Micro A P 2007-2008

Westminster International University in Tashkent
Microeconomic Analysis
and Policy
Module Handbook
BSc Economics
Level 5
4UZE502
Lecturer:
Alexey Kim
Contact details:
1 e-mail: [email protected]
tel: 138-74-09
Content:
Syllabus 3
Assessment Schedule 7
“The Real Reason I went into Economics” by Dr Steven D Levitt. 10
Lecture 1. Demand Analysis.
Utility maximization and Indifference curve analysis 13
Tutorial 1. Demand Analysis.
Utility maximization and Indifference curve analysis 18
Lecture 2. Consumer's surplus and Marshalian Consumer Theory 20
Tutorial 2. Consumer's surplus and Marshalian Consumer Theory 25
Case study. Social Security Reforms in Russia. 26
Lecture 3. The Individual Supply of Labour. Brands and Branding. 28
Tutorial 3. The Individual Supply of Labour. Brands and Branding. 32
Lecture 4. Properties of the Production Function 33
Tutorial 4. Properties of the Production Function 37
Lecture 5. Cost Functions 39
Tutorial 5. Cost Functions 43
Lecture 6. Perfect Competition, Equilibrium models and Applications 45
Tutorial 6. Perfect Competition, Equilibrium models and Applications 51
Case study. Organ donor market. 52
Lecture 7. Monopoly and monopolistic competition 54
Tutorial 7. Monopoly and monopolistic competition 58
Case study. Mean Vending Machines. 59
Lecture 8. Oligopoly. Further Analysis 62
Tutorial 8. Oligopoly. Further Analysis 65
Lecture 9. Strategy and Game Theory 67
Tutorial 9. Strategy and Game Theory 71
Case study. Pepsi and Coke’s secret formula. 72
Case study. A treatise on dating: the Prisoner’s Dilemma 73
Lecture 10. The Demand for Factors of Production in Competition 76
Tutorial 10. The Demand for Factors of Production in Competition 79
Lecture 11. Monopoly and Monopsony 80
Tutorial 11. Monopoly and Monopsony 82
2
Full Module Title: MICROECONOMIC ANALYSIS AND POLICY
Short Module Title: MICRO A. & P.
Module Code: 4UZE502
Module Level: 5
Academic credit weighting: 15
School/Department: Faculty of Business
Length: One semester
Module Leader(s): Alexey Kim e.mail: [email protected]
Site: Tashkent
Host course: BSc Economics
Status: Core
Relevant course titles/pathways:
Subject Board: Economics
Pre-requisites: Microeconomics level 4 (2UZE401) or equivalent
Co-requisites: none
Assessment: 70%examination/30%coursework
Special features: none
Access restrictions: none
Summary of Module content:
Recently there have been significant developments in areas of microeconomic policy,
such as privatisation and competition policy and also in a number of key issues in
corporate governance. These are likely to have important implications for corporate
objectives and the interests of the main stakeholders of firms. The module covers the
conceptual tools and underlying framework necessary to appreciate the key factors
involved in these issues and to apply analysis to specific situations. This involves
exploring further the fundamental decisions made by economic agents as consumers,
producers and suppliers of factors of production.
Module Aims
This module extends and enhances the microeconomic analysis studied at level 4. It
enables students to appreciate the coherence, rigour and, in some cases, the limitations of
microeconomic theory. In order to achieve these aims in each part of the module the main
theoretical concepts and tools are applied to particular real-world cases.
Learning Outcomes
On successful completion of this module students should be able to:
1. Explain the neoclassical model of the economy at the microeconomic level
2. Demonstrate an understanding of the theory of prices and markets
3. Explain the main models of market behaviour, with particular reference to
oligopoly markets
4. Provide an analysis of factor markets
5. Choose the appropriate tools and methods for solving particular microeconomic
problems.
3
Indicative syllabus content
The scope and purpose of microeconomic theory
Consumer choice: further demand analysis; utility maximisation and indifference curve
analysis; Lancaster’s characteristics approach; application examples: empirical demand
functions; brands and branding
Production and costs: further analysis of production and cost decisions; economies of
scale and scope and measurement; learning effects; application examples: empirical cost
functions
Market models: further analysis of market behaviour; strategic and structural barriers to
entry and exit; monopolistic competition; oligopoly markets and Cournot analysis; cartels
and co-operative behaviour; application examples: competition policy; contestable
markets; price leadership
Factor market analysis: demand and supply of factors; competitive factor markets;
monopoly and monopsony power; application examples: inequality and poverty;
minimum wage legislation; impact of trade unions
Teaching and Learning Methods
The module will be taught by a combination of lectures and seminars. The lecture
provides an overall summary of the key material for each topic, while the seminar takes
the form of exercises and group discussions based on questions and case studies. The
lecture introduces a particular topic and the seminar aims to reinforce and extend
understanding through the use of questions and cases and by examining any issues that
might arise.
Assessment rationale
The module will be assessed by coursework and examination. The coursework consists
of an assignment that tests students’ grasp of key concepts and issues and enables
feedback on progress in time for remedial action if required.
The examination provides a more general assessment of students’ knowledge by testing
their ability to analyse microeconomic behaviour and its applications.
Assessment criteria
In the coursework students will be expected to demonstrate an understanding of key
microeconomic concepts and to show their ability to employ these in support of a
particular argument or case. They should also demonstrate an appreciation of
microeconomic relationships and be able to use relevant economic reasoning.
In the examination students will be expected to write under time constraints and to show
an understanding of microeconomic analysis and its applications by answering specific
questions using appropriate analysis and reasoning.
Assessment Methods and Weightings
Assessment Description Weighting Learning Student

outcomes time
Coursework A 2000 word essay requiring 30% 1,2,3,5 20 hours

microeconomic reasoning
and explanation of a
particular case or example
using relevant data or
analysis
4
Examination A time-constrained closed- 70% 1,2,3,4,5 2.15 hours
book examination consisting
of one compulsory question
plus a choice of two from
approximately five questions
requiring essay-type answers
Sources
Essential reading:
W. Nicholson, ‘Intermediate Microeconomics and its Applications’, 9th edition, 2004,
Thomson Learning
Further reading:
D. Besanko and R. Braeutigam, ‘Microeconomics: Theory and Applications’, 2001,
Wiley
H. Varian, ‘Intermediate Microeconomics, 6th edition, 2002, Norton
S.Estrin and D. Laidler, Microeconomics, 4th edition, 1995, Pearson Education
A.Koutsoyiannis, ‘Modern Microeconomics, 1979, Macmillan
Periodical references:
Economic Journal; Review of Economics and Statistics; Econometrica; American
Economic Review; Quarterly Journal of Economics
WWW references:
Office of Fair Trading: www.oft.gov.uk
Competition Commission: www.competition-commission.org.uk
Federal Trade Commission: www.ftc.gov
US Dept. of Justice: www.usdoj.gov
Statistics: www.statistics.gov.uk
OECD: www.oecd.org
Date of initial Validation: July 2004
5
MODULE CODE 4UZE502
MODULE TITLE Microeconomic Analysis and Policy Skills assessment weighting % of whole
assessment
t p a % Short description
Communication Verbal – one2one
Presentations
Written reports x x x Coursework
e-mail etc
Giving and receiving feedback x x Coursework, seminar
Team Working Relationships within groups

Leadership
Task-centred working x x x Coursework, seminars
Group communication
Electronic Groups
Information for Research x Coursework

Decisions Problem formulation
Methods and tools x x Seminars
Options and outcomes
Decision making x x Examination
ICT in Business Functions of ICT in business; DP

Everyday software x Coursework
Databases for daily use
Using the Internet
Working away from home base
Personal Skills Self confidence, social ease x

Career Sensitive to others/situations x
Self/time management x x x Examination
Flexibility; working with uncertainty
Learning abilities
Career Management Self-awareness; opportunities

Skills Evidence of abilities
Personal Development Plan
An appetite for life long learning
Transfer skills into new situations
Business Awareness Opportunities – risks and rewards x x Lectures, seminars

Customers – the marketing approach x x Lectures , seminars
Cost and cash management
Operations, logistics, supply chains x x
Managing people in organisations
The total business environment
The competitive environment x x Lectures , seminars
Economic, social, political forces x x Lectures, seminars
Legal issues
Technological changes
Environmental/sustainability issues
Globalisation, internationalisation
The ethical dimension of business
Strategic overview
Module specific skills
6
Westminster International University in Tashkent
Microeconomic Analysis and Policy - Assessment Schedule
Lecturer: Alexey Kim
Course: Economics
Module Code: 4UZE502
Module Title: Microeconomic Analysis and Policy
Session: 2006/2007
Semester: One
Assessment: 30% coursework 70% exam
Schedule Summary
Assessment Component 1. Coursework 2. Final Exam
Date Set -
Deadline To be specified
Value 30% 70%
Feedback To be specified
Results Date To be specified
Notes on the summary
Assessment Component
Your assessment on this module consists of one or more parts – we call them components. A component
might be a test, an essay, an exam or some other type of activity.
Date Set
This is the date by which your Module Leader will give you a detailed description of the component.
Deadline
This is the date that you have to submit your work. You must submit your work to the Registrar’s Office -
see below for more information on submitting your work
Value
This is the value of the component as a percentage of the overall module mark
Feedback
This entry describes the method and date by which your Module Leader will provide you with feedback
after the deadline. For example they might provide you with a model answer or a list of the things that you
did well and the things that you did badly. Also you should have the chance to discuss the coursework in
class with your tutor. Remember that the purpose of assessment is to help you learn…we know that you
will be waiting impatiently to have your grade but listening to the feedback and thinking about the
strengths and weaknesses of your work is actually more important than knowing your mark.
Results Date
This is the date by which we will publish your mark. It may take three or four weeks to do this because
your work has to be seen by several people. Your Module Leader or your tutor will mark it, and then it may
be second-marked by another member of staff. Samples of work are sent to the University of Westminster
for their approval and comments.
How to contact Alexey Kim

Phone: 138-74-09
Email: [email protected]
Office Hour is: Friday at 16.00 during term-time
7
Component Descriptions
Component one-Coursework
Coursework is a 2000 word essay requiring microeconomic reasoning and explanation of a particular case or
example using relevant data or analysis.
In the coursework students will be expected to demonstrate an understanding of key microeconomic concepts and to
show their ability to employ these in support of a particular argument or case. They should also demonstrate an
appreciation of microeconomic relationships and be able to use relevant economic reasoning.
Tested learning outcomes are:
1. Explain the neoclassical model of the economy at the microeconomic level
2. Demonstrate an understanding of the theory of prices and markets
3. Choose the appropriate tools and methods for solving particular microeconomic problems.
Component two-Final Exam

A time-constrained closed-book examination consisting of one compulsory question plus a choice of two from
approximately five questions requiring essay-type answers.
In the examination students will be expected to write under time constraints and to show an understanding of
microeconomic analysis and its applications by answering specific questions using appropriate analysis and
reasoning.
Deferrals
• If - as a result of submitting extenuating circumstances - you are offered a deferral in any of the
components then you will be responsible for finding out from the Registrar’s Office about the deadline
and other details of the deferred assessment.
Calendar of Assessments: Microeconomic Analysis and Policy 2006/2007
Teaching Lecture Deadline

Date Week
01 Oct. 2007 1 Basics of Consumer Theory
08 Oct. 2007 2 Consumer’s Surplus and Marshalian Consumer Theory
3 The Individual’s Supply of Labour. Brands and Branding.
15 Oct. 2007 Advertisement.
22 Oct. 2007 4 Properties of the Production Function.
29 Oct. 2007 5 Cost Functions.
05 Nov.2007 6 Perfect Competition. Equilibrium models. Applications.
12 Nov.2007 7 Monopoly and Monopolistic Competition.
19 Nov.2007 No classes Independent Learning Week.
26 Nov.2007 8 Models of Oligopoly.
03 Dec.2007 9 Theory of Games
10 Factor market Analysis. Demand and supply of factors. Competitive
10 Dec.2007 factor markets.
11 The Demand for Factors of Production: Monopoly and Monopsony.
17 Dec.2007
24 Dec.2007 12 Revision week.
31 Dec.2007 New Year Holiday.
07 Jan.2007 Consolidation Week: no classes, time for you to reflect and revise
14 Jan.2007 Assessment Weeks 1-2
21 Jan.2007
28 Jan 2007 Marking Weeks 1-2
04 Feb. 2007
11 Feb.2007 Semester 2 Begins
8
Important notes
Submission of work
You must submit your work via the Registrar’s Office on or before the published deadline. The Registrar’s
Office will keep a record of all work submitted.
Never give your work directly to the lecturer.
Late work
Work which is submitted late, but no more than 24 hours late, will score a maximum mark of 40% (unless
there are extenuating circumstances).
Work which is submitted more than 24 hours late will automatically score zero (unless there are
extenuating circumstances).
If you cannot submit your work on time then you must always submit it as soon as you possibly can even
if there are extenuating circumstances.
Extenuating circumstances affecting any coursework/class test
If there are extenuating circumstances which mean that:
• You are unable to attend a test
• Your performance in a test is adversely affected
• You cannot submit your work on time
Then you must fill an extenuating circumstances form. The correct form must be collected from and
returned to the Registrar’s Office. The deadlines for submission of extenuating circumstances forms are
• 17.00 4 February 2007 for assessments with a deadline in Semester One
• 17.00 10 June 2007 for assessments with a deadline in Semester Two
For more information refer to your course handbook and student handbook. You must provide strong
evidence to support your case. In the case of illness you will need a medical certificate.
Reassessment
The pass mark for this module is 40%. You do not have to pass each and every component but you do have
to achieve an overall mark of 40%.
Additionally you must achieve a minimum of 30% in any component worth 30% or more of the module
mark.
If you fail to achieve 40% overall or if you have less than 30% in a component, then you have not passed
the module but you may be offered a referral (a referral is a second chance to pass the module with the final
mark capped at 40%). It is your responsibility to check your results (published by the Registrar’s Office at
the end of the semester) and to find out about any referrals that you might have been offered.
Referrals usually take place the next time the module runs (i.e. in the next academic year).
Keeping a copy of work
You must keep a copy of every piece of work handed in (a printed copy as well as an electronic copy).
Standard format for submission of work
Unless otherwise stated, coursework must be submitted as follows:
• We would prefer word-processed work rather than hand-written work
• Include a cover page with the assessment title, and your student registration number. NO NAME.
Never put your name. Registration number only.
• Include a contents page giving the headings and page numbers of each section
• Pages should be numbered
• Work should be kept to the minimum number of pages possible
• Please do not submit any loose pages
• Put one staple in the top left-hand corner, please do not bind or cover your report
• VERY IMPORTANT: your name should not appear on the cover page or anywhere else. We
will be operating a system of anonymous marking (when the lecturer marks your work they
will not see your name). Please put your registration number on the cover page and nowhere
else.
9
Dear Students,
Just a food for thought given to you by famous economist Dr. Steven D. Levitt.
The real reason I went into economics1

