Samenvatting PDF

19-11-2010 Group 2E
Dhr. A. Schram 2010/2011

Microeconomics Semester 1, Block II
Summary of Microeconomics (seventh edition) Pindyck, R.S., Rubinfeld, D.L.

M.J.H.Schellekens
Chapter 1 Introduction: Markets and Prices
Economics studies the allocation of scarce resources.

Microeconomics in particular deals with the constituting individual entities of an economy, that is the
consumers, firms, workers etc. Describes and analyses the trade-offs these entities face. Investigates the role
of prices and how they are determined.
Important themes in microeconomics are
-Trade-offs
-Prices
-Markets
-Theories and Models
-Positive analysis (cause and effect) versus Normative analysis (what ought to be)
Individual economic units can be divided in two broad groups according to function- buyers and sellers.
Together, buyers and sellers interact to form markets. A market is the collection of buyers and sellers that,
through their actual or potential interactions, determine the price of a product/products. On a competitive
market a single price will prevail (individual buyers do not influence price significantly), while on non-
competitive markets different prices are charged by distinct firms. A market includes more than one industry.
An Industry is a collection of firms that sell the same or closely related products, in effect this is the supply
side of the market.
Definitions related to markets:

cartel = a group of producers that acts collectively
arbitrage = practice of buying at a low price at one location and selling at a higher price in another.
Definitions related to prices:
nominal price absolute price of a good, unadjusted for inflation
real price price of a good relative to an aggregate measure of prices; adjusted
for inflation
CPI-consumer price index measure of the aggregate price level
PPI-producer price index measure of the aggregate price level for intermediate products and
wholesale goods
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Chapter 2 Supply, Demand, & Equilibrium
The supply-demand model combines two important concepts:

supply curve Relationship between the quantity of a good that producers are willing to sell
and the price of the good. QS = QS (P)
The supply curve slopes upward. The higher the price, the more that firms are able and willing to sell. The
response of quantity supplied to changes in price can be represented by movements along the supply curve.
The response of supply to changes in other supply-determining variables (costs, wages etc.) is shown
graphically as a shift of the supply curve itself.
demand curve Relationship between the quantity of a good that consumers are willing to buy
and the price of the good. QD = QD (P)
The demand curve slopes downward. Consumers usually are ready to buy more if the price is lower.
Price changes results in movement along the curve, change in variables such as consumer income result in a
shift of the supply curve itself.
Changes in price of related goods also affect demand. Goods are substitutes when an increase in the price of
one leads to an increase in the quantity demanded of the other. Goods are complements when an increase in
the price of one leads to a decrease in the quantity demanded of the other.
The market mechanism

The supply and demand curve intersect at the equilibrium, or market-clearing, price and quantity. At this
price, the quantity supplied and quantity demanded are equal. The market mechanism is the tendency in a
free market for the price to change until the market clears.
Surplus = a situation in which the quantity supplied exceeds quantity demanded
Shortage = situation in which the quantity demanded exceeds the quantity supplied
Elasticities of supply and demand

Elasticity is a measure of the sensitivity of one variable with respect to changes in another variable.
The number tells us the percentage change that will occur in one variable in response to a 1-percent change
in another variable. The price elasticity of demand measures the sensitivity of quantity demanded to price
changes.
The percentage change in a variable is just the absolute change in the variable divided by the original level
of the variable. We can also write price elasticity of demand as follows:
Q / Q P Q
EQ, P = = .
P / P Q P
If elasticity < -1 the product is price elastic. If 0 > elasticity > -1 we say the product is price inelastic.
Existence of close substitutes leads to a price elastic demand, while if there are no close substitutes available
demand will be price inelastic.
The price elasticity of demand must be measured at a particular point on the demand curve and will
generally change as we move along the curve.
Other demand elasticities
Income elasticity of demand - percentage change in the quantity demanded resulting from a 1-percent
increase in income.
I Q
EI = .
Q I
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
PM QB
EQB PM = .
QB PM
If the goods are substitutes, the cross-price elasticity will be positive. If goods are complements, cross-price
elasticity negative.
So far, only point elasticities of demand are considered. If price elasticity is calculated over a range of
prices this is called arc elasticity of demand. Rather than choosing an initial or final price, an average is
used.
Chapter 3 Consumer Behavior
consumer behavior is best understood in three distinct steps:

-Consumer preferences
-Budget constraints
-Consumer choices
A consumption bundle is a collection of one or more commodities. One bundle may be preferred over
another bundle containing different combination of goods
There are some important basic assumptions about preferences:

1. Completeness, consumers can compare and rank all possible bundles
2. Transitivity, if A is preferred to B and B to C then A must be preferred to C
3. More is better, consumers always prefer more of any good to less
4. The Marginal Rate of Substitution is diminishing, as more and more of a good is consumed, the
consumer is willing to give up less of a second good in order to get more of the first good.
Indifference curve is a graphical representation of a consumers preferences. It shows all combinations of

market baskets that provide a consumer with the same level of satisfaction. That person is therefore
indifferent to which market basket he gets along the curve.
Facts about indifference curves:

