DRAFT: Review for 14.

100x Proctored Exam

14.100x Course Team

May 14, 2017

Contents

1 Mathematics Review 3
1.1 Derivatives & Partial Derivatives . . . . . . . . . . . . . . . . . . 3
1.1.1 Basic Derivative Rules . . . . . . . . . . . . . . . . . . . . 3
1.1.2 Important Derivatives to Remember . . . . . . . . . . . . 3

2 Economics Review 5
2.1 Some Important Equations to Remember . . . . . . . . . . . . . 5
2.2 Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.2 Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.2.3 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2.4 What you should know and be able to do: . . . . . . . . . 7
2.3 Consumer Theory . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3.2 Indifference Curves of Perfect Substitutes and Perfect Com-
pliments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3.3 Budget constraints and constrained choice . . . . . . . . . 9
2.3.4 Deriving Demand Curves . . . . . . . . . . . . . . . . . . 10
2.3.5 Changes in Income . . . . . . . . . . . . . . . . . . . . . . 10
2.3.6 Changes in prices . . . . . . . . . . . . . . . . . . . . . . . 10
2.3.7 Income/Substitution Effects and Labor Supply . . . . . . 11
2.3.8 What you should know and be able to do: . . . . . . . . . 11
2.4 Producer Theory & Competition . . . . . . . . . . . . . . . . . . 12
2.4.1 The Production Function . . . . . . . . . . . . . . . . . . 12
2.4.2 Production and Costs . . . . . . . . . . . . . . . . . . . . 13
2.4.3 Deriving the Cost function . . . . . . . . . . . . . . . . . 13
2.4.4 Relationship between Long-Run Average Cost vs. Short-
Run Average Cost Curve . . . . . . . . . . . . . . . . . . 14
2.4.5 Economics of Scope & Economics of Scale . . . . . . . . . 14
2.4.6 Perfect Competition . . . . . . . . . . . . . . . . . . . . . 14
2.4.7 Residual Demand . . . . . . . . . . . . . . . . . . . . . . . 15
2.4.8 Profit Maximization . . . . . . . . . . . . . . . . . . . . . 15
2.4.9 Profit Maximization in the Short-Run . . . . . . . . . . . 15
2.4.10 Competition in the Long Run . . . . . . . . . . . . . . . . 16

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 2.4.11 Note on Economic Profit and Opportunity Costs . . . . . 16
2.4.12 What you should know and be able to do: . . . . . . . . . 16
2.5 Welfare Economics . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.5.1 Consumer Surplus . . . . . . . . . . . . . . . . . . . . . . 18
2.5.2 Producer Surplus . . . . . . . . . . . . . . . . . . . . . . . 18
2.5.3 Competition Maximizes Welfare . . . . . . . . . . . . . . 19
2.5.4 What you should know and be able to do: . . . . . . . . . 19
2.6 Monopoly and Oligopoly . . . . . . . . . . . . . . . . . . . . . . . 20
2.6.1 Monopoly Profit Maximization . . . . . . . . . . . . . . . 20
2.6.2 Welfare Effects of Monopoly . . . . . . . . . . . . . . . . 21
2.6.3 Price Discrimination (Monopolies) . . . . . . . . . . . . . 21
2.6.4 How do Monopolies Arise? . . . . . . . . . . . . . . . . . 21
2.6.5 Regulating Monopolies/Reducing DWL . . . . . . . . . . 22
2.6.6 What you should know and be able to do: . . . . . . . . . 22
2.7 Oligopoly, Game Theory & Cartels . . . . . . . . . . . . . . . . . 22
2.7.1 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.7.2 Game Theory - Definitions . . . . . . . . . . . . . . . . . 23
2.7.3 Cournot Model of Non-cooperative Equilibrium . . . . . 23
2.7.4 Cooperative Equilibrium - Cartels . . . . . . . . . . . . . 23
2.7.5 Comparing Equilibria . . . . . . . . . . . . . . . . . . . . 24
2.7.6 Many Firms . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.7.7 Price Competition . . . . . . . . . . . . . . . . . . . . . . 24
2.7.8 What you should know and be able to do: . . . . . . . . . 24
2.8 Other Topics in Economics . . . . . . . . . . . . . . . . . . . . . 25
2.8.1 International Trade . . . . . . . . . . . . . . . . . . . . . . 25
2.8.2 Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.8.3 Capital Markets . . . . . . . . . . . . . . . . . . . . . . . 27
2.8.4 Equity & Efficiency . . . . . . . . . . . . . . . . . . . . . 28
2.8.5 Behavioral Economics . . . . . . . . . . . . . . . . . . . . 29
2.8.6 Health Economics . . . . . . . . . . . . . . . . . . . . . . 30
2.8.7 What you should know and be able to do: . . . . . . . . . 30

2
Chapter 1

Mathematics Review

1.1 Derivatives & Partial Derivatives

1.1.1 Basic Derivative Rules
• Constant Rule: The derivative of a constant is 0, i.e. for a constant c,
∂
∂x (c) = 0

• Constant Multiple Rule: The derivative of a constant multiplied by a

function is the constant multiplied by the derivative of the original func-
∂ ∂
tion, i.e. ∂x (a · f (x)) = a · ∂x (f (x))
∂ 2 ∂ 2
– Example: ∂x 2x =2· ∂x (x ) = 2 · (2x) = 4x
• Power Rule: For an equation that is raised to the power of a number
(e.g. x5 ), you take the exponent, multiply it by the coefficient in front of
the variable of interest (if there is one) and decrease the exponent by one,
∂
i.e. ∂x kxn = n · kxn−1

– Example (1): ∂
∂x (2x
3/4
) = 34 · 2x3/4−1 = 23 x−1/4
– Example (2): ∂ 1 ∂ −2
∂x x2 = ∂x x = −2x−3 = −2 x3

• Partial Derivatives: If you are taking the partial derivative of a function

that has multiple variable with respect to only one variable, then you
should treat the other variable as a constant.
∂ 2 4
– Example: ∂x x y = 2xy 4

1.1.2 Important Derivatives to Remember

∂
• ln x = x1
∂x
∂ √
• ∂x x = 21 x−1/2 = 1
√
2 x

3
 ∂ x
• ∂x e = ex

There are many other rules for derivatives, but if you understand these, you
should be good for the exam!

