GRA 6031 MICROECONOMICS

Lecture 1. Foundations.1 (Ch. 1 - 4 in PRN)

1 Preferences
We consider a consumer faced with possible consumption bundles in some set X, her consumption set. Consider a consump-
tion bundle consisting of two goods (e.g., X = R2+ ), and let x1 denote the amount of one good and x2 the amount of the other.
The complete consumption bundle is therefore x = (x1 , x2 ).

Suppose there are two consumption bundles (x1 , x2 ) and (y1 , y2 ), and the consumer can rank them according to their de-
sirability (i.e., x  y, or y  x). So, if she always chooses x when y is available, it is natural to say that she prefers (x1 , x2 ) to
(y1 , y2 ).

Our consumer has preferences on the consumption bundles in X, and these preferences are rational.
Definition 1 The preference relation  is rational if it possesses the following two properties:
1. Completeness: for all x, y ∈ X, we have that x  y or y  x (or both).
2. Transitivity: for all x, y, z ∈ X, if x  y and y  z, then x  z.
The completeness axiom says that the individual has well-defined preferences between any two possible alternatives (i.e., alter-
natives can be compared). The transitivity axiom implies that it is impossible to face the decision maker with a sequence of
pairwise choices in which her preferences appear to cycle (i.e., there is some alternative which maximizes preferences).

We often describe preferences by a utility function. A utility function u(x) assigns a numerical value to each element in
X, raking them according to the individual’s preferences.
Definition 2 A function u : X → R is a utility function representing preference relation  if, for all x, y ∈ X,
xy ⇔ u(x) ≥ u(y).
1
by Øyvind Nilsen Aas. Feel free to send any comments or suggestions to oyvind.n.aas@bi.no
Note that a utility function that represents a preference relation  is not unique. Fall 2015
For any strictly increasing function f : R → R, v(x) = f (u(x)) is a new utility function representing the same preferences as
u(·).

Claim 1 A preference relation  can be represented by a utility function only if it is rational.

This claim states that a preferences can be represented by a utility function if it is rational, but it need not be (e.g., lexicographic
preference relations). To ensure existence of utility function the preference relation must be continuous. In order to talk about
continuity, we need a notion of distance, which in euclidean spaces is defined by

d(x, y) = |x − y| x, y ∈ Rk

Furthermore, we can use balls to talk about neighborhoods in euclidean space.

Definition 3 If x ∈ Rk and r > 0, the open (or closed) ball B with center at x and radius r is the set of all y ∈ Rk such that
|y − x| < r (or |y − x| ≤ r).

We are now ready to defined a continuous preference relation

Definition 4 (Continuity) A preferences relation  on X is continuous if whenever a  b, there are balls (or neighborhoods)
Ba and Bb around a and b respectively, such that for all x ∈ Ba and y ∈ Bb , x  y.

Continuity says that the consumer’s preferences cannot exhibit ”jumps”. The intuition is that if a is preferred to b, then ”small”
deviations from a or b will not reverse the ordering.

Claim 2 Suppose that the rational preference relation  on X is continuous. Then there is a (continuous) utility function u(x)
that represents .

Note that the claim tells us if the preference relation is continuous, there exists some continuous utility function representing
it. But a strictly increasing but discontinuous transformation of a continuous utility function also represents the preference
relation.

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Further restrictions

To put some restrictions of the form of utility functions, we impose two additional assumptions. First, monotonicity gives
commodities the meaning of ”good”, i.e., more is better.

Definition 5 (More is better) The preference relation  on X is monotone if x ∈ X and y > x implies y  x.

Monotonicity implies that the utility function is increasing: u(x) > u(y) if x > y.

Second, convexity of the preference relation concerns the trade-offs the consumer is willing to make among different goods.
With convex preferences it takes increasingly larger amounts of one commodity to compensate for successive unit losses of the
other (i.e., averages are preferred to extremes).

Definition 6 (Average is preferred to extremes) The preference relation  on X is convex if for every x ∈ X , the upper
contour set {y ∈ X : y  x} is convex, that is, if y  x and z  x, then αy + (1 − α)z  x for any α ∈ [0, 1].