-Since more is better, any point on an indifference curve to the right and above the original point provides
more satisfaction and is therefore preferred
-An indifference map is a graph containing a set of indifference curves showing the market baskets among
which a consumer is indifferent
-Indifference curves cannot intersect, since this would violate more is better
-The fact that indifference curves slope downward from left to right follows directly from our assumption
that more of a good is better than less
Y
5
4
3
2 U
1
1 2 3 4 X
The Marginal Rate of Substitution (MRS) = Maximum amount of a good that a consumer is willing to
give up in order to obtain one additional unit of another good. It is defined in terms of the amount of the
good on the vertical axis that the consumer is willing to give up in order to obtain 1 extra unit of the good on
the horizontal axis.
Convexity = the fact that the marginal rate of substitution falls as we move along the indifference curve.
This is because consumers generally prefer balanced market baskets to market baskets that contain all of one
good and none of another.
Two extreme cases in terms of MRS are:

a. Perfect Substitutes - the marginal rate of substitution of one for the other is a constant. The consumer is
entirely indifferent to having one or the other.
b. Perfect Complements - two goods for which the MRS is zero or infinite; the indifference curves are
shaped as right angles. For example, a left shoe will not increase a certain consumers satisfaction unless he
or she can obtain the matching right shoe.
Sometimes it is useful to rate individual market baskets in terms of numerical values. This concept is known
as utility - assigning a numerical score which represents the satisfaction a consumer gets from a given
market basket. A utility function is a formula that assigns a level of utility to individual market baskets.
An ordinal utility function is a utility function that generates a ranking of market baskets in the order of
most to least preferred. It does not indicate by how much one is preferred to another. A utility function that
does describe by how much one market basket is preferred to another is called a cardinal utility function.
In microeconomics we only deal with ordinal utility functions for the time being.
Budget constraints are constraints that consumers face as a result of limited incomes. The budget line
indicates all combinations of for example F and C for which the total amount of money spent is equal to
income.
budget line: PF F + PC C = I
P
The slope of the budget line, F is the negative of the ratio of the prices of the two goods.
PC
A change in income causes the budget line to shift parallel to the original line, shifting outwards if income
increases. Price changes rotate the original budget line outward, pivoting from the intercept of the product
that does not change price.
Consumers are assumed to make their choices of which and how much of certain goods to buy in a rational
way - they want goods to maximize the satisfaction, given their limited budget.
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line
2. It must give the consumer the most preferred combination of goods and services
The market basket which maximizes satisfaction must lie on the highest indifference curve that touches the
PF
budget line. This is at the point where MRS =
PC
So satisfaction is maximized where marginal rate of substitution (of F for C) is equal to the ratio of the
prices (of F to C).
Sometimes consumers buy in extremes, when one good is not consumed, the consumption bundle is situated
at the corner of the graph. This is called a corner solution. When a corner solution arises, the consumers
MRS does not necessarily equal the price ratio.
Marginal utility (MU) measures the additional satisfaction obtained from consuming one additional unit of
a good. Diminishing marginal utility is the principle that as more of a good is consumed, the consumption
of additional amounts will yield smaller additions to utility.
MU F
MRS =
MU C
Because the MRS is also equal to the ratio of marginal utilities of consuming F and C it follows that
MU F PF
=
MU C PC
Utility maximization is thus achieved when the budget is allocated so that the marginal utility per dollar of
expenditure is the same for each good. (equal marginal principle)
Cost-of-living indexes
Cost-of-living index = ratio of the present cost of a typical bundle of consumer goods and services
compared with the cost during a base period. There are a number of ways to calculate this index.
Ideal cost-of-living index - cost of attaining a given level of utility at current prices relative to the
cost of attaining the same utility at base-year prices.
Laspeyres index - amount of money at current year prices that an individual requires to purchase a
bundle of goods and services chosen in a base year dividing by the cost of purchasing the same bundle at
base-year prices. The Laspeyres index assumes that consumers do not alter their consumption patterns as
prices change.
Paasche index - amount of money at current-year prices that an individual requires to purchase a
current bundle of goods and services divided by the cost of purchasing the same bundle in a base year.
PFt FB + PCt C B PFt Ft + PCt Ct

LI = PI =
PFb FB + PCbC B PFb Ft + PCbCt
Chapter 4 Individual and Market Demand
The price-consumption curve traces the utility-maximizing combinations of two goods as the price of one
changes. An individual demand curve relates the quantity of a good that a single consumer will buy to the
price of that good.
This demand curve has two important properties:

The level of utility that can be attained changes as we
move along the curve
At every point on the demand curve, the consumer is
maximizing utility by satisfying the condition that the
marginal rate of substitution of food for clothing equals
the ratio of the prices of food and clothing.
Every point on the demand curve reflects the
individuals marginal benefit of the good at that point.
Income consumption curve - curve tracing the utility-maximizing combinations of two goods as a
consumers income changes
If the income-consumption curve has a positive slope then:
the quantity demanded increases with income.
the income elasticity of demand is positive.
we call the good a normal good.
If the income-consumption curve has a negative slope then:
the quantity demanded decreases with income.
the income elasticity of demand is negative.
we call the good an inferior good.
In some cases, the quantity demanded falls as income increases; the income elasticity of demand is negative.
We then describe the good as inferior.
Engel curve - Curve relating the quantity of a good consumed to income
If a normal good, the Engel curve is upward sloping
(higher income higher consumption level)
If an inferior good, the Engel curve is backward bending
(higher income lower consumption level).
Income and substitution effects

A fall in the price of a good has two effects:
1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are
now relatively more expensive
2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power
Substitution effect - change in consumption of a good associated with a change in its price, with the level
of utility held constant
Income effect - the change in food consumption brought about by the increase in purchasing power, with
relative prices held constant
Total Effect ( F1F2 ) = Substitution effect ( F1E ) + Income effect ( EF2 )
The direction of the substitution effect is always the same: A decline in price leads to an increase in
consumption of the good. However, the income effect can move demand in either direction, depending on
whether the good is normal or inferior. A good is inferior when the income effect is negative.
Theoretically, the income effect may be large enough to cause the demand curve for a good to slope
upward. We call such a good a Giffen good.
The Market demand curve is a curve relating the quantity of a good that all consumers in a market will
buy to its price. In a graph, the market demand curve is obtained by adding the consumers individual
demand curves horizontally.
Even though each of the individual curves is a straight

line, the market demand curve need not to be. The
market demand curve might be kinked because one
consumer makes no purchases at prices that other
consumers find acceptable
Two points noted about the market demand curve:

