ECO 304k Midterm 3 Study Guide: Market Structures, Costs, and Game Theory

Definitions and Concepts to Know

Accounting Profit vs. Economic Profit

Understanding the distinction between accounting profit and economic profit is fundamental in microeconomics.

• Accounting Profit: The difference between total revenue and explicit costs (actual out-of-pocket expenses).

• Economic Profit: The difference between total revenue and total costs, where total costs include both explicit and implicit (opportunity) costs.

• Example: If a firm earns $100,000 in revenue, pays $60,000 in explicit costs, and forgoes $30,000 in potential income elsewhere, accounting profit is $40,000, but economic profit is $10,000.

Long-Run Average Total Cost (ATC) Curve

The long-run ATC curve shows the lowest possible cost at which any output level can be produced when all inputs are variable.

• It is derived from the envelope of short-run ATC curves.

• Key concepts: economies of scale (cost per unit decreases as output increases), diseconomies of scale (cost per unit increases as output increases), and constant returns to scale.

• Equation: $ATC = \frac{TC}{Q}$, where $TC$ is total cost and $Q$ is quantity produced.

Market Structures

Market structure refers to the degree of competition in each market type, the nature of that competition, and how firms make their production decisions in each market.

Types of Market Structures

• Perfect Competition: Many firms, identical products, no barriers to entry, firms are price takers.

• Monopolistic Competition: Many firms, differentiated products, some control over price.

• Oligopoly: Few firms, may sell identical or differentiated products, significant barriers to entry, interdependent decision-making.

• Monopoly: One firm, unique product, high barriers to entry, firm is a price maker.

Comparing Market Structures

Market Structure	Number of Firms	Product Type	Entry Barriers	Price Control
Perfect Competition	Many	Identical	None	None
Monopolistic Competition	Many	Differentiated	Low	Some
Oligopoly	Few	Identical or Differentiated	High	Some/Collusive
Monopoly	One	Unique	Very High	Significant

Short-Run vs. Long-Run in Market Structures

• Short-Run: At least one input is fixed; firms can earn profits or losses.

• Long-Run: All inputs are variable; entry and exit drive economic profit to zero in competitive markets.

• Transition: Firms enter or exit the market in response to profits or losses, moving the market toward long-run equilibrium.

Price Discrimination

Price discrimination occurs when a firm sells the same product at different prices to different consumers, not based on cost differences.

• First-degree (perfect) price discrimination: Each consumer is charged their maximum willingness to pay.

• Second-degree price discrimination: Price varies according to quantity consumed or product version.

• Third-degree price discrimination: Different prices for different consumer groups (e.g., student discounts).

• Example: Movie theaters charging different prices for children, adults, and seniors.

Game Theory and Oligopoly

Game theory analyzes strategic interactions where the outcome for each participant depends on the actions of others. It is especially relevant in oligopoly markets.

• Payoff Matrix: A table showing the payoffs for each player for every possible combination of strategies.

• Nash Equilibrium: A situation where no player can benefit by changing their strategy while the other players keep theirs unchanged.

• Dominant Strategy: A strategy that is best for a player, regardless of what the other players do.

• Example: The Prisoner's Dilemma, where two firms must decide whether to collude or compete.

How to Compute: Key Calculations

• Cost Functions: Be able to derive and interpret cost functions such as Average Total Cost (ATC), Average Variable Cost (AVC), and Marginal Cost (MC).

• Profit Maximization: Find the output level where Marginal Cost (MC) equals Marginal Revenue (MR).

• Market Outcomes for Perfect Competition: Calculate price (P), output (Q), consumer surplus (CS), producer surplus (PS), total surplus (TS), and deadweight loss (DWL).

• Market Outcomes for Monopoly: Calculate the same outcomes as above, noting that monopolies typically produce less and charge a higher price than competitive markets, resulting in deadweight loss.

Key Formulas

• Average Total Cost: $ATC = \frac{TC}{Q}$

• Marginal Cost: $MC = \frac{\Delta TC}{\Delta Q}$

• Profit: $\text{Profit} = TR - TC$

• Consumer Surplus: $CS = \text{Area below demand curve and above price}$

• Producer Surplus: $PS = \text{Area above supply curve and below price}$

• Deadweight Loss: $DWL = \text{Loss in total surplus due to market inefficiency}$

Additional info: These notes expand on the brief points in the original study guide, providing definitions, examples, and formulas for clarity and completeness.