Chapter 8: Profit Maximization and Competitive Supply

 Price Taking Firm: A price-taker is an individual or company that must accept

prevailing prices in a market, lacking the market share to influence market price on
its own.

 Product Homogeneity: A homogeneous product is one with no unique physical

characteristics or perceived attributes (or very few)

 Competitive Market - A market where there are a large number of buyers and sellers,
where no single buyer or seller can affect the price of goods being sold. It’s analogous to
perfect competition. In a competitive market, no one dominates the market and there is no
difference in quality, price, or quantity between the competing companies and what they
offer. Hence, this concept is largely theoretical.

 Perfect Competition - Perfect competition occurs when there are several buyers and
sellers, all companies sell identical/homogenous products, market share does not influence
price, companies are able to enter or exit without barriers, buyers have perfect or full
information, and companies cannot determine prices. As a result, the actions of any single
buyer or seller in the market has a negligible impact on the market price; they’re price
takers.

 Total Revenue – Calculated as, TR = Price x Quantity. It is proportional to the amount of

output.

 Average Revenue - It is the revenue that is earned per unit of output. In other words, it is
the revenue that is obtained by the seller on selling each unit of the commodity. Calculated
as, AR = Total Revenue / Quantity Sold

 Average Revenue in Perfect Competition – Avg. revenue will be equal to price, which in
turn will be equal to marginal revenue

 Marginal Revenue: It is the change in total revenue from an additional unit sold; calculated
as MR = ΔTR/ΔQ. For competitive firms, marginal revenue equals the price of the good.

 Marginal Cost (MC): ΔTC/ΔQ. For a certain increment in output, how much is it costing us?
As long as the cost of producing one more unit of output is higher than the current average,
the average will rise. At low quantities, the marginal cost curve is downward sloping. But as
MPL decreases (higher quantities), MC increases, and vice-versa. You can also say, when
diminishing returns sets in, the marginal cost (MC) goes up. The MC curve looks like a Nike
swoosh.

 Demand Curve of a Perfectly Competitive Firm: It’s horizontal, since each

quantity it sells extracts the same revenue and because it’s a price taker, its sales
will have no impact on the market demand. However, the industry demand curve will
continue to be downward sloping. In this case, both MR and AR will be equal to the
Price.
 Producer Surplus: It is the total amount that a producer benefits from producing
and selling a quantity of a good at the market price. The total revenue that a
producer receives from selling their goods minus the marginal cost of production
equals the producer surplus.

 Producer Surplus Graph: Producers would not

sell products if they could not get at least the
marginal cost to produce those products. The
producer surplus occurs between the seller’s
supply curve and the market price.

The producer surplus area falls above the

supply curve and below the market price
line. The supply curve is the marginal cost curve
for a business.

To know the overall economic surplus of the

market, the producer surplus is combined with the consumer surplus which tells the
benefits gained by both producers and consumers in the market.

 Zero Economic Profit: It is a term economists use when a company's total costs
are equal to its total revenues, which means its economic profit is equal to zero.
Usually, when a company is competitive and has revenues that cover its expenses, it
can report a zero economic profit. This just means that the market is competitive,
and not necessarily that the firm is performing poorly.

 Economic Rent: It is the amount of money earned that exceeds that which is
economically or socially necessary. Market inefficiencies or information asymmetries
are usually responsible for creating economic rent. Generally, economic rent is
considered unearned.

 Constant Cost Industry: It is an industry where each firm's costs aren't impacted
by the entry or exit of new firms. The supply curve of the constant cost industry is
horizontal.

 Increasing Costs Industry: The industry in which the cost of production increases
with the expansion of the market is known as the increasing cost industry. The
supply curve of the increasing cost industry is upward sloping.

