• Market Equilibrium is Pareto Efficient:

Price (P)
it is a state where economic resources Changes in Demand

Price (P)
are most efficiently distributed. Market A change in a good’s price causes a Increase in income
Equilibrium
Increase in competitor’s prices
Linear Demand Curves take the form: Consumer
Supply movement along the demand curve. Increase in advertising
Surplus
𝑑 (𝑃) = 𝐴 − 𝐵(𝑃) Price
A change in another variable can
Line
Log Linear Curves take the form: Producer
Surplus
Demand cause the demand curve to shift. For
𝑑 (𝑃) = 𝐴(𝑃)−𝐵 example: Demand
Decrease in income
Decrease in competitor’s prices
Gains from Trade
Cost
• Income Decrease in advertising

Quantity (Q) • Competitor’s prices (substitutes)

• The shaded area under the Supply

Price (P)
Curve represents the total costs Consumer
• Advertising Quantity (Q)
Surplus
incurred by Producers.
Introducing Elasticity Measuring Elasticity
• The shaded area under the Demand Curve Deadweight
Loss Supply

represents the total valuation of the Elasticity describes how sensitive a The following can be used to
consumers.
Tax Revenue
variable is to changes in the value of estimate Own Price Elasticity:
• Together, the consumer and producer Producer
Demand
another variable. It expresses this Generally:
sensitivity in terms of percentage, not
Surplus
surpluses represent the Gains from
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄
Cost
Trade. the curve’s slope.
𝐸=−
• Taxes and Imperfect Competition Quantity (Q) • Elasticity increases as you move % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃
reduce the size of the gains from trade. up the Demand Curve (to the
This creates a Deadweight Loss. left). Point Elasticity (Linear Demand):
• Goods with a higher Choke
Revenue and Margins Price are less elastic than goods 𝐸=−
𝑑𝑄 𝑃
× 𝐸=
𝑃
with a lower Choke Price. 𝑑𝑃 𝑄 𝑃ത − 𝑃
Price (P)

• Revenue is the product of Price and

Quantity. Total Cost • Higher Choke price, more
inelastic remand, higher is profit Arc Elasticity:
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑅) = 𝑃(𝑄) × 𝑄
maximising price
• Marginal Revenue (MR) describes the 𝑄2 − 𝑄1 𝑃 − 𝑃1
rate revenue changes as quantity Marginal
Demand Cross-Elasticities 𝐸=
1
൙
1
purchased changes. Revenue (𝑄 +𝑄 ) (𝑃 +𝑃 )
Marginal Cost Cross-price elasticities describe 2 2 1 2 2 1
𝑑𝑅(𝑄) Fixed Cost

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑀𝑅) = how demand for one good changes as

𝑑𝑄 Quantity (Q)
the price of another good changes. Log Linear Curve:
• Marginal Costs (MC) describes the • Two goods are complements if 𝐸 = 𝐵 𝑤ℎ𝑒𝑟𝑒 𝑑 (𝑃 ) = 𝐴(𝑃)−𝐵
rate cost changes as the quantity
Price (P)

their cross-price elasticity is

produced changes. 𝑃 =𝐴 negative (in a Demand Curve Own price elasticity:
𝐵
𝑑𝑐(𝑄) equation, these are negative).
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡(𝑀𝐶) =
𝑑𝑄 %∆𝑄 𝐸𝐷 < 1 inelastic; P↑→R↑
• Two goods are substitutes if their 𝐸𝐷 = − 𝐸𝐷 = 1 unit elastic; max R
%∆𝑃 𝐸𝐷 > 1 elastic; P↑→R↓
cross-price elasticity is positive (in
Choke Price a Demand Curve equation, these Income elasticity:
• The Choke Price is the highest price any are positive).
consumer is prepared to pay for a good. %∆𝑄 𝐸𝑌 > 0 normal goods
For a Linear Demand Curve, the Choke Quantity (Q) Income Elasticity 𝐸𝑌 =
%∆𝐼
𝐸𝑌 < 0 inferior goods
𝐸𝑌 > 1 luxury goods
Price can be calculated by dividing the
intercept (A) by the gradient (B). Income Elasticity describes how
demand for a good changes as Cross price elasticity:
Fixed Marginal Costs consumer income changes.
Monopoly 𝐸𝑐 =
%∆𝑄𝑥 𝐸𝑐 > 0 substitute
• If demand for a good falls when
Price (P)

