ECON 1220 (Fall 2024)

16 September 2024(Tutorial 1)

Chapter 1 Principles of Economics

ž Economics is the social science that studies the choices that individuals, businesses,
governments and entire societies make when they cope with scarcity and the incentives
that in and reconcile those choices.
ž How do people make economic decisions/interact? How does the economy work?

ž Microeconomics
ž Individual level
ž Examples: price of a particular good, consumer preference, budget, opportunity cost

ž Macroeconomics
ž Aggregate level: studies the economy as a whole
ž Examples: Long run economic growth, business cycles, unemployment, inflation,
international trade, macroeconomic policies: Monetary and Fiscal Policy

ž 10 principles of economics (6 principles are covered in this course)

(1) People face trade-offs
(2) The cost of something is what you give up to get it
(3) Rational people think at the margin
(4) People respond to incentive
(5) Trade can make everyone better off
(6) Markets are usually a good way to organize economic activity

ž Economic questions arise because we always want more than we can get, so we face
scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can
satisfy all his or her wants.

ž Scarcity: the limited nature of society’s resources

ž Scarcity forces us to make choices over the available alternative. The choices we make
depend on incentives, a reward that encourages a choice or a penalty that discourages a
choice.
ž Scarcity requires choices and choices create trade-offs.
ž A trade-off is an exchange which is giving up one thing to get another.
ž For example, there is a trade-off between Consumption and Saving.

ž opportunity cost of something is the highest-valued alternative that must be given up to

get it.
ž So, for instance, the opportunity cost of being in school is all the good things that you
can’t afford and don't have the spare time to enjoy.
ž What is the Opportunity Cost of coming here to attend they tutorial?

ž Sunk cost: a cost that has already been committed and cannot be recovered (not
relevant in decision making)

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ž Example: What is your opportunity cost of going to a movie?
The total cash expenditure (price of tickets, cost of soda and popcorn, etc.) needed to go
to the movie
Time cost (the value of your time)

ž Example: What items would you include to figure out the opportunity cost of a vacation
to Universal Studio?
Monetary costs (ticket, travel, souvenirs, etc.)
Time cost (if you go to work instead, the time cost is the money you could have earned)

ž Example: You win $100 in a basketball pool. You have a choice between spending the
money now and putting it away for a year in a bank account that pays 5 percent interest.
What is the opportunity cost of spending the $100 now?
If you spend $100 now instead of saving it for a year and earning 5 percent interest, you
are giving up the opportunity to spend $105 one year from now.

ž Thinking at the Margin

ž Marginal change: a small incremental adjustment to a plan of action (e.g. marginal cost
and marginal benefit)

ž Making choices at the margin means looking at the trade-offs that arise from making
small changes in an activity.
ž People make choices at the margin by comparing the benefit from a small change in an
activity (which is the marginal benefit) to the cost of making a small change in an activity
(which is the marginal cost).
ž Changes in marginal benefits and marginal costs alter the incentives that we face when
making choices. When incentives change, people's decisions change.

Discussion on the Buffet Dinner and Mobile Plan Example (lecture notes)

Example: Why is water so cheap while diamonds are expensive?

The marginal benefit of a good depends on how many units a person already has.
If water is plentiful, the marginal benefit of an additional cup is small.
Diamonds are rare, the marginal benefit of an extra diamond is high.

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Chapter 2 Thinking like an Economist
ž Positive VS Normative analysis
ž Normative statements are based on opinions or ethics— what someone believes should
be.
ž Positive statements, on the other hand, are testable, even if they may not necessarily be
true

ž Circular flow diagram shows how dollars flow through markets among households and
firms.

ž Expenditure equals income because every dollar

spent by a buyer becomes income to the seller.

ž Measure GDP: Expenditure Approach = Income

Approach = Production Approach

ž The Production Possibility Frontier (PPF) shows the combinations of output that the
economy can possibly produce given the available factors of production and the
available production technology.

ž Point A and B (Efficient)

ž Point C (not possible)
ž Point D(Inefficient)

ž Trade off (PPF is downward sloping)

ž Opportunity cost (For example: the opportunity

cost of increasing the production of car from
600 to 700 is 200 computers)

ž Shape of PPF (Linear? Bowed outward? Why?)

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 ECON 1220 (Fall 2024)
23 September 2024 (Tutorial 2)

Chapter 3 Interdependence and the Gains from Trade

ž Trade allows people to specialize in the production of goods for which they have a
comparative advantage and then trade for goods that other people produce.
ž Total output rises because of specialization, and people can benefit through trade
ž Absolute advantage: the ability to produce a good using fewer inputs than another
producer
ž Comparative advantage: the ability to produce a good at a lower opportunity cost than
another producer
ž Opportunity cost: whatever must be given up to obtain some item

ž Production possibilities frontier: PPF shows the combinations of output that the
economy can produce given the amount of inputs and technology

ž Efficient production point?

ž Inefficient production point?
ž Feasible/ infeasible production point?
ž Trade off
ž Slope of PPF: opportunity cost
ž Shape of PPF? (bowed outward? Linear?
ž Increasing opportunity cost (Why?)
ž Shifts of PPF (change in technology)

Example:
It takes 10 minutes for Adrian to make a bread and it takes him 20 minutes to make a cake.
Suppose Adrian has 2 hours, draw PPF. (shape of PPF? Opportunity cost?)

In 2 hours, Adrian can make 12 breads OR 6 cakes.

Opportunity cost: 1 Bread = 0.5 Cake, equivalently 1 Cake = 2 Bread

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Specialization and Trade
ž 2 goods: Meat and Potatoes
ž 2 people: Frank and Ruby
ž Both work 8 hours per day and use the time to grow potatoes, raise cattle, or both
ž Production possibilities:
Time needed to make 1 ounce of In 8 Hours
Meat Potatoes Meat Potatoes
Frank 60 min/oz 15 min/oz Frank 8 oz 32 oz
Ruby 20 min/oz 30 min/oz Ruby 24 oz 16 oz

ž Opportunity costs:
Frank: 1 oz of meat = 4 oz of potato, 1 oz of potato = 0.25 oz of meat
Ruby: 1 oz of meat = 2/3 oz of potato, 1 oz of potato = 1.5 oz of meat
ž Frank has comparative advantage in potato à specializes in producing potato
ž Ruby has comparative advantage in meat à specializes in producing meat

ž Specialization, trade and gain from trade

(1) When there is no trade, Frank and Ruby spend half of their time in producing each good
(2) Frank and Ruby specialize according to their comparative advantage
(3) Trade after specialization (Suppose they trade at a rate of 1 oz of meat = 2oz of potato,
Frank buys 5 oz of meat from Ruby)

Meat Meat
Specialization
24
After trade

Before trade
8 After trade
Ruby’s Frank’s
PPF Specialization
PPF Before trade
Potato Potato
16 32

ž What is the gain from trade? (Production? Consumption?)

ž What is the range of the exchange ratio that make trade possible?

