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Lecture Notes

ECON 200

Module 1: Tradeoffs and Choices

Module 2: Supply and Demand

Module 3: Market Interventions

Module 4: Production and Costs

Module 5: Perfectly Competitive Markets

Module 6: Monopoly and Imperfect Competition

Module 1 Lecture 1

What is Economics?

  • Economics is the study of how people make choices as they try to attain their goals in a world of scarcity.
  • Choices are made to attain a goal; purchases are made to promote our welfare in some way.’
    • However, we cannot purchase everything we want; we need to deal with this fact.
  • Scarcity: a situation in which unlimited wants exceed the limited resources available to fulfill those wants.
  • Economics is fundamentally studying how individuals - people or firms - make these decisions.
  • Economists use economic models can be sophisticated mathematical models based on simplified versions of reality.
    • Are used to analyze real-world situations.
    • Analyze: understand why choices are made and which situations/circumstances may need to change for individuals to make different choices.

Typical Economics Questions

  • We will answer questions like:
    • How are the prices of goods and services determined?
    • Why does the government control the prices of some goods and services, and what are the effects of those controls.
  • Economic tools can be applied to other decisions, too, like:
    • Why do people have so many or so few children?
    • How do people choose between hours spent working and hours spent relaxing?
  • Actual research of University of Washington Economists:
    • What is the effect of having a daughter on women’s decision-making power?
    • How does the gender of school peers affect future outcomes?
    • What is the correct way to estimate air pollution?

Three Key Ideas

People are rational.

  • Rationality: using all available information to achieve your goals.
  • Rational consumers and firms weigh the benefits and costs of each action and make the best decisions.
  • We try to understand benefits and costs, where they come from, and how they are calculated in the minds of individuals.
  • Rational individuals always use this information to make the best possible outcome - to make themselves as best off as possible.

Optimal decisions involve calculating true costs and making marginal decisions.

  • Opportunity cost: the true cost of a choice is the value you could have gained by choosing the next-best alternative instead.
    • Not only the cost one may pay in terms of money, but the value forfeited by making one decision.
  • Marginal cost and benefit (MC and MB): the additional cost or benefit associated with a small amount extra of some action.
    • Not only the cost of the entire decision; what is the cost of making the next choice?
    • e.g. I have come to class for the past two classes, what is the cost/benefit of attending the next class (not of attending 2 vs. 3 classes in total)?
  • Comparing marginal cost and benefit is known as marginal analysis.

People respond to incentives.

  • As tradeoffs change, so do the choices that individuals make.
  • Incentives can be positive or negative.
  • Group lending - if one member of your group defaults on a loan, no one can borrow from the bank.
    • Incentive to pressure other members of the group to pay loans.
    • Incentive to choose groups more likely to pay back their loans.

Economic Models

  • Economists develop economic models to analyze real-world issues.
  • Steps to building an economic model:
    1. Decide assumptions to use in developing the model;
    2. Formulate a testable hypothesis;
    3. Use economic data to test the hypothesis;
    4. Revise the model if it fails to explain the economic data well.
  • Important features of economic models:
    • Assumptions and simplifications
    • Testability
    • Economic variables

The Scientific Nature of Economics

  • When analyzing human behavior, we are using the scientific method.
  • We can perform:
    • Positive analysis: the study of “what is?”
    • Normative analysis: the study of “what ought to be?”
  • Normative analysis can be disguised as positive analysis - are you reading positive or normative analysis?
  • Economists generally try to perform positive analysis.

Microeconomics and Macroeconomics

  • Microeconomics is the study of
    • how households and firms make choices,
    • how they interact in markets,
    • how the government attempts to influence their choices
  • Macroeconomics is the study of the economy as a whole, including topics like inflation, unemployment, and economic growth.
  • There are many parallels between microeconomics and macroeconomics, but the difference lies in the analysis of the decisions of an individual or a government entity.

Production Possibilities Frontier and Production

Production Possibilities Frontier

  • How do you decide how much of each type of good and service to produce in an economy?
  • Households, firms, and governments face decisions about how best to use scarce resources.
    • There is no unlimited amount of resources; resources need to be allocated into forms of production.
  • Scarcity requires trade-offs. Economics allows us to make good trade-offs.
  • A production possibilities frontier (PPF) is a curve showing maximum attainable combinations of two products that may be purchased with available resources and current technology.
  • Points on the PPF are attainable; points below the curve are inefficient (not purchasing the maximum production); points above the curve are unattainable with current resources.
  • Opportunity cost: the highest-valued alternative that must be given up to engage in an activity.

Concave PPFs

  • Linear PFPs suggest that the trade-offs between the two dimensions are always the same; opportunity cost rates remain constant.
  • Concave PFPs: as we produce more of a good, it becomes more expensive to produce.
    • The opportunity cost of producing an additional unit of a good increase as more resources are allocated to its production.
  • It is also possible to have a curved PPF.
  • The opportunity cost represents the suitability of the next input that is transferred from one production process to the other.

