BSP1707B MICROECONOMICS

Jing Hoong
Table of Contents
Lecture 1 – Introduction, Consumers, and Demand.............3
Economics..........................................................................3
Microeconomics principle.................................................3
Primary concepts...........................................................3
Demand Curve...............................................................3
Supply Curve..................................................................3
Market Equilibrium.......................................................3
Consumer Theory: Preference..........................................3
Utility.............................................................................3
Characteristics of preferences/utility functions............3
Marginal Utility..............................................................3
Utility function for 2 goods...........................................3
Indifference curve.........................................................4
Marginal rate of substitution........................................4
Non-typical preference.................................................4
Budget Constrain...............................................................4
Relative price.................................................................4
Budget line....................................................................4
Optimal choice..................................................................5
Tangency condition.......................................................5
Problem solving algorithm................................................5
Individual demand.............................................................5
Market demand.................................................................6
Additional examples..........................................................6
Lecture 2 - Cost Structure, Firms, Producers, and Supply.....7
Seller perspective..............................................................7
Preliminaries (Economic cost and sunk cost)....................7
Accounting cost.............................................................7
Economic cost...............................................................7
Sunk cost.......................................................................7
Short run costs..................................................................7
Economic cost of production........................................7
Cost structure................................................................7
Average costs................................................................7
Marginal costs...............................................................7
Shape of cost curves..........................................................7
Average marginal relationship......................................8
Short run cost behaviour...................................................8
Perfectly competitive market........................................8
Revenue and marginal revenue....................................8
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 Maximising profits.........................................................8
Visualising firm profits...................................................8
Short run supply curve......................................................8
Supply curve..................................................................8
Shutting down...............................................................8
Firm behaviour and supply in the long run.......................9
Economies and diseconomies of scale..........................9
Economies of scale........................................................9
Diseconomies of scale...................................................9
LR supply........................................................................9
Firm behaviour..............................................................9
LR adjustment under perfect competition....................9
LR Equilibrium under perfect competition....................9
Point of operating under zero profit...........................10
Lecture 3 - Supply & Demand, welfare and government intervention 11
Demand Analysis.............................................................11
Demand curve.............................................................11
Substitutes and complements.....................................11
Demand Function........................................................11
Supply Analysis................................................................11
Supply Curve................................................................11
Market analysis...............................................................11
Perfect competition....................................................11
Market mechanism.....................................................11
Elasticities........................................................................11
Price elasticity of demand (own).................................12
Income Elasticity of demand.......................................12
Cross Price Elasticity of Demand.................................12
Price Elasticity of Supply..............................................12
Welfare analysis..............................................................12
Consumer surplus........................................................12
Producer surplus.........................................................12
Total surplus (Total welfare for all agents).................13
Welfare under perfect competition............................13
Government intervention...............................................13
Price Ceiling.................................................................13
Price Floor....................................................................13
Import Tariff................................................................13
Lecture 4 - Market Power and Economics of Monopoly....14
Market power..................................................................14
Market Structure.........................................................14
Sources of market power............................................14
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 Measurement approaches..........................................14
Uniform price strategy....................................................14
Demand and Marginal Revenue..................................14
AR and MR curve.........................................................14
Monopoly’s Production Decision................................15
Oligopoly profit...........................................................15
Algorithm for max profit.............................................15
Monopoly pricing and elasticity..................................15
Social cost of monopoly..............................................15
Price Discrimination........................................................15
First Degree (Perfect) Price Discrimination.................16
Second Degree Price Discrimination...........................16
Third Degree Price Discrimination..............................16
Lecture 5 – Game Theory....................................................17
Strategic thinking............................................................17
Fundamental of games................................................17
Non-cooperative vs cooperative.................................17
Order of movement....................................................17
Information and Knowledge.......................................17
Likely outcome prediction...........................................17
Equilibrium concept (Nash equilibrium).....................17
Other solution concepts..............................................17
Static Games....................................................................17
Dominant strategy.......................................................17
Checkpoints.................................................................18

Lecture 1 – Introduction, Consumers,

and Demand
Economics
 Study of how agents choose to allocate scarce
resources and how those choices affect society
 Those who make these choices are called economic
agents (individuals, firms, consumers, workers,
governments)

