Principles of Microeconomics - Semester 2 key terms

Conditions for Price discrimination:

1. Sellers must be price makers

   1. Must be able to influence market price / price-setting power

2. Buyers must be different and sellers must be able to identify

   1. Market differentiation / distinguish consumers

3. Consumers must NOT be able to participate in arbitrage

   1. Cannot - buy at low and sell to buyer who would have paid a high price

Characteristics of market structure:

Market structure: A structure that refers to characteristics of a market that may affect trades

Characteristics:

• n. and size of sellers (firms)

• Barriers to entry

• Product differentiation

• n. and size of buyers (individuals)

  • Assumption market = product market

Perfect competition:

• Extreme on the competition spectrum, with unrealistic assumptions with few IRL examples

• However, agricultural and financial markets are close.

Rules of perfect competition:

Rule 1: Marginal output rule	Rule 2: Shutdown
MR = MC, prevent shut down	Shutdown if p < AC
MR > MC, then P increases (^ = TR - TC)	SR: p < AVC 😟
	LR: p < LRAC 😟

Assumptions of Perfect competition

• Buyers = Price Takers

• Complete information

• Sellers = Price Takers

• All firms have no market power

• Free entry (L-R decision)

  • capital —> employ —> Q rises

Characteristics of perfect competition:

• Many small sellers

• Low B2E

• Undifferentiated products

• as output is a small fraction of total industry output

• Firms do not actually compete with each other e.g. Essex and Somerset farmers

LR EQ of Perfect competition:

• Occurs when firms earn zero profit at the break-even price

• Change due to factor variability and low barriers to entry

• Sellers and buyers produce or purchase as much as the other desires

  • TF, sellers make NP in the LR

• Third condition - Incumbent sellers stay and potential sellers do not enter

• No incentive to enter or leave the industry as they break even and can invest elsewhere

Assumptions of a Monopoly:

• Buyers are PT and complete information

• Monopolist = Price maker with price setting power

  • Seller sells more with lower price

  • Seller’s output choice does not trigger a reaction from competitors

• Entry is BLOCKED; legal, structural or strategic B2E

Monopoly market structure:

• One large firm

• High B2E and differentiated products

• Opposite of PC which include many small firms, low B2E and undifferentiated product

Monopoly EQ

• Q* along the AR curve and the AC curve

• Pm = monopolist price

• SNP at Qm, MC through minimum of AC

• Produces on the elastic part of the demand curve

Positive MR —> TR rises with extra Q unit, elasticity > 1

Negative MR —> TR falls with extra Q unit, 0 < e < 1

Monopoly vs perfect competition:

Monopoly is worse in terms of total welfare (PS + CS) than PC on the consumer

Consumer surplus: different between demand curve and the price (above P*)

Producer surplus: difference between price and supply curve (below P*)

• Producer surplus has increased (compared to usual CS PS diagram),

• Consumer surplus has decreased

• DWL has arisen

• Lower quantity and higher price

• Total welfare has fallen compared to under PC

Monopoly inefficiency:

Monopolies are allocatively inefficient as consumer surplus is lower than perfect competition and there is no incentive to reduce price

• This creates DWL

• The firm does not maximise producer and consumer surpluses

First-degree price discrimination:

• Sellers charge each buyer the max price the buyer is willing to pay

• Another unit is sold at a lower price so TR increases but there is no marginal forthcoming decline of price level due to PD. MR = AR

  • TR = p = AR

e.g. Miss Rich is willing to pay £40 for the first unit and £20 for the second unit

• would be charged both these prices for both these units

• Unlikely in the real world, but an important foundation

First-degree price discrimination and welfare diagram:

• Produces at the same point of Perfect Competition

• NO DWL or CS; this is because every consumer is charged at their max willingness to pay and thus reap no additional benefit

• Monopolist changes different prices for each unit sold

• Produces more than what it would if it couldn’t price discriminate

Third-degree price discrimination:

• seller can identify groups of buyers and differ prices charged

  • Grouped by characteristics e.g. students / non-students

  • Grouped by location e.g. HIC vs LIC

• Marginal costs increase in output

• Must be able to identify markets, keep them separate and maintain different prices, whilst also preventing arbitrage

Third-degree price discrimination diagram:

• Market X and Market Y differ depending on level of demand

• Summing MRx and MRy gives the total market MR curve

  • intersecting with MC —> Pmax and draw line across, then connect to x axis

• Market X - charged higher price with more inelastic demand

• Market Y - charged lower price with more elastic demand

• Total = Market X + Market Y

• CS = positive, higher than first degree

• DWL where prices > MC

• price lies between two groups

Second-degree price discrimination and linear / non-linear tariffs

A seller can use a menu of “non-linear tariffs” to get buyers to reveal preferences when they select their preferred tariff

Linear tariff: same price charged for every unit sold

• 25p per minute for phone calls

Non-linear tariff: average price per unit changes

• £10 per month and 5p per minute

Characteristics of Monopolistic Competition:

• many sellers in competition

• price-setting power

  • Seller can raise price and not lose all its sales

• low barriers to entry

• differentiated products / imperfect substitutes

  • horizontal: same quality, diff tastes

  • vertical: quality differs, same tastes

Assumptions of Monopolistic Competition

• buyers are price takers

• complete information

• Sellers are price makers

  • Sells more with lower price

  • Does not trigger a rival reaction if Q changes

• Free entry - LR entry has no incurring costs; LR decision (FoP)

Pub example of symmetric sellers in Monopolistic competition:

Symmetric demand:

• 4000 people who go to 40 pubs

• at market price, each pub would have 100 people

+10 pubs with constant pubs

• Each pub would have 80 regulars (4000 / 50 pubs)

• Incumbent lose 20 people to entrants

Short-run Equilibrium for Monopolistic Competition

• R EQ is just price maker

• AVC on y axis is correlating to Q*

• demand is down-sloping in the market with EQ

• more sellers —> less buyers so EQ price falls, thus shifting along demand curve

• demand curve shifts to the left (ARn1)

• MR curve shifts to the left (MRn1)

• New Q (p1n1) and price (p1)

• This means price falls and AVC rises

Long-run equilibrium of Monopolistic Competition:

• All factors variable and other sellers can freely enter

• Sellers make Normal profit in the LR

• In the LR, cost curves are flatter

• Firm is more efficient as costs fall

• firms will enter the market until LR profit is zero

  • P (LR) = AR (LR) = LRAC

• LR price = Where MR and MC in the LR intersect to meet the AR curve

• Zero economic profit

PC vs MC vs Monop:

Feature	Perfect Competition	Monopolistic Competition	Monopoly
1. Output rule	MR = MC	MR = MC	MR = MC
2. Short-run profits?	Supernormal	Supernormal	Supernormal
3. Price taker?	Yes	No	No
4. Price	Equals MC	Above MC	Above MC
5. Efficient output?	Yes	No	No
6. Number of firms	Many	Many	One
7. Entry in long run?	Yes	Yes	No
8. Long-run profits?	Normal	Normal	Supernormal

Dominant strategy:

The strategy that provides a player with the highest payoffs, regardless of an opponent’s strategy

Nash Equilibrium:

There is no dominant strategy equilibrium

• When no player can do better than their chosen strategy, given their beliefs of how the other players will play

1. Best response against opponent conjecture

2. Conjectures must be correct

Nash here is 5,5 (double underline)

Subgame perfect nash equilibria:

Subgame perfection is a refinement on the Nash equilibrium that allows us to make better predictions for sequential move games It requires there to be a Nash equilibrium in every “subgame”

Subgame perfect nash equilibria example:

1. A + UP —> B + Right (16,12)

2. A + Down —> B + Left (14,14)

3. A would go up

4. Nash Equilibrium is Up, Right

Correct conjectures

Assumptions of Oligopoly:

• A1 Buyers are price takers + A2 complete information

• A3 Sellers = Price makers ; downward sloping demand curve, as well as output choices triggering a reaction from its rivals

• A4 Entry is BLOCKED; SR and LR

Cournot’s model of Oligopoly (specific assumptions):

• A1 two sellers (duo-polists)

  • they choose the level of output to produce and make simultaneous decisions

• A2 further entry is blocked to sustain the number of firms

• A3 Homogenous products (for simplicity)

• A4 the market’s inverse demand = P = a - Q

  • P = market’s inverse price

  • a = intercept of the inverse D curve

  • Q = total amount of output in the market

  • a > 0

  • e.g. if Firm A produces Qa + B produces Qb then Q = Qa + Qb

    • P = a - Qa - Qb

Firm A residual demand curve in Cournot’s Oligopoly Model:

• the RDC = Firm’s demand curve, given the rival output (market demand that its rival has not supplied)