4
Chapter 2

Economics Review

2.1 Some Important Equations to Remember

(Disclaimer: this may not be all the equations you should know)
∂Q P %∆Q
• Price elasticity: ∂P · Q → D = %∆P
∂U
M UX
• Marginal Rate of Substitution: M RSXY = M UY = ∂x
∂U
∂X

• Budget Constraint: I = pX X + pY Y
px
• Marginal Rate of Transformation: M RTXY = py .
∂Q
Q
• Income Elasticity of Demand: γ = ∂I
I

∂q
• Marginal Product of Labor: M PL = ∂L
∂q
• Marginal Product of Capital: M PK = ∂K
∂q
M PL
• Marginal Rate of Technical Substitution: M RT SLK = M PK = ∂L
∂q
∂K

• Expected value:
E[X] = x1 p1 + x2 p2 + · · · + xk pk

• Exponential discounting
T
X
U = u(C1 ) + u(Ci )δ i = u(C1 ) + δu(C2 ) + δ 2 u(C3 ) + · · ·
i=2

• Quasihyperbolic discounting
T
X
U = u(C1 ) + β u(Ci )δ i = u(C1 ) + βδu(C2 ) + βδ 2 u(C3 ) + · · ·
i=2

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2.2 Supply and Demand
2.2.1 Overview
• Demand is the measure of the willingness of consumers to buy a particular
good; supply is the willingness of producers to sell.
• The intersection of supply and demand curves is the market equilibrium
• Demand curves are downward sloping since at lower prices, consumers
will want to buy more of a good; Supply curves are upward sloping due
to higher marginal costs of production, or in other words, diminishing
returns and increasing costs.
• Supply and demand curves can shift when there are
– shocks to the ability of producers to supply (e.g. increased input
costs)
– shocks in consumers tastes (e.g. a public health campaign exposes
people to the dangers of consuming too much sugar, which leads to
people to be less willing to consume soda).
– shocks to the price of a complement/substitute good. A rise in the
price of a substitute for good X raises the demand for good X. What
do you think would happen to the demand for good x if the price of a
complement good increased?
• Interventions in markets can lead to disequilibrium. Remember that the
perfectly competitive market gives the most efficient equilibrium. Inter-
ventions that lead to a disequilibrium reduce efficiency, but may result in
greater equity.
– e.g. Imposing a minimum wage will result in more people being
willing to work than employers want to hire at the minimum wage.
This results in a loss of efficiency (since trades that would make both
parties better off are not being made) and results in unemployment.

2.2.2 Elasticity
• perfectly elastic demand ( = −∞): At a certain price, demand is
infinite (i.e. the demand curve is horizontal). For any small changes in
price, the demand falls to 0. For a good to be perfectly elastic, it must
have perfect substitutes.
• perfectly inelastic demand ( = 0): quantity demanded is unaffected
by a change in price (i.e. the demand curve is vertical). For a good to be
perfectly inelastic, it must be a good with no substitutes (e.g. life-saving
medication).

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 ∂Q P
• Equation for Price Elasticity of Demand: ∂P · Q → This can also
%change in quantity
be thought of as D =
%change in price

• Note: The above definitions/equations all hold in the case of elasticity of

supply (simply substitute out the word demand for supply)
• The elasticity affects consumers’ response to a shift in price: If the elas-
ticity is between 0 and -1, then firms can raise revenues by raising the
price (since consumers will still buy the good in significant quantities); if
 < −1, then raising the price will result in a decline in firm revenue

2.2.3 Taxes
• Statutory incidence: Whoever pays the check for the tax, bears the
burden of the tax
• Economic incidence: Who actually bears the burden of the tax as a
result of the market reaction to the tax. Typically different than who
sends in the check for the tax.
• Who ends up bearing the burden of the tax depends on the elasticities of
supply and demand
• Two Types of Sales Tax:
– Ad valorem tax: Tax is a fraction of the price
– Specific/unit tax: Specified dollar amount is collected per unit of
output

2.2.4 What you should know and be able to do:

• Understand how to determine what happens to equilibrium price and
quantity as a result of shocks in supply and demand
• Know how to determine the supply and demand curves from a table of
price, demand quantity and supply quantity
• Explain the difference between a movement along the demand (supply)
curve and a shift of the demand (supply) curve.

• Solve for the equilibrium price and quantity

• Know how to calculate and interpret elasticities
• Know how to determine aggregate supply and demand when given indi-
vidual supply and demand curves

• Be able to interpret the impact of price ceilings and price floors on market
equilibrium. Be able to calculate the excess demand or excess supply

7
 • Calculate price elasticity of demand and price elasticity of supply from
equations for demand and supply (respectively) at a point along the curve.
• Explain what the elasticity of demand/supply imply about changes in
prices (i.e. what will happen?)

