basics of microeconomics

Economics 2 - RevisionContentsMicroeconomics2L1 and 2: Modern Microeconomics2Economists2Theories3Facts4L3: Utility and Demand5Economists5Theories5Facts6L4: Costs and Supply7Economists7Theories8Facts8L5: Market Supply and Demand9Economists9Theories10Facts10L6: Consumer and Producer Surplus10Economists10Theories10Terms and Facts11L7: Elasticity11Economists11Theories11Facts and concepts12L8: Externalities13Economists13Theories13Facts and Concepts14L9: Common Property and Pool Resources15Theories15Facts and Concepts16L10: The Public Sector16Economists16Theories17Facts and Concepts17L11: Competitive Markets17Theories17Facts and Concepts18L12: Monopoly20Economists20Theories20Facts and Concepts20L13 and 14: Oligopoly and Cooperation21Economists21Theories22Facts and Concepts22L16 and 17: Labour Markets23Economists23Theories23Facts and Concepts25L17 and 18: Land Markets25Theories25Facts and Concepts26L19 and 20: Household Models26Theories26Facts and Concepts27

MicroeconomicsL1 and 2: Modern Microeconomics

EconomistsAdam Smith (Optimist): The invisible hand is the forces of supply and demand working to attain equilibrium in a competitive economy. Increasing returns. Labour theory of value labour as determinant for value. Malthus (Pessimist): Theory of population growth. Malthus ignored the importance of technological progress to increase productivity and output.Ricardo: Famous theory of diminishing returns. From the law of diminishing returns Ricardo decduced that every economy has a maximum level of income per person that could be produced from an optimum quantity of inputs. Ricardo was opposed to all forms of taxes, levies and tariffs on input into the productive system, including tariffs on imported food. Karl Marx: The economy does not grow forever, but the end comes not from a stationery state but from crises associated with overpopulation and social upheaval. He predicted that capitalism would eventually collapse through its own inner contradictions, and will then be replaced by socialism. This did not happen for two reasons:1. There is a confusion in Marxs work between money and real wages2. Underestimated the rate of technical progress in industry. Marxist theory of surplus value: Value=Constant capital (c) + variable capital (v) + surplus value (s).Hirschman (1970): Defined exit and voice as methods by which consumers express dissatisfaction and thereby set in motion efforts by firms to adjust their standards of performance, for example by changing the products they produce. TheoriesThe Law of Eventually Diminishing ReturnsEconomic growthUse of land of progressively lower productivity is being used higher costs higher prices = Good for farmers with good land (Higher prices + low costs=Huge return)The Theory of Comparative AdvantageThis theory argues that unrestricted exchange between countries will increase total world output if each country specializes in those goods it can produce at a relatively lower cost compared to its potential trading partners.With free trade among nations, all countries will find that their consumption possibilities have been expanded by such specialization and trade beyond what would have been possible from their domestic production possibilities alone, i.e. from a situation of autarky. Says LawSupply creates its own demand so that the level and growth of output is a function of the supply of physical inputs alone.The Rate of Surplus ValueThe Rate of Profit:The Rate of Surplus Value: s= surplus value or profitv= variable capital and wage billc= constant capital (plant and machinery, the raw material used in production)Game TheoryCan be used in any situation where the best course of action for an individual depends on what others do situations when strategic planning is necessary. The dominant strategy is the preferred strategy by a player regardless of the strategy of the other players. FactsAt equilibrium, both consumers and producers gain from the exchange, and there are no shortages or surpluses. Private vice becomes public virtue ONLY when competition is present to limit/hinder the creations of cartels and monopolies Governments can help maintain a competitive environment. Decentralized markets do not necessarily reach efficient outcomes.Allocations can be organized in essentially 3 different ways: Gift exchange, Market exchange and hierarchies. Many microeconomic theories and models have failed to recognize trade intermediation. Certain trading firms seem to enjoy considerable market power, and the theories also fail to acknowledge that certain kinds of trade can be very profitable. Markets cannot exist without coordinated action, if only to define and protect property rights. (The alternative to the state doing this, is mafia and private armies). Institutional economists see an analysis of the institutional context as vital to any study of economics. Perspectives on technology:1. Neoclassical economists: Technology is exogenous2. Institutional economists: Technology is explained by interactions with other institutions. New institutionalism assumes that individuals are self-interested and rational. Institutionalism was important in the US before WW2 but declined after the war, revival in the 1970s as new institutionalism.Mercantilists: People who argue that countries become richer by trade where value is created.Physiocrats: Exchange cannot create new value, and value can only be created by farmers. Behavioural economics: physiological foundations of economic behaviour to improve explanatory power of economics. People are not really capable of complete rationality, but of bounded rationality. L3: Utility and DemandEconomistsEngel CurveRelates income and fraction of income; The Engel curve on food typically declining, and is sometimes used as a measure for poverty. TheoriesLaw of DemandThe claim that, other things equal (ceteris paribus), the quantity demanded of a good falls when the price of the good rises. Movement along the Demand Curve1. The income effect: Their real income, what a given amount of money can buy at a point in time, has increased and part of the increase in quantity demanded can be put down to this effect. 2. The substitution effect: Some consumers will choose to substitute the more expensive item with the now cheaper item. Shifts in the Demand CurveCan happen e.g. due to researchPrices of Other Goods1. Substitutes: Two goods for which an increase in the price of one leads to an increase in the demand for the other2. Complements: Two goods for which an increase in the price of one leads to a decrease in the demand for the other. Law of SupplyThe claim that, ceteris paribus, the quantity supplied of a good rises when the price of a good rises.Shifts in the Supply CurveFactors affecting supply other than price: Profitability of other goods in production and prices of goods in joint supply Technology Natural shocks/ social factors Costs of production Expectations of producers Number of sellersThe Marginal Rate of SubstitutionMarginal Rate of Substitution is the rate of which a consumer is willing to trade one good for another. The MRS between two goods depends on their marginal utilities.