Consumer %∆𝑃𝑦 𝐸𝑐 < 0 complement

Definition
Surplus
income rises, then that good is an
Deadweight
inferior good.
By definition, monopoly is
Loss

P* Perfectly Inelastic Demand Curve

characterized by an absence of Profit • If demand for a good rises when
competition, which often results in MC Demand
income rises, then that good is a
Price (P)

high prices and inferior products. Cost

normal good.
MR
Demand
• If demand for a good rises faster
Price Quantity (Q)
than income rises, then that good is
In a monopoly a firm is a Price Setter. Rising Marginal Costs a luxury good.
The firm should seek to produce at
Extreme Examples
Price (P)

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡

Consumer
Surplus

Deadweight • A perfectly elastic demand curve

For a Linear Demand Curve, the mid Loss

P* MC
has an infinite elasticity.
point pricing rule Price is: Quantity (Q)

𝑀𝐶 + 𝑃ത
• A perfectly inelastic demand
𝑃=
Profit
curve has an elasticity of zero.
Demand

2 Perfectly Elastic Demand Curve

MR
Cost
• A unit elastic good has an
Price (P)

For a Log Linear Demand Curve, the Quantity (Q) elasticity of one.
Price is:
𝑃=
𝐵
𝑀𝐶
How does this relate to Elasticity? Key Relationships
𝐵−1 Demand

Price and Marginal Cost • More substitutes = higher elasticity

Rationale 𝐸
• Differentiation = lower elasticity
𝑃= 𝑀𝐶 • Particular goods = higher elasticity
The reason firms should charge a Price 𝐸−1 than an “industry” average
where MC = MR is because selling one
Price and Marginal Revenue • More advertising = lower elasticity
more unit would generate a loss while
𝑀𝑅 • Lower income = higher elasticity
selling one fewer unit would generate a Quantity (Q)

