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Textbook Notes

ECON 200

Chapter 1: “Economics and Life”

Making an Impact with Small Loans

  • Bangladeshi economist Muhammad Yunus won the Nobel Peace Prize for the Grameen bank.
  • Grameen serves some of the poorest people in the world; before Grameen, other banks had been unwilling to work in poor communities.
  • Yunus realized that economic thinking holds the key to solving hard problems that truly matter.

The Basic Insights of Economics

  • Economics is the study of how people manage resources.
    • Resources can be physical (e.g. cash), or intangible (time, ideas, experience).
  • People compare choices available to them and behave in a way to best achieve their goals.


  • Scarcity is a fact of life; it is the condition of wanting more than we can get with available resources.
    • Some things, like knowledge, sunlight, and air, are not considered to be restricted by resources.
    • However, most goods are considered to be scarce.
  • What are the wants and constraints of those involved in a complex economic problem?
    • Banks want to make profits by lending to people who will pay them back. They are constrained by limited funds. Banks prioritize making large loans to customers likely to pay them back.
    • Villagers want to increase their incomes. They are constrained in their ability to borrow money.

Opportunity Cost and Marginal Decision Making

  • Every decision in life involves weighting the trade-off between costs and benefits.
    • We choose to do things only when we think benefits will be greater than the costs.
  • Opportunity cost: the opportunity you must give up for something that you might have enjoyed otherwise.
    • Value of what you had to give up to get something.
    • The opportunity cost of life: can the money be equated with life via opportunity cost?

Marginal Decision Making

  • Rational people make decisions at the margin.
  • Marginal decision-making: rational people compare the additional benefits of a choice against the additional costs, without considering related benefits and costs of past choices.
  • In practice, many people do not make decisions on the margin.
  • Sunk cost: a cost that has already been incurred. Sunk costs should not have a bearing on your marginal decision about what to do next.


  • As trade-offs change, so do the choices people make.
  • Central idea in economics: collective reaction to a changing trade-off:
    • What happens when prices change?
    • What happens when the government implements a new policy?
    • What happens when a company introduces a new product?
  • Incentive: something that causes people to behave in a certain way by changing their trade-offs.
    • Positive incentive - makes people more likely to do something.
    • Negative incentive - makes them less likely to do it.
  • Economists make two assumptions:
    • People respond to incentives.
    • Nothing happens in a vacuum. A change will always elicit a response from others.
  • Collateral - a possession (e.g. house or car) pledged by a borrower to a lender.
  • Group responsibility - proposed by Yunus, concluded that borrowers have a strong incentive to repay their loans if one person’s loan is at the stake of others paying off their loans.


  • Efficiency: not only about maximizing productivity but about ensuring people get what they most want and need, given their current resources.
  • Efficiency does not necessarily mean that the outcomes are fair or ethical.
  • When an economy is efficient, there is no way to reorganize things to make anyone better off without someone else becoming worse off.
  • Resource: anything that can be used to make something of value.
  • When an economy is efficient, resources are used to create the greatest total economic value of society.
  • Under normal circumstances, individuals and firms will act to provide the things people want.
    • If a profit-making opportunity exists, someone will take advantage of it sooner rather than later.
  • How can abnormal circumstances lead to not taking an opportunity to profit off an idea?
    • Innovation: the idea is too new.
    • Market failure: something prevents benefits of the opportunity to be captured, or additional costs are imposed.
    • Intervention: the government intervenes in the economy and disrupts “normal” transactions.
    • Unprofitable idea: your idea won’t produce a profit.
  • If you have an idea that has not been exploited yet, ask:
    • Have you misjudged people’s wants and constraints?
    • Have you miscalculated people’s tradeoffs?
    • Have you misunderstood how people respond to incentives?

An Economist’s Problem-Solving Toolbox

  • Economic analysis requires us to combine theory with observations.
  • We need to distinguish the way things are and what they should be.

Correlation and Causation

  • If two variables have a consistent relationship, there is a correlation between them.
  • Causation means one variable causes the other.
  • Correlation and causation can be confused in three ways.
    • Coincidence: correlation may be the result of pure coincidence.
    • Omitted variables: an underlying factor that links both variables has not been examined.
    • Reverse causation: A caused B, rather than vice versa.


  • A model is a simplified representation of a complicated situation.
    • By carefully simplifying a situation to essentials, we can get approximate useful answers.
  • Circular flow model: shows how transactions in an economy work.
    • Households supply land and labor to firms and invest capital in firms. They buy goods and services that firms produce.
      • Land, labor, and capital are factors of production.
    • Firms buy or rent land, labor, and capital supplied by households, and produce and sell goods and services.
    • Households and firms are tightly interconnected through production and consumption.
  • Two markets emerge: market for goods and services, *market for the factors of production.
  • A model should do three things:
    • Predict cause and effect. A causes B because of X.
    • State its assumptions clearly.
    • Describes the real world accurately.

Positive and Normative Analysis

  • Positive statement: “what is”; makes a factual claim about how the world works.
  • Normative statement: “what ought to be”; claims what should be done.


Key concepts from Chapter 1:

  • Scarcity
  • Opportunity cost
  • Incentives
  • Efficiency

Chapter 2: “Specialization and Exchange”

Production Possibilities

  • Good models help us understand complex situations by simplifying assumptions.

Drawing the Production Possibilities Frontier

  • A production possibilities frontier (PPF) is a curve showing all possible combinations of outputs that can be produced using all available resources.
  • PPF allows us to answer: what are the wants and constraints of those involved? and what are the trade-offs?
    • Also allows us to represent constraints (points outside the PPF).
  • In linear PPFs, opportunity cost is represented by the slope.

Production Possibilities Frontiers When Opportunity Costs Differ

  • Linear PPFs assume that all workers can make the same amount of a good; in reality, some workers may be more efficient at producing a certain product.
  • Curved PPFs allow for more complex relationships between opportunity costs.
  • At each point of the curved PPF, the slope represents the opportunity cost of getting more of any axis.

Choosing Among Production Possibilities

  • Choosing a production point inside the frontier means it is not using all of its resources; it is inefficient.
  • Points that lie on the frontier are efficient because they have the most output from the available resources.

Shifting the Production Possibilities Frontier

  • Two main actors drive changing U.S. production possibilities:
    • Number of workers
    • Changes in technology.
  • With these two changes, a country can economically grow by expanding out its PPF.
  • An increase in available resources shifts the entire frontier outward.
  • An improvement in technology for a good rotates the frontier outward.

Absolute and Comparative Advantage

  • If there is no trade between countries, then a country can only consume goods it produces on its own.
  • Absolute advantage: a producer can generate more output than others with a given amount of resources.
  • Comparative advantage: a producer can make a good at a lower opportunity cost than other producers.
  • Countries can have a comparative advantage without having an absolute advantage.
  • The opportunity cost of producing on one axis unit is the inverse of the opportunity cost of producing one of the other axis units.
  • No producer has a comparative advantage at everything, and each producer has a comparative advantage at something.

Why Trade?

  • Two countries that trade can consume more when they specialize in producing the good for which they have a comparative advantage and trade.


  • All of us are dependent on one another for things we need daily.
  • Specialization - focusing on producing a good for which it has a comparative advantage.
    • Total production increases from specialization.

Gains From Trade

  • When countries specialize in producing the goods for which they have a comparative advantage, total production increases.
  • Improvement in outcomes resulting from the specialized exchange of goods or services is called gains from trade.
  • There is room for trade as long as two conditions are met:
    1. Countries differ in opportunity costs to produce a good;
    2. A favorable trading price is set.
  • Countries value a good based on their opportunity costs.
    • If a trade price falls between opportunity costs, two countries benefit.
  • Not all citizens gain from international trade.
    • In practice, international trade policy can be controversial, despite its advantages.

