Commerce

172 Review
Managerial Economics


2.1 Supply and Demand

Supply

Supply Curve: Relationship between the quantity of a good that producers are willing to sell and the
price of the good
The higher the price, the more willing and able firms are to produce and sell shift along supply
curve
Other variables affecting supply: production costs (wages, interest, cost of raw materials) shift
of the supply curve itself

Demand

Demand Curve: Relationship between quantity of a good consumers are willing to buy, and price
The lower the price, the more willing and able firms are to buy shift along demand curve
Other variables affecting demand: Income

Substitute and Complementary Goods

Substitute: Two goods for which an increase in the price of one leads to an increase in the quantity
demanded of another

Complement: Two goods for which an increase in the price of one leads to a decrease in the
quantity demanded of the other

2.2 The Market Mechanism

Equilibrium: Price that equates quantity demanded and quantity supplied (price at which the market
clears)

Market Mechanism: Tendency in a free market for price to change until the market clears

Surplus: Situation in which the quantity supplied exceeds the quantity demanded

Shortage: Situation in which the quantity demanded exceeds the quantity supplied
2.3 Changes in Market Equilibrium

When supply shifts right, equilibrium price decreases, quantity increases
Things can be indeterminate if the magnitude of shifts is unknown

2.4 Elasticties of Supply and Demand

Elasticity: Percentage change in one variable resulting from a one percent increase in another.

Price elasticity of demand measures the sensitivity of quantity demanded to price changes. For
one percent increase in price, what happens to quantity demanded.
PED is usually a negative number
PED > 1 elastic (decline in quantity demanded is greater than increase in price)
PED = 1 unit elastic
PED < 1 inelastic
Steeper slope more inelastic

Note: When there are close substitutes, price increases will have a larger effect.

Price Elasticity of Demand:
= (% Change in Q) / (# Change in P)

% Change: Absolute change in the variable, divided by the original level of the variable.

Thus Price Elasticity of Demand can also be written as:
= P/Q (Change in Q/Change in P)

Linear Demand Curve
Elasticities along a linear curve are not the same, it is different at every point as prices and
quantities change.

Infinitely Elastic Demand (slope is infinity)
Principle that consumers will buy as much of a good as they can for a single price, but for any
higher price the quantity demanded drops to zero, while for any lower price the quantity
demanded increases without limit. EX. Indistinguishable goods like paper clips

Completely Inelastic Demand (slope is 0)
Principle that consumers will buy a fixed quantity of a good regardless of its price. EX. Drugs

Income Elasticity of Demand
Percentage change in the quantity demanded resulting from a 1 percent increase in income
= (I/Q) (Change in Q/Change in I)

Cross Price Elasticity of Demand
Percentage change in the quantity demanded of one good resulting from a 1 percent increase in
the price of another
For substitutes the cross price elasticity is positive
For complements the cross price elasticity is negative
= (Pm/Qb) (Change in Qb/Change in Pm)

Elasticities of Supply
Percentage change in quantity supplied resulting from a 1 percent increase in price.
Elasticity is usually positive because a higher price gives producers an incentive to increase
output
Elasticity would be negative when referring to an increase in the price of an input

Point versus Arc (Midpoint) Elasticities

1. Point elasticity: At a particular point on the demand curve
= P/Q (Change in Q/Change in P)
2. Arc elasticity: Price elasticity calculated over a range of prices (when it is unclear what is original
and what is not). It is usually half way between point elasticities (not always). Use only when
two data points are known.
EP = ( / Average Q) (

2.5 Short-Run versus Long-Run Elasticities

Short Run: One year or less
Long-Run: Enough time is allowed for consumers or producers to adjust fully to the price change

Demand
In the short run, an increase in price of gas will not cause substantial decrease in driving. In
longer run, they switch to more fuel efficient cars.
Demand is more elastic in the long run
For durable goods, demand is more elastic in the short run than in the long run because (if a
new car is expensive, I wont buy, however when my old car depreciates I will have to buy)

Income Elasticities
More elastic in long run than in short run because of rising incomes
For durable goods, more elastic in the short run because they must be replaced in the long run