 Decreasing Costs Industry: It indicates a market situation when the average cost
of production decreases with a rise in output production. It happens due to
economies of scale. The supply curve of the decreasing cost industry is downward
sloping.
Chapter 10: Market Power – Monopoly and Monopsony

 Monopoly: A market structure characterized by a single seller, selling a unique

product in the market. In a monopoly market, the seller faces no competition, as he
is the sole seller of goods with no close substitute. It’s in stark contrast to perfect
competition – it has imperfect market conditions.

 Monopsony: A market condition in which there is only one buyer, the monopsonist.
Like monopoly, this has imperfect market conditions.

 Characteristics of a Monopolist Market: They include –

 A monopolist faces a market demand curve

 Has lower quantities, higher prices

 Consumers pay more, as supply is short

 They charge a price higher than marginal cost

 Completely controls the output

 Monopolist must have knowledge of demand and cost to maximize profit

 Monopolist charges a price that exceeds marginal cost, but by an amount that
depends inversely on the elasticity of demand

 Market is said to be highly concentrated when only a few firms account for
most of the sales in a market

 Characteristics of a Monopsony Market: They include –

 Chooses a quantity to buy, that maximizes benefit derived

 Unusual – does not happen in most markets

 Market Power: It refers to a buyer or seller’s relative ability to manipulate the price
of an item in the marketplace by manipulating the level of supply, demand, or both.

 Monopolist’s Revenue Curve:

 The firm will have to reduce the price of the

product if it wants to sell more. Hence, the
demand curve is downward sloping and
Marginal Revenue < Price
  The average revenue per unit is identical to the price, hence, Demand =
Average Revenue

 AR and MR are both negative sloped (downward sloping) curves

 AR cannot be zero, but MR can be zero or even negative

 Average revenue is greater than marginal revenue because all units are sold at
the same price

 If an additional unit has to be sold, price must come down, and therefore all
additional units sold will earn lesser revenue

 If MR exceeds MC, a Monopolist should increase output, because they’re losing

out on profit owing to producing less

 If MC exceeds MR, a Monopolist should decrease output, because they’re losing

out on profit by producing too much and selling it at a lower price

 Therefore, profit is maximized when MR = MC. At this level, the slope of the
profit curve is zero.

 In this case, MR = ΔR / ΔQ and also, Δ(PQ) / ΔQ

 The amount by which price exceeds MC is inversely proportional to the elasticity

of demand

 Shift in Demand for a Monopolist:

 In a monopolistic market, there’s no supply curve

 In other words, there’s no one-to-one relationship between price and quantity

produced

 Several quantities could be sold at the same price, or the same quantity at
different prices

 For a monopoly, the price depends on the shape of the demand curve

 Shift in demand usually causes changes in both price and quantity

 The less elastic the demand curve, the more monopoly power a firm has

 Effect of Taxes: Unlike a competitive market, in a monopoly, the monopolist might

absorb some portion of a tax even in the long run. However, they can also increase
the price which is not proportional to the tax charged.

 Key Differences Between Perfect Competition and Monopoly:

  For a competitive firm, price equals marginal cost. For a firm with monopoly
power, price exceeds marginal cost.

 Lerner’s Index of Monopoly Power: It’s a measure of the market power of a firm.

 It’s the difference between price and marginal cost, divided by price

 Lerner index = (P – MC)/P. P represents the price of the good set by the firm
and MC represents the firm’s marginal cost.

 Lerner’s index always has a value between zero to one

 The higher the value of the Lerner index, the more the firm can charge over its
marginal cost, hence the greater its monopoly power.

 When ‘L = 0’, it signifies perfect competition; similarly, when ‘L = 1,’ it

indicates a pure monopoly.

 Markup Price: It is the difference between a product's selling price and cost as a
percentage of the cost.

 Factors that Determine Monopoly Power: They include –

 Elasticity of Market Demand – If there’s only one firm, it’s demand curve is the
market demand curve

 Number of Firms – The more the no. of the firms in the market, the lesser each
firm has power/control over the price

 Interaction among Firms – If firms work individually, their monopoly power

decrease. If they collude with each other (illegal), it will increase their
monopoly.