They teach you a lot of things when you study economics: about marginal cost, incentives,
dynamic optimization, etc. But up until now, the real reason for why people study economics had
been a closely held secret known only to economists—kept carefully hidden away from the hoi
polloi.
Well, it turns out Joey Cheek, of all people, is the one who blew the secret. You may remember
Joey Cheek as a gold medal speed skater from the Winter Olympics. It turns out he is also quite
smart. He was admitted to Yale, Princeton, and Stanford. (Harvard, however, turned him down.)
Parade magazine quotes Cheek as saying that he plans to study economics. And then he goes on
to blow the secret we economists have so carefully guarded for all these years. He plans to study
economics because “that’s what gets the chicks.”
(My wife Jeannette adds that I am living proof.)
Posted by Steven D. Levitt @ 10:40 pm on Sunday, May 21, 2006 in General
23 Responses to “The real reason I went into economics”

melissa Says:
May 21st, 2006 at 11:34 pm
When I declared an economics major, I admittedly thought some of my male economics professors were really quite
attractive and even noticed my female professors had some good looking husbands.
dachisb Says:
May 22nd, 2006 at 1:32 am
That’s because economists do it with models!
shining Says:
May 22nd, 2006 at 2:11 am
Then why do women study econ?
Speedmaster Says:
May 22nd, 2006 at 6:31 am
LOL! I’ve taken a lot of econ classes, and as I looked around the room, it looked only marginally better than the
computer science classes!
Monkeydarts Says:
May 22nd, 2006 at 9:02 am
On the other hand…
1
http://www.freakonomics.com/blog/2006/05/21/the-real-reason-i-went-into-
economics/#comments
10
Dave Meleney Says:
May 22nd, 2006 at 9:52 am
He doesn’t say the othere econ students are hot…. he says they know how to (or have what it takes to)get the chicks.
Which is a lot more interesting, no?
StCheryl Says:
May 22nd, 2006 at 10:24 am
I think he’s confusing economics and finance. Just a thought.
kkwan Says:
May 22nd, 2006 at 11:55 am
‘Tis true. I went to Yale. Majored in Economics. Met my wife in Macro. I got my BA, she got a MRS.
ciara86 Says:
May 22nd, 2006 at 2:19 pm
I can testify that it doesn’t work the other way around. I’m a girl studying Financial Maths and Economics and
when I tell men this they PHYSICALLY step away from me….
tim in tampa Says:

May 22nd, 2006 at 2:49 pm
when I tell men this they PHYSICALLY step away from me….
That’s funny, I’ve been looking for an econ major my whole life.
You’re talking to the wrong men, I think
Newfred Says:
May 22nd, 2006 at 5:14 pm
I put this down to an apparent predeliction amongst British economists for long hair in extravagant styles,
evidenced by the economics correspondents for all major UK networks.
Grant Says:
May 22nd, 2006 at 5:23 pm
I never thought this concept to be the case in my economics class…

Of course, what do I know? I’m just an engineer.
ciara86 Says:
May 22nd, 2006 at 6:03 pm
That’s probably true but until I start talking to the right men I’m going to keep on pretending I study nursing
zbicyclist Says:
May 22nd, 2006 at 10:17 pm
So, who are the top 10 sexiest economists? Photo link must accompany nomination. Any sex or sexual orientation is
eligible.
kkwan Says:
May 23rd, 2006 at 11:31 am
Dear God, I hope no one includes Greenspan.
synapticmisfires Says:
May 23rd, 2006 at 5:58 pm
11
“That’s because economists do it with models!”
Harimau Says:
May 24th, 2006 at 3:13 am
ciara86, i kind of know how you feel. I’m a (male) actuarial studies student, and almost half the girls i meet always
take a physical step back every time i tell them i do actuarial studies. Suddenly they don’t seem as interested
before…
Does this happen to economics students as well?
Leviathan Says:
May 24th, 2006 at 2:07 pm
woe is you. Try getting a masters in accounting. It works like magic when you’re out on saturday night.
I guess I have to back to school. Again.
Aaron_B Says:
May 25th, 2006 at 7:39 pm
Heheh.
Saying you “study economics” doesn’t get the girls. Using the concepts you learn as an economist in addition to
telling them you “enchance and measure human happiness”, however, does.
johnleemk Says:
May 28th, 2006 at 8:53 am
To those saying that the people in their economics class are unattractive, I thought what Cheek (and dear Dr. Levitt)
is saying is that being an economics students gets you chicks (who don’t have to be economics students themselves).
Indeed, it might even be subtly implied that economics students are physically unattractive, but their study of supply
and demand lends them an aura of desirability.
There are couple of things I know for sure:

1. I have yet to get a date in college despite repeatedly stating my interest in economics;
2. None of the girls in my economics class are hot.
saibhin Says:
June 1st, 2006 at 11:17 am
ok first of all, in my experience economists aren’t the sexiest creatures alive. in fact, i’d rank engineers, advertising
creatives, architects and doctors and trust fund layabouts all much higher.
however, i would like to draw your attention to the first rule of freakonomics which is that just because two
variables are related doesn’t mean that you can assume which causes what. so. people back away from you at
parties. is this because you’re an economist and the very idea of dating an economist is anathema to gorgeous guys
and hot chicks OR is it because geeky types are atracted to economics in the first place? i work in advertising. i
heard a few years ago that people who worked in advertising had the shortest life expectancy of any profession. i
immediately asked myself whether this is because advertising is bad for your health or because advertising attracts
live life on the edge over indulgent stress-heads?!
i think the latter.
just askin…
12
Microeconomic analysis and policy Agenda
• Consumer choice, budget constraint.
Lecture 1. • Consumer’s tastes
• Solution to the choice problem
• Income and price consumption curves
BASICS OF CONSUMER THEORY
• Engel’s curve
• Hicks and Slutsky real income
• The idea of revealed preference
Consumer choice, budget constraint The consumer’s tastes.

• Recall core assumptions about
consumer preferences.
Y • Two goods case
• Preferred bundles.
• The budget constraint
equation is: • Indifference curves must
Bu
dg
et
- have a negative slope and

co
M = p X X + pY Y
ns
tra
- to be convex to the origin.

in
t
X
• Indifference curves cannot
intersect.
Consumer preferences: assumptions Consumer preferences: assumptions
Completeness. For any pair of bundles A and B, • Transitivity. For any three bundles A, B, C, if A ≥
either A ≥ B or B ≥ A (or both). B and B ≥ C then A ≥ C.
It implies that indifference set have no intersection.
It implies that given some bundle X, every other • Reflexivity. A ∼ A.
bundle can be put into one of three sets:
1. The set of bundles preferred to X, which is called It ensures that every bundle belongs at least one
the “better set” for X; indifference set.
2. The set of bundles indifferent to X, which is • Continuity. The graph of an indifference set is a
called the indifference set of X; continuous surface.
3. The set of bundles to which X is preferred, which It implies that the surface has no gaps or breaks at
is called the “worse set” for X. any point.
13
Consumer preferences: assumptions
Consumer preferences phenomena
• Strict convexity. Given any consumption
bundle A, its better set is strictly convex.
Cup of coffee and bit of sugar
X 2
A
a
x2
B
b
x2
a
x1
b
x1 X1 Seats in the theatre and ticket
pricing
The reason is principle of diminishing marginal
utility.
Consumer preferences phenomena

London Coliseum Consumer tastes.
The shape of indifference
curve represents a
law of diminishing
marginal rate of
substitution
between the goods.
Solution to the Choice problem The income consumption curve

Y
Y
Y
Y
• Consumer wishes to B
maximize utility,
B
subject to a budget
A A A B
Maximum constraint.
B
satisfaction
A
Y1 • See the attachment 1. X
X X
(A) (B) (C)
• As the consumer income increases consumption shifts from A
to B.
X1
• (A) is an increase in consumption of both goods: they are
X
normal.
• (B) consumption of X falls: it is an inferior good, Y-normal.
• (C), X is normal, Y is inferior.
14
Income-consumption curve Price consumption curves
Y Y Y
Price
Price
Income consumption curve consumption
consumption
• Y is everywhere curve
curve
normal Price
Y consumption
curve
• X is normal at low
levels of income, but (A)
X
(B)
X
(C)
X
becomes inferior at
• As the price of X falls the consumer moves along a
higher levels.
price consumption curve.
• (A) X and Y are complements
• (B) X and Y are substitutes
X
• (C) X is a “Giffen” good
The Engel curve. The demand curve.

Y Y
Y X
3
Income
Engel Curve Price
M3 / PY Consumption X3 consumption
Curve
curve P1
X2
M2 / PY 2
1
X1 P2
M1 / PY
P3 Demand
Curve
X1 X 2 X 3 M1 M2 M 3 Income (Y) 3
1 2
(A) (B)
X1 X 2 X 3 X1 X2 X3
X X
(A) (B)
The relationship between a consumer’s income
Demand curve is easily derived through the
and the quantity of good bought.
elasticity concept.
Constant Real Income and

Income and Substitution Effect the Compensating Variation in Money Income
Y
Y Y
II
Income 2 Constant real income
Y0 Demand curve
consumption
I curve 1
Y2 Price p1
A B consumption
curve p2
Normal (constant money income)
Demand curve
C II
3
I X1 X3 X2 X X 1 X3 X 2 X
X0 X2 X1 X (a) (b)
15
Two Measures of Real Income
Two measures of real income. Y p p H
Income H
S
consumption
S
curve
Price
• Hicks real income B consumption p1`
curve p1`
A S
C H
H
S
1 3 2
• Slutsky real income. (a)
X X1 X X1 X
(b) (c)
• (a) An alternative way to analyse the income and

substitution effects.
• (b) X is a normal good.
• (c) X is an inferior good.
Constant Real Income and The Idea of Revealed Preference

Equivalent Variation in Money Income
Y
Y Y
Income Income
consumption consumption
curve curve
Price Price
consumption consumption b
C curve C curve
B
B B
A A A b
C
1 3 2 1 3 2
X X 1 3 2
(a) (b)
X
Reading
• Laidler D., Estrin S. 1995. Introduction to
Microeconomics. 4th Edition, Cambridge
University Press: Cambridge. Ch 1,2,3, pp1-39.
• Varian H. 2002. Intermediate Microeconomics.

6th Edition, Norton&Company: New York. Ch 2,
3,4,5,6,7,8,14,15 pp20-155, 245-279.
• Nicholson W. 2004. Intermediate

Microeconomics and its applications. 9th Edition,
Thomson Learning. Ch 1,2,3,4. pp3-148.
16
Lecture 1. Consumer Theory.
Attachment 1. An algebraic solution to the choice problem.
Here: M is the consumer’s money income; X and Y are goods, and money prices p x and p y .
Hence any pattern of expenditure which satisfies the inequality below is feasible:
M ≥ p x X + p yY (1.1)
The consumer’s utility is: U = u( X ,Y ) (1.2)

Taking the total differential of (1.1)
∂U ∂U
dU = dX + dY (1.3)
∂X ∂Y
The utility is constant when dU = 0 , therefore:
∂U ∂U
dX + dY = 0 (1.4)
∂X ∂Y
∂Y ∂U / ∂X
Rearranging the (1.4) − = (1.5)
∂X ∂U / ∂Y
∂Y
Since is the slope of the indifference curve (the way in which Y changes when X changes).
∂X
The Choice problem is to maximize (1.2) subject to (1.1).
Let’s limit the analysis to situation in which the consumer is on the budget constraint, so that
(1.1) becomes:
M − p x X − p yY = 0 (1.6)
using the Lagrange multipliers, by forming the function:
V = u ( X , Y ) + λ (M − p x X − p yY ) (1.7)
λ is the Lagrange multiplier.
The first order conditions for (1.7) to be maximized are:
∂V ∂U
= − λp x = 0 (1.8)
∂X ∂X
∂V ∂U
= − λp y = 0 (1.9)
∂Y ∂Y
∂V
= M − p x X − p yY = 0 (1.10)
∂λ
Equation (1.10) tells us that consumer must choose a bundle of goods on the budget constraint
to maximize utility.
Dividing equation (1.8) by (1.9) yields:
∂U / ∂X p
= x (1.11)
∂U / ∂Y py
the right had side is the ratio of prices of the two goods, and the left-hand side is the ratio of
marginal utility of X to that of Y.
∂U / ∂X ∂U / ∂Y
Equations (1.8) and (1.9) taken together yield: λ = = .
px py
17
TUTORIAL 1. DEMAND ANALYSIS.
Task 1. Golfer’s problem.
Derive the relationship between the quantity of X and the price of X, if the
consumer’s indifference map compared with X and Y has curves concave to the origin.
Let X be games of golf per annum and Y all other goods. Draw the indifference map and
budget constraint of:
(a) An amateur who pays to play golf;
(b) A professional who is paid to play golf.
May we conclude that golfers turn professional because they dislike the game?
Task 2. Ticket Scalping.

Tickets to major concerts or sporting events are not usually auctioned off to the
highest bidder. Instead promoters tend to sell most tickets at “reasonable” prices and then
ration the resulting excess demand either on a first-come-first-served basis or by limiting
the number of tickets each buyer can purchase. Such rationing mechanism create the
possibility for further selling of tickets at much higher prices in the secondary market-that
is, ticket “scalping”.
Describe the situation using indifference map analysis.
Scalping is just one example of the “black markets” that arise when goods are
rationed by means other than price. What are a few other examples? Are these black
markets undesirable?
Task 3. Engel’s Law.

One of the most important generalization about consumer behaviour is that the
fraction of income is spent on food tends to decline as income increases. Table 1 illustrated
the data that Engel used. They clearly show that richer families spent a smaller fraction of
their income on food.
Table 1. % total expenditure on various items in Belgian families in 1853.

Annual Income
Expenditure Item $225-$300 $450-$600 $750-$1000
Food 62% 55% 50%
Clothing 16% 18% 18%
Lodging, light, and fuel 17% 17% 17%
Services (education, legal, health) 4% 7.5% 11.5%
Comfort and recreation 1% 2.5% 3.5%
Total 100% 100% 100%
18
Recent data.
Recent data for US consumers (table 2) tend to confirm Engel’s observation.
Wealthy families devote a smaller proportion of their purchasing power to food than do
poor families. Comparisons of the data from table 1 and table 2 also confirm Engel’s law-
even current low-income US consumers are much more affluent than 19th century Belgians
and, as might be expected spend a much smaller fraction of their income on food.
Table 2. % total expenditure on various items by US consumers in 2000.