Cyclical Industries
Industries in which sales tend to magnify cyclical changes in gross domestic product and national
income

Supply
Long run supply is much more price elastic than short run supply as firms face capacity
constraints in the short run and the long run enables them to adjust these
Durable goods are more elastic in the short run than in the long run

4.3 Market Demand

Market Demand Curve: Curve relating the quantity of a good that all consumers in a market will buy to
its price (it is kinked as it is an aggregate of individual demand curves)
As more consumers enter market shift right (as well as other factors)

Isoelastic Demand: Demand curve with a constant price elasticity

Speculative Demand: Demand driven not by the direct benefits one obtains from owning or consuming
a good, but instead by an expectation that the price of the good will increase

4.4 Consumer Surplus

Difference between what a consumer is willing to pay for a good and the amount actually paid

Chapter 6

Theory of the Firm: How a firm makes cost-minimizing production decisions and how the firms resulting
costs vary with outut

The Production Decisions of a Firm
1. Production Technology: We need a practical way of describing how inputs (such as labour,
capital, and raw materials) can be transformed into output
2. Cost Constraints: Firms must take into account the prices of labour, capital, and raw materials
3. Input Choices: Given production technology and the prices, the firm must choose how much of
each input to use in producing its output

6.1 Firms and Their Production Decisions

The Technology of Production
Factors of Production: Inputs into the production process (capital, material, labour)

The Production Function
Is the function showing the highest output that a firm can produce for every specified
combination of inputs
Q = F (K,L) given technology held constant

The Short Run and The Long Run
Short Run: Amount of time in which the quantities of one or more factors of production cannot
be changed (fixed input)
Long Run: The amount of time needed to make all inputs variable

6.2 Production with One Variable
When deciding how much of an input to buy, a firm should compare the benefit that will result from the
cost, whoch is often done on an incremental basis to focus on the additional output that results from an
incremental addition to an input. This can also be done on an average basis.

Average Product: = Q/L measures productivity in terms of how much each worker produces on
average
Marginal Product: = Change in Q/Change in L measures productivity of one additional unit of labour

 Marginal product is positive as long as total product increases, then goes

negative when total product begins decreasing.
When the marginal product is greater than the average product, average
product is increasing as each additional worker has a greater output than average,
therefore making the average increase
When the marginal product is less than the average product, the average
product is decreasing
The marginal product must equal the average product at the AP max

APL: Slope of the line drawn from origin to the point on TP curve (output/labour)
MPL: Slope of the tangent of the point on the TP curve

Law of Diminishing Marginal Returns: Principle that as the use of an input
increases with other inputs fixed, the resulting additions\ to output will eventually
decrease


6.3 Production with Two Variable Inputs

Isoquant: Curve showing all possible combinations of inputs that yield the same output
Isoquant map: Graph combining a number of isoquants, used to describe a production function
Isoquants display flexibility, an output can be obtained with a variety of combinations.
There are diminishing marginal returns when one input is held fixed (this is why isoquants are
closer together output diminishes)

Substitution Among Inputs
Marginal Rate of Technical Substitution: Amount by which the quantity of one input can be reduced
when one extra unit of another input is used, so that output remains the same
MRTS is diminishing, as one input is varied relative to a fixed one, its productivity decreases
= -Change in capital input/change in labour input (for a fixed level of q)

Two Special Cases of Production Functions
1. Fixed Proportions Production Function: substitution is impossible, each level of output requires
a specific combination of labour and capital. Additional output cannot be obtained unless more
capital and labor are added. As a result the isoquant is L shaped.
The corner point of L represents the capital and labour necessary
The horizontal and vertical portions of the L have a marginal product of 0

2. Perfect Substitutes as Inputs: Isoquants are straight lines, MRTS is constant as each input can be
perfectly substituted for another

6.4 Returns to Scale
The rate at which output increases as inputs are increased proportionately

Increasing Returns to Scale: Situation in which output more than doubles when all inputs are doubled
This may be due to specialization of tasks
Isoquants are increasingly closer to eachother


