the LAC.

Chapter 8: Profit Maximization and Competitive Supply

Perfect Competition:
A competitive firm is a price-taker: cant influence the price; Product
homogeneity; Free entry (or exit)
A firm faces a perfectly elastic demand curve at the market price: P = MR

27

Profit: (q) =
Revenue Cost
Rule of profit
maximization:
MR = MC
A perfectly
competitive firm
maximizes profit
when P = MC

Short-run Profit Maximization by a Competitive Firm:

In the SR, competitive
firm maximizes profit by
choosing output q* where
MC = P (or MR).
The profit is rectangle
ABCD.
Any change in output will
lead to lower profit.
Here, economic profit > 0
because P > SRAC at q*.

In the SR, assume that FC is sunk.

Firm choose q* where P = SRMC
If the firm stays open, it produces q*
If the firm shuts down, it still has to pay the fixed cost, but produce q = 0.
Firm stays open in the short run as long as P AVC.
The Short-Run Supply Curve for Competitive Firm
28

Supply of a competitive firm

describes the relationship
between price and profitmaximizing output.
In the SR, firm chooses its
output so that P = MC as long as
P AVC.
The short-run supply curve is
above AVC where MR crosses
AVC.

Market supply is MORE ELASTIC than individual firm supply (flatter).

Market Supply Curve in Short-Run
Market supply is more
elastic than individual
firm supply (flatter)

29

Short-Run Equilibrium
A price P* so that QD = QS at P*
The number of firms is fixed to n
Q* = nq*
SR:
Find a supply curve
Find a market supply curve
Find the equilibrium

Example: QD = 100 P; FC = 100, MC = 2q, C = 100 + q2; n = 4

VC = C FC = (q2 + 100) 100 = q2
q2
AVC =
=q
q
MC is always > AVC (2q > q) => P shut-down = 0
MC is the supply curve: S curve: P = 2q
P = MC = 2q => q = P
Market Supply Curve:
QS = n(P/2) = 4(P/2) = 2P
Equilibrium:
QS = QD
2P = 100 P
P* = 100/3; Q* = 200/3

30

Long-Run Profit Maximization

If the firm stays in
business, it produces at q2
where P = LRMC
Firm wants to exit the
industry when P = LRAC

Long-Run Equilibrium

Equilibrium: A price P* so that Q D = QS at P*. Firms can freely enter and exit the industry. At P 1 = $40, profit >
0 => entry the market (number of firms n increases). Short-run supply curve shifts to the right => Decrease
market price to P2 = $30. At P2, profit = 0.
Example:
MC = 2q
C(q) = 100 + q2 => ATC = 100/q + q
P = 100 Q => Q = 100 P

In Long-Run Equilibrium: profit = 0 so P = ATC

Profit maximization: P = MC
MC = ATC: 2q* = 100/q* + q*
q* = 100/q*
q* = 10
P* = MC at q* => P* = 2q* = 2(10) = 20
31

Q* = 100 P* = 100 20 = 80
n* = Q*/q* = 80/10 = 8 firms
MODEL FOR LONG-RUN EQUILIBRIUM (analysis from Professor St. Pierre & example from Midterm 2)

In (b), the long-run supply curve in a constant-cost industry is a horizontal line (S L). When demand increases,
initially causing a price rise (move from A to C), the firm initially increases its output from q 1 to q2, shown in (a)
=> Profit > 0. This leads to entry of new firms, causing a shift to the right in industry supply. Because input
prices are unaffected by the increased output of the industry, entry occurs until the original price is obtained (at
point B in (b)).
Analysis:
Initial equilibrium: q1, Q1, P1, n1

Demand curve shifts right to D2

New Short-run equilibrium: q2, Q1* (between Q1 and Q2), P2, n1

New Long-Run equilibrium:

Because P2 > AC at q2, number of firms n1 increases to n2.

