ECON1101

Microeconomics
Zhi Ying Feng
Contents
Thinking as an Economist .................................................................................................................... 2
Comparative Advantage: the Basis for Trade ...................................................................................... 3
Supply and Demand: an Introduction .................................................................................................. 4
Elasticity............................................................................................................................................... 7
Demand: the Benefit Side of the Market ........................................................................................... 11
Perfectly Competitive Supply: the Cost Side of the Market .............................................................. 12
Efficiency and Exchange ................................................................................................................... 15
International Trade and Policies ........................................................................................................ 17
Profit and the Invisible Hand ............................................................................................................. 20
Monopoly and Other Forms of Imperfect Competition ..................................................................... 23
Thinking Strategically ........................................................................................................................ 27
Externalities and Resource Allocation ............................................................................................... 29
Public Goods and Private Goods ....................................................................................................... 32
Information Asymmetry..................................................................................................................... 33

1.

Thinking as an Economist

The fundamental economic problem is that there is scarcity, i.e. our resources are finite and not
enough to satisfy our boundless needs and wants. Therefore, we must make choices and
compromises between competing interests. Microeconomics is the study of small economic units,
such as households, firms and industries that together makes up the entire economy.
Opportunity Cost
Opportunity cost is the cost of an action, implicit and explicit, measured as the value of the next
best alternative to that action.
Cost-Benefit Principle
An individual/firm/society etc. should only take an action if, and only if, the extra benefits from
taking the action are at least as great as the extra costs. We assume ceteris paribus, i.e. only 2
variables change and others remain constant, and everyone is rational.
Economic Surplus
Economic surplus is the difference between the benefits and the costs of an action. An economists
goal is to maximise the positive economic surplus
Pitfalls of Cost-Benefit Principle
Failing to account for all opportunity costs, including time
Measuring costs and benefits as proportions rather than absolute dollar amounts
- Saving $10 off $25 and $10 off $2000 is equivalent in rational decision making
Failing to ignore sunk costs
- Sunk cost is a cost that cannot be recovered and should not affect future decisions
Failing to know when to use averages costs and benefits and when to use marginal cost
and benefits
- Marginal benefit should be considered when expanding production or trials
Average Cost
The total cost of n units divided by n
Marginal Cost
The cost associated with a small increase in unit
or level of activity

Average Benefit
The total benefit of n units divided by n
Marginal Benefit
The benefit associated with a small increase in
unit or level of activity

2.

Comparative Advantage: the Basis for Trade

Specialisation is where everyone in the economy concentrates on producing goods or services at

which they perform the best at relative to others. They then satisfy their needs for other goods and
services by trading among themselves.
Absolute Advantage
When one person is able to produce a good or
service, or perform a certain task, with less
resources than another person

Comparative Advantage
When one persons opportunity cost of
producing a good or service, or performing a
certain task, is lower than anothers.

The principle of comparative advantage:

Everyone can do better when each person concentrates on the activities for which their opportunity
cost is lowest, i.e. for which they have a comparative advantage. By specialising, the total output is
greater due to the difference in opportunity costs.
Comparative Advantage can also be illustrated on a production possibility curve, a graph
comparing the production rate of two good/services. Features of this curve are:
o Attainable point: any combination of goods that can be produced using available resources,
i.e. all points on or under the curve
o Unattainable point: any combination of goods that cannot be produced using available
resources, i.e. all points on right and outside of the curve
o Efficiency point: maximum amount of any goods that can be made with available resources,
i.e. any point on the curve
o Inefficiency point: any amount of goods for which available resources can increase the
production of one good without any reduction in the other, i.e. points on the left of the curve
o Gradient: the slope at any point indicates the opportunity cost of the action

Principle of increasing opportunity cost (low-hanging fruit principle)

In the expansion of the production of any good, first employ those resources with the lowest
opportunity cost, and only turn to those with higher opportunity cost after

3.

Supply and Demand: an Introduction

A market for any good consists of all the buyers and sellers of that good. Due to scarcity,
production and resources must be allocated
o Central planning: where all economic decisions are made centrally by a small group of
individuals on behalf of a larger group.
o Free market: where production and distribution decisions are left to individuals interacting
in private markets
Market concentration refers to the number and size of firms in a market, while market power is
the ability of an individual firm to influence price by altering output. Any market can have:
- High concentration: small number of large firms, hence high market power
- Low concentration: large number of small firms, hence low market power
- Price takers: those who must accept the market price and have little control over price
- Price makers: those who can control price by restricting output due to little competition
Market Demand and Supply
We analyse market demand and supply under the assumption of ceteris paribus and that the market
is in perfect competition, i.e. no participants has enough market power to set prices:
- Low market concentration
- No government intervention and regulations
- Everyone is a price taker
- No non-price related competition, e.g. advertising, brand names
- Homogeneous products, i.e. all products are identical
- Ease of entry/exit for new sellers
Demand Curve
The demand curve is a representation of the relationship between the amount of a particular good or
service that buyers want to purchase in a given time period and the price of that good or service. If
we add up all the individual demand curves, we have the demand curve of the market.
Changes in demand caused by a change in price occur for 2 reasons:
- Substitution effect: where other goods or services become more or less expensive
relatively, i.e. people switch out to cheaper alternatives
- Income effect: where the purchasing power of a buyers income changes
Supply Curve
The supply curve is a representation of the relationship between the amount of a good or service
that sellers want to supply in a given time period and the price of that good. Supply increases with
price because suppliers can make a greater profit
Buyers reservation price: the most a buyer is willing to pay for a good or service.
Sellers reservation price: the least amount for which a seller would be willing to sell an additional
unit, usually equal to the marginal cost.