𝑃=
lower profit. 1 − 1/𝐸

Consequences
Although Monopolies can promote innovation (e.g. through patenting) and
lower costs, it results in a Deadweight Loss (to society) and higher costs
for consumers.
 Definitions Key Formulae
• Sunk Costs: Costs that are immutable and are the same
for all alternatives. These costs should be ignored! Total Cost 𝑐 𝑄 = 𝑓𝑐 + 𝑣𝑐(𝑄)
Logs
Firm Production and Costs
• Long Run Costs: Costs that can be changed (or
removed altogether if the firm shuts down) in the long 𝑐(𝑄)
log(𝑥 × 𝑦)= log(𝑥)+ log(𝑦)
Average Cost 𝑎𝑐(𝑄) =
run. 𝑄
log(𝑥/𝑦) = log(x)− log(𝑦)
• Short Run Costs: Costs that can be changed in the 𝑑𝑐(𝑄)
short term – many costs cannot be changed (e.g. Plant & Marginal Cost 𝑚𝑐(𝑄) =
𝑑𝑄
Equipment). log (𝑥𝑦 ) = 𝑦 × log(𝑥)
• Fixed Costs (fc): Costs that are independent of the 𝑣𝑐(𝑄)
Average Variable Cost 𝑎𝑣𝑐(𝑄) = log10(x) = 𝑦 𝑚𝑒𝑎𝑛𝑠 10𝑦 = 𝑥
number of number of units produced, but need to be 𝑄
incurred in order to produce a good.
𝑓𝑐
• Variable Costs (vc): Costs that vary with the number of Average Fixed Cost 𝑎𝑓𝑐(𝑄) = ln(𝑥) = 𝑦 𝑚𝑒𝑎𝑛𝑠 𝑒𝑦 = 𝑥
𝑄
units produced.
• Marginal Costs (mc) describes the rate cost changes Explicit Market Segmentation
as the quantity produced changes.
Market Power Calculus
Economies and Diseconomies of Scale • Must have ability to set the price Function Derivative
Observability (No deception)
Sources of Sources of Diseconomies of • An easily observed trait which is correlated 𝑦=𝑎 𝑑𝑦/𝑑𝑥 = 0
Scale with willingness to pay
Economies of Scale
• Customer cannot masquerade as someone else 𝑦=𝑥
• Specialisation • Spreading resources thin 𝑑𝑦/𝑑𝑥 = 1
No arbitrage/resale
• Indivisible inputs • Larger firms pay higher • Customers from one segment cannot sell
• Setup costs wages goods to others 𝑦 = 𝑥𝑛 𝑑𝑦/𝑑𝑥 = 𝑛𝑥𝑛−1
• Distribution • Bureaucracy and Principle of Explicit Market Segmentation
network costs hierarchy Constant MC: 𝑀𝑅𝐴 𝑄𝐴 = 𝑀𝐶; 𝑀𝑅𝐵 𝑄𝐵 = 𝑀𝐶
• Slower decision making 𝑦 = ln(𝑥) 𝑑𝑦/𝑑𝑥 = 1/𝑥
Varying MC: 𝑀𝑅𝐴 𝑄𝐴 = 𝑀𝐶 𝑄𝐴 + 𝑄𝐵
𝑀𝑅𝐵 𝑄𝐵 = 𝑀𝐶 𝑄𝐴 + 𝑄𝐵 𝑦 = 𝑒𝑥 𝑑𝑦/𝑑𝑥 = 𝑒𝑥

Cost is a Dynamic Concept 𝑦 = 𝑎𝑥 𝑑𝑦/𝑑𝑥 = ln(𝑎)𝑎𝑥

A cost may be highly relevant at one point, only to become irrelevant after some
irreversible commitments have been made. This is shown in the decision tree below:
Not all tax is passed on to consumers
Stage 1 Stage 2 Stage 3 • Tax (τ) is an additional cost, which forces firms to adjust
the quantity they chose to produce.
Stay out • In a Monopoly situation, the Price would be as follows:
Industry Costs
Start Exit 𝑀𝐶 + 𝜏 + 𝑃ത 𝐵
𝑃 (𝑙𝑖𝑛𝑒𝑎𝑟) = 𝑃 (𝑙𝑜𝑔) = (𝑀𝐶 + 𝜏)
2 𝐵 −1
Enter
Commit to Pricing • In a Perfectly Competitive market, the effect of the tax
Production Decision will depend on who is paying the tax. Establish whether
the tax is on Demand or Supply. Then change one of the
$ Sunk Costs $ Fixed Costs $ Marginal Costs Pricing Strategies
functions (Demand or Supply) to reflect the new tax.

Under this framework, a firm should only look forward when considering whether to Advice on Pricing Strategies
enter or exit a market or what price to set. In Stage 1, the firm should ignore sunk costs • Raise your price if your Marginal Cost (mc) increases;
when moving to Stage 2 (but it should consider Fixed Costs). In Stage 2, the firm
should only consider Marginal Costs in its decision making. • Never choose a price at which demand is inelastic;
• Advertising shifts your demand curve up so, charge a
higher price;
Perfect Competition • Raise your price if your competitor (producing a
Price substitute) raises their price;
Price (P)

In perfect competition, the firm is a Price Fixed Marginal Costs • Raise your price if consumer income increases;
Taker. The firm should still seek to • Lower your price if a complementary good’s price
produce a Quantity where MR = MC.. In Consumer Surplus increase;
this case, MC and MR also equal Marginal
• Charge a higher price if the Choke Price is high (i.e.
Valuation (MV).
less-elastic goods); and
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 P*
MC MV • Use Price Discrimination strategies such as bundling,
𝑆𝑢𝑝𝑝𝑙𝑦 = 𝐷𝑒𝑚𝑎𝑛𝑑
Cost two-part tariffs, and differential pricing to extract more
Cost consumer surplus (see Page 3).
In the Short Run, Prices will converge to Quantity (Q)
the industry’s Average Variable Cost. Rationale
Price (P)