Annual Income (000)
Expenditure Item $15-$20 $40-$50 $70+
Food 15.4% 14.7% 11.4%
Clothing 4.8% 4.7% 5.3%
Housing 32.9% 30.4% 30.2%
Other Items 46.9% 50.2% 53.1%
Total 100% 100% 100%
Hint: Reverse % into dollars and the Engel’s curve will appear.
Question: The data in table 2 includes food both eaten at home and in restaurants.
Do you think eating at restaurants follows Engel’s law?
Task 4. Crime and Punishment.

You may hear many times that bribery increases when government tries to tackle
the problem of corruption. For example, government announces the policy to reduce
corruption among officials, although such a policy only increases the amount of bribe
taken. Can you explain such a paradox, taking into account the information below?
Economist looks at crime as a rational act of an economic agent, who faces the
problem of allocating time between legal and illegal activities. Suppose that a person must
decide whether to be a criminal or not. Anyway he will work for 8 hours a day and must
allocate these 8 hours between legal and illegal activities.
If the person is honest he will receive an hourly wage of wh (honest wage). If the
person is dishonest his wage will be wd (dishonest wage). The person has some ethics and
therefore has preferences how he earns his income. However money is money and
dishonest £ is just as good as honest £.
If the person engages in criminal activities there is a chance for him to be caught
and sent to jail. Hence such a risk makes illegal activity less attractive. The cost of the
person being put in jail is π , which is subtracted from his dishonest wage. The π will
depend on certain factors like the number and efficiency of police, person’s distaste for
spending time in jail.
19
Agenda.
Lecture 2.
• The “Standard of Living” and the ”Cost of Living”.
• Measuring Changes in the Cost of Living
CONSUMER’S SURPLUS. • The Concept of Consumer’s Surplus.
• An application of Consumer’s Surplus.
• Marshalian Consumer Theory.
MARSHALIAN CONSUMER THEORY • Marshalian Analysis and Indifference Curves.
• The Algebra of Marshalian Analysis.
• The Idea of Duality.
Measuring Changes in the Cost of Living

The Standard of Living and the Cost of Living
''
Y2 3
Y
Y4
4
1
Y0 Y0
'' C ' ''
C Y3 A
Y1 A C' B
3 B A B
2 3
C 1 3' 3
''' 2
X X
2
1
X
Indexes Reservation price and consumer’s surplus.
( p X 1 X 0 + pY 1Y0 ) Price Price

Laspeyres = r1 r1
( p X 0 X 0 + pY 0Y0 ) r2 r2
r3 r3
p
r4 r1 r4
r5 r5
( p X 1 X 1 + pY 1Y1 ) r6 r6
Paasche =
( p X 0 X 1 + pY 0Y1 ) 1 2 3 4
A) Gross Surplus
5 6 Quantity 1 2 3 4 5
B) Gross Surplus
6 Quantity
20
Approximating a continuous demand The change in consumer’s surplus.
Price Price
p Demand
Curve
Change in
'' Consumer’s
p Surplus
p p
R
T
'
p
x Quantity x Quantity
A) Approximation to Gross Surplus B) Approximation to Net Surplus
x '' x' x
Cost-benefit analysis
Producer’s surplus
(Impact of price ceiling)
Price
P
P
S
Producer’s
Change in
surplus
S producer’s surplus CS
S Pe
p* p’`
p` Po
Pc
PS
x* x` x`` D
Qc = Qe Qo Quantity
An Application of Consumer’s Surplus Marshalian Consumer Theory.

MU
Y1
B
Y0 A
Y2
X1 X1 X
X0 X
21
Marshalian Consumer Theory Marshalian Analysis and Indifference Curves
MU p
B B A2 Y
C p1 p1
A1
Y3
A p2 p2
S
Y2
D S
Y1 A3
D
A2 4
Y0
(a) X2 X1 X (b) X 1 X2 X A1 3
(a) The consumer’s surplus from so doing is given by the area SBA. A0 2
1
(b) The gain in consumer’s surplus as a result of the price of X
falling from p1 to p2 is given by p1A1A2p2. X
The Algebra of Marshalian Analysis. Attachment 2.

Idea of Duality.
Y
• See the attachments 1 and 2.
A
Y * ( p X , pY , u )
u
O X* X
EV / p 2 Compensated Compensated
demand curve demand curve
B4 through p 2
through p1
CV / p2 B B2
1
D Y
B3 A
C
p1 B G
C B
I1 I2
X
Y
F
p2
D1
A D E Uncompensated
0 a d demand curve
p 1
through
c b X 1* X 2*
p11 X
h 10 h11
22
Reading
University Press: Cambridge. Ch 2,3, pp39-65.
• Varian H. 2002. Intermediate Microeconomics. 6th

Edition, Norton&Company: New York. Ch 14,
pp245-263.
• Nicholson W. 2004. Intermediate Microeconomics

and its applications. 9th Edition, Thomson
Learning. Ch 3. pp89-124.
23
Lecture 2. Consumer’s Surplus and Marshalian Consumer Theory .
Attachment 1. The Algebra of Marshalian Analysis.
We need to find a specific form of the utility function which has the following characteristics:
1. Interdependence of the marginal utilities of X and Y
2. Constancy of the marginal utility of Y
3. Tendency of the marginal utility of X to decline with its quantity
Such a utility function is given by:
U = aX α + bY , α < 1 (1.1)
We may write the budget constraint as:
M − p x X − p yY = 0 (1.2)
Forming the Lagrangian expression:
V = aX α + bY + λ ( M − p x X − p y Y ) (1.3)
Taking the partial derivatives of (1.3) with respect to X, Y, and λ , and setting it equal to zero
gives us first-order conditions for a maximum:
∂V
= α aX α −1 − λ p x = 0 (1.4)
∂X
∂V
= b − λp y = 0 (1.5)
∂Y
∂V
= M − p x X − p yY = 0 (1.6)
∂λ
Eq (1.5) may be rearranged to yield:
b
λ= (1.7)
pY
∂V
If we hold the price of Y constant (hence (1.5) is = b − λ p y = b − λ 1 = 0 ; b = λ ), we may
∂Y
define it as being equal to unity and (1.4) becomes
α aX α −1 − bp x = 0 (1.8)
We can solve the equations (1.6) and (1.8) for the unknowns Y and X as functions M and p x .
Equation (1.6) may be rearranged as:
M −Y
X = (1.9)
pX
and (1.8) as
1 /( α −1 )
X = Rp x (1.10)
where
b 1 /( α −1 )
R=( ) (1.11)
αa
Substituting (1.9) into (1.10) gives us the demand for Y a function of M and p x :
α /( α −1 )
Y = M − Rp x (1.12)
and substituting this back into (1.9) gives us the demand function for X:
α /( α −1 ) 1 /( α −1 )
X = [ M − M + Rp x ] / p x = Rp x (1.13)
24
TUTORIAL 2. CONSUMER’S SURPLUS AND
MARSHALIAN CONSUMER THEORY.
Task 1. Ambiguous Altruists.
As you know consumer’s choice theory is based on certain assumptions. One of

such assumptions is the selfishness of people in other words people are egoistic. Some
economic activity that looks altruistic on the surface still satisfies the selfishness
assumption if one takes a long-term view on the situation.
For example, consider the action of office workers who set up a voluntary coffee
club. They agree to pay 50 cents for each cup they drink and to make coffee when the pot
is empty. Clearly, when no one is looking, it is possible to drink the last cup, not make any
more coffee, and not contribute the 50 cents owed for the cup that was consumed.
Despite their ability to cheat and make a “clean gateway”, people usually do not
take advantage of the opportunity. Compliance with the voluntary rules of the coffee club
is not motivated by unselfishness but by a fear that failing “to do one’s part” will break the
socially beneficially norm of the contribution and cause the coffee club to cease operations.
Of course, this would deprive everyone in the office of the advantage of convenient
and cheap cups of coffee. Selfish people are capable of acting in what appears to be a
socially considerate manner while pursuing their own self-interest. Are the members of the
coffee club altruists or not?
Task 2. Calculating the Indexes.

The following observations are taken on a consumer’s behaviour on two successive weeks:
Week 1: price of X =£10 Quantity of X bought =10 units per week
price of Y = £10 Quantity of Y bought =10 units per week
Week 2: price of X =£5 Quantity of X bought =20 units per week

price of Y = £20 Quantity of Y bought =5 units per week
1. Has the consumer’s money income changed between the two weeks?
2. Calculate the Laspeyres price index for week 2 taking its value in week 1 to be 100.
3. Calculate the Paasche price index for week 2 taking its value in week 1 to be 100.
4. Has the cost of living risen between week1 and week2?
Task 3. Car and Consumer’s Surplus.
Suppose that it costs 12 pence a mile in direct operating costs to run a car. Let X be
miles per week and p be measured in pence and an individual’s demand curve for car
transport is given by:
p=400-4Q
(a) How many miles a week will be driven?
(b) How much consumer’s surplus will be gained from operating the car?
(c) Would the person be wiling to pay a fixed cost, over and above variable costs, of
£60 per week to operate the car?
(d) Suppose the direct cost of operating a car rose to £2 per mile because of increase
in the price of petrol. How would your answers to questions (a), (b), (c) change?
Use the Marshalian demand curve assumptions in answering this question.
25
Task 4. TV Watching and Electricity Costs.
Starting with individual’s Marshallian demand curve for hours of television
watching and the knowledge that each hour’s watching uses a given amount of electricity,
show how a fall in the price of electricity will affect:
(a) the amount an individual is willing to pay to rent a television;
(b) the market demand curve for rented television.
Task 5. Should I turn down my stereo?

You have settled into a comfortable chair and are listening to your stereo when you
realize that the next two tracks on the album are ones you dislike. If you had a compact
disk player, you would have programmed it not to play them. But you don’t and so you
must decide whether to get up and turn the music down or to stay put and wait it out.
The benefit of turning it down is not having the songs you don’t like blare away at
you. The cost, in turn, is the inconvenience of getting out of your chair. If you are
Extremely comfortable and the music is only mildly annoying, you will probably stay put.
But if you haven’t been settled for long or if the music is really bothersome, you are most
likely to get up.
Can you translate the costs and benefits into a monetary framework, using the
notion of reservation price?
Task 6. Calculating CV and EV.

A consumer chooses weekly quantities of X and Y in order to maximize the utility
1 1
function: U = X 2 Y 2 . Total income over the week is $100, and the prices of X and Y are $5
and $10 respectively.
(a) How much of X and Y will the consumer buy?
(b) What happens to the demand for X if the price for X rises to $10?
(c) What happens to the demand for Y if the price of X rises to $10?
(d) What is the equivalent and compensating variation from the increase in the price of
X from $5 to $10?
(Hint: calculate the utility levels at each price combination and apply the formulas in eq. (2.9) and (2.10) in
your lecture attachments).
Task 7. Social Security Reforms in Russia1.

Please read the following article and think about the social security reforms in
Russia. Did this reforms benefit people? Answer this question using the CV and EV.
“On Friday, Duma First Deputy Speaker Lubov Sliska said that she does not rule
out that Mikhail Fradkov’s government will resign. She said that anything is possible,
commenting on pensioners and invalids protesting across the country against substitution
of benefits and discounts by cash payouts. Sliska said that there are already grounds for
resignation.
The government is reforming the social security system, removing the outdated
Soviet system of non-cash benefits and discounts. Pensioners and invalids receive
discounts for local telecom services, transportation, housing services, etc. In total, annual
benefits that the government by law should pay amount to two or three years of federal
budget receipts. The government implemented legislation, which eliminated benefits from
1 January 2005. Simultaneously, it increased social cash payments that are to be paid later
1 www.mdmbank.com, Equity Markets Daily 17 January 2005
26
this year. The difference in timing led to protests. For some reason that we cannot fathom,
this was a surprise for the government.
Although social reforms are very difficult for any government, social protests
indicate that the government’s work was not very effective. Last autumn, the president
called for smooth implementation of social reform but the government failed. Now, the
ministries are trying to correct the situation.
Later, Duma Speaker and head of the Yedinstvo party Boris Gryzlov downplayed
Sluska’s comments. He suggested that the party and the government should cooperate to
solve problems with reform. Various political groups started to call for the government to
resign. This reform already led to the decline of the government’s and President Putin’s
rating. People are dissatisfied with their work. In some regions, pensioners, a very
politically active group, started to demand the resignation of Putin. Eventually, Putin may
have to make some hard decisions because of the reform. After the Beslan tragedy, this
reform is the second development decreasing faith in Putin. This could restrain the
government’s ability to implement other reforms. On the other hand, it could give
the president grounds to change the government sooner.
We would also point out that in the five years of Putin’s rule, this is the first serious
protest.”
27
Agenda.
Lecture 3. • The Nature of the Choice Problem.
• Variations in the Wage Rate.
• Overtime Payments
THE INDIVIDUAL’S SUPPLY OF • The effect of fixing the length of the working week
LABOUR. • Household Production and the Labour Market.
• Household Production and the Labour Supply Function.
• Lancaster’s Characteristic Approach
• Goods, Attributes and Choice
BRANDS AND BRANDING • The Basic Framework
• Brand Loyalty and Branding
• Product Differentiation and Market Research
• Advertising
The Nature of the Choice Problem Indifference map and the choice.
• The object of choice are income and leisure.