1. The market demand curve will shift to the right as
more consumers enter the market
2. Factors that influence the demands of many
consumers will also affect market demand
Consumer surplus: Difference between what a consumer is willing to pay for a good and the amount
actually paid. When the consumer surpluses of all consumers who buy a good are added, the aggregate
consumer surplus is obtained.
The demand curve gives the marginal benefit of every unit of a good: The demand curve gives the
maximum willingness to pay.
To calculate the aggregate consumer surplus in a market, the area below the market demand curve and
above the price line is obtained.
Network Externalities
Up to this point we have assumed that a persons demand for a good is independent of the demand of other
people. In fact, a persons demand may be affected by the number of other people who have purchased the
good. If this is the case, we say that a network externality exists.
Network externalities may be:

positive: quantity of a good demanded by a consumer increases in response to purchases by
others
bandwagon effect (for example: ipods, fashion)
negative: quantity of a good demanded by a consumer decreases in response purchases by others
snob effect (exclusive goods like sports cars)
Chapter 6 Production
A firms purchasing decision can be understood in three steps:

1. Production technology - how inputs can be turned into outputs
2. Cost constraints - prices of labor, capital and other inputs
3. Input choices - how much of each input to use in producing output
These three steps are the building blocks of the theory of the firm - explanation of how a firm makes cost-
minimizing production decisions and how its cost varies with its output.
Factors of production include anything the firm must use as part of the production process. These inputs
can be divided in the broad categories of labor, material and capital
A production function describes the highest output q that a firm can produce for every specified
combination of inputs.
q = F ( K, L )
The production function shows what is technically feasible when a firm operates efficiently.
Note: inputs and outputs are flows; input used in a particular time span, output in the same time span.
Short-run versus long-run

Short-run period of time in which quantities of one or more production factors cannot be
changed. These inputs are called fixed inputs.
Here we use:
q = F(L)
Long-run Amount of time needed to make all production factors variable
Here we use:
q = F ( K, L )
The contribution that labor makes to the production process can be described on both an average and an
marginal basis. Average product of labor (APL ) is the output per unit of a particular input.
The marginal product of labor (MPL ) is the additional output produced as an input is increased by one
unit.
q
Average product of labor = Output / labor input =
L
q
Marginal product of labor = Change in output / change in labor input =
L
The average product and marginal product are closely related. When the marginal product is greater
(smaller) than the average product, the average product is increasing (decreasing).
The labor curve
In general, the average product of labor is geven by the slope of the line drawn from the origin to the
corresponding point on the total product curve. The marginal product of labor is given by the slope of the
total product at that point.
Law of diminishing marginal returns - as the use of an input increases with other inputs fixed, the
resulting additions to output will eventually decrease
Labor productivity can increase if there are

improvements in technology, even though any
given production process exhibits diminishing
returns to labor
Long-run: production with two variable inputs
As stated previously, in long-run production all inputs (K,L) can be varied.

A firm can choose among different combinations of labor and capital that generate the same output. These
combinations are described by isoquants. These isoquants can be used to analyze and compare different
combinations of K,L giving an output q.
Isoquants are downward sloping because both K and L have positive marginal products (i.e. to keep output
constant as more of one input is used less of the other is necessary).
When a number of isoquants are combined in a single graph this is called an isoquant map. Isoquants show
the flexibility that firms have when making production decisions: They can usually obtain a particular output
by substituting one input for another. Because adding one factor while holding the other factor constant
eventually leads to lower and lower incremental output, the isoquant must become steeper as more capital is
added in place of labor and flatter when labor is added in place of capital. The slope of each isoquant
indicates how the quantity of one input can be traded off against the quantity of the other, while output is
held constant.
This slope is called the marginal rate of technical substitution (MRTS). The MRTS of labor for capital is
the amount by which the input of capital can be reduced when one extra input of labor is used.
Diminishing MRTS holds that the MRTS falls as we move down along an isoquant. The diminishing MRTS
tells us that the productivity of one input is limited. Production needs to be a balanced mix of both inputs.
The MRTS is closely related to the MPL and the MPK . The additional output resulting from increased labor
input is equal to the additional output per unit of additional labor times the number of units of additional
labor:
Additional output from increased use of labor = ( MPL ) .( L )
Similarly, the decrease in output resulting from the reduction in capital is the loss of output per unit reduction
in capital times the number of units of capital reduction
Reduction in output from decreased use of capital = ( MPK ) .( K )
Because output is constant by moving along an isoquant, total change in output must be zero. Thus,
( MPL ).( L ) + ( MPK ).( K ) = 0
by rearranging terms we see that
( MPL ) = K = MRTS
( MPK ) L
The marginal rate of technical substitution between two inputs is equal to the ratio of the marginal products
of the inputs.
Two special cases of production functions are:

1-Perfect substitutes
2-Fixed-proportions production function - Leonitief production function
Production function with L-shaped isoquants, so that only one combination of labor and capital can be used
to produce each level of output.
Returns to scale
In the long-run, since all inputs are variable, the firm must also consider the best way to increase output.
One way to do so is to change the scale of the operation by increasing all of the inputs to production in
proportion. Returns to scale is the rate at which output increases as inputs are increased proportionally.
The three possible cases are:
1) Constant returns to scale:
output doubles when all inputs are doubled
Size does not affect productivity
Isoquants are equidistant
2) Increasing returns to scale:
output more than doubles when all inputs are doubled
larger output associated with lower cost (automobiles)
one firm is more efficient than many firms (utilities, natural monopoly)
The isoquants get closer together as you move outward
3) Decreasing returns to scale:
output less than doubles when all inputs are doubled
decreasing effectiveness with large size
due to: monitoring and communication problems
many firms on the market
isoquants get farther apart one moves outward
Chapter 7 The Cost of Production
Economists think of cost differently from financial accountants.

