ECON 110A
When to use the supply curve: when you want to understand producer behaviour
When to use demand curve: when you want to understand consumer behaviour.
Demand curve: Focuses on consumers and what affects how much they want to buy.
Supply curve: Focuses on producers and what affects how much they want to produce and sell.
Opportunity Cost:
Opportunity cost represents the potential benefits a business, an investor, or an individual consumer misses out on when choosing one alternative.
While opportunity costs can't be predicted completely, considering them can lead to better decision-making.
Income elasticity of demand:
Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in the real income of consumers who buy this good.
Price elasticity of demand: Q^D= Q^D1-Q^D0/Average value of the two. Times by 100 to get percent. Then do the same thing with price. Then finally divide the two. Quantity on top.
Elasticity: A numerical measure of the responsiveness of QD or QS to one of the determinants (eg, price, income).
Five classifications:
Elasticity falls as you move down the linear demand curve
perfectly elastic - Demand=infinity
Elastic - Demand>1
unit elastic - Demand=1
Inelastic - Demand<1
perfectly inelastic - Demand=0
Market Efficiency occurs when the quantity of a good produced and consumed maximizes total economic surplus (the sum of consumer surplus and producer surplus). This happens at the equilibrium point where supply equals demand—at a price and quantity where no further gains in surplus are possible from changing production.
Marginal cost (the additional cost to produce an extra unit)
When MC is higher than MB it results in a loss of economic surplus.
Marginal benefit (the value consumers place on an additional unit)
A binding price ceiling is a government-imposed maximum price set below the equilibrium price. It leads to a shortage because the quantity demanded exceeds the quantity supplied at the ceiling price.
Elastic = sensitive to price changes.
Inelastic = Not very sensitive to price changes.
The tax incidence refers to how a tax burden is divided between consumers and producers. The division of this burden depends on the relative elasticities of supply and demand.
The elasticity of demand: How responsive consumers are to changes in price.
Elasticity of supply: How responsive producers are to changes in price.
DWL is the value of the lost transactions that, if the market were functioning efficiently, would have benefited both buyers and sellers.
Consumer Surplus: marginal benefit(demand)-price
Producer Surplus: price-marginal cost (supply)
Taxes are the burdens on individuals that are either paid producer( In direct tax) or by a consumer (direct tax).
Equilibrium is where supply meets demand at a certain price, and the market is balanced.
Normal goods: Demand ↑ as income ↑
Inferior goods: Demand ↓ as income ↑
Tax Incidence: how the burden (who feels it the most/affected) of tax is shared between consumers and producers, depending on how much each can adjust to price changes (elasticity)
Subsidy: when the government gives money back (rebate)/negative tax - increase the quantity demanded and supplied
Normative/positive analysis:
Positive: a statement of what is happening
Normative: what should or will happen - prediction
Externalities: A side effect of an activity that affects bystanders whose interests are not taken into account.
When people make decisions without facing the full consequences of their actions (when externalities are involved), bad outcomes can result.
Externality = Side effect of an activity that affects others (bystanders).
This leads to market failure: Society gets too much of the bad stuff (negative) and too little of the good stuff (positive).
Negative Externalities: (Bad stuff)
Example: Driving a car → pollution, traffic, accidents.
People do these too much because they don’t pay for the harm.
Fix: Make them pay (taxes, rules, etc.).
Positive Externalities: (Good stuff)
Example: Vaccinations or planting flowers → benefits others.
People do these too little because they don’t get all the rewards.
Fix: Reward them (subsidies, support).
Solutions to Externalities:
Private Bargaining: People make deals to reduce harm (works best for small problems like noisy neighbours).
Taxes and Subsidies: Taxes discourage bad stuff; subsidies encourage good stuff.
Cap and Trade: Limit harmful activities (like pollution) with tradeable permits.
Laws/Regulations: Rules to control negative behaviour (e.g., speed limits, noise laws).
Public Goods: (Like parks, defence)
Marginal Private Cost: The extra costs paid by the seller from producing one extra unit.
Marginal External Cost: The extra cost imposed on bystanders from producing one extra unit
Marginal Private Benefit: The extra enjoyment by the buyer from purchasing one additional unit.
Marginal External Benefit: The extra benefit to bystanders from the additional unit.
PUBLIC GOODS
Problem: Free riders enjoy benefits without paying, so private companies won’t provide enough.
