Economics 214: revision

Concepts
o Scarcity problem: the gap between limited resources and theoretically limitless wants
o Time: biggest constraint for most of us
o Money
o If it were not for this, life would be stripped of much of its intensity
o Cost benefit analysis: compare the cost and benefits of doing a specific activity
o If B(x) > C(x), do x, otherwise don’t
o To apply this, need to define and measure costs and benefits – can be by applying with
monetary value
o Benefit (B(x)) as the maximum rand amount you would be willing to pay to do x – often
hypothetical
o Cost (C(x)) as the value of all the resources you must give up in order to do x – also often
hypothetical
o Positive vs normative:
o Positive: a question about the consequences of specific policies or institutional arrangements
o Correct answer can be determined
o Normative: a question about which policies or institutional arrangements lead to best outcomes
o No right or wrong answer
o Micro vs macro:
o Micro: firm level, the study of choice under scarcity (individual choices, study of group behaviour
in markets)
o Macro: country level (broad aggregation of markets)
Some pitfalls (things that shouldn’t be done in ecos)
1) Ignoring implicit costs:
o Overlooking costs that are not explicit
o Implicit cost: the value of the next best alternative not chosen
o Eg: if doing x means not being able to do y then the value of doing y is an oppourtunity cost of
activity x
2) Failing to ignore sunk costs:
o Costs that you cannot change/are fixed regardless of what you do should be excluded/ignored
o Sunk costs: cost beyond recovery at the moment a decision is made
3) Failing to understand average vs marginal
o Marginal: the difference between the current benefit/cost and the previous
o Average: the average of the total cost by the number of items
o Marginal cost: the increase in total cost that results from carrying out one additional unit of an
activity
o Marginal benefit; the increase in total benefit that results from carrying out one additional unit of
an activity
o Possible combinations:
o MB>MC: more of activity should be done
o MB<MC activity should be stopped
 o MB=MC: perfect quantity of activity is being performed (if more performed: decreasing
total benefit, less performed: can be made better off by carrying out an additional unit)
Some definitions
o Economic systems:
o Eg: capitalism, (open market system with private enterprise, demand and supply determines
everything), communism, socialism (government knows best, government is in charge), a
mixed system
o Capitalism, yes efficient but if you are not at the top, you have no say in the system youre not
part of the market systems – only benefits the rich and those with oppourtunity
o PPC: Production Possibility curve – shows various combinations of 2 goods that can be produced
within given resources
o Determinants D & S:
o Demand: Price, incomes, tastes, price of substitutes and
compliments, expectations, population
o Supply: price, technology, factor prices, number of suppliers,
expectations, weather
Consumer and producer surplus
o Consumer surplus: the difference between what price
consumers are willing to pay & what they actually pay)
o Producer surplus: the difference between what price
producers are willing to sell at & what they actually sell at
Important rules for derivatives
1. y=k
y’ = 0
2. y = xn
y’ = nxn-1
3. y =k xn
y’ = knxn-1
4. y = f(x) ± g(x)
y’ = f’(x) ± g’(x)
5. y = f(x) . g(x)
y’(x) = f’(x) g(x) + f(x) g’(x)
6. y = f(x)/g(x)
y’ = [f’(x)g(x) – f(x)g’(x)] / [g(x)]2
7. y = ex
y’ = ex
8. y = ln x
y’ = 1/x
9. y = [f(x)]n
y’ = n[f(x)n-1 . f’(x)]
10. y = f(u) and u = f(x)
Dy/dx = dy/du x du/dx
Partial derivatives
o more than one independent variable
o normal rules of derivatives & treat other variables as constant
Chapter 3: rational consumer choice
Consumer preferences
o preference ordering: a ranking of all possible consumption bundles in order of preference
o properties:
o completeness: if it enables the consumer to rank all possible combinations of goods and
services
o more-is-better: other things being equal, more a good is preferred to less
o Transivity: if you prefer A to B and B to C you will always prefer A to C, simple consistency
property & applies to the relation “equally attractive as”.
o Convexity: mixtures of goods are preferable to extremes – you are indifferent between 2
extreme bundles, preferences are convex if you prefer a bundle that contains half of each.
This is proven by diminishing MRS of indifference curves
o Cardinal vs ordinal utility: ordinal (must be able to rank preferences) and cardinal (must be able
to give a specific value to your level of satisfaction
Generating equally preferable bundles (fig 3.1)
o more is better assumption of preference
orderings
o A,B & C lie on same indifference curve,
therefore equally attractive

Indifference curves and indifference map

o Curve: A set of bundles among which the consumer is indifferent
o Map: a representative sample of the set of a consumer’s indifference curves used as a graphical
summary of their preference ordering

o Ordinal utility: can rank bundles in order of preference, but no quantitative statements on how much
they like each bundle
o Cardinal utility: can make quantitative statements on how much they like a specific bundle
Properties of indifference curves
o Infinite number, negative slope, downward sloping, cannot cross, more utility to right, slope becomes
less from left to right
Diminishing marginal rates of substitution
o MRS: at any point on an indifference curve, the rate at which a consumer is willing to exchange good
measured on y axis for good on the x axis, equal to the absolute value of the slope of the
indifference curve
o When you have lot of one thing, willing to give up more of it to obtain an item of which you have
little
the more food consumer has, more willing they are to give it up
to obtain an additional unit of shelter – at A, MRS is 3 and at C is
¼ - more willing to give up food for shelter at A
decreases as you move down the indifference curve – hence,
diminishing MRS

movement between 2 points on indifference curve

o 0 = MUy(ΔY) + MUx(ΔX)
o -MUy(ΔY) = MUx(ΔX) [|MUy(ΔY)| = |MUX(ΔX)|]
o -ΔY/ΔX = MUY/MUx
o -ΔY/ΔX = MRS of Y for X
o MUx/MUY = MRS
*MU = Marginal utility
People with different tastes
o Slope of indifference curves differ
1st: give up 1 sushi to gain 1 apple
2nd: give up 1 apple to gain 2 sushi – prefer apples

Budget limitations
o Bundle: a particular combination of 2 or more goods, which exhausts a specific amount of income
o Set of bundles exactly exhausts income at
given prices – the budget line or budget
constraint
o Slope: reverse price ratio of 2 goods =
- (price of X)/(price of Y)
changes in the budget line
o Change price in one product: change in
slope, the effect of a rise or fall in the price
of a product
o Eg: the price of shelter increases

o Change in income level – causes a shift in

the budget line
o Eg: cutting income by half

Budget involving 2 or more goods

o The budget line with the composite good:
o Composite good: in a choice between a good
X and other numerous other goods, the
amount of money the consumer spends on
the other goods

o Budget line can also be kinked – when the price is not constant the entire time – costs x for the
first amount and then y thereafter
Best feasible/affordable bundle
o Best affordable budget: most preferred bundle of those that are affordable
o Consumer: highest utility level given budget
constraint – furthest point away from the origin
– want to be as far as possible to the right,
where you can be on your highest indifference
curve
o Why where budget line is tangent to
indifference curve: where MRS=MRT
o At point F: MRS < Ps/Pf
o MUs/MUf < Ps/Pf
o MUs/Ps < MUf/Pf
Corner solution
o In a choice between 2 goods, a case in which
the consumer does consume only one of the
goods
o According to the way the preference of the
consumer falls
Chapter 4: individual and market demand
Deduct demand curve: The effects of a change in price
Price consumption curve
PCC: holding income and the price of Y
constant, the PCC for a good X is the set of
optimal bundles traced on an indifference map
as the price of X varies

the individual consumer’s demand curve

o Budget line in above: dependent on price of housing:
at price of 480: 2400/480 = 5 (will intersect at 5) and
so on for 240, 120 & 80
o Y is a composite good
o Can then plot a demand curve which you can derive
from the PCC

Effect on equilibrium (delta Y)

o The effect of a price change causes the quantity demanded to increase/decrease

Deduct engel curve: effects of a change in income

Income consumption curve
ICC: holding the prices of X & Y constant the ICC for a good
X is the set of optimal bundles traced on an indifference
map as income varies
Y -axis: everything consumer can spend that is not good x