Economic Growth on the PPF

  • You can measure economic growth with PPF.
  • The PFP should shift outward for all axes.
  • As more economic resources become available, the economy can shift outwards.
  • Economic growth: the ability of the economy to increase the production of goods and services.

Technological Change in One Industry

  • Some sort of technological advancement allows for the amount of output to increase for a particular input.
  • One axis remains unchanged, while the other expands.

Who Produces Which Goods and Why?

  • People around the globe coordinate production activities to sell to consumers what they want.
  • Figuring out how these decisions are made.
  • Global production is a natural outcome of people acting in their self-interest to improve their own lives.
  • The invisible hand: this coordination mechanism.
    • How we think about how market economics operates.

Absolute and Comparative Advantage

  • The PPF is the key trade-off faced by an economy.
    • Need to think about the relative efficiency of each of the axes of the PPF.
  • Context of trade: if there is no trade between economies, then what a country produces is what it consumes.
    • Two countries agree on the exchange of goods.
    • If there is no trade, a country can only consume what it produces.
  • On the scale of the individual: you can only consume what you produce.
  • With trade between individuals, you can create an abundance of a specialized good or service (more than you need for yourself) and use the excess to trade to others.
  • Using PPFs, we can understand how individuals decide what to produce and interact in a market economy.
  • Absolute advantage: when one individual can consistently produce more than another of a certain good.
    • Absolute advantage does not aid in understanding how individuals decide which goods to produce.
    • Trade is based instead on opportunity cost.
  • Comparative advantage: when an individual can produce a good at a lower opportunity cost than other individuals.
  • No country has a comparative advantage in everything, yet each country has a comparative advantage in producing something.

Why Specialize?

  • With specialization, given the trade-off nature of PPFs, more products can be produced net-wise.
  • There are many ways for which countries can come to a rational decision and be made better off with trade.
  • Ultimately, we study this not because we are interested in trade but because it is an analogy for how individuals make a trade.

Module 2 Lecture 2

Why Trade?

  • In isolation, each country produces and consumes on its own.
  • If each country specializes by producing the good for which it has a comparative advantage, total production increases.
  • Gains from Trade: the improvement in outcomes that occurs when specialized producers exchange goods and services.
  • With specialized production, consumption is outside the PPF.
  • Specialization and trade can make everyone better off.
  • An economy is driven by individuals seeking to make a profit.
    • People specialize to exploit comparative advantages.

Considerations for Designing an Economy

  • What goods and services are produced? Firms/governments/individuals must decide this while considering trade-offs and opportunity costs.
  • How are goods and services produced? A firm might have several different ways to produce an item.
    • Which resources do we allocate and how?
  • Who will receive the goods and services? By income? By equity?

Centrally Planned Economies

  • Centrally planned economies: governments decide what to produce, how to produce it, and who receives the goods and services.
  • Market economies: households and firms make decisions with prices and markets as the deciding force.
  • Market: a group of buyers and sellers of a good or service and the institution by which they come together to trade.
    • Market structure: how do firms interact with customers? What kind of relationship do they have?
  • Thinking about the cost of producing an item in terms of dollars; dollars represent what you could have bought.


  • Perfectly competitive market:
    • Standardized good - goods are all the same; every seller is selling the same product
    • No transaction costs - there is no transactional cost in switching or purchasing a product.
    • Full information - you know everything there is to know about the product.
    • Participants are price takers - you don’t have control over which price you buy at; you take the price.
  • Markets are assumed in this context to be perfectly competitive.

Efficiency of Economies

Market economies promote:

  • Productive efficiency - goods or services are produced at the lowest possible cost.
  • Allocative efficiency - the marginal benefit of production is equal to its marginal cost.
  • Production is consistent with consumer preferences.
    • If people have a demand for something, a perfectly competitive economy will supply it.

Caveats About Market Economies

Markets may not result in fully efficient outcomes:

  • Governments might interfere with market outcomes
  • Market outcomes may ignore the desires of people not involved in transactions

Markets may result in high inequality.

The Interaction of Demand and Supply

  • How do markets decide how much of a good or service to produce?

Demand Schedules and Quantity Demanded

  • To understand demand, we can understand something about the relationship between the price and the quantity demanded.
  • Price, in this case, is the independent variable.
  • Market demand - the demand by all the consumers of a given good or service.
  • Ceteris paribus - all variables except price and quantity are assumed to be held constant.
  • When we move along the demand curve, we are assuming the law of demand.
    • Ceteris paribus, when the price of a product falls, the quantity demanded of the product will increase.
    • Demand curves slope downward.

What Explains the Law of Demand?

