Microeconomics

 Notes:  
 
Learning  Outcomes  of  this  Unit:  
1. Understand  the  economic  behaviour  of  individual  consumers  and  
producers.    
2. Understand  concepts  relating  to  the  cost  of  production  in  both  the  short  
and  long  run.  
3. Explain  the  determinants  of  price  and  output  outcomes  under  different  
market  structures  in  both  the  short  and  long  run  and  the  welfare  
implications  of  these  outcomes.  
4. Describe  the  virtues  and  shortcomings  of  free  markets.  
5. Have  knowledge  of  remedies  to  overcome  market  failure.  
 
Week  1  –  Introduction  to  Economics:  
Part  1  –  ‘Introduction’  –  Chapter  1  –  ‘Economics:  Foundations  
and  models’:  
1. Three  important  economic  ideas:  people  are  rational;  people  respond  to  
incentives;  optimal  decisions  are  made  at  the  margin:  
Three  Key  Economic  Ideas:  as  we  study  how  people  make  choices  and  interact  
in  markets,  we  will  return  to  these  three  important  ideas  (base  our  economic  
philosophy  on  these  facts  about  human  beings):  
• People  are  rational  –  although  not  all  consumers  behave  rationally,  
economists  assume  that  consumers  and  firms  use  as  much  of  the  available  
information  as  they  can  to  achieve  their  goals  (e.g.  weighing  the  benefits  
and  the  costs  of  each  action,  only  choosing  an  action  if  the  benefits  
outweigh  the  costs).    
• People  respond  to  economic  incentives  –  economists  emphasise  that  
consumers  and  firms  consistently  respond  to  economic  incentives  (e.g.  if  
the  government  subsidised  the  entire  fee  of  prescriptions  there  would  be  
little  incentive  for  patients  or  doctors  to  use  medicines  wisely).    
• Optimal  decisions  are  made  at  the  margin  –  ‘marginal’  in  this  context  
means  an  extra  benefit  or  cost  of  a  decision.  Economists  reason  that  the  
optimal  decision  is  to  continue  any  activity  up  to  the  point  where  the  
marginal  benefit  equals  the  marginal  cost.  The  analysis  that  involves  
comparing  marginal  benefits  and  marginal  costs  is  called  a  marginal  
analysis.    
-­‐ Marginal  Benefit  –  the  additional  benefit  to  a  consumer  from  consuming  
one  more  unit  of  a  good  or  service  (e.g.  a  consumer  is  wishing  to  buy  an  
additional  burger.  If  this  consumer  is  willing  to  pay  $10  for  that  
additional  burger,  then  the  marginal  benefit  of  consuming  that  burger  is  
$10.  The  more  burgers  the  consumer  has,  the  less  he  will  want  to  pay  
for  the  next  one.  This  is  because  the  benefit  decreases  as  the  quantity  
consumed  increases).    
-­‐ Marginal  Cost  –  the  additional  cost  to  a  firm  of  producing  one  more  unit  
of  a  good  or  service.  
 
2. The  issues  of  scarcity  and  trade-­‐offs,  and  how  the  market  makes  decisions  
on  these  issues:  
Scarcity,  Trade-­‐Offs  and  the  Economic  Problem  that  every  society  must  
solve:  
-­‐ Because  of  scarcity  (i.e.  only  a  limited  amount  of  resources  available  to  
satisfy  each  person’s  unlimited  needs  and  wants)  only  a  limited  amount  
of  goods  and  services  can  be  produced.    
-­‐ Therefore  scarcity  causes  society  to  face  a  trade-­‐off:  producing  more  of  
one  good  or  service  means  producing  less  of  another.    
-­‐ The  concept  of  opportunity  cost  is  used  by  economists  when  evaluating  
the  alternative  choices  available.  The  opportunity  cost  of  any  activity  is  
the  highest-­‐valued  alternative  that  must  be  given  up  to  engage  in  that  
activity.  Therefore  opportunity  cost  enables  us  to  understand  the  trade-­‐
offs.  
 
The  3  fundamental  economic  questions:  
1. What  goods  and  services  will  be  produced?  
2. How  will  the  goods  and  services  be  produced?  
3. Who  will  receive  the  goods  and  services  produced?  
 
To  answer  each  of  the  three  fundamental  economic  questions  (stated  above),  
societies  organise  their  economies  in  two  main  ways:  
• Centrally  Planned  Economy  -­‐  an  economy  in  which  the  government  
decides  how  economic  resources  are  allocated.  
• Market  Economy  –  an  economy  in  which  the  decisions  of  households  and  
firms  interacting  in  markets  allocate  economic  resources.  It  is  ultimately  
consumers  who  dictate  the  answers  to  the  economic  questions  in  a  
market  economy  since  firms  must  produce  goods  and  services  that  meet  
the  needs  and  wants  of  consumers  or  else  they  will  go  out  of  business.  
This  is  known  as  consumer  sovereignty.    
However,  most  economies  (including  Australia’s)  are  mixed  economies,  in  
which  consumers  and  firms  make  most  economic  decisions,  but  in  which  the  
government  also  plays  a  significant  role.    
 
3. Understand  the  role  of  models  in  economic  analysis:  
Economic  Models:  economists  rely  on  economic  theories  or  models  to  analyse  
real-­‐world  issues.  One  purpose  of  economic  models  is  to  make  economic  ideas  
sufficiently  explicit  and  concrete  to  be  used  for  decision-­‐making  by  individuals,  
firms  or  the  government.  Economists  accept  and  use  an  economic  model  if  it  
leads  to  hypotheses  that  are  confirmed  by  statistical  analysis.      
-­‐  Economists  use  economic  models  to  answer  questions.  E.g.  how  do  we  deal  
with  water  scarcity  in  Australia?    
-­‐  Sometimes  economists  use  an  existing  model  to  analyse  an  issue,  but  in  other  
cases  economists  must  develop  a  new  model.    
-­‐  Economics  is  a  ‘social  science’  because  it  applies  the  scientific  method  to  the  
study  of  the  interactions  between  individuals.    
 
4. Distinguish  between  microeconomics  and  macroeconomics:  
Microeconomics  –  is  the  study  of  how  households  and  firms  make  choices,  how  
they  interact  in  markets  and  how  the  government  attempts  to  influence  their  
choices.  
Macroeconomics  –  is  the  study  of  the  economy  as  a  whole,  including  topics  such  
as  inflation,  unemployment  and  economic  growth.    
 
Chapter  2  –  ‘Choices  and  trade-­‐offs  in  the  market’:  
1. Use  a  production  possibility  frontier  to  analyse  opportunity  costs  and  
trade-­‐offs:    
Production  Possibility  Frontiers:  a  curve  showing  the  maximum  attainable  
combinations  of  two  products  that  may  be  produced  with  available  resources.  It  
is  used  to  illustrate  the  trade-­‐offs  that  arise  from  scarcity.    
-­‐ Points  on  the  curve  are  points  where  all  available  resources  are  being  
used  to  their  maximum  efficiency.    
-­‐ Points  within  the  curve  are  inefficient  because  maximum  output  is  not  
being  obtained  from  the  available  resources.  
-­‐ Points  beyond  the  PPF  are  unattainable  given  the  firm’s  current  
resources.  More  resources/advancements  in  technology  or  efficiency  
are  required  to  expand  the  PPF.  These  outward  shifts  in  the  PPF  
represent  economic  growth  because  they  allow  the  economy  to  
increase  the  production  of  goods  and  services.  
-­‐ The  PPF  can  also  shift  inwards  if  an  economy  experienced  a  reduction  
in  its  productive  resources  (e.g.  a  war,  a  natural  disaster,  etc.).  
 
Because  of  increasing  marginal  opportunity  costs,  PPFs  are  usually  bowed  out  or  
concave  rather  than  being  in  the  form  of  a  straight  line.  E.g.  this  is  because  as  the  
economy  moves  down  the  PPF,  more  and  more  resources  that  are  better  suited  
to  television  production  are  switched  into  computer  production.  As  a  result,  the  
increases  in  computer  production  become  increasingly  smaller  while  the  
decreases  in  television  production  become  increasingly  larger.  This  reveals  that  
the  more  resources  already  devoted  to  an  activity,  the  smaller  the  payoff  to  
devoting  additional  resources  to  that  activity  (e.g.  the  more  hours  you  have  
already  spent  studying  economics,  the  smaller  the  increase  in  your  test  grade  
will  be  from  each  additional  hour  you  spend).    
 
2. Comparative  advantage  and  how  it  is  the  basis  for  trade:  
• Absolute  Advantage  –  the  ability  of  an  individual,  firm  or  country  to  
produce  more  of  a  good  or  service  than  competitors  using  the  same  
amount  of  resources.  
• Comparative  Advantage  –  the  ability  of  an  individual,  firm  or  country  to  
produce  a  good  or  service  at  a  lower  opportunity  cost  than  other  
producers.    
It  is  possible  to  have  an  absolute  advantage  in  producing  a  good  or  service  
without  having  a  comparative  advantage.  
It  is  possible  to  have  a  comparative  advantage  in  producing  a  good  or  service  
without  having  an  absolute  advantage.    
E.g.  
Fruit  picked  each  
month  without  trade  
You   You   Neighbour   Neighbour  
  Apples   Cherries   Apples   Cherries  
All  time  to  picking   20kg   0kg   30kg   0kg  
apples  
 All  time  to  picking   0kg   20kg   0kg   60kg  
cherries  

Opportunity  cost  of  picking   Opportunity  cost  of  picking   Opportunity  cost  of  picking  
apples  and  cherries   1kg  of  apples   1kg  of  cherries  
You   1kg  of  cherries   1kg  of  apples  
Your  neighbour   2kg  of  cherries   0.5kg  of  apples  
Your  neighbour  has  an  absolute  advantage  over  you  in  picking  both  apples  and  
cherries.  However,  they  only  have  a  comparative  advantage  in  picking  cherries  
since  they  sacrifice  only  0.5kg  of  apples  per  1kg  of  cherries  picked,  while  you  
have  a  comparative  advantage  in  picking  apples.  The  aim  here  is  for  both  parties  
to  allocate  all  their  resources  in  picking  the  fruit  that  they  are  have  a  
comparative  advantage  in  and  trade  amounts  of  it  with  each  other  for  the  other  
fruit  that  they  don’t  have  a  comparative  advantage  in.  
 
-­‐  The  basis  for  trade  is  comparative  advantage,  not  absolute  advantage.  
Individuals,  firms  and  countries  are  better  off  if  they  specialise  in  producing  
goods  and  services  for  which  they  have  a  comparative  advantage  and  obtain  the  
other  goods  and  services  they  need  by  trading.    
 
3. The  basic  idea  of  how  a  market  system  works:  
The  Market  System:  in  Australia  and  most  other  countries,  trade  is  carried  out  
in  markets  
Key  Terms:  
• Market  –  a  group  of  buyers  and  sellers  of  a  good  or  service  and  the  
institution  or  arrangement  by  which  they  come  together  to  trade.  
Households  and  firms  interact  in  two  types  of  markets:  
-­‐ Product  Markets  –  markets  for  goods  and  services.  Households  are  
demanders  and  firms  are  suppliers.  
-­‐ Factor  Markets  –  markets  for  the  factors  of  production  (i.e.  land,  
labour,  capital  and  entrepreneurial  ability).  Households  are  
suppliers  and  firms  are  demanders.  
• Free  Market  –  a  market  with  few  government  restrictions  on  how  a  good  
or  service  can  be  produced  or  sold,  or  on  how  a  factor  of  production  can  
be  employed.  
• The  Price  Mechanism  –  the  system  in  a  free  market  where  price  changes  
lead  to  producers  changing  production  in  accordance  with  the  level  of  
consumer  demand  (i.e.  firms  respond  to  changes  in  prices  by  making  
decisions  that  ended  up  satisfying  the  wants  of  consumers,  e.g.  a  rise  in  
the  price  of  tables  means  a  shortage  in  their  supply  or  rise  in  their  
demand,  causing  producers  to  allocate  more  resources  into  producing  
more  tables  as  there  is  greater  profit  involved).    
 
4.  Understand  why  property  rights  are  necessary  for  a  well-­‐functioning  market:  
Property  Rights:  the  rights  individuals  or  firms  have  to  the  exclusive  use  of  
their  property,  including  the  right  to  buy  or  sell  it.  Property  can  be  tangible,  
physical  property  such  as  a  shop  or  factory.  Property  can  also  be  intangible,  such  
as  the  right  to  an  idea.    
If  firms  are  to  risk  their  investment  to  develop  a  new  product,  they  must  be  
awarded  with  some  form  of  protection  from  competitors  copying  their  product  
in  order  to  reap  the  rewards  and  returns  on  their  investment.    
If  the  law  cannot  guarantee  this,  or  the  enforcement  of  the  law  cannot  ensure  the  
protection  of  property  rights,  there  will  be  little  incentive  for  firms  to  invest  in  
research  and  development  for  new  products.    
Therefore  if  property  rights  do  not  exist  or  are  not  well  enforced,  the  production  
of  goods  and  services  will  be  reduced.  
 
Lecture  1:  
What  is  Economics?  
Definition  –  study  of  the  choices  people  and  societies  make  to  attain  their  
unlimited  needs  and  wants,  given  their  scarce  resources.  
 
Schools  of  thought  in  economics:    
• Neoclassical  –  supply  and  demand,  rationality,  capitalism  and  profit  
maximisation.  
• Free  Market  Economics.    
• Keynesian  –  economic  output  influenced  by  demand  in  the  short  range  
(SR)  and  demand  is  influenced  by  government  expenditure.  
• Development  Economics.  
• Marxian  –  class  relations,  communism  and  social  change  and  institutions.  
• Creative  Destruction.  
• Behavioural  Economics  –  social  norms  and  influences,  heuristics  (rules  of  
thumb)  and  bounded  rationality.  
• Institutional  Economics.    
 
Neoclassical  Economics:  In  this  unit  we  study  choice  making  and  interaction  in  
markets  from  a  neoclassical  viewpoint.  
• Supply  and  demand  –  elasticity  and  shifts  and  movements  in  supply  and  
demand.  
• Market  players  –  government  (eg:  taxes,  intervention,  price  setting,  etc.),  
individuals  and  firms  (eg:  production,  costs,  etc.).    
• International  trade.  
• Efficiency  and  market  failure  –  externalities,  public  goods  and  market  
power/monopolies.    
• Types  of  markets  –  perfect  competition,  monopolies,  oligopolies,  
monopolistic  competition,  etc.    
Big  neoclassical  ideas  in  this  unit:  
-­‐ People  are  rational.  
-­‐ People  maximise  utility,  firms  maximise  profit.  
-­‐ People  act  on  full  and  relevant  information.  
-­‐ People  respond  to  economic  incentives.    
 
Why  do  we  need  to  make  decisions?  
Scarcity  –  there  are  only  a  limited  amount  of  resources  available  to  satisfy  each  
person’s  unlimited  amount  of  needs  and  wants.    
Trade-­‐off  –  where  producing  more  of  one  good  or  service  means  producing  less  
of  another  good  or  service,  because  of  scarcity.  
 
Decisions  about  what?  
1.  What  to  produce?    
• Opportunity  cost  –  the  value  of  the  next  best  alternative  that  must  be  
sacrificed  in  order  to  engage  in  that  activity.  
• Most  profitable  option  is  selected.  
2.  How  to  produce?  
• With  more  workers  or  more  machines?  
3.  For  whom  to  produce?  
• Largely  depends  on  how  income  is  distributed.    
 
Key  Terms:  
• Consumer  Sovereignty  –  a  central  feature  of  market  economies,  which  
occurs  because  firms  must  produce  goods  and  services  that  meet  the  
needs  and  wants  of  the  consumers  in  order  to  be  successful  (i.e.  
consumers  dictate  resource  allocation,  not  firms).    
• Trade  –  the  act  of  buying  or  selling  a  good  or  service  in  a  market.  
 
Efficiency:  
Types  of  Efficiency:  
• Productive/Technical  Efficiency  –  least  amount  of  resources  used  to  
produce  a  good  or  service.    
• Allocative  Efficiency  –  where  production  reflects  consumer  preferences  
(i.e.  the  goods  that  are  most  desired  by  society  are  produced),  resources  
are  allocated  to  their  best  uses,  and  every  good  and  service  is  produced  
up  to  the  point  where  the  last  unit  provides  a  marginal  benefit  to  
consumers  equal  to  the  marginal  cost  of  producing  it.    
• Dynamic  Efficiency  –  firms  are  aware  of  changing  circumstances  and  are  
able  to  adapt  to  meet  these  new  needs  (e.g.  improved  technology  has  led  
to  firms  adopting  the  use  of  computers).    
• Inter-­‐temporal  Efficiency  –  a  suitable  balance  between  resources  being  
allocated  towards  current  consumption  on  the  one  hand,  and  saving  for  
financing  future  investments  on  the  other.    
 