SR supply shifts right to S2.
New LR equilibrium: P1 (original price), Q2, q1, n2
Long-Run Market Supply
The LR Market supply is perfectly elastic for constant cost industries => The minimum ATC is independent
of the scale of the industry (Q).
The LR Market supply is upward sloping for increasing cost industries (ATC increases as Q increases).
The LR Market supply is downward sloping for decreasing cost industries (ATC decreases as Q decreases).

32

Chapter 9: The Analysis of Competitive Market

Consumer Surplus: sum of
differences between willingness to
pay & prices for all units consumed.
Producer Surplus: sum of
differences between price and MC
for all units supplied.
Total Surplus: TS = CS + PS
Efficient output: when TS is maximized
(allocate efficiency)

Why deviation from competitive output creates loss of welfare? At perfectly competitive market output Qo:
P* = MC (Supply curve). Willingness to pay for last unit purchased equals to marginal cost of last unit sold.
That is when total surplus is maximized. It is exactly what happens in competitive market: Consumers purchase
the good up until willingness to pay = P*; Suppliers produce the last unit when P* = MC. Price P is what
ensures MC = willingness to pay for the last unit purchased.
Deviation from competitive output Example: Incidence of a tax:
Pb is the price (including tax) paid by buyers,
Ps is the price that sellers receive, less the
tax: Pb Ps = t
Consumer surplus loses A + B
Producer surplus loses D + C
The government earns A + D in
revenue
Deadweight loss is B + C

Subsidy Case (graph + welfare analysis)

Ps Pb = s (subsidy)

Demand is often more price elastic in the

long run than in the short run because it
takes time for people to change their
consumption habits and/or because the
demand for a good might be linked to the
stock of another good that changes
slowly.
33

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.
PMC 1
=
Market power measure: Markup over marginal cost as a percentage of price
P
Ed
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
MC
1
Compute Price: P =
1+( )
Ed

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%?
MC
1
Since P =
: P = MC / (1 ) = MC/0.5 = 2MC = 2($20) = $40
1+( )
Ed
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:
34

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.
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
same.
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).

35

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
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
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
OR A DIFFERENT WAY TO SOLVE THIS USING MR = MC + t
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:
(a) The elasticity of market demand
(b) Number of firms in the market
(c) Interaction among firms
2. Social Costs of Monopoly Power:

36

When moving from a competitive price and

output (Pc and Qc) to a monopoly price and
quantity (Pm and Qm):
a. Consumer lose A + B
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
activities.
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.

37

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:

a. Elasticity of market supply
b. Number of buyers
c. Interaction among buyers
4. Social Costs of Monopsony Power:
MONOPOLY vs. MONOPSONY
When moving from a competitive price and
output (Pc and Qc) to a monopsony price
and quantity (Pm and Qm):
c. Increase in consumer surplus A B
d. Producer surplus falls by A + C
e. DWL = B + C

a. Monopoly:
b. Produce where MR = MC
c. AR (Demand) > MR so P > MC
d. Monopsony:
e. Produce where ME = MV
f. AE (Supply) < ME so P < MV
38

A
H
B
F
G
E

C
D

g. Chapter 18: Negative Externality and Public Goods

a. 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
h. 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
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.
s.
t.
u.
v.
w.
x.
y. Welfare Analysis
z.
aa. Equilibrium Output: Q1
ab. Efficient Output: Q*
ac. CS
ad. A + B + F + G
ae. A
af. PS
ag. C + D + E
ah. B + C + D + F
ai. Externality Cost
ak. D + E + F + G + H
al. F + D
aj. (between MSC
and MC)
am.TS
an. A + B + C - H
ao. A + B + C
ap. 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.
b. 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) @
MSB = MC.