Microeconomics principle
Primary concepts
 Choices: What to buy, how many units to buy, how
much to save
 Scarcity: Resources are limited (money, time, capital)
 Trade-off: What you could have done instead
(opportunity cost)

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Demand Curve  increasing function: du/dx > 0
 the amount of a good that consumers are willing to buy  This rule is for good/positive things only; “bad”
at different prices during a particular period, holding things such as pollution is the opposite
other factors constant (ceteris paribus)
 Downwards sloping curve 
E
Supply Curve
 the amount of a good that sellers are willing to sell at
different prices during a particular period, holding
other factors constant
 usually upwards sloping curve

Market Equilibrium
 Market: a collection of economic agents that, through
their interactions, determine the price 𝑝𝑝 and quantity
𝑞𝑞 of a product being traded

xhibit diminishing marginal utility (DMU)

 increment is getting smaller—U(x) becomes flatter
as consumption of 𝑥 rises
 the more you consume a good, the less impact
each unit of the good has on your happiness

Marginal Utility
 the additional utility one receives from (one) additional
Consumer Theory: Preference
unit of consumption of good x
 Slope of the U(x) curve
 Positive for preference items, negative for “bad” or
non-preference items
 MUx = change in U / change in x = du/dx

Utility function for 2 goods

 With 2 goods, say food 𝐹 and clothing 𝐶, the utility
function has two arguments, 𝐹 and 𝐶 ─ Goods F and C
together form a “bundle”
 utility function is U(F,C) = sqrt(FC)
 The bundle (3,3) is preferred to the bundle (2,2) /
(1,4) / (4,1)
Utility
Indifference curve
 Utility functions: a measure of satisfaction from a good
or bundle of goods
 ICs represent the locus of bundles that give a consumer
 Units: utils
an identical utility level
 U(x) = sqrt (x)
 A consumer is indifferent for all bundles found on the
U(x,y) = sqrt (xy)
same IC
Characteristics of preferences/utility functions  Slope of the indifference curve (in absolute value) tells
 Non-satiation us the relative valuation between two goods from the
 More is always better, even if just a little bit better perspective of the consumer
 Non satiation means that bundle (3,4) must be  Indifference Maps: a set of ICs representing different
preferred to (2,4) utilities of a consumer

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 Characteristics of ICs for typical preferences:
 ICs never cross one another
 Utility increases in the NE direction (because of
non-satiation only, not DMU)
 ICs slope downwards
 ICs are convex to the origin (bowed inwards)
 For points on/within the budget line, they are
attainable. For points outside of the budget line, they
are not attainable.
Relative price

Marginal rate of substitution

 MRSFC is the number of units of good 𝐹 that a
consumer is willing to give up in order to obtain one
more unit of good 𝐶
 Absolute value of the slope of the indifference
curve (always positive in value)
 Gives the subjective relative value of 𝐹 and 𝐶 (from
the perspective of the individual consumer)
 As MRS diminishes, ICs will be convex to origin
 As the consumer consumes more 𝐹, she is less and
less willing to give up consumption of 𝐶
 Consumers generally prefer balanced bundles
 The steeper the curve, the less willing one is to
give up x for y
 The slope of the curve ( -PF/PC) gives the relative price
of F and C as of objective relative valuation (from the
perspective of the market)
Budget line
 Changes in income : Parallel shift the budget line
 Shift right = income increases
 Shift left = income decreases
 Changes in price: Budget line rotates about one
intercept (take note of which intercept and price)
 Shift right = price decreases
 Shift left = price increases

Optimal choice
 Getting the most utility possible given the budget
constraint
 The best/utility-maximizing/optimal choice:
 located on the budget line (all money spent)
 on the highest indifference curve
 Budget line is tangent to the indifference curve

Non-typical preference
 Perfect substitutes: linear ICs
 Orange juice and apple juice
 U = x1+x2
 MRS = -1
 Perfect complements: L-shaped ICs
 Left shoe and right shoe
 U = min(x1,x2)
 MRS = -∞ or 0

Budget Constrain
 A consumer’s BC represents all possible bundles of
goods she can consume given her disposable income
and market prices of goods