  • When the price of a product falls, there are two effects:
    • Substitution effect: the product becomes cheaper relative to other groups, so consumers substitute toward it.
    • Income effect: the consumer has greater purchasing power and purchases more goods overall.
      Substitution effect + Income effect = Total change in quantity demanded due to a price change

Increase and Decrease in Demand

  • A change in something other than price (violation of ceteris paribus): will induce a shift in demand.
  • As the demand curve shifts, the quantity demanded changes at every possible price.

Change in Income of Consumers

  • Normal good: a good for which demand increases as income increases.
  • Inferior good: a good for which the demand decreases as income rises.
  • Substitutes: goods and services that can be used for the same purpose.
    • The price of substitutes is important in determining the price of a good.
    • When the price of a substitute goes up, demand for a good goes up.
  • Complements: goods and services that are used together. When the price of a complement goes up, demand for a good goes down.
  • Other sources of shifts: change in tastes, change in demographics

Change in Demand vs Change in Quantity Demanded

  • A change in the price of the product causes a movement along the demand curve.
    • Change in quantity demanded.
  • A change in a nonprice determinant causes the entire demand curve to shift.
    • Change in demand.

Module 2 Lecture 3

Supply Schedules and Supply Curves

  • Supply curve: shows the relationship between the price of a product and the quantity of the product supplied.
    • As the price goes up, producers want to supply more goods.
  • Law of Supply: ceteris paribus, increases in price cause increases in the quantity supplied.
    • Less strict than the law of demand, but generally applies.
    • Supply curves hence slope downward.

Increase and Decrease in Supply

  • A change in something other than price that affects supply causes the entire supply curve to shift.
  • As the supply curve shifts, the quantity supplied will change, even if the price doesn’t change.
  • The quantity supplied changes at every possible price.

Change in Prices of Inputs

  • Inputs: things used in the production of a good or service?
  • Increase in the price of the input decreases the profitability of selling the good, causing a decrease in supply.

Technological Change

  • A firm can experience positive or negative change to produce a given level of output with a given quantity of inputs.
    • Technological change.
  • The same number of inputs can produce more output, which means that more can be supplied for each price.
  • Changes raise or lower firms’ costs and hence impact the quantity of the good supplied.

Prices of Substitutes and Number of Firms

  • Many firms can produce and sell more than one product.
  • More firms in the market will result in more products available at a given price - greater supply.

Change in Supply vs Change in Quantity Supplied

  • Change in quantity supplied: the price changes, and the quantity changes. Movement along the supply curve.
  • Change in supply: shifting the entire supply curve.

Market Equilibrium Price and Quantity

  • The supply and demand curves intersect; this is the equilibrium point.
  • Equilibrium price and quantity derived from the equilibrium point.
  • Buyers and sellers want to trade the same quantity at the equilibrium price, so we do not expect the price to change.
  • Surplus: quantity supplied is greater than quantity demanded.
    • When there is a surplus, suppliers will lower the price to make more out of their supply.
  • Shortage: quantity demanded is greater than the quantity supplied.
    • When there is a shortage, suppliers will increase the price to make more out of their supply.
    • The people who benefit are randomly selected in a way (buyers who happen to get the good).
  • Market equilibrium: no tension, no shortage, or surplus.
    • A situation in which quantity demanded equals quantity supplied.
    • Perfectly competitive market equilibrium.

Demand and Supply Both Count

  • Price is determined by the intersection of buyers and sellers.
  • Neither group can dictate the price; all are price-takers, even though sellers contribute to the price.
  • Changes in supply and/or demand will affect the price and quantity traded.
    • Changes in the underlying position of the demand and supply curves (nonprice determinants).

Module 2 Lecture 4

Curve Shifting and Changes in Equilibrium

  • We can predict the direction of an equilibrium change, but we don’t know the magnitude.
  • Knowing the price responsiveness of producers and consumers can help us predict this.
  • Knowing something about the slope of the demand curve tells us about how things shift.

Price Elasticity of Demand

  • Use percentage changes; lessens the impact of units.
  • The price elasticity of demand is a negative number; negative elasticities are “larger” or “higher”, “more elastic”.
    • More responsive to price.

Price Elasticity of Demand Terminology

  • “Large value” means that quantity changes a lot in response to a price change.
  • “Small value” means that consumers are less responsive.
  • Price elastic - price elasticity is larger than 1.
  • Price elastic - price elasticity is less than 1.
  • A vertical demand curve means that quantity demanded does not change as price changes. Perfectly inelastic; elasticity is zero.
  • A horizontal demand curve means that the quantity demanded is infinitely responsive to price changes. Perfectly elastic; elasticity is infinite.

Percentage Changes and the Midpoint Formula

  • Percent change from A to B is different from the percent change from B to A.
  • Midpoint formula avoids the confusion of whether we are going from A to B or from B to A.

