Micro test 3

In labor markets, supply and demand determine wage (W) and quantity of employment (Q)
• Supply curve is workers supplying their labor/hours
• Demand curve is firms demanding workers
The labor supply curve is upward sloping: the higher the wage the more hours workers are
willing to work (though can also be backward-bending)
The labor demand curve is downward sloping: the higher the wage the fewer hours firms are
willing to hire.
Equilibrium in labor market
Three possible conditions – what do these entail?
• 𝑄𝐷 = 𝑄𝑆 = 𝑄∗ at current price
• 𝑄𝐷 < 𝑄𝑆 at current price
• 𝑄𝐷 > 𝑄𝑆 at current price
Labor demand – thinking like an employer
Marginal produce of labor
Marginal revenue product of labor
What is the marginal cost of an extra worker? Wage
What is the rational rule for employers? Firms should hire another worker if...
The law of demand – a firm’s labor demand curve is downward sloping (as W falls, Q of
workers demanded increases) because of diminishing marginal product of labor
Labor demand is a derived demand

As with usual demand, a change in wage results in a movement along the demand curve (i.e., a
change in quantity demanded), but it does not result in a change in labor demand (i.e., the
demand curve shifting)
Shifts in labor demand
• Increase in labor demand (hire more workers at every wage) ⇒ demand curve shifts right
• Decrease in labor demand (hire less workers at every wage) ⇒ demand curve shifts left
Several things do cause the demand curve to shift (meaning that a firm would hire a different
amount of workers at a given wage):
1. Change in demand for the firm’s product, which changes the price of the product
2. Change in the price of capital (we didn’t cover this one much, so don’t worry about it)
3. Changes in labor productivity
4. Changes in nonwage costs of workers
• How does the demand curve shift when each of these increases and decreases?
Robots/new technology
• Higher wages create an incentive firm to invest in capital (substitute away from labor)
• New technology helps owners of robots at the expense of workers
• Technology leads to the end of some jobs and the creation of others
Labor supply – thinking like a worker
What is leisure?
• Labor + leisure = ? hours
The cost of working for an another hour is the marginal benefit (MB) of another hour of leisure
(whatever you would have been doing if not working)
The benefit of working for another hour is the wage
What is the rational rule for workers? Workers should work another hour if...
There are two effects from higher wage rates:
1. Substitution effect – higher wages make work more attractive
2. Income effect – higher income makes leisure more attractive
If income effect dominates substitution effect, how does this affect slope of labor supply curve?
The substitution effect is often larger than the income effect, leading the market labor supply
curve to be upward sloping. Evidence:
• Higher wages induce people to enter labor market.
• Existing workers are likely to increase hours.
• Some people may switch occupations (i.e., if increase teacher salaries, number of
education majors will increase).

• (Note that if the income effect dominates the substitution effect, the labor supply curve is
backward bending)
The extensive margin: choosing whether or not to work
• Benefits of working
• Costs of working
• Higher wages lead more people to enter the workforce
Choosing your occupation
• Benefits of a job
• Costs of a job
A change in the wage rate results in a movement along the labor supply curve—we simply from
one point on our labor supply curve to another point on the labor supply curve. It does not result
in labor supply/a shift in the supply curve
Shifts in labor supply
• Increase in labor supply (supply more at every wage) – supply curve shifts right
• Decrease in labor supply (supply less at every wage) – supply curve shifts left
Several things do cause the labor supply curve to shift (a worker will work more/less for a given
wage).
1. Changes in wages in other occupations
2. Changes in population (number of potential workers, for example immigration)
3. Changes in benefits of not working
4. Changes in nonwage benefits and costs
Chapter 12: Wages, Workers, and Management
(Only sections 12.1-12.3)
Labor demand: what employers want
Human capital and signaling
Relationship between productivity and wages
Key reason productivity varies is human capital.
More educated people earn more on average
Two reasons people with education get paid more:
• Education increases human capital
• Education also serve as a signal of ability
o What is a signal and how do employers use it?