 Deadweight Loss: It is a cost to society created by market inefficiency, which

occurs when supply and demand are out of equilibrium. This concept can be applied
to any deficiency caused by an inefficient allocation of resources.

 Rent Seeking: It’s an economic concept that occurs when an entity seeks to gain
wealth without any reciprocal contribution of productivity. An example of rent
seeking is when a company lobbies the government for grants, subsidies, or tariff
protection. Rent seeking comes in many forms from lobbying or donating funds.

 Price Regulation / Price Control: It refers to the legal minimum or maximum

prices set for specified goods. It’s normally mandated by the government and are
implemented as a means of direct economic intervention to manage the affordability
of certain goods and services.
  Natural Monopoly: It is a monopoly in which high infrastructural costs and other
barriers to entry relative to the size of the market give the largest supplier in an
industry, often the first supplier in a market, an overwhelming advantage over
potential competitors.

 Rate-of-Return Regulation: A regulatory method that provides the firm with the
opportunity to recover prudently incurred costs, including a fair return on
investment. Revenue requirements equal operating costs, plus the allowed rate of
return, times the rate base.

 Monopsony Power: This happens when one buyer faces little competition from
other buyers for that labor or good, so they are able to set wages or prices for the
labor or goods they are buying at a level lower than would be the case in a
competitive market. The less elastic the supply (elastic demand), the more
monopsony power the buyer will have.

 Bilateral Monopoly: This monopoly exists when a market has only one supplier and
one buyer. The one supplier will tend to act as a monopoly power and look to charge
high prices to the one buyer. However, both have bargaining power.

Chapter 11: Pricing with Market Power

 Consumer Surplus: Consumer Surplus or Buyer’s Surplus is an economic

measurement of the customer’s excess benefit. In an economy, a consumer surplus
takes place when the consumer is willing to pay more for a product than its market
price.

 Capturing Consumer Surplus: For consumers

who would be willing to pay more than ‘P’, the
seller increases the price to ‘P1’ . These consumers
would fall under the ‘A’ area, which is the
consumer surplus that the seller extracts.

For consumers who are unwilling or unable to

purchase at price ‘P’, the seller would reduce the
price to ‘P2’ and those consumer fall under the
area ‘B’.

 Price Discrimination: It is a selling strategy that charges customers different prices

for the same product or service based on what the seller thinks they can get the
customer to agree to pay. In pure price discrimination, the seller charges each
customer the maximum price they will pay.
 Types of Price Discrimination: There are three types of price discrimination: first-
degree or perfect price discrimination, second-degree, and third-degree.

These degrees of price discrimination are also known as personalized pricing (1st-
degree pricing), product versioning or menu pricing (2nd-degree pricing), and group
pricing (3rd-degree pricing).

 First-Degree Price Discrimination: First-degree discrimination, or perfect price

discrimination, occurs when a business charges the maximum possible price for each
unit consumed (or the reservation price of the customer). Because prices vary
among units sold, the firm captures all available consumer surplus for itself or the
economic surplus. Many industries involving client services, practice first-degree
price discrimination, where a company charges a different price for every good or
service sold.

 Second-Degree Price Discrimination: Second-degree price discrimination occurs

when a company charges a different price for different quantities consumed, such as
quantity discounts on bulk purchases. E.g., A single light bulb may cost more than a
dozen light bulbs.

 Third-Degree Price Discrimination: Third-degree price discrimination occurs

when a company charges a different price to different consumer groups. For
example, a theater may divide moviegoers into seniors, adults, and children, each
paying a different price when seeing the same movie. This discrimination is the most
common.

 Reservation Price: It’s the highest price a buyer is willing to pay for a good or
service, and the minimum price that a seller is willing to accept.

 Imperfect Price Discrimination: It’s the opposite for perfect price discrimination
(first-degree discrimination), where the sellers are not looking to necessarily extract
consumer surplus. Examples could include college tuition fees, rates charged to the
underprivileged by doctors, etc.