Accounting Costs actual expenses plus depreciation charges for capital equipment
Economic Costs cost to a firm utilizing economic resources in production, including
cost associated with foregone opportunities (opportunity cost)
Opportunity costs cost by not putting the firms resources to their best alternative use,
these are the relevant costs for economic decisions
Although an opportunity cost is often hidden, it should be taken into account when making
economic decisions. Exactly the opposite is true for a sunk cost, this is an expenditure that has
been made and cannot be removed. Because a sunk cost cannot be recovered, it should not
influence the firms decisions.
A prospective sunk cost is an investment. The firm must decide whether that investment is
economical.
Fixed Cost and Variable Costs

Fixed cost (FC): a cost that does not vary with the level of output and that can be eliminated only
by going out of business
Variable cost (VC): a cost that varies as output varies
Total output is a function of variable inputs and fixed inputs. Therefore, the total cost of production
is equal to the fixed costs plus variable costs
TC(q) = FC + VC(q)
note: The definition of fixed and variable cost often depends on time horizon.
Marginal and Average Cost

Marginal Costs (MC) = change in costs if output changes by one unit
dTC(q) dVC(q)
MC(q) = =
dq dq
Average total cost (ATC) = Firms total cost cost per unit of output
TC(q) FC VC(q)
ATC(q) = = + = AFC(q) + AVC(q)
q q q
Determinants of Short-Run Cost
A firm can hire labor at a fixed wage rate w. The marginal cost MC is the change in variable cost
for a 1-unit change in output. But the change in variable cost is the per unit cost of extra labor w
times the amount of extra labor needed to produce extra output L
VC w.L
MC = =
q q
w
MC =
MPL
When there is only one variable input, the marginal cost is equal to the price of the input divided
by its marginal product.
Important relationships between production functions and costs

Production with decreasing marginal returns:
-output decreasing relative to input
-variable costs and total costs will rise relative to output
Production with increasing marginal returns:
-output increasing relative to input
-variable costs and total costs will fall relative to input
Relationship between marginal costs and marginal product:

dVC(q) d(w.L) dL 1
MC(q) = = = w. = w.
dq dq dq MPL
Diminishing marginal product leads to increasing marginal costs.
Costs in the Long-Run
In the long-run a firm can change all its inputs; also capital. The fundamental problem is: How to
choose inputs to produce a given output at minimum cost?
An important opportunity cost to be accounted for is the user cost of capital. This is the annual
cost of owning and using a capital asset, equal to economic depreciation plus foregone interest.
User cost of capital = Economic depreciation + (interest rate) x (value of capital)
An isocost line shows all possible combinations of labor and capital that can be purchased for a
given total cost. Cost of producing any output is the sum of labor cost wL and capital cost rK:
C = wL + rK
When the total cost equation is rewritten as an equation for a straight line:
C w
K= L
r r
K
It follows that the slope of the isocost line is which is the ratio of the wage rate to the rental
L
cost of capital.
The point of tangency of the isoquant and the isocost line gives the cost-minimizing choice of
inputs, L and K. So when a firm minimizes the cost of producing a particular output, the following
MPL w MPL MPK
condition holds: = we can rewrite this as follows: =
MPK r w r
The curve passing through the points of tangency between the firms isocost lines and its isoquants
is its expansion path. The expansion path describes the combinations of labor and capital that the
firm will choose to minimize costs at each output level.
The long-run average cost curve is the envelope of short-run average cost curves
Shape of the Long-Run Average Cost (LAC) curve:
I. Constant Returns to Scale:

input doubled output doubled
average costs constant across output.
II. Increasing Returns to Scale:
input doubled output more than doubled
average costs decreasing with output
III. Decreasing Returns to Scale:
input doubled output less than doubled
average costs increasing with output.
and of course:
LMC < LAC LAC will fall
LMC > LAC LAC will rise
LMC = LAC at the minimum of LAC
Chapter 8 Profit Maximization and Competitive Supply
The model of a perfectly competitive market rests on three basic assumptions:

1. Price taking - individual decisions have no influence on market price, firm takes price as given
2. Product homogeneity - products in a market are perfectly substitutable with one another
3. Free entry and exit - there are no special cost that make it difficult for a new firm to enter or exit
This leads to firms facing a horizontal demand curve.
Profit Maximization - Short-Run

= R(q) C(q)
Firm maximizes profit at output level where difference

between revenue and cost is the greatest
Determining Firms Profit Maximizing Output Level

The slope of the revenue curve is the marginal revenue - the change in revenue resulting from a one-unit
increase in output. The slope of the cost curve is the marginal cost. At the point where difference between
revenue and cost is greatest, the slopes of the curves are equal. Profit is maximized when marginal revenue
is equal to marginal costs.
Maximum profit: MR(q) = MC(q)
-if MR>MC then increase output

-if MR<MC then decrease output
-if MR=MC then output is profit maximizing
A competitive firm is a price taker.

faces a horizontal demand curve
revenues are R(q) = P . q (a straight line)
MR(q) = P = AR (q)
rule for profit maximization for a perfectly competitive firm:
marginal cost pricing: MC(q) = MR(q) = P
A firm should shut down if the price of the product is less than the average variable economice cost (AVC)
of production at the profit maximizing output.
A supply curve for a firm tells us how much output it will produce at every possible price. The firms
supply curve is the portion of the marginal cost curve for which marginal cost is greater than average
variable cost.
The short-run market supply curve shows the amount of output that the industry will produce in the short-
run for every possible price. It is a horizontal summation of the supply curves of the firms.
Elasticity of Market Supply