Market Equilibrium
In economics, equilibrium is where neither the price nor the quantity of a particular good or service
is changing. The price and quantity to achieve this is known as the equilibrium price and
equilibrium quantity. This point is given by the point of intersection between the demand and
supply curve.
In market equilibrium, all buyers and sellers are satisfied with their respective quantities at the
market price

Change in Equilibrium
o Excess Supply (Surplus): Prices above the equilibrium point leads to competition between
sellers for less demand from buyers, eventually lowering price to equilibrium.
o Excess Demand (Shortage): prices below equilibrium leads to greater demand thus
incentive for more suppliers, eventually raising price to equilibrium
In an unregulated market, any changes to equilibrium will eventually revert back to the
equilibrium. However, in a regulated market, governments may introduce:
- Price ceiling: the maximum allowable price, specified by law
- Price floor: the minimum allowable price, specified by law
Shift in Demand Curve
o Proportional to price of the compliments. Two products are compliments in consumption if
an increase in the price of one causes a fall in demand for the other
o Inversely proportional to price of substitutes. Two products are substitutes in consumption
if an increase in the price of one causes a rise in demand of the other
o A normal goods demand curve shifts right with increase in income, people want more of it
o An inferior goods demand curve shifts left with increase in income, people want less of it
o Increase preference by buyers
o Increase in population of potential buyers
o An expectation of higher prices in the future, people buy more to stock up now
Shift in Supply Curve
o Decrease in costs of inputs
o Improvements in technology that reduces production costs
o Improvements in weather, for agricultural products
o Increase in number of suppliers
o Expectation of lower prices in the future
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Economic Surplus
- Buyers surplus is the difference between the buyers reservation price and the price they
actually pay
- Sellers surplus is the difference between the price received by the seller and their
reservation price
- Total economic surplus is the sum of the buyers surplus and the sellers surplus
The Equilibrium Principle:
A market in equilibrium leaves no unexploited opportunities for individuals, i.e. no cash on the
table, but may not exploit all gains achievable through collective group actions. A market out of
equilibrium still offers surplus but some transaction won't take place so there is surplus, or cash on
table, not exploited.
The socially optimal quantity of any good is the quantity that results in the maximum possible
difference between the total benefits and total costs from producing the good. It takes into account
of all costs, not just monetary costs. E.g. total cost of car production also takes into account the
pollution it emits.
Therefore, socially optimal quantity is usually different to the actual equilibrium quantity, which
only takes into account private costs. When a quantity of a good is:
- Less than the socially optimal quantity, boosting production increases the surplus of benefits
over costs
- More than the socially optimal quantity, reducing its production increases total surplus
Economic efficiency occurs when all goods and service in the economy are produced and
consumed at their respective socially optimal quantities. It reflects how efficiently resources are
being used. A market is ONLY efficient if it is in equilibrium i.e. no cash on table.
The Efficiency Principle:
Efficiency is an important social goal, because when the economic pie grows larger, it is possible
for everyone to have a larger slice

4.

Elasticity

Elasticity is the measure of the responsiveness of one variable to changes in another variable that
determines it. The price elasticity of demand for a good is a measure of the responsiveness of the
quantity demanded of that good to changes in its price.
Price elasticity of demand () is equal to the percentage change in quantity demanded that results
from a 1% change in its prince:
% change in quantity demanded
% change in price
Elasticity
1 Elastic
demand
1 Unit elastic
demand
1 Inelastic
demand

Effect
The good is elastic with respect to price so a small % change
in price results in a large % change in quantity demanded
Any % of change in the price of the good will result in an
equal % change in quantity demanded
the good is inelastic with respect to price so that a large %
change in price will only result in a small change in quantity
demanded

Example
Overseas
holidays
Table salts,
anti-snake
venom

Factors affecting Price Elasticity of Demand:

Substitution Possibilities
Price elasticity of demand is generally higher for products with close substitutes readily available.
For example, salt is an inelastic product because it has no close substitutes, even if the price
changes a lot, people will still buy it since there are no other substitute possibilities.
Budget Share
Price elasticity of demand is generally higher for products/services with a large share of the budget
in terms of high cost or frequent usage, because if the prices of these products rise, there is greater
incentive to switch to a substitute.
Time
Price elasticity of demand for any good is higher in general for long term items than short terms
items. For example, if you bought an air conditioner and then the price of electricity went up, it is
unlikely you will replace it straight away for a more efficient model, rather wait until it breaks
Graphical Interpretation of Price Elasticity
The formula for price elasticity can be rearranged to incorporate the demand curve. The price
elasticity of demand at any point along a demand curve is the ratio of price to quantity at that point,
multiplied by the gradient (absolute value) at that point:

Q P
P Q

P
Q

1
m

Note:
- Price elasticity decreases along the demand curve
- Price elasticity is greater for curves with greater gradient

We can also apply the 3 cases of elasticity to the graph

of a demand curve.
o Midpoint has unit elasticity
o Top half is elastic
o Bottom half is inelastic
Special Cases
o Perfectly elastic demand

: when the price elasticity of demand is infinite at every

point along a horizontal demand curve. This means that even the slightest increase in price
results in the consumers completely abandoning the product in favour of substitutes
o Perfectly inelastic demand

0 : when price elasticity of demand is zero at every point

along a vertical demand curve. This means that consumers will not, or cannot, switch to
substitutes even if the prices increase significantly

Elasticity and Total Expenditure

Total expenditure is the total amount of money spent, i.e. the number of units bought multiplied by
the price each unit was sold. Since all the money spent goes towards the seller of that product, then
the total revenue must be equal to the total expenditure
Total expenditure P Q Total revenue
For a straight line demand curve, the total expenditure curve has a maximum at the midpoint where
it corresponds to unit elasticity.

