Four structures from perfect competition to monopoly
Four structures from perfect competition to monopoly
Perfect Competition: many sellers, identical products, price takers. Monopolistic Competition: many sellers, differentiated products. Oligopoly: few large firms, interdependent. Monopoly: single seller, no close substitutes.
Perfect competition
P = MC = minimum ATC in long run. Zero economic profit. Maximum efficiency.
Monopoly
MR < P. Produces where MR = MC, charges from demand curve. Creates deadweight loss. Economic profit persists.
Oligopoly
Game theory applies. Nash equilibrium. Kinked demand curve explains price rigidity.
Consumers maximize utility by equalizing marginal utility per dollar
Consumers maximize utility by equalizing marginal utility per dollar
Marginal utility (MU) = additional satisfaction from one more unit. Diminishing MU: falls as consumption increases. Equilibrium: MU of A / Price A = MU of B / Price B. Last dollar on each good gives equal MU.
Diminishing MU
First slice great, fourth slice not so much. Explains downward-sloping demand curve.
Consumer surplus
Difference between WTP and actual price. Area above price, below demand curve.
Substitution and income effects
Price decrease: buy more of cheaper good (substitution) and real income rises (income effect).
Production & Costs
TC (Total Cost) = FC (Fixed Cost) + VC (Variable Cost) ยท Profit maximized where MR = MC
Short run: fixed + variable costs. Long run: all costs variable.
Short run: fixed + variable costs. Long run: all costs variable.
Short run: Total Cost = Fixed Cost + Variable Cost. Marginal Cost = cost of one more unit. Long run: all inputs variable. Economies of scale: ATC falls as output rises. Minimum efficient scale = lowest LRAC point.
Cost curve relationships
MC intersects ATC and AVC at their minimums. When MC < ATC, ATC falls. When MC > ATC, ATC rises.
Profit max rule
All firms maximize profit where MR = MC. Shut down short-run if P < AVC.
Economies of scale
ATC falls with output: specialization, bulk purchasing, spreading fixed costs.
Markets fail to achieve efficient allocation in four ways
Markets fail to achieve efficient allocation in four ways
Markets fail when producing inefficient outcomes. Monopoly power, externalities (costs/benefits not in price), public goods (non-excludable, non-rival), information asymmetry. Government intervention may be justified.
Negative externalities
Social cost > private cost. Market overproduces. Carbon tax corrects. Cap-and-trade creates market for pollution rights.
Positive externalities
Social benefit > private benefit. Market underproduces. Government subsidies encourage more. Education, vaccination.
Public goods
Non-excludable + non-rival. National defense, public fireworks. Market underprovides โ free rider problem.
Labor Markets
Wage = MRP (Marginal Revenue Product): workers paid their marginal contribution to revenue
In competitive labor markets, wages equal the value of marginal product
In competitive labor markets, wages equal the value of marginal product
Firms hire until W = MRP (marginal product x price). Labor supply determined by work-leisure tradeoff. Monopsony (single buyer of labor) pays below competitive wage. Human capital increases MRP and wages.
MRP
MRP = MP x P (for perfect competitors). Higher productivity or product price = higher wages.
Monopsony
Single buyer of labor. Pays below MRP, hires fewer workers. May explain why minimum wage does not reduce employment.
Economic rent
Payment above minimum to keep factor in current use. Much of superstar earnings is economic rent.
Opportunity Cost
TINSTAAFL โ There Is No Such Thing As A Free Lunch. Every choice costs the next-best alternative.
Opportunity cost is the value of the best forgone alternative โ the true cost of any decision
Opportunity cost includes implicit costs โ what you give up, not just what you pay
Opportunity cost = value of best forgone alternative. Explicit costs: actual money payments. Implicit costs: forgone income or value (owning a building instead of renting it out). Economic profit = revenue minus explicit AND implicit costs. Accounting profit ignores implicit costs. PPF: opportunity cost is the slope. Bowed-out shape reflects increasing opportunity costs as resources are specialized.