aq.
ar.
as.
c. Ways of correcting Market Failure:
Targeting the emission:
a. Tax emissions
b. Regulate emissions (standards)
Target the market for paper: Tax the market for paper
The optimal tax is set to the value of MEC (NOT marginal private cost) at Qefficient
at.
au. Exercise #6
av. QD = 160,000 2000P => P = 80 0.0005QD
aw. QS = 40,000 + 2000P => P = (QS 40,000)/2,000 = 0.0005QS 20
ax. MEC = 0.0006QS
- Produced under competitive conditions:
ay.
Equilibrium price: QD = QS => 160,000 2000P = 40,000 + 2000P
az. P = $30
ba. Q = 100,000
- Socially efficient price and output:
bb. MSC = MEC + MC = 0.0006QS + 0.0005QS 20 = 0.00011QS 20
bc. Set this equal to Demand: 0.00011Q 20 = 80 0.0005Q
bd. Q = 62,500
be. P = $48,75
- The optimal tax is set to the value of MEC at Qoptimal
bf. t = MEC at Q = 62,500
bg. t = 0.0006(62,500) = $37.5
bh. Pc = 80 0.0005(62500) = $48.75
bi. Ps = 0.0005(62500) 20 = $11.25
bj. (Difference of t = $37.5)
bk. The market should face the real cost: P represents MSC. To obtain efficiency, the price needs to reflect
MSC.
bl.
Exercise #7
bm.
Demand: P = 100 Q
bn. MC = 10 + Q
bo. MEC = Q
Competitive conditions:
bp. Set P = MC (supply curve):
bq. 100 Q = 10 + Q
br. Q = 45
bs. P = $55

 Socially efficient price and output:

bt. MSC = MEC + MC = 10 + 2Q
bu. Set this equals to Demand: 100 Q = 10 + 2Q
bv. Q = 30
bw.P = $70
The optimal tax is set to the value of MC at Q optimal:
bx. t = MEC = Q = 30
by. Pc = 100 30 = $70
bz. Ps = 10 + Q = $40
Monopolistic conditions:
ca. MR = 100 2Q (double the slope of Demand curve)
cb. Profit maximization: MR = MC => 100 2Q = 10 + Q
cc. Q = 30
cd. P = $70
ce. This coincides with the socially efficient level.
Tax for monopoly would be 0 because the monopolist is already producing at the socially efficient output
in this case.
cf. SolutionstoSecondhandSmoke:
a. Abillisproposedthatwouldlowertarandnicotinelevelsinallcigarettes.
cg. Somesmokersmightactuallysmokemoreinanefforttomaintainaconstantlevelofconsumptionof
nicotine,althoughthetotalamountoftarandnicotinereleasedintotheairwouldprobablybereduced.
Thesmokerisworseoffbecauseheorshewillspendmoreoncigarettesandconsumelesstarand
nicotine.Nonsmokerswouldbebetteroffbecauselesstarandnicotinewouldbeintheair.Itisdifficult
toknowwhethersocietyasawholewouldbebetterorworseoff.
b. Ataxisleviedoneachpackofcigarettes.
ch. Producerswillpaysomeofthetaxandconsumers(i.e.,smokers)willalsopayaportion.Thustheprice
ofcigaretteswillincrease,andsmokerswillsmokefewercigarettes.Theextentoftheeffectofthetax
dependsontheelasticityofdemandforcigarettes.Nonsmokerswouldbebetteroffbecausethereisless
smokingbutsmokersareworseoff,soitisunclearwhethersocietyasawholebenefits.Also,some
smokersmightsubstitutecigarsorpipesforcigarettes,whichmightactuallybeworsefornonsmokers.
c. Ataxisleviedoneachpackofcigarettessold.
ci. Itdoesnotmatteruponwhomthetaxislevied,itwillbesharedbetweenconsumersandproducersin
exactlythesameproportionsasinpartb,sotheeffectswillbethesameasinpartb.
cj. d.Smokerswouldberequiredtocarrygovernmentissuedsmokingpermitsatalltimes.
ck. Smokingpermitseffectivelytransferpropertyrightstocleanairfromsmokerstononsmokers.Amajor
issuewiththisprogramwouldbethehighcostofenforcingthepermits.Thepriceofthepermitwould
inducesomesmokerstoquitsmoking,butitwouldnotraisethemarginalcostofsmoking.Therefore
smokerswhoboughtpermitswouldcontinuetosmokeaboutthesameamount.Again,smokerswould
beworseoffandnonsmokersbetteroff,soitisunclearwhethersocietybenefitsasawhole.