Comparative Advantage Over Time

  • This simplified model of production possibilities helps us to understand why Americans buy certain products from other countries.
  • To understand changes, we can apply models to shifts in comparative advantage over time, causing changes to economies and trade patterns.
  • When a country acquires a comparative advantage in one field, it has strengthened it in another industry.


  • Specialization and trade can make everyone better off.
  • People specialize to exploit comparative advantages.

Chapter 3: “Markets”


  • An economy organized by the “invisible hand”: private individuals, rather than a centralized planning authority, make decisions.
    • Known as the market economy.

What is a Market?

  • Market - buyers and sellers that trade a particular good or service.

What is a Competitive Market?

  • Making simplifying assumptions allows us to focus on important ideas.
  • Assumption: markets are competitive.
  • Competitive market - fully informed, price-taking buyers and sellers easily trade a standardized good or service.
  • Price taker - a buyer or seller who cannot affect the market price.
  • Standardized good - a good or service for which all units have the same features and are interchangeable.
  • Transaction costs - costs incurred by the buyer and seller agreeing to the sale of goods or services. Competitive markets assume no transaction costs.
  • Few markets are perfectly competitive; however, the assumption of competitive markets leads to useful insights.


  • Demand - how much of something people are willing or able to buy under certain circumstances.
  • Different people buy their cell phones at different prices; individual choices summed up to form the market demand.
  • Amount of goods that buyers in the market purchase at a specific moment are the quantity demanded.
  • Law of Demand: The lower the price goes, the higher the quantity demanded; the inverse relationship between price and quantity.
    • Ceteris paribus - all other things being the same. When all else is held equal, the inverse relationship is true.
  • Ceteris paribus is used to isolate the expected effect of a change in the economy.

The Demand Curve

  • Demand schedule - shows the quantities of a particular good or service that customers are willing and able to purchase (demand) at different prices.
  • Demand curve - visually displays the demand schedule.

Determinants of Demand

  • The demand curve represents the relationship between price and quantity if everything else is held constant.
  • If ceteris paribus is not true, nonprice factors can influence demand changes and shift the curve.
  • Nonprice determinants of demand:
    • Consumer preferences: personal likes or dislikes that make buyers more/less inclined to purchase a good.
    • Price of related goods: substitutes (similar-purpose) and complements (goods consumed together).
    • Income of customers: the amount of income people earn affects the demand for goods and services.
      • Normal goods - an increase in income causes an increase in demand.
      • Inferior goods - an increase in income causes a decrease in demand.
    • Expectations of future prices: when prices are expected to drop in the future, demand decreases, and vice versa.
    • Number of buyers in the market: an increase in the number of potential buyers increases demand, and vice versa.

Shifts in the Demand Curve

  • When one of the nonprice determinants of demand changes, the entire demand curve shifts left or right.
    • Horizontal (rather than vertical) shift: nonprice determinants affect the quantity demanded at each price.
    • “increase in demand” or “decrease in demand”. A shift of the entire demand curve.
  • A change in price causes movement along the demand curve; this is an “increase in quantity demanded” or “decrease in quantity demanded”.


  • Supply - describes how much of a good or service producers will offer.
  • Quantity supplied - the amount of a good that producers will offer for sale at a specific price.
  • Market supply can be found by adding individual decisions of each producer.
  • Each producer has a different price point at which they decide it is worthwhile to supply cell phones.
  • Law of Supply - ceteris paribus, quantity supplied increases as price increases.
  • Supply varies with price because the decision to produce a good is about the trade-off between the benefit to the producer and opportunity cost.

The Supply Curve

  • Supply Schedule - table that shows quantities of a good or service that producers supply.
  • Supply curve shows a graph of information in the supply schedule.

Determinants of Supply

  • Several nonprice factors determine the opportunity cost of production.
  • When a nonprice determinant of supply changes, the entire supply curve shifts.
  • Five major categories of nonprice determinants of supply:
    • Prices of related goods. The price of related goods determines supply because it affects the opportunity cost of production.
    • Technology. Improved technology enables firms to produce more efficiently.
    • Prices of inputs. Prices of the inputs used to produce a good are important to its cost.
    • Expectations. Suppliers’ expectations in the future affect quantity supplied.
    • Number of sellers. The number of sellers in the market is considered a fixed part of the supply curve.

Shifts in the Supply Curve

  • Changes in price cause suppliers to move to a different point on the same supply curve.
  • A change in nonprice determinant increases or decreases supply.
  • Change in the nonprice determinant of supply: “Increase in supply”
  • Movement along the supply curve: “Increase in quantity supplied”

Market Equilibrium

  • To find what happens in the market, we need to combine supply and demand.
  • Convergence of supply with demand happens at a point when the demand curve intersects the supply curve, called the Market equilibrium.
    • Price at this point: equilibrium price
    • Quantity at this point: equilibrium quantity.
  • There is no sale without a purchase; when markets work well, the quantity supplied exactly equals the quantity demanded.

Reaching Equilibrium

  • Sellers set prices by trial and error; incentives buyers and sellers face naturally drive the market towards an equilibrium price and quantity.
  • Excess supply/surplus: when quantity supplied is higher than the quantity demanded.
  • Excess demand/shortage: when the quantity demanded is higher than the quantity supplied.
  • At any price above or below the equilibrium price, sellers face an incentive to raise or lower prices.

Changes in Equilibrium

  • Some changes affect both supply and demand curves.
  • To determine the effect on market equilibrium of a change in a nonprice factor:
    1. Does the change affect demand? Does demand increase or decrease?
    2. Does the change affect supply? If so, does supply increase or decrease?
    3. How does the combination of changes in supply and demand affect equilibrium price and quantity?
  • In the case where both demand and supply shift, we need to know if demand or supply increases more.
  • When supply and demand shift together, it is possible to predict either the direction of the change in quantity or the direction of the change in price without knowing how much the curves shift.
    • When supply and demand shift in the same direction, we can predict the direction in a change in quantity, but not in a price change.
    • When supply and demand shift in opposite directions, the price change is predictable, but not the change in quantity.
Supply ChangeDemand ChangePrice ChangeQuantity Change
  • Remember: what do buyers and sellers agree on?

Chapter 4: “Elasticity”

What is Elasticity?

  • Elasticity - a measure of how much consumers and producers will respond to a change in market conditions.
  • Elasticity allows economic decision-makers to anticipate how others will respond to market condition changes. Several measures of elasticity.
    • Price elasticity of demand and price elasticity of supply: how much quantity demanded and quantity supplied change when the price of good changes.
    • Cross-price elasticity of demand - how much the demand curve shifts when the price of another good change.
    • Income elasticity of demand - how much the demand curve shifts when consumer incomes change.

Price Elasticity of Demand

  • Price elasticity of demand: the size of the change in the quantity demanded of a good or service when the price changes.
  • Sensitivity to price changes is measured as:
    • more elastic - a small change in price causes a large change in the quantity demanded.
    • more inelastic - a small change in price causes a small change in the quantity demanded.

Calculating price elasticity of demand

\[\text{Price elasticity of demand} = \frac{\text{\% change in qty demanded}}{\text{\% change in price}} = \frac{\left(Q_2\:-\:Q_1\right)\left(\frac{P_2\:+\:P_1}{2}\right)}{\left(\frac{Q_2\:+\:Q_1}{2}\right)\left(P_2\:-\:P_1\right)}\] \[\text{\% change in qty demanded} = \frac{Q_2 - Q_1}{\left(\frac{Q_2 + Q_1}{2}\right)}\] \[\text{\% change in price} = \frac{P_2 - P_1}{\left(\frac{P_2 + P_1}{2}\right)}\]

In this context, percent change uses the average rather than an endpoint because using endpoints would make the direction relevant. This poses problems when calculating elasticity.

