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Flashcards in Economics: Microeconomic Analysis Deck (109):

Demand and Supply: Types of Market

  • Factor markets: Factors of production
    • Raw materials, labor, etc.
    • Firms are buyers
  • Product Markets: Services and Finished Goods
    • Firms are Sellers
    • Intermediate Markets: One firm's finished products (components) used in the production of another firm's output.


Demand and Supply: The Demand Curve

QDX = f (Px, I, Py,...)

Quantity demanded is a function of:

  • Price of Px
  • Individuals income i
  • Price of related products (Py)
  • Many other factors may be added

Law of Demand: Typically, quantity increases as price decreases


Demand and Supply: The Supply Function

QSX = f (Px, Cx, ...)

Quantity supplied is a function of:

  • Price of good Px
  • Cost of production Cx
    • Labor cost
    • Material cost
    • Production overheads
    • Technology
    • Many other factors may be added


Demand and Supply: Shifts and Movements

Changes in price (Px) cause movements along the supply and demand curves.


Demand and Supply: Aggregating Demand and Supply Curves

Market supply = aggregate of the supply functions of the firms in the market

The same approach can be used to formulate market demand

Example: 50 firms in the market

  • Supply function: Qs = -250 +2.5Px
  • Market supply = Qs = -(50 x 250) + (50 x 2.5 Px)
  • Qs = -12,50 + 125Px
  • Invert function: Px = 0.008Qs + 100
  • 0.008 = slope coefficient of supply curve


Demand and Supply: Equilibrium Quantity and Price


Demand and Supply: Movement to Equilibrium: Supply > Demand


Demand and Supply: Movement to Equilibrium: Demand > Supply


Demand and Supply: Stable and Unstable Equilibria

  • Stable: Market forces move price and quantity back to equilibrium.
  • If downward sloping, supply curve must cut demand curve from above to reach stable equilibrium.


Demand and Supply: Calculation of Equilibrium

  • Supply function: Qs = -600 + 10Px
  • Demand function: Qd = 3,000 - 15Px
  • Equilibrium: Supply = Demand

-600 + 10Px = 3,000 - 15Px

Solve for Px      Qs = -600 + 10 (144) = 840

3600 = 25Px     Qd = 3,000 - 15(144) = 840

Px = 144



Demand and Supply: Excess Demand and Supply

Supply function: QS = -600 +10Px

Demand function: QD = 3,000 - 15Px


Demand and Supply: Auctions: Common and Private Value

Alternatives to markets for establishing equilibrium prices

  • Common value auction
    • Value of items same for all bidders
    • Bidders do not know value at time of auction
    • Beware: Winner's curse
    • (e.g. mining rights)
  • Private value auction
    • Value of item different for all bidders
    • Maximum bid is that value the item has for the bidder
    • (e.g. antiques auctions)


Demand and Supply: Auctions: Ascending Price and Sealed Bid

  • Ascending Price Auction (English Auction)
    • Bidder must bid higher than previus bid
    • Bids publically disclosed
    • Process continues until no one is willing to bid higher
    • Highest bidder wins and pays bid price (last bid made_
    • (e.g. automobile auctions)
  • Sealed bid auction
    • Each bidder provides one bid
    • All bids remain unknown to other bidders (concealed)
    • Highest bid wins and pays bid price
    • Optimal bid < reservation price
    • (e.g. government contracts)


Demand and Supply: Auctions: Second Price Sealed Bid and Descending Price

  • Second price sealed bid auciton (Vickrey auction)
    • Each bidder provides one bid
    • All bids remain unknown to other bidders (concealed_
    • Highest bid wins and pays price of second highest bidder
    • Optimal bid = reservation price
    • (e.g. stamp collecting [apparently]
  • Descending price auction (Dutch auction)
    • Starts with a price > bidders are willing to pay
    • Reduces price until bidder agrees to pay
    • Bidder normally states quantity
    • Price is then further reduced until all is sold
    • Bidders pay price bid


Demand and Supply: Auctions: Descending Price Auction modified and Noncompetitive bid