d. Public Goods:
Public good: Nonexclusive and non-rival good:
1. Non-rival: when the marginal cost of providing the good to an additional consumer is 0.
cl. Ex: Highway without congestion, TV signal => can be exclusive
2. Non-exclusive: when people cant be excluded from consuming a good
cm.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
Anexternalityoccurswhenanactionbyaconsumerorproduceraffectsotherconsumersand/orproducers,
butisnotaccountedforinthemarketprice.Sinceusersbenefitfromtheinformationtheygleanfrom
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
plagiarizewhenwritingresearchpapers.Thisimposesacostoninstructorswhomustcheckstudentwork
forsuchbehavior.
cn. Example: Three stores Demand for security:
co.
Store 1: P = 80 10Q
cp.
Store 2: P = 40 5Q
cq.
Store 3: P = 40 5Q
cr.
MC = $60/hour (Constant => horizontal MC curve)
a. Market outcome (equilibrium):
cs.
80 10Q = 60
ct.
Q=2
b. Efficient provision of security: Add all willingness to pay:
cu. P = 160 2Q = 60
cv. Q = 5
cw. Exercise #10: Three groups in a community:
cx.
Demand curves for public TV in hours of programing T are:
cy.
W1 = $200 T
cz.
W2 = $240 2T
da.
W3 = $320 2T
db.
MC = $200/hour
(a) Efficient number of hours of public TV:
dc. Add all willingness to pay: W = $760 5T
dd. Set this equal to MC = $200
de. T = 112 hours
(b) How much public TV Would a competitive private market provide:
df. Assume TV is not a public good, and it costs $200 to produce each hour for each group.
dg. Group 1: W1 = 200 T = 200 => T = 0
dh. Group 2: W2 = 240 2T = 200 => T = 20
di. Group 3: W3 = 320 2T = 200 => T = 60
dj. Total number of hours demanded are 80 hours.
dk.
dl. Chapter 16: General Equilibrium and Economic Efficiency
a. 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.
dm. Example 1: Good 1 and Good 2 are substitutes
dn. QD1 = 10 2P1 + P2
do. QD2 = 10 2P2 + P1
dp. QS1 = 5

dq. QS2 = 5
a. Partial Equilibrium: Analysis of market for good 1: Suppose P1 = P2 = $5
dr. Q1 = 5; P1 = $5
ds. Suppose QS1 increase to 10
dt. QD1 = 10 2P1 + 5 = 15 2P1 = 10
du. P1 = $2.5
b. General Equilibrium Analysis:
dv. Initial equilibrium: P1 = 5; Q1 = 5; P2 = 5; Q2 = 5
dw.Suppose QS1 increase to 10
dx. Final equilibrium:
dy. 10 2P1 + P2 = 10
dz. 10 2P2 + P1 = 5
ea. P1 = 5/3
eb. P2 = 10/3
ec.
ed. Exercise #1: Gold and Silver are subtitutes
ee. Pg = 975 Qg + 0.5Ps; Qg = 75
ef. Ps = 600 Qs + 0.5Pg; Qs = 300
a. Equilibrium prices:
eg. Pg = 975 75 + 0.5Ps = 900 + 0.5Ps
eh. Ps = 600 300 + 0.5Pg = 300 + 0.5Pg
ei. Ps = 300 + 0.5(900 + 0.5Ps) = 750 + 0.25Ps => 0.75Ps = 750; Ps = $1,000
ej. Similarly, Pg = $1400
b. Qg = 150:
ek. Plug in new numbers:
el. Pg = $1300
em.Ps = $950
en.
b. 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

eo. Starting at A, any trade that moved the allocation outside the shaded area would make the consumers
worse off.
ep. At B, the trade is mutually beneficial, but not yet efficient (because UJ and UK did not intersect)
eq. Even if a trade from an inefficient allocation makes both people better off, the new allocation is NOT
necessarily efficient.
er. At C, the two indifference curves intersect => MRS of two people are identical => Pareto efficient.
es. 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).
et.
eu. Pareto Efficient allocations are not all equally desirable from a social point of view. Society also cares
about equity (whether the allocation is fair).

