Microeconomics – ECON10803.

A2020 Charles Bisson

CHAPTER 1: Gains from Trade

Utility: abstract concept reflecting the satisfaction an individual derives from an activity.
Valuation: is the monetary value that an individual attach to a given activity.
Buyer’s valuation: the maximum amount of money that the buyer is willing to pay. Noted "V".
Seller’s valuation: the lowest amount of money that the seller is willing to accept in order to
give up an item. Noted "C".
Free trade condition: C ≤ P ≤V
Buyer’s gains from trade (BG): 𝑉(q)−𝑃*(q)
¿
Seller’s gains from trade (SG): P −C(q)
Sum of gains of trade: ( V −P )+ ( P−C )=V −C , if trade takes place, prices have no effect on
total gains from trade.

Reasoning at the margin: one will buy an extra unit only if, 𝑉𝑞+1−𝑉(𝑞)>𝑃.
Buyer’s total valuation: V(q), is the maximum amount of money a buyer is willing to pay in
exchange for a total of q units of the good. Is the area under his MV curve. M V ' ( Q )=V ( q ) .

Seller’s total valuation: C(q), is the lowest amount of money a seller is willing to pay in
exchange for a total of q units of the good. Is the area under his MC curve. M C ' ( q )=C ( q ) .

Buyer’s marginal valuation: V ' ( q )=MV (q), is the additional amount of money related to the
purchase of one extra unit. MV ( q )=V ( q ) −V ( q−1 ). Also called marginal valuation.

Seller’s marginal valuation: C ' ( q )=MC (q), is the additional amount of money related to the
sell of one extra unit. MC ( q )=C ( q ) −C(q−1). Also called marginal cost. Is the supply.

Efficiency: a situation is (PARETO) efficient if it is impossible to make someone better off

without making someone worse off. A situation is efficient if no further gains from trade cannot
be made (=0). q ¿=efficiency .
•If MV ( q)> MC (q), then some gains of trade are left unexploited;
•If MV ( q)< MC (q), then the buyer is not willing to pay enough for the seller to give up his
items: the seller would have to buy back units from the buyer.
∆y 10−6
Marginal rate of substitution: related to the slope of the indifference curve: . Ex: =2
∆x 4−2
. Then, it means that he/she willing to trade at a rate of 2 units of y for one unit of x.
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CHAPTER 2: Demand
Individual demand: relationship between the price of a good and the quantity a consumer needs
and is able to purchase at that price.
Quantity demanded: the amount a consumer is willing and able to purchase at the given price.
The consumer will purchase units of the good for as long as his/her MV ≥ P .
Consumer surplus (CS): difference between the MV of consumers and the price paid for the
product, summer over all units purchased. Is the area contained below the demand curve and
above the price line up to the quantity traded.

Revenue: income generated by normal business operations: P∗Q=R.

Expenses: costs occurred by normal business operations: C∗Q=E .
Total valuation: area under MV. Area of expenses+surplus.
Negative surplus: the amount of when q units cost more than its worth to the consumer.
Demand: relationship between price and quantity demanded. Is not affected by the quantity
demanded. THEY ARE DIFFERENT.

Consumer surplus maximization: when C S' ( q ) =MV ( q ) .

Individual demand curve: a consumer’s marginal valuation is the relationship between price
and quantity purchased, so an individual demand curve is the marginal valuation curve.
Market demand: the relationship between price and quantity demanded by a whole population.
n
Q=number of consumers*q or Q ( P )=∑ qi ( P )∨Q=a−bP. DO NOT ADD P FUNCTIONS!
i=1
ADD THE Q FUNCTIONS!! Ex: if, Q 1=10−P , Q 2=20−2 P . Then, market demand is
Q=30−3 P. Re-write your P functions into a Q function if needed.