To interpret the elasticity:

  • Elasticity describes the size of the change in the quantity demanded of a good when the price changes.
    • -1.38 price elasticity of demand for iPhones means that a 1% decrease in the price of iPhones will lead to a 1.38% increase in the number of iPhones demanded. Or, a 1% increase in the price of iPhones will lead to a 1.38% decrease in the quantity of iPhones demanded.
    • Price elasticity of demand will always be a negative number because price and quantity demanded move in opposite directions.
    • Economists often drop the negative sign and express price elasticity of demand as a positive number.
    • Measuring percent change in quantity rather than absolute chance in quantity allows the elasticity of demand for a good to be the same regardless of the unit of measurement.

Determinants of price elasticity of demand

  • Consumers are more sensitive to price changes for some goods and services than others.
  • When consumers are very responsive to price changes, the demand for the good is more elastic; in the opposite scenario, demand for that good is more inelastic.
  • Factors determining consumer responsiveness to price changes:
    • Availability of substitutes. If close substitutes are available for a particular good, the demand for the good will be more elastic than if only distant substitutes are available.
    • Degree of necessity. When a good is a basic necessity, people will still buy it if its price rises.
    • Cost relative to income. If consumers spend a small % of their incomes on a good, their demand will be less elastic.
    • Adjustment time. Goods often have more elastic demand over the long run.
    • Scope of the market. Caveat for determinants - it depends on how you define the market for a good or service.

Using price elasticity of demand

  • At the extreme, demand can be perfectly elastic or inelastic.
    • Perfectly elastic demand - quantity demanded drops to zero when the price increases a minuscule amount. Is a horizontal demand curve.
    • Perfectly inelastic demand - quantity demanded remains the same regardless of the price. Is a vertical demand curve.
  • Within the extremes, elasticity is divided into three categories:
    • Elastic demand - absolute value of the price elasticity of demand is greater than 1.
    • Inelastic demand - absolute value of the price elasticity of demand is less than 1.
    • Unit-elastic demand - absolute value of the price elasticity of demand is equal to 1.
  • Knowing whether demand is elastic or inelastic is extremely useful.
    • Total revenue - amount a firm receives from the sale of goods and services; \(\text{total revenue} = \text{quantity sold} \times \text{price paid per unit}\). Tells us how much money sellers recieve when they sell something.
  • Increase in price affects total revenue:
    • Quantity effect - decrease in total revenue because of fewer units sold.
    • Price effect - increase in total revenue because of a higher price for each unit.
  • When the quantity effect outweighs the price effect, the total revenue will drop.
  • When demand is elastic, price increase causes total revenue to fall; when demand is inelastic, total revenue increases.
  • Elasticity varies along the curve. Demand tends to be more elastic when the price is high and more inelastic when the price is low.
    • For prices above the unit-elastic price, the demand is elastic.
    • For prices below the unit-elastic price, the demand is inelastic.
  • Slope is not the same thing as elasticity.

Price Elasticity of Supply

  • How will the increase in price increase production?
  • Price elasticity of supply - the size of the change in quantity supplied of a good or service when the price changes. Measures producers’ responsiveness to a change in price.

Calculating price elasticity of supply

\(\text{Price elasticity of supply} = \frac{\text{\% change in qty supplied}}{\text{\% change in price}} = \frac{\left(Q_2\:-\:Q_1\right)\left(\frac{P_2\:+\:P_1}{2}\right)}{\left(\frac{Q_2\:+\:Q_1}{2}\right)\left(P_2\:-\:P_1\right)}\)

\[\text{\% change in qty supplied} = \frac{Q_2 - Q_1}{\left(\frac{Q_2 + Q_1}{2}\right)}\] \[\text{\% change in price} = \frac{P_2 - P_1}{\left(\frac{P_2 + P_1}{2}\right)}\]
  • Price elasticity of supply can be categorized as elastic, inelastic, or unit-elastic, just as with price elasticity of demand.
  • Perfectly elastic supply - quantity supplied could be anything at a given price.
  • Perfectly inelastic - quantity supplied is the same regardless of price.
  • Elasticity of demand is always negative; elasticity of supply is always positive.

Determinants of price elasticity of supply

  • Whether supply is elastic or inelastic depends on the supplier’s ability to change the quantity produced given price changes.
  • Factors determining supplier responsiveness to price changes:
    • Availability of inputs. The production of some goods can be changed easily just by adding extra inputs. The elasticity of supply depends on the elasticity of the supply of inputs to the production of the good.
    • Flexibility of the production process. Producers may or may not be able to easily draw production capacity away from other goods when a good’s price rises.
    • Adjustment time. Supply is more elastic over long periods than in short periods.

Other Elasticities

Cross-price elasticity of demand

  • Price elasticities are affected by the availability of alternative options.
  • Cross-price elasticity of demand: describes how much demand changes when the price of different goods changes.
\[\text{Cross-price elasticity of demand between A and B} = \frac{\text{\% change in quantity of A demanded}}{\text{\% change in price of B}}\]
  • The initial quantity demanded is on one demand curve and the final quantity demanded is on another demand curve because nonprice determinants shift a demand curve.
  • When goods are substitutes, the cross-price elasticity of demand is positive. The increase in the price of one will cause an increase in the quantity demanded of the other.
  • When two goods are complements, the cross-price elasticity of demand is negative. The increase in the price of one will cause a decrease in the quantity demanded of the other.
  • Cross-price elasticity shows how closely two goods are complements or substitutes.

Income elasticity of demand

  • Income elasticity of demand: describes how much demand changes in response to a change in consumers’ incomes.
  • Change in income causes the demand curve to shift; measure change by observing the change in quantity demanded.
\[\text{Income elasticity of demand} = \frac{\text{\% change in quantity demanded}}{\text{\% change in income}}\]
  • For normal goods, the income elasticity is positive. As income rises, demand increases.
  • For inferior goods, the income elasticity is negative. As income rises, demand decreases.
  • For necessity goods, the income elasticity will be positive and less than 1 (inelastic with respect to income).
  • For luxury goods, the income elasticity will be positive and larger than 1 (elastic with respect to income).

Chapter 5: “Efficiency”


  • How do we know that people are better off when they bull and sell things?
  • Surplus - measure the benefits people receive when they buy something for less than they would have been willing to pay.
  • Surplus shows how important equilibrium price and quantity are: maximize the total well-being of those involved.
  • Maximizing total surplus - efficiency - is a powerful feature of a market system.
    • It can be achieved without centralized coordination.

Willingness to Pay and Sell

  • Potential buyers want to pay as little as possible, and each buyer has a maximum price they’re willing to pay.
    • Maximum price: willingness to pay, or reservation price.
  • Willingness to sell - minimum price a seller is willing to accept in exchange for a good or service.

Willingness to pay and the demand curve

  • We can conduct an exercise in a large market and plot out the willingness of millions of people to pay; we get a smooth demand curve.
  • Each buyer’s willingness to pay is driven by different factors.
  • Willingness to pay is the point where the benefit a person will get from the camera is equal to the benefit of spending the money on another alternative (the opportunity cost).

Willingness to sell and the supply curve

  • The shape of the supply curve is driven by potential sellers’ willingness to sell.
  • Sellers’ willingness to sell is determined by the trade-offs they face, and the opportunity cost of the sale.
  • In a market where manufacturers are producing and selling products, the minimum price must be high enough to make it worth it to continue making products.

Measuring Surplus

  • Surplus - measuring who benefits from transactions and by how much.
    • If you get something for less than you were willing to pay or sell for more than the minimum you were willing to sell for, this is a good thing.
  • Surplus - the difference between the price at which a buyer or seller would be willing to trade and the actual price.
    • Surplus is a better measure of the value that buyers and sellers get from the market than the price itself.
  • Consumer surplus - the maximum extra amount you would pay over the current price to maintain the ability to buy something. Difference between willingness to pay and actual price.
    • Consumer surplus better represents how much you value a good.