Elasticity determines whether increase in price will increase or decrease total expenditure:
1 , changes in price is always in OPPOSITE direction to change in total expenditure
- If
1 , changes in price is always in SAME direction to change in total expenditure
- If
1 , changes in price has NO EFFECT on total expenditure
- If
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Cross-Price Elasticity of Demand

The cross-price elasticity of demand is the percentage change of the quantity demanded of a good in
response to a 1% change in the price of ANOTHER good:
o Positive Value: means the two goods are substitutes, as price increase in the good B will
increase the demand of good A, since people abandon B for A as a substitute
o Negative Value: means the two goods are compliments, as price increase in good B will
decrease the demand for good A, since both needs to be used together
Income Elasticity of Demand
The income elasticity of demand is the percentage change of the quantity demanded of a good in
response to a 1% change in income:
o Positive Value: means the good is a normal good, since as income increase people can
afford more of it and thus demand for more. If it the value is very small, i.e. <1, then the
good is an essential good. E.g. people won't buy THAT much more bread even when their
income increases
o Negative Value: means the good is an inferior good, since as income increase people
abandon it for better products
Price Elasticity of Supply
Price elasticity of supply () is equal to the percentage change in quantity supplied that occurs in
response to a 1% change in price. It has the exact same formula as price elasticity of demand:

Q P
P Q

P
Q

1
m

Similarly, the price elasticity of supply can have 3 values:

1 , i.e. a small % change in price will lead to a larger % change in supply.
- Elastic if
1 , i.e. a large % change in price only leads to a small % change in supply
- Inelastic if
1 this occurs when the supply curve goes through the origin, i.e. any
- Unit elastic when
% change in price results in an equal % change in supply
There are also two special cases:
Perfectly Inelastic Supply
0
Supply is perfectly inelastic with respect to price when
meaning supply is always fixed and won't be affected by any %
change in price. For example, lakefront properties may fluctuate in
price but the amount of land available is always the same.
Perfectly Elastic Supply
Supply is perfectly elastic with respect to price when
meaning no matter how much supply is produced, the price for
each unit is always the same. So whenever additional units of
good can be produced at the same cost it has been using so far, the
supply is perfectly elastic. For example, if a cup of lemonade cost
20 cents and no matter how many cups are made the cost is the
same, then the marginal cost of lemonade is always 20 cents.

Factors affecting Price Elasticity of Supply:

Flexibility of Inputs
The supply of a good is elastic if it is easy to lure additional inputs away from production of other
goods, i.e. the relative ease of acquiring additional inputs. For example, making lemonade requires
minimum skill so if the price of lemonade increases it is easy to convert many workers in other
fields to lemonade production to significantly increase supply. However, even if the salary of brain
surgery rose significantly, supply of brain surgeons will not increase, at least in the short run, as it
requires specialised training
Mobility of Inputs
The supply of a good is elastic if it the inputs can be easily transported from one site to another, so
that an increase in the price of one product in one market will attract inputs from other markets,
thereby increasing supply. For example, supply in entertainment industry is relatively elastic
because entertainers are willing to travel for gigs.
Ability to Produce Substitute Inputs
The supply of a good is elastic if technology can overcome limitations imposed by inputs that are
fixed in supply. For example, raw diamonds have limited supply so even if their prices go up, not
much more supply is available. But new technology creating synthetic diamonds is able to make
diamonds more elastic
Time
Price elasticity of a good is higher in the long term than short term, due to the time it takes for
producers to respond to an increase in price by switching from one activity to another, building new
factors, or training more skilled workers

10

5.

Demand: the Benefit Side of the Market

The law of demand states that the quantity demanded of a good or service in a given time period
declines as its price increases, ceteris paribus. Demand is a result of peoples wants for satisfaction.
Utility is a measure of the satisfaction or happiness people get from their consumption activities,
measured by an abstract unit utils. Utility maximisation is then the assumption that rational
people try to allocate their incomes so as to maximise their utility. Marginal utility is the additional
utility gained from consuming an additional unit of a good in a given period
The law of diminishing marginal utility is the tendency for additional utility gained from
consuming an additional unit of a good in a given time period to diminish as consumption increases
beyond a certain point. By this law, marginal utility will become negative at some point.
Allocation of Fixed Income between Two Goods
Law of diminishing marginal utility imply that spending it all on a single good is not a good idea.
Instead, rational people should aim for the optimal combination of goods, i.e. the affordable
combination of goods that yields the highest total utility, in order to maximise utility.
To do so, we follow the rational spending rule, which states that spending should be allocated
across goods and services so that the marginal utility per dollar is the same for each good.

Demand and Consumer Surplus

Consumer surplus is the difference between a buyers reservation price (the maximum price they
are willing to pay) for a good and the price actually paid. On a demand curve, the consumer surplus
is the area that lies between the demand curve and the market price.
E.g. in the oil market, the equilibrium price and quantity is $2 and 4000 gallons a day respectively.
All the customers whose reservation price is more than $2 is therefore receiving consumer surplus.
For all these buyers, the consumer surplus is the cumulative difference between their reservation
prices and the prices they actually paid

11

6.

Perfectly Competitive Supply: the Cost Side of the Market

The law of supply states that an increase in price results in an increase in quantity supplied, ceteris
paribus. The supply curve has an increasing slope because suppliers exploit their most attractive
opportunities first, i.e. the principle of increasing opportunity cost.
Production Time Periods
o Short run: period of time sufficiently short that at least one factor remains fixed but long
enough to change some variable factors, although existing fixed factors can be used more
o Long run: period of time of sufficient length to vary all factors, i.e. no fixed factors
Factors of Production in Short Run
o Variable factors of production: an input that changes in the short as the output of a
particular good or service produced in a given time period changes, e.g. labour
o Fixed factors of production: an input that does not change as the output of a particular
good or service produced in a given time period changes, even if output is zero
The law of diminishing return states that in the short run when at least one factor is fixed,
successive increase in input of a variable factor eventually makes less and less of a difference to
output. This is due to the eventual overcrowding or overusing of a fixed factor. This means that
increase production of a good eventually requires larger and larger increase in input of a variable
factor.