• Determine the fraction of tax incidence that the consumers and producers
bear (respectively).

2.3 Consumer Theory

2.3.1 Preferences
We impose three assumptions about rational consumer preferences.

1. Completeness: Rules out the possibility that the consumer cannot de-
cide which bundle is preferable. A consumer can always rank bundles a
and b as either (1) prefers a over b, (2) prefers b over a, or (3) is indifferent
between a and b.
2. Transitivity: A consumer’s preferences over bundles is consistent. e.g.
if a consumer prefers a to b (”a > b”) and prefers b to c (”b > c”), then
the consumer will prefer a to c (”a > c”).
3. Non-satiation: More is always better.
These three assumptions result in the following properties of indifference curves:

• Consumers prefer further-out indifference curves

• Indifference curves are downward sloping
• Indifference curves never cross

• There is one and only one indifference curve through every consumption
bundle
You should be able to link each of the properties above to the assumption that
results in that property

2.3.2 Indifference Curves of Perfect Substitutes and Per-

fect Compliments
The indifference curves of perfect substitutes and perfect compliments are as
follows:

8
Utility

• A utility function is a function that transfers bundles of goods into scale

of utils; note that it provides only an ordinal ranking, not a cardinal one.
• Often we assume diminishing marginal utility, i.e. that consumers receive
less utility from each unit of a good they consume.
• The slope of an indifference curve is called the marginal rate of substi-
tution and it is equal to the ratio of marginal utilities:
∂U
M UX
– M RSXY = M UY = ∂x
∂U
∂X

2.3.3 Budget constraints and constrained choice

• Budget constraint over two goods X and Y is defined I = pX X + pY Y.

• Slope of the budget constraint is defined as marginal rate of transfor-

mation: rate at which you can transform one good into the other in the
marketplace: M RTXY = ppX Y

• Shifts in price and income alter the position and slope of the budget con-
straint.

• The optimal bundle that a consumer can choose is defined by the point
of tangency between the budget curve and the budget line, i.e. where
M RS = M RT . This is equivalent to equating the marginal cost and the
benefit of consuming each good.
• Note: The above equation provides an interior solution (in which the
consumer consumers some of each good). If indifference curves are linear,
or intersect the axes, there can also be corner solutions in which the
consumer only consumes one good.

9
2.3.4 Deriving Demand Curves
• We can use the constrained optimization problem to derive the demand
curve. In other words, as we change prices of goods, we can observe
how quantities demanded for those goods change, thereby tracing out the
demand curve (the relationship between quantity and price demanded)

2.3.5 Changes in Income

• As you change income, you can trace out the relationship between income
∂Q
Q
and consumption, which provides the income elasticity of demand: γ = ∂I
I

• Types of Goods:
– Normal goods: Income elasticity is positive, so as income rises, you
consume the same or more of these goods. There are two types of
normal goods:
∗ Necessities: 0 < γ < 1. Goods where you spend a smaller share
of your income as it increases (e.g. food). You still buy more of
it when your income rises, but you spend a smaller fraction of
your income on it.
∗ Luxury goods: γ > 1 You spend a larger share of your income
on them as income rises (e.g. cars, jewelry).
– Inferior goods: Income elasticity is negative, which means you
consume less of these goods as your income rises.
∗ Giffen goods are a type of inferior good for which you consume
more as their price rises.

2.3.6 Changes in prices

• An increase in price has two effects:
– It makes the consumer relatively poorer (income effect), and
– It also makes this specific good less attractive relative to alternatives
(substitution effect).
• The substitution effect can be interpreted as the shift in goods consumed
from the original point to the optimal point for a budget constraint that
has the new slope, but is tangent to the old indifference curve.
• Substitution effect is always negative, but income effect can be positive.
• Accordingly, the overall effect of a price increase on consumption of a good
can be negative, i.e. you consume less of it as price increases - this is true
for a normal good). Or the overall effect could be positive, i.e. you
consume more of it as price increases - this is true for inferior goods and
the income effect is larger than the substitution effect.

10
2.3.7 Income/Substitution Effects and Labor Supply
• Income and substitution effects can be used to analyze labor supply:
– Leisure is a consumption good; price of leisure is the wage; we con-
sider leisure to be a normal good.
– When the wage increases, this has both an income and substitution
effect
∗ Income effect: Each worker is now richer, and may want to
work less (consume more leisure).
∗ Substitution effect: returns to work are higher, therefore work-
ers may want to work more (leisure is more costly)
∗ If the income effect is greater than the substitution effect (it more
than offsets it), then labor supply would go down when income
rises.

2.3.8 What you should know and be able to do:

• Indifference Curves & Utility Functions
– Be able to determine if an individual’s preferences satisfy all the
assumptions
– Draw indifference curves corresponding to perfect complements and
perfect substitutes
– Know the corresponding utility functions for perfect complements
and perfect substitutes perfect complements: U(a,b) = min(a,b)
– Calculate the marginal utilities given a utility function
– Calculate the M RS given a utility function
– Understand the difference effects of a specified voucher (e.g. food
stamps) and a cash-transfer in respect to a given consumption bundle
prior to receiving the voucher or cash.
• Budget Constraints & Constrained Choice

– Know how to write down a budget constraint given prices and in-
comes
– Know how to graphically find the bundle that maximizes the con-
sumer’s utility subject to the budget constraint.
– Solve mathematically for the optimal bundle given a utility function,
prices of two goods, and income. Be able to check for corner solutions
• Deriving Demand Curves
– Calculate the income elasticity of demand