Trade-­‐off  between  equity  and  efficiency:  
-­‐ The  two  goals  are  considered  to  be  incompatible.    
-­‐ Resources  can  only  be  allocated  to  achieve  one  of  them  (i.e.  whatever  
the  initiative  is,  one  will  benefit  while  the  other  is  hindered).  
 
Key  terms:  
• Equity  –  a  fair  distribution  of  economic  benefits  between  individuals  and  
between  societies.  
• Voluntary  Exchange  –  the  situation  that  occurs  in  markets  when  both  
buyer  and  seller  of  a  product  are  made  better  off  by  the  transaction.    
 
Positive  Vs.  Normative  Analysis:  
Positive  –  objective  and  fact  based.  Must  be  able  to  be  tested  and  
proved/disproved.  Economics  is  concerned  with  positive  analysis  rather  than  
normative  as  positive  analysis  measures  the  costs  and  benefits  of  different  
courses  of  actions.    
Normative  –  subjective  and  opinion  based  and  is  concerned  with  what  ought  to  
be.  Involves  making  value  judgements  that  can’t  be  tested  or  proved/disproved.  
E.g.  Individuals  should  receive  reductions  in  taxation,  as  they  are  able  to  decide  
how  to  spend  money  to  maximise  their  satisfaction  better  than  the  government.    
 
Production  Possibility  Frontier  (PPF):    
-­‐ The  PPF  and  the  concept  of  opportunity  cost  can  be  used  to  explain  the  
economic  gains  from  specialisation  and  trade.    
 
Tutorial  2:  
Michael.wang@monash.edu  
Tools  used  in  economics:  
-­‐ Vocabulary.  
-­‐ Math  (linear  algebra  -­‐  optimisation,  econometrics  –  empirical  
evidence):  
 
Tutorial  Questions:  
Chapter  1:  
Q2)  has  almost  unlimited  financial  resources.  However  does  face  scarcity  
through  other  resources  (e.g.  time,  legal  limitations  such  as  can  only  be  married  
to  one  woman  at  a  time,  natural  resources,  etc.).    
Q12)  Centrally  planned  economy:  against  –  no  incentive  which  therefore  causes  
inefficiency,  corruption  (asymmetric  information  –  the  government  may  have  
more  information  compared  to  the  population).  Pros  –  equality  (income  
distribution,  health  care,  etc.).  *The  economic  vocabulary  that  you  need  to  show  
in  answers  is  words  such  as  information,  incentives,  etc.    
 
 
Week  2  –  Supply  and  Demand:  
Part  2  –  ‘How  the  Market  Works’  –  Chapter  3  –  ‘Where  prices  
come  from:  The  interaction  of  demand  and  supply’:  
1. The  variables  that  influence  the  demand  for  goods  and  services:  
Many  variables  other  than  price  can  influence  market  demand.  If  any  of  these  
variables  change,  the  demand  curve  will  shift  (examples  drawn  in  exercise  book),  
which  is  an  increase  or  decrease  in  demand.  The  following  5  are  most  important:  
• Income  –  refers  to  the  income  consumers  have  available  to  spend  (i.e.  
their  disposable  income).  E.g.  if  it  is  higher,  they  are  more  likely  to  be  
more  willing  and  able  to  purchase  MP3  players.  This  will  result  in  the  
demand  of  MP3  players  to  increase.  Therefore  an  MP3  player  would  be  a  
normal  good.  
§ Normal  Good  –  a  good  for  which  the  demand  increases  as  income  
rises  and  decreases  as  income  falls.  
§ Inferior  Good  –  a  good  for  which  the  demand  increases  as  
income  falls  and  decreases  as  income  rises.    
 • Prices  of  related  goods  –  e.g.  if  the  prices  of  substitutes  fall,  it  is  likely  
consumers  will  increase  their  demand  for  the  substitute  and  reduce  
demand  for  the  initial  product.  If  the  price  of  a  complement  rises  it  is  
likely  consumers  will  reduce  their  demand  for  the  main  product  since  it  is  
more  expensive.    
• Tastes  –  a  broad  category  that  refers  to  the  many  subjective  elements  
that  can  enter  into  a  consumer’s  decision  to  buy  a  product.  A  consumer’s  
taste  can  change  for  many  reasons  (e.g.  trends  and  fashions,  seasonal,  
advertisements,  etc.).      
• Population  and  demographics  –  refers  to  the  characteristics  of  a  
population  (e.g.  age,  race,  gender,  etc.).  As  the  demographics  for  a  
particular  region  change,  the  demand  for  particular  goods  and  services  
will  change  also.    
• Expected  future  prices  –  if  enough  consumers  become  convinced  that  
the  selling  price  for  a  PS4  will  lower  in  3  months  time,  the  demand  for  
PS4’s  will  decrease  for  the  time  being  and  the  price  will  fall  with  it.  On  the  
other  hand,  if  consumers  believe  the  price  for  a  product  will  increase  in  3  
months  time,  demand  will  increase  quickly  and  the  prices  will  increase  
along  with  the  demand.  
 
2. The  variables  that  influence  the  supply  of  goods  and  services:  
There  are  many  variables  other  than  a  product’s  own  price  that  affect  the  
willingness  of  firms  to  supply  goods  and  services.  If  any  of  these  variables  
change,  the  supply  curve  will  shift  (in  exercise  book),  which  is  an  increase  or  
decrease  in  supply.  The  following  are  the  most  important  variables  that  shift  
supply:  
• Prices  of  inputs  –  the  change  in  price  of  anything  that  is  used  in  the  
production  of  a  good  or  service  (i.e.  the  resources  used  in  production).  
E.g.  an  increase  in  wages  of  Sony  employees  will  cause  the  cost  of  
producing  PS4s  to  increase,  resulting  in  a  decrease  in  supply.  
• Technological  Change  –  the  change  in  the  ability  of  a  firm  to  produce  a  
given  level  of  output  with  a  given  quantity  of  inputs.  E.g.  a  positive  
technological  change  occurred  when  the  productivity  of  workers  at  Sony  
increased.  This  means  Sony  can  produce  more  output  with  the  same  
amount  of  input,  lowering  the  production  costs  per  unit.  As  a  result  
supply  increases.  
• Prices  of  substitutes  in  production  –  e.g.  if  a  substitute  product  
becomes  more  profitable,  that  firm  will  shift  some  of  their  resource  away  
from  their  initial  product  to  the  substitute  which  is  more  profitable.  This  
results  in  a  decline  in  the  supply  of  the  initial  product.  
• Number  of  firms  in  the  market  –  refers  to  a  change  in  the  number  of  
firms  in  the  market.  E.g.  when  new  firms  enter  a  market  the  supply  curve  
shifts  to  the  right,  as  there  is  now  a  greater  supply  of  that  particular  good  
in  the  market.    
• Expected  future  prices  –  if  a  firm  expects  that  the  price  of  its  product  
will  be  higher  in  the  future  than  it  is  today,  it  has  an  incentive  to  decrease  
supply  now  (e.g.  storing  resources  for  that  later  date)  and  increase  it  in  
the  future,  when  prices  are  higher.  This  results  in  a  decrease  in  supply  for  
the  time  being,  raising  prices.    
  
3. How  equilibrium  in  a  market  is  reached,  and  use  a  graph  to  illustrate  
market  equilibrium:    
Market  Equilibrium:  putting  demand  and  supply  together:  the  point  of  
market  equilibrium  is  where  the  quantity  demanded  equals  the  quantity  
supplied.    
-­‐ This  is  demonstrated  on  a  graph  at  the  one  point  where  the  demand  
curve  intersects  the  supply  curve.  It  is  only  at  this  point  that  the  
quantity  of  the  product  consumers  are  willing  to  purchase  is  equal  to  
the  quantity  of  the  product  that  the  firm  is  willing  to  supply.    
-­‐ Markets  eliminate  surpluses  and  shortages  through  the  fact  that  market  
equilibrium  is  always  either  being  achieved,  or  the  market  is  working  
towards  achieving  it.    
-­‐ E.g.  the  price  for  MP3  players  was  $250  rather  than  the  equilibrium  
price  of  $200.  At  $250  the  quantity  supplied  would  be  45  million  while  
the  quantity  demanded  would  only  be  35  million.  This  results  in  a  
surplus  (of  10  million  MP3  players).  Due  to  the  surplus,  the  MP3  
producing  firms  have  unsold  MP3s  piling  up  which  gives  them  
incentives  to  increase  their  sales,  which  can  only  be  done  by  reducing  
the  price.  Reducing  the  price  will  simultaneously  increase  the  quantity  
demanded  and  decrease  the  quantity  supplied.  The  price  will  eventually  
fall  back  down  until  the  market  is  in  equilibrium  ($200).    
 
4. Use  demand  and  supply  graphs  to  predict  changes  in  prices  and  
quantities:  completed  in  exercise  book.    
 
Lecture  2:  
Demand:  
Key  Terms:  
• Quantity  Demanded  –  the  amount  of  a  good  or  service  that  a  consumer  is  
willing  and  able  to  buy  at  a  given  price.  
• Demand  Schedule  –  a  table  showing  the  relationship  between  the  price  of  
a  product  and  the  quantity  of  the  product  demanded.    
• The  Law  of  Demand  –  holding  everything  else  constant,  the  higher  the  
price,  the  lower  the  demand.  The  lower  the  price,  the  higher  the  demand.    
 
Explaining  the  Law  of  Demand:  
• Substitution  Effect  –  change  in  the  quantity  demanded  that  results  from  a  
change  in  price,  making  the  good  or  service  more  or  less  expensive  
relative  to  other  goods  and  services  (holding  constant  the  effect  of  the  
price  change  on  consumer  purchasing  power).    
• Income  Effect  –  change  in  the  quantity  demanded  that  results  from  the  
effect  of  a  change  in  price  on  consumer  purchasing  power  (holding  all  
other  factors  constant).  E.g.  an  increase  in  price  would  lower  the  demand  
for  an  elastic  product,  as  it  would  now  represent  a  larger  proportion  of  an  
individual’s  disposable  income.        
 
Alternative  interpretation  of  demand  –  the  maximum  willingness  to  pay.  
 
Supply:  
Key  terms:  
• Quantity  Supplied  –  the  amount  of  a  good  or  service  that  a  firm  is  willing  
and  able  to  supply  at  a  given  price.  
• Supply  Schedule  –  a  table  showing  the  relationship  between  the  price  of  a  
product  and  the  quantity  of  the  product  supplied.  
• The  Law  of  Supply  –  holding  everything  else  constant,  the  higher  the  price,  
the  higher  the  supply.  The  lower  the  price,  the  lower  the  supply.    
 
Market  Equilibrium:  
• Shortage:  a  situation  in  which  the  quantity  demanded  is  greater  than  the  
quantity  supplied.  
• Surplus:  a  situation  in  which  the  quantity  supplied  is  greater  than  the  
quantity  demanded.  
-­‐  The  effects  of  shifts  in  demand  and  supply  on  the  market  equilibrium  can  be  
demonstrated  through  shifts  in  the  supply  and  demand  curves.  
 
Tutorial  3:  
Trade:  
Original  idea  -­‐  Adam  Smith:  “Wealth  of  nations”.  Absolute  advantage.  
David  Riccardo  –  comparative  advantage.    
E.g.  of  comparative  cost  with  IBM.  They  chose  to  allocate  their  resources  in  high-­‐
end  military  products  instead  of  continuing  with  laptop  production.  As  the  
opportunity  cost  was  much  higher  if  they  continued  to  produce  laptops  they  
decided  to  sell  that  to  Lenovo,  and  produce  high-­‐end  military  products  since  
profitability  was  higher.  
 
 
Week  3  –  Elasticity:  
Chapter  4  –  ‘Elasticity:  The  Responsiveness  of  Demand  and  
Supply’:      
Elasticity  –  a  measure  of  how  much  one  economic  variable  responds  to  changes  
in  another  economic  variable.  
1. Define  price  elasticity  of  demand  and  how  to  measure  it:  
The  Price  Elasticity  of  Demand  -­‐  the  responsiveness  of  the  quantity  demanded  
to  a  change  in  price.    
Measurement  –  by  using  the  slope  of  the  demand  curve  because  it  tells  us  how  
much  quantity  demanded  changes  as  price  changes.  However,  the  measurement  
of  slope  is  sensitive  to  the  units  chosen  for  quantity  and  price.    
To  avoid  the  confusion  over  units,  economists  use  percentage  changes  when  
measuring  the  price  elasticity  of  demand.    
Formula  for  calculating  price  elasticity  of  demand:  the  percentage  change  in  the  
quantity  demanded  of  a  product  ÷  the  percentage  change  in  the  product’s  price.    
The  Price  Elasticities  of  Demand:  
• Elastic  Demand  –  when  the  %  change  in  quantity  demanded  is  greater  
than  the  %  change  in  price,  so  the  price  elasticity  is  greater  than  1  in  
absolute  value.  In  other  words,  if  the  quantity  demanded  is  very  
 responsive  to  changes  in  price  (e.g.  a  10%  decrease  in  the  price  of  bread  
rolls  results  in  a  20%  increased  in  the  quantity  of  bread  rolls  demanded).    
• Inelastic  Demand  –  when  the  %  change  in  quantity  demanded  is  less  than  
the  %  change  in  price,  so  the  price  elasticity  is  less  than  1  in  absolute  
value.  I.e.  if  the  quantity  demanded  isn’t  very  responsive  to  price  changes  
(e.g.  a  10%  decrease  in  the  price  of  wheat  results  in  only  a  5%  increase  in  
the  quantity  of  wheat  demanded).    
• Unit-­‐Elastic/Unitary  Elastic  Demand  –  when  the  %  change  in  quantity  
demanded  is  equal  to  the  %  change  in  price,  so  the  price  elasticity  is  equal  
to  1  in  absolute  value.    
• Perfectly  Elastic  Demand  –  if  the  demand  curve  is  a  horizontal  line  it  is  
perfectly  elastic.  In  this  case  the  quantity  demanded  would  be  infinitely  
responsive  to  price  changes  and  the  price  elasticity  of  demand  equals  
infinity  (i.e.  an  increase  in  price  causes  the  quantity  demanded  to  fall  to  
0).    
• Perfectly  Inelastic  Demand  –  if  the  demand  curve  is  a  vertical  line  it  is  
perfectly  inelastic.  In  this  case  the  quantity  demanded  is  completely  
unresponsive  to  price  changes  and  the  price  elasticity  of  demand  equals  
zero  (e.g.  however  much  the  price  may  increase  or  decrease,  the  quantity  
demanded  remains  the  same).      
 
2. The  determinants  of  the  price  elasticity  of  demand:  
Price  elasticities  differ  between  products  due  to  the  alternative  determinants  of  
the  price  elasticity  of  demand.  These  determinants  are  as  follows:  
• Availability  of  Close  Substitutes  –  how  consumers  react  to  a  change  in  
the  price  of  a  product  depends  on  what  alternatives  they  have  (e.g.  when  
the  price  of  petrol  rises  consumers  have  few  alternatives,  so  the  quantity  
demanded  falls  only  a  little  =  inelastic/less  elastic  demand).  If  a  product  
has  more  substitutes  available,  it  is  likely  to  have  more  elastic  demand.  If  
a  product  has  fewer  substitutes  available,  it  is  likely  to  have  less  elastic  
demand.  The  most  important  determinant  of  price  elasticity  of  demand.  
• Length  of  Time  Involved  -­‐  the  time  it  takes  for  consumers  to  adjust  their  
purchasing  habits  once  prices  change.  In  addition,  it  may  take  more  time  
for  available  substitutes  for  a  product  to  be  developed.  The  more  time  
that  passes  after  a  price  change,  the  more  elastic  demand  for  a  product  
becomes.    
• Luxuries  Vs.  Necessities  –  the  demand  curve  for  a  luxury  is  more  elastic  
than  the  demand  curve  for  a  necessity  (e.g.  the  demand  for  milk  is  
inelastic  because  milk  is  a  necessity  for  most  households  and  the  quantity  
demanded  is  not  very  dependent  on  price  as  it  is  always  required.  The  
demand  for  concert  tickets  is  much  more  elastic  than  the  demand  for  milk  
as  it  is  a  luxury  and  therefore  will  reduce  in  quantity  demanded  if  its  price  
rises).    
• Definition  of  the  Market  –  in  a  narrowly  defined  market,  consumers  will  
have  more  substitutes  available  (e.g.  if  the  price  of  Kellogg’s  Sultana  Bran  
rises  many  consumers  will  start  buying  another  brand  of  sultana  bran,  
therefore  the  %  change  in  quantity  demanded  will  be  greater  than  the  %  
change  in  price  =  elastic  demand).  The  more  narrowly  we  define  a  
market,  the  more  elastic  demand  will  be.    
 • Share  of  the  Good  in  the  Consumer’s  Budget  –  the  quantity  demanded  
for  a  good  will  be  less  elastic  if  purchasing  the  good  involves  a  small  share  
of  the  average  consumer’s  budget  (e.g.  if  the  price  of  salt  increased  by  
50%,  it  is  likely  to  result  in  only  a  small  decline  in  the  quantity  demanded  
as  it  only  represents  a  very  small  proportion  of  a  household’s  income  =  
inelastic/less  elastic  demand).    
 