ev.
c. 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

ew.
ex. A is initial allocation.
ey. Price line PP represents the ratio of prices
ez. Competitive market will lead to an equilibrium at C, the point of tangency of both indifference curves
and the price line.
fa. Example:
fb. Jens MRS of orange juice for coffee is 1 (willing to trade 1 coffee for 1 orange juice)
fc. Drews MRS of orange juice for coffee is 3 (willing to trade 3 coffee for 1 orange juice)
fd. Porange = $2; Pcoffee = $3 => possible to trade 2/3 coffee for 1 orange juice
fe. 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 increase.
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.
ff. MRSA = MRSB = MRT = P1/P2
d. Equity and Efficiency:
The Utility Possibilities Frontier: Curve showing all efficient allocations of resources measured in terms of
the utility levels of two individuals
(1) Any point on the frontier are Pareto
efficient
(2) Any point below the frontier are
inefficient
(3) From H to F: James gains utility while
Karen doesnt lose anything
(4) From H to E: Karen gains utility while
James doesnt lose anything
(5) L is not attainable (not enough of both
goods)
fg.

e. Social Welfare Functions:

Measure describing the well-being of society as a whole in terms of the utilities of individual members
fh. FIRST WELFARE THEOREM:
fi. Every competitive equilibrium allocation is Pareto efficient
fj. SECOND WELFARE THEOREM:
fk. 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.
f. Efficiency in Production:
Results about efficiency also extend to economies where production is possible
fl. 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

fm.
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

fn.

c. Exchange efficiency:
The outputs are traded until MRSs are equalized for everyone: MRS = Px/Py
g. Market Failure: When the market equilibrium is not Pareto efficient:
Market power (Monopoly, monopsony)

fo. Missing market:

Incomplete information
Externality
Public goods
fp.
fq.
fr.
fs.
ft.
fu.
fv.
fw.
fx.
fy.
fz.
ga.
gb. PRACTICE MIDTERM EXAM 3
gc. Question 1:
The First Welfare Theorem: Every competitive equilibrium is Pareto efficient.
The endowment: A: C =2 W =1; B C = 3 W = 2; MRS = -W/C
gd. Point e is not Pareto efficient because MRSA is not equal to MRSB

ge.
The allocation that is the competitive equilibrium is:
Consume all the goods in the endowment (not 1)
MRSA = MRSB (not 2)
3 => Point W
gf. At W, MRSA = MRSB = -3/5 (= Price ratio). Price ratio is Pc/Pw = 3/5
gg. Question 2:
gh. Q = 50,000 P => P = 50,000 - Q
gi. MC = $1000/oz
gj. MEC = 1,000 + Q
(1) Competitive equilibrium quantity and price:
gk. Set P = MC
gl. 50,000 Q = 1,000
gm.
Q = 49,000oz
gn. P = $1,000
(2) Efficient production level:
go. MSC = MC + MEC = 2000 + Q

gp. 50,000 Q = 2000 + Q

gq. Q* = 24,000oz
gr. P* = $26,000
(3) Dead Weight Loss: between MSC and MC, between two quantities:
gs. (49,000 24,000)(51,000 1,000)/2 = 25,0002
(4) Specific tax on gold:
gt. t = MEC = 1000 + Q* = 1000 + 24,000 = $25,000 per oz
gu. Pc = $26,000
gv. Ps = $1,000

gw.
gx. Question 3:
1. 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
2. Competitive markets fail to provide the efficient quantity of a public good:
gy. 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.
gz.
ha. 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 market.
hb. General equilibrium: Looking at simultaneous equilibrium in all relevant markets, taking feedbacks
effects into account.