  • Descending price auction modified (Modified Dutch Auction)
    • Starts with a price > bidders are willing to pay
    • Reduces prices until bidder agrees to pay
    • Bidder normally state quantity
    • Price is then further reduced until all is sold
    • All bidders pay price of the bidder who wins the last units offered.  Single price to all.
    • (e.g. U.S. Treasuries)
  • Noncompetitive bid
    • Bidders state quantity not price
    • Pay the single price from modified Dutch auction
    • (e.g. U.S. Treasuries)


Demand and Supply: Consumer Surplus


Demand and Supply: Marginal (Opportunity) Cost and Producer Surplus



Demand and Supply: Competitive Equilibrium

  • Equilibrium in a competitive market occurs at the intersection of the industry suply and demand curve
  • The quantity supplied at the equilibrium price equals the quantity demanded at that price.


Demand and Supply: Efficient Resource Allocation

  • Efficient resource allocation occurs at the quantity for which marginal benefit equals marginal cost for the last unit produced and consumed
  • The sum of producer surplus and consumer surplus is maximized at that quantity.


Demand and Supply: Underproduction

Underproduction means producing at a quantity less than equilibrium.  Consumers are willing to pay more than the cost to supply.  MB > MC


Demand and Supply: Overproduction

Overproduction means producing at a quantity greater than equilibrium.   Consumers are willing to pay less than the cost to supplu.  MB < MC.


Demand and Supply: Deadweight Loss

  • Both overproduction and underproduction are examples of inefficient allocation of resources
  • The scale of inefficiency is measured by deadweight loss
  • Deadweight loss is the decrease in total surplus that results from an inefficient level of production


Demand and Supply: Calculating Surplus


Demand and Supply: Price Ceiling (e.g., Rent Ceiling) Chart


Demand and Supply: Price Ceiling

Long-run impact:

  • Long waiting period to purchase
  • Sellers discriminate
  • Sellers take bribes
  • Sellers reduce quality
  • Black market develops (Black market prices > ceiling prices)


Demand and Supply: Price Floors (e.g. Minimum Wage) Chart


Demand and Supply: Price Floor

Long-run effects

  • Excess supply of the good
  • Substitution in consumption away from price of controlled good

Mimumum wage is an example of a price floor

  • Excess supply of labor increases unemployment
  • Producers substitute capital for labor
  • Non-monetary benefits, working conditions, on-the-job training all decrease.


Demand and Supply: Effect of Taxes


Demand and Supply: Actual Incidence of a Tax is Independent of Who Must Pay


Demand and Supply: Actual Incidence of a Tax: Inelastic Demand

  • Inelastic demand: Buyer suffers great burden
  • Actual incidence depends on both the elasticities of supply and demand.


Demand and Supply: Actual Incidence of a Tax: Inelastic Supply

  • Inelastic supply: Seller suffers great burden
  • Actual incidence depends on both the elasticities of supply and demand.


Demand and Supply: Subsidies Lead to Overproduction


Demand and Supply: Quotas Lead to Underproduction


Demand and Supply: Price Elasticity of Demand

As the price of a normal good increases, quantity demanded decreases

  • Elastic demand: Percentage increase in price leads to a larger percentage decrease in quantity demanded
  • Inelastic demand: Percentage increase in price leads to a smaller percentage decrease in quantity demanded


Demand and Supply: Price Elasticity of Demand Charts


Demand and Supply: Factors That Influence Elasticity of Demand


Demand and Supply: Elasticity on a Straight-line Demand Curve


Demand and Supply: Price Elasticity of Demand and Total Revenue

  • Greatest total revenue (P x Q) at the point where elasticity = -1
  • Inelastic range: Price increase will increase total revenue; percentage decrease in quantity demanded > percentage increasei in price
  • Elastic range: Price increase will decrease total revenue; percentage decrease in quantity demanded > percentage increase in price.