Convexity of preferences implies that u(·) is quasiconcave.2

We can represent the consumers problem as an optimization program, i.e.,

max u(x)
x≥0
(1)
s.t. p · x ≤ w

where p denote the price of the good and w is the consumer wealth. If we assume that the consumption set is compact (i.e., closed
and bounded), the consumers has rational, continuous and monotone preferences, and that the utility function representing
these preferences is continuous, then this system has a solution (follows directly from an application of Weierstrass Theorem).
If we also assume that the preferences are strictly convex, then the solution is unique (follows directly from an application of
the Maximum Theorem).

2
The utility function is quasiconcave if u(αx + (1 − α)y) ≥ min{u(x), u(y)} for any x, y and α ∈ [0, 1].

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1.1 Choice under uncertainty
So far, we have evaluated the necessary assumptions for a sufficient treatment of choice with certain outcomes. However, we
are also interested in choices over uncertain outcomes in order to answer questions like: How much of my wealth should I invest
in a risky project? What political party should I vote for? Who should I marry?

When thinking about decision making, we often distinguish between actions and consequences. An action is chosen and
leads to a consequence. Economic agents have preferences over the set of consequences and is suppose to choose a feasible
allocation that leads to the most desired consequence. In the previous section, actions and consequence were the same. Now,
we will evaluate choice in a environment where the correspondence between actions and consequences are stochastic.

1.1.1 Lotteries
Let Z be a set of consequences (prizes), for now assumed to be finite with outcomes indexed by n = 1, . . . , N . A lottery is
a probability measure on Z, that is, a lottery p is a function that assigns a nonnegative number p(n) to each price n, where
P N
n=1 pn = 1. Let L(Z) denote the (infinite) space containing all lotteries with prices in Z

Given the set of consequences Z, the space of lotteries L(Z) can be identified with a simplex in Euclidean space:
X
{x ∈ RZ+ | xz = 1}

where RZ+ is the set of functions from Z to R+ . The extreme points of the simplex correspond to degenerate lotteries, where
one prize is received in probability 1. We will discuss preferences of L(Z).

Definition
P 7 (Simple lottery) A simple lottery L is a list L = (p1 , . . . , pN ) with pn ≥ 0 for all n and
p
n n = 1 where pn is interpreted as the probability of outcome n occurring.

In a simple lottery, the outcomes that may result are certain. A more general variant of a lottery, know as compounded lottery,
allows the outcomes of a lottery themselves to be simple lotteries.

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Definition
P 8 (Compounded lottery) Given K simple lotteries Lk = (pk1 , . . . , pkN ),
k = 1, . . . , K and the probabilities αk ≥ 0
with k αk = 1, the compounded lottery (L1 , . . . , LK ; α1 , . . . , αK ) is the risky alternative that yields the simple lottery Lk with
probability αk for k = 1, . . . , K.

Moreover, we assume that for any risky alternative, only the reduced lottery over final outcomes is of relevance to the decision
maker. Whether the probabilities of various outcomes arise as a result of a simple lottery or of a more complex compounded
lottery has no significance.

We take the set of alternatives, denoted L(Z), to be the set of all simple lotteries over the set of consequences (outcomes). Also,
we assume that the decision maker has a rational preference relation  on L, i.e., a complete and transitive relation allowing
comparison of any pair of simple lotteries.

Furthermore, we assume the preference relation is continuous. However, here continuity is related to small changes in the
probabilities of the lotteries.

Definition 9 The preferences relation  satisfy continuity if for all p, q ∈ Z, p  q implies that there are neighborhoods B(p)
and B(q) such that for all p0 ∈ B(p) and for all q 0 ∈ B(q), p0  q 0 .

As before, we can then represent the preference relation by a utility function, U : L → R, such that L  L0 if and only if
U (L) ≥ U (L0 ).

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1.1.2 Independence axiom
We have now arrived at a crucial assumption regarding the choice under uncertainty, namely the independence axiom.
Definition 10 (Independence) The preference relation  on the space of simple lotteries L satisfies the independence axiom
if for all L, L0 , L00 ∈ L and α ∈ (0, 1) we have
L  L0 if and only if αL + (1 − α)L00  αL0 + (1 − α)L00
In other words, if we mix each of two lotteries with a third one, then the preferences ordering of the two resulting mixtures does
not depend (i.e., is independent of) the particular third lottery used.