The Consumers OptimumThe consumer chooses the point on his budget constraint that lies on the highest achievable indifference curve (Consumer Equilibrium). At the consumer optimum, MRS equals the ratio of prices:

Because the marginal rate of substitution equals the ratio of marginal utilities, we can write this condition for optimization as: At the optimum, the marginal utility per Euro spent on good x equals the marginal utility per Euro spent on good y. UtilityThe satisfaction derived from the consumption of a certain quantity of a product.

Where u = total utility, c = amount of consumption good, f is a positive function.Marginal Utility:Increase in utility for an additional unit of consumption, is normally:

FactsA competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. In a perfectly competitive market the products are identical (homogenous), so a seller has little reason to charge less than the going price, and if he or she charges more, buyers will make the purchase elsewhere.Market: A group of buyers and sellers of a particular good or service. Monopoly: Markets with one seller who sets the price.Oligopoly: Few sellers that do not always compete aggressively. Monopolistically competitive: Contains many sellers but each offers a slightly different product. Because the quantity demanded falls as the price rises, and rises as the price falls, we say that the quantity demanded is negatively or inversely related to the price. Demand Curve: A graph of the relationship between the price of a good and the quantity demanded.Market Demand: The sum of all the individual demands for a particular good or service. Normal Good: If the demand for a good falls when income falls, and vice versa (ceteris paribus)Inferior Good: A good for which, ceteris paribus, an increase in income leads to a decrease in demand, and vice versa. The Standard Economic Model: Seeking to maximize your utility subject to the constraint of a limited income. Assumes that humans behave rationally when making consumption choices. Opportunity Cost: The cost of something is what you have to give up to get it.Budget Constraint: The limit on the consumption bundles what a consumer can afford. If income increases, there is a parallel shift of the budget constraint with the same slope of the initial budget line because the relative price of the two goods has not changed.

Giffen Good: A good for which an increase in the price raises the quantity demanded. (very rare)The Engel Curve: A line showing the relationship between demand and levels of income.

L4: Costs and SupplyEconomistsThe Cobb-Douglas Production Function

In the short run, K is fixed and L is variable. Short-run production function: Average Product of Labour (APL): Total output per unit of Labour

TheoriesThe Production FunctionTechnological relationship between quantities of inputs and quantities of outputs.

Where Q= output of product, L= Labour, and K=Capital (e.g. land in hectares)Marginal Product of Labour (MPL)Value of MPL (Marginal Product of Labour): MPL*PMPL is additional output from one additional unit of labour. The Law of Diminishing Marginal ProductMarginal product of an input decreases in the short run (note other inputs are held constant)Marginal Cost (MC):Increase in total cost for additional unit of output( ) in the short run. The Marginal Cost Curve is the supply curve. To maximise profit, produce until MC=P of productSupply positively related to price of the product.

FactsOpportunity Cost: Benefits foregone in the form of next best choice, e.g., opportunity cost of educationSocial costs: The cost to society at large, not only individuals; e.g. production and pollution (Economists as social accountants.Costs of Production:1. Fixed costs (FC): Does not vary with the level of output in the short run (e.g. land rent)2. Variable cost (VC): Changes with the level of output in the short run (e.g. wages)3. Total Cost (TC=FC+VC): curve as inverse of production function diminishing marginal product increasing marginal cost.