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 Meat (oz) Potato (oz) Frank buys 5 oz of meat, and sells 10 oz of
No Trade potato to Ruby (price of exchange: 1 oz of
Frank 4 16 meat = 2 oz of potato)
Ruby 12 8
Specialization Ruby sells 5 oz of meat, and buys 10 oz of
Frank 0 32 potato to Frank
Ruby 24 0
On Ruby’s PPF, when 19 oz of meat is
After Trade produced, 3.x oz of potato is produced
Frank 5 22
Ruby 19 10

Joint PPF with and without specialization

ž To find out the individual output and total output without specialization and under
specialization, we first have to decide the amount of meat and potato they can produce
in 1 hour.
Time needed to make 1 ounce of In ONE hour
Meat Potatoes Meat Potatoes
Frank 60 min/oz 15 min/oz Frank 1oz 4oz
Ruby 20 min/oz 30 min/oz Ruby 3oz 2oz
ž
ž Frank: (Hours × 1M, Hours × 4P)
ž Ruby: (Hours × 3M, Hours × 2P)

Meat

A
32 Upper part
by Frank
Joint PPF with
specialization
24
B

Joint PPF without Lower part

Ruby
specialization by Ruby
8
Frank
C
Potato
16 32 48

ž When both Frank and Ruby spend all their time on producing Meat, 32 oz of meat is
produced. (24 + 8)
ž When both Frank and Ruby spend all their time on producing Potato, 48 oz of potato is
produced. (16 + 32)

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Joint PPF without specialization
ž We assume they will spend the same amount of time on doing the same task
ž In total, they have 16 hours
ž For example: both Frank and Ruby spend 1 hour in producing potato, 7 hours in
producing meat.
ž Frank produces 4 oz of potato and 7 oz of meat
ž Ruby produces 2 oz of potato and 21 oz of meat
ž Total: (6 oz of potato and 28 oz of meat)

Joint PPF with specialization

ž Initially both produce meat only, then 32 oz of meat is produced. (Point A)
ž Suppose they decide to increase the production of potato, Frank who has a comparative
advantage in potato will start to produce potato by giving up some meat. Ruby will still
produce meat only.
ž With 8 hours, Frank can produce 32 oz of potato (Point B). If they still want to further
increase the production of potato, Ruby will start to take part in the production of
potato by reducing the amount of meat produced

ž Comparing the Joint PPF with specialization and without specialization, specialization
increases total output
ž Gain from trade

Resources (Total 16 hours) Outcome (Meat, Potato)

Spent on meat Spend on potato Specialization No Specialization
0 16 Frank: (0×1M, 8×4P) Frank: (0×1M, 8×4P)
Ruby: (0×3M, 8×2P) Ruby: (0×3M, 8×2P)
Total: (0M, 48P) (Point C) Total: (0M, 48P)
2 14 Frank: (0×1M, 8×4P) Frank: (1×1M, 7×4P)
Ruby: (2×3M, 6×2P) Ruby: (1×3M, 7×2P)
Total: (6M, 44P) Total: (4M, 42P)
4 12 Frank: (0×1M, 8×4P) Frank: (2×1M, 6×4P)
Ruby: (4×3M, 4×2P) Ruby: (2×3M, 6×2P)
Total: (12M, 40P) Total: (8M, 36P)
6 10 Frank: (0×1M, 8×4P) Frank: (3×1M, 5×4P)
Ruby: (6×3M, 2×2P) Ruby: (3×3M, 5×2P)
Total: (18M, 36P) Total: (12M, 30P)
8 8 Frank: (0×1M, 8×4P) Frank: (4×1M, 4×4P)
Ruby: (8×3M, 0×2P) Ruby: (4×3M, 4×2P)
Total: (24M, 32P) (Point B) Total: (16M, 24P)
10 6 Frank: (2×1M, 6×4P) Frank: (5×1M, 3×4P)
Ruby: (8×3M, 0×2P) Ruby: (5×3M, 3×2P)
Total: (26M, 24P) Total: (20M, 18P)
12 4 Frank: (4×1M, 4×4P) Frank: (6×1M, 2×4P)
Ruby: (8×3M, 0×2P) Ruby: (6×3M, 2×2P)
Total: (28M, 16P) Total: (M24, 12P)
14 2 Frank: (6×1M, 2×4P) Frank: (7×1M, 1×4P)
Ruby: (8×3M, 0×2P) Ruby: (7×3M, 1×2P)
Total: (30M, 8P) Total: (28M, 6P)
16 0 Frank: (8×1M, 0×4P) Frank: (8×1M, 0×4P)
Ruby: (8×3M, 0×2P) Ruby: (8×1M, 0×4P)
Total: (32M, 0P) (Point A ) Total: (32M, 0P)

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Example: (Mankiw, Chapter 3, #6)
The following table describes the production possibilities of two cities.

Pairs of red socks /worker per hour Pairs of white socks /worker per hour
Boston 3 3
Chicago 2 1

(a) Without trade, what is the price of white socks (in terms of red socks) in Boston? What
is the price in Chicago?
(b) Which city has an absolute advantage in the product of each color sock? Which city has
a comparative advantage in the production of each color sock?
(c) If the cities trade with each other, which color sock will each export?
(d) What is the range of prices at which mutually beneficial trade can occur?

(a) Boston: 1R = 1W, 1W = 1R

Chicago: 1R = 0.5W, 1W = 2R

(b) Boston has an absolute advantage in the production of both types of socks,
because a worker in Boston produces more (3 pairs of socks per hour) than
a worker in Chicago (2 pairs of red socks per hour or 1 pair of white socks
per hour).

Boston: CA in producing white socks (compare the opportunity cost)

Chicago: CA in producing red socks (compare the opportunity cost)

(c) If they trade, Boston will produce white socks for export, because it has the
comparative advantage in white socks, while Chicago produces red socks for
export, which is Chicago's comparative advantage.

(d) Mutually beneficial trade ratio/ term of trade:

0.5W < 1R < 1W OR
1R < 1W < 2R
Reason:
At a price lower than 1 pair of red socks per pair of white socks, Boston will
choose to produce its own red socks instead of buying them from Chicago.
At a price higher than 2 pairs of red socks per pair of white socks, Chicago
will choose to produce its own white socks instead of buying them from
Boston.

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Example:
In an hour, Sue can produce 40 caps or 4 jackets and Ted can produce 80 caps or 4 jackets.
(a) Calculate Sue’s opportunity cost of producing a cap.
(b) Calculate Ted’s opportunity cost of producing a cap.
(c) Who has a comparative advantage in producing caps and jackets?
(d) Suppose that before trade Sue produces 20 caps and 2 jackets and Ted produces 40
caps and 2 jackets. If Sue and Ted specialize in producing the good in which each of
them has a comparative advantage, and they trade 2 jackets for 30 caps, who gains
from specialization and trade?

(a) Sue
Opportunity cost of 1 cap = 1/10 jacket. Opportunity cost of 1 jacket = 10 caps
(b) Ted
Opportunity cost of 1 cap = 1/20 jacket. Opportunity cost of 1 jacket = 20 caps
(c) Ted has comparative advantage in producing caps
Sue has comparative advantage in producing jackets
(d) Both Sue and Ted gain from specialization and trade
Before trade Sue Ted
Caps 20 40
Jackets 2 2
Specialize Sue Ted
Caps 0 80
Jackets 4 0
Trade Sue Ted
Caps Buy 30 Sell 30
Jackets Sell 2 Buy 2
After trade Sue Ted
Caps 30 50
Jackets 2 2
Gain from trade Sue Ted
Caps +10 +10
Jackets +0 +0
Jackets Jackets

Sue’s PPF Ted’s PPF

4 B 4

2 A C 2 A C

Caps B Caps
20 30 40 40 50 80

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 ECON 1220 (Fall 2024)
September 30 (Tutorial 3)

Chapter 4 The Market Forces of Supply and Demand

ž Market: a group of buyers and sellers of a particular good or service
ž Competitive market: a market in which there are so many buyers and so many sellers
that each has a negligible impact on the market price

