Dlbbwme01 e Course Book-2

COURSE BOOK
Managerial Economics
DLBBWME01_E
Course Book
DLBBWME01_E
2 Masthead
Masthead
Publisher:
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DLBBWME01_E
Version No.: 001-2021-0802
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Module Director 3
Module Director
Prof. Dr. Andreas Simon
Mr. Simon has been a professor in business administration at IU

International University of Applied Sciences since 2020.
Mr. Simon received his PhD in business administration with a focus

on accounting and finance from the University of Queensland, Aus-
tralia. After his doctoral studies, he was a visiting scholar at the Uni-
versity of Michigan’s Ross School of Business and the University of
Mannheim.
His research focuses on capital market research and the intersection

between accounting and finance. He spent 12 years in the US as an
associate professor of accounting, finance, and taxation at Pepper-
dine University’s Graziadio Business School, and as an assistant pro-
fessor of accounting and finance at California Polytechnic State Uni-
versity.
Prior to his academic career, Mr. Simon worked in the assurance and
business advisory for PriceWaterhouseCoopers in Berlin. He is also a
trained banker, holds a Certified Public Accounting (CPA) license in
the US, and runs his own consulting firm.
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4 Contents
Table of Contents
Module Director . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Introduction
Managerial Economics 7
Signposts Throughout the Course Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Unit 1
Fundamentals 12
1.1 Definition of Terms and Subjects of Economics . . . . . . . . . . . . . . . . . . . . . 12
1.2 How Do Economists Think? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Unit 2
The Invisible Hand of the Market 22
2.1 Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.2 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
2.3 Elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
2.4 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Unit 3
Consumer Decisions 40
3.1 Utility Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2 Willingness to Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.3 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
3.4 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
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Contents 5
Unit 4
Business Decisions I: Full Competition 62
4.1 Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
4.2 Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
4.3 Offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
4.4 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Unit 5
Business Decisions II: Incomplete Competition 82
5.1 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
5.2 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
5.3 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Unit 6
Business Decisions III: Game Theory 100
6.1 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
6.2 Simultaneous Games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
6.3 Sequential Games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
Unit 7
Advanced Microeconomics 114
7.1 Information Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
7.2 Behavioral Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Appendix 1
List of References 128
Appendix 2
List of Tables and Figures 132
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Introduction
8 Introduction
Signposts Throughout the Course Book
Welcome
This course book contains the core content for this course. Additional learning materials can
be found on the learning platform, but this course book should form the basis for your
learning.
The content of this course book is divided into units, which are divided further into sections.
Each section contains only one new key concept to allow you to quickly and efficiently add
new learning material to your existing knowledge.
At the end of each section of the digital course book, you will find self-check questions.
These questions are designed to help you check whether you have understood the concepts
in each section.
For all modules with a final exam, you must complete the knowledge tests on the learning
platform. You will pass the knowledge test for each unit when you answer at least 80% of the
questions correctly.
When you have passed the knowledge tests for all the units, the course is considered fin-
ished and you will be able to register for the final assessment. Please ensure that you com-
plete the evaluation prior to registering for the assessment.
Good luck!
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Introduction 9
Learning Objectives
The Managerial Economics course provides an overview of the fundamentals of economics.

In particular, it addresses the issue of scarcity as a starting point for economic questions and
presents economics as the science of markets. Building on these fundamentals, this course
takes an in-depth look at three central themes of economics, the understanding of which is
of great practical importance for a company’s decision-makers. Firstly, the interplay between
supply and demand in markets is analyzed. Secondly, the text offers insights into how con-
sumers behave in their respective markets. Thirdly, the course explains the theoretical foun-
dations of entrepreneurial decisions on markets and of the strategic interaction with com-
petitors.
We will look at how these concepts can be applied practically. At the beginning of each chap-
ter, a current, practice-relevant question is posed, later answered by the content of the text.
The course thus concerns itself with both the theoretical examination and eventual applica-
tion of economics. The main objective of this course is to convey the importance of eco-
nomic understanding for business practice and its application for solving current challenges
in company management.
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Unit 1
Fundamentals
STUDY GOALS
On completion of this unit, you will have learned …
… what economic theory entails.
… the central concepts of economics.
… the two major branches into which economics can be divided.
… how economists think and what methods they use.
… why economists often come to different conclusions.
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12 Unit 1
1. Fundamentals
Case Study
Mr. Schmidt, the managing partner of a mid-sized company in the manufacturing
industry, is sitting at the breakfast table. While contemplating what to have for break-
fast, he goes through the day’s appointments in his mind. In the morning, he will meet
with the production manager to discuss the purchase of a new production machine.
Shortly before lunch, he will have a phone appointment with the advisor of his local
bank to clarify some financial questions. After a business lunch with a new customer
from the United States, Mr. Schmidt will meet with the head of human resources. They
will discuss possible solutions for the shortage of skilled workers and how to fill long-
standing vacancies in a timely manner. In the evening, he will have to decide whether
to accompany his wife to the opera or play tennis with a business partner.
Mr. Schmidt, skimming the newspaper, notices an article that addresses the question of
whether Germany should set an example for China’s industrial and economic policy. Mr.
Schmidt learns that even the so-called five “economic wise men” (the five members of
the Council of Economic Experts) are divided on this point. While four of the five mem-
bers of the Council recommend that the federal government refrain from industrial pol-
icy intervention, one member is open to a guiding industrial policy.
As a graduate engineer lacking a comprehensive education in economics, Mr. Schmidt

is not sure what to make of this discussion. In particular, he is not aware of the conse-
quences of any industrial policy intervention or waiver, and to what extent such a pol-
icy would affect him as an entrepreneur and private individual. Additionally, it raises
the question of the basis on which the economists’ respective recommendations are
made and why they arrive at contradictory judgments in the first place.
1.1 Definition of Terms and Subjects of Economics
Scarcity of Resources as a Starting Point of Economics
Like Mr. Schmidt, people all over the world make a multitude of decisions in their pro-
fessional and private lives every day. This involves both mundane issues, such as what
breakfast to have or how to spend their free time, and more critical decisions, such as
choosing a career or partner. Generally speaking, the human decision-making process
means weighing alternatives and resolving conflicting goals. As a rule, in order to
obtain something they want, people have to give up something that they also value.
Opportunity costs In economics, one speaks here of opportunity costs. Mr. Schmidt, for example, is faced
These are what must with the choice of spending the evening with his wife at the opera or a business part-
be given up in order ner on the tennis court. If he opts to attend the opera with his wife, he will miss the
to gain something chance to develop a better business relationship with his colleague. Students enrolled
else. in universities or technical colleges must also contend with opportunity costs. The
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Unit 1 13
Fundamentals
average student will not be able to simultaneously pursue a full-time job and manage
a full-time course load. In this example, the opportunity costs of studying take the form
of lost wages that could have been earned.
Opportunity costs, therefore, always arise. This is because resources can only be used
once and are not simultaneously available for more than one purpose. In both exam-
ples, time is the resource unable to be allocated to both decisions.
However, other resources, both tangible and intangible, are also subject to scarcity. In
economics, scarce societal resources, which are necessary for the production of goods
and services, are roughly divided into the following three categories known as the fac-
tors of production: land, labor, and capital (Mankiw & Taylor, 2018). Factors of produc-
tion
Land encompasses all the natural resources produced by the earth such as under- These are resources
ground mineral deposits, marine fish stocks, and foodstuffs. Labor is the physical and which, from an eco-
mental performance of individuals that goes into any production process. Lastly, capital nomic standpoint,
refers to the facilities and equipment (i.e., physical capital) required for producing are required for the
goods and services. production of goods.
At Mr. Schmidt’s company, there is currently an acute shortage of labor and capital. In
order to counteract the shortage of capital as a production factor, a new manufacturing
machine must be purchased. To address the shortage of skilled workers, a strategy
must be developed.
Due to the scarcity of resources, consumers, workers, and businesses have had to con-
tinually make decisions and weigh the alternative choices in the best possible way. For
each company, there are three basic questions that must be resolved (Mankiw & Taylor,
2018):
• Which goods and services should be produced?

• How much of these goods and services should be produced?
• Who should receive the produced goods and services?
These questions would be easy to answer if scarcity were not a factor. Unfortunately,
resources are not infinite, and neither organizations nor economies are ever truly able
to produce enough goods and services that satisfy the needs and wants of every con-
sumer all of the time. As an academic and scientific discipline, economics concerns
itself with the methods for coping with this scarcity and the decisions one can take to
mitigate its effects.
Economics as the Study of Markets
In addition to being described as the study of managing scarce societal resources, eco-
nomics is often referred to as the study of markets (Bofinger, 2015). In the introductory
example at Mr. Schmidt’s company, we have already encountered a few different mar-
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14 Unit 1
Market kets: the labor market; the banking market; and the retail and wholesale markets, the
A market is a collec- latter of which include the procurement of production equipment or the sales market
tion of buyers and for the products within Mr. Schmidt’s company.
sellers that deter-
mine the price of The interaction between buyers and sellers is fundamental to all types of markets. For
goods or services example, in retail and wholesale markets, buyers demand goods and services that the
through potential or sellers offer. In a market economy system, the price and quantity of the individual
real interactions. goods sold are determined by the joint interaction between buyers (potential or actual)
and sellers. Here, the three basic questions of the economic problem are thus not
Goods resolved through actions taken by the state or government. Rather, they are resolved
This is a generic through the decentralized decisions made by numerous companies and households
term for products (and/or individual people). Here, companies decide themselves which employees to
(tangible goods) and hire and which products they should manufacture. Likewise, individual households
services (intangible decide which company they want to work for and which products they want to buy.
goods).
By contrast, in a centrally administered economy, activity is directed by a central gov-
ernment authority. Prices and wages are often subject to government regulation and,
therefore, are not the result of free interaction between buyers and sellers within a
market. The notion of a centralized economy proposes that the state can organize eco-
nomic activity in a way that promotes overall prosperity and contributes to a more just
and equal distribution of wealth. However, with the collapse of the Eastern Bloc around
1990, most countries worldwide underwent a transition from a centralized economy to
a market economy (Mankiw & Taylor, 2018).
Although the state does not usually set prices and wages itself in a market economy, it
does have an important function there, too: protecting the integrity of the markets. This
is because the pricing mechanism in markets can only work if the property rights of the
participating buyers and sellers can be enforced. No farmer would cultivate a field if
the harvest was expected to be stolen. Similarly, no department store would offer its
goods if it could not be ensured that customers would pay for them. Therefore, it is
important that state institutions, such as courts and the police, ensure that legal claims
on the goods and services produced and purchased can actually be enforced.
Whether the state should also intervene in the economic process of a market economy
is a controversial issue even among economists. The diverging opinions of the afore-
mentioned five “economic wise men” evince this. In general, state intervention is most
likely to be endorsed in a market economy if it can increase the efficiency of the mar-
Economic cake ket solution or promote fairness—that is, the (macro)economic cake is expanded or its
This image is often distribution becomes more equal (Mankiw & Taylor, 2018). Whether and how state inter-
used to describe the vention can achieve this at all, however, often depends on each specific case. This is
sum of the economic the subject of numerous economic studies.
activities of all per-
sons in an economy.
Subareas of Economics
In general, economics can be divided into two central areas: microeconomics and mac-
roeconomics. Microeconomics is concerned with the behavior and decisions of individ-
ual economic units such as consumers, employees, investors, landowners, or commer-
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Unit 1 15
Fundamentals
cial enterprises. It also addresses the question of how the respective economic units Microeconomics
interact in particular markets. Macroeconomics, on the other hand, focuses on phe- This is a branch of
nomena occurring within the economy as a whole such as the level and rate of growth economics that
of gross domestic product, interest rates, unemployment, and/or inflation. However, the deals with the
boundaries between microeconomics and macroeconomics are becoming increasingly behavior of individ-
blurred. More and more frequently, macroeconomists initially analyze the behavior of ual economic enti-
individual economic units in order to better understand the macroeconomic phenom- ties and their inter-
ena of interest based on the microeconomic knowledge gained (Pindyck & Rubinfeld, action with the
2018). markets.
The distinction between microeconomics and macroeconomics is particularly impor- Macroeconomics

tant when individual economic decisions lead to unintended macroeconomic conse- This is a branch of
quences. Thus, it may make sense for each individual private household to save and economics that
consume less. However, if all households in an economy were to save by cutting back deals with variables
on consumer spending, this would reduce the revenue of the companies. If, as a conse- regarding the econ-
quence, companies got into financial difficulties and had to lay off employees, house- omy as a whole such
hold income would decrease further. As a result, households may end up with fewer as the unemploy-
assets despite an increased effort to save—this phenomenon is known as the savings ment rate, interest
paradox (Bofinger, 2015). rate levels, or price
increases.
Savings paradox
1.2 How Do Economists Think? This is a situation in
which the microeco-
nomic increase in
Economists as Scientists the propensity to
save leads to a
As in many other branches of scientific study, economics focuses on the explanation of reduction in overall
observed phenomena and the prediction of future developments. For example, eco- economic wealth.
nomics explains why demand for certain consumer goods declines (perhaps due to an
increase in price) while the sales of other goods increase. Predictions are also made as
to how, for example, the introduction of a tax on CO2 emissions affects the demand for
electric cars.
Explanations and forecasts in economics are based on scientific theories, as is common

practice in science as a whole. There are basically two different methodological ways to
gain new knowledge. The inductive method begins with a real-life observation from Inductive method
which certain structures and relationships are derived. This observation forms the This is a scientific
basis of a hypothesis and, in turn, a theory is developed. Conversely, using the deduc- method for gaining
tive method begins with a theory from which a hypothesis is derived. It is tested based knowledge by draw-
on empirical observations, later adjusted if necessary. Neither of the two methods is ing conclusions from
better than the other. Rather, they are two different ways of conducting research, and empirical, individual
both approaches can be closely linked (Mankiw & Taylor, 2018). observations about
the general.
The relationship between the induction and deduction methods can be illustrated
through a classic example of observing swans. A researcher observing water birds on a
lake over a period of time might find that all the swans present there are white. Accord-
ing to the inductive method, they now formulate the hypothesis that all swans are
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16 Unit 1
Deductive method white. They then test this hypothesis by means of further empirical observations on
This is a scientific other lakes and rivers. If they continue to only encounter white swans there, the
method for gaining researcher may develop a theory that explains the phenomenon of exclusively white
knowledge in which swans. Other researchers could subsequently test the hypothesis and come to the
conclusions are same conclusion, thus rendering the theory valid—until someone else observes a black
drawn from the gen- swan. Once a black swan has been observed, the theory of the exclusively white swans
eral to the particular. must be modified. In this case, one speaks of falsification. A researcher could then
develop a new theory to explain why the majority of swans are white, taking into
Falsification account the occurrence of black swans. According to the deductive method, hypotheses
The refutation of a can be derived on the basis of this new theory, which also become the subject of
scientific theory or empirical observation (Mankiw & Taylor, 2018).
hypothesis through
a counter-example is Economic researchers face a particular challenge when developing and reviewing theo-
called falsification. ries. If, for example, economists observe in survey data that people with greater for-
tunes claim to be happier in their lives, they must first discover the cause and effect.
The question, therefore, is whether money makes people happy or, conversely, happier
people are more likely to acquire a large fortune. One also speaks here of the problem
of reverse causality.
Furthermore, it is difficult to keep everything constant when using observational data

from real life. Therefore, it is unclear whether (and to what extent) other omitted varia-
Omitted variable bles may be responsible for the observed relationship between life satisfaction and
An omitted variable wealth. For example, high-paying jobs may make people happier and more satisfied
is a factor that has than do low-paying jobs. Thus, in this example, both the assets and the level of satis-
not been taken into faction of these people are positively influenced by their profession. Here, the assets
account and that can have no direct influence over the level of satisfaction, and vice versa. In the natural sci-
explain the results of ences, controlled experiments can be carried out by the researcher in order to specifi-
the investigation cally distinguish cause and effect from one another—that is, to address the problem of
(instead of the varia- reverse causality in order to rule out the influence of omitted variables.
ble under considera-
tion). Unfortunately, this is not usually possible in economics. Rather, economists must often
resort to natural experiments in which the investigation of a phenomenon is deter-
Natural experiment mined by natural circumstances that are not under the control of the researcher con-
This is an empirical ducting the experiment. Economists still take the division of Germany as a natural
research method in experiment. From 1949 to 1990, two culturally and historically comparable regions on
which the research German soil were exposed to very different political and economic conditions. If differ-
units are divided ences between the East and West can still be found after German reunification in 1990,
into an experimental economists conclude that the reason likely stems from the period of German division.
group and a control For example, through taking German division as a natural experiment, researchers have
group based on nat- found out that basic political convictions are influenced by the ruling parties. The gen-
ural events that can- eral population in the eastern half of the county still has a significantly higher prefer-
not be controlled by ence for a stronger state and state-organized redistribution than does the population
the researcher. in the western half (Alesina & Fuchs-Schündeln, 2007).
In recent years, laboratory experiments have increasingly found their way into the sci-
entific methodology of economics, especially in the field of microeconomics. In this
way, (micro)economic theories specifically can be tested in a similar way as in the natu-
ral sciences. In practice, economic experiments are carried out in computer laborato-
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Unit 1 17
Fundamentals
ries. Participants in the experiment, the test subjects, receive instructions according to Laboratory experi-
the respective research question and must make decisions. Typically, the participants ment
are monetarily compensated upon completion of the experiment. Laboratory experi- A laboratory experi-
ments have two fundamental advantages over empirical work with observational data: ment is a man-made
laboratory experiments are flexible, meaning the scientist directing the experiment can experimental
control the external conditions and investigate research questions of interest in a more arrangement in
targeted manner; laboratory experiments are also repeatable (this factor is called repli- which a scientist
cability), meaning that the results can be checked by other researchers and, if neces- exercises specific
sary, falsified. However, laboratory experiments in economics are limited to questions control and can
concerning the decision-making behavior of individuals and (small) groups. Experimen- exert influence.
tal testing of macroeconomic questions is usually not possible in a laboratory.
As scientists, economists often use models to illustrate their theories. A model is an

image of the real world in which details irrelevant to the investigation of a specific
question are excluded based on a set of assumptions. The procedure is similar to an
anatomical model used in secondary school biology lessons in which individual details
of the human body are abstracted to achieve a certain didactic goal. Making assump-
tions offers the researcher an advantage in that they help to reduce the complexity of
the real world and, thus, make it easier to understand. However, there is a risk involved
—that models based on assumption may deviate too much from reality. In the after-
math of the financial crisis of 2008, macroeconomics in particular faced this accusa-
tion. Many claimed its models were based on unrealistic assumptions and, therefore,
could not have predicted the crisis. For this reason, it is imperative to constantly vali-
date the assumptions required for a new model and to make appropriate decisions
based on that analysis. That, in essence, is the art of scientific, academic thought (Man-
kiw & Taylor, 2018).
Economists as Political Consultants
In the previous section, the focus was on the economist as an (objective) researcher
concerned with the explanation of observed phenomena and forecasts deduced from a
scientific methodology. In addition to this role, economists often need to make con-
crete recommendations to improve economic outcomes and processes. One example is
the German Council of Economic Experts, who publish their recommendations in an
annual report as well as intermittent special reports (German Council of Economic
Experts, n.d.). The article Mr. Schmidt read at the breakfast table focused on these five
“economic wise men” and how they serve as political advisors and assess the guiding
industrial policy in Germany.
As academics, economists usually deal with positive issues; as policy advisors, they are
often confronted with normative questions. Positive analyses are descriptive of how Positive analyses
the world actually is. The claims made through positive analyses specifically can be A positive analysis
objectively verified and, if necessary, refuted. Methodologically, both the inductive and makes verifiable
the deductive procedure play a role here. By contrast, normative analyses are prescrip- statements to
tive and aim to show how the world should be. Normative analyses also contain the describe the rela-
researcher’s opinions and value judgments that elude objective examination and can- tionship between
not simply be dismissed through falsification (Pindyck & Rubinfeld, 2018). cause and effect.
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18 Unit 1
Normative analyses For example, a positive analysis by an economist could result in the suggestion that a
A normative analysis tax on CO2 emissions would place a financial burden on commuters. The analysis thus
is concerned with describes the relationship between cause and effect. Conversely, a normative state-
the examination of ment by an economist might suggest that Germany should introduce a CO2 tax in the
the following ques- interest of climate protection. This statement aims to show how the world should be
tion: “What should and contains a value judgment with regard to the economist’s personal attitude
be?” towards environmental protection. This example also shows that positive and norma-
tive analyses can be related to each other, and that the result of positive analyses con-
cerning how a CO2 tax actually works will, in fact, influence our normative views on the
political measures we as a society want to see.
Economists as Managers
Economists are not only in demand as scientists or as policy advisors. They are also
increasingly taking on positions of responsibility within private companies. For exam-
ple, international technology companies have recently begun to recruit economists as
employees and develop entire teams with economic expertise to handle strategic and
operational issues (Athey & Luca, 2019). Two specific skills taught in economics prove to
be particularly useful: the analysis of empirical relationships in data sets and the
knowledge of how markets and incentive systems work (as well as their precise design).
For example, on the introduction of its Express Pool service, Uber was advised by a
team of economists who used experimental methods to rule out the possibility of a
Cannibalization cannibalization effect on its other services (Fossett et al., 2018). Major companies such
effect as Google, Yahoo!, and Microsoft also use the expertise of economists to design mar-
This is the competi- ketplaces for the sale of advertising (Athey & Luca, 2019). The importance of economic
tion and (partial) understanding will continue to increase as digitization progresses and the platform
substitution of an economy expands, enabling managers to better understand digital business models,
existing product due exchange ideas with experts in these fields, and make sustainable decisions in the
to the marketing of a future.
new product by the
same supplier.
Why Economists Contradict Each Other
Platform economy
This refers to inter- While reading the newspaper at his breakfast table, Mr. Schmidt asked himself how it
net-based business can happen that economists contradict each other. According to the explanations in
models that connect this lesson, two specific causes for this can be identified (Mankiw & Taylor, 2018):
providers with inter-
ested parties or cus- • Economists disagree on whether a positive theory for how the world works is
tomers in a digital actually valid.
marketplace. • Economists have different normative views on how the world should be and what
politics should strive to achieve.
The concrete example of a guiding industrial policy from Mr. Schmidt’s newspaper com-
mentary shows that there is no consensus among economists as to how such state
intervention actually works (i.e., in terms of positive analysis). Critics often refer to the
targeted state subsidies for the solar industry in eastern Germany in the 2000s, which,
after a reduction in subsidies and a drop in global market prices, ultimately resulted in
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Unit 1 19
Fundamentals
numerous corporate insolvencies. On the other side of the debate, proponents of a