Average Total Cost (ATC): Mean cost of a unit of output Average Fixed Cost (AFC): Average Variable Cost (AVC):

L5: Market Supply and DemandEconomistsMarcel FafchampsInstitutional arrangements and transaction costs shape patterns of trade and partly determine the extent to which allocative efficiency is achieved. Decentralized markets do not necessarily reach efficient outcomes. Dan ArielyAnchor: The first price we see for a commodity influences our willingness to pay for it.Supply and demand does not singularly explain the market price, because people can be easily manipulated and influenced. The IKEA effect: The more work you put into something, the more ownership you feel for it. Virtual Ownership: Attaching feelings of ownership to something we do not yet own. If we see a discounted item, we will instinctively assume that its quality is less than that of a full-price item, and then we will make it so. Context Effects: People are susceptible to irrelevant influences from their environment, irrelevant emotions, short-sightedness and other forms of irrationality

Daniel KahnemannEndowment Effects (divestiture aversion): People value things they own, and are therefore more sensitive to loss than gain.

TheoriesMarket Equilibrium The quantity of the good buyers are willing and able to buy is the same as the amount seller sell.

Surplus: Too many sellers, not enough buyers. Shortage: Too many buyers, not enough sellersMarket equilibrium can be stable, unstable or neutral. Deviations from equilibrium will create competitive pressures that return it back to equilibrium.

Shifts in Demand and SupplyThe demand/supply curve shows how much quantity is demanded at different prices, ceteris paribus. Whenever other things affecting demand/supply change, shift in demand/supply curve, not moving on the same demand curve. Institutional EconomicsEmphasises the factors neglected in conventional economics. Protection of property rights, rule of law, informal contractual obligation, acceptable behaviour, etc., necessary for the functioning of markets. FactsAnchoring Effects: Focus on a specific aspect that biases decision. (E.g. bid prices and social security numbers (Dan Ariely: Mind anchored to the last 2 numbers of their social security numbers, and this affects their bidding at the auction)).Trust: Individualised and generalised trust. Non-market exchanges: gift exchange and hierarchies.

L6: Consumer and Producer SurplusEconomists

TheoriesEvaluating the Market Equilibrium1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their WTP. 2. Free markets allocate the demand for goods to the sellers who can produce them at least cost. 3. Free markets produce the quantity of goods that maximizes the sum of consumers and producer surplus. Terms and FactsWelfare Economics: The study of how the allocation of resources affects well-being. Well-being: Happiness or satisfaction with life as reported by individuals.Allocative Efficiency: A resource allocation where the value of the output by sellers matches the value placed on that output by buyers. Willingness to Pay (WTP): The maximum amount that a buyer will pay for a good. Consumer surplus (CS): A buyers willingness to pay for a good minus the amount the buyer actually pays. The area below the demand curve and above the price measures the consumer surplus in a market.Because buyers always want to pay less for the goods they buy, a lower price makes buyers of a good better off and improves their well-being. Willingness to Sell (WTS): The price offered would have to exceed the cost of doing the work. Producer Surplus: The amount a seller is paid for a good minus the sellers cost. The area below the price and above the supply curve measures the surplus in a market. The increase in producer surplus occurs in part because existing producers now receive more, and in part because new producers enter the market at the higher price. Total Surplus: The total value to buyers of the goods as measured by their WTP, minus the cost to sellers of providing these good. Competitive Markets allocate demand for goods to sellers producing at least cost, and maximize total surplus (CS+PS)Efficiency: The property of a resource allocation of maximizing the total surplus by all members of society. Pareto Efficiency: Occurs if it is not possible to reallocate resources in such a way as to make one person better off without making anyone else worse off. Pareto Improvement: When an action makes at least one economic agent better off without harming another economic agent. Equity: The property of distributing economic prosperity fairly among the members of societySocial Welfare Function: The collective identity of society which is reflected by consumer and producer surplus. L7: ElasticityEconomists

TheoriesPrice of Elasticity of Demand Demand depends on price.Ranges for elasticity (in absolute terms): Ep = 1: Unitary elastic Ep < 1:Inelastic Ep > 1: ElasticFactors affecting elasticity are close substitutes. The more close substitutes, the more elastic demand.

Income Elasticity of DemandHow much quantity demanded changes for a percentage change in income.

Normal goods: EI > 0Necessities: inelastic (EI < 1, e.g., cerealsInferior goods: EI < 0, e.g. kids, grains for FFWPrice Elasticity of SupplyHow much the quantity supplied changes for a percentage change in price.