Tangency condition
 The slope of the IC is the MRS
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 The slope of the budget line is the relative price
 At the optimal price bundle, the subjective relative
value equals the objective relative price
 MRSFC = PF / PC
 As MRSFC = MUF / MUC, Goods F and C give the same
marginal “bang-for-buck”
Problem solving algorithm
 This is for the exceptions of corner solutions (optimal
bundle is such that the quantity of one good is zero)
 There is no way for the customer to buy any less qty of
an item below 0 as we do not typically allow negative
quantities or prices
Individual demand
 how the individual’s demand for a good changes when
conditions change (eg. price of good changes)
 As customers choose different bundles at different
prices, the budget line changes with optimal bundles at
different prices
 PF1 > PF2 >PF3
 For typical preferences, the consumer buys
more food: QF1 < QF2 <QF3 while holding
constant income and the price of clothing (and
preferences)
 We get the consumer’s demand curve for food
by tracing out PF and QF combinations. This
can be represented by an individual’s demand
function for food 𝑞(𝑝)
 Demand slopes downwards (for typical
preferences)
Market demand
 Sum of individual consumers’ demand at any given
price (heterogeneous demand combined into one)
 Algebraic solution:
© Chee Jing Hoong
 Graphical solution:

Additional examples
Quiz 1

Solution (step-by-step based on problem solving algorithm):

1. MUf = C, MUc = F
2. MRSfc = MUf / MUc = C/F
3. Tangency: MRSfc = Pf/Pc therefore C/f=1/2
4. MUf / Pf = MUc/ Pc
5. C = 1/2F ---(1)
6. 20F + 40C = 600 ---(2)
7. 40F = 600 => F = 15 , C = 7.5

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  In the short run, FC occurs even if Q=0 as long as you
Lecture 2 - Cost Structure, Firms, stay in business. But variable costs are zero if Q=0
Producers, and Supply  Also, many costs become variable as time horizon
Seller perspective becomes longer (long term)
 Goal of any firm: maximize profits 𝜋 (total revenue Cost structure
minus total cost). Each firm is a price taker in a
competitive environment
 𝜋 = TR(q) – TC(q)
 Very quantity dependent factor
 If the firm produces more, it gets more revenue
 In order to produce more, it needs to buy more
inputs
 TC also depends on process/technology

Preliminaries (Economic cost and sunk cost)

Accounting cost
 Accounting costs: costs that appear on the books (eg.
 Total cost is just the variable cost shift upwards
payroll, rents)
(same gradients)
 Accounting cost ≠ economic cost (accounting cost is an
explicit cost, a subset of economic cost) Average costs
 Just take average of every cost (average means average
Economic cost
over quantity)
 Economic costs: costs that are relevant to decision-
making (sum of implicit and explicit cost)
 Opportunity cost: the value of using the resources in
their next best alternative use
 Total economic cost = opportunity cost
 When we are talking about profit/loss, we will look at
Sunk cost
the ATC
 Expenditures that have been made and cannot be
recovered Marginal costs
 Irrelevant for decision-making (not economic  Increase in cost resulting from production of one extra
costs/involve zero opportunity costs) unit of output (by definition, it is also the gradient of
 Dependent on the time point (current point in time) the TC curve)
 Sunk cost fallacy: People make decisions based on
accounting cost rather than economic cost, that is
not rational if based on economic thinking
 Paying less at this point in time without regards to
sunk cost is a more favourable choice than paying  When we are talking about maximising profits, we will
less overall with consideration of sunk cost. look at MC

Short run costs Shape of cost curves

 Short run (SR): a time horizon within which firms
cannot adjust at least one input
 Long run (LR): a time horizon long enough for firms
to adjust all inputs
 In general, labour cost is easier to adjust than capital

Economic cost of production

 Total cost (TC) = Fixed cost (FC) + Variable cost (VC)
 Fixed cost (FC): the cost that does not vary with
the level of output (eg. insurance, implicit rent,
electricity)
 Variable cost (VC): the cost that varies with it
(eg. implicit wages, salary, raw materials)
 All 3 costs are considered to be only economic costs

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 For MC and AVC, it is also possible for them to not Visualising firm profits
decrease initially, as factors such as specialization and
other economies of scale factors are not present.