hc. 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).
hd.
he. Edgeworth Box Special Cases:
hf.
hg. Case 1: A has perfect complement utility, B has convex preference (convex indifference curve):

hh.
hi. Case 2: Both have perfect substitutes preferences (but with difference MRS)
hj.

hk.
zxzzxxz
hl. 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).
hm.

hn. Final

Examination: 6 questions
ho. Demand/supply with government intervention.
hp. Income/substitution effect.
hq. Analysis of competitive markets in both short-run and longrun.
hr. Monopoly power.
hs. Externality.
ht. Relating to efficiency concepts...
hu.

hv. Useful Assignments:

hw.Midterm 2: Long-run and Short-run equilibrium
hx. Question 2: LRMC = q, Supply curve: P = 10
a. QD = 100 P
hy. P = 100 Q = 10 => Q* = 90
hz. P = LRMC => q* = 10
ia. n* = 9 firms
ib. P = 10
b. Increase in government spending: QD = 300 P
ic. QD = 100 P
id. P = LRMC = q => P = q
ie. In the short-run, number of firms remain fixed; n* = 9
Market supply curve: QS = n*(P) = 9P
if. SR equilibrium: 300 P = 9P => P** = 30
ig.Q** = 300 30 = 270
ih.q** = 270/9 = 30
c. New long-run equilibrium:
ii. In the long-run, since profit > 0, there are more firms entering the market.
ij. QD = 300 P = 300 10 = 290
ik. q*** goes back to q* = 10
il. P = 10
im. n* = Q/q = 29 firms
d. If the increase in government spending was temporary, then new long-run equilibrium would go
back to old long-run equilibrium in part a.
in. Practice Final Exam
io. Question 1:
a. Externality:
Action by some producers or consumers that affect other producers or consumers, but are not accounted for
in their market price.
Positive externality: Education, Research and Development
Negative externality: Smoking in public, pollution from paper mills
b. Market for paper:
ip. QD = 160,000 2000P => P = 80 0.0005QD
iq. QS = 40,000 + 2000P => P = 0.0005QS 20
MEC = 0.0006QS
ir.
is. Unregulated equilibrium price:
it. QD = QS => 160,000 2000P = 40,000 + 2000P
iu. P = $30
iv. Q = 100,000
iw. Graph:

ix.
c. Efficient output level:

iy. MSC = MC + MEC = 0.0005QS 20 + 0.0006QS+ = 0.0011QS 20

iz. Efficient output level: 80 0.0005Q = 0.0011Q 20
ja. Q* = 62500
jb. P* = $48.75
d. Part b and part c have different results because there is external marginal cost that the equilibrium
price and output did not take into account. The market for paper produces negative externality
(polluting the environment), but the external cost was not included in the private cost. Thus marginal
cost is underestimated, and firm produces too much output compared to efficient output level. There
is a deadweight loss in equilibrium.
jc. Deadweight loss: Compute based on the graph = 1125000
e. Tax should be set equal to MEC at Q* to maximize welfare:
jd. t = 0.0006(Q*) = 0.0006(62500) = $37.5
je.
jf. Question 2:
(1) q = 10K1/2L1/2; r = 50, w = 18; L = 9, K = 25 for an output of q = 150:
jg. q = 10(25)1/2(9)1/2 = 150 => technologically efficient
jh. MRTS = -25/9 = -2.78; -w/r = -18/25 => not economically efficient
(2) q = 2K + L; r = 40, w = 25; L = 50, K = 5 for an output of q = 60:
ji. q = 2(5) + 50 = 60 => technologically efficient
jj. MRTS = -1/2 (draw graph); -w/r = -25
/40 is not equal to -1/2 => not economically efficient
(3) q = 10K; r = 50, w = 5; K = 5, L = 0, output of q = 50: both technologically and economically efficient
jk. Question 3: x1 is a Giffen good. An increase in price of good 1 will leads to an increase in consumption
of good 1. X2 is a normal good because one cant consume all inferior goods (violate the more the better).