Depends on the flexibility of production, whether overall supply is fixed (e.g. land) and the time horizon (elastic in the long run)Facts and conceptsTotal Revenue (TR) = P * QA price rise will increase TR, but is dependent on the price and quantity effects, and therefore is dependent on elasticity. Elastic Demand: Price increase will decrease TR (Price decrease increases TR) Inelastic demand: Price increase increases TR, and vice versa.Cross-Price Elasticity of DemandHow much quantity demanded changes for a percentage change in the price of another good.

Ec < 0 : Complements, e.g. cars and petrolEc > 0: Substitutes, e.g. kerosene and wood.Elasticity: A measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. Some general rules about what determines the price elasticity of demand: 1. Availability of close substitutes.2. Necessities vs Luxuries3. Narrowly defined markets tend to have more elastic demand than broadly defined markets. 4. Proportion of income devoted to the product5. Time horizon: Goods tend to have a more elastic demand over longer time horizons. The Midpoint Method:The midpoint method computes a percentage change by dividing the change by the midpoint (or average) of the initial and final levels.

Heuristic The flatter the demand curve that passes through a given point, the smaller the price elasticity of demand.

L8: ExternalitiesEconomistsThirwallExternalities occur when the actions of one economic agent affect other economic agents and the actions are not controlled through the operation of the market. Externalities have 2 related causes:1. Lack of individual property rights2. Jointness in either production or consumptionTheoriesThe Coase TheoremThe position that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient. Lack of clearly defined property rights is the problem. Why Private Solutions Doesnt Always Work1. Transaction Costs: The costs that parties incur in the process of agreeing to and following through on a bargain. 2. Bargaining problems: Bargaining breaks down Can lead to strike or war3. Coordinating interested parties: Difficult if there are many parties4. Asymmetric information and the assumption of rational behavior:a. Both parties have imperfect information about the situation of the other and so incentives may be distorted.b. In real life such rational behavior may be clouded by all sorts of behavioral and psychological influences Pigovian TaxesA tax enacted to correct the effects of a negative externality. (internalizing externality)Pigovian taxes raise revenue for the government, but they also enhance economic efficiency. Problems:1. Identifying the appropriate rate to levy. 2. Political problems associated with levying Pigovian Taxes3. The cost of levying and administering these taxes might be higher compared to regulation.

Public Choice TheoryThe analysis of governmental behavior, and the behavior of individuals who interact with governments.What public choice theory looks at are cases where that individual interest leads to decisions and the allocation of resources which may not be the most efficient allocation. Facts and ConceptsExternality: The cost or benefit of one persons decision on the well-being of a bystander (a third party) which the decision maker does not take into account when making the decision.

Negative Externality: The cost imposed on a third party of a decision. Positive Externality: The benefits to a third party of a decision. The market equilibrium only reflects the private costs of production.Internalizing an externality: Altering incentives so that people take account of the external effects of their actions.Negative externalities lead markets to produce a smaller quantity than is socially desirable. To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities, and subsidizing goods with positive externalities. Positional externality: A situation which exists when the payoff to one individual is dependent on their relative performance to others. Positional Arms Races: A situation where individuals invest in a series of measures designed to gain them advantage but which simply offset each other. When an externality causes a market to reach an inefficient allocation of resources, the government can respond in one of two ways:1. Command and control policies Regulate behavior directly2. Market-based policies Provide incentives so that private decision makers will choose to solve the problem on their own through manipulation of the price signal. Tradable Pollution Permits: Transferring the right to pollute from one firm to another. Viewed as a cost-effective way to keep the environment clean. Property Rights: The exclusive right of an individual, group or organization to determine how a resource is used. Government Failure: A situation where political power and incentives distort decision making so that decisions are made which conflict with economic efficiency. Public Interest: Making decisions based on a principle where the maximum benefit is gained by the largest number of people at minimum cost. The Rational Ignorance Effect: The tendency of a voter to not seek out information to make an informed choice in elections. The Special Interest Effect: Where benefits to a minority special-interest group are outweighed by the costs imposed on the majority. Rent seeking: Where individuals or groups take actions to redirect resources to generate income (rents) for themselves or the group. Cronyism: A situation where the allocation of resource in the market is determined in part by political decision making and favors rather than by economic forces. L9: Common Property and Pool ResourcesTheoriesRivalry and Excludability - Matrix

Solutions to the Free-Rider and Tragedy of the Commons Problem1. Government regulations and taxes, buta. Lack of local knowledgeb. Lack of infrastructurec. Bureaucracy, etc2. Privatisationa. Resource may not be optimally usedb. Can lead to conflicts. 3. Local institutions