Constant Returns to Scale: Situation in which output doubles when all inputs are doubled
As a result it is not the firms size that affects output/productivity of its factors

Decreasing Returns to Scale: Situation in which output less than doubles when all inputs are doubled
Difficulties in coordination with more inputs
Isoquants are increasingly further away from each other

Read Written Notes on Productivity Lag in Canada

7.1 Measuring Cost: Which Costs Matter?

Accounting Cost: Actual expenses plus depreciation charges for capital equipment
Economic Cost: Cost to a firm of utilizing economic resources in production
Opportunity Cost: Cost associated with opportunities forgone when a firms resources are not put to
their best alternative use
Economic Cost = Opportunity Costs

Sunk Costs: Expenditure that has been made and cannot be recovered. Because a sunk cost has no
alternative use, its opportunity cost is 0.

Total Cost: Total economic cost of production, consisting of fixed and variable costs.
Fixed Cost: Cost that does not vary with the level of output and that can be eliminated only by
shutting down. In the long run, most fixed costs become variable.
Variable Cost: Cost that varies as output varies

The only way to eliminate a fixed cost is to shut down.

Marginal and Average Cost

Marginal Cost: Increase in cost resulting from the production of one extra unit of output
= Change in VC/Change in Q = Change in TC/Change in Q

Average Total Cost: Firms total cost divided by its level of output
Average Fixed Cost: Total fixed cost divided by the level of output
Average Variable Cost: Variable cost divided by the level of output

7.2 Cost in the Short Run

When MC is below AC, AC falls

When MC is above AC, AC rises
When AC is at a minimum, MC = AC

Vertical distance between ATC and AVC decreases as output
increases because AFC decreases











7.3 Cost in the Long Run

User Cost of Capital: Annual cost of owning and using a capital asset, equal to the economic
depreciation plus forgone interest

Isocost Line: Graph showing all possible combinations of labor and capital that can be purchased for a
given total cost

C = wL + rK

Read further about Isocosts in October 1st slides/page 245 onwards

7.4 Long-Run versus Short-Run Cost Curves

Long-Run Average Cost Curve: Curve relating average cost of production to output when all inputs,
including capital, are variable

Short-Run Average Cost Curve: Curve relating average cost to output when its level of capital is fixed

Long-Run Marginal Cost Curve: Curve showing the change in long-run total cost as output is increased
incrementally by one unit

Note: The long run average cost curve is U shaped based on increasing and decreasing returns to scale,
whereas the short run is based on diminishing returns to a factor of production

Economies and Diseconomies of Scale: Situation in which output can be doubled for less than a
doubling of cost

Economies of Scale Occur Because:
Firm operates on a larger scale, workers can specialize in activities they are productive in

Firm can acquire inputs at a cheaper cost due to large purchasing volumes

Diseconomies of Scale:
Situation in which doubling of output requires more than a doubling of cost

7.6 Dynamic Changes in Costs The Learning Curve
The idea that management gets more efficient and more knowledgeable as time passes, allowing the
whole operation to become more efficient. They learn to schedule better and order better, for example.

8.1 Perfectly Competitive Markets

1. Price Taking: Each individual firm sells a sufficiently small proportion of total market output, its
decisions have no impact on market price, thus each firm must take the market price as given
2. Product Homogeneity: Price-taking behavior typically occurs in the markets where firms
produce identical, or nearly identical, products. When the products of all of the firms in a
market are perfectly substitutable no one firm can charge a higher price than other, they would
lose the business. EX. Commodities
3. Free-Entry and Exit: Conditions under which there are no special costs that make it difficult for a
firm to enter or exit an industry

8.2 Profit Maximization: Basic assumption

Cooperative: Association of business or people jointly owned and operated by owners for mutual
benefit

8.3 Marginal Revenue, Marginal Cost, and Profit Maximization

Profit: Difference between total revenue and total cost
To maximize the firm selects the output for which the difference between revenue and total
cost is the greatest
Marginal Revenue: Change in revenue increasing from a one unit increase in output (reflects
that greater q can be sold by lowering price). MR is the slope of R
Profit is maximized when marginal revenue = marginal cost (this is where the distance
between revenue and cost curves is the greatest)
MC = change in cost/change in quantity
MR = change in revenue/change in quantity