Demand
ž Demand schedule: the entire relationship between the price of a good and the quantity
demanded. (Demand curve is negatively sloped)
ž Quantity demanded: the amount of a good that buyers are willing and able to purchase.
ž Law of demand: other things remaining the same, the higher the price of a good, the
lower is the quantity demanded.
ž Market demand is the horizontal summation of individual demands
ž Movement along the demand curve VS a shift in the demand curve
ž Willing to pay, diminishing marginal value/ marginal benefit

Factors affecting demand (shift of demand curve)

(1) The prices of related goods
ž Substitutes: a good can be used in place of another good. Example: Coke and Pepsi
ž Complements: a good used together with another good. Example: car and gasoline,
cereal and milk
(2) Expected future prices and income
(3) Income
ž Normal good: A good is a normal good if demand rises as income rises.
ž Inferior good: A good is an inferior good if demand falls as income rises
(4) Population/ Number of buyers
(5) Preferences/ Tastes

Supply
Supply schedule: the entire relationship between the price of a good and the quantity
supplied (supply curve is positively sloped)
ž Quantity supplied: the amount of a good that sellers are willing and able to sell
ž Law of supply: other things remaining constant, the higher the price of a good, the
greater is the quantity supply
ž Market supply is the horizontal summation of individual supplies
ž Movement along the supply curve VS a shift in the supply curve
ž Increasing marginal cost of production

Factors affecting supply (shift of supply curve)

(1) Prices of factors of production/ input
(2) Expected future price
(3) Number of producers
(4) Technology
(5) Prices of related goods (substitutes in production/ complements in production)

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Market equilibrium and predicting changes in equilibrium

Surplus ž The market equilibrium is determined by the

intersection of the demand and supply curve. It occurs
when the price balances the plans of buyers and
sellers

Shortage ž Equilibrium price: the price at which the quantity

demanded equals the quantity supplied.
ž Equilibrium quantity: the quantity bought and sold at
the equilibrium price.

ž Price as a regulator and price adjustment

- If P >P*, there will be excess supply (QS > QD / surplus) and the price will fall.
- If P < P*, there will be excess demand (QS < QD / shortage) and the price will rise.

Change in demand, change in supply, change in demand and supply

ž Why a market moves toward its equilibrium?
- Price adjusts when buying and selling plans do not match
ž How would the equilibrium price and quantity be affected when there are changes in
demand and supply?

DDD/ DSS DP DQ
DD↑ P↑ Q↑
DD↓ P↓ Q↓
SS↑ P↓ Q↑
SS↓ P↑ Q↓
DD↑ and SS↑ P uncertain Q↑
DD↑ and SS↓ P↑ Q uncertain
DD↓ and SS↓ P uncertain Q↓
DD↓ and SS↑ P↓ Q uncertain

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Example: (Chapter 4, Q5)
Over the past 40 years, technological advances have reduced the cost of computer chips.
How do you think this has affected the market for computers? For computer software? For
typewriters.
Supply of computer increases. P? Q?
Demand for computer software increases. Why? P? Q?
Demand for typewriter drops. Why? P? Q?
[Use supply-and-demand diagrams to illustrate]

Example: (Chapter 4, Q6)

Using supply-and-demand diagrams, show the effect of the following events on the market
for sweatshirts. (Please try to draw the diagrams)
(a) A hurricane in South Carolina damages the cotton crop
(b) The price of leather jackets falls
(c) All collages require morning exercise in appropriate sports uniform
(d) New knitting machines are invented

(a) When a hurricane in South Carolina damages the cotton crop, it raises input prices for
producing sweatshirts. Supply of sweatshirts shifts to the left. In the new equilibrium,
price is higher, quantity is lower.
(b) Demand for the sweatshirts decreases. P? Q?
(c) Demand for sweatshirts increases. P? Q?
(d) Supply of sweatshirts increases? P? Q?

Example: (Chapter 4, Q10)

Because bagels and cream cheese are often eaten together, they are complements.
(a) We observe that both the equilibrium price of cream cheese and the equilibrium
quantity of bagels have risen. What could be responsible for this pattern: a fall in the
price of flour or a fall in the price of milk? Illustrate and explain your answer.
(b) Suppose instead that the equilibrium price of cream cheese has risen but the equilibrium
quantity of bagels has fallen. What could be responsible for this pattern: a rise in the
price of flour or a rise in the price of milk? Illustrate and explain your answer.

(a)

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Flour is an ingredient in bagels, a decline in the price of flour would shift the supply curve
for bagels to the right. The result would be a fall in the price of bagels and a rise in the
equilibrium quantity of bagels.
Cream cheese is a complement to bagels, the fall in the equilibrium price of bagels increases
the demand for cream cheese. The result is a rise in both the equilibrium price and quantity
of cream cheese. So, a fall in the price of flour indeed raises both the equilibrium price of
cream cheese and the equilibrium quantity of bagels.
Milk is an ingredient in cream cheese, the fall in the price of milk leads to an increase in the
supply of cream cheese. This leads to a decrease in the price of cream cheese, rather than a
rise in the price of cream cheese. So a fall in the price of milk could not have been
responsible for the pattern observed.

(b)

If the price of flour rose, it would lead to a fall in the price of cream cheese and a fall in the
equilibrium quantity of bagels. Because the question says the equilibrium price of cream
cheese has risen, it could not have been caused by a rise in the price of flour.
A rise in the price of milk would cause a rise in the price of cream cheese. Because bagels
and cream cheese are complements, the rise in the price of cream cheese would reduce the
demand for bagels. The result is a decline in the equilibrium quantity of bagels. So a rise in
the price of milk does cause both a rise in the price of cream cheese and a decline in the
equilibrium quantity of bagels.

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 ECON 1220 (Fall 2024)
October 21, 2024 (Tutorial 5)

Chapter 7 Efficiency of Market

ž Employ the demand and supply model and develop consumer surplus and producer
surplus as a measure of Welfare and Efficiency

1. Demand, willingness to pay and value

ž Marginal benefit shows the value/ the maximum price that people are willing to pay for
another unit of a good or service
ž Demand curve shows the maximum amount the person is willing to pay for a given
quantity
ð Demand curve = MB curve
ž Price decreases, CS increases (for a lower price paid and a higher quantity purchased)

2. Supply, willingness to sell and cost

ž Marginal cost is the minimum price that producers must receive to induce them to
produce another unit of the good or service.
ž Supply curve shows the minimum acceptable price the seller needs to be paid for given
quantities.
ð Supply curve = MC curve
ž Price rises, PS increases (for a higher price received and additional unit sold)

Consumer surplus = Value to buyers – Amount paid by buyers

Producer surplus = Amount received by sellers – Cost to Sellers

Total Surplus = Consumer Surplus + Producer Surplus

Total Surplus is maximized at the equilibrium (assume perfectly

competitive market and no externalities)
Underproduction Overproduction

ž The free market allocates the supply of a good to the buyers who value it most highly
(WTP) and allocates the demand for goods to the sellers who can produce it at the
lowest cost
- Underproduction - the value of the product to the marginal buyer is greater than the
cost to the marginal seller so total surplus would rise if output increases.
- Overproduction- the value of the product to the marginal buyer is less than the cost to
the marginal seller so total surplus would rise if output decreases.

ž Efficiency: the property of a resource allocation of maximizing the total surplus received
by all members of society.
ž Equality: the property of distributing economic prosperity uniformly the members of
society.