Facts and ConceptsRivalry: Does consumption by one reduce availability by others? The property of a good whereby one persons use diminishes other peoples use.. Excludability: Can individuals be easily prevented from using a good? The property of a good whereby a person can be prevented from using it when they do not pay for it.Free-Riding: Getting benefits without paying the cost; little incentive to invest. Mainly a problem in non-excludable and open-access resources. Some ingredients for successful preservation of common pool resources:1. Clearly defined boundary of resource2. Knowledge of the micro-environment3. Clearly defined and widely accepted fair and just principles. 4. Trust and cooperation5. Punishment System and willingness to punish6. LeadershipPublic Sector: That part of the economy where business activity is owned,, financed and controlled by the stae, and goods and services are provided by the state on behalf of the population as a whole. Private Sector: That part of the economy where business activity is owned, finances and controlled by private individuals.Cost-Benefit Analysis: A study that compares the cost and benefits to society of providing a public good. Merit Goods: Goods which can be provided by the market, but may be under-consumed as a result. E.g. education, health care, insurance and pensions. De-Merit Goods: Goods that are over-consumer if left to the market mechanism and which generate both private and social costs which are not taken into account by the decision maker. E.g. tobacco and alcohol. Intertemporal choice: Where decisions made today can affect choices facing individuals in the future. L10: The Public SectorEconomistsThirwallThe state has 4 key roles to play in the development process:1. To provide public goods2. To correct market imperfections3. To protect the vulnerable and ensure an equitable distribution of income, both intratemporally and intertemporally4. To provide an institutional environment in which markets can flourishTheoriesTax BurdensEven though only buyers or sellers pay the tax, the burden is shared by both. If supply is more elastic than demand, more burdens fall on consumers. If demand is more elastic than supply, more burden falls on suppliers. Facts and ConceptsPrice ceiling: A legal maximum on the price at which a good can be sold Binding Price ceiling: The price ceiling is below the market equilibrium, and will in turn bind the market price. Some suppliers might find it unprofitable to supply, and this can create a shortage in the market.Price floor: A legal maximum on the price at which a good can be sold. Above market quilibrium: Creates surplus of supplies. Two Categories of Taxes: Direct Taxes: A tax levied on income and wealth Indirect Taxes: A tax levied on the sale of goods and services. Two types of tax on expenditure: Specific Tax: A fixes rated levied on goods and services expressed as a sum per unit. Ad Valorem Tax: A tax levied as a percentage of the price of a good. Tax incidence: Refers to the distribution of a tax burden. A tax burden generally falls more heavily on the side of the market that is less elastic. Subsidy: Payment to buyers and sellers to supplement income or lower costs and which thus encourages consumption or provides an advantage to the recipient.Public Goods: Non-excludable and non-rival

L11: Competitive MarketsTheoriesTotal Cost Curve

L(Q)=Labour Hours, K(Q)=Capital employed for 1 QPL= Price of Labor per hourPK= The price of hiring capital3 Properties of Cost Curves: Most Important to Remember1. Marginal cost eventually rises with the quantity of output. 2. The average total cost curve is u-shaped. 3. The marginal cost curve crosses the average total cost curve at the minimum of average total cost. The Meaning of CompetitionWhere more than one firm offers the same or similar products.Competition can also manifest itself where substitutes exists.The closer the degree of substitutability, the greater will be the competition that exists.Firms may influence the level of competition through the way they build relationships with consumers. Characteristics of a Competitive MarketThere are many buyers and sellersThe goods offered by the various sellers are largely the sameFirms have to accept the price determined by the market as a wholeThere are no restrictions on firms entering or exiting the market.There is a high degree of information available to buyers and sellers in the market. Facts and ConceptsA market is competitive if each buyer and seller is small compared to the size of the market and, therefore, has little ability to influence market prices. Explicit costs: Input costs that require an outlay of money by the firm. Implicit costs: Input costs that do not require an outlay of money by the firm. The Short Run: The period of time in which some factors of production cannot be changedThe Long Run: The period of time in which all FoPs can be altered. Fixed Costs: Costs that are not determined by the quantity of output produced (e.g. wage)Variable Costs: Costs that are dependent on the quantity of output produced (e.g. salami, flour, etc.)Average Total Cost (ATC): Total cost divided by the quantity of output.

Average Fixed Cost (AFC): Fixed costs divided by the quantity of output. AFC always declines as output rises because the fixes cost does not change as output rises and so gets spread over a large number of units.

Average Variable Cost (AVC): Variable costs divided by the quantity of output.

Total Cost: The sum of fixed and variable costs.