Average marginal relationship

 MC intersects AVC and ATC at their respective
minimum points
 If MC<AVC/ATC, the marginal unit produced is
pulling down the average
 If MC>AVC/ATC, the marginal unit is pulling up the
average Short run supply curve
 At this q value, the line from origin to the VC/TC curve Supply curve
is tangent (see point A in previous slide)  At every market price 𝑝, if a firm produces any output,
it will use MC(q) = p (=MR) to choose a different
Short run cost behaviour
quantity 𝑞 to sell
Perfectly competitive market  This is (almost) the firm’s short run supply curve for the
 We assume that firms and consumers operate in good (except for firm shutting down)
perfect competition until monopoly
 3 main assumptions:
 Sellers and buyers are price-takers: no influence
over market price (there are many sellers and
buyers; each is very “small”)
 Product homogeneity (identical goods)
 Free entry and exit in the market

Revenue and marginal revenue

 The firm is a price-taker, so p is just the market price (a
fixed number from the firm’s perspective)
 Total revenue = p x units sold


Shutting down
Marginal  There is still fixed cost incurred after shutting down.
revenue: Increase in revenue resulting from production  𝜋 (Shut down) = TR(0) – FC - VC(0) = -FC
of one extra unit of output (equals to p under perfect  Rule of thumb: If operating gives more profit than –FC,
the firm should operate
competition)
 Operation rule (shut down condition):
 Therefore, the firm’s short run supply curve is the MC

Maximising profits
 Profits maximising when MC(q) = MR(q) = p

curve above the AVC

 Market supply is the sum of individual firms’ supply at
each price level. This is done with horizontal
summation of quantity at each price level

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Firm behaviour and supply in the long run
 ATC curves in the long run as the firm adjusts capital, to
achieve the minimal ATC for each output level
 The LR ATC curve is the lower envelope of all the SR
ATC curves . Also, the SR ATC curves are above the LR
ATC curve
 However, there are no fixed costs in the LR (all inputs
are variable; LR ATC = LR AVC)
 LR decision rule: Operate if 𝑝 ≥ LARC(q)
 The market supply curve is the horizontal summation
of all firms’ supply

Firm
behaviour
 Firms enter or exit the industry in response to changes
in profitability
 If I see that there is profit to be made, I adjust K
(e.g. build a plant) to enter the market
 If I make negative profits, I adjust K (e.g. sell off my
Economies and diseconomies of scale plant) to exit the market
Economies of scale
 situation in which ATC decreases as output increases
due to size-related reasons LR adjustment under perfect competition
 Reasons for economies of scale:
 Specialization of inputs
 Some technologies might require larger scale
 Managerial flexibility
 Bulk purchasing at cheaper prices
 Larger firms can bear risk better

Diseconomies of scale
 situation in which ATC increases as output increases
due to size-related reasons
 Reasons for diseconomies of scale:
 Complexity of managing a larger firm
 Inputs become more expensive at larger scale
LR Equilibrium under perfect competition
LR  All firms are maximizing profits, at zero (i.e. 𝜋 = 0)
 P = MR (q) = LRMC (q) = LRAC (q)
 No firm has incentive to enter or exit
 All firms are minimizing their LR AC
 Optimal amount of all inputs, including capital
 Efficient scale

supply
 LR MC curve associated with the LR ATC
 Cuts the LR ATC its min point (same logic)
 Yields the LR supply curve, together with the
operation rule

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Point of operating under zero profit
 Dynamic process
 Earn profits/cut losses before reaching the LR
 Innovation can still earn a profit before other firms
copy the innovation
 Economic profit
 A statement about use of resources (e.g. earning a
competitive return on their investment in capital)
 Cannot do better by using its resources elsewhere
 Profit = 0 reflects TR = TC
 Scarce factors of production (e.g. capital and
labour) are earning the returns
 Economic rent: payment in excess of the costs
needed to bring a factor into production (the extra
you can earn on top of the bare minimum)