Determinants of Price Elasticity of Demand

  • Availability of close substitutes - a product with more substitutes has a higher elasticity of demand.
  • Passage of time - over time, people adjust their buying habits. Elasticity is higher in the long run than in the short run.
  • Luxury or necessity good - people are more flexible with luxuries than necessities, so the price elasticity of demand is higher for luxuries.
  • Definition of the market - the more narrowly defined the market, the more substitutes are available, and hence demand is more elastic.
  • Share of the good in the consumer’s budget - if a good is a small portion of your budget, you will likely not be very sensitive to its price.

Elasticity and the Pricing Decision

  • How do businesses take into account elasticity?
  • What will happen to my total revenue if I cut my price?
  • If demand for your product is price inelastic, decreasing the price gains only a few customers. Total revenue goes down.
  • If demand for your product is price elastic, decreasing the price gains many few customers. Total revenue should increase.
  • Change between the price effect and the quantity effect.

Price Elasticity of Supply

  • Similar to how we think about price elasticity of supply.
  • Price elasticity of supply measures producers’ response to a change in price.
  • Price elasticity of supply is always positive.

Determinants of Price Elasticity of Supply

  • Availability of inputs.
  • Flexibility of the production process.
  • Adjustment time.

Cross Price Elasticity of Demand

  • If the price of an alternative/substitute good changes, then demand for a good changes.
  • A measure of how the quantity demanded of one good changes when the price of different good changes.
  • The midpoint formula calculates elasticity between the quantity demanded of good A and the price of good B.
  • Cross-price elasticity of demand can be positive or negative.
  • If the cross-price elasticity of demand is positive, the two goods are substitutes. If they are negative, they are complements.

Income Elasticity of Demand

  • A measure of how much quantity demanded changes in response to a change in consumer incomes.
  • If the income elasticity of demand is:
    • larger than 0 but less than 1, it is a normal good.
    • larger than 1, it is a luxury.
    • less than 0, it is inferior.

Module 2 Lecture 5


  • The market sets a price. Are we happy with that? Should society intervene?
  • Society may intervene when the market outcome is not equitable or when it fails.
  • We can understand the consequences of government intervention by returning to efficiency and a new concept - surplus.

Consumer and Producer Surplus

  • Something that remains above what is used or needed. NOt the same as excess supply.
  • What is left over after the buyer or seller makes a transaction.
  • Consumer surplus - the difference between the highest price a consumer is willing to pay and the actual price the consumer pays.
  • Producer surplus - the difference between the lowest price a firm is willing to accept and the price it receives.

Consumer Surplus

  • How much is a consumer willing to pay? (WTP)
  • Maximum price a consumer is willing to pay or a marginal good: the marginal benefit of that good.
  • Demand curve: marginal benefit curve.
  • Depends on the price and marginal benefit - consumer’s additional benefit from consuming one more unit of a good or service.

Producer Surplus

  • Difference between the lowest price a firm would accept and the price it receives.
  • What is the lowest price a firm would accept for a good or service?
    • The marginal cost: the additional cost of producing one more unit.

What Consumer and Producer Surplus Measure

  • Consumer surplus: net benefit to consumers from participating in the market, rather than a total benefit.
  • Producer surplus: net benefit to producers from participating in the market.

Surplus and Economic Efficiency

  • Definitions of economic efficiency:
    1. A market is efficient if the marginal benefit equals or exceeds the marginal costs for all trades.
    2. A market is efficient if it maximizes the sum of consumer and producer surplus. Known as economic surplus, or total welfare.

The Efficiency of Competitive Equilibrium

  • Demand: marginal benefit of each good unit.
  • Supply: the marginal cost of each good unit.
  • Only at the competitive equilibrium is the last unit valued by consumers and producers equally. Economic efficiency.
  • At the competitive equilibrium quantity, the economic surplus is also maximized.
  • Our two concepts of economic efficiency result in the same levels of output.
  • Deadweight loss (DWL): the amount of inefficiency in a market. IN a competitive equilibrium, deadweight loss is zero.

Module 2 Lecture 6

Market Equilibrium and Efficiency

  • The market equilibrium maximizes the total well-being (surplus) of all participants in the market.
  • Prices above and below the market equilibrium decrease the total surplus

Changing the Distribution of Total Surplus

  • Surplus is transferred between consumers and producers when an artificial price is imposed.

Deadweight Loss

  • Occurs between what a perfectly competitive market output would be and the actual output; transactions that no longer take place.
  • Reduces consumer and producer surplus.

Why Intervene?

  • Correcting market failures or misset markets.
    • Market failures: the market is not producing efficiently.
  • Changing the distribution of benefits.
  • Encouraging or discouraging consumption of certain goods.

Module 2 Lecture 7

Price Controls

  • Price ceiling: maximum legal price a good can be sold. Usually placed on essential goods and services.
  • Price floor: minimum legal price a good can be sold. Usually placed on agricultural goods risky to produce.

