‘MBA50 – Notes in

Managerial Economics’

by Panagiotis Fousekis and

Vangelis Tzouvelekas
Introduction
➢ Economic vs Accounting Cost
✓ Explicit cost: monetary cost of using market-supplied resources (e.g.,
wages, cost of materials)
✓ Implicit cost: monetary cost of using owner-supplied resources –
opportunity cost (e.g., equity capital, land, time)

➢ Economic vs Accounting Profit

✓ Accounting profit = Total revenues - Explicit cost
✓ Economic profit = Accounting profit - Implicit cost

➢ Maximizing the Value of the Firm

✓ Equivalent to maximize economic profits
✓ Different than market share (i.e., total revenues) maximization

➢ Ownership and Control

✓ The goals of manager do not match the goals of the owner
✓ Either the manager or the owner has an incentive not to abide the
agreement and no-one can effectively monitor the agreement
The Market of Goods and Services: The Demand Function
➢ Market Demand: Quantities consumers are willing to purchase at
each price.

➢ General Demand Function: 𝑄𝑑 = 𝑓 𝑝𝑞 , 𝑝𝑦 , 𝑀, 𝑝𝑞𝑒 , 𝑇, 𝑛

✓ 𝑄𝑑 : quantity of good or service demanded
✓ 𝑝𝑞 : price of good or service (-)
✓ 𝑝𝑦 : price of related good or service (+ for substitutes, - for complements)
✓ 𝑀: consumer’s income (+ for normal goods, - for inferior goods)
✓ 𝑝𝑞𝑒 : expected price of good or service (+)
✓ 𝑇: taste preferences (+, -)
✓ 𝑛: number of consumers (+)

➢ Assume a linear relationship between 𝑄 𝑑 and 𝑝𝑞 , all else constant:

✓ Direct demand function: 𝑄𝑑 = 𝑎 − 𝑏𝑝𝑞
𝑎 1
✓ Indirect (or inverse) demand function: 𝑝𝑞 = 𝑏 − 𝑏 𝑄𝑑
The Market of Goods and Services: Shifts in the Demand Function

𝑝𝑞
𝐴 → 𝐵: Δ𝑝𝑞 > 0
𝐴 → 𝐶: Δ𝑛 > 0
𝐴 → 𝐸: Δ𝑀 < 0 and 𝑄 normal good

𝐸
•𝐴 𝐶

0 𝑄2𝑑 𝑄0𝑑 𝑄1𝑑 𝑄

The Market of Goods and Services: Demand Elasticities (Point Estimates)
%Δ𝑄𝑑 𝑑𝑄𝑑 𝑝𝑞
➢ Own-Price Elasticity of Demand: 𝜀𝑞𝑑 = =
%Δ𝑝𝑞 𝑑𝑝𝑞 𝑄𝑑
✓ −1 < 𝜀𝑞𝑑 < 0: inelastic demand
✓ 𝜀𝑞𝑑 = 0: perfectly inelastic demand
✓ −∞ < 𝜀𝑞𝑑 < −1: elastic demand
✓ 𝜀𝑞𝑑 → −∞: perfectly elastic demand

𝑑 %Δ𝑄𝑑 𝑑𝑄𝑑 𝑝𝑦
➢ Cross-Price Elasticity of Demand: 𝜀𝑞,𝑦 = =
%Δ𝑝𝑦 𝑑𝑝𝑦 𝑄𝑑
𝑑 > 0: goods 𝑞 and 𝑦 are substitutes
✓ 𝜀𝑞,𝑦
✓
𝑑 = 0: goods 𝑞 and 𝑦 are independent
𝜀𝑞,𝑦
✓
𝑑 < 0: goods 𝑞 and 𝑦 are complements
𝜀𝑞,𝑦
𝑑 %Δ𝑄𝑑 𝑑𝑄𝑑 𝑀
➢ Income Elasticity of Demand: 𝜀𝑀 = =
%Δ𝑀 𝑑𝑀 𝑄𝑑
𝑑
✓ 𝜀𝑀 > 1: 𝑞 is a luxury good
𝑑
✓ 0 < 𝜀𝑀 < 1: 𝑞 is a necessity good
𝑑
✓ 𝜀𝑀 < 0: 𝑞 is an inferior good
The Market of Goods and Services: Demand Elasticities (Arc Estimates)
➢ Own-Price Elasticity of Demand:
𝑑 𝑑 𝑑 𝑝 1 + 𝑝 2 Τ2
%Δ𝑄 𝑄2 − 𝑄 1 𝑞 𝑞
𝜀𝑞𝑑 = = ∗
%Δ𝑝𝑞 𝑝𝑞2 − 𝑝𝑞1 𝑄1𝑑 + 𝑄2𝑑 Τ2

➢ Cross-Price Elasticity of Demand:

𝑑 𝑑 𝑑 1 + 𝑝 2 Τ2
𝑑
%Δ𝑄 𝑄 2 − 𝑄 1 𝑝 𝑦 𝑦
𝜀𝑞,𝑦 = = ∗
%Δ𝑝𝑦 𝑝𝑦2 − 𝑝𝑦1 𝑄1𝑑 + 𝑄2𝑑 Τ2

➢ Income Elasticity of Demand:

𝑑 𝑑 𝑑
𝑑 %Δ𝑄 𝑄 2 − 𝑄1 𝑀1 + 𝑀2 Τ2
𝜀𝑀 = = ∗
%Δ𝑀 𝑀2 − 𝑀1 𝑄1𝑑 + 𝑄2𝑑 Τ2
The Market of Goods and Services: Example #1
PK Corp. estimates that its demand function is as follows:
𝑞𝑘𝑑 = 150 − 5.4𝑝𝑘 + 0.8𝐴𝑘 + 2.8𝑀 − 1.2𝑝𝑏

where 𝑞𝑘𝑑 is the quantity demanded per month (in ths), 𝑝𝑘 is the price
of its product (in €), 𝐴𝑘 its advertising expenses (in ths €), 𝑀 the per
capita disposable income (in ths €) and 𝑝𝑏 the price of the product of
BJ Corp. (also in €). Using these, please answer the following:

1. In the next five years, per capita disposable income is expected to

increase by 2.5 ths €. What effect will this have on PK Corp. sales?
𝑑𝑞𝑘𝑑
Answer: From the estimated demand we get = 2.8. Since
𝑑𝑀
𝑑𝑞𝑘𝑑
𝑑𝑀 = 2.5 ths €, it holds that = 2.8 ⇒ 𝑑𝑞𝑘𝑑 = 7 ths.
2.5
The Market of Goods and Services: Example #1
2. If PK Corp. wants to raise its price by enough to offset the effect of
the increase in per capita disposable income, by how much must
it raise its price?
𝑑𝑞𝑘𝑑 7
Answer: = −5.4 which implies that − = −5.4 ⇒ 𝑑𝑝𝑘 =
𝑑𝑝𝑘 𝑑𝑝𝑘
1.30€.