• Firm A believes Firm B will produce QB1

  • A output = zero —> MP = Pb

  • A output = Q1-Qb1 —> MP = P1 (what is left by B is produced)

  • A output = Q2 - Qb1 —> MP = P2 (what is left by B is produced)

  • Match each point on Firm A’s diagram and connect to create the residual demand curve

How to find Firm A’s best response, given Firm B’s output —> Pmax under Cournot’s Nash Equilibrium:

• Assume B will produce Qb1 —> shift-in by QB1 (MD - rival output) —> DR1

  • Find MRr1 curve as usual

  • Cross over with MC for A ; MCa

  • price = PA1

1. Firm A believes what output B will produce

2. Establish residual curve

3. Shift curve by rival output

4. Determine P-max

Constructing best response functions:

1:

1. Firm B output = zero, so there is no rival output

   1. Best response = to produce at monopoly level

   2. Qm (on output axis)

2:

1. Firm B output = QB1, so subtract QB1 from market demand Dm to find what’s left

   1. best response = produce at Qa1, where MCa meets MRa1 (profit max)

   2. Qa1 on output axis

3:

1. Firm B produces Qb2, complete rival output

   1. best response = produce zero at Qa2

   2. Qa2 on y-axis (where output is zero and price is high); same point where Dm meets y-axis

Cournot’s Nash Equilibrium diagram:

Nash equilibrium consists of two output levels,

1. Given that Firm B produces Q*b, Firm’s A profit is maximised by producing Qa

2. Given that Firm A produces Q*a, Firm B’s profit is maximised by producing Qb

• To solve for the Nash equilibrium, we must find the firms’ best responses!

• Ra = Firm A’s best response —> Pmax

• Rb = Firm B’s best response —> Pmax

• A duopolist’s output level is determined by the marginal output rule

We need to find each duopolist’s MR curve from their D curve

Comparisons of Cournot Oligopoly to Monopoly and Perfect Competition

• Perfect competition, MCA and MRM

• Monopoly still has higher price

Bertrand’s model of Oligopoly Assumptions:

1. two firms, duopolists, simultaneous price-setters

2. entry is blocked

3. Firms have the same constant MC, c, and no fixed costs

   1. increasing MC is upward curve, whilst constant is where MC = AC

4. Homogenous products, not differentiated

   1. buyers purchase cheaper good

5. Market demand is: Q = a - P

   1. Q = TD when lowest price is P, where a > 0

   2. If Firm A sets Pa below Firm B’s price of Pb, Q = a - Pa If Firm A sets Pa above Firm B’s price of Pb, Q = a - Pb

How to construct Bertrand best response function:

1. Set first point where P1 = Q1 as Firm A believes Firm B will set the same price

2. Find the residual demand curve which is DR, according to Firm A’s demand

3. Find points of Pmax which are Qa1 and Pa1, where MR crosses MC and complete

4. To create best response function, draw corresponding price diagram using 45 degree line (as both are simultaneous) and correlate Pm (from step 2) and the believed B price at b1

5. New scenario - Firm B price is below, same thing correlate Pb2

6. Correlate dots on Firm A best response function

7. Draw the inverse for Firm B on the best response function diagram

Thus this is the Bertrand-Nash EQ; where the two firm’s best responses intersect

Comparing Bertrand Nash EQ with Monopoly and PC in terms of price and welfare:

• Duopolists set a lower price than the monopoly

• Duopolists set the same price as the MP of PC and there is no DWL, maximised welfare

Bertrand Paradox and its 4 solutions:

Bertrand Paradox

• Suppose there is one firm (monopolist) —> high P

• One firm enters and sells identically, setting price under PC

• We go from Extreme of Monopoly —> Extreme of PC???

Solutions:

• Product differentiation

  • sellers don’t lose all of their customers when prices are higher

• Capacity constraints

  • controls residual demand if control supply

• Incomplete information

  • lower prices cannot attract if those are unaware

• Repeated interaction

  • less intense competition

Bertrand and Cournot Pure Strategy Nash Equilibrium, and similarity to the Prisoner’s Dilemma:

• Betrand - Pure Strategy Nash Equilibrium:

  • Equilibrium E where Firm A price = Firm B price

  • Collusion:

    • Both firms could collude and set higher prices where Pm= PM

    • This goes from HB VA —> VB HZ

      • Incentive to deviate

        • e.g. firm could increase onto its best response function —> Pmax (purple) and vice versa