Explicit costs
Actual out-of-pocket payments โ wages, rent, materials
Implicit costs
Forgone alternatives โ your own time, owned resources
MB = MC: produce until Marginal Benefit equals Marginal Cost โ the universal rule for optimal decisions
Every economic decision is made at the margin โ comparing extra benefit to extra cost
If MB greater than MC do more. If MC greater than MB do less. Stop where they are equal.
Marginal = additional. Marginal utility: extra satisfaction from one more unit. Law of diminishing marginal utility: each additional unit gives less extra utility. Firms maximize profit where MR = MC. Consumer maximizes utility where MU/P is equal across all goods. Sunk costs are irrelevant โ only future costs and benefits matter for marginal decisions.
MR = MC
Profit maximization rule for all market structures
Diminishing MU
Each extra unit gives less additional satisfaction
Sunk costs
Already spent โ irrelevant to current decisions, ignore them
Production Costs
FC + VC = TC. ATC = TC/Q. MC = change in TC per unit. Shutdown: P less than AVC. Exit: P less than ATC.
Cost curves and the shutdown vs exit decision rules
Produce if price covers variable costs. Stay long-run only if price covers ALL costs.
Fixed costs (FC): do not change with output. Variable costs (VC): change with output. TC = FC + VC. ATC = TC/Q. AVC = VC/Q. MC = change in TC per additional unit. MC crosses ATC and AVC at their minimums. Short-run shutdown rule: P less than AVC. Long-run exit rule: P less than ATC.
Shutdown rule
P less than AVC โ shut down short run, lose only FC
Exit rule
P less than ATC โ exit long run, cannot cover total costs
MC and ATC
MC crosses ATC at minimum โ most efficient output level
Market Failure Types
MOPE โ Monopoly power, Outcomes with externalities, Public goods, Externalities from information. Each justifies government intervention.
Four situations where free markets fail to allocate resources efficiently
Market failure justifies government intervention โ but intervention can also create government failure
Externalities: costs or benefits on third parties. Negative (pollution): overproduced โ Pigouvian tax corrects. Positive (education): underproduced โ subsidize. Public goods: non-excludable and non-rival (national defense) โ free-rider problem leads to underprovision. Information asymmetry: adverse selection (insurance), moral hazard. Market power: monopolies restrict output and raise prices creating deadweight loss.
Negative externality
Overproduced โ Pigouvian tax shifts supply left to efficient level
Public goods
Non-excludable plus non-rival equals free rider problem
Adverse selection
Hidden information before transaction โ lemons problem, insurance
Labor Markets
MRP = MRC: hire workers until Marginal Revenue Product equals wage. Labor demand is derived from product demand.
Labor market equilibrium and the firm hiring rule
Wage equals MRP in competitive market. Monopsony pays below MRP and hires fewer workers.
Labor demand is derived from demand for the product. MRP (Marginal Revenue Product) = MP times MR. Hire until MRP equals wage. Minimum wage above equilibrium creates surplus of labor. Monopsony: single employer of labor pays below competitive wage and hires fewer workers. Union effects: increase wages and reduce employment in non-union sector.
MRP = MP x MR
Value of one more worker to the firm
Derived demand
Labor demand rises when product demand rises
Monopsony
Single buyer of labor โ wage below MRP, fewer hired
Behavioral Economics
HALTS โ Heuristics, Anchoring, Loss aversion, Time inconsistency, Status quo bias. Why people deviate from rational choice.
Behavioral economics challenges the rational actor model with psychological insights
Loss aversion: losing 100 dollars feels twice as bad as gaining 100 dollars feels good.
Heuristics: mental shortcuts that lead to systematic errors. Anchoring: first number seen disproportionately influences judgment. Loss aversion: losses hurt more than equivalent gains feel good (about 2x). Present bias: overweight immediate costs and benefits. Status quo bias: default options matter hugely. Nudges: small design changes that guide behavior. Applications: retirement savings defaults, organ donation opt-out systems.