Production Costs
Average Fixed Cost (AFC)
AFC is the total fixed cost divided by the total output quantity. The AFC decreases with quantity as
the fixed cost spread among a greater quantity of outputs.
TFC
AFC
and lim AFC 0
Q
Q
Average Variable Cost (AVC)
AVC is the total variable cost divided by the total output quantity. The AVC decreases initially due
to specialisation, but increases afterwards as the law of diminishing return takes place.
TVC
AVC
and lim AVC
Q
Q

12

Average Total Cost (ATC)

ATC is the sum of all variable and fixed costs divided by the total output quantity. Equivalently, it
is the sum of average total cost and average variable cost. ATC approaches AVC as quantity
increases because the AFC is becoming smaller due to spreading.
TC
ATC
AFC AVC and lim ATC AVC
Q
Q
Marginal Cost (MC)
MC is the cost of producing an extra unit of output. Marginal cost decreases initially because due to
specialisation, output is increasing greater than the increase in costs. However, it then increases due
to diminishing returns. It corresponds to the increasing slope of supply curves:
Change in Total Cost
P
Marginal Cost
m
Change in Quantity
Q
Short-Run Shutdown Rule:
A firm should consider shutting down production in the long run when the price of the good is less
than the minimum value of its average variable cost, i.e. revenue is less than variable cost
VC
P Q VC
P
Q
i.e. P AVC
Shutdown Rule and Profit
Profit is given by revenue minus total costs such that a firm is profitable if its price is greater than
its average total cost. Thus, a firm should shut down if price is less than average total cost

Profit

Profitable IF P

ATC

Q P

ATC

ATC

When the curves of MC, ATC and AVC are graphed together, the marginal cost curve must
intersect the average total cost curve (ATC) and the average variable cost curve (AVC) at their
respective minimum points

13

Maximum-Profit Condition
For a firm to maximise their profit, they should supply at a quantity such that the price (P) at that
quantity is equal to the marginal cost, assuming output and employment can be varied continuously.
Graphically, it is where y P intersects the marginal cost curve.
Therefore, for a firm in a market where:
- P MC then INCREASING output INCREASES profit
-

MC then DECREASING output INCREASES profit

Measuring Profit
Profit can be measured graphically, it is the region bound between the rectangle formed by the price
and the rectangle formed by the ATC
Profit ( P ATC ) Q

14

7.

Efficiency and Exchange

Pareto efficiency is a state where there is no opportunity for exchange or trade that will make at
least one person better off without harming others. Pareto efficiency occurs when market is at
equilibrium. When the market is out of equilibrium, it is always possible to make a Paretoimproving transaction, one that benefits at least one person without harming others.
Price Ceilings
A price ceiling is a government imposed limit on the price of a product/service.

Under perfect competition, the market of milk reaches equilibrium at $1.4/litre, this results in
maximum economic surplus of $1800. However, with a price ceiling of $1, producers will only
supply 1000 litres so their surplus is reduced to $100. Also with the low supply, only those with
willing to pay $1.80 or more can afford milk. The total lost in surplus is $800
Price Subsidies
Subsidy is when government pays the producers directly so that consumers can purchase the
product at a lower cost.

Normally, the consumers in this country will receive $4,000,000 surplus per month. Since the
country can import as much milk as it wants, the supply is perfectly elastic. With a $1/litre subsidy,
the price consumer pays for a litre of milk drops to $1, which leads to a total of 6 million litres
consumed per month. Seemingly, consumer surplus would have increased by $5,000,000 However,
the cost of subsidy is paid for by taxpayers and its equal to $6,000,000 per month, so economic
surplus has actually reduced by $1,000,000
15

Taxes and Efficiency

Governments often impose taxes on sellers and businesses but it can inadvertently affect buyers too.
E.g. consider the market for hamburgers shown below; what is the effect of a $1 tax on sellers?

The equilibrium price increased by $0.50, since the $1 tax is essentially an increase in marginal
cost. Therefore, although only sellers were taxed, buyers now have to pay $0.50 more for a burger
and suppliers pay $0.5 more to make a burger. The tax also reduces the economic surplus, as the
size of the triangle decreased. The area would have decreased from $9000 to $6250 but they also
pay $2500 les tax elsewhere so the total loss in surplus is $250. This is known as the deadweight
loss, the reduction in total economic surplus that arise when a market does not operate where
marginal cost equal to marginal benefit. The rectangle represents tax revenue.
Taxes, Elasticity and Efficiency
In general, for goods with smaller the price elasticity of demand or supply for a good, the smaller
is the deadweight loss from a tax imposed on seller of that good. E.g. salt is inelastic so, if a 50%
tax was placed upon it people would still buy it so there is minimal loss of surplus. Therefore, it is
more efficient to tax sellers for goods with lower price elasticity of demand or supply
E.g. consider the deadweight loss in the following two markets with different elasticity of demand

In both markets, the original equilibrium is the same. However, the demand in (b) is more inelastic
than (a) since its gradient is larger. So with tax, the deadweight loss represented by the triangle is:
A a 0.5 1 5 $2.5
A b

0.5 1 3

$1.5

So the good with a less elastic demand has less deadweight loss as a result of tax
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8.

International Trade and Policies

Production Possibility Curve (PPC)

- Concave down curve for a many person economy
- Gradient of the curve represents opportunity cost
- Gradient is increasingly negative which represents: law of increasing opportunity cost
Consumption Possibilities Curve (CPC)
The CPC is a graph that shows the maximum amount of one good that can be consumed for every
possible level of consumption of the other good, i.e. all the combinations of two goods that
consumed. The relationship between PPC and CPC depends on international trade:
- Closed economy: one that does not trade externally, CPC can only equal to PPC
- Open economy: one that does trade externally, CPC can be greater than PPC through trade
Important Features
- Gradient of the CPC represents the relative price of the two goods on the world market.
- Point of intersection: where the OC of the production of a good is equal to its price on the
world market. PPC will ALWAYS intersect CPC at some point

The economy should produce at point C because:

- If it produced at H, opportunity cost of producing a computer is greater than that of buying
one on world market, so it should reduce its domestic production and import more instead
- If it produced at I, opportunity cost of producing a computer is less than that of buying one
on world market, so it should reduce its imports and produce more domestically instead
Demand and Supply Perspective on Trade
In a closed economy, the equilibrium price and quantity is determined by the intersection of the
domestic demand and supply curve.
In an open economy, the domestic price of a good must equal its world price, the price at which a
good is traded on the international market. If this price is:
- Lower than the equilibrium price, then the world has a comparative disadvantage. Thus,
demand is greater than supply and this difference must be imported
- Greater than equilibrium price, then the domestic economy has a comparative advantage.
Thus, supply is greater than demand and this difference must be exported
17

In general:
- If the price of a good in a closed economy is greater than the world price, the economy
becomes a net importer of that good
- If the price of a good in a closed economy is less than the world price, the economy
becomes a net exporter of that good
Winners and Losers from Trade
Although international free trade benefits the economy as a whole, some groups within the
economy are better off while others are worse off.