jl.
jm.
jn. Question 4: QD = 100 0.05P; QS = 19.95P
a. Equilibrium:
jo.
QD = QS => 100 0.05P = 19.95P
jp.
P = $5
jq.
Q = 99.75 (thousands units)
jr.
ED = -0.05(5/99.75) = about 0
js.
ES = 19.95(5/99.75) = 1
jt.
Demand is almost perfectly
inelastic
ju.
Supply is unit elastic.
jv.
It makes sense because this is the
market for cigarettes. We would expect
demand to be very inelastic (addiction).
b. t = 1:
Pc = (Es)/(Es Ed) = 1/1 = 1
jw.
jx. Consumer will approximately bear the entire burden of the tax. Thus Pc = 6; Ps = 5

jy.
Pc = Ps + t = Ps + 1
jz.
100 0.05Pc = 19.95Ps = 19.95(Pc 1)
ka.
100 0.05Pc = 19.95Pc 19.95
kb.
Pc = $5.9975 = approximately $6
kc.
Ps = approximately $5
c. The assumptions were correct or not:
(i)
Tax will generate additional government revenue: yes
(ii)
Tax will reduce smoking in the population: maybe not, depend on the long run and short
run. It is hard to give up smoking in the short run.
(iii)
Free up income for individuals: incorrect. Almost the entire burden of tax falls on
consumers (because of their perfectly inelastic demand for cigarettes. Producers pays
barely any tax, so they will keep producing!).
kd.
ke. Question 5:
a. Monopoly is a market failure because firm has market power to manipulate price. Firms can set
price above marginal cost (does not reflect the true cost of production), and produce too little
compared to competitive equilibrium output. Monopoly violates the output efficiency, thus is a
market failure. Graph (Show MC, MSC, Demand curve and DWL).
b. Yes. Monopoly can spend as much as their entire profit on rent seeking to acquire, remain, or
exercise their market power. Rent seeking makes monopoly even more inefficient. The loss of
welfare could correspond to DWL and profit in the worse case scenario.
kf. Question 6: Bad weather => increase in the price of staple foods.

kg.
a. Long-run equilibrium for a perfectly competitive market firm:
kh.
Initially, firm produces q1 at price P1, market produces Q1, and there is fixed number of
firms n1.
ki.
b. Bad weather affect equilibrium in the short-run:
kj.
Bad weathers increase cost and reduce output of firms. MC and AC both shifts up. This
leads to a shift to the left of Market Supply curve.
kk.
Short-run new equilibrium: output produced by firms decreases to q 2, market output
decreases to Q2, Price increases to P2 (due to decrease in quantity supplied), and there are still n 1
firms.
c. Bad weather repeats itself. At q2, profit is negative because price increase is less than the cost
increases. Thus firms exit => number of firms decrease to n 2. Market supply shifts left to S3, thus
push price even higher to P3. The remaining firms break even again and produces at q3 = q1.
kl.
Note: the entire increase in cost is reflected in the overall price increase (P3 P1).