Marginal Cost: The increase in total cost that arises from an extra unit of production.

The efficient Scale: The quantity of output that maximizes ATC. The marginal cost curve crosses the total cost curve at its minimum. Economies of Scale: The property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of Scale: The property whereby long-run average total cost rises as the quantity of output increases. Returns to Scale:

Average Revenue:

Total Revenue: TR= P*QMarginal Revenue: The change in total revenue from an additional unit sold.

Economic Profit: Total revenue minus total cost, including both explicit and implicit costs. Accounting Profit: Total revenue minus total explicit costs. Assumption: One goal of a competitive firm is to maximize profit. As long as marginal revenue exceed marginal cost, increasing the quantity produced adds to profit. The profit maximising output occurs where MR = MC.Normal Profit: The minimum amount required to keep factors of production in their current use. Abnormal Profit: The profit over and above normal profit. Shut-Down: Refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. A firm will shut down if

Exit the Market: Refers to a long-run decision to leave the market. A firm will exit ifThe criterion for entry is exactly the opposite of the criterion for exit.

L12: MonopolyEconomists

TheoriesWhy Monopolies Happen The fundamental cause of monopoly is barriers to entry: A barrier to entry exists where something prevents a firm from entering an industry. Barriers to entry have 4 main sources:1. A key resource is owned by a single firm2. The government gives a single firm the exclusive right to produce some good or service3. The cost of production make a single producer more efficient than a large number of producers. 4. A firm is able to gain control of other firms in the market and thus grow in size. The Social Cost of MonopoliesOutput is lesser and price higher under monopoly than competitive marketLess output: Social benefit: producer saves cost Social cost: consumers lose utility.The social cost of monopoly: excess of utility lost over cost saved. Responses by Governments to the Problem of Monopoly1. Trying to make monopolized industries more competitive. 2. Regulating the behavior of the monopolies. 3. Turning some private monopolies into public enterprises4. Doing nothing at all. sssFacts and ConceptsMonopoly: A sole seller of a product with no close substitute (Price-maker)Why monopoly: Control of key resources, exclusive right given by government, or natural monopolies. Monopolists have to reduce price to sell more, and therefore has a downward sloping demand curve. Monopoly is crucial for development, as competitive markets can easily copy inventions, and this is not good for innovation. Imperfect competition: Exists where firms are able to differentiate their product in some way and so can have some influence over price. Strictly, a monopoly is a market structure with one firm; however, in reality firms can exercise monopoly power by being the dominant firm in the market.Market Share: where a firm is able to rise the price of its product and not lose all its sales to rivals. Patent: The right conferred on the owner to prevent anyone else making or using an invention or manufacturing process without permission. Copyright: The right of an individual or organization to own things they create in the same way as a physical object to prevent others from copying or reproducing the creation. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. They are excludable but non-rival. A monopolys marginal revenue is always less than the price of its good. When a monopoly increases the amount it sells, it has two effects on total revenue: 1. The output effect: More output is sold so Q is higher, which tends to increase total revenue. 2. The price effect: The price falls, so P is lower, which tends to decrease total revenue. Price discrimination: The business practice of selling the same good at different prices to different customers. Perfect Price Discrimination: A situation in which the monopolist knows exactly the WTP of each customer and can charge each customer a different price. (e.g. cinema tickets, airline prices, discount coupons and quantity discounts)L13 and 14: Oligopoly and CooperationEconomistsThe Cournot ModelResidual Demand: The difference between the market demand curve and the amount supplied by other firms in the market. The Reaction Function: The Decision of the firm on a particular issue such as the profit maximizing output in response to the profit maximizing output decisions of its rivals. The Bertrand ModelFirms strategies are based on setting price they are competing on price rather than on output. The Bertrand model predicts that the equilibrium in an oligopoly will give an outcome the same as that in perfect competition with P=MC. In such a situation both firms will be making its own pricing decisions based on its own optimal outcome given the optimal behavior of its rivals. The Stackelberg ModelThe Stackelberg Model describes the advantages a firm can gain through moving before that of its rivals, so called first mover advantage. TheoriesOligopolyCompetition amongst the few a market structure in which only a few sellers offer similar or identical products and dominate the market. The group of oligopolists is best off cooperating and acting like a monopolist producing a small quantity of output and charging a price above marginal cost.Raising ProductionAt any point, any producer has the option to raise production. Weighs 2 effects to decide:1. The output effect: Because price is above marginal cost, producing more at the going price will raise profit. 