3. The  relationship  between  the  price  elasticity  of  demand  and  total  
revenue:  
Firms  are  interested  in  price  elasticity  because  it  allows  them  to  calculate  how  
changes  in  price  will  affect  its  total  revenue  (figure  4.2,  page  96  –  shows  this  
relationship  in  graph  form).  
Total  Revenue  –  the  total  amount  of  funds  received  by  a  seller  of  a  good  or  
service,  is  calculated  by  multiplying  price  per  unit  by  the  number  of  units  sold.    
• When  demand  is  elastic,  price  and  total  revenue  move  inversely:  an  
increase  in  price  reduces  total  revenue,  and  a  decrease  in  price  raises  
total  revenue  (e.g.  an  increase  in  price  reduces  revenue  because  the  
decrease  in  quantity  demanded  is  proportionally  greater  than  the  
increase  in  price).    
• When  demand  is  inelastic,  price  and  total  revenue  move  in  the  same  
direction:  an  increase  in  price  raises  total  revenue,  and  a  decrease  in  price  
reduces  total  revenue  (e.g.  a  decrease  in  price  reduces  revenue  because  
the  increase  in  quantity  demanded  is  proportionally  smaller  than  the  
decrease  in  price).      
• When  demand  is  unit-­‐elastic:  a  change  in  price  is  exactly  offset  by  a  
proportional  change  in  quantity  demanded,  therefore  leaving  total  
revenue  unaffected.    
 
4. Define  cross-­‐price  elasticity  of  demand  and  income  elasticity  of  demand,  
and  their  determinants  and  how  they  are  measured:  
In  addition  to  price  elasticity,  two  other  demand  elasticities  are  important:  
• Cross-­‐Price  Elasticity  of  Demand  –  is  important  to  managers  because  it  
allows  them  to  categorise  products  sold  by  other  firms  in  relation  to  their  
own  product.  
Calculation  -­‐  %  change  in  quantity  demanded  of  one  good  divided  by  the  
%  change  in  the  price  of  another  good.    
E.g.  suppose  you  work  at  Apple  and  you  need  to  predict  the  effect  of  an  
increase  in  the  price  of  Microsoft’s  MP3  players  on  the  quantity  of  iPods  
demanded,  ceteris  paribus.  This  can  be  done  by  calculating  the  cross-­‐price  
elasticity  of  demand.  If  the  products  are  ‘…’  then  the  cross-­‐price  elasticity  
will  be:  
§ Substitutes  –  positive  (two  brands  of  digital  music  players).  
§ Complements  –  negative  (digital  music  players  and  song  
downloads).  
§ Unrelated  –  zero  (e.g.  digital  music  players  and  peanut  butter).  
• Income  Elasticity  of  Demand  –  a  measure  of  the  responsiveness  of  
quantity  demanded  to  changes  in  income.  
 Calculation  -­‐  %  change  in  quantity  demanded  divided  by  the  %  change  in  
income  (usually  disposable  income:  consumer  income  after  income  
taxation).  If  the  income  elasticity  of  demand  is  ‘…’,  then  the  good  is:  
§ Positive,  but  less  than  1  -­‐  normal  and  a  necessity  (e.g.  milk).  I.e.  if  
the  quantity  demanded  is  not  very  responsive  to  changes  in  
income  (inelastic/less  elastic).      
§ Positive  and  greater  than  1  -­‐  normal  and  a  luxury  (e.g.  caviar).  I.e.  if  
the  quantity  demanded  is  very  responsive  to  changes  in  income  
(elastic).    
§ Negative  –  inferior  (e.g.  canned  foods).  I.e.  if  the  quantity  
demanded  falls  as  income  increases.    
If  the  quantity  demanded  of  a  good  increases  as  income  increases,  
then  the  good  is  a  normal  good.  Normal  goods  are  often  further  
subdivided  into  luxury  and  necessity  goods,  as  seen  above.  
 
5. Use  price  elasticity  and  income  elasticity  to  analyse  economic  issues:  
The  concepts  of  price  elasticity  and  income  elasticity  can  help  us  understand  
many  economic  issues.    
E.g.  the  diminishing  number  of  farms  in  Australia  –  because  the  income  elasticity  
for  food  is  low,  the  demand  for  food  has  not  increased  proportionally  as  incomes  
in  Australia  and  the  rest  of  the  world  have  grown.  In  addition,  farmers  have  
become  more  productive  and  have  therefore  increased  the  supply  of  most  foods.  
Because  the  price  elasticity  of  demand  for  food  is  low,  the  increasing  supply  has  
resulted  in  continually  falling  food  prices.  The  result  is  more  abundant  and  
cheaper  food,  which  benefits  consumers  but  causes  farmers  to  suffer.    
 
6. Define  price  elasticity  of  supply,  and  understand  its  main  determinants  
and  how  it  is  measured:  
The  Price  Elasticity  of  Supply:  the  responsiveness  of  the  quantity  supplied  to  a  
change  in  price.  
Measurement:  it  is  measured  by  the  %  change  in  the  quantity  supplied  of  a  
product  ÷  the  %  change  in  the  product’s  price.    
The  Price  Elasticities  of  Supply:  
• Elastic  Supply  –  if  the  price  elasticity  of  supply  is  greater  than  1.  
• Inelastic  Supply  -­‐  if  the  price  elasticity  of  supply  is  less  than  1.  
• Unit-­‐Elastic  Supply  -­‐  if  the  price  elasticity  of  supply  is  equal  to  1.  
• Perfect  Elasticity  of  Supply  –  if  the  supply  curve  is  a  horizontal  line  it  is  
perfectly  elastic.  This  is  when  the  quantity  supplied  is  infinitively  
responsive  to  price  changes  and  the  price  elasticity  of  supply  equals  
infinity.  I.e.  a  very  small  increase  in  price  causes  a  very  large  increase  in  
quantity  supplied.    
• Perfect  Inelasticity  of  Supply  –  if  the  supply  curve  is  a  vertical  line  it  is  
perfectly  inelastic.  When  the  quantity  supplied  is  completely  
unresponsive  to  price  changes  and  the  price  elasticity  of  supply  equals  
zero.  Regardless  of  how  much  price  may  increase  or  decrease,  the  
quantity  supplied  remains  the  same.    
Determinants  of  the  Price  Elasticity  of  Supply:  whether  supply  is  elastic  or  
inelastic  depends  on  the  ability  or  willingness  of  firms  to  alter  the  quantity  they  
produce  as  prices  increase.  The  key  determinants  of  supply  are  as  follows:  
 • Length  of  Time  Involved  –  firms  often  have  difficulty  increasing  the  
quantity  of  the  product  they  supply  during  any  short  period  of  time.  The  
shorter  the  period  of  time,  the  more  inelastic  supply  will  be  (e.g.  
producers  may  not  be  prepared  for  a  very  sudden  increase  in  price  and  
therefore  won’t  have  the  necessary  resources  on  hand  to  increase  supply  
by  a  greater  proportion  than  the  increase  in  price).    
• Type  of  Industry  –  the  characteristics  of  some  industries  allow  them  to  
change  the  quantity  supplied  quite  quickly,  while  for  other  industries  this  
isn’t  possible  (e.g.  some  manufacturing  industries  can  increase  supply  
relatively  quickly  by  operating  machines  for  additional  hours.  The  
agricultural  produce  that  can  be  supplied  cannot  be  changed  quickly  as  
crops  take  time  to  grow).  Those  quantities  of  supply  that  can  be  altered  
quickly  usually  face  an  elastic  price  elasticity  of  supply.    
• Availability  of  Inputs  –  some  goods  and  services  require  resources  that  
are  themselves  in  fixed  supply  (e.g.  a  wine  relying  on  a  particular  type  of  
grape  cannot  produce  any  extra  as  there  is  no  land  available  for  extra  
production  =  inelastic  supply.  Some  producers  may  be  able  to  divert  
resources  from  the  production  of  one  product  into  the  production  of  
another  which  has  experienced  a  rise  in  price,  enabling  a  more  elastic  
supply  response).    
• Existing  Capacity  –  some  products  are  elastic,  even  in  the  short  run.  If  a  
firm  has  excess  productive  capacity  or  has  stock  in  storage,  then  the  
quantity  supplied  may  be  able  to  respond  quite  quickly  to  changes  in  
price  (e.g.  those  producers  already  operating  at  their  full  productive  
capacity  won’t  be  able  to  respond  quickly,  therefore  their  product  will  be  
inelastic).  
• Inventories  Held  –  involves  storage  premises  and  keeping  stock  that  is  
currently  not  generating  revenue  from  sales  (quite  expensive).  E.g.  those  
supermarkets  that  are  able  to  hold  stocks  in  warehouses  can  refill  store  
shelves  quickly  if  prices  suddenly  increase  (i.e.  more  elastic  supply).  
However,  those  products  like  fresh  food  (e.g.  vegetables  and  fruit)  
generally  experience  price  inelasticity  due  to  the  fact  that  they  can’t  be  
stored  without  going  rotten.    
 
Tutorial  4  –  elasticity:  
-­‐ Responsiveness:  how  x  and  y  respond  to  each  other’s  changes.  
-­‐ %Q/%P.  
1  good  has  an  elasticity  of  0.61:  
-­‐ 0.61<1,  therefore  it  is  inelastic.  
-­‐ It  is  a  positive  value,  therefore  supply.  
2  different  goods:  
-­‐ -­‐0.61,  the  two  goods  are  complements.  A  positive  value  would  mean  the  
two  goods  are  substitutes.    
 
Types  of  Elasticity  Qs:  
-­‐ %  is  given,  and  you  need  to  interpret  the  result  (e.g.  Q2).  
-­‐ %  is  not  given  –  midpoint  formula:  used  to  calculate  and  interpret  
elasticity.  
-­‐ Elasticity  of  a  certain  point.    
  
 
Week  4  –  Economic  Efficiency,  Government  Price  Setting  and  
Taxes:  
Chapter  5  –  ‘Economic  Efficiency,  Government  Price  Setting  and  
Taxes’:      
1. The  concepts  of  consumer  surplus  and  producer  surplus:  
We  can  analyse  the  effects  of  government  interventions  in  markets,  such  as  
imposing  price  ceilings  and  floors,  using  the  concepts  of  consumer  surplus  and  
producer  surplus:  
• Consumer  Surplus  –  the  difference  between  the  highest  price  a  
consumer  is  willing  to  pay  and  the  price  the  consumer  actually  pays  (e.g.  
the  price  you  are  willing  to  pay  for  a  DVD  is  $25  but  it  is  priced  at  $20.  
The  consumer  surplus  is  $5).  I.e.  the  total  benefit  received  by  consumers  
minus  the  total  amount  they  must  pay  to  buy  the  good  or  service.  
Because  the  demand  curve  measures  the  marginal  benefit  received  by  
consumers,  we  can  draw  the  conclusion  that  the  total  amount  of  consumer  
surplus  in  a  market  is  equal  to  the  area  below  the  demand  curve  and  above  
the  market  price.    
• Producer  Surplus  –  the  difference  between  the  lowest  price  a  firm  would  
have  been  willing  to  accept  and  the  price  it  actually  receives.  I.e.  the  total  
amount  firms  receive  from  consumers  minus  the  cost  of  producing  the  
good  or  service.    
The  supply  curve  is  also  the  marginal  cost  curve.  The  total  amount  of  
producer  surplus  in  a  market  is  equal  to  the  area  above  the  market  supply  
curve  and  below  the  market  price.    
Firms  will  supply  an  additional  unit  of  a  product  only  if  they  receive  a  price  
equal  to  or  above  the  additional  cost  of  producing  that  unit.    
The  marginal  cost  of  producing  a  product  increases  as  more  of  the  product  is  
produced  during  a  given  period  of  time.  This  is  the  key  reason  that  supply  
curves  are  upward  sloping.    
 
2. The  concept  of  economic  efficiency:    
Economic  Efficiency  –  a  market  outcome  in  which  the  MB  (marginal  benefit)  to  
consumers  of  the  last  unit  produced  is  equal  to  the  MC  (marginal  cost)  of  
production,  and  in  which  the  sum  of  consumer  surplus  and  producer  surplus  is  
at  a  maximum.    
MB  =  MC  in  Competitive  Equilibrium:  
To  achieve  economic  efficiency  in  a  market,  the  MB  from  the  last  unit  sold  should  
=  the  MC  of  production.    
Equilibrium  in  a  competitive  market  results  in  the  economically  efficient  level  of  
output,  where  MB  =MC.  This  outcome  is  economically  efficient  because  every  
product  has  been  produced  where  the  MB  to  buyers  is  greater  than  or  equal  to  
the  MC  of  producers.    
 
Economic  Surplus  –  is  the  sum  of  consumer  surplus  and  producer  surplus.  This  
is  at  maximum  when  the  market  is  in  equilibrium.  
Deadweight  Loss  –  is  the  reduction  in  economic  surplus  resulting  from  a  market  
not  being  in  competitive  equilibrium.  E.g.  if  the  price  is  below  equilibrium,  
MB>MC  as  the  supply  is  inefficiently  low.  If  the  price  is  above  equilibrium,  
MB<MC  as  the  supply  is  inefficiently  high.    
 
Economic  Surplus  and  Economic  Efficiency:  
Equilibrium  in  a  competitive  market  results  in  the  greatest  amount  of  economic  
surplus,  or  total  net  benefit  to  society,  from  the  production  of  a  good  or  service.    
 
3. The  economic  effect  of  government-­‐imposed  price  ceilings  and  price  
floors:  
When  a  market  is  at  its  competitive  equilibrium  the  economic  surplus/total  net  
benefit  to  society  is  greater,  but  not  every  individual  is  better  off.  Any  individual  
producer  would  rather  charge  a  higher  price  and  any  individual  consumer  would  
rather  pay  a  lower  price.    
Producers  or  consumers  who  are  dissatisfied  with  the  competitive  equilibrium  
price  can  lobby  the  government  to  require  legally  that  a  different  price  be  
charged.  However,  when  moving  a  price  away  from  equilibrium,  economic  
efficiency  is  reduced  (i.e.  a  deadweight  loss).    
• Price  Floors  –  when  the  government  intervenes  with  the  aim  to  aid  
sellers  by  requiring  that  a  price  be  above  equilibrium.  I.e.  it  is  a  legally  
determined  minimum  price  that  sellers  may  receive.    
• Price  Ceilings  –  when  the  government  intervenes  with  the  aim  to  aid  
buyers  by  requiring  that  a  price  be  below  equilibrium.  I.e.  a  legally  
determined  maximum  price  that  sellers  may  charge.  
Black  Markets:  
When  governments  try  to  control  prices  by  setting  price  ceilings  and  price  floors,  
buyers  and  sellers  often  find  a  way  around  the  controls.  This  results  in  a  black  
market,  where  buying  and  selling  takes  place  at  prices  that  violate  government  
price  regulations.    
 
4. The  economic  impact  of  taxes:  
When  the  government  taxes  a  good,  it  affects  the  market  equilibrium  of  that  
good.  Just  as  with  a  price  ceiling  or  price  floor,  one  result  of  a  tax  is  a  decline  in  
economic  efficiency.    
The  Effect  of  Taxes  on  Economic  Efficiency:  
Whenever  a  government  taxes  a  good  or  service,  less  of  that  good  or  service  will  
be  produced  (e.g.  a  $1  tax  on  each  cigarette  pack  will  cause  the  cost  of  selling  
cigarettes  to  increase  by  $1  per  pack.  This  causes  the  supply  curve  to  shift  to  the  
left  because  sellers  will  now  require  a  price  that  is  $1  greater  to  supply  the  same  
quantity  of  cigarettes).    
There  is  a  loss  of  consumer  surplus  because  consumers  are  paying  a  higher  price.  
The  price  producers  receive  falls,  so  there  is  also  a  loss  of  producer  surplus.  
Some  of  the  reduction  in  consumer  and  producer  surplus  becomes  tax  revenue  
for  the  government.  The  rest  of  the  reduction  is  equal  to  the  deadweight  loss  
from  the  tax.    
Therefore,  the  true  burden  of  a  tax  is  not  just  the  amount  consumers  and  
producers  pay  to  the  government,  but  it  also  includes  the  deadweight  loss.  The  
deadweight  loss  from  a  tax  is  referred  to  as  the  excess  burden  of  the  tax.    
A  tax  is  efficient  if  it  imposes  a  small  excess  burden  relative  to  the  tax  revenue  it  
raises.    
Who  Actually  Pays  a  Tax?  
There  is  a  difference  between  who  legally  pays  the  tax  and  who  bears  the  burden  
of  the  tax.  The  actual  division  of  the  burden  of  a  tax  is  referred  to  as  tax  
incidence.    
As  a  general  rule:  when  demand  is  price  inelastic  (e.g.  petrol)  consumers  bear  a  
greater  proportion  of  the  tax  burden,  while  producers  bear  a  greater  proportion  
of  the  tax  burden  for  elastic  demand.    
Does  it  matter  whether  the  tax  is  on  buyers  or  sellers?  
It  does  NOT  depend  on  whether  the  government  collects  a  tax  from  the  buyers  of  
a  good  or  from  the  sellers.    
 