Consumer Surplus

  • Consumer surplus - a net benefit that a consumer receives from purchasing a good or service.
\[\text{Consumer surplus} = \text{Willingness to pay} - \text{Actual price}\]
  • Total consumer surplus can be found by summing all the individual consumer surpluses.
  • Consumer surplus is the area underneath the demand curve and above the horizontal line of the equilibrium price.
  • How does a change in the market price affect buyers?
    • A decrease in price makes buyers better off
    • An increase in price makes buyers worse off.
  • Some people do not buy at all when prices rise - their surplus becomes 0.
  • Measuring consumer surplus tells us how much better or worse off buyers are when the price changes.

Producer Surplus

  • Producer surplus - net benefit a producer receives from a sale of a good or service.
\[\text{Producer surplus} = \text{Willingness to sell} - \text{Actual price}\]
  • Total producer surplus can be found by summing individual producer surpluses.
  • Sellers prefer prices to be higher:
    • an increase in price makes them better off
    • a decrease in price makes them worse off.
  • Measuring producer surplus tells us how much better or worse off sellers are when the price changes.

Total surplus

  • What will the actual market price be?
  • Put demand and supply curves together, and locate the point where they intersect.
  • Consumer surplus: find the area under the curve but above the equilibrium price.
  • Producer surplus: find the area above the curve but under the equilibrium price.
  • Total surplus - a measure of combined benefits everyone receives from participating in the exchange of goods and services.
    • Also can be thought of as the value created by the existence of the market.
  • The economy is not a fixed quantity of money, a zero-sum game.
  • Surplus shows that both the buyer and the seller are winners since each gains surplus.

Using Surplus to Compare Alternatives

  • In a competitive market, buyers and sellers will find their way to the equilibrium price.

Market equilibrium and efficiency

  • Surplus allows us to appreciate something important about market equilibrium: it is the point where transactions maximize total surplus.
  • When the price deviates from the equilibrium price, the quantity decreases, and total surplus is lost.
  • A higher or lower price causes fewer trades to take place because some people are no longer willing to buy or sell.

The equilibrium in a perfectly competitive, well-functioning market maximizes total surplus.

  • The market is efficient when it is at equilibrium: no exchange can make anyone better off without someone becoming worse off.

Changing the distribution of total surplus

  • Reassignment of surplus from customers to producers for transactions that take place when the price is moved away from the equilibrium price:
    • When the price was raised, sellers gained at the expense of buyers.
    • When the price was lowered, buyers gained at the expense of sellers.
  • Transfer of well-being reduced total surplus.
  • A price below the market equilibrium will always reduce producer surplus.

Deadweight loss

  • Intervention that moves the market away from equilibrium might benefit producers or consumers but comes with a decrease in surplus.
  • Where does the surplus go? Disappears and becomes deadweight loss.
  • Deadweight loss is the loss of total surplus that occurs when the quantity of a good is below market equilibrium quantity.
  • Two ways to calculate deadweight loss:

\(\text{Deadweight loss} = \text{Total surplus before intervention} - \text{Total surplus after intervention}\) \(\text{Deadweight loss} = \frac{b \times h}{2} \text{(directly calculate using triangle method)}\)

  • Deadweight loss is the surplus that is lost to both producers and consumers because of fewer transactions taking place.

Missing markets

  • When people would like to make exchanges but cannot, we miss opportunities for mutual benefit.
    • Missing market.
  • Markets can be missing for several reasons.
    • Public policy prevents the market from existing.
    • A tax leads to fewer transactions.
    • Lack of accurate information between buyers and sellers.
  • We can increase total surplus by creating new markets and improving existing ones.
  • Not just redistributing pieces of the pie; making the pie bigger.

Chapter 6: “Government Intervention”

Why Intervene?

  • Markets gravitate towards equilibrium.
  • At equilibrium, there is no way to make some people better off without harming others.
  • Why intervene?

Changing the Distribution of Surplus

  • Efficient markets maximize total surplus, but an efficient outcome may still be seen as unfair.
  • Even if a job market is efficient, wages can drop.
  • The government can respond by intervening in the labor market to impose a minimum wage, changing the distribution of surplus.

Encouraging or Discouraging Consumption

  • Governments can use taxes to discourage people from consuming “bad” products.
  • Governments can use subsidies to encourage people to consume “good” products.

Correcting Market Failures

  • Markets do not always work efficiently.
  • Situations in which the assumption of efficient, competitive markets fails to hold: market failures.
  • Intervention can increase total surplus.

Price Controls

  • One policy tool: price control; regulate the maximum or minimum legal price for a good.
    • Hold the price of a good up or down when the market shifts, preventing the market from reaching a new equilibrium.

Price Ceilings

  • Price ceiling - maximum legal price a good can be sold.
  • Many countries have price ceilings on necessities.
  • Assess the full effect of the price ceiling but looking at what happened to consumer and producer surplus.
  • Changes in the economic well-being of market participants are welfare effects.
  • When the price ceiling is below the equilibrium price, there is a shortage.
  • Nonbinding price ceiling - if the ceiling is set above the equilibrium price in a market, it is nonbinding, and the equilibrium price and quantity will prevail.
    • Price ceilings are usually binding when implemented, and shifts in the market can render ceilings nonbinding.

Price Floors

  • Price floor - minimum legal price a good can be sold.
  • A price floor can allow supplies a minimum income in face of difficulties, keeping them in business.
  • When the price floor is above the equilibrium price, there is an excess.
  • Producers win at the expense of consumers.
  • Nonbinding price floor - price floors are not always binding. A price floor can become binding in response to change in the market.

Taxes and Subsidies

  • Taxes are the main ways governments raise revenue to pay for public programs.
  • Taxes and subsidies can be used to correct market failures.


  • When a good is taxed, either the buyer or seller must pay some extra amount to the government on top of the sale price.
  • Taxes have two effects:
    • Discourage production and consumption of the good being taxed.
    • Raise government revenue.
  • Tax wedge - the difference in price paid by buyers and price received by sellers.
  • Tax revenue - tax wedge multiplied by the quantity of goods bought and sold.
  • Tax causes deadweight loss and redistributes surplus.
  • Under a tax, both producers and consumers lose surplus.
    • Consumers pay more for the same quantity of good, and producers receive less for the same good.
    • Lost surplus in taxes doesn’t disappear like deadweight loss, though, but becomes government revenue.
  • If the tax is imposed on buyers rather than sellers, the outcome is the same.
  • Tax causes some deadweight loss; the value of the revenue the government collects is less than the reduction in total surplus caused by the tax.
  • Weigh the goal against the loss of surplus in the market when evaluating a tax.
Does the tax onaffect… ?Answer
sellerssupplyYes, supply decreases. Sellers will behave as if the price they are receiving is actually [tax amount] lower.
sellersdemandNo, demand stays the same (quantity demanded does change, though).
sellersmarket equilibriumEquilibrium price rises and quantity demanded falls.
buyerssupplyNo, supply stays the same.
buyersdemandYes, demand increases.
buyersmarket equilibriumEquilibrium price and quantity fall.
  • Who bears the burden of a tax?
    • Relative tax burden carried by buyers and sellers: tax incidence.
    • Often, tax incidence is not split equally.
When demand is … elastic than supply,… shoulder more of the tax burden.
just asno one; equally shared
  • Tax changes the price of a good to both buyers and sellers.
  • Relative responsiveness of supply and demand will determine the tax burden.
  • The market that is more price elastic will be able to adjust to price changes and will shoulder less of the tax burden.
  • Market outcome of a tax (new equilibrium quantity and price) is the same regardless of the tax is imposed upon buyers or on sellers.
    • Tax burden will be the same no matter which side of the market is taxed.
  • There can be a difference between economic incidence and statutory incidence.
    • Economic incidence: economic effect of a tax on buyers or sellers
    • Statutory incidence: person legally responsible for paying the tax


  • A subsidy is the reverse of a tax - the government pays an extra amount to producers or consumers of a good.
  • Governments use subsidies to encourage production and consumption of a good or service; it can be an alternative to price controls without generating a shortage.
Intervention MethodQty SuppliedQty DemandedGovernment…
taxdecreasedecreasecollects revenue
subsidyincreaseincreasespends money
\[\text{Government subsidy expenditure} = \text{Subsidy} \times Q_\text{post-subsidy}\]
Does the tax onaffect… ?Answer
sellerssupplyYes, supply increases
sellersdemandNo, demand stays the same
market equilibriumEquilibrium price decreases and equilibrium quantity increases. 
  • Subsidies cause deadweight loss and redistribute surplus.
  • The subsidy lowers the cost to the producer, causing producers and consumers to exchange more goods than is efficient, leading to deadweight loss.
  • The government expenditure is less than the increase in total surplus; this expenditure is passed onto taxpayers in the form of taxes.
  • The side of the market that is more price inelastic receives more of the benefit.
  • The share of the benefit does not depend on who receives the subsidy.