𝑃 = 𝑚𝑐(𝑄) = 𝑎𝑣𝑐(𝑄) Rising Marginal Costs In a perfectly competitive market, barriers to entry are low and prices are transparent. Firms will
try to undercut each-other until the Price reaches Market Equilibrium. In theory, the profit at this
In the Long Run, Prices will converge to level is zero (technically, Opportunity Cost).
Consumer Surplus
the industry’s Average Cost. Supply Consequences
𝑃 = 𝑚𝑐(𝑄) = 𝑎𝑐(𝑄) P* Consumers get the lowest possible prices (assuming taxes and tariffs are
Profit
If the firm is unable to break even at this MV zero), while firms generate little or no profit. In theory, there is no
Cost
Price, it should stop producing. Deadweight Loss to society.

Quantity (Q)
 Period 1 | Prices and Markets | Revision Notes | 3 of 4

Pricing With Market Power

Types of Market Categories Analysis
The Quantity that a firm choses to produce 1. A Monopoly (just one player); We use different tools to make decisions
and the Price a firm is able to set depends 2. An Oligopoly (several large players); and depending on the type of market we’re studying.
on the level of competition in the market. For Oligopolies we use Game Theory (Page 4).
3. Perfect Competition (many players).

Monopoly Perfect Competition

Definition Definition
Fixed Marginal Costs
A monopoly is a situation in which a Fixed Marginal Costs Perfect Competition is the situation in a

Price (P)
single company or group owns all or market in where buyers and sellers are so
Price (P)

nearly all of the market for a given type Consumer

Surplus numerous and well informed that all Consumer
Surplus

of product or service. By definition, Deadweight

elements of monopoly are absent and the
monopoly is characterized by an market price of a commodity is beyond the
Loss

P*
absence of competition, which often Profit control of individual buyers and sellers. P* MC MV
results in high prices and inferior MC Demand
Price Cost
products. Cost
MR
In perfect competition, the firm is a Price
Price Quantity (Q) Taker. The firm should still seek to
Quantity (Q)

In a monopoly a firm is a Price Setter. produce a Quantity where MR = MC.. In

Rising Marginal Costs Rising Marginal Costs
The firm should seek to produce a this case, MC and MR also equal Marginal
Valuation (MV).
Price (P)

Price (P)
Quantity where Marginal Revenue (MR) Consumer
Surplus
equals Marginal Cost (MC): 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡
Consumer
Surplus
Deadweight

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡

Loss

P* MC 𝑆𝑢𝑝𝑝𝑙𝑦 = 𝐷𝑒𝑚𝑎𝑛𝑑
Cost
Supply

For a Linear Demand Curve, the Price is: P*

Profit Demand In the Short Run, Prices will converge to z Profit MV

𝑀𝐶 + 𝑃ത the industry’s Average Variable Cost.

𝑃= MR
Cost
2
Cost

Quantity (Q)
𝑃 = 𝑚𝑐(𝑄) = 𝑎𝑣𝑐(𝑄) Quantity (Q)
For a Log Linear Demand Curve, the
Price is: In the Long Run, Prices will converge to
𝐵
𝑃= 𝑀𝐶 How does this relate to Elasticity? the industry’s Average Cost.
𝐵−1
Price and Marginal Cost 𝑃 = 𝑚𝑐(𝑄) = 𝑎𝑐(𝑄)

Price (P)
Marginal

Cost
Average
Cost (ac) Cost (mc)