”From completeness, transitivity and continuity we obtain the existence of a continuous preference function over probability
distributions. From independence we get restrictions on the functional form of the preference function. It implies that the
preference function may be represented as the expectation with respect to the given distribution of a fixed utility function defined
over the set of possible outcomes (i.e., you can write it as expectations). The preference function is constrained to be a linear
functional over the set of distribution functions, or as commonly phrased, ”linear in probabilities”. (Machina, 1982, p. 278)
Definition 11 (Expected utility form) The utility function U : L → R has an expected utility form if there is an assignment
of numbers (u1 , . . . , uN ) to the N outcomes such that for every simple lottery L = (p1 , . . . , pN ) ∈ L we have
U (L) = u1 p1 + · · · + uN pN
A utility function U : L → R with the expected utility form is called a von Neumann-Morgenstern (v.N-M) expected utility
function.
The term expected utility is appropriate because with the v.N-M expected utility form, the utility of a lottery can be though of
as the expected value of the utilities un of the N outcomes.
Claim 3 A utility function U : L → R has an expected utility form if and only if it is linear, that is, if and only if it satisfies
the property that !
XK XK
U αk Lk = αk U (Lk ) (2)
k=1 k=1
P
for any K lotteries Lk ∈ L, k = 1, . . . K and probabilities (α1 , . . . , αK ) ≥ 0, k αk = 1.
P
The expression U (L) = n un pn is a general form for a linear function in the probabilities (p1 , . . . , pN ).

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1.1.3 Expected utility theorem
The expected utility theorem says that if the decision maker’s preferences over lotteries satisfy the continuity and independence
axiom, then his preferences are representable by a utility function with the expected utility form.

Claim 4 (Expected Utility Theorem) Suppose that the rational preference relation  on the space of lotteries L satisfies the
continuity and independence axioms. Then  admits a utility representation of the expected utility form. That is, we can assign
a number un to each outcome n = 1, . . . , N in such a manner that for any two lotteries L = (p1 , . . . , pN ) and L0 = (p01 , . . . , p0n ),
we have
XN XN
0
L  L if and only if U (L) = un pn ≥ un p0n = U (L0 ) (3)
n=1 n=1

un is the utility function representing the preferences over consequences and acts as a building block for the construction of
U (L), a utility function representing the preferences on L(Z).

We can describe a monetary lottery by means of a cumulative distribution function F : R → [0, 1]. That is, for any x,
F (x) is the probability that the realized payoff is less than or equal to x.

The application of the expected utility theorem to outcomes defined by a continuous variable tells us that under the as-
sumptions of the theorem, there is an assignment of utility values u(x) to nonnegative amounts of money with the property
that any F (·) can be evaluated by a utility function U (·) of the form
Z Z
U (F ) = u(x)f (x)dx = u(x)dF (x) (4)

It is important to distinguish between the utility function U (·), defined on lotteries, and the utility function u(·) defined on sure
amounts of money. For this reason, we call U (·) the von-Neumann-Morgenstern (v.N-M) expected utility function and u(·) the
Bernoulli utility function.

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1.2 Optimal portfolio allocation
Exercise 1 You must decide a fraction (α) of your wealth W which will be invested in a risky project, and the complimentary
fraction will be invested in a safe asset. The risky project either pays 4 times or 1 times the investment, with equal probability.
Alternatively, the safe asset pays 2 times the investment. Your utility function is u(x) = log(x).
1. What is the expected payoff in the two states?
2. What is the optimal portfolio allocation?
3. What happens if the government introduces a 50% wealth tax?
4. Should the Norwegian government have wealth tax if they want to promote economic growth?

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2 Technology
Consider next the firm behavior. The first thing to do is to examine the constraints on a firm’s behavior. When a firm makes
choices it faces many constraints, some are imposed by the customers, some by the competitors and some by nature.

We will focus on the constraints imposed by nature. Nature imposes that there are only certain feasible ways to produce
outputs from inputs, i.e., there are only certain kinds of technologies available to the firm.

2.1 Inputs and Outputs

Inputs to production are called factors of production. Factors of production are often classified into broad categories like
land, labor, capital and raw materials.

