Study Guide For Introductory Microeconomics: Ka-Fu WONG

Study Guide for Introductory Microeconomics
Ka-fu WONG
December 7, 2020
Contents
Contents i
Preface iii
Acknowledgments iv
0 Required Mathematical Tools 1

0.1 Linear Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Slope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Intercept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
0.2 Solving a system of (Two) Linear Equations . . . . . . . . . . . . . . . . . . . . . . . . 3
0.3 Quadratic Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
0.4 Coordinate Geometry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1 Cost and Benefit Analysis 8

1.1 Important Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2 Frequently Asked Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2 The Power of Trade and Comparative Advantage 11

3 Supply, Demand, and Market Equilibrium 15

4 Comparative Statics 22
5 Elasticity 26
i
CONTENTS ii
6 Taxes and Subsidies 33

6.1 Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
6.2 Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
7 Price Ceilings and Floors 38

7.1 Price Ceilings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Problems of Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Solutions to Allocative Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
7.2 Price Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
8 Externalities 43
9 Public Goods and Tragedy of Commons 47

10 Cost and Profit Maximization Under Competition 50

11 Monopoly 57
12 Price Discrimination 63
13 Oligopoly and Strategic Behavior 65

Preface
This guide aims to provide additional help to students to study Introductory Microeconomics. It is
not a replacement of the textbook or lectures. Rather it is meant to complement the other learning
activities of the course – the textbook, the lectures, the weekly assignments, etc.
Students should keep in mind that concepts of later chapters build very much on previous chap-
ters. Lacking a good foundation of previous chapters, students often have difficulty understanding the
concept in later chapters.
There is no room to procrastinate. Do not let your questions and problems accumulate. Ask your
teaching assistants and teachers as soon as you have difficulty learning a concept.
Check your understanding with the numerous practice questions early.
The best way is to put in consistent effort and practice sample questions throughout the semester.
Remember, the exams tend to be packed with questions, and you will do well in the exam only if you
are very familiar with the concepts and the approach in solving the questions.
Memorizing the terms and understanding the concepts are just basic. The key is to apply concepts
to solve the problems. Because economic decisions and analysis require the comparison of cost and
benefits, most of the applications are often quantitative.
iii
Acknowledgments
In developing this guide, we try to involve students who had performed well in the course. Their
experience and advice are most important.
This guide would not be possible without the contribution of the following contributors:
• Ka-fu WONG supervised the development of this study guide.
• Pak Hei Oswin CHOW and Julian PALLINGER contributed most of the chapters. (Both worked
as research assistants for this project in the summer of 2020.)
iv
Chapter 0
Required Mathematical Tools
The following secondary school mathematical concepts are assumed. To do well in this course, you
need polish up your proficiency in these concepts.
0.1 Linear Functions

A linear function is a relation of the form,
y = a + bx
where a and b are constants. The value of x is related to exactly one functional value y. Graphically,
a linear function represents a line on the two-dimensional coordinate plane (the vertical y-axis and the
horizontal x-axis). The parameter a is called the y-intercept because it indicates where the function
cuts the y-axis when x is zero. The parameter b indicates the slope of the line. If it is positive, the line
is upward-sloping, if it is negative, the line is downward-sloping. The x-intercept of a linear function
is found, when setting y = 0 and solving for x.
Slope
If we have an equation in the form of y = a + bx, we can directly read the slope as “b”.
If we have an equation in the form of x = c + dy, we will have to rewrite the equation
x = c + dy
dy = −c + x
c 1
y = − + x
d d
Thus, the slope of the line is 1/d.
If we are given two points on the line, (x1 , y1 ) and (x2 , y2 ), we can compute the slope as
y2 − y1 y1 − y2
slope = =
x2 − x1 x1 − x2
1
CHAPTER 0. REQUIRED MATHEMATICAL TOOLS 2
Intercept
Remember, y-intercept is the value of y coordinate when x takes the value of zero. If we have an
equation in the form of y = a + bx, we can directly read the y-intercept as “a”.
y =a+b×0=a
If we have an equation in the form of x = c + dy, we can find the y-intercept by setting x = 0.
0 = c + dy
dy = −c
c
y = −
d
Similarly, x-intercept is the value of x coordinate when y takes the value of zero. If we have an
equation in the form of x = c + dy, we can directly read the y-intercept as “c”.
x=c+c×0=c
If we have an equation in the form of y = a + bx, we can find the x-intercept by setting y = 0.
0 = a + bx
bx = −a
a
x = −
b
Example. A line passes through two points (x, y) , P1 = (2, 7) and P2 = (6, 1). The slope of the line
can be calculated as:
∆y 1−7
b= = = −1.5
∆x 6−2
The y-intercept is given by:
7 + 2 × 1.5 = 10
The x-intercept is calculated as

3 20
0 = 10 − x ⇔ x =
2 3
The equation of the line is thus
y = 10 − 1.5x
Figure 0.1: Example of a linear function
0.2 Solving a system of (Two) Linear Equations

Suppose we have two linear equations:
Line 1 f1 (x): y = 3 + 2x
Line 2 f2 (x): y =7−x
Let the intersection point be (x∗ , y ∗ ). To solve for the intersection point of these two equations, we
set
y∗ = y∗
3 + 2x∗ = 7 − x∗
3x∗ = 4
4
x∗ =
3
Using the equation of line 1, we can find the implied y value at the intersection point (i.e, y ∗ ).
17
y ∗ = 3 + 2x =
3
We can easily verify that we can get the same y ∗ by substituting x∗ into the equation of line 2.
17
y∗ = 7 − x =
3
Then the point of intersection is given by

∗ ∗ 4 17
(x , y ) = ,
3 3
Figure 0.2: A system of linear equations
Two lines on a two dimensional plane can intersect, be parallel, and can coincide with each other.
They intersect when they have different slopes. They are parallel when the slopes are the same, but
with different y-intercepts. They are identically overlapping when both the slopes and the y-intercepts
are identical.
Consider the two lines
Line 1: y = a1 + b1 x
Line 2: y = a2 + b2 x
Slope Intercept Relationship

b1 = b2 a1 = a2 ⇒ line 1 and line 2 are identical
b1 = b2 a1 6= a2 ⇒ line 1 and line 2 are parallel
b1 6= b2 a1 = a2 ⇒ line 1 and line 2 intersect (specifically at y-axis)
b1 6= b2 a1 6= a2 ⇒ line 1 and line 2 intersect
0.3 Quadratic Equations

A quadratic function is a polynomial of degree two. Its general form is
y = ax2 + bx + c, a 6= 0
where a, b and c are constants. It represents a parabola where a indicates the steepness of the function
and whether the parabola has a global minimum (a > 0) or maximum (a < 0). The parameter c
indicates the y-intercept of the quadratic function which is given by (0, c). The vertex of the quadratic
function is given by
b2 − 4ac

b
vertex = − ,−
2a 2a
The x-intercepts can be found by solving the equation
ax2 + bx + c = 0
via the quadratic formula as

√ !
−b ± b2 − 4ac
, 0
2a
Figure 0.3: A quadratic function f (x) with a < 0
Example. Let P = 10 − 2Q. What is the quantity that will maximize total revenue?
We know the total revenue is
Revenue = P × Q
= (10 − 2Q) × Q
= 10Q − 2Q2
Mapping into our functional form discussed earlier (y = ax2 + bx + c) we have
a = −2
b = 10
c = 0
Thus, the quantity that maximized revenue is

b
Q∗ = −
2a
10
= −
2 × (−2)
= 2.5
The maximized revenue is

b2 − 4ac
Revenue∗ = −
2a
2
10 − 4 × (−2) × 0
= −
2 × (−2)
= 25
0.4 Coordinate Geometry

The area of a triangle with base a and height h is,
1
Atriangle = ×a×h
2
Figure 0.4: Area of a triangle
For instance, the area enclosed by the two functions above and the y-axis in Figure 0.2 is given by,
1 4 2 8
Atriangle = × (7 − 3) × = 2 =
2 3 3 3
.
The area of a trapezium with horizontal sides a, b and height h is given by,
1
Atrapezium = (a + b) × h ×
2
Figure 0.5: Area of a trapezoid
In this course, the area formula of triangles and trapezia are often used to calculate consumer and
producer surplus, as well as changes in welfare.
Chapter 1
Cost and Benefit Analysis
Cost and benefit analysis is the foundation to most decisions. In this chapter, students are expected
to:
• understand the cost and benefit principle
• understand the distinction between “total”, “average” and “marginal”
• be able to identify the cost and benefit relevant for decisions correctly
• be able to apply the cost and benefit principle to evaluate decisions in various scenarios
1.1 Important Concepts

Economics Economics is the study of rational human behavior in terms of their decision making
processes. Decision of individuals, firms and governments, etc.
Scarcity Scarcity refers to the situation where resources available are not enough to satisfy all human
wants. Human wants are generally unlimited. Resources are generally limited. There is no need
for decision when there is no scarcity. The primary reason for decision is scarcity. Economics is
about how to allocate the limited amount of resources to satisfy human wants the best.
Trade-off Nothing comes from nothing. To obtain something (say, A), we need to give up something
(say, B). We do not want to give up B, we do not get A. There is always trade-offs to every
decision.
Cost-Benefit Principle The principle says that a rational individual (or a firm, or a society) should
take an action if, and only if, the extra benefits from taking the action are at least as great as
the extra costs. That is:
T ake Action x ⇔ B (x) ≥ C (x) (1.1)
The action is assumed undertaken when B (x) = C (x) in order to ensure completeness, or to
avoid the case of indeterminacy.
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CHAPTER 1. COST AND BENEFIT ANALYSIS 9
Economic Surplus The net benefit of taking any action, in other words, the benefit of taking any
action net of its cost,
ES(x) = B(x) − C(x) (1.2)
Opportunity Cost The value of the next best alternative that must be forgone in order to undertake
an activity. Opportunity cost is generally the sum of relevant explicit (monetary) costs and
implicit costs.
Sunk Cost The cost that has been incurred and is beyond recovery at the time a decision must be
made. As our decision does not affect such cost, it should not be taken into consideration in
making our decision. Again, in making a decision, we only take into account the costs and
benefits that are affected by the decision. Thus, sunk costs should be omitted when evaluating
the costs and benefits of a decision.
Marginal Benefit/Cost/Revenue The additional benefit/cost/revenue when doing something. For

easier understanding, “marginal” simply means “additional”.
• Let T B (n) denote total benefit as a function of a discrete/not perfectly divisible quantity
n. Then, marginal benefit we will obtain from an additional one unit when we have already
gotten n units is:
M B (n) = T B (n + 1) − T B (n) (1.3)
• We can think about increasing our quantity by ∆ unit but to make the discussion compa-
rable, we will still define the marginal benefit we will obtain from “an additional unit”. In a
way, this is just a standardization.
T B (n + ∆) − T B (n)
M B (n) = (1.4)
∆
• When quantity are perfectly divisible, we can imagine ∆ being extremely small. We can
define
T B (n + ∆) − T B (n)
M B (n) = lim (1.5)
∆→0 ∆
In this course, you are not required to know calculus (differentiation in our current situation).
Therefore, in exams, when quantity is assume perfectly division, marginal benefit/cost/revenue
will be provided.
Economic Model An economic model is an abstraction of the real world. The abstraction helps
reduce the difficulty of analysis. The purpose of a model is to predict the outcome when the
environment parameters are changed. As the environment parameters can be changed by policy,
such prediction also allows us to formulate policies to achieve certain outcome.
CHAPTER 1. COST AND BENEFIT ANALYSIS 10
1.2 Frequently Asked Questions

1. When can we differentiate to calculate marginal benefit/cost and the optimal quan-
tity, or when must I calculate the simple difference instead?
Whenever the quantity is discrete (not perfectly divisible), we must calculate marginal costs
or benefits as the change in total cost or benefit when quantity is increased by one unit. In
mathematical notation, M B (n) = T B (n + 1) − T B (n). One example would be: How many
trips will Jon take to the museum assuming than his total benefit function is given by:
T B (n) = 50 × n0.5
and his cost per trip is $10. Here, n = 0.5, i.e. half a trip, hardly makes sense. Therefore, his
total benefit function is only defined for non-negative integer values of n.
If we have a perfectly divisible quantity of n. Then the marginal benefit/cost is defined as the first
derivative of the total benefit/cost function. While not required in this course, we can use calculus
to obtain the marginal benefit/cost function. For example, if Jona’s total benefit from watching
TV (in min) which is given by T B (n) = 50 × n0.5 , the marginal benefit is M B(n) = 25 × n−0.5 .
2. Why is the explicit monetary cost an opportunity cost?