Engel curve
o Have income: divide by the price, gives you x
axis intercept for budget lines – 800/200 = 4
o Derive an engel curve
o Engel curve: a curve that plots the relationship
between quantity of x consumed & income
o Y axis: shows consumers total income by
period
Effect on equilibrium (delta Y)
o As the level of income changes the quantity demanded increases or decreases: when Y increases,
Qd will increase
Normal vs inferior goods
Normal good: demand increases as income
rises – has a positive slope on Engel curve
Inferior good: demand decreases as income
rises – negative slope on Engel curve

Income and substitution effect

o Substitution effect: the component of the
total effect of a price change that results
from the associated change in the relative
attractiveness of the good – as a result of
price change
o Income effect: the component of the total
effect of a price change that results from
the associated change in real purchasing
power – as a result of change in real
income
o Total effect: sum of substitution and
income effects – graph on right (for a normal good)
o A to C = substitution effect
o C to D = income effect
o (normal good)
Giffen goods
o One for which the quantity demanded rises as its price rises
o Income effect > substitution effect
o Is inferior

Income and sub effect for perfect compliments

o the sub effect is shown from A to C – the effect is
equal to 0
o Therefore, the income effect (C to D) is equal to the
total effect

Income and sub effect for perfect substitutes

o the substitution effect is shown by A to C – very
large
o The income effect is the movement from C to D
o For small price changes, consumers may switch from
consuming one good to only the other
Income and substitution effect for a price-sensitive good
o eg: housing
o The income and substitution effect tend to be larger than
normal
o The quantities demanded of goods with large sub & income
effects are highly responsive to changes in price

Market demand curve

horizontal summation of the individual
demands
say you have: Qd = 15 – (p/20) and Qd = 10
– (p/30)
add: Q = Qd + Qd = 25 – (p/12)

price elasticity of demand

o The percentage change in the quantity of a good demanded that results from a 1% change in its
price
o ε= OR 1/slope x P/Q
o elastic: ε < -1
o inelastic: ε > -1
o unit elastic: ε = -1
a = normal
b = absolute
the point-slope method
o P = 1600 – 2Q
o Q = 800 – 0.5P
o dQ/Dp = -0.5
o εA = -0.5 x 1200/200 = -3
o εB = -0.5 x 400/600 = -1/3
o Every point on a demand curve therefore has different
demand curves
o If inelastic: an increase in price will result in an increase in total revenue, and decrease in price will
result in decrease in revenue
o If elastic: an increase in price will result in a decrease in total revenue, and a decrease in price will
result in an increase in revenue
2 polar cases

Elasticity is unit free

o Independent unit of measurement
o Slope however is dependent on the
responsiveness to changes in price

The effect on total expenditure of a reduction in price

When price falls, people spend less on existing units (E) but they
also buy more units (G) – here G is larger than E so total
expenditure rises

when demand is elastic, total expenditure of consumers

change in the opposite direction from a change in price. When
demand is inelastic, total expenditure & price both move in the
same direction. At the midpoint of the demand curve (M), total
expenditure is a maximum

elasticity and total revenue

o If |ε| < 1
o P↑ => TR ↑
o If |ε| > 1
 o P↑ => TR ↓
Determinants of price elasticity of demand
o Substitution possibilities: sub effect of a price change tens to be small for goods with no close subs
o The absolute value of price elasticity will rise with the availability of attractive substitutes
o Budget share: the larger the share of total expenditure accounted for by the product, the more
important will be the income effect of a price change
o The smaller the share of total expenditure accounted for by a good, the less elastic the demand
will be
o Direction of income effect: Is it positive or negative
o a normal good will have a higher price elasticity than an inferior good, other things being equal
because the income effect reinforces the sub effect for a normal good but offsets for an
inferior good
o time: to find alternatives

the segment ratio method

the absolute value of price elasticity at any point is the ration of the 2
demand curve segments from that point
at point C: the absolute value of the price elasticity of demand is equal
to EC/AC

income elasticity of demand

o the percentage change in the quantity of a good demanded that results from a 1% change in income
dQ Y
o η = dY Q
o η > 1 = luxury: change in income will result in a greater proportional change in Qd
o η < 1 = necessity: change in income will result in a lesser proportional change in Qd
o η <0 = inferior: Qd decreases as income increases
engel curve for different types of goods
(a) – the good whos engel curve is shown has an
income elasticity of 1, for such goods, a given
proportional change in income will produce the same
proportional change in quantity demanded. Thus when
average income doubles Mo to 2Mo the quantity
demanded also doubles
(b) the engel curve shows that the consumption increases more than in proportion to income for a
luxury & less than in proportion for a necessity, thus falls with income for an inferior good
Cross price elasticities
∆"! ∆#"
εXZ = /
"! #"

o positive: substitutes
o negative: compliments
o If 0 – products not related

Elasticity and tax income

o inelastic (left): consumers pay bulk of tax
o Elastic (right): producers pay bulk of tax
o Gov receives more income tax from inelastic
goods than elastic goods
o Therefore, beneficial for gov to tax inelastic
goods

energy tax with a rebate

o εd = -0.5 and η = 0.3
o Y = 90 000
o Eq: uses 1200 units electricity @ R10/unit
o Spend R12 000 electricity R78 000 other
o Energy tax = R5/unit
o Rebate: R4500
 an energy tax with a tax rebate will put the average
consumer in a slightly worse position, while the
consumption of electricity will decrease

(example 4.7 pg 119)

Network externalities
o Other consumers influence your consumption
o Positive: if a consumer demands more of a product because more people are buying it (eg:
bandwagon)
o Negative: customer demands less of the good (eg: snob)
Bandwagon effect: desire to have a good because everyone else has it
demand curves shift rightward
examples: facebook, twitter, phones – sms, whatsapp,
voicenote, Microsoft windows
positive externality

Snob effect: want to own exclusive product

when more people buy the product, the demand decreases –
appeal is to be the only one to have it
eg: artworks, sportscars, made-to-measure clothing
negative externality

intertemporal consumption bundles

o Choosing between consumption now or later – save or spend
o Max consumption future: M1(1+r) + M2
o Max consume now = M1 + M2/(1+r)
Intertemporal indifference map
the absolute value of the slope of the indifference curve =
Marginal rate of time preference (MRTP) – at A= DC2/DC1

Optimal intertemporal allocation

o Marginal rate of time preference: number of units of consumption in the future a consumer would
exchange for 1 unit of consumption in the present – change in C2/change in C1
o MRTP>1: positive time preference, consumer requires more than 1 unit of future consumption to
compensate for the loss of current consumption (impatience)
o MRTP<1: negative time preference, consumer is willing to forgo 1 unit of current consumption
for less than 1 unit of future consumption (patient)
o MRTP=1: neutral time preference
 as in the atemporal model, the optimal intertemporal
consumption bundle (A) lies on the highest attainable
indifference curve, here that occurs at a point of tangency

Patience & impatience

Econ 214 – chapter 7
Short run production
The input-output relationship (production function)
o Production: any activity that creates or present or future utility
o Process that transforms inputs (factors of production)
into outputs
o Eg inputs: land, labour, capital and entrepreneurship
o Production function: the relationship by which inputs are
combined to produce output
o Properties:
o Passes through origin
o Initially the addition of variable inputs augments
output at an increasing rate
o Beyond some point additional units of the variable
input give rise to smaller & smaller increments of production function
output
o The relationship: Q = F(K,L)
o Q = output
o K = capital
o L = labour
o F = mathematical function, rule to tell how much Q we get when we employ specific quantities
of K & L
Intermediate products
o Capital & labour insufficient to produce final goods by themselves
o Intermediate products can for example be foodstuffs – to make a meal
Fixed & variable inputs
o Production function tells us how output will vary with a change in inputs
o Long run: the shortest period of time required to alter almost every input
o Short run: the longest period of time during which at least one of the inputs used in a production
process cannot be varied
o Variable input: an input that can be varied in the short run
o Fixed input: an input that cannot vary in the short run

Production in the short run

o Observe which variable is fixed (such as capital)
while another is variable – this allows you to
plot a 2D graph
o Graphs do not always have to be straight lines:

à L=4 – diminishing output growth (initially

increasing growth rate)
à L=8 output decreases

o Law of diminishing returns: if other inputs are fixed, increase in output resulting from an increase in
the variable input must eventually decline