The price elasticity of market supply measures the sensitivity of industry output to market price. The
elasticity of supply is the percentage change in quantity supplied Q in response to a 1-percent change in
price P:
(Q / Q)
Es =
(P / P)
At one extreme is the case of perfectly inelastic supply, which arises when the industrys plant and
equipment are so fully utilized that greater output can be achieved only if new plants are build.
At the other extreme is the case of perfectly inelastic supply, which arises when marginal cost is constant.
Producer Surplus in the Short-Run
Producer surplus = the difference between the maximum a person would pay for an item
and the market price. It is the sum over all units produced by a firm of differences between
the market price of a good and the marginal cost of production
Producer surplus can be alternatively described as the difference between the firms revenue and its total
variable cost.
Surplus vs. Profit
PS = R VC
= R VC FC
PS = + FC
Choosing Output in the Long-Run
In the long-run firms can alter all inputs, including its size. The long-run output of a profit-maximizing
competitive firm is the point at which long run marginal cost equals the price
Economic profit = = R w.L r.K (w.L = labor cost, r.K = cost of capital)
Zero economic profit = A firm is earning a normal return on its investment -i.e., it is doing as well as it
could by investing its money elsewhere. In a market with entry and exit, a firm enters when it can earn a
positive long-run profit and exits when it faces the prospect of a long-run loss.
Economic rent = The payment for a scarce factor of production less the minimum amount necessary to
hire that factor. In the long-run in a competitive market, producer surplus is equal to the economic rent
generated by all scarce factors of production.
The long-run market supply cannot be found by summing

individual long-run supply curves.
Because in the long-run firms exit and entry the market.
For the analysis assume
all firms have access to the available production technology.
output is increased by using more inputs, not by invention.
market for inputs does not change with expansions and contractions of the industry.
distinguish between three types of industries: constant-cost, increasing-cost, decreasing cost (only
constant & increasing here).
In all three cases assume that an initial demand increase causes prices to rise in the short-run, thus
creating profits
In analyzing long-run supply, it is useful to distinguish between three types of industries:

-constant cust industry (long-run supply curve is horizontal)
-increasing cost industry (long-run supply curve is upward sloping)
-decreasing cost industry (long-run supply curve is downward sloping)
Chapter 10 Market Power
Monopoly a market that has only one seller but many buyers
In general, the monopolists quantity will be lower and its price higher than the competitive quantity and
price. Pure monopoly is rare, but in many markets only a few firms compete. Firms may e able to affect
price and find it profitable to charge a price higher than marginal cost. These firms have monopoly power.
Monopsony a market with many sellers but only one buyer

A monopsonist pays a price that depends on the quantity that it purchases. The problem is to choose the
quantity to maximize the benefit from the purchase - value derived less money payed for a good.
Market power is the ability of a seller or buyer to affect the price of a good.
Average Revenue and Marginal Revenue

The monopolists average revenue is precisely the market demand curve. To choose profit-maximizing
output, the monopolist must know marginal revenue: change in revenue resulting from a 1-unit increase in
output.
The Monopolists Output Decision

To maximize profit, a firm must set output so that marginal revenue is equal to marginal cost.
R P.Q
MR = =
Q Q
The extra revenue from an incremental unit of quantity, has two components:
1. Revenue (1)x(P) = P
2. But because the firm faces a downward-sloping demand curve, producing and selling this extra
unit also results in a small drop in price, which reduces the revenue from all units sold
Thus,
P Q P
MR = P + Q. = P + P .
Q P Q
Q P 1
. is the reciprocal of the elasticity of demand, , measured at the profit-maximizing output
P Q Ed
Therefore: MR = P + P.(1 / Ed ) = MC at the profit-maximizing output
Which can be rearranged to give us:
P MC 1
= , which is Lerners index of monopoly power
P Ed
MC
this can also be expressed as P =
1 + (1 / Ed )
A monopolist charges a price that exceeds marginal cost, but by an amount that depends inversely on the
elasticity of demand. Note that a monopolist will never produce a quantity of output that is on the inelastic
portion of the demand curve - less than 1 in absolute value.
Monopoly power - the ability to set price above marginal cost and that the amount by which price exceeds
marginal cost depends inversely on the elasticity of demand facing the firm. The less elastic its demand
curve, the more monopoly power a firm has.
Three factors influence a firms elasticity of demand

Elasticity of market demand
The numbers of firms in the market
The interaction among firms
The Effect of a Tax

Under a monopoly, price can sometimes rise by more than tax. Suppose a specific tax of t dollars per unit is
levied, so that the monopolist must remit t dollars to the government for every unit it sells. Optimal
production is now given by: MR = MC + t
The marginal cost curve will shift upward by an amount t, resulting in a smaller quantity and a higher price.
The Social Costs of Monopoly Power
Natural monopoly is a firm that can produce the entire output of the market at a cost that is lower than
what it would be if there were several firms.
Pure monopoly is rare, monopoly power (firms demand curve) depends on:
price elasticity of market demand.
number of (potential) competitors on the market:
concentration of industry (# of big players)
natural barriers to entry (e.g. high set-up cost)
legal barriers to entry (e.g. protective laws)
form of interaction between firms:
fierce competition
explicit or implicit collusion
Note: Large monopoly power does not necessarily imply high profits (cost curves!).
In competitive markets, price regulations generally creates a deadweight loss. In case of a monopoly price
charged by monopolist is above marginal cost - social cost
Price regulation may bring price down to marginal cost.
Chapter 11 Pricing with Market Power
All pricing strategies have one thing in common: they are means of capturing consumer surplus and
transferring it to the producer.
Price discrimination = the practice of charging different prices to different consumers for similar goods
Price discrimination can take three broad forms:
1. First-Degree price discrimination
If a firm could, it would charge eacht customer the maximum price that the customer is willing to pay for
each unit bought - or reservation price. The pratice of charging each customer his or her reservation price
is known as first-degree price discrimination.
If the firm can perfectly price discriminate, incremental revenue is simply the price paid for
that unit; given by the demand curve. The additional profit from selling one more unit is now the difference
between demand and marginal cost.
In practice, perfect price discrimination of the first degree is almost never possible. Since a
firm does not know usually the reservation price of each customer. Firms can discriminate imperfectly by
charging a few different prices based on estimates of customers reservation prices.
2. Second-Degree price discrimination