3. What is the relationship between PK Corp. and BJ Corp.? Explain

your answer.
Answer: The two companies make complementary products
𝑑𝑞𝑘𝑑
because it holds that = −1.2 < 0.
𝑑𝑝𝑏
The Market of Goods and Services: Example #1
4. If PK Corp. intends to charge 15 € for its product and spend 10 ths €
per month on promotion while at the same time it believes that per
capita disposable income will be 12 ths € and BJ Corp. price will be 3€,
calculate the income elasticity of demand.
Answer: Income elasticity of demand is calculated from
𝑑𝑞𝑘𝑑 𝑀 2.8×12
= = 0.314.
𝑑𝑀 𝑞𝑘𝑑 150− 5.4×15 + 0.8×10 + 2.8×12 − 1.2×3

5. What's the effect on profits if advertising expenses increase by 1 ths

€? Assume that average cost is 10 € and the product is sold for 15€.
𝑑𝑞𝑘𝑑
Answer: From the demand function we know that = 0.8. Thus,
𝑑𝐴𝑘
𝑑𝑞𝑘𝑑 = 0.8 × 1 = 0.8 ths. This implies that Δ𝑇𝑅𝑘 = 0.8 × 15 = 12 ths €.
Total cost changes by Δ𝑇𝐶𝑘 = 0.8 × 10 + 1 = 9 ths €. Therefore, any
additional ths € spent on advertising, increases profit by Δ𝜋𝑘 =
Δ𝑇𝑅𝑘 − Δ𝑇𝐶𝑘 = 12 − 9 = 3 ths €.
The Market of Goods and Services: The Supply Function
➢ Market Supply: Quantities firms are willing to sell at each price.

➢ General Supply Function: 𝑄 𝑠 = 𝑓 𝑝𝑞 , 𝑤, 𝑝𝑦 , 𝑡, 𝑝𝑞𝑒 , 𝐹

✓ 𝑄 𝑠 : quantity of good or service supplied
✓ 𝑝𝑞 : price of good or service (+)
✓ 𝑤: price of variable inputs used in production (-)
✓ 𝑝𝑦 : price of related good or service (- for substitutes, + for complements)
✓ 𝑡: technological advances (+)
✓ 𝑝𝑞𝑒 : expected price of good or service (-)
✓ 𝐹: number of firms in the market, i.e. capacity of the industry (+)

➢ Assume a linear relationship between 𝑄 𝑠 and 𝑝𝑞 , all else constant:

✓ Direct supply function: 𝑄 𝑠 = 𝑐 + 𝑑𝑝𝑞
𝑐 1
✓ Indirect (or inverse) supply function: 𝑝𝑞 = − 𝑑 + 𝑑 𝑄 𝑠
%Δ𝑄𝑠 𝑑𝑄𝑠 𝑝𝑞
➢ Price Elasticity of Supply: 𝜀𝑞𝑠 = =
%Δ𝑝𝑞 𝑑𝑝𝑞 𝑄𝑠
The Market of Goods and Services: Shifts in the Supply Function

𝐴 → 𝐵: Δ𝑝𝑞 > 0 𝑄2𝑠

𝑝𝑞 𝐴 → 𝐶: Δ𝐹 > 0
𝐴 → 𝐸: Δ𝑤 > 0
𝑄0𝑠
𝐵
𝐸 𝐴 𝐶 𝑄1𝑠
•

0 𝑄
Equilibrium in a Perfectly Competitive Market
𝑝𝑞
𝑝𝑞1 : 𝑄1𝑑 − 𝑄1𝑠 < 0 → Δ𝑝𝑞 < 0
𝑝𝑞2 : 𝑄2𝑑 − 𝑄2𝑠 > 0 → Δ𝑝𝑞 > 0
𝑝𝑞∗ : 𝑄 𝑑 − 𝑄 𝑠 = 0 → Δ𝑝𝑞 = 0 𝑄𝑠

𝑝𝑞1

𝑝𝑞∗ 𝐴

𝑝𝑞2

𝑄𝑑
0 𝑄1𝑑 𝑄2𝑠 𝑄∗ 𝑄2𝑑 𝑄1𝑠 𝑄
Equilibrium in a Perfectly Competitive Market: Comparative Statics

𝑝𝑞 𝑄1𝑠

𝑄0𝑠

𝐵
𝑝𝑞1
𝐴
𝑝𝑞∗
𝐶
𝑝𝑞2

0 𝑄2 𝑄1 𝑄∗ 𝑄1𝑑 𝑄0𝑑 𝑄
Firm Technology: Production Function
𝑄 The production
𝑀𝑃𝐿 = 0 function is the
technical relationship
𝑀𝑃𝐿 = 𝐴𝑃𝐿 𝑇𝑃 between the amount
of inputs used to
produce a good and
𝑀𝑃𝐿 < 𝐴𝑃𝐿 the amount of the
(region of decreasing
returns to scale) good produced.

𝑇𝑃 = 𝑓 𝐿
𝑇𝑃 𝐿
𝐴𝑃𝐿 =
𝐿
𝑑𝑇𝑃 𝐿
𝑀𝑃𝐿 =
𝑀𝑃𝐿 > 𝐴𝑃𝐿 𝑑𝐿
(region of increasing
returns to scale)
0 𝐿1 𝐿2 𝐿
Firm Technology: Short-run Cost Function
➢ The cost function is an economic relationship between the cost
and the level of output produced.