a) Consumers benefit from lower prices from imports so they can consume more. Therefore,
consumer surplus increases by the sum of the purple and green area. Domestic producers
lose because they now have to sell at lower prices, so producer surplus decreases by the
purple area.
b) Consumers lose because they now have to pay higher prices and consume less, so consumer
surplus decreases by the purple area. Domestic producers benefit from being able to sell at
higher prices as economy opens up to international trade at world prices. Thus, producer
surplus increases by the sum of the purple and green area
In general:
- When a good is imported, domestic consumers benefit and producers suffer
- When a good is exported, domestic consumers suffer and producers benefit
Protectionist Policies
Protectionism is the use of policies intended to protect domestic industries from competition, since
producers are hurt when imported goods are cheaper than domestically produced goods. Free trade
allows countries to specialise in the production of those in which they have the greatest comparative
advantage. This makes the economic pie as big as possible whereas protectionism prevents this and
thus protectionist policies are inefficient. However, producers are better organised politically so
they are often successful in lobbying for trade barriers.
Instead, the gains from free trade should be used to compensate the loss producers suffer, or at least
reduce its impact, such as retraining workers for other sectors.
18

Import Tariff
Tariff is a tax imposed on an imported good which essentially raises the world price of that good,
allowing domestic producers to raise their prices of that good to match the new world price while
consumers must pay more. This decreases
demand and increases supply, so the
difference between demand and supply, i.e.
the amount imported, decreases.
The clear winners are the domestic
producers, who can now charge more for
their products. Government also win because
they collect revenue from tariffs, which is
equal to the bright blue area in middle.
However, total economic surplus decreases,
so there is deadweight loss
Deadweight Loss:
- Consumption Loss (green area): some people can't afford anymore, so less is bought
- Production Loss (purple area): loss of efficiency, as resources taken from other goods,
where they are more efficiently produced
Import Quota
Quota is a legal limit on the quantity of a good
that can be imported. At world price, the
quantity that needs to be imported is qD qS
but by limiting it with a quota, producers now
need to supply more to cover the demand. For
producers to do that, price has to rise as an
incentive. Thus it can be thought of a shift in
supply to match the new price as well.
The market effect of quota and tariff is exactly
the same, if the quota is set to permit the same
level of import as the tariff. However, with a
quota, the government collects no revenue!
With quotas, the revenue that wouldve gone to the government with a tariff instead goes to firms or
individuals that have the right to import the good. E.g. importers of computers can purchase them at
world price on international market, and then sell them at a higher price in domestic market to
pocket the difference.
With Tariff
With Quota
Decrease
Decrease
Consumer surplus
Increase
Increase
Producer surplus
Increase
No effect
Government surplus
Decrease
Decrease
Economic surplus
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9.

Profit and the Invisible Hand

Two Types of Cost

When calculating profit, all costs must be taken into account:
- Explicit cost: the opportunity costs of resources that the firm uses that are supplied from
outside the firm, i.e. actual payments made for production
- Implicit cost: the value of the best opportunity forgone by the firm when it uses resources
supplied by the firms owners, e.g. time
Three Types of Profit
- Economic profit: total revenue minus ALL costs
- Accounting profit: total revenue minus explicit cost ONLY
- Normal profit: when economic profit is zero, i.e. equal to implicit cost

Economic Profit = Total Revenue - Explicit Costs +Implicit Costs

Accounting Profit = Total Revenue - Explicit Costs
Assuming that all firms are profit maximising firms, then to stay in the market firms need to make
AT LEAST a normal profit
The Invisible Hand Theory
The invisible hand theory states that the independent, selfish actions of buyers and sellers for their
own gains in a free market, will result in the socially optimal allocation of resources. It describes
the self-regulating nature of the marketplace where price has two underlying functions:
- Rationing function: to distribute scarce goods to those consumers who value them most
- Allocative function: to distribute resources away from overcrowded markets towards
markets that is underserved.
How the Invisible Hand Works in Long Run
Consider the short-run market for apples where firms are currently earning an economic profit, i.e.
their revenue exceeds all costs. We make these assumptions:
- The cost of inputs required to enter the apple market, e.g. land and labour, are constant
- Anyone is free to enter the apple market
- All apple grower face the same costs, i.e. ATC curves are identical for everyone
Initially, apple growers make an economic profit as the price is above ATC. Their demand and
supply, MC and ATC curves are:

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The existence of economic profit entices others to enter the apple market. This causes the supply to
increase, so equilibrium price decreases and thus each producer makes less economic profit.

As long as economic profit exists in the apple market, price will continue to fall until it is at the
minimum value of ATC. At this point, there is NO more economic profit.

However, if the initial price was below the ATC due to demand curve being lower than the previous
case, then producers make an economic loss:

If this low demand persists, apple growers will keep leaving the market. Eventually, this will push
prices back up to the minimum value of ATC for a normal profit, thus no need to quit anymore
In conclusion, for firms in a competitive market that pose no barriers to entry or exit, all firms will
tend to earn zero economic profit (normal profit) in the long run. This also reflects the no cash on
table principle, as people always exploit opportunities for gains, in this case either by entering for
the profits or leaving the market to pursue profits elsewhere

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Long Run Supply Curve

At the point of zero economic profit, i.e. minimum value of ATC, the production of apple can be
reduced or expanded indefinitely in the long run. This means that the supply is perfectly elastic, i.e.
horizontal. At this price, the market is in long run equilibrium.