Market demand curve: obtained by aggregating (adding) individual demand curves by adding,
at any given price, the quantities demanded by all consumers at that price. Thus, amounts to
summing demand curves horizontally.
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Demand function: Q=a−bP+ eI +eP s−fP c+ …. I=Income, Ps=Price of goods which are
substitutes, and Pc=price of goods which are complements. To determine the relation of goods,
you need to look at each element. Ex:
Qx=50−0.8 P x +2 P y−4 P z+10 I
1. Look at the demand function. In this case it is for the good x.
2. Px is the price for good x;
3. Py is the price of good y;
4. Pz is the price of good z;
5. I is income;
6. Good y is a substitute to good x, because if the price of x increases the quantity demanded
for y augments;
7. Good z is a complement to good x because if the price of x rises the demand for z
decreases;
8. The Px variable is negative because if its price rises the quantity demanded for good x
decreases;
9. If we look at I, we can see that it is a normal good because demand increases as income
increases.
Factors affecting demand:
1. Price of the good;
2. Price of other goods (if the price of a compliment goes up, the quantity demanded for a
good goes down/if the price of a substitute goes up, the quantity demanded goes down);
3. Household income (if the income increases the quantity demanded for a normal good
increases/if the income increase the quantity for an inferior good goes down);
4. Others (regulation, changes in interests, etc.).
Shifts in the demand curve:
1. The price of the good: a change in the good’s own price results in a movement along the
demand curve. Law of demand, if price goes up, demand goes down, and vice-versa;
2. All other factors: a change in a factor other than the good’s own price results in a shift of
the demand curve (factors 2,3,4).
Price elasticity of demand: the sensitivity of quantities demanded, Q, to a change in price, P.
∆Q
∗P
% change∈Q ∆ Q /Q ∆ P −const∗P . Ex: if Ep=-2, a 1% change in price will
E p= = = =
% change∈ P ∆ P / P Q Qd
result in a 2% decrease in demand.
1. When Ep=0, we say that demand is perfectly inelastic at that point. It takes an infinite %
change in P to affect quantity demanded;
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2. When E p=∞ that no consumer wants to buy the good at that price the price elasticity is
infinite. So, we say that it is perfectly elastic. Any small change in price will result in an
infinite % change in quantity demanded;
3. When −1< E p < 0 , we say that demand is relatively inelastic. A 1% change in price will
lead to a less than 1% change in quantity demanded. Meaning consumers are captive and
will largely keep buying the product despite the increase in price;
4. When E p ←1 , we say that demand is relatively elastic. A 1% change in price will result
in a greater than 1% change in quantity demanded. Consumers are highly price sensitive;
5. When E p=−1, we say that demand is unit elastic. A 1% change in price equals to a 1%
change in quantity demanded. Is the midpoint in a linear demand curve.

Perfectly inelastic demand: corresponds to a vertical demand curve.

Perfectly elastic demand: corresponds to a horizontal curve.

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Income Elasticity of Demand: is the % change in quantity demanded resulting from a 1%

increase in household income.
1. If E I >0, quantity demanded increases as income increases. This means it is a normal
good. Will result in a shift to the right of the demand curve if income increases
(remember factor 3);
2. If E I <0, quantity demanded decreases as income increases. This means it is an inferior
good. Will result in a shift to the left of the demand curve if income increases.
Cross-price Elasticity of Demand: is the % change in quantity demanded of good x resulting
from a 1% increase in the price of another good y. Noted:
∆ Qx
∗Py
% change∈Qx ∆ Qx /Qx ∆ Qy Ex: if Ecxy=3, means that a 1% increase in
E cxy= = =
% change∈Qy ∆ Qy /Qy Qx
price of good y leads to a 3% increase in quantity demanded for good x.
1. If E cxy >0, the quantity demanded for good x increases as the price of y increases. Means
that x and y are substitutes. Will result in a shift to the right of the demand curve for good
x if the Py increases;
2. If E cxy <0, the quantity demanded for good x decreases as the price of y increases.
Means that x and y are complements. Will result in a shift to the left of the demand curve
for good x if the Py increases.

CHAPTER 3: Firms, Costs, and Profit

Firm: organization that transforms inputs into outputs.
Inputs: factors of production. 3 categories:
1. Materials
2. Capital
3. Labour
Output: products and/or services resulting from the production process.
Profit: noted π , is the money inflow resulting from a business activity of net costs.
π=R−C .

Elasticity of revenue: is linked to the price elasticity of demand (Ep). A % change in revenue in
∆R
∗P
response to a 1% change in price. % change∈ R ∆ R /R ∆ P .
E R= = = =1+ E p
% change∈ P ∆ P/P R
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1. When −1< E p < 0 , demand is relatively inelastic. An increase in price is equal to an

increase in revenue. Industry revenue increases when price rises. Consumers will keep
buying even with a price rise;
2. When E p ←1 , demand is elastic. An increase in price is equal to a decrease in revenue.
Industry revenue decreases. Consumers are price sensitive;
3. When E p=−1∨E R=0, demand is unit elastic. REVENUE is maximized.
Accounting costs: monetary outflows corresponding to transcriptions made to acquire inputs.
Explicit transactions.
Opportunity costs: represent the potential benefit that someone misses out when choosing one
alternative over the other.

Sunk costs: result of a monetary transaction that is out of your control. Should not be considered
when making decisions. Money that has already been spent and which cannot be recovered.

Economic cost: the costs that are relevant to decision-making.

Economic Costs= Accounting costs+Opportunity costs−Sunk costs.