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Chapter 6 Supply, Demand and Government Policies

Price ceiling
A legal maximum on the price at which a good can be sold

The price ceiling is a binding constraint if it is lower than the

equilibrium price and a shortage is created

Example: Rent control (shortage of quality housing,

disincentive for building maintenance)

Price floor
A legal minimum on the price at which a good can be sold

The price floor is a binding constraint if it is higher than the

equilibrium price and a surplus is created

Example: minimum wage (Higher unemployment rate

especially for teenage and low skilled workers)

Chapter 8 Application: The Costs of Taxation

Taxes (Per unit tax)

Tax on sellers
If the government requires the seller to pay a certain
dollar amount for each unit of a good sold, the supply
curve will shift left by the exact amount of the tax.

Tax on buyers
If the government requires the buyer to pay a certain
dollar amount for each unit of a good purchased, the
demand curve will shift left by the exact amount of
the tax.

ž In both cases, the quantity of the good sold will decline

ž Buyers and sellers will share the burden of the tax. Buyers pay more for the good and
sellers receive less.
ž The tax burden does not depend on whether the tax is imposed on buyers or sellers.

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Elasticity and Tax Incidence
ž Tax incidence: the manner in which the burden of a tax is shared among participants in a
market.
ž A tax burden falls more heavily on the side of the market that is less elastic.

Inelastic
Demand

Welfare implications of a tax

SupplyTax
Before tax
CS = A + B + C
PS = D + E + F
TAX Total surplus = (A + B + C + D + E + F)

After Tax
CS = A
PS = F
Tax Revenue = B + D
Total surplus = (A + F+ B+D)
Decrease in total surplus = - (B + C + D + E)
DWL = C + E

Deadweight loss: the fall in total surplus that results from a market distortion

ž Taxes have deadweight losses because the quantity transacted is lower than the
efficient quantity that maximized total surplus. (MB = MC)

ž The price elasticities of supply and demand will determine the size of the deadweight
loss that occurs from a tax. (larger the elasticities imply larger DWL)

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The Laffer Curve
ž Deadweight loss grows larger as a tax grows larger. Tax revenue first rises with the size
of a tax, As the tax increases, the level of tax revenue will eventually fall.
ž As taxes increase, the deadweight loss rises more quickly than the size of the tax.
[compare figure (a) and (b) tax doubles, DWL rises by more than double]

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Example: Chapter 7, Q7
The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some
implications of this fact.
(a) Draw a supply and demand diagram to show the effect of falling production costs on the
price and quantity of flat-screen TVs sold.
(b) In your diagram, show what happens to consumer surplus and producer surplus.
(c) Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling
production costs --- consumers or producers of these TVS?

(a) The supply curve of flat-screen TVs shifts to the right. In the new equilibrium,
equilibrium price declines and equilibrium quantity increases.

(b) Consumer surplus: changes from A to (A + B + C + D). An increase of (B+ C + D).

Producer surplus: changes from (B + E) to (E + F + G). A change of (F + G – B) which could
be positive or negative.
Total surplus rises by (B + C + D) + (F + G – B) = (C + D + F + G)

(c) If the supply of flat-screen TVs is very elastic, then the shift of the supply curve benefits
consumers most. To take the most dramatic case, suppose the supply curve were
horizontal, then there is no producer surplus at all. Consumers capture all the benefits of
falling production costs, with consumer surplus rising from A to (A + B).

Example: Chapter 7, Q9
One of the largest changes in the economy over the past several decades is that
technological advances have reduced the cost of making computers.
(a) Draw a supply-and-demand diagram to show what happened to price, quantity,
consumer surplus, and producer surplus in the market for computers.
(b) Forty years ago, students used typewriters to prepare papers for their classes; today
they use computers. Does that make computers and typewriters complements or
substitutes? Use a supply-and-demand diagram to show what happened to price,
quantity, consumer surplus, and producer surplus in the market for typewriters.
(c) Are computers and software complements or substitutes? Draw a supply-and-demand
diagram to show what happened to price, quantity, consumer surplus, and producer
surplus in the market for software. Should software producers have been happy or sad
about the technological advance in computers?
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(a)

Supply curve shifts to the right. The equilibrium

price of computers declines and the equilibrium
quantity increases.
Consumer surplus increases from A to (A + B + C +
D).
Producer surplus increases by F + G – B (From B +
E to E + F + G)

(b)

As typewriters are substitutes for computers, the

decline in the price of computers shifts the
demand for typewriters to the left and it results in
a decline in both the equilibrium price and
equilibrium quantity of typewriters.
Consumer surplus in the typewriter market
changes by C – B (From A + B to A + C).
Producer surplus changes drops by C + D (From C +
D + E to E).

(c)
As software and computers are complements, the
decline in the price and increase in the quantity of
computers increases the demand for software and
results in a higher price and quantity of software.
Consumer surplus in the software market changes
by A – C (From B + C to A + B).
Producer surplus changes by C + D (From E to C + D
+ E).

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 Example: Chapter 6, Q2
The government has decided that the free-market price of cheese is too low.
(a) Suppose the government imposes a binding price floor in the cheese market. Draw a
supply and demand diagram to show the effect of this policy on the price of cheese and
the quantity of cheese sold. Is there a shortage or surplus of cheese?
(b) Producers of cheese complain that the price floor has reduced their total revenue. Is this
possible? Explain.
(c) In response to cheese producers’ complaints, the government agrees to purchase all the
surplus cheese at the price floor. Compared to the basic price floor, who benefits from
this new policy? Who loses?

(a) In the absence of the price floor, the price would be

P1 and the quantity would be Q1. With the floor set
at Pf, which is greater than P1, the quantity
demanded is Q2, while quantity supplied is Q3, so
there is a surplus of cheese in the amount Q3 – Q2.

(b) The producers’ complaint that their total revenue

has declined is correct if demand is elastic. With
elastic demand, the percentage decline in quantity
would exceed the percentage rise in price, so total
revenue would decline.

(c) If the government purchases all the surplus cheese at the price floor, producers benefit and
taxpayers lose. Producers would produce quantity Q3 of cheese, and their total revenue
would increase substantially. However, consumers would buy only quantity Q2 of cheese, so
they are in the same position as before. Taxpayers lose because they would be financing the
purchase of the surplus cheese through higher taxes.

7
Example: Chapter 8, Q3
Consider the market for rubber bands.
(a) If this market has very elastic supply and very inelastic demand, how would the burden
of a tax on rubber bands be shared between consumers and producers? Use the tools of
consumer surplus and producer surplus in your answer.
(b) If this market has very inelastic supply and very elastic demand, how would the burden
of a tax on rubber bands be shared between consumers and producers? Contrast your
answer with your answer to part (a)

(a) With very elastic supply and very inelastic

demand, the burden of the tax on rubber bands will
be borne largely by buyers. Consumer surplus
declines considerably, by area A + B, but producer
surplus decreases only by area C+D.

(b) With very inelastic supply and very elastic

demand, the burden of the tax on rubber bands will
be borne largely by sellers. Consumer surplus does
not decline much, just by area A + B, while producer
surplus falls substantially, by area C + D. Compared
to part (a), producers bear much more of the
burden of the tax, and consumers bear much less.

8
Example: Chapter 8, Q9
Hotel rooms in Smalltown go for $100, and 1000 rooms are rented on a typical day.
(a) To raise revenue, the mayor decides to charge hotels a tax of $10 per rented room. After
the tax is imposed, the going rate for hotel rooms rises to $108, and the number of
rooms rented falls to 900. Calculate the amount of revenue this tax raises for Smalltown
and the dead weight loss of the tax.