© Chee Jing Hoong

Lecture 3 - Supply & Demand,
welfare and government intervention
Demand Analysis
Demand curve
 Demand curve shows the amount of a good that
consumers are willing to buy at different prices during
a particular period, holding other factors constant
 Demand curves usually slope down, representing the
maximum price that consumers are willing to pay at
each quantity
 Affected by other factors such as the prices of other
goods, income, tax rate, etc
 Shift along demand curve: When prices change, we
move along the demand curve
 Shift of demand curve: The demand curve shifts if at
every price, the quantity demanded has gone up (shift
right) or down (shift left). This is affected by factors
such as income, preferences and tastes and prices of
related goods
Substitutes and complements
 Substitutes: If an increase in the price of one good
leads to an increase in the quantity demanded of
another good (eg. Coke and Pepsi)
 Complements: If an increase in the price of one good
leads to a decrease in the quantity demanded of
another good (eg. cars and petrol)
down (shift left). This is affected by costs of input
factors, technology and weather (for agricultural
products)
Market analysis
Perfect competition
 Three main assumptions
1. Sellers and buyers are price-takers: no influence
over market price (there are many sellers and
many buyers; each sellers and buyers are “small”
and this produce or consume a negligible part of
total industry output)
2. Product homogeneity (identical goods)
3. Free entry and exit
 Ancillary assumption: complete information
Market mechanism
 Market mechanism: the tendency in a free market for
the price to change until the market clears
 Under perfect competition, we achieve the eqm price
and quantity where quantity supplied equals quantity
demanded
 If price is too high, there are excess supply, sellers
can do better by lowering price
 If price is too low, there are excess demand,
buyers who really want the good can do better by
offering higher price

Demand Function
 The quantity demanded of a good is mathematically
related to the price of the good
 𝑄x = 10 − 2𝑃x
 𝑄x = 10 − 2𝑃x + 𝐼 + 𝑃s, where 𝑃s is the price of
substitutes. Therefore, we can see that quantity
demanded for a good is proportional to the price of
substitutes.
 𝑄s = 10 − 2𝑃x + 𝐼 – 𝑃c, where 𝑃c is the price of
complements (inversely proportional)
 Inverse demand function: 𝑃x = 5 – 1/2 𝑄x. This is the
equation for the demand curve.
Elasticities
Supply Analysis  Elasticities measure the % change in one variable
associated with a 1% change in another variable
Supply Curve  Elasticities measure only the percentage change, not
 The amount of a good that sellers are willing to sell at absolute number change (unitless to allow
different prices during a particular period, holding comparability)
other factors constant
 Supply curves usually slope up, representing the
minimum price that firms are willing to accept at each
quantity
 Affected by other factors such as wages, interest rates,
costs of raw materials, technology, etc
 Shift along supply curve: When prices change, we move
along the supply curve
 Shift of supply curve: The supply curve shifts if at every
price, the quantity supplied has gone up (shift right) or
© Chee Jing Hoong
Price elasticity of demand (own)
 Percentage change in quantity demanded of a good
resulting from a 1% change in its own price
 Measures the sensitivity of quantity demanded to
price
 Known as the demand elasticity
 Theref
ore,
the equilibrium demand at a point can be derived by
multiplying the gradient of the demand curve against
the price and quantity values at that point
 𝑒𝐷 is negative (demand slopes down)
 𝑒𝐷 is different at different points on the demand
curve
 For linear demand, revenue is maximized at the point
where demand is unit elastic (where |𝑒𝐷| = 1)
Special cases
 Perfectly elastic: Horizontal line (no matter how the
quantity change, the price is constant; once price
change abit, quantity change a lot)
 Perfectly inelastic: Vertical line (no matter how the
price changes, the quantity demanded is constant;
expensive or cheap also must buy)
 Isoelastic/Constant elasticity: The value of 𝑒𝐷 does not
change along the demand curve.
Income Elasticity of demand
 % change in 𝑄𝐷, resulting from a 1% change in income
 𝑒𝐼 > 0, normal good (as we become richer, we want
to consume more of these goods; eg. restaurant
food, car)
 𝑒𝐼 < 0, inferior good as we become richer, we want
to consume less of these goods; eg. public
transport)
Cross Price Elasticity of Demand
 % change in 𝑄𝐷 of product X (𝑄𝑋) resulting from a 1%
change in the price of product Y (𝑃𝑌)
 𝑒𝑄𝑋𝑃𝑌 > 0: Substitute
 𝑒𝑄𝑋𝑃𝑌 < 0: Complement
Price
Elasticity of Supply
 % change in 𝑄𝑆 resulting from a 1% change in price
Special cases
 Perfectly elastic supply: Horizontal line (suppliers is
very sensitive to the price; when price drop, supply
become 0)
 Perfectly inelastic supply: Vertical line (suppliers are
insensitive to price; fixed quantity supplied no matter
what price the market offers)
Welfare analysis
Consumer surplus
 The difference between what a consumer is willing to
pay for a good and the amount that she actually pays
 Area under the demand curve and above the price:
triangle APB
Producer surplus
 The difference between the price of a good and what
the least price seller is willing to accept for producing
the good (associated with the marginal cost, but has
nothing to do with the fixed costs)
 Area under the price and above C the supply
curve: triangle CPB
© Chee Jing Hoong
Total surplus (Total welfare for all agents)
 Since there are only consumers and producers, TS = CS
+ PS
 The sum of both triangle APB and CPB in the 2
diagrams above
Welfare under perfect competition
 At 𝑄𝑆 = 𝑄𝐷, total welfare will be maximised without the
need for a central planner
 Invisible hand
 Each consumer maximizes his/her own utility, and
each firm maximizes its own profit
Import Tariff
 Prices of goods in small open economies are usually set
by world prices when not regulated by govt
intervention.
 Domestic producers supply QS at the world price Pw ,
while domestic consumers consume QD
 The difference for both quantity will be imports
 To protect domestic industries, governments often
impose import tariffs or quotas
 Growth of infant industries
 Some industries might be “critical” or strategically
important