Demand and Marginal Revenue for a Competitive Firm
The demand curve facing an individual firm is given by a horizontal line as the firms sales will
have no effect on the price. An individual firm can also sell an additional unit of output without
lowering the price.
The demand curve facing an individual firm in a competitive market is both its average
revenue curve and its marginal revenue curve. Along this demand curve, MR, AR, and price are
all equal.
A firms demand curve is downward sloping because consumers buy more wheat at lower prices
Price is determined by the interaction of all firms and consumers in he market, boy by the
output decisions of a single firm

Profit Maximization by a Competitive Firm

Profit Maximization Point = Where MC = P (which is also = MR)

8.4 Choosing Output in the Short Run
Marginal revenue equals marginal cost at a point at which marginal cost is rising

When Should a Firm Shutdown
A competitive firm should shut down when price is below AVC, the firm may produce in the
short run is price is greater than AVC












8.5 The Competitive Firms Short Run Supply Curve
A firm will supply when price is greater than AVC up to the point where price equals
marginal cost. Therefore, the firms supply curve is the portion of the marginal cost curve for
which the marginal cost curve is greater than the average variable cost.
When the price of an input increases, MC shifts to the left, causing output to decrease

8.6 The Short-Run Market Supply Curve
Every individual firms MC curve above the AVC is added together to get an aggregate market
supply curve

Producer Surplus in the Short-Run
Consumer Surplus: Difference between the maximum that a person would pay for an item and
its market price
Producer Surplus: Sum over all units produced of the differences between the market price of
the good and the marginal cost of production

8.7 Choosing Output in the Long-Run
The long-run output of a profit maximizing firm is the point at which long-run marginal cost
equals the price

Zero Economic Profit: A firm is earning a normal return on its investment, it is doing as well as it could
by investing its money elsewhere.

Long Run Competitive Equilibrium: All firms in an industry are maximizing profit, no firm has an
incentive to enter or exit, and price is such that quantity supplied equals quantity demanded

Economic Rent: Amount that firms are willing to pay for an input less the minimum amount necessary to
obtain it. This benefit is include in producer surplus calculations

9.2 The Efficiency of a Competitive Market

Economic Efficiency: Maximization of aggregate consume and producer surplus

Market Failure: Situation in which an unregulated competitive market is inefficient because prices fail to
provide proper signals to consumers and producers
1. Externality: Action taken by either producer or consumer which affects other producers or
consumers but is not accounted for by the market price
2. Lack of Information: Market failure can occur when consumers lack information about the
nature of product and cannot make utility maximizing decisions

Price Ceiling: A price held below the market clearing price. There is a shortage of supply.

Deadweight loss: Area between price and equilibrium

9.3 Minimum Prices read

9.5 Import Quotas and Tariffs

Import Quota: Limit on the quantity of a good that can be imported
Tariff: Tax on an imported good

9.6 The Impact of a Tax or Subsidy
If demand is inelastic, the price increase is usually borne by buyers (mostly)

Subsidy: Payment reducing the buyers price below the sellers price (negative tax)

Final Review

Chapter 10: Market Power: Monopoly and Monopsony

Monopoly: Market that has only one seller but many buyers. Typically offers higher price, lower
quantity.
Monopsony: Market with many sellers, only one buyer
Market Power: Ability of a seller/buyer to affect the price of a good

10.1 Monopoly
Average revenue = market demand curve = price
Marginal revenue has the same y int as demand, but has twice the slope
Output quantity for a monopoly is where MR = MC. Draw the line up from this point and that is
the price level.
Note: Revenue = Price equation all multiplied by Q

Rule of Thumb for Pricing:
P = MC/(1 + 1/ED)
Where Ed must be entered a negative number, relies on the elasticity of the firm
This denominator also indicates mark up. If MC =0, then profit is maximized where ED = -1. If the
firm has an elastic demand curve, then there is still market power, it is just less and the mark up
will be smaller.
Elastic smaller markup. Inelastic larger markup.
If an excise tax is implemented, then the profit maximizing point is where MR = MC + t
For a firm that has multiple plants, the MR = MC1 = MC2
To measure market power, the Lerner index is used, which is represented by (P-MC)/P (always
has a value between 0 and 1), which is also equal to -1/ED

10.2 Monopoly Power

An individual firm faces a demand curve which is more elastic than the market demand curve,
but which is not infinitely elastic like the demand curve facing a perfectly competitive firm.