 
Week  5  –  Labour  Markets/International  Trade:  
Part  5  –  ‘Markets  for  Factors  of  Production’  –  Chapter  12  –  ‘The  
Markets  for  Labour  and  other  Factors  of  Production’:  
Factors  of  production  –  labour,  capital,  natural  resources  and  entrepreneurial  
ability  used  to  produce  goods  and  services.  
1. How  firms  choose  the  profit-­‐maximising  quantity  of  labour  to  employ:  
The  Demand  for  Labour:  this  is  different  to  the  demand  for  final  goods  and  
services  because  this  is  a  derived  demand.  
• Derived  Demand  –  the  demand  for  a  factor  of  production  that  is  derived  
from  the  demand  for  the  good  or  service  the  factor  produces  (e.g.  Sony’s  
demand  for  the  labour  to  make  televisions  is  derived  from  the  underlying  
consumer  demand  for  televisions).  
• Marginal  Product  of  Labour  –  the  additional  output  a  firm  produces  as  a  
result  of  hiring  one  more  worker.    
 
When  deciding  how  many  workers  to  hire  a  firm  isn’t  interested  in  how  much  
output  will  increase  as  it  hires  another  worker,  but  in  how  much  revenue  will  
increase  as  it  hires  another  worker.  This  can  be  calculated  by  multiplying  the  
additional  output  produced  by  the  product  price.  This  amount  is  called  the  
Marginal  Revenue  Product  of  Labour  (MRP).    
• MRP  –  the  change  in  the  firm’s  revenue  as  a  result  of  hiring  one  more  
worker.  
To  decide  how  many  workers  to  hire,  the  organisation  must  compare  the  
additional  revenue  it  earns  from  hiring  another  worker  to  the  increase  in  its  
costs  from  paying  the  worker.  This  difference  is  the  additional  profit  or  loss  from  
hiring  one  more  worker.  Firms  maximise  profit  by  hiring  workers  up  to  the  point  
where  the  wage  =  MRP  (i.e.  the  optimal  number  of  workers  and  is  maximising  
profits).      
The  marginal  revenue  product  curve  tells  the  firm  how  many  workers  it  should  
hire  at  any  wage  rate.  I.e.  the  marginal  revenue  product  of  labour  curve  is  the  
demand  curve  for  labour.    
• The  Market  Demand  Curve  for  Labour  –  determined  by  adding  up  the  
quantity  of  labour  demanded  by  each  firm  at  each  wage,  ceteris  paribus.  
Factors  that  shift  the  labour  demand  curve:  
An  increase  or  decrease  in  the  wage  causes  an  increase  or  decrease  in  the  
quantity  of  labour  demanded,  which  we  show  by  a  movement  along  the  demand  
curve.    
If  any  other  variable  changes,  the  result  is  an  increase  or  decrease  in  the  demand  
for  labour,  which  we  show  by  a  shift  of  the  demand  curve.    
• Increases  in  Human  Capital:  human  capital  refers  to  the  accumulated  
training  and  skills  that  workers  possess.  E.g.  if  workers  become  more  
educated  and  are  therefore  able  to  produce  more  output  per  day,  the  
demand  for  their  services  will  increase,  shifting  the  labour  demand  curve  
to  the  right.  
• Changes  in  Technology:  as  new  machinery  and  equipment  are  developed,  
workers  become  more  productive.  This  effect  causes  the  labour  demand  
curve  to  shift  to  the  right  over  time.  However,  some  technology  replaces  
labour.  This  can  make  certain  jobs  redundant,  therefore  shifting  the  
demand  for  those  specific  workers  to  the  left.  
• Changes  in  the  price  of  the  product:  the  MRP  depends  on  the  price  the  
firm  receives  for  its  output.  E.g.  a  higher  price  increases  the  MRP  and  
shifts  the  labour  demand  curve  to  the  right.  
• Changes  in  the  quantity  of  other  inputs:  if  workers  have  more  inputs  
available  to  them  (e.g.  more  machinery),  their  productivity  increases.  If  
this  is  the  case,  the  demand  for  labour  will  shift  to  the  right.  
• Changes  in  the  number  of  firms  in  the  market:  if  new  firms  enter  the  
market  the  demand  for  labour  will  shift  to  the  right  (as  more  firms  
require  more  workers).  
 
2. How  people  choose  the  quantity  of  labour  to  supply:  
The  higher  the  wage  we  could  earn  working,  the  higher  the  opportunity  cost  of  
leisure.  Therefore  as  the  wage  increases,  we  might  supply  a  greater  quantity  of  
labour  and  spend  less  of  our  time  on  leisure.  This  explains  why  the  labour  supply  
curve  is  upward  sloping  for  most  people.  
However,  it  is  possible  that  at  very  high  wage  levels  the  supply  curve  for  an  
individual  might  be  backward  bending.  This  means  that  higher  wages  actually  
result  in  a  smaller  quantity  of  labour  supplied.  To  explain,  the  substitution  and  
income  effects  from  price  changes  are  now  applied  to  wage  changes:  
• Substitution  Effect:  the  fact  that  an  increase  in  the  wage  raises  the  
opportunity  cost  of  leisure  and  therefore  causes  a  worker  to  devote  more  
time  to  working  and  less  to  leisure.    
• Income  Effect:  because  leisure  is  a  normal  good  (i.e.  a  good  for  which  the  
demand  increases  as  income  rises  and  decreases  as  income  falls),  the  
income  effect  of  a  wage  increase  will  cause  a  worker  to  devote  less  time  to  
working  and  more  time  to  leisure.  This  occurs  because  the  incomes  of  
these  workers  are  already  high,  so  they  may  decide  to  give  up  additional  
income  for  more  leisure.    
Whether  a  worker  supplies  more  or  less  labour  following  a  wage  increase  
depends  on  whether  the  substitution  effect  is  larger  than  the  income  effect.    
 
• The  Market  Supply  Curve  for  Labour  –  determined  by  adding  up  the  
quantity  of  labour  supplied  by  each  worker  at  each  wage,  ceteris  paribus.    
Factors  that  shift  the  labour  supply  curve:  
In  constructing  the  labour  supply  curve  we  hold  constant  all  other  variables  that  
would  affect  the  willingness  of  workers  to  supply  labour,  except  the  wage.  If  any  
of  these  other  variables  change,  the  supply  curve  will  shift.  The  three  most  
important  variables  that  cause  the  labour  supply  curve  to  shift  are:  
• Increases  in  Population:  as  the  population  increases  due  to  natural  
increase  and  immigration,  the  labour  supply  curve  will  shift  to  the  right.    
• Changing  Demographics:  demographics  refers  to  the  composition  of  the  
population.  The  more  people  who  are  between  the  ages  of  16-­‐65  and  are  
able  and  willing  to  work,  the  greater  the  quantity  of  labour  supplied.  
Another  major  point  is  the  changing  role  of  women.  The  increase  in  the  
labour  force  participation  of  women  has  significantly  increased  the  
supply  of  labour  in  Australia.  
• Changing  Alternatives:  the  labour  supply  in  any  particular  labour  market  
depends,  in  part,  on  the  opportunities  available  in  other  labour  markets.  
E.g.  during  the  GFC  opportunities  were  reduced  for  financial  planners.  
Many  workers  left  this  market  –  causing  the  labour  supply  curve  to  shift  
to  the  left  –  and  entered  other  markets,  causing  the  labour  supply  curves  
to  shift  to  the  right  in  those  markets.    
 
3. How  equilibrium  wages  are  determined  in  labour  markets:  
We  can  use  demand  and  supply  to  analyse  changes  in  the  equilibrium  wage  and  
the  level  of  employment  for  the  entire  labour  market,  and  we  can  also  use  it  to  
analyse  markets  for  different  types  of  labour  (graphs  in  exercise  book).    
The  effect  on  equilibrium  wages  of  a  shift  in  labour  demand:  
If  labour  supply  is  unchanged,  an  increase  in  labour  demand  will  increase  both  
the  equilibrium  wage  and  the  number  of  workers  employed.  
The  effect  on  equilibrium  wages  of  a  shift  in  labour  supply:  
If  labour  demand  is  unchanged,  an  increase  in  labour  supply  will  decrease  the  
equilibrium  wage  but  increase  the  equilibrium  level  of  employment.    
 
 
Part  6  –  ‘International  Markets’  -­‐  Chapter  13  –  ‘International  
Trade’:  
1. The  role  of  international  trade  in  the  Australian  economy:  
International  trade  has  generally  been  increasing  in  recent  decades,  in  part  
because  of  reductions  in  tariffs  and  other  barriers  to  trade.  Other  factors  leading  
to  this  increase  in  trade  include  the  improvements  in  the  areas  of  transportation  
and  communication,  which  have  created  a  global  marketplace.  In  addition,  over  
the  past  50  years  many  governments  have  changed  policies  to  facilitate  
international  trade  (i.e.  reduced  protection).  E.g.  tariff  rates  have  fallen.    
 
2.  The  difference  between  comparative  advantage  and  absolute  advantage  
in  international  trade:  
Comparative  Advantage  –  is  the  ability  of  an  individual,  business  or  country  to  
produce  a  good  or  service  at  the  lowest  opportunity  cost.    
Absolute  Advantage  –  is  the  ability  to  produce  more  of  a  good  or  service  than  
competitors  when  using  the  same  amount  of  resources.    
Countries  trade  on  the  basis  of  comparative  advantage,  not  on  the  basis  of  
absolute  advantage.    
  
3. How  countries  gain  from  international  trade:  
• Autarky:  a  situation  in  which  a  country  does  not  trade  with  other  
countries.    
• Terms  of  Trade:  the  ratio  at  which  a  country  can  trade  its  exports  for  
imports  from  other  countries.    
Through  specialising  in  what  a  country  has  a  comparative  advantage  in  and  
trading  it  for  goods  that  other  countries  have  a  comparative  advantage  in,  all  of  
the  countries  involved  in  the  trade  are  better  off.  This  is  demonstrated  through  
each  country  experiencing  an  increase  in  the  quantity  of  goods  consumed  than  
without  trade.    
This  outcome  is  possible  because  world  production  (i.e.  total  production)  of  both  
goods  increases  after  trade.    
 
4. The  economic  effects  of  government  policies  that  restrict  international  
trade:  
 Free  Trade:  trade  between  countries  that  is  without  government  restrictions.    
International  trade  helps  consumers  but  hurts  firms  that  are  less  efficient  than  
foreign  competitors.  As  a  result,  these  firms  and  their  workers  are  often  strong  
supporters  of  government  policies  that  restrict  trade.  These  policies  usually  take  
one  of  two  forms:  
• Tariffs  –  are  taxes  imposed  by  the  government  on  goods  imported  into  a  
country.  Like  any  other  tax,  a  tariff  will  increase  the  cost  of  selling  a  good.    
Their  effects  include  helping  Australian  producers  but  hurting  Australian  
consumers,  the  efficiency  of  the  Australian  economy  and  those  countries  
that  supply  the  imported  goods  being  taxed.    
• Import  Quotas  –  a  numerical  limit  imposed  by  the  government  on  the  
quantity  of  a  good  that  can  be  imported  into  a  country.    
Voluntary  export  restraints  are  an  agreement  negotiated  between  two  
countries  that  places  a  numerical  limit  on  the  quantity  of  a  good  that  can  
be  imported  by  one  country  from  the  other  country.    
The  main  purpose  of  most  quotas  is  to  reduce  foreign  competition  faced  
by  domestic  firms.    
By  limiting  imports,  a  quota  forces  the  domestic  price  of  a  good  above  the  
world  price.  This  occurs  because  the  quota  keeps  foreign  producers  from  
selling  the  additional  quantity  of  their  goods,  which  would  drive  the  price  
down  to  the  world  price.  Less  supply  allows  the  domestic  price  to  rise,  
causing  domestic  suppliers  to  increase  their  supply  and  consumers  to  cut  
back  their  demand  for  the  product.  This  then  results  in  an  oversupply  by  
domestic  producers  which  can  ultimately  depress  world  market  prices.    
 
5. The  arguments  over  trade  policy  and  globalisation:  
• World  Trade  Organization  (WTO):  an  international  organization  that  
enforces  international  trade  agreements.    
• Globalisation:  the  process  of  countries  becoming  more  open  to  foreign  
trade  and  investment.    
 
Sources  of  opposition  to  the  WTO:  
 • Anti-­‐Globalisation:  free  trade  and  foreign  investment  destroys  the  
distinctive  cultures  of  many  countries.  Globalisation  has  also  allowed  
multinational  corporations  to  relocate  factories  from  high-­‐income  
countries  to  low-­‐income  countries.  These  new  factories  (e.g.  in  Pakistan,  
Indonesia  or  India)  pay  much  lower  wages  than  those  in  high-­‐income  
countries  and  often  do  not  meet  the  environmental  or  safety  regulations  
that  are  imposed  in  high-­‐income  countries.    
• Protectionism:  the  use  of  trade  barriers  to  shield  domestic  firms  from  
foreign  competition.    
Despite  its  negative  effects  such  as  causing  losses  to  consumers,  eliminating  
jobs  in  the  domestic  industries  that  use  the  protected  products  and  reducing  
the  ability  of  countries  to  produce  according  to  comparative  advantage,  
which  reduces  incomes,  protectionism  still  attracts  support.  It  is  supported  
based  on  the  following  arguments:  
-­‐ Saving  jobs:  
-­‐ Protecting  high  wages:  
-­‐ Protecting  infant  industries:  
-­‐ Protecting  national  security:  
 
• Dumping:  selling  a  product  for  a  price  below  its  cost  of  production,  
usually  referred  to  in  the  context  of  when  a  country  sells  a  product  on  
international  markets  for  a  price  below  its  cost  of  production.    
The  WTO  allows  countries  to  use  tariffs  in  cases  of  dumping.    
 
Radical  Environmentalism:  an  argument  put  forward  by  environmental  groups  
in  favour  of  protection  suggest  that  trade  restrictions  be  put  in  place  to  reduce  
environmental  damage.  These  arguments  fall  into  two  main  categories:  
-­‐ Trade  restrictions  should  be  imposed  against  those  countries  that  lack  
environmental  protection  laws  or  do  not  actively  enforce  their  laws.  
Continuing  to  trade  with  these  countries  only  encourages  further  
production  by  these  countries,  leading  to  further  environmental  
degradation.    
-­‐ Free  trade  increases  CO2  emissions  due  to  the  transportation  of  goods  
around  the  world.  This  argument  suggests  that  trade  restrictions  be  
imposed  so  that  goods  are  purchased  from  the  domestic  market,  
thereby  reducing  emissions  caused  by  international  transportation.    
 
 
Week  6  –  Market  Failure  and  Government  Intervention:  
Part  7  –  ‘The  Role  of  Government’  –  Chapter  14  –  ‘Government  
Intervention  in  the  Market’  (pp.  418-­‐420):  
3.  Distinguish  between  market  failure  and  government  failure:  
Market  failure:  a  situation  in  which  the  market  fails  to  produce  the  efficient  
level  of  output  (e.g.  public  goods,  externalities,  etc.).    
 
This  is  the  public  interest  view  of  government,  which  sees  it  as  the  responsibility  
of  the  government  to  correct  for  areas  of  market  failure.    
 
Government  failure:  occurs  when  the  government  fails  to  correct  adequately  
for  market  failure  or  takes  actions  that  lead  to  a  more  inefficient  outcome  than  
the  market.  I.e.  while  the  public  interest  view  supports  government  intervention  
in  the  event  of  market  failure,  there  may  be  times  when  the  government  fails  to  
improve  economic  efficiency  to  the  level  preferred  by  society.    
E.g.  how  does  the  government  know  what  level  of  pollution  society  is  willing  to  
accept  or  what  level  is  sustainable?  Even  the  best-­‐intentioned  government  
ultimately  faces  budget  limitations  in  its  attempts  to  correct  for  market  failure.    
 
According  to  the  private  interest  view,  government  regulatory  policy  can  reflect  
the  lobbying  by  and  influence  of  rent-­‐seeking  individuals  or  groups  (i.e.  these  
people  and  groups  actively  encourage  certain  types  of  government  regulation  
that  will  enable  them  to  capture  economic  rents  for  themselves  at  the  expense  of  
both  the  general  public  and  a  more  efficient  outcome).  These  groups  may  include  
unions,  business  organisations,  environmental  groups,  religious  lobbyists  and  
even  public  service  departments.      
-­‐  Rent-­‐seeking  behaviour:  an  unproductive  activity  of  an  individual  or  firm  in  the  
pursuit  of  economic  surplus  above  that  which  would  result  from  a  competitive  
market  outcome.      
 