Demand and Supply: Income Elasticity of Demand

The sensitivity of quantity demanded to changes in income


Demand and Supply: Cross Price Elasticity of Demand


Demand and Supply: Calculating Elasticities: Price Elasticity of Demand

QDX = 4,000 - 140 PX + .75 I - 300 PY


  • QDX = Quantity demanded of good X
  • PX = Price of good X
  • I = Consumers' average income in $ (normal good; positive coefficient
  • PY = Price of complementary product (negative coefficient)


  • I = $40,000  QDX = 4,000 - 140 PX + 30,000 - 4,500
  • PY = $15      QDX = 29,500 - 140 PX


Demand and Supply: Calculating Elasticities: Income Elasticity


QDX = Quantity demanded of good X 

PX = Price of good X 

I = Consumers' average income in $ (normal good; positive coefficient

PY = Price of complementary product (negative coefficient) 



Demand and Supply: Calculating Elasticities: Cross Price Elasticity of Demand


QDX = Quantity demanded of good X 

PX = Price of good X 

I = Consumers' average income in $ (normal good; positive coefficient

P= Price of complementary product (negative coefficient) 


Consumer Demand: Utility Theory

Explains consumer choice/behavior

  • Preferences based on combination of goods
  • Based on satisfaction
  • Satisfaction measured by utility

Utility function:

  • Utility = U(Q1, Q2, Q3,..., QN)
  • Variables are quantity consumed of goods 1 to N
  • Quantity must be >= 0 for each good
  • Increase in quantity of a good holding all others constant, increae utility (non-satiation)
  • Utility is an ordinal measure.


Consumer Demand: Indifference Curves

  • Consumer is indifference among bundles of goods that lie on the same curve.
  • Indifference curves for 2 goods slope downwards
  • Indifferrence curves are convex
  • Higher indifference curves have more utility than lower ones (ordinal scale)
  • Slope at any point is the marginal rate of substitution (MRS), the rate at which the consumer is willing to exchange until of good X for units of good Y
  • Indifference curves may not cross


Consumer Demand: Indifference Curves Chart


Consumer Demand: Budget Constraints

  • Based on consumer income and the price of 2 products
  • Budget line shows all combinations of both goods that wille exhaust consumer's income.


Consumer Demand: Consumer's Equilibrium Bundle


Consumer Demand: Substitution and Income Effects

Price of Good X decreases

  • Substitution effect always shifts consumption to more of Good X
  • Total expenditure on the original bundle is now less than full income (budget line shifts)
    • Normal goods: Income effect increases consumption of Good X
    • Inferior goods: Income effect decreases consumption of Good X

Giffen good: Negative income effect > positive substitution effect


Consumer Demand: Veblen Good

  • Higher price increases desirability
  • Increase in price: Increase in status
  • High end designer / luxury goods
  • Positively sloped demand curve for some individuals (within a range)
  • Not supported by the rules of consumer choice.


The Firm: Economic Profit

  • Accounting profit is net income

accounting profit = revenue - explicit costs

  • Economic profit = acccounting profit - implicit costs

implicit opportunity costs = 

return on owner capital

+ opportunity cost of owner's time

  • Normal profil when economic profit = 0
  • Effect on equity values.


The Firm: Economic Rent

Economic rent - when supply is inelastic



The Firm: Price and Marginal Revenue-Perfect Competition


The Firm: Price and Marginal Revenue-Imperfect Competition


The Firm: Factors of Production

  • Land 
  • Labor 
  • Capital
  • Materials

Often we simply use Labor (L) and Capital (K)


The Firm: Production Function


The Firm: Total Costs for the Firm


The Firm: Costs per Unit of Output


The Firm: Breakeven and Shutdown


The Firm: Economies and Diseconomies of Scale


The Firm: Breakeven and Profit Maximization


The Firm: Profit Maximization - Perfect Competition: P > ATC


The Firm: Profit Maximization - Perfect Competition P < ATC


The Firm: Profit Maximization - Imperfect Competition

Profit is maximized at the Output for which marginal cost = marginal revenue.


The Firm: Profit Maximization in the Long Run

  • Under perfect competition, the market price will be P2 in the long run as firms move to minimum efficient scale.