Economic profit:
Economic Profit=Revenue−( Accounting costs+Opportunity costs−Sunk costs).

Variable costs: VC (q), the portion of costs that varies with the quantity of output produced.
Fixed costs: F, the portion of costs that doesn’t a vary to output. F=( AC ( q ¿ ) )− ( AVC ( q¿ ) )∗q ¿.
Fixed costs in the long-run: a firm is comp templating stopping its activities can ignore fixed
costs in its shutdown decision if planning enough ahead, whereas a firm contemplating starting
an activity must take fixed costs into account even if it does not intend to get into business until
much later. The long-run cost curve lies below the short-run curves because you can chose the
cheapest alternative to reach any given level of output in the long-run.

Total cost: C ( q )=F +VC (q ).

Marginal cost: C ' ( q )=MC (q), is the extra cost resulting from the production of one additional
unit of output. MC ( q )=C ( q ) −C(q−1). Also called seller’s marginal valuation.
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Marginal revenue: R' ( q )=MR (q) , is the increase in revenue that results from the sell of one
additional unit of output. In a perfection competition MR=P.
Average cost: AC(q), the cost associated with a unit of production on average.
C (q) F+VC (q)
AC ( q ) = = .
q q
Average variable cost: AVC(q), show how a typical unit of output costs are once fixed costs
VC (q)
are taken out of the equation. AVC ( q ) = .
q
Average variable cost curve: lies entirely below the AC curve. If fixed costs=0, then the AC
and AVC curves coincide. MC=AC where AC is at its minimum.

Average fixed cost: AFC(q), show how a typical unit of output costs are once variable costs are
FC( q)
taken out of the equation. AFC ( q )= .
q

Economies of scale: a production process which its average cost decreases when output
increases. (quadratic formula). High fixed costs, job specialization, merge of firms, etc. are
typical sources of economies of scale when its average cost increases with output.
Diseconomies of scale: a production process which its average cost increases when output
increases. (quadratic formula). Typically arise from the firm becoming too big because the
control of fixed costs becomes too difficult to manage.

Profit Maximization: for whichever type of firm, when

π ¿ =R' ( q )−C ' ( q )=0∨MR ( q ¿ )=MC ( q ¿ )∨E p=−1∨E R=0
When MR ( q ) > MC (q), the firm can increase its profits by producing more output.
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When MR ( q ) < MC (q), the firm can increase its profits by producing less output.

Market frictions: the fact that adjustments are not instantaneous.

CHAPTER 4: Competitive Supply

Perfect competition: a situation where all firms are price takers. They cannot influence the
market price. Faces a perfectly elastic demand. If for some reason, consumers believe that one’s
firm product is better than another’s (brand names), perfect competition breaks down: becomes
am imperfect competition.

Conditions for perfect competition:

1. Number of firms and consumers must be large;
2. The products sold by the firms in the market must be identical;
3. Consumers and firms must be perfectly informed;
4. Firms must be able to freely enter and exit the market;
5. There must be no transaction costs.
Demand curve of a perfect competition: maximizes profits by choosing q*.
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Supply: relationship between the price of a good and the quantity the firm is willing to offer at
that price. Is the marginal cost.

Monopsony: a single consumer on the market.

Price maker: a monopoly.
Free entry: means that an outside firm in a given market may suddenly choose to start operating
in that market at little cost. Meaning fixed costs are low.
Transaction costs: the costs that must be borne by the trading parties, on top of the price paid
by consumers for the transaction to take place.

Profit maximization in a perfectly competitive market:

π =R ( q )−C ( q )=0∨MR ( q )=MC ( q )=P∨E p=−1∨E R=0∨π =¿
¿ ' ' ¿ ¿ ¿

Short-run shutdown decision: fixed costs are considered as sunk. A firm in this market cannot
change its prices because it’s a price taker and cannot change its output if π ¿.
Pshutdown=minAVC ( q¿ )=( MC= AVC )∨π ¿ <0;

Pbreakeven=minAC ( q¿ ) =( MC= AC )∨π ¿ =0 ;

So, as longer as R ( q ¿ ) >VC ( q ¿ )∨R> AVC ( q ¿ ) ∨π ¿ >0∨π (q¿¿ ¿)>−F∨P> AVC ( q¿ ) ¿, then the
firm should stay in business.
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Firm’s short-run supply curve: in a perfectly competitive market, it is where the MC curve lies
above the AVC curve. To maximize profits in the short run, a firm will produce q* such that
¿
P=MC ( q ) .