In some markets, the reservation price of consumers declines with the number of units purchased. In this
situation a firm can use second-degree price discrimination - which is the practice of charging different
prices per unit for different quantities of the same good or service.
Block pricing = practice of charging different prices for different quantities or of a good
3. Third-Degree price discrimination

The third and most prevalent form of price discrimination is third-degree discrimination - where consumers
are divided into two or more groups with separate demand curves and charging different prices to each
group. If this is feasible, a firm should decide on what price to charge considering:
-Whatever the two prices, they much be such that the marginal revenues for different groups
are equal (otherwise, the firm would not be maximizing profit)
-Total output must be such that the marginal revenue for each group of consumers is equal
to the marginal cost of production
Managers may find it easer to think in terms of relative prices. The following relationship must hold:
P1 (1 + 1 / E2 )
=
P2 (1 + 1 / E1 )
Inter-temporal Price Discrimination and Peak-Load Pricing
Two other closely related forms of price discrimination are important and widely practiced.
Inter-temporal price discrimination - Practice of separating consumers with different demand functions
into different groups by charging different prices at different points in time (for example an LCD tv priced
high initially and then lower after the first group of consumers has purchased it).
Peak-load pricing - Practice of charging higher prices during peak periods when capacity constraints cause
marginal costs to be high
The Two-Part Tariff

Another form of price discrimination is the two-part tariff. Consumers are charged both an entry and a
usage fee. The problem for the firm is how to set the entry fee versus the usage fee. There are different
scenarios to take into account regarding this problem.
Single consumer: Usage fee P should be set equal to marginal cost and entry fee T equal to
the total consumer surplus for each sonsumer. In this way the firm captures all the consumer surplus as its
profit.
Two consumers: The firm should set the usage fee above marginal cost and then set the
entry fee equal to the remaining consumer surplus of the consumer with the smaller demand.
Many consumers: There is always a trade-off: A lower entry fee means more entrants and
thus more profits from sales. On the other hand, as the entry fee becomes smaller and the number of
entrants larger, the profit derived from the entry fee will fall.
Chapter 12 Monopolistic Competition and Oligopoly
In addition to a perfectly competitive market and a monopoly, there are a number of market structures in
between: monopolistic competition, oligopoly and cartel.
A monopolistically competitive market is similar to a perfectly competitive market in two key respects:
There are many firms and entry by new firms is not restricted. But it differs from perfect competition in that
the product is differentiated. Monopolistic competition means that in a market, firms can enter freely, each
producing its own brand or version of a differentiated product.
Unlike a perfectly competitive market, with monopolistic competition the there are two sources of
inefficiency: 1. The equilibrium price exceeds marginal cost
2. The output is below that which minimizes average cost
An oligopolistic market is characterized by

-Containing only a small number of firms
-The existence of barriers to entry, categorized -natural: economies of scale, patents
-strategic: incumbents may take actions to deter
-legal: tariffs, import restrictions
-Strategic interaction: when making a decision, a firm has to take into account (possible) reactions by other
firms; at the same time other firms will take into account that firms reaction.
-Solution concept
A duopoly is a form of oligopoly in which there are only two firms competing with each other. Both firms
do the best they can given its competitors actions, this is called a Nash Equilibrium.
The Cournet model - is an oligopoly model in which firms produce a homogeneous good, each firm treats
the output of its competitors as fixed, and all firms decide simultaneously how much to produce. If each
firm correctly assumes how much its competitor will produce and sets its own production level accordingly
this is called a cournot equilibrium (which is also a case of a Nash Equilibrium).
So far we assumed the two duopolists make their output decision at the same time. But it is possible that
one firm sets its output before other firms do. This is called the Stackelberg model, and in analyzing this
model it turns out that the firm that goes first has an competitive advantage. The reason is that announcing
first creates a fait accompli: No matter what your competitor does, your output will be large.
A Cartel is a market in which some or all firms explicitly collude, coordinating prices and output levels to
maximize profit.
Competition Versus Collusion
A Nash equilibrium is a noncooperative equilibrium: Each firm makes decisions creating highest possible
profit, given actions of its competitors. The profit resulting is lower than it would be when firms colluded.
Firms could agree implicitly (e.g. secret price agreement) or explicitly (e.g. cartel) to maximize joint profits
(which means they would act as if together they were a monopoly)
Problem for firms: The agreed upon prices or quantities are not on the firms reaction curves.
each firm could increase her profit by unilaterally deviating from the agreement
In other words: collusive agreements (implicit or explicit) are not a Nash equilibrium.
such agreements are inherently unstable.
In deciding what price to set, the two firms are playing a noncooperative game: each firm independently
does the best it can, taken the competitor into account. A payoff matrix is useful in analyzing this game - it
is a table showing profit to each firm given its decision and the decision of its competitor.
Prisoners Dilemma
A classic example in game theory is the prisoners dilemma, a theory example in which two prisoners
must decide separately whether to confess to a crime; if a prisoner confesses, he will receive a lighter
sentence and his accomplice will receive a heavier one, but if neither confesses, sentences will be lighter
than if both confess.
Oligopolistic firms often have a strong desire for price stability. This is why price rigidity - firms are
reluctant to change prices - can be a characteristic of oligopolistic industries. Price rigidity is the basis of
the kinked demand curve model of oligopoly. This is the oligopoly model in which each firm faces a
demand curve kinked at the currently prevailing price: at higher prices demand is very elastic, whereas at
lower prices it is inelastic.
Sometimes a pattern is established whereby one firm regularly announces price changes and other firms in
the industry follow suit. This pattern is called price leadership: Where one firm is implicitly recognized as
the leader.
In oligopolistic markets where one large firm has a major share of total sales, the larger firm might act as a
dominant firm, setting a price that maximizes its own profits.
Chapter 13 Game Theory and Competitive Strategy
A Game is any situation in which players make strategic decisions - i.e., decisions that take into account
each others actions and responses. Strategic decisions result in payoffs to the players: outcomes that
generate rewards or benefits. A key objective for game theory is to determine the optimal strategy for each
player. A strategy is a rule or plan of action for playing the game.
In short:
Game: situation in which rational economic agents (players) make strategic decisions taking into account
each others actions and reactions.
Strategy: complete plan of actions for playing game.
Payoff: the benefit (utility, profit) generated by a combination of players strategies
Optimal strategy: strategy that maximizes players payoff.
Dominant strategy: strategy that is optimal no matter what the other players are doing.
Dominated strategy: strategy a player will never use, because there is another strategy that is better in all
possible circumstances.
The economic games that firms play can be either cooperative or noncooperative. In a cooperative game,
players can negotiate binding contracts that allow them to plan joint strategies. In a noncooperative game,
negotiation and enforcement of binding contracts are not possible. Whatever the game, the following is a
key point to keep in mind: It is essential to understand your opponents point of view and to deduce his or
her likely responses to your actions.
When every player has a dominant strategy, we call the outcome of the game and equilibrium in dominant
strategies. Unfortunately, such an equilibrium does not always exist.
The Nash equilibrium states that each player chooses his or her optimal strategy given (anticipating) the
strategies of al other players. For finite games such an equilibrium always exists. When no one has a reason
to change: equilibrium
Comparison of solution concepts
Equilibrium in Dominant actions Nash Equilibrium
Each player is choosing an action that is optimal Each player is choosing an action that is
against any action the other player could choose optimal against the action the other player
is playing
Any equilibrium in dominant actions is a Nash eq. Some Nash equilibria may not involve dominant actions.
Chapter 16 General Equilibrium and Economic Efficiency
A partial equilibrium analysis is a determination of equilibrium prices and quantities in a market

