Chapter 2: Consumers

Indifference curve Combinations of products in which the consumer is

indifferent (equally well off).
 Downward sloping (no satiation principle)  we need
more of a product to compensate for less of the other.
 Convex  diminishing utility from getting more and
more of one product (we need increasing amounts of
the product to keep us equally satisfied).
 Indifference curves father from the origin represent
higher levels of satisfaction.

Budget set 𝑝𝐴 𝑞𝐴 + 𝑝𝐵 𝑞𝐵 ≤ 𝑌

We can rewrite this to get a downward-sloping line by solving

for 𝑞𝐴 (if 𝑞𝐴 is on the vertical axis!)

𝑌 𝑝𝐵
𝑞𝐴 = − 𝑞
𝑝𝐴 𝑝𝐴 𝐵

Demand function 𝑞𝑖 (𝑝𝑖 , 𝑧)

Where 𝑞𝑖 denotes the quantity demanded for a given price of

the good 𝑝𝑖 and for given values of other variables 𝑧, which
might include income, the prices of all other goods and any
other relevant factors that affect the demand of good 𝑖.

Inverse demand function 𝑝𝑖 (𝑞𝑖 , 𝑧)

Denotes that the price must be if the quantity demanded is to

be equal to 𝑞𝑖 .

Demand curve The demand curve shows 𝑞𝑖 as a function of 𝑝𝑖 . It corresponds

to the demand function under the assumption that all variables
other than 𝑝𝑖 are constant (that is, z is constant).

A change in price leads to a movement along the demand

curve and a change in other factors leads to a shift in the
demand curve itself.

Consumer surplus Consumer surplus is the difference between willingness to pay

and price and given by the area under the demand curve and
above the price paid by the consumer.

Price elasticity of demand Measures the sensitivity of demand to changes in price, in

terms of percentages.
𝑑𝑞
𝑞 𝑑𝑞 𝑝
∈= =
𝑑𝑝 𝑑𝑝 𝑞
𝑝
 The price elasticity of demand is the ratio between the
percentage change in quantity and the percentage change in
price, for a small change in price
∆𝑞 𝑝
∈≈
∆𝑝 𝑞

Note: elasticities are generally negative (quantity demanded

declines when price increases).

|∈|>1  the products have an “elastic demand”, i.e. the

quantity demanded is very sensitive to the price.
0<|∈|<1  the products have an “inelastic demand”, i.e. the
quantity demanded is relatively insensitive to the price.

Note: demand elasticity varies along the demand curve.

Logarithms and elasticity 𝑑𝑞

formulas 𝑑(log 𝑞) =
𝑞
Therefore,
𝑑𝑞
𝑞 𝑑 log 𝑞 ∆ log 𝑞
∈= = ≈
𝑑𝑝 𝑑 log 𝑝 ∆ log 𝑝
𝑝

Revenue and price When

elasticity of demand |∈|>1, a decrease in price leads to an increase in revenue.
|∈|<1, an increase in price leads to an increase in revenue.

The percent change in revenue induced by a (small) change in

price is
𝑑(𝑝𝑞) 𝑑𝑝
= (1+∈)
𝑝𝑞 𝑝

That is, the percent change in revenue following a price

change is (1+elasticity) * (% change in price)

Cross price elasticity The sensitivity of demand to the price of another product

𝑑𝑞1
𝑞
∈1 2 ≡ 1
𝑑𝑝2
𝑝2

Substitutes  cross-price elasticity is positive.

Complements  cross-price elasticity is negative.

Income elasticity 𝑑𝑞
𝑞
𝜂≡
𝑑𝑦
𝑦
 The income elasticity of demand is given by the percent
change in quantity demanded induced by a 1% change in
income (=y)

Inferior goods  negative income elasticities.

Normal goods  positive income elasticities (0<|∈|<1 are
necessities and |∈|>1 are luxuries).

Chapter 3: Firms
Production function 𝑓(𝑥1 , … , 𝑥𝑛 )
where 𝑥𝑖 is the quantity of input i
For a given set of inputs, how much output is the firm able to
produce.

Isoquant curve A curve over what combination of inputs leads to a given

level of output.
Perfect complements  the production function corresponds
to fixed proportions and is given by 𝑓(𝑥1 , 𝑥2 ) = min{x1 , 𝑥2 }.
Isoquants with kinked curves (right-angle isoquants).
Perfect substitutes  straight line isoquants.

Cobb-Douglas production 𝑞 = 𝐾 𝛼 𝐿𝛽
function
Isoquants can be derived with this production function
if capital (K) and labor (L) are the two main inputs in the
production process.

Diminishing marginal returns: for a given output level, if

we use less L, we need to use more K to compensate for the
decrease in L; and the further we decrease L the greater the
increase in K required to compensate for the decline in L.

Note: isoquants are convex (and the closer complements two

inputs are, the more convex the isoquant).

Total factor productivity Measure of productivity.