guiding industrial policy are turning their attention to China and emphasizing the suc-
cessful economic development in recent decades. These recent developments, includ-
ing a guiding economic and industrial policy, are largely due to the state capitalism
prevailing there.
Normative analysis can also lead to different view points amongst economists, which is
then expressed in contradictory recommendations—for example, the four economists
of the German Council of Economic Experts who reject a guiding industrial policy are of
the opinion that a free market is best suited to create prosperity and that the state
should interfere as little as possible. Proponents of a guiding industrial policy, however,
are more open to stronger state involvement—here and in other areas as well.
Summary
Economics is concerned with the management of scarce social resources, particu-

larly labor, capital, and land. Because of this scarcity, we all make decisions every
day that involve giving up something in order to gain something else. In doing so,
we take the opportunity cost of our decisions into account.
Economics is also often referred to as the study of markets, which focuses on ana-
lyzing the interplay of buyers and sellers within markets and the state’s role.
Economics can be roughly divided into macroeconomics and microeconomics.
Explanations and predictions in economics are based on academic theories

through which knowledge can be gained deductively (from the general to the spe-
cific) or inductively (from the specific to the general).
With the exception of laboratory experiments in microeconomics, controlled experi-

ments in economics are usually not possible. This is why economists often rely on
natural experiments (which cannot be controlled by the researcher.)
As scientists, economists often deal with positive analyses, which can be falsified.
As political consultants, they are also entrusted with crafting normative analyses.
These include the economists’ value judgments.
Both as scientists and as political advisors, economists can contradict each other in
their judgments.
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20 Unit 1
Knowledge Check
Did you understand this unit?
You can check your understanding by completing the questions for this unit on the
learning platform.
Good luck!
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Unit 2
The Invisible Hand of the Market
STUDY GOALS
On completion of this unit, you will have learned ...
… upon what supply and demand in a market depends.
… the role the prices of goods play in a competitive market.
… how balance is achieved in a competitive market.
… what the invisible hand of the market entails.
… what an economist means when talking about elasticities.
22 Unit 2
2. The Invisible Hand of the Market
Case Study
Nina, a student, is very concerned about climate change and endangered species. She
is also involved in the Fridays for Future movement. She was very pleased to learn that,
in February of 2019, more than 1.7 million people across Bavaria, Germany had regis-
tered in support of the petition for a referendum on “biodiversity and natural beauty in
Bavaria—Save the Bees.” One of the best-known demands of the petition was a call for
the proportion of agricultural land in Bavaria that is farmed organically to be increased
from 10 percent (in 2018) to 30 percent by 2030 (Schwägerl, 2019).
After the approval of the legislative text in the petition by the Bavarian parliament in
July 2019, the Bavarian Farmers’ Association immediately reminded the public that the
petition’s supporters were also obliged to support the proposed change and would be
required to change their shopping habits and opt for more organic products. Some dai-
ries already have a freeze on admissions, yielding long waiting lists of dairy farmers
wanting to switch to organic production in order to avoid further excess supply and
additional pressures on the price of milk. First, demand must increase, and consumers
must be prepared to pay higher prices for organic milk in order to allow for an expan-
sion of supply, the Farmers’ Association said (European Milk Board, 2019).
The statements of the Farmers’ Association leave Nina somewhat perplexed. She was
actually very pleased with the outcome of the referendum. Now, however, she does not
understand why demand has to first increase in order for organic farming to expand.
She is also unsure what the concept of supply and demand has to do with the price
consumers have to pay for organic milk and how this price is actually determined.
2.1 Supply and Demand
The Demand Curve as a Relationship Between Price and Level of Demand
In view of the statements by the Bavarian Farmers’ Association, Nina thought about her
own purchasing habits. She normally pays a lot of attention to her shopping habits and
has found that, as a student, she prefers to buy cheaper milk from conventional farm-
ing. The amount of organic milk each month depends on many factors, including price.
In the table below, she has noted how many liters of organic milk she buys or would
buy in a month and at what price. For example, at a price of two euros per liter, Nina
does not buy organic milk and prefers to buy milk from conventional production.
Prohibitive price Therefore, two euros is the prohibitive price for Nina. From time to time, when organic
The prohibitive price milks costs less than two euros per liter, she buys it as a matter of principle. When the
of a good is the price price is less than one euro per liter, she buys even more organic milk than she usually
at which the quan- does and, for example, uses it more often in her cooking. However, at 20 liters per
tity demanded is month, her saturation level is reached—that is, even if Nina were to be given organic
zero. milk as a gift, she still could not consume more than 20 liters of milk in one month.
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Unit 2 23
Saturation level
Nina’s Demand Table The demanded
quantity of a good at
Organic milk price per liter (€) Level of demand (liters/month) a price of zero is
called the saturation
level.
2.00 0
1.50 5
1.00 10
0.50 15
0.00 20
The table above shows that the lower the price, the more organic milk Nina buys. An
economist would say that, in Nina’s case, the demand for organic milk is negatively
dependent on the price. Such a relationship between price and quantity demanded can
be observed for most goods and services in an economy. This defines the law of
demand: under otherwise equal conditions (i.e., the same income or prices for other
goods), the demand for a good decreases as the price increases, and, conversely,
demand increases as the price falls (Mankiw & Taylor, 2018).
To understand how markets work, one must look at the demand-related behavior of
more than one person. This is done by totaling the demand levels of all buyers at any
given price and obtaining what is called the market demand. The market demand can
also be represented graphically as a demand curve. In the figure below, the quantity Demand curve
demanded by all buyers of a good (Q) is plotted on the horizontal axis and the prices This is a graphic rep-
of a good (P) on the vertical axis. resentation of the
relationship
between prices and
the quantity of a
good in demand
within a market.
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24 Unit 2
The downward slope of the demand curve (D) illustrates the negative relationship
between price and quantity demanded in accordance with the law of demand: If the
price of the product rises, the quantity demanded decreases. Conversely, if the quantity
demanded increases, the price falls. A change in the price of a good thus causes a shift
along the demand curve (Mankiw & Taylor, 2018).
Thus far, we have considered the influence of price on market demand under the cete-
Ceteris paribus ris paribus assumption, or assuming all other contributing factors remain the same.
assumption Specifically, changes in a consumer’s income have so far played no role in their
This Latin expression demand-related behavior. However, Nina, for example, could consume more organic
means “all other milk as a result of an increase in financial aid or if she took on a part-time job. In
things being equal” theory, Nina would be able to purchase more milk because of her more flexible budget,
and is often assuming that the price of organic milk per liter has remained unchanged. The follow-
assumed in simpli- ing figure shows the influence of factors other than price on the demand for a good.
fied models of real-
ity.
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Unit 2 25
A change such as a higher income, which leads to an increase in demand at any given
price, is expressed in the figure by a shift in the demand curve to the right. This is mir-
rored by a change that leads to a reduction in demand for any given price, such as
lower income, but which is caused by a shift in the demand curve to the left (Mankiw &
Taylor, 2018).
As shown in the figure above, the demand curve can shift to the left or the right if the
demand for goods change but the price remains the same. In addition to income, the
following factors can also influence demand (Mankiw & Taylor, 2018).
• Consumer preferences: One example of this would be an increase in environmental

awareness in the population that leads to an increase in demand for organic prod-
ucts (causing a right shift in the demand curve).
• Population size and structure: One example of this is a society’s age distribution.
This can lead to an increase in goods and services used more commonly by older
people such as home-delivery food services or health resorts (causing a right shift
in the demand curve).
• Advertising: For example, companies seeking to increase demand for their products
(right shift in the demand curve)
• Consumer expectations: Regarding future price developments, that demand will
decline if consumers expect prices to fall in the future (left shift in the demand
curve).
• The price of related goods
Regarding the prices of related goods, one must first consider the direction of the
demand curve. A distinction must be made as to whether the goods in question are
complementary or substitute goods. In our previous example, we have already seen
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26 Unit 2
that Nina sometimes replaces organic milk with conventional milk. In economics, such
Substitute goods replacements are referred to as substitute goods. If, for example, the price of milk from
These are two goods conventional agriculture rises, Nina will substitute this milk with organic milk, which
for which an causes a shift in the demand curve (in the above figure) to the right. If, on the other
increase in the price hand, the quantity demanded of one good decreases when the price of another good
of one leads to an increases, then we speak of complementary goods. For example, cereal and milk are
increase in demand complementary goods. They are often eaten together at breakfast, and the demand for
for the other. milk decreases when the price of cereal increases. Graphically, a price increase for
cereal is expressed in the above figure by a shift in the demand curve of milk to the
Complementary left.
goods
These are two goods
for which an The Supply Curve as a Relationship between Price and Quantity Supplied
increase in the price
of one leads to a As with the quantity demanded, price also plays a decisive role in the quantity of a
decrease in demand good offered. In the initial example, we learned that dairies in Bavaria have waiting lists
for the other. of farmers who would like to switch to organic production. One of the reasons why
farmers want to make this change is the higher price that dairies are prepared to pay
for organic milk compared to conventional milk.
Let’s look at an example. If we were to ask the Mayers, dairy farmers from the Allgäu
region in Bavaria, how many liters of organic milk they would produce per month on
their dairy farm according to the principles of organic farming, depending on the price
paid per liter, you would get the following information:
The Mayers’ Supply Table
Organic raw milk price per liter (€) Quantity offered in thousands (liters/
month)
0.30 0
0.45 5
0.60 10
0.75 20
0.90 30
The Mayers cannot produce milk according to the principles of organic farming below a
price of 30 cents per liter of raw milk. At a price of 45 cents per liter, however, they are
prepared to make a partial farm conversion and produce around 5,000 liters per month.
At a price of 90 cents per liter, they would even consider converting the entire farm and
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Unit 2 27
exclusively practice organic farming. The higher the price per liter of organic raw milk
they are paid by the dairy, the more the Mayers convert the dairy farm to organic milk
production ceteris paribus and the higher the quantity of organic milk they can offer.
This positive dependence on price and supply quantity is typical of most goods and
services offered in an economy. This is referred to as the law of supply. Law of supply
All other factors
Just as market demand is the sum of the individual demands of all potential buyers, being equal (the
the supply quantities of all actual and potential sellers add up to the market supply. ceteris paribus
The relationship between market supply and price can also be graphically represented assumption), the
according to the demand curve. The following figure shows such a supply curve. For our quantity of a good
purposes, the quantity offered by all actual and potential producers of a good (Q) is offered increases as
plotted on the horizontal axis and the respective prices of a good (P) on the vertical the price of the good
axis. increases, and vice
versa.
Supply curve
This graphically rep-
resents the relation-
ship between prices
and the quantity of a
good offered in a
market.
The positive slope of the supply curve (S) illustrates the positive relationship between
price and quantity offered, as already mentioned, in accordance with the law of supply.
If the price of the good falls, the quantity offered decreases ceteris paribus, and, con-
versely, the quantity offered increases if the price rises. Thus, a change in the price of a
good causes a movement along the supply curve.
Concerning market supply, it is also true that there are many other factors that can
lead to a change in the quantity offered by individual producers. As shown in the figure
below, the following factors lead to a shift in the supply curve (Mankiw & Taylor, 2018):
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28 Unit 2
• prices of production factors (e.g., if producers reduce their output volume or with-
draw from a market altogether as a result of increases in the cost of labor or materi-
als, causing a shift to the left in the supply curve)
• technological advancements (e.g., the invention of fertilizers or more efficient milk-
ing parlors that increase the milk yield per cow and contribute to an increase in the
availability and quantity of milk, causing a shift to the right in the supply curve)
• environmental and societal factors (e.g., failed harvests or regulations on the man-
datory expansion of the proportion of organic farmland in Bavaria, the former caus-
ing a shift to the left and the latter a shift to the right)
• expectations of suppliers (e.g., if producers anticipate rising prices in the future and
are already expanding their production capacities, causing a shift to the right)
• the number of suppliers entering (causing a shift to the right) or exiting (causing a
shift to the left) the market
2.2 Market Equilibrium
Interaction of Supply and Demand on a Competitive Market
It is possible to show how supply and demand determine the quantity sold and the
price on a market by looking at them together. For this purpose, the supply and
demand curves are plotted in the following figure. This results in a point at which the
Market equilibrium supply and demand curves intersect: market equilibrium.
This is a market sit-
uation in which the
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Unit 2 29
quantity supplied
corresponds to the
quantity demanded.
Price and quantity in market equilibrium are simply called equilibrium price or quan-
tity. In market equilibrium, a stationary state has been reached in which the market Stationary state
forces of supply and demand no longer strive for change. The quantity that consumers A system is in a sta-
wish to purchase at the equilibrium price corresponds exactly to the quantity that pro- tionary state when a
ducers are prepared to offer at that same price. In this context, economists speak of stable equilibrium
market clearance, or the fact that the market has been cleared and there is neither a exists and the acting
surplus of demand nor a surplus of supply. forces do not cause
any further change.
To understand why markets tend to be cleared, we first look at the situation when there
is a price above the equilibrium price. As can be seen in the following diagram, a price
above the equilibrium price represents an excess supply:
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30 Unit 2
With the price (P1) above the equilibrium price (P0), there are more producers wanting
to offer their goods than there are buyers wanting to purchase them. In such a situa-
tion, there is movement along the supply and demand curve. In general, suppliers who
are unable to sell their goods will be prepared to lower their prices, which will lead to a
reduction in supply. In turn, according to the law of demand, a lower price contributes
to consumers demanding more of that commodity. In the end, a balance between sup-
ply and demand is achieved in the equilibrium price. For example, there is an excess
supply in the market for organic milk in Bavaria (as mentioned previously). There are
more farmers prepared to offer organic milk at the current market price than consum-
ers who demand it. Market forces, as the Bavarian Farmers’ Association has correctly
recognized, would thus work toward ensuring a decrease in the price of organic milk in
the event that dairies allow more farmers to convert to organic farming. The Bavarian
Minister of Agriculture, Michaela Kaniber, has also recognized the problem of falling pri-
ces. Above all, Kaniber wants to increase demand and sees a great deal of potential
there, especially in a changeover of the communal catering system (Hermannsen, 2019).
However, if the price (P2) is below the equilibrium price (P0), there is excess demand,
as shown in the graph above. At this price, the quantity offered is too small, and the
buyers of goods are not able to buy the quantity they want. In such a situation, there is
also a movement along the supply and demand curve: Suppliers will try to expand their
supply volume and, in doing so, possibly increase the prices of their goods due to the
higher costs associated with supply expansion. At first, due to the excess demand, they
can also sell these goods. Only when prices continue to rise will an increasing number
of consumers reduce the quantity demanded (in accordance with the law of demand),
which ultimately leads to a balance between supply and demand.
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Unit 2 31
The Assumptions of the Market Model
It should be noted that the market mechanism described above is a model (ie., a sim- Market mechanism
plified representation of reality based on certain assumptions). In particular, the model This is the tendency,
is based on a competitive market where there is a large number of suppliers and buy- on a (competitive)
ers and where each buyer and seller represents only a very small share of the total vol- market, for prices to
ume of the market (two-way polypoly). None of the individual market participants is change until the
presumably large enough or has sufficient market power to influence the price on the market is cleared.
market itself, at least not single-handedly. Rather, suppliers and consumers take the
market price as a given and merely adjust their quantities accordingly. For this reason, Competitive market
we also speak of price-takers and quantity adjusters. Moreover, in a competitive market This is a market with
(i.e., a market with perfect competition) there are no market barriers or roadblocks for a very large number
actual and potential suppliers or buyers. Therefore, there is free entry and exit. Another of buyers and sell-
assumption of the market with perfect competition model is that all sellers offer iden- ers, whereby the
tical (homogeneous) products. Therefore, a supplier has no reason to charge less than individual can only
the market price for their goods, and if they charged more, consumers would buy them influence the market
elsewhere. Additionally, in a competitive market, buyers and sellers have perfect or price to a minor
complete information regarding all decision-relevant factors and make their own deci- extent and not in a
sions completely independently of each other (Mankiw & Taylor, 2018). targeted manner.
In reality, the assumptions of a competitive market only fully apply to a few markets. A
frequently cited example of a market where the assumptions of full competition are
largely valid is the market for agricultural products. Even if consumers neither have
complete information nor know the prices across all supermarkets and farms, the
product on the organic milk market, mentioned above, is largely homogeneous. Simi-
larly, on both sides of the market, there is a large number of market players without
market power (i.e., no single market player has total influence on the price). This sup-
ports the assumption of a two-way polypoly. As a result, on the organic milk market,
both the suppliers and consumers are generally price-takers and merely adjust their
supply or demand volume according to the prevailing market price. The stock market is
often cited as another example of a market in which the assumptions of full competi-
tion are more or less met.
However, the model can also serve as a useful frame of reference in analyses of mar-
kets in which the assumptions do not apply. According to economic theory, the mecha-
nism in a market with perfect competition leads to a market equilibrium that ensures
an efficient allocation of economic resources. In this context, a state is described as Allocation
efficient if it is pareto-optimal, i.e., if no other distribution of scarce resources is possi- This refers to the
ble and at least no one participant can be better off without simultaneously putting issuance of scarce
another participant at a disadvantage. In a competitive market in which all participants resources to differ-
act as price-takers, all mutually beneficial bartering is carried out, and the resources of ent uses within an
an economy are automatically, efficiently distributed without external intervention—for economy.
example, by the state—as if guided by an invisible hand (Pindyck & Rubinfeld, 2018).
The metaphor of the invisible hand is often attributed to moral philosopher Adam
Smith (1723—1790), one of the founders of economics. In all actuality, however, he used
the metaphor in a different context (Rothschild, 1994).
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32 Unit 2
Pareto-optimal
This is a situation in 2.3 Elasticities
which it is not possi-
ble to improve the
position of one per- Elasticities of Demand
son without making
another person According to the law of demand, under otherwise equal conditions, the quantity of a
worse off. good in demand decreases as the price increases. However, this does not say anything
about the extent to which demand will decline in the event of a price increase. In order
Elasticity to be able to make a precise statement on this, economists use elasticities.
This is a number
used as a measure An elasticity measures the sensitivity of one variable to the change of another. For
of the percentage example, the price elasticity of demand measures the percentage change in the quan-
change in one varia- tity of a good in demand in response to a percent change in price:
ble due to a percent
change in another. Change in quantity demanded in %
Price elasticity of demand =
Change in price in %
The price elasticity of demand is normally a negative number since demand decreases
when price increases, and vice versa. For example, if demand increases by 10 percent as
a result of a 5 percent price decrease, the price elasticity of demand is:
10 %
= −2
−5 %
In economics, however, the minus sign is often neglected, and simply the amount of
elasticity is used. If the price elasticity of demand is greater than one, as in the above
example, demand is termed price-elastic because the percentage change in demand is
greater than the percentage change in price. Conversely, the change in the quantity
demanded being smaller in percentage terms than the price change is referred to as
price-inelastic demand.
Let’s take a look at the following example. The price per liter of premium fuel rises by
10 percent from 1.30 euros to 1.43 euros. As a result, a motorist decides to start walking
short distances rather than take the car. Accordingly, the motorist only buys 95 liters of
fuel in a month at the filling station instead of 100 liters. In this instance, the demand
has fallen by 5%, meaning there will be a price elasticity of demand of
−5 %
= −0.5 = 0.5
10 %
The availability of substitute goods is one of the factors that determines whether the
demand for goods reacts to a price change elastically or inelastically. If substitute
goods are available (i.e., ones that can easily replace the goods affected by a price
increase), which are themselves not affected by changes in price, a price-elastic
demand (i.e., a relatively strong percentage decrease in demand for the affected good)
can be expected. Conversely, if there are no suitable substitutes for consumers,
demand tends to be price-inelastic (Pindyck & Rubinfeld, 2018).
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Unit 2 33
Thus, the demand for organic milk, as previously mentioned in an earlier example, can
be described as relatively price-elastic. Organic milk can easily be replaced by conven-
tional milk or milk alternatives (e.g., oat-based or soy-based). On the other hand, the
demand for fuels such as gasoline or diesel tends to be inelastic to price. Since many
people are commuters dependent on their cars and the necessary fuel type cannot be
replaced by another energy source in the short term (excluding hybrid cars), demand
tends to react only slightly to price changes.
It should be noted that elasticities can, by definition, assume absolute values between
0 and ∞. The closer the value is to 0, the more inelastic the demand is. This means
that a price change leads to hardly any reaction in the quantity demanded. Conversely,
the higher the absolute value of the price elasticity of demand, the more elastic the
demand is and the greater the difference in quantity resulting from a price change. The
two extreme cases are, therefore, a price elasticity of demand of 0 and ∞. If the price
elasticity of demand is 0, we speak of a completely inelastic demand. The demand
curve to the left in the following figure illustrates such elasticity.
The demand curve is vertical, and consumers always demand the same quantity of a
good regardless of price. With an elasticity with a limit value of ∞, however, one speaks
of a completely elastic demand. The demand curve runs horizontally, as shown in the
figure above on the right. In this context, even a slight price increase leads to a decline
in demand to 0 (Pindyck & Rubinfeld, 2018).
In addition to the price elasticity of demand, other demand elasticities can be deter-
mined in practice. Two examples are income elasticity and cross-price elasticity of
demand. The income elasticity of demand measures changes in demand for goods
when consumer income changes:
Change in demand quality in %
Income elasticity of demand =
Change in income in %
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34 Unit 2
Normal goods Normal goods have a positive income elasticity of demand since higher income leads
This refers to goods to higher demand for these goods. For normal goods, a further distinction can be
that are consumed made. Necessary products (such as basic foodstuffs) have relatively small, positive
more in absolute income elasticities since consumers have to buy certain quantities of them regardless
terms when income of their income level. By contrast, luxury goods (such as caviar, jewelry, or yachts) are
increases. characterized by relatively large, positive income elasticities. Consumers can—or must—
do without them completely if their income is too low. Negative income elasticities, in
Inferior goods turn, are a sign of inferior goods. The demand for these goods decreases with rising
This refers to goods income or increases with falling income. Public transport is an example of an inferior
that are consumed good, as people with higher incomes are more likely to own a car and therefore use
less in absolute public transport less.
terms when income
increases. The cross-price elasticity of demand allows changes in demand for one good to be
understood when the price of another good changes:
Change in the demand quantity of good 1 in %
Cross‐price elasticity of demand =
Change in price of good 2 in %
For substitute goods such as butter and margarine, the cross-price elasticity is positive.
Here, consumers increasingly switch to margarine when the price of butter rises. For
complementary goods such as cars and car tires, however, cross-price elasticity is neg-
ative. In this example, a price increase for cars would typically lead to a decrease in
demand for car tires.
Supply Elasticities
According to the demand elasticities mentioned in the previous chapter, supply elastic-
ities can also be determined. For example, the price elasticity of supply measures the
percentage change in the quantity of goods offered in response to a percentage change
in price:
Change in the quantity offered in %
Price elasticity of supply =
Change in price in %
The price elasticity of supply is normally positive, as supply increases when the price
rises, and vice versa. For example, if the quantity offered increases by 10 percent as a
result of a 5 percent price increase, the price elasticity of the offer is
10 %
=2
5 %
The price elasticity of supply can assume values greater than or equal to 0. The closer
the value is to 0, the more inelastic the offer is—that is, a price change hardly leads to
a change in the quantity offered. The closer the price elasticity of supply goes towards
∞, the more elastic the supply is and the greater the quantity change resulting from a
change in price.
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Unit 2 35
2.4 Applications
Supply and Demand During Winter Holidays
The amount one must pay for a one-week ski vacation in the Alps can be easily
explained using the basics presented in this lesson. We first compare the low season
(i.e., time outside the winter holidays) versus the main travel season between the end
of November and the start of January. The relatively large number of suppliers and
demanders of ski vacations in the Alps makes it seem plausible, even at this stage, to
use the competitive market model to determine the market equilibrium. According to
the supply and demand curves (S1 and D1) for the low season (shown below), a market
price of 450 euros for a week-long ski trip, including overnight stays and ski passes, will
be established. At this price, the balance (i.e., the number of skiers per week), is
250,000 people.
If fresh snow and bright sunshine are now predicted for the upcoming week, some ski
enthusiasts will consider taking a week’s holiday and traveling to the mountains at
short notice. In the figure, the demand curve shifts to the right accordingly. This results
in a new market equilibrium (G2) at the intersection of the still valid supply curve (S1)
and the new demand curve (D2). In order to satisfy the increased demand from the
vacationers, for example, hoteliers have to increase their staff in the short term and
heretofore dormant ski lifts have to be quickly reactivated. This means higher costs. As
a result, the market price rises from 450 to 510 euros. At this new market price, the
number of skiers increases to 320,000.
If some ski resorts close because of an avalanche warning just that week, the overnight
stays in these resorts will be canceled. In the figure, this leads to a left shift in the sup-
ply curve from (S1) to (S2). Other resorts not affected by the avalanche risk may still
have capacity available to accommodate more vacationers in the low season. However,
this would be make for higher costs such as overtime for local staff. This translates into
a higher price of 550 euros for a week-long ski vacation. For some ski enthusiasts who
are considering a trip to the mountains, this price is already too high. Compared with
the market equilibrium (G2), the number of vacationers therefore falls from 320,000 to
290,000.
Compared to the initial situation in market equilibrium (G1), the market price has risen
from 450 to 550 euros increase in demand (due to the weather forecast) and a decline
in supply (due to resort closures). Also, the number of skiers has risen from 250,000 to
290,000 in the new market equilibrium (G3).
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36 Unit 2
Elasticities in Winter Holidays
In the off-season, the supply curve is relatively elastic, as shown in the figure above.
The increase in demand due to the good weather forecast only leads to a relatively
small price increase from 450 to 510 euros, as there is sufficient capacity of hotel rooms
and ski lifts for vacationers.
The situation is different during the high season. As the figure below illustrates, the
supply curve becomes much steeper. It is said that the supply curve is relatively inelas-
tic. The reason for this is that, in the high season, many hotels are fully booked for
weeks at a time, and the ski slopes are already crowded starting in the early morning. It
is therefore very difficult to expand supply in the short term. An increase in demand
due to a favorable weather forecast (as we saw during the off-season) will, therefore,
result in a much starker price increase during the peak season (Mankiw & Taylor, 2018).
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Unit 2 37
Summary
The law of demand states that the lower the price of goods, the higher the demand.
The demand curve illustrates this relationship. A change in the price of a good
leads to movement along its demand curve, while other influencing factors (such as
changes in consumer income, price changes for other goods, or advertising efforts
by companies) lead to a shift in the demand curve.
The law of supply states that the higher the price of a good, the higher the supply.
The supply curve shows this relationship. Here, a change in the price of a good
leads to movement along its supply curve, while other factors (such as the prices of
production, technical progress, or social concerns) lead to a shift in the supply
curve.
In a competitive market, the interplay between supply and demand leads to a sta-
tionary market equilibrium. There is neither a surplus of supply nor demand.
Through the free play of market forces, an efficient and pareto-optimal allocation
of scarce economic resources is achieved, as if guided by an invisible hand. The
allocation is pareto-optimal if no actor can be better off without another being
worse off.
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38 Unit 2
Elasticities measure the sensitivity of one variable to a change in another. Two