Total, marginal & average products

o Short run production functions often referred to
as total product curves:
o A curve showing the amount of output as a
function of the amount of variable input
o Marginal product: the change in the total product
that occurs in response to a unit change in the
variable input (all other inputs held fixed)
o DQ/DL – if have total product you can look
at the change from one to the next
o Equal to slope of total product curve
o The maximum point on the marginal product
curve correlates to the inflection point on
the total product curve (where marginal
product starts diminishing or is equal to 0)
o Average product: the total product divided by the number of units of the variable input used in the
production process
o When MP > AP, the average product is increasing
Relationship between total, marginal & average product curves
à the maximum average product is where the MP
and AP intersect
Relationship for MPC and APC = when the marginal
product curve lies above the average product curve
must be rising, when the MPC lies below the APC the
APC must be falling. The 2 intersect at the max value
of the APC
The practical significance of the average-marginal distinction
o General rule for allocating input efficiently is to allocate the next unit of input to the production
activity where marginal product is its highest – applies to resources not perfectly divisible (where the
marginal product of a resource is always higher in one activity than the other)
o For products that are perfectly divisible: allocate the resource so that the marginal product is the
same in each activity
o Solve this by: allocating resources to the highest average product OR by equalising products
across activities

Production in the long run

o All inputs variable
o Isoquant: set out output combinations that yield the same level of output
o MRTS: Marginal rate of technical substitution – the ration one input can be exchanged for another
& production levels unchanged
Isoquant map
production increases as you move to the right
describes the properties of the production process
similar to indifference curves and consumer preferences

Cobb-douglas production function

àQ=mKαLβ
Alpha and beta any number between 0 and 1 & m any
positive number
This example is K = Q02/L
The marginal rate of technical substitution
any point on the curve is technically efficient
rate at which one input can be exchanged for another
input without a change in production levels
decreasing MRTS (-dK/dL)

o (MPL) x (ΔL) + (MPK) x (ΔK) = 0

o (MPL) x (ΔL) = -(MPK) x (ΔK)
o (MPL)/(MPK) = -(ΔK)/(ΔL)
o But MRTS = -(ΔK)/(ΔL)
o Thus MRTS = (MPL)/(MPK)

isoquant maps for perfect substitutes and perfect complements

Returns to scale
Long run = all inputs variable
What happens to output when all inputs are increased by exactly the same proportion
o Increasing: output increases at higher percentage than inputs
o Constant: output increases at same percentage than inputs
o Decreasing: output increases at lower percentage than inputs
 returns to scale shown on isoquant map

à returns to scale illustrated with

isooquants
(a) – increasing returns (inputs increase by
100% and outputs by more than 100%)
(b) – constant returns (both inputs and
outputs increase by 100%)
(c) – decreasing returns (inputs increase by 100% & outputs increase by less than 100%)
Economics chapter 8: costs
Costs in the short run
o Accounting costs: equal to the exact amount paid in expenses when producing a good or providing a
service
o Economic costs: also take oppourtunity cost into account
o Oppourtunity cost of an activity is equal to the value of the next-best value activity that you can
now no longer afford
o Fixed costs: costs that do not vary with the level of output in the short run (the cost of all fixed
factors of production)
o Variable costs: cost that varies with the level of output in the short run (the cost of all variable factors
of production)
o Sunk costs: those the firm has already paid which cannot be recovered
o Total cost: all economic costs of production – sum of variable & fixed costs

Graphing the total, variable and fixed costs

at L=4 – marginal product starts to decrease
(diminishing returns)
àoutput as a function of one variable input

à total, fixed and variable cost curves

At Q = 43 (marginal cost start to increase)
Before it is decreasing

Other short run costs

o Average fixed cost: total fixed cost divided by quantity of output
o Average variable cost: total variable cost divided by quantity of output
o Average total cost: the cost divided by the quantity of output – what a product costs on average to
produce
o Marginal cost: change in total cost that results from a one-unit change in output. The additional
production cost of the last unit produced
o MC = dTC/dQ OR dVC/dQ (because fixed cost does not change can use the variable cost to
work out)
Graphing the short run average and marginal cost curves
o The process where AFC falls with output = spreading overhead costs
à cost curves
MC curve intersects AVC and AFC at their respective
minimum turning point
TC = FC + VC
ATC = AFC + AVC
Because AFC constantly declines – ATC continues falling
even when AVC has begun to turn upwards

Allocating production between 2 processes

o How would you allocate resources to get the lowest possible total cost
o Minimum cost condition – best option (equate marginal costs)
Example 8.4
Suppose production processes A and B give rise to the following marginal and average total cost curves:

where the superscripts denote processes A and B, respectively. What is the least costly way to produce a
total of 32 units of output?
The minimum-cost condition is that with QA + QB = 32. Equating marginal costs, we have

Substituting QB = 32 − QA into Eq. 8.16, we have

which solves for QA = 8. QB = 32 − 8 = 24 takes care of the remaining output, and at these output levels marginal
cost in both plants will be R96/unit of output (see Fig. 8.8). The line MCT = 3QT is the horizontal sum of MCA and
MCB.6

Figure 8.8 The minimum-cost production allocation

To produce a given total output at minimum cost, it should be allocated across production activities so that the marginal cost of each
activity is the same.

The average total cost values that correspond to this allocation are ATCA = R50/unit of output and ATCB = R58/unit
of output. From the average total cost curves we can deduce total cost curves in this example (just multiply ATC
by Q).7 They are given by TCA = 16 + 6(QA)2 and TCB = 240 + 2(QB)2. The cost-minimizing allocation results in
TCA = R400 and TCB = R1392, illustrating that the cost-minimizing allocation does not require equality of total costs
either.
The relationship between MP, AP, Mc & Avc
o MC = w/MP
o AVC = w/AP

Costs in the long run

o All inputs are variable
o P L = w & PK = r
o Isocost line: a set of input bundles, each of which costs the same amount
o C = rK + wL
o Intersection: C/r & C/w
o Slope = -w/r
à isocost line for (r=40 & w=80)
 à maximum output for a given expenditure
Where isocost is tangent to isoquant
(MRTS = w/r at point on graph)

o The problem of producing the largest output for a given

expenditure is solved the same way as the problem of
producing a
given level of
output for the
lowest possible
cost
à the minimum
cost for a given
level of output
MPL/MPK = w/r
MPL/w = MPK/r

The relationship between optimal input choice & long-run costs

o Output expansion path: the locus of tangencies (minimum cost input combinations) traced out by an
isocost line of given slope as it shifts outwards into the isoquant map for a production process (shown
by curve EE)
à the long run expansion path
With fixed input prices r and w bundles, S,T,U and
other along locus EE represent the least costly ways of
producing the corresponding levels of output
 à the long-run total, average and marginal cost
curves
∆"#$
𝐿𝑀𝐶 = ∆%

- LMC = long run marginal cost

- LTC = long run total cost
Therefore, the long run marginal cost is the slope of
the long run total cost curve
The LAC and LMC intersect where the LTC and
the slope of the ray to LTC are the same (seen at
Q3)
Constant returns to scale:

With constant returns, long run total cost curve is a straight line (a), long run marginal cost is constant
and equal to long-run average cost
Therefore: %d LRTC = $d output
Decreasing returns to scale

Under decreasing returns, a certain % increase in all inputs will lead to a smaller % increase in output, &
additional units of production will become more expensive to produce
Therefore: %d LRTC > %dLR output
Increasing returns to scale

With increasing returns, a certain % increase in all inputs will lead to a larger % increase in output and
additional units of production will get cheaper to produce
Therefore: %d LRTC < %dLR output

LAC curves characteristic of highly concentrated industrial sectors

o Minimum efficient scale (MES): production level for min LAC
o Economies of scale: downward sloping part of LAC (production less expensive)
o Diseconomies of scale: upward sloping part of LAC (production more expensive)

LAC curves characteristic of unconcentrated industrial sectors

The relationship between the short-run and long-run expansion paths
à the short-run and
long run expansion paths

