Econ Cheat Sheet

Demand (competitive):Firms/custs=price takers; Prices set by mkt

Consumer Surplus: area below demand and above price line.

[pic 1]

Elastic: |E| > 1 → appr. neg. inf. Inelastic: |E| < 1 → approaches 0

E= -1.1, means: “A 1% incr. in price results in a 1.1% decr in qty”

-Cost paid by custs→Pass through: Es/(Es-Ed) More inelastic cust bears burden

-Income Eof D: %∆QD/%∆QIncome. Cross-P E: %∆QD1 /%∆PD2.

Substitutes: Positive XED Complements: Negative XED

Alusaf Takeaways

- Marginal firm (firm with highest cost relative to others) determines the price of good

- price volatility comes from steep supply or demand

Supply (competitive)

[pic 2]

- MC = ∆Cost/∆Q = ∆VC/∆Q

- Profit max when P = MC(Q*) if firm is operating.

Economic costs:  [pic 3]

-AC = TC/Q

-MC = ∆Cost/∆Q = ∆VC/∆Q

-Econ. of Scale: AC ↓with output  → MC < AC

-Disecon. of scale: AC ↑ with output → MC > AC    

- All costs matter for startup/shut down but only MC matters if operating. If producing, MC matters for decisions that impact output (pricing, ads)

- FC: does not vary with level. of output

- VC: vary with level of output

- Opp. Cost: highest-valued alternative use of an asset

- Sunk Cost: cost spent & cannot be recovered, opp cost = 0

Firms produce as long as MR ≥ MC. AKA, they produce up to the point MR = MC This point can hypothetically be below or above point where MC = AC (i.e., might operate in disecon. of scale) but typically below [right, below]

- Total costs matter for startup/shut down decision, but only MC matters for decisions if operating (ex: pricing, advert.)

Perfect Competition: P=MR in competitive market

IN COMP. MKTS FIRMS FACE A FLAT DEMAND (PERF. ELASTIC) AT THE MARKET PRICE

Total welfare is maximized: P* = MC(Q*) = MWTP(Q*)

Externalities

Activity generates externality when it imposes cost (or benefit) that is not reflected in the price mechanism → produce too much/little

Ex: (-) Factory pollutes river, garbage dump lowers nearby home price. (+) R&D of new ideas; flower farm raises nearby home prices

DWL: Lost surplus due to a distortion from competitive mkts

→when trades occur where the social benefit < social cost & vv

DWL=Tot. Surplus Poss. – ToT. Surplus Achieved (=0 in comp mkts) - Trag. Of Commons = others’ access to the resource impairs everyone’s because of overuse

- Coase theorem = w/ 0 transaction cost, eff. solution occurs regardless of property rights.

- Taxing externalities can increase efficiency.

[pic 4]

Sum of demand and supply: HORIZONTALLY

QTOT = 100 – P when P > 50

QTOT = the sum of the demands when when P < 50

The sum of the demands: we add QUANTITIES (“horizontal sum”)

QD1 = 100 – 2P + QD2 = 100 – P = QTOT = 200 – 3Px

[pic 5]

DWL: Price Ceiling: gov mandates max P. Total loss=B+C. DWL = total loss in welfare. Inelastic D=loss to consumers.

[pic 6]

Similar with price floors (but A is next to B)

Price supports: Gov sets price above the market eq thru  purchases of excess S or production restrictions. Consumers lose by paying higher price; producers win; gov has to fund purchases[pic 7]

Tax Subsidies:[pic 8]

Monopoly Power

Firm has market power if faces downward sloping demand curve. In competitive markets firms face flat (perfectly elastic) D curves at market price. Pick Q* such that  MR(Q*)=MC(Q*).

P(Q*)>MR(Q*)=MC(Q*). Solve for monopoly price/profit:

1. Find MR (Rev = P*Q, dRev/dQ = MR) → 2. Find MC → 3. Set MR = MC, find Q. For 2 MCs: MR(q1+q2) = MC1(q1)=MC2(q2) → 4. Find P by using Q in original DEMAND function → Calculate profit

-P(Q*) = MC(Q*) for comp. mkt;  P > MR, since to increase output, monopolist must lower price for all units. MR has same intercept & 2x slope as inverse demand.

[pic 9][pic 10]

Market Segmentation

[pic 11]

- First degree: extracts all CS for producer

- Second degree: non-linear pricing (eg: different prices/unit for diff quantities of good)

- Third degree: diff groups diff prices

- Mkt Power: firm’s ability to charge markup over MC.

GAME THEORY

Dominant strategy: best course of action regardless of what your opponents do.

In a Nash equilibrium, each player is playing a best response to the actual strategy choices of their rivals. A Nash equilibrium is a stable outcome –no one wants to deviate given what everyone else is doing.

Not always a Nash equilibrium, and sometimes more than one

The Bertrand Model: lowest price firm takes the whole market (split the market if same price).

What is the Nash equilibrium? All at p=c

Even with 2 firms, we get perfect competition outcome.

Unrealistic model: no product differentiation; no uncertainty about demand, no capacity constraints.

How do firms get out of the Bertrand Trap? Matching prices model, Repeated interaction Example: in the following pricing game, the cooperative solution is P1=30 and P2=30. They both continue setting P = 30 as long as the other firm has done so (cooperation phase). If anyone has deviated in the past, start a “price war” in which P = 20 forever after (a Nash reversion “punishment”).