Sources of Market Power:
Restrictive business practices (high capacity and ability to flood the market)
Patents and IP
Government regulation

Factors that affect a firms elasticity:
1. Elasticity of the market demand: firms own demand will be at least as elastic as market
demand, elasticity of marker demand limits the potential for monopoly power
2. Number of firms in the market: If there are many firms, less impact on price
3. Interaction among firms and existing rivalries: Rivalry moving prices

There is a deadweight loss from monopolies to society

Rent Seeking: spending money in socially unproductive efforts to acquire, maintain, or exercise
monopoly.


If price regulation for a monopoly comes into play, then dead weight loss shrinks. By knowing the
maximum price, monopolies will often charge that, then simply calculate Q.
They will regulate to force to produce where MC equals demand curve in which cse the curve
will likely make a negative profit in which case the monopolist will shit down the firm
So instead, they set the average cost equal to demand meaning they make zero economic return

Natural Monopoly: firm that can produce the entire output of the market at a cost lower than it would
be if there were other firms

Rate of Return Regulation: Maximum price allowed is based on the expected rate of return that the firm
will earn. This is difficult because capital stock is difficult to value and the cost of capital depends on the
regulatory agency.

Chapter 11 Pricing with Market Power

11.1 Capturing Consumer Surplus

Price Discrimination: Charging different prices to different consumers for similar goods.

11.2 Price Discrimination

Reservation price: Maximum price that a customer is willing to pay for a good

First Degree Price Discrimination: charging each consumer his/her reservation price. With perfect price
discrimination, the MR is no longer relevant as prices that are paid are given by the demand curve. Profit
= D MC
There would be zero consumer surplus in the market

Second Degree: charging different prices per unit for different quantities of the same good or service.
First block is a high price, and then it decreases from there.

Third Degree: Dividing customer into two or more groups with separate demand curves and charging
different prices to each. Where Qi and Q2 are chosen so that MR1 = MR2 = MC, or P1/P2 =
(1+1/E2)/(1/1+1/E1)
Horizontal summation of mr curves, then set it equal to your overall marginal cost curve, then
trace left to decide on quantities

Intertemporal Price Discrimination: Separating consumers with different demand functions by charging
different prices at different times (hurdle pricing) new technology is very expensive at first

Peak-Load Pricing: charging higher prices during peak periods when capacity constraints cause MC to be
high. 407. Is different than third degree price discrimination because the MR for different time periods
does not need to be the same. This is because the marginal costs are different during different time
periods.
IF peak load were regulated, they would charge prices where demand curves intersect with MC
rather than where MR intersects with MC

11.4 The Two-Part Tariff
Form of pricing in which consumers are charged both an entry and usage fee

Two Part Tariff: consumers are charged both an entry fee and a usage fee. Set P* = MC, then each
consumer will pay up to maximum, giving the producer the entire surplus. T* = entire CS. If you have
many consumers, there is a trade off between low entry fee and more consumers, and higher fee with
fewer consumers
With two consumers, the profit maximizing usage fee exceeds marginal cost, the entry fee is
equal to the surplus of the consumer with the smaller demand
Usage fee is higher then the marginal cost
Profit is 2T + (P*- MC)(Q1 + Q2)



Bundling: Practice of selling two or more products as a package, and usually includes a less desirable
item. The price should be the sum of the lowest willingness to pay

Tying: requiring customers to purchase one good in order to purchase another

11.6 Advertising

Profit = PQ(P,A) C(Q) A (difference between P0 and average cost)
Advertising is a fixed cost of the firm and thereby causes the average cost curve to rise (MC
remains the same)
MC = MR is the quantity you produce at