Solution: The government provides them with taxes.
COMMON RESOURCES: (Like fish in the ocean)
Tragedy of the Commons: People overuse these because no one owns them.
Fix: Assign ownership to make someone responsible for managing them properly.
Market Structure: Refers to the competitive environment for a business. Determines pricing and strategy.
Types of Market Structures:
Perfect Competition: Many sellers, identical products. No market power (e.g., farmers selling corn).
Monopoly: One seller, unique product. Lots of market power (e.g., De Beers in diamonds).
Natural Monopoly: A market cheapest for a single business to service the demand.
Oligopoly: Few big sellers, similar/different products. Some market power (e.g., telecom companies).
Monopolistic Competition: Many small businesses, differentiated products. Some market power (e.g., different brands of jeans).
Market Power: Ability to raise prices without losing customers. More competitors = less market power.
Pricing Decisions:
Balance selling more items at a lower price vs. fewer items at a higher price.
Key concepts: Demand curve, marginal revenue, and cost-benefit analysis.
Problems with Market Power: Higher prices, smaller quantities, inefficiency, and unfair profits.
Government Solutions:
Policies for competition: Prevent monopolies and collusion.
Antitrust laws: Stop mergers or actions that harm competition.
Price controls: Limit monopoly abuse (e.g., price ceilings).
Natural monopolies: Sometimes regulated or controlled by the government (e.g., utilities).
Profit Basics:
Total Revenue = Money made from sales.
Total Cost = Money spent to produce stuff.
Profit = Revenue - Cost.
Positive = Profit, Negative = Loss.
Types of Costs:
Explicit Costs: Actual payments that have to be made(wages, rent).
Implicit Costs: Lost opportunities (like forgone salary).
Accounting Profit: Revenue - Explicit Costs.
Economic Profit: Revenue - (Explicit + Implicit Costs).
Production Terms:
Labor (L), Capital (K), and sometimes materials (M)
Input: Stuff used to make products (labour, capital).
Output: Final product.
Production Function: Shows how inputs turn into output (Q = f(K, L)). KxL
Marginal Product:
Extra output from adding one more input (like hiring another worker).
Change in output divided by the change in input
Marginal Product of Labor (MPL) - q/L
Marginal Product of Capital (MPK) - q/K
Diminishing Marginal Product: Adding more workers eventually gives less extra output. ("Too many cooks in the kitchen.")
Costs:
Fixed Costs (FC): Don’t change (e.g., rent).
Variable Costs (VC): Change with production (e.g., materials).
Total Cost: FC + VC.
Marginal Cost (MC): Cost to make one more unit.
Cost Curves:
Average Total Costs (ATC): Total cost per unit.
Average Variable Cost (AVC)
Average Fixed Cost (AFC)
U-shaped because of diminishing productivity (costs rise after a point).
Key Idea:
"The average follows the margin" (e.g. if a new score is higher than the average, the average rises).
Predatory pricing: Charging prices so low that you force your competitor out of business,
to then raise prices later.
Entry:
Cost-benefit principle: It’s worth entering a new market if the benefits exceed the costs.
Rational Rule for Entry: Enter a market if you expect to earn a positive economic profit, which occurs when the price exceeds your average cost.
Exit:
Cost-benefit principle: It’s worth exiting a market if the costs exceed the benefits.
Rational Rule for Exit: Exit a market if you expect to earn a negative economic profit, which occurs when the price is less than your average cost.
Exit any unprofitable markets.
Long Run:
New rivals will enter the market as long as economic profits are positive.
Entry STOPS when there’s no longer an incentive to enter - when economic profits are ZERO
In the long run, price equals average cost.
Barriers to entry:
Obstacles that make it difficult for new suppliers to enter a market. Can prevent new entrants from competing away profits of incumbent firms
4 Strategies for creating barriers to entry:
Demand-side strategies that create customer lock-in - don’t let new entries to the market win over your customers.
Supply-side strategies to develop unique cost advantages - deter any new rivals to the market by creating cost advantages, learning by doing, mass production, and demand discounts.
Regulatory strategies that enlist government policy to prevent entry - lobbying: The government regulates who can enter a market for two main reasons: to counter a market failure and because politicians are swayed by corporate lobbyists.