Market supply curve: the horizontal sum of all firm’s supply curves. Q=q 1+ q 2. ADD
QUANTITIES, NOT PRICES. Supply Curve=MC Curve.
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Price elasticity of supply: % change in in QS when P increases by 1%. Positive for most goods.
S
∆Q
S S ∗P
% change ∈Q ∆ Q /Q ∆P .
Ep= = =
% change ∈P ∆ P /P Q S

1. When Ep=0, we say that supply is perfectly inelastic at that point. There is no change in
quantity supplied when the price changes;
2. When E p=∞ , where the quantity supplied is unlimited at a given price, but no quantity
can be supplied at any other price;
3. When 1< E p < 0 , we say that demand is relatively inelastic. Means the % change in
quantity supplied changes by a lower % than the % change in price;
4. When E p> 1, we say that supply is relatively elastic. A 1% change in price will result in a
greater than 1% change in quantity supplied;
5. When E p=1, we say that supply is unit elastic. A 1% change in price equals to a 1%
change in quantity supplied.
Long-run shutdown decision: Main difference is that the long-run firms have not yet
committed to paying their fixed costs. NO costs are sunk in the long run! Firms make 0
economic profit, which means that firm could do just as well in a different activity.
Pshutdown=R< C LR ( q ¿ )∨P< min AC LR ( q ¿ )∨π < 0
¿ ¿ ¿
Pbreakeven=R=C LR ( q )∨P=min AC LR ( q )∨( MC LR= AC LR )∨π =0∨ AC ( q )=MC ( q ) ;
¿
Pshutdown=Pbreakeven=min AC LR if min AC LR ( q )
¿ ¿
So, as longer as R>C LR ( q )∨P>min AC LR ( q )∨π >0 , the firm should operate in the long run.
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¿ ¿
Long-run market supply curve: P=min AC LR ( q ). If P>min AC LR ( q ), then an infinite number
¿
of firms would enter the market. If, P<min AC LR ( q ), then firms will exit the market which will
lead to an increase in price until the equilibrium is found again.
Quantity supplied in a perfect competition: P=MC

CHAPTER 5: Market Equilibrium

Market forces: the result of competition between economic agents involved. The effects of
competition are broken down into 2 forces:
1. Competition between consumers, which drives prices upward;
2. Competition between producers, which drives prices downward.
Market Equilibrium: when P=P*, at P* the Qs=Qd, we say that the market is clear. No
consumer nor producer wants to change its behavior given this market condition.
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Factors affecting supply:

Factors affecting demand:

Excess demand (shortage): at a relatively low price, consumers are willing and able to
purchase more units than at the equilibrium. Consumers would be willing to pay more. Prices
¿
will rise as long as P< P . Knowing that the demand curve is downward slopping, producers are
less inclined to produce than at the equilibrium price (Q s ( P ) <Q ¿ <Q d (P)¿ . Market forces push
the price upward. To find the units currently sought by consumers who are unable to buy them
from anyone: Qd ( P )−Q s (P).
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Excess supply (surplus): at the given relatively high price, producers are willing to accept a
¿
lower price to sell its units. Prices will fall as long as P> P and producers will offer discounts.
Market forces pull the price downward. To find the units currently sold by producers who are
seeking consumers: Q s ( P )−Q d (P). We say that (Q d ( P ) <Q ¿ < Q s ( P).

Demand Shocks: a sudden and surprise event that dramatically increases or decreases demand
for particular good or service.

Positive demand shock: a sudden increase in demand while the price increases and leads to a
decrease in demand;
Negative demand shock: a decrease in demand while the price goes down and leads to a
surplus demand.
Supply shocks: unexpected event that suddenly changes the supply of a product or service
resulting in a change in price.
Positive supply shock: a sudden increase in supply while the price goes down and leads to a
surplus;
Negative supply shock: a decrease in supply while the price goes up and leads to an excess
demand.

3 Steps to know the effect of an economic shock:

1. What is the impact of the shock on the demand curve?
2. What is the impact of the sock on the supply curve?
3. Using step 1 and 2, read on a supply and demand graph
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Market regulation: some governments constraints are imposed on the market preventing it to
reach competitive equilibrium.

Price floor: minimum wages, minimum price on goods like alcohol and tobacco.
Price ceiling: mandated maximum amount a seller is allowed to charge for a product or service.
For example: rent, MSRP on a vehicle, etc.
Welfare: how the allocation of resources and goods affect social welfare, is the study of
economic efficiency. 2 types: consumer surplus and producer surplus. W=CS+PS.

Consumer surplus: noted CS, is the difference between marginal valuation of consumers and
the price paid for the product, summed over all units purchased. Is also the difference between
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total valuation and total consumer expenses. Is the area contained below the demand curve and
d d
( max Pd −P )∗Q d
above the price line up to the quantity traded, Q ∗Q = .
4 2

NOTE THAT WE ARE LOOKING AT THE DEMAND CURVE IN THIS GRAPH!