2.2 Describing technological constraints

Nature imposes technological constraints on firms: only certain combinations of inputs are feasible ways to produce a given
amount of output, and the firm must limit itself to technologically feasible production plans.

We can list all combinations of inputs and outputs that are technologically feasible. The set of all combinations of inputs
and outputs that comprise a technologically feasible way to produce is called a production set.

Suppose, for example, that we have only one input - wine gapes, and one output - bottles of wine. Then a production set
might have the shape indicated in Figure 1. To say that some point (x, y) is in the production set is just to say that it is
technologically possible to produce y amount of output if you have x amount of input. The production set shows the possible
technological choices facing a firm.
As long as the inputs to the firm are costly it makes sense to limit ourselves to examining the maximum possible output for
a given level of input. This is the boundary of the production set depicted in Figure 1. The function describing the boundary
of this set is known as the production function. It measures the maximum possible output that you can get from a given
amount of input.

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Figure 1: A production set. Here is a possible shape for a production set (a diminishing marginal product)

The concept of a production function applies equally well if there are several inputs. If, for example, we want to make
better wine, we need some machines in addition to the wine grapes. The production function f (x1 , x2 ) would measure the
maximum amount of wine (output) y that we could get if we had x1 units of wine grapes and x2 units of machines.

In the two-input case there is a convenient way to depict production relations known as the isoquant. An isoquant is the set
of all possible combinations of inputs 1 and 2 that are just sufficient to produce a given amount of output.

2.3 Examples of Technology

Fixed Proportions
Suppose that we are producing holes and that the only way to get a hole is to use a man and one shovel. Extra shovels aren’t

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Figure 2: Examples of technology. Left - Fixed proportions. Middle - Perfect Substitutes. Right - Cobb-Douglas.

worth anything, and neither are extra men. Thus the total number of holes you can produce will be the minimum of the number
of men and the number of shovels that you have. We write the production function as

f (x1 , x2 ) = min{x1 , x2 } (5)

The isoquants looks like those depicted in left panel in Figure 2.

Perfect Substitutes
Suppose now that we are producing homework and the inputs are red and blue pencils. The amount of homework produced
depends only on the total number of pencils, so we write the production function as

f (x1 , x2 ) = x1 + x2 (6)

Cobb-Douglas
If the production function has the form
f (x1 , x2 ) = Axa1 xb2 (7)
then we say that is it a Cobb-Douglas production function. The parameter A measures, roughly speaking, the scale of
production: how much output we would get if we used one unit of each input. The parameters a and b measure how the amount
of output responds to changes in input.

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2.4 Returns to scale
Let’s consider an experiment. Let’s increase the amount of all inputs to the production function. In other words, let’s scale the
amount of all inputs up by some constant factor: f.ex. use twice as much of both factor 1 and factor 2.

If we use twice as much of each input, how much output will we get? The most likely outcome is that we get twice as
much output. This is called constant returns to scale. In terms of the production function, this means that two times as
much of each input gives two times as much output. In the case of two inputs we can express this analytically by

2f (x1 , x2 ) = f (2x1 , 2x2 ) (8)

In general, if we scale all of the inputs up by some amount t, constant returns to scale implies that we should get t times
as much output:
tf (x1 , x2 ) = f (tx1 , tx2 ) (9)
Note: It is perfectly possible for a technology to exhibit constant returns to scale and diminishing marginal product. Returns
to scale describes what happens when you increase all inputs, while diminishing marginal product describes what happens
when you increase one of the inputs and hold the others fixed.

Increasing returns to scale: If we scale up both inputs by some factor t, we get more than t times as much output.
More precisely, increasing returns to scale means that

tf (x1 , x2 ) < f (tx1 , tx2 ) ∀ t > 1 (10)

Example: Learning by doing, or doubling the diameter, we use twice as much material, but the cross section of the pipe goes
up by a factor of 4.

Decreasing returns to scale: We get less than twice as much output from having twice as much of each input.

tf (x1 , x2 ) > f (tx1 , tx2 ) ∀ t > 1 (11)

Example: Studying microeconomics. If you study with one friend for one hour, then adding one more friend and one more
hour typically result in more talk and less studying. Adding 10 friends and 10 hours, then you’re not studying microeconomics

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anymore, you are having a party.