11
 – Decompose the effect of a price change into the income and substi-
tution effects
– From the income and substitution effects, be able to determine if the
good is a normal good or an inferior good
• Income/Substitution Effects and Labor Supply

– Calculate the income and substitution effect due to changes in wages

2.4 Producer Theory & Competition

2.4.1 The Production Function
• q = f (L, K)

– q: units of output
– L, K: labor and capital inputs
• Marginal Product

– The additional output gained from one extra unit of an input, holding
the other inputs constant
– Marginal Product of Labor: The additional output gained from
one extra unit of an labor, holding the other inputs constant
∂q
∗ M PL = ∂L
– Marginal Product of Capital: The additional output gained from
one extra unit of an labor, holding the other inputs constant
∂q
∗ M PK = ∂K

• Isoquants

– Slices of the production function that show combinations of K and

L that produces the same level of output q
∗ Isoquants are the analogues of indifference curves
∗ Their shape is determined by the substitutability between K and
L
– The slope is called the Marginal Rate of Technical Substitution
(MRTS)
∂q
M PL
∗ M RT SLK = M PK = ∂L
∂q
∂K
∗ The isoquant exhibits diminishing margins of returns - i.e. each
additional unit of labor (capital) increases q less than the previ-
ous unit and it worth less in terms of forgone capital (labor)

12
2.4.2 Production and Costs
• Fixed costs: Are the costs of inputs that cannot be varied. In the short
run, K (capital) is fixed (i.e. the size of the plant/firm). In the long run,
there are no fixed costs
• Variable costs: Costs that can be varied. In the short run, labor can be
varied. In the long run, all costs are variable.
• Total cost: Fixed cost(s) + Variable cost(s)
• Marginal costs: Additional cost of producing one more unit
∂C
– MC = ∂q , where C is the total cost
– Note: In the short-run, M C = ∂V ∂q
C
where the marginal cost is
determined by the increase in the variable cost, since fixed costs do
not vary with output.
• Average Cost: The average cost of production per unit produced
C
– AC = q Average costs
VC
– AV C = q Average variable costs
FC
– AF C = q Average fixed costs

2.4.3 Deriving the Cost function

The question we are trying to answer is: for a given amount of q, what is the
lowest-cost way to combine K and L to produce it?
1. We start by defining the analogue of the budget constraint - the isocost
line
• Isocost Line - combinations of labor and capital that produce
the same level of cost
– C = wL + rK
2. Like in consumer optimization, we want to produce at the tangency point
between the isocost and the isoquant. In other words, we want to find the
lowest isocost for a given isoquant
M PL w
• M RT S = M PK = r

3. Deriving the total cost curve

• Use your production function and point (2) to derive relationships
between inputs and q
• Plug these relationships back into the total cost function C = wL +
rK
Remember that in the short run, capital is fixed so your cost function should
reflect this.

13
2.4.4 Relationship between Long-Run Average Cost vs.
Short-Run Average Cost Curve
• The LRAC is the lower envelope of the SRAC for different plant sizes
• The LR cost of production is lower than the SR cost of production

2.4.5 Economics of Scope & Economics of Scale

• Economies of Scope: Situation in which it is less expensive to produce
goods jointly than separately. In other words, firms that produce multiple
goods more cheaply should produce goods together rather than separately.
• Economics of Scale: Average cost function of production decreases as
output increases. Diseconomies of scale: refers to the opposite phe-
nomenon - average cost increases when output increases.
• Constant Returns to Scale: f (2L, 2K) = 2f (L, K)
• Decreasing Returns to Scale: f (2L, 2K) < 2f (L, K)

• Increasing Returns to Scale: f (2L, 2K) > 2f (L, K)

• Economies of Scale in Production:
– C(2q) < 2C(q)
– C(2q)/q < 2C(q)/q
– C(2q)/2q < C(q)/q
– Average cost of producing more is less than average cost of producing
less
• Diseconomics of Scale in Production: C(2q) > 2C(q) → AC(q) increases

2.4.6 Perfect Competition

In a perfectly competitive market, there are:
1. many small buyers and sellers

2. identical products
3. symmetric information
4. no transactions costs
5. free exit and entry in the long run

14
2.4.7 Residual Demand
• Residual Demand is the market demand that is not met by other sellers
at a given price.
• Equation: Dr (p) = D(p) − S ◦ (p), where Dr (p) is the quantity demanded
from a particular firm at price p, D(p) is the total quantity demanded by
the market, and S ◦ (p) is the amount supplied by other firms.
• The residual demand (or the demand curve a firm faces) is much more
elastic than the overall demand curve of the market.

2.4.8 Profit Maximization

A firm will want to maximize profits, which is equal to: π = R(q) − C(q), where
R(q) are the total revenues the firm receives from selling output q and C(q) is
the cost function that it faces. A firm therefore solves the following problem:

max π(q) = R(q) − C(q)

q

To do this, we do the following steps:

∂π(q) ∂R(q) ∂C(q)
1. ∂q = ∂q − ∂q

∂R(q) ∂C(q) ∂π(q)

2. ∂q = ∂q (want the point at which profits are maxed, or ∂q = 0)

Note: The last step can be rewrite as marginal revenue = marginal cost (M R =
M C)