 Block Pricing: The consumer is charged different prices for different quantities or
‘blocks’ of a good. For example, a pack of 1–10 units costs $10, while a pack of 11–
20 units costs $18.

 Intertemporal Price Discrimination: This kind of discrimination provides a

method for firms to separate consumer groups based on willingness to pay. The
strategy involves charging a high price initially, then lowering price after time
passes. Many technology products and recently released products follow this
strategy. E.g., iPhone

 Peak Load Pricing: This strategy involves charging a high price during demand
peaks, and a lower price during off-peak time periods.
 Two-Part Tariff: This is a form of price discrimination wherein the price of a product
or service is composed of two parts – a lump-sum fee as well as a per-unit charge.
E.g., amusement parks often charge an admission fee and an additional price per
ride.

 Bundling: This is when companies package several of their products or services

together as a single combined unit, often for a lower price than they would charge
customers to buy each item separately. When demands are heterogenous and
negatively correlated, bundling can increase profits

 Mixed Bundling: Selling two or more goods both as a package and individually

 Pure Bundling: Selling goods only as a bundle

 Tying: Practice of requiring a customer to purchase one good in order to purchase

another

 How Much Advertising?

 When a firm advertises, the demand curve shifts to the right as the demand
rises, since more advertising leads to more sales and output

 When this happens, AC rises, MC remains the same

 Advertising must be increased until MR equals the full MC of advertising

Chapter 12: Monopolistic Competition and Oligopoly

 Monopolistic Competition: Monopolistic competition exists when many companies

offer competing products or services that are similar, but not perfect, substitutes.
The barriers to entry in a monopolistic competitive industry are low, and the
decisions of any one firm do not directly affect its competitors.

 Characteristics of Monopolistic Competition: These include –

 Downward (negative) sloping curve

 They have some monopoly power since products are differentiated

 Since barriers to entry is negligible, it will attract more firms, which will inurn
drive economic profits to zero

 In the short run, firms earn profit. In the long run, price equals average cost,
hence economic profits will be zero

 From a consumer perspective, the firms and their brands are easily
substitutable
  Consumers have a diverse set of products to choose from, and hence the
demand curve will be fairly elastic

 Oligopoly: It is a market structure with a small number of firms, none of which can
keep the others from having significant influence. This is imperfect competition as
the decision of one vendor affects the decision of others in the market, although the
competition is very limited. The main characteristics of this type of market is the
interdependence of the vendors that urge them to either collaborate or compete with
each other to control the market, affecting the demand and supply based on the
prices.

 Nash Equilibrium: This is a concept in game theory where the optimal outcome is
when there is no incentive for players to deviate from their initial strategy. The
players have knowledge of their opponent’s strategy and still will not deviate from
their initial chosen strategies because it remains the optimal strategy for each
player. In simple terms, it means that each firm is doing the best it can, given what
its competitors are doing.

 Cournot Model: The firms produce homogenous goods and know the demand
curve. Each firm must decide how much to produce depending on the output level of
its competitors, which is treated as fixed. Both firms make this decision
simultaneously, and the market price depends on total output of both firms. For e.g.,
if the market demand is for 100 goods, and Firm A assumes that Firm B’s output is
75, then Firm A will decide to produce only 25 units

 Cournot – Nash Equilibrium: Each firm correctly assumes how much its competitor
will produce and sets its own production level to maximize its profits accordingly.

 Which Outcome is Better for Firms? Cournot outcome is better for firms than
perfect competition but not as good as collusion (Oligopoly).

 Stackelberg Model: It an oligopoly market model based on a non-cooperative

strategic game where one firm (the “leader”) moves first and decides how much to
produce, while all other firms (the “followers”) decide how much to produce
afterwards, unlike the Cournot model.

 Bertrand Model: It’s a model of competition in which two or more firms produce a
homogenous good, each firm treats the price of its competitors as fixed, and all firms
simultaneously decide what price to charge (unlike Cournot model where they decide
on output levels instead of prices).