Y
Y
Y1
• Constraint upon the choice is the total number of
hours in a week.
Y2
Y0
• Individual’s tastes are the usual bundles of two
goods (leisure and income). 0 L1 L2 L0 0
( A) L (B) L0 L
Variations in the Wage Rate

Variations in the Wage Rate
W Y W
Y S 2 S
2
B W2
B W1
1 1
A
A
W2
W1
Y0 Y0
0 0 0 L1 L2 L3 L0
0
L1 L3 L2 L0 L ( L0 − L2 ) ( L0 − L3 ) hours L ( L0 − L3 ) ( L0 − L2 ) hours
worked worked
(A) (B)
(A) (B)
28
Variations in the Wage Rate Overtime Payments
Y Y 2
2
3 3
B B
C C
1 Y2 I1
1
Y3
Y0
A Y1 A
Y0
Y1
0 L1 L0 0
L L1 L2 L0 L
Household Production: the Simple Case. Household Production: The Simple Case
Y
Y Y B
Y1 B
Y1
Y1 C
C
Y2
Y2
Y2 A
Y0 Y0
0 L1 L2 L0
0 L L L L0
Y0 A
L 1 3 2 L
0 L1 L2 L0 L
Household Production and the Labour Market

Household Production and the Labour Market.
3
Y
E Y3
E' D' 2
Y1
B D Y3' 1
Y2'' B
Y2' D '' D' D
Y2
Y0 A A
Y0
0 L1 L12 L 0
L2 L0 L1 L'2 L2 L0
' ''
L3 L 3 L
2
29
Household Production and the Labour Supply Function Goods, Attributes and Choice
2 • Individual gets satisfaction in consumption:

- not from the goods themselves,
- but rather from their attributes.
Y3 1
Y3' B
Y2' D' • The constraint upon choice is determined by income, prices and
D the technical characteristics of the goods.
Y2
• The demand for goods and services is:
A
Y0 - not a result of choice making behaviour,
- but an indirect result of more fundamental choice-making
0 L1 L2 L0 process.
L'3 '
L3 L 2
The Basic Framework A Simple Application-Brand Loyalty

R brand 1
“Brand Loyalty” is the phenomenon of
brand 2
continuing to buy a particular brand even
X1 though its price may have risen relative to
X 2* others.
brand 3
X2
I3
I2
X3
I1
O
S
An Elaboration-Combining Brands Product Differentiation and market

Research.
R
brand 1 R
brand 1 brand 4
brand 2
X1 B X1
A ' A
X 2 brand 2
X2
X2
'
X 0
X0 brand 3 X3 brand 3
X3
O
O S
S
30
Advertising Reading
• Consumers are usually unfamiliar with the Microeconomics. 4th Edition, Cambridge
technical characteristics of each particular University Press: Cambridge. Ch 5,8, pp69-80,
brand. 111-122.
• Advertising informs consumers about • Varian H. 2002. Intermediate Microeconomics. 6th

brands, where and at what price they are Edition, Norton&Company: New York. Ch 9,
available, and their attributes. pp158-177.
• Advertising attempt to change consumer’s • Nicholson W. 2004. Intermediate Microeconomics

tastes and can be interpreted as informative and its applications. 9th Edition, Thomson
Learning. Ch 4. pp126-154.
tool.
31
TUTORIAL 3. THE INDIVIDUAL SUPPLY OF LABOUR. BRANDING.
Task 1. Perfect Substitutes.
Suppose that income and leisure are perfect substitutes. Use indifference curve and
budget line diagrams to illustrate the cases when:
(a) The individual will work for every hour available.
(b) The individual will not work at all.
(c) The individual will work an indeterminate number of hours.
Task 2. Income Tax and Individual Supply of Labour.
An individual is known to increase the hours per week worked when non-wage
income is decreased. What will happen to the hours worked if:
(a) A proportional income tax is levied on wage income;
(b) A proportional income tax is levied on total income;
(c) A proportional tax on wage income is used solely to finance an increase in non-
wage income?
Would any of your answers differ if the individual were known to decrease working hours
when non-wage income decreased?
Task 3. Numerical Example.
Draw the budget constraints on the work/leisure choice implied by the following
information:
(a) non-wage income=$100 per week;
wage rate=$4 per hour.
(b) non-wage income=$200 per week;
wage rate=$2 per hour.
(c) non-wage income=$200 per week;
wage rate for first 40 hours=$2 per hour.
(d) non-wage income=$0 per week;
for 40-hour week with no hours less than 40 = £120 per week.
Overtime payment rate=$5 per hour.
Task 4. Substitutes, Complements and Branding.
A fall in the price of a particular brand of good could lead to less of it being
demanded. Where the good in question has two attributes, R and S (a) could this happen if
R and S were substitutes for each other; and (b) must it happen if they are complements?
32
• Activities and the Isoquant
• Production Function
• Long-run and Short-run Analysis
Lecture 4. • Returns to Scale and Variable Returns to Scale
• Substitutability and Elasticity of Substitution
Properties of the Production Function. • The Short-run Production Function and Returns
to a Factor
• Cobb-Douglas Production Function.
Introduction Think of these:

• Production of housing services
• Production is a very general term. It is:
- not only the production of physical goods, (child care, home maintenance, cooking etc.)
- but also services. • Production of health
(purchased medical care and own time to produce
• It will be assumed the production of good to health)
be (X) and two inputs to production. • Production of children
(children have both quantity and quality dimensions,
• These are factors of production: optimum combination?
- capital (K) and investment is an irreversible process, hence people
- labour (L). view it as a quite risky investment.)
Activities and the Isoquant Production Function

K
K K
R
1 1
2
5X 1
4X 1
2
3X 1 3X 1
3
A 5X 2
2X 1
B
4X 2
3X 2
1X 1 3X 2 3X 3 5X
4X
2X 2
4
3X
1X 2
3X 4 2X
O O 1X
(A) L (B) L O
L
33
Returns to Scale and Homogenous Functions
The long-run production function.
α X = f ( tL , tK )
X = f ( L, K )
K
Assumptions:
f (⋅) is monotonic function, so that if X rises, then either L or K, • If t and α vary in the same
•
or both rises. proportion, these are constant
returns to scale.
• Free disposal • Production function is 4X
homogenous of degree k if : 3X
• Average product of labour or labour productivity is (X/L)
t X = t f ( L , K ) = f (tL , tK )
k k
O
2X
• Average product of capital or capital productivity is (X/K) L
• Marginal product of labour : ∂X / ∂L where k is constant, t>0 and

.
• Marginal product of capital is: ∂X / ∂K
Substitutability Substitutability
• It is the rate at which the K
capital can be used to replace K
labour or vice versa. If capital and labour are

perfect substitutes then:
X = f ( L, K ) = αL + bK
X3
• Leontief technology
X2
X = f ( L, K ) = min( L, K )
X1 X3
X2
X1
O
L O
L
The Elasticity of Substitution. The Derivation of Elasticity of Substitution
• The precise measure of the mrts is :

∂X ∂X
dX = dL + dK
∂L ∂K
The slope of the isoquant is marginal rate of
technical substitution (mrts) between inputs. • then
∂L ∂X / ∂K
mrts KL = =−
∂K ∂X / ∂L
• Denoting the elasticity of substitution by σ we have:
∂(K / L) ∂ ( mrts LK ) ∂ ( K , L ) ∂ (∂K / ∂L )

σ ≡ ≡
K /L mrts LK K /L ∂K / ∂L
34
Short-run production function and returns to a factor
The Cobb-Douglas Production
X Function
X X = f ( L, K ) • See the attachment.
m pl
a pl
O
L L
Policy Implications Reading

1. It is possible to find the returns to scale • Laidler D., Estrin S. 1995. Introduction to
characteristics over different ranges of output. Microeconomics. 4th Edition, Cambridge
University Press: Cambridge. Ch 10, pp131-150.
2. Technology can be measured by the elasticity • Varian H. 2002. Intermediate Microeconomics. 6th
of substitution. Edition, Norton&Company: New York. Ch 19,
pp326-342.
3. In the short-run competitive firms always
operate in the region of the production • Nicholson W. 2004. Intermediate Microeconomics
function, where the returns to a factor Learning. Ch 5. pp157-185.
diminish.
35
Lecture 4. Attachment.
Cobb-Douglas Production Function.
The Cobb-Douglas Production Function takes the form,

X = f ( L, K ) = ALα K β (1)
Taking Logs we get:
ln X = ln A + α ln L + β ln K (2)
First, suppose that:
α + β = 1 so β = 1 − α
Hence the Cobb-Douglas production function takes the form:
α
⎛L⎞
X = A⎜ ⎟ K (3)
⎝K⎠
If we increase L and K in the same proportions, their ratios doesn’t change, so the
term A( L / K )α remains the same. However K has change by a given proportion, and equation
(3) implies that X will change in the same proportion. So that, doubling its inputs will double
output. Therefore the assumption that α + β = 1 implies that Cobb-Douglas function displays
constant returns to scale.
Considering the Cobb-Douglas production function in more general terms, we can take
differential of equation (1):
dX = αALa −1 K β dL + βALα K β −1dK (4)
α β
Considering that X = AL K and substituting, the equation (4) can be written as:
X X
dX = α dL + β dK (5)
L K
The concept of returns to scale refers to the way in which output changes as both inputs vary
holding factor proportions, the ratio K/L, constant. Suppose then, that
dL dK
= (6)
L K
Hence equation (5) becomes:
dL dK
dX = X (α + β ) = X (α + β ) (7)
L K
or
dX dL dK
= (α + β ) = (α + β ) (8)
X L K
if α + β = 1 , output increases in strict proportion to labour (or capital) input so long as the
capital-labour ratio is held constant, and we have constant returns to scale. If α + β f 1 , output
increases in strict proportionally more than labour (or capital) input and we have increasing
returns to scale. On the other hand, α + β p 1 implies diminishing returns to scale.
In the Cobb-Douglas case, so long as α and β are each less than one, the marginal products
of factors decline as their use increases, and bear a constant proportion to average products.
36
TUTORIAL 4. PRODUCTION FUNCTION.
Task 1. Proper management?
Roy Dingbat is the manager of a hot-dog stand that uses only labour and capital to
produce hot-dogs. The firm usually produces 1000 hot dogs a day with 5 workers and 4 grills.
One day a worker is absent but the stand still produces 1000 hot-dogs. What does this imply
about the 1000 hot-dog isoquant? Why do Roy’s management skills justify his name?
Task 2. Microeconomics Examination.
Ben Fail wrote the following answer on his micro exam. “Virtually every production
function exhibit diminishing returns to scale because my lecturer said that all inputs have
diminishing marginal productivities. So when all inputs are doubled, output must be less than
double.” How would you grade Ben’s answer and why?
Task 3. Desert and Production.
Assume that you are stranded on a desert island and you have exactly 100 hours of
labour to allocate between producing good X and good Y. Your output of goods X and Y
depends solely on the hours of labour you spend in the following way:
X = L X and Y = LY
a. If you can sell your output of goods X and Y at the fixed prices PX =10 and PY =5, how
much of goods X and Y would you produce to maximize your profits?
b. Now assume further that you have the following utility function:
U = 10 XY
If you can trade a bundle of goods X and Y that you produce in the market at fixed
prices of PX =10 and PY =5, what bundle would you produce and what bundle would you
consume to maximize your utility? Are you a net demander and a net supplier of the two
goods? Draw a diagram to depict what is happening.
Task 4. Leontief Technology and vineyard owner.
Grapes must be harvested by hand. This production function is characterized by fixed

proportions-each worker must have one pair of stem clippers to produce any output. A skilled
worker with clippers can harvest 50 pounds of grapes per hour.
a) Sketch the graph production isoquants for q=500, q=1000, q=1500 and indicate where
on these isoquants firms are likely to operate.
b) Suppose a vineyard owner currently has 20 clippers. If the owner wishes to utilize fully
these clippers, how many workers should be hired? What should grape output be?
c) Do you think the choices described in part b are necessarily profit-maximizing? Why
might the owner hire fewer workers than indicated in this part?
d) Ambidextrous harvesters can use two clippers-one in each hand-to produce 75 pounds
of grapes per hour. Draw an isoquant map (for q=500, 1000, 1500) for ambidextrous
harvesters. Describe in general terms the considerations that would enter into an
owner’s decision to hire such harvesters.
37
Task 5. Mixing technologies in Goat Lawn Company.
Power Goat Lawn Company uses two sizes of mowers to cut lawns. The smaller
mowers have a 24-inch blade and are used on lawns with many trees and obstacles. The larger
mowers are exactly twice as big as the smaller mowers and are used on open lawns where
maneuverability is not so difficult. The two production functions available to Power Goat are:
Output per hour (square Capital input (no. of 24'' Labour
meter) mowers) input
Large
Mowers 8000 2 1
Small
Mowers 5000 1 1
a) Graph the q=40,000 square meter isoquant for the first production function. How much
K and L would be used if these factors were combined without waste?
b) Answer part a for the second function.
c) How much K and L would be used without waste if half of the 40,000 square foot lawn
were cut by the method of the first production function and half by the method of the
second? How much K and L would be used if three-fourths of the lawn were cut by the
first method and one-fourth by the second? What does it mean to speak of fractions of
K and L?
d) On the basis of your observations in part c, draw a q=40,000 isoquant for the
combined production functions.
38
• Expenditure on inputs and the cost function
• Long-run cost minimisation
• Long-run total cost and the expansion path
Lecture 5. • The Cobb-Douglas case
• Average and marginal costs in the long-run
• Long-run costs with varying returns to scale
Cost Functions
• Short-run cost functions
• Short- and Long-run average cost-the Envelope
• From production to cost function in the short-run
• Managerial Inputs and Principal Agent problem
Introduction Expenditure on inputs and the Cost function.

• Price for labour is the wage per week (hour) worked,
denoted w.
• To keep analysis manageable we deal with
homogenous (at least homothetic) production • Price for capital, denoted r, is:
functions. - not the price of a new machine,
- but a weekly (hourly) rental price of a machine
• Firm minimizes costs to maximize profit. Price for a machine is an opportunity cost of owning the
machine.
• Total cost is: C=wL+rK
• Cost Function: C=C(X,w,r)
Long-run Cost Minimisation Long-run total cost and the expansion path.
• minC=wL+rK; subject to X=f(L,K)
K
• Tradeoffs between inputs available to the firm are formalised in
terms of isocost curves. C5
K
C4
A
C3 5X
10K B
C 4X
3X
O O
20L L
39
The Cobb-Douglas Case Average and marginal costs in the long-run
• Cobb-Douglas function is homogenous and hence
homothetic.
(− β / α )( L / K ) TC TC LTC TC
LTC
• The mrts between labour and capital is C5 LTC C3

and the ratio of prices is exogenous for the firm, and
C4
fixed at w/r C3
C3
• In equilibrium: O
3X 4X 5X X
O
3X X
O
3X X
(a) (b) (c)
−β L and K − βr
= w/ r =
α K L wα
Long-run costs with Varying returns to scale The concept of short-run

LTC • In the short-run we assume that at least one factor
TC
input is fixed.
• Labour input is more likely to change in the short-

run. (It is easy to change labour, rather than install
new machinery).
• However it is a naïve assumption, since for

example labour can be on long-term contract or it
O
X* is easier sometimes to install new equipment.
X **
Short-run cost functions Short-run cost functions

STC
Long-run TC
K expansion
path B LTC
CB
A
Short-run CA D
expansion CD
A B 4X path *
K* K C0
D
3X
1X O
O 1X 3X 4X
CD CA CB
40
The relationship between long and short- Shifts in the cost curves
run average and marginal costs
SMC
AC • Changes in input prices
MC LMC
SAC
LAC • Technological Innovation
A
• Economies of Scope
O
3X X
The U-shaped Average Cost Curve and

From Production to Cost Functions in
Managerial Inputs
the short-run. A formal treatment.
• The production process is:
- not only engineering matter,
See the attachment.
- but also administrative issue.
• When firm increases inputs equiproportionally, the

managerial inputs are usually held constant.
• When there is a low level of production, the managerial

skills are underutilised and vise versa.
Principle Agent Problem Reading

Profits • Laidler D., Estrin S. 1995. Introduction to
π MAX Agent’s
constraint
University Press: Cambridge. Ch 11, pp152-168.