Producer surplus: noted PS, is the difference between the MC of producers and the price
received in exchange for the product summer over all units sold. Is the area above the supply
Q ∗Q ( P−min P )∗Q
s s s s b b
curve and below the price line, = =∫ MR−∫ MC=R−VC . For a
4 2 a a
monopolist: (P-MC)*Q=Profit+FC.

NOTE THAT WE ARE LOOKING AT THE SUPPLY CRUVE IN THIS GRAPH!

Total welfare: W*, at the market equilibrium. Market equilibrium maximizes total welfare.
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Invisible hand of competitive markets: guides individual agents to an efficient allocation in

the sense of maximizing total welfare. When total welfare is maximized there is no way to
improve the situation of all agents. This means the market is at its equilibrium.
Deadweight loss: noted DWL, is the inefficient allocation of resources at a given price. This
means that there are wasted opportunities for Q*-Q, if positive means that there are untraded
units, if negative it means that there are superfluous units. The DWL area can either be under the
demand curve and over the supply curve OR be over the demand curve and under the supply
curve. Look at the possible quantities traded, and its output is lower.

¿
Q
Number of firms: N=
q¿
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CHAPTER 6: Monopoly and Market Power

Monopoly: a market with only one seller and many buyers. The seller is the monopoly and is a
price maker. Market power originates from the distance perceived by consumers between the
product sold by the monopolist and its imperfect substitutes. The distance can be geographic,
habits and behaviors, computability issues, or by quality. Its asking price is higher than the one
of a perfection competition.

Sources of market power: barriers to entry: defined as any obstacle that limits the possibility of
firms to enter a market. Market power is directly linked to the elasticity of demand of the firm’s
product.
1. Economic barriers: cost advantages, economies of scale (natural monopoly), and network
externalities (significant customer base);
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2. Legal barriers: regulation on the possibility of operating in a given market (intellectual

propriety);
3. Deliberate actions to create barriers to entry.
Monopoly VS. Competitive markets
Monopoly Perfect Competition
Number of firms 1 Many
Cost Function Same
Objective Maximize profits (MR=MC)
Demand function Decreasing Perfectly elastic
MR MR< P MR=P
P P> MC P=MC

Profit maximization: MR ( Q¿ )=MC ( Q¿ ) , if P ≠ MR , see the tab above.

OR
1. Find the MR curve by computing the derivative of R(q);
2. Find the MC Curve by computing the derivative of C(q);
3. Solve MR(Q)=MC(Q);
4. Find P* with the demand curve;
5. Compute profit.
Demand curve: demand curve=market demand and is decreasing. As output increases, price
decreases.

Supply curve: there is no supply curve in a monopoly. The monopolist chooses its supply.
Revenue: P∗q
Monopolist MR=1+¿)
If, Ep=-1, then MR=0.
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Demand curve and marginal revenue curves: the demand curve is twice the slope of MR.
Trade-off of a monopolist: selling more units at a low price VS. selling less units at a higher
price.
Profit margin of a monopolist: P-MC.
Market power: firm’s ability to charge a price greater than its MC without losing all of its
customers. The more power the higher the margin. Market power can be measured by calculating
the ratio of the price margin to the price (the %).
(P−MC) −1
Lener index: measures the market power. L= = . Takes values between 0 and 1.
P ED
The Lener index in a perfectly competitive market is when L=0 or P=MC. The bigger the
difference between P and MC, the larger L, thus the greater the market power. If L=0.67, then
67% of the sale’s price contributes to the monopolist’s profits at the margin (profit margin of
67%). A firm with market power P> MC . The elasticity of demand and the lener index are
related, they are proportional. The less elastic the demand, the higher the margin for the
monopolist, thus a higher lener index.
Welfare in a monopoly: leads to an inefficient ressource allocation, to a decrease in consumer
welfare and to and overall loss for society (deadweight loss).
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Natural monopoly: exists because fixed costs are extremly high. A natural monopoly is the
only supplier in the market. In this case, economies of scale are powerful. Governments should
avoid imposing more firms to enter the market because this could lead to inefficiencies.
Anti-trust legislation: limit the strategies that firms can use to monopolize their industry and to
limit the extent of inefficiencies linked to excessive market power.

Monopolistic competition: firms aim to differentiate their product from those of the
competition to obtain market power. Combines market power and competition.
1. There are many firms in the market and no firm has complete control on the market
prices;
2. Consumers perceive differences between the products sold by different firms;
3. There are no real barriers to entry;
4. Firms have some market power;
5. In the short run, each firm can increase its price without losing all its customers due to
product differentiation. Individual firms have a downward-sloping demand curve and not
an horizontal one like a monopoly;
6. In the long run, it shares similarities with a perfectly competitive market. Economic
profits will be 0 due to the entry of firms with new products.