✓ The cost of production may be divided into variable and fixed. In

the short-run, part of the total cost is fixed because the quantities
of certain inputs cannot be freely adjusted.
✓ Assume that a production process that utilizes two inputs 𝐿 and 𝐾
with unit prices 𝑤 and 𝑟, respectively. Assume further that the
quantity of 𝐿 is perfectly variable in the short-run, while that of 𝐾
is absolutely fixed. The total cost 𝑇𝐶 in this case in 𝑇𝐶 = 𝑤𝐿 +
𝑟𝐾 and it consists of the variable part 𝑆𝑉𝐶 = 𝑤𝐿 and the fixed part
𝐹 = 𝑟𝐾.
✓ Since the amount of 𝐿 used depends on the level of output 𝑄, we
write 𝑆𝑇𝐶 𝑄 = 𝑆𝑉𝐶 𝑄 + 𝐹.
Firm Technology: Short-run Cost of Production

𝑆𝑇𝐶, 𝑆𝑉𝐶, 𝐹𝐶 𝑆𝑇𝐶 𝑄

𝑆𝐴𝐶 𝑄 = 𝑆𝑀𝐶 𝑄 𝑆𝑉𝐶 𝑄

Total, Average, and
Marginal Cost in the
Short-run :
𝑆𝐴𝑉𝐶 𝑄 = 𝑆𝑀𝐶 𝑄
𝐹𝐶 𝑆𝑇𝐶 𝑄 = 𝑆𝑉𝐶 𝑄 + 𝐹𝐶
𝑆𝑉𝐶 𝑄 𝐹𝐶
0 𝑄 𝑆𝐴𝐶 𝑄 = +
𝑄 𝑄
𝑆𝑀𝐶, 𝑆𝐴𝑉𝐶, 𝑆𝑉𝐶 𝑄
𝑆𝐴𝐶 𝑄 𝑆𝑀𝐶 𝑄 𝑆𝐴𝑉𝐶 𝑄 =
𝑆𝐴𝐶 𝑄
𝑆𝐴𝑉𝐶 𝑄 𝑆𝐴𝐹𝐶 = 𝑆𝐴𝐶 𝑄 − 𝑆𝐴𝑉𝐶 𝑄
𝑑𝑆𝑇𝐶 𝑄
𝑆𝑀𝐶 𝑄 =
𝑑𝑄
𝑚𝑖𝑛 𝑆𝑀𝐶 𝑄

0 𝑄1 𝑄 2 𝑄 3 𝑄
Firm Technology: Average Cost, Marginal Cost, and Cost Elasticity
in the Long-run

𝐿𝑀𝐶, 𝐿𝐴𝐶
𝐿𝑀𝐶 𝑄
𝐿𝐴𝐶 𝑄

𝐴
𝑚𝑖𝑛 𝐿𝐴𝐶 In the long-run, the
quantities of all inputs
can be adjusted. Thus,
the cost is variable.

𝜀<1 𝜀>1

0 𝑀𝐸𝑆 (minimum efficient scale) 𝑄

𝒅𝑻𝑪 𝑸 𝑸
Cost elasticity: the % change in 𝑻𝑪 due to an 1% change in 𝑸 (obtained as 𝜺 = )
𝒅𝑸 𝑻𝑪 𝑸
Firm Technology: The Duality between
Production and Cost Functions
➢ The production and the cost function provide exactly the same
information about the underlying technology.
a) When the production increases at an increasing (decreasing) rate the
cost increases at a decreasing (increasing) rate.
b) When 𝑀𝑃 > < 𝐴𝑃, then 𝑀𝐶 < > 𝐴𝐶.
c) When production takes place at the region of increasing (decreasing)
returns the cost elasticity is below (above) 1; when production takes
place at constant returns to scale, the cost elasticity equals 1.
In addition,
d) The 𝑀𝑃 curve cuts the 𝐴𝑃 curve from above at the input level where
𝐴𝑃 receives its maximum value.
e) The 𝑀𝐶 curve cuts the 𝐴𝐶 curve from below at the level of 𝑄 where
𝐴𝐶 receives its minimum value.
Different Market Structure: Basic Characteristics

Perfect Monopolistic Oligopoly Monopoly

Competition Competition
No of Many Many Few One
Firms
Barriers to No No High barriers High barriers
Entry (free entry) (free entry) (difficult entry) (no entry)
Type of Homogeneous Differentiated Homogeneous Unique
Product (identical) or differentiated
Control No control Yes Yes Considerable
over Price (less than in (take into amount of
monopoly) account what control
competitors do)
Examples Agricultural Airliners, Car industry, Electricity,
products restaurants pharmaceuticals trains
Managerial Decisions in Perfectly Competitive Markets
➢ Conditions for Perfectly Competitive Markets:
✓ Many buyers and sellers: fragmented industry so that each

company has negligible market share that cannot change the whole
structure.
✓ Homogeneous product: Consumers will not incur additional costs

in collecting additional information.

✓ Perfect mobility of inputs: no entry or exit barriers.

✓ Perfect information.

✓ No transaction costs.

➢ Firms’ Revenues and Profits:

𝑇𝑅 𝑞 𝑑𝑇𝑅 𝑞
✓ 𝑇𝑅 𝑞 = 𝑝𝑞 × 𝑞, 𝐴𝑅 𝑞 = = 𝑝𝑞 and 𝑀𝑅 𝑞 =
𝑞 𝑑𝑞
Managerial Decisions in Perfectly Competitive Markets:
The Perfectly Elastic Demand for an Individual firm

𝑝𝑟𝑖𝑐𝑒

The individual firm in perfect competition is a price taker; it cannot

influence the market price by changing the quantity it brings into the
market. Therefore, it faces a demand curve that is parallel to the 𝑸
axis at the prevailing market price 𝒑𝒒 . This, in turn, implies:

𝑀𝑅 𝑞 = 𝐴𝑅 𝑞 = 𝑝𝑞
𝑄0𝑑

0 𝑄
Managerial Decisions in Perfectly Competitive Markets:
Short-run Equilibrium of an Individual Firm

➢ The Profit Maximization Rule

✓ The objective of the individual firm is to maximize profit. Since it

cannot control price, the only choice variable it has is the quantity it
brings into the market.