The Firm: Decreasing Cost and Increasing Cost Industries


The Firm: Total, Marginal, and Average Product


The Firm: Marginal Product


The Firm: Marginal and Average Product


The Firm: Cost and Product Curves


The Firm: Profit Maximizing Input Amounts

Marginal revenue product (MRP) is the addition to total revenue from selling the addiitonal output (MP) from employing one more unit of input.

As each extra input is added, output increases but at a decreasing rate (diminishing marginal returns)

To maximize profits, use additonal amounts of an input until MRP = unit costs.

Labor: Hire more worker until MRPL = wage.


The Firm: Minimizing the Cost of Production


Market Structures: Characteristics of Market Structures



Market Structures: Perfect Competition

Firms in perfect copetition are price takers

  • No influence over market price
  • "Take" the equilibirum market price given


  • Homogenous product
  • Large number of independent firms; each small relative to the total market
  • Perfectly elastic demand curve
  • No barriers to entry or exit
  • Supply and demand determine market price


Market Structures: Perfect Competition - Short-Run Profit to a Firm


Market Structures: Perfect Competition - Equilibrium


Market Structures: Firm vs. Industry Short-Run Supply Curves


Market Structures: Short-Run Increase in Demand

In the long run new firms:

Will enter the industry when profits > 0

Will exit the industry when profits < 0


Market Structures: Effects of a Permanent Increase in Demand


Market Structures: Costs and Output - Problem


Market Structures: Monopolistic Competition

  • A large number of firms in industry
    • Each firm has a small market price
    • Concerned about average price
    • Collusion not possible
  • Firms produce differentiated products (close but not perfect substitutes
  • Relatively elastic demand
  • Firms compete on price, quality, and marketing
  • Low barriers to entry


Market Structures: Monopolistic Competition Charts


Market Structures: Monopolistic Competition - Potential Allocative Efficiency

  • Firms face downward sloping, highly elastic (flat) demand curves
  • Potential allocative efficiency is not clear
    • Social cost of not producing where P = MC
    • Long-run average cost is not minimized
    • Excessive advertising may take place
    • Fewer producers could be more efficient
    • However, increased product diversity has positive value to consumers


Market Structures: Efficiency of Monopolistic Competition

Brand names provide signals about quality

Product innovation and differentiation has value to consumers

Advertising provides valuable information to consumers

  • High advertising expenditures increase fixed costs and total costs
  • If advertising greatly increases sales, ATC can decline because AFC fall



Market Structures: Monopolistic Competition vs. Perfect Competition

Excess capacity: Q < efficient quantity

Markup: P > ATC


Market Structures: Oligopoly Characteristics

  • Small number of sellers - downward sloping demand
  • Firms' demand curve less elastic than monopolistic competition
  • Interdependence among competitiors and their deman curves
  • Significant barriers to entry (e.g. scale of operations)
  • Products may be similar or differentiated


Market Structures: Kinked-Demand Model - Oligopoly

Kinked Demand Curve

  • Competitors will not follow a price increase
  • Competitiors will follow a price decrease
  • Models gives a discontinuua marginal revenue curve (gap)
  • Model does not specify what determines the market price Pk


Market Structures: Nash Equilibrium

Choices of all firms are such that no choice makes any firm better off (increases profits or decreases loss)

Strategic games model the best choice for a firm depending on the actions and reactions of competitors


Market Structures: Cournot Model

  • Duopoly model (Can be extended for more than two firms)


  • Homogenous product
  • Firms have market power (quantity will affect price)
  • Both firms determine profit maximizing quantity assuming the other firm will not change its quantity (no retaliation)
  • Firms choose quantities simultaneously
  • Both firms have identical and constant marginal costs of production


Market Structures: Cournot Model Conclusions

  • Quantities produced by both firms change each period until they are equal (remember both firms are identical)
  • Both firms will choose Nash equilibrium output levels
  • Market price will be lower than monopoly
  • Market price will be higher than perfect competition (marginal cost)
  • As more firms are added, market price moves towards marginal cost