examples are the price elasticities of demand or supply. These measure the per-
centage change in demand or supply of the good concerned in response to a per-
centage change in the price.
Knowledge Check
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Unit 3
Consumer Decisions
STUDY GOALS
On completion of this unit, you will have learned...
… what economists mean by usefulness.
… the meaning of indifference curves.
… which characteristics exhibit indifference curves.
… which factors influence a consumer’s willingness to pay.
… how consumers divides their limited budget between different goods.
… how the individual demand curve of a consumer can be derived.
40 Unit 3
3. Consumer Decisions
Case Study
Mr. Huber is an employee in the development department of a large German automo-
bile manufacturer. Just in time for this year’s International Motor Show in Frankfurt, Mr.
Huber’s company will be presenting electric cars designed for the mass market for the
first time. The CEO also announced the company’s plans to launch almost 70 electri-
cally-powered models by 2028. Mr. Huber is very pleased about this, as he has often
been concerned about the future viability of the German automotive industry. Now, he
is looking toward the future with much more confidence.
At the show, Mr. Huber spoke to an analyst for the automotive market. As an engineer,
Mr. Huber is convinced of the technical advantages of the latest generation of electric
cars. The analyst also shared Mr. Huber’s positive assessment of the current progress of
the industry, but was less optimistic about the potential market success of electric cars.
For example, it is not certain whether consumers will actually buy electric cars to the
extent expected. After all, there are still a number of disadvantages from the custom-
er’s point of view, such as the short operating range, long charging times, and the
energy-intensive production of the batteries. All of this negatively affects the positive
ecological assessment of an electric car. Last but not least, the significantly high pur-
chase price (as compared to an internal combustion engine) represents a hurdle on the
mass market that should not be underestimated. The analyst claimed that there is little
benefit to the everyday consumer and spoke of how difficult it is to estimate the cur-
rent willingness to pay, leaving Mr. Huber feeling less certain and less secure.
3.1 Utility Theory
The Concept of Utility in Standard Microeconomic Theory
In a market economy system, consumers are confronted with a variety of goods and
services, in different forms, from which they can choose. In the automotive market, for
example, customers can choose between different manufacturers, price classes, equip-
ment features, and even (as mentioned in the introductory example) decide how the
car is powered.
The decisive factor for consumer behavior (i.e., the decision for or against buying
goods) is the appreciation of the respective goods or service by the individual con-
sumer. This applies to all markets. For example, Person A uses their car mainly for short
distances to work or when shopping. Therefore, the shorter driving range of an electric
car does not play a role in their purchasing decision. Person B, on the other hand,
wants to travel long distances and therefore prefers a car with a combustion engine.
They decide against the electric car mainly because of its insufficient driving range.
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Unit 3 41
Consumer Decisions
In economics, the concept of utility is used to explain different consumer preferences. Utility
This describes the value that the consumption of a good or service gives to a person. This term refers to
The utility is a subjective measure and an ordinal concept. It is subjective because it the measure of sat-
describes the personal preferences of an individual consumer without another person isfaction or content-
necessarily sharing those preferences. For example, driving around the Nordschleife of edness that consum-
the Nürburgring, a closed driving track in Germany, is probably of great utility to a ers derive from
motorsports fan, whereas a passionate environmental activist may only shake their purchasing a certain
head in disapproval. It is ordinal because the utility helps establish a hierarchy quantity of goods.
between alternatives. However, ordinal utility cannot be used to determine absolute
differences between consumer preferences in a mathematically precise manner. For
example, it is possible to ask people in a survey to rank different car models according
to their personal preferences on a utility scale of 1 to 10 and conclude that one auto-
maker is more popular than another. If Peter rates a certain car with an 8 and Claudia
with just a 4, one cannot conclude that Peter values the car twice as much as Claudia.
The only possible conclusion is that Peter places the Ferrari higher on his utility scale
than does Claudia (Mankiw & Taylor, 2018).
Representation of Consumer Preferences by Means of Indifference Curves
Utility is not only used as a measurement of the satisfaction provided by a single good,
but also for that of a whole basket of goods. If, for example, one looks exclusively at Basket of goods
the area of clothing and nutrition, it is possible to examine which basket of clothing The compilation of
and food items a consumer prefers over another, i.e., which gives them greater utility. In certain quantities of
the interest of simplification, no distinction will be made between the different types of one or more goods
food and clothing offered—pasta, rice, tomato sauce, shirts, trousers, caps, etc. Only dif- is called a “bundle
ferences between clothing and food units and their respective quantities will be con- of goods” or “basket
sidered. For example, the following monthly shopping baskets, containing different of goods.”
clothing and food units, are available to a consumer.
Selection of Baskets of Goods
Basket of goods Number of food units Number of clothing units
A 20 30
B 10 50
C 10 40
D 30 20
E 30 40
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42 Unit 3
Basket of goods Number of food units Number of clothing units
F 10 20
When selecting the preferred basket of goods from the above table, the consumer is
assumed to behave rationally and without contradiction in accordance with the stand-
ard microeconomic model explaining consumer preferences. In particular, the following
three assumptions are made (Pindyck & Rubinfeld, 2018).
• Completeness: The consumer is able to compare and rank the baskets of goods
available for selection. For example, in the case of the two baskets of goods A and B,
a consumer can decide which basket they prefer, or whether they are indifferent to
the two baskets of goods, i.e., whether they would benefit equally from A and B.
• Transitivity: If a consumer prefers basket A over basket B and at the same time also
prefers B over the third basket C, then we can deduce that they also prefer basket A
over basket C. Similarly, if a consumer is indifferent towards A and B and also B and
C, then it can be said that they are also indifferent towards baskets A and C.
• Unsaturation: Baskets of goods are assumed to be desirable, with the consequence
that a consumer will always prefer a larger quantity of goods to a smaller one,
although the difference may be small.
The preferences of a consumer can be graphically represented by means of indiffer-

Indifference curve ence curves. Using the example of the baskets of goods in the above table, an indiffer-
The indifference ence curve describes all those combinations of clothing and food that provide the
curve is used to same utility to a consumer, i.e., satisfy equally. In principle, there is an infinite number
graphically represent of indifference curves. However, the following figure, which contains the six baskets of
all combinations of goods from the above table, is limited to the representation of three such indifference
bundles of goods curves for illustration purposes.
that provide a con-
sumer with the same
degree of satisfac-
tion.
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Unit 3 43
Consumer Decisions
This is done by plotting the quantity of food on the horizontal axis and the quantity of
clothing on the vertical axis. All combinations of food and clothing that lie on the indif-
ference curve U1 provide the same utility to the consumer.
Therefore, although the consumer buys more food in point A and more clothes in point
B, they will ultimately derive the same utility from the combination of goods in both
points. Likewise, they achieve the same satisfaction of needs with the basket of goods
in point D as in points A and B, since all points lie on the same indifference curve U1.
In point F, on the other hand, they consume both less food and less clothing than in
point A. Because of the assumption of non-saturation (according to which more is
always better), there must be a lower utility in point F. This is symbolized by the lower
lying indifference curve U2. At point E, in turn, the consumer receives more clothing
and more food than at point A, which is why there is a higher level of utility at point E.
This is also shown by the higher U3 indifference curve. In the above example, the high-
est level of satisfaction is therefore achieved with the indifference curve U3. The indif-
ference curves U1 and U2 follow in descending order of priority.
Properties of Indifference Curves
Since indifference curves reflect consumer preference when choosing between differ-
ent combinations of goods, they have the following four characteristics that reflect
these preferences (Mankiw & Taylor, 2018).
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44 Unit 3
• ��Higher lying indifference curves are always preferred over lower lying indiffer-
ence curves.
• Curves of indifference do not intersect each other.
• Indifference curves have a negative slope.
• Indifference curves are convex (curved inwards).
The four properties mentioned above will be explained in more detail below. The first
property of the indifference curves is already illustrated in the above figure, according
to which higher-lying indifference curves symbolize a higher level of utility. Accordingly,
consumers also always prefer baskets of goods on higher-lying indifference curves to
baskets of goods on lower-lying indifference curves. This is because they prefer a larger
quantity of goods to a smaller one due to the non-saturation.
The second property states that indifference curves cannot intersect. In order to prove
this, the opposite will be assumed, and it will be examined to what extent this results
in contradictions to the assumptions on consumer behavior. The following figure aims
to show two indifference curves that intersect at point Y.
Since point X lies on the same indifference curve UX as point Y, the baskets of goods
in question provide the same utility to the consumer. Moreover, since point Y is on the
same indifference curve UZ as point Z, baskets of goods would therefore also satisfy
the consumer equally on these two points. In line with the assumption of transitivity
mentioned above, however, this would lead to the conclusion that baskets of goods
also provide the same utility to consumers in points X and Z. However, this conclusion
cannot be correct. Since the basket of goods in point X contains both more food and
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Unit 3 45
Consumer Decisions
clothing than the basket of goods in point Z, point X must be of greater utility to the
consumer. Therefore, intersecting indifference curves contradict the assumption of
transitivity.
According to the third property mentioned above, indifference curves have a negative
slope. Here, the slope of an indifference curve indicates the ratio to which a consumer
is willing to exchange one good for another. In economics, the absolute amount of this
ratio is known as the marginal rate of substitution. In our example, we look at the Marginal rate of sub-
exchange between food and clothing and, as a rule, consumers will want to purchase stitution
both food and clothing. Consequently, if the amount of clothing is reduced, the amount This is the ratio at
of food must increase in order to satisfy the consumer equally. For this reason, the which a consumer is
slope of an indifference curve is usually also negative. If we look again at the first figure willing to exchange
in this section, a consumer in point B, for example, is willing to give up 20 units of one good for
clothing to get 10 additional units of food. The marginal rate of substitution in this case another.
is, therefore, 2.
However, the first figure in this section also illustrates that the exchange ratio along an
indifference curve is not constant. When moving from point B to point A, the consumer
is willing to give up 20 units of clothing to get 10 additional units of food. However,
when moving from point A to point D, the consumer is only willing to give up 10 units
of clothing to get 10 additional units of food. In the first case, therefore, the marginal
rate of substitution is 2; in the second case, it is only 1. The difference is due to the fact
that the consumer has more clothing and less food in the first starting point B than in
the second starting point A and is, therefore, also prepared to give up more clothing in
B than in A in order to receive 10 food units in return. In general, people are more will-
ing to give or exchange something if they have an abundance of it than if they only
have a little. For this reason, indifference curves usually also run convexly, i.e., curved
inwards. The convex course of an indifference curve reflects the fact that the greater
the quantity of a good already in his possession, the greater the consumer’s willingness
to give up a unit of a good.
To illustrate the fourth characteristic of indifference curves, imagine a Saturday after-

noon spent with your partner shopping for clothes in the city center. After several
hours of shopping, you realize that you have not had anything to eat or drink—but you
have already filled some shopping bags. Now, you are faced with the choice of either
going to another clothing store to buy a pair of trousers, or getting a snack in a small
restaurant. In this situation, the need for an additional pair of trousers will probably be
low. The economist here speaks of marginal utility. In contrast, the utility of a meal Marginal utility
should be quite high, as you have not eaten for a long time and are very hungry. So it The marginal utility
should be easy for you to do without the extra pair of trousers in exchange for getting a is the increase in
meal, as you have already bought many articles of clothing. utility that a con-
sumer obtains by
As a rule, goods (such as an additional pair of pants after a long day of shopping) have consuming an addi-
a decreasing marginal utility, i.e., the additional satisfaction through the consumption tional unit of a good.
of a good tends to decrease with each additional unit consumed. Due to the decreasing
marginal utility, people tend to find it easier to do without goods of which they have
already consumed a lot. Thus, the assumption of diminishing marginal utility also
applies to the meal from the above example. If you have chosen a pizza as a snack dur-
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46 Unit 3
ing your Saturday afternoon shopping trip, you will likely eat the first slice with quickly.
The second and third pieces will still taste good, but you won’t be as hungry as before.
Thus, the utility is increased in absolute terms by consuming these pieces of pizza, but
the marginal utility already starts to decrease after the first slice. By the fifth piece, you
may already be saturated, and your utility will only increase slightly. You may not even
like the last piece and you may even leave it behind. The marginal utility will have
therefore fallen to zero. With each additional slice, you would probably start to feel
sick, and the marginal utility of further pizza slices would be negative.
The curvature of an indifference curve thus provides information about the willingness
of a consumer to exchange one good for another. The smaller the curvature, the easier
the goods can be replaced by each other. Conversely, if a consumer finds it difficult to
replace one good with another, the corresponding indifference curves show a strong
curvature. For clarification, the two extreme cases are shown in the following figure.
The graph on the left shows linear indifference curves. Here, it makes no difference to a
consumer whether they drink apple juice or orange juice. The borderline rate of substi-
tution is always 1. Therefore, regardless of the amount of juice drunk, the consumer is
always willing to exchange a glass of one juice for a glass of the other juice. In this
Perfect substitutes case, one speaks of perfect substitutes.
These are two goods
for which the indif- The graph on the right shows perfect complements. A simple example might be to
ference curves are think about shoes. If you have five pairs of shoes and someone offers you just a left
linear. shoe, your utility will not increase unless you get a matching right shoe, and vice versa.
For this reason, the indifference curves for perfect complements are angular. The utility
only increases if you receive the same number of both goods. If you receive more of
only one good, this does not increase the utility. In reality, most consumer goods are
neither perfect substitutes (such as the juices mentioned earlier) nor perfect comple-
ments (such as complete pairs of shoes). Therefore, indifference curves typically run
inwardly curved.
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Unit 3 47
Consumer Decisions
Perfect complements
3.2 Willingness to Pay Two goods for which
the indifference
curves are at right
Budget Constraints and Budget Line angles are called
perfect comple-
The final purchase decision of a consumer is not based solely on their preferences and ments.
the utility they derive from consuming a good or basket of goods. In the end, it is more
a question of which of the preferred goods a consumer can actually afford. The initial
example of electric cars already indicated that the actual willingness of consumers to
pay is one of the central factors that influences the consumer’s decision to buy. While
one assumption of standard microeconomic theory is that people prefer to consume
more rather than less, they will, because of limited income, always have to weigh what
goods they really want against those they are able to acquire.
In economics, the limited resources available to a consumer to purchase goods are

referred to as budget constraints. To illustrate this, let us look again at the example of Budget constraints
food and clothing. We assume that a consumer has 80 euros of their income every This term refers to
month available for clothing and food. Here, 80 euros is the budget constraint. With an the amount of
assumed price of two euros per unit of clothing (PB) and one euro per unit of food money available to
(PL), a consumer can either purchase 40 units of clothing and no food; 80 units of food the consumer to
and no clothing; or combinations of both goods, each in smaller quantities. The follow- purchase product
ing table shows some of the possible combinations. bundles.
Possible Combinations of Food and Clothing
Bundle of goods Number of food Number of cloth- Total expenditure