π* B U2 Edition, Norton&Company: New York. Ch 19-23,
π ** pp326-413.
U1 Owner’s
constraint • Nicholson W. 2004. Intermediate Microeconomics
π *** Quantity Learning. Ch 6, 7. pp187-249.
* **
B B BMAX
41
Lecture 5. Attachment.
From Production to Cost Functions in the short-run. A formal treatment.
In the short-run, with capital costs fixed at Co(r K = Co) the total cost of function
(C=wL+rK ) becomes
C=wL+Co
and variable costs (VC) are given by wL.
The short-run production function is of course: X = f ( L, K )
Which, since there is only one variable factor, can be represented as:
L = f −1 ( X , K )
So with capital fixed, the level of output is unambiguously determined by employment only
and vice versa. For given w, average variable cost (AVC) is inversely associated with average
product.
VC wL
AVC = =
X X
while short-run marginal cost is also specified as depending on the wage and the marginal
product of labour. ∂C ∂L
=w
∂X ∂X
The relationship between average and marginal cost will not in general remain constant as
output changes. Although, in the Cobb-Douglas case, marginal costs are a constant multiple of
average costs, with
VC wL ∂C wL
= and =
X X ∂X aX
so that
∂C VC wL wL 1
= =
∂X X αX X α
42
TUTORIAL 5. COST FUNCTION.
Task 1. Businessman thoughts.
Since an entrepreneur can always built the same factory next door, there is no reason to
believe that long-run average costs will actually even increase as output rises. Discuss.
Task 2. Hospital and restriction on beds.
A medical centre produces health services using two inputs: hospital beds and labour.
There is a government regulation restricting the number of beds to B. Assume that the medical
centre is currently using B beds and L units of labour to produce Q1 units of health services.
Also assume that the medical centre plans to expand its output to Q2 units of health services.
Prepare a diagram to show how this government regulation restricting the number of hospital
beds would affect the efficiency of delivering health services. (Hint: Show the expansion path
with and without this government regulation.).
Task 3. Long and short-run cost curves.
Suppose that a firm has long-run total cost of $1000 for producing 100 units of output.
The two inputs of production are labour and capital. Labour costs $10 per unit, and capital
costs $10 per unit. The firm is currently producing 100 units of output and is using the cost-
minimizing combination of 50L and 50K for labour and capital.
a) On an isoquant diagram, show that an increase in output from 100 units to 150 units
will result in higher short-run than long-run total costs, average costs, and marginal
costs.
b) Show that a decrease in output from 100 units to 50 units will result in higher short-run
than long-run total costs and average costs, but higher long-run than short-run marginal
costs.
c) Give an intuitive explanation for these relationships between the short-run and long-
run cost curves.
Task 4. Trucking firm.
A trucking firm’s output is measured by the number m of truck-miles moved per day.
The firm’s operating costs are as follows:
i. Wages of truckers, $w per hour.
ii. Cost of gasoline, $p per gallon.
iii. Fuel consumption, g=A+Bs, where g is gallons of gasoline per truck mile, s is the speed at
which a truck is driven, and A and B are constants.
a. Derive the total variable cost function of the firm if it has an unlimited number of
trucks.
b. What does the cost function look like if the firm has only one truck and that truck can
be driven for a maximum of 10 hours per day?
43
Task 5. Skateboards production.
The long-run total cost function for a firm producing skateboards is:
TC = q 3 − 40q 2 + 430q
where q is the number of skateboards per week.
a) What is the general shape of this total cost function?
b) Calculate the average cost function for skateboards. What shape does the graph of this
function have? At what level of skateboard output does average cost reach minimum?
What is the average cost at this level of output?
c) Find the marginal cost function and show that this marginal cost curve intersects
average cost at its minimum value.
d) Graph the average and marginal cost curves for skateboard production.
Task 6. Principal-Agent Problem.
Suppose that candidates for managerial positions at Fly-by-Night Waterbeds, Inc., can
command salaries of $10,000 per year in other employment, but on those jobs they are not
able to play golf during working hours. Fly-by-Night, however is located next to a golf course,
so it is possible for managers to sneak off to play, though this does harm the company’s
profits. Suppose that a potential manager’s utility function is given by:
Utility = 0.1 s + 2 g
Where s is the manager’s annual salary and g is the number of golf games he or she can play
each week during the year, whose value can be only 0, 1, or 2. Annual profits for the firm
prior to paying the manager are $19,000 if g=0, $16,000 if g=1, and $8,000 if g=2.
a). Suppose that Fly-By-Night can write a contract that specifies precisely how much golf its
manager may play. What will be the profit-maximizing combination of salary and golf that
will allow the firm to hire a manager? What will the firm’s net profits be in this situation?
b). Suppose that a manager is hired under the contract specified in part (a) but that the firm’s
owners cannot monitor how much golf the manager actually plays. What will the manager do?
What will the firm’s net profits be?
c). Suppose that the firm’s owner’s recognize the principal-agent problem that arises in part
(b) and decides to use a profit sharing contract to ameliorate the problem. If the manager’s
salary is to be based only on a share of the firm’s profits, what share must be paid? How much
golf will the manager choose to play with this contract? Will the firm choose to offer this
contract to the manager?
44
Microeconomic analysis and policy
Agenda
• Very short-run
Lecture 6.
• Short-run
• Long-run
Models of market equilibrium. • Price controls and shortages
Perfect Competition and • Tax incidence
Applications to the Competitive Model
Short-run
Very short-run
Ethanol Subsidies in Brazil Ethanol Subsidies

Price
Ethanol – ethyl alcohol. It is used in fuel for $/gallon
S1
automobiles and reduces air pollution. S2
Ethanol is made of sugar cane in Brazil.

P1
P2
Government subsidized the production of Subsidy
ethanol. D
Q1 Q2 Quantity
mln gallons
45
Long-run equilibrium (constant cost case) Movie rentals (constant cost case)
The VHS revolution.
No significant barriers to entry (rent, shelves, low wage workers).
More than 70% of US households owned VHS

players by the end of 1980.
Industry perfectly elastic long run supply curve met

increase in demand with no increase in price.
Movie rentals (constant cost case) Movie rentals (constant cost case)
DVD – new technology. Future technology?
Mid 1990s was a critical threshold of DVD

player owners. Hence the market quickly Internet, cable TV, Satellite (charge per view).
emerged.
Advantages:
Internet also enhanced supply response. no repeated trips by customers, cost saving.
Absence of barriers to entry resulted in constant Disadvantages?

cost model
Increasing cost case.

Increasing costs (examples)
• Firms may increase demand for scarce
inputs (natural resources, skilled labour).
• Additional firms may impose external costs

such as air or water pollution, road
congestion, etc.
46
Decreasing cost case Decreasing cost case
(Network externalities)
• Telecommunications. The larger the number
of people using phone or fax, the greater the
benefits of having it.
• Software. The greater the number of users
for the software, the larger the benefits.
Microsoft and Windows Operating System
and related applications.
• Internet. Ability to deliver all kinds of
digital files.
Price controls and shortages Tax incidence. (Constant cost case)
Tax incidence (Increasing cost case)

Reading
• Nicholson W. 2004. Intermediate
Microeconomics and its applications. 9th
Edition, Thomson Learning. Ch 8-9. pp253-
300.
47
Attachment for lecture 6.
Production functions, cost functions and the demand for factors of production.
1. From Production to Cost Function in the Long-run.

C = wL + rK (1.1)
C = C ( X , w, r ) (1.2)
There are two ways to think about linking costs to output for given input prices.
The first method, if we fix the level of cost at C , the cost-minimisation problem becomes an
output-maximization problem. So as to maximize:
X = f ( L, K ) (1.3)
subject to
C = wL + rK (1.4)
we can therefore form the Lagrange function:
H 1 = f ( L, K ) + λ1 (C − wL − rK ) (1.5)
where λ1 is the Lagrange Multiplier. The first order conditions are:
∂H 1 ∂X
= − λ1 w = 0 (1.6)
∂L ∂L
∂H1 ∂X
= − λ1r = 0 (1.7)
∂K ∂K
∂H 1
= C − wL − rK = 0 (1.8)
∂λ1
from (1.6) and (1.7),
1 w r
= = (1.9)
∂λ1 ∂X / ∂L ∂X / ∂K
w
As we know, the expression ( ) defines marginal cost in the short-run. Therefore the
∂X / ∂L
Lagrange Multiplier λ1 is equal to short-run marginal cost.
Rearranging terms in (1.9), we have
∂X / ∂L w
= (1.10)
∂X / ∂K r
As we know the ratio of marginal products equals the slope of the isoquant,
dL ∂X / ∂K
the mrts KL = =− . Hence since
dK ∂X / ∂L
dK ∂X / ∂L
=− (1.11)
dL ∂X / ∂K
we have established that
dK
= −w / r (1.12)
dL
Output maximisation for a given cost requires that the ratio of relative input prices equals the
mrts between them.
Another way, with exactly the same result can be obtained by minimizing cost for a given
level of output X. The problem here is to choose capital and labour inputs to:
Min L , K C = wL + rK (1.13)
subject to
48
X = f ( L, K ) (1.14)
The Lagrangian is
H 2 = wL + rK + λ2 ( X − f ( L, K )) (1.15)
with first order conditions:
∂H 2 ∂X
= w − λ2 =0 (1.16)
∂L ∂L
∂H 2 ∂X
= r − λ2 =0 (1.17)
∂K ∂K
∂H 2
= X − f ( L, K ) = 0 (1.18)
∂λ2
From (1.16) and (1.17) we derive
w r
λ2 =
= (1.19)
∂X / ∂L ∂X / ∂K
from which (1.12) can be derived as usually.
C3 / r
C2 / r
C1 / r
C/r
C/r
X*
X1 X*
X2
X3
X*
C3
C2
C C1
C C
X 3 X 2 X1 X * X*
2. Fixed Proportions Technology. (Leontief Production Function)

X = min(γL, θK ) (2.1)
and the isoquants are L-shaped as in the figure below.
K
C3' / r1
C 3' / r2
C 2' / r1 O'
C 2' / r2
X3
C
C1' / r1 X2
C1' / r2 B
X1
A
L
49
To produce each unit of X, we therefore need both X / γ of labour and X / θ of capital, at a
cost of w and r respectively. The minimum cost is therefore:
Xw Xr
C= + (2.2)
γ θ
rearranging as:
⎛w r ⎞
C = X ⎜⎜ + ⎟⎟
⎝γ θ ⎠
∂C w r
= + (2.3)
∂X γ θ
We can also examine the relationship between costs and input prices at a given level of output.
Differentiating (2.2) by each input price,
∂C X
= =L>0 (2.4)
∂w γ
∂C X
= =K >0 (2.5)
∂r θ
X X
We know from the production function that is the amount of labour services L, and is
γ θ
the amount of capital services, K, being used to produce X units of output.
3. Perfect Substitutability
This time we assume that labour and capital are perfect substitutes in the production process.
As we know the production function takes the form:
X = aL + bK (3.1)
and the isoquants are straight lines, as it is shown in the figure below.
K
A X1
X1
C B L
The cost minimising firm will, choose the cheaper option, so that cost function is
⎛w r⎞
C = min ⎜ , ⎟ X (3.2)
⎝ a b⎠
50
TUTORIAL 6. Perfect Competition, Equilibrium models and Applications
Task 1. New drug and the price for wool fibers.
An Australian researcher has discovered a drug that weakens a sheep’s wool fibers just above
the sheep’s skin. The drug sharply reduces the cost of sheering (cutting the wolf off) sheep
because the entire coat pulls off easily in one piece. The world wool market is reasonably
close to the model of perfect competition in both the product and factor sides. Trace out all of
the effects of the introduction of this new drug.
Task 2. The case of perfect substitutability.
Suppose that the weekly production function takes the form X=2L+K, with the firm facing a
weekly wage rate of $100 and capital rentals of $300.
a) Will the firm use any labour at all in the production process?
b) Suppose that output of X is 500 units per week. What are the marginal costs? What are
the average costs?
c) Suppose that the wage rate increases by 60%. What happens to the cost of production?
What happens to average and marginal costs?
Task 3. The case of fixed proportions technology.
Suppose that the production function takes the form X=min(10L,5K) and that a competitive
firm faces a wage rate of $60 per week and a weekly capital rental of $32.
a) How much must the firm spend to produce 100 units of output, and what is the average
cost of production when X=100?
b) What is the incremental cost of producing the 101st unit of output?
c) What happens to the cost of producing 100 units of output if the wage rate and the
rental cost of capital rise by 25 % each? What happens to the average and marginal
cost?
d) What happens to the cost of producing 100 units of output if the wage rate increases by
$1, or if the cost of capital increases by $1.
Task 4. Competition and School choice.
Would introducing competition into our educational system improve the quality of our schools?
What are the pros and cons of competition in educational system? Do you think it is
appropriate to apply economic models of competition to education?
51
Task 5. Organ Donor Market.1
Is America Ready for an Organ-Donor Market?
Probably not. But, in what is either a very odd coincidence or some kind of concerted effort to
get out the organ-market message, there are OpEds in both the N.Y. Times and Wall Street
Journal today arguing the case.
The first one, headlined “Death’s Waiting List,” is by Sally Satel, a psychiatrist and American
Enterprise Institute scholar. Satel herself received a kidney transplant and is now arguing that
the delivery system is terrible and that the Institute of Medicine’s new report, “Organ
Donation: Opportunities for Action,” is even worse. “Unfortunately,” Satel writes, “the report
more properly should be subtitled ‘Recommendations for Inaction.” Satel’s main point is that
the conventional argument against an organ market—i.e., that no part of the human body
should ever be “for sale”—has been made obsolete, and then some, by the “markets for human
eggs, sperm, and surrogate mothers.”
The WSJ piece, headlined “Kidney Beancounters” (abstract only), is by Richard Epstein, the
University of Chicago legal scholar and Hoover Institution fellow. Epstein is even more
hostile to the IOM’s report (though maybe the Journal just let him get away with more than
the Times let Satel get away with), saying the report is “so narrowminded and unimaginative
that it should have been allowed to die inside the IOM.” Epstein writes further that “The major
source of future improvement lies only in financial incentives; yet the IOM committee (which
contains one lawyer but no economist) dismisses these incentives out of hand … The key
lesson in all this is that we should look with deep suspicion on any blanket objection to market
incentives—especially from the high-minded moralists who have convinced themselves that
their aesthetic sensibilities and instinctive revulsion should trump any humane efforts to save
lives.”
Though his OpEd doesn’t say so, I am pretty sure that Epstein is an advisor to LifeSharers, a
self-described “non-profit voluntary network of organ donors” that seeks to use non-financial
incentives to encourage organ donation. A while ago, we received an e-mail from David Undis,
the executive director of LifeSharers. He wrote:
Incentives are missing in organ donation. That’s one of the reasons so many people are dying
waiting for organ transplants.
A free market in human organs would save thousands of lives a year, but politically speaking
it’s a pipe dream. There’s very little likelihood Congress will legalize buying and selling
organs in the foreseeable future.
1
http://www.freakonomics.com/blog/2006/05/page/3/
52
I formed LifeSharers to introduce a legal non-monetary incentive to donate organs—if you
agree to donate your organs when you die then you’ll receive a better chance of getting an
organ if you ever need one to live.
It is surprising to me, and to many people much closer to the subject than me, that so little
headway has been made in reforming the organ-donation process. I have never heard a single
person say they were happy with the way things are—and, while I am sure Undis is right when
he writes that a free market in organs is, politically speaking, a pipe dream, it seems that things
are starting to move at least a bit in that direction. As Satel writes in her Times piece today,
“Ethics committees of the United Network for Organ Sharing, the American Society of
Transplant Surgeons and the World Transplant Congress, along with the President’s Council
on Bioethics and others, have begun discussing the virtues” of offering organ donors
incentives such as “tax breaks, guaranteed health insurance, college scholarships for their
children, deposits in their retirement accounts, and so on.”
It is interesting that, while all these incentives are financial, none of them are in the form of
cold hard cash, which may make them more palatable.
I wouldn’t be surprised if, between these two OpEds,
53
Agenda
• Monopoly’s profit maximization
Lecture 7. • Linear Demand Curve and Monopoly
• Deadweight Loss of Monopoly
• Natural Monopoly
• Price Discrimination
Monopoly and Monopolistic competition • The idea of monopolistic competition.
• The firm in monopolistic competition.
• Monopolistic competition and Efficiency
• Formal analysis of monopolistic competition.
• Mark-up pricing
• Criticism of Monopolistic Competition
Linear Demand Curve and Monopoly Markup Pricing