Market Structures: Oligopoly Profits with Collusion


Market Structures: Prisoners' Dilemma and Oligopoly

  • Oligopoly firms can earn a greater profit if they collude, fix industry output at the monopoly (profit maximizing) quantity, and share the profits.
  • Game theory suggests that if competitors cannot detect cheating, they will choose to violate the collusion agreeement and increase output


Market Structures: Nash Equilibrium and Oigopoly

Collusion will be more successful with:

  • Fewer firms
  • Homogenous products
  • Similar cost structures
  • Certain and severe retaliation for cheating
  • Little competition from firms outside the agreement


Market Structures: Dominant Firm Oligopoly

  • One dominant firm is the low cost producer
  • Dominant firms produces most of the output
  • Dominant firm essentially sets market price P


Market Structures: Monopoly Characteristics

Barriers to entry

  • Economies of scale (natural monopoly)
  • Government licensing and legal barriers
  • Resource control

A single price monopolist faces downward sloping demand and must reduce price to increase sales; the, marginal revenue is less than price

Price settitng strategies:

  • Single-price, price discriminarion


Market Structures: Monopoly Costs, Price, Revenue


Market Structures: Price Discrimination

  • Must have two identifiable groups with different demand elasticities
  • Must be able to prevent resale between groups


Market Structures: Perfect Price Discrimination is Efficient

  • Charge each consumer the maximum the consumer is willing to pay for each unit
  • No deadweight loss
  • Produce same quantity as perfect competition
  • No consumer surplus; entire surplus goes to producer


Market Structures: Monopoly vs. Perfect Competition


Market Structures: Natural Monopoly

Significant economies of scale

ATC declines as output increases

Often high fixed costs industries

Marginal cost tends to be low

Example: Utilities


Market Structures: Regulating Monopolies

  • Average cost pricing → reduce price to where ATC intersects the market demand curve
    • Increases output and social welfare
  • economic profit = 0
  • Marginal cost pricing → reduce price to where MC intersect the demand cure (MC = price)
    • May lead to a loss, require a government subsidy if MC < ATC


Market Structures: Natural Monoplies


Market Structures: Monopoly Market - Problem


Market Structures: Firm's Supply Function

Perfect Competition:

  • MC Curve above average variable cost
  • Market supply - sum of suppply of market participants

Monopolistic Competition, Oligopoly, Monopoly:

  • No well defined supply function (can't construct quantity supplied as a function of price)
  • Supply driven by intersection of MR and MC; price is then determined by the demand curve


Market Structures: Pricing Strategy

  • Perfect Competition: Price = MR = MC at profit maximizing output quantity
  • Monopoly, Monopolistic Competition: MR = MC at profit maximizing output quantity; price determined by downward- sloping demand curve; P > MR
  • Oligopoly: Optimal pricing stategy depends on how other firms are expected to react
    • Kinked demand curve
    • Dominant firm
    • Game theory
    • Collusion


Market Structures: Identifying Market Structure

  • Regression analysis: Cross sectional  

  • Requires substantial data gathering 

  • Using slightly different measures of the independent variables yield dramatically differing results

Price Elasticity of Demand

  • Inelastic may indicate market power (monopoly)
  • Analyst must estimate both demand and supply functions

Estimating Price Elasticity

  • Regression analysis : Time series
  • Rquires a large number of observations
  • Market structure may have changed significantly over the period (coefficient instability)



Market Structures: N- Firm Concentration Ratio

Sum of the percentage market shares of the N largest firms in an industry. Advantage: Simple

Market share = firms sales/total market sales

  • N-firm ration near 0% perfect competition
  • Lower ration indicate competitive market; higher ratios indicate oligopoly
  • N-firm ratio = 100% for monopoly


  • Ignores barriers to entry
  • Largely unaffected by mergers


Market Structures: Herfindahl-Hirschman Index (HHI)

HHI = sum of squared market shares of N largest firms in a market

  • Very low in a market with perfect competition
  • approx = .1 to .18 moderately competitiove; .18+ uncompetitive market
  • 1 = 100% for a monopoly


  • More sensitive to mergers than N-firm ratio
  • Widely used by regulators


  • Ignores barriers to entry
  • Ignores demand elasticity


Market Structures: Types of Markets Problem