units ing units (€)
G 0 40 80
A 20 30 80
H 40 20 80
I 60 10 80
J 80 0 80
The baskets of goods listed in the table can also be shown graphically, with the straight
line drawn in the figure below, the budget line, reflecting the budget constraints of the
consumer. If you move along the budget line from basket G, which contains only
clothes, to basket J, which consists only of food, we see that a consumer spends less on
clothes but more on food. Since clothing costs two euros per unit and food costs one
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48 Unit 3
1
Budget line euro per unit, exactly half a unit 2 of clothing can be abandoned to obtain one unit
All combinations of of food. The exchange ratio between clothing and food is thus determined by the ratio
goods for which the of the food price to the clothing price:
total amount spent
is equal to the 1 euro 1
=
budget constraint 2 euros 2
form the budget line
1
in the graphical rep- Accordingly, the gradient of the budget lines in the figure above is − 2 which corre-
resentation. sponds to the negative relationship between the prices of the two goods.
The five baskets of goods listed in the table above are all on the budget line. In other
words, a consumer spends their entire available budget on the consumption of the
goods. With a combination of goods below or to the left of the budget line, they would
not exhaust their entire budget, rather these combinations are equally attainable for
the consumer. In contrast, baskets of goods above or to the right of the budget lines
are outside the budget constraints, meaning the consumer cannot afford any of these
combinations. The range below and on the budget line (i.e., the range of all quantity
Budget quantity combinations that a consumer can afford) is also referred to as the budget quantity or
This is the quantity consumption option quantity (Mankiw & Taylor, 2018).
of all bundles of
goods that meet the
budget constraint,
i.e., those below or
on the budget line.
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Unit 3 49
Consumer Decisions
Influence of Income and Price Changes on the Budget Line
If the income available to a consumer for food and clothing increases, they can afford
more of both provided the prices of the two goods do not change. The effect on the
budget constraint can be seen in a shift of the budget line to the right, as shown in the
figure below.
The new budget limit of 160 euros allows the consumer to purchase twice as much of
both goods if desired. The above graph also illustrates that a change in income, as long
as the prices of the two goods remain constant, would result in a parallel shift in the
budget lines with the slope of the lines remaining unchanged. A reduction in income
would also lead to a parallel shift in the budget lines, but this time to the left. Accord-
ingly, in the event of a reduction in income, only baskets of goods with smaller quanti-
ties would be available to consumers.
On the other hand, if the price of one of the goods changes, the slope of the budget
line changes. The following figure illustrates two such cases.
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50 Unit 3
In the left-hand chart, the price of clothing has risen from two euros to four euros,
meaning that consumers can only afford half as many items of clothing if they do not
eat at all. The slope of the straight line, defined as the negative ratio of the prices of
the two goods, changes to
1 Price for food 1 euro
− = − = −
4 Price for clothing 4 euro
The budget line therefore turns inwards and becomes flatter. If the price of clothing
were to fall, the budget line would turn correspondingly outwards and become steeper.
This is because the consumer would now be able to afford more items of clothing if
they were to forgo food completely.
In the right-hand chart, a price increase in food is shown. The price increase from one
to two euros causes the budget line to turn inwards since the slope, calculated as the
negative ratio of the two prices, changes and thus becomes steeper:
Price for food 2 euros
−1 = − = −
Price for clothing 2 euros
However, with a reduction in food prices, the consumer could afford more food on an
unchanged budget, meaning the budget line would become flatter and turn outwards.
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Unit 3 51
Consumer Decisions
3.3 Demand
Consumer Decision as an Optimization Problem
Microeconomic theory assumes a rational consumer decision, taking into account the
preferences and budget constraints of the consumer. Accordingly, a consumer maximi-
zes the utility they derive from the consumption of goods within the constraints of a
limited budget. In the concrete example of food and clothing, a consumer will thus
want to realize the combination of quantities that lies on the highest possible indiffer-
ence curve. However, they are limited here by the resources available to them, i.e., their
budget. Ultimately, the consumer is thus faced with an optimization problem under
constraints. To illustrate the solution of this optimization problem, we will now look at
the budget line, seen here together with a set of indifference curves.
In the graph above, the highest indifference curve (U3) is not accessible to the con-
sumer because it is to the right of their budget line. Indifference curve U1, on the other
hand, is partially within the budget quantity. For example, the combination of goods in
point A, which lies both on the indifference curve U1 and on the budget line, would be
an appropriate basket of goods. However, without having to spend more money, the
consumer can further increase their utility. They could achieve a higher indifference
curve by starting from point A—if they go without clothing and buy more food instead.
The best possible combination of food and clothing that can be achieved in this way is
finally achieved in point H. At this point, the highest possible indifference curve U2
touches the budget line. The tangent point H between the budget line and the indiffer-
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52 Unit 3
Budget optimum ence curve U2 is also called the budget optimum. In this point, the marginal utility of
The budget optimum every euro spent on clothing is equal to the marginal utility of every euro spent on
is a person’s con- food. At every other point, the consumer is not in equilibrium. They could increase their
sumption decision utility by buying less of the good with lower marginal utility (clothing in point A) and
that maximizes their more of the good with higher marginal utility (food in point A) without spending more
benefit within a lim- money (Mankiw & Taylor, 2018).
its of their budget.
Formally expressed, the slope of the indifference curve U2 at the tangent point H corre-
sponds exactly to the slope of the budget line. We have already seen that the marginal
rate of substitution corresponds to the negative value of the slope of an indifference
curve. At the same time, the slope of the budget line is defined by the negative ratio of
the prices of the two goods. Thus, a consumer maximizes their utility when the mar-
ginal rate of substitution is equal to the ratio of the prices of the two goods. In the
1
figure above, the slope of the budget line is 2 (price for food/price for clothing). In the
1
household optimum H, the slope of the indifference curve is 2 with the consumer pre-
1
pared to forgo 2 units of clothing in order to receive another unit of food (Pindyck &
Rubinfeld, 2018).
Influence of Income and Price Changes on Consumption Volumes
When a consumer’s income changes but the price of goods remains constant, they can
afford either more or fewer goods. Thus, when income changes, it is an incentive to
redistribute the expenditure in order to achieve a better combination of goods and
maximize the utility. Graphically, as explained above, a change in the income of a con-
sumer causes a parallel shift in the budget lines whereby their slope remains
unchanged. In the following figure, the example of an increase in income is discussed.
Here, the budget line is shifted to the right so that the indifference curve U2 (instead of
the indifference curve U1) is reached.
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Unit 3 53
Consumer Decisions
In the left-hand chart, two examples of normal goods are shown: vacations and the
inhabited living space. Here, the consumer consumes more of both goods after an
increase in income. The basket of goods in point B, at the intersection of the new
budget lines and the indifference curve U2, thus contains more vacations and a larger
living space than the basket of goods in point A (the original household optimum
before the income increase).
In the right-hand graph, the good on the horizontal axis is a normal good; the good on
the vertical axis there is an inferior good. While the consumed quantity of the normal
good increases after an increase in income, the consumed quantity of the inferior good
decreases. The example given here concerns store-bought bread compared with bread
from a bakery. When income rises, a consumer goes more often to the bakery to buy
bread (normal good) and purchases bread from the supermarket less often (inferior
good). Thus, in the right graph, the shopping basket at point B, at the intersection of
the new budget lines after the income increase and the indifference curve U2, contains
more bread from the bakery and less bread from the supermarket than the shopping
basket representing the original household optimum at point A. The consumer realizes
a higher level of utility in point B of the new household optimum, as the indifference
curve U2 is higher than the indifference curve U1.
While changes in income cause a parallel shift in the budget lines, changes in the price
of consumed goods cause the budget lines to rotate. The extent to which this also
results in changes in the quantities consumed of the two goods depends on the con-
crete manifestation of two effects triggered by a price change. We can return to the
clothing and food example to better understand these concepts. If the price of food
decreases, a consumer can buy more food with the same income. But this consumer
could also buy as much food as before and use the remaining budget to buy more
clothes. By reducing the price of one of these goods, the consumer can acquire more
goods overall and achieve a higher indifference curve. In other words, the consumer
has become factually richer. This is called the income effect. Moreover, after a reduc- Income effect
tion in the price of food, a consumer receives more food in exchange for one unit of The income effect is
clothing than before. Therefore, clothing has become relatively more expensive (com- defined as the
pared to food). The consumer could now decide to buy less clothing and more food change in the vol-
because of the change in relationship between the prices. This is called the substitu- ume of consumption
tion effect (Mankiw & Taylor, 2018). due to a price-
induced change in
In order to establish the quantitative effect a reduction in food prices actually has, one the real income of
must consider the two effects together with their direction of action. In the case of the consumer.
foodstuff, substitution and income effects work in the same direction. As a result of the
price reduction, the consumer has become, in fact, richer and can buy more food. This Substitution effect
is the income effect. Moreover, the consumer also buys more of this food simply A change in the vol-
because it has become cheaper. This is the substitution effect. Thus, when grocery pri- ume of consumption
ces are reduced, the consumer buys more food in total. resulting from a
change in relative
In the case of clothing, however, the substitution and income effects work in opposite prices is called sub-
directions. This is why the quantity effect in this instance depends on which effect is stitution volume.
stronger. The consumer is in fact richer and can buy more clothing (income effect) due
to the reduction in food prices. However, they buy fewer items of clothing, as these
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54 Unit 3
have become more expensive due to the reduction in food prices (substitution effect).
The overall effect on clothing quantity can therefore not be predicted with certainty
and depends on the concrete strength of the two effects.
Derivation of the Individual Demand Curve
Based on the purchasing decisions made by a consumer, their individual demand curve
can be derived from the different household options at different goods prices. We will
use the example of clothing and food again for this purpose. However, this time, the
consumer only has a budget of 20 euros. To this end, the graph above in the following
figure shows the budget lines of a consumer at different food prices (two euros, one
euro, and 0.50 euro per unit), while the price of clothing (two euros per unit) and
income (20 euros) are kept constant. This is the rule: the lower the price of food, the
further out the budget line turns. Indeed, both the income effect and the substitution
effect mean that a consumer will buy more food at a lower price. The curve connecting
the household’s optima at the respective food price in the upper graph is also known
Price-consumption as the price-consumption curve. The price-consumption curve shows the development
curve of the household optimum for two goods when the price of one good changes and the
The price-consump- price of the other good and the income of the consumer remain constant.
tion curve is the
graphic representa-
tion of the respec-
tive benefit-maximiz-
ing combinations of
two goods when the
price of one
changes.
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Unit 3 55
Consumer Decisions
The bottom graph in the figure illustrates the above-mentioned relationship between
the price and the quantity of food demanded. The vertical axis shows the prices of
food; the horizontal axis shows the corresponding amount of food purchased. In
accordance with the law of demand—which states that the lower the price of a good,
the higher the demand—this will result in a falling individual demand curve.
3.4 Applications
In September 2019, the governing federal coalition between German political parties
the CDU/CSU and the SPD presented the cornerstones of a climate protection program
aimed at reducing the emission of greenhouse gases by at least 40 percent by 2030
(using the rate from 1990 as a point of comparison) (Bundesregierung, 2019). One of the
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56 Unit 3
measures of the climate protection program is the introduction of CO2 pricing for the
transport and heating sectors from 2021 onward. This should lead, among other things,
to an increase in the price of fuel and, subsequently, a reduction in fuel consumption.
According to the German government, the goal of CO2 pricing is explicitly not to gener-
ate additional revenue for the state. Rather, the revenue should flow back to the citi-
zens. Among other things, the commuter rate will increase from the current 30 cents to
35 cents per kilometer, but only from the 21st traveled kilometer onward (Bundesregier-
ung, 2019).
The opposition criticized the increase in the commuter allowance because it would
counteract the effect of the CO2 price in terms of the planned reduction of fuel con-
sumption. This would be socially unbalanced. This criticism will be explained in more
detail below with the help of the microeconomic theory of consumer decisions. First,
we will discuss the influence of a price increase as a result of a CO2 pricing structure
for an amount of fuel. Then, the relief for consumers through an increase in commuter
allowance will be included in the analysis.
The following figure shows the consumption of fuel on the horizontal axis and the con-
sumption of other goods on the vertical axis. At the starting point, the consumer is
located at point A, the intersection of the indifference curve U1 and the budget line
before the introduction of a CO2 pricing structure.
The pricing structure for CO2 causes an increase in cost for fuel producers and traders,
which ultimately results in the rise in the price passed on to consumers. In the above
figure, the price increase leads to an inward rotation of the budget lines, since a con-
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Unit 3 57
Consumer Decisions
sumer can now afford less fuel with an unchanged budget. Regarding the quantity
effect, both the income effect and the substitution effect lead to consumers demand-
ing less fuel. First, fuel has become more expensive compared to other goods, and so
they consume less fuel (substitution effect). Also, the consumer is only able to achieve
a lower indifference curve with the same income. Because of the increase in fuel price,
the consumer has become, in fact, poorer and will therefore consume less fuel. In the
figure above, this results in a new household optimum in point B with a lower fuel con-
sumption than in point A. The decrease in fuel consumption depends on both the
degree at which the budget line turns and the increase in price. The greater the degree,
the greater the reduction in fuel consumption.
In order to assess the actual quantitative effect, however, it is necessary to take into
account how the revenue from the CO2 pricing structure, which should be returned to
the public, will work. The proposed increase in the commuter allowance will reduce the
tax burden for citizens, as they will be able to deduct more of their taxable income for
every kilometer traveled on the way to work. Thus, the net income (the income after the
deduction of income tax) increases. An increase in income leads to a right shift in the
budget lines in the graphical representation. The consequence, based on the assump-
tion that fuel remains a normal good (i.e., that its consumption increases with rising
income), is shown below.
The consumer uses part of their higher budget for the purchase of fuel. This means
that, in their new household optimum (C), their fuel consumption is higher than in
point B. In the above figure, however, fuel consumption has at least decreased com-
pared to the initial situation concerning the household optimum in point A. This situa-
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58 Unit 3
tion is plausible for consumers with low to medium income, as they pay little income
tax and therefore benefit only slightly from the relief granted by a higher commuter
allowance. On the other hand, if you look at a person with a high income and who ben-
efits more from tax relief, it is conceivable that fuel consumption will actually increase.
The reason for this is a significant further shift of the budget line to the right. This is
illustrated in the following figure.
At point D, the intersection of the budget lines after the increase in commuter allowan-
ces and the U4 indifference curve, the consumer uses slightly more fuel than at the
original starting point A. Such a situation occurs when the increase in the price of fuel
(causing an inward shift in the budget line) is relatively small and the relief offered by
the commuter allowance (i.e., the shift in the budget line to the right) is very significant.
In order to avoid such a situation, the green opposition party (Die Grünen) has argued
for a higher price for CO2 and thus a higher increase in fuel prices (Bündnis 90/Die
Grünen, 2019).
On the other hand, the opposition party had advocated for a refund of the additional
revenues generated by the CO2 price regardless of income. The last two graphs illustrate
why the opposition has claimed that the increase in the commuter allowance is socially
unbalanced. The household optimum in point D is on a much higher indifference curve
than the household optimum in point C. In other words, high-income households will
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Unit 3 59
Consumer Decisions
achieve a higher level of utility than low-income households after the reform. Although
low-income households are burdened with higher fuel prices in the same way as high-
income households, they benefit much less from the relief provided by the higher com-
muter allowance. For this reason too, Die Grünen has proposed a per capita reimburse-
ment via a specific energy repayment that is independent of income. This way, all
citizens would benefit from it regardless of their level of income (Bündnis 90/Die Grü-
nen, 2019).
Summary
In economics, utility measures how the consumption of a certain quantity of goods

results in a consumer’s needs being satisfied.
For baskets with different quantities of goods, an indifference curve indicates the
combinations of said goods that provide equal utility to the consumer.
Indifference curves have a negative slope and a convex shape. They do not inter-
sect each other. Consumers always prefer higher indifference curves to lower ones.
The budget constraint reflects the maximum amount of money available to the
consumer for purchasing goods and services. Graphically, the budget constraint is
represented by the budget line. An increase in income leads to a parallel shift of
the budget lines. Price changes of goods cause a rotation of the budget lines.
In the household optimum, a consumer chooses the highest indifference curve

they can achieve within their budget constraint. The gradient of the indifference
curve corresponds exactly to the gradient of the budget line.
Changes in the price of goods always lead to an income effect and a substitution
effect. Together, they determine the change in the quantity consumed due to a
change in the price of a good.
The price-consumption curve outlines the utility-maximizing combinations arising

from situations in which the price of one good has changed while both the price of
the second good and the consumer’s income remain constant. The individual
demand curve can be derived from the price-consumption curve.
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60 Unit 3
Knowledge Check
learning platform.
Good luck!
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Unit 4
Business Decisions I: Full Competition
STUDY GOALS
… what production functions are.
… how isoquants are used to represent the use of production factors.
… why the production decision is ultimately a minimization problem.
… the difference between marginal and average costs.
… how the profit-maximizing amount is determined in the face of full competition.
… how the individual supply curve of a company can be derived.
62 Unit 4
4. Business Decisions I: Full Competition
Case Study
In 2017, Germany’s largest sporting goods manufacturer opened a speed-factory, the
world’s first fully automated, digital sports shoe factory. It was designed to be able to
fulfill individual customer wishes within the shortest possible time with the help of 3D
printers. The factory is not located in an East Asian country (as is common in the global
sporting goods industry), but in Ansbach, Franconia, some 50 kilometers from the head-
quarters of the DAX company. According to industry experts, cost savings through short
transport routes and the elimination of warehousing in particular may have played a
decisive role in the choice of location. According to experts, the disadvantage of the
significantly higher wage level compared to the East Asian countries would play only a
minor role in fully automated production when compared to the conventional mass
production of shoes still glued by hand. The latter continues to take place in low-wage
countries such as China, Vietnam, and Indonesia (Vetter, 2019).
However, only two years after the factory opened and one year after its concept was
awarded the 2018 German Innovation Prize, the sporting goods manufacturer
announced its closure. The mayor of Ansbach is disappointed by the development and
fears for the new jobs created in the city. “In the end, were the costs higher than expec-
ted and ultimately the decisive factor for the relocation of production to Asia?” he asks
himself during an appointment with the press after the announcement (Vetter, 2019).
4.1 Production
The Production Function
In a market economy system, companies are at the center of the production process.
Companies decide for themselves where, what, and how much they produce and offer
on the market. As long as companies do not violate the law, in a market economy (in
contrast to a centrally administered economy), the state is generally not involved in
production decisions. For example, the sports goods manufacturer mentioned in the
opening example made the decision to relocate its sports shoe production to Asia
without having to obtain the approval of a government agency or the town mayor. They
only had their own corporate success to consider.
Whether it is a globally active sports goods manufacturer or a small local bakery, every
Production factors company transforms production factors into finished end products (the output) during
These are the the production process. In a bakery, machinery such as ovens or a kneader reactor, raw
resources needed to materials such as flour and eggs, and the baker’s labor are needed to produce breads
produce goods. and pastries. In economics, the relationship between the factors necessary for the
process and the resulting output of goods is described by the production function. The
production function indicates the highest production quantity (q) that an enterprise
can produce with combinations of the respective production factors. For reasons of
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Unit 4 63
simplification, in economics, often only the production factors labor (L) and capital (K) Production function
are considered for the production function. Thus, a simple production function (F) can The production func-
be written in the following manner (Pindyck & Rubinfeld, 2018). tion reflects the
maximum produc-
q = F K, L tion quantity that an
enterprise can pro-
The production function makes it possible to combine the production factors in differ- duce with any given
ent ratios to produce the same quantity of goods in different ways. As seen in the combination of pro-
example at the beginning, sports shoes can be manufactured industrially in a fully duction factors.
automated way with high capital expenditure and little manual effort. Conversely, they
can be produced by hand with little capital expenditure using much more labor, as is
often still the case in low-wage countries in East Asia.
To illustrate the production function, we return to the idea of a sports goods manufac-
turer. Production of sports shoes requires production machines (capital) and workforce
(labor). The following table illustrates the different possible combinations of the two
production factors and the resulting volume of sports footwear produced annually.
The Production of Sports Footwear with Two Variable Production Factors
Capital Labor input

invest-
ment 100 200 300 400 500
10 300,000 400,000 550,000 650,000 750,000
20 400,000 600,000 750,000 800,000 900,000
30 550,000 750,000 900,000 1,000,000 1,050,000
40 650,000 800,000 1,000,000 1,200,000 1,150,000
50 750,000 900,000 1,050,000 1,150,000 1,500,000
The capital input (i.e., the number of production machines) is shown in the left-hand
column; the labor input is shown in the second row from the top. For example, to pro-
duce 750,000 pairs of shoes per year, the sporting goods manufacturer can employ
either 300 workers on 20 production machines or 500 workers on 10 production
machines. The table also makes it clear that, in order to increase production volume, at
least one of the factors of production must always be increased.
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64 Unit 4
Graphical Representation of the Production Function Using Isoquants
Graphically, the various possible combinations of production factors can be represen-