𝐸 If the firm is unable to break even at this

In this case, the producers Quantity is 𝑃= 𝑀𝐶 Price, it should stop producing.
mc(Q) = ac(Q)

determined by the Pricing above. 𝐸−1

Price and Marginal Revenue Rationale
Rationale
𝑀𝑅 In a perfectly competitive market, barriers
The reason firms should charge a Price 𝑃= to entry are low and prices are transparent.
Average Variable
Cost (avc)

where MC = MR is because selling one 1 − 1/𝐸

Firms will try to undercut each-other until mc(Q) = avc(Q)

more unit would generate a loss while the Price reaches Market Equilibrium. In Quantity (Q)

selling one fewer unit would generate a theory, the profit at this level is zero
lower profit. (technically, Opportunity Cost).
Consequences Consequences
Although Monopolies can promote innovation (e.g. through patenting) and Consumers get the lowest possible prices (assuming taxes and tariffs are
lower costs, it results in a Deadweight Loss (to society) and higher costs zero), while firms generate little or no profit. In theory, there is no
for consumers. Deadweight Loss to society.

Competitive Market Strategy Price Discrimination

Entering a Competitive Market Why use Price Discrimination? Fixed Marginal Costs
Price (P)

There are two types of entry into a competitive market: In an ideal world (for a firm), the firm can set a Consumer
Surplus = 0

• Weak Form: There are no legal barriers to entry; no threats of price at each customer’s reservation price,
retaliation by active firms; and cost structures are different. which converts all consumer surplus to profit.
Profit

𝑀𝑎𝑥 𝑃𝑟𝑜𝑓𝑖𝑡: 𝑀𝑅 𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝐴 = 𝑀𝑅(𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝐵)

• Strong Form: Anybody can set up a firm with the same cost structures
P*
(hence same cost functions) as other active firms. Explicit Market Segmentation
MC MV

Cost

What Happens in Competitive Markets? • Charge different customer groups different

prices for the same product (e.g. student Quantity (Q)

Any competitive market with high profits will attract more firms. As more
discounts, “tourist” prices) Rising Marginal Costs
firms enter, the industry supply curve is pushed to the right and prices
Price (P)

• US railways charge more to ship coal than

fall to the same level as opportunity costs, effectively wiping out profit. Consumer
grain as coal is less elastic than grain. Surplus

To prevent this happening to your firm: Implicit Market Segmentation MC

• Create new profit opportunities through a relative cost advantage; • Product differentiation (e.g. coffee) Profit

• Protect current profits and generate profits through differentiation; • Screening (e.g. Priceline, coupons) MV

• Capture a superior market opportunity with a first mover advantage; & • Bundling (e.g. season tickets)
• Change industry structure through consolidation. • Two part tariff (e.g. bar entry fees)
Cost

Quantity (Q)
 Period 1 | Prices and Markets | Revision Notes | 4 of 4

Game Theory and Business Strategies

Why Game Theory? Example Strategy Games How to Win Strategy Games
Game theory is the study of rational behaviour in 1. If you have a dominant strategy use it. Expect
situations involving interdependence: Prisoner's Dilemma your opponent to use their dominant strategy
• May involve common interests: if they have one.
This is the classic
coordination. strategy game Kelly 2. If you have dominated strategies avoid them.
• May involve competing interests: rivalry Eliminate dominated strategies to predict
Confess Deny outcomes.
• Players do the best they can, in their eyes.
3. If no dominant strategies or dominated
5 0

Confess
• Because of the players’ interdependence, a strategies exist, look for a Nash Equilibrium.
rational decision in a game must be based on 5 Nash 20 4. Price Wars are dangerous games – be careful!
a prediction of others’ responses.