One should advertise until the marginal revenue from an additional dollar of advertising just equals the
FULL marginal cost of that advertising (sum of dollar pent on advertising and the marginal production
cost resulting from increased sales the advertising causes).
MRAds = P (Q /A) = 1 + MC ( Q / A)

= Full marginal cost of advertising

Advertising to Sales Ratio: Ratio of a firms advertising expenditures to its sales

Advertising Elasticity of Demand: Percentage change in quantity demanded resulting from a 1%
increase in advertising expenditures

Rule of Thumb for Advertising: (P MC)* ( Q / A) = 1

Which can be re-written as A/PQ = - (EA/EP)
(Advertising to sales ratio should be equal to minus the ratio of advertising and price elasticies
of demand

Profit Maximizing Point of Advertising: ( profit / A) = 0




Or where:
A/PQ = -EA/EP

The higher the markup, the higher the amount spent on advertising
In terms of Ea is high relative to Ep that means you should advertise

Chapter 12: Monopolistic Competition and Oligopoly

Monopolistic Competition: Market in which firms can enter freely, each producing its own brand or
version of a differentiated product

Oligopoly: Market in which only a few firms compete with one another, and entry by new firms is
impeded

Cartel: Market in which some or all firms explicitly collude, coordinating prices and output levels to
maximize joint profits

12.1 Monopolistic Competition
Firms compete by selling differentiated products that are highly substitutable for one another,
but not perfect substitute, like the toothpaste market (Crest and Colgate). The cross price
elasticites of demand are large but not infinite.
There is free entry and exit meaning the demand curve will become tangent with the average
cost curve in the long run
Because there is free entry and exit, the firm may be making a profit in the short run, but in the
long run there is no profit being made, as demand curve shifts leftward. DLR = AC

Should Monopolistically Competitive markerts be regulated? No
Usually the products are such close substitutes that the firms dont have a whole lot of market
power, so any DWL is small
Consumers prefer product diversity, which can be offered by the firms. The market must
therefore be segmented because consumers have product preferences.

12.2 Oligopoly
High barriers to entry, beyond having to simply spend a lot of money. Often firms create strategic
barriers, like flooding the market, price cuts (and matching and cutting even more).

Nash Equilibrium: each firm is doing the best it can, given what its competitors are doing.

Duopoly: Market in which two firms compete with one another

Cournot Model: Each firm treats the output level of its competitor as fixed when deciding how much to
produce. All firms make decisions simultaneously.
This is an unrealistic model as usually more than 2 firms exist and simultaneous decision-making
is uncommon.
Cournot Equilibrium: Equilibrium in the Cournot model in which each firm correctly assumes
how much its competitor will produce and sets its own production level accordingly
This does not maximize industry profit, but helps individual profit. Smaller firms have a greater
proportionate revenue gain.
Smaller firms can really rock the boat by lowering the price, as small firms will only lose a little
while large tend to lose a lot

This can be found by setting the total quantity (Q1 + Q2) = Q, then inputting that value input the
total revenue curve, then differentiating R in terms of Q. Cournot is reached where Q1 = Q2

Reaction Curve: Relationship between a firms profit maximizing output and the amount that it thinks its
competitor will produce (usually using only 2 firms).

Q = Q1 +Q2
P = 30 Q,
MC = 0
R1 = PQ1
=(30-Q)*Q1
= 30Q1 - (Q1 + Q2)Q1
= 30 Q 1 - Q 21 - Q 2 Q 1
MR1 = MC

=R1/Q1

=30 - 2Q1 - Q2

0
1

Q1 = 15 1/2 Q2
Q2 = 15 1/2 Q1

Use substitution If the firms were to collude, keep Q in the equation, then differentiate for MR (or the
slope simply doubles). Next, simply divide the collusion amount by two for the individual firms
production.