Price Ceilings

  • The price ceiling is below the equilibrium price for it to be effective.
  • Producers supply a lower quantity. Consumers demand a higher quantity.
  • Excess demand, shortage.
  • Welfare effects: analyze how surplus changes.
  • Are price ceilings worth the decrease in total surplus?
  • Goods must be rationed; how? Equally? First-come first serve? Preference/corruption?
  • Shortages cause people to engage in rent-seeking behavior, like bribing whoever is in charge of allocating scarce supplies.

Price Floors

  • For it to be effective, the price floor must be imposed above the equilibrium price.
  • Excess supply.
  • The government can buy the excess supply.
  • How does the price floor affect welfare?
  • How much excess milk will the government buy?
    • The government must buy the excess supply created by the price floor.
  • Ignore the welfare impact of the excess amount being purchased - we don’t know what is happening with it.

Price Incentives

  • Taxes: buyer or seller must pay some extra amount to the government on top of the sale price.
  • Subsidy: buyer or seller receives payment from the government that lowers sale price.


  • A tax will reduce consumption and provide a source of revenue.

Tax on the supplier

  • You shift the supply curve; the willingness to sell is \(n\) and the willingness to buy is \(n+t\).
    • \(t\): tax imposed.
  • Tax wedge: the difference between the equilibrium price of the shifted supply curve and demand curve and the price for the same quantity supplied on the “unshifted” supply curve.
  • Tax Revenue: \(\text{quantity sold} \times \text{tax wedge}\).
  • Total surplus lost is the tax revenue plus the deadweight loss.

Tax on the buyer

  • The demand curve shifts down/left.
  • The tax wedge and the new equilibrium is the same.
  • Impositions of the tax on the supplier and the buyer have the same effect.

Tax incidence

  • Who will bear the burden?
  • What matters is the relative elasticities.
  • Whichever side of the market is more price elastic will shoulder less of the burden.
  • The burden of the tax (price change) is the person with the more or less elastic supply or demand.

Welfare effects of a tax

  • Both buyers and suppliers lose surplus.
  • Lost surplus goes to the government and deadweight loss.


  • Subsidies have two primary effects: encourage production and consumption, provides money to producers and buyers.
  • The incidence of the subsidy is not determined by who the subsidy goes to.

Subsidy for the supplier

  • The supply curve shifts down/right by the equilibrium.
  • Buyers pay a lower amount, suppliers receive a higher amount.
  • Subsidy causes overproduction; there is an area where the marginal cost of production increases and the marginal benefit declines. This is an area of negative surplus.
    • Overproduction causes welfare loss.

Government expenditures from subsidy \(\text{GE} = \text{Subsidy} \times Q_\text{post-subsidy}\)

  • Producers and consumers gain surplus because they are producing and consuming more, respectively.

Effect of a Tax or Subsidy

  • We can predict the effect on equilibrium quantity if the price elasticity of supply and demand are known.
  • The more elastic the supply or demand, the greater the change in equilibrium quantity.

Long-Run Versus Short-Run Impact

  • In the long run, the elasticity increases.
  • Buyers and sellers take time to respond to changes in price; the full effect of price controls becomes clear only in the long run.

Module 3 Lecture 8

Why trade? A Review

  • With specialization and trade, they can coordinate their production and produce more goods.
  • Importing and exporting.
  • We would expect many countries to produce many goods.

The Roots of Comparative Advantage

  • Firms produce goods and services for which they have a comparative advantage.
  • Characteristics that affect the cost of production are:
    • Technology
    • Factor endowment (does it have a lot of a certain type of worker or capital)
    • Natural resources and climate

From Autarky to Free Trade

  • Autarky - an economy that is self-contained and does not engage in trade.
  • If people want to buy t-shirts, they no longer need to buy them from domestic suppliers.
  • If the world price is less than the autarky domestic price, domestic buyers will buy at the world price.
    • Domestic price decreases to equal the world price.
    • Excess demand occurs; imports fill the excess.
  • If the world price is larger than the autarky domestic price, domestic sellers will sell at the world price.
    • Excess supply occurs; exports fill the excess.
  • Consumer and producer surpluses are affected.

International Labor and Capital

  • Free demand increases demand for factors of production that are domestically abundant and increases the supply of domestically sparse factors.
  • Owners of domestically scarce resources suffer from trade liberalization.

Government Policies in Restriction of Trade

  • Tariffs: a tax imposed by a government on goods imported into a country.
  • Quotas (Voluntary Export Restraints): limits imposed upon countries on the quantity of a good imported by one country from another. The government doesn’t get any tax money.


  • Tax targeted at certain imports.
  • Purpose: reduce the number of imports to protect domestic producers.
  • World price: technically world supply curve. It is perfectly flat (elastic).
  • Tariffs increase the world price for domestic consumers and decrease the amount of shortage made up by imports.
  • Domestic welfare effects: producers gain surplus, governments raise revenue, deadweight loss is generated, and consumers lose surplus.