Isoquant ted using isoquants. An isoquant indicates all possible combinations of production fac-
An isoquant is the tors with which the same amount of output can be produced. In the following figure,
graphical represen- three such isoquants are shown according to the example of the sports equipment
tation of all possible manufacturer from the above table.
combinations of the
factors of production
with which the same
amount of output
can be produced.
The horizontal axis shows the labor input, and the vertical axis shows the capital input
(here, the number of production machines). The lower isoquant (q1) indicates all possi-
ble combinations of the two production factors with which 550,000 pairs of shoes can
be produced per year. As can be seen from the table above, two examples of such com-
binations are 30 machines and 100 workers (point A) or 10 machines and 300 workers
(point F).
The negative slope of an isoquant illustrates that for a constant output, one production
factor must always be substituted by another. If fewer workers are to be employed, the
capital employed must be increased in order to produce the same amount, and vice
versa. Here, this refers to the same amount of sports shoes. The respective exchange
ratio is called the marginal rate of technical substitution (MRTS) and corresponds to
the absolute amount of the slope of an isoquant. However, the above graph also shows
that the slope of an isoquant, and thus the marginal rate of technical substitution, is
not the same at all points of an isoquant. Rather, isoquants exhibit a convex (inwardly
curved) course, meaning that the MRTS decreases with increasing factor input. For
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Unit 4 65
example, at point D, if the labor input is increased from 100 to 200 people, 20 machines Marginal rate of
can be discarded to achieve the same output of 750,000 pairs of shoes. Here, the MRTS technical substitu-
20
is 0.2 = 100 . In point B, on the other hand, the MRTS is only 0.1. This is because, while tion (MRTS)
maintaining the same output of 75,000 pairs of shoes, only ten machines can be discar- The marginal rate of
ded upon an increase in labor input by 100 people. The decreasing marginal rate of technical substitu-
technical substitution illustrates that the productivity of each factor of production is tion is the amount
limited. If more and more labor is used in production (instead of capital), the produc- by which, for the
tivity of labor decreases. Similarly, the productivity of capital decreases when labor is same output, the
increasingly replaced by capital. In economics, it is said that the factors of production quantity of one pro-
have decreasing marginal yields. This means that the increase in output becomes duction factor can
smaller and smaller as the quantity of one such factor increases (while the other be reduced if an
remains constant). additional unit of
the other production
The decreasing marginal returns of the production factors (labor and capital) can also factor is used.
be read in the above graph. If the capital input is kept constant there (for example, at
30 machines), then an even lower output will be achieved with each additional worker. Marginal yield
If instead of 100 workers (point A), 200 workers (point B) are employed, the output This is an additional
increases by 200,000 pairs of shoes from 550,000 to 750,000 pairs. If another 100 work- output obtained by
ers are hired, the output increases by only 150,000 pairs of shoes from 750,000 to increasing a produc-
900,000 pairs at point C. Capital also shows decreasing marginal returns. For example, tion factor by one
an increase in the number of machines starting from point F by ten machines coupled additional unit.
with a constant number of employees (300) results in an increase in the output of
200,000 pairs of shoes. An increase by ten machines starting from point E only results
in an increase by 150,000 pairs of shoes in point C.
Returns to Scale
The marginal rate of technical substitution illustrates how a company can substitute
one factor for another and still produce the same output. But what happens to the out-
put if production factors are not replaced by each other, but all are increased by the
same factor proportionally? One answer to this question is provided by the returns to
scale. Returns to scale can be constant, increasing, or decreasing. In the example con- Returns to scale
cerning the sporting goods manufacturer, there were constant returns to scale. If they This term refers to
double the factor input from ten machines and 100 workers to 20 machines and 200 the rate at which
workers, the output will double from 300,000 to 600,000 pairs of shoes. Similarly, a tri- output increases
pling from 100 to 300 workers and from ten machines to 30 machines will lead to a tri- when all factors of
pling of the output from 300,000 to 900,000 pairs of shoes. Thus, at constant returns to production are
scale, an increase in all factors of production by a certain factor (such that the ratio of increased propor-
the two factors of production remains constant) leads to an increase in output by the tionally.
same factor.
However, as returns to scale increase, output increases by more than the factor by
which all factors of production are increased. According to this, a doubling of the input
of labor and capital leads to an increase in output by more than double. Conversely, as
returns to scale decrease, output increases by less than the factor by which all factors
of production are increased. A tripling of the labor and capital input thus leads to an
increase in output that is less than a factor of three.
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66 Unit 4
Increasing and decreasing returns to scale can have different causes in business prac-
tice. For example, an increasing production volume enables the employees of a small
company to specialize in the production process for the first time. This is why output
increases disproportionately with factor input. Also, the productivity-enhancing effect
of a modern production plant for companies may be reflected in a disproportionately
high growth in output as the number of units increases. Thus, while increasing returns
to scale are often observed in new firms or production facilities that are still in their
early stages of development, decreasing returns to scale often occur in firms that have
grown strongly in the past. The larger a company and the more complex the company
management become, the more likely it is that internal coordination and communica-
tion problems will lead to inefficient factor input. This would be reflected in decreasing
returns to scale (Mankiw & Taylor, 2018; Pindyck & Rubinfeld, 2018).
4.2 Costs
Selection of Factor Input as a Minimization Problem
The isoquants illustrate the flexibility that companies have in their production deci-
sions. As explained, they can achieve a certain output in different ways using different
combinations of the individual production factors. But for which combination of pro-
duction factors will a company, wanting to produce a specific output, ultimately opt?
The answer to this question depends on the costs of the production factors. As a rule, a
company will want to produce the desired output at the lowest possible cost (Pindyck
& Rubinfeld, 2018).
We will once again consider sporting goods manufacturers, which require machines
(capital) and workforce (labor) to complete production, in order to illustrate the mini-
mization problem of a company. The annual wage costs for one worker are assumed to
be 10,000 euros. Annual costs for a production machine are assumed to be 100,000
euros. The cost of capital covers both the financing costs (e.g., the interest expense for
Depreciation a bank loan) and the annual depreciation due to wear and tear of the machine. The
This is an accounting following table illustrates the respective total annual costs resulting from the different
treatment in which combinations of factor input.
the one-off cost of a
machine is treated
as an annual cost Production Costs as a Function of Factor Input
spread over its use-
ful life. Capital Labor input (€)
employed
100 200 300 400 500
10 2 million 3 million 4 million 5 million 6 million
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Unit 4 67
Capital Labor input (€)

employed
100 200 300 400 500
Using the example of the production of 900,000 pairs of shoes (isoquant q3), the fol-
lowing diagram illustrates the decision-making behavior of the company.
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68 Unit 4
In the above figure, it is clear that, with a total cost of three million euros, 900,000 pairs
of sports shoes cannot be produced. This is because the isoquant q3 (which represents
all possible combinations of production factors that can be used to produce 900,000
pairs of shoes) does not intersect at any point with the straight line C0 (which repre-
sents all factor combinations that cause total costs of three million euros). Such a
straight line, which reflects all possible combinations of production factors that cause a
Isocost line certain total cost, is called an isocost straight line. However, 900,000 pairs of shoes
The iso-cost line could be produced for an annual cost of seven million euros, for example, with 500
represents all possi- workers and 20 machines (point H in the above diagram) or with 200 workers and 50
ble combinations of machines (point G in the above diagram). In either case, however, such production is
production factors not cost-minimizing. This is because, in point C, the combination of 300 workers and 30
that can be pur- machines could also produce 900,000 pairs of shoes, but at an annual cost of just six
chased at a certain million euros. The graph makes it clear that all combinations of labor and capital that
total cost. lie on the plotted isocost line C2 cannot represent the optimal choice. Rather, the pro-
duction is cost-minimizing at the point where the isocost line C1 and the selected iso-
quant just touch (at point C). This is because no further costs can be saved by substi-
tuting one production factor for another. At the tangent point C, the slope of the
isoquants (i.e., the marginal rate of technical substitution) corresponds to the slope of
the isocost line, which reflects the ratio of the costs of labor to capital.
If a company wants to produce more or less than the 900,000 pairs in the above dia-
gram, it will always face the same minimization problem. It will always choose the cost-
minimum tangent point of the respective isoquant and the lowest isocost line. The fol-
lowing figure shows examples of the minimum cost for production quantities of
300,000 and 600,000 pairs of shoes per year.
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Unit 4 69
The straight line that connects all three cost minima with each other and on which all
other cost minima not shown are also located is called the expansion path. In the spe- Expansion path
cific case of the sporting goods manufacturer, the expansion path is a straight line. The expansion path
However, this only applies if constant returns to scale and constant costs per unit of is the curve that
capital and labor for the sporting goods manufacturer are assumed. If, in such a case, runs through the
the quantity of pairs of shoes produced and the total costs required for this are com- tangential points of
pared in a diagram, a linear progression of the total costs as a function of the output the isoquant and
quantity can be seen. isocost lines of a
company.
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70 Unit 4
Consideration of Average and Marginal Costs
The linear progression of the total cost curve in the figure above illustrates that the
Average cost sporting goods manufacturer faces constant average costs. The company must there-
6,000,000 euros
The average cost is fore always pay an average of 6.67 euros for a pair of shoes (= 900,000 pair of shoes or
4,000,000 euros 2,000,000 euros
the total cost of the 600,000 pair of shoes
or 300,000 pair of shoes ) regardless of how many shoes the company
company divided by actually produces. In this case, the marginal cost of an additional unit of output to be
its production level. produced is equal to the average cost. However, this is a special case because, in busi-
ness practice, the price for an additional unit of output often varies depending on the
Marginal costs total output quantity. For example, companies that are growing will initially benefit
These reflect the from economies of scale. As output increases, a company may be able to purchase
increase in costs some inputs at a lower cost because it purchases larger quantities and can therefore
resulting from the negotiate better prices.
production of an
additional unit of However, from a certain point onwards, increasing company size can also lead to prob-
output. lems. For example, internal coordination and communication problems can lead to
inefficiencies in the production process as output volumes increase and the costs of
factor inputs rise disproportionately in comparison to outputs. In this case, one speaks
of diseconomies of scale. It should be noted that economies of scale can include
increasing returns to scale as a special case. However, they are typically more general in
nature, as they also include changing proportions of the production factors as the firm
adjusts its level of output (Pindyck & Rubinfeld, 2018).
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Unit 4 71
Where there are advantages and disadvantages in terms of size, the average and mar- Economies of scale
ginal costs of a company are not constant and depend on the total output quantity. This term refers to
This typically results in a U-shaped average and marginal cost curve as a function of the phenomenon
the output quantity. This is shown in the following illustration (Pindyck & Rubinfeld, that costs rise only
2018). disproportionately if
output is increased
by a certain factor.
Diseconomies of
scale
The phenomenon
that costs rise dis-
proportionately
when the output is
increased by a cer-
tain factor.
The U-shape of the average and marginal cost curves show that firms face economies
of scale when production levels are relatively low and diseconomies of scale when pro-
duction levels are relatively high. It should be noted that the marginal cost curve
always runs below the average cost curve as long as the average cost curve is falling. As
soon as the average cost curve increases, the marginal cost curve is above it. The point
of intersection of the two curves is therefore always at the minimum of the average
cost curve. Why this has to be the case can easily be explained by a simple numerical
example. If the total current cost of producing three pairs of sports shoes is 15 euros,
15 euros
the average cost is 5 euros = 3 pair of shoes . However, if the marginal cost is only 3
euros, the production of another pair of sports shoes leads to lower average costs of
18 euros
now 4.50 euros = 4 pair of shoes , so the average cost curve falls. However, once mar-
ginal costs are higher than average costs, average costs increase with each additional
pair of sports shoes produced. Therefore, the average cost curve increases from that
moment.
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72 Unit 4
4.3 Offer
Profit-Maximizing Supply Quantity with Full Competition
Price-takers In a market where competition is fully competitive, companies are price-takers. This
If, in a competitive means that the market price cannot be influenced by an individual company and must
market, a supplier is be taken for granted. Consequently, in a competitive market, companies can only pre-
able to take the mar- sumably change the quantity of goods offered in order to maximize their profits. When
ket price for granted determining the individual, profit-maximizing supply quantity of a company, the costs
and merely adjust known from the previous lesson play a decisive role. For this reason, the familiar illus-
their own supply tration of the average and marginal cost curve is presented again below. This time,
according to it, that however, it is supplemented by a straight line for the market price. The market price is
supplier is consid- shown as a horizontal line since it is always the same on a competitive market, regard-
ered the price-taker. less of the output volume of a single company. For this reason, the market price always
also represents the marginal revenue, or the additional turnover from the sale of
Marginal revenue another unit of output of a company (Mankiw & Taylor, 2018).
The change in the
total proceeds from
the sale of an addi-
tional product unit is
called marginal reve-
nue.
With the help of the figure above, the profit-maximizing production quantity can be
determined. If a manufacturer only produced the quantity q1, the marginal cost curve
would be below the marginal revenue curve (the market price). Consequently, they
could make a profit with one more unit of output, as the price of one more unit is
higher than the additional costs. Conversely, if a manufacturer produced the quantity
q2, the marginal cost curve would be above the marginal revenue curve (the market
price). Thus, it would be advisable for the manufacturer to produce fewer units of out-
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Unit 4 73
put since, with each unit of output left unproduced, more costs are saved than revenue
is lost. The only point at which the manufacturer has no incentive to change production
volume is, therefore, point O. This is the profit-maximizing production quantity (qmax),
and the following applies: marginal costs = marginal revenues (Mankiw & Taylor, 2018).
To illustrate, one can look to a small local baker who offers bread at the market price of
4 euros. This prices also reflects demand from other bakers in the city. Its marginal rev-
enue is, therefore, 4 euros. If the additional costs they incur for a further loaf of bread
(for example, for the ingredients), the pro rata working time, and the use of machinery
amount to 3 euros, they should produce this further loaf of bread in order to make an
additional profit of 1 euro (= 4 euros market price – 3 euros marginal costs). They
should continue to bake additional breads until their marginal costs finally amount to
four euros. This is because they will not make any additional profit with one loaf of
bread: 4 euros market price – 4 euros marginal costs = 0 euros additional profit. How-
ever, if the baker bakes another loaf of bread instead and incurs marginal costs of 5
euros, they will make a loss of –1 euro with (= 4 euro market price – 5 euro marginal
costs). Therefore, they should refrain from baking any extra bread.
The example of the local baker illustrates why the contents covered in this lesson are
essential for every entrepreneur. Thus, it should be less important for a company to
generate the maximum possible output (i.e., to achieve the greatest possible growth). If
the profit actually decreases from a certain output quantity onwards, the goal should
rather be to aim for the optimum (i.e., profit-maximum production quantity). To do this,
however, an entrepreneur must understand that marginal income and costs are the rel-
evant factors in this context. In economics, the marginal principle is also used in this Marginal principle
context when the marginal income and costs—and not the averages—are relevant to the This is a fundamen-
decision. tal methodological
principle of the eco-
Therefore, the marginal cost curve is decisive for determining the maximum profit pro- nomic behavior of
duction quantity. The average cost curve is again needed to calculate and graphically economic agents,
represent the total profit of a company. Indeed, the maximum total profit in the above according to which
graph can be calculated by multiplying the maximum profit production quantity (qmax) the additional mar-
by the difference between market price (P) and average cost (DK). The difference ginal returns and
between the market price and average costs reflects how much profit a company makes costs resulting from
on average per unit of volume. Multiplied by the total number of units, the total profit a change in behavior
is calculated. Graphically, the total gain can be represented as a rectangle. This is are relevant for deci-
shown in the following figure (Mankiw & Taylor, 2018). sion-making.
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74 Unit 4
Derivation of the Individual Offer Curve
Based on the above graph of profit maximization and the corresponding argumenta-
tion, the individual supply curve of a company can be derived on a competitive market
where the market price always represents the marginal revenue for a company. If the
market price changes (e.g., due to a change in the conditions on the world market), a
profit-maximizing company adjusts its production volume. The following figure illus-
trates this behavior starting from the profit maximum in point O (in the above dia-
gram).
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Unit 4 75
If, for example, the market price rises from P1 to P2, an enterprise increases its produc-
tion quantity. This is because the intersection of the marginal cost curve and the mar-
ginal revenue curve (of the market price) is at a higher quantity (qmax2). Conversely, if
the market price falls to P3, a company reduces its production quantity. This is because
the intersection of the marginal cost curve and the marginal revenue curve (the market
price) is now at a lower quantity (qmax3). Since the marginal cost curve thus determines
the quantities that the company is willing to offer at any given market price, it forms
the supply curve of a company in a fully competitive market, provided that the market
price is higher than the average costs a company. Indeed, a company will cease produc-
tion in the long term if the market price is permanently below average costs. Otherwise,
the market price will not cover all the costs incurred by a company in the long term. A
price below the average cost curve would, on average, result in higher unit costs than
would the revenue that can be obtained from the unit price. Even at the intersection of
the market price and the marginal cost curve, if it is below the average cost curve, a
loss would be incurred—specifically, a loss per unit (average cost DK – market price P)
multiplied by the quantity (qv). The shaded area in the figure below illustrates such a
loss.
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76 Unit 4
Long-Term Supply Volume at Market Entry and Exit
In the case of the losses just described, where the market price is below the average
cost curve of a company, the company would exit the market in the long term so as not
to suffer permanent losses. In a competitive market with full competition, the loss of
supply from this one company will initially have no effect on the market price. However,
if the market price and average costs of other companies on this market do not coin-
cide, they will also exit the market. Consequently, the more companies that exit the
market, the more the volume of supply in the market as a whole is reduced. A demand
surplus triggered by the decline in supply on the market as a whole can ultimately lead
to a renewed increase in the market price at the end of this process.
If the market price is now, again, above the average cost curve, it may be worthwhile for
a company to enter the market again as, in this case, a profit can be made. In turn,
market entry by an individual company will not affect the market price. If, however, a
large number of companies enter the market in the hope of making a profit and there
is a supply surplus on the market as a whole, this can lead to a further reduction in the
market price (Mankiw & Taylor, 2018).
An interesting fact arising from the interplay between market entry and market exit in a
competitive market with full competition is that, in the long run, the market price set-
tles down in such a way that the intersection with the marginal cost curve is also the
point at which it meets the minimum of the average cost curve. Therefore, in the long
term, in a competitive market where there is full competition, a single company will not
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Unit 4 77
make a loss or a profit and will produce the efficient output. This is the output with the Efficient production
lowest average costs and that will cover all costs in the long term. The following figure volume
illustrates this situation (Mankiw & Taylor, 2018). The efficient produc-
tion volume is the
production quantity
that leads to the
minimization of
average costs.
4.4 Applications
Economies and Diseconomies of Scale in Container Shipping
Economies of scale based on the square-cube law relate to many areas of any given Square-cube law
economy. The law described by Galileo Galilei as early as 1638 states that a change in The square-cube law
the size of a body results in a quadratic increase in its surface area and a cubic is a physical law
increase in its volume. Put simply, the volume of a body grows faster than its surface according to which
(Galilei, 1638). For container shipping in particular, this regularity has led to goods being the surface area of
transported across the world’s oceans by ever larger ocean liners. This is because the an enlarged body
cost of building a container ship (e.g., of the steel used) is proportional to the surface increases in square
area of the ship, which increases in a quadratic manner, whereas the cargo capacity is form and its volume
proportional to the volume, which increases cubically. This means that freight capacity increases in cubic
increases disproportionately compared to costs as larger and larger cargo ships are form.
built. The total cargo capacity of a typical container ship in the 1950s was still around
21,000 cubic meters. By 2013, that capacity had already reached 366,000 cubic meters—
more than 17 times the original figure (Mankiw & Taylor, 2018).
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78 Unit 4
One question that inevitably arises is whether this trend of a steady increase in the
size of container ships will continue in the future. The answer to this question depends
on whether (aside from certain ship sizes) diseconomies of scale occur that overpower
the advantages of ever larger ships on the high seas. This ultimately leads to a rise in
marginal costs. Diseconomies of scale may arise, in particular, in the loading and
unloading of container freighters. It can already be observed today that ships are
sometimes too large for the existing port facilities. This makes discharging the cargo
increasingly complex and expensive. It can also render some ports inaccessible, making
the expansion of shipping lanes or the construction of new ports necessary.
Wage Differentials in the Sporting Goods Industry
In the example at the beginning of this unit, the mayor pondered whether the costs
were not perhaps higher than expected, leading to relocation of the fully automated
production to Asia. Even if the production of sports shoes is fully automated and the
capital costs for this do not differ between Asia and Germany, the remaining work con-
cerning the factory (such as logistics, administration, or maintenance of machines and
equipment) still requires people to carry out these activities. Also, wage costs in East
Asia are still significantly lower than in a high-wage country such as Germany. The con-
sequences of this fact for the initial example will be explained using the sporting goods
manufacturer that can produce 900,000 pairs of sports shoes at a minimum total
annual cost of 6,000,000 euros; at capital costs of 100,000 euros per machine; and labor
costs of 10,000 euros per worker. As the figure below illustrates, if the labor costs are
30,000 euros, the manufacturer can no longer produce 900,000 pairs of sports shoes at
a total cost of 6,000,000 euros. For a total cost of 6,000,000 euros, with labor costs of
30,000 euros, the manufacturer can achieve, at most, the isoquant q1 with an output of
550,000 pairs of sports shoes. This is because a higher wage leads to an inward rotation
of the isoquant line.
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Unit 4 79
This figure illustrates that the sporting goods manufacturer has probably decided to
relocate to East Asia also in light of the higher output volume that can be achieved at
lower labor costs.
Summary
In economics, the relationship between the production factors necessary for pro-
duction and the goods produced is described by the production function.
An isoquant graphically represents all possible combinations of production factors

with which the same amount of output can be produced.
If all factors of production are increased proportionally (i.e., by the same factor),
returns to scale may increase, decrease, or remain constant.
A company minimizes its production costs by choosing the lowest isocost line that
can be used to achieve the desired output level. In the cost minimum, the isoquant
and the isocost straight line, therefore, touch each other, with the slopes of the two
curves corresponding to each other.
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80 Unit 4
The average and marginal cost curves usually are U-shaped and intersect at the
minimum of the average curve.
In a competitive market where there is full competition, a company chooses the

volume of production so that marginal costs correspond to the market price. If the
market price changes, a company adjusts its production volume. Therefore, the
individual supply curve of a company in a competitive market corresponds to the
marginal cost curve if it is above the average cost curve.
In the long term, free market entry and exit will lead to all companies producing
the efficient output in a competitive market with full competition, i.e., producing at
minimum average costs. In this case, the intersection of the market price and the
marginal cost curve is at the minimum of the average cost curve.
Knowledge Check
learning platform.
Good luck!
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Unit 5
Business Decisions II: Incomplete
Competition
STUDY GOALS
… what the economist means by incomplete competition.
… the different forms of incomplete competition.
… why there is only one supplier in certain markets.
… why the German postal service cannot increase its prices at will.
… why incomplete competition can be negative for the consumer.
… what measures the state takes against incomplete competition.
82 Unit 5
5. Business Decisions II: Incomplete Competi-