Efficiency wages
When employers pay workers more to encourage higher worker productivity (the higher pay is
not a reward for greater productivity in the past, but is to encourage greater productivity in the
future). Why would they do this and what can it lead to?
The market for superstars
In certain markets such as movie actors, athletes, and singers, there are some superstars that do
much better than the average person in their industry. Why?
Winner-take-all markets
Labor supply: what workers want
Compensating differentials
Compensating differential – what is it?
• You should think of it as a person with the same amount of human capital and
productivity gets paid differently based on being in a job with more or less desirable
attributes.
• Do jobs with undesirable attributes pay more or less than jobs with more desirable
attributes?
• Do jobs with desirable attributes pay more or less than jobs with less desirable attributes?
• Compensating differentials depend on the preference of other workers
Graph
Institutional factors that explain why wages vary
• Note that:
o Laws and institutions tend to lessen influence of supply and demand forces
o Anything that causes the wage to be above the equilibrium wage causes
unemployment (quantity of labor supplied exceeds the quantity of labor
demanded)
1. Government regulations
a. Occupational licensing laws – do these increase or decrease supply? How do they
affect wages?
i. Graph
b. Minimum wage laws – what do these do?
c. Others:
i. overtime pay over 40 hours,
ii. minimum education or training for many jobs (note that this may or may
not be instituted by the government)
1. graph

2. Unions
a. Unions increase bargaining power of members and increase wages (by effectively
shifting the supply curve up/left). How does this affect wage?
3. Monopsony
a. What is a monopsony? What does monopsony power do to wages?
Chapter 14: Market Structure and Market Power
Market structures
Market Structure – Characteristics of a market (number of firms, uniformity of product, ease of
entry/exit).
1. Perfect competition
2. Monopoly
3. Oligopoly
4. Monopolistic competition
• What are the characteristics that define each of these structures?
Imperfect competition - Firms face some competition but sell products that differ from its
competitors. Imperfect competition groups monopolistic competition and oligopoly together.
Market structure determines market power
Market power – what is it?
• Your market structure (among other things) determine your market power.
• Which market structures have the most and least market power? Which fall in the
middle? What are the sources of market power?
• Chart
Perfect competition
• Price taker – what does this mean and why is this the case?
Perfect competition and monopoly are both rare. Imperfect competition is more common
Insights into imperfect competition
● The more competitors you have the less market power you have.
● Market power allows firms to pursue independent pricing strategies.
o As stated above, perfectly competitive firms (which have no market power) are
price takers and use the market price
o But firms with market power can choose their optimal P, Q combination
▪ There is a tradeoff between raising the price (and getting more money per
unit sold) and selling a smaller quantity (because the demand curve is
downward-sloping)

● The more you can differentiate your product the more market power you have
(advertising).
● Imperfect competition among buyers gives them market power
● When there are few firms (oligopoly), your best choice depends on actions of competitors
(Ch 18)
(In)efficiency
• There is a market failure/deadweight loss (chapter 7) with firms with market power.
• Compared to perfect competition, market power leads to:
o Underproduction (lower quantity)
o Higher prices
o Deadweight loss
o Larger economic profits
o Inefficient businesses can survive
Patents
• What are patents?
• One thing that arises from patents is that they create monopolies (with the associated
underproduction, higher prices, and deadweight loss). Why do governments grant
patents? What is the tradeoff?
Ways to restrain market power
• Recall that with externalities, market failure could sometimes be resolved privately (i.e.,
the Coase theorem). In addition, government price and quantity regulations could
improve efficiency and reduce or eliminate DWL. The same is true for market failures
associated with market power.
1. Anti-collusion laws
a. What is collusion?
2. Merger laws
a. What is a merger?
3. Anti trust
4. Encouraging international trade promotes competition.
5. Price ceilings
a. Governments sometimes grant monopoly rights to a firm in a natural monopoly
industry (what is that?)
b. In natural monopoly industries, price ceilings can be used to increase output and
reduce or eliminate DWL.
c. Or the government might decide to instead provide the service in the natural
monopoly industry itself.
Chapter 16: Price Discrimination
Price discrimination – what is it?
Conditions for price discrimination
• The firm must have market power