Stackelberg Model: One firm sets output before others, and is the leader. First mover advantage. Derive
the revenue function input the followers reaction curve as Q2, derive and set MR to 0, and solve for Q1.
Price competition is avoided whenever possible in an oligopoly as this usually results in lower
profits for everyone. Theoretical explanations include:
o Kinked demand curve
o Dominant firm model (one large firm with a number of fringe firms) Fringe firms will
act as perfect competitors
o Explicit collusion (cartels)

12.3 Price Competition

Bertrand Model: firms produce a homogeneous good, each firm treats the price of its competitors as
fixed, and all firms decided simultaneously which price to charge. Set MC1 = MC2 and where MR = MC
Each firms demand curve is input into their profit equation, and then differentiated to find the
reaction curve. Where the two firms curves intersect is the optimal price.
Firms can collude again to set a higher price by equating their price.

Price Competition with Differentiated Products slide 20

12.4 Competition versus Collusion: The Prisoners Dilemma

Noncooperative game: Game in which negotiation and enforcement of binding contracts are not
possible

Payoff Matrix: Table showing profit (or payoff) to each firm given its decision and the decision of its
competitor.

Prisoners Dilemma: Game theory example in which two prisoners must deices separately whether to
confess to a crime, if a prisoner confesses, he will receive a lighter sentence and his accomplice will
receive a heavier one. If neither confesses, sentences will be lighter than if both confess.

12.5 Implications of the Prisoners Dilemma for Oligopolistic Pricing

Price Rigidity: Firms are reluctant to change prices, regardless of changes in prices in costs or demand

Kinked Demand Curve: each firm faces a demand curve kinked at the current price: at higher prices,
demand is very elastic, whereas very inelastic at lower prices. This is usually why firms will avoid price
competition.

Price Signaling: A form of implicit collusion in which a firm announces a price increase in the hope that
other firms will follow

Price Leadership: one firm regularly announces price changes that other firms match.

Dominant Firm: firm with a large share of total sales that sets the price to maximize profits, taking into
account the supply response of smaller firms.

12.6 Cartels

Cartels: Explicit collusion where they use the monopoly price (MR = MC) and the rest of the world simply
follows that price.
Must agree on price and output which is difficult, if profit is large enough they have incentive to
undercut

Chapter 13 Game Theory and Competitive Strategy

13.1 Gaming and Strategic Decisions

Game: Any situation in which players make strategic decisions

Payoffs: Outcomes that generates rewards or benefits

Cooperative Game: Game in which participants can negotiate binding contracts that allow them to plan
joint strategies
Non-Cooperative Game: Game in which negotiation and enforcement of binding contracts are not
possible
Contracting Possibilities: binding contracts are possible in a cooperative situation, but not in a
noncooperative one

13.2 Dominant Strategies
One that is optimal no matter what an opponent does.

Maximin Strategy: maximizing the minimum gain that can be earned.
Using probabilities to calculate expected payoff for both options might need to be done

Pure Strategy: strategy in which a player makes a specific choice or takes a specific action
Mixed Strategy: Strategy in which a player makes a random choice among two or more possible actions
based on a set of chosen probabilities.

13.4 Repeated Games
Repeated Game: game in which actions are taken and payoffs received over and over again. If it is finite,
they will not cooperate on at least the last time, as they know they will never see one another again. If it
is infinite, they may work together, but its not guaranteed.

Tit for Tat: Repeated game strategy in which a player responds in kind to an opponents previous play,
cooperating with cooperative opponents and retaliating against uncooperative ones.

13.5 Sequential Games
Sequential Games: games in which players move in turn, responding to each others actions and
reactions. (one after the other, tit for tat is simultaneous)

13.6 Threats, Commitments, Credibility
Must publicly commit/threaten something to convince another firm of actions youre going to take.

13.7 Entry Deterrence
Entry Deterrence: convincing potential competitors that entry would be unprofitable. One can
accommodate (maintain price), or engage in warfare (lower price).
There is the possibility that preventing entry may be more beneficial in the long run, even
though there may be short term losses

Chapter 17 Markets with Asymmetric Information

When some parties know more than others.

17.1 Quality Uncertainty and the Market for Lemons

Lemon Problem: Due to asymmetric information, high quality products select out of the market so it is
left with lemons.