Evaluating Government Interventions

  • We need to assess the effects of each intervention and unintended consequences.
  • Key rules:
    • Price controls have opposing impacts on the quantities supplied and demanded, causing a shortage or excess supply.
    • Taxes and subsidies move the quantities supplied and demanded in the same direction.

The Magnitude of the Effect of a Tax or Subsidy

  • It’s important to know how much a policy will change equilibrium quantity and price.
  • The more elastic supply or demand, the greater the change in quantity.
  • To predict the size of the effect of a tax or subsidy, policy-makers need to know the price elasticity of supply and demand.

Short-run Versus Long-run Impact

  • Price controls cause shortages or excess supply.
  • Sometimes, the full effect of price controls becomes clear only in the long run.
  • In the short run, demand and supply are not very elastic, so the price floor may result in only a small supply excess.

Chapter 12: “The Costs of Production”

The Building Blocks of Business: Revenue, Costs, and Profits

  • A firm’s goal is to maximize profit.

Profit is revenue minus costs

  • The amount a firm receives from the sale of goods and services is its total revenue.
  • The amount a firm pays for its inputs to produce goods and services are its total cost.
    • One-time expenses and ongoing expenses.
  • Profit is \(\text{total revenue} - \text{total cost}\).
  • Revenue is \(\text{Quantity} \times \text{Price}\).

Fixed and variable costs

  • Fixed costs don’t depend on the quantity of output produced.
    • One-time or ongoing.
  • Variable costs depend on the quantity of output produced.
    • Raw materials, labor costs, etc.
  • A firm’s total cost is the sum of its fixed and variable costs.

Explicit and implicit costs

  • True costs are opportunity costs.
  • A firm’s opportunity cost of operations has an explicit cost and implicit cost components.
  • Explicit costs: require a firm to spend money. Rent, employee salaries, materials, etc.
  • Implicit costs: costs of forgone opportunities.

Economic and accounting profit

  • When a company reports its profits, it usually reports accounting profit.
  • However, economic profit is a better measure of how well a business is doing.
\[\text{accounting profit} = \text{total revenue} - \text{explicit costs}\] \[\text{economic profit} = \text{total revenue} - \text{explicit costs} - \text{implicit costs}\]

Production Functions

  • Firms create values by bringing together different ingredients to create a good or service consumers want.
  • Relationship between quantity of inputs and quantity of output: production function.

Marginal Product

  • Marginal product: increase in the production that results from increasing the input.
  • Principle of diminishing marginal product: holding other inputs constant, the marginal product of a particular input decreases as its quantity increases.
  • Average product: number of goods produced by each worker on average.

Cost Curves

Total, average, and marginal costs

  • Average fixed cost (AFC): fixed cost divided by the quantity of output.
  • Average variable cost (AVC): variable cost divided by the quantity of output.
  • Average total cost (ATC): total cost divided by the quantity of output.
  • Marginal cost: variable cost of producing the next unit of output, or \(\frac{\Delta \text{ total cost}}{\Delta \text{ quantity}}\).
  • Marginal cost curve has the inverse shape of the marginal product curve.
  • The marginal cost curve intersects the lowest point of the average total cost curve.

Production in the Short Run and the Long Run

  • Supply is more flexible over longer periods.

Costs in the long run

  • A cost that is “fixed” in the short run may not be so in the long run.
  • In the long run, all costs are considered variable.

Economies and diseconomies of scale

  • ATC is U-shaped because additional inputs have an increasing marginal product, but the principle of diminishing return kicks in, and average total cost increases.
  • Economies of scale, diseconomies of scale, and constant returns to scale: describe the relationship between the quantity of output and average total cost.
  • Increasing the quantity of output enables it to lower its average total cost; the firm is facing economies of scale.
  • Bigger isn’t always better; increasing scale can, at a certain point, lead to higher average total cost; facing diseconomies of scale.
  • In between economies of scale and diseconomies of scale, there are various quantities of output a firm can operate in without experiencing higher or lower average cost: constant returns to scale.
  • A firm’s long-run ATC curve covers a greater range of output than its short-run ATC curve.
  • Long-run ATC curve is made up of points from the firm’s short-run ATC curves.
  • If a firm cannot lower its average total cost by increasing or decreasing its scale, it is operating at an efficient scale.

Chapter 13: “Perfect Competition”

A Competitive Market

  • What are firms’ wants and constraints?.
  • Want: maximize profits.
  • Constraints: will be covered in this chapter.

Characteristics of a Competitive Market

  1. Buyers and sellers cannot affect prices (they are price-takers).
    • Most sellers and buyers in most markets face some degree of competition.
    • In a perfectly competitive market, buyers and sellers face so much competition that they cannot set their price at all.
    • Opposite of a price taker: having market power.
  2. Goods are standardized.
    • Standardized goods are interchangeable.
    • When goods are not standardized, producers can charge different prices.
    • Standardized goods like crude oil and gold are referred to as commodities.
  3. Buyers and sellers have full information.
    • Goods in a perfectly competitive market are standardized.
    • There are no information asymmetries.
  4. There are no transaction costs
  5. Firms can freely enter and exit.
    • New firms can be created and begin producing goods and services, as existing firms can close.
    • Free entry keeps firms on their toes and drives innovation.

Revenues in a Perfectly Competitive Market

  • In a perfectly competitive market, producers can sell as much as they want without affecting the market price.
    • When firms make decisions about the quantity they produce, they do not think about whether their actions will change the market price or if they will find buyers.
\[\text{Total revenue} = P \times Q\] \[\text{Average revenue} = \frac{\text{Total revenue}}{\text{Quantity sold}} = \frac{P \times Q}{Q}} = P\] \[\text{Marginal revenue} = \frac{\text{Change in total revenue}}{\text{Change in quantity sold}}\]
  • Average revenue is equal to the price of the good for a firm selling one product.
  • In a perfectly competitive market, average revenue and marginal revenue are equal.

Profits and Production Decisions

  • Quest for profits drives firms’ behavior.

Deciding How Much to Produce

  • The only choice a company can make to affect profits is the number of roasted plantains.
    • Profit depends not only on revenue but costs.
  • When marginal revenue stays the same but marginal cost increases, a firm should stop production when the two are equal.
    • As long as marginal revenue \(>\) marginal cost, the production of an additional unit increases profits.

Deciding When to Operate

  • A firm can decide if to produce nothing.
  • A firm needs to pay fixed costs regardless of how much it produces.
  • In a perfectly competitive market, the market price is the same thing as the firm’s average revenue.
\[\text{Profit} = \left(\text{Average revenue} - \text{ATC}\right)\timesQ = \left(\text{Price} - \text{ATC}\right) \times Q\]
  • As long as the price is above average total cost, the firm makes positive profits.
  • If the market price falls below the bottom of a firm’s ATC curve, there is no level of output at which the firm can make a profit.
    • In this case, it wants to exit the market.