✓ Maximizing 𝜋 𝑄 = 𝑇𝑅 𝑄 − 𝑆𝑇𝐶 𝑄 with respect to 𝑄 leads to

𝑀𝑅 𝑄 = 𝑆𝑀𝐶 𝑄 or (because under perfect competition 𝑀𝑅 = 𝑝𝑞 )
to 𝑝𝑞 = 𝑆𝑀𝐶 𝑄 . The last relationship is the profit-maximizing rule
for the competitive firm in the short run, according to which the
firm maximizes profit by selecting the output level that equates
marginal cost to the prevailing output price.
Managerial Decisions in Perfectly Competitive Markets:
Short-run Equilibrium of an Individual Firm

𝑝𝑞 , 𝑐
𝑆𝑀𝐶 = 𝑞 𝑠 𝑆𝐴𝑇𝐶
𝑆𝐴𝑉𝐶

𝜋>0 𝐵
𝑝𝑞1 𝜋=0
𝜋<0
𝐴 If 𝑝𝑞∗ > 𝑆𝐴𝑇𝐶 → 𝜋 > 0
𝑝𝑞0 If 𝑝𝑞∗ = 𝑆𝐴𝑇𝐶 → 𝜋 = 0
𝑠ℎ𝑢𝑡 𝑑𝑜𝑤𝑛 𝑝𝑟𝑖𝑐𝑒
If 𝑆𝐴𝑉𝐶 ≤ 𝑝𝑞∗ < 𝑆𝐴𝑇𝐶 → 𝜋 < 0
If 𝑝𝑞∗ < 𝑆𝐴𝑉𝐶 → firm exit

0 𝑞0 𝑞1 𝑞
Managerial Decisions in Perfectly Competitive Markets:
Short-run Equilibrium of a Perfectly Competitive Industry
𝑝𝑞 , 𝑐1 𝑝𝑞 , 𝑐2 𝑝𝑞
𝑄𝑑 𝑞1𝑠
𝑆𝑀𝐶2 = 𝑞2𝑠
𝑆𝑀𝐶1 = 𝑞1𝑠
𝑄 𝑠 = 𝑞1𝑠 + 𝑞2𝑠
𝑆𝐴𝑇𝐶2
𝑆𝐴𝑇𝐶1
𝑐20 𝐸
𝐵 𝑝𝑞∗
𝑝𝑞∗ 𝐴
𝑝𝑞∗ 𝐷 𝑆𝐴𝑉𝐶2
𝑐10 𝑆𝐴𝑉𝐶1
𝐶

𝑞10 𝑞1 𝑞20 𝑞2 𝑞10 𝑄∗ 𝑄

Firm 1: 𝑝𝑞∗ = 𝑆𝑀𝐶1 > 𝑆𝐴𝑇𝐶1 ⇒ 𝜋1 > 0
Firm 2: 𝑆𝐴𝑉𝐶2 < 𝑝𝑞∗ = 𝑆𝑀𝐶2 < 𝑆𝐴𝑇𝐶2 ⇒ 𝜋2 < 0
For both firms: 𝑝𝑞∗ = 𝐴𝑅 𝑞
Managerial Decisions in Perfectly Competitive Markets:
Long-run Equilibrium for a Constant Cost Industry

𝑝𝑞 , 𝑐 𝑝𝑞
𝑀𝐶𝑖
𝑦 𝑄1𝑑 𝑄0𝑠 𝑄1𝑠

𝑄0𝑑 𝐶
𝑝𝑞1 𝐷
𝑦
𝐴𝐶𝑖
𝜋𝑖

𝐵 𝐸 𝑠
𝑄𝐿𝑅
𝐴
𝑝𝑞0

0 𝑞0 𝑞1 𝑞 0 𝑄 0 𝑄1 𝑄2 𝑄
(Individual firm equilibrium) (Industry Equilibrium)
Welfare Measures in a Perfectly Competitive Market (Consumers’
Surplus (CS) , Producers’ Surplus (PS), and Total Market Welfare (W))
• Marginal Willingness to Pay at 𝑸 (𝑴𝑾𝑷(𝑸)): The
𝑝𝑞 maximum amount consumers are willing to pay
for an additional unit when 𝑄 is already available
𝐵 in the market. It is given by the vertical distance
𝑄𝑠 from the demand function to the 𝑄 axis (e.g.,
𝑴𝑾𝑷 𝑸𝟐 = 𝑲𝑸𝟐 ).

• Total Willingness to Pay at 𝑸 (𝑻𝑾𝑷 𝑸 ): The

maximum amount consumers are willing to pay in
order to have 𝑄 units available in the market. Here,
for example, 𝑻𝑾𝑷 𝑸𝟐 = 𝑩𝟎𝑸𝟐 𝑲.

• Marginal cost at 𝑸 ( 𝑴𝑪(𝑸) ): The minimum

𝐿 amount producers are willing to accept in order to
supply an additional unit when they have already
𝐾 supplied 𝑄 units. It is given by the vertical distance
from the supply function to the 𝑄 axis (e.g.,
𝑴𝑪 𝑸𝟏 = 𝑳𝑸𝟏 ).
𝑄𝑑
𝑀 • Total variable cost at 𝑸 (𝑻𝑽𝑪 𝑸 ): is the minimum
amount producers are willing to accept in the
short-run to supply 𝑄 units. Here, for example,
0 𝑄1 𝑄2 𝑻𝑽𝑪 𝑸𝟏 = 𝑴𝟎𝑸𝟏 𝑳.
Welfare Measures in a Perfectly Competitive Market (Consumers’
Surplus (CS) , Producers’ Surplus (PS), and Total Market Welfare (W))
1
𝐶𝑆 = 𝑝𝑞∗ 𝐵 × 𝑝𝑞∗ 𝐴 = 𝐴𝐵𝑝𝑞∗
𝑝𝑞 2
(Difference between 𝑻𝑾𝑷 and actual payments made at 𝑸∗ )
𝐵 1
𝑃𝑆 = 𝑂𝑝𝑞∗ × 𝑝𝑞∗ 𝐴 = 𝐴𝑂𝑝𝑞∗
2
(Difference between actual payments received and 𝑻𝑽𝑪 at 𝑸∗ )
𝑄𝑠