tion
Case Study
Sam is passionate about writing letters and therefore very much looking forward to the
start of his partial retirement in a year’s time. Sam will have even more time to culti-
vate friendships with pen pals all over the world. However, his anticipation is some-
what dampened after learning that the Deutsche Post (the postal service in Germany)
will increase letter postage by ten cents to 80 cents per standard letter from the first of
July onward.
Sam bitterly complains to his partner Alex that the Deutsche Post, as a monopolist, can
set prices as it likes. Alex is somewhat surprised by Sam’s statement and replies that
the German Letter Monopoly, which granted Deutsche Post an exclusive license for let-
ter mail, was abolished in the mid-2000s.
“Yes, but the postal service has a natural monopoly because it would not be profitable
for any competitor to transport letters throughout Germany itself,” replies Sam. Alex
does not quite understand what Sam means by a natural monopoly. Alex also wonder
why Deutsche Post is not raising its prices even further if they have nothing to fear
from competition. Sam has no answer for Alex’s question.
5.1 Monopoly
The Supply Monopoly as an Example of Incomplete Competition
In the model of a competitive market with full competition, companies offer homoge-
neous goods, are price-takers, and can maximize their profits only by adjusting the
quantity offered to the respective market price. In reality, however, companies are spe-
cifically looking for ways to differentiate their products from those of their competitors,
and many companies can influence the sales price in some way. When individual com-
panies can influence the price of goods, one speaks of incomplete or imperfect com-
Incomplete/imper- petition (Mankiw & Taylor, 2018).
fect competition
This term defines There are different forms of incomplete competition. This section will first consider the
markets in which extreme form of monopoly, where, according to strict definition, only one company acts
individual compa- as supplier of a good in a market. However, it is often the case that the term monopoly
nies can differenti- (or monopoly power) is used in markets where a dominant company with a high mar-
ate their products ket share has a dominant position. Deutsche Post, mentioned in the example at the
from those of the beginning, dominates the letter market in Germany. It is subject to licensing constraints
competition and (letters up to 1,000 grams) and, in 2018, had a revenue share of 86.5 percent and a vol-
thus influence the ume market share of 85.9 percent (Monopolies Commission, 2019).
price offered.
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Unit 5 83
Business Decisions II: Incomplete Competition
Monopoly
Causes for the Creation of Monopolies A monopoly is a
market situation in
The main reason for the creation of a monopoly in a market is the existence of entry which only one com-
barriers. These prevent or impede the entry of a competitor into a market or industry. pany acts as a sup-
The higher the barriers to entry, the more difficult it is for a company not previously plier of a good.
active in a market to gain access to that very market. The more power a company
already active in the market can exercise, the likelier it could become a monopolist. We Market entry barrier
will now look at four concrete examples of monopolies and the barriers to market entry This term refers to a
behind them (Mankiw & Taylor, 2018): reason why a com-
pany cannot access
• State-created monopolies or enter a market.
• Natural monopolies
• Monopolies through sole ownership of a critical resource
• Monopolies due to external company growth
In the case of state monopolies, the state grants a supplier an exclusive right to sell
certain goods or services. The German Letter Monopoly in effect until the mid-2000s
was an example of such a state-created monopoly. Until December 31, 1997, the trans-
port of written communications was even reserved exclusively for the Deutsche Bun-
despost or its successor company Deutsche Post AG. With the adoption of the Postal
Act (PostG) on December 22, 1997, the incremental transition from monopoly to full Postal Act (PostG)
market opening by the mid-2000s was then regulated by law (Federal Network Agency, The Postal Act is the
2018). legal framework that
still governs the pro-
Another example of state-created monopolies are patent rights to inventions. A patent vision of postal serv-
grants a company or a private individual the sole right to manufacture and sell a newly ices in Germany
created product for a certain period of time (usually 20 years). In this way, the state today.
wants to promote research and development activity by allowing a company to market
a product on its own after a successful market launch and protect it from imitators. Patent
A patent is a state-
A natural monopoly arises in areas where a single company can provide a good at a guaranteed right to
lower cost than two or more companies could ever do. Natural monopolies are found, manufacture and
for example, in the field of public utilities (electricity, gas, and water), where very high sell a novel product
investment costs are first required to build a network or infrastructure before a com- exclusively for a
pany can become active on the market. Indeed, if two or more companies were to com- defined period of
pete to become water distribution services, each would have to individually bear the time.
fixed costs of laying the water pipes and setting up its own network. Thus, the average
total public service costs are lowest when a single company serves the whole market. Natural monopoly
The postal service mentioned above is also an example of a natural monopoly. The cost A natural monopoly
of setting up an infrastructure that makes it possible to transport a shipment from any arises when a single
location in Germany to any other location is enormously high and is only worthwhile if company can always
large quantities are involved. High volumes, in turn, cannot be achieved without a suit- provide a good at a
able infrastructure. This is why Deutsche Post, for example, has been able to maintain a lower price than two
market share of more than 85 percent despite the abolition of the state monopoly or more companies,
(Deutsche Post DHL Group, 2020). regardless of the
output volume.
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84 Unit 5
A monopoly can also arise when a single company has sole ownership of an important
resource. In past centuries, this was an important factor in the emergence of monopo-
lies, especially in the case of natural raw materials. However, in today’s globalized
economy, examples of monopolies resulting from sole ownership of a resource are rare.
As a result of international trade and low transport costs, the market for raw materials
has become global, meaning that a single company can rarely develop into a monopoly
power.
The fourth point that explains the creation of a monopoly is the external growth of
companies. The acquisition of competitors, or the merger of two or more companies,
Concentration of increases concentration in a market and reduces the number of companies. As a result
companies of this concentration process, a company can become so strong against its competitors
This term refers to that it ends up having monopoly power, making it more difficult for new companies to
both the actual sit- enter the market (e.g., through aggressive pricing). For this reason, takeovers and merg-
uation in a market ers of companies are regulated by the state and examined for possible effects on com-
with a few compa- petition. In Germany, for example, the Federal Cartel Office (Bundeskartellamt) is
nies and the process responsible for the control of mergers and acquisitions (Mankiw & Taylor, 2018).
of reducing the
number of market
participants. Production and Pricing Decisions of Monopolists
Federal Cartel Office The main difference between a supplier in a monopoly market and a competitive mar-
The Federal Cartel ket is that the monopolist can influence the market price of the goods and services
Office (Bundeskartel- sold. The supplier on the competitive market, also known as the polypolist, is very
lamt) is a German small in relation to the total market volume and has to accept the market price as
competition author- given. The monopolist, however, is the sole supplier whose supply volume always influ-
ity whose task is to ences the price.
protect competition;
it is also responsible The difference becomes clear when comparing the respective demand curve that an
for merger control. individual company faces between the two market forms. In a competitive market, the
demand curve runs horizontally from the point of view of an individual company. This
is seen below in the left-hand chart of the figure. Since a polypolist is very small in
relation to the market volume, the supplier can sell any quantity in the event of full
competition, but only at the market price (P0). If a polypolist were to charge a price
above the market price, it would lose its entire clientele to the competition since only
the market price is charged. For a single supplier in a competitive market, demand is
therefore completely elastic.
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Unit 5 85
For a monopolist, the situation is quite different. Since the monopolist is the sole sup-
plier on its market, demand corresponds to market demand. According to the law of
demand, the demand curve for a monopolist has a negative slope (as shown in the
right-hand graph of the above figure). If the monopolist increases the price, fewer cus-
tomers will buy their good. If they lower the price, more customers will buy the good.
Falling market demand thus limits the monopolist’s ability to turn its existing market
power into profit. But what price or quantity should a monopolist (or a quasi-monopo-
list like Deutsche Post) choose, in concrete terms, in order to maximize profits?
To answer this question, we will first look at the proceeds of a drug manufacturer that
has been granted a patent on a new drug and has thus become a monopolist. The fol-
lowing table shows how the total, average, and marginal revenues of the monopolistic
pharmaceutical manufacturer depends on the quantity of packages of medicine sold
daily.
Total, Average, and Marginal Revenue of a Monopolistic Pharmaceutical Company
Quantity of Price per Total pro- Average reve- Marginal rev-

packages package ceeds (€) nue (€) enue (€)
0 11 0 0 –
1 10 10 10 10
2 9 18 9 8
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86 Unit 5
Quantity of Price per Total pro- Average reve- Marginal rev-

packages package ceeds (€) nue (€) enue (€)
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 –2
8 3 24 3 –4
The first two columns show the monopolist’s demand curve, and the following applies:
The higher the price for a pack of medicine, the lower the daily quantity sold. The third
column shows the total revenue of the pharmaceutical manufacturer, i.e., the product
of price and quantity sold. The fourth column shows the average revenue per pack, that
is the total revenue from the third column divided by the quantity of pharmaceutical
packs sold in the first column. The last column shows the marginal revenue, i.e., the
monopolist’s additional revenue from the sale of an additional pack of medicine.
The marginal revenue is crucial for understanding the monopolist’s behavior. In the
case of full competition, the (market) price corresponds to the marginal revenue. In a
monopoly, however, the marginal revenue is always lower than the price of the goods.
For example, if the pharmaceutical manufacturer sells four packages a day instead of
three, the total revenue increases by only four euros, even though the selling price per
package is seven euros. This is due to the fact that, at a price of seven euros, the
monopolist will only earn seven euros for the other three packages (instead of eight)—
in other words, a total of three euros less. The monopolist is faced with a price and vol-
ume effect in the event of a change in quantity. An increase in the quantity sold has a
positive volume effect on the one hand (since a higher sales volume increases the total
revenue) and a negative price effect on the other (since the price is lower, reducing the
total revenue). If the price effect is stronger than the quantity effect, an increase in
quantity may even result in a loss of total revenue. This is the case with a quantity of
six packs of medicine in the above table. There is no price effect for a company in a
competitive market with full competition. If a vendor there increases his sold quantity
by one unit, they receive the market price for this—just like for all other units of meas-
ure already intended for sale. Since the polypolist is a price-taker, their marginal reve-
nue always corresponds to the price of the goods.
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Unit 5 87
As the following figure illustrates, the marginal revenue curve of the monopolistic drug
manufacturer is below the demand curve. This shows the relationship between price
and quantity sold in line with the above explanations, according to which the marginal
revenue of a monopolist is always lower than the price.
If the average and marginal cost curve is considered (along with the demand and mar-
ginal revenue curve), the profit-maximum production volume of a monopolist can gen-
erally be determined. The following figure shows U-shaped average and marginal cost
curves.
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88 Unit 5
With the help of the above figure, the profit-maximizing production volume of a
monopolist can be determined. If a monopolist were to produce only Q1, the marginal
cost curve would be below the marginal revenue curve. Consequently, it could make a
profit with one more unit of output, as the additional revenue is higher than the addi-
tional costs. If, on the other hand, a monopolist were to produce Q2, the marginal cost
curve would be above the marginal revenue curve. It would therefore be advisable for
the monopolist to produce fewer units of output, as the cost saving is greater than the
loss of revenue. The only point at which the monopolist has no incentive to change its
production volume is, therefore, point A in the above diagram. This is where the profit-
maximizing production quantity Qmax is present, since marginal costs correspond to
marginal revenues. The monopolist finds the profit-maximizing price via the demand
curve, because this curve relates the consumers’ willingness to pay to the sales volume.
In the figure above, the profit-maximizing price Pmax for a profit-maximizing production
quantity Qmax is in point B (Mankiw & Taylor, 2018).
The fact that a company maximizes its profits when marginal revenues correspond to
marginal costs is thus true, both in a monopoly and in a competitive market with full
competition. However, there is a difference. In the polypoly, the price corresponds to
the marginal costs; in the monopoly, the price is always higher than the marginal costs
(i.e., there is a price premium equal to the price minus the marginal costs). A monopo-
list therefore charges a higher price at maximum profit and, due to the falling demand
curve, sells a smaller quantity than would be the case in the long term in a competitive
market with full competition.
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Unit 5 89
Economic Policy Measures Against Monopolies
Monopolists therefore produce a smaller quantity than companies in a competitive

market and charge a higher price for it. Should the state therefore intervene in the
market in order to achieve a better market result for the consumer? As already indica-
ted, no general answer can be given to this question. In some areas, such as patents for
innovations, the state even wants companies to be able to earn a monopoly rent for a Monopoly rent
limited period of time in order to provide targeted incentives for entrepreneurial The monopoly rent
research and development activities. On the other hand, monopolies are undesirable in is an additional
other areas, and, as explained above, the state prescribes the control and review of profit that a monop-
mergers and acquisitions and their effects on competition. olist makes com-
pared to a competi-
Especially in the case of natural monopolies, the state also takes further action by pro- tive market with full
hibiting companies from charging arbitrarily high prices, thus limiting the monopoly competition because
rent. For example, Deutsche Post is regulated by the Federal Network Agency, which they have the ability
prevents abusive price mark-ups and unjustified discrimination of demand. The regula- to set a price above
tion of charges by the Federal Network Agency is also the reason why Deutsche Post, marginal costs.
from the initial example, cannot continue to increase letter postage without reason
despite having a natural monopoly. Federal Network
Agency
The Federal Network
Agency is a higher
5.2 Monopolistic Competition German federal
authority with the
task of promoting
Characteristics of a Market with Monopolistic Competition and maintaining
competition in the
The supply monopoly considered in the previous chapter is an example of an extreme five network markets
form of a market with incomplete competition. In reality, however, markets in which of electricity, gas,
only one supplier is active and no competitors enter the market are rare. Much more telecommunications,
frequently, monopolistic competition, another type of imperfect competition, is postal, and rail
observed. As the term suggests, this is a mixture of the market characteristics of a transport.
monopoly and a competitive market with full competition. An example of such a mar-
ket is the gastronomy sector in a city. Although there are numerous suppliers who have Monopolistic compe-
free access to the market, as in full competition, they all differ in the selection and tition
quality of their food. This means there are no homogeneous goods and the individual This is a market form
restaurants are therefore not pure price-takers or quantity adjusters, but rather can with free market
influence the sales price themselves. Following the example of a city’s restaurant mar- entry and a large
ket, the following three central characteristics define a market with monopolistic com- number of suppliers
petition (Mankiw & Taylor, 2018): offering similar, but
not identical, goods.
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90 Unit 5
• There are a large number of companies on the market competing for the same (very
large) group of customers.
• Each supplier produces products or services that differ at least slightly from the
goods of the competition. As a result, a company is neither a price-taker nor a vol-
ume adjuster (as it would be in full competition). Rather, the individual supplier
faces a falling individual demand curve, similar to that of a monopoly. This is called
product differentiation.
• There are no relevant barriers to market entry, and companies can enter and exit
the market freely without restrictions. This is called free market entry. In this con-
text, one also speaks of a contestable market.
In addition to the catering trade, the markets for many everyday products (such as
toothpaste, deodorants, soap, or shampoo) are often characterized by monopolistic
competition. On these markets, there are a large number of suppliers that differentiate
their products by means of different brand names or variation in taste and scent. For
example, customers are often willing to pay a few cents more for a certain variant of a
toothpaste and do not change brands if the price is higher than that of another manu-
facturer. If products are successful, imitators can also enter the market relatively easily
themselves and offer a similar product (Pindyck & Rubinfeld 2018).
Production and Price Decisions in a Market with Monopolistic Competition
Since a supplier in a market with monopolistic competition faces a falling demand

curve in the same way as a monopolist, the decision rule of profit maximization in the
case of monopolistic competition also follows the monopoly. For example, a supplier
chooses the production and supply quantity so that marginal costs and revenues
match and sets the price according to this quantity based on the demand curve. The
following figure illustrates this maximization calculation.
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Unit 5 91
As explained above, the company’s individual demand curve shown is decreasing, as

the company’s products are somewhat different from those of its competitors. It should
be noted, however, that the company’s demand curve does not correspond to the mar-
ket demand curve, which would be even steeper, as in the case of monopoly. In the
case of monopolistic competition, a company is not the sole supplier, but only one of
many companies on the market and thus covers only part of the total market demand.
The profit-maximizing production quantity (qmax) lies at the intersection of the marginal
revenue curve and the marginal cost curve. Since the price (pmax) corresponding to this
exceeds the average costs (DX), the company achieves an average profit per unit of
volume equal to the price, minus the average costs. The total profit, that is the average
profit per unit of quantity multiplied by the number of units sold (qmax), is marked by
the shaded rectangle (Pindyck & Rubinfeld, 2018).
A company in a market with monopolistic competition therefore determines quantity

and price in the same way as a monopolist. In the short term, the two forms of compe-
tition are therefore similar. However, there is a clear difference made to a monopoly if
free market entry, due to the absence of barriers to entry in a market with monopolistic
competition, is also taken into account. Indeed, if the profit shown by the shaded rec-
tangle in the figure above persists over a longer period of time, other companies will
enter the market in order to also benefit from the profitable opportunities. The more
competing products introduced, the more the market share and sales figures of an
individual company decline. Consequently, the demand curve of an individual company
shifts to the left. In the long run, market entry by competitors will shift the demand
curve of an individual company to the left until it just touches the average cost curve.
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92 Unit 5
The figure below illustrates that if the maximization calculus (marginal costs equal
marginal revenues) is fulfilled, in this case, the total profit is zero. This is because the
price for this production quantity (qmax) corresponds exactly to the average costs.
Monopolistic Competition as a Market Form Between Monopoly and Full

Competition
The above graph illustrates well the two relevant characteristics of long-term equili-
brium in a market with monopolistic competition. This can be explained in the follow-
ing ways (Mankiw & Taylor, 2018).
• As with a monopoly, the price exceeds marginal costs. This is because a company
has monopoly power even in the long term in the case of monopolistic competition:
its demand curve is falling even in the long term, as it can differentiate its products
from those of its competitors.
• As in the competitive market with full competition, the price is in line with the aver-
age total costs. This is because free market entry and exit drives the long-term profit
of an individual company to zero.
The first point illustrates the difference between the market forms of monopolistic and
full competition. In the case of monopolistic competition, a company demands a mark-
up on marginal costs. As a consequence, the output volume produced by a company in
the presence of monopolistic competition is also lower than in the presence of perfect
competition and does not correspond to the efficient production volume. The second
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Unit 5 93
point, again, highlights the difference between a monopoly and monopolistic competi-
tion. Since a monopolist is the exclusive distributor of a product without close substi-
tutes, they can make a profit even in the long term. The profit of a company in the case
of monopolistic competition, on the other hand, will tend towards zero in the long term
due to the free market entry of competitors.
In summary, the following table once again compares the market form of monopolistic
competition with a monopoly and with a competitive market with full competition
(Mankiw & Taylor, 2018).
Monopolistic Competition Between Full Competition and Monopoly
Complete compe- Monopolistic Monopoly

tition competition
Company objec- Profit maximiza- Profit maximiza- Profit maximiza-

tive tion tion tion
Maximization rule marginal revenue marginal revenue marginal revenue

= marginal costs = marginal costs = marginal costs
Quick win oppor- yes yes yes

tunity
Price-taker yes no no
Price Price = marginal Price > marginal Price > marginal

cost costs costs
Efficient output yes no no
Number of com- many many one

panies
Free market entry yes yes no
Long-term profit no no yes

opportunity
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94 Unit 5
5.3 Oligopoly
The Oligopoly as Competition from a Few
The third example of a market with incomplete competition, in addition to the monop-
Oligopoly oly and monopolistic competition, is the oligopoly. In an oligopoly, a relatively small
An oligopoly is the number of very large companies dominate the market. In an oligopolistic market struc-
competition ture, there may be thousands of companies in the market, but supply is dominated by
between a few, i.e., a just a few. An example of an oligopoly is the mineral oil market in Germany. While there
market structure in may well be a large number of small independent fuel stations in the region, the Ger-
which only a few man fuel station market is dominated by five large, well-known, international mineral
suppliers offer simi- oil companies and their brands.
lar or identical
goods and dominate Since oligopolistic markets are dominated by a few large companies, each of these
the market. companies exerts a certain influence on the market outcome. In particular, there are
interdependencies (also known as mutual dependencies) between the dominant com-
panies. These do not occur with companies in competitive markets with full competi-
tion. Although, even in an oligopoly, each company in the market concentrates on its
own activities and objectives, its behavior is influenced by the reactions to its own
behavior that can be expected from competitors. The result of these interdependencies
is a constant tension between cooperation and self-interest. This tension and its influ-
ence on the market outcome of an oligopoly will be illustrated using the example of
Duopoly the duopoly (Mankiw & Taylor, 2018).
A duopoly is a spe-
cial form of oligopo-
listic market with Production and Price Decisions the Oligopoly Using a Duopoly
exactly two domi-
nant suppliers. The regional drinking water supply, which is dominated by two large companies with
their own spring, Regiobrunnen and Bergsprudel, will serve as an example. The regional
demand for drinking water is shown in the table below. The first column shows the
total quantity demanded, and the second column shows the price. The third column
shows the total revenue from water sales (i.e., the product of the first two columns of a
row). For the sake of simplification, it should be assumed that no subsidy or other
costs are incurred by the two producers, so that the total revenue directly reflects the
profit.
Demand for Drinking Water
Quantity (in million lit- Price per thousand liters Total proceeds (in thou-
ers) sands of euros)
0 120 0
10 110 1,100
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Unit 5 95
Quantity (in million lit- Price per thousand liters Total proceeds (in thou-
ers) sands of euros)
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,000
120 0 0
In a fully competitive market, the production decisions of the individual companies