2. The Price Effect: Raising production will increase total amount sold, which will lower the price of all units sold. If the output effect is larger than the price effect, the producer will increase production. Game TheoryGame Theory is the study of how people behave in strategic situations. Payoff Matrix: A table showing the possible combination of outcomes (payoffs) depending on the strategy chosen by each player. Prisoners Dilemma: A particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when its mutually beneficial. Similar to the tensions that exists between firms in imperfect competition and particularly between oligopolistic firms. Examples of the prisoners dilemma:1. Advertising: Gives you a larger market, but cost of advertising is high. The two companies would advertise anyways.2. Common Resources: People tend to over-use due to self-interest.Dominant Strategy: A strategy that is best for a player in a game regardless of the strategies chosen by other players.Controversies over Competition PolicyThree examples of firms whose effects are not obvious:1. Resale Price Maintenance: Business practices that appear to reduce competition may in fact have legitimate purposes. 2. Predatory Pricing: Firms with market power normally use that power to raise prices above the competitive level. 3. Tying: Tying together two products (2 for 1) to expand market power. Facts and ConceptsConcentration Ratio: The proportion of total market share accounted for by a particular number of firmsMarket Segments: The breaking down of customers into groups with similar buying habits or characteristics.Interdependence means that what one firm does, have some influence on the others and each firm may or may not react to the decisions of others. A duopoly is an oligopoly with two members. Collusion: An agreement among firms in a market about quantities to produce or prices to charge. Cartel: A group of firms acting in unison. Must agree not only on the total level of production, but also on the amount produced by each member. Nash Equilibrium: A situation in which economic actors interacting with one another choose their best strategy given the strategies that all other actors will choose. Neither economic actor has an incentive to choose any different strategy.Price rigidities: The other firms will lower price if one firm lowers price, but not increase price if one firm increases price. Non-Price Competition: A situation where two or more firms seek to increase demand and market share by methods other than through changing price. Cooperative Game Theory: Assumes that there is a set of outcomes or agreements that is known to each player and that each player has preferences over these outcomes. Non-Cooperative Game Theory: Assumes players have a series of strategies they could use to gain an outcome and that each player has a preference over their desired outcome. Cooperation in oligopoly is better for society as a whole, because it maximized total surplus. It is easier to enforce in repeated games. Tacit Collusion: When firm behaviour results in a market outcome that appears to be anti-competitive, but has arisen because firms acknowledge that they are interdependent. Oligopolies would like to act like monopolies, but self-interest drives them closer to competition. Policymakers regulate the behaviour of oligopolists through competition law. L16 and 17: Labour MarketsEconomistsBeckers Employer Taste ModelThe basis of the employer taste model is that some employees will resist working with other employees, possibly because of gender or race. People may, therefore, have a taste for only working with certain groups of people. Those outside this accepted group may end up being disadvantaged as a result. TheoriesWhat Causes the Labour Demand Curve to ShiftThe Output Price: When the output price changes, the value of the marginal product changes, and the labour demand curve shifts. (A decrease in the price reduces the value of the marginal product and decreases labour demand.)Technological Change: Technological advance raises the marginal product of labour, which in turn increases the demand for labour. The Supply of Other Factors: The quantity available of one factor of production can affect the marginal production of other factors. What causes the Labour Supply Curve to ShiftThe labour supply curve shifts whenever people change the amount they want to work at a given wage. 1. Changes in tastes: From housewives to working mothers2. Changes in Alternative Opportunities: Changing occupations. 3. Immigration: Changes labour equilibrium. Equilibrium in the Labour MarketHow wages are determined in competitive markets:1. The wage adjusts to balance the supply and demand for labour. 2. The wage equals the value of the marginal product of labour. Any event that changes the supply or demand for labour must change the marginal product by the same amount, because these must always be equal. In competitive labour markets, labour supply and labour demand together determine the equilibrium wage, and shifts in the supply or demand curve for labour cause the equilibrium wage to change. Signalling Theory of EducationSchooling has no real productivity benefit, but the worker signals his innate productivity to employers by his willingness to spend years at school. The Superstar PhenomenonSuperstars arise in markets that have two characteristics:1. Every customer in the market wants to enjoy the good supplied by the best producer.2. The good is produced with a technology that makes it possible for the best producer to supply every customer at low cost. The Principal Agent ModelAn agent (a) performs a task on behalf of principal (p). there is asymmetric information. The principal does not have complete information about the agent, for instance the intentions, type of risk preferences, etc. Important characteristics: There is hidden action: agents effort is not fully observable. Contracts are incomplete: effort cannot be contracted perfectly. Adverse selection: Before entering the contract (type of worker).principals do not observe the fixed characteristics or type of agent. Agents try to signal their type, but some may use accepted signals to hide their real type.Moral Hazard: Once entered the contract (intention of worker). Strategic behaviour from the agent that is detrimental to the principal. (e.g., shirking, opportunistic behaviour, etc.) This increases the monitoring cost for the principal.