2.4.9 Profit Maximization in the Short-Run

1. Firm maximizes profits by producing output where M R = M C;
2. Competitive firm faces a perfectly elastic demand curve, M R = P . Hence,
for a perfectly competitive firm, P = M C;
3. In short run firms use short run cost curves (SRMC, ATC, AVC) to make
profit maximization and shut down decisions;
4. Firm shuts down if P < min AV C;
5. Derive individual firm short run supply curve using P = M C and Q = 0
(shut down) for P < min AV C.
6. SR market supply curve is horizontal sum of individual firm SR supply
curves.
7. Industry profits can be positive or negative in SR.
−w
8. K is fixed, therefore cannot choose input mix by setting M RT S = r ,
and the following is also true:

15
 • Fixed cost: F C = rK
• Variable cost: V C = wL
• Short run cost: SRC = rK + wL

2.4.10 Competition in the Long Run

• In LR free entry and exit drives economic profits to 0, i.e. P = M C = AC.
Hence, LR industry supply curve is perfectly elastic at P = min AC and
each firm produces at q = arg min AC;

• With barriers to entry, problem is as in the SR only firms use their LR

cost curves; LR individual supply curve with barriers to entry is LRMC
curve above minimum of AC and 0 below.
• SR supply less elastic than LR supply with entry barriers, which is less
elastic than LR supply with free entry.

• Increasing input prices can lead to an upward sloping LR supply curve

even with free entry
• Long run cost: LRC(Q) = rK(Q) + wL(Q) → recall in the LR there is
no fixed costs, therefore the following is also true:
w
– M RT S = r
M PL w M PL M PK
– M PK = r → w = r

2.4.11 Note on Economic Profit and Opportunity Costs

Also remember that in this course, we are considering the opportunity costs
and not just the accounting costs The opportunity costs take into account the
amount that would have been earned at the next best investment. Therefore, in
this course, when we talk about economic profit, we are referring to revenue
minus opportunity costs. And so, when we say in the long-run that economic
profit is zero, what we mean is that the firm is earning the normal business
profit that the firm would have earned with its next best investment.

2.4.12 What you should know and be able to do:

• Production Theory and Isoquants
– Given a production function and the inputs for capital and labor, be
able to calculate the MRTS, the marginal product of capital, and the
marginal product of labor.
– Be able to determine the marginal returns to labor and capital (i.e.
are they diminishing, constant, or increasing)
– Be able to determine the returns to scale given a production function

16
 – Given a production function and the cost of capital and labor, be
able to minimize costs for a given quantity produced.
– Graph isoquants and isocost curves, finding the (L,K) combination
that will produce any level of q most cheaply; don’t forget to check
for corner solutions

• Production and Costs:

– Know the definitions for total cost, variable cost, and fixed cost.
Understand difference between short-run and long-term costs.
– Understand the relationship between SRMC, LRMC, SRTC, LRTC,
SRAC, and LRAC.
– Know the difference between opportunity costs and accounting costs.
– Be able to determine if a production process exhibits returns to scale
and identify what type of returns to scale (increasing, constant, or
decreasing).

• Residual Demand:
– In a perfectly competitive market with n firms, calculate residual
demand that a single firm faces
• Short run vs. Long run

– Explain the difference between the short run and the long run
– Explain why average costs are at a minimum when they cross the
marginal cost curve
– Explain/know the condition when a firm will shut down (1) in the
short run and (2) in the long run
– Explain when firms will enter/exit in the long run
– Explain why, in theory, long run supply in a perfectly competitive
market will be flat at min ATC when there are identical firms
– Know why ATC = MC = p in the long run for a firm in a perfectly
competitive market
– In a perfectly competitive market in the short-run, given cost curves
for firms, demand, and the number of firms, find the equilibrium
price, what each firm produces, and the total quantity
– In a perfectly competitive market in the long run, given a cost curve
for each firm and demand, determine the equilibrium price, what
each firm produces, the total quantity, and the number of firms
– In a perfectly competitive market, given a short run cost curve, find
the short run supply curve for a firm

17
2.5 Welfare Economics
2.5.1 Consumer Surplus
• The area under the demand curve and above the price is consumer sur-
plus since the demand curve represents the marginal willingness to pay
for a good

2.5.2 Producer Surplus

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

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2.5.3 Competition Maximizes Welfare
• Total welfare (CS + PS) is maximized when demand = supply in a per-
fectly competitive market.
• At any other output level, other than the market equilibrium in a perfectly
competitive market, there will be a deadweight loss
– Deadweight loss: Gains from trade that are left unexploited
– Deadweight loss can be caused by monopolies, government taxation,
etc.
∗ The government may enact some policies that lead to dead weight
loss in order to raise tax revenues or to increase equity (i.e. take
from the rich to give to the poor)

2.5.4 What you should know and be able to do:

• Understand the concept of dead weight loss and why it occurs in non-
perfectly competitive market scenarios (i.e. explain why competition max-
imizes total surplus.

19
 • Understand how changes in prices would affect the calculation of consumer
surplus (same for producer surplus) in the case that the market remains
perfectly competitive.
• Know how to calculate consumer surplus, producer surplus, and dead-
weight loss from various government policies (e.g. price floor, price ceiling,
etc.)

2.6 Monopoly and Oligopoly

2.6.1 Monopoly Profit Maximization
• Total Revenue is
T R = P (Q) · Q

• Average Revenue for a firm is given by demand curve

AR = P (Q)

• Marginal Revenue is additional revenue from selling one more unit,

∂T R
MR =
∂Q

• Perfectly Competitive firm faces a perfectly elastic demand curve,

P (Q) = P and hence, M R = P = AR.
• Monopoly faces downward sloping demand curve and hence

∂T R ∂(P (Q)Q) ∂P
MR = = = P (Q) + Q
∂Q ∂Q ∂Q

∂P ∂P
• Notice that M R = P (Q) + Q ∂Q < P (Q) since ∂Q < 0.
• Monopolist has to decrease price on all units sold in order to sell one
additional unit. This is not the case with a perfectly competitive firm,
which cannot influence the price at which it sells.