• Cournot - Pure Strategy Nash Equilibrium

  • Equilibrium E where Firm A price = Firm B price

  • Collusion:

    • both firms could restrict output (half) where Qm/2 = Qm/2, they share Monopoly profits and both are in equal positions

      • Incentive to deviate

        • e.g. firm could pr

Conditions necessary for Oligopolists to collude:

1. Sellers must interact repeatedly

   1. Incentive to deviate must be counteracted by a credible L-T punishment, usually a price war (period of low prices)

2. Sellers must have complete information of each other’s strategies

   • if they are not aware, then a price war cannot be threatened

Infinite Prisoner’s Dilemma:

• The one-shot Nash Equilibrium (if played ONCE), is (deviate, deviate)

  • Both earn (75.75)

• Cooperation —> 150,150 to benefit, but both would have an incentive to deviate to earn 200 instead of 150, at the expense of the other firm .

  • Is (cooperate, cooperate) a Nash Equilibrium of the repeated game?

Grim trigger strategy in collusion:

• Each firm will cooperate, as long as the other has always done so

• If a player deviates, both firms revert to playing the one-shot Nash equilibrium (deviate, deviate)

• Punishment - price war forevermore.

Calculating present value of future payoffs:

Having £100 today =! £100 in the future:

• in one period the future, assume r = 0.05 (IR), so £100 —> £105

Having £100 in one period’s time equivalent to today:

If £X is invested

X + (X x 0.05) = X (1 + 0.05) or X x 105%

X (1 + 0.05) = 100

X = 1 / 1.05 (100) = 95.24

£100 tomorrow is equal to δ(100) today where δ = 1 / (1+r)

Having £100 in two period’s time equivalent to today:

If £X is invested

X (1+0.05)^2 = 100

X = 1 / (1.05)^2 x 100 = 90.71

£100 day after tmrw = δ^2 (100) today, where δ = 1 / 1+r

Formula here: X = (1 / (1+r)^t )) x 100 = δ^t x 100

X = (1 / (1+r)^t )) x 100 = δ^t x 100

Expected presented discounted value of this stream of payoff =

X (δ + δ^2 + δ^n + …..) =~ X δ / (1-δ)

period 1 = X x δ = Xδ

period 2 = X x δ^2 = Xδ^2

period n = X x … = Xδ^n

Expected present discounted value of this stream of payoff =

X (δ + δ^2 + δ^n + …..) =~ X δ / (1-δ)

If you sub δ = 1 / (1+r), then Xδ / (1-δ) = X /r

Factors of production, units and cost to firm:

• Labour: people available for employment —> output

  • Units: n. people, work hours

  • cost to firm: wage, salary

  • Variable in SR

    • LR - capital can replace it

• Capital: machines and equipment used by labour to produce output

  • units: n. machines, tools, factories

  • cost to firm: rent, price

• Land: site of production

Supply of labour by an individual:

Two main costs: sacrificing leisure and unappealing work / high disutility

Substitution effect:

• Higher wages —> more hours worked; greater OPPC of leisure

Income effect:

• Higher wages —> afford more leisure time

Supply of labour (to an employer and the market):

• Employer wage taker —> perfectly elastic supply curve

• Employer wage maker —> upward sloping supply curve

  • market labour supply curve

  • shifts caused by: # qualifications, NW benefits, cost of jobs (S’ —> S)

Responsiveness level to change in wages depends on:

• difficulty to change jobs

• LR or SR

Wages will rise more with demand if supply is more inelastic

Marginal Revenue Product of Labour (MRPL):

The change in TR revenue due to employing one more unit of labour

Marginal Cost of Labour (MCL):

MCL is the change in TC due to employing one more unit of labour

Relation between marginal input rule and marginal output rule:

(1) Marginal input rule: so long as the firm does not shut down, a buyer should employ the number of units of labour where

<aside> 💡

*marginal revenue product of labour) MRPL = MCL (marginal cost of labour)

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• MRPL: The change in TR due to +1 unit of labour

• MCL: The change in TC due to +1 unit of labour

• MRPL > MCL —> +1 unit —> TR increase > TC increase

(2) Relation to the Marginal output rule:

<aside> 💡

MRPL = MR x MPPL (MR x Marginal physical product of labour)

</aside>

MRPL = MPPL x MR = MC

MR = MCL / MPPL = cost of extra UoL / n. units it produces (extra cost of producing one of those units of output)

Therefore, Marginal input rule and Marginal output rule are effectively the same

Assumptions for perfectly competitive labour markets:

• A1 Buyers of labour (firms) operate in a perfectly competitive output market

  • Can sell as much as they want at current price without affecting price, p = MR

  • MRPL = MR x MPPL = p x MPPL

• A2 Buyers of labour are wage takers in the labour (input) market

  • Can employ as much as they want at current wage rate without affecting wage rate, MCL = w

• A3 Complete information

  • Workers are aware of available jobs and their conditions

  • Employers know quantity of available labour and productivity level

• A4 Workers are wage takers

  • Cannot influence market price

    • Can supply as much labour at a given wage

    • Choice —> NO reaction from other workers

• A5 Free entry for workers

  • No incurring costs, movement restrictions, no union barriers

  • Takes time and entry = LR

Characteristics of perfectly competitive labour markets:

• Many small sellers (workers)

• Low barriers to entry

• Undifferentiated seller substitutability

• Many small buyers (firms)

Pmax position for an individual firm in the labour market:

• same curve shape as MPPL curve

• Pmax = I* and W* intersected

• Surplus is where quantity is above wage bill; any quantity before I* > wage bill, so below Pmax

• if output price falls; MRPL1 shifts down to MRPL

  • I1 shifts left to I2,

SR EQ in the Labour Market:

• Buyers choose optimal employment levels

• Sellers choose optimal supply levels

• Sellers supply as much as buyers want to purchase

Product market price is determined by S&D

Market wage is determined by market S&D

Seller’s output is determined seller-specific S&D

Monopsony assumptions:

Assumptions

• Perfectly competitive

• Complete information

• Workers = wage takers

• Free entry

A2 - the firm is a wage maker in the labour market; can influence the wage at which it employs labour

Monopsony market characteristics:

• undifferentiated workers

• complete information

• Workers are equally productive and buyers and sellers are fully informed

• Many small sellers (workers)

• One large buyer (firm)

Equilibrium under Monopsony and diagrammatic analysis:

+1 unit:

• another unit is employed at wage w, TCL increase w

• all other units are employed at a slightly higher wage, so TCL increase by sL

  • L represents the units employer at the lower wage

  • S represents how much the wage has risen (Supply curve slope)

• Supply curve = s = W = ACL (as established)

• MCL = left of the SC as MCL > ACL

• MRPL = MPPL x MR (as established) - how much TR rises if +1 unit employed

• Pmax is where MCL = MRPL at Qm

  • Qm = how much labour the Monopsony should employ

  • Wm = wage rate at which the Monopsony should employ

Comparing Equilibrium under Monopsony and Perfect Competition:

• COMPARISON: Perfectly Competitive EQ is where Qpc = Wpc on ACL curve

  • Q is higher and W is higher at pc, but there is now only one firm and thus a wage maker and can employ more workers are lower wages.

Discriminating Monopsony:

• there are Lpc units of labour employed

• This is determined by the intersection of MCLD and MRPL

• Same units of labour employed as under perfect labour markets but wage bill is lower, so the surplus for the firm is larger

• There is no deadweight loss

• at Qdm, wage rate is higher compared to non-discriminating

Monopoly Union Assumptions:

• Perfectly competitive output market

• Complete information

• Firms = wage takers

• Free entry

• Workers are wage makers; each worker is a member of a union, facing no outside competition

  • common interest of maximising insider wages and employment

  • Assume the union sets a minimum wage

Evaluation of Monopoly Union:

• Benefits those in employment

• Benefit’s their members by increasing wages

• Higher wages —> lower total employment

• Harms those who became unemployed and those who purchase output as price = higher

Monopoly Union and diagrammatic analysis:

• Increased wages —> higher TC and exit —> lower EMP and Higher prices

  • shift from S to S’ at lower Q and higher Price

• No union: wage determined by intersection between Wpc and Lpc

• With union: Minimum wage —> perfectly elastic supply curve at W

  • at W (above Wpc)< employment falls from Lpc to Ld

• Unemployment = Ls-Ld

  • Ls = units of labour want to be employed at MWR

  • Ld = units actually employed

• Benefits those in employment

• Harms those who became unemployed and those who purchase output as price = higher

Bilateral Monopoly assumptions

• perfectly competitive output market

• Complete information

• Free entry

• Firm = wage maker

• Workers = wage maker

  • both can influence wages

Bilateral Monopoly characteristics:

• undifferentiated workers

• complete information

• One large worker (union)

• One large buyer (large change)