Short-run decisions

  • If a firm shuts down production, it will stop producing for a period of time until market conditions change.
  • A firm is stuck with fixed costs. They are irrelevant in deciding whether to shut down production in the short run.
  • If the market price is lower than ATC but higher than AVC, the firm should still produce (yields more revenue than the variable cost).
    • Not about gaining profits anymore, but about losing the least amount.
  • Profit-maximizing level of production is at the quantity which the market price intersects the marginal cost curve.
  • If the market price is below average variable cost, it is more advantageous to produce nothing.

Long-run decisions

  • In the long run, all costs become variable.
  • Only in the long run can firms completely exit the market.
  • Firms should consider whether average revenue is greater than average total cost.
    • If the market price is less than the lowest point on the ATC curve, the firm should make a long-run decision to exit the market.

Behind the Supply Curve

  • The supply curve for the market reflects the sum of choices of many individual suppliers.

Short-run Supply

  • In the short run, the number of firms in the market is fixed.
  • Firms have the same cost structure.

Long-run Supply

  • In the long run, firms can enter and exit the number.
  • Firms exit the market if the price falls below the lowest point on the ATC curve in the long run. Firms enter the market if they can produce at a level of ATC below the market price.

Effects of market entry on the long-run supply curve

  • The existence of economic profits signals that there is money to be made; firms will enter the market to take advantage of the opportunity.
  • As the equilibrium market price falls, revenues and profits fall.
  • If economic profit is positive, firms have an incentive to enter the market.
  • When the price is so low that economic profits are reduced to zero (\(P = ATC\)), firms no longer have an incentive to enter the market.

Effects of market exit on the long-run supply curve

  • When firms exit the market, the supply curve shifts to the left; the new market equilibrium quantity decreases, and price increases.
  • In the long run, in a perfectly competitive market,
    • Firms earn zero economic profits.
    • Firms operate at an efficient scale.
    • Supply is perfectly elastic.

Firms earn zero economic profit.

  • A business might be earning accounting profit, but not economic profit.

Firms operate at an efficient scale

  • A firm’s optimal production is at the point where marginal revenue equals marginal cost.
  • The marginal cost curve intersects the average total cost curve at its lowest point.
  • In the long run, economic profits are zero - price is equal to the average total cost.
  • In the long run, price equals marginal cost equals average total cost.

Supply is perfectly elastic.

  • Price must be equal to the minimum of ATC.
  • Anything that moves the price will result in firms entering and exiting the market.

Why the long-run market supply curve shouldn’t slope upward but does

  • Assumption that the price of a good or service never changes, and all firms face identical costs.
  • Adding nuances: some firms are more efficient than others (different cost structures).
  • Newer firms with higher costs will enter only markets with higher prices.
  • The long-run supply curve slopes upward because the price has to rise for new firms to enter.
  • Price equals the minimum of ATC for the least efficient firm in the market, not every firm in the market.
  • The last firm to enter the market earns zero economic profit since ATC \(=\) price.
  • More efficient firms with a lower ATC will be able to earn a positive economic profit.
  • Over time, the average total cost changes.

Responding to Shifts in Demand

  • The long-run supply curve is not perfectly elastic in practice.
  • The demand curve shifts; the long-run supply curve remains horizontally in a perfectly competitive market (at least for purposes of theory); the short-run supply curve shifts because more firms enter the market until there is no more profit to be made.
  • The result of the demand curve shifting is an increase in quantity traded without change in price.

Chapter 14: “Monopoly”

Why Do Monopolies Exist?

  • Most firms face some degree of competition.
  • What happens when a firm faces no competition at all?
  • Monopoly - a firm that faces no competition, the producer of a good or service with no close substitutes.
  • Perfect monopoly - controls all (\(100\%\)) of the market in a product.
  • Monopoly power - the power of a monopoly that can be exercised even when a firm controls less than all of the market of a product.

Barriers to Entry

  • In a monopoly market, some barriers prevent firms other than the monopolist from entering the market.
  • Scarce resources. Some key resource or input to the production process is limited.
  • Economies of scale. In some industries, the fixed cost of infrastructure creates economies of scale that help a single firm produce the entire quantity of output demanded at a lower cost than other firms.
    • Natural monopoly - this monopoly can be the “natural” outcome of competitive forces.
  • Government intervention. Governments can create or sustain monopolies when they would have otherwise not existed. Can occur via state-owned firms, recognition of intellectual property rights.
  • Aggressive tactics. Punishments, predatory pricing, buying up.

How Monopolies Work

  • A monopoly wants to maximize its profits.
  • The monopoly is constrained by the market demand curve.

Monopolists and the Demand Curve

  • In a perfectly competitive market, the demand curve for the market slopes downward.
  • In a perfectly competitive market, an individual firm faces a horizontal demand curve.
  • When there is only one producer in the market, the monopolist faces the demand curve for the entire market.

Monopoly Revenue

  • Total revenue is price times quantity sold.
  • Total revenue increases in sections of the demand curve where demand is price-elastic.
  • Average revenue is the price.
  • Marginal revenue is not equal to price in a monopoly market.
    • A monopoly’s choice to produce an additional unit drives down market price and marginal revenue.
  • Producing an additional unit of output has the quantity and price effect.
    • Quantity effect: increase in total revenue due to money brought in by the sale of more units.
    • Price effect: decrease in total revenue due to lower price of an increase in quantity.
  • Price effect works in the opposite direction of the quantity effect, decreasing revenue.
    • In a monopoly market, marginal revenue is always less than price.
  • Marginal revenue curve lies below the demand curve because marginal revenue is always less than the price.
  • Revenue maximizing-quantity: the point at which the MR curve crosses the \(x\)-axis.
  • Marginal and average revenue slope downward for the monopolist.
  • Profit-optimizing quantity is when the marginal revenue intersects marginal cost.
  • In a competitive market, marginal revenue \(=\) price. In a monopoly market, \(\text{price} > \Delta\text{revenue}\); price is greater than marginal cost at the optimal production point.
    • Monopolies can make positive economic profits in the long run.
    • In a monopoly market, other firms cannot enter the market. The monopolist can maintain a price higher than ATC.

Problems with Monopoly and Public Policy Solutions

  • Monopolies have welfare costs.

The Welfare Costs of Monopoly

  • Monopoly’s ability to keep quantity low and prices high hurts society and consumers.
  • Monopoly is inefficient.

Public Policy Responses

  • Policymakers have developed many policy responses to monopolies.

Antitrust laws

  • Trusts - massive corporations that dominate entire industries.
  • Breaking up corporations perceived to be engaging in anti-competitive behavior.
  • Block mergers.
  • Antitrust action could break up a natural monopoly.

Public ownership

  • Natural monopolies pose a problem for policymakers.
  • Monopolist can achieve lower costs of production than multiple competing producers would.
  • A natural monopoly still chooses to produce at the profit-maximizing quantity, which is inefficient and causes deadweight loss.
  • Governments can run natural monopolies as public agencies.


  • Governments can allow private monopolies to exist but cap prices.
  • Firms have an incentive to avoid giving regulators useful information, though.

Vertical splits

  • Split an industry “vertically” to introduce competitions into different parts of it.

Market Power and Price Discrimination

  • Price discrimination - the ability to charge customers different prices for the same good.
  • Firms cannot engage in price discrimination in a perfectly competitive market.

Perfect Price Discrimination

  • With perfect price discrimination, the area under the demand curve is the producer surplus.
  • In fact, monopolies that price-discriminate are efficient - all possible mutually beneficial trades take place.

Price Discrimination in the Real World

  • Problems with price discrimination:
    • Defining categories of customers
    • Products can be resold.
  • Perfect price discrimination is essentially impossible.