– MR curve for monopolist is below AR curve (the demand curve)

• A monopoly never produces at the inelastic part of the demand curve

∂T R ∂(P (Q)Q) ∂P Q ∂P 1
MR = = = P (Q)+Q = P (Q)(1+ ) = P (1+ )
∂Q ∂Q ∂Q P (Q) ∂Q D

For |D | < 1, M R < 0

• Profit maximization

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 • ⇒ M R = M C.
1
M R = P (1 + ) = MC
D
P − MC 1
Markup → =−
P D
• Hence mark-up, measure of monopoly power, depends on the elasticity of
demand
• Shut down decision is like that of a competitive firm.

2.6.2 Welfare Effects of Monopoly

• Because MR < AR, monopolist would supply less than the socially optimal
(welfare maximizing) level of output, which leads to a deadweight loss

2.6.3 Price Discrimination (Monopolies)

• The above analysis is for a uniform pricing monopoly, i.e. the monopolist
sets the same price for every unit sold or for every consumer type.
• However, a monopolist can price discriminate, i.e. set different prices
for different units, charge different uniform prices for different consumer
groups, use two part tariffs, etc.

• Perfect Price Discrimination

– Monopolist charges each consumer their willingness to pay for the
good, and hence extracts all the consumer surplus. MR curve is now
the AR curve, i.e. the demand curve.
– Set output where new MR curve equals MC, i.e. where demand
intersects MC.
– Hence, a perfectly price discriminating monopolist produces the so-
cially optimal output level, i.e. there is no dead weight loss.

2.6.4 How do Monopolies Arise?

1. Cost advantages - Natural monopoly, for any output produce at lower
AC than any other firm can (AC is declining).
2. Barriers to entry - Fixed costs, patents.

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2.6.5 Regulating Monopolies/Reducing DWL
• Government regulation of monopoly, through a price ceiling can improve
welfare.
– Setting a price ceiling at the competitive price leads to zero DWL.
– Effect of a unit tax on the price of good - price of good can increase
by less than 1 for 1 with the tax or by more
• Note difference with perfectly competitive market → in perfectly compet-
itive markets, usually a government intervention leads to a dead weight
loss
• Contestable markets also helps regulate monopolists → threat of en-
try disciplines monopolist and they charge a price close to the perfectly
competitive price.

2.6.6 What you should know and be able to do:

• Conceptually
– Explain why marginal revenue is less than average revenue for a mo-
nopolist but not for a competitive firm
– Know why both a monopolist and perfectly competitive firm want to
set M R = M C
– Explain why there is dead weight loss (DWL) when a monopolist
cannot price discriminate
– Explain why there is no dead weight loss (DWL) when a monopolist
can price discriminate
– Explain how certain policies (e.g. price ceilings) can reduce or elim-
inate the dead weight loss created by a monopoly.
• Mathematically/Empirically
– Given a cost function and a demand curve, solve for the price and
quantity in a market with a monopolist; be sure to check whether
the monopolist will want to shut down

2.7 Oligopoly, Game Theory & Cartels

2.7.1 Oligopoly
• Small number of firms that interact strategically (not price takers but
have to take into account other firms’ decisions when making their own
decisions);
• Duopoly: Particular type of oligopoly - market with two firms

22
2.7.2 Game Theory - Definitions
• Game Theory: Study of the outcome of strategic interactions. In game
theory, a player’s objective is to maximize payoffs given actions of others
• Non-cooperative games: Players cannot enforce mutually beneficial
strategies
• Strategies: possible actions that players choose from to maximized pay-
offs
• Dominant strategy: Strategy that maximizes a player’s payoff no mat-
ter what the other player does
• Nash equilibrium: Each player is doing the best it can (maximized
payoff) given the actions of its opponents;

2.7.3 Cournot Model of Non-cooperative Equilibrium

• Cournot duopoly - two firms compete by setting output levels simulta-
neously. Each firm treats the output of its competitor as fixed; –
• Reaction curve - relationship between firm’s profit maximizing output
and output it thinks its competitor will produce;

• Cournot equilibrium - Nash equilibrium of Cournot duopoly game.

Output levels for which reaction curves intersect.
• Cournot Math : All firms set quantities at the same time
1. Calculate residual demand for a given firm (in other words, the de-
mand for a firm’s product subtracting out other firms’ output deci-
sions)
2. Create a total revenue function
3. From the total revenue function, derive marginal revenue
4. Solve its profit maximization problem (M R = M C). This will give
you a firm’s best response function to other firms’ output decisions.
5. Solution is a set of quantities (one for each firm) that solves the
system of equations in step 4.

2.7.4 Cooperative Equilibrium - Cartels

• Firms can form a cartel and behave like a single monopolist, maximizing
total industry profits.
• Cartels are unusual because they are fundamentally unstable (incentive to
“cheat” and raise own production) and because they are illegal (antitrust
laws).