Suppose that monopolist faces a linear demand curve: • The optimal pricing
p(y)=a-b(y) policy for monopolist
MC
• The revenue function is: r ( y ) = p ( y ) y = ay − by 2 Price
can be expressed
1− 1 / ε MC
• The marginal revenue function is: MR(y)=a-2by through elasticity
concept:
P Profits = π p1 MC ( y * )
a p( y) =
Demand 1 − 1 / ε ( y)
MC
AC
p* • The markup is given
O y * Output by:
1
MR
Demand
(slope=-b) 1 − 1 / ε ( y)
(slope=-2b)
O y* Output
Deadweight Loss of Monopoly Natural Monopoly
P MC
P MC AC
p*
Monopoly AA p AC
price B
Losses to
C Demand pMC the firm from
Competitive marginal cost pricing
price
Demand
MR
O y AC yMC Output
O y* Output
54
First- degree price discrimination Second-degree price discrimination
• Selling each unit of output for the highest price • It is also known as non-linear pricing.
obtainable. • The price per unit of output is not constant but
• Extracts all of the consumer surplus available in a depends on how much you buy.
given market.
Willingness to pay
Willingness to pay
Willingness to pay
Willingness to pay
Willingness to pay
B
B
B
A
B C
A A A
MC MC C C D
Quantity Quantity Quantity

Quantity Quantity A B C
A B
Second degree price discrimination. Third-degree price discrimination
• Mobile phone call packs. • It is the most common form of price

discrimination.
• Buy two get one free.
• E.g. students’ discount at shops, senior
• Monthly, weekly bus tickets. citizens’ discounts at the drug stores.
• One way air tickets or return tickets.
A Location Model of Product

The Idea of Monopolistic Competition
Differentiation
• There are quite a large number of firms.
• Panel (a) shows the socially optimal location pattern.
• Firms are independent from each other in • However each vendor will find in its private interests to
decision-making and there is freedom of entry of move toward the middle.
new firms into the industry. • Hence the only equilibrium location is for both vendors
to be in the middle (panel (b))
• The product is differentiated.
L R L R
• Spatial economics better motivates the
monopolistic competition. Market Share Market Share Market Share Market Share
of Vendor L of Vendor R of Vendor L of Vendor R
• Although spatial economics is not the only source
of downward sloping demand curve. a b
55
Product Differentiation More Vendors
• Suppose there are three vendors.
• Suppose now that market is large and vendors’ market • At least one vendor is located between the other two
areas don’t overlap. • Two vendors at the end will move to the middle
• Thus vendors will sit at both ends of the line and would • But if they get too close, the third one will jump to the
be monopolists. right or left.
• Although the similar situation can occur in product • Hence there is no pure strategy equilibrium with 3
differentiation vendors.
• Each firm want to differentiate the product from their • Now, think what will happen if there are more than 3
competitors and convince customers, that there are no vendors.
Shift right Shift left
substitutes, hence charge higher price.
• Such a “product positioning” is much like the two L R
vendors locating far away from each other, in order to
Jump right
avoid head-to-head competition.
The firm in monopolistic competition Monopolistic Competition and Efficiency

P
LMC
p1 • It is argued that a firm in monopolistic
LAC
AC1 competition is inherently less efficient than
D
the firm in perfect competition.
MR
O X1 X
P • The reason is that a former firm ends up
LMC producing output at more than minimum
average cost, while the latter at the bottom
p1
LAC
of LAC.
D
MR
O X1 X
Mark-up Pricing Criticism of Monopolistic Competition.
• Output price is set by adding a fixed mark-up to • Critics argue that monopolistic competition is just a
special case of monopoly.
average costs.
• There is also a problem at levels too.
• Monopolistic firms produce similar products, but how

• The more inelastic demand is, the greater the similar they are.
mark-up on costs to reach the selling price.
• Critics argue that the notion of monopolistic
competition adds little to our ability to understand
firms’ behaviour.
56
Reading

Edition, Norton&Company: New York. Ch24- 25,
pp415-455.

University Press: Cambridge. Ch 15-16, pp224-
262.
57
TUTORIAL 7. MONOPOLY AND MONOPOLISTIC COMPETITION.
Task 1. Author’s dilemma.
An Author has signed a contract in which the publisher promises to pay her $10000
plus 20% of gross receipts from the sale of her book. True or False: If both the publisher and
the author care only about their own financial return from the project, then the author will
prefer a higher book price than the publisher.
Task 2. Price discrimination.
Consider an island served by one Ferry Company. There are two types of people who
visit the island, day trippers who come in the morning to enjoy the island’s beaches on a
Saturday or Sunday (or sometimes a weekday) and permanent summer residents who work in
the city during the week but come to the island on Friday night to spend the weekend and then
leave on Monday to return to work. The ferry has the following rate schedule: $6.50 for a
same-day round trip and $5 for a one-way trip. There are no round-trip savings for people who
don’t travel both ways on the same day.
a. Given the description of the two groups who visit the island, do you think that price
discrimination could work here?
b. Is the rate schedule of the ferry company an effective price-discrimination device?
Why or why not?
c. If so, what will be the round trip cost for the permanent summer residents? What will
be the round-trip cost for the day-trippers?
Task 3. Water-vendors and spatial economics.
Two mineral water-vendors, A and B, occupy fixed locations at opposite ends of a 1-

mile beach. There are 1000 people distributed uniformly over the beach and each person buys
one bottle of mineral water from the vendor whose inclusive price (money price plus round-
trip transportation cost) is lowest. Unit transportation cost is equal $0.25/mile. If the marginal
cost of mineral water is zero, and A is committed to charge money price of $1, what is the
profit-maximizing price for B?
Task 4. Taxes on monopoly.
Consider the following possible schemes for taxing a monopoly:

a. A proportional tax on profits.
b. A tax on each unit produced.
c. A proportional tax on the gap between price and marginal cost.
1. Explain how each of these taxes would affect the monopolist’s profit maximizing output
choice. Would the tax increase or decrease the deadweight loss of the monopoly?
2. Graph your results for these three cases.
58
Task 5. Numerical Exercise.
A monopolist can produce at constant average and marginal costs of AC=MC=5. The
firm faces a market demand curve given by Q=53-P. The monopolist’s marginal revenue
curve is given by MR=53-2Q.
a. Calculate the profit-maximizing price-quantity combination for the monopolist. Also
calculate the monopolist’s profits and consumer surplus.
b. What output level would be produced by this industry under perfect competition (where
price-marginal cost)?
c. Calculate the consumer’s surplus obtained by consumer in part b. Show that this exceeds the
sum of the monopolist’s profit and consumer surplus received in part a. What is the value of
the “deadweight loss” from monopolization?
Task 6. Price Discrimination1.

Imagine a vending machine that charges a different price for a can of soda depending
on how hot is outside! Well, that’s exactly what Coca-Cola ha din mind when it was
considering putting thermostats in their wending machines.
Please read the article below “Mean Vending Machines”. Use a graph to illustrate and
discuss the economic rationale behind Coca-Cola’s pricing scheme. Be sure to apply the
notion of elasticity. Which consumers would be better off and which would be made worse off
by this pricing scheme? Suppose instead of thermostats, Coca-Cola installed a mechanism that
would increase the price of the soda as the number of cans left in the machine decreases.
Would this be a form of price discrimination? Explain why or why not.
Mean Vending Machines.

Posted by John Irons at November 03, 1999 02:39 PM
This past weekend the news wires were all buzzing about the latest idea to come from the
world of soft drinks. Coca-Cola is apparently considering creating a new kind of vending
machine that would test the outside temperature and adjust the price of a can of soda upwards
when it is warmer outside.
Here's some of the typical reactions to the idea:

"a cynical ploy to exploit the thirst of faithful customers" (San Francisco Chronicle)
"lunk-headed idea", (Honolulu Star-Bulletin)
"Soda jerks" (Miami Herald)
"latest evidence that the world is going to hell in a handbasket" (Philadelphia Inquirer)
"ticks me off" (Edmonton Sun)
What did they think the Coca-Cola company was doing anyway? Selflessly providing the
world with a glorious beverage to further the goals of all mankind? Why should all these
people be suddenly offended by a company trying to maximize profits?
"Price discrimination" is the term economists use to describe the practice of selling the same
good to different groups of buyers at different prices. In the Coke case, the groups of buyers
are segmented by the outside temperature (i.e. Jill when it is hot outside vs. Jill when it is
1
Intermediate Microeconomics and its Applications, Walther Nicholson, 9th edition, p. 361.
59
cold). If possible, a company would like to charge a high price to those who place a high value
on the good, while charging less to those that do not.
So, are you personally offended by Coke's plan to charge more for soda's when it is warm
outside? Well, you had better get over it pretty quickly, there is already plenty of price
discrimination out there, and there is MUCH more to come.
Rampant Price Discrimination
Price discrimination is quite common. Ever wonder why hardcover books are produced first
and are so much more expensive than paperback books? Or, why it is so much cheaper to buy
airline tickets far in advanced? Or, why there are student discounts? Or, why matinee prices
are cheaper for movies? Ever tried to buy a soda from a vending machine at a hotel or at a
movie theater?
All these examples are attempts by sellers to charge different people different prices for the
same good.
Much of the price discrimination in the economy may in fact be quite hidden. How do you
know that the Crate and Barrel catalogue you just received has the same price for you as for
someone living in another zip code? Perhaps those with a 90210 zip code see higher prices on
their catalogues.
Why is the Vending Machine different?
In principle, the temperature sensitive vending machine is no different from any other form of
price discrimination.
Although, I do think the idea that the process is automatic generates some additional
discomfort - it is the idea that technology can effectively gauge our buying interests. The heat
sensitive machine is a small step toward applying machine "intelligence" to profit
maximization.
If you think that the vending machine idea is worrisome, just wait - the internet will be the
most sophisticated price discriminator the world has ever seen. Smart vending machines will
be the least of your worries. Online vendors such as Amazon.com may know quite a lot about
you - your past purchasing habits, your internet preferences, your zip code, etc, - and they
may want to use this information to adjust prices. Did you buy a Stephen King book last
month? Maybe you'd like to buy another, more expensive, Grisham novel this month with a
smaller "discount" chosen just for you.
The internet is much better than the "real world" at price discrimination, because it is so much
easier to change prices. In fact they can set a price just for you. It's hard to imagine a
traditional store doing this ("Hey, here comes John. Quick, raise the price of the new Krugman
Book."). But for an on-line e-commerce store, this is feasible and, with a clever programmer
on the payroll, quite easy.
Not all bad: Discrimination means increased efficiency
60
Actually, price discrimination can actually increase the overall efficiency of a market.
A loss of economic efficiency may occur when a company has some abililty to set prices and
there is no discrimination. The seller must pick a price that balances their desire to charge a
high price to those that really want a product, with their desire to sell a higher overall quantity
to those that are not willing to pay very much for it. Because of this, there are trades which
would benefit both buyer and seller that do not happen - the resulting price is "too high" and
the total quantity traded is "too low".
By identifying individual groups of consumers, a seller can provide an additional unit at a

lower price to someone who before would have been priced out of the market. The company
would now be willing to do this since they would not have to sacrifice profits by lowering
prices for the high-demand group.
In the Coke case, some consumers - those who drink Cokes on hot days - will be worse off
since they must pay a higher price, while some consumers - those who drink Coke on cold
days - will be better off since they will receive a lower price. The Coca-Cola company, of
course, will be better off. The sum total will be positive (pick your favorite Introduction to
Economics textbook to see why).
Would you really be as offended if it was described as a discount on cold days?
So, if you are still stewing about the potential of higher Coke prices, I suggest you stock up the
refrigerator and put some of that retirement money into Coca-Cola stock.
61
Agenda
• The concept of Oligopoly
Lecture 8. • Kinked Demand Curve
• Quantity Leadership
• Price Leadership
Oligopoly
• Simultaneous Quantity Setting
Kinked Demand Curve

The Concept of Oligopoly
d
P
D mr
Key features
LMC
a
• There are various barriers of entry.
p1
• Interdependence of the firms.