It is best understood by considering the following examples.
• Assume I have a coupon to obtain one of the three drinks: a cup of coffee, a cup of tea, a
cup of OJ (orange juice). And I like tea better than OJ. The opportunity cost of a cup of
coffee is obviously the value of a cup of tea.
• Assume I have a coupon to obtain one of the three things: a cup of coffee, $100 dollars and
a cup of OJ (orange juice). And I value OJ less than $100. The opportunity cost of a cup
of coffee is obviously $100.
• Assume I have a $100 bill to obtain one of the three things: a cup of coffee, $100 dollars
and a cup of OJ (orange juice). And I value OJ less than $100. The opportunity cost of a
cup of coffee is obviously $100. That is, the price of a cup of coffee ($100) is obviously the
opportunity cost of a cup of coffee.
Chapter 2
The Power of Trade and Comparative

Advantage
Trade is essential in the modern society and it can potentially improve our overall living standards. In
this chapter, students are expected to:
• understand the concept of absolute advantage and comparative advantage
• understand the linkage of comparative advantage, specialization and gain from trade
• be able to identify the admissible range of term of trade
• be able to deduce the the production possibility curve of a small economy (two or more indivi-
duals) from the individual production possibility curves (linear)
• be able to determine the production and consumption mix of an economy when an economy has
a specific preference or constraint
• understand and deduce the optimal output choice and consumption possibility curve when inter-
national trade is available to a small economy
• understand the factors that can affect the extent of gain from trade

Absolute Advantage A person has an absolute advantage over another person if he/she can produce
a good at a higher productivity than another person. In other words, the person is either able
to use less inputs to produce the same amount of output or, use the same amount of input to
produce more outputs.
Comparative Advantage A person has a comparative advantage over another person if he/she can
produce a good more efficiently than another person. This essentially means that the person can
produce a good at a lower opportunity cost than another person.
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CHAPTER 2. THE POWER OF TRADE AND COMPARATIVE ADVANTAGE 12
Term of Trade (ToT) The price of the good in terms of the amount of another good, also known as
relative price in some context. In other words, the amount of one good needed to exchange for
another good. For example, if there are two goods, X and Y , the term of trade can be expressed
as 1X = 2Y .
Principle of Comparative Advantage The economy will be better off if each individual concen-
trates on the activity that he/she has a comparative advantage in. In other words, if everyone
specializes on the activity that he/she has a comparative advantage in, the total societal well-
being will be maximized.
Production Possibility Curve (PPC) A curve that describes the maximum amount of one good
that can be produced for every possible level of production of the other good. We graph the
amount of one good against the amount of another good.
• The slope of the production possibility curve is the opportunity cost of producing the good
on the x-axis.
• Factors that shift the production possibility curve include: improvements in knowledge and
technology, increases in productive resources, increases in population etc.
• The production possibility curves must shift outwards when more persons are added to the
economy.
• The outward shift of production possibility curve can be parallel or non-parallel in nature
when more resources are available in society. If the increase in resources is biased towards
one of the goods, the outward shift of the production possibility curve will not be parallel.
Otherwise, it will be parallel.
Principle of Increasing Opportunity Cost In expanding the production of any good, to minimize
the cost of production, we will first employ those resources with the lowest opportunity cost, and
only afterwards turn to resources with higher opportunity costs.
Consumption Possibility Curve (CPC) A curve that describes the maximum amount of one good
that can be consumed for every possible level of consumption of the other good. In a world
without any trade, it is simply the production possibility curve, because what you produce is
what you can consume. In a world with trade, it is the curve that represents the terms of trade.
• With trade, the CPC will not be the same as the PPC. Given the world prices, a production
mix on the PPC will be chosen. The point that maximizes the total revenue will be chosen.
Given the income (total revenue) and the prices of the goods, we can find out all the
combination of consumption we can afford. That will be our CPC. With trade, generally
CPC is bigger than PPC.
Voluntary trade Unless there is coercion from a third party, trade is assumed voluntary. Whether
to trade is essentially a result of cost-benefit consideration. That is, John will agree to a specific
trade deal only if he will be better off with the trade deal. In a two-person economy, voluntary
trade will occur if and only if the term of trade lies between the respective opportunity cost of
producing a good of the two persons.

1. Under free trade, if people end up consuming the products produced in their own
country, do they still pay the international price?
Certainly. Suppose we are considering a small open economy that produces apples. If the world
price of apples is $2, can we produce apples? Yes. How much will we sell the apples? Local
producers will sell the apples at $2 to local consumers. If the local consumers are unwilling to
pay $2, the local producers will sell it on the world market at $2. Thus, the cost of consuming a
locally produced apple is the same as buying an apple in the world market.
2. How to solve problems with three persons and two goods?

The logic is the same as in a two person economy. You first compute the opportunity cost of each
person for producing the goods. Then, the person with the lowest opportunity cost will have
the comparative advantage in producing the good. By the principle of increasing opportunity
cost, if the three persons are to decide their production jointly, then the person with the lowest
opportunity cost will produce the good first before the other two persons.
3. How is the term of trade determined?

In this chapter, the term of trade is determined exogenously. That is, the term of trade is given.
We only know that the productivity, and hence the opportunity cost of production will determine
the admissible term of trade.
The exact term of trade is determined by bargaining power. Since rational individuals use
cost-benefit analysis to make decisions, individuals will sort themselves into different production
activities when they see appropriate cost and benefit information. The market prices of goods
serve as the terms of trade agreed between the buyers and sellers. When there are only one
buyer and one seller in the market, the arrangement is a simple bargaining. The resulting
price depends on the bargaining power of the involved parties. The bargaining power of the
corresponding parties determines how the gains from trade are split among the involved parties.
In this chapter, students are often asked to find the admissible term of trade. That is, the term
of trade that will result in voluntary trade from parties involved.
4. The cost and benefit principle states that we should choose the activity which ge-
nerates the greatest total economic surplus. However, only the opportunity cost is
compared between the two persons/countries to determine which good they should
specialize in producing. How do we ascertain that individuals are maximizing their
economic surplus when they specialize in producing a good?
In the chapter of Power of Trade and Comparative Advantage, we try to illustrate the potential
gain from trade when we specialize according to our comparative advantage. An individual will
allocate a fixed amount of resources on several activities or the production of goods. The possible
combination of activities or output he can achieve are summarized in a production possibilities
curve of this individual. When we have two or more individuals, we imagine these individuals
jointly allocate a fixed amount of resources on several activities. Again, the possible combination
of activities or output they can jointly achieve are summarized in a production possibilities curve
of this small group. Keep in mind, PPC are just possible combinations.
Remember, in our cost-benefit analysis chapter, we talked about how to allocate a fixed amount
of resources on several activities. There, we developed a rule, when we allocate a fixed amount
of resources, we allocate the resources to the activities with the highest marginal benefit first.
The marginal benefit can be affected by our preference, and market price. Note, in most of our
discussion, we do not really talk about preference. We discuss, however, when the market prices
are given, we will choose to produce a specific production combination. If you had tried the
test bank questions, you would have seen questions with consumption ratio. Such ratio is way
to specify preference. With this preference, we will be able to pin down the exact production
combination.
5. When both individuals have negligible bargaining powers, they cannot determine the
terms of trade but only take it as what it is. Is it true that when individuals make the
decision of whether they should specialize in producing a good, they cannot ascertain
that terms of trade must be favorable, as it may have changed after the production?
We look at the prices and decide what to produce. When the prices are not favorable, we will not
produce. If we are not sure about the prices, we may want to sign a contract with someone who
will guarantee the prices of the good on delivery. Then, the price become certain. (Contracts are
a way to reduce uncertainty.) If the terms of the contract are not favorable, we will not sign the
contract and thus will not engage in the production.
Chapter 3
Supply, Demand, and Market Equilibrium
This chapter introduces the demand and supply model to determine the market equilibrium. In this
chapter, students are expected to:
• understand the reason behind the typical shape of the supply and demand curves (upward sloping
supply and downward sloping demand)
• understand the meaning of horizontal and vertical interpretation of demand and supply
• be able to drive the market demand and supply curves from the demand and supply curves of
sub-markets or individuals
• understand the concept of equilibrium
• be able to determine and compute market equilibrium (price and quantity) given a set of linear
demand and supply curves
• understand the concept of excess demand/supply at a given price and the transacted quantity in
such situation
• be able to identify and compute consumer/producer surplus

Market The place where sellers and buyers meet to transact goods or services. This place may be
physical such as wet markets. It may also be a virtual marketplace such as Alibaba or eBay.
Market Structure It describes the overall properties of a market depending on the nature of its
composition. The common types of market structure are:
1. Perfect Competition: There are many different buyers and sellers in the market who are
price-takers and have negligible market power. This is the type of market structure is
assumed in the demand and supply framework.
15
CHAPTER 3. SUPPLY, DEMAND, AND MARKET EQUILIBRIUM 16
2. Monopoly: There is only one producer in a market which has complete price-setting power.
3. Monopsony: There is only one buyer in a market who can determine the market price. One
example would be a large company such as Foxconn in a small town. Because it is the only
significant buyer of labor, it has greater flexibility in setting wages.
4. Oligopoly: The type of market structure in which there are a few producers (or buyers) who
engage in strategic interactions with one another.
5. Monopolistic Competition: There are many different buyers and sellers in the market. Ho-
wever, because of heterogeneous products and imperfect information, sellers will have some
degree of freedom in price-setting. This is a type of market structure that lies between
monopoly and perfect competition.
Static Model In static economic models, the time factor is exogenous and it is not explicitly conside-
red in the model. Therefore, static models are best used for equilibrium analysis or comparative
statics (change in equilibria). For instance, the supply and demand model is a static partial
equilibrium model. While we assume that when there is excess demand or supply in the market
the model should revert to equilibrium, the model does not tell us how long the reversion to
equilibrium should take. Conversely, a model that contains time as an endogenous variable is
called a dynamic model.
Partial Equilibrium Model A model that only considers the equilibrium in a single market, while
regarding prices in other markets, incomes, preferences, and technology as exogenous. Its simpli-
city makes relating a partial equilibrium model to real world scenarios easy. But it can also lead
to serious misjudgments when the assumptions that govern the model do not apply in reality.
General Equilibrium Model General equilibrium considers the simultaneous equilibrium of several
markets together. The advantage is that it takes the interaction and interdependence among
several markets together. The drawback is that it is difficult to analyze. Imagine a typical
market is described by a demand equation and a supply equation. When we considers two
markets, we will have at least four equations. And, yet, we have to add the interaction of the
two markets. The equilibrium is difficult to keep track. That is why, the analysis of general
equilibrium tends to be much more mathematical.
Willingness to Pay WTP is the subjective individual valuation of a good. It reflects the consumer’s
preference as well as it budget constraint. The notion “John is willing to pay $10 for a cup of
coffee” means that “If the price is $10 or less, John will buy a cup of coffee.”
Demand Curve The set of all price and quantity pairs at which the buyers are satisfied. As a
function, the demand curve is given by Qd (P ), that is, quantity demanded as a function of price.
Conversely, the inverse demand function is given by P Qd , the price as a function of quantity

demanded. The demand curve is generally downward sloping.
• Horizontally, it can be interpreted as how much buyers are willing and able to purchase at
a certain price.
• Vertically, it can be interpreted as the highest price buyers are willing to pay for a certain
quantity. Therefore, a demand curve can also be viewed as the marginal benefit of consuming
the additional quantity of a good.
Linear demand equation A typical linear demand equation is written as P = a − bQ or Q =

(a/b) − (1/b)P where a and b are all non-negative numbers. Take P = a − bQ as example. If we
take the function P = a−bQ literally, both P and Q can take negative values. However, P and Q
are meaningful only if they are non-negative. Thus, imposing non-negative P on P = a − bQ, we
know that such relationship applies only on the range of Q from 0 to a/b. For Q larger than a/b,
P is taken as zero (not negative as the equation will imply). Similarly imposing non-negative Q
on P = a − bQ, we know that such relationship applies only on the range of P from 0 to a. For
P larger than a, Q is taken as zero (not as negative as the equation will imply).
Supply Curve The set of all price and quantity pairs at which the sellers are satisfied. The supply
curve is given by Qs (P ), and the inverse supply curve is given by P (Qs ). The supply curve is
generally upward sloping.
• Horizontally, it can be interpreted as how much suppliers are willing and able to sell at a
certain price.
• Vertically, it can be interpreted as the minimum price for which suppliers are willing to sell
a certain quantity. Therefore, the supply curve is also the marginal cost for producers to
produce an additional unit of a good.
Linear supply equation A typical linear demand equation is written as P = a + bQ or Q = (a/b) +