Chapter  15  –  ‘Externalities,  Environmental  Policy  and  Public  
Goods’:  
1. Examples  of  positive  and  negative  externalities  and  use  graphs  to  show  
how  externalities  affect  economic  efficiency:  
Externality:  is  a  benefit  or  cost  to  parties  who  are  not  involved  in  the  
transaction.    
• What  causes  externalities?  Externalities  and  market  failures  result  from  
incomplete  property  rights  or  from  the  difficulty  of  enforcing  property  
rights  in  certain  situations.  E.g.  a  paper  company  builds  its  paper  mill  on  
privately  owned  land  on  the  banks  of  a  lake  that  is  owned  by  the  
government.  In  the  absence  of  government  regulations,  the  company  will  
be  free  to  discharge  pollutants  into  the  lake.  This  cost  will  become  
external  because  the  firm  doesn’t  have  to  pay  to  clean  up  their  pollution  
in  the  lake.  This  will  allow  for  more  than  the  economically  efficient  level  
of  paper  to  be  produced,  resulting  in  a  negative  externality  and  hence  
market  failure.    
• The  effect  of  externalities:  they  interfere  with  the  economic  efficiency  of  
market  equilibrium.  We  saw  in  chapter  5  that  a  competitive  market  
achieves  economic  efficiency  by  maximising  economic  surplus,  but  that  
result  only  holds  if  there  are  no  externalities  in  production  or  
consumption.  
 
Negative  Externality  –  causes  a  difference  between  the  private  cost  (i.e.  the  cost  
borne  by  the  producer  of  a  good  or  service;  e.g.  wages,  raw  materials,  etc.)  of  
production  and  the  social  cost  (i.e.  the  total  cost  of  producing  a  good  or  service;  
the  private  cost  +  any  other  external  cost;  e.g.  health  care  costs  arising  from  
pollution).  Unless  there  is  an  externality,  the  private  cost  =  the  social  cost.  
 • How  it  reduces  economic  efficiency  in  production:  when  there  is  a  
negative  externality  in  producing  a  good  or  service,  too  much  of  the  good  
or  service  will  be  produced  at  market  equilibrium.    
This  is  because  the  firm  doesn’t  bear  the  social  cost  of  their  production  (i.e.  
social  cost  >  private  cost).  
 
Positive  Externality  –  causes  a  difference  between  the  private  benefit  (i.e.  the  
benefit  received  by  the  consumer  of  a  good  or  service)  of  consumption  and  the  
social  benefit  (i.e.  the  total  benefit  from  consuming  a  good  or  service;  the  private  
benefit  +  any  other  external  benefit;  e.g.  the  benefit  to  others  from  your  
university  education).  Unless  there  is  an  externality,  the  private  benefit  =  the  
social  benefit.  
• How  it  reduces  economic  efficiency  in  consumption:  when  there  is  a  
positive  externality  in  consuming  a  good  or  service,  too  little  of  the  good  
or  service  will  be  consumed  and  produced  at  market  equilibrium.    
This  reduces  economic  efficiency  because  the  social  benefit  >  private  benefit.  
Because  only  the  private  benefit  is  reflected  in  the  market  demand  curve,  the  
quantity  of  the  good  or  service  produced  and  consumed  is  too  low.  At  the  
market  equilibrium  there  is  a  deadweight  loss  because  economic  surplus  is  
not  being  maximised  (i.e.  the  deadweight  loss  is  equal  to  the  loss  experienced  
when  the  good  is  being  under  consumed).  If  the  market  demand  curve  was  
D2  instead  of  D1  (i.e.  the  market  demand  curve  reflecting  the  social  benefit),  
economic  efficiency  would  be  improved  as  more  of  that  good  or  service  is  
being  consumed  and  produced.    
 
If  externalities  exist  in  production  or  consumption,  the  market  will  not  produce  
the  optimal  level  of  a  good  or  service.  This  outcome  is  referred  to  as  market  
failure.    
 
2. The  Coase  theorem.  Explain  how  private  bargaining  can  lead  to  economic  
efficiency  in  a  market  with  an  externality:  
Apart  from  government  intervention  increasing  economic  efficiency  and  
enhancing  the  wellbeing  of  society  when  externalities  are  present,  it  is  also  
possible  that  private  solutions  to  the  problem  of  externalities  can  be  found.    
To  understand  Coase’s  argument,  it  is  important  to  recognize  that  completely  
eliminating  an  externality  is  usually  not  economically  efficient.    
• The  economically  efficient  level  of  pollution  reduction:    
 
The  Coase  Theorem:  the  argument  of  economist  Ronald  Coase  that  if  
transaction  costs  are  low,  private  bargaining  will  result  in  an  efficient  solution  to  
the  problem  of  externalities.  In  addition  to  low  transaction  costs,  all  parties  to  
the  agreement  have  to  be  willing  to  accept  a  reasonable  agreement,  with  no  
unreasonable  demands.    
 
-­‐ Transactions  Costs:  the  costs  in  time  and  other  resources  that  parties  
incur  in  the  process  of  agreeing  to  and  carrying  out  an  exchange  of  
goods  or  services.  Although  the  possibility  of  a  private  solution  to  the  
problem  of  externalities  always  exists,  practical  difficulties  often  arise  
when  creating  one.  E.g.  there  are  often  both  many  polluters  and  many  
 people  suffering  from  the  negative  effects  of  pollution.  Bringing  
together  all  those  suffering  from  pollution  with  all  those  causing  the  
pollution  and  negotiating  an  agreement  often  fails  due  to  high  
transactions  costs.  In  such  cases,  a  private  solution  is  not  feasible.    
 
3. Government  policies  to  achieve  economic  efficiency  in  a  market  with  an  
externality:  
When  private  solutions  to  externalities  aren’t  feasible,  the  government  should  
intervene  to  correct  the  market  failure.  There  are  multiple  ways  of  doing  this:  
• Price  based  instruments:  imposing  a  tax  equal  to  the  external  cost  to  
internalise  the  negative  externality,  or  by  providing  a  subsidy  equal  to  the  
external  benefit  to  internalize  the  positive  externality.    
• Market  based  approaches:  includes  the  above  price-­‐based  instrument  of  
imposing  taxes  and  subsidies.  Also  includes  emission-­‐trading  schemes.    
• Command  and  control  policies:  government  imposed  quantitative  
limits  on  the  amount  of  pollution  firms  are  allowed  to  generate,  or  
government  required  installation  by  firms  of  specific  pollution  control  
devices  (i.e.  usually  in  the  form  of  regulations).  Other  examples  (apart  
from  pollution):  all  students  must  have  a  health  checkup,  maximum  
residue  limits  on  chemicals  in  agriculture,  etc.  
 
4. How  goods  can  be  categorised  on  the  basis  of  whether  they  are  rival  or  
excludable:  
The  type  of  good  differs  by  whether  its  consumption  is  rival  and  excludable.    
• Rivalry:  the  situation  that  occurs  when  one  person  consuming  a  unit  of  a  
good  means  no  one  else  can  consume  it  (e.g.  a  Big  Mac).    
• Excludability:  the  situation  in  which  anyone  who  does  not  pay  for  a  good  
cannot  consume  it  (e.g.  a  Big  Mac).  
The  consumption  of  a  good  can  be  rival  and  excludable,  or  it  can  be  non-­‐rival  (i.e.  
one  person’s  consumption  doesn’t  interfere  with  another  person’s  consumption)  
and  non-­‐excludable  (i.e.  it’s  impossible  to  exclude  others  from  consuming  the  
good,  whether  they  have  paid  for  it  or  not)  or  even  have  both  of  these  
characteristics.    
4  categories  into  which  goods  can  fall:  
• Private  Goods:  a  good  or  service  that  is  both  rival  and  excludable  (e.g.  
food,  clothing,  haircuts,  etc.).    
• Public  Goods:  a  good  or  service  that  is  both  non-­‐rival  and  non-­‐excludable  
(e.g.  national  defence,  street  lighting,  footpaths,  etc.).  Public  goods  are  
often,  although  not  always,  supplied  by  a  government  rather  than  by  
private  firms  since  private  firms  cannot  profitably  supply  them.  The  
behavior  of  consumers  in  this  situation  is  referred  to  as  free  riding  (i.e.  
benefiting  from  a  good  or  service  without  paying  for  it).    
• Quasi-­‐Public  Goods:  a  good  or  service  that  is  excludable  but  not  rival.  E.g.  
a  toll  road  –  anyone  who  doesn’t  pay  the  toll  doesn’t  use  the  road  (i.e.  
excludable),  but  one  person  using  the  road  doesn’t  interfere  with  
someone  else  using  the  road  (non-­‐rival).  Another  example  is  
cable/satellite  TV  or  a  golf  club.  
• Common  Resources:  a  good  or  service  that  is  rival  but  not  excludable.  E.g.  
fish  in  the  ocean  and  public  parks  are  common  resources.  If  one  person  
 catches  some  fish,  no  one  else  can  catch  them  (i.e.  rival).  But  if  no  one  has  
property  rights  to  the  rivers  or  oceans,  no  one  can  be  excluded  from  using  
them  (i.e.  not  excludable).  Common  resources  are  typically  overused  
(referred  to  as  the  tragedy  of  the  commons).  Tragedy  of  the  commons  
results  from  a  lack  of  clearly  defined  and  enforced  property  rights.    
 
5. Define  a  public  good  and  a  common  resource  and  use  graphs  to  illustrate  
the  efficient  qualities  of  public  goods  and  common  resources:    
The  demand  for  a  public  good:  we  find  the  market  demand  curve  for  a  public  
good  by  adding  vertically  the  price  each  consumer  would  be  willing  to  pay  for  
each  quantity  of  the  good  (unlike  private  goods  which  we  add  the  quantity,  
adding  horizontally,  of  the  good  demanded  by  each  consumer  at  each  price).  This  
can  be  done  because  with  a  public  good,  each  consumer  consumes  the  same  
quantity.    
The  optimal  quantity  of  a  public  good  occurs  where  the  demand  curve  intersects  
the  supply  curve  (i.e.  the  marginal  cost  of  supplying  the  good).  This  is  where  
economic  surplus  is  maximised.  This  can  be  achieved  through  the  government’s  
use  of  a  cost-­‐benefit  analysis  or  by  a  political  process  (i.e.  trade  offs  are  realised).  
 
Common  Resources:  refers  to  those  goods  or  services  that  are  rival  but  not  
excludable.    
The  tendency  for  a  common  resource  to  be  overused  is  called  the  tragedy  of  the  
commons.  Examples  include  
 
Lecture  6:  
Information  Failure:  an  efficient  allocation  of  resources  requires  that  everyone  
be  informed  about  everything.  This  raises  3  questions:  
Do  markets  generate  optimal  amounts  of  information?  
• Markets  do  not  generate  information  in  an  optimal  way  given  that  once  
produced,  knowledge  is  non-­‐rival  in  consumption  and  has  positive  
externalities.  
• Hence  firms  are  likely  to  underinvest  in  research  or  knowledge.  
 
What  happens  when  some  agents  have  information  not  available  to  others  (i.e.  
asymmetric  information)?  
-­‐ E.g.  customer  has  more  knowledge  than  the  insurer.    
 
Do  individuals  act  in  their  best  interests  (i.e.  merit  goods)?  
• Merit  goods:  government  considers  individuals  should  consume  these  
even  though  they  don’t  demand  them  (e.g.  seat  belts  and  compulsory  
education).    
• Demerit  goods:  government  considers  individuals  should  consume  these  
in  smaller  quantities  (e.g.  alcohol,  cigarettes,  gambling,  etc.).    
 
Government  intervention  to  solve  information  failure:  
  
 
Tutorial  7:  
Price  Regulation:  
Q’s  chapter  3  –  q11  and  12.  
 
Chapter  15:  
Externalities  –  implications  on  third  party.    
Q7:  a)  chewing  gum  –  negative  externality  is  the  costs  of  cleaning  it  (studies  
found  that  removing  chewing  gum  would  improve  MRT  efficiency  by  30%).    
b)  listening  devices  (maximum  of  100  decibels)  –  negative  externalities  -­‐  hearing  
damages  mean  the  government  increases  health  care  expenditure.    
 
American  Civil  War:  
-­‐ Lincoln  freed  the  slaves  because  their  costs  were  too  high.    
 
 
Week  8  –  Technology,  Production  and  Cost:  
Chapter  7  –  ‘Technology,  Production  and  Costs’:  
1. Technology  definition  and  examples  of  technological  change:  
• Technology  Definition:  technology  refers  to  the  processes  a  firm  uses  to  
turn  inputs  into  outputs,  being  the  goods  and  services.    
• Technological  Change:  the  change  in  the  ability  of  a  firm  to  produce  a  
different  level  of  output  with  a  given  quantity  of  inputs.    
Whenever  a  firm  experiences  technological  change,  it  is  able  to  produce  more  
output  using  the  same  amount  of  inputs,  or  the  same  output  using  fewer  
inputs  (i.e.  increased  productivity).  It  can  come  from  many  sources,  e.g.  the  
firm’s  workers  may  go  through  a  training  program,  the  firm  may  install  new  
and  advanced  machinery  and  equipment,  etc.    
 
2. The  economic  short  run  and  the  economic  long  run:  
• The  Short  Run:  the  period  of  time  during  which  at  least  one  of  the  firm’s  
inputs  is  fixed  (e.g.  the  firm’s  technology  and  the  size  of  its  physical  plant  
is  fixed  in  the  short  run).  The  actual  length  of  time  in  the  short  run  will  
vary  from  firm  to  firm  (e.g.  a  pizza  shop  may  be  able  to  increase  its  
physical  plant  by  adding  another  pizza  oven,  while  General  Motors  
Holden  may  take  more  than  a  year  to  increase  the  capacity  of  one  of  its  
 car  assembly  plants).  However,  some  inputs  are  variable  in  the  short  run,  
such  as  the  number  of  workers  the  firm  hires.  
• The  Long  Run:  a  period  of  time  long  enough  to  allow  a  firm  to  vary  all  of  
its  inputs,  to  adopt  new  technology  and  to  increase  or  decrease  the  size  of  
its  physical  plant.    
 
Fixed  costs  and  variable  costs:  
Total  Cost  –  is  the  cost  of  all  the  inputs  a  firm  uses  in  production  (total  cost  =  
fixed  costs  +  variable  costs).  
In  the  short  run,  some  inputs  are  fixed  while  others  are  variable:  
• Fixed  Costs  –  are  the  costs  of  fixed  inputs.  These  costs  remain  constant  as  
the  quantity  of  output  changes  (e.g.  lease  payments  for  the  factory  or  
retail  space,  insurance  costs,  advertising,  etc.).    
• Variable  Costs  –  are  the  costs  of  variable  inputs.  These  costs  change  as  the  
quantity  of  output  changes  (e.g.  labour  costs,  raw  materials  costs,  etc.).  
 
Implicit  costs  vs.  explicit  costs:  
Economists  always  measure  costs  as  opportunity  costs,  which  can  be  categorised  
into  two  types  of  opportunity  costs:  
• Explicit  Costs  –  a  cost  that  involves  spending  money  (e.g.  the  wages  paid  
to  workers,  payments  made  for  electricity,  etc.).  
• Implicit  Costs  –  a  non-­‐monetary  opportunity  cost  (e.g.  depreciation,  
forgone  salary,  forgone  interest,  etc.).  
Economic  costs  =  explicit  +  implicit  costs.    
 
The  production  function:  refers  to  the  relationship  between  the  inputs  
employed  by  the  firm  and  the  maximum  output  it  can  produce  with  those  inputs.  
Because  a  firm’s  technology  is  the  processes  it  uses  to  turn  inputs  into  outputs,  
the  production  function  represents  the  firm’s  technology.    
 
The  relationship  between  production  and  cost:    
Average  total  cost  –  total  cost  divided  by  the  quantity  of  output  produced.    
As  production  increases  from  low  levels,  the  average  cost  falls.  After  reaching  a  
minimum  average  cost  level,  the  average  cost  then  begins  rising  at  higher  levels  
of  production  (i.e.  average  total  cost  curve  is  U-­‐shaped).  To  understand  the  U-­‐
shape  of  the  average  total  cost  curve  we  must  look  more  closely  at  the  
technology  of  producing  that  good  or  service,  as  shown  by  the  production  
function.    
 
3. The  marginal  product  of  labour  and  the  average  product  of  labour:  
Marginal  product  of  labour:  the  additional  output  a  firm  produces  as  a  result  of  
hiring  one  more  worker.  This  can  be  calculated  by  determining  how  much  total  
output  increases  as  each  additional  worker  is  hired.    
The  increases  in  the  marginal  product  of  labour  result  from  the  division  of  labour  
(i.e.  reduces  the  time  workers  lose  from  moving  from  one  activity  to  the  next)  
and  specialisation  (i.e.  the  worker  becomes  more  skilled  and  efficient  if  they  are  
responsible  for  only  the  one  activity).    
 