Profit maximization of a monopolitic competition: is the same as the one of a monopoly.

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CHAPTER 7: Pricing Strategies and Price Discrimination

Price discrimination: different consumers paying different prices for the same good or
service. Ex: lower prices for students or senior citizens, utility companies, happy hours,
buying a car, etc. Where CS=0 and DWL=0.

2 Sources of profit improvement:

1. Consumers aren’t paying as much as they are ready to pay, they have some CS left
(different elasticities);
2. Some possible gains from trade are lost, deadweight loss.
Perfect price discrimination (first-degree price discrimination): occurs when a business
charges the maximum possible price for each unit consumed from different consumers.
To do so, the monopolist must sell to each customer at a price equal to their total
valuation for the goods bought. It breaks the dilemma that a monopolist faces between a
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high price/low quantity and a low price/high quantity. All prices are different.

Personalized pricing: mean of first-degree discrimination, means that the monopolist will
propose to each consumer a price that corresponds as closely as possible to the
consumer’s valuation of the good. Marginal revenue is always the marginal valuation of
consumers. With personalized pricing, a monopolist increases profits and captures all the
CS.
Profit maximization of a monopolist: still is MR=MC, where MR=demand curve. Note
that the competitive price is only paid by the last consumer whose valuation is equal to
the MC. All other consumers who have a higher valuation pay a higher price.
Welfare from perfect discrimination: is as efficient as in a perfectly competitive market.
All gains from trade are realized. Thought, all the CS is distributed to the monopolist and
none to the consumer.
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Implicit market segmentation (2nd degree price discrimination): When the firm has
information about the heterogeneity of consumers’ preferences and valuations but cannot
relate observable characteristics to their valuations. Lets consumers self-select. Ex: bulk
discounts, lunch specials, 2-part tariffs).
Block pricing: strategy that exhibits quantity discounts because per-price unit fall with
the quantity purchased.
Two-part tariff: the price paid by a consumer for a product or service is composed of 2
parts:
1. Lump-sum fee (fixed charge) = CS;
2. Per-unit price = MC.
To set the per-unit price, it must be =MC and the lump-sum fee=CS when the consumer
buys the optimal number of goods at the unit price. This strategy leads to perfect
discrimination. Because the unit price=MC, there is no DWL, because consumers buy the
sake quantity of goods as in a competitive market. The personalized lump-sum fee allows

the monopolist to capture the entire CS.

Explicit market segmentation (3rd degree price discrimination): When the firm can
observe some consumer’s characteristics that are correlated to their valuations, the seller
can establish different prices as a function of the buyer’s characteristics. Ex: a theatre
might divide moviegoers into seniors, adults, and children, each paying a different price
when seeing a movie. This is the most common.
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Tying and Bundling: consist of selling different products in one package as a way to
capture a larger portion of the CS.
Conditions Price discrimination:
1. Information: monopolist must have knowledge of consumer’s valuations;
2. Arbitrage possibilities: to be effective, a price discrimination strategy shouldn’t
allow consumers to resell the products they purchased, these arbitrage possibilities
(one who bought at a low price who resells at a higher price), would reduce the
effects sought of pricing strategies;
3. Legality of discrimination practices (market power).

CHAPTER 8: Uncertainty and the Value of Information

Attitude towards risk: amount of risk people are willing to take.
Marginal Utility: MU ( w )=U ' ( w). The answer describes the attitude towards risk.
Expected value (Expected payoff): noted EV =( p1∗r 1 )+( p2∗r 2)+( p n∗r m), average of
possible payoffs weighted by their respective possibility of occurring. If the net payoff
(minus cost) is equal to 0, it is a fair bet.
Charles Bisson Groupe 11 (the BEST)

Expected Utility: noted EU =¿ , average of all possible utility outcomes weighted by their
respected possibilities of occurring. MUST KNOW THE UTILITY FUNCTION OR
NUMBER (is not valued in dollars). The expected utility is found by drawing the line
connecting the points on the utility curve for the possible scenarios. When bother
outcomes are equally likely, the EU is the height of the midpoint of the line.
Utility of Expected Value: measures the investor’s utility if he/she could get the EV with
2 2
( ) ( ) w 1,800
certainty. U EV =U∗ EV , ex : EV =1,800∧U = → =324
10,000 10,000
3 types of attitudes: 1. Risk-Averse 2. Risk Neutral 3. Risk-Seeking
Risk Aversion: most people are risk-averse, they are willing to expose themselves to risk
unless the expected payoff is large enough. They are willing to take a fair bet.
Exhibits diminishing marginal utility: the impact of a
small increase in income falls as income increases.
Implies that the individual prefers security over an average
of possible outcomes.
'
EU <U ( EV )∨U ( w ) isdecreasing

Risk-neutral: unaffected by the presence of risk. All they care about is the expected
payoff.
Implies that the utility curve coincides with the line joining
the possible outcomes.