Government intervention
 Government interventions may prevent free market
adjustment in the market mechanism.
 For example, price ceiling/floor, taxes (not covered)
and tariff

Price Ceiling
 Artificial price set below market eqm price

 Deadweight loss is the difference between

intervention and non-intervention (Net TS change
by -EDC)
 Deadweight loss triangle is bounded by 3 distinct
points: Equilibrium point, the price ceiling point
and the equilibrium qty that buyers are willing to
pay at that qty of the price ceiling

Redistribution of Surplus
 Some consumers pay lower price (CS gain by
P*FDPceiling) Welfare of import tariffs
 Some consumers lose chance for transaction (CS loss
by EFC)
 Producers receive lower price and sell less

Price Floor
 Government sets a (binding) minimum price for a
product in the market (eg. minimum wages)
 Excess supply; buyers may find that it is not worth
to buy at the price floor level, resulting in a loss in
total surplus; “short side of the market”

© Chee Jing Hoong

For the increase in Qs to Qs’, this increase in quantity is due
to the fact that the price has increased, which means that
tariffs must have been put in place by the govt. As such,
there must also have been imports involved.

© Chee Jing Hoong

  Performance measure: about the degree of
Lecture 4 - Market Power and performance via profitability of the firms in the
Economics of Monopoly industry
Market power  Lerner index (LI) : LI = (P - MC) / P
 Perfect competition: 𝐿𝐼 =0 since P = 𝑀𝐶
Market Structure  Monopoly: 0 < 𝐿𝐼 ≤ 1
 Perfect Competition:  Market power ≠ high profits
 Many small firms  𝐿𝐼 can be a good measure for market structure,
 Identical products but it has its own misspecification for a good
 Price takers performance measure.
 Free entry  A dominant firm can charge very low price to
 Examples: Agricultural products, Electronic prey upon competitors or to deter new
components entrants
 Market Power:  A severe price competition among few firms
 A few firms (oligopoly) may lead to near competitive price
 Differentiated products
 Certain power to set price Uniform price strategy
 Certain level of entry barrier
Demand and Marginal Revenue
 Examples: Automobiles, Aircraft manufactures
 Total market demand is the monopoly’s individual
 Monopoly:
demand
 A single firm
 The demand curve represents the highest price the
 No close substitutes
monopoly can charge
 Complete power to set price
 Marginal revenue curve is located below the demand
 High level of entry barrier
curve
 Examples: Patented pharmaceuticals, Microsoft
windows

Sources of market power

 Access to scarce resources (OPEC and oil)
 Control over intellectual property, patent and copy
right (Microsoft and Windows 10)
 Economies of scale (companies with high set up cost)
 Network effect (online platforms, eg. Grab)
 Gov. regulation (public transport, natural gas)