The long-run expansion path is the line 0E. With K fixed at the short-run expansion path is a horizontal
line through the point ( ). Because is the optimal amount of K for producing 2 units of output, the
long-run and short-run expansion paths intersect at T. The short-run total cost of producing a given level
of output is the cost associated with the isocost line that passes through the intersection of the relevant
isoquant and the short-run expansion path. Thus, for example, STC3 is the short-run total cost of
producing 3 units of output.
à the LAC, LMC and 2 ATC curves
associated with the cost curves from
above
Short run average cost is tangent to
long-run average cost at the same
output level for which the corresponding
LTC and STC curves
The family of cost curves associate with the U shaped LAC curve
The LAC curve s the outer envelope of the
ATC curve
LMC = SMC at the Q value for which the
ATC is tangent to the LAC.
At the min point on the LAC,
LMC=SMC=ATC=LAC

The learning curve

o Measures impact worker’s experience on costs of production
o New firms experience learning experience, not economies of scale
o Older firms small gains from learning
o Economies of scale: when all inputs are increased by a certain %, which results in a larger % increase
in outputs (average cost per product decreases as production levels increase)
o A firm’s marginal & average costs may decline because:
o When workers first undertake a task it may take them a long time. As they become familiar with
it, their speed increases
o Managers of the production process learn by their mistakes & over time, plan the whole
production process better to increase efficiency
o Engineers may streamline their product designs to save time without increasing defects. Better,
specialised & more effective plant organisation may also lower production cost
o Some suppliers of the materials used in the production process may also become more efficient,
pass this on via lower prices & thus lower costs for the manufacturer
o *learn from these thus decreasing average production cost
indicates the relationship between
a firm’s cumulative output and the
extent to which the labour needed
to produce it falls as cumulative
output increases
Economies of scale vs learning experience
Econ 214: Chapter 9 – perfect competition
The goal of profit maximisation
o Economist traditionally assume that the firm’s central objective is to maximise profit
o Profit (economic profit): the difference between total revenue and total cost, where total cost
includes all costs, both explicit & implicit (includes opportunity & implicit costs)

4 conditions for perfect competition

o Firms sell a standardised product (product sold by one firm is assumed to be a perfect substitute for
the product sold by another)
o Firms are price takers (individual firm treats the market price of good as given, market price will not
be affected by how much output it or its competitors produce)
o Free entry & exit with perfectly mobile factors of production in the long run
o Firms & consumers have perfect information

The short run condition for profit maximisation

o Firm chooses output level that has the largest difference between total revenue and total cost in the
short run to maximise profit
à revenue, cost and economic profit
Different between TR and TC is the economic profit (at Q=74)
MR=MC

o Marginal revenue: the change in total revenue that occurs as a result of a one-unit change in sales
Shutdown condition
o If price falls below min AVC, the firm would shut down in the short run
o SR supply: MC curve >= Min AVC
The short run supply curve

When price lies below minimum value of AVC, firm will make losses at every level of output – keep
losses to a minimum by producing 0
For prices above min AVC, firm will supply that level of output for which MR=MC

The short-run supply curve for a competitive industry

o Sum of all the short run marginal cost curves

Short run competitive equilibrium

o Individual competitive firm must choose the most profitable level of output in response to a given
price
o Below: short-run price & output determination under pure competition
 the short-run supply & demand curves
intersect to determine the short-run
equilibrium price P* = 200 (a)
the firms demand curve is a hirzontal line at
P* = 200 (b)
taking P* = 200 as given, the firm maximises
economic profit by producing 80 units/wk for
which it earns an economic profit of II – 6400/wk (shaded rectangle in b)
o Below: short run equilibrium with losses
The short-run supply and demand curves
sometimes intersect to produce an
equilibrium price P* = R100/unit of output
(panel a) that lies below the minimum value
of the ATC curve for the typical firm (panel
b), but above the minimum point of its AVC
curve. At the profit-maximizing level of
output (in this case, minimum
losses), units/wk, the firm earns an economic loss of Πi = −R1200/wk.

The efficiency of short-run competitive equilibrium

o Allocative efficiency: a condition in which all possible gains from exchange are realised (MSC = MSB)
o Below: short-run competitive equilibrium is efficient
At the equilibrium price and quantity, the
value of the additional resources required
to make the last unit of output produced
by each firm (MC in panel b) is exactly
equal to the value of the last unit of
output to buyers (the demand price in
panel a). This means that further mutually
beneficial trades do not exist.

Producer surplus
o Defined as: the rand amount by which a firm benefits from producing a profit-maximising level of
output
o Difference between total revenue & total variable cost
o In short run: PS is larger than economic profit
(because the firm would lose more than its economic
profit if it were prevented from participating in the
market), long run they are equal (all costs are variable)
Aggregate producer surplus when individual marginal cost curves are upward sloping
throughout
for any quantity, the supply curve measures the
minimum price at which firms would be willing to
supply it.
The difference between the market price & supply
price is the marginal contribution to aggregate
producer surplus at that output level

the sum of aggregate producer & consumer surplus

measures the total benefit from exchange
Example 9.3
Suppose there are two types of firework user: careless and careful. Careful users never get hurt, but careless ones sometimes
injure not only themselves but also innocent bystanders. The short-run marginal cost curves of each of the 1000 firms in the
firework industry are given by MC = 100 + Q, where Q is measured in kilograms of cherry bombs per year, and MC is
measured in rands per kilogram of cherry bombs. The demand curve for fireworks by careful users is given by P = 500 −
0.001Q (same units as for MC). Legislators would like to continue to permit careful users to enjoy fireworks. But since it is
logistically impossible to distinguish between the two types of user, they have decided to outlaw fireworks altogether. How
much better off would consumers and producers be if legislators had the means to affect a partial ban? Use the consumer and
producer surplus approach.
If the entire firework market is banned completely, the total of consumer and producer surplus will be zero. So to measure the
benefits of a partial ban, we need to find the sum of consumer and producer surplus for a firework market restricted to
careful users. To generate the supply curve for this market, we simply add the marginal cost curves of the individual firms
horizontally. The marginal cost of an individual firm is given as P = 100 + Q, implying Q = P − 100. For the entire industry, Q =
1000P − 100 000, which converts to P = 0.001Q + 100, the curve labelled S in Fig. 9.12. The demand curve for careful users would
intersect S at an equilibrium price of R300 and an equilibrium quantity of 200 000 kg/yr.

Figure 9.12 Producer and consumer surplus in a market consisting of careful firework users

The upper shaded triangle is consumer surplus (R20 000 000/yr). The lower shaded triangle is producer surplus (R20 000
000/yr). The total benefit of keeping this market open is the sum of the two, or R40 000 000/yr.
By outlawing the sale of fireworks altogether, legislators eliminate producer and consumer surplus values given by the areas of
the two shaded triangles in Fig. 9.12, which add up to R40 000 000/yr. In the language of cost–benefit analysis, this is the cost
imposed on producers and careful users. The benefit of the ban is whatever value the public assigns to the injuries prevented
(net of the cost of denying careless users the right to continue). It is obviously no simple matter to put a rand value on the pain
and suffering associated with fingers blown off by cherry bombs. In Chapter 12 we shall discuss how rough estimates have been
attempted in similar situations. But even in the absence of a formal quantitative measure of the value of injuries prevented, the
public can ask itself whether the forgone surplus of R40 000 000/yr is a reasonable price to pay.
Adjustments in the long run
à a price level that generates economic profit
A price level P = 100, the firm adjusted plant size so that SMC =
100, at profit maximising level of output, Q=200, firm earns an
economic profit = to R6000 in each time period, indicated by
shaded area
à a step along the path towards long run equilibrium
Entry of new firms causes supply to shift rightwards, lowering
price from 100 to 80 – causes existing firms to adjust capital
stocks downwards, giving rise to new short run cost curves –
as long as price remains about short run AC, economic profits
will be positive
Above continues until: LRAC is at minimum & SATC is tangent to LRAC at minimum
Efficiency
o Allocative efficiency: when the economy produces only those type of goods and services that are
more desirable in society & in high demand
o Goods traded will be equal to marginal cost
o Social surplus is also maximised because there is no DWL
o Productive efficiency: it must be a production point on your production possibility frontier (PPF)
o Also implies that production takes place at the minimum point on a firm’s average cost curve –
also the case with perfect competition equilibrium
à long run equilibrium under perfect comp
If price starts at P*, entry keeps occurring & capital
stocks of existing firms keep adjusting until the
rightward movement of industry supply curve causes
price to fall to P*
At P* the profit maximising level of output for each
firm is Qi* the output level for P* = SMC = ATC*
Economic profits of all firms are equal to 0
 The long-run supply curve for a competitive industry
Long run supply curve with U shaped LAC
curves
à long run competitive supply curve if
demand increases
When firms are free to enter/leave the
market, price cannot depart from the min
value of LAC curve in the long run
If input prices are unaffected by an increase in
industry output, the long run supply curve is
Slr, a horizonal line at min point of LAC