23
2.7.5 Comparing Equilibria
• In terms of welfare, usually Perfect Competition > Oligopoly > Monopoly
• Quantity as an indicator of social welfare

• Recall: DWL in welfare analysis comes from trades that aren’t made

2.7.6 Many Firms

• In Cournot, as number of firms → ∞, Cournot equilibrium approaches
competitive equilibrium
• As number of firms → 1, approaches monopoly
• Markup over competitive price depends on number of firms and elasticity
of demand: P −M
P
C
= − n1D

2.7.7 Price Competition

• Bertrand Price Competition: firms set prices (instead of quantities)
at the same time
• Two firms may be enough to remove market power (i.e. restore competi-
tive outcome) if products are identical
• Recall proof from class that identical Bertrand duopolists drive price down
to marginal cost. In other words, firms who compete via Bertrand, will
set their prices at marginal cost.

2.7.8 What you should know and be able to do:

• Conceptually
– Explain the “prisoner’s dilemma” problem
– Understand when/how a Nash Equilibrium occurs
– Understand why cooperation can be sustained in a infinitely repeated
game but not in a game with finite periods
– Explain why cartels are unstable
– Compare welfare from different forms of competition (monopoly, oligopoly,
perfect competition)
– Know the difference between quantity (Cournot) and price (Bertrand)
competition
• Mathematically/Empirically

– Find the Nash equilibrium of a game, given a payoff matrix

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 – Solve for quantities and prices when two firms compete in Cournot
equilibrium
– Solve for a cartel equilibrium with n firms
– Solve for price and quantity when firms compete in a model of Bertrand
price competition

2.8 Other Topics in Economics

2.8.1 International Trade
• Key Definitions:
– Autarky: an environment in which trade does not exist
– Trade Deficit: imports − exports
• Comparative Advantage and Gains from Trade:
– We say a country has a comparative advantage in the production
of a good when the opportunity cost of producing a particular good
is lower in any one country.
– Differences in opportunity costs lead to comparative advantage in
different goods
– Even when countries have an absolute advantage in producing a
good, there can be a comparative advantage
– When countries have different comparative advantages in production
of different goods, there are potential gains from trade through spe-
cialization, i.e. each country produces what it has a comparative
advantage in producing.
• Welfare Implications from International Trade
– In competitive model, opening to trade unambiguously increases total
welfare but usually at the expense of either consumers or producers

2.8.2 Uncertainty
• Expected value:
– A random variable X can take the values x1, x2, ...xk and each value
occurs with probability p1, p2, ...pk . Then the expected value of X is

E[X] = x1 p1 + x2 p2 + . . . + xk pk

In other words, the expected value is the sum of the probability of

each outcome times the value of that outcome
– A fair gamble: Zero expected value

25
• Expected utility:
– Probability-weighted average of utility

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

– Note: expected utility can also be written as EU = Pr(Lose) U(Lose)

+ Pr(Win) U(Win)
– Different than utility of expected value, since utility functions usually
concave (diminishing MU of income)! Diminishing MU of income
means that the next dollar is worth less to you than the last one was
in terms of happiness you gain
• Risk preferences

– Risk Averse: Concave utility (decreasing MU of income)

√
U (C) = C

– Risk Neutral: Linear utility (constant MU of income), i.e. an agent

only cares about expected value!

U (C) = C

– Risk Loving: Convex utility (increasing MU of income)

U (C) = C 2

• Applications

– Insurance
1. Risk averse people will pay money to turn a gamble into a certain
payoff since they get higher utility from certain income than from
a gamble with the same expected value
2. Maximum amount they’re willing to pay for this is their risk
premium
∗ The risk premium rises as the size of the loss rises (holding
other variables constant)
∗ The risk premium falls as income rises (because loss is closer
to linear)
– Lottery behavior is a puzzle
∗ Maybe risk averse at low incomes and risk loving at high incomes
∗ Maybe people get utility out of lottery
∗ Maybe people don’t know what they are doing or misinformed
about payoffs/probability

26
2.8.3 Capital Markets
• Key Concepts: Capital Markets
– Capital Markets: pools of money that firms can draw on to make
investments
– Supply of capital comes from household decisions about how much
to save - increasing in the interest rate
– Demand for capital comes from firms with potentially productive
investments to make - decreasing in the interest rate
– Interest Rate: rate firms have to pay a household to lend money;
the interest rate can also be thought of as the price of consumption
today, since by consuming today, you are foregoing the opportunity
to save and get the interest rate.
• Present Value

– A dollar today is worth more than a dollar tomorrow because today’s

dollar can be invested and an interest rate can be earned
– Need to translate all future dollars into today’s terms in order to
compare investment and consumption options
– Present value:the value of each period’s payment in today’s terms-
each payment is weighed according to how far in the future it is
1. For a single payment of future value (FV) in year t:

FV
PV =
(1 + r)t

This can also be written as

F V = P (1 + r)t

Note P , which stands for principal, is the same as P V present

value.
2. More generally, the formula can be written as F V = P (1 +
r/m)mt where m is the number of compounding periods per year.
3. Equations (1) and (2) are cases of discrete compounding.
4. There is also the case of continuous compounding: If m becomes
really large (e.g. the interest rate could just be 10%, but com-
pounded each minute. Future value rises as m increases, but at
a diminishing rate. As m → ∞, future value is described by
an exponential functionF V = P ert , where e is the base of the
natural logarithm.
• Present value, utility functions, budget constraints and house-
hold maximization