would result in the market price falling to the level of marginal costs. Assuming mar-
ginal costs in the example of zero euros, 120 million liters of drinking water would be
demanded and produced according to the above table, which corresponds to the effi-
cient production volume in the case of full competition.
A monopolist, on the other hand, would try to maximize profits and set prices and vol-
umes accordingly. Since there are no costs for drinking water production (according to
the assumption in the example), the total revenue in the above table also corresponds
to the profit, which can be a maximum of 3,600,000 euros. This is achieved with a quan-
tity of 60 million liters of drinking water at a price of 60 euros per thousand liters. As
usual in the monopoly case, the price is above the marginal cost of zero euros. The
market result in the monopoly would thus maximize the profits of the monopolist;
however, from an economic standpoint, it would be inefficient because the efficient
production volume of 120 million liters of drinking water would not be produced.
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96 Unit 5
In order to achieve the maximum profit, the two oligopolists could now try to act like a
monopolist through consultation and cooperation. They could jointly offer 60 million
liters of drinking water at 60 euros per thousand liters. Such an agreement between
Collusion companies on production volume and price is called collusion in economics, and the
If companies agree companies involved are called cartels. The decisive question for the actual market out-
on production vol- come in the case of the oligopoly is whether the two producers can agree on the
umes and prices, monopoly volume and the monopoly price, or whether there are reasons why no profit-
this is called collu- maximizing cartel between Regiobrunnen and Bergsprudel will come about.
sion.
One reason is that restrictive collusion between two or more companies is prohibited
Cartel in most countries of the world under the prevailing competition laws. In Germany, the
A cartel is a group of Act Against Restraints of Competition (GWB) was enacted for this purpose. Section 1 of
companies acting in this Act (as cited in Mankiw & Taylor, 2018, p. 477) explicitly states that “agreements
concert (by collu- between companies, decisions by associations of companies and concerted practices
sion). which have as their object or effect the prevention, restriction, or distortion of competi-
tion” are prohibited.
However, even if the cartel members do not shy away from the risk of prosecution in
the event of collusion being uncovered, there is a second reason why the monopoly
result might not be achieved. Indeed, a cartel must agree not only on the total volume
of production, but also on its allocation between the individual cartel members. In the
example case, Regiobrunnen and Bergsprudel would have to agree on how to share the
monopoly production of 60 million liters of drinking water. A larger production or mar-
ket share always means a higher profit for a cartel member. On the basis of an agreed
share of 50 percent of the monopoly volume for each of the two duopolists, there is an
incentive for both suppliers to unilaterally increase output. If, for example, Regiobrun-
nen produces 40 million liters of drinking water instead of the agreed 30 million liters,
while Bergsprudel keeps to the agreement, a total of 70 million liters of drinking water
is offered. That, according to the above table, would result in a price of 50 euros per
thousand liters of drinking water. The profit of Regiobrunnen would increase from
1,800,000 million euros (30 million liters – 0.06 euros per liter) to 2,000,000 million
euros (40 million liters – 0.05 euros per liter). However, there is an analogous incentive
for Bergsprudel to pump 40 million liters of drinking water instead of 30 million liters.
As a result, 80 million liters of drinking water are offered at a price of 40 euros, and
each supplier makes a profit of only 1,600,000 euros. Thus, although each duopolist
individually seeks to gain an advantage when deciding on production volume, together,
they end up offering more than the actual profit-maximizing monopoly volume at a
lower price, thereby achieving an overall profit that is lower than the monopoly profit.
Although the driving force of self-interest increases the production volume beyond the
monopoly volume, it does not lead to efficient production volume as in the case of full
competition. One of the suppliers might consider whether, on the basis of 40 million
liters of drinking water produced in each case, they should unilaterally increase their
output by a further 10 million liters. However, because this would cause profits to fall,
they refrain from doing so. This is because, according to the above table, with a total
production volume of 90 million liters, the price would be reduced to 30 euros per
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Unit 5 97
thousand liters. This would mean a profit of only 1,500,000 euros (50 million liters –
0.03 euros per liter) instead of the previous 1,600,000 euros (40 million liters – 0.04
euros per liter).
Thus, in the example case of the duopoly, a stable market equilibrium of 40 million lit-
ers of drinking water produced by each of the two companies is established, whereby
neither Regiobrunnen nor Bergsprudel have an incentive to change their behavior. The
determination of such or even more complex market outcomes, in which the best pos-
sible strategy of one actor is determined in relation to the reaction of the other market
participants, is the subject of game theory, a field of research at the interface between Game theory
economics and mathematics. This is used to
model decision-
making situations in
which several partic-
Summary ipants interact with
each other.
In economics, the concept of imperfect competition is used to describe market
forms in which individual companies can influence the market price and are there-
fore not pure price-takers as in the case of complete competition. Examples of mar-
ket forms with incomplete competition are the monopoly, monopolistic competi-
tion, and the oligopoly.
In the case of a monopoly, only one supplier appears on the market, and barriers
to entry prevent other companies from competing with the monopolist on the
monopoly market.
A profit-maximizing monopolist selects its output quantity in such a way that mar-
ginal costs and marginal revenue correspond to each other. The profit-maximizing
price is higher than the marginal costs. As a result of the falling demand curve
faced by a monopolist, it produces a lower output volume than companies in a
competitive market with full competition.
The profit maximization calculation of a company, in the case of monopolistic com-

petition, corresponds to that of a monopolist. However, the free market entry and
exit of competitors leads to a situation in which profits in a market with monopolis-
tic competition tend toward zero in the long term.
An oligopoly is a competition of a few large companies that dominate a market. In

the case of the oligopoly, the market outcome depends on the interdependent
decisions of the oligopolists. Although a coordinated approach would maximize
profits, the oligopolists’ own interests often lead to a sub-optimal result from the
companies’ perspectives.
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98 Unit 5
Knowledge Check
learning platform.
Good luck!
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Unit 6
Business Decisions III: Game Theory
STUDY GOALS
… what is meant by a game in the context of game theory.
… how game theory is applied to economics.
… how simultaneous and sequential games differ.
… why stable equilibria do not have to be optimal.
… how to give credibility to an empty threat.
100 Unit 6
6. Business Decisions III: Game Theory
Case Study
Ali is the founder of Fintech, a promising start-up. After successfully entering the mar-
ket in Germany, they now want to expand abroad with their new app, an innovative
mobile payment solution. The first country they looked to was France. In the short term,
however, Fintech lacks the volume of staff with sufficient language skills required to
take such a step. In order to make it clear to competitors that Fintech sees itself as the
top market leader for the launch in France, and to prevent said competitors from
expanding there, Fintech issues a press release in which their imminent entry into the
French market is announced (despite all the short-term obstacles). A few weeks later,
however, Ali realizes that, despite the press release, a German company, Universalbank,
has preempted Fintech’s release and entered the French market with a similar mobile
payment solution. For Fintech, the expansion into France is no longer profitable, as it
would hardly be able to make up the time lag in customer acquisition. It is therefore
forced to abandon its original expansion plans. Instead, Fintech is now targeting Italy as
the next market launch destination. In doing so, Ali naturally wonder whether another
failure like the one in France can be avoided and how they can credibly assure compet-
itors in advance that Fintech truly is close to a market launch in order to deter them
from entering the Italian market.
6.1 Methodology
The introductory example makes clear that the result of entrepreneurial decisions usu-
ally depends on their own decisions as well as the reactions and decisions of their
competitors. In addition to market entry, there are many other decision-making situa-
tions in business in which the reactions of others have to be taken into account. For
example, we might consider the advertising decisions of a company, research and
development decisions, or strategic production and price decisions, particularly when
launching or revising products.
In economics, game theory, also known as interactive decision theory, is used to ana-
Game lyze all of these questions. In this context, a game is a mathematical model used to
In game theory, a describe a decision-making situation with several participants who influence each
game is understood other in their decisions. The consequences of a decision in a game, therefore, depend
as a situation in on both one’s own actions and the actions of others. For this reason, a strategic inter-
which actors make action takes place. The term “game theory” originates from the early days of this field
strategic decisions of research when the analysis of multiplayer board games was often the focus of inter-
that incorporate the est. Irrespective of the actual game under consideration, the decisions of the individual
actions and reac- players in a game lead to payouts (i.e., to a result that may give them advantages and
tions of other actors. benefits or disadvantages and costs). For companies, the payout usually consists of the
profit or loss that can be realized. Game theory aims to determine the optimal strategy
for each player that maximizes their expected payout. A strategy in the sense of game
theory consists of rules and a concrete plan of action for a game (Pindyck & Rubinfeld,
2018).
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Unit 6 101
The economic games in which companies participate can be divided into cooperative Payout
and non-cooperative games. In cooperative games, the players are able to conclude A payout, in the
binding contracts on the basis that they can, under certain circumstances, develop sense of game
joint strategies. An example of a cooperative game is a negotiation of prices when a theory, is the value
legally binding sales contract is concluded. Here, the buyer and the seller must agree attributed to a pos-
on a price in advance, which is then also contractually fixed, legally valid, and enforcea- sible outcome.
ble. In contrast, non-cooperative games do not allow for the negotiation and enforce-
ment of binding contracts between the players. For example, oligopolists are unable to Cooperative game
enforce agreements reached by means of litigation, as it is legally prohibited for them In a cooperative
to agree on prices or quantities between themselves. Therefore, each oligopolist can game, the players
only consider the most likely reaction of the competitors and include it in their own can conclude bind-
decision-making process. It should be noted that, for reasons of simplification, this ing contracts to
chapter only considers two-person games in which two companies are involved. How- develop strategies
ever, the concepts and methods mentioned above are also applicable to games with together.
more than two players or companies (Pindyck & Rubinfeld, 2018).
Non-cooperative
The games considered in this unit are also based on rational participants who are game
aware of the consequences of their actions and who have complete information A non-cooperative
regarding their options for action and the payouts associated with them. Ultimately, the game is one in which
concrete question concerns how a company should behave in order to maximize its it is impossible to
payout if it has to assume that all other companies also behave in such a way that will negotiate and
maximize their profits. An important game theory concept in this context is common enforce binding con-
knowledge. Common knowledge refers to information and events that each individual tracts.
player is aware of. Each player also understands that all other players have the same
information. Common knowledge
This term refers to a
Let’s first consider simultaneous games. These are decision-making situations in which game theory concept
the players either make their decisions simultaneously, or the individual player does according to which
not yet know the decision of the opponents at the time of their own decision-making. the knowledge of the
Next, we have sequential games in which the order the individual players make their players consists of
decisions plays a role in the outcome. If each player knows the previous decisions both pure facts and
made by their fellow players at all times, including possible random decisions—mean- the understanding
ing the previous game events are fully known—then we speak of games with perfect that all other players
information. Examples of (social) games with perfect information are chess, mill (also have the same infor-
known as nine men’s morris), or backgammon. Sequential games, such as card games mation.
in which one does not know the contents of the other players’ hands, offer a counter-
example. Simultaneous games, like rock-paper-scissors, are games in which the moves Simultaneous game
take place at the same time are another. A simultaneous
game is a decision-
making situation in
which none of the
players knows the
concrete decision of
the other in advance.
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102 Unit 6
Sequential game
A sequential game is 6.2 Simultaneous Games
a decision-making
situation in which
the players act one Dominant Strategies
after the other (i.e.,
the decisions of As an example of a simultaneous game, the decisions made by two dominant compa-
some players are nies on advertising measures in one market should be considered. Companies A and B
already known). sell competing products and have to decide whether to take promotional measures to
increase sales and maximize profits. The profit of each company is also influenced by
the decision of its competitor. The possible outcomes of such a game are displayed in a
Payout matrix payout matrix, as is common in game theory. In the following payout matrix, the first
The payout matrix is number in each field represents the profit of Company A and the second number repre-
a table that shows sents the profit of Company B (Pindyck & Rubinfeld, 2018).
the payout for each
actor for different
decision-making Payout Matrix for a Promotional Game
options.
Company B
Advertising No advertising
Company A Advertising 10, 5 15, 0
No advertising 6, 8 10, 2
The above payout matrix shows that, if both companies advertise, Company A makes a
profit of 10 and Company B makes a profit of 5. If neither of the companies advertises,
the profit of Company A is 10 and that of Company B is 2. If only Company A advertises,
its profit is 15 and Company B makes no profit. If Company B advertises unilaterally, it
makes a profit of 8 and company A makes a profit of 6.
Which strategy should each company choose? As the payout matrix shows, it is always
better for Company A to promote its product. This is because Company A always makes
a higher profit with the strategy “advertising” compared to ”no advertising” regardless
of whether Company B advertises (10 compared to 6) and or refrains from advertising
(15 compared to 10). Also, for Company B, it is always better to advertise its product.
This is because both when Company A advertises (5 compared to 0) and when Company
A does not advertise (8 compared to 2), Company B still makes a higher profit. For both
Dominant strategy Company A and Company B, “advertising” is thus a dominant strategy. If both players
A dominant strategy pursue a dominant strategy, as in the example of the advertising game above, the
is one that is always result of this game is called a balance in dominant strategies (Pindyck & Rubinfeld,
optimal, regardless 2018).
of the actions of the
other actors.
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Unit 6 103
Balance in dominant
Nash Balance strategies
This is the result of a
However, there is not a balance in dominant strategies in every game. To illustrate such game in which all
a game, the payout for Company A in the lower right-hand field of the above payout players choose the
matrix should be changed. This change results in the following situation: best possible strat-
egy for themselves,
regardless of the
Modified Advertising Game strategy of their
competitors.
Company B
Advertising No advertising
Company A Advertising 10, 5 15, 0
No advertising 6, 8 20, 2
Now Company A no longer has a dominant strategy, because its optimal strategy
depends on what Company B will do. If Company B advertises, the “advertising” strat-
egy continues to be the best response from Company A (gain of 10 compared to 6 for
“no advertising”). However, if Company B does not advertise, the best strategy for Com-
pany A is not to advertise either (profit of 20 compared to 15 for “advertising”). If both
companies make their decision simultaneously (that is, they do not know each other’s
choice when making their own decision), what should Company A do then?
For this purpose, Company A should first put itself in the position of its competitor and
ask itself which decision is the best from Company B’s point of view—and what Com-
pany B is therefore most likely to do. The answer to this question is obvious, as Com-
pany B continues to have the dominant strategy of “advertising,” regardless of what
Company A does. Company A can therefore conclude that Company B will advertise. In
such a case, Company A should also advertise in order to achieve a profit of 10 (instead
of 6 by not advertising). Thus, a stable equilibrium is established in the upper left field
of the payout matrix, where no company has the incentive to change its strategy unilat-
erally. This is because, starting from the equilibrium that both companies advertise,
Company A’s profit would be reduced from 10 to 6 if it decided to stop advertising and
Company B’s profit would also be reduced from 5 to 0 if it unilaterally changed strategy
(Pindyck & Rubinfeld, 2018).
Such a stable equilibrium, in which each company makes the best possible decision
given the decisions of the other companies, and in which no company has an incentive
to change its strategy unilaterally, is called the Nash equilibrium. This balance is a spe-
cial case of the Nash equilibrium in which both actors pursue a dominant strategy.
However, the Nash equilibrium also applies to cases where not every player has a dom-
inant strategy. It is therefore broader than the equilibrium in dominant strategies.
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104 Unit 6
Nash equilibrium However, a game does not have to have a clear Nash equilibrium. Some games do not
This is the balance show a Nash balance at all, while several Nash equilibria are possible in others. That is
in which all players to say that several strategy combinations are stable. An example of the product choice
act in an optimal of companies illustrates such a situation. Müslifitt and Naturgenuss are both manufac-
way, taking into turers of cereal products. Both consider whether their respective latest cereal products
account the actions would be better crispy or sweet. The following payout matrix illustrates the profit
of competitors. depending on the decisions of the two companies.
Product Selection Game (I)
Naturgenuss
Crispy Sweet
Müslifitt Crispy —5, —5 10, 20
Sweet 20, 10 —5, —5
In this case, there are two Nash equilibria (the lower left and the upper right), because,
in both cases, neither Müslifitt nor Naturgenuss have an incentive to change their deci-
sion unilaterally. This is because the gain of 10 or 20 would be transformed into a loss
of —5. However, which of the two Nash equilibria actually occurs in the market under
consideration (i.e., whether Müslifitt produces the sweet variant and Naturgenuss the
crunchy variant, or vice versa) cannot be predicted without additional information at
the beginning of a game.
Prisoner’s Dilemma as a Contradiction Between Individual and Collective

Rationality
The concept of Nash equilibrium helps to identify which combinations of strategies in a

game lead to a stable equilibrium. However, a stable equilibrium simply means that no
actor has a unilateral incentive to deviate from its decision. This does not exclude the
possibility that a coordinated, joint deviation by both actors could possibly lead to an
even better result for both.
In game theory, a situation where individual rationality deviates from collective ration-
Prisoner’s dilemma ality is referred to as the prisoner’s dilemma. The problem can be illustrated quite well
This is a vivid exam- with an example concerning the interrogation of two prisoners in custody. For example,
ple of a game that in the prisoner’s dilemma, two suspects are accused of joint armed robbery with aggra-
illustrates why coop- vated assault. They are therefore interrogated individually in separate prison cells. This
eration between prevents them from communicating with each other. Both prisoners must, without
actors is difficult, knowing the statement of the other prisoner, consider whether to confess to the crime.
even when it could If both confess, they will each be sentenced to five-years imprisonment. If neither of
bring advantages. the detainees confesses, the prosecutor will only be able to only prove that the two are
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Unit 6 105
illegally in possession of firearms and both will only receive a two-year prison sen-
tence. However, if only one of the two prisoners confesses while the other one denies
it, leniency will only apply to the former. This means that the first prisoner gets off
unpunished while the other prisoner is sent to prison for ten years. The following pay-
out matrix graphically represents the described situation.
Prisoner’s Dilemma
Prisoner B
Confess Deny
Prisoner A Confess —5, —5 0, —10
Deny —10, 0 —2, —2
It turns out that “confessing” is a dominant strategy for both prisoners. Therefore, the
upper left field represents a balance in dominant strategies—or the only Nash equili-
brium in the game. However, the payout matrix also makes it clear that both actors
could improve their circumstances if they both denied. In that instance, they would
then only have to go to prison for two years instead of five. However, since both prison-
ers are held in separate cells and cannot communicate with each other, they have no
possibility of entering into a binding agreement. This is why each prisoner has an
incentive to confess—to benefit from the notice of leniency. The bottom line is that a
stable balance will be achieved, with both prisoners confessing and thus being worse
off than would be possible with a coordinated approach.
Such a prisoner’s dilemma, in which individual rationality differs from collective ration-
ality, can be applied to many other situations such as the decision between disarma-
ment and the production of new nuclear weapons by a state. During the Cold War
between the United States and the Soviet Union, each of the two countries had an
interest in living safely away from each other’s nuclear weapons; each also, however,
had an interest in expanding its own nuclear arsenal in order to strengthen its own
position of global power relative to the other. Such a situation, known as a balance of
terror, is illustrated in the following figure. Balance of terror
This is a term most
often used to
describe the state of
the nuclear arms
race between the
USA and the Soviet
Union.
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106 Unit 6
Balance of Terror
Soviet Union
Armament Disarmament
United States Armament endangered, safe and power-

endangered ful, vulnerable
and weak
Disarmament vulnerable and safe, secure

weak, safe and
powerful
If the Soviet Union decides to rearm, the United States will also rearm to its own
advantage. If the Soviet Union decides to disarm, it is nevertheless advantageous for
the United States to arm itself, as this improves its own position of power. For each
country, therefore, “armament” is the dominant strategy (individual rationality), and a
continuous arms race takes place, with the result that both countries are constantly
under threat. It would be collectively rational, on the other hand, if both states were to
submit to a disarmament agreement that is binding on both sides. They would thus be
able to live in a state of security.
The prisoner’s dilemma also often plays a role in business practice where it is not pos-
sible to negotiate and enforce binding contracts between the companies involved. For
example, it would be profit-maximizing for the oligopolists in a market if they produced
the monopoly quantity at the monopoly price together. However, each company has an
incentive to produce a higher quantity, which leads to a market outcome where a
higher quantity is offered at a lower price than in the case of coordinated action. The
regional drinking water supply of the two duopolists Regiobrunnen and Bergsprudel
will serve as an example.
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Unit 6 107
Prisoner’s Dilemma in Business Practice (Profit in Thousands of Euros)
Regiobrunnen
40 thousand lit- 30 thousand lit-