(1/b)P where b is a non-negative number (usually positive) while a can be positive or negative.
Take P = a + bQ as example. If we take the function P = a + bQ literally, both P and Q can take
negative values. However, P and Q are meaningful only if they are non-negative. Thus, imposing
non-negative P on P = a + bQ, we know that if a is positive, such relationship applies only on
the non-negative range of Q. If a is negative, for Q less than −a/b, P is taken as zero. Similarly
imposing non-negative Q on P = a + bQ, we know that if a is negative, such relationship applies
only on the range of P larger than 0. If a is positive, for P less than a, Q is taken as zero (not
as negative as the equation will imply).
Ceteris Paribus Latin meaning “other things equal”. In economics, it means that all other variables
that may perturb or interfere with a system are being held constant to analyze the isolated effect
of a variable on another. For example, quantity demanded (Q) is determined by a lot of factors.
Demand curve is a relationship between P and Q. Thus, on a demand curve, all factors other
than P are help constant.
Substitution Effect The effect of changes in price of a good on the quantity demanded of that good
can be separated into two effects. One is through the change in relative price (the price of this
good relative to the price of other goods). The other is through the change in the real income.
The former is called the substitution effect and it is always negative. That is, when the price of
good x increases relative to another, we will switch to consume other goods, causing the quantity
demanded for good x to fall.
Income Effect When the price of good x increases, our purchasing power (real income) will fall. A
fall in real income will cause a decrease in quantity demanded of good x if good x is a normal
good, and an increase in quantity demanded of good x if good x is an inferior good. The effect
that such change real income originated from a change in price of good x has on the quantity
demanded of good x is called income effect1 .
Law of Demand The market quantity of a good is inversely related to its price. When the price of
good x increases, quantity demanded of good x decreases. This implies that the demand curve
is downward sloping.
Equilibrium Conceptually, an equilibrium is a state of stability where competing forces cancel them-
selves out. For instance, in the supply and demand model, the market equilibrium is where
demand and supply curves intersect. At this equilibrium point (P ∗ and Q∗ ), both buyers and
sellers are satisfied and there will not be any force to cause deviation from the P ∗ and Q∗ .
Excess Demand/Shortage Excess demand refers to the situation where quantity demanded is larger
than quantity supplied, when the price is lower than equilibrium. It is given by:
ED (p) = Qdx (p) − Qsx (p) (3.1)
which is the difference between quantity demanded and quantity supplied at a given price p.
Excess Supply/Surplus Excess supply refers to the situation where quantity demanded is smaller
than quantity supplied, when the price is higher than equilibrium. It is given by:
ES (p) = Qsx (p) − Qdx (p) (3.2)
Quantity Transacted The quantity that is transacted in the market. At market equilibrium, the
quantity transacted is the quantity demanded and supplied. In the case of excess demand, the
quantity transacted is the quantity supplied, while in the case of excess supply, the quantity
transacted is the quantity demanded.
Horizontal Summation The technique used to derive market demand/supply from individual de-
mand/supply. First, we write the quantity as a function of price. Then, we will add up the
quantity to get the market demand function. Beware of the relevant price and quantity range of
the individual demand/supply curves when adding up the quantities. The key restriction is that
price and quantity of the individual demand and supply curves cannot be negative. Thus, even if
the underlying individual demand curves are linear, the market demand and supply curves tend
to be kinked.
1
How the quantity demanded of a good x changes when its price changes can be decomposed as the sum of substitution
and income effect. This process is called Slutzky decomposition and is beyond the scope of this course.
Total Revenue (TR) Total revenue is the total amount of money paid by consumers and received
by producers of a good. It is simply the product of price and quantity.
Consumer Surplus (CS) It is the economic surplus consumers receive. For the market, it is the
collective difference between the willingness to pay of the consumers and the market price of a
good. In other words, it is the difference between the total willingness to pay of consumers and
the actual amount that they pay. Graphically, it is the area bounded by the demand curve and
the market price. Referring to Figure 3.1, suppose the inverse demand function is given by D (q),
and the equilibrium quantity and price are q ∗ and p∗ , respectively. Then the consumer surplus
is: Z q∗
CS = D (q) dq − p∗ q ∗ (3.3)
0
When the inverse demand function D (q) is linear, consumer surplus can be simplified as:
1
CS = (D (0) − p∗ ) q ∗ (3.4)
2
where D (0) represents the y-intercept of the inverse demand function. This is simply the area
of the triangle bounded by the demand curve and the market price.
Producer Surplus (PS) It is the economic surplus producers receive. Analogous to the consumer
surplus, the producer surplus is the collective difference between the price of a good and what
producers are willing to accept for it. In other words, it is the difference between the actual
amount of money producers receive and the total variable cost of production. Graphically, it is
the area bounded by the market price and the supply curve. Referring to Figure 3.1, suppose
the inverse supply curve is given by S (q), and the equilibrium price and quantity by q ∗ and p∗ ,
respectively. Then the producer surplus can be written as:
Z q∗
∗ ∗
PS = p q − S (q) dq (3.5)
0
When the inverse supply function S (p) is linear, the producer surplus can be simplified as:
1 ∗
PS = (p − S (0)) q ∗ (3.6)
2
where S (0) is represents the y-intercept of the inverse supply function. This again is the area of
a triangle bounded by the supply curve and the market price.
Total Economic Surplus (TES) The total economic surplus is the total benefit net of its cost when
transacting a good in the market. Suppose there are n units of good x transacted in a competitive
market. Then the marginal economic surplus of the ith unit is given by:
M ES (xi ) = M B (xi ) − M C (xi )
where M B (xi ) denotes the marginal willingness to pay for the ith unit. Then, total economic
surplus (TES) in the market is given by the sum of all individual economic surpluses:
n
X
T ES (n) = M ES (xi ) (3.7)
i=1
If demand and supply are real-valued and integrable by:

Z q∗
|D (q) − S (q)| dq (3.8)
0
In the absence of any market distortions, another way to understand total economic surplus is
as the sum of consumer and producer surplus:
T ES = Consumer Surplus + P roducer Surplus (3.9)
Figure 3.1: Consumer, producer, and total economic surplus
Maximization of Total Economic Surplus (TES) Under a perfectly competitive market without
any distortions, total economic surplus is maximized at the market equilibrium. We will learn
more about that at later chapters.

1. How common is it to observe a (perfectly) competitive market in the real world?
Not very common in fact. A competitive market requires that there be many buyers and sellers
with negligible market power. For some markets such as wheat or soy, that sell highly homoge-
neous or similar goods, this is a reasonable assumption and the supply and demand model can
be useful for economic inference or predictions. Most consumer markets such as for smartphones
are closer to oligopolies or monopolistic competition and products are at least somewhat diffe-
rentiated. While perfect competition assumption may not be totally applicable in some markets,
most of the time it still serves as a good approximation.
2. Under what conditions is the market equilibrium socially optimal?

For the market equilibrium to be socially optimal, we must have all costs of production borne
by sellers and all benefits of consumption received by buyers. This may not be the case when
externalities are involved (more on this later). For example, when a coal power plant pollutes
the nearby environment which leads to more incidents of lung cancer. When this “external”
production cost is not considered during the production decision, not all the costs of production
are borne by sellers. This would be called a negative externality. Likewise, there are goods with
positive externalities such as public hygiene, vaccines, parks, education.
3. Why is the sum of consumer and producer surplus (total economic surplus) maxi-
mized at the demand and supply equilibrium?
Take another quick look at Figure 3.1. Suppose that you are to the right of the intersection.
Then for every unit above Q∗ the marginal cost to supply another unit (supply curve) exceeds
the marginal willingness to pay (demand curve), so it is clearly not efficient to produce another
unit. On the other hand, when the demand is above the supply curve, the marginal willingness
to pay will exceed the marginal cost of supplying another good. Thus, expanding production will
be worthwhile. Because total economic surplus increases before the equilibrium and decreases
thereafter, it must be that it is maximal at the equilibrium. In sum, in perfectly competitive
markets, goods will be allocated to those who value them the most and produced by those firms
which can produce them most efficiently.
Chapter 4
Comparative Statics
In this chapter, we will learn more about the comparison between different economic outcomes given
the changes in exogenous variables using the demand and supply model. Students are expected to:
• understand and distinguish the economic jargon of change in demand versus change in quantity
demanded, and change in supply versus change in quantity supplied
• understand the shifters of demand and supply curves
• understand that policies can be a major shifter of the supply and demand curves
• understand and predict the qualitative change in market equilibrium due to demand shifts and
supply shifts
• be able to compute quantitatively the change in market equilibrium due to demand shifts and
supply shifts
• be able to compute and predict the changes of consumer surplus and producer surplus due to
demand and supply shifts (potentially due to policy shifts) and hence infer how much each group
is willing to lobby the government to support or prevent such demand and supply shifts
• understand the relationship between the change in consumer surplus and producer surplus due
the demand and supply shifts and elasticities

Comparative Statics The comparison of two different economic outcomes (in our case, market equi-
libria) with respect to exogenous circumstances is called comparative statics. We can use com-
parative static to predict the new equilibrium, infer about the changes in demand/supply curve,
and evaluate the usefulness of policies.
Change in Quantity Demanded/Supplied A change in the quantity demand because of a change

in price. It is a movement along the same demand/supply curve.
22
CHAPTER 4. COMPARATIVE STATICS 23
Change in Demand A change in the quantity demanded because of a change in any factor other
than price. It is a shift of the whole demand curve.
• If there is an increase in demand, it means that consumers buy more at every price level,
or consumers are willing to pay more for each quantity. The demand curve will shift to the
right. Both the equilibrium price and quantity will increase.
D↑ ⇒ P ∗ ↑, Q∗ ↑
D↓ ⇒ P ∗ ↓, Q∗ ↓
Demand Shifters Demand shifters are the factors that result in the shift of the whole demand curve.
Several exogenous factors can shift demand in a market:
1. Income: A change in the income may lead to a change in demand, depending on the type
of the good.
• Normal good : Goods for which the income effect is positive. When income increases,
demand for such goods will increase. Examples: premium laptops, business class flights,
etc.
• Inferior good : Goods for which the income effect is negative. When income increases,
demand for such goods will decrease. Examples: low quality clothing, potatoes, etc.
2. Population: A change in the population may lead to a change in the demand. For example,
it is obvious that the demand for baby food will increase when the baby population increases.
3. Prices of Related Goods: A change in the price of some related goods may lead to a change
in the demand.
• Complements: Two goods that are consumed together. More generally, two goods A
and B are considered complements if an increase in the price of one good leads to a
decrease in demand for the other good. Examples: cars and tires, game consoles and
games, etc.
• Substitutes: Two goods that can be consumed instead of one another or “substituted”.
Two goods A and B are considered substitutes if an increase in price of one good leads
to an increase in demand for the other good. Examples: Pepsi and Coke, tea and coffee,
iPhones and Samsung smartphones.
4. Expectations: The expectation of a higher (lower) price for a good in the future increases
(decreases) current demand for the good.
Change in Supply A change in the quantity supplied because of a change in any factor other than
price. It is a shift of the whole supply curve.
• If there is an increase in supply, it means that producers sell more at every price level, or
the producer are willing to accept a lower compensation for each quantity. The entire sup-
ply curve will shift to the right. The equilibrium price will decrease, while the equilibrium
quantity will increase.
S↑ ⇒ P ∗ ↓, Q∗ ↑
S↓ ⇒ P ∗ ↑, Q∗ ↓
Supply Shifters Supply shifters are the factors that can shift the whole supply curve. Several exo-
genous factors can shift supply in a market:
1. Technological Advancements: A technological innovation makes sellers willing to offer more

at a given price, or sell a quantity at a lower price. Therefore, it will lower the cost and
increase the supply.
2. Input Prices: A decrease in the price of an input (all else equal) increases profits and
encourages producers to increase their supply, and vice versa.
3. Expectations: The expectation of a higher price for a good in the future decreases current
supply of the good, as producers can store the good now and sell it later, and vice versa.
• Let’s think about the supply of private housing in Hong Kong. If producers expect that
the housing market will continue to expand, they will likely only supply a low amount
of housing. This is one reason why the prices of private housing in Hong Kong keeps
high for decades.
4. Entry and Exit of Producers: The entry of new producers will increase the supply, while
the exit of producers will reduce the supply.
5. Changes in Opportunity Cost: Inputs used in production have opportunity costs. Sellers
will supply less of a good if the price of an alternate good using the same inputs rises, and
vice versa.

1. Must the supply and demand curves be linear?
No. The equation or curve describing demand/supply is a summary of data. They need not
be linear. Linear functions are assumed mainly for illustration purpose and simplification of
calculation in this course.
2. Can a good be a normal and inferior good at the same time?