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 – Households maximize utility over time subject to an inter-temporal
budget constraint
– The total utility of a household that lives in two periods and consumes
c1 in period 1 and c2 in period 2 and discounts the future with discount
factor β is
U = u(c1 ) + βu(c2 )
– Budget Constraint
∗ Household can save s of its income in the first period (y1 ), or it
can borrow against its second period income (y2 )
∗ Interest rate on both savings and on loans is equal to r
∗ Budget constraint in first period of life c1 + s = y1
∗ Budget constraint in second period of life c2 = y2 + (1 + r)s
c2 y2
∗ Together c1 + 1+r = y1 + 1+r
• Investment Decisions
– Net Present Value (NPV) = PV of revenues - PV of costs
– Rule: Invest if NPV greater than zero
– if revenues Rt in each period and costs Ct , NPV of investment is:
R1 − C1 R2 − C2 Rt − Ct
N P V = (R0 − C0 ) + + + ... +
(1 + i)1 (1 + i)2 (1 + i)t

2.8.4 Equity & Efficiency

• Socially Optimal Allocation
– Social welfare function (SWF) can be thought of as a utility
function for society taking individual utilities as inputs
SW F = f (U1 , U2 , ....)
– Isowelfare curves: distributions of utility across which society is
indifferent
– Utilitarian: Social welfare function is just the sum of all individual
utilities (by definition). In this equation, every personal is given equal
weight.
SW F = U 1 + U 2 + . . .
∗ Note: This does not mean that utilitarians are indifferent about
who holds the money ⇒ the diminishing marginal utility of
money means that money will increase poor person’s utility more
than rich persons’.
∗ Additionally, utilitarians would not necessarily seek to maximize
the size of the economy if redistributing to poor people caused
the economy to shrink but overall utility to grow.

28
 – Rawlsian SWF: should maximize the utility of the worse off person
in society.
SW F = min(U 1, U 2, ....)
• Taxation and Redistribution

– What Should We Tax?

1. European countries raise most revenue through VAT on con-
sumption
2. Consumption taxes encourage savings but not progressive
3. Excise taxes usually on “sin goods”
4. Negative externality: Negative impacts on society which the
individual does not pay for. Must abide by two conditions
∗ Costs on others, not self
∗ Costs that the individual doesn’t pay for, ex: smoking, drink-
ing
∗ Individuals tend to overconsume these as they do not bear
all of the costs
– Corrective taxation
∗ Society wants individuals to internalize the externality; price of
the good includes the cost of the good to society

• What is the Right Tax Rate?

– Tax revenues = base · τ
– As tax rate rises, base shrinks

d(taxrevenue) d(base)
= base + τ
dτ dτ
– Laffer curve: tax revenue initially rising, then falling with tax rate
(depends on elasticity of tax base)

2.8.5 Behavioral Economics

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

• Hyperbolic discounting
T
X
U = u(C1 ) + β u(Ci )δ i = u(C1 ) + βδu(Ci ) + βδ 2 u(Ci ) + . . .
i=2

29
 • Time inconsistency/time-inconsistent preferences: the choices a
person wants for her future self to make are not the choices that her
future self does make. Time consistent agents keep the same preferences
about an intertemporal trade-off even as it approaches in time.
• Loss aversion: refers to people’s tendencies to prefer avoiding losses to
acquiring equivalent gains - extremely high levels of risk aversion such that
it cannot be explained by the standard definition of risk aversion alone.
• Other terms that you should be familiar with:
– Framing effects
– Statistical biases
– Endowment effects
– Intrinsic motivation

2.8.6 Health Economics

• Health insurance markets suffer from issues of
– adverse selection: health insurance cannot perfectly determine the
health status or health behaviors of an individual
– externalities: one person getting sick makes it more likely others will
get sick; hospitals often still treat uninsured people who cannot pay
(especially in acute situations)

2.8.7 What you should know and be able to do:

International Trade
• Distinguish between comparative advantage and absolute advantage
• Explain why international trade unambiguously raises social welfare
• Given costs of production for two nations, determine, for each good, which
country has an absolute and/or comparative advantage
• In diagrams and math, show the welfare impact of imports and exports in
US markets (In lecture, we did an example with roses and computers.)
• Analyze the welfare impact of an import tariff

Uncertainty
• Given a utility function, be able to determine whether the agent is risk
neutral, risk averse, or risk loving
• Calculate the expected value and expected utility from a gamble, given a
utility function and a description of the gamble

30
 • Calculate the risk premium for insurance, given a utility function and a
description of the relevant risks

Capital Markets
• Explain how the interest rate is determined in a capital market equilibrium
• Describe how individuals make intertemporal consumption decisions

• Intuitively describe the income and substitution effects on current con-

sumption when the interest rate changes
• Explain the reasons why supply of funds in a capital market is upward
sloping while demand for funds in downward sloping

• Calculate how a consumer chooses C1 (consumption this year) and C2

(consumption next year) given an income in the first year and a utility
function
• Solve problems involving present and future values

• Solve problems in which agents have different potential income streams

over time and have to make intertemporal utility maximization decisions.
• Calculate the present value (PV) of a payout stream over time
• Calculate the net present value (NPV) of an investment choice for a firm

Equity & Efficiency

• Explain what different social welfare functions imply about optimal allo-
cations
• Do simple calculations to determine welfare under different SWF
• Identify whether a particular tax is progressive, flat, or regressive

• Discuss the Laffer curve and implications for the tax rate

Behavioral Economics
• Know the difference between the exponential discounting model and the
hyperbolic discounting model
• Given a utility function that demonstrates either exponential or hyperbolic
discounting, be able to calculate present value of a given action and then
determine which choice a person will make (e.g. PS 11’s question on
reading a book vs. seeing a movie)
• Be able to determine whether or not a utility function and a course of
action demonstrates time inconsistency

31
Health Economics
• Understand the issues with insurance markets (e.g. adverse selection)
• Understand how different aspects of the Romneycare/Obamacare address
these issues.

32