The  law  of  diminishing  returns:  the  principle  that,  at  some  point,  adding  more  
of  a  variable  input  (e.g.  labour)  to  the  same  amount  of  a  fixed  input  (e.g.  capital)  
will  cause  the  marginal  product  of  the  variable  input  to  decline.    
The  effects  of  the  law  of  diminishing  returns  are  experienced  because  at  some  
point,  the  firm  uses  up  all  the  gains  from  the  division  of  labour  and  from  
specialisation.  This  begins  to  occur  when  total  output  is  still  increasing,  but  at  a  
decreasing  rate  (e.g.  hiring  4  workers  raises  the  quantity  of  output  by  400  units,  
but  the  increase  in  the  quantity  of  output  when  the  third  worker  was  hired  was  
875).    
In  other  words,  this  law  explains  why  short  run  MC  curves  slope  upwards  
(unrelated  to  diseconomies  of  scale  which  explains  why  long  run  AC  curves  
eventually  slope  upwards).    
 
The  relationship  between  marginal  and  average  product  of  labour:  
Average  product  of  labour  –  the  total  output  produced  by  a  firm  divided  by  the  
quantity  of  workers.    
The  relationship  between  the  marginal  and  average  products  of  labour  is:  the  
average  product  of  labour  is  the  average  of  the  marginal  products  of  labour.    
Whenever  the  marginal  product  of  labour  is  greater  than  the  average  product  of  
labour,  the  average  product  of  labour  must  be  increasing.    
Whenever  the  marginal  product  of  labour  is  less  than  the  average  product  of  
labour,  the  average  product  of  labour  must  be  decreasing.    
E.g.  MPL  for  1st  worker  is  625,  MPL  for  2nd  worker  is  700  and  the  MPL  for  3rd  
worker  is  875.  Add  all  these  together  and  ÷  3  =  APL,  which  is  733.3.    
 
4. The  relationship  between  marginal  cost  and  average  total  cost:  
We  have  seen  that  technology  determines  the  values  of  MPL  and  APL.  In  turn,  
MPL  and  APL  will  affect  the  firm’s  short-­‐term  costs.  
 
Marginal  Cost:  the  change  in  a  firm’s  total  cost  from  producing  one  more  unit  of  
a  good  or  service.    
 
The  relationship  between  MC  and  ATC:  to  explain  this  relationship,  we  have  to  
look  at  why  MC  increases  and  decreases.  It  is  determined  by  the  MPL.  When  the  
MPL  is  rising,  the  MC  of  output  will  be  falling.  When  the  MPL  is  falling,  the  MC  of  
production  will  be  rising.  We  can  conclude  that  the  MC  of  production  falls  and  
then  rises  –  producing  a  U-­‐shape  –  because  the  MPL  rises  and  then  falls.    
The  relationship  between  MC  and  ATC  follows  the  usual  relationship  between  
marginal  and  average  values.  When  MC  is  below  ATC,  ATC  will  fall.  When  MC  is  
above  ATC,  ATC  will  rise.  This  relationship  between  MC  and  ATC  explains  why  
the  ATC  curve  also  has  a  U-­‐shape.    
 
5. Graph  average  total  cost,  average  fixed  cost  and  marginal  cost:  
*Graphing  of  cost  curves  in  exercise  book.  
There  are  3  key  facts  about  the  cost  curve:  
• The  MC,  ATC  and  AVC  are  all  U-­‐shaped,  and  the  MC  curve  intersects  the  
AVC  and  ATC  curves  at  their  minimum  points.  Since  when  MC  is  above  
AVC  and  ATC  it  causes  them  to  increase,  and  when  MC  is  below  them  it  
causes  them  to  decrease,  their  minimum  points  would  be  when  the  MC  =  
 AVC  or  ATC  (i.e.  when  MC  intersects  them  is  where  their  minimum  point  
occurs).    
• As  output  increases,  AFC  gets  smaller  and  smaller.  This  happens  because  
in  calculating  AFC  we  are  dividing  something  that  gets  larger  and  larger  –  
output  –  into  something  that  remains  constant  –  FC.  This  is  often  referred  
to  as  ‘spreading  the  overhead’.    
• As  output  increases,  the  difference  between  ATC  and  AVC  decreases.  This  
occurs  because  the  difference  between  ATC  and  AVC  is  AFC,  which  gets  
smaller  as  output  increases  (which  is  stated  in  the  previous  point).    
 
6. How  firms  use  the  long-­‐run  average  cost  curve  in  their  planning:  
The  distinction  between  FC  and  VC  we  have  just  discussed  in  the  short  run  does  
not  apply  in  the  long  run.  This  is  because  in  the  long  run,  all  costs  are  variable  (i.e.  
long  run  TC  =  VC  and  ATC  =  AVC).    
 
Economies  of  scale:  exist  when  a  firm’s  long  run  average  costs  fall  as  it  
increases  scale  of  production  and  the  quantity  of  output  it  produces.    
Managers  can  use  long  run  average  cost  curves  for  planning  because  they  show  
the  effect  on  cost  of  expanding  output  by,  for  example,  building  a  larger  factory.    
Why  firms  may  encounter  economies  of  scale:  
• As  with  the  case  of  the  larger  bookshop,  the  firm’s  technology  may  make  
it  possible  to  increase  production  with  a  smaller  proportional  increase  in  
at  least  one  input.  
• Both  workers  and  managers  can  become  more  specialized,  enabling  them  
to  become  more  productive,  as  output  expands.  
• Large  firms  may  be  able  to  purchase  inputs  at  lower  costs  than  smaller  
competitors.  This  is  because  their  bargaining  power  with  respect  to  its  
suppliers  increased.  
• As  a  firm  expands  it  may  be  able  to  borrow  money  more  cheaply,  thereby  
lowering  its  costs.  
Economies  of  scale  do  not  continue  forever.  Over  time,  most  firms  will  build  
factories  or  stores  that  are  at  least  as  large  as  the  minimum  efficient  scale  but  not  
so  large  that  diseconomies  of  scale  occur.    
• Constant  returns  to  scale:  exist  when  a  firm’s  long  run  average  costs  
remain  unchanged  as  it  increases  its  scale  of  production  and  the  quantity  
of  output.    
• Minimum  efficient  scale:  the  level  of  output  at  which  all  economies  of  
scale  have  been  exhausted.  As  these  firms  increase  their  scale  of  
production  and  quantity  of  output,  they  will  have  to  increase  their  inputs  
proportionally.    
• Diseconomies  of  scale:  exist  when  a  firm’s  long  run  average  costs  rise  as  it  
increases  its  scale  of  production  and  quantity  of  output.  This  occurs  
because  managers  begin  to  experience  difficulty  in  coordinating  the  
operation  of  the  store  due  to  the  more  complex  organisational  structure  
of  the  firm  that  comes  with  a  larger  operation  (e.g.  numerous  locations,  
increased  number  of  management  layers,  etc.).  The  increased  difficulty  of  
monitoring  and  controlling  the  larger  operation  increases  the  firm’s  costs.    
E.g.  long  run  ATC  curves  for  bookshops:  for  the  small  bookshop,  the  ATC  of  
selling  1000  books  per  month  would  be  $22  per  book.  For  a  much  larger  
bookshop,  the  ATC  of  selling  20000  books  per  month  would  only  be  $18  per  
book.  This  decline  in  average  cost  represents  the  economies  of  scale  that  exist  in  
bookselling.  The  reason  for  the  larger  bookshop  having  lower  average  costs  is  
that  it  is  selling  20  times  as  many  books  per  month  as  the  small  store,  but  might  
need  only  6  times  as  much  electricity.  This  saving  in  electricity  cost  would  
reduce  the  larger  bookshop’s  cost  of  selling  books.    
 
 
The  4  Market  Structures  (weeks  9-­‐11):  
Industries  can  be  grouped  into  4  market  structures:  
• Perfect  Competition  (week  9).  
• Monopoly  (week  10).  
• Monopolistic  Competition  (week  10).  
• Oligopoly  (week  11).  
Characteristic   Perfect   Monopoly   Monopolistic   Oligopoly  
Competition   Competition  
Number  of   Many   One   Many   Few  
firms  
Type  of  product   Identical   Unique   Differentiated   Identical  or  
differentiated  
Easy  of  entry   High   Entry  blocked   High   Low  
Examples   Wheat,  apples   Letter  delivery,   Restaurants,   Manufacturing  
tap  water   selling  DVD’s   cars,  computers  
 
 
Week  9  –  Firms  in  Perfectly  Competitive  Markets:  
Chapter  8  –  ‘Firms  in  Perfectly  Competitive  Markets’:  
1. What  a  perfectly  competitive  market  is  and  why  a  perfect  competitor  
faces  a  horizontal  demand  curve:  
A  perfectly  competitive  market:  a  market  that  meets  the  conditions  of:  
-­‐ Many  buyers  and  sellers.  
-­‐ The  products  sold  by  all  firms  in  the  market  must  be  identical.  
-­‐ No  barriers  to  new  firms  entering  the  market.    
• A  perfectly  competitive  firm  cannot  affect  the  market  price:  because  a  
firm  in  a  perfectly  competitive  market  is  very  small  relative  to  the  market  
and  because  it  is  selling  exactly  the  same  product  as  every  other  firm,  it  
can  sell  as  much  as  it  wants  without  having  to  lower  its  price.  But  if  a  
perfectly  competitive  firm  tries  to  raise  its  price  their  sales  will  drop  to  
zero,  because  consumers  will  switch  to  buying  the  product  from  the  firm’s  
competitors.  Therefore,  the  firm  will  be  a  price  taker  (i.e.  a  buyer  or  seller  
that  is  unable  to  affect  the  market  price).  Any  one  competitive  firm  cannot  
affect  the  market  price  because  the  market  supply  curve  will  not  shift  by  
enough  to  change  the  equilibrium  price  by  even  one  cent  (i.e.  they  are  too  
small  relative  to  the  market).  
• The  demand  curve  for  the  output  of  a  perfectly  competitive  firm:  a  firm  in  
a  perfectly  competitive  market  is  selling  exactly  the  same  product  as  
many  other  firms.  Therefore  it  can  sell  as  much  as  it  wants  at  the  current  
market  price,  but  it  cannot  sell  anything  at  all  if  it  raises  the  price  by  even  
one  cent.  As  a  result,  the  demand  curve  for  a  perfectly  competitive  firm’s  
output  is  a  horizontal  line  (i.e.  perfectly  elastic)  at  the  market  price.    
  
2. How  a  firm  maximises  profits  in  a  perfectly  competitive  market:  
• Revenue  for  a  firm  in  a  perfectly  competitive  market:    
-­‐ Average  Revenue  (AR):  total  revenue  ÷  the  number  of  units  sold.  
-­‐ Marginal  Revenue  (MR):  change  in  total  revenue  from  selling  one  
more  unit  (the  MR  curve  for  a  perfectly  competitive  firm  is  the  same  
as  its  demand  curve,  as  it  is  at  a  constant  price).    
For  a  firm  in  a  perfectly  competitive  market,  price  is  equal  to  both  AR  and  MR  at  
any  level  of  output.    
Determining  the  profit-­‐maximising  level  of  output:  To  maximise  profit,  the  
firm  should  produce  the  quantity  where  the  difference  between  the  total  revenue  
they  receive  and  their  total  cost  is  as  large  as  possible.  This  profit  maximising  
level  of  output  is  also  where  MR  =  MC  (if  there  isn’t  a  quantity  where  MR  exactly  
=  MC,  you  would  produce  the  quantity  where  MC  <  MR  that  is  closest  to  MR  =  
MC).    
Producers  will  continue  to  produce  until  the  MR  they  receive  from  selling  an  
additional  unit  is  equal  to  the  MC  of  producing  it.  At  this  level  of  output,  they  will  
make  no  additional  profit  by  selling  another  unit,  so  they  will  have  maximised  
profits.    
 
3. Graphs  to  show  a  firm’s  profit  or  loss:  
Total  profit  is  represented  by  the  area  of  the  rectangle  which  has  a  height  equal  
to  (P  –  ATC)  and  a  width  equal  to  Q.    
 
We  have  seen  that  to  maximise  profit  a  firm  produces  the  level  of  output  where  
MR  =  MC.  But  will  the  firm  actually  make  a  profit  at  that  level  of  output?  It  
depends  on  the  relationship  between  price  (P)  and  ATC.  There  are  3  possibilities:  
-­‐ P  >  ATC,  which  means  the  firm  makes  a  profit.  
-­‐ P  =  ATC,  which  means  the  firm  breaks  even.  
-­‐ P  <  ATC,  which  means  the  firm  experiences  losses.  In  this  case,  
maximising  profits  amounts  to  minimising  losses.  
*A  graph  of  these  possibilities  are  on  page  237-­‐239.    
 
4. Why  firms  may  shut  down  temporarily:  
In  the  short  run,  a  firm  suffering  losses  has  two  choices:  
• Continue  to  produce:  a  firm  can  reduce  its  loss  below  the  amount  of  the  
TFC  by  continuing  to  produce  provided  that  the  TR  >  VC.  The  revenue  
over  and  above  the  VC  can  be  used  to  cover  part  of  the  firm’s  FC,  resulting  
in  the  firm  experiencing  a  smaller  loss  by  continuing  to  produce  than  if  it  
shut  down.    
• Stop  production  by  shutting  down  temporarily:  even  during  a  
temporary  shut  down  a  firm  must  still  pay  its  fixed  costs.  Therefore,  if  a  
firm  doesn’t  produce  it  will  suffer  a  loss  equal  to  its  fixed  costs.  This  loss  
is  the  maximum  the  firm  will  accept.  The  firm  will  shut  down  if  producing  
would  cause  it  to  lose  an  amount  greater  than  its  fixed  costs.    
In  analysing  the  firm’s  decision  to  shut  down,  we  are  assuming  that  its  FC  are  
sunk  costs  (i.e.  a  cost  that  has  already  been  paid  and  that  cannot  be  recovered).  
Therefore,  the  firm  should  treat  its  sunk  costs  as  less  relevant  to  its  decision  
making.  Whether  the  firm’s  TR  is  greater  or  less  than  its  VC  is  the  key  to  deciding  
whether  or  not  to  shut  down  (i.e.  if  P  <  AVC  the  firm  will  shut  down).  
One  option  not  available  to  a  firm  with  losses  in  a  perfectly  competitive  market  is  
raise  its  price.  If  they  did  this  they  would  lose  all  its  customers  due  to  its  
perfectly  elastic  demand  curve.  
 
The  supply  curve  of  the  firm  in  the  short  run:    
The  perfectly  competitive  firm’s  MC  curve  is  also  its  supply  curve.    
If  P  <  AVC,  the  firm  will  have  a  smaller  loss  if  it  shuts  down  and  produces  no  
output.  This  then  causes  the  supply  curve  below  the  minimum  price  at  which  the  
firm  will  continue  to  produce  to  become  a  vertical  line  along  the  price  axis,  which  
shows  that  the  firm  will  supply  0  output  at  those  prices.  Therefore  the  firm’s  MC  
curve  is  its  supply  curve  only  for  prices  at  or  above  AVC.  
 
The  market  supply  curve  in  a  perfectly  competitive  industry:  the  key  point  
here  is  that  we  can  derive  the  market  supply  curve  by  adding  up  the  quantity  
that  each  firm  in  the  market  is  willing  to  supply  at  each  price.    
 
5. How  entry  and  exit  ensure  that  perfectly  competitive  firms  earn  zero  
economic  profit  in  the  long  run:  
Economic  Profit:  a  firm’s  revenue  minus  all  its  costs,  implicit  and  explicit.  
 
Economic  profit  leads  to  entry  of  new  firms:  once  other  firms  see  that  a  firm  is  
earning  an  economic  profit  greater  than  what  they  are  currently  earning,  they  
will  convert  to  that  particular  industry.  The  greater  number  of  firms  in  the  
market  that  this  creates  now  shifts  the  supply  curve  further  to  the  right.  This  in  
turn  lowers  the  market  price  and  also  reduces  the  output  of  the  firms.  In  the  long  
term,  this  results  in  their  TR  =  TC  (same  as  P  =  ATC)  and  zero  economic  profit.    
*Although  these  firms  may  be  earning  an  accounting  profit  (i.e.  $40,000),  an  
economist  would  see  the  firm  as  just  breaking  even.  This  is  because  the  
economic  profit  takes  into  account  all  the  costs  (i.e.  implicit  as  well  as  explicit  
costs).  
 