à the long run supply curve if demand

decreases
Same description as above

Industry supply curve when LAC curve is horizontal

o U shaped: can predict that each firm will produce quantity that responds to min point
o No unique minimum point
o Cannot predict what size distribution of firms will look like

How changing input prices affects long run supply

o Pecuniary diseconomy: a rise in production cost that occurs when an expansion of industry output
causes a rise in the prices of inputs
o Pecuniary economy: a fall in production cost that occurs when expansion of industry output causes a
drop in the price of inputs
 Long run supply curve for an increasing cost
industry
When input prices rise with industry output, each firm’s
LAC curve will also rise with industry output (b). Thus
the firm’s LAC curve when industry output is Q2 lies
above its LAC curve when industry output is Q1 (b).
Firms will still gravitate to the minimum points on their
LAC curves, but because this minimum point depends
on industry output, the long-run industry supply curve
(SLR in panel a) will now be upward sloping.
Long run supply curve for a decreasing cost
industry
When input prices decrease with industry output, each
firm’s LAC curve will also rise with industry output if
production volume decreases (panel b). Thus the firm’s
LAC curve when industry output is Q2 lies above its
LAC curve when industry output is Q1 (panel b). Firms
will still gravitate to the minimum points on their LAC
curves, but because this minimum point depends on
industry output, the long-run industry supply curve (SLR, panel a) will now be downward sloping.

The elasticity of supply

o Price elasticity of supply: the % change in quantity supplied that occurs as a response to a 1% change
in product price

o Formula:

Applications & practical examples – pg 284-286

Econ 214: chapter 10: monopoly
Defining monopoly
o Monopoly is a market structure in which a single seller of a product with no close substitutes serves as
the entire market
o Monopoly has significant control over the price it charges
5 sources of monopoly
o Exclusive control over important inputs (technical barrier)
o Company controls an input that cannot easily be duplicated
o Economies of scale (technical barrier)
o Natural monopoly: an industry who’s market output is produced at the lowest cost when production
is concentrated in the hands of a single firm
o Occurs when a market has a declining long-run average cost curve
o 1 supplier will be able to provide the good/service at a lower cost than more suppliers
à natural monopoly and concentrated
industries
(a) when LAC curve is always declining,
always cheaper for a single firm to serve
entire industry
(b) U-shaped LAC curves who’s min points
occur at a substantial share of total market output are characteristic of markets served by only a small
handful of firms (oligostic market share)
o Patents (technical barrier)
o A document that causes all benefits from the exchange of the good/service to go to the inventor
o Cost: results in higher prices for consumers
o Benefit: allows for innovation, as many products that have patents were the result of years of
expensive research. The higher price allows these firms to recoup their costs, without which there
would be no motivation to innovate
o Network economies (technical barrier)
o A product becomes more valuable as more people consume it
o Initial success of a product can have a massive impact on its future
o As a product sells more, there are more facilities available to it
o Government licensing or franchises (legal barrier)
o Only specific companies allowed to operate with the government license
o Often accomplished with strict regulations
o Information as a growing source of economies of scale
o A distinctive feature of information is that almost all costs associated with its production are fixed
o This results in information rich products having high economies of scale
The profit maximising monopolist
The monopolist’s total revenue curve
à total revenue curve for a perfect competitor
Price for perfect competitor remains at short-run
equilibrium P*, irrespective of firm’s output
TR = P*Q
Difference in perfect competitor and monopolist: the
way in which total, and hence marginal revenue varies
with output

à demand, total revenue & elasticity

Monopolist with downward sloping demand curve: P=800 – 1/5Q
TR= PQ
For monopolist to sell larger amount of output, it must cut its
price, not only for marginal unit but for preceding as well
TR cuts through origin – selling no output generates no revenue
Reaches max at midpoint on demand curve

à total cost, revenue and profit curves for a monopolist

Short run total cost & total revenue curve
Bottom = economic profit
Production level where vertical distance between TC & TR
is greatest
Marginal revenue
!"#
o 𝑀𝑅 =
!$
o Optimality condition for a monopolist: a monopolist maximises profit by choosing the level of output at
which marginal revenue = marginal cost
!"# !"%
o 𝑀𝑅 = = = 𝑀𝐶
!$ !$
o Monopolist wants to sell all units for which MR>MC, So MR should lie above MC prior to intersection
o Monopoly: MR p/unit will always be less than price
à changes in total revenue resulting from a price cut
Want to increase output (Q0 + dQ), need to cut price
by the dP
&'( "#*+,-.-&/0 "#
To calculate marginal revenue: 12/&.' -& +34534,!$

A = loss in revenue from change in price

B = gain in revenue from selling more units

àmarginal revenue and position on demand curve

Can see with A & B: B is larger than A, clearly MR is
positive,
Changes at C & D: C is larger, MR becomes negative
New total revenue: (P0-dP)x(Q0-dQ)
!7
MR = P0 - !$
𝑄0

Marginal revenue and elasticity

o MR = P(1 – 1/|ε|)
Graphing marginal revenue
à the demand curve & corresponding MR curve
P = 800 – 0.2Q
At Y-intercept, ε is infinite, therefore MR = 800(1-1/ ε)
At B, MR = 0, TR at a maximum at midpoint of straight-line
demand curve
At C, effect of producing extra unit of output is to reduce
TR by 400 (MR = -400)
Graphical representation of the short-run profit-maximisation condition
à profit maximising price & quantity for a monopolist
Differ from perfectly competitive firms because they don’t ask
where MR=MC, monopolist can influence price, can ask the
price that is available for a specific quantity demanded
Earn an economic profit of shaded square

Profit maximising monopolist will never product on the inelastic portion of the demand
curve
o At inelastic: price increase, cause TR to increase which causes quantity produced to decline & then total
cost – this point is then never profit maximising
o Where in elastic: price increase, TR decreases and quantity produced decreases
Profit maximising mark-up
o Formula:
o Tells us: if demand is elastic, profit maximising mark up is small & vice versa
o Has no s-curve (price maker)
o Price rule: MC=MR
Measuring monopoly power
o Learner index (between 0 & 1):
o The extent to which the profit-maximising monopolist price exceeds marginal cost
o With perfect competition: P=MC, monopoly: P>MC
o The larger the value of L, the more monopoly power
The monopolist’s shutdown condition
à a monopolist who should shut down in the short
run
Condition: if there exists no quantity for which the
demand curve lies above the AVC curve
Cease operation whenever average revenue is below
AVC at every level of output
A monopolist has no supply curve
o Monopolist is not a price taker, there is no unique correspondence between price & marginal revenue
when the market demand curve shifts
Adjustments in the long run
à long-run equilibrium for a profit-maximising
monopolist
Best place: MR=LRMC
Choosing a capital stock that gives rise to short-run-
average and marginal cost curves (ATC* & SMC*)
Economic profits tend to vanish (the factors that gave
rise to firm’s monopoly position come under attack in
long run, downward pressure on profits): competing
firms develop substitutes, competitors may develop
subs that don’t infringe patent rights
Profits can also persist: natural monopolies (declining LR Average cost curves), economic profits may be
highly stable over time

Example 10.3
A monopolist has marginal costs MC = 10Q and home market demand PH = 300 − 10Q. The monopolist
can also sell to a foreign market at a constant price PF = 120. Find and graph the quantity produced,
quantity sold in the home market, quantity sold in the foreign market and price charged in the home
market. Explain why the monopolist’s profits would fall if it were to produce the same quantity but sell
more in the home market.
The linear demand curve P = 300 − 10Q has associated marginal revenue MR = 300 − 20Q. The profit-
maximizing level of output for a monopolist selling to segmented markets occurs where ∑MR = MC. The
horizontal sum of the marginal revenues across markets is the home marginal revenue function MRH up to
home output where MRF = MRH, and then the foreign marginal revenue function MRF = 120 for any
further units (see Fig. 10.14). Total marginal revenue equals marginal cost at MRF = MC, which solves for Q =
12. Marginal cost for this level of output equals home marginal revenue at 300 − 20QH = 120, so QH = 9
with the remaining units sold abroad:

Figure 10.14 A monopolist with a perfectly elastic foreign market

The curve ∑MR follows MRH as long as MRH ≥ MRF, and then follows MRF. The profit-maximizing output
level is where the ∑MR curve intersects the MC curve, here Q* = 12.
In the home market, the monopolist charges

Any further units sold at home would yield marginal revenue less than 120. Since sales to the foreign
market yield a constant marginal revenue of 120, shifting sales to the home market would decrease profits
as a result of the lost marginal revenue for each unit shifted.
Price discrimination
o Asking different prices for different consumers
o Third degree: charging different prices for consumers in completely different markets
o Second degree: different prices according to block (more you buy = cheaper)
o First degree: perfect – ask reservation price (price consumer is willing to pay)
Sales in different markets – 3rd degree (2 distinct markets)
à profit-maximising monopolist that sells in 2
markets
Given that MR in 2 markets must be same, the
profit-maximising total quantity will be the one
for which this common value is the same as
marginal cost
Total: add 2 individual markets together

o Arbitrage: the purchase of something for costless risk-free resale at a higher price
Intertemporal price discrimination
à intertemporal price discrimination
Market is split in 2: initially ask high price, later you
lower it
De = inelastic demand, of people who don’t want to
wait
Dl = elastic demand, people who want to wait
Initially: profits are = triangle P0ADPe in the inelastic
market & later to area P0BCPl in the more price
sensitive market
Peak-load pricing
à peak-load pricing
Less an effort to capture consumer surplus & more a means of
increasing efficiency (soccer world cup)
Business charging higher prices with higher demand, and lower
prices with low demand
Off-peak: output increases from Qop to Q’op (costs fall by area
under SMC curve and benefits fall by area under demand curve –
costs fall more than benefits, therefore net gain – shaded triangle)
Peak: output decreases from Qpp to Q’pp (costs fall by area under SMC curve and benefits fall by area
under demand curve – costs fall more than benefits, therefore net gain – shaded triangle)
Perfectly discriminating monopolist – first degree price discrimination
à perfect price discrimination
The largest possible extent of market segmentation
Different prices at each quantity output
Monopolist captures all consumer surplus – consumer pays
maximum he would have been willing to pay for each unit,
therefore receives no surplus
Monopolist increases their profit by charging different prices and
converting consumer surplus into profit for the firm
à perfectly discriminating monopolist
MR curve for monopolist who can perfectly discriminate is same as
demand curve, profit maximizing output Q*, where SMC and
demand curve intersect (economic profit = shaded area)

Second degree price discrimination

à second-degree price discrimination
Not a single price, but a price that declines with quantity bought
Block rate structures
Difference to 1st degree: same rate structure is available to
every customer under 2nd degree schemes, which means that
they make no attempt to tailor charges to elasticity differences
among buyers
- limited number of rate categories tends to limit the amount
of consumer surplus that can be captured under 2nd degree schemes
 The hurdle model of price discrimination
à a perfect hurdle
Firm induces the most elastic buyers to identify themselves
Seller sets up a hurdle, makes a discount price available o
those buyers who elect to jump it – those buyers ore
sensitive to price will be more likely than others to jump the
hurdle
Rebate coupons
When a hurdle is perfect, the only buyers who become
eligible for the discount price (Pl) by jumping it are those who
would not have been willing to pay the regular price. Perfect hurdle also imposes no significant costs on
those who jump it

The efficiency loss from monopoly

à the welfare loss from a single-price monopoly
profit maximizing quantity = Qm (MR+MC) – sell at price
Pm
the value of an additional unit of output to buyers is Pm
which is greater than the cost of producing an extra
unit, MC – thus single-price monopolist doesn’t exhaust
all possible gains from exchange, not allocative efficient
(firm not operating at min point of LAC, also not
productively efficient)
all possible gains from exchange can only achieved by
asking different prices of every consumer
PS = area 0EGPm, loss of C
CS – decreases by A & B, area HGPm
Loss of B & C = DWL
 Public policy towards natural monopoly
à a natural monopoly
Ideal allocation at Qc, but monopoly will operate
where MC=MR (at Qm)
2 objections: it earns economic profit, and it results in
the loss of consumer surplus (S)
Policymakers respond with alternatives: (below)

o State ownership and management: efficiency requires P=MC

o State takes over industry
o X-inefficiency: a condition in which a firm fails to obtain maximum output from a given combination
of inputs
o State regulation of private monopolies
o Exclusive contracts for a natural monopoly
o Vigorous enforcement of antitrust laws
o A laissez-faire policy
à the efficiency losses from single-price and
two-price monopolies
2 price, much smaller (area Z) than single price
(area W)
2 price expands the market
Econ 214: chapter 11: imperfect competition, a game theoretic approach
The Cournot model
o Assume competitor keeps output constant – don’t react to your actions
o Derive reaction curve
o Reaction function: profit maximising level of output for oligopolist for each amount supplied by another
o Best response given what other firms are doing
o Equilibrium where reaction curves intersect
Example
o Market demand: P = 204-2Q (Q1+Q2 = Q)
o P1 = (204-2Q2) – 2Q1
o MR1 = (204-2Q2) – 4Q1
for when MC = 0
maximise profit at MC = MR
MR = 204-2Q2-4Q1 = 0 = MC
Q*1 = 51 – (½)Q2
Q*1 = R1(Q2) = reaction curve of firm one, which
is determined by value of Q2 = 51-(1/2)Q2
Q*2 = R2(Q1) = what is true for firm one is true
for firm two = 51-1/2(Q1)

Draw reaction curves:

to get equilibrium point (we know Q1 must = Q2)
so: Q*1 = 51 – (½)Q1 (change Q2 to be Q1)
therefore, Q1 = 34
to get TR: P = 204 - 2(Q1 + Q2)
= 204 – 2(68) = 68
TR = PQ = 68x34 + 68x34 = 4624 (split equally
– each rim gets 2312)
 Example 11.1 (shows for one where MC is not equal to 0)
Cournot duopolists face a market demand curve given by P = 56 − 2Q, where Q is total market
demand. Each can produce output at a constant marginal cost of 20/unit. Graph their reaction
functions, and find the equilibrium price and quantity.
Figure 11.5(a) shows the residual demand curve facing firm 1 when firm 2 produces Q2 units. Firm 1’s
marginal revenue curve has the same vertical intercept as its demand curve, and is twice as steep.
Thus the equation for firm 1’s marginal revenue curve is MR1 = (56 − 2Q2) − 4Q1. Equating MR1 to
marginal cost (20), we solve for firm 1’s reaction function, = R1 = 9 − (Q2/2). As a result of symmetry,
firm 2’s reaction function is R2 = 9 − (Q1/2). The two reaction functions are shown in Fig. 11.5(b), where
they intersect at Q1 = Q2 = 6. Total market output will be Q1 + Q2 = 12. Consulting the market demand
curve, we see that the market price will be P = 56 − 2(12) = 32.