EU =U ( EV )∨U ' ( w ) is consant

Charles Bisson Groupe 11 (the BEST)

Risk-seeking: risk is something they enjoy, to the point of being willing to accept a lower
EV in order to face risk.
Exhibits an increasing marginal utility: the impact of a
small increase in income increases as income increases.
'
EU >U ( EV )∨U ( w ) isincreasing

Reducing exposure to risk:

1. Insurance: way of making wealth less uncertain by paying more money today in
exchange of a guaranteed compensation in case of a bad outcome in the future
2. Diversification: way of making wealth less uncertain by spreading the risk over
different unrelated investments. Is the reason why insurance exists.
Insurance premium: is the price of insurance (P) and M is the maximum premium that
someone is willing to pay. If P=EL , then the premium is actuarily fair. The price of
insurance depends on the risk behavior: if you are risk-averse you are willing to pay more
than the EL, risk-neutral people would pay the actuarily fair price, and risk-seeking
people would be willing to pay less than the EL. Ex: Value of Asset=2,000, and is risk
2 2
w ( 2,000− X )
seeking with an EU=360, with a U ( w )= . Meaning: U ( )=EU . Thus,
10,000 10,000
( 2,000− X )2
M= =360→ $ 102.63. You can find M by doing V −CE
10,000

Perfect information: resolves the uncertainty surrounding a business decision entirely

(clairvoyant).
EV of perfect information: must determine the EV before consulting the clairvoyant.
EV clairvoyant =( p1∗r 1 ) + ( p 2∗r 2 ) +…+ ( p n∗r n)

Imperfect information: partially reduces the uncertainty surrounding a business decision

(economist).
Charles Bisson Groupe 11 (the BEST)

EV of imperfect information: must determine EV before consulting the economist.

EV economist =( p1∗r 1) + ( p 2∗r 2 ) + …+ ( pn∗r n )

Value of information: how much a risk-neutral decision-maker is willing to pay to obtain

the information. Value of Information=EV info−EV no info , ex:
EV clairvoyant =340,000∧EV no info=180,000 , thus 340,000−180,000=$ 160,000

CHAPTER 9: Game Theory and Strategic Information

Strategic interaction: agents cannot make decisions in isolation.
Strategic game: a scenario in which 2 or more decision-makers interact.
Players: participants in the game.
Strategy: a player’s plan of action for the game.
Payoffs: the gains players can achieve for all possible outcomes of the game
(utility or monetary).
Best response: the strategy that maximizes a player’s payoff given the strategy
chosen by the OTHER players.
Best response strategy: strategy yielding the largest payoff in response to the
strategies played by other players.
Nash Equilibrium: the solution of the game; the strategies of players should play if
they were behaving rationally. Where each player is playing his best response
strategy against the other’s strategy. No single player is better off deviating
unilaterally.
Dominant strategy: yields a higher payoff than any other strategy against all
possible strategies given by other players.
Tragedy of the commons: overexploitation of shared resources by individuals, each
one acting to his own self-interest Contrary to the group’s long-term best interests.
Pricing game: strategic thinking of managers in oligopoly markets. 2 strategies: 1.
Collusion strategy with high prices 2. Price war strategy with lower prices.
Charles Bisson Groupe 11 (the BEST)

Stag-hunt game (coordination game): when they agree to cooperate. There are 2
Nash equilibriums.
Battle of the sexes: players agree that it is better to cooperate than not, but they
disagree about the outcomes. There are 2 Nash equilibriums.
Game of chickens: one backs down and the other maintains the challenge. There
are 2 Nash equilibriums.
Sequential games: strategic interactions that are sequential.
Backward induction: process of starting at the end of the decision tree and solve it
backwards.
If you are player 2: look at the columns and look at the values on the left. Choose
the values based on the ones you just looked at with the highest payoff.
If you are player 1: look at the lines and look at the values on the right. Choose the
values based on the ones you just looked at with the highest payoff.