(TFP)
We assume that
a) market price is given
b) each firm has a Cobb-Douglas production function
with inputs K and L
c) all firms have the same 𝛼 and 𝛽 coefficients but differ
with respect to a multiplying coefficient:
𝛽
𝑞𝑖 = 𝜔𝑖 𝐾𝑖𝛼 𝐿𝑖
The coefficient 𝜔𝑖 is the TFP.
 Estimating TFP: We need to obtain 𝛼 and 𝛽 to estimate 𝜔
for the individual firm
𝑟∗𝐾
𝛼=
𝑝∗𝑞
where r=rent, K=capital, p=price, q=quantity
𝑤∗𝐿
𝛽=
𝑝∗𝑞
where w=wages, L=labor

Cost function 𝐶(𝑞)

Shows the least total cost of inputs the firm needs to pay in
order to product output 𝑞.

Note: marginal cost is the appropriate cost concept to decide

𝑇𝐶
how much to produce, whereas average cost (𝐴𝐶 = 𝑞 ) is the
appropriate cost concept to decide whether to produce at all.

Price-taking firm A price-taking firm’s supply function is given by the marginal

cost function for values of price greater that the minimum of
the average cost function.

Optimal pricing: calculus Optimal output level can be found by maximizing profits, 𝜋
approach 𝜋(𝑞) = 𝑅(𝑞) − 𝐶(𝑞)
We find the maximum of 𝜋 by setting the derivative equal to
zero
𝑑𝜋(𝑟)
= 𝑀𝑅(𝑞) − 𝑀𝐶(𝑞) = 0
𝑑𝑞
or
𝑀𝑅(𝑞) = 𝑀𝐶(𝑞)

Example: finding 𝒑 and 𝒒 for optimal pricing

Suppose D: 𝑞 = 𝑎 − 𝑏𝑝 and 𝑀𝑅 = 𝑐
𝑎−𝑞
Revenue is then given by 𝑅 = 𝑝𝑞 = 𝑏 𝑞
𝑎−2𝑞
And thus 𝑀𝑅 = 𝑏
We equate MR to c (=MC) and solve with respect to q:
𝑎 − 𝑏𝑐
𝑞=
2
Finally, substituting this value for q into the inverse demand
function to obtain optimal price level
𝑎 − 𝑏𝑐
𝑎 − 𝑞 𝑎− 2 𝑎 + 𝑏𝑐
𝑝∗ = = =
𝑏 𝑏 2𝑏

Marginal revenue First plot the inverse demand curve. Then, the intercept of the
(graphically) MR curve is the same as the demand curve and with twice the
slope.
 Note: this is only for linear demand curves.

Chapter 4: Competition, Equilibrium, And Efficiency

Perfect competition Characteristics:
 Atomistic firms: many competitors that are all small
relative to the market and unable to affect the market
price.
 Homogenous product: all competitors produce the
same product.
 Perfect information: everyone (firms and consumers)
knows about prices and product characteristics.
 Free entry: no barriers to enter the market.

Firm supply in Each firm faces a flat (infinitely elastic) demand curve, that is,
competitive markets it can sell all it wants at the market price.

The firm’s total revenue is 𝑅(𝑞) = 𝑝𝑞, and since 𝑝 is given,

the firm’s marginal revenue is equal to 𝑝. The profit-
maximizing condition thus becomes 𝑀𝐶(𝑞) = 𝑝, and the firm
supplies the quantity at which marginal cost equals price.

Market supply in 𝑆(𝑝) = 𝑞1 + ⋯ + 𝑞𝑛

competitive markets
We derive the industry supply curve by summing all
individual firms’ supply curves.

Market equilibrium The point where supply and demand curves intersect.

Comparative statics The exercise of looking at what happens to the equilibrium by

shifting the supply or demand curves.

The size of changes in 𝑝 and 𝑞 depends on the slopes of the

curves.
 The effect of a shift in the supply curve depends on the
slope of the demand curve. If the demand curve is steep, price
will change more than quantity, and if the demand curve is
flat then quantity will change more than price.
 The effect of a shift in the demand curve depends on the
slope of the supply curve. If the supply curve is steep, price
will change more than quantity, and if he supply curve is flat
then quantity will change more than price.

Short-run equilibrium The short run is defined as the period when the number of
firms is fixed.
Long-run equilibrium The long run considers the possibility of entry and exit.
 In the long-run equilibrium under perfect competition, firms
produce at the minimum average cost and make zero profits.

Chapter 6: Price Discrimination

Price discrimination The practice of setting different prices for the same good.

Why price discriminate The goal of price discrimination is to get a slice of untapped
revenues by selling for a higher price to consumers whose
willingness to pay is higher and selling for at lower price to
consumers whose willingness to pay is lower.

Perfect price When the seller has perfect information about each buyer’s
discrimination valuation and is able to set a different price for each buyer.

The seller increases profit by areas A and B:

Note: price discrimination allows the seller to create

additional consumer surplus and to capture existing consumer
surplus. Its success requires that resale be expensive or
impossible.