(b) The mayor now doubles the tax to $20. The price rises to $116, and the number of
rooms rented falls to 800. Calculate tax revenue and deadweight loss with this larger tax.
Are they double, more than double, or less than double? Explain.

(a) The tax revenue = A + B = ($10)(900) = $9,000.

The deadweight = C + D = (0.5)($10)(100) = $500.

(b) The tax revenue = A + B = ($20)(800) = $16,000.

The deadweight = C + D, = (0.5)($20)(200) = $2,000.

9
 ECON 1220 (Fall 2024)
November 18, 2024 (Tutorial 6)

Chapter 14 The Costs of Production

ž The goal of a firm is to maximize profit (given technology and input prices)
ž Total revenue (TR): the amount a firm receives for the sale of its output (TR = P x Q)
ž Total cost (TC): the market value of the inputs a firm uses in production
ž Profit: TR – TC

ž Costs of production include all the opportunity costs of inputs used

ž Total opportunity costs include both implicit and explicit costs (what are they?)

ž Accounting profit: Total revenue – Total explicit cost

ž Economic profit: Total revenue – Total cost
= Total revenue – Total explicit cost – Total implicit cost
ž If implicit costs > 0, accounting profit > economic profit.

Example:
ž Suppose Caroline uses $300,000 of her savings to start her firm. It was in a savings
account paying 5% interest. The potential $15,000 interest per year on this savings
(implicit cost) is a part of the opportunity cost.
ž Alternatively, if Caroline borrowed $200,000 from a bank at 5% interest and used
$100,000 from her savings. Opportunity cost is the sum of interest on the bank loan
($10000) (explicit cost) and the forgone interest on savings ($5000) (implicit cost).
ž The opportunity costs in the two cases are the same given the interest rate does not
change.

Production
ž Production function: the relationship between quantity of inputs used to make a good
and the quantity of output of that good.
ž A firm’s technology is represented by a production function: f (L, K).
ž If L units of labor and K units of capital are used, then total output, i.e., the amount of
output produced, is f (L, K).
ž Short run: period of time over which there is a fixed input, i.e., the amount of that input
cannot be varied.
ž Long run: period of time over which all inputs can be varied.

ž Total product (TP):

Quantity of a firm can produce with given
quantity of capital and different quantity of
labor.

1
ž Marginal product: the increase in output that arises from an additional unit of input.
ž Marginal product of labor: (MPL = DTP/DL) (assume capital is fixed, SR)
ž The slope of the production function measures marginal product (diagram?)
ž Diminishing marginal product: the property whereby the marginal product of an input
declines as the quantity of the input increases. (the production function becomes flatter
as labor used increases)

Costs of production (SR)

ž Fixed costs: costs that do not vary with the quantity of output produced.
ž Variable costs: costs that do vary with the quantity of output produced

ž Total cost: the sum of fixed cost plus variable cost.

ž The total cost curve gets steeper and steeper as output rises.

ž The slope of the total cost curve is marginal cost

ž Increasing opportunity cost due to diminishing marginal

product

ž Total cost: TC = TVC + TFC

ž Total fixed cost (TFC): part of costs that do not depend on
output. (Cost for fixed inputs)
ž Total variable cost (TVC): part of costs that depend upon
output. (Costs for variable inputs)

ž Average total cost: total cost divided by the quantity of output. (ATC = TC/Q)
ž Average fixed cost: fixed costs divided by the quantity of output. (AFC = TFC/Q)
ž Average variable cost: variable costs divided by the quantity of output. (AVC = TVC/ Q)

ž Marginal cost: increase in total cost that arises from an extra unit of production. (MC
= DTC/DQ) (MC is Slope of TC curve/TVC curve at a point)
ž MC decrease at low outputs because of the gains from specialization, but eventually
increases due to the law of diminishing returns.
Relationship between AC and MC
ž AFC is decreasing
ž AVC approaches ATC as the level of output gets larger.
ž AFC = ATC – AVC
ž TC = TFC + TVC ð TC/Q = TFC/Q + TVC/Q ð ATC = AFC + AVC

ž MC below AC means that AC is falling

ž MC above AC means that AC is rising.
ž MC equals AC at the minimum AC (MC cuts the minimum
Long run cost curves point of ATC and AVC)
2
ž In the long run, both labor and capital are variable.
ž LRTC: total cost of production q units of output when both capital and labor are variable.

Cost LRAC shows the minimum cost of producing q units of

LRAC output which both K and L can be varied.

The LRAC exhibits economics of scale when AC is

decreasing and exhibits diseconomies of scale when AC
is increasing.

Minimum efficient scale is the quantity of output where

AC reaches its minimum. (Q*)
Output
Q*

SRATC to LR ATC
ž LRAC is just the envelop of the SRACs

Example:
The table below provides partial cost information for a firm. Complete the table.
Output Total Cost TFC TVC ATC AVC MC
0 100 100 0
1 140 100 40 140 40 40
2 160 100 60 80 30 20
1
3 190 100 90 63 /3 30 30
4 230 100 130 57.5 32.5 40
5 280 100 180 56 36 50

3
Example:
The table shows the production function of Mario’s Pizza-to-Go. Mario must pay $100 a day
for each oven he rents and $75 a day for each kitchen hand he hires

Labor Output
(workers (pizzas per day)
per day) Plant 1 Plant 2 Plant 3 Plant 4
1 4 8 11 13
2 8 12 15 17
3 11 15 18 20
4 13 17 20 22
Ovens 1 2 3 4

(a) Find and graph the average total cost curve for each plant size.
(b) Draw Mario’s long-run average cost curve.
(c) Over what output range does Mario experience economies of scale?
(d) Explain how Mario uses his long-run average cost curve to decide how many ovens to
rent.

(a)
Labor Output Output Output Output
Plant 1 ATC 1 Plant 2 ATC 2 Plant 3 ATC 3 Plant 4 ATC 4
1 4 43.75 8 34.38 11 34.09 13 36.54
2 8 31.25 12 29.17 15 30.00 17 32.35
3 11 29.55 15 28.33 18 29.17 20 31.25
4 13 30.77 17 29.41 20 30.00 22 31.82
Ovens 1 2 3 4

ATC

Output

(b) LRAC is the envelop of SRACs

(c) Mario experiences economies of scale at output levels of 4 to 15 pizzas a day. When
economies of scale are present, the LRAC curve slopes downward. Mario’s LRAC curve
slopes downward between the output levels of 4 to 15 pizzas a day.
(d) Mario will choose the plant (number of ovens to rent) that gives him minimum average
total cost for the normal or average number of pizzas that people buy.

4
 Chapter 15 Firms in Perfect Competitive Market
Characteristics of Perfect Competition
1. Large buyers and sellers
ð No individual seller can influence the market price by his individual action. (Market price
is determined in the market). Sellers are price-takers in the product market.
2. Homogeneous product
3. Free entry and exit
4. Full information (Firms and consumers are well informed about price)

Market demand and individual demand

P P
Market Individual firm
S

P* P*
DD = MR = AR

D Q q
*
Q
ž The market equilibrium and quantity is determined in the market
ž The demand curve facing the firm is horizontal at the market price
ð The firms are price takers. The demand for his product is perfectly elastic. Products sold
by other sellers are perfect substitute

Firm’s decision in the SR

ž As the market price is given in the perfectly competitive market, a firm need not decide
the price for his goods. Instead, a firm decides how much output to produce to maximize
profit.