Yes. Whether a good is a normal good or an inferior good only depends on the person who is
using the good. It is possible that a person thinks a good as a normal good, while the other
thinks it is an inferior good. Generally speaking, for people with lower income, more goods will
be classified as a normal good.
3. Are two goods complements or substitutes when they use a common input to produce?
What will happen if the price of one of the goods increases?
No. They are neither complements nor substitutes. Complements and substitutes are used to
describe the relationship of two goods in consumption or demand. If two goods uses a common
input to produce, when the price of one goods increases, we know that quantity supplied of that
good will increase. Then, the opportunity cost of producing the other good will increase. The
supply of the other good will therefore decrease.
4. If Good A is the raw material of Good B, what will happen if the price of Good A
increases? What will happen if the price of Good B increases?
If Good A is the raw material of Good B, if the price of Good A increases, it is obvious that the
supply of Good B will decrease. However, if the price of Good B increases, then more Good B
will be supplied. As Good A is the raw material used to produce Good B, the demand for Good
A will increase.
5. If the demand of a good increases, what will happen to the consumer surplus?
We do not know. If the demand of a good increases, the consumer surplus may increase, decrease,
or remain unchanged. Think about the effect of an increase in demand without any change in the
price. In this situation, we are sure an increase in demand will raise consumer surplus. The issue
is the increase in demand may cause the price to rise. How much the price will rise depends on
the extent of change of demand and the shape of the supply curve. For example, if the increase in
demand is in the form of a parallel shift and supply curve is vertical, then the consumer surplus
will remain unchanged. When the increase in demand is a non-parallel shift with the increase
bigger at lower price range coupled with a steep or vertical supply curve, consumer surplus can
decrease.
Chapter 5
Elasticity
This chapter introduces the concept of elasticity as a measure of supply and demand responsiveness
and its implications on policies. After studying the chapter, students are expected to:
• understand the concept of price elasticity of demand and price elasticity of supply, and related
concepts of elasticities
• be able to apply the concept elasticity to evaluate the impact of price or income changes on
quantity demanded or supplied
• understand the determinants of price elasticity of demand and price elasticity of supply
• understand the different price elasticity of demand on different points of a linear demand curve
• understand the relationship between price elasticity of demand and total revenue
• understand the relationship between the change in market equilibrium due the demand and
supply shifts and elasticities
• be able to use the quick prediction formulas to predict the impact on price due to demand or
supply shifts
• understand the relationship between elasticity and consumer and producer surpluses, and hence
draw conclusions on whether the two groups will support or oppose the occurrence of demand
and supply shifts

Price Elasticity of Demand (PED) A unit-free measurement that indicates the responsiveness of
quantity demanded to a change in price. It is defined as:
percentage change in quantity demanded %∆Q

ηd = = (5.1)
percentage change in price %∆P
26
CHAPTER 5. ELASTICITY 27
Midpoint Formula When two points (price-quantity pairs) on a demand curve is given, we often
compute the price elasticity of demand using the so called mid-point formula.
∆Q P ∆Q P
ηmid = = × (5.2)
Q ∆P Q ∆P
where Q = (Q0 + Q1 )/2 and P = (P0 + P1 )/2 denote the mean of the quantity and price,
respectively. Mid-point formula avoids the dependency of price elasticity of demand on the
choice of the initial price-quantity pair.
Point Formula For a very small change in price and a linear demand function, we can write the
elasticity of demand as:
1 P0
ηd = × (5.3)
slope Q0
This formula is used when we have to evaluate the price elasticity at a given point.
Degrees of Elasticity Price elasticity of demand is always negative because demand itself is down-
ward sloping1 . We say that demand is elastic when a percentage change in price of x% leads to
more than x% change in quantity demanded. In this case, the price elasticity of demand will be
smaller than -1 (η < −1). Likewise, we say that demand is inelastic when a percentage change
in price of x% leads to an under-proportional percentage change in quantity demanded < x%.
In this case, the price elasticity of demand will be larger than 1 (η > −1).
• As indicated by Figure 5.1, demand elasticity changes along a linear demand function.
Consequently, we cannot say that a demand is generally more elastic than the other one.
We can say, however, the price elasticity of a demand curve is more elastic than the other at
the intersection point (common point). At the point of intersection, using the point formula,
such comparison boils down to a comparison of the slopes. The steeper one is more price
inelastic than the flatter one.
1
The negative sign will sometimes be omitted because the price elasticity of demand is always negative.
Figure 5.1: Elasticity of demand on a linear function
Constant Elasticity Demand (Demand with Constant Price Elasticity) Demand functions with
any constant price elasticity of demand can be written as:
ln (Q) = ln (k) + η ∗ ln (P ) (5.4)
where k is a constant and η is the constant elasticity.
Determinants of ηd The variables discussed below influence the relative price elasticity of demand
of a good. However, it does not tell you whether the demand of a good itself is elastic or inelastic
in absolute terms.
• Availability of substitutes: Price elasticity of demand is more (less) elastic when there are
more (less) substitutes.
• Classification of goods: The less specific the good classification of the same class, the less
substitutes there are, making demand more inelastic. For example, demand for “clothes”
(less specific) is less elastic than demand for “Adidas clothes” (more specific).
• Expenditure share of income: When the expenditure is only a small fraction of our income,
we are less sensitive (more inelastic) to changes in price. For example, if the price for soap
increases by 30 %, quantity demanded would not decrease significantly (inelastic demand),
because the good makes up only a small fraction of our income. The converse is also true.
• Temporary change in price: If a price change is temporary, such as a sale for limited time,
people will rush to buy, leading to a bigger change of quantity demanded. Hence the demand
is more price elastic.
• Time: The longer the time horizon, the more elastic the price elasticity of demand. It takes
time to adjust our consumption decisions. Smaller adjustment in the short time horizon.
Larger adjustment in the longer time horizon. For example, people may switch to electric
vehicles when the gasoline price rises permanently.
• Nature of the good: In general, demand for essential goods or necessities is more inelastic
than demand for luxury goods.
Total Revenue and Price Elasticity of Demand Given a downward sloping market demand function,
it must be the case that total firm revenue (not profit!) is maximized at the point where demand
is unitary elastic. For instance, this happens exactly at the midpoint of a linear market demand
function. This comes from the relationship between marginal revenue and elasticity of demand:

1
M R (Q) = P 1 + (5.5)
ηd
When elasticity of demand equals −1 (ηd = −1), marginal revenue is zero. In other words, total
revenue is maximized.
Cross Price Elasticity The responsiveness of Qdx or Qsx to the price of another good y. For the cross
price elasticity of demand, it is defined as:
∆Qdx ∆Py
ηxy = (5.6)
Qdx Py
When the cross price elasticity of demand is greater than 0 (ηxy > 0), x and y are substitutes.
When the cross price elasticity of demand is smaller than 0, (ηxy < 0), x and y are complements.
Income Elasticity of Demand The responsiveness of Qdx to the income I. It is defined as:
∆Qdx ∆I
ηIN C = (5.7)
Qdx I
When the income elasticity of demand is positive (ηIN C > 0), x is a normal good. On the other
hand, when the income elasticity of demand is negative (ηIN C < 0), x is an inferior good.
Price Elasticity of Supply (PES) Supply elasticity indicates the sensitivity of the quantity sup-
plied given changes in price and is classified analogously to demand elasticity (elastic, unitary
elastic, inelastic). It is given by:
∆Qsx ∆Px
ηs = (5.8)
Qsx Px
The price elasticity of supply is usually positive as the supply curve is upward sloping.
Determinants of ηs Several factors may influence the relative (but not absolute) elasticity of supply
in a market.
• Technology: New technology that makes it easier to adapt the production quantity makes
supply more elastic.
• Share of input market: Supply of a good is more elastic when production can be expanded
without causing higher prices for its inputs. On the other hand, supply will be less elastic
when the good/industry makes up a large part of the demand in the input market. For
example, the quantity supplied of toothpicks (more elastic) can be more easily increased
without causing the price of wood to increase, than increasing supply of laptops without
increasing the price of mobile processors.
• Time: Similar to demand, in the long run, price elasticity of supply becomes more elastic,
as producers adapt over time.
• Geographic scope of the market: If the geographical scope is larger, the supply will be less
elastic. For example, the supply of mangoes to Hong Kong will be more elastic than the
supply to Asia as a whole.
Quick Prediction Formulas The percentage change in price can be found by knowing the percen-
tage change in demand/supply, the price elasticity of demand and supply. The percentage change
in price from a shift of demand ∆Q is given by:
∆Q
∆P Q0 %∆Q
= = (5.9)
P0 ηs|(P0 ,Q0 ) + ηD0 |(P0 ,Q0 )
|P ED| + P ES
The percentage change in price from a shift of supply ∆Q is given by:

∆Q
∆P Q0 %∆Q
=− =− (5.10)
P0 ηs|(P0 ,Q0 ) + ηD0 |(P0 ,Q0 ) |P ED| + P ES

1. Why are we not using the change in quantity over the change price as a measure of
responsiveness, instead of the percentage change?
The advantage of using the percentage change for a measure of sensitivity or elasticity is that it
makes the analysis independent of the units the variables take. This enables us to better compare
goods from different classes with one another.
2. What is the relationship between total revenue and point elasticity? Why is total
revenue maximized when demand is unitary elastic?
[See Textbook Ch .5 9-11 for a more precise non-calculus treatment]
First it is useful to gain a geometric intuition of why this is the case. Recall the graph that shows
the different elasticities of demand on a linear inverse demand function, shown at the beginning
of the chapter (figure 5.1). Notice that the unit elasticity point is exactly in the middle of the
graph (ηd = −1).
When the price quantity bundle is below this point on the blue line, the firm can raise its price by
%; > 0, and quantity demanded will decrease by less than %. This implies that the change
in total revenue is positive overall when is small. Likewise, when we are at the red part of the
line, the firm can lower its price by %; > 0 and quantity demand will increase by more than
% which would increase total revenue T R = Q ∗ P . Since total revenue increases on the red
section and decreases on the blue section, we can infer that the revenue must be maximized at
the point of unitary elasticity.
In fact, we can derive a relationship between total revenue and elasticity as follows:
[Optional]: In calculus notation elasticity of demand is defined as:
dQ
Q P dQ
ηd := dP
= × (5.11)
P
Q dP
Now we use the product rule and this definition to derive a formula for marginal revenue:

0 dP Q dP
M R (Q) = T R (Q) = P + Q =P 1+ ×
dQ P dQ
Notice that the second part of the expression in the parenthesis is just the inverse of the elasticity.
Therefore, we can write:
1
M R (Q) = P 1 +
ηd
Now, if T R(Q∗ ) is the maximum point, it must be that M R (Q∗ ) = 0 (first order condition). If
this is the case, it must be that ηd = −1 which implies that demand is unitary elastic at this
point.
3. Is total profit maximized at the point with unitary price elasticity of demand ?
No. Total revenue is maximized at the point with unitary price elasticity of demand but total
profit is not. Total profit is not the same as total revenues, since the former also includes costs
(π = T R − T C). A necessary condition for total profit to be maximized at a point Q∗ is that
M R (Q∗ ) = M C (Q∗ ) (a result due to the cost-benefit analysis). Recall that