D
d
mr MR
O X1 X
Choosing a Strategy Quantity Leadership

• For simplicity assume a duopoly.
• Such a model also called Stackelberg
model.
• There are four variables of interests: the price each
firm charges and the quantity each firm produces.
• The Stackelberg model is often used to
• The classification scheme gives us four describe industries in which there is a
possibilities:
dominant firm or a natural leader.
- price leadership,
- quantity leadership,
- simultaneous price setting or • See the Attachment 1 for formal Analysis.
- simultaneous quantity setting.
62
Derivation of a reaction function Stackelberg Equilibrium
y2 =output
of the firm 2
Isoprofit lines
y2
for firm 2
f 2 ( y1 )
Reaction
curve f ( y1 )
2
y1 y1 =output
of the firm 1
y1
Price Leadership
For a formal analysis see attachment 2 Comparing Price and Quantity Leadership
• Firm which is able to make an investment in

Price Market Follower’s
demand supply Demand curve
capacity first is naturally modelled as a
facing leader
(residual demand)
quantity leader.
MR facing • Suppose that prices are more important than

p* leader capacity choices. So it is natural to think of
this firm as a price setter.
MC of Leader
* * Quantity
y L y r
Simultaneous quantity setting Cournot Equilibrium.
• Leader-follower model is asymmetric: one firm is Reaction

able to make decisions before the other firm. y 2 = output Curve f1 ( y2 )
of firm 2
• However if two firms are simultaneously trying to ( y1t + 4 , y2t + 4 )
y 2*
decide which quantity to produce, they have to ( y1t + 2 , y2t + 2 )
forecast what the other firm’s output will be. ( y1t + 3 , y2t + 3 )
Reaction
Curve f 2 ( y1 )
• An equilibrium in forecasts is examined through ( y1t +1 , y2t +1 ) ( y1t , y 2t )
Cournot Model.
y1* y1 = output of firm 1
63
Simultaneous Price Setting Collusion and Cartel
• Cartel is a group of
• The Bertrand Equilibrium has a very simple y2
oligopolists that set
prices and quantities as
structure-competitive equilibrium, where price Isoprofit curves
Output combinations
for firm 2
that maximize total if they are monopolist.
equal MC. industry profit
a
2b
• Cartel is inherently
• The result seems paradoxical, however this instable and Cartel
Isoprofit curves
model can be considered as the model of for firm 1 members will try to
competitive bid. cheat each other.
a y1
2b
• Firms need to detect and
punish cheating.
Punishment Strategies
• Firm will choose to cheat if : πd f πm Comparison of the solutions.
πm
Present va lue of cartel behaviour = π m +
r • Collusion results in the smallest industry
πc
Present va lue of cheating = π d +
r output and the highest price.
πm πc
πm + f πd + • Bertrand Equilibrium-highest output and
r r
lowest price.
π −πc
rp m • Other models gives results in between the
πd −πm
• As long as the interest rate is sufficiently small, so that two extremes.
the prospects of future punishment is sufficiently
important, it will pay the firms to stick to quotas.
Reading

Edition, Norton&Company: New York. Ch 27, pp468-
491.

Microeconomics. 4th Edition, Cambridge University
Press: Cambridge. Ch 17, pp264-284.
• Nicholson W. 2004. Intermediate Micoreconomics and

its applications. 9th Edition, Thomson Learning. Ch 11,
pp362-385.
64
TUTORIAL 8. OLIGOPOLY. FURTHER ANALYSIS.
Task 1. Forming a Cartel.
Consider an industry with five suppliers. One is very large relative to total supply,
with the capacity, in the relevant price range, to supply a significant proportion of market
supply on its own. The remaining suppliers comprise two middle size firms and two that
are relatively small. The largest and the smallest firms each have relatively low (constant)
unit costs, but average costs are somewhat higher for the two middle size firms. Discuss
the problems that the five suppliers will face in forming and maintaining a cartel.
Task 2. Cournot Equilibrium.
There are two identical firms in the industry, 1 and 2, each with cost
function Ci = 10 X i , i=1, 2. The industry demand curve is P=100-5X where industry
output, X is the sum of the two firms outputs ( X 1 + X 2 ).
(a) If each firm makes its output decisions on the assumption that the other will not
react to its choices (the Cournot assumption), what is the equilibrium output for
each firm. What is the equilibrium output for each firm? What is the equilibrium
price?
(b) Suppose that each firm takes it in turn to choose its level of output, on the
assumption that the other’s output level is fixed. Would the process of adjustment
be stable?
(c) Suppose that firm 1 introduces a cost saving innovation, so that its cost curve
becomes C1 = 8X 1 . Firm 2’s cost curve and the industry demand curve are
unchanged. What happens to the equilibrium quantity produced by each firm and to
market price?
Task 3. Stackelberg Game.
Suppose the two firms in task 2 are now playing a Stackelberg game, with firm 1 as
a leader and firm 2 as a follower. What are the equilibrium levels of output and industry
price? How does your answer change if firm 1 has the cost function given in Task 2 (c).
Task 4. Clorox case.
In the Clorox case, Procter&Gamble was alleged to be a potential entrant into the
liquid bleach market and was therefore prevented from buying Clorox Company. Can you
devise any way to use firm’s cost curves and the demand curves facing the firms to
differentiate among actual entrants? Potential entrants? No entrants? Use your analysis to
suggest what the court should have looked for in the antitrust case.
65
Task 5. Crude oil market.
Suppose that the total market demand for crude oil is given by:
QD=-2000P+70000
Where Q is the quantity of oil in thousands of barrels per year and P is the dollar price per
barrel. Suppose also that there are 1000 identical small producers of crude oil, each with
marginal costs given by:
MC=q+5
where q is the output of the typical firm.
a. Assuming, that each small oil producer acts as a price taker, calculate the typical
firm’s supply curve (q=…), the market supply curve (QS=…) and the market
equilibrium price and quantity (where QD=QS).
b. Suppose a practically infinite supply of crude oil is discovered in New Jersey by a
would-be price leader and that this oil can be produced a constant average and
marginal cost of AC=MC=$15 per barrel. Assume also that the supply behaviour of
the competitive fringe described in part a is not changed by this discovery.
Calculate the demand curve facing the price leader.
c. Assuming that the price leader’s marginal revenue curve is given by
MR=-Q/1500 +25
How much should the price leader produce in order to maximize profits? What price
and quantity will now prevail in the market?
d. Graph your result indicating the market demand curve, the supply curve for the
competitive fringe, and the price leader’s demand, MR, and MC curves.
e. Does the consumer surplus increase as a result of the New Jersey oil discovery?
How does consumer surplus after the discovery compare to what would exist if the
New Jersey oil were supplied competitively?
66
• The Payoff Matrix
• Nash Equilibrium
Lecture 9.
• Mixed Strategies
• Prisoner’s Dilemma
Strategy and Game Theory • Repeated Games
• Enforcing a Cartel
• Sequential Games
• Games of Entrance Deterrence
Basic Concepts
The Payoff Matrix of the Game
All games have three basic elements:
• Dominant Strategy is Bottom Left.
1. Players (individuals, firms, nations)
Player B
2. Strategies (another card in poker, antimissile defense)
Left Right
3. Pay-offs (utility, profits, self-esteem)
Top 1;2 0;1
Games may be cooperative (binding agreements) or non-
cooperative (no agreements). Player A Bottom 2;1 1;0
Nash Equilibrium Two Simple Games

a. Rock, Scissors, Paper-No Nash Equilibria
1. A game may have more than one Nash equilibrium
Player B
2. A game may not have Nash equilibrium Rock Scissors Paper

Rock 0;0 1;-1 -1;1
Scissors -1;1 0;0 1;-1
Player A Paper 1;-1 -1;1 0;0
Player B b. Battle of the Sexes-Two Nash Equilibria
Left Right Player B
Top 2;1 0;0
Mountain Seaside
Player A Bottom 0;0 1;2
Mountain 2;1 0;0
Player A Seaside 0;0 1;2
67
Mixed Strategies Mixed Strategies
See Attachment
• If each agent chooses a strategy once and for all it is Best Response Curves
called a pure strategy. c
1
• A chooses to play top 50% of the time and bottom Player B
50% of the time, while B might choose to play left
50% of the time and right 50% of the time. This is a
mixed strategy. Left Right
Row’s best response
A game with no Nash
Equilibrium (in pure
strategies) Player B Top 2;1 0;0
1/3
Left Right Column’s best response

Top 0;0 0;-1 r
0 2/3 1
Player A Bottom 1;0 -1;3
Prisoner’s Dilemma Repeated Games

• Nash Equilibrium is for both to confess, although it is
not Pareto efficient. • In the prisoner’s dilemma agent plays a single time.
And both to confess is the Nash Equilibrium.
• Prisoner’s Dilemma can be applied to many real world
situations. Excessive advertising, “bonus mileage” in • The situation is different if the game is played
airline companies and cartel agreements. repeatedly. Then opponent can be “punished” for “bad”
behaviour.
Player B
• However it is not the case if the game is to be played
Confess Deny definite number of times.
Confess 3 Years; 3 Years 6 Months; 10 Years • The best strategy is “tit-for-tat” in the indefinite number
of plays.
Player A Deny 10 Years; 6 Months 1 Year; 1 Year
Enforcing a Cartel Sequential Games

• If each firm charging a zero price is a Nash • Player A has to choose first, and B has to observe A
Equilibrium in pricing strategies is also a and then choose the best possible outcome.
Bertrand equilibrium.
• Tit-for-tat strategy is able to support the

cartel arrangement for some time. Player B
Left Right
Top 1;9 1;9
68
Extensive form of the game A Game of Entry Deterrence
A;B • Monopolist and the threat of new entrant
Player B Left 1;9 Entrant;Incumbent
chooses
Incumbent Fight 1;9
Top Chooses
Right 1;9 Stay Out
Don’t Fight 1;9
Player A
chooses Entrant
Left
0;0 Chooses
Fight 0;2
Bottom
Enter
Player B Incumbent
chooses Right
2;1 Chooses 2;1
Don’t Fight
Games of Coordination Other Games

• Battle of the Sexes.
• Prisoner’s Dilemma.
• Assurance Games: • Games of Competition (Penalty Point in Soccer)
1. US-USSR arms race and assurance to refrain.
• Games of Coexistence (Hawk-Dove game)
2. Chicken and Macho.
• How to coordinate?: • Games of Commitment (Frog and the Scorpion,
1. Cooperate at an equilibrium that both like (assurance Kidnapping, Hold-up)
games). • Bargaining (Nash and Rubinstein bargaining)
2. Cooperate at an equilibrium one of you likes (battle of
the sexes).
3. Make a choice leading to your preferred outcome
(chicken).
Reading
Edition, Norton&Company: New York. Ch 28, 29,
pp497-539.

Press: Cambridge. Ch 19, pp267-282.

pp387-416.
69
Lecture 9. Strategy and Game Theory
Attachment 1.
• r-probability that row plays top;

• (1-r)-probability that row plays bottom
• c-probability that column plays left;
• (1-c)-probability that column plays right
• The pure strategies occur when r and c equal 0 or 1.
Combination Probability Payoff to Row

Top, Left rc 2
Bottom, Left (1-r)c 0
Top, Right r(1-c) 0
Bottom, Right (1-r)(1-c) 1
The Row’s payoff = 2rc+(1-r)(1-c)

Row’s payoff=2rc+1-r-c+rc
Suppose that row contemplates increasing r by ∆r .
∆ payoff to row=2c ∆r - ∆r +c ∆r =(3c-1) ∆r
This expression will be positive when 3c>1 and negative when 3c<1.
Row will want to increase r whenever c>1/3, decrease r when c<1/3, and be happy with
any value of 0 ≤ r ≤ 1 when c=1/3.
The Column’s payoff=cr+2(1-c)(1-r)

∆ payoff to column=r ∆c +2r ∆c -2 ∆c =(3r-2) ∆c
Column will want to increase c whenever r>2/3, decrease c when r<2/3, and be happy
with any value of 0 ≤ c ≤ 1 when r=2/3.
70
TUTORIAL 9. STRATEGY AND GAME THEORY.
Task 1. Nash Equilibrium.
The following table reports the payoff matrix for an advertising game. Explain why
the strategy pair “A: high, B: low” is a Nash equilibrium in this game and all the other
strategy pairs are not.
B's strategy
High Low
High A:5; B:2 A:3; B:3
A's strategy Low A:4; B:3 A:2; B:4
Task 2. Game Theory and Cournot Equilibrium.
“The common characteristic of the Cournot model is that assumes a common pattern
of reaction by competitors in each period which, despite the fact that the expected reaction
doesn’t in fact materialize, is never altered. This assumption that firms never learn from
their past experience is excessively naïve.” Discuss with reference to the distinction
between Cournot behaviour and the Cournot equilibrium, and in the light of the insights
that game theory yields about the character of the Cournot equilibrium.
Task 3. Healthy cigarettes.
Two firms (A and B) are considering bringing out competing brands of a healthy
cigarette. Payoffs to the companies are as follows (A’s profits are given first):
Firm B
Don't
Produce produce
Produce 3,3 5,4
Firm A Don't produce 4,5 2,2
a. Does this game have a Nash equilibrium?

b. Does this game present any first mover advantages for either firm A or firm B?
c. Would firm B find it in its interest to bribe firm A enough to stay out of the market?
71
Task 4. Threat of new entrant.
The Wave Energy Technology (WET) company has a monopoly on the production
of vibratory waterbeds. Demand for these beds is relatively inelastic-at a price of $1000
per bed, 25000 will be sold; whereas, at a price of $600, 30000 will be sold. The only costs
associated with waterbed production are the initial costs of building a plant. WET has
already invested in plant capable of producing up to 25000 beds, and this sunk cost is
irrelevant to its pricing decisions.
a. Suppose a would-be entrant to this industry could always be assured of half the
market but would have to invest $10 mln in a plant. Construct entrant’s strategies
(enter; don’t enter). Does this game have Nash equilibrium?
b. Suppose WET could invest $5mln in enlarging its existing plant to produce 40000
beds, Would this strategy be a profitable way to deter entry by its rival?
Task 5. Strategic substitutes and complements.
Game theorists sometimes use the terms “Strategic complements” and “Strategic
substitutes” to describe the relationship between the strategic choices made by two firms.
Firm’s activities are strategic substitutes if and when firm A increases the activity and firm
B reduces it. The activities are strategic complements if an increase in the activity by firm
A causes firm B to increase the activity as well. Use these definitions to provide intuitive
proofs of the following propositions:
a. In the Cournot model, quantities (or production capacities) are strategic substitutes.
b. In the Bertrand model, prices are strategic complements.
Task 6. Pepsi and Coke’s secret formula.1
How much would Pepsi pay to get Coke’s secret formula?
A few days back some dastardly Coca-Cola employees got nabbed trying to sell corporate
secrets to Pepsi. Pepsi turned the bad guys in and cooperated in the sting operation.
Did the executives at Pepsi give up the chance to make huge profits at Coke’s expense in
order to “do the right thing?”
I had lunch with my friend and colleague Kevin Murphy yesterday. He made an interesting
point: knowing Coke’s secret formula is probably worth almost nothing to Pepsi. Here is
the logic.
Let’s say that Pepsi knew Coke’s secret formula and could publish it so that anyone could
make a drink that tasted just like Coke. That would be a lot like what happens to
prescription drugs when they go off patent and generic drug companies come in. The
impact would be that the price of real Coke would fall a lot (probably not all the way to the
price of the generic Coke knockoffs). This would clearly be terrible for Coke. It would
1
http://www.freakonomics.com/blog/2006/07/page/5/
72
probably also be bad for Pepsi. With Coke now much cheaper, people would switch from
Pepsi to Coke. Pepsi profits would likely fall.
So if Pepsi had Coke’s secret formula, they wouldn’t want to give it away to everyone.
What if they instead kept it to themselves and made their own drink that tasted exactly like
Coke? If they could really convince people that their drink was identical to Coke, then the
new Pepsi-made version of Coke and the Real Thing would be what economists call
“perfect substitutes.” When two goods are essentially interchangeable in consumers’
minds, that tends to lead to fierce price competition and very low profits. Neither Coke nor
the Pepsi knockoff of it would be very profitable as a consequence. With the price of Coke
lower, consumers would switch away from the original Pepsi to either Coke or the new
Pepsi-made Coke knockoff, which would be far less profitable than original Pepsi anyway.
In the end, both Coke and Pepsi would likely be worse off if Pepsi had Coke’s secret
formula and acted on it.
So, maybe the executives at Pepsi were acting morally and honorably when they turned in
the criminals stealing Coke’s secrets.
Or maybe they are just good economists.
Task 7. Prisoner’s dilemma2.
A treatise on dating: the Prisoner’s Dilemma