Ned
• Put yourself in the other’s shoes and
How to Avoid Prisoner’s
20 10
Dilemma
Deny
predicting what action the other person will
choose , you can decide your own best action. 0 10 • Merge and/or collude with competitors;
Features of Game Theory • Be the cost leader;
• Limit you capacity;
• Game Theory, like business, it is not always • Differentiate your produce;
win-lose (not zero-sum): it is often possible Battle of the Sexes • Adopt dynamic strategies (e.g. Trigger); and
for all players to win. • Alter customer incentives
This has two Nash
• Apart from the law, there is no rule book. Equilibria Shril Sequential Games
• Others will change the game to their Sequential Games are solved by starting with the
Theatre Concert
advantage. last move in the game. Try to determine what the
• The game is made up of five PARTS: Players; 1 -1 player would do. Then trim the tree by
Concert Theatre

Added Values; Rules; Tactics; and Scope. eliminating dominated strategies or the path that
Nash
• Success comes from playing the right game. -1 the game will not take. Repeat this procedure
2
Hal

working backwards until you reach the start. This

Strategy Games (Normal-form) -1 2 is known as the Backward Induction procedure.
• Strategy games are usually represented by a Nash Game (-20, -20)
payoff matrix which shows the players, -1 Enter
1 Tree (-20, -20)
strategies, and payoffs.
• The most famous example of normal-form Boeing
game is the Prisoner’s Dilemma. In this Battle of the Bismarck Enter
example there are two players; one chooses Not (100, 0)
the row and the other chooses the column. Imamura South is a
Imamura enter
Each player has two strategies (Confess or dominated strategy Airbus
Deny), hence there are two rows and two North South (0, 100)
Enter
columns. The payoffs are provided in the
Not
interior -2 -2
North

enter
Nash Boeing
Nash Equilibrium 2 2
Kenney

• A Nash Equilibrium occurs where no player Not (0, 0)

has any incentive to change his or her action, -1 -3 (Airbus, Boeing) enter
South

assuming that the other player(s) have chosen

1 3 Collusion
their best actions for themselves.
Tacit or implicit collusion is sustainable if the “game” is
• We can use arrows in the payoff matrix to see being played repeatedly and infinitely. This relies on
what each player should do, given the other dynamic or trigger strategies. It also relies on some
player’s action. Bertrand-Nash Equilibrium form of “punishment” for those who play non-co-
• The Nash equilibrium is a self-reinforcing operatively (Grim Trigger Strategy). This punishment
Bertrand-Nash This occurs where two could be a reversion to the Nash Equilibrium.
focal point, and expectations of the other’s
behaviour are fulfilled. Not necessarily
Equilibrium competitor’s “Best Auctions
P2

Response” curves
efficient. Open, sequential:
intersect. It is found
by solving: • English (ascending) (=2nd price)
Dominant Strategy 𝑃=
𝑀𝐶 + 𝑃ത - Highest bid wins, winner pays the bid
• Dutch (descending) (=1st price)
• A player has a dominant strategy if this 2
- First bidder to accept price wins, pays the price
strategy gives her higher payoffs regardless Note that P2 will feature Private, simultaneous:
of what others do. It is uniformly better than in P1’s Choke Price. • First price, seal
P1
all other strategies. - Highest bid wins, winner pays the bid
- Bid lower than value, v*(n-1)/n, otherwise 0 surplus
• If you have a dominant strategy use it!
However, expect your opponent to use their
Cournot-Nash Equilibrium • Second price, seal (Vickrey)
- Highest bid wins, winner pays second highest bid
dominant strategy if they have one. A Nash This occurs where two - Bidding at value is a dominant strategy
Equilibrium occurs where both players are competitor’s capacity • Winner's Curse: highest bid above the value of good
Q2

using their dominant strategies. Cournot-Nash interests align. To find • Bid shading: bid below value to compensate Winner's
Equilibrium this point, set the Q in curse
the Demand Curve to
Dominated Strategy be Q1+Q2. Find MR =
• Rev. equivalence theorem: 1st and 2nd price auction
generates same expected income for seller
• A dominated strategy is a strategy that always MC
- Assumptions: No collusion, bidder risk neutral,
for Q1 and Q2. Then
offers lower payoffs, regardless of what others and plot Q1 with experienced bidders, bidders' values not correlated
do. If you spot a dominated strategy, respect to Q2 (and visa • Auctioneers: inexperienced = 2nd sealed; risk averse
eliminate it! Q1 versa) = 1st sealed/ Dutch; collusion = sealed; animal spirits
= English