1
M R (Q) = P 1 +
ηd
Thus, M R (Q∗ ) = M C (Q∗ ) means

1
P 1+ = M C (Q∗ )
ηd
Because in general it will not be the case that marginal cost is zero at the optimal quantity, it
will not be the case that demand is unitary elastic when total profit is maximal.
4. Does every demand curve have different price elasticity of demand across price-
quantity pairs?
No. For linear demand curves, price elasticity of demand varies across price-quantity pairs.
However, such result needs not hold in the case of nonlinear demand curves. There are in fact
demand functions that have constant elasticities. They generally have the form, Q = A × P ηd .
Taking the natural logarithm gives, lnQ = ln (A) + ηd ln (P ). Such linear relationship means
when “ln (P )” increases by one unit, “ln (Q)” would decrease by ηd units (ηd is negative). Thus,
we can verify that
∆ ln (Q)
≈ ηd
∆ ln (P )
Such relationship is often used in empirical work.
5. Why does the y-intercept determine the relative elasticity of a linear supply function?
Suppose we have a supply curve P = a + b × Q, where a, b > 0, Q ≥ 0 and hence P ≥ a. Using
the price elasticity formula, we have,
P 1 P 1
ηs = × = × (5.12)
Q slope Q b
P −a
The slope of the supply curve can be expressed as, b = Q . The price elasticity given this slope
will be:
P Q P
ηs = × = (5.13)
Q P −a P −a
Therefore, we know that if a is positive, that is, the y-intercept is positive, the price elasticity
of supply will be larger than 1 and supply will be elastic. If “a” is negative the price elasticity
of supply will be smaller than 1 and the supply will be inelastic. If “a” is zero, then the supply
will be unit elastic. In other words, the y-intercept will determine the price elasticity of a linear
supply curve.
To find out what happens, when P goes to infinity, mathematically, we will use l’hospital rule to
evaluate the limit,
P
lim ηs = lim =1
P →∞ P →∞ P − a
Therefore, when price approaches infinity, the price elasticity of supply will approach 1. That is,
when price increases, the supply will converge towards unit elasticity.
Chapter 6
Taxes and Subsidies
This chapter will provide a framework for tax and subsidy analysis using the demand-supply diagrams.
Students are expected to:
• be able to analyze the effect of a tax/subsidy on the market equilibrium
• be able to identify and compute the new equilibrium price, equilibrium quantity and the welfare
distribution when a tax/subsidy is imposed
• be able to relate the distribution of tax/subsidy burden between producers and consumers given
the price elasticities of demand and supply
• be able to relate the tax revenue and per unit tax imposed
6.1 Taxes
Taxes are an important source of government revenue. There are three different types of taxes:
1. Lump-Sum Tax: A lump-sum tax is a tax in which the taxpayer is assessed the same amount
regardless of circumstance.
2. Per Unit Tax: A per unit tax is a tax that is defined as a fixed amount of charges per unit of
a good or service sold.
3. Sales Tax/Ad Valorem Tax: A sales tax is a tax that is defined as a percentage of the sales
of (expenditure on or revenue from) certain goods and services.
When the government levies a $ t per unit tax on buyers, the demand facing the sellers will shift
downward in parallel by $ t. This is illustrated in Figure 6.1. Alternatively, when the government
levies a $t per unit tax on sellers, the supply facing the buyers will shift upward in parallel by $t. This
is illustrated in Figure 6.2. Under normal demand and supply curves, when there is a per unit tax,
we can expect the following:
33
CHAPTER 6. TAXES AND SUBSIDIES 34
Figure 6.1: Downward shift of demand due to unit tax
Figure 6.2: Upward shift of supply due to unit tax
• Quantity transacted decreases. It occurs because the tax discourages the marginal consumers to
consume and discourages the marginal producers to supply to the market.
• Price paid by buyers increases, but price received by sellers decreases. The difference between
the price paid by buyers and price received by sellers is the amount of the per unit tax.
• Consumer surplus and producer surplus decrease.

• Deadweight loss exists, because the decrease in total economic surplus is larger than the total
tax revenue.
• Total welfare to the society = Consumer Surplus + Producer Surplus + Tax Revenue
6.2 Subsidies
A subsidy is a reverse tax where the government gives money back to consumers or producers. Similar
to tax, there can be lump sum subsidies, ad valorem subsidies and per unit subsidies.
When the government levies a $s per unit subsidy on buyers, the demand facing the sellers will
shift upward in parallel by $s. This is illustrated in Figure 6.3. Alternatively, when the government
levies a $s per unit subsidy on sellers, the supply facing the buyers will shift downward in parallel by
$s. This is illustrated in Figure 6.4. Under normal demand and supply curves, we would expect that
Figure 6.3: Upward shift of demand due to unit subsidy on consumption
when there is a per unit subsidy:
• Quantity transacted increases.
• Price paid by buyer decreases, but price received by seller increases. The difference between price
paid by buyers and price received by sellers is the amount of the per unit subsidy.
• Consumer surplus and producer surplus increases.
• Deadweight loss exists, because the increase in total economic surplus is smaller than the total
subsidy expenditure.
• Total welfare to the society = Consumer Surplus + Producer Surplus - Subsidy Expenditure
Figure 6.4: Downward shift of supply due to unit subsidy on production

Tax/Subsidy Wedge It is the difference between the price paid by consumers and the price received
by producers. The difference is always equal to the amount of the per unit tax or subsidy.
Indifference between a Tax/Subsidy on Sellers and Buyers Regardless of whether the tax or
subsidy is levied on a buyer or a seller, the output, welfare distribution, the resulting welfare
loss and the distribution of tax burden are the same. In other words, there is no difference for
the government to levy a tax on producers and consumers. By using the tax or subsidy wedge
approach, we do not need to know whether the government has levied a tax or subsidy on the
buyer or the seller in order to analyze the effect of such tax or subsidy.
Distribution of Tax Burden Tax burden falls more on the producers or consumers who are more
price inelastic. The more inelastic side will bear more of the tax burden because they are more
insensitive to price changes.
Distribution of Subsidy "Burden" Subsidy burden falls more on the producers or consumers who
are relatively more price inelastic. The more inelastic side will receive more of the subsidy burden
because they are more insensitive to price changes.
Welfare Loss Welfare loss is the reduction of total economic surplus from the original equilibrium to
the new equilibrium after the tax/subsidy has been imposed.
• Welfare loss depends on the change in quantity transacted. It will be larger when the impact
of tax/subsidy on quantity transacted is larger. Therefore, welfare losses are larger when
the demand or supply is more elastic.

1. What will happen to tax revenue if the government increases the amount of the per
unit tax?
The effect is uncertain. As the amount of the unit tax increases, the quantity transacted will
be reduced. If the percentage decrease in the quantity transacted is smaller than the percentage
increase in the amount of the unit tax, tax revenue will increase, and vice versa. In general, the
tax revenue will increase when the amount of the unit tax is low, however eventually the tax
revenue will decrease after it reaches some critical point. This is also known as the Laffer effect.
2. Must a per unit tax result in a deadweight loss?

No. It depends on the shape of the demand and supply curve. If either the demand or supply
curve is perfectly inelastic, then regardless of the amount of the unit tax, quantity transacted
will remain unchanged. Therefore, a deadweight loss will not result even if there is a unit tax.
3. How does the elasticity of demand and supply affect the distribution of tax burden
and the total tax revenue?
Tax burdens are distributed between producers and consumers. The more inelastic side always
bears more of the tax burden. Therefore, if the demand is more inelastic than the supply,
consumers will have to bear a larger tax burden than the producers. Regarding total tax revenue,
if the demand and/or supply are more inelastic, the change in quantity transacted upon the
imposition of the tax will be smaller. As a result, the total tax revenue will be larger.
4. How to correctly identify the location of the deadweight loss in the demand and
supply diagram?
In the case of taxes and subsidies, the deadweight loss is the part of the government tax reve-
nue/subsidy expenditure in excess of the change in total surplus. Therefore, we can first identify
the area of tax revenue/subsidy expenditure. Then, we can locate the changes of consumer sur-
plus and producer surplus upon the imposition of tax/subsidy. The difference of the two will be
the deadweight loss.
Chapter 7
Price Ceilings and Floors
This chapter will revolve around the effects of price ceilings and floors on market equilibria, as well as
their welfare implications. Students are expected to:
• be able to use the supply and demand framework to analyze and compute the effects of (in)effective
price ceilings and floors on welfare when different alternative allocation mechanisms are adopted
(waiting in line, bribery, lottery, etc.)
• understand relative merits in using price control (ceilings and floors) versus taxes/subsidies in
achieving the same policy objective
• understand the difference of using minimum wage and wage subsidy in achieving the same wage
target
7.1 Price Ceilings

A price ceiling is a maximum limit on price set by the government to prevent the market price to
rise beyond a specific price level. Typical examples are rent control, or price ceilings on gasoline.
• For a price ceiling to be called effective, the ceiling price must be below the equilibrium price
that would prevail in the market in the absence of government intervention. An effective price
ceiling is visualized in Figure 7.1.
• An effective price ceiling will lead to a decrease in both the quantity transacted and price.
Ultimately, the total revenue must decrease.
• The minimum deadweight loss (orange) caused by an effective price ceiling comes from the
marginal producer who will refrain from supplying the good once the effective ceiling price has
been imposed.
• Whether the green area is part of the deadweight loss, producer, or consumer surplus (or neither)
depends on how the shortage of goods are allocated. For example, if it is allocated to the highest
38
CHAPTER 7. PRICE CEILINGS AND FLOORS 39
valuation consumers via bribery without transaction cost, the green area will be part of social
welfare. If it is allocated by waiting in line, it will be part of the market’s deadweight loss.
Figure 7.1: Effective price ceiling and excess demand
Problems of Allocation
There are two major problems associated with price ceilings:
• Allocative Problems: In markets where there are effective price ceilings, allocation issues can
arise. They occur because the price is below the competitive equilibrium price and there will be
excess demand. Without mechanisms to solve the allocation problem during a shortage, it may
well be the case that the goods are NOT allocated to the consumers with the highest willingness
to pay. For instance, it could be the case that consumers whose valuations are still marginally
above the ceiling price, but below the willingness to pay of the highest valuation consumers, can
get the good, while the high valuation consumers cannot. Then, the overall deadweight loss will
be bigger than the orange triangle (labeled “min(DWL)”).
• Lowered Quality: As the market price of a good is artificially held below the market price, the
product quality may deteriorate as producers are incentivized to lower production costs. This in
turn will lower willingness to pay, causing excess demand to decrease. Another in part opposed
effect is that, in the long run, supply will become relatively more elastic, which will cause the
associated excess demand/shortage to increase.
Solutions to Allocative Problems

Some of the mechanisms to “solve” the allocation problem are presented below:
• Lotteries: Allocating goods via a lottery is not very common. Assuming demand and supply
are linear, there are enough consumers in the market and everyone, if selected, can purchase only
one good, the expected consumer surplus from a lottery is given by:
S (Pc ) 1 1
E (CSl ) = ∗ (a − Pc ) ∗ D (Pc ) = S (Pc ) ∗ ∗ (a − Pc ) (7.1)
D (Pc ) 2 2
In the equation above, “a” is the y-intercept of the inverse demand curve (i.e., D(0) in Figure
7.1, Pc is the effective ceiling price, S(.) is the supply function, and D (.) is the demand function.
S(Pc ) 1
Also, D(Pc ) is the probability that a specific person is selected, 2 (a − Pc ) the expected consumer
surplus of a random person, and D (Pc ) the number of people participating given the ceiling price
Pc .
• Waiting in line: A more common way to allocate goods, particularly in planned economies that
control prices and in front of Apple stores, is by waiting in line. Assuming that everyone’s time
valuation of time is identical, the goods will be allocated to those with the highest valuation. In
terms of economic welfare, the time spent waiting constitutes a pure loss, and hence the green
area in the graph above will be part of the deadweight loss. If valuations of time are not identical
across individuals, the analysis will become much more complicated.
• Bribery: Since bribes are essentially a transfer of resources from one person to another, they
are not per se social welfare loss. Whether the bribed amount belongs to the producer surplus or
general economic surplus depends on who receives the bribes. If government officials do so, the
latter applies, and the bribed amount is neither part of consumer nor producer surplus but still
part of social welfare (analogous to tax revenues). However, in the long-term bribery may be very
costly because in introduces uncertainty, delay, and inequality, distorts labor markets towards
the public sector, as well as hampers investment spending, and ultimately economic growth.
7.2 Price Floors

A price floor is a minimum limit on price set by the government to prevent the market price to fall
below a floor price. Typical examples are minimum wage legislation or price floors on agricultural
products such as milk or butter.
• For a price floor to be called effective, the floor price must be above the equilibrium price that
would prevail in the market in the absence of government intervention. An effective price floor
is illustrated in Figure 7.2.
• When there is an effective price floor, the quantity transacted will decrease, while the equilibrium
price will increase. The change in total revenue depends on the price elasticity of demand.
• Likewise, the minimum deadweight loss (orange) comes from the marginal consumer who will
now refrain from purchasing the good once the effective ceiling price has been imposed.
• For an effective price floor (see below), the green area belongs to producer surplus if we assume
that it is only the most efficient firms that manage to sell their goods. Under this efficiency
assumption, producer surplus will be the sum of the green and red areas, otherwise the deadweight
loss will be larger.
Figure 7.2: Effective price floor and excess supply
As opposed to price ceilings, an effective price floor may cause unnecessary increases in product
quality. This will cause excess supply to decrease as both supply and demand curves adjust to a higher
equilibrium level. Also, in the long run the price elasticity of demand will become relatively more
elastic which will cause excess supply to increase.