Measurement approaches
 Concentration measure: about the degree of
concentration via number and size distributions of
firms
 Concentration ratio 𝑪𝑹𝒏: the total (i.e. sum of)
market shares of top n firms in the market AR and MR curve
 Herfindahl – Hirschman index (H or HHI): the sum  For linear demands, MR curve has the same vertical
of square of each firm’s market share for the top (price) intercept as the demand curve and twice the
50 firms (or for all firms if total number of firms is slope
smaller than 50)

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Monopoly’s Production Decision
 Profit is maximized when marginal revenue equals
marginal cost
 𝑄 ∗ is the output level at which 𝑀𝑅 = 𝑀𝐶
 Profit max output level is 𝑄 ∗ and profit max price
is 𝑃 ∗
 Max profit is 𝜋 ∗ = 𝑃 ∗ABC

 Different elasticity determines different mark-ups

Social cost of monopoly

 Deadweight loss = loss of economic efficiency
 For monopoly, the profit max production level is strictly
below social optimal one. Deadweight loss thus occurs
indicating social inefficiency in this case

Oligopoly profit
 𝜋 (𝑄) = 𝑇𝑅 (𝑄) − 𝑇𝐶(𝑄)
 At first order condition,
 Therefore, profit max production level occurs when
MR=MC. Also, 𝑃 ∗ > MR=MC

Algorithm for max profit

1. Find the inverse demand function (expressing P in
terms of Q)
2. Write down total revenue 𝑇𝑅 = 𝑃(𝑄) × 𝑄
3. Differentiate 𝑇𝑅 w.r.t. 𝑄 to find M𝑅(𝑄)
4. Differentiate 𝑇𝐶 w.r.t. 𝑄 to find M𝐶(𝑄)
5. Solve for 𝑄 ∗ by setting M𝑅 𝑄 = M𝐶(𝑄)
6. Solve for 𝑃 ∗ by substituting 𝑄 ∗ into 𝑃(𝑄)
7. Determining 𝜋 ∗ by substituting 𝑃 ∗ and 𝑄 ∗ into 𝜋 =
𝑇𝑅 𝑄 − 𝑇𝐶(𝑄)
Monopoly pricing and elasticity
 A good’s (own) price elasticity of demand is defined as
 𝑒𝑑 measures the percentage change in quantity
demanded to the percentage change in price of the
good
Price
Discrimination
 Practice of charging different prices to different
consumers for identical/similar goods
 Pricing of a product over different quantities (milk
price) or pricing of a product over various
consumer segments (airline fares)
 Price discrimination is about:
 How to identify different customers
 How to capture consumer surplus
 As market demand is about the “highest price” some
consumers are willing to pay, there are some
consumers that are willing to pay higher than others
or willing to pay higher for the first units than
subsequent units
 Information on demand characteristics (in addition to
the production cost conditions) is critical, allowing
managers to take advantage of market power to
improve profitability