TR, TC
TC
Breakeven point TR ž A firm’s objective is to maximum profit.
ž Profit = TR – TC

ž From 0 to q’ and output > q” ® loss

Economic profit ž From q’ to q* ® profit
(TR - TC) is maximized ð q* is the profit maximizing quantity.
q
’ * ’’
q q q
P
MC
ž Profit maximizing condition: MR = MC or P = MC
ž q0 is not the profit maximizing output, since when
output is expanded from q0 to q1, MR from an
DD = AR = MR extra unit is larger than MC.
P*
ž The profit maximization output level is q* and this
firm will take the price of P*

q
q0 q1 q*
5
 To Go on or to Shut down? (SR analysis, i.e. no entry or exit)
P
MC ž TR = P*´ q*
ATC ž TC = ATC ´ q*
AVC ð Total Profit = TR – TC = shaded area
P* DD
Go on if P (or TR) > AVC (TVC)
Shut down if P (or TR) < AVC (TVC)
q
0 q *

P When P > AVC

MC
ATC
ž Go on: TR = 0P*Bq*, TC = 0P1Aq* à Loss = P* P1AB
P1 A
ž Shut down: TR = 0, TC = P0P1AC (TFC) à Loss = P0P1AC
AVC
P* B DD
P0 ž P0P1AC > P* P1AB
C ð Loss if shut down > loss if go on
q ð When P > AVC, the firm should GO ON
0 q*
P When P < AVC
MC ATC
A
ž Go on: TR = 0P*Cq*, TC = 0P1Aq* à Loss = P*P1AC
P1 AVC ž Shut down: TR = 0, TC = P0P1AB (TFC) àLoss = P0P1AB
B
P0
P* DD
C ž P*P1AC > P0P1AB
ð Loss if go on > loss if shut down
ð When P < AVC, the firm should SHUT DOWN
0 q
q*

Firm’s SR supply curve

P MC ž When P < AVC, firms will shut down.
AVC ž A firm’s supply curve in the SR is its MC above minimum AVC.

P*
ž Industry supply curve (SR): The industry supply curve is the
DD
horizontal summation of firms’ SS in SR.

q
q*

SR and LR Equilibrium
ž The market is in both short and long run equilibrium, each firm produces at minimum
efficient scale. (Min LRAC)
P SR:
P Industry
Firm
MC ATC LRAC ž q* is profit maximizing in SR
SI
ž QS (P*) = QD (P*)
ž P = Min ATC
ž Firms earn positive/negative/ 0 profit
P* LR:
ž P* = Min LRAC
D ž Firms earn zero profits
q Q ž q* is profit maximizing in the LR6
q Q*= nq*
*
Firm’s decision in the LR: Entry and Exit
P > ATC and Entry
P Firm P Industry
MC SI
S’
ATC S^
P*
P’
P^
D
0 q Q
^ ^ ^ ^
q q’ q* Q*= n*q* Q =n q
Q’= n’q’
ž Suppose in the SR, the market is in the equilibrium with P* and Q*. In the SR, firms earn
profits.
ð In the LR, as there are profits, some new firms enter into the market
ž Market supply shifts from S1 to S’. New market equilibrium is P’ and Q’. At P’, the
individual firm still earns profit
ž Entry will continue. Market supply will shift from S’ to S^
ð Price will fall to P^. As P^ = Min ATC, no firm can earn any profit
ð In the LR equilibrium, price = P^, each firm produces q^.
ž Note: q^ < q*, n^ > n*

P < AVC and Exit

P Firm P S^
Industry
MC ATC SI

P^
P*

D
0 * qq Q
q q ^ ^ ^ ^
Q =n q Q =n q * * *

ž Suppose in the SR, the market is in the equilibrium with P* and Q*. In the SR, firms suffer
losses.
ð In the LR, as there are losses, some firms leave the market
ž Market supply shifts from S1 to S^. New market equilibrium is P^ and Q^
ð Price will rise to P^. As P^ = Min ATC, no firm suffers any loss or earns any profit
ð In the LR equilibrium, price = P^, each firm produces q^.
ž Note: q^ > q*, n^ < n*

7
Changes in the market (Example: Change in demand)
Firm Industry
P MC ATC P SI’
SI

P*
P*
P’
P’

D’ D
q Q
q’ q* n’q* nq’ nq*
SR: LR:
ð The market price falls to P’ ð Existing firms tend to exit the industry
ð Firm output falls to q’ ð As firms exit, the SI curve shifts left. It
ð Industry output falls to nq’ continues to shift until price returns to P*
ð Firms suffer losses ð Firm output remains at q*
ð Industry output falls from nq* to n’q*.
ð Firms earn zero profits.
Long run industry supply (Identical and constant costs for all firms)
ž In the LR, the market price is P* and firms supply whatever quantity is demanded
Firm Industry
P ATC P
MC
SI
SI’
P’ P’
P*
P* LRSS

D’
D
q Q
q* q’ nq* nq’ n’q*

SR: LR:

ð Demand increases ð New firms enter into the industry

ð The market price rises to P’ ð As firms enter, the SI curve shift right. It continues
ð Firm output increases to q’ to shift until price returns to P*
ð Industry output increases to nq’ ð Firm’s output falls back to q*
ð Firms earn profit ð Industry output increases from nq* to n’q*.
ð Firms can earn zero profits. (n’ > n)

ž The LR supply curve is upward sloping when firms have different costs (P38 of lecture
notes)

8
 Example: Chapter 14 Question 8
The market for fertilizer is perfectly competitive. Firms in the market are producing output
but are currently incurring economic losses.
(a) How does the price of fertilizer compare to the average total cost, the average variable
cost, and the marginal cost of producing fertilizer?
(b) Draw two graphs, side by side, illustrating the present situation for the typical firm and
for the market.
(c) Assuming there is no change in either demand or the firms’ cost curves, explain what
will happen in the long run to the price of fertilizer, marginal cost, average total cost, the
quantity supplied by each firm, and the total quantity supplied to the market.

(a) If firms are currently incurring losses, P < ATC. P > AVC as the firm is producing output. P =
MC if the firms are maximizing profits.
(b) The present situation is depicted in the figure above. The firm is currently producing q1
units of output at a price of P1.
(c) As firms are incurring losses in the SR, there will be exit in this industry in the LR. The
market supply curve will shift to the left, increasing the price of the product. As the price
rises, the remaining firms will increase quantity supplied. Exit will continue until price is
equal to minimum average total cost. Average total cost will be lower in the long run than
in the short run. The total quantity supplied in the market will fall.

9
Example:
Suppose that the U.S. textile industry is competitive and there is no international trade in
textiles. In long-run equilibrium, the price per unit of cloth is $30.
(a) Describe the equilibrium using graphs for the entire market and for an individual
producer.

Now suppose that textile producers in other countries are willing to sell large quantities
of cloth in the United States for only $25 per unit

(b) Assuming that U.S. textile producers have large fixed costs, what is the short-run effect
of these imports on the quantity produced by an individual producer? What is the short-
run effect on profits? Illustrate your answer with a graph.
(c) What is the long-run effect on the number of U.S. firms in the industry?