• The firm must be able to prevent resale
• The firm must be able to target the right prices to the right customers (and different
customers must have different demand)
o I.e., distinguish between who is willing to pay higher prices and who isn’t
• Why are these conditions necessary?
Efficiency of price discrimination
• Price discrimination increases the quantity sold (compared to a firm with market power
charging a single price)
• Price discrimination increases producer surplus
• Price discrimination may either increase or decrease consumer surplus
Reservation price – what is this?
To maximize profits, a firm would like to charge a price as close to the buyer’s reservation price
as possible.
• The price also needs to be greater than or equal to the firm’s marginal cost.
Perfect price discrimination
What is perfect price discrimination?
Perfect price discrimination is efficient, meaning there is no deadweight loss.
• However, consumers get 0 consumer surplus. Producers capture all of the surplus in the
market.
Perfect price discrimination is rare, if ever, actually observed in practice. Why?
Group pricing
Group pricing – charging different prices to different groups of people
• Why do firms use group pricing?
Group pricing method 1: group people based on observable characteristics
Examples
How to segment the market/create groups
1. Choose groups whose demand differs. The more the better.
2. Target groups based on verifiable characteristics.
a. Want to make lying hard
3. Choose groups based on difficult-to-change characteristics. Why?
Group pricing method 2: The hurdle method

If it is hard to figure out people’s reservation prices (and use something like perfect price
discrimination or group pricing), then the firm might use the hurdle method, where people
effectively sort themselves into groups
Hurdle method – charge lower prices to the people who are _____
• Are people with low or high reservation prices the ones who are willing to overcome the
hurdle?
Types of hurdles – what do each of these mean and what are examples?
1. Alternative timing
2. Alternative versions
3. Shopping around
a. Looking for the best deal
b. Price fluctuations
c. Haggling
4. Extra hassle, bad service, and imperfect goods
a. Extra hassle (like travel time, rewards cards)
b. Coupons and rebates
c. Slightly worse service/quality
d. Imperfect goods
5. Quantity discounts
a. Per unit price is lower when buy more.
i. Can either be like a buy one get one free
ii. Or if you buy something in bulk, like a huge container of ketchup, which
might be cheaper per ounce than a small container of ketchup
b. Bundling
Chapter 18: Game Theory and Strategic Choices
Only sections 18.1 and 18.2
Game theory is helpful when studying strategic interactions where your best choice depends on
the choices of others.
Payoff matrix – presents the outcomes based on choices of each player (firm, person, etc.)
How to solve a static game theory problem:
1. Consider all possible outcomes.
2. Break down the “what ifs?”
3. Play your best choice/best response.
a. What is the best response?
4. Put yourself in someone else’s shoes.
a. Basically, repeat the above steps for the other player.
I recommend using the check mark method, where you put a check mark in the cell that
represents the best response to each of the other player’s actions.

A common mistake is to consider a row when you should consider the column and vice versa.
Here is the correct way to do it:
• For the player represented by the rows (in the second example from class, the row player
is Tom), you want to first consider their best response to if the other player (the column
player) played their first action. Do this by considering the first column and putting a
check mark in the cell with the best outcome for the row player (ignore the outcome for
the column player). Then consider their best response to the other player’s second action.
Do this by considering the second column and putting a check mark in the cell with the
best outcome for the row player.
• For the player represented by the columns (in the second example from class, the column
player is Bob), you want to first consider their best response to if the other player (the
row player, e.g., Tom) played their first action. Do this by considering the first row and
putting a check mark in the cell with the best outcome for the column player (ignore the
outcome of the row player). Then consider their best response to the other player’s
second action. Do this by considering the second row and putting a check mark in the cell
with the best outcome for the column player.
And remember that what the payoffs/outcomes mean depends on the context. For example, for
firm profits, higher numbers are better. But for prison sentences, lower numbers are better.
A player has a dominant strategy when their best choice does not depend on the choice of the
other player.
• The row player has a dominant strategy if their check marks are in both of the cells of one
row. This row is their dominant strategy.
• The column player has a dominant strategy if their check marks are in both of the cells of
one column. This column is their dominant strategy.
• A player might or might not have a dominant strategy.
Nash equilibrium – an equilibrium in which the choice that each player makes is a best response
to the choices other players are making
• When each player makes their best response to the other player’s choice.
• Using the check mark method, the Nash equilibrium is the cell(s) that have a check mark
from both players.
• In a Nash equilibrium, neither player can get better payoff by changing what they do,
holding the choice of the other player constant.
Prisoner’s dilemma – a game where the Nash equilibrium outcome (where they both defect) is
worse for both players than is another outcome where they both cooperate.
• Why do we end up in a prisoner’s dilemma?
o Agreements to cooperate are not credible, and each player has an incentive to
cheat.
• Note that not all games are prisoner’s dilemmas; it depends on the particular numbers.