© Chee Jing Hoong

First Degree (Perfect) Price Discrimination
 Pricing each unit sold at the consumer's maximum
willingness to pay; this willingness to pay is directly
observable by the monopolist
 If the monopolist can observe the willingness to
pay of each customer, then the monopolist can
observe demand perfectly and can "perfectly“
price discriminate
 Three steps of FDFP:
1. The seller identifies the reservation price of each
consumer
2. The monopolist sells to every potential buyer, and
leaves no buyer with any surplus
3. The monopolist continues selling units until the
reservation price exactly equals marginal cost.
Hence the firm will produce and sell the efficient
quantity of output (same as 𝑄𝑐 in competitive
equilibrium)
 Implications of FDFP:
 Not easy to implement in practice (Customers are
too many and the information about individual
customer demands is hard to establish +
Additional transaction costs may occur)
 Despite the imperfect information, FDFP is more
attractive than uniform pricing
Second Degree Price Discrimination
 Practice of charging different prices per unit for
different quantities of the same good or service
 Seller offers different “menu” without knowing the
“types” of different consumers
 Consumers self-select their most preferred plan
given their own type
 Eg. telecom companies charge different prices for
different smartphone plans
Third Degree Price Discrimination
 Different price for each segment of the market when
membership in a segment can be observed
 Different market segmentation
 Implementation needs identifiable characteristics
(e.g., Age, Location, Nationality, etc)
 Eg. Mrt fares for elderly / student discounts
 We know that; however much is produced, total
output should be divided between the groups of
customers so that marginal revenues for each group
are equal (𝑀𝑅1 = 𝑀𝑅2)
 If 𝑀𝑅1 > 𝑀𝑅2, more products should be
reallocated to Group 1 consumers
 We know that total output must be such that the
marginal revenue for each group of consumers is equal
to the marginal cost of production. (𝑀𝑅1 = 𝑀𝑅2 =
𝑀C𝑇)
 Example:
© Chee Jing Hoong
Lecture 5 – Game Theory
Strategic thinking
 In a game situation, final outcome is often influenced
not only by your decision, but also by the decision(s) of
others’ (eg. opponents)
 The decision of others’ is not under you control
 When others make their decisions, they may also
need to take consideration of your decision
 Interdependence is the key aspect of game and
strategic thinking is the focus of game theory
Fundamental of games
 Game: A situation in which players (participants) make
strategic decisions that take into account each other’s
actions and responses
 Game framework consists of :
 Players: a set of rational, profit-maximizing
competitors
 Strategies: rule or plan of actions to play a game
 Payoff: value associated with each possible
outcome of the game
 For payoffs, it is not entirely dependent on
absolute size, but ordering matters! (Payoffs are
not cardinal, but ORDINAL). For example, 1st,2nd…
Non-cooperative vs cooperative
 Cooperative game (not in syllabus): participants can
negotiate binding contracts that allow them to play
joint strategies (collusion is legal)
 E.g. trade agreement negotiations, OPEC
 Non-cooperative game: Not possible to negotiate and
enforce binding strategies (collusion is illegal)
Order of movement
 Simultaneous movement: static games, normal form
games (eg. rock-paper-scissors)
 Sequential movement: dynamic games, extensive form
games (eg. entry game)
 For simultaneous vs sequential moving games, what
matters is the information or knowledge, not the
physical order of players’ movements
Information and Knowledge
 Information: Entails more than just knowing something
(about a fact that A is true)
 Knowledge: ‘I know A is true’
 Mutual knowledge: ‘I know A is true and you know
A is true’
 Common knowledge: I (you) know you (I) know I
know …. A is true
Likely outcome prediction
 Game theory predicts the optimal strategy for each
player
 The optimal strategy maximizes a player’s payoff
given others’ strategic plays
 Solution concept: Nash equilibrium
 Nash equilibrium is a strategy profile (a
combination of strategies) at which no player has
incentive to deviate
Equilibrium concept (Nash equilibrium)
 At a Nash Equilibrium, each player’s strategy is the best
response to other players’ strategies
 Best response: the strategy of a player resulting in
the best payoffs to him/her, given the combination
of other players’ strategies
 A player is unable to do strictly better by
unilaterally switching his/her strategy (no
incentive for me to deviate from optimal
calculated strategy unless my opponent does sth
else)
Other solution concepts
 Pre Nash Equilibrium concept
 Dominant strategy equilibrium
 Iterated (iterative) dominance equilibrium
 Maximin strategy equilibrium
 Post Nash Equilibrium
 Subgame perfect Nash Equilibrium
 Bayesian Nash Equilibrium
 Perfect Bayesian Nash Equilibrium
Static Games
 Simultaneous move game
 Players make decision without knowing what others
did
 Static games are usually presented using a game
matrix (called normal form game) highlighting the
following three key aspects of the strategic situation
1. The players and their identities
2. The feasible strategy (action) set for each player
3. The payoffs associated with each strategy profile
 A payoff matrix is used to represent a static game
 One player chooses strategy from the “row” (row
player), while the other payer chooses strategy
from the “column” (column player)
 In each cell of the payoff matrix, the first entry
indicates the payoff of the row player, while the
second entry indicates the payoff of the column
player
Dominant strategy
 a strategy gives the player better payoff than her other
strategies regardless of what the opponent might
choose
 Rational player will always choose a dominant strategy
whenever such strategy exists
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Checkpoints
 Games are strategic in the sense that one player’s
optimal choice depends on other players’ choices
 It is easy to predict the game outcome with dominant
strategies for all players, since rational players will
always choose dominant strategy

© Chee Jing Hoong