1. Why does the introduction of a marginally binding price floor increase total firm
revenues when demand is inelastic?
To answer this question, it is important to realize that for a binding or effective price floor the
quantity transacted, i.e. the minimum between quantity supplied and quantity demanded, is
given by the demand curve. This is because, for a price floor to be binding, the price must
be above the equilibrium price which in turn implies that the quantity supplied will exceed the
quantity demanded. Therefore, to evaluate the impact on total revenue, we will need to consider
the change of total revenue along the demand curve.
Recall from our discussion on elasticity in chapter 6 that total firm revenue will increase following
a marginal increase in price only when the change is on the inelastic section of the demand
function. Since this is the case when there is an effective price floor, total firm revenue will
increase. Note however, that when the binding price floor becomes too high, revenues will
decrease again and correspondingly demand will no longer be inelastic at the intersection.
2. Will the converse, i.e. that marginally binding price ceilings decrease total revenue
when supply is elastic, also be true?
Yes, but for reasons that have little to do with elasticity. If a binding or effective price ceiling
is imposed, both transacted quantity and the prevailing market price will decrease as compared
to the competitive market equilibrium. Since both quantity and price decrease, it must be that
total firm revenues decrease as well.
3. What is the difference between bribery and waiting in line in terms of social welfare?
While the total bribed amount is considered part of the economic surplus, the total time wasted
whilst waiting in line is not. This is because the former is merely a transfer of resources of
consumers to producers or government officials, whereas the time spent could have been used
productively for something else. However, even if the immediate transaction costs are assumed
to be zero, using bribes to allocate a shortage of goods may have negative long run repercussions
such as less investment spending, distorted labor markets, or slower economic growth. Thus, it
may well have implicit negative effects on social welfare in the long term.
4. Is the bribed amount part of producer surplus?

In the question bank examples, the bribed amount is usually assumed to be neither part of
the consumer nor producer surplus. But it will be part of social welfare, such as the earned
tax revenues for instance. Despite that if producers receive the bribe it may well be part of
producer surplus. Yet, if this is that case and the price ceiling is ignored via “side payments” and
“service charges”, the quantity transacted in the market would eventually converge to the market
equilibrium level.
Chapter 8
Externalities
In this chapter, we will learn about a very important economic concept – externality. In fact, externality
is something that always exists in our daily lives. Students are expected to:
• understand the basic concepts of externalities and name examples of externalities that exists in
daily lives
• understand the private cost versus social cost, and private benefit versus social benefit
• be able to determine and compute the socially efficient outcome, and the associated welfare
• be able to use the supply and demand framework to analyze the effects of external costs and
external benefits
• be able to identify and compute the welfare gain when externalities are properly addressed by
policies
• understand well-defined property rights as a solution to achieve the socially efficient outcome
(Coase Theorem)
• be able to evaluate Pigouvian taxes and subsidies as a policy to correct for externalities
• be able to evaluate the merits of different policies in addressing externalities

Social Optimality Social optimality is achieved when the total economic surplus to the society (eco-
nomic surplus to consumers and producers involved in the transaction and everyone else who may
be affected) is maximized. As learned in earlier chapters, if the market is a perfectly competitive
market without any externality, the market equilibrium price and quantity are socially optimal.
Externality The situation when costs or benefits that result from an activity accrue to people not
directly involved in the activity. It can be an external cost or an external benefit.
43
CHAPTER 8. EXTERNALITIES 44
• Examples of external costs: road congestion, noise pollution, etc.

• Examples of external benefits: education, development of vaccines, etc.
Private Cost/Benefit The cost/benefit faced by a consumer who purchases the good or a producer
who produces the good. The intersection of private marginal cost and private marginal benefit
is the (unregulated or unintervened) market equilibrium.
Social Cost/Benefit The cost/benefit to everyone in the society, including the consumers who pur-
chase the good, the producers who produce the good and the third party who may bear some
costs or enjoy some benefits. Thus, the social cost/benefit is the sum of private cost/benefit
and external cost/benefit. The efficient point of production happens at the intersection of social
marginal cost and social marginal benefit.
External Cost/Benefit The cost/benefit faced by people (i.e. a third party) other than the consumer
or producer in the market. It is also the difference between private cost/benefit and social
cost/benefit.
Welfare Implications of Externality Regardless of whether it is an external benefit or an external

cost, the existence of externality will lead to welfare losses if the quantity is determined by the
normal demand and supply curves.
• When an external cost exists, the private marginal cost is lower than the social marginal
cost. Therefore, the market equilibrium quantity will be larger than the efficient quantity.
This case is presented in Figure 8.1.
Figure 8.1: Deadweight loss resulting from an external cost in production

• When an external benefit exists, the private marginal benefit is lower than the social mar-
ginal benefit. Therefore, the market equilibrium quantity will be smaller than the efficient
quantity. This case is presented in Figure 8.2
Figure 8.2: Deadweight loss resulting from an external benefit in consumption
Coase Theorem The Coase theorem states that, if property rights are fully assigned and if people
can negotiate costlessly with one another, they will always arrive at efficient solutions to problems
caused by externalities.
Reaching Market Efficiency There are three ways that the market can achieve efficiency when an
external benefit/cost exists:
1. By market adjustment: If the property rights are fully assigned and people can negotiate
costlessly with one another, by Coase Theorem, the parties will arrive at efficient solutions
on their own.
2. By Pigouvian tax/subsidy: A Pigouvian tax/subsidy is a tax/subsidy set equal to the level
of the external cost/benefit at the socially optimal quantity. When a Pigouvian tax/subsidy
is imposed on market participants, their private marginal cost/benefit will be equal to the
social cost/benefit. Therefore, they will produce and consume at the efficient point.
3. By tradable allowances/quota: Allowance/quota is like the right to engage in certain eco-
nomic activity. If the allowance and quota are allowed to trade and the transaction cost is
negligible, the allowance/quota will end up in the hands who value them the most or the
most efficient in the production. The key is the number of allowance/quota. If there is an
external cost and the number of allowances is set equal to the efficient quantity, the market
will be able to produce the efficient quantity. Therefore, efficiency can be achieved.
In general, imposing a Pigouvian tax or introducing a tradable allowance will give the same
results if there is perfect information in the market. Both will allow the market to operate at an
optimal point.

1. If the government uses a tradable quota instead of a Pigouvian tax to tackle the
externality problem, it will not be able to gain the tax revenue. Is this true?
Yes, if the government uses a tradable quota instead of a Pigouvian tax, then it cannot obtain
the tax revenue. However, the government can sell the tradable quota to the producers. If the
number of tradable quota is exactly at the optimal level of quantity, the price of each tradable
quota will be the same as the amount of the Pigouvian tax in order to bring the market to the
optimal level of quantity. In this case, the government will be able to obtain the same level of
revenue regardless of whether a tradable quota or a Pigouvian tax is used.
2. Can we, according to the Coase theorem, conclude that “if there is negotiation cost
(e.g. transaction cost) during negotiation between parties, the efficient solutions will
never be reached”?
When the cost of negotiation is nontrivial, there will be no negotiation. When there is no
negotiation, we will get stuck in the initial allocation. The outcome is efficient if the initial
allocation is the efficient one. The outcome is not efficient if the initial allocation is not efficient.
Thus, the corollary of Coase Theorem is “If property rights are fully assigned but the cost of
negotiation is non-trivial, whether the outcome is efficient or not hinges on whether the initial
allocation is efficient.”
Chapter 9
Public Goods and Tragedy of Commons
This chapter will discuss the characteristics of public goods and the challenges in their provision. It
will introduce the tragedy of commons that occurs regularly when resources are shared across multiple
owners. Students are expected to:
• be able to classify goods according to their degree of excludability and rivalry
• be able to derive the marginal benefit of the public good to the society from the marginal benefits
of individuals
• be able to identify and compute the socially optimal quantity of a public good
• understand free-rider problem and that the public goods are often under-provided if let to the
market
• understand and apply the Clark-Groves incentive revelation mechanism as a solution of public
good provision
• be able to explain why and how the tragedy of common occurs and different options for mitigating
such problem

Excludability A good is called excludable if we can easily prevent someone from consuming the good
who did not pay for it. Excludability is usually true for consumer goods, but not for public
goods, such as street lighting.
Rivalry A good is called rival if consuming the good of a person reduces other’s availability in
consuming the same good. If I eat a dumpling, the same one cannot be consumed by someone
else.
Goods Classification Goods can be classified in terms of relative rivalry and excludability on a
continuum as in Table 9.1.
47
CHAPTER 9. PUBLIC GOODS AND TRAGEDY OF COMMONS 48
Excludable Non-Excludable
Rival Private goods (clothes, com- Common resources (sea water,
puters ...) fish reserves, rain forests ...)
Non-rival Club goods (Wi-Fi, cinemas, Public goods (fireworks, natio-
golf courses ...) nal defense, parks ...)
Table 9.1: Goods classification according to excludability and rivalry
Vertical Summation It is the technique used to find out the marginal benefit of society for a public
good. We will first write the marginal benefit of each individual as a function of quantity. Then,
we will add up the marginal benefit of each individual to find the marginal benefit of society. Note
carefully that although MBs are often written as linear equations, the MBs cannot be negative.
That is, to get the marginal benefit to the society, we should only add up the marginal benefit of
an individual when the individual marginal benefit is larger than or equal 0 at the given quantity.
Optimal Provision of Public Good The optimal provision of public good follows the same econo-
mic principle as other goods - the cost and benefit principle as introduced earlier. To solve for
the socially optimal quantity, we have to set:
M SB (Q∗ ) = M SC (Q∗ ) (9.1)
i.e. marginal social benefit equals marginal social cost.
Free Rider Problem An individual’s incentive not to pay for or contribute to the provision of a
public good, since one can enjoy its benefits whatever provided by others. Because everyone
has the same incentive, without government/institutional intervention, public goods are often
under-provided.
Forced Rider Problem An individual is forced to pay for the provision of a public good which he
will barely consume. For example, the taxes you have paid may be used to finance the street
lights. If the taxpayer never uses the street lights, he is likely a forced rider.
Clark-Groves Mechanism A mechanism that provides people with the incentive to reveal their true
preference or valuation of a public good. Under the mechanism, everybody must pay the total
cost of the public good minus the observed valuation of all other participants, whenever the total
reported valuation of the good exceeds the costs of its provision1 .
Second Price Sealed Auction A type of auction in which other’s bids or valuations are unknown
(sealed) and the buyer with the highest bid wins the auctioned item but only pays the price of
the second highest bid.
Tragedy of the Commons The tendency or incentive to overuse shared common resources on the
presumption that others will do so as well. In fact, the tragedy of commons is simply a problem
caused by external cost.
1
See section 9.4 in the corresponding textbook chapter on public goods for a more detailed discussion.
CHAPTER 9. PUBLIC GOODS AND TRAGEDY OF COMMONS 49
• For instance, if the fish reserves are shared among different nations but there are no shared
agreements, every nation has the incentive to over-fish to increase individual benefit. Ho-
wever, if the fish populations were given time to recover, there would be more fish overall.
• One option to tackle such problem would be to tax the use of the common resources, until
the socially efficient quantity is used. Others include defining clear and enforceable property
rights on the use of the resource, as well as internalizing the externality by collectivizing the
choice on how much to use the resource such that overall long-term output is maximized.
Tradable fishing quota will be an example.
• Typical examples of tragedy of commons include: road congestion externality, misuse of
public toilets and destruction of facilities in parks that are opened to the public etc.

1. Must the budget be balanced after using the Clark-Groves mechanism to determine
payments for the provision of a public good?
No. In fact, most of the time the budget will not be balanced, which means that the payment
implied by the Clark-Groves exceeds or falls short of the actual cost of the public good. The
former is not really an issue. If the latter is the case, the budget can be supplemented by other,
unrelated taxes such as a lump sum tax. A lump sum tax would not distort the participant’s
incentives to tell the truth.
2. Can a good fall into different categorization of goods under different situations?
Certainly. It is best to understand goods on a continuum of excludability and rivalry. Also, some
of the goods may fall into different categories in different scenarios. The nature of the good is
very important when we are classifying the goods. It is in fact very difficult to find an absolute
example of a public good.
Chapter 10
Cost and Profit Maximization Under

Competition
Profit maximization is the fundamental assumption for modeling the behavior of firms. Firm’s behavior
differs across market structure. Here we focus on the behavior of firms under perfect competition. In
this chapter, students are expected to understand:
• the characteristics of a perfectly competitive firm
• the law of diminishing marginal returns and its relationship with cost of production
• the relationship among cost curves of a typical firm
• the output decision of a typical competitive firm
• the shape of the supply curves of individual competitive firms and the market supply curves in
the short run
• the relationship between supply curve and marginal cost curve of individual competitive firms,
and the shut down condition in the short run
• the entry and exit, and the zero profit as a condition for the long run
• the shape of the long-run industry supply curves

Perfect Competition A market structure in which there are many buyers and sellers. Each of them
is very small relative to the size of the market in a sense that they are not able to affect the
market price by themselves. In a market with perfect competition, products are similar across
sellers.
• Because each of the buyers and sellers is very small that they could not affect the market
price, they take the market price as given.
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CHAPTER 10. COST AND PROFIT MAXIMIZATION UNDER COMPETITION 51
Factor of Production A factor of production is an input (usually labor or capital) used in the
production of a good or service.
• Fixed factor: A fixed factor of production is an input whose quantity cannot be altered in
the short run. Machines and tools are examples of fixed factors and are often categorized
as “capital”.
• Variable factor: A variable factor of production is an input whose quantity can be altered
in the short run. Raw materials and workers are examples of variable factors. Often, to
simplify our discussion, we consider “labor” as a variable factor and ignore the other variable
factors in our discussion.
Diminishing Marginal Returns The assumption that marginal product (additional output when
there are more variable factors) will diminish eventually when more and more variable factors
are added to the same amount of fixed factors, ceteris paribus. (Mathematically, this means that
the production function is concave.)
Shape of Marginal Cost When the law of diminishing marginal returns applies, marginal cost goes
up as the marginal returns diminishes when the firm expands production beyond some point.
That is, the marginal cost curve must be upward sloping beyond a certain amount of quantity.
Shape of Marginal Revenue In a perfectly competitive market, marginal revenue facing an indi-
vidual firm is horizontal. It is a constant because no matter how much a producer sells, the
next unit will always sell for the market price. The producer is too small that his decision could
never affect the market price. Therefore, the additional revenue that the seller will receive simply
equals the price.
Profit Maximization of a Competitive Firm Because M R(Q) = P for competitive firms, the
profit maximizing output level for a perfectly competitive firm is when price equals marginal
cost, that is:
P = M C (Q∗ ) (10.1)
Profit (Π) can be calculated in two different ways. Profit is the difference between total revenue
and total cost, that is:
Π = TR − TC (10.2)
Some factorization will bring us to another formula, that is, the difference between price and
average cost multiplied by quantity:
Π = (P − AC) Q∗ (10.3)
The profit is illustrated as a green rectangle in Figure 10.1.