Example. You are the CEO of Clothing Ltd. and you’re producing white t-shirts. You use labor, denoted L to produce
the t-shirts. You technology is given by f (L) = 8L0.5 .
(a) Characterize the returns to scale of the technology using the formal definition, and draw it in a graph.

2.5 Cost functions

Cost functions can be written as
Ctotal (q) = C(q) + F (12)
where q is the quantity (# of units) produced, C(q) is the variable costs and F is the fixed cost. The fixed costs are independent
of the quantity produced. If we take the derivative of the variable cost C 0 (q) we get the marginal cost (incremental cost).

Ctotal C(q)
average cost of production; average variable cost (13)
q q
The longer the time horizon, the larger fraction of the costs are variable. Consider American Airlines. What are variable
costs on the route from Chicago to New York on a particular day, a particular month, a year?
Other cost concepts:

• Sunk costs: fixed costs incurred only once, and cannot be recovered

• Avoidable cost: a cost that obtain only if q > 0.

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3 Competition
Consider the following example. There is a market with the following characteristics.
• Firms: n identical cost functions: C(q) = 1 + q 2 , where 1 represents a fixed cost
• Buyers: inverse demand function: p = 1000 − Q
Suppose that there are 200 firms in the market. Let us calculate the individual supply function
max Π = pq − C(q) = pq − (1 + q 2 )
q
dΠ 1 (14)
= p − 2q = 0 → q= p
dq 2
since there are 200 firms, we get the following market supply curve Q = nq = 200q = 100p.

In order to find the short run equilibrium price, we equate the demand function with the supply function
1000
1000 − p = 100p p∗ =
→ = 9.9 market price;
101

1000
 (15)
∗ ∗
Q = 100p = 100 = 990.1 total quantity
101
summing up, the market price is 9.9 per unit, and the total trade quantity is 990.1.

Let us now find the long run equilibrium and price. For each firm we have that
  "  2 #
1 1 1
Π = pq − (1 + q 2 ) = p p − 1+ p = p2 − 1 (16)
2 2 4

In a perfectly competitive setting, we require that profit is zero in the long run. This results in
1 2 1
p −1=0 → p̃ = 2, q̃ = p̃ = 1 → Q̃ = nq̃ = n (17)
4 2

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equating this long run supply function with the demand function from above we get

n = 1000 − p̃ → n = 998. (18)

General solution
The optimization program for a competitive firm is to choose a quantity, taking the
market price as given.
Π = pq − c(q) (19)
First-order condition
dΠ
= p − c0 (q) = 0 ⇒ p = c0 (q) (20)
dq
Figure 3: Welfare
which says that the price for your product is equal to the marginal cost. Aggregate up for all firms in the economy to get the
market supply function and combine that with the market demand curve to get the equilibrium price and quantity.

3.1 Welfare
Definition 12 The aggregate consumer’s surplus is the difference between the maximum willingness to pay for a product and
the actual price the consumer has to pay.

Definition 13 The (aggregate) producers’ surplus is the difference between the price the firm is willing to supply a particular
quantity for, and the actual price the firm can charge in equilibrium.

Definition 14 The total welfare of an economy is equal to the aggregate consumer’s and producers’ surplus.

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4 Monopoly
The word monopoly originally meant the right to exclusive sale. It has come to be used to describe any situation which some
firm or small group of firms have exclusive control of a product in a given market. The difficulty with this definition comes in
defining what one means by a ”given market”. There are many firms in the computer tablet market, but only one firm control
the iPad.
The relevant feature of a monopolist from the viewpoint of economic anal-
ysis is that a monopolist has market power in the sense that the amount
of output that it is able to sell responds continuously as a function of the
price it charges. This is to be contrasted to the case of a competitive
firm whose sales drop to zero if it charges a price higher than the prevail-
ing market price. A competitive firm is a price-taker, a monopoly is a price-
maker.