 Prisoner’s Dilemma: The police have arrested two suspects and are interrogating
them in separate rooms. Each can either confess, thereby implicating the other, or
keep silent. No matter what the other suspect does, each can improve his own
position by confessing. If the other confesses, then one had better do the same to
avoid the especially harsh sentence that awaits a stubborn holdout. If the other
 keeps silent, then one can obtain the favorable treatment accorded a state’s witness
by confessing. Thus, confession is the dominant strategy for each. But when both
confess, the outcome is worse for both, than when both keep silent.

 Payoff Matrix: It’s a matrix or table that shows the profit or payoff to each firm
given its decision and the decision of its competitors.

 Price Rigidity: It refers to a situation in which the price remains constant despite
changes in demand and supply conditions. Firms use other methods like advertising,
better services to customers etc. to compete with each other.

 Kinked Demand Curve: In many oligopolist

markets, it has been observed that prices tend to
remain inflexible for a very long time. According
to the kinked demand curve hypothesis, the
demand curve facing an oligopolist has a kink at
the level of the prevailing price. This kink exists
because of two reasons:

 The segment above the

prevailing price level (higher prices) is
highly elastic.

 The segment below the prevailing price

(lower prices) level is inelastic.

 Price Signaling: It’s a form of implicit collusion in which a firm announces a price
increase in the hope that the other firms will follow suit, so that all of them can earn
higher profits.

 Price Leadership: A pattern that occurs when a leading firm, in a given industry, is
able to exert enough influence in the sector that it can effectively determine the
price of goods or services for the entire market. Other firms try to match.

 Cartels: It’s a group of independent market participants who collude with each other
in order to improve their profits and dominate the market. Cartels are usually
associations in the same sphere of business, and thus an alliance of rivals. Most
jurisdictions consider it anti-competitive behavior and have outlawed such practices.

Chapter 13: Game Theory and Competitive Strategy

 Game: A situation in which firms make strategic decisions that take into account
each other’s’ actions and responses.
 Dominant Firm: A firm which accounts for a significant share of a given market and
has a significantly larger market share than its next largest rival. Dominant firms are
typically considered to have market shares of 40 per cent or more.

 Payoff: It’s the value associated with a possible outcome.

 Optimal Strategy: A strategy that maximizes a player’s expected payoff.

 Dominant Strategy: A strategy that’s optimal no matter what the opponent does.

 Cooperative Vs Non-Cooperative: A game in which participants can negotiate

binding contracts that allow them to plan joint strategies is a cooperative game
strategy. Game in which negotiation and enforcement of binding contracts are not
possible, is called a non-cooperative game.

 Equilibrium in Dominant Strategies: Outcome of a game in which each firm is

doing the best it can regardless of what the competitors are doing.

 Maximin Strategy: A firm determines the worst outcome for each option, then
chooses the option that maximizes the payoff among the worst outcomes.

 Tit for Tat Strategy: A strategy for playing a repeated game that is founded on the
principle of retaliation. An agent using this strategy will first cooperate, then
subsequently replicate an opponent's previous action. If the opponent previously was
cooperative, the agent is cooperative. If not, the agent is not cooperative.

 Sequential Game: This involves multiple players who do not make decisions
simultaneously, and one player's decision affects the outcomes and decisions of
other players. A sequential game is represented by a game tree (also called the
extensive form) with players moving sequentially.

Chapter 17: Markets with Asymmetric Information

 Asymmetric Information: It is also referred to as ‘Information Failure’ and it occurs
during economic transactions when one side has more material information about
the goods and services than the other side. Typically, sellers possess greater
knowledge about goods or services than consumers.

 Lemons Problem: The lemons problem refers to issues that arise regarding the
value of an investment or product due to asymmetric information possessed by the
buyer and the seller. E.g., selling a used car.