Figure 11.5 Deriving the reaction functions for specific duopolists

Panel a shows the profit-maximizing output level for firm 1 ( ) when firm 2 produces Q2. This, and the
parallel expression for firm 2, constitute the reaction functions plotted in panel b.

bertrand model
o Firms produce identical product
o Each firm treats the price of its competitors as fixed in determining profit maximising output
o All firms set prices simultaneously
o Outcome: set P=MC
o Can undercut competitors from P0, continues until you reach P = MC
Example
o P = 204-2Q & MC = 0
o 204 – 2Q = 0
o Q = 102
o Split: Q1 = 51 & Q2 = 51
 o Makes P = 0 – no market would exist here where price is set at 0 (model is therefore unrealistic)

Stackleberg model
o Firms produce identical product
o One firm (Stackelberg leader) sets output before other firms (Stackelberg followers) do
o Leader chooses Q to maximise profit, given impact of output on followers
o First mover advantages
o Leaders Q > followers Q
P = 204 – 2Q
So Q*2 = R2(Q1) = 51 – (1/2)Q1 (see above in cournot
how this is obtained)
Therefore: P1 = 204 – 2(Q1+Q2)
= 204 – 2(Q1 + 51 – (1/2)Q1)
= 102 – Q1
TR = (102-Q1)(Q1)
Therefore, MR = 102 – 2Q1
Find where MR = MC (at 0, MC = 0) – Q1 = P1 = 51
Reaction curves: firm 1 ignores own reaction function
(will produce at 51)
Q2 = 51 – (1/2)Q2 = 51 – (1/2)(51) = 25,5 – firm 2 will
produce at Q = 25,5
Total Revenue:
Firm 1 = PQ = (51)(51) = 2601
* this is better than Cournot equilibrium – which is why
firm 1 doesn’t react
Firm 2 = PQ = (51)(25,5) = 1300,50 – worse off than in
Cournot equilibrium
Comparing equilibrium price and quantity
monopolist: maximise profit where MR = 0,
since there are no marginal production
costs

Model Industry output Market price Industry profit

Shared Qm = a/(2b) Pm = a/(2) пm = a2/(4b)

monopoly = 51 = 102 = 5 202
(4/3)Qm (2/3)Pm (8/9) пm
Cournot
= 68 = 68 = 4 624
(3/2)Qm (1/2)Pm (3/4) пm
Stackelberg
= 76.5 = 51 = 3 901.5
Bertrand 2Qm = 102 0 0
Perfect
2Qm = 102 0 0
competition
(overview of comparison)

Price rigidity
o Firms do not adjust prices even if cost & demand change
o Firm has kinked demand curve at MP, more elastic = higher price & less elastic = lower price
- kinked demand curve
Firm believes that if they rise price above P*,
other firms will not follow suit & it will lose much
of its sales, if it lowers it, other firms will follow
Result: demand curve is kinked at a price of P* &
MR is a discontinuous curve at that point – MC
can thus increase from MC1 to MC2 while
production remains unchanged at Q* and price
remains at P*
Price setting by a dominant firm
o In some oligopolistic markets, one large firm has the major
share of total sales while other smaller firms supply remainder
of the market
o Large firm acts as dominant firm – setting a price that will
maximise its profit, while other firms sell the rest of the
demand of that market at same price

Opec oil cartel (self study)

producer in cartel agree to cooperate in setting prices
& output levels
demand should be sufficiently inelastic: then cartel can
drive prices well above competitive levels
(read in textbook)

Concentration indexes
o Concentration ratio: is & of industry output produced by a specific number of the largest firms
o Concentration ratio for n firms: adding markets shares of these n firm
o Four-firm concentration markets: (CR4) total market share held by 4 biggest firms in the industry
o Large = very concentrated, low = more competitive
Hirschman-herfindahl index
o From 0 – 10 000
o Calculated by adding square of individual market shares of all firms in the industry

Monopolistic competition
o Many firms that compete via differentiated products that are good substitutes
o Free entry and exit
The monopolist competitors 2 demand curves – The chamberlin model
dd – Chamberlinian firm – alone varies its price
At P’’ – if all firms change to this price, each will sell at Q’’ BUT
if only one firm changes to this price, that one will sell at Q’’’

Chamberlinian equilibrium in the short run

same process as for a monopoly – because
chamberlinian firm is only seller of a specific brand
– therefore monopolist in that specific brand of
the product
make abnormal profits (economic profits) new
firms enter the market until this reaches 0
where MRC = SMC

Chamberlinian equilibrium in the long run

Long run equilibrium: no incentive to enter/exit the
market – making normal profits but no economic
profits
LRE position = where demand curbe dd tangent
to LAC, also MR=MC – this is the maximum profit
point
Perfect competition vs chamberlinian monopolistic competition
competition meets the test of allocative
efficiency (monopoly doesn’t)
competition: price = long run marginal cost,
no unexploited possible gains
monopoly: price > long run marginal cost

game theory
o Components: players, possible strategies & payoff
Definitions
o Dominant strategy: produces best results irrespective of strategy chosen by one’s opponent
o Nash equilibrium: neither player has incentive to change strategy, given strategy of opponent
o Maximin strategy: option that makes largest payoff as large as possible
o Tit-for-tat strategy: first round cooperate, & then do what opponent did in previous interaction
o Sequential game: one player moves first, and other makes choice with this knowledge
o Strategic entry deterrence: change potential rivals’ profitability to enter
Prisoner’s dilemma
Prisoner Y
Confess Remain silent
5 yr Y 20 yr Y
Confess
5 yr X 0 yr X
Prisoner X
0 yr Y 1 yr Y
Remain silent
20 yr X 1 yr X

Dominant strategy for both is to confess, BUT both end up worse off if they both follow it
Point where both firms follow dominant strategy is also the nash equilibrium for this game
Both firms playing their dominant strategy leads to suboptimal result
Nash equilibrium
Firm 1
Don’t
Advertise
Advertise
Don’t Π1 = 500 Π1 = 750
Advertise Π2 = 400 Π2 = 100
Firm 2
Π1 = 200 Π1 = 300
Advertise
Π2 = 0 Π2 = 200

Firm 1: has dominant strategy to advertise – payoff is higher regardless of firm 2 decision
Firm 2: has no dominant strategy
Nash equilibrium: is for both firms to advertise
Nuclear deterrence as a sequential game
full knowledge of opponent’s choice – eg: can se if
USSR attacks, best option for US is to not attack (less
of a loss)

Strategic entry deterrence

if X enters, Transnet will build higher, worsening
the payoff for X, thus its best option is to not
enter (At point C – this is the game’s nash
equilibrium)
a spatial interpretation of monopolistic competition
an industry when location is important
everyone will go to company closest to them – max trip is 1km (1/2
there and ½ back)

Distances with n outlets

The optimal number of outlets

total transportation cost devlines with the number of
outlets – optimal number is where the meal cost &
transportation cost is minimised – at point N*
paying for variety
buyers who care most about variety
will generally choose the model with
premium features, by pricing its models
differently, seller recovers most of
extra costs of variety form buyers who
are most responsible for their
incurrence
 Econ 214: chapter 12 – labour
The perfectly competitive firm’s short run demand for labour
o 2 inputs: capital (K) & labour (L) – where capital is fixed in short run
o VMPL: the value, at current market price, of the extra output produced by an additional unit of input
o (MPL)(P)
o Extra revenue firm will get by selling extra output producing by additional unit of labour
o VMPL decreases as L increase – because marginal product is decreasing
o OPTIMAL – VMPL = wage rate (w)
o VMPL > w (employ more) and if less, fire people
o Competitive firm’s short-run demand for
labour
(a) diminishing marginal product
(b) VMPL = P x MPL

The perfectly competitive firm’s long-run demand for labour

Long run – all inputs variable
Demand for labour will be more elastic

Market demand for labour

o deriving this curve is similar to that of market
demand curve for a product BUT here it is the
summation of VMPL where output price is equal (like
P1 or P2 on graph)
o when the market drops P – aggregate demand will
fall
o because there are different price at which product is
sold in the market – the market demand curve (DD)
is steeper than the summation of the VMPL curves
o assumption for this: one single type of labour & all
employed by one competitive industry
The firm’s situation in a competitive labour market
o individual firm cannot influence going wage rate
o more labour supplied at higher wages & more labour demanded at lower wages
o equilibrium: demand = supply

- a firm’s hiring decision for labour in a

competitive market
Current going wage given for a firm – they
cannot influence it
Only thing firm decides: how many workers to
employ

Marginal revenue product (MRP)

o the amount by which total revenue increases with the employment of an additional unit of input
o MRP of labour = MRPL
o Firm will hire the number of workers where MRPL = w (wage rate fixed for individual firm)
o MPL x MR
o dTR/dL

the supply of labour – the optimal choice of leisure and income

o Consumer’s preference shown by indifference
map – om graph of income vs leisure
o B = Budget constraint
o More leisure = less income
o Find point where IC is tangent to B
o In this eg: wage = R150/hour

- optimal leisure choices for different wage options

 - the labour supply curve for the ith worker
o For points below w=120 – can further go up for
higher labour supply (sub effect > income effect)
o For points above w=120 – backward bending,
more hours worked doesn’t directly translate to a
better labour supply (Income effect > sub effect)

- substitution & income effects of a wage increase

o Total movement – A à B (with wage increase to
180)
o Substitution effect: when wage increases will work
more – A à c
o Income effect: when wage increases will work less
–CàB