Example. Dr. Dre has had a huge success with his audio products, in particular
Beats by Dr. Dre. Suppose that the inverse demand curve for Beats by Dr. Dre is
given by p(q) = 348 − 10q. The cost of producing one set of headphones is $52 and the
fixed costs are $1390.4. Thus, Dr. Dre solves the following optimization program
Figure 4: Beats by Dr. Dre
max Π(q) =p(q)q − C(q) = (348 − 10q)q − (52q + 1390, 4)
q
dΠ(q)
= 348 − 20q − 52 = 0 (21)
dq
348 − 52
q∗ = = 14.8 p∗ = 348 − 10 · 14, 8 = $200
20

Π(14.8) = 200 · 14.8 − 52 · 14.8 − 1390.4 = $800

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4.1 Optimal output and price
Let p(q) be the inverse demand function - the price that must be charged to sell q units of output. Then the revenue that the
monopolist can expect to receive if it produces q units of output is r(q) = p(q) · q. Let the cost function be given by C(q). We
can pose the monopolist’s maximization problem as
max Π = p(q) · q − C(q) (22)
q

The first-order condition for this problem is

dΠ
= p(q) + p0 (q)q − C 0 (q) =0
dq
(23)
p(q) + p0 (q)q = C 0 (q)
| {z } | {z }
MR MC
By the first-order condition we have that at the profit-maximizing choice of output marginal revenue (MR) must equal marginal
cost (MC).

Let us consider this condition more closely. When the monopolist considers selling dq units more output, it has to take
into account two effects. First, its revenue increase by p · dq because it sells more output at the current price. But secondly, in
order to sell additional output it must reduce its price by dp = dp dq
dq, and this lower price applies to all the units q it is selling.
The additional revenue from selling the additional output is therefore given by
 
dp
p · dq + dp · q = p + q dq (24)
dq
and it is this quantity that must be balanced against marginal cost.
Exercise 2 You are the CEO of TeleMonopoly and your company is the only one selling cellphone subscriptions. The inverse
demand for cellphone subscriptions is given by p(q) = 20 − q, where q is the number of hours. The marginal cost of making a
phone call is zero. There are fixed costs of 35.
(a) Derive the optimal monopoly price and quantum.
(b) Show the consumer surplus, the producer surplus and the deadweight loss in a (p, q)-diagram.
(c) Compute the profit of the firm.

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The first-order condition can be rearranged to take the form
 
0 dp q
r (q) = p(q) 1 + = C 0 (q)
dq p
  (25)
1 dq p
p(q) 1 + = C 0 (q); ε(q) ≡ price elasticity of demand
ε(q) dp q

Note that the elasticity will be a negative number as long as the consumers’ demand curve has a negative slope, which is
certainly the standard case.

Figure 5: Optimal quantity for a monopoly (increasing marginal cost).

The optimal output of the monopolist is represented graphically in Figure 5. The marginal revenue curve is r0 (q) =
p(q) + p0 (q)q. Since p0 (q) < 0 by assumption, the marginal revenue curve lies beneath the inverse demand curve. The optimal
level of output of the monopolist is where the marginal revenue curve crosses the marginal cost curve. In order to satisfy the
second-order condition, the MR curve must cross the MC curve from above. Given the level of output, say q ∗ , the price charged
will be given by p(q ∗ )

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4.2 Special case
There are two special cases for monopoly behavior that are worth extra attention. The first is that of linear demand. If the
inverse demand curve is of the form p(q) = a − bq, then the revenue function will be of the form r(q) = aq − bq 2 and the marginal
revenue takes the form r0 (q) = a − 2bq. If firm exhibit constant marginal costs of the form C(q) = cq, we can solve the
marginal revenue equals marginal cost equations to determine the monopoly price and output directly:
a−c a+c
q∗ = p∗ = (26)
2b 2
The other case is when we have a constant elasticity demand function, q = Ap−b . The elasticity of demand is then
p p
ε = q 0 (p) = (−b)Ap−b−1 = p(−b)p−1 = −b (27)
q Ap−b

In this case we can apply Eq. (25) and write

 
1 c c
p(q) 1 + = C 0 (q) ⇒ p(q) = 1 ⇒ p(q) = (28)
ε 1+ ε
1 − 1/b

hence, for the constant elasticity demand function, price is a constant markup over marginal cost, with the amount of the
markup depending on the elasticity of demand.