CHAPTER 10: OLIGOPOLY

Oligopoly: a market with only a few producers. A producer is an oligopolistic
market is called an oligopolistic. Is an example of an imperfect competition. Firms
have market power, entry to the market is impeded, and there are strategic actions
between firms.
Duopoly: 2 firms.
¿
Market share: sales ¿ a firm total sales∈the market

Herfindahl-Hirschman index: how competitive a market is, measure of

n

concentration. If H ≥1,000 ; H ≠10,000 ,it is an oligopoly. H=∑ S 2i ; H [0 ; 10,000]. Ex: 3

i=1

firms, F1 has 70% of the market, F2 15%, and F3 15%. Thus,

H=70 +15 +15 =5,350.
2 2 2
Charles Bisson Groupe 11 (the BEST)

Cournot duopoly: 2 firms competing in a marketing with homogenous products.

They both know the demand curves and need to decide how much to produce at the
same time such that QS =Q D. Where each firm need to predict what the other firm is
going to do. Unique market price determined by demand. The demand=output of
all firms.
Nash Equilibrium of the Cournot model: a firm correctly anticipate the output
decision of the other firm and chooses their output as the best response.
Corresponds to the point where the reaction curves intersect. Ex:
q1
q2 q1 6−
2
q 1=6− ∧q2 =6− . Then, q 1=6− =4 ,∧q 2=4
2 2 2

Stackelberg model: first mover advantage. Firm 1 chooses its output before firm 2.
Ex:
R1=¿

MR=MC → 1=7−q 1 → q1=6 , q2=3∧P=$ 4

Comparisons between an oligopoly, monopoly, and perfect competition:

1. Oligopoly is a middle-ground between a monopoly and a perfect
competition;
2. An oligopoly as less market power than a monopolist but earns more
economic profits;
3. Quantity supplied of an oligopoly is greater than a monopolist but lesser
than in a competitive market;
4. The price in a oligopoly is greater than in a competitive market (=MC), but
the price is lower than in a monopoly;
5. The profits are greater in a competitive market (=0) than an oligopoly, the
highest in a monopoly, and balanced in an oligopoly;
Charles Bisson Groupe 11 (the BEST)

6. Consumer welfare and total surplus are greater in a perfect competition than
in an oligopoly, the lowest in a monopoly, with an oligopoly in between;
7. The Stackelberg model has more output than in the Cournot model, thus
meaning it is a more competitive model.

Collusive strategy: collectively behave as a monopolist.

CHAPTER 11: Asymmetric Information

Asymmetric information: when a person had access to economically relevant
information that is not known by all.
Incomplete asymmetric information: uncertainty is common to all agents.
Charles Bisson Groupe 11 (the BEST)

Adverse selection: asymmetric information related to hidden information. Occurs

when the agents with the highest value self-selects out of the trade, lowering the
EV of the company conditionally on the trade taking place.
Moral hazard: asymmetric information related to hidden actions.
Common price: average quality on the market (EV).
Solutions to adverse selection:
1. Certification
2. Brands and reputation
3. Signaling and Screening
Efficient market: if all possible gains of trade have been realized.
Incentive contracts:
1. Revenue sharing
2. Performance bonus
3. Pay-for-performance
4. Insurance: deductibles
5. Implicit incentives: threat of being fired
6. Explicit incentives: stock-options, end-of-year bonuses

CHAPTER 12: Moral Hazard and Contracts

Moral hazards: result of an action taken by an agent without another agent
observing it. This action has different consequences for the agent that takes the
action than for the other agents involved. Can create economic distortions. Is a
situation in which an individual takes a hidden action that benefits him/her at the
expense of the others.
Agent: is a person who acts (employee).
Principal: is a party affected by the agent’s actions (employer).
Effort: actions that the agent would not take if he/she was not paid for them. It
represents not only the number of hours worked, but also care, honesty, and the
quality of work. Ex: commissions, stock options, bonuses, grades at exams,
promise of a promotion or threats of being fired.
Charles Bisson Groupe 11 (the BEST)

Incentive schemes: used by the principal to solve or at least lowers the moral
hazard problem and to increase his profits.
3 ways to design incentives and contracts:
1. Fixed salary: compare EU for low effort vs. EU for high effort;
2. Revenue sharing: compare the w(R) functions for low effort vs. high effort
by using their respective probabilities;
3. Performance premium: compare the 2 EUs for low effort vs. the 2 EUs for
high effort;
where EU =expected wage−monetary cost of effort

Incentive schemes: used by the principal to solve or at least lowers the moral
hazard problem and to increase his profits.
Incentive contracts:
1. Revenue sharing
2. Performance bonus
3. Pay-for-performance
4. Insurance: deductibles
5. Implicit incentives: threat of being fired
6. Explicit incentives: stock-options, end-of-year bonuses
Charles Bisson Groupe 11 (the BEST)