Two main features of perfectly competitive long-run market equilibrium:

- Market outcome is efficient. At $1/kg, the marginal benefit of every apple sold ($1) is
exactly equal to the marginal cost of producing it ($1). Thus there is no Pareto efficient
transaction possible.
- Goods are produced at lowest cost possible. Since buyers pay no more than the total cost of
production, all resources of supplied by owner earn equal to their opportunity cost.
Economic Profit vs. Economic Rent
Although the invisible hand eventually leads to zero economic profit, many people have become
incredibly rich. This is due to barriers to entry, forces that prevent firms from entering a new
market, which leads to economic rent. Economic rent is the part of the payment for a factor of
production that EXCEEDS the owners reservation price, it is a similar concept to producer surplus
- Economic profit is driven to zero by competition in the long run
- Economic rent can persist in the long run
If the elasticity of supply is:
- Perfectly elastic: then suppliers entire income is all opportunity cost and no economic rent
- Perfectly inelastic: all suppliers income is economic rent
E.g. if a landowner is willing to lease his land to farmers for $1000 a year and a farmer pays $1500
a year for it. What is the landowners economic rent and why does it persist in the long run?
Economic rent = $1500 - $1000 = $500
This economic rent does not disappear because of barriers to entry, i.e. fixed amount of land
The Invisible Hand and Cost-Saving Innovations
A perfectly competitive firm is a price taker with no influence over market price and eventually
earns a normal profit. However, there is still incentive to develop cost-saving innovations. This is
because costs saving innovations earn an economic profit in the short run for that firm, since the
decrease in that firms costs has no impact on market price. Other producers eventually adopt these
innovations and again drive economic profit to zero. At that point, any firm that did NOT adopt the
new strategy would suffer a loss.
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10. Monopoly and Other Forms of Imperfect Competition

An imperfectly competitive market is a market in which firms have at least some ability to set
their own price, i.e. price setters. They enjoy a degree of market power, able to raise the price of a
good without losing all its sales.
- Perfectly competitive market faces perfectly elastic demand curve for their products and it is
equivalent to the market price for that product. There is NO incentive to change the price
- Imperfectly competitive market faces downward sloping demand curve for their products

Types of Imperfect Competition

o Pure Monopoly: a market in which a single firm is the only supplier of a product for which
there are no close substitutes and high barriers of entry.
o Monopolistic Competition: a market in which a large number of firms produce slightly
different products that are reasonably close substitutes to one another.
- Product differentiation over product quality, price, marketing and branding
- Firms can charge slightly higher prices, unlike perfect competition
- No barriers to entry, therefore still forced to normal profit in long run
Barriers to Entry
Market power arises from barriers to entry that limits competition and the invisible hand from
driving economic profit to zero. Barriers to free entry that give rise to market power are:
o Exclusive control over important inputs: control over raw materials such as rare-earth metal
o Government created monopolies: patents, licenses and copyright protection
o Network economies: products that become valuable to an individual user as the network of
users grow, e.g. Facebook, mobile phones. Essentially a form of economies of scale
Economies of scale:
- Constant returns to scale: if a given proportion of change in inputs yields the same
proportion of change in outputs
- Increasing returns to scale: if a given proportion of change in inputs yields a greater proportion of change in outputs
- Natural monopoly: a monopoly that results from increasing returns to scale, where a single
firm can serve the entire market at a lower cost than two or more firms.
For firms with economies of scale over production, the initial start-up fixed costs can be
substantially large, e.g. for a pharmaceutical developing a new drug. However, once established, the
marginal cost of production is very low. Thus, average total cost of production for such goods will
decrease as output increases, since the large fixed cost is being spread among output
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Monopolists Marginal Revenue

In an imperfectly competitive market, e.g. monopoly, a monopolist must cut price in order to sell
additional units due to downward sloping demand curve, but it must cut price not only for the extra
unit but for all existing units. Therefore marginal revenue is less than its selling price.

Graphically:
- Marginal revenue curve meets the demand curve at the y-intercept
- Marginal revenue curve cuts the x-axis at half of the demand curve
Monopolists Profit Maximising Rule
By the cost-benefit principle, monopolist should continue to expand output as long as the marginal
revenue exceeds marginal cost. Profit maximisation rule is the same as perfectly competitive
markets, i.e. marginal benefit to marginal cost, just that now marginal benefit doesnt equal to price!

Monopolist and Economic Profit

For a monopolist to earn an economic profit, the profit maximising price, i.e. price on demand
curve, must be GREATER than the average total cost.

a) Profit is maximised at selling 20 million minutes per day, however the firm still suffers
$400,000 economic loss because the profit maximising price is less than ATC
b) The firm makes an economic profit because the profit maximising price is greater than ATC
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Monopoly and Social Efficiency

For monopolists, since profit maximisation occurs when marginal cost equals marginal revenue
which is ALWAYS less than price, the profit-maximising output is always below the socially
efficient level

Demand curve represent marginal benefit to society

To achieve social efficiency, the monopolist should expand production until marginal
benefit equals to marginal cost, e.g. 12
Socially efficient output level: where market demand intersects monopolists marginal cost
Monopolist will only produce at 8, the profit maximising output
Since expanding production will benefit society, this unrealised economic surplus
contributes to deadweight loss, thus inefficiency

Monopolist and the Invisible Hand

The invisible hand does not work to prevent a monopolist from earning an economic profit in the
long run. However, individual self-interest still leads to people to respond to the incentive of
unexploited opportunities. Potential competitors will still have incentive to develop substitute goods
and lobby politicians to remove barriers to entry.
Price Discrimination to Expand Markets
Price discrimination is the practice of charging different buyers different prices for essentially the
same good or service, where the differences do not simply reflect differences in costs of supplying
different buyers.
Perfectly discriminating firms are price makers that charge each buyer exactly his or her
reservation price for each unit purchased.
- Increase or maintain economic profit by reaching out to a larger market
- Serve the socially optimum output and thus efficient
- Benefit to monopolist of selling additional unit is the same as benefit to buyers in society
- Thus marginal revenue curve equals to demand curve
Whereas a firm that does NOT engage in price discrimination will only serve the high end of the
market, i.e. those with high reservation prices, and only serve the profit maximising output. They
will not serve those with lower reservation prices because that requires them to reduce the price to
sell all units at the same price. From the monopolists point of view, this is a loss.