  • Quota: a limit on how much of a good can be imported.
  • Quota rents: profits earned by foreign firms or governments under a quota.
  • Effects of a quota:
    • Decreases imports
    • Increases import price
    • Increases producer surplus
    • Decreases consumer surplus
    • Generates quota rents for foreign entities.
    • Deadweight loss is generated.

Module 3 Lecture 9


  • Private costs: firms make decisions about how to produce based on these; they are paying these themself.
  • Social cost: a cost that exists as a byproduct of the production. Not considered in private costs, but is felt by society.
  • Firms produce according to their marginal private cost; consumers purchase according to their marginal private benefit.
  • The social cost includes both the private and external cost of pollution.
  • Externality: a benefit or cost that affects someone not involved in the trade of a good.
    • Choices made by firms and consumers are not allocatively efficient.
  • The optimal level of production is where the marginal cost to society is equal to the marginal benefit.

Market Failure

  • When there are unconsidered externalities, the market equilibrium will not be efficient; there will be a deadweight loss.
  • Market failure: the market fails to produce an efficient level of output.
    • Have externalities been taken into consideration?

Inefficiency Due to Negative Externalities

  • The market price is too low, the market quantity is too high. There is too much market production.
  • The cost to society exceeds the benefit to society; too much of the good is produced, and deadweight loss is produced.

Inefficiency Due to Positive Externalities

  • Positive externalities result in underproduction.
  • The true benefit has not been realized, and thus deadweight loss is generated.

What Causes Externalities?

  • Externalities arise because of incomplete property rights, or from difficulty enforcing property rights.
  • Deadweight loss from pollution can be reduced if property rights allow for parties to come to a mutually beneficial trade and increase surplus.

The Coase Theorem

  • Private parties can solve an externality problem given ownership rights to arrive at a socially efficient output through private bargaining.
    • Transaction costs must be low and property rights are assigned & enforceable.
    • Parties must have full information about costs and benefits.
  • It does not matter who gets the property rights, for efficiency’s sake.
    • The owner of the property rights will benefit more, but this does not alter the efficiency.

Pigovian or Corrective Taxes for Negative Externalities

  • Internality: a cost placed on individual publishes.
  • What is a situation in which the consumption of goods can be shifted.
  • Taxes caused inefficiency, but Pigovian taxes that capture negative externalities return to an increased level of efficiency.
  • A tax is applied to move the private marginal demand or cost curve towards the social marginal demand or cost curve.
  • Consumers pay the efficient price, while producers receive the efficient price minus the tax.
  • Pigovian taxes are popular because they increase efficiency while bringing in tax revenue; they bring a double dividend of taxation.

Corrective Subsidies for Positive Externalities

  • We can subsidize curves; producers receive the efficient price and consumers pay the efficient price minus the subsidy.

Other Public Solutions

  • Quotas can counteract inefficiently high consumption but don’t always maximize surplus.
  • Quotas can be improved via tradable allowances, in which quota allowances can be bought and sold.
    • The market quantity is socially optimal, and total surplus is maximal.
  • Tradable allowance does not create any government revenue.

Module 4 Lecture 10

The Costs of Production

  • The basic activity of a firm is to use inputs, like workers, machines, and natural resources to produce outputs of goods and services.
  • This process - turning inputs into outputs - is called technology.
  • Improvement in the ability to turn inputs into outputs is a positive technological change.
  • A firm’s good is to maximize profits.
  • Total revenue: the amount a firm receives from the sale of goods and services.
  • Total cost: the amount a firm pays for inputs used to produce goods or services.

The Short and the Long Run in Economics

  • Short-run - period of time in which at least one of a firm’s inputs is fixed.
  • Inputs are often simplified as labor and capital.
  • In the long run, no inputs are fixed, and the firm can adopt new technology.

Fixed and Variable Costs

  • Variable costs: costs that change as output changes.
  • Fixed costs: costs that remain constant as output changes.
  • In the long run, all the firm’s costs are variable.
  • Total cost; the sum of variable costs and fixed costs.

Explicit and Implicit Costs

  • Economists like to consider all the opportunity costs of an activity (both explicit and implicit costs).
  • Explicit cost: A post involving spending money
    • Usually easier to identify.
  • Implicit cost: A non-monetary opportunity cost
    • Composed of forgone opportunities that could have generated revenue.

Economic and Accounting Profit

  • Accounting profit: total revenue minus explicit costs.
  • Economic profit: total revenue minus explicit costs and implicit costs.


  • Marginal product: the increase in output generated by an additional unit of input.
  • Principle of marginal product: marginal product of input decreases as the quantity of the input increases.
  • Average product: total production divided by the number of workers.
  • Marginal and Average Product are defined relative to some input, ceteris paribus.

Average Product of Labor

  • Average of the marginal products of labor.

Marginal Product of Labor

  • Marginal product curve passes through the maximum of the average product curve.

Graphs of Output and Marginal Product of Labor

  • The output curve flattens out and the marginal product curve decreases because of the principle of diminishing returns.