Facts and ConceptsDerived Demand: A situation where demand is determined by the supply in another market. Marginal Revenue Product: The extra revenue a firm gets from hiring an additional unit of a factor of production. Monopsony: A market with a single buyer. A monopsony firm in a labour market hires fewer workers than would a competitive firm. A monopsonist will look to equate the marginal cost of labour with the marginal product. Compensating Differentials: A difference in wages that arises to offset the non-monetary characteristics of different jobs. Human Capital: The accumulation of investments, such as education and on-the-job training. Union: A worker association that bargain with employers over wages and working conditions. Strike: The organized withdrawal of labour from a firm by a union. Discrimination: The offering of different opportunities to similar individuals who differ only by race, ethnic group, sex, age or other personal characteristics. Economic Rent: The amount a factor of production earns over and above its transfer earnings. Transfer Earnings: The minimum payment required to keep a factor of production in its current use.

L17 and 18: Land Markets TheoriesSupply of LandMay often be fixed, although there is expansion to unsettled land, land brought to the market, reclamation of land, investment improving the quality of land. As a result, land supply is relatively price inelastic. Therefore the rental market is often as important as the sales market. Demand for Land 1. To build a home2. As production factor Y = f (K,L), especially for agriculture. 3. It determines location, especially impotant for traders. Property RightsProperty Rights over the Use of Land: Important for agricultural production since they affect ncentives for investment and labour arrangements. It is important to have more information about property rights: What type they are, if they are well-defined (e.g. exclusive, secure, enforceable, transferable), and how they play out. Property rights are economically important:1. Secure property rights provide an incentive for investment 2. Insecure property rights imply a cost of uncertainty.Entrepreneurs will only invest in projects with high probability of success. Property Rights across regions: 1. Historic population densities play a key role2. Disease patterns and colonial institutionsFacts and ConceptsLand Tenure refers to the way people own land and rent it out to others if they do not cultivate it themselves. There are different types of land tenures, often dominating different regions and/or periods. Inheritance: Institution of how land can be transferred without the market. The type of land tenure is important because1. It affects efficiency2. It affects equity Highly unequal land distribution may threaten political stability. 3. Both from an efficiency and equity perspective, the family farm seems ideal. But family farms may be suboptimal if there are economies of scale (e.g. increasing returns to scale over the relevant range). What welfare function should society maximize?1. Utilitarian: Maximize total outcome2. Egalitarian: Equalize outcome3. Rawlsian: Maximize outcomes of the poorest. Types of Land Reform: Reform for rent contracts Rent reduction Land to the tiller with compensation Land to the tiller without compensation. L19 and 20: Household ModelsTheoriesUnitary Household Models (Traditional Economics)Households as unitary decision-making units. Assumptions: Utility theory based on the individual can be extended to the household. Which household member earns income doesnt matter. (income pooling)Possible justification for unitary household models: Identical preferences of individuals in the household Altruism/love Household utility reflecting consensus of its members (Samuelsons welfare function) Dictator Patriarchy/matriarchy Parents are altruistic, children are selfishCritique of unitary household models Theoretically difficult to derive household utility from individual utility. Income by husband or by wife has different effects on household consumption Education of husband and wife has different effects on child health and educationCooperative ModelsNash bargaining models based on cooperative game theory (binding contracts are possible)

Uh = Utility of husband ; Uhs = Utility of husband when single ; Uhm = Utility of husband in marriageUw = Utility of wife; Uws = Utility of wife when single ; Uwm = Utility of wife in marriageNet utility for marriage should be positive for marriage to survive. What each gets depends on opportunities outside marriage (when single)The better the threat point, the better the position of the spouse within marriage. Non-cooperative ModelsSpouses interact as if there is no binding contract in non-cooperative models. (similar to the case of duopoly). Other considerationsSocial customs: e.g. sexual division of labour as manifestation of socio-economic conditions. Social Preferences: like fairness norms rather than bargaining?Facts and ConceptsTheories of production, consumption and labour should be simultaneously considered. The economies of agricultural households can be argued to be more complex than more modern households. Consumption Choice: Between own and marketed goods, different consumer goodsProduction Choice: For household consumption or for the marketLabour Choice: Using labour on ones own farm, selling or buying labourMarket failure when markets are not physically accessible, and when there is a wide band between low selling and high buying prices. Farmers are not insensitive to price incentives (or irrational) but constrained by market failures.

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