Economic  losses  lead  to  exit  of  firms:  a  decline  in  demand  for  a  good  reduces  
that  good’s  market  price  and  the  existing  firms’  output.  This  results  in  economic  
losses  of  the  firms  in  that  particular  market.  These  losses  result  in  the  exit  of  
some  loss-­‐making  firms,  which  will  continue  as  long  as  P  <  ATC,  but  will  stop  
when  P  =  ATC.  The  exit  of  loss-­‐making  firms  shifts  the  supply  curve  to  the  left  
and  raises  the  market  price.  In  the  long  run,  the  remaining  firms  will  then  break  
even  as  P  =  ATC,  and  will  earn  zero  economic  profit.    
 
Long  run  equilibrium  in  a  perfectly  competitive  market:  this  refers  to  the  
situation  in  which  the  entry  and  exit  of  firms  has  resulted  in  the  typical  firm  
breaking  even:  
-­‐ The  entry  of  firms  forces  the  market  price  down  until  the  typical  firm  
is  breaking  even.  
-­‐ The  exit  of  firms  forces  up  the  equilibrium  market  price  until  the  
typical  firm  is  breaking  even.    
In  any  perfectly  competitive  market  an  opportunity  to  make  economic  profits  
never  lasts  for  long.  ‘If  everyone  can  do  it,  you  can’t  make  money  at  it’.    
 
The  long  run  supply  curve  in  a  perfectly  competitive  market:  the  long  run  
supply  curve  shows  the  relationship  between  market  price  and  the  quantity  
supplied.  
In  the  long  run,  a  perfectly  competitive  market  will  supply  whatever  amount  of  a  
good  consumers  demand  at  a  price  determined  by  the  minimum  point  on  the  
typical  firm’s  ATC  curve  (i.e.  the  price  at  which  the  typical  firm  in  the  industry  
breaks  even).  
Because  the  position  of  the  long  run  supply  curve  is  determined  by  the  minimum  
point  on  the  typical  firm’s  ATC  curve,  anything  that  raises  or  lowers  the  costs  of  
the  typical  firm  in  the  long  run  will  cause  the  long  run  supply  curve  to  shift.  E.g.  if  
disease  infects  fruit  trees  and  the  costs  of  treating  the  disease  adds  $2  per  box  to  
the  cost  of  producing  the  fruit,  the  long  run  supply  curve  will  shift  up  by  $2.  
 
6. How  perfect  competition  leads  to  economic  efficiency:    
• Productive  Efficiency:  the  situation  in  which  a  given  quantity  of  a  g  or  s  
is  produced  using  the  least  amount  of  resources.  The  managers  of  every  
firm  in  a  perfectly  competitive  market  strive  to  earn  an  economic  profit  
by  reducing  costs.  In  the  long  run,  only  the  consumer  benefits  from  cost  
reductions.  
• Allocative  Efficiency:  a  state  of  the  economy  in  which  production  reflects  
consumer  preferences  (i.e.  the  g  +  s  that  consumers  value  the  most  are  
produced),  in  particular  every  g  or  s  is  produced  up  to  the  point  where  
the  last  unit  provides  a  MB  to  consumers  equal  to  the  MC  of  producing  it.    
• Dynamic  Efficiency:  the  ability  of  firms  over  time  to  develop  and  utilise  
technological  innovation,  and  to  adapt  their  product  to  changes  in  
consumer  preferences  and  tastes.  Firms  must  be  dynamically  efficient  in  a  
perfectly  competitive  market  in  order  to  survive  in  the  highly  competitive  
environment.  3  
   
 
Week  10  –  Monopoly  and  Monopolistic  Competition:  
Chapter  9  –  ‘Monopoly  Markets’:  
1. Define  monopoly:  
A  monopoly  is  a  firm  that  is  the  only  seller  of  a  g  or  s  that  does  not  have  a  close  
substitute.  Although  substitutes  of  some  kind  exist  for  just  about  every  product,  
firms  can  still  be  monopolies,  provided  that  the  substitutes  are  not  ‘close’  
substitutes.  
Deciding  if  a  substitute  is  a  close  substitute  can  be  determined  by  seeing  whether  
a  firm  can  ignore  the  actions  of  all  other  firms.  If  it  can,  then  it  is  a  monopoly  and  
there  is  no  close  substitutes  (e.g.  tap  water  and  bottled  water  are  substitutes  as  
they  serve  the  same  purpose,  however  no  customer  will  give  up  tap  water  for  
bottled  water  so  the  local  water  company  can  ignore  bottled  water  prices).    
E.g.  a  pizza  shop  may  not  be  a  monopoly  since  many  customers  can  buy  other  
food  to  avoid  starving.  However,  the  pizza  shop  may  be  a  monopoly  in  the  
market  for  pizzas.    
 
 2. The  four  main  reasons  why  monopolies  arise  (the  lecture  calls  these  
sources  of  market  power  for  a  monopoly):  
Barriers  to  entry  may  be  high  enough  to  keep  out  competing  firms  for  4  main  
reasons:  
• Entry  blocked  by  government  action:  in  Australia  the  government  
blocks  entry  in  two  main  ways:  
-­‐ By  granting  a  patent  or  copyright  to  an  individual  or  a  firm,  which  
gives  it  the  exclusive  right  to  produce  a  product:  a  patent  is  the  
exclusive  right  to  produce  and  sell  a  product  for  a  period  of  time  from  
the  date  the  product  was  invented  (e.g.  because  Microsoft  has  a  patent  
on  the  Windows  operating  system  other  firms  cannot  sell  their  own  
versions  of  Windows).  Patents  encourage  firms  to  spend  money  on  the  
R&D  necessary  to  create  new  products.  If  other  firms  could  have  freely  
copied  Windows,  Microsoft  would  have  been  unlikely  to  develop  it.  
The  profits  the  firm  earns  will  increase  during  the  patent  protection  
period.  After  the  patent  has  expired,  other  firms  are  now  legally  free  to  
produce  identical  products.  Gradually,  competition  from  these  
identical  products  will  eliminate  the  profits  the  original  firm  had  been  
earning.      
A  copyright  is  the  legal  right  of  the  creator  of  a  book,  movie,  piece  of  
music  or  software  program  to  the  exclusive  right  to  use  the  creation  
during  the  creator’s  lifetime,  plus  an  additional  period  of  time  for  their  
heirs.  In  effect,  copyrights  create  monopolies  for  the  copyrighted  
items.  Without  copyrights,  individuals  and  firms  would  be  less  likely  
to  invest  in  creating  new  books,  films,  music  and  software.    
-­‐ By  granting  a  firm  a  public  franchise:  which  makes  a  firm  the  exclusive  
legal  provider  of  a  g  or  s.  A  public  franchise  is  a  designation  by  the  
government  that  a  firm  is  the  only  legal  provider  of  a  g  or  s.  E.g.  the  
state  government  will  often  designate  one  company  as  the  sole  
provider  of  electricity  or  water.  
• Control  of  a  key  resource:  this  means  that  a  firm  has  their  own  access  to  
a  resource  which  no  other  firm  can  reach.  However,  this  happens  
infrequently  because  most  resources  are  widely  available  from  a  variety  
of  suppliers.  A  few  examples  exist  including  Alcoa  and  BHP  Billiton.    
• Network  externalities:  exist  when  the  usefulness  of  a  product  increases  
with  the  number  of  consumers  who  use  it.  E.g.  if  you  owned  the  only  
mobile  phone  in  the  world  it  would  not  be  very  useful.  The  more  mobile  
phones  in  use,  the  more  valuable  they  become  to  consumers.  
This  is  a  barrier  to  entry  because  of  the  cycle  it  sets  off  –  if  a  firm  can  
attract  enough  customers  initially  it  can  attract  additional  customers  
because  its  product’s  value  has  been  increased  by  more  people  using  it,  
which  attracts  even  more  customers  and  so  on  (e.g.  because  eBay  was  the  
first  internet  auction  site,  more  people  continue  to  prefer  it  over  
Amazon.com  and  other  auction  sites  because  eBay  already  has  the  largest  
number  of  users).    
• Natural  monopoly:  a  situation  in  which  economies  of  scale  are  so  large  
that  one  firm  can  supply  the  entire  market  at  a  lower  average  cost  than  
two  or  more  firms.  Natural  monopolies  are  most  likely  to  occur  in  
markets  where  FC  are  very  large  relative  to  VC.  E.g.  a  firm  that  produces  
 electricity  must  make  a  substantial  investment  in  the  machinery  and  
equipment  necessary  to  generate  the  electricity.  Once  the  initial  
investment  has  been  made,  the  MC  of  producing  another  kilowatt-­‐hour  of  
electricity  is  relatively  small.    
 
3. How  a  monopoly  chooses  price  and  output:  
Life  every  other  firm,  a  monopoly  maximises  profit  by  producing  where  MR  =  
MC.  A  monopoly  differs  from  other  firms  in  that  a  monopoly’s  demand  curve  is  the  
same  as  the  demand  curve  for  the  product.    
A  monopoly  is  a  price  maker.    
 
MR  curve  and  the  demand  curve:  if  a  monopoly  raises  their  prices  they  will  
lose  some,  but  not  all,  of  their  customers.  Therefore  they  face  a  downward  
sloping  demand  curve.  Because  of  this  they  face  a  downward  sloping  MR  curve  
as  well,  which  is  actually  positioned  below  its  demand  curve.  A  firm’s  MR  curve  
slopes  downwards  if  its  demand  curve  slopes  downwards  because:    
E.g.  to  sell  more  subscriptions  Austar  must  lower  the  price  (i.e.  downward  
sloping  demand  curve).  When  this  happens  it  gains  revenue  from  selling  more  
subscriptions,  but  loses  revenue  from  selling  the  subscriptions  at  a  lower  price  
than  they  could  have  been  sold  at  (the  firm’s  MR  =  the  change  in  revenue  from  
selling  another  subscription).  As  a  result,  Austar’s  MR  <  the  price  for  every  
subscription  sold  after  the  first  one.  Therefore,  Austar’s  MR  curve  will  be  below  
its  demand  curve.    
Every  firm  that  has  the  ability  to  affect  the  price  of  a  g  or  s  that  it  sells  will  have  a  
MR  curve  that  is  below  its  demand  curve.  
 
Profit  maximisation  for  a  monopolist:  to  maximise  profit  Austar  should  sell  
subscriptions  up  to  the  point  where  the  MR  from  selling  the  last  subscription  =  
its  MC.  In  this  case  the  MR  from  selling  the  6th  subscription  and  the  MC  are  both  
$27  (i.e.  6  subscriptions  is  the  profit  maximising  quantity).  Its  profit  maximising  
price  is  $42.    
The  green  box  in  panel  (b)  represents  Austar’s  profits.  The  box  has  a  height  =  
$12  (height  =  P  –  ATC  =  $42  -­‐  $30  =  $12)  and  a  width  =  6  (width  =  quantity  =  6).  
Therefore  its  profit  =  $12  x  6  =  $72.  We  could  also  calculate  Austar’s  total  profit  
as  TR  from  selling  6  subscriptions  –  its  total  cost  (profit  =  (6  x  $42)  –  ($30  x  6)  =  
$252  -­‐  $180  =  $72).  
It’s  important  to  note  that  even  though  Austar  is  earning  economic  profits,  new  
firms  will  not  enter  the  market.  Because  Austar  is  a  monopoly  it  will  not  face  
competition  from  other  pay  television  operators.  Therefore,  ceteris  paribus,  
Austar  will  be  able  to  continue  to  earn  economic  profits,  even  in  the  long  run.  
 
4. Graph  to  illustrate  how  a  monopoly  affects  economic  efficiency:  
What  happens  to  economic  surplus  under  monopoly?  
Comparing  monopoly  and  perfect  competition:  unlike  perfect  competition,  a  
monopoly  will  restrict  output  levels  and  charge  a  price  higher  than  MC.    
 
Measuring  the  efficiency  losses  from  monopoly:    
• Consumer  surplus:  the  higher  price  in  a  monopoly  reduces  consumer  
surplus  compared  with  perfect  competition.  
 • Producer  surplus:  the  increase  in  price  due  to  monopoly  increases  
producer  surplus.  
• Economic  surplus:  by  increasing  price  and  reducing  the  quantity  
produced,  the  monopolist  has  reduced  economic  surplus.  This  reduction  in  
economic  surplus  is  called  deadweight  loss  and  represents  the  loss  of  
economic  efficiency  due  to  monopoly  (specifically  a  reduction  in  
allocative  efficiency).    
 
How  large  are  the  efficiency  losses  due  to  monopoly?  We  know  that  there  are  
relatively  few  monopolies,  so  the  loss  of  economic  efficiency  due  to  monopoly  
must  be  small.  
Many  firms  though,  have  market  power  (i.e.  the  ability  of  a  firm  to  charge  a  price  
greater  than  MC).  Some  loss  of  economic  efficiency  will  occur  whenever  a  firm  
has  market  power,  even  if  the  firm  isn’t  a  monopoly.  The  only  firms  that  do  not  
have  market  power  are  firm  in  perfectly  competitive  markets,  as  they  must  
charge  a  price  =  MC.  Because  few  markets  are  perfectly  competitive,  some  loss  of  
economic  efficiency  occurs  in  the  market  for  nearly  every  g  or  s.    
The  closer  price  is  to  MC,  the  smaller  the  size  of  the  deadweight  loss.  This  is  one  
of  the  main  reasons  as  to  why  governments  of  market  economies  usually  have  
policies  promoting  competition  in  the  market.  
 
5. Government  policies  towards  monopolies:  
Because  monopolies  reduce  economic  efficiency  and  consumer  surplus,  most  
governments  have  policies  that  regulate  their  behaviour.    
Firms  that  are  not  monopolies  have  an  incentive  to  avoid  competition  by  
colluding  (i.e.  an  agreement  between  firms  to  charge  the  same  price,  or  
otherwise  not  compete)  on  output  and  price.  In  Australia  trade  practices  laws  
are  aimed  at  deterring  monopolies,  eliminating  collusion  and  promoting  
competition  between  firms.    
 
Trade  practices  laws  and  enforcement:  in  Australia  the  competitive  behaviour  
of  firms  is  monitored  by  the  Australian  Competition  and  Consumer  Commission  
(ACCC).  These  are  a  set  of  policies  formed  by  the  federal  government  in  1995  to  
promote  competition,  openness  and  efficiency  in  the  Australian  economy.    
The  central  component  of  Australian  law  regarding  business  trading  practices  is  
the  Competition  and  Consumer  Act  2010  (CCA).  Trade  practices  law  aims  to  
foster  competition  between  firms  to  increase  economic  efficiency  and  to  lead  to  
greater  welfare  for  consumers.  The  ACCC  has  the  responsibility  of  enforcing  the  
CCA,  and  if  companies  are  found  by  the  courts  to  be  in  breach  of  the  CCA  they  
face  large  fines  and  possible  jail  terms.    
 
Public  ownership:  usually  for  natural  monopolies  (e.g.  telephone,  gas,  
electricity,  rail,  etc.)  
   
Direct  regulation  of  price:  average  cost  pricing  and  price  cap.  
 
Mergers  –  the  trade-­‐off  between  market  power  and  efficiency:  the  ACCC  
regulates  business  mergers  because  it  knows  that  if  firms  gain  market  power  by  
merging,  they  may  use  that  market  power  to  raise  prices  and  reduce  output.    
 • Horizontal  mergers:  a  merger  between  firms  in  the  same  industry.  These  
are  more  likely  to  increase  market  power  than  vertical  mergers.  
• Vertical  mergers:  a  merger  between  firms  at  different  stages  of  
production  of  a  good  (e.g.  a  merger  between  a  company  making  personal  
computers  and  a  company  making  computer  hard  drives).    
 
Regulating  natural  monopolies:  if  a  firm  is  a  natural  monopoly,  competition  
from  other  firms  will  not  play  its  usual  role  of  forcing  price  down  to  the  level  
where  the  company  earns  zero  economic  profit.  Since  natural  monopolies  can  
achieve  very  low  costs  when  producing  large  quantities,  they  have  the  potential  
to  charge  high  prices  and  earn  large  economic  profits.  As  a  result,  in  Australia  
state  regulatory  commissions  often  set  the  prices  for  natural  monopolies:  
-­‐ A  natural  monopoly  that  is  not  subject  to  government  regulation  will  
charge  a  price  equal  to  PM  and  produce  QM.    
-­‐ To  achieve  economic  efficiency,  regulators  should  require  the  
monopoly  to  charge  a  price  =  to  MC.  But  here,  PE  is  below  ATC  and  the  
natural  monopoly  will  suffer  a  loss  (shown  by  the  red  shaded  
rectangle).    
-­‐ Because  the  monopoly  will  not  continue  to  produce  in  the  long  run  if  it  
suffers  a  loss,  government  regulators  set  a  price  =  to  ATC,  at  which  the  
demand  curve  intersects  the  ATC  curve.  At  that  price  deadweight  loss  
is  reduced  while  the  monopoly  is  still  able  to  break  even  on  their  
investment  by  producing  the  quantity  QR.    
 