𝐶𝑆
𝑝𝑞∗ 𝐴 Welfare level generated by a
perfectly competitive market:
𝑃𝑆 𝑾 = 𝑪𝑺 + 𝑷𝑺

𝑄𝑑

0 𝑄1 𝑄2 𝑄∗ 𝑄
More Comparative Statics: (a) The Effect of a Tax
𝐶𝑆0 = 𝐸𝐴𝑝𝑞∗ 𝐶𝑆1 = 𝐸𝐶𝑝𝑞2
𝑃𝑆0 = 𝐴𝑂𝑝𝑞∗ 𝑃𝑆1 = 𝐵𝑂𝑝𝑞1
𝑝𝑞 𝑄0𝑠
𝑇 = 𝐵𝐶𝑝𝑞2 𝑝𝑞1
𝐸 Δ𝑊 = −𝐴𝐵𝐶

𝑝𝑞2 𝐶
𝐴
𝑝𝑞∗
𝐵
𝑝𝑞1
𝑡 (%) 𝑄0𝑑
𝑄1𝑑

0 𝑄1 𝑄∗ 𝑄
More Comparative Statics: (b) Effect of a Production Quota
𝐶𝑆0 = 𝐸𝐴𝑝𝑞∗ 𝐶𝑆1 = 𝐸𝐵𝑝𝑞2
𝑝𝑞
𝑃𝑆0 = 𝑂𝐴𝑝𝑞∗ 𝑃𝑆1 = 𝑂𝐶𝑝𝑞1 + 𝑝𝑞1 𝐶𝐵𝑝𝑞2
𝐸 Δ𝑊 = −𝐴𝐵𝐶 𝑄𝑠

𝑝𝑞2 𝐵

𝐴
𝑝𝑞∗

𝑝𝑞1 𝐶
𝑄𝑑

0 𝑚𝑎𝑥 𝑄 𝑄∗ 𝑄
Perfectly Competitive Markets: Example #1
Suppose that the demand and supply curves of coffee beans are given from
the following equations:
𝑄 𝑑 = 800 − 8𝑝𝑞 and 𝑄 𝑠 = 200 + 4𝑝𝑞
where 𝑄 𝑑 and 𝑄 𝑠 are the quantities demanded and supplied per month in
kgs and 𝑝𝑞 the price of coffee beans in €. Please answer the following:

1. Find the market equilibrium of coffee beans and calculate consumer's

and producer's surpluses.
Answer: In the equilibrium it holds: 𝑄 𝑑 = 𝑄 𝑠 ⟹ 800 − 8𝑝𝑞∗ = 200 + 4𝑝𝑞∗ .
Solving for 𝑝𝑞∗ we get: 12𝑝𝑞∗ = 600 ⟹ 𝑝𝑞∗ = 50€. Replacing the equilibrium
price into either the demand or the supply function we get the
equilibrium quantity: 𝑄 𝑑 = 800 − 8 × 50 ⟹ 𝑄 ∗ = 400kgs.
For the calculation of CS and PS we use the equilibrium price and
quantity and the inverse demand and supply functions (see the graph):
𝐶𝑆 = 0.5 × 100 − 50 × 400 = 10,000
𝑃𝑆 = 0.5 × 50 − −50 × 400 − 0.5 × 0 − −50 × 200 = 15,000
Perfectly Competitive Markets: Example #1
Inverse Demand Function:
1
𝑝𝑞 = 100 − 𝑄 𝑑
8
𝑑
𝑝𝑞 𝑄 = 0 → 𝑝𝑞 = 100
𝑄𝑠 𝑝𝑞 = 0 → 𝑄 𝑑 = 800
100 Inverse Supply Function:
1 𝑠
𝑝𝑞 = −50 + 𝑄
𝐶𝑆 4
𝑠
𝑄 = 0 → 𝑝𝑞 = −50
50
𝑝𝑞 = 0 → 𝑄 𝑠 = 200
𝑃𝑆
𝑄𝑑
0 𝑄
200 400 800

−50
Perfectly Competitive Markets: Example #1
2. Calculate the price demand and supply elasticities corresponding to the
market equilibrium.
𝑑𝑄𝑑
Answer: From the supply and demand functions we get = −8 and
𝑑𝑝𝑞
𝑑𝑄𝑠
= 4. Using the equilibrium price and quantity and the elasticity
𝑑𝑝𝑞
𝑑𝑄𝑑 𝑝𝑞∗ 50 𝑑𝑄𝑠 𝑝𝑞∗ 50
formula we obtain: = −8 × = −1 and =4× = 0.5.
𝑑𝑝𝑞 𝑄∗ 400 𝑑𝑝𝑞 𝑄∗ 400

3. Assume that a tax 𝑡 = 15€ is levied on the producers. Find the after tax
market equilibrium and calculate the incidence of a tax (the percentage
of a tax passed on to consumers as a price increase).
𝑓
Answer: After tax coffee bean producers receive 𝑝𝑞 = 𝑝𝑞∗ − 15. Hence,
800 − 8𝑝𝑞∗ = 200 + 4 × 𝑝𝑞∗ − 15 ⇒ 𝑝𝑞∗ = 55€. Using the demand
function we get 𝑄 𝑑 = 800 − 8 × 55 ⟹ 𝑄 ∗ = 360kgs. Then using supply
𝜀𝑞𝑠
and demand elasticities we can calculate tax incidence from 𝑖 = =
𝜀𝑞𝑠 −𝜀𝑞𝑑
0.5 1 𝑑𝑝𝑞 55−50 1
= 3 or 𝑖 = = = 3 (see the graph).
0.5+1 𝑑𝑡 15
Perfectly Competitive Markets: Example #1
Inverse Supply Function:
𝑝𝑞 𝑄1𝑠 1 𝑠
𝑝𝑞 = −35 + 𝑄1
4
100 𝑠
𝑄 = 0 → 𝑝𝑞 = −35
𝑝𝑞 = 0 → 𝑄 𝑠 = 140
𝑄0𝑠