By Joshua Steinman
March 12, 2004 in Viewpoint, Chicago Maroon online edition – student newspaper.
After reading V.R. Dupont’s hilariously honest contribution on Tuesday (“The Economics
of Meat Markets: Addressing the Question of Efficiency”), I felt compelled to stand up for
the social sciences (in particular, international relations) and share with you a portion of a
theory I’ve been working on.
At moderately large schools like Chicago where social interactions (read: attempts to get
digits) rarely happen repeatedly between two people, there is a disproportionate incentive
for all individuals involved to show disinterest toward each other, regardless of the reality.
“Wait, really?” you ask. “So that girl in my Hum class who was blowing me off at Bar
Night might actually be interested?” Rein in the stallions, Casanova. In reality, it was
probably the Bartlett breath that turned her off. But you’ve read this far, so I owe you an
explanation.
This theory is based on the “Prisoner’s Dilemma.” The theory scenario consists of two
“players” of a simple game where the goal is to acquire points. There are two options: truth
or deception. If both choose truth, both experience a point gain. If both choose deception,
there is no gain. But if one chooses truth and the other deception, the player who chose
deception will gain, and the one who chose truth will remain at status quo (and will
experience a relative loss).
2
http://maroon.uchicago.edu/
73
We (students) are the players, because even though you crush on that girl in Hum every
day, as far as romantic overtures are concerned, you two are strangers. And the “points”
are actually a rough estimation of each player’s exclusivity.
Exclusivity works as a reward system because girls brag to each other about how many
guys hit on them at the last ultimate frisbee party, and guys brag about how many drunken
girls they turned down at the last Psi U bash. Similarly, girls communicate when they fail
in attracting a guy, and guys do the same. In each situation, the players use communication
to establish exclusivity, thus increasing their own desirability or communicating failure.
When both parties express interest, the mutual gain is the exchange of contact information
(or perhaps a quick make-out session behind University Church). When neither party
shows interest, the result is status quo. When one player attempts to get the other’s digits
and is rebuffed, the player who “turned down” the other experiences a gain in exclusivity.
Let us apply this concept now to your typical, possible male-female interaction at a random
College Programming Office event. Side note: typical U of C students will claim they
“pre-gamed” in order to lower expectations of exclusivity, when in fact they are stone-cold
sober, since they want to read Heidegger for pleasure on the third floor of the Reg after the
event is over.
So you’re standing there, munching on a mini-croissant with a cup of tea, when all of a
sudden you spot that cutie that you haven’t seen since O-Week. You’re gazing, when all of
a sudden, she catches your glance, and lo! smiles back at you. Let’s look at the possibilities
for interaction through the lens of the Prisoner’s Dilemma.
For both parties, there are two options (assuming both are interested)—deception or truth.
Since neither can know if the other is definitely interested, interaction has the following
result matrix: “Truth” on the part of one player and “deception” on the part of the other
player will lead to heightened exclusivity for the second player, who will return to his/her
peer group and brag about the failed attempt by the other party, thus increasing their
exclusivity. Truth from both parties will lead to a positive interaction, such as getting
his/her number. Deception will yield the status quo.
A truth-teller (assuming they are interested) will experience a gain one-third of the time,
status quo one-third of the time, and a loss of exclusivity one-third of the time, whereas
deception will yield a gain in exclusivity one-third of the time and status quo two-thirds of
the time. Thus, there are risks only when either player makes the decision to interact
truthfully.
The benefits and detriments are heightened when one party is not interested. Denial of
interest in this situation yields positive ancillary benefits (“that drunk loser just tried to hit
on me! Ewww!” or “What a ho”), similarly increasing perceived exclusivity.
The benefits resulting from the denial of interest are the only constant benefits that can
occur in the male-female interaction scenario. Just like the Prisoner’s Dilemma, in a
situation where you’re not dealing with certain individuals on a regular basis (which would
allow for them to develop a relationship wherein there will be external repercussions for
deceptive behavior), and where your reputation among the opposite sex is determined by
exclusivity, the only constant action that consistently yields either status quo or a positive
benefit is the denial of interest.
74
So, what should you do next time? The answer is simple: nothing! I call this tactic “pre-
emptive protection of exclusivity.” Personally, I use my predictive abilities (I’m honing
them for a career in law) and realize that I’ll likely be shot down. And that she’ll probably
brag to her friends about how “the columnist” tried to hit on her. So I do nothing. This is
my way of really sticking it to girls whom I think aren’t interested in me.
Unfortunately I can’t really complete the comparison, because in international relations,

there’s no corollary event to walking home alone.
But if the outlook seems bleak (and believe me, it does), check back next quarter, when I
extend the theory and find a solution to what I’m calling “The Dating Dilemma.”
75
Agenda
• Physical products and revenue products
Lecture 10. • Factor demand in the short-run
• The firm’s factor demand in the long-run
The Demand for Factors of Production • Industry demand for labour
• Factor payments and the value of output
Substitution and Output effects of a decrease

Profit-maximizing behavior and the in price of labour
hiring of inputs. • Substitution effect is a move from A to B.
• Output effect is a move from B to C.
• MEK=MRK
• MEL=MRL Capital Price
MC MC /
per week
A
K1
C
Price taking behaviour: K2
q2
• r=MEK=MRK B P
q1
• w=MEL=MRL
O L1 L2 L O q1 q2 Output
(a) Input choice (b) Output decision per week
Physical products and revenue products Physical products and revenue products
3X
K 2X X MP
1X 3X
AP
L
2X
K ** K **
APL
1X
K* K* MPL
O L1 L2 L3 L O L1 L2 L3 L
(a) (b)
O L1 L2 L3 L
76
Physical products and revenue products Algebraic notation
• For competitive firm:
w
p = mc =
TR w ∂X / ∂L
TR, TFO
ARP
MRP • Profit maximization requires that marginal factor
MFO
outlay=wage in competitive labour market=MRP
TFO
of labour:
MRP
∂X
w= p
w = MFO
ARP
∂L
O L0 L O L0 L
(a) (b)
The firm’s factor demand in the long-run

Factor demand in the short-run
w
w w1
w1
w2
w2
∑ MRP 1 MRP2 D
MRP1
D ∑ MRP 2
O L1 L2 L O L1 L2 L
Influences on the elasticity of factor demand

Industry demand for labour
• The greater the degree of substitutability, the more
elastic is the demand for that factor.
w w • The larger the increase in output as a result of fall in

w1 wages, the greater change in the demand for labour.
w1
w2
w2
∑ MRP 1
• The greater the proportion of production costs made up
of wages, and the more elastic the demand for the final
output, the more elastic will be the demand for labour.
∑ MRP D
∑ MRP
2
∑ MRP 1
D 2
O L1 L2 L O L1 L2 L • The elasticity of supply of other factors. The higher it

(a) (b)
is, ceteris paribus, the higher is the elasticity of demand
for labour.
77
Minimum wage – good or bad? Minimum wage – good or bad?
• Empirical evidence shows that changes in
minimum wage law have serious effects in
increasing teenage employment.
• Theoretical models predict that higher
minimum wages should reduce
employment.
• However empirical studies have disputable
conclusions.
Factor payments, the value of output and the Factor payments, the value of output and
Euler theorem the Euler theorem
• The ratio of factor prices is given by the slope of the isocost line II=ratio of
• Shaded area available for payments to capital. marginal productivities of the inputs given by the slope of the isoquant at point A
w K L1
I
w1
K1 A K1
I
MRPL
O L1 L O L1 L
Factor payments, the value of output Reading

and the Euler theorem
• Shaded area available to meet the wage bill.
r 472.

r1 Press: Cambridge. Ch 22, pp309-324.

MRPK pp419-435.
O K1 K
78
TUTORIAL 10. THE DEMAND FOR FACTORS OF PRODUCTION.
Task 1. Discussion.
“In competitive equilibrium, workers always earn less than their average product”.
Discuss.
Task 2. Analysis.
Analyse the effect of an increase in the price of capital on the demand for labour
when the elasticity of substitution between labour and capital is low and the elasticity of
the demand for output is high.
Task 3. Minimum wage.
What will be the effect on the following of fixing a minimum wage above the
market equilibrium level:
a. Employment in a perfectly competitive industry in which all firms are equally
efficient;
b. The number of firms operating in the industry; and
c. Employment in a firm that, prior to the fixing of the minimum wage, faced an
upward-sloping supply curve of labour?
Task 4. The Economics of Superstars.
Why the “Three Tenors” receive vast amount of money, while others with similar
voice characteristics receive much less? Why tennis, soccer, hockey superstars receive
enormous profits?
79
Agenda
• The monopolist’s factor demand curves
Lecture 11.
• Monopsony and Discriminating Monopsony
Monopoly and Monopsony.
• Transfer price and Rent
The monopolist’s factor demand curves

Monopsony
w
TFO TFO
w
S=AFO
w1
(a)
L
(b) L
VMP
MRP
L1 L2
Monopsony Monopsony
MFO MFO
w w
S=AFO S=AFO
w1
w1
w2 VMP
MRP
MRP
L1 L2 L2 L1
80
Discriminating Monopsony Why is the wage inequality increasing?
MFO1
B
w w w
S1
MFO2 • Over the past 30 years wage inequality
MFO
A C
D E
among workers increased substantially.
S1 + S 2
w2 S2 G • Average ratio of high to low salary was 4.3
w*
F D
in 1965 and 5.4 in 1995 in the US and UK.
w1
• What do you think is the cause of
O
L1 L*1 L* 2 L2 L* L
inequality?
Transfer price and rent Transfer price and rent

w
w w
S
S
w1 w1 S w1
rent
rent rent
D D
L1 L1
(a) (b)
D
L1
Reading
472.

Press: Cambridge. Ch 22, 23, pp325-341.

pp419-435.
81
Tutorial 11. Monopoly and Monopsony.
Task 1. Monopsonist in the input market.
How would you measure the strength of a monopsonist in an input market? Would a
monopsony necessarily be very profitable? What would you need to add to the figure
below in order to show a monopsonist profit graphically?
Wage
ME
S
MVP1
w
w1
D
L1 L
Labour hours
per week
Task 2.
A monopsonist in the labour market faces a relatively inelastic supply of female labour and
hence pays its female employees a lower wage than its male employees even though the
two groups are equally productive. What will be the effect on:
a. the wage level paid to women
b. the number of women employed
c. the wage level of men
d. the number of men employed, of legislation forcing the firm to pay the same wage to all
employees.
82

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Westminster International University in Tashkent

Assessment Description Weighting Learning Student

Coursework A 2000 word essay requiring 30% 1,2,3,5 20 hours

Team Working Relationships within groups

Information for Research x Coursework

ICT in Business Functions of ICT in business; DP

Personal Skills Self confidence, social ease x

Career Management Self-awareness; opportunities

Business Awareness Opportunities – risks and rewards x x Lectures, seminars

Module specific skills

How to contact Alexey Kim

Component two-Final Exam

Calendar of Assessments: Microeconomic Analysis and Policy 2006/2007

Teaching Lecture Deadline

The real reason I went into economics1

(My wife Jeannette adds that I am living proof.)

Posted by Steven D. Levitt @ 10:40 pm on Sunday, May 21, 2006 in General

23 Responses to “The real reason I went into economics”

That’s because economists do it with models!

Then why do women study econ?

On the other hand…

I think he’s confusing economics and finance. Just a thought.

tim in tampa Says:

I never thought this concept to be the case in my economics class…

Dear God, I hope no one includes Greenspan.

Does this happen to economics students as well?

There are couple of things I know for sure:

i think the latter.

Consumer choice, budget constraint The consumer’s tastes.

- have a negative slope and

- to be convex to the origin.

Consumer preferences: assumptions Consumer preferences: assumptions

Consumer preferences phenomena

between the goods.

Solution to the Choice problem The income consumption curve

The Engel curve. The demand curve.

Constant Real Income and

• (a) An alternative way to analyse the income and

Constant Real Income and The Idea of Revealed Preference

• Varian H. 2002. Intermediate Microeconomics.

• Nicholson W. 2004. Intermediate

The consumer’s utility is: U = u( X ,Y ) (1.2)

Task 2. Ticket Scalping.

Task 3. Engel’s Law.

Table 1. % total expenditure on various items in Belgian families in 1853.

Table 2. % total expenditure on various items by US consumers in 2000.

Task 4. Crime and Punishment.

Measuring Changes in the Cost of Living

Indexes Reservation price and consumer’s surplus.

( p X 1 X 0 + pY 1Y0 ) Price Price

An Application of Consumer’s Surplus Marshalian Consumer Theory.

The Algebra of Marshalian Analysis. Attachment 2.

• Varian H. 2002. Intermediate Microeconomics. 6th

• Nicholson W. 2004. Intermediate Microeconomics

Task 1. Ambiguous Altruists.

As you know consumer’s choice theory is based on certain assumptions. One of

Task 2. Calculating the Indexes.

Week 2: price of X =£5 Quantity of X bought =20 units per week

Task 3. Car and Consumer’s Surplus.

Task 5. Should I turn down my stereo?