Selection by indicators Under discrimination by market segmentation, a seller should

(market segmentation) charge a lower price in those market segments with greater
price elasticity.

Self-selection Price discrimination by self-selection is the situation when the

seller does not directly identify the consumer but instead
indirectly sorts consumers by group by offering different
“deals” or “packages”.

Non-linear pricing Consumers make the choice of how much to consume of a

product.

Homogenous consumers:
If the seller can set a two-part tariff and all consumers have
identical demands, then the variable price that maximizes total
 profits is the same that maximizes total surplus, that is, a price
equal to marginal cost. The fixed price 𝑓 is equal to the
consumer surplus at the variable price (see gym membership
p. 138).

Chapter 7: Games & Strategies

Nash equilibrium A pair of strategies is a Nash equilibrium if no player can
unilaterally change its strategy in a way that improves its
payoff.

Dominant strategy: a dominant strategy yields a player the

highest payoff regardless of the other player’s strategy.

Dominated strategy: a dominated strategy yields a player a

payoff which is lower than that of a different strategy,
regardless of what the other players do.

Prisoner’s dilemma: the conflict between individual

incentives and joint incentives.

Note: when analyzing games, it is not only important whether

players are rational, it is also important whether players
believe the other players are rational.

Best responses A useful way to find a game’s Nash equilibrium.

Sequential games We use game trees and refer to them as games in extensive
form.

Backward induction (to get rid of “unreasonable”

equilibria”): we solve the game backward.

Credible commitment A credible commitment may have significant strategic value.

Short-run and long-run We assume that players choose the long-run variable first and
the short-run variable second. Short-run variables are those
that players choose given the value of the long-run variables.

Repeated games A one-short game (each player chooses one action only once)
which is repeated a number of times.

Because players can react to other players’ past actions,

repeated games allow for equilibrium outcomes that would
not be an equilibrium in the corresponding one-shot game.
Chapter 8: Oligopoly
Bertrand model Firms choose prices simultaneously.

The Bertrand model is the simplest model of duopoly. The

model consists of two firms in a market for a homogenous
good and the assumption that firms set prices simultaneously.
We also assume the have the same 𝑀𝐶 = 𝑐.

In Bertrand competition (homogenous good and same 𝑀𝐶),

firms price at the level of marginal cost (the firm with the
lowest price gets all of the demand and this happens until 𝑝 =
𝑀𝐶).

Avoiding the Bertrand trap (no profits):

 Product differentiation.
 Dynamic competition.
 Asymmetric costs.
 Capacity constraints.

Price competition with capacity constraints:

If capacities are relatively small, equilibrium prices are such
that total demand equals total capacity, 𝑝1 = 𝑝2 = 𝑃(𝑘1 +
𝑘2 ). Equilibrium prices are greater than 𝑀𝐶.

Cournot model Firms choose output levels simultaneously. The market price
is set at the level such that demand equals the total quantity
produced by both firms.

Under Cournot, equilibrium output is greater than monopoly

output and lower than perfect competition output. Likewise,
the duopoly price is lower than the monopoly price and
greater than the price under perfect competition. The Cournot
equilibrium extends to the case of firms with different
marginal costs as well when there are more than two
competitors.

Algebraic derivation of best response function (two firms

with same 𝑴𝑪):
Inverse demand: 𝑃(𝑞𝑄) = 𝑎 − 𝑏𝑄
Cost: 𝐶(𝑞) = 𝑐𝑞
Where 𝑞 is the firm’s output and 𝑄 = 𝑞1 + 𝑞2 is total output.

Firm 1’s profit:

𝜋1 = 𝑃𝑞1 − 𝐶(𝑞1 ) = (𝑎 − 𝑏(𝑞1 + 𝑞2 ))𝑞1 − 𝑐𝑞1

Take the derivative of 𝜋1 with respect to 𝑞1 and set equal to 0:

𝜕𝜋1
=0
𝜕𝑞1
 −𝑏𝑞1 + 𝑎 − 𝑏(𝑞1 + 𝑞2 ) − 𝑐 = 0
𝑎−𝑐 𝑞2
𝑞1 = −
2𝑏 2

This gives the optimum 𝑞1 for each value of 𝑞2 and is Firm

1’s best response, 𝑞1∗ (𝑞2 ).

When we assume that both firms have the same cost function,
Firm 2’s best response, 𝑞2∗ (𝑞1 ), is symmetric of Firm 1’s.

Shortcut:
Since the two firms are identical (same cost function), we
have:
𝑎 − 𝑐 𝑞̂
𝑞̂ = −
2𝑏 2
𝑎−𝑐
𝑞̂ =
3𝑏
𝑎−𝑐 𝑎−𝑐
The Cournot-Nash equilibrium is: (𝑞̂1 , 𝑞̂2 ) = ( 3𝑏 , )
3𝑏

Bertrand vs. Cournot If capacity and output can be adjusted easily, then the
Bertrand model describes duopoly competition better. If
output and capacity are difficult to adjust, then the Cournot
model describes duopoly competition better.