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Price discrimination is fair because:

- It allows sellers to charge what each buyer is willing to pay
- Many buyers benefit from the discrimination by not being excluded from purchasing a
product they could otherwise not afford
Price discrimination is socially efficient because:
- It can increase economic surplus and the number of buyers served
- Allows price setters to expand output without losing profit, thus reducing deadweight loss
Group Pricing
Group pricing is a form of price discrimination where different discounts are offered in different
sub-markets, where members of a particular sub-market all receive the same discount, e.g.
discounted tickets to seniors. Group pricing also prevents arbitrage, the act of buying a product at a
low price and then reselling it to others at a higher price.
Hurdle Method of Price Discrimination
The hurdle method of price discrimination, or versioning, is when a seller offers a discount to all
buyers who overcome a particular obstacle. E.g. sellers who offer a rebate to any buyer who makes
the effort to mail in a rebate coupon.
A perfect hurdle is one that completely separates buyers whose reservation prices lie above it from
others whose reservation price lie below it, imposing no cost on those who jump the hurdle. With a
perfect hurdle, the highest reservation price among those buyers who jumped the hurdle will still be
lower than the lowest reservation price among buyers who dont.
Regulating Price Discrimination
Governments often regulate monopolies such as energy companies because of:
- Potential loss in efficiency
- Restricted output levels
- Economic profit at the buyers expense
Government can regulate monopolies by:
- Marginal cost pricing: forcing natural monopolies to produce output level such that price
equals to marginal cost. This results in economic loss for the monopoly as they can never
recover the initial fixed start-up cost
- Average cost pricing: forcing output levels such that price equal to average total cost,
allowing the firm to make a normal profit.

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11. Thinking Strategically

Oligopoly is another type of imperfectly competitive market, where a small number of firms
dominate. Characteristics of an oligopoly are:
- Natural or legal barriers of entry
- Small number of firms interdependent of each other, with temptation to cooperate in order to
increase their joint profit
- Products are either differentiated or homogenous
- Engage in non-price competition, e.g. marketing, advertising
- Engage in infrequent price wars
- Inflexible prices that rarely change and changes are adopted by all firms
- Economic profit exists in the long run
Game Theory
Game theory is a tool for studying strategic behaviour, which is behaviour that takes into account
the expected behaviour of others and the mutual recognition of interdependence. The basic
elements of a game are the:
- Players
- Strategies available to each player
- Payoff for each possible combination of strategies
Strategies of a Game
o Dominant strategy: one that yields a player a higher payoff no matter what the other
players in the game choose
o Dominated strategy: any other strategy available to a player who has a dominant strategy
o Nash Equilibrium: a set of strategies, one for each player, in which each players strategy
is the best choice given the other players strategy
Prisoners Dilemma
The prisoners dilemma is a game in which each player has a dominant strategy, and when each
plays their dominant strategy; the resulting payoffs are smaller than if each had played a dominated
strategy.
E.g. Horace and Jasper are two prisoners in prison for a bank robbery they did in fact commit.
However, the prosecutor can only convict one of them. Each is told that if they confess, they will go
free and the other would receive a 20-year sentence. However, if both confess then they will receive
5 years each and if neither confesses then they will receive 1 year each.
Both prisoners have a dominant strategy:
- Horace should confess because if he doesnt and Jasper confesses, then he will get 20
instead of the 5. If Jasper doesnt confess, then Horace goes free. So either way the payoff is
better than the other choice
- Same for Jasper
- Nash equilibrium established, since each players strategy is their best, no matter what

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When both prisoners play their dominant strategy, i.e. confess, they will get 5 years each. However,
if both played their dominated strategy, i.e. deny, then they will get 1 year each only.

Prisoners Dilemma and Imperfectly Competitive Markets

This form of prisoners dilemma is often seen in oligopoly markets, where competing with other
firms may be the dominant strategy but yields less profit for both firms. Jasper and Horace can
collude to both deny, which benefits both of them more. Similarly, firms in oligopoly can collude to
fix price instead of trying to cut prices and compete in order for a greater profit for all firms
Cartels
A cartel is a group of firms that conspires to coordinate production and pricing decisions in an
industry for the purpose of earning an economic profit. However, cartels are often unstable:
- Incentive to cheat by selling cheaper/more than the agreed price/quantity. This result in a
repeated prisoners dilemma and each player will use a tit-for-tat strategy, where both
players start off cooperating, but one cheats and the other will continue to copy. This
continues until economic profit becomes zero.
- Individual firms have different cost and demand curves so its hard to agree on one price
- Large number of firms, e.g. OPEC, hard to get everyone to agree

By colluding, both firms capture half the market (500 out of 1000) and make an economic profit of
$500, as given by the profit maximising condition where MR equals MC (marginal cost is zero).
However, if firm X decides to cut prices to $0.9 per bottle, then it will capture the entire market
demand of 1100 and make an economic profit of $990. Now firm Y must also match this new price,
otherwise it will make zero profit. By matching the price, both again split the market but now only
make $495 economic profit, less than the $500 before. This cycle will continue until there is no
more economic profit for either firm.
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12. Externalities and Resource Allocation

Externality is an external cost or benefit of an activity that affects people who are not directly
involved in the activity. Individuals or firms that consider only their own cost and benefits will tend
to engage too much in activities that generate external cost and too little in activities that generate
external benefits.
In general:
- For a good that produces external benefits, market equilibrium quantity is LESS than
socially optimal quantity
- For a good that produces external costs, market equilibrium quantity is MORE than socially
optimal quantity
E.g. consider an energy company using coal-burning generators, where each ton of output has a
pollution cost of $1000. Show how this situation is not socially optimal
For the company, equilibrium price is $1300 at 12000 tonnes a year. The $1000 pollution cost is an
external cost since it doesnt affect the company itself. Thus, the social marginal cost is $1000 more
than the companys marginal cost. In this case, last tonne of output brings $1300 benefit but at a
cost of $2300 to society. This gives rise to deadweight loss and society can benefit from reducing
production.

Socially optimal level is at 8000 tonnes a year.