Figure 10.1: AC|AVC|MC and profit region for perfectly competitive firm
Sunk Cost A cost that once incurred can never be recovered. Fixed cost is sunk in the short run
because the cost has been incurred already.
Firm Supply When the market price increases, the profit maximizing output level will increase accor-
ding to the upward sloping marginal cost. The supply of a firm is the collection of price-quantity
pairs under profit maximization. Therefore, the marginal cost is generally the supply curve of
the firm, except when P < AV C(Q):
• Shut down condition: A firm will produce only when total revenue is larger than or equal
to total variable cost, that is, P Q ≥ T V C(Q) for some positive quantity Q. As fixed cost
is sunk in nature, the goal of the firm will be to maximize profit net of fixed cost. If we
divide the inequality by Q, we can restate firm’s shut down condition as P < AV C(Q) for
any Q > 0.
• In other words, a firm’s short run supply curve is the section of the marginal cost that is
above the average variable cost.
Marginal & Average Cost The marginal cost intersects the average cost at its minimum point. At
the quantity where the marginal cost is below the average cost, the average cost curve must
be falling with an increase in quantity1 . At the quantity where the marginal cost is above the
average cost, the average cost curve must be increasing with an increase in quantity. Be careful
when you are drawing the cost curves!
1
See the corresponding textbook chapter to see why this is the case.
Entry and Exit Decisions In a competitive market, a firm will be profitable if price is larger than
average cost, that is, P > AC for some positive Q, and not profitable if P ≤ AC for any
Q > 0. Therefore, in the long run, firms will enter profitable industries when P > AC and exit
unprofitable ones when P < AC. Such entry and exit decision drives the long-run profit to zero,
i.e., P = AC.
Figure 10.2: Price ranges for SR-shut down, LR-exit, and LR-entry for average firm
Zero Profits Condition The profit level where the firm has zero economic profits after covering all
its opportunity costs.
• If firms can costlessly enter and exit the industry as in a perfectly competitive market, each
firm will earn zero profits. Any profitable opportunities will be eliminated by the entry and
exit of firms.
• Because of this special feature of the perfectly competitive market, at the market equili-
brium, the price of the good must be equal to its average cost, that is, P = AC. Any
deviation of the price will be eliminated by the entry or exit decisions of firms in the long
run.
Industry Long Run Supply Curve The shape of the long-run supply curve for a particular industry
is determined by the change in costs as industry output increases or decreases. There are incre-
asing cost industries, constant cost industries and decreasing cost industries.
Constant Cost Industry When the output of the industry increases, the cost structure will not be
affected and will remain constant. This would be the case if the demand for input by the whole
industry is only a very small/insignificant part of the demand of the input. Then, although the
increase in output of the industry will lead to a higher demand for factor input, such increase in
demand for factor input is insufficient to have any impact on the price of the factor input.
• Suppose the market is originally at equilibrium where price equals average cost. When there
is an increase in the market demand of a good, the price of the good will go up. Existing
firms will increase their output in the short run (move along the market supply). The
positive profit (P>AC) will cause firms to enter the market, increasing the market supply
(shift of supply curve). In a constant cost industry, the increase in the number of firms (and
hence demand for input) will not cause any change in input prices. Hence, the cost curves
remain in the same position. In particular, the minimum point of AC remains unchanged.
In the long run, when all entry and exit are completed, we will end up with a price the same
as the average cost of the good.
• In a nutshell, the price of the good remains unchanged after the increase in demand. The-
refore, the industry long-run supply curve of a constant cost industry is horizontal.
Figure 10.3: Long run industry supply curve (Constant-cost industry)
Increasing Cost Industry When the output of the industry increases, the cost of producing the good
will increase. This is often because the industry’s demand for its factor inputs is a substantial
percentage of the total demand for the factor inputs. When the increase in the industry’s output
causes an increase in the demand for the input, the price of input will increase and thus increases,
and consequently, the cost of producing each output will be increased.
• Suppose the market is originally at equilibrium where price equals average cost. When
there is an increase in the market demand of a good, the price of the good will go up.
Existing firms will increase their output in the short run (move along the market supply).
A price higher than the average cost will attract new firms to enter the market, increasing
the market supply (shift of market supply). In an increasing cost industry, the additional
demand for input drives up the price of input. The whole set of cost curves (AC, AVC and
MC) will shift upward. The minimum point of AC will shift upward and leftward. When
the entry and exit are completed (zero profit again, P=AC again), the price will be higher
than the original long-run equilibrium price.
• In a nutshell, the price of the good increases in the long run after an initial increase in
demand. Therefore, the industry long-run supply curve of a increasing cost industry is an
upward sloping curve.
Figure 10.4: Long run industry supply curve (Increasing-cost industry)

1. At the equilibrium point, all firms will make zero profit. Where did the producer
surplus go?
In an idealized setting of perfect competition we would assume that in the long run, the industry
supply curve would be horizontal for a constant-cost industry. Since the long run industry supply
curve is horizontal in nature, the corresponding producer surplus will look like zero. This is wrong.
Remember, at any instance, we live in the short run. The producer surplus is computed based
on the short-run supply curve or the firms marginal cost curves. Also note that profit is not the
same as producer surplus. We can show that profit = P S − F C, in general.
2. Why is it the case that when two firms are facing the same marginal cost, they will
produce the same quantity of the good?
If the two firms have the same marginal costs, they have the same supply curve. Under perfect
competition, the demand of an individual firm is horizontal. Individual firms do not have any
market power to alter the price of the good. Therefore, facing the same demand and supply
curve, the two firms must produce the same quantity.
Chapter 11
Monopoly
While we have previously only considered a perfectly competitive market, this chapter introduces a
model that analyzes the other extreme, that is, when there is only one producer in a market. Students
are expected to:
• be able to write down the marginal revenue (MR) curve for any given linear demand curve
• be able to solve the profit maximization problem of a monopoly
• be able to compute the welfare loss (or inefficiency) due to monopoly
• understand the relationship between mark-up price, marginal revenue, marginal cost, and elasti-
city of demand in the monopolized market
• be able to analyze the impact of policies (such as price ceiling, price floor, taxes and subsidies)
on quantity produced and welfare
• understand the source of monopoly

Monopoly A market structure where there is only one producer in a market. It has complete price
or quantity-setting power, but not both. Setting P , Q is determined by the demand. Setting Q,
P is determined by the demand.
Profit Maximization Assuming profit maximization, any firm, regardless of the market structure
that it is in, faces a maximization problem given by:
max π (Q) = T R (Q) − T C (Q) (11.1)

Q
If the functions are differentiable, the first order condition implies:

dπ dT R dT C
= − = M R (Q) − M C (Q) = 0
dQ dQ dQ
57
CHAPTER 11. MONOPOLY 58
By rewriting the equations, we will have the general decision making principle where marginal
revenue equals marginal cost at the optimal Q∗ :
M R (Q∗ ) = M C(Q∗ ) (11.2)
In other words, for any profit maximizing firm, production should be expanded until marginal
revenue equals marginal cost.
Marginal Revenue of a Monopoly The marginal revenue of a monopoly is not as straightforward

as that in a perfectly competitive market. As the monopoly has complete price setting power,
increasing the quantity will lead to a different price. Suppose that the monopoly faces a linear
downward sloping market demand Pd (Q) = a − bQ with a, b > 0.
• The total revenue of a monopoly is simply price multiplied by quantity, as defined in earlier
chapters. The total revenue of such monopoly will be:
T R (Q) = P × Q = aQ − bQ2 (11.3)
• The marginal revenue is simply the first derivative of the total revenue. For the linear
demand curve, we can use differentiation to derive
dT R
M R (Q) = = a − 2bQ (11.4)
dQ
Notice that a monopoly that faces a linear demand curve has a marginal revenue that has
the same y-intercept as the demand curve and a slope that is two times steeper than the
demand curve, as demonstrated in figure 11.1.
In this course, in the study of monopoly, we often assume linear demand curve as such.
Students are required to memorize the implied MR.
D: Pd (Q) = a − bQ ⇒ MR: M R(Q) = a − 2bQ
Profit Maximization of a Monopoly As opposed to a competitive market, since a monopoly is

the only producer in a market, the market price will vary depending on the quantity of the
good it produces. Suppose that the monopoly faces a linear downward sloping market demand
Pd (Q) = a − bQ with a, b > 0. We can write the monopoly’s profit maximization problem as:
max π (Q) = aQ − bQ2 − T C (Q) (11.5)

Q
By applying the general profit maximization principle, where marginal cost must equals marginal
revenue at the profit maximizing output, we will have1 :
M R(Q) = M C (Q) (11.6)

a − 2bQ = M C (Q) (11.7)
1
You can assume that the second order condition for a maximum holds.
Figure 11.1: Relationship between market demand and marginal revenue
The results that we have from profit maximization for a monopoly is rather different than that
in a perfectly competitive market. Here are the results:
• When setting M R (Q) = M C (Q), the profit maximizing quantity Q∗m is determined by the
∗ is the determined by the profit maximizing
intersection of MR and MC curves. The price Pm
quantity and the demand curve, as given in Figure 11.2.
• Total revenue is represented by the checker shaded area (green checker plus red checker),
total variable cost in red, and producer surplus in green. In addition, deadweight loss is
marked as an orange triangle, consumer surplus is marked as a blue triangle. Notice that
the producer surplus is in fact the profit before deducting the fixed cost.
• Deadweight loss arises because the profit-maximizing output (Q∗m ) is less than the socially
optimal output (Q∗c ).
Mark-up Formula If marginal cost is not zero, that is M C 6= 0, a profit maximizing monopolist will
usually set the price P such that:
ηd 1
P = MC = MC (11.8)
1 + ηd 1 + η1d
where ηd is the point elasticity of demand. Hence, the mark-up (in percentage higher than M C)
is given by:
ηd 1
mark-up = −1=− (11.9)
1 + ηd 1 + ηd
Figure 11.2: Monopoly base case profit maximization where M R (Q∗m ) = M C (Q∗m )
Ceteris paribus, the relatively more inelastic the demand, the higher the mark-up, and vice versa.
This is not all too surprising given that when demand is relatively more inelastic, consumers are
relatively insensitive to increases in price. The monopoly will then take advantage of this to
charge a higher price.
Monopoly Inefficiency Inefficiency happens because the profit-maximizing output of a monopoly

(Q∗ ) is less than the social optimal output (Q∗∗ ).
Social efficient output Q∗c D(Q∗c ) = M C(Q∗c )

Profit maximizing output Q∗m M R(Q∗m ) = M C(Q∗m )
Monopoly Regulation To reduce deadweight loss caused by a monopoly, an effective price ceiling
that lies below the monopoly price can be implemented. Contrary to the perfect competition case,
this price ceiling can in fact increase the monopoly’s production because it alters the marginal
revenue and limits the incentives to raise the price by producing less. Alternatively, production
or consumption of monopoly goods can be subsidized to increase output to deadweight loss.
Monopoly Sources A monopoly does not arise without a reason. In fact, there are several common
sources of monopolies, including:
• Exclusive control over important inputs that are difficult to replicate. E.g. wine from
Bordeaux, diamond mines from de Beers, or white sturgeon caviar.
• Natural monopolies: Monopolies that can supply whole markets more cheaply than many
small competitive firms could. This occurs when there are substantial economies of scale,
meaning that average production costs decline with increasing output (within a range).
Natural monopolies are usually characterized by large fixed costs and lower variable costs.
E.g. telecommunications providers, railways, electricity, or gas providers.
• Patents: An exclusive right to a product or invention granted by a governmental or regional
authority for a limited amount of time. While protecting intellectual property rights and
encouraging innovation, patents also promote monopoly power. E.g. drug patents and other
technological innovations.
• Government licenses: Some monopolies exist because of government protection or regula-
tion, either to provide essential services, or sometimes to serve as income to the political
elite. E.g. postal services, water supply, casinos, or tobacco production (in some countries).
• Network Economies: A type of economy of scale where the more users a network has, the
higher its value for others. E.g. Facebook, Uber, WhatsApp, Reddit, etc. Because larger
networks become more valuable, they tend to monopolize.