independent of effects from other markets.
General equilibrium analysis determines the prices and quantities in all markets simultaneously, and it
explicitly takes feedback effects into account. A feedback effect is a price or quantity adjustment in one
market caused by price and quantity adjustments in related markets.
In order to find the equilibrium prices (and quantities) in practice, we must simultaneously find two prices
that equate quantity demanded and quantity supplied in all related markets.
Efficiency in Exchange
Outcomes such as a general equilibrium are analyzed by their efficiency. An outcome is (Pareto) efficient if
no other outcome exists that could make everyone better off. This means that an efficient outcome
maximizes surplus.
Allocation of production inputs is technically efficient if output of one good can not be increased without
decreasing output of the other.
As a rule, voluntary trade between two people or two countries is mutually beneficial. The Edgeworth Box
is a diagram showing all possible allocations of either two goods between two people or of two inputs
between two production processes.
To determine efficient use of inputs in production, assume:
fixed total supplies of two inputs; L and K

produce two products; X and Y
income (from L) distributed between X and Y (consumption)
note: this links supply and demand for L (income expenditures)
change in input price(s) change in income and demand feedback effect
technical efficiency: allocation of inputs in production process is technically efficient if output of one
good cannot be increased without decreasing output of other good
To find all possible efficient allocations, we look for all points of tangency between each of their
indifference curves. This shows the contract curve: the curve drawn through all such efficient allocations.
Adam Smith invisible hand:

If everybody follows his or her own self interest this will result in an efficient allocation of resources.
This is often described as the first theorem of welfare economics - which involves the normative
evaluation of markets and economic policy. Normally, the first theorem states the following:
If everyone trades in the competitive marketplace, all mutually beneficial trades will be competed and the
resulting equilibrium allocation of resources will be economically efficient.
At a competitive equilibrium from the consumers perspective:

1. Because indifference curves are tangent, all marginal rates of substitution between consumers are
equal
2. Because each indifference curve is tangent to the price line, each persons MRS of e.g. clothing for
food is equal to the ratio of the prices of the two goods.
Then, if Pc and PF are the two prices,
PF
MRS J FC = = MRS K FC
PC
The Production Possibilities Frontier

shows various combinations of two goods that can be produced with fixed total quantity of inputs
describes efficiently produced levels of both goods
assumes technology is fixed
every point off the production contract curve is inefficient.
The Marginal rate of Transformation - is the amount of one good that must be given up to produce one
additional unit of a second good. The slope of the production possibilities frontier measures the marginal
cost of producing one good relative to the marginal cost of producing the other. At every point along the
frontier, the following condition holds:
MCF
MRT =
MCC
For an economy to be efficient, goods must not only be produced at minimum cost; goods must also be
produced in combinations that match peoples willingness to pay for them.
An economy produces output efficiently only if, for each customer, MRS = MRT
MC X
Derivation of MRTXY = , from production functions:
MCY
dy
MRTXY = , is the slope of the production possibilities frontier
dx
w r
dL + dK
dY = MPL Y dL + MPK Y dK dy MCY MCY MC X
therefore: = =
dX = MPL X dL + MPK X dK dx w
dL +
r
dK MCY
MC X MC X
Chapter 17 Markets with Asymmetric Information
Asymmetric information means a buyer and a seller posess different information about a transaction
The lemons problem: with asymmetric information, low-quality goods can drive high-quality goods out of
the market.
start with a market for high quality and a market for low quality, two different equilibria
buyers buy on average mediocre cars
willing to pay less for high quality and more for low quality
demand for high quality shifts up, low quality shifts down then average is even lower quality: shifts
continue
continues until only lemons are sold
An important problem that affects many markets is the problem of adverse selection. This problem arises
when products of different qualities are sold at a single price because buyers or sellers are not sufficiently
informed to determine the true quality at the time of purchase. As a result, too much of the low-quality
product and too little of the high-quality product are sold in the marketplace.
Government intervention or the development of a reputation can help alleviate the problem of asymetric
information (lemon problem). Another important mechanism through which sellers and buyers deal with
the problem of asymmetric information is market signaling. The concept of market signaling was
developed by Michael Spence, who showed that in some markets, sellers send buyers signals that convey
information about a products quality.
To be strong, a signal must be easier for high-productivity people to give than for low-productivity people
to give, so that high-productivity people are more likely to give it (e.g. education).
Sometimes a party whose actions are unobserved affects the probability or magnitude of a payment. This is
called a moral hazard.
Chapter 18 Externalities and Public Goods
Extarnalities -the effects of production and consumption activities not directly reflected in the market- can
arise between producers, customers, or producers and customers. They can me either negative or positive.
-a negative externality imposes cost on another
-a positive externality benefits another
Externalities are not reflected in market prices and therefore they can be a source of economic inefficiency.
Negative Externalities and Inefficiency