Module 4 Lecture 11

Marginal Costs of Production

  • Marginal cost: change in firm’s total cost from producing one more unit of a good or service.
  • Can be rewritten as wage divided by marginal product labor (assuming the wage stays the same).

Graphing Average and Marginal Costs

  • Since the average cost of production follows the marginal post down and up, it forms a U-shaped curve.

Observations About Costs

  • Average Total Cost is the sum of Average Fixed Cost and Average Variable Cost.
  • When the Marginal Cost is above the Average Total Cost, it is rising.
  • The Marginal Cost curve cuts through the ATC and AVC at their minimum point.
  • The ATC is the vertical sum of AVC and AFC curves.

The Long Run and Average Costs

  • Long run average cost curve - lowest cost at which a firm can produce a given quantity of output in the long run, in which no inputs are fixed.
  • Think about long-run cost curves as an agglomeration of short-run total cost curves.
  • As a firm moves to larger quantities, they experience economies of scales.
    • The ability not only to vary the number of workers but also technology (size of factories, machines, etc.)
  • Constant returns to scale: flat region of the long-run average cost.
  • Minimum efficient scale: lowest level of output at which all economies of scale are exhausted.
  • Eventually, firms get so large they experience diseconomies of scale.

Module 5 Lecture 12

Market Structures

Market Structures: models of how firms in a market interact with buyers to sell their output.

  • Perfectly competitive markets
  • monopolistically competitive markets
  • Oligopolies
  • Monopolies

Introduction to Perfectly Competitive Markets

  • A perfectly competitive market has
    • Many buyers and sellers
    • Identical products sold
    • No barriers to new firms entering the market
  • Competitive firms are price-takers (unable to affect market price)

The Demand Curve for a Perfectly Competitive Firm

  • A perfectly competitive firm is too small to affect the market price no matter what quantity is sold.
  • An individual can sell any amount they want at any price. They do not need to lower the price to sell more.

How Is the Firm’s Demand Curve Determined

  • Collective supply determines the market price, but the individual takes a flat demand curve.

Firm Revenue in PC Markets

  • For perfectly competitive firms, price equals average revenue equals marginal revenue.

Profit Maximization: The Goal of the Firm

  • Why don’t all firms sell an infinite quantity?
  • Firms don’t care about revenue, but instead profit.
  • The cost curve is nonlinear.
  • Firms choose an output that maximizes profit.
  • Quantity at which we maximize profit is when marginal revenue equals marginal cost.

Rules for Profit Maximization

  1. Profit-maximizing level of output is where the difference between total revenue and the total cost is the greatest.
  2. Profit maximizing level of output is where MR = MC.
  3. These are true for every firm.
  4. For PC firms, P=MR, meaning that profit-maximizing level of output is also when P = MC.

A Useful Formula for Profit

  • Average profit = Price - ATC.
  • Profit = \((P - ATC) \times Q\).
  • Rectangle of length \(Q\) and height \(P - ATC\).

Module 5 Lecture 13

Short Run Responses to Perfectly Competitive Firms to Losses

  • A firm in a perfectly competitive market making a loss has two options:
    1. Continue to produce
    2. Stop production by shutting down temporarily
  • If the firm shuts down, it still needs to pay for fixed costs.
    • These are sunk costs - nothing the firm can do about it.
  • Look at variable costs. Profit is (price minus AVC minus AFC) times quantity.
    • Pull out: Profit is (price minus AVC) times quantity minus FC.
  • If profit is negative and the price is larger than the variable cost, profit is still higher than -FC. Production should continue to minimize losses.
  • The firm’s shut down decision is based on its variable costs.
  • The marginal cost is the short-run market supply curve.

The Effects of Entry on Economic Profit

  • Firms can leave the market in the long run if they are not making a positive profit in the long run.
  • When firms make positive profits, other firms enter the market to benefit from positive profits. The supply curve shifts until the marginal firm make no profit.

The Effects of Economic Losses

  • Long-run equilibrium price occurs at the minimum of the ATC curve.
    • Intersection of demand and supply curves.
  • When demand decreases, economic profit becomes negative, and firms exit.
  • Supply falls again; the price rises again back to the break-even equilibrium price.

Long-Run Supply

  • Long-run market supply curve located at the minimum point on the ATC curve, is flat.
  • Firms will adjust; in the long run, the supply curve is flat.
  • Increasing cost industry: some factor of production cannot be replicated (e.g. natural resources)
  • Decreasing cost industry: additional firms generate profits for existing firms.

Types of Efficiency

  • Productive efficiency - a situation in which a good or service is produced at the lowest possible cost.
  • Allocative efficiency - every good or service is produced up to the point where the last unit provides a marginal benefit equal to the marginal cost.
  • Perfectly competitive markets are both productively and allocatively efficient.
  • Perfectly competitive markets are useful benchmarks.