1. Why does the monopoly not produce on the inelastic section of the demand function?
Recall Figure 5.1 in the chapter on Elasticities. It shows the point elasticities of demand on
a downward sloping linear market demand function. Since we know that the marginal revenue
function M R(Q) is double the slope of the market demand (see figure 11.1), it is only positive
at the elastic section of the linear demand function. As marginal cost M C (Q) is non-negative,
it must be that the intersection M R (Q) = M C(Q) can only occur in the elastic region of the
demand curve.
2. Why does a monopoly NOT have a supply curve?

The monopoly does not have a supply curve because for every fixed quantity Q∗ , there can be
∗ which depend on the market demand it faces (and its elasticity).
multiple corresponding prices Pm
Therefore, for monopolies there does not exist a stable price quantity relationship that can be
called a supply curve.
3. [Optional] How is the markup formula derived?

In the chapter on Elasticity, using the product rule of differention, we derived a relationship
between marginal revenue and point elasticity of demand given by:

1
M R (Q) = P × 1 +
d
The monopoly will maximize profits when M R (Q) = M C(Q). Using the formula from above
we can write the markup as:

1
P − MC P − P × 1 + η
1
1
Mark-up = = d = − ηd = − (11.10)
MC P × 1 + η1d 1 + η1d 1 + ηd
just as desired.
Chapter 12
Price Discrimination
Price discrimination is an essential technique that a monopolist will employ to further improve its
profits. In this chapter, students are expected to:
• understand different types of price discrimination
• understand the principles and the conditions of price discrimination
• understand how the cost of arbitrage will affect the extent of price discrimination
• be able compute the price, quantity, deadweight loss and profits of a monopolist that employs
price discrimination and compare to that of the single-price monopoly
• learn how to price discriminate and yet be socially responsible

Price Discrimination Different buyers, different groups of buyers, or different units of the good pur-
chased by the same buyers are charged a different price by the producer according to willingness
to pay and some characteristics of the buyers. Such price discrimination allows the monopolist
to earn a higher profit.
Perfect Price Discrimination (First Degree Price Discrimination) In perfect or first degree
price discrimination, each buyer and each unit of the good is charged exactly the willingness to
pay by the buyer.
• For a perfectly discriminating monopolist, because marginal revenue to monopoly is the

same as the marginal benefit to the society, there is no efficiency loss. It is because all
buyers who are willing to pay a price high enough to cover marginal cost will be served.
Arbitrage Arbitrage refers to the situation where a person takes advantage of price differences for
the same good in different markets. By buying low in one market and selling high in another
market, profit is made.
63
CHAPTER 12. PRICE DISCRIMINATION 64
Principles for Price Discrimination The principle to practice price discrimination is to separate
the market into different segments and arbitrage is either impossible or relatively costly. When
the market is separated into sub-market based on the basis observable characteristics (age, gender,
location, etc.) of consumer groups, it is called third degree price discrimination. If characteristics
used the the separation is unobservable and the firm can use incentives (such as discounts)
to let consumers self-select themselves into different groups, it is called second degree price
discrimination.
• Difference in demand: The demand curve of different sub-markets is different (third degree
price discrimination). To maximize profits the monopolist should set a higher price in
markets with relatively more inelastic demand.
• Prevention of arbitrage: Firms are incentivized to create policies or hurdles (e.g. age,
gender) to prevent arbitrage opportunities. This is because arbitrage makes it difficult for
a firm to set different prices in different markets.
Tying A form of price discrimination in which one good, called the base good, is tied to a second
good called the variable good.
• Example: Printer and ink cartridges. The printer company tries to price discriminate
higher-volume users. Therefore, higher-volume users, who have a higher willingness to pay,
will be charged more through the bigger and more frequent purchase of ink.
Bundling Buyers are allowed to purchase the individual items bound together as a bundle or package.

1. Why is the welfare loss reduced with price discrimination when compared to the
single-price monopoly?
When price discrimination is practiced, each consumer or each group of consumers is charged
different price. This will in turn increase the quantity sold by the monopolist. As the quantity
produced by the monopolist is closer to the socially optimal quantity, the welfare loss is reduced.
Chapter 13
Oligopoly and Strategic Behavior
This chapter aims to give students a taste of the analysis of strategic behavior – game theory. It
introduces basic concepts in game theory, just enough to analyze strategic and oligopolistic behavior.
Students are expected to:
• be able to identify the different elements in a game
• be able to map the prisoner’s dilemma game into some real-life situations
• be able to solve for the dominant strategy equilibrium and Nash equilibria and equilibria of
dominant strategies in simple games
• be able to solve simple games with time elements using backward induction
• be able to identify the best response function and hence solve the game with strategy set that
are perfectly divisible

Oligopoly A market structure in which there are a few dominant sellers. The few dominant sellers
will then interact with each other through strategic behavior in terms of price setting, quantity
setting, cost-reduction investment activity, or demand promotion investment activity.
Cartel A collection independent businesses that use implicit or explicit agreements to coordinate the
supply of goods with the goal of limiting competition, raising prices, and maximizing collective
profits.
• A cartel usually cannot sustain for a long time because of three reasons: cheating by cartel
members, new entrants and demand response, and government prosecution.
• A cartel member has the incentive to cheat on a cartel. Profit is often shared in a cartel
according to some agreement. However, if a member cheats on the cartel, the profit due to
cheating is kept all by itself.
65
CHAPTER 13. OLIGOPOLY AND STRATEGIC BEHAVIOR 66
Game Theory The study of multi-person decision problems that tries to find solutions when strategic
interactions between decision-makers are involved.
Normal Form Game A normal form game is described by three major components, namely players,
strategies and payoffs. They are the three crucial elements of a normal form game:
1. Players: N players, N ≥ 2. Typical players are firms, people, or states.
2. Strategies: Strategies are actions available to a player. The set of actions/strategies is often
called strategy set.
3. Payoffs: The payoffs depends on the combination of strategies chosen by the players in the
game. Suppose we have only two players (labeled Tom and Stephanie, say), and there are two
possible actions available to each of them (labeled Left and Right, say), we can have the map-
ping of the strategy combination (or strategy profile) to the payoffs, so called a payoff function
π. An essential feature of the payoff function is that the payoff depends on the combination of
the strategies played.
Tom’s strategy + Stephanie’s strategy −→ Payoff

L L πT (L, L), πS (L, L)
L R πT (L, R), πS (L, R)
R L πT (R, L), πS (R, L)
R R πT (R, R), πS (R, R)
In a game with low dimension, the information of players, strategies and payoffs are often sum-
marized in a payoff matrix.
Matrix/Table Representation of a Game A two-player finite game, such as the prisoner’s dilemma,
can be represented by a three by three matrix. Hereby, {A, B} is the action set for player 1 and
2. The payoffs depending on the other player’s choice are given in parenthesis where player 1’s
(row player’s) payoff is the first number and player 2’s (column player’s) payoff is the second
number.
Player 2
A B
A (1, 1) (2, 2)
Player 1
B (3, 3) (4, 4)
Table 13.1: Matrix/table representation of a two-player finite game
Dominant Strategy A strategy X is a dominant strategy for player i if conditional on all other
player’s possible choices, strategy X yields at least as high payoff than any other strategies
available to player i. Conversely, a strategy Y is dominated strategy for player i if conditional on
all other player’s possible choices, strategy X yields the lowest payoff than any other strategies
available to player i.
Equilibrium of Dominant Strategies A strategy combination (or profile) is a dominant strategy

equilibrium if the corresponding strategy of each player in the combination is a dominant strategy
of the player.
Nash Equilibrium A strategy combination (or profile) is a Nash equilibrium, if conditional on the
corresponding strategy played by all the others in the combination, the corresponding strategy
played by the specific player in the combination is the best, i.e., yields the highest payoff.
Game Tree Game tree is way to represent the element in a game when there is a time sequence
element. An example of the game tree of a two-person sequential game is illustrated in Figure
13.1.
Figure 13.1: A two-player sequential game tree
Backward Induction The technique used in analyzing the equilibrium of a game tree. We start at
the last decision node to predict which strategy the last player would choose. Then, given such
strategy, we predict the strategies that earlier players would have played.

1. Why is an equilibrium in dominant strategies always a Nash equilibrium but not the
other way around?
A dominant strategy is the best-response to any strategy profile by other players. Therefore, for
an equilibrium in dominant strategies where the strategic choice of each player is dominant, it
must be that each choice is the best response to other’s choices. However, the reverse need not
be the case, i.e. a Nash equilibrium need not be dominant. Instead, for a Nash equilibrium we
only consider unilateral deviations by a player from a strategy profile.

Study Guide For Introductory Microeconomics: Ka-Fu WONG

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Study Guide For Introductory Microeconomics: Ka-Fu WONG

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Study Guide for Introductory Microeconomics

0 Required Mathematical Tools 1

1 Cost and Benefit Analysis 8

2 The Power of Trade and Comparative Advantage 11

3 Supply, Demand, and Market Equilibrium 15

6 Taxes and Subsidies 33

7 Price Ceilings and Floors 38

9 Public Goods and Tragedy of Commons 47

10 Cost and Profit Maximization Under Competition 50

13 Oligopoly and Strategic Behavior 65

• Ka-fu WONG supervised the development of this study guide.

Required Mathematical Tools

0.1 Linear Functions

The x-intercept is calculated as

Figure 0.1: Example of a linear function

0.2 Solving a system of (Two) Linear Equations

Figure 0.2: A system of linear equations

Slope Intercept Relationship

0.3 Quadratic Equations

via the quadratic formula as

Figure 0.3: A quadratic function f (x) with a < 0

Mapping into our functional form discussed earlier (y = ax2 + bx + c) we have

Thus, the quantity that maximized revenue is

The maximized revenue is

0.4 Coordinate Geometry

Figure 0.4: Area of a triangle

Figure 0.5: Area of a trapezoid

Cost and Benefit Analysis

• understand the cost and benefit principle

• understand the distinction between “total”, “average” and “marginal”

1.1 Important Concepts

Marginal Benefit/Cost/Revenue The additional benefit/cost/revenue when doing something. For

1.2 Frequently Asked Questions

2. Why is the explicit monetary cost an opportunity cost?

The Power of Trade and Comparative

• understand the concept of absolute advantage and comparative advantage

• be able to identify the admissible range of term of trade

2.1 Important Concepts

2.2 Frequently Asked Questions

2. How to solve problems with three persons and two goods?

3. How is the term of trade determined?

Supply, Demand, and Market Equilibrium

• understand the concept of equilibrium

• be able to identify and compute consumer/producer surplus

3.1 Important Concepts

demanded. The demand curve is generally downward sloping.

Linear demand equation A typical linear demand equation is written as P = a − bQ or Q =

Linear supply equation A typical linear demand equation is written as P = a + bQ or Q = (a/b) +

ED (p) = Qdx (p) − Qsx (p) (3.1)

ES (p) = Qsx (p) − Qdx (p) (3.2)

M ES (xi ) = M B (xi ) − M C (xi )

If demand and supply are real-valued and integrable by:

T ES = Consumer Surplus + P roducer Surplus (3.9)

Figure 3.1: Consumer, producer, and total economic surplus

3.2 Frequently Asked Questions

2. Under what conditions is the market equilibrium socially optimal?

• understand the shifters of demand and supply curves

4.1 Important Concepts

Change in Quantity Demanded/Supplied A change in the quantity demand because of a change

quantity will increase.

1. Technological Advancements: A technological innovation makes sellers willing to offer more

4.2 Frequently Asked Questions

2. Can a good be a normal and inferior good at the same time?