55
50
40

𝑄𝑑
0 𝑄
140 200 360 400 800
−35

−50
Perfectly Competitive Markets: Example #1
4. What would be the effect of a subsidy 𝑠 = 30€ per kg given to coffee bean
producers by the government in the market equilibrium? Calculate
consumer's and producer's surplus and the loss in the social welfare
𝑓
Answer: After subsidy coffee bean farms receive 𝑝𝑞 = 𝑝𝑞∗ + 30. Hence,
800 − 8𝑝𝑞∗ = 200 + 4 × 𝑝𝑞∗ + 30 ⇒ 𝑝𝑞∗ = 40€. Using the demand
function we get 𝑄 𝑑 = 800 − 8 × 40 ⟹ 𝑄 ∗ = 480kgs.
1
Consumer’s surplus after the subsidy would be 𝐶𝑆𝑆 = 2 × 100 − 40 ×
480 = 14,400. Accordingly, coffee bean producers will enjoy a surplus
1 1
𝑃𝑆𝑆 = × 70 − −50 × 480 − × 0 − −50 × 200 = 23,800.
2 2

The cost of subsidy for the government is 𝑆 = 70 − 40 × 480 = 14,400.

Finally, the loss for the social welfare is: Δ𝑊 = 𝐶𝑆𝑆 − 𝐶𝑆 + 𝑃𝑆𝑆 − 𝑃𝑆 −
𝑆 = 14,400 − 10,000 + 23,800 − 15,000 − 14,400 = −1,200 (see the
graph).
Perfectly Competitive Markets: Example #1
𝑝𝑞 Inverse Supply Function:
1 𝑠
100 𝑄0𝑠 𝑝𝑞 = −80 + 𝑄1
4
𝑠
𝑄 = 0 → 𝑝𝑞 = −80
𝑝𝑞 = 0 → 𝑄 𝑠 = 320

70 𝑄1𝑠
50
40

𝑄𝑑
0 𝑄
200 320 400 480 800

−50
−80
Perfectly Competitive Markets: Example #2
Suppose Bella's Birkenstocks produces sandals in the perfectly competitive
sandal market. It's total cost of production both in the short-run and the
long-run is 𝑆𝑇𝐶, 𝐿𝑇𝐶 = 64 + 𝑞 2 . Please answer the following:

1. Find the short-run average and marginal cost.

𝑆𝑇𝐶 64+𝑞2 64
Answer: From the cost function we get: 𝑆𝐴𝐶 = = = + 𝑞 and
𝑞 𝑞 𝑞
𝜕𝑆𝑇𝐶
𝑆𝑀𝐶 = = 2𝑞.
𝜕𝑞

2. If the price of sandals is 32€, what is Bella's production?

Answer: Bella produces at a quantity level so as to maximize profits:
max 𝜋 ⇒ 𝑀𝑅 = 𝑆𝑀𝐶 . For the competitive firm it holds that 𝑀𝑅 = 𝑝 .
Hence, 32 = 2𝑞 ⇒ 𝑞 = 16.
3. What is Bella’s profit if the price of sandals is 32€?
Answer: Bella produces at a quantity level so as to maximize profits: 𝜋 =
𝑇𝑅 − 𝑆𝑇𝐶 = 32 × 16 − 64 + 162 = 512 − 320 = 192.
Perfectly Competitive Markets: Example #2
4. If the price of sandals were 8€, what is Bella's production and profit?
Answer: Production is obtained: max 𝜋 ⇒ 𝑀𝑅 = 𝑆𝑀𝐶 ⇒ 8 = 2𝑞 ⇒ 𝑞 = 4.
Accordingly, Bella’s profit will be 𝜋 = 𝑇𝑅 − 𝑆𝑇𝐶 = 8 × 4 − 64 + 42 =
32 − 80 = −48.
5. What is Bella's short-run supply curve?
Answer: At the equilibrium it holds that 𝑆𝑀𝐶 = 𝑝. Hence, 2𝑞 = 𝑝 ⇒
𝑝
𝑞 = 2.

6. In the short run there are 19 other sandal producers, each with the same
costs as Bella. What is industry output at a price of 32€?
Answer: Since firms are identical, then everyone will produce the same
quantity at the equilibrium. Hence, 𝑄 = 20 × 𝑞 ⇒ 𝑄 = 20 × 16 = 320.
7. What is the industry short-run supply curve?
𝑝
Answer: Industry supply is 𝑄 = 20 × 𝑞 ⇒ 𝑄 = 20 × 2 = 10𝑝.
Perfectly Competitive Markets: Example #2
8. If the sandal industry is a constant cost industry in the long run, what is
the long run price and quantity?
Answer: Long-run equilibrium is where 𝐿𝑀𝐶 = 𝑝, and since 𝑝 = 𝐿𝐴𝐶, the
long-run equilibrium is given by 𝐿𝑀𝐶 = 𝐿𝐴𝐶. Given the long-run total
𝐿𝑇𝐶 64 𝜕𝐿𝑇𝐶
cost function 𝐿𝐴𝐶 = 𝑞
= 𝑞
+ 𝑞 and 𝐿𝑀𝐶 = 𝜕𝑞
= 2𝑞. Hence, 𝐿𝐴𝐶 =
64 64
𝐿𝑀𝐶 ⇒ + 𝑞 = 2𝑞 ⇒ 𝑞 = 8. From 𝑝 = 𝐿𝐴𝐶 we get that: 𝑝 = + 8⇒𝑝=
𝑞 8
16.
9. How many firms are there in the industry? Assume that the demand for
sandals is 𝑄 𝑑 = 640 − 10𝑝.
𝑄𝑑
Answer: The number of firms in the industry are 𝑛 = 𝑞
. The long-run
equilibrium quantity will be 𝑄 𝑑 = 640 − 10𝑝 = 640 − 10 × 16 = 480.
𝑄𝑑 480
Therefore, 𝑛 = 𝑞
= 8
= 60.
Barriers to Entry and Market Power: Definitions
➢ In some markets there are barriers preventing free entry and exit for
individual firms due to:
✓ economies of scale and scope
✓ government intervention
✓ essential inputs
✓ brand loyalties
✓ consumer’s lock-in
✓ network externalities
✓ significant sunk costs