For the Beats by Dr. Dre example, we can use the formulas from Eq. (26) and see that
a−c 348 − 52
q∗ = = = 14.8
2b 2 · 10
(29)
a+c 348 + 52
p∗ = = = 200
2 2

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4.3 Market power
One way to show how the elasticity of demand affects a monopoly’s price relative to its marginal cost is to look at the firm’s
Lerner Index (or price markup).

Definition 15 (Lerner Index) The ratio of the difference between price and marginal cost to the price.

The Lerner Index is zero for a competitive firm because a competitive firm cannot raise its price above its marginal cost. The
greater the difference between price and marginal cost, the larger the Lerner Index and the greater the monopoly’s ability to
set price above marginal cost.
 
1
p(q) 1 + = C 0 (q)
ε(q)
1
p(q) + p(q) = C 0 (q) (30)
ε(q)
p(q) − C 0 (q) 1
=−
p(q) ε(q)

The Lerner Index for a competitive firm will be 0. Monopolies that face demand curves that are only slightly elastic set prices
that are multiples of their marginal cost and have Lerner Indexes close to 1.

Exercise 3 Calculate the Lerner Index for Dr. Dre, with price equal 200 and marginal cost equal 52. Also, calculate the
corresponding elasticity of demand.

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 Fall 2015
4.4 Welfare effects of Monopoly
Welfare, W , which defined as the sum of the consumer surplus (CS) and the producer
surplus (PS), is lower under monopoly than it is under competition. You have seen
earlier that a competitive equilibrium maximizes welfare since price equals marginal
cost.

Last year, Apple launched its newest version of the iPad tablet. Suppose that the
inverse demand for the iPad is given by p(q) = 698 − q, where q is denoted in millions.
The cost function of making iPads is C(q) = 300q (We assume no fixed cost cost for
simplicity). Apple is therefore faced with the following problem:

max Π = (698 − q)q − 300q (31)

q

Figure 6: iPad The first-order condition and solution are

dΠ
= 698 − 2q − 300 = 0
dq (32)
∗ 698 − 300
q = = 199, p∗ = 698 − 199 = $499
2
If this was a competitive market the quantity produced would be

max Π = pq − 300q (33)

q

First-order condition and solution

dΠ
= p − 300 = 0
dq
(34)
pS = 300
pS =pD ⇒ 300 = 698 − q ∗ ⇒ q ∗ = 398

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 Fall 2015
Let us first look at the consumer surplus and producer surplus in the monopoly case:

(698 − 499)199
CS = = 19.800, 5
2
PS = (499 − 300)199 = 39.601 (35)
WM = 19.800, 5 + 39.601 = 59.401, 5

Then, the CS and PS under a competitive equilibrium case:

(698 − 300)398
CS = = 79.202
2
PS = (300 − 300)398 = 0 (36)
WCM = 79.201 + 0 = 79.202
Figure 7: Welfare effects (constant
The deadweight loss is therefore the difference between the two welfare measures. marginal cost)

79.202 − 59.401, 5 = 19.800, 5 (37)

Alternatively, the deadweight loss can be calculated as

(pM − pCE )(qCE − qM ) (499 − 300)(398 − 199)

= = 19.800, 5 (38)
2 2

Exercise 4 Why do patents exist when we know that monopolies create inefficient allocations?

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 Fall 2015
5 Bibliographic Notes
• Machina, M. (1982) ”Expected utility analysis without the independence axiom”, Econometrica, Vol 50 (2): 277 - 323.

• Mas-Colell, A., Whinston, M. and Green, J. (1995) Microeconomic Theory, Oxford university press.

• Pepall, L., Richards, D., and Norman, G. (2014) Industrial organization: contemporary theory and empirical application,
5th edition, Wiley.

• Rudin, W. (1976) Principles of mathematical analysis, 3rd edition, McGraw hill.

• Rubinstein, A. (2013) Lecture notes in microeconomic theory, Princeton university press.

• Sundaram, R. (1996) A first course in optimization theory, Cambridge.

• Varian, H. (1992) Microeconomic analysis, 3rd edition, W.W. Norton and Company.

• Varian, H. (2010) Intermediate Microeconomics: A modern approach. 8th edition, W.W. Norton and Company

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