Loss aversion
Losses feel about 2x as painful as equivalent gains feel good
Anchoring
First number seen biases all subsequent judgments
Nudge
Default design guides behavior โ opt-out organ donation increases donors
🎓 Common Exam Questions
Q: Explain opportunity cost and the Production Possibilities Frontier.
A: Opportunity cost is the value of the best forgone alternative โ the true cost of any choice including implicit costs like forgone income from owned resources. The PPF illustrates this graphically: the slope equals the opportunity cost showing how much of one good you sacrifice for more of the other. The bowed-out shape reflects increasing opportunity costs as resources are not perfectly substitutable across uses โ each additional unit costs progressively more of the other good. Points inside the PPF represent inefficiency (unemployed resources). Points on the frontier are efficient. Points outside are currently unattainable but can be reached through economic growth or technology.
Q: Explain economic profit vs accounting profit and why long-run economic profit is zero in perfect competition.
A: Accounting profit equals revenue minus explicit costs (actual cash payments). Economic profit equals revenue minus both explicit AND implicit costs (forgone alternatives, including opportunity cost of owner's time and capital). Economic profit can be negative even when accounting profit is positive. In perfect competition, positive economic profit attracts new firms into the industry, supply increases, price falls, and profit returns to zero. Negative economic profit causes firms to exit, supply decreases, price rises, and profit returns to zero. Zero economic profit means firms earn exactly their opportunity cost โ a normal return. This self-correcting mechanism through free entry and exit is the invisible hand at work.
Q: Compare the four market structures on efficiency, output, price, and long-run profit.
A: Perfect Competition: many identical sellers, price takers, P = MR = MC = minimum ATC in long run, zero economic profit, allocatively efficient (P = MC) and productively efficient (minimum ATC). Monopolistic Competition: many sellers, differentiated products, some pricing power, zero long-run economic profit through entry and exit, P greater than MC, excess capacity. Oligopoly: few large firms, strategic interdependence, economic profit possible long-run due to barriers, game theory applies to behavior. Monopoly: single seller, price setter, MR less than P, set MR = MC then charge from demand curve, persistent economic profit due to barriers, P greater than MC creating deadweight loss. Efficiency and consumer welfare decrease while market power increases moving from perfect competition toward monopoly.
Q: Explain externalities and the policy approaches to correcting them.
A: An externality is a cost or benefit that falls on a third party not involved in the market transaction โ the market price does not reflect the full social cost or benefit. Negative externality (pollution): social cost exceeds private cost, firm overproduces compared to the efficient level. Pigouvian tax set equal to the external cost per unit makes the producer internalize the externality and shifts supply left to efficient output. Cap and trade: government sets total pollution cap, issues tradeable permits, firms reduce pollution where it is cheapest. Positive externality (education, vaccines): social benefit exceeds private benefit, market underproduces. Policy: subsidize producers or consumers to increase output to the efficient level. Coase theorem: if property rights are well-defined and transaction costs are low, private bargaining achieves efficient outcome regardless of initial rights assignment.
Q: Explain consumer and producer surplus and how taxes affect total welfare.
A: Consumer Surplus: area below the demand curve and above the market price โ what buyers gain from market participation beyond what they pay. Producer Surplus: area above the supply curve and below the market price โ what sellers gain beyond their minimum acceptable price. Total Surplus equals CS plus PS and is maximized at competitive equilibrium โ the efficiency result of the invisible hand. A per-unit tax creates a wedge between the price buyers pay and the price sellers receive, reducing the quantity exchanged below equilibrium. Tax revenue is a transfer from buyers and sellers to the government โ not lost to society. Deadweight loss consists of the two triangles of surplus that no one receives โ these represent mutually beneficial trades that no longer occur because of the tax-induced price difference. Larger elasticities produce larger deadweight losses because quantity falls more.