Chapter 15: “Monopolistic Competition and Oligopoly”

What Sort of Market?

  • Oligopoly and monopolistic competition market structures are common in the real world.

Oligopoly and Monopolistic Competition

  • Oligopoly - a market with only a few firms.
    • Products may/not be standardized but are similar enough such that the firms compete with each other.
  • Interactions between firms and rivals impact success.
  • In an oligopoly, it is important to keep your eye on competitors.
  • Oligopolies have the existence of barriers to entry. There are not any barriers to entry, but not monopoly-level barriers.
  • Monopolistic competition - a market with many firms that sell goods & services that are similar but slightly different.
  • In a monopoly, a product has no close substitutes.
  • Monopolistic competition markets, between perfect competition (all products are standardized) and monopoly.
  • Products are slightly different; consumers can pay a little bit more, but if the price is too large, they will choose a substitute.
  • A firm can have a monopoly, in a limited sense.
  • Oligopoly is about number of firms.
    • Can exist when products are standardized.
  • Monopolistic competition is about variety of products.
    • Can exist with many small firms.

Monopolistic Competition

  • Product differ estimation: firms must offer goods that are similar to competitors’ products but are more attractive.

Monopolistic Competition in the Short Run

  • Product differentiation allows firms in monopolistic competitive markets to behave like a monopolist in the short run.
  • When monopolistically competitive firms behave like monopolists:
    1. Firms face a downward-facing demand curve; a firm cannot adjust its price without changing the quantity consumers demand.
    2. Firms face a u-shaped ATC curve.
    3. Profit-maximizing quantity is where \(MR = MC\). Price is the corresponding point on the demand curve.

Monopolistic Competition in the Long Run

  • Monopolistic competitive firms face a problem monopolists do not - other firms can enter the market.
  • The availability of substitute goods is a determinant of demand. The demand curve for the original firm shifts leftwards.
  • In the long run, monopolistically competitive market firms face the same profit situation as in a perfectly competitive market.
    • Profits go to zero.
  • Entry-exit continues to shift the demand curve left or right until ATC touches the demand curve at the point where \(MR = MC\).
CharacteristicPerfect CompetitionMonopolyMonopolistic Competition
How many firms?Many firmsOne firmMany firms
Price taker or price maker?Price takerPrice makerPrice maker
Marginal revenue?\(MR = \text{Price}\)\(MR < \text{Price}\)\(MR < \text{Price}\)
Profit-maximizing quantity occurs at\(MR = MC\)\(MR = MC\)\(MR = MC\)
Can earn economic profits in short run?YesYesYes
Can earn economic profits in the long run?NoYesNo
Quantity is efficient?YesNoNo
  • monopolistically competitive firms operate at a smaller-than-efficient scale.
    • Optimal production point in the long run is when the ATC curve touches the demand curve.
    • This will always be on the section of the ATC curve that is down-sloping
    • Efficient scale - when firms produce an ATC-minimizing quantity.
    • Monopolistically competitive firms maximize profits by operating at a smaller scale; it has excess capacity.
  • Firms need to respond to competitors entering the market with continual product differentiation.

The Welfare Costs of Monopolistic Competition

  • Monopolistic competition is inefficient; firms maximize profits at a price higher than marginal cost.
  • A government can set a single price for all firms and let natural forces take over.

Product Differentiation, Advertising, and Branding

  • Product differentiation enables firms to keep making economic profits in the short run.
  • Firms can persuade customers that their products cannot easily be substituted.
  • Advertising can both be informative and inaccurate.
    • Decreases customers’ willingness to substitute between similar products.
  • Asymmetric information: firms no more about the true quality of their products than consumers do.
  • Advertising: The more expensive advertising is, the more consumers assume the firm is confident it has a good product.
  • Branding.


  • Firms in an oligopoly compete with a few identifiable competition firms.
  • Oligopolists make strategic decisions about price and quantity.

Oligopolies in Competition

  • Duopoly - oligopoly with two firms.


  • In a duopoly, the two firms could agree to act as joint monopolists.
  • Competition between oligopolists drives price and profits down to below the monopoly level. Oligopolistic competition does not necessarily drive profits down to the efficient level, as perfect competition does.
  • When \(\text{quantity effect} > \text{price effect}\), an increase in output increases profit.
    • Otherwise, the firm has no incentive to increase output.

Three or More Firms

  • Smaller increases in total increases in total quantity in a three+-firm market have a smaller downward effect on market price.
  • An oligopolist will continue to increase output up to the point where $\text{quantity effect} = \text{price effect}$$.
  • Oligopolist production decisions affect the profits of other firms.

Compete or Collude

  • Collusion: the act of working together to make decisions about price and quantity.
  • The dominant strategy is to compete.
  • No player has an incentive to break the equilibrium.
  • Cartel - a number of firms that collude to make collective production decisions about quantities or prices.
  • It is in the long-term interest to collude rather than compete.
  • Cartels are usually illegal.

Oligopoly and Public Policy

  • It is illegal for an oligopolist to offer to collude.
  • In a monopoly, there is a deadweight loss.
    • Monopoly and collusion deadweight loss are identical.

Chapter 17: “International Trade”

A Review on Trading

  • Comparative advantage - ability to produce a good at a lower opportunity cost than others can.
  • Gains from trade - increase in welfare in both countries that result from specialization and trade.

The Roots of Comparative Advantage

  • Countries are described as a national entity, but trade is usually carried out by firms and individuals, not by governments.
  • When everyone responds to the profit motives they face, they produce products with which they have a comparative advantage.
  • What causes firms in one country to have a lower opportunity cost of production.
    • Natural resources and climate. Geography can also affect the cost of transporting goods.
    • Factor endowment. The relative abundance of different factors of production affects comparative advantage. Land, capital, labor.
    • Technology.

Incomplete Specialization

  • Why doesn’t every country produce just one good?
    • No national economy is a perfectly free market.
    • Specialization is limited by trade agreements.
  • Within each country, there are differences in the natural resources, climate, and relative factor endowment of different areas.

From Autarky to Free Trade

  • Free and unrestricted exchange between buyers and sellers maximizes surplus, just as free trade between countries does.
  • Imports: goods and services produced in other countries and consumed domestically.
  • Exports: goods and services produced domestically and consumed in other countries.
  • Autarky: no trade, a self-contained economy.

Becoming a Net Importer

  • World price - a useful simplification to describe a complex situation.
  • If an economy once under autarky engages in free trade and \(\text{Autarky domestic price} > \text{World price}\), the product is imported. The country becomes a net-importer of that product.
  • Trade does not affect the supply and demand curves.
  • New surplus is created by trade.

Becoming a Net Exporter

  • If an economy once under autarky engages in free trade and \(\text{Autarky domestic price} < \text{World price}\), the product is exported. The country becomes a net exporter of that product.
  • Post-trade equilibrium is more efficient than pre-trade (autarky) equilibrium.

Big Economy, Small Economy

  • Whether a country engaging in free trade impacts the world price depends on how big or small it is.
  • Buyers and sellers are price takers if they are too small relative to the size of the market.
  • We need to add nuance and consider the supply and demand in world markets.
    • For instance, if the US joins the world market for computer software, both the supply and demand curves for the world market would shift rightwards.

Restrictions on Trade

  • Who wins and who loses from trade?

Why restrict trade?

  • Trade is efficiency-enhancing: it always increases total surplus.
  • Some trade restrictions are the result of global politics.
  • However, often trade restrictions protect those who lose surplus because of free trade.
  • Laws limiting trade are trade protection, part of protectionism.
  • Policies that promote free trade: trade liberalization.