Irrelevant External Effects

o Pecuniary externality: an effect on the welfare of other people that occurs through changes
in relative prices. It is an application of the invisible hand that allocates resources, i.e. some
people are better off, some are worse off but market is not more or less efficient
o Inframarginal externalities: the magnitude of the eternal cost or benefits of activities that
does not depend on small changes in the level of activity in the market

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Coase Theorem
The Coase theorem states that if people can negotiate, at no cost, the purchase and sale of the right
to perform activities that cause externalities, they will arrive at efficient solutions to the problems
caused by the externalities.
E.g. Consider Ruth whose factory dumps toxic waste into the river which harms fisherman Hugh.
Ruth can install a filter at a cost to remove this harm, how should Hugh negotiate?
With Filter
Without Filter
Hugh Pays $40 for Filter
$100
$130
$140
Gain to Ruth
$100
$50
$60
Gain to Hugh
Hugh should offer $40 to Ruth for the filter, this way both are $10 better off for a net gain of $20
Legal Remedies for Externalities
Legal remedies such as laws help people to reach efficient solutions where negotiation is difficult.
These laws generally require the adjustments to be made by the party that can do it with the lowest
cost. E.g. restrictions on loud music are often on late weekend nights, because the cost of loud
music to other people is less on weekend than weekdays.
Market-Based Instruments (MBIs)
MBIs are policies that positively influence the behaviour of people in markets to achieve targeted
outcomes, i.e. to lower production of goods that generate negative externalities.
Price Based MBIs
Price based MBIs include:
- Subsidies to encourage activities with positive externalities
- Taxes to discourage activities with negative externalities
Both tax and subsidy should be equal to the external cost/benefit in order to achieve socially
optimal levels. They make the economy more efficient by making produces take account of relevant
social cost that they ignore as a profit maximising firm

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Quantity Based MBIs

The best known quantity based MBI is the marketable permit system, it creates a market to
facilitate the trade of environmental goods, such as pollutant. It involves:
- Set a quantity cap that limits allowable emissions
- Define entitlements and distribute these among users
- Create a market to enable the trade of entitlements
E.g. consider firm X and Y that can use 5 production processes with different amounts of pollution.
To half emissions, government can either enforce a law to cut emissions or impose a tax.
Processes
A (4 tonnes)
B(3 tonnes)
C(2 tonnes)
D(1 tonne)
E(0 tonne)
100
200
600
1300
2300
Cost to X
300
320
380
480
700
Cost to Y
Without regulations, both will use process A and produce 8 tonnes of pollution
Legal Remedy law that requires produces to cut emissions by half
This law forces both to use process C, adding cost of $500 to X and $80 to Y, for a total of $580
Price Based MBI Tax of $101 per tonne
Firm X will now use B, since producing another tonne of pollution cost $101 but only saves $100
on production cost. Firm Y now use process D, since the saving on production cost for ever extra
tonne is $100, $60 and $20, all less than the tax of $101. Total cost is $100 + $180 = $280.
Advantage of tax is that it concentrates pollution reduction on firms that can do it with the least
cost. Laws requiring every producer to cut the same amount ignore the fact that some producers can
cut pollution much cheaper than others.
Quantity Based MBI Government auctions 4 permits at $101 each
Without permits, X and Y must use process E at cost of $2300 and $700. If 4 permits are sold at
$101 each, firm X will demand 3, since moving from E to D, C and B saves more than $101 each
time. Firm Y will demand 1, since moving from E to D saves $280, more than the permit.
Advantage of permits is that it does not force firms to commit to costly investments. It also allows
the public to determine where emissions levels should be, e.g. people who want higher reduction
targets can buy permits in order to prevent companies from emitting more

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13. Public Goods and Private Goods

All goods and services differ in terms of two basic properties:
- Rivalry: the extent to which the consumption of a good by one person diminishes its
availability to others
- Excludability: the extent to which non-payers can be excluded from consuming a good
Public goods are goods or services that are to some degree both non-rival and non-excludable.
For example, national defence and New Years fireworks are public goods, i.e. one person viewing
fireworks does not diminish its value to other viewers, and it cannot charge admission. Public goods
have a community demand but can't be delivered for a profit, e.g. streetlights, which is why they are
often provided by the government. Pure public goods are those that area completely rivalrous and
present no possibility of exclusion.
Private goods are goods or services that are both excludable and rivalrous in consumption. E.g.
hamburgers, if one person eats it then nobody else can eat it and those who dont pay can't eat it
Common goods are goods, services or resources that are rivalrous but non-excludable. E.g. a fish
in the sea can be fished by anyone, but once fished it is no longer available to anyone else
Collective goods are goods and services that are non-rivalrous and excludable. E.g. pay TV is not
available to people who dont pay for it, but an additional viewer does not diminish its value to
other viewers.

Differences between Private and Public Goods

Measure of Benefit
- Benefit of an additional unit of private good is the highest sum that a buyer is willing to pay
- Benefit of an additional unit of public good is the sum of reservation prices of all people
who would benefit from that good
Construction of Demand
- Market demand curve of a private good is the horizontal addition of all individual demand
curves, i.e. choose a price and add all the quantities
- Market demand curve of a public good is the vertical addition of all individual demand
curves, i.e. choose a quantity and add all the prices

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14. Information Asymmetry

Information gathering, just like any other activities, involves the use of scarce resources. Therefore,
the cost-benefit principle states that a rational consumer will continue to gather information as long
as its marginal benefit exceeds marginal cost.
In searching for further information, one must accept certain costs in return for unknown benefits,
thus it carries an element of risk:
- Expected value: the average amount one would win or lose if a gamble is played infinite
number of times. It is the sum of all possible outcomes multiplied by their probability
- Fair gamble: a gamble whose expected value is zero
- Risk neutral person: someone who would accept any gamble that is fair or better
Asymmetric information describes a situation in which people on different sides of an economic
exchange are not equally well informed about a particular aspect of the transaction that will affect
the outcome for them. E.g. seller of a second hand car may not disclose faulty parts of the car to
potential buyers to fetch a higher price.
Asymmetric information leads to market failure, because the true costs and benefits are not known
to both sides. This prevents the market from reaching equilibrium, i.e. where marginal benefit equal
to marginal cost, and thus is a cause of inefficiency.
As a result of specialisation, people hire experts who are better informed about certain tasks to
carry out work. These arrangements are called principal-agent relationships:
- Principal: someone who contracts another party to perform work on their behalf
- Agent: someone who is contracted by another party to perform work on their behalf
The principal-agent problem is a situation where an agents objectives are not aligned with the
principal and takes actions that do not result in the best outcome for the principal, yet it is too costly
for the principal to monitor the agents actions

33