➢ When strong barriers exist, firms can raise price above 𝑀𝐶 𝑄 earning
economic profits even in the long-run.
➢ In these cases, firms posses a degree of market power facing a
downward sloping demand curve.
𝑝𝑞 −𝑀𝐶 𝑄 1
➢ Lerner Index of market power: 𝐿𝐼 = =−
𝑝𝑞 𝜀𝑞𝑑
(note: in oligopolistic markets 𝐿𝐼 is different)
Managerial Decisions for Monopolistic Firms: Market
Characteristics

𝑝𝑞 There is only one firm satisfying all market demand.

The demand for a monopoly (in

contrast to that of the individual
firm in a perfectly competitive
industry) IS NOT perfectly elastic!

𝐷 = 𝐴𝑅 𝑞 = 𝑝𝑞 > 𝑀𝑅

𝑀𝑅

0 𝑄
Managerial Decisions for Monopolistic Firms: Market Equilibrium

𝑝𝑞 , 𝑐 𝑚𝑎𝑥 𝜋 ⇒ 𝑀𝑅 = 𝑀𝐶 𝑇𝑅 = 𝑝𝑞∗ × 𝑄∗ = 𝑂𝑝𝑞∗ 𝐵𝑄 ∗

𝑇𝐶 = 𝑐 ∗ × 𝑄∗ = 𝑂𝑐 ∗ 𝐶𝑄 ∗
∗ = 𝑇𝑅 − 𝑇𝐶 = 𝑝 ∗ 𝐵𝐶𝑐 ∗
𝜋𝑚 𝑞
𝑀𝐶
𝐴𝐶
𝑝𝑞∗ 𝐵

∗
𝜋𝑚
𝑐∗ 𝐶
𝐴
𝐷 = 𝐴𝑅
𝑀𝑅
0 𝑄∗ 𝑄
Managerial Decisions for Monopolistic Firms: Welfare Effects

𝑝𝑞 , 𝑐
𝑀𝐶 = 𝐴𝐶 = 𝑐 ∗ 𝑊𝑚 = 𝑐 ∗ 𝐸𝐵𝐴
𝐸
𝑊𝑐 = 𝑐 ∗ 𝐸𝐶
𝐷𝑊𝐿 = 𝑊𝑚 − 𝑊𝑐 = −𝐴𝐵𝐶
𝐶𝑆 𝐵
𝑝𝑞∗

𝜋
𝐷𝑊𝐿
𝐶
𝑐∗ 𝑀𝐶 = 𝐴𝐶
𝐴

𝐷 = 𝐴𝑅
𝑀𝑅
0 𝑄∗ 𝑄
Managerial Decisions for Monopolistic Firms: Perfect Price Discrimination

𝑝𝑞 , 𝑐
For each unit, a consumer pays her (his) 𝑴𝑾𝑷. At the
𝐾 market equilibrium (𝑸𝒄 ), the aggregate consumer surplus
𝐶 is zero and the social welfare equals the firm’s profit.
𝑝𝑞1
𝐸
𝑝𝑞2
𝐵
𝑝𝑞𝑚
𝐹
𝑝𝑞4
𝐺
𝑝𝑞5
𝑎 𝑏 𝑐 𝑑 𝑒 𝐾
𝑝𝑞𝑐 𝑀𝐶 = 𝐴𝐶
𝐴

0 𝑄1 𝑄2 𝑄𝑚 𝑄4 𝑄5 𝑄𝑐 𝑄
Managerial Decisions for Monopolistic Firms: Non Linear Pricing
A. Two-Part Pricing:
Consider an amusement park, where the consumer pays an entrance fee
and a price per attraction. The higher the number of attractions a
consumer chooses, the lower the unit price.
➢ The consumers are heterogeneous; they are of two types, A and B.
➢ The monopolist firm is aware of it, but it cannot tell whether a
particular consumer is of type A or of type B.
➢ To address this problem, it designs combinations of entrance fees
and prices in such a way as to extract the maximum possible surplus.
➢ The offered packages are subject to two type of constraints:
participation and incentive compatibility ones.
➢ The participation constraints ensure that each type of consumer
receives in equilibrium a non negative surplus.
➢ The incentive compatibility constraints ensure that each consumer
prefers the package designed for his type over the package designed
for the other type.
Managerial Decisions for Monopolistic Firms: Non Linear Pricing
B. Selling in Packages:
Firms often offer for sale packages containing at least two different
(mostly complementary) goods. This marketing strategy may turn out to
be profitable for the firm when consumers are heterogeneous and
preferences are negatively correlated.
Example: John and Anne are going to the cinema
➢ Before going to the movie they want to buy something to drink and
eat from the bar.
➢ The bar is selling only popcorn and diet Coke.
➢ John has a high valuation for popcorn whereas Anne has a high
valuation for diet Coke.
One potential strategy for the bar is to sell both goods as a package. If
selling in packages is not allowed, the bar may either set low prices and
sell both products to both consumers or set high prices and sell popcorn
to John and diet Coke to Anne (i.e., each product is purchased by the
consumer with the higher valuation for it).
Managerial Decisions for Monopolistic Firms: 3rd Degree Price Discrimination
𝑑 𝑑
𝑚𝑎𝑥 𝜋 → 𝑀𝑅𝐺𝑅 = 𝑀𝑅𝑈𝐾 = 𝑀𝐶 𝑀𝐶 = 𝐴𝐶 = 𝑐 0 , 𝜀𝐺𝑅 ≠ 𝜀𝑈𝐾