 Adverse Selection: It occurs when one party in a negotiation has relevant

information which the other party lacks. The asymmetry of information often leads to
making bad decisions, such as doing more business with less profitable or riskier
market segments. Buyers or sellers of a product or service can use their private
knowledge of the risk factors involved in the transaction to maximize their
 outcomes, at the expense of the other parties to the transaction. E.g., price
of premium set by insurance companies.

 Market Signaling: A signal sent by the seller to the buyer, to convey information
about product quality. A job seeker may signal a potential employer using skills or
educational qualifications, a used product seller may signal a customer,
guarantee/warranty on a product, etc.

 Moral Hazard: It’s the risk that a party has not entered a contract in good faith or
has provided misleading information about its assets, liabilities, or credit capacity. In
addition, moral hazard also may mean a party has an incentive to take unusual risks
in a desperate attempt to earn a profit before the contract settles. E.g., Not locking
doors after buying theft insurance, not taking fire safety precautions after purchasing
accident insurance, etc. Thus, moral hazard not only alters behavior, but it also
creates economic inefficiency.

 Principal-Agent Problem: This problem is a conflict in priorities between the owner

of an asset and the person to whom control of the asset has been delegated. The risk
that the agent will act in a way that is contrary to the principal’s best interest can be
defined as agency costs. Examples can include CEOs or insurance agents catering to
their own interests instead of the shareholders or clients.

 Horizontal vs Vertical Integration: Horizontal integration is an expansion strategy

adopted by a company that involves the acquisition of another company in the same
business line. Vertical integration refers to an expansion strategy where one
company takes control over one or more stages in the production or distribution of a
product.

 Efficiency Wage Theory: Increasing wages can lead to increased labor productivity
because workers feel more motivated to work with higher pay. Therefore, if firms
increase wages – some or all the higher wage costs will be recouped through
increased staff retention and higher labor productivity.

 Shirking Model: The argument is that if workers are paid a higher wage, they have
more to lose from being made redundant. Therefore, if they have a job with a wage
significantly higher than benefits or alternative jobs, they will have greater
motivation to do a good job. They will still have an incentive to shirk if the company
pays them a market-clearing wage.

 Efficiency Wage: It refer to employers paying higher than the minimum wage to
retain skilled workers, not to shirk, increase productivity, or ensure loyalty.

Chapter 18: Externalities and Public Goods

 Externalities: An externality is a cost or benefit caused by a producer that is not
financially incurred or received by that producer. An externality can be both positive
or negative and can stem from either the production or consumption of a good or
service. The costs and benefits can be both private—to an individual or an
organization—or social, meaning it can affect society as a whole.
 Negative Externality: Most externalities are negative. Pollution is a well-known
negative externality. A corporation may decide to cut costs and increase profits by
implementing new operations that are more harmful to the environment. The cost for
this would have to be paid by the public who are harmed by the pollutants released
by the factory.

 Positive Externality: Positive externalities occur when there is a positive gain on

both the private level and social level. A person may repaint their house and plant a
garden, which is not done keeping the public interest in mind but ends up benefitting
the public anyway.

 Stock Externalities: They represent a type of consumption externality in which

individual consumption of a particular good leads to production of a public bad, such
as in the arms race and in the greenhouse effect.

 Coase Theorem: It offers a potentially useful way to think about how to best resolve
conflicts between competing businesses or other economic uses of limited resources.
For the Coase Theorem to apply fully, the conditions of efficient, competitive
markets, and most importantly zero transaction costs, must occur.

 Public Good: It refers to a commodity or service that is made available to all

members of a society. Typically, these services are administered by governments
and paid for collectively through taxation.

 Types of Public Good: Rival Good vs. a Non-Rival Good -

A rival good is something that can only be possessed or consumed by a single user. A
good that can be consumed or possessed by multiple users, on the other hand, is
said to be a non-rival good.

 Non-Excludable Goods: It refers to public goods that cannot exclude a certain

person or group of persons from using such goods. As a result, restricting access to
the consumption of non-excludable goods is nearly impossible. For example, a public
road allows practically everyone to use it regardless of the type of motor vehicle they
are using, or even if they are just walking.