km.
Practice Midterm 1 - Question 3:
kn. Cobb-Douglass with a = 1, b = 2
ko. I = $12
kp. P1 = $0.5; P2 = $1
a. Optimal choice: Spending = Income
kq.
Thus, I = P1X1 + P2X2
kr.0.5X1 + X2 = 12
ks.
MRS = (-a/b)(X2/X1) = -1/2 (X2/X1)
kt. MRT = MRS
-P1/P2 = -1/2(X2/X1)
ku.
-1/2 = -1/2 (X2/X1) => X1 = X2
kv.
Substitute into function => optimal choice: (8, 8)
b. New optimal choice => do everything again!
c. Effect of new information: Want to consume more chickens over soda. The preference changes shift
demand for chicken to the right and demand for soda to the left.
kw.Exercises Chapter 2:
kx. #6. Long-run elasticities differ from short-run elasticities.
ky. For durable goods, long-run demand for goods is more inelastic than short-run (example: TV, cars)
kz. For most other goods (food, services, beverages), long-run demand for goods is more elastic than in
short-run.
la.
lb. #7.
a. Elasticity of demand is NOT the same as the slope of the demand curve. It also depends on the prices of
the goods. Elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in the price of the product.
b. The cross-price elasticity is positive for substitutes and negative for complements.
c. Supply of apartments is more inelastic than in the short run. In the short run, it is difficult to change
supply of apartments in response to a change in price. In the long run, more apartments can be built if
price increases.
lc.
ld. #9. Price ceiling might not benefit all students. For those students who get an apartment, students may
find this benefit. However, students who cant find an apartment, the cost of finding one will increases.
The rent for other places might also increase (live outside of the college town). Impose subsidy or price
ceiling with lead to excess demand and shortage of supply => higher price of alternative
products/options.
le.
lf. #7. ED = -0.4; ES = 0.5
a. QD = a bP
lg.
QS = c + dP
lh.
P* = $5
li.
-b(P/Q) = -b(5/15.75)= -0.4
lj.
b = 1.26
lk.
a = 15.75 + (1.26)(5) = 22.05
ll.
QD = 22.05 1.26P
lm.
Similarly, QS = 7.875 + 1.575P
b. Change in price: P = 5 2 = 3; Q = 15.75 23.5 = -7.75
ln.
Average price: (5 + 2)/2 = 3.50
lo.
Average quantity: (23.5+15.75)/2 = 19.625
P Q
lp.
ED =
= -0.46
Q P
lq.
lr.

ls.
lt. Chapter 3:
lu.
lv. #6.
lw.
The MRS describes the rate at which the consumer is willing to trade off one good for another to
maintain the same level of satisfaction. The ratio of prices describes the trade-off that the consumeris
able to make between the same two goods in the market. The tangency of the indifference curve with the
budget line represents the point at which the trade-offs are equal and consumer satisfactionis maximized.
If the MRS between two goods is not equal to the ratio of prices, then the consumer could trade one good
for another at market prices to obtain higher levels of satisfaction. For example, if the slope of the
budget line (the ratio of the prices) is 4, the consumer can trade 4 units of Y(the good on the vertical
axis) for one unit of X (the good on the horizontal axis). If the MRS at the current bundle is 6, then the
consumer is willing to trade 6 units of Y for one unit of X. Since the two slopes are not equal the
consumer is not maximizing her satisfaction. The consumer is willing to trade 6but only has to trade 4,
so she should make the trade. This trading continues until the highest level of satisfaction is achieved. As
trades are made, the MRS will change and eventually become equal to the price ratio.
lx.
ly. Chapter 4:
lz. #2. An individual cant consume both inferior goods.
ma.No,thegoodscannotbothbeinferior;atleastonemustbeanormalgood.Hereswhy.Ifanindividual
consumesonlyfoodandclothing,thenanyincreaseinincomemustbespentoneitherfoodorclothing
orboth(recall,weassumetherearenosavingsandmoreofanygoodispreferredtoless,evenifthe
goodisaninferiorgood).Iffoodisaninferiorgood,thenasincomeincreases,consumptionoffood
falls.Withconstantprices,theextraincomenotspentonfoodmustbespentonclothing.Thereforeas
incomeincreases,moreisspentonclothing,i.e.,clothingisanormalgood.

mb.
Explainthetermmarginalrateoftechnicalsubstitution.Whatdoesa
MRTS4mean?MRTSistheamountbywhichthequantityofoneinputcanbe
reducedwhentheotherinputisincreasedbyoneunit,whilemaintainingthe
samelevelofoutput.IftheMRTSis4thenoneinputcanbereducedby4unitsas
theotherisincreasedbyoneunit,andoutputwillremainthesame.
mc. 5.Whatisthedifferencebetweenaproductionfunctionandanisoquant?
md.
Aproductionfunctiondescribesthemaximumoutputthatcanbeachieved
withanygivencombinationofinputs.Anisoquantidentifiesallofthedifferent
combinationsofinputsthatcanbeusedtoproduceoneparticularlevelofoutput.
me.
mf.
mg.