The market supply curve

Monopsony
o Only buyer of labour – workers cannot or will not leave & no new firms can enter
o SA example: school education market (government level)
o Supply curve of labour for monopsonist is market supply curve
o AFC: average factor cost – another name for the supply curve for an input
o TFC: total factor cost – the product of the employment level of an inputs & its average factor cost
o MFC: marginal factor cost – the amount by which total factor cost changes with the employment of an additional
unit of input
o Optimum employment: MFC = VMPL
- average and marginal factor cost
o Shaded rectangle: additional wage to be paid to existing workers with the
introduction of additional unit of labour
o MFC = dTFC/dL
o For 101st worker: MFC = R71 + R100 (needs to be paid to existing workers)
o MFC curve slope is twice that of the AFC
 - profit maximising wage and employment levels for a monopsonist
o demand curve constructed same as any firm – it is a perfect
competitor in its product market
o optimal employment level – MFC = D (VMP)
o thus supply at w* as on supply curve

- comparing monopsony and competition in the labour market

o labour employed rises to L** - in a competitive market
o monopsony equilibrium inefficient like a monopoly
o monopsony takes into account: employment expansions on wages
paid to existing workers – employ less & pay less than corresponding
values under competition

Minimum wage laws

o labour relations act 97 of 1995:
o basic conditions of employment act of 1997
o skills development act 97 of 1998
o employment equity act 55 of 1998
o how labour is regulated in South Africa
some laws
o may not work for longer than 45 hours per week or more than 9 hours on a specific day if a worker works 5
days or less
o not allowed to work more than 12 hours overtime per week & must be paid 1,5 times normal wage
o if on Sundays or public holidays: wage doubles
o 21 days annual leave or one day for every 17 days worked
o 6 weeks paid sick leave in a period of 36 months
o Meal break of 60 minutes after 5 hours of work, which can be shortened to 30 minutes if employee works less
than 6 hours a day
o Maternity leave of 4 months
 - statutory minimum wage
o The supply and demand – reaches equilibrium wage of wo
o With minimum wage: there is unemployment of Sm – Dm
(there is not the same supply and demand at this wage level) –
this unemployment is that attributable to minimum wage
o At Dm – number of employed workers

- minimum wage law in case of monopsony

o MFC curve becomes horizontal from 0 – L1
o Moves new employment level at wm and Lm – effect of the
law thus increases both the wage and the employment level
o If min wage set above MFC – effect would reduce employment

Labour/trade unions
o In SA: 25% of workers are members of labour unions
o Bargain collectively
o Facilitate communication

- allocative effects of collective bargaining

o Union sector: wage rises and employment
falls
o Non-union sector: wages drop and
employment rises
o Result: reduction in national output

Monopoly power and the wage rate

- monopoly power of sellers of labour
o When trade union is monopolist – can decide on point among
buyers demand curve for labour DL
o Can maximise workers at L* and w*
o Maximise rent of employees at L1 and w1
o Maximise total wages at L2 and w2
Discrimination in the labour market
o Non-market discrimination: affect productivity before entering labour market
o Customer discrimination: firm’s customers do not wish to deal with minority employees
o Co-worker discrimination: when some workers feel uneasy about working with other types of workers (women
or POC)
o Employer discrimination: wage differentials that arise from an arbitrary difference by the employer for one group
over another

Statistical discrimination
o result of average productivity difference between groups and reduces wages variation within each group

- a hypothetical uniform
productivity distribution

o complete a productivity test:

o conditions: 100% accurate, 50% of the time
1. write: VMPL = R480 p/hour (what the worker scores)
2. best estimate: 0,5(score) + 0,5(group average)
eg: 0,5(480) = 0.5(400) = R440 – what the worker will be paid

- productivity distributions for 2 groups

(where discrimination comes into play)

o complete same productivity test – same conditions

1. both groups write – score R560 p/hour
2. VMP (A) – 0,5(560) + 0,5(400) = R480
3. VMP (B) – 0,5(560) + 0,5(600) = R580
*can see how discrimination of the different groups comes into play – can affect your wage with statistical
discrimination

The internal wage structure

o Many private firms use fixed salary scales although clear productivity differences between workers. Not warranted
under marginal productivity theory of wages
o Most people prefer high-ranked to low-ranked positions among their co-workers
o No one can be forced to remain in a firm against their wishes
Econ 214: Chapter 16 – general equilibrium and market efficiency
General equilibrium of 2 interdependent markets
o General equilibrium analysis: how conditions in one market affect equilibrium outcomes in other
markets
2 interdependent markets: Movie tickets & dvds
2 substitute goods
Smov àS*mov: as a result of an added
tax (increasing the price), supply shifts left,
or vertically upwards, causes Q to decrease
from Qm à Q’m
Result of this, cause the demand for DVDs
to go from Ddvd à D’dvd, increasing P &
Q for DVDs, which then cause Dmov
àD’mov
This process continues until equilibrium is reached with S*mov=D*mov & S*dvd=M*DVD

A simple exchange economy

o Only 2 consumers (for eg: Julia and Thandi) & 2 goods (food and clothing) – 2X2 economy
o Edgeworth exchange box: diagram of general equilibrium of an exchange economy
R – initial endowment
2 options: can consume what they already have, or
exchange with each other
Criteria for exchange: must put on higher indifference
curve (make someone better off)

Gains from exchange:

Indifference map for both individuals
Initial endowment, R lies on indifference curves, BUT
any point in the blue shaded area is pareto superior to
that of R (at least on of the consumers will be better
off if you move, essentially moving to a higher IC
pareto optimal: it is impossible to make one person
between off without making at least some others worse
off
pareto optimal allocation at point M

the contract curve: a curve along which al final,

voluntary contracts must lie
all the efficient ways of dividing the 2 goods between
the 2 consumers

where consumers end up depends on the initial

endowment: if endowment at F, will end up
somewhere between V & U

Sustaining efficient allocations

On line HH’: any initial endowment that lies on that line,
will reach the point E as the competitive equilibrium
Pareto efficiency
o Goods and services efficiently allocated between consumers
o Production factors allocated efficiently between firms
o Combination goods & services is efficient

Efficiency in production
o Suppose we now add a productive sector to our exchange economy
o Suppose firm C produces clothing and firm F produces food
o Use capital (K) & labour (L) as inputs
o The MRTS for the 2 firms will be equal in competitive equilibrium – any point along the contract
curve = for the MRTS between K & L
An Edgeworth production box
Works similar to the one for 2 individual consumers
MRTS for 2 firms will be equal (efficiency ini
production)
Competitive general equilibrium is efficient not only in
the allocation of a given endowment of consumption
goods, but also in the allocation of the factors used
to produce the goods (efficiency in production)

Efficiency in product mix

o Production possibility frontier: the set of all possible output combinations that can be produced with a
given endowment of factor inputs]
Generating the production possibilities frontier
Each point on contract curve gives rise to specific quantities of food &
clothing production
Efficiency in the product mix: MRS =MRT
Marginal rate of transformation: rate at which one output can be
exchanged for another at a point along the production possibilities
frontier
 - an inefficient product mix – MRS not equal to
MRT

- MRT = ratio of marginal cost

MRTz = dF/dC = MCc/MCf
* MCc = dTC/dQ

Output efficiency
o Consumers: MRS = Pc/Pf
o Profit maximising firms = P*f = MCf & P*c = MCc
o MRT = MCc/Mcf = Pc/Pf
Competition and output efficiency
If production doesn’t take place at MRS=MRT, there will be
shortages or surpluses in production
Consumers choose point where MRS = price ratio &
producers choose point where MRT = price ratio, therefore at
MRS=MRT is efficient
To be efficient, quantity of each good produced must be equal
to quantity of goods consumed

Say market generates price ratio of P1c/P1F – producers will the produce at A, and consumers will
consume at B – leads to a shortage in clothing and surplus in food – market will correct itself by
lowering the price of food and an increase in the price of clothing – this will move the ratio to
P*C/P*F – here consumers will consume at C and producers will produce at C – thus output
efficiency (MRS = MRT)

Other source of inefficiency

o Monopoly – market prower
o Incomplete information
o Externalities – positive & negative
o Public goods – non excludable & non rival and free riders