Entry deterrence strategies to scare off potential rivals: Convince your potential rivals that if they enter your market, you will CRUSH THEM.
Price Discrimination: Selling the same product at different prices
The goal of price discrimination: Charge each customer the highest price that you can get them to pay
Reservation price: The maximum price a customer will pay for a product - perfect price discrimination
Steps:
Charge higher prices to those who will pay them.
Offer selective discounts to induce new customers to buy.
You can only do this if your business has market power, you can prevent resale, and you can target the right prices to the right customers.
Group pricing: Price discrimination by charging different prices to different groups of people.
Insights:
Charge higher prices to groups that value your product more.
Charge lower prices to especially price-sensitive groups.
Market segmentation:
Identify groups:
whose demand differs
based on verifiable characteristics
based on difficult-to-change characteristics
Group targeting:
Target your group discounts based on verifiable characteristics to ensure that people can’t lie about their status to get the discount.
Hurdle Method:
Offer lower prices only to those buyers who are willing to overcome some obstacles. An effective hurdle is not too difficult, not too easy.
Alternative Verison and Timing:
Certain times when things are popular, no discounts.
Things are not popular, discounts
Depends on the timing
Fluctuating Prices:
The discount: Cheaper cereal if you buy whichever one is on sale.
The hurdle: Switching over to a less preferred brand or type of cereal.
Those who are price-sensitive will get over the hurdle
Those who are brand-sensitive will not.
Haggling:
Sellers haggle because it can be a powerful form of price discrimination—they can tailor the price to each customer.
The hurdle: The annoying, time-consuming, and sometimes uncomfortable process of haggling.
Who will NOT jump the hurdle: People who prefer to pay a bit more to avoid spending time and energy haggling.
Who will jump the hurdle: Price-sensitive People, with low reservation prices.
Bundling:
Selling different goods together as a package. Sold for a
lower price than if you bought the components separately.
Example: Netflix, Hulu, HBO Max, and any other streaming service
You pay for the shows you want to watch...AND for the shows you don’t have any interest in.
Companies often bundle something you like with something you don’t want or need
Game Theory: Science behind making good decisions involving strategic interaction
Strategic interaction: when the best choice might depend on what you chose
4 Steps for making strategic decisions:
Consider all possible outcomes
Think about the “what-ifs” separately
Play your best response
Put yourself in the other player's shoes
Nash equilibrium: An equilibrium where the choice that each player makes is the best response to the choices other players are making - nobody can do better by changing their choice alone, making the best choices given the choices that others are making.
Socially Optimal Decision: jointly better off if they cooperate
Multiple Equilibria and the Problem of Coordination:
Figure out how to coordinate with your allies to make complementary choices:
Coordination game: when all players have a common interest in coordinating their choices - you want to make a complementary choice to mine, might be difficult to coordinate because multiple equilibria are yielding an out-of-equilibrium outcome
Examples:
Business Hours
Cell Phones
Romance or Friendships
Anti-coordination game: times when your best response is to take a different action than the other player - examples: traffic jams, phone gets dropped
Solutions to coordination games:
Communication: works when all players want the same thing
Focal points, culture, and norms - Focal points: a cue from an outside game that helps coordinate on a specific equilibrium: should we bow or shake hands as a greeting
Laws and regulations: which side of the road to drive on: left or right?
Sequential Games: you can see your rival's action before choosing your ex. Tik tac toe
Simultaneous games: you make your choice without knowing what the other player has chosen ex. Rock paper, scissors
First mover advantage: the strategic gain from an anticipatory action that can force a rival to respond less aggressively
Solving game trees:
Look forward: in games that play out over time, you should look forward to anticipating the likely consequences of your choices.
Reason backward: start by analyzing the last period of the game, to figure out what will happen in the second to last period, and keep reasoning backward until you can see all the consequences that follow from today's decision
Start from the end and reason backward
First and second mover example:
Moving early or late depends on the value of commitment versus flexibility
Second mover advantage: the strategic advantage that can follow from taking an action that adapts to your rival's choice - flexibility to adapt your strategy in light of the choices made by the first mover
Examples:
Pricing: as the second mover, you watch what your competitor does, and then you sell the same products at slightly lower prices
Product positioning: the second mover waits to see which parts of the market remain underserved, then positions to gain the largest customer base
Cake cutting game: they cut, you pick