Module 6 Lecture 14

What is a Monopoly?

  • A monopoly is a market with only one firm that is the only seller of a good or service w/out a close substitute.
    • The “antithesis” of perfect competition.
  • Some firms are monopolists; firms can also collude to act as a monopolist; give insight into the most extreme case of market power.
  • Some firms may have monopoly power to raise prices and obtain positive economic profits, even if they are not perfect monopolies.

Why do Monopolies Exist?

  • Monopolies exist because of barriers to entry that prevent other firms from entering the market.
    • Scarce resources: there are not enough resources for new firms.
    • Economies of scale: natural monopoly, long-run costs are lower for higher levels of output.
    • Government intervention: patent, copyright, for instance.
    • Aggressive business tactics: drive out competition, price changing.

Monopolies and the Demand Curve

  • Monopolists are beholden to the demand curve.
  • Monopolies must look at the demand curve and make choices as to how to choose the price.

Monopoly Revenue

  • When a monopolist produces more of a good, the market price is driven down.
  • Producing an additional unit of output has two effects on total revenue:
    • Quantity effect
    • Price effect
  • Total revenue can increase or decrease, depending on which effect is larger.
  • To maximize profit, monopolies produce at the point where \(MC = MR\).
  • Total revenue is maximized when \(MR = 0\).
  • \(AR = P\), average revenue, and price are greater than marginal revenue.

Profit-Maximizing Price and Output for a Monopoly

  • \(MC = MR\) determines quantity for a monopolist.
  • No distinction between the short run and long run for monopoly, except for lower costs.
  • Monopolists continue to earn profits in the long run.

Comparing Monopoly and Perfect Competition

  • Marginal revenue is always less than price; the price must be greater than marginal cost.
  • There will be deadweight loss and the market will not be efficient.
  • Monopolies sell at a lower quantity and higher price than perfect competition.

Measuring the Efficiency Losses from Monopoly

  • Consumer surplus will fall, producer surplus will rise.
  • Can an increase in producer surplus offset the decrease in consumer surplus? - No. The quantity decreases.
  • Many firms have market power - the ability of a firm to charge a price greater than marginal cost.

Module 6 Lecture 15

Monopolistic Competition

  • A market with many firms that sell similar but differentiated goods and services.
    • Able to earn a positive profit in the short run by selling a differentiated product.
    • Offer goods that are similar to competitors’ products but more attractive.
  • Advertising and branding - a manifestation of product differentiation.
  • Each firm forms its own market and thus is able to operate like a ‘small’ monopoly.

Demand Curve for a Monopolistically Competitive Firm

  • Face a downward sloping demand curve that is not very steep; pretty elastic because consumers can switch to other firms, are pretty price-sensitive.
  • Firm has to lower the price to sell more goods.

How a Price Cut Affects Firm Revenue

  • When the price decreases, the revenue increases by the quantity effect but decreases by the price effect.
  • Marginal revenue is less than price.

Demand and Marginal Curves

  • The point at which marginal revenue equals zero is the revenue-maximization location.

Profit Maximization

  • Occurs where marginal cost equals marginal revenue.
  • Profit is assumed to be larger than zero because of product differentiation.

Long Run Profits

Product Differentiation in the Long Run

  • In the short run, firms can make a positive profit.
  • In the long run, firms can enter the market and ‘threaten’ product differentiation.

How the Entry of New Firms Affects Profits of Existing Firms

  • Substitutes for the firm’s good increase
  • Demand falls and becomes more elastic for any one firm
  • In the long run, no profit can be made, so price equals ATC (demand tangent to ATC).
    • As more firms enter, existing firms are driven to zero profit.

Short Run Firms Making Loss

  • When firms make a loss, there is no quantity at which demand (price) is above ATC, and thus the firm makes a short-run economic loss.
  • In the long run, firms exit, and price rises again to where the demand curve is tangent to ATC.
  • In the long run, the firm must break even.
  • The firm can, at best, produce at the quantity where the ATC curve is tangent to the demand curve.

Zero Profit in the Long Run

  • Brand management: convince customers that the product/experience is better than other firms. Intended to maintain product differentiation, keep the demand curve downward-sloping.
  • Innovate so costs are lower than that of other firms.
  • Firms do not passively affect the long-run outcome.

The Efficiency of Monopolistic Competition

  • Monopolistic competition is neither productively nor allocatively efficient.
  • When the demand curve is flat, it can touch ATC at the lowest point.
  • When the price is equal to ATC in monopolistic competition, the demand curve is sloped and therefore not productively efficient. Always produces less than is efficient.

Monopolistic Competition and Welfare

  • Monopolsiitcally competitive firms maximize profits by setting prices larger to marginal cost, leading to deadweight loss.
  • Entry can drive monopolistically competitive firms to zero profit in the long run, but markets will still produce a deadweight loss.
  • Firms operate at a smaller-than-efficient scale.