*As  we  will  see  in  the  following  2  chapters  (chapters  10  &  11),  the  degree  of  
competition  faced  by  most  firms  lies  somewhere  between  perfect  competition  
and  monopoly.      
 
Chapter  10  –  ‘Monopolistic  Competition’:  
 
Monopolistic  competition:  a  market  structure  in  which  barriers  to  entry  are  
low,  and  many  firms  compete  by  selling  similar,  but  not  identical,  products.    
 
1. Why  a  monopolistically  competitive  firm  has  downward-­‐sloping  demand  
and  marginal  revenue  curves:  
Because  changing  the  price  affects  the  quantity  sold,  a  monopolistically  
competitive  firm  will  face  a  downward  sloping  demand  curve,  rather  than  the  
horizontal  demand  curve  faced  by  a  perfectly  competitive  industry.    
 
Marginal  revenue  for  a  firm  with  a  downward  sloping  demand  curve:  a  
monopolistically  competitive  firm  must  reduce  the  price  to  sell  more,  so  its  MR  
curve  will  slope  downwards  and  will  be  below  its  demand  curve.  
For  a  perfectly  competitive  firm,  the  MR  received  =  price.  This  will  not  be  true  for  
a  monopolistically  competitive  firm  because  in  order  to  sell  another  unit,  it  has  
to  reduce  its  price.  When  the  firm  lowers  the  price,  it  experiences  one  good  thing  
and  one  bad  thing:  
-­‐ Good:  it  sells  one  more  unit  (i.e.  the  output  effect).  E.g.  Starbucks  
reduces  the  price  of  a  caffé  latte  from  $3.50  to  $3.00.  Selling  the  sixth  
caffé  late  adds  the  $3.00  price  to  the  firm’s  revenue  –  the  output  effect.  
 -­‐ Bad:  it  earns  less  for  each  unit  sold  compared  to  what  it  could  have  
sold  it  for  at  the  higher  price  (i.e.  the  price  effect).  E.g.  but  Starbucks  
now  receives  a  price  of  $3.00,  rather  than  $3.50,  on  the  first  5  caffé  
lattes  sold  –  the  price  effect.    
 
Every  firm  that  has  the  ability  to  affect  the  price  of  a  g  or  s  that  it  sells  will  have  a  
MR  curve  that  is  below  its  demand  curve  (a  monopoly  also  shares  this  
characteristic).  Only  firms  in  perfectly  competitive  markets,  which  can  sell  as  
many  units  as  they  want  at  the  market  price,  have  MR  curves  that  are  the  same  
as  their  demand  curves.    
 
2. How  a  monopolistically  competitive  firm  maximises  profits  in  the  short  
run:  
All  firms  use  the  same  approach  to  maximise  profits  –  produce  where  MR  =  MC.    
For  a  perfectly  competitive  firm,  P  =  MR,  so  the  profit  maximising  quantity  would  
be  where  P  =  MC.  However,  for  a  monopolistically  competitive  firm  P  >  MR  due  
to  the  fact  that  its  MR  curve  is  below  its  demand  curve.  As  a  result,  unlike  a  
perfectly  competitive  firm  which  produces  where  P  =  MC,  a  monopolistically  
competitive  firm  maximises  profits  where  P  >  MC.    
 
3. The  situation  of  a  monopolistically  competitive  firm  in  the  long  run:  
How  entry  of  new  firms  affects  the  profits  of  existing  firms:  The  short  run  
demand  curve  shows  that  Starbucks  can  charge  a  price  above  ATC  and  make  a  
profit.  But  this  profit  attracts  additional  coffee  houses  to  the  area  and  shifts  the  
demand  curve  for  the  Starbucks’  caffé  lattes  to  the  left.  As  long  as  Starbucks  is  
making  an  economic  profit  there  is  an  incentive  for  additional  coffee  houses  to  
open  in  the  area  and  the  demand  curve  will  continue  shifting  to  the  left  and  
becoming  more  elastic.    
 
4. Compare  the  efficiency  of  monopolistic  competition  and  perfect  
competition:  
 
5. Key  factors  that  determine  a  firm’s  profitability:  
The  factors  under  a  firm’s  control  –  the  ability  to  differentiate  its  product  and  the  
ability  to  produce  it  at  a  lower  cost  –  combine  with  the  factors  beyond  its  control  
to  determine  the  firm’s  profitability.  
Factors  beyond  a  firms  control  can  include  rising  prices  for  jet  fuel  which  
reduces  the  profitability  of  airlines,  the  chance  that  the  government  
unexpectedly  decides  to  build  a  new  road  near  a  McDonald’s  will  increase  the  
profitability  of  McDonald’s,  etc.      
 
 
Week  11  –  Oligopoly:  
Chapter  11  –  ‘Oligopoly:  Firms  in  Less  Competitive  Markets’:    
 
Oligopoly:  a  market  structure  in  which  a  small  number  of  interdependent  firms  
compete.    
 
1. How  barriers  to  entry  explain  the  existence  of  oligopolies:  
 • Barrier  to  entry  –  anything  that  prevents  new  firms  from  entering  an  
industry.  
There  are  4  important  barriers  to  entry:  
-­‐ Economies  of  scale:  exist  when  a  firm’s  long-­‐run  average  costs  fall  as  it  
increases  output.  
-­‐ Network  externalities:    
-­‐ Ownership  of  a  key  input:  
-­‐ Government  imposed  barriers:    
 
2. Use  game  theory  to  analyse  the  strategies  of  oligopolistic  firms:  
Because  an  oligopoly  has  only  a  few  firms,  interactions  between  those  firms  are  
particularly  important.  
Game  Theory:  can  be  used  to  analyse  any  situation  in  which  groups  or  
individuals  interact.  In  the  context  of  economic  analysis,  game  theory  is  the  study  
of  the  decisions  of  firms  in  industries  where  the  profits  of  each  firm  depend  on  
its  interactions  with  other  firms.    
In  all  games  (from  board  games  to  a  duopoly  game),  the  interactions  between  the  
players  are  crucial  in  determining  the  outcome.  In  addition,  games  share  3  key  
characteristics:  
1. Rules  that  determine  what  actions  are  allowable  (e.g.  laws,  other  things  
that  are  beyond  a  firm’s  control  such  as  its  production  function).  
2. Strategies  that  players  employ  to  attain  their  objectives  in  the  game.  A  
business  strategy  is  a  set  of  actions  taken  by  a  firm  to  achieve  a  goal.  
3. Payoffs  that  are  the  results  of  the  interaction  between  the  players’  
strategies  (i.e.  the  profits  earned  as  a  result  of  a  firm’s  strategies  
interacting  with  the  strategies  of  other  firms).    
 
• Payoff  Matrix:  a  table  that  shows  the  payoffs  that  each  firm  earns  from  
every  combination  of  strategies  by  the  firms.    
• Collusion:  an  agreement  between  firms  to  charge  the  same  price,  or  
otherwise  not  to  compete.  This  is  against  the  law  in  Australia  (the  ACCC  
enforces  anti-­‐competition  laws).  
• Dominant  Strategy:  a  strategy  that  is  the  best  for  a  firm,  regardless  of  
what  strategies  other  firms  use.    
• Nash  Equilibrium:  a  situation  where  each  firm  chooses  the  best  strategy,  
given  the  strategies  chosen  by  other  firms.      
 
Firm  Behaviour  and  the  Prisoner’s  Dilemma:  A  prisoner’s  dilemma  is  a  game  
where  pursuing  dominant  strategies  results  in  non-­‐cooperation  that  leaves  
everyone  worse  off  (i.e.  named  after  the  situation  when  police  lack  evidence  so  
they  separate  the  two  suspects  and  question  them  individually.  Because  each  
suspect  has  a  dominant  strategy  to  confess  to  the  crime,  they  will  both  confess  
and  serve  a  jail  term,  even  though  they  would  have  gone  free  if  they  had  both  
remained  silent  =  both  worse  off  because  they  pursued  their  dominant  
strategies).      
Cooperative  Equilibrium:  an  equilibrium  in  a  game  in  which  players  cooperate  to  
increase  their  mutual  payoff.  
Non-­‐cooperative  Equilibrium:  an  equilibrium  in  a  game  in  which  players  do  not  
cooperate  but  pursue  their  own  self-­‐interest.    
  
Can  firms  escape  the  prisoners’  dilemma?  Although  cooperative  behaviour  
seems  to  always  break  down  in  a  prisoners’  dilemma  game,  we  know  that  it  
doesn’t.  The  reason  the  basic  prisoners’  dilemma  story  is  not  always  applicable  is  
that  it  assumes  the  game  will  only  be  played  once.  Most  business  situations,  
however,  are  repeated  over  and  over.    
This  is  known  as  a  repeated  game:  in  a  repeated  game  the  losses  from  not  
cooperating  are  greater,  and  players  can  also  employ  retaliation  strategies  
against  those  who  don’t  cooperate.  As  a  result,  we  are  more  likely  to  see  
cooperative  behaviour.    
The  potential  profit  that  is  lost  by  not  charging  higher  prices  increases  the  
incentive  for  the  store  managers  to  cooperate  by  implicitly  colluding.  Explicit  
collusion,  such  as  the  managers  meeting  and  agreeing  to  charge  the  same  price,  
is  illegal.  But  if  the  managers  can  find  a  way  to  signal  to  each  other  that  they  will  
charge  a  certain  price  may  be  within  the  law.  E.g.  Big  W  and  Kmart  both  
advertise  that  they  will  match  the  lowest  price  offered  by  the  other  competitor.  
The  signal  is  clear  because  each  store  knows  that  if  it  charges  $700,  the  other  
store  will  automatically  retaliate  by  also  lowering  their  price  below  $700.  This  
will  punish  its  competitor  for  charging  a  lower  price  and  not  cooperating.  This  
will  reduce  the  competitor’s  profits,  which  will  then  cause  them  to  charge  the  
higher  price  that  will  increase  the  profits  of  both  firms.    
Price  leadership:  a  form  of  implicit  collusion  in  which  one  firm  in  an  oligopoly  
announces  a  price  change  and  the  other  firms  in  the  industry  match  the  change.    
 
3. Use  sequential  games  to  analyse  business  strategies:  
Rather  than  analysing  games  where  both  players  move  simultaneously,  
sequential  games  analyse  those  business  situations  where  one  firm  will  act  first  
and  then  the  other  firms  will  respond.  Sequential  games  can  be  illustrated  using  
decision  trees.  
We  will  use  sequential  games  to  analyse  2  business  strategies:  
• Deterring  entry:  barriers  to  entry  are  a  key  to  firms  continuing  to  earn  
economic  profits.  Firms  creating  barriers  to  deter  new  firms  from  
entering  an  industry  can  occur  through  such  actions  as  Big  W  building  a  
larger  store  which  would  cause  Kmart  to  experience  an  economic  loss  if  it  
enters  the  market.  Therefore  Big  W  deters  Kmart’s  entry.    
• Bargaining  between  firms:  the  success  of  many  firms  depends  on  how  
well  they  bargain  with  other  firms.  E.g.  firms  often  bargain  with  their  
suppliers  over  the  prices  they  pay  for  inputs.    
 
4. The  five  competitive  forces  model:  
The  number  of  firms  is  not  the  only  determinant  of  the  level  of  competition  in  an  
industry.  Michael  Porter  has  developed  a  model  showing  how  five  competitive  
forces  determine  the  overall  level  of  competition  in  an  industry:  
• Competition  from  existing  firms:  other  than  price  competition  between  
firms  in  an  industry  that  can  lower  profits,  there  is  also  competition  
between  firms  in  the  form  of  advertising,  customer  service  or  even  longer  
warranties.  E.g.  Amazon.com  offer  free  shipping  which  has  caused  its  
competitors  to  increase  their  competitiveness.  This  has  raised  the  costs  of  
Amazon’s  competitors  and  reduced  their  profits.    
 • The  threat  from  potential  entrants:  the  competition  from  companies  
that  are  currently  not  in  the  market.  E.g.  actions  aimed  at  deterring  entry  
such  as  creating  product  loyalty  or  setting  lower  prices  to  keep  profits  at  
al  level  that  would  make  entry  less  attractive.  
• Competition  from  substitute  goods  or  services:  firms  are  always  
vulnerable  to  the  introduction  of  a  new  product  that  fills  a  consumer  need  
better  than  their  current  product  does.  E.g.  computer  encyclopaedias  took  
over  from  printed  encyclopaedias.    
• Bargaining  power  of  buyers:  if  buyers  have  enough  bargaining  power  
they  can  insist  on  lower  prices,  higher-­‐quality  products  or  additional  
services.  E.g.  car  companies  have  significant  bargaining  power  over  tyre  
manufacturers  since  the  tyre  manufacturers  don’t  really  have  any  other  
buyers  apart  from  car  companies.  Therefore  the  tyre  manufacturers  face  a  
lower  selling  price.    
• Bargaining  power  of  suppliers:  if  many  firms  can  supply  an  input  and  
the  input  is  not  specialised,  the  suppliers  are  unlikely  to  have  the  
bargaining  power  to  limit  a  firm’s  profits.  E.g.  suppliers  of  paper  
serviettes  to  McDonald’s  have  very  little  bargaining  power  since  many  
other  suppliers  could  also  supply.  Therefore  the  supplier  faces  a  lower  
selling  price.      
 
Tutorial  12:  
John  Nash.  
 
 
EXAM  REVISION:  
 
Tables,  Graphs  and  Formulas:  
• Week  1:  PPFs.    
• Week  2:  shifts  in  supply  and  demand  curves,  changes  in  quantity  supplied  
and  demanded,  market  equilibrium  graphs,  changes  over  time.  
• Week  3:  formulas  for  PED  -­‐  cross-­‐price  elasticity  of  demand  formula,  
income  elasticity  of  demand  formula,  point  formula,  arc  (aka  midpoint)  
formula,  PED  and  total  revenue  or  expenditure.  Elasticities  of  supply  and  
demand.  Formula  for  PES.  Elasticity  of  a  certain  point.    
• Week  4:  consumer,  producer  and  economic  surplus  graphs,  marginal  
benefit  and  cost  curves,  deadweight  loss,  price  floor,  price  ceiling,  the  
effect  of  taxes,  tax  incidence  and  the  deadweight  loss  of  a  tax.  
• Week  5:  the  profit  maximising  quantity  of  labour  (MP,  MR,  MRP,  demand  
curve  for  labour),  quantity  of  labour  to  supply  (labour  demand  curve,  
backward  bending  labour  supply  curve),  firms  as  a  price  maker  and  price  
taker,  equilibrium  in  the  labour  market  (shifts  in  labour  demand  and  
labour  supply).  Winners  and  losers  from  trade  (exports  and  imports),  
import  tariffs  or  quotas.    
• Week  6:  the  demand  curve  for  public  goods,  the  optimal  quantity  of  a  
public  good,  overuse  of  a  common  resource.  Negative  and  positive  
externalities,  negative  externalities  and  taxes,  positive  externalities  and  
subsidies.    
 • Week  8:  formulas  of  the  average  product  of  labour  (AP)  and  the  marginal  
product  of  labour  (MP),  total,  variable  and  fixed  costs  (TC,  VC  &  FC),  
average  total,  variable  and  fixed  costs  (ATC,  AVC  &  AFC).  Graphing  of  cost  
curves.  Short-­‐run  production  and  cost  table.  Graphing  total  output  and  
marginal  product  of  labour.  Graphing  the  relationship  between  short-­‐run  
average  cost  and  long-­‐run  average  cost.    
• Week  9:  perfectly  elastic  demand  curve,  the  market  demand  vs.  demand  
for  an  individual  firm,  revenue  for  a  firm  in  a  perfectly  competitive  
market  (AR  &  MR),  the  profit  maximising  level  of  output  (total  revenue,  
total  cost  and  profit  &  marginal  revenue  and  marginal  cost),  showing  a  
profit  or  loss  on  the  cost  curve  graph  (also  break  even),  the  supply  curve  
of  the  firm  in  the  short  run  (shutdown  point),  the  market  supply  curve  in  
a  perfectly  competitive  industry,  the  effect  of  entry  and  exit  on  economic  
profits,  the  long-­‐run  supply  curve  in  a  perfectly  competitive  industry.    
• Week  10:    
Monopoly  -­‐  ATC  for  a  natural  monopoly,  calculating  a  monopoly’s  revenue,  
profit  maximising  price  and  output  for  a  monopoly,  deadweight  loss  of  
monopoly  and  regulating  a  natural  monopoly.    
Monopolistic  Competition  –  downward  sloping  demand  and  marginal  revenue  
curves,  profit  maximising  quantity  and  price  for  a  monopolistic  competitor,  
short  and  long  run  profits  for  a  monopolistic  competitor,  comparing  long  run  
equilibrium  under  perfect  and  monopolistic  competition.    
• Week  11:  payoff  matrix  (a  duopoly  game,  prisoner’s  dilemma,  a  repeated  
game),  decision  trees  (sequential  games:  deterring  entry  and  bargaining  
between  firms).