(a) With no international trade, the market is in long-run equilibrium, Q* = Q1 and P = $30,
each firm produces q1.
(b) With imports at $25, the market supply curve follows the old supply curve up to a price
of $25, then becomes horizontal at that price (red dotted line). Demand exceeds
domestic supply, so the country imports textiles from other countries. The domestic
firms reduce to q2, incurring losses, because the large fixed costs imply that average
total cost will be much higher than the price.
(c) In the long run, domestic firms will be unable to compete with foreign firms because
their costs are too high. All the domestic firms will exit the market and other countries
will supply enough to satisfy the entire domestic demand.

10
 ECON 1220 (Fall 2024)
November 25, 2024 (Tutorial 7)
Chapter 16 Monopoly
Monopoly: Sole seller of a product without any close substitutes
ž A monopolist has market power to choose price instead of taking prices (price setter)
High barriers to entry:
(1) Legal barriers/ government regulation (for example: exclusive franchise or patent)
(2) Monopoly resources: firm owns a significant portion of the key resource
(3) Production process (natural monopoly)

Natural monopoly: a monopoly that arises because a single firm can

supply a good or service to an entire market at a smaller cost than
could two or more firms.

A natural monopoly occurs when there are economies of scale,

implying that average total cost falls as the firm's scale becomes larger.
(ATC is decreasing)

Demand and Marginal revenue of a monopoly

ž Firm demand = market demand
ž MR: extra revenue earned by selling one more units of output
ž MR < P (To sell one more unit, the monopoly has to lower the price of the extra unit as well as
the previous units)
P
P
Loss in revenue = $4
P = a – bQ (Demand curve)
ED>1 TR = PQ = aQ – bQ2
ED =1 16 Gain in revenue = $14 MR = a – 2bQ
14
ED<1 Slope of DD = - b
Slope of MR = -2b
MR DD DD
Q Q MR’s slope is twice of the DD
2 3

Profit maximization
P
MC ž Single price monopoly
Monopoly
profit ž A monopoly determines profit maximizing output by
equating MR = MC and charges a price according the
demand curve.
ATC ž A monopoly never charges a price on the inelastic
PM
portion of demand curve (MR < 0). Since MC is always
positive.
ž Therefore, the monopoly produces QM and set the
price on DD curve at PM
MR DD Monopoly profit (shaded area)
Q ž
QM

1
 Comparing Perfect Competition and Monopoly
1. Behavior: same rule of MR = MC in determining output.
2. Output, Prices and Profit
ž Monopoly does not have a supply curve as he
P (For competitive firms)
S = MC
is not given the price, but chooses the price.
I

ž Monopoly (MR < P) produces less output and

PM
charges higher prices comparing to perfect
PC competition (MR = P).

DD= MB
ž Monopoly earns positive profit and a
MR
Q perfectly competitive firm earns zero profit.
QM QC

3. Surplus and Efficiency

P P
S = MSC MC
CS CS

PM
PC DWL
PS PS
DD = MSB MR DD
Q Q
QC QM QC
ž Competitive equilibrium is efficient: ž Compare with perfect competition, CS
MSB = MSC ¯, PS ­ and Total surplus ¯
ž Total surplus is maximized (CS + PS) ž DWL, since only QM produced

Price Discrimination
ž Identical goods are sold to different buyers at different prices.
ž Price discrimination requires: (1) Resale can be prevented, (2) Different groups could be
separated and identified
ž Price discrimination transfers consumer surplus to the monopolist.
(1) Perfect price discrimination
ž Each consumer is charged exactly what he is willing to pay.
ž All the surplus is captured by the monopolist
ž Quantity increases to the efficient maximizing level of output.
(2) Different prices are charged to different groups of buyers (Two groups with different WTP)
(3) Discriminating among Units of a Good: A firm can charge a higher price for the first units
purchased and a lower price for later units purchased. (Quantity discount)
(4) Others: two-part pricing, tying and bundling, quality discrimination, flat monthly fee

2
Regulating monopoly
1. MC pricing (1st best in terms of efficiency, loss for the firm)
2. AC pricing (2nd best)
3. Regulating by ownership the costs of government regulation
outweigh the benefits.

Example:
Suppose the demand curve is P = 10 – Q and the marginal revenue curve is MR = 10 – 2Q. If the
marginal cost is constant at 4. Find the profit-maximizing monopoly price, output and profit.
Calculate the consumer surplus. Graphically demonstrate the monopoly outcome.
P
The monopoly maximizes profit by equating MR and
10
MC.
10 – 2Q = 4
P* = 7, Q* = 3 P*

Profit = 9
Consumer surplus = 4.5 4 MC

MR DD
Q
Q* 5 10

3
Example: Chapter 15, Question 12
Many schemes for price discriminating involve some cost. For example, discount coupons take up
the time and resources of both the buyer and the seller. This question considers the implications of
costly price discrimination.
To keep things simple, let’s assume that our monopolist’s production costs are simply proportional
to output so that average total cost and marginal cost are constant and equal to each other.
(a) Draw the cost, demand, and marginal-revenue curves for the monopolist. Show the price the
monopolist would charge without price discrimination.
(b) In your diagram, mark the area equal to the monopolist’s profit and call it X. Mark the area
equal to consumer surplus and call it Y. Mark the area equal to the deadweight loss and call it Z.
(c) Now suppose that the monopolist can perfectly price discriminate. What is the monopolist’s
profit? (Give your answer in terms of X, Y and Z.)
(d) What is the change in the monopolist’s profit from price discrimination? What is the change in
total surplus from price discrimination? Which change is larger? Explain. (Give your answer in
terms of X, Y and Z.)
(e) Now suppose that there is some cost of price discrimination. To model this cost, let’s assume
that the monopolist has to pay a fixed cost C to price discriminate. How would a monopolist
make the decision whether to pay this fixed cost? (Give your answer in terms of X, Y, Z and C.)
(f) How would a benevolent social planner, who cares about total surplus, decide whether the
monopolist should price discriminate? (Give your answer in terms of (Give your answer in terms
of X, Y, Z and C.)
(g) Compare your answers to parts (e) and (f). How does the monopolist’s incentive to price
discriminate differ from the social planner’s? Is it possible that the monopolist will price
discriminate even though it is not socially desirable?

(a) The figure shows the cost, demand, and marginal-

revenue curves for the monopolist. Without price
discrimination, the monopolist would charge price
PM and produce quantity QM.
(b) The monopolist's profit consists of the two areas
labeled X, consumer surplus is the two areas
labeled Y, and the deadweight loss is the area
labeled Z.
(c) If the monopolist can perfectly price discriminate,
it produces quantity QC, and has profit equal to X
+ Y + Z.
(d) The monopolist's profit increases from X to X + Y + Z, an increase in the amount Y + Z. The
change in total surplus is area Z. The rise in the monopolist's profit is greater than the change in
total surplus, because the monopolist's profit increases both by the amount of deadweight loss
(Z) and by the transfer from consumers to the monopolist (Y).
(e) A monopolist would pay the fixed cost that allows it to discriminate as long as Y + Z (the increase
in profits) exceeds C (the fixed cost).
(f) A benevolent social planner who cared about maximizing total surplus would want the
monopolist to price discriminate only if Z (the deadweight loss from monopoly) exceeded C (the
fixed cost) because total surplus rises by Z – C.
(g) The monopolist has a greater incentive to price discriminate (it will do so if Y + Z > C) than the
social planner would allow (she would allow it only if Z > C). Thus if Z < C but Y + Z > C, the
monopolist will price discriminate even though it is not in society's best interest.