  • A tariff: tax on imported goods. Causes deadweight loss and is inefficient.
    • Used to protect domestic producers.
  • Tariffs have the same effect on the U.S. steel market as an increase in world price; a higher price pushes domestic producers up the supply curve.
  • Fewer items are imported, and domestic producers supply more.
  • Domestic steel producers enjoy an increase in surplus.
  • However, domestic steel consumers can also lose surplus.


  • Multifiber Arrangement (MFA): regulated clothing items, used a quota.
  • Import quota - limit on how much of a particular good can be imported.
  • The effect of a quota is similar to that of a tariff.
    • Domestic quantity demanded decreases.
    • Domestic quantity supplied increases.
    • Quantity of imports falls.
  • Domestic producers gain surplus from selling a higher quantity at a higher price, but domestic consumers lose surplus from buying a lower quantity at a higher price.
  • Difference in who benefits from the difference between the value of a good in the domestic market and the value of the good in a world market:
    • Tariff: the domestic government collects tax revenue. $$\text{quantity of imports} \times \left\text{domestic price} - \text{world price}$$.
    • Quota: value goes to whoever has the rights to import, or quota rent. The importing country/firm receives surplus. This results in profits for foreign agents.

Trade Agreements

  • Why do trade agreements happen?

International labor and capital

  • Although countries as a whole gain from liberalizing trade, some segments of the population lose out.
  • Free trade equalizes supply and demand of the factors of production across countries.
    • Factor prices (wages, for example) converge across countries.
    • Owners of domestically scarce factors lose, because of increased competition.
    • Owners of domestically abundant factors win, because of increased demand.
  • Arguments over trade policy are debates over the distribution of benefits.

The WTO and Trade Mediation

  • When a country doesn’t like another country’s trade restrictions, it can appeal to the World Trade Organization.
    • “Most favored nation status” to incentivize countries to follow rules.
    • Members of the WTO offer the same trade terms to all other members of the organization.
  • Trade brings more benefits than costs.

Labor and Environmental Standards

  • Every country has its own set of rules, which causes friction in trade.
  • Many clothes sold in the United States are produced in illegal ways to United States.

Import standards.

  • Some countries impose standards on imported goods.
  • Blanket standards: address issues affecting customers. Imports on products that violate standards are restricted.
  • Import standards: placed on specific countries to address production issues on a country of origin.
  • North American Agreement on Labor Cooperation (NAALC), part of NAFTA. Working towards a set of labor standards.
    • Does not expect each country to maintain the same standards, but only that each country enforce its existing labor law.

Pocketbook activism.

  • Individual consumers can make choices about what they will buy, even if there are no regulations for standards.
  • Consumers can pay more for fair-trade goods, and producers can differentiate their products.

Embargoes: Trade as Foreign Policy

  • Sometimes, trade restrictions are not implemented for economic reasons but foreign policy reasons.
  • Restricting the ability to trade can be a punishment.
  • Embargo: prohibition or restriction on trade to put political pressure.

Chapter 18: “Externalities”

What Are Externalities?

  • Every time you make a decision, there is an underlying trade-off you consider.
  • The price and quantity at which buyers and sellers trade their goods and services reflect their private costs and benefits.
  • With many people making decisions, however, the costs add up.
    • Examples: pollution caused by car use, the production of $$CO_2$.

External Costs and Benefits

  • Private costs: costs that fall directly on the economic decision-maker.
  • External costs: uncompensated costs imposed on someone other than the person who caused them.
  • Social cost: \(\text{private costs} + \text{external costs}\).
  • This also applies to private benefits, external benefits, and social benefit.
  • Externality: an external cost or benefit.
    • Negative externality: an external cost.
    • Positive externality: an external benefit.
  • Externalities are one of the most common causes of a market failure.
  • We assume externalities are constant and predictable.
  • Network externality: the effect the user of a good has on the value of that good for others. People help or harm others simply by participating in a group.

Negative Externalities

  • Production externality: externality that occurs when a good or service is being produced.
  • Consumption externality: externality that occurs when a good or service is being consumed.

Negative production externality

  • We can quantify the cost imposed every time a good is produced and plot a social cost curve, such that the external cost is equal to the vertical distance between the social cost curve and the private supply curve.
  • The deadweight loss society represents the loss of economic surplus to society. Negative production externalities result in “too much” production of some goods.

Negative consumption externality

  • A cost is imposed upon others when a good or service is being consumed.
  • Overconsumption produces a deadweight loss and decreases overall economic surplus.

Positive Externalities

  • A positive externality also pushes quantity away from the efficient equilibrium level, reducing the total surplus.

Positive consumption externality

  • A third party benefits when a good or service is being consumed.
  • A new social benefit curve can be formed by adding the external benefit to the demand curve.
  • Underproducing a good of service will reduce economic surplus and generate a deadweight loss.

Positive production externality

  • A third-party benefit when a good or service is being produced.
  • A positive production externality results in “too little” production.

Private Solutions to Externalities

  • Externalities reduce the total surplus by creating a deadweight loss for society.
  • We can transform external costs and benefits into private costs and benefits.
  • Individuals will pursue mutually beneficial trades. Someone will always gain something by pursuing it.
  • Externalities reduce surplus: therefore, there must be mutually beneficial trades waiting to be exploited.
    • Example: why don’t those who suffer from pollution pay drivers to drive less? There is a surplus to be gained from decreasing the quantity of gas burned.
  • Coase theorem: individuals can reach an efficient equilibrium through private trades, even in the presence of an externality.
    • Assumptions: people can make enforceable agreements to pay each other, there are no transaction costs in coordinating and enforcing agreements.
    • However, these two assumptions usually never hold.
  • A private solution yields an efficient outcome, but the distribution of the surplus is different.
    • Assumptions of “fairness” are different.
    • Private solution: drivers have a “right” to pollute and are paid not to.
    • Government intervention: citizens have a “right” to live free of pollution and need to be paid to accept pollution.
  • Efficiency is about maximizing total surplus, but nothing about the fairness of the distribution of surplus.

Public Solutions to Externalities

  • People often turn to public policy for solutions to externalities.
    • These are often addressed via taxes, subsidies, quotas, or tradable allowances.
  • That a market works efficiently only means that it maximizes surplus; but increasing surplus for society does not mean anything for the distribution of the surplus.

Taxes and Subsidies

Countering a negative externality with a tax

  • A tax meant to counter the effect of a negative externality: Pigovian tax.
  • A Pigovian tax increases the effective price paid for a good to that of the social cost.
  • Pigovian taxes must be set at the right level; if the estimate is too high or too low, the result will be inefficient.
  • Pigovian taxes do not guarantee the government can help people bearing the external cost.
  • The tax still maximizes surplus in society by moving the car market to an efficient equilibrium.

Capturing a positive externality with a subsidy

  • A subsidy can help consumers or producers capture the benefits of positive externalities.
  • Using a subsidy to increase efficiency does not equal fairness, but it does maximize total surplus.

Quotas and Tradable Allowances


  • If we know the socially optimal quantity of something, we can set a quota, rather than imposing taxes.
  • Limiting total consumption to the efficient quantity does not make the market level.
  • The invisible hand allocates resources to hose with the greatest WTP; maximizing surplus depends not only on how much of a good is sold but also on who produces them.
    • A tax allows the market to sort itself out, whereas a quota does not.

Tradable Allowances

  • Different manufacturers have different abilities to reduce emissions; there is a missed opportunity for a mutually beneficial trade.
  • Tradable allowance: a production or consumption quota that can be bought and sold.
    • Set a quota, and allow firms to buy and sell their quota allowances.
  • Tradable allowances result in efficient quantity and maximize surplus.
  • A Pigovian tax results in revenue for the government, whereas tradable allowance creates a market where quotas are sold between private parties.

Targeting Externalities with Public Policy

  • Economists try to propose taxes based on the externality itself, but this is hard to do.
  • Policies that target individual goods and policies give consumers and producers an incentive to find clever ways around it.