𝑝𝐺𝑅 , 𝑐 𝑝𝑈𝐾 , 𝑐

∗ 𝐵
𝑝𝐺𝑅
∗ 𝐷
𝜋𝐺𝑅 𝑝𝑈𝐾
0
𝜋𝑈𝐾 𝑀𝐶 = 𝐴𝐶
𝑐
𝐴 𝐶

𝑄𝐺𝑅 𝑄𝑈𝐾
∗ ∗
𝑄𝐺𝑅 𝑀𝑅𝐺𝑅 𝑑
𝑄𝐺𝑅 = 𝐴𝑅𝐺𝑅 𝑄𝑈𝐾 𝑑
𝑀𝑅𝑈𝐾 𝑄𝑈𝐾 = 𝐴𝑅𝑈𝐾

e.g., air-conditions in Greece and UK

Managerial Decisions for Monopolistic Firms: Multiplant Monopolist

𝑝𝐶𝐻 , 𝑐 𝑝𝑈𝑆𝐴 , 𝑐 𝑝𝑞 , 𝑐
𝑀𝐶𝑈𝑆𝐴
𝑀𝐶𝐶𝐻

𝐴𝐶𝐶𝐻 𝑀𝐶
𝐴𝐶𝑈𝑆𝐴
𝑝𝑞∗ 𝐸 𝐹 𝐵
𝜋𝐶𝐻 𝜋𝑈𝑆𝐴
𝑄𝑑
𝑝𝑞0 𝐴
𝐷 𝐶
𝑀𝑅

𝑄
𝑄𝐶𝐻 𝑄𝑈𝑆𝐴 𝑄𝐶𝐻 + 𝑄𝑈𝑆𝐴
𝑚𝑎𝑥 𝜋 → 𝑀𝐶𝐶𝐻 = 𝑀𝐶𝑈𝑆𝐴 = 𝑀𝑅
e.g., production of NIKE’s shoes in China and USA
With many plants: 𝑚𝑎𝑥 𝜋 → 𝑀𝐶1 = ⋯ = 𝑀𝐶𝑛 = 𝑀𝑅
Managerial Decisions for Monopolistic Firms: Example #1
Red Rose is a monopolist selling flowers in two villages, namely, Trenton and
Stenton. There are 100 individuals in Trenton, each with a demand function for
𝑝𝑇
flowers 𝑞𝑇 = 0.4 − 100. There are 500 individuals in Stenton, each with a demand
𝑝
function for flowers 𝑞𝑆 = 0.16 − 𝑆 . Red Rose’s cost function is 𝐶 𝑄 = 10𝑄,
500
where 𝑄 = 𝑄𝑇 + 𝑄𝑆 is the total volume of flowers sold.

1. Suppose that price discrimination is possible. Find the equilibrium and the
price elasticities of demand in each village. Comment on your findings.
Answer: The aggregate demand function for Trenton is 𝑄𝑇 = 𝑞𝑇 × 100 = 40 −
𝑝𝑇 whereas that for Stenton is 𝑄𝑆 = 𝑞𝑆 × 500 = 80 − 𝑝𝑆 . Accordingly, the total
revenue functions are: 𝑇𝑅𝑇 = 𝑝𝑇 𝑄𝑇 × 𝑄𝑇 = 40𝑄𝑇 − 𝑄𝑇2 and 𝑇𝑅𝑆 = 𝑝𝑆 𝑄𝑆 ×
𝑄𝑆 = 80𝑄𝑆 − 𝑄𝑆2 . This implies that 𝑀𝑅𝑇 = 40 − 2𝑄𝑇 and 𝑀𝑅𝑆 = 80 − 2𝑄𝑆 . In
equilibrium, it holds 𝑀𝑅𝑇 = 𝑀𝑅𝑆 = 𝑀𝐶 = 10 .
Substituting from above and solving the resulting equations one gets 𝑄𝑇 =
15, 𝑄𝑆 = 35, 𝑝𝑇 = 25 and 𝑝𝑆 = 45. The price elasticities of demand are 𝜀𝑇𝑑 =
𝜕𝑄𝑇 𝑝𝑇 25 𝜕𝑄 𝑝 45
= −1 × 15 = −1.67 and 𝜀𝑆𝑑 = 𝜕𝑝𝑆 𝑄𝑆 = −1 × 35 = −1.29.
𝜕𝑝𝑇 𝑄𝑇 𝑆 𝑆
The results make economic sense; the higher price is charged in the market
where the elasticity of demand is lower.
Managerial Decisions for Monopolistic Firms: Example #1
2. Suppose that price discrimination is not possible. Find the new equilibrium.
Answer: The aggregate (two-markets) demand is 𝑄 = 𝑄𝑇 + 𝑄𝑆 = 120 − 2𝑝,
where 𝑝 is the common price. The respective marginal revenue function is
𝑀𝑅 = 60 − 𝑄, which when equated to the marginal cost 𝑀𝐶 = 10 yielding
𝑄 = 50 and 𝑝 = 35.

3. Compare Red Rose's profits, aggregate (village) consumer surpluses and total
welfare under both scenarios.
Answer: With the discriminatory price policy the firm's profit is 𝜋 =
15 × 25 + 35 × 45 − 10 × 50 = 1,450. Consumer surpluses are: 𝐶𝑆𝑇 =
0.5 × 40 − 25 × 15 = 112.5 and 𝐶𝑆𝑆 = 0.5 × 80 − 45 × 35 = 612.5 .
Therefore, the two-market consumer surplus is 𝐶𝑆 = 725 and the welfare
level is 𝑊 = 1,450 + 725 = 2,175.
With the non-discriminatory pricing the firm's profit is 𝜋 = 50 × 35 −
10 × 50 = 1,250. The consumer surplus in Trenton is 𝐶𝑆𝑇 = 0.5 × (40 −
35) × 5 = 12.5 and in Stenton is 𝐶𝑆𝑆 = 0.5 × 80 − 35 × 45 = 1,012.5. The
corresponding welfare level is 𝑊 = 1,250 + 12.5 + 1,012.5 = 2,275 (increases
by 100).