If there are negative externalities there exists a marginal external cost. This is an increase in cost imposed
externally as one or more firms increase output by one unit. From a social point of view, the firm produces
too much output. The efficient level of output is the level at which the price of the product is equal to the
marginal social cost (MSC) of production: the marginal cost of production plus the marginal external cost.
MSC= MC + MEC
Positive Externalities and Inefficiency

There can also exist externalities that are of a positive influence. A marginal external benefit is an
increased benefit that accrues to other parties as a firm increases output by one unit. The marginal social
benefit curve, MSB, is calculated by adding the marginal private benefit and the marginal external benefit
at every level of output. MSB = D + MEB
Ways of Correcting Market Failure
The government can play a role in trying to combat externalities. Examples regarding emissions are:
-emissions standard - legal limit on the amount of pollutants a firm can emit
-emissions fee - charge levied on each unit of a firms emissions
Standards vs Fees
Can efficiency be obtained without government intervention?
Bargaining and Economic Efficiency:
Economic efficiency can be achieved without government intervention when the externality affects
relatively few parties and when property rights are well specified.
When parties can bargain without cost and to their mutual advantage, the resulting outcome will
be efficient, regardless of how the property rights are specified. (Coase Theorem)
Externalities can also arise when resources can be used without payment.
Common property resources are those to which anyone has free access. As a result they are likely to be
over utilized.
Goods that private markets are not likely to produce (efficiently) are either nonrival or nonexclusive.
-Non-rival good -good for which marginal cost of its provision to an additional consumer is zero
-Nonexclusive good - good that people cannot be excluded from consuming, so that it is difficult or
impossible to charge for its use
there is no way to provide some public goods and services without (potentially) benefiting everyone.
households have no incentive to pay what its worth to them.
free riders understate the value of a good or service so that they can enjoy its benefit without paying for
it.
once supplied, the marginal cost per consumer is zero. A private (profit maximizing) supplier will not
provide the good efficiently (p = MC = 0) undersupply
government production of public good may therefore be advantageous because the government can raise
taxes (fees) to pay for it.

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19-11-2010 Group 2E

Dhr. A. Schram 2010/2011

Summary of Microeconomics (seventh edition) Pindyck, R.S., Rubinfeld, D.L.

Chapter 1 Introduction: Markets and Prices

Economics studies the allocation of scarce resources.

Definitions related to markets:

The supply-demand model combines two important concepts:

The market mechanism

Elasticities of supply and demand

consumer behavior is best understood in three distinct steps:

There are some important basic assumptions about preferences:

Indifference curve is a graphical representation of a consumers preferences. It shows all combinations of

Facts about indifference curves:

Two extreme cases in terms of MRS are:

PFt FB + PCt C B PFt Ft + PCt Ct

This demand curve has two important properties:

Income and substitution effects

Total Effect ( F1F2 ) = Substitution effect ( F1E ) + Income effect ( EF2 )

Even though each of the individual curves is a straight

Two points noted about the market demand curve:

Network externalities may be:

A firms purchasing decision can be understood in three steps:

Short-run versus long-run

Labor productivity can increase if there are

Long-run: production with two variable inputs

As stated previously, in long-run production all inputs (K,L) can be varied.

Two special cases of production functions are:

Economists think of cost differently from financial accountants.

Fixed Cost and Variable Costs

Marginal and Average Cost

Important relationships between production functions and costs

Relationship between marginal costs and marginal product:

Diminishing marginal product leads to increasing marginal costs.

I. Constant Returns to Scale:

The model of a perfectly competitive market rests on three basic assumptions:

Profit Maximization - Short-Run

Firm maximizes profit at output level where difference

Determining Firms Profit Maximizing Output Level

-if MR>MC then increase output

A competitive firm is a price taker.

Elasticity of Market Supply

Surplus vs. Profit

Choosing Output in the Long-Run

The long-run market supply cannot be found by summing

In analyzing long-run supply, it is useful to distinguish between three types of industries:

Chapter 10 Market Power

Monopsony a market with many sellers but only one buyer

Average Revenue and Marginal Revenue

The Monopolists Output Decision

Therefore: MR = P + P.(1 / Ed ) = MC at the profit-maximizing output

Which can be rearranged to give us:

Three factors influence a firms elasticity of demand

The Effect of a Tax

price elasticity of market demand.

number of (potential) competitors on the market:

concentration of industry (# of big players)

natural barriers to entry (e.g. high set-up cost)

legal barriers to entry (e.g. protective laws)

form of interaction between firms:

explicit or implicit collusion

2. Second-Degree price discrimination

3. Third-Degree price discrimination

The Two-Part Tariff