Market Failure: Occurs when there is deadweight loss, and only in perfect competition will there be an
optimal outcome, and surplus is maximized. There is market failure in a monopoly.

Adverse Selection: form of market failure resulting when products of different qualities are sold at a
single price because of asymmetric information, so that too much of the low-quality product and too
little of the high quality product are sold. (Lemons/Cars)

17.2 Market Signaling

Market Signaling: Process by which sellers send signals to buyers conveying information about product
quality (i.e. the hiring process and interviews to foresee productivity and save costs of turnover)
Guarantees and warrantees are often put into place in order to avoid buying a low quality
product and being ripped off.

17.3 Moral Hazard

Moral Hazard: When a party whose actions are unobserved can affect the probability or magnitude of a
payment associated with an event (i.e. insurance, and when performing below standard at work when
unsupervised).

17.4
Principle-Agent Problem: Problem arising when agents (i.e. firms manager) pursue their own goals
rather than the goals of principals (firms owner).
Sometimes there is a negative correlation between CEO salary increases and performance

17.6 Asymmetric Information in Labor Markets: Efficiency Wage Theory

Efficiency Wage Theory: Explanation for the presence of unemployment and wage discrimination which
recognizes that labour productivity may be affected by the wage rate

Shirking Model: Principle that workers still have an incentive to shirk if a firm pays them a marketclearing wage, because fired workings can be hired somewhere else for the same wage

Efficiency Wage: Wage that a firm will pay to an employee as an incentive not to shirk

Chapter 18: Externalities and Public Goods

18.1 Externalities

Externalities: Can arise between producers, between customers, or between consumers and producers.
Negative: when the action of one party imposes costs on another party
Positive: when the action of one party benefits another party

The efficient level of output is the level at which the price of the product is equal to the marginal cost
of production plus the marginal external cost of dumping.
MSC = MEC + MC

Marginal External Cost: Increase in cost imposed externally as one or more firms increase output by one
unit

Marginal Social Cost: Sum of the marginal cost of production and the marginal external cost

Marginal External Benefit: Increased benefit that accrues to other parties as a firm increases output by
one unit

Marginal Social Benefit: Sum of the marginal private benefit plus the marginal external benefit
D + MEB

18.2 Ways of Correcting Market Failure

Marginal Cost of Abating Emissions: Measures the additional cost to the firm of installing
pollution control-equipment.
Efficiency is achieved when the marginal external cost of emission is equal to the marginal cost
of abating emissions

Encourage Firms to Reduce Emissions to the socially optimal amount by:
1. Emissions Standard: Legal limit on the amount of pollutants that a firm can emit
2. Emissions Fee: Charge levied on each unit of a firms emissions

Standard versus Fees
With different abatement curves use fees. With a standard, it will force the cost of abatements
to be different which is unfair. The fee structure achieves the same level of emissions at a
lower cost than the equal per-form emissions standard.
Fees give a strong incentive to install new equipment that would allow it to reduce emissions
even further

Tradeable Emissions Permits: System of marketable permits, allocated among firms, specifying the
maximum level of emissions that can be generated

18.3 Stock Externalities
Accumulated result of action by a producer or consumer, which though not account for in the market
price, affects other producers or consumers

18.4 Externalities and Property Rights

Property Rights: legal rules stating what people or firms may do with their property

Coase Theorem: Principles that when parties can bargain without cost and to their mutual advantage,
the resulting outcome will be efficient regardless of how property rights are specified

18.5 Common Property Resources

Common Property Resource: Resource to which anyone has free access

18.6 Public Goods

Public Good: Nonexclusive and non-rival, the marginal cost of provision to an additional consumer is
zero and people cannot be excluded from consuming it. Use vertical summation.

Non-Rival Good: Good for which the marginal cost of its provision to an additional consumer is zero

Non-exclusive Good: Good that people cannot be excluded from consuming, so that it is difficult or
impossible to charge

Free-rider: Consumer or producer who does not pay for a nonexclusive good in the expectation that
others will