4
Chapter 18 Strategic Interaction and Oligopoly
ž Oligopoly: a small number of firms producing reasonably close substitutes or identical product
ž Duopoly: oligopoly market with two firms
ž Interdependence: each firm’s profit depends on its actions and the actions of its competitors
(the firm will take competitors’ decision into consideration)
ž Cartel/ Collusion: a group of firms collude to limit output, raise price, and increase economic
profit

Game theory
ž Game theory: a tool for studying strategic behavior when decisions interact
ž A game is characterized by:
- Players: at least 2 players
- Strategies: a plan of all feasible actions of the players
- Payoffs: Payoff of a player depends not only on his own strategy, but also the strategy of the
other player (interdependence)
- Outcomes: players make rational choices in pursuit of their own best interests, given the
action taken by the other player. (Nash equilibrium/ mutually best response)

Prisoner’s dilemma
The story: Ann and Bob have been caught for being suspected of robbing the bank. The police has
no evidence for the robbery, and need one to confess to get a conviction. Ann and Bob are
separated and each told:
If each confesses, then each will get a 10-year sentence.
If one confesses, but the other denies, then he will get 0 year and his accomplice will get 20 yrs.
If neither confesses, then each will get a 1-year sentence for auto theft.

ž Representation of the prisoner’s dilemma in a payoff matrix:

Bob
Confess Deny
Confess 10 years, 10 years 0 year, 20 years
Ann
Deny 20 years, 0 years 1year, 1year

ž Let’s consider Ann,

ð If Ann expects Bob to confess, then Ann should confess. (10 yrs > 20 yrs)
If Ann expects Bob to deny, then Ann should confess. (0 yr > 1 yr)
ð Ann gets a higher payoff with confess than deny no matter what she expects Bob to do. (Confess
is the dominant strategy for Ann). If Ann is rational, she will confess.
ð Similarly, if Bob is rational, he will confess. (Confess is the dominant strategy for Bob)

ž In the prisoner’s dilemma, if both players are rational, they will choose to confess. The
equilibrium for this game is (Confess, Confess) with a payoff of 10 years for each player.
ž We find that the payoff will for both players will be much better {–3, –3} if they both choose
deny, however in the prisoner’s dilemma the NE is (Confess, Confess).

5
ž Nash equilibrium: a pair of strategies such that given the other players chooses their NE
strategies, each player prefers her or his own NE strategy. (best response)
ž When the NE is reached, there is no incentive for any player to deviate from it. No player can
benefit or increase his/her payoff by deviating from the NE.
ž For example, Ann would not deviate if given Bob uses his dominate strategy confess. Deviation
would lower her payoff given Bob stay puts.

Cournot Duopoly
ž Duopoly: two firms competing with each other.
ž Both firms know the market demand and the market price is determined given firm’s choice of
quantity. Firms choose quantities simultaneously and independently
ž The two firms choose quantity to maximize their profit, it is a simultaneously move game and we
could represent the game by a payoff matrix.

ž Cournot Duopoly in equation (Lecture notes P36 – 42)

Example:
The demand function of the market is given by P = 26 – Q, and Q = qA + qB, where P is the market
price, qA and qB are outputs of firm A and firm B, respectively.
Assume that the two firms act simultaneously and independently.
MC = 2 for both Firm A and Firm B

Scenario 1: Cournot equilibrium

Market Demand: P = 26 – (qA + qB)
Firm A Residual demand: P = (26 – qB) – qA, MR = (26 – qB) – 2qA
Firm B Residual demand: P = (26 – qA) – qB, MR = (26 – qA) – 2qB

Firm A maximizes profit by equating MR and MC, that is 2 = 26 – 2qA – qB

Firm A’s Best Response function: qA* = 12 – 0.5qB
Similarly, Firm B’s Best Response function: qB* = 12 – 0.5qB
Solving for the Cournot equilibrium, qA* = qB* = 8, P* = 10. Profit for each firm is 64.

Scenario 2: Collusion/ Cartel (behave like a monopolist)

ž If the two firms collude, instead of maximizing individual profits, they will maximize the total
profit by choosing the total quantity, Q. (just like a Monopolist)
ž The two firms maximize profit jointly by equating MR and MC, which MC = 2

Market demand P = 26 – Q, then MR = 26 – 2Q

MR = MC, 26 – 2Q = 2
Q = 12, qA = qB = 6, P = 14 and Profit for each firms: Pq– 2q = 72

ž However, this Cartel is not stable. We could show that both firms will have incentive to depart
from the collusion. In the end, they will act independently with the equilibrium as in the case of
oligopoly (Cournot equilibrium).
ž In the Cartel, qA = qB = 6. Both firms will have incentive to increase production for a higher profit,
given the other firm follow the cartel.

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Scenario 3: One of the firm deviates
ž Suppose Firm B follows the cartel and produces qB = 6
ð Given qB = 6, Firm A’s best response is qA = 9
ð P = 11, Profit for A = 81 and Profit for B = 54
ð Firm B will also have incentive to deviate from the cartel too.

Scenario 4: Both of the firms deviate

ž If both firm A and B deviate and qA = 9, qB = 9, P = 8
ð Profit for each firm = 54 (In fact, this is also a Prisoner’s dilemma game!)
ð From the above example, we could show that the cartel is not stable, both of them will deviate
and it end up in the Cournot equilibrium again.

ž We could represent this game with payoff matrices as follows.

Firm B
6 8 9
6 72, 72 60, 80 54, 81
Firm A 8 80, 60 64, 64 56, 63
9 81, 54 63, 56 54, 54

ž Given the other firm’s quantity, each firm will choose a quantity which maximizes its profit.
ð By inspecting the best responses, NE is (qA = 8, qB = 8) and profit = 64 for each firm.
ð This game is a prisoner dilemma (why?). The pursuit of self-interest does not promote the social
interest in these games.

Comparing Monopoly, Duopoly and Perfect Competition

ž Monopoly: P = 14, Q = 12, Profit = 72 for each firm
ž Duopoly: P = 10, Q = 16, Profit = 64 for each firm
ž Perfect competition: P = 2, Q = 24, Profit = 0 for each firm

ž Profit: Monopoly > Duopoly > Perfect competition

ž Price: Monopoly > Duopoly > Perfect competition
ž Quantity: Monopoly < Duopoly < Perfect competition
ž Consumer surplus: Perfect competition > Duopoly > Monopoly.

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Example: Chapter 17, Question 7
A case study in the chapter describes a phone conversation between the presidents of American
Airlines and Braniff Airways. Let’s analyze the game between the two companies.
Suppose that each company can charge either a high price for tickets or a low price. If one company
charges $300, it earns low profits if the other company charges $300 also and high profits if the
other company charges $600.
On the other hand, if the company charges $600, it earns very low profits if the other company
charges $300 and medium profits if the other company charges $600 also.
(a) Draw the decision box for this game.
(b) What is the Nash equilibrium in this game? Explain.
(c) Is there an outcome that would be better than the Nash equilibrium for both airlines? How
could it be achieved? Who would lose if it were achieved?

(a) The decision box for this game is:

Braniff
Low Price High Price
Low Price Low profit, Low profit High profit, Very low profit
American
High Price Very low profit, High profit Medium profit, medium profit

(b) Both Braniiff Airways and American Airlines has a dominant strategy to set a low price. The
Nash equilibrium is for both to set a low price.
(c) A better outcome would be for both airlines to set a high price; they would both get higher
profits. That outcome could only be achieved by cooperation (collusion). If that happened,
consumers would lose because prices would be higher and quantity would be lower.