ers ers
Bergsprudel 40 thousand lit- 1,600, 1,600 2.000, 1,500

ers
30 thousand lit- 1,500, 2,000 1,800, 1,800

ers
If both companies shared the monopoly quantity of 60,000 liters of drinking water in
total and each producer produced 30,000 liters each, each company would make a
profit of 1,800,000 euros (lower right field). However, each company has an incentive to
deviate from such an agreement, as the profit from a production of 40,000 liters is two
million euros higher than if the other company continues to produce 30,000 liters. As a
result of this prisoner’s dilemma, both companies will thus produce 40,000 liters
(upper left field) and make a lower profit than would be possible if they were to coop-
erate (lower right field).
6.3 Sequential Games
Solution of Sequential Games and Advantage of the First Move
In the previous section, games were presented in which the players do not know the
decision of the other player when making their own decision. However, in business
practice, there are often cases in which companies do not make decisions simultane-
ously, but sequentially (i.e., one after the other). The influence this has on the equili-
brium being established is to be illustrated by the product selection game already dis-
cussed, the payout matrix of which is as follows.
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108 Unit 6
Product Selection Game (II)
Naturgenuss
Crispy Sweet
Müslifitt Crispy —5, —5 10, 20
Sweet 20, 10 —5, —5
In the case of a simultaneous decision, it was not possible to determine without fur-
ther information which of the two Nash equilibria (lower left field and upper right field)
would be the market equilibrium. However, if the companies decide one by one, this
statement is no longer true. Assuming that Müslifitt is ready for production sooner and
can introduce its cereal first, which flavor will it choose? When making its decision,
Müslifitt must take into account the later reaction of Naturgenuss. Müslifitt knows,
regardless of which flavor it chooses, that Naturgenuss will always choose the other to
avoid a loss. So Müslifitt’s choice will be the sweet variant, as this is where the highest
possible profit of 20 can be achieved, and Naturgenuss will, accordingly, introduce a
crispy cereal and make a profit of 10. The stable Nash equilibrium of a sequential game
in which Müslifitt has the first move is the lower left box in the above payout matrix.
Although the outcome of the product selection game can also be determined using the
above payout matrix, it is often easier to do so in a sequential game using the exten-
Extensive form sive form of a game. The possible actions of the players are displayed in the form of a
The extensive form decision tree. This is shown in the figure below.
is a representation
of possible actions
in a game in the
form of a decision
tree.
The illustration shows the possible actions of Müslifitt (crunchy or sweet cereal) and
the possible reactions of Naturgenuss to each of these actions in their temporal
sequence. The different decision-making levels of the product selection game are sym-
bolized by circles and are called nodes or decision nodes. In keeping with the image of
a tree, the topmost node is also called the root or trunk. The connecting lines shown
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Unit 6 109
are the branches. The resulting payouts of the game are at the end of the lowest
branches. The first number represents the payout for Müslifitt, and the second number
represents the payout for natural enjoyment.
In order to find the solution of the product selection game by means of extensive form,
the method of backward induction is used. In doing so, it goes backwards from the end Backward induction
of the decision tree and seeks a stable balance. It is therefore first considered which This is a method for
decision Naturgenuss will make depending on the respective decision of Müslifitt. If determining the
Müslifitt has opted for the crunchy flavor, Naturgenuss will then opt for the sweet flavor Nash equilibrium in
—a gain of 20 is better than a loss of —5 when choosing a crunchy cereal. If, on the sequential games.
other hand, Müslifitt has opted for the sweet variety, Naturgenuss will introduce the
crunchy cereal in the second step—a gain of 10 is better than a loss of —5 when intro-
ducing a sweet cereal.
Based on these considerations, Müslifitt is faced with the decision of whether to intro-
duce a sweet cereal and make a profit of 20 (because, as shown, Naturgenuss will
respond to a sweet cereal from Müslifitt with a crunchy cereal); or whether to choose a
crunchy cereal and make a profit of 10 (because, as shown, Naturgenuss will respond to
a crunchy cereal from Müslifitt with a sweet cereal). Thus, using the above decision tree,
Müslifitt can easily deduce that it should introduce the sweet taste itself, to which
Naturgenuss will react with the introduction of a crunchy cereal (Pindyck & Rubinfeld,
2018).
The example of the sequential product selection game shows that the company that
acts first has an advantage over its competitor. By introducing the sweet flavor, Müslifitt
establishes a situation in which Naturgenuss is only left with one option: introducing
the crunchy flavor. In this context, one also speaks of the advantage of the first train. Advantage of the
Another example of this was mentioned in the introductory example as part of the first train
international expansion of the mobile payment app. There, the company first to enter a The first move
foreign market has an advantage/lead that is difficult to catch up to later. In this advantage is a com-
instance, the company can build up a loyal customer base without competition. Univer- mon advantage of
salbank’s entry into the market created a situation in which Fintech was forced to can- the player who is
cel its own expansion in order to avoid a loss. allowed to act first in
a sequential game.
Empty Threats, Commitment, and Credibility
But why was the press release, which Fintech issued during the run-up and which was
supposed to scare off the competition, not successful? An explanation is provided by
the following payout matrix that uses a very simple numerical example to simulate the
winning situation in the market entry game under consideration.
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110 Unit 6
Empty Threat in the Market Entry Game
Universalbank
Market entry No market entry
Fintech Market entry —2, —2 10, 0
No market entry 0, 10 0, 0
If neither player enters the market, neither company makes a profit or a loss. If, on the
other hand, only one of the two players enters the market, this player makes a profit of
10 and the other, who stays away from the market, makes a profit of 0. If both players
enter the market, the strong competition and the necessary costly advertising meas-
ures result in a loss of —2 for both. Since Fintech had not yet entered the market and
thus had not created any established facts, Universalbank benefited from the advant-
age of the first move. For a better understanding, the described market entry game will
be considered in extensive form.
As the decision tree makes clear, Universalbank does not need to fear market entry by
Fintech once it has entered the market on its own. For Fintech, the “no entry” decision
with a payout of 0 represents the best possible response to the previous “market entry”
decision made by Universalbank In this context, the press release should be seen as an
empty threat, as it does not entail any credible commitment on the part of Fintech.
Although market entry would indeed be advantageous for Fintech, this would only be
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Unit 6 111
the case if the competitor were not active on the market (profit of 10 for the Fintech if
Universalbank does not enter the market). However, once Universalbank has entered
the market, Fintech has no incentive to do so itself, as it would suffer a loss of —2. Con-
sequently, the announcement in the press release is not credible.
However, Fintech could indeed lend credibility to its announcement of a market entry
in advance. For this to happen, however, the decision “no market entry” for Fintech with
simultaneous market entry of Universalbank would have to be more loss-making than
the “market entry” decision. The following payout matrix provides a numerical example
of this.
Credible Commitment in the Market Entry Game
Universalbank
Market entry No market entry
Fintech Market entry —2, —2 10, 0
No market entry —3, 10 —3, 0
Now Fintech has a dominant strategy and will always enter the market, regardless of
Universalbank’s decision. But what could make the “no entry” decision costlier than the
“entry” decision? One possibility would be for Fintech to enter into commitments in
advance. This would entail high consequential costs or penalties in the event of a
failed market entry. For example, cooperation agreements with Italian banks are con-
ceivable, which would involve high penalties in the event of Fintech failing to enter the
market. Provided that Fintech makes these agreements public in advance, it could
credibly assure that, in any event, it would enter the market. As a result, no competitor
would have an incentive to enter the market itself, otherwise the result would be a loss
of —2 (upper left-hand field). On the contrary, Fintech achieves the result in the upper
right field by the credible commitment to enter the market. The paradox thus arises
that an initially disadvantageous act, namely that Fintech restricts itself in its behavior
and risks high penalties, subsequently develops into an advantage because no compet-
itor is willing to enter the market.
Summary
Game theory is used to analyze decision-making situations with several partici-

pants whose decisions influence each other, distinguishing between simultaneous
and sequential games.
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112 Unit 6
In simultaneous games, the players do not know the decisions of the other players
when making their own decisions; in sequential games, the players decide one
after the other—the previous decisions of the other players are, therefore, known.
If one player, regardless of the decision of the others, always decides on a fixed
strategy, this is called a dominant strategy. If all players have a dominant strategy,
the result of the game is a balance in dominant strategies.
The Nash equilibrium defines a stable equilibrium in which no player has an incen-
tive to deviate from their strategy. It also includes the equilibrium in dominant
strategies as a special case, but is more broadly defined.
The prisoner’s dilemma describes a situation in which all players would have an
advantage but cooperation between them does not succeed.
In sequential games, the player who is allowed to act first is usually better off. This
is referred to as the advantage of the first move.
Empty threats and credible commitments must be taken into account when analyz-
ing the outcome of sequential games.
Knowledge Check
learning platform.
Good luck!
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Unit 7
Advanced Microeconomics
STUDY GOALS
… what an economist means by incomplete information.
… the negative consequences of information deficits between market players.
… how market participants can overcome knowledge differences.
… that people often behave less rationally than they think.
… how decisions are influenced by the respective situation.
… why fairness is also a part of economics.
114 Unit 7
7. Advanced Microeconomics
Case Study
Mr. Mayer is a divisional manager at a publicly listed insurance group where he is
responsible for the product area of private health and supplementary dental insurance.
During the regular quarterly discussion, the responsible controller informs him that the
divisional result has once again declined since the previous quarter. In particular, the
rising cost reimbursements for healthcare services are increasingly cutting into earn-
ings.
After an intensive discussion with his colleagues in divisional management, Mr. Mayer
decides to increase insurance premiums as of next month in order to compensate for
the rising costs. At the same time, the company wants to launch an advertising cam-
paign to position itself on the market as a premium provider that offers comprehensive
coverage and can, accordingly, justify higher insurance premiums. In particular, it is
intended to appeal to health-conscious city dwellers with higher incomes who, due to
their conscious lifestyle, have low medical costs.
After six months, the controller reports again on the development of earnings. Contrary
to expectations, the divisional results have deteriorated further. It is also striking that,
contrary to the aim of addressing health-conscious, high-income earners, the newly
acquired customers generate particularly high reimbursements. Mr. Mayer cannot
explain the development. He begins to doubt the strategy pursued and wonders
whether and how one could better estimate, even before the conclusion of the con-
tract, whether a customer will later incur high cost reimbursements.
7.1 Information Economy
Incomplete Information
According to the assumption of the standard microeconomic model, rational economic

Complete informa- actors make their decisions based on complete information. For example, a household
tion that maximizes its utility or a company that maximizes its profits will presumably have
The theoretical all the information necessary to make the best possible decision. The competitive mar-
assumption that ket model is also based on the assumption of complete information on the part of
economic agents are both demanders and suppliers. However, as seen in the example at the beginning, this
aware of all past, theoretical assumption is often not fulfilled in practice. Mr. Mayer and his employer do
present and future not have any reliable information to estimate what costs an insured person will incur
facts and events that in the future. The economist speaks of incomplete information in this case. Incomplete
influence their information on economically relevant variables can be divided into two classes: infor-
actions is called mation deficits that affect all economic actors equally and those that affect economic
complete informa- actors in different ways (Wigger, 2006).
tion.
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Unit 7 115
The weather next summer is an example of an information deficit that belongs to the Incomplete informa-
first type. No one can predict with certainty what the weather will be like. However, the tion
lack of information is evenly distributed, as no one systematically knows better than When the accept-
the other what the weather will be like in a few months. This form of incomplete infor- ance of complete is
mation is, therefore, ultimately unproblematic for the functioning of a competitive mar- violated, the situa-
ket. As this is the case, contracts can be concluded that account for later-occurring or tion is then defined
expected conditions. For example, for agricultural products such as wheat or rye (which by incomplete infor-
are only harvested every few months), purchase contracts based on the expected mation.
weather are customary. The purchase price is often different in good weather in sum-
mer than in bad weather (Wigger, 2006).
More problematic for a functioning market mechanism are the information deficits of
the second type. Since the economic actors have different amounts of information at
their disposal, this is referred to as asymmetric information. The level of information is Asymmetric informa-
not symmetrical (i.e., the same for all actors), but asymmetrical (i.e., it differs between tion
the various parties). Thus, some economic operators have information that others do This refers to a sit-
not. It can be also said that these actors have access to private information. uation where eco-
nomic actors have
Asymmetric information is of economic importance, especially for principal-agent rela- different access to
tionships, where the conclusion and performance of contracts between two or more information.
contracting parties are central. In this context, “principal” refers to a client and “agent”
to an authorized representative. Usually, the agent has a knowledge advantage (i.e., pri- Principal-agent rela-
vate information) that can be used in various ways, either to the benefit or the disad- tionship
vantage of the principal. There are plenty of examples of such principal-agent relation- This is an economic
ships in economic practice. For example, an employee (agent) knows more about how model according to
much effort he puts into his work than his employer (principal) does. Also, the seller which the principal
(agent) of a used car is better informed about the actual condition and defects of the instructs an agent
car than the buyer (principal). In the first case, the information deficit refers to a hid- and the latter knows
den action (work effort); in the second case, it refers to a hidden property (condition of or does something
the car). In both cases, the principal would like to have the relevant information, but that the principal
there are incentives for the agent, as the better informed party, to conceal the informa- cannot observe.
tion.
Hidden action
Due to these incentives, hidden characteristics and hidden actions can have far-reach- A hidden action is a
ing economic consequences for the conclusion and subsequent fulfillment of a con- type of information
tract. This was already indicated in the example about health insurance (Mankiw & Tay- asymmetry that
lor, 2018). occurs after the con-
tract is signed, when
the principal cannot
Hidden Properties and Inverse Selection fully observe the
actions of the agent.
In the example of health insurance, the hidden property refers to the risk of illness of a
person. To illustrate this, it is assumed that there are only two types of people: those
with a high probability of getting sick and those with a low probability of getting sick.
The former are the so-called high risk group and the latter the so-called low risk group,
and both groups should occur equally often in the population. As an example, expected
medical costs are assumed to be 10,000 euros, and the probability of becoming ill is
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116 Unit 7
Hidden property assumed to be one percent for the low risk group and five percent for the high risk
A hidden property is group. Both groups shy away from the cost risk associated with an illness and would
a type of informa- like to have comprehensive insurance against it.
tion asymmetry that
occurs before the If both types of people are concerned and the insurance company can now observe the
conclusion of a con- respective risk characteristics of a person, they will both buy comprehensive insurance.
tract, when the prin- This is based on the assumption that, in the health insurance market, insurance poli-
cipal is not aware of cies are offered at an appropriate or insurance-equivalent premium, such that the
the characteristics of insurance premium corresponds to the expected and insured loss. Accordingly, the low
the agent or the risk group pays a lower premium of 100 euros = 1% · 10,000 euros and the high risk
goods and services group pays a higher premium of 500 euros = 5% · 10,000 euros. Similarly, both groups
offered. would take out comprehensive insurance if neither the policyholder nor the insurance
company knew the risk characteristics of a policyholder. Both persons would then pay a
premium of 300 euros = 3% · 10,000 euros based on the average risk of
1% + 5%
3% = 2
(Wigger, 2006).
However, if asymmetric information is available and the policyholder (agent) knows his
risk characteristics, while the insurance company (principal) cannot observe the risk,
Adverse selection this can lead to adverse selection (also known as negative selection). Since the insur-
This can occur in a ance company does not know the risk of illness, it charges an insurance premium of
market if there are 300 euros based on the average risk of three percent, even if the information is asym-
hidden characteris- metrical. However, this premium is too high for those in the low risk group who know
tics so that some that they are subject to a low risk of illness. They are therefore prepared to pay a maxi-
market participants mum risk premium of 100 euros, which corresponds to the expected value of their
refrain from con- medical costs.
cluding a contract.
However, since insurance companies only offer insurance with a premium of 300 euros,
the low risk group remains uninsured and bears the medical costs themselves. Conse-
quently, only those in the high risk group would take out insurance, meaning that only
they would select themselves into the market. However, as can be seen in the example
presented at the beginning, the average insurance premium, in the long run, will then
not be enough to cover the costs that the high risk group generates. This will lead to
rising insurance premiums. Advocates of statutory health insurance cite precisely this
as an argument for not relying on private health insurance companies to ensure ade-
quate health insurance coverage for a population. Rather, the problem of adverse
selection could be solved by means of compulsory insurance organized by the state
such that all citizens have to take out compulsory statutory insurance and insurance
premiums are based on the income of the insured rather than the risk (Mankiw & Tay-
lor, 2018).
However, adverse selection is not a phenomenon limited to the insurance market.

Rather, it can occur wherever there are hidden characteristics and the principal is
unable to assess the characteristics of the agent or the goods or services offered by the
agent before the contract is concluded. For example, George A. Akerlof, winner of the
2001 Nobel Prize for Economics, explains the occurrence of adversarial selection in the
used car market in a famous essay (Akerlof, 1970). The seller (agent) normally has bet-
ter knowledge about the condition of a used car than a potential buyer (principal). For
fear of being taken advantage of and unintentionally buying a used car of poor quality,
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Unit 7 117
the imperfectly informed buyers, who cannot distinguish between inferior and high-
value cars, are not prepared to pay the reasonable, higher price for high-quality used
cars. As a result, only used cars of poor quality are traded and offered, i.e., a negative
selection is made, and the market for good quality cars comes to a standstill (Mankiw
& Taylor, 2018).
Hidden Actions and Moral Hazard
While there is a danger of adverse selection in the case of hidden characteristics, moral
hazard typically occurs in the case of hidden actions. This only occurs after the contract Moral hazard
has been concluded (i.e., while both parties are under contract) and can be attributed The tendency of a
to misguided economic incentives when agents irresponsibly or recklessly trigger or person whose
intensify a risk. In the case of insurance, for example, moral hazard describes the risk of behavior is insuffi-
changes in the behavior of insured persons, to the detriment of the insurer. The insurer ciently observable to
cannot observe this due to asymmetric information. Changes in behavior prior to the behave dishonestly
occurrence of damage are termed “ex ante moral hazard,” and corresponding changes or otherwise unde-
after the occurrence of damage are termed “ex post moral hazard” (Wigger, 2006). sirable is called a
moral hazard.
If health insurance companies are taken as a concrete example, the term ex ante moral
hazard describes the fact that insured persons have less incentive to prevent illness
than persons without extensive insurance cover. According to this, after taking out sup-
plementary dental insurance, people brush their teeth less often or neglect regular
check-ups with their dentist because they know that they no longer have to pay the
costs of potential dental treatments.
In this context, ex post moral hazard refers to the fact that health insurance under-
mines the incentive to be cost-conscious even after the onset of illness. An example of
this would be if an insured person with only a slight flu-like infection, which could be
cured after a few days of bed rest, takes advantage of a complex treatment—involving
several visits to the doctor and medication—because they do not bear the costs for this
alone, but the health insurance company. Thus, moral hazard is also a problem for the
insurance company mentioned in the introductory example. As a premium provider of
comprehensive coverage, it undermines the usual precautionary behavior and cost
awareness of the insured. This is clearly reflected in the rising costs of the health serv-
ices to be reimbursed.
Another example of moral hazard is the employment relationship between an employer

and an employee. Here, the employer (principal) can only monitor the behavior and
activity of the employee (agent) to a limited extent. The moral hazard problem now
rests in the temptation of the employee—who is aware of the inadequate possibility of
control—to either shirk official duties or carry out their duties according to regulations
(Mankiw & Taylor, 2018).
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118 Unit 7
Signaling and Screening to Overcome Information Asymmetries
Individual market participants have incentive to overcome the asymmetrical distribu-

tion of information—information deficits affecting only one side of the market also
negatively affect the market mechanism and can lead to adverse selection and moral
hazard. A distinction can be made between measures, depending on whether they are
taken by the informed or the uninformed party.
Signaling One of these possibilities for overcoming asymmetric information is signaling. In doing
Actions taken by an so, the informed party takes steps to credibly disclose its private information to others.
informed party to For example, companies spend money on advertising to signal to customers that they
credibly reduce have high-quality products to offer. Likewise, a guarantee for several years, which the
asymmetric informa- seller (agent) offers voluntarily, can send a signal to the buyer (principal) about the
tion with third par- high quality of the respective product. Similarly, university degrees are seen by some
ties are called sig- economists as a signal to a future employer that the graduate is particularly capable
naling. and hardworking, thus justifying a higher salary. In the case of the low risk group in the
example of health insurance (which, as a result of adverse selection, does not take out
insurance because the premium is too high), it would also be conceivable that an
insured person discloses their medical history to the insurance company, thus sending
a credible signal that they are at low risk for illness.
In all these examples, therefore, the informed party (the seller of a product, the gradu-
ate, or the policyholder) uses a signal to convince the uninformed party (the buyer of a
product, the employer, or the insurance company) that the informed party has some-
thing of high value to offer or, as in the case of health insurance, that it represents a
low risk (Mankiw & Taylor, 2018).
The decisive factor for an effective signal is that it must be costly. A signal that would
be free of charge would be used by everyone and therefore fail to divulge any informa-
tion. In addition, the signal must be more cost-effective for or beneficial to providers of
high-value products and persons of low risk than providers of low-value products and
persons of high risk. Otherwise, again, everyone would have the incentive to pay the
cost of using the signal, and it would not convey information. Thus, an expensive
advertising campaign is more worthwhile as a signal for companies offering high-qual-
ity products, since customers who buy the product once will probably buy it again out
of conviction. Similarly, a product guarantee is significantly cheaper for manufacturers
of high-quality products than for producers of low-value products, as cost-intensive
guarantee cases are likely to occur less frequently. In the case of higher education, it is
easier for a gifted person to go to university than a less-gifted person. In this regard, a
university degree can be interpreted as a signal of credibility. Moreover, disclosure of
medical records is obviously more beneficial for someone who is rarely ill than for
someone with a long medical history (Mankiw & Taylor, 2018).
With signaling, the informed party tries to send a credible signal to the uninformed
party. With screening, however, the uninformed party itself takes action in order to
obtain the private information of the informed party. For example, a buyer of a used
car could have the car in question checked for defects by a mechanic friend before
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Unit 7 119
signing the contract. This way, the buyer can check whether they are getting a high- Screening
quality car for the higher asking price. In the case of an employment relationship, for This refers to the
example, the interview or the recruitment test serves as a screening. Here, the actions of an unin-
employer wants to test the work ethic and abilities of the applicant, both of which are formed party aimed
unknown. Likewise, private health insurance companies ask potential insurees about at persuading the
their previous medical history before concluding a contract. It is often contractually informed party to
agreed upon that an obligation to provide certain benefits is rendered void in the case disclose private
of untruthful information and later cases of illness. information.
Another way of screening when providing insurance is to offer the insurance with and
without deductibles. This finds customers assigning themselves to a risk group. A policy
without a deductible would carry a higher premium; a policy with a deductible would
carry a significantly lower premium. The deductible is a burden, especially for people of
high risk, which is why they tend to opt for the former tariff. People of low risk, on the
other hand, may be attracted by a tariff with a low premium and a higher deductible.
As a result, the two risk groups would, thus, reveal their private information by choos-
ing one tariff or the other. The introduction of tariffs with deductibles is, therefore, also
the solution sought by Mr. Mayer’s employer. This is because, in addition to the possi-
bility of avoiding adverse selection before the conclusion of the contract, the obligation
of the insured to always bear part of the medical costs themselves helps to reduce the
problem of moral hazard.
7.2 Behavioral Economics
Limited Rationality
The information economy departs from the standard microeconomic model in that it
assumes that economic actors usually do not have complete information at their dis-
posal when making decisions. Nevertheless, even within the framework of models of
information economics, it is still assumed that actors act strictly rationally. In this way,
rational entrepreneurs maximize their profits, even with incomplete information, and
rational consumers maximize their utility. Taking into account the given limitations and
information deficits, rational actors always decide on the best possible alternative from
their point of view. In this context, one often speaks of the homo economicus. Homo economicus
In the economic sci-
Although, in some situations, people and their organizations sometimes come close to ences, homo eco-
these rationally calculating actors of the microeconomic standard model, in reality, nomicus is the
deviations from this model are still regularly observed. Instead of making rational deci- model of a rational
sions, people sometimes make short-sighted, unbalanced decisions. People can also actor who always
be forgetful, impulsive, confused, and emotionally charged. In particular, it is often maximizes the bene-
criticized that completely rational behavior would require a person to have unlimited fits.
cognitive abilities so that all available information and action alternatives and their
consequences could be mentally processed within the shortest time possible. While the
assumption of rationality still seems plausible for simple decisions, this becomes more
and more difficult as the complexity of the decision-making situation increases. Some
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120 Unit 7
Limited rationality economists, therefore, assume that people only have limited rationality. Thus, some
This is a model of scientists also recommend an alternative view of human beings—not as (utility) maxi-
individual decision- mizers, but as satisficers. In accordance with this view of man, an individual only
making under the searches for alternative courses of action until they have reached a desired level of
assumption of limi- utility—regardless of whether there are undiscovered alternatives that could offer a
ted cognitive resour- higher utility. In recent years, behavioral economics has developed into a separate
ces. branch of economics that is devoted to these questions (Mankiw & Taylor, 2018).
Satisficer In terms of both methodology and content, behavioral economics shares similarities
A satisficer is a deci- and overlaps with psychology. For example, as in psychology, laboratory experiments
sion-maker who and surveys are used to investigate the decision-making behavior in people. In addi-
makes decisions tion, completely new methods are also being used in economics such as functional
merely to ensure a magnetic resonance imaging. For example, in neuroeconomics, a branch of behavioral
satisfactory outcome economics, we investigate which areas of the brain are active during economic deci-
rather than an opti- sion-making (and which are thus playing a role in the decision-making process) in
mal result. order to draw conclusions about the reasons and motives of the person in action. In
the following section, some findings of behavioral economics will be presented. These
Neuroeconomics will illustrate the fact that people do not proceed in their decision-making process
This is the interdisci- entirely rationally according to the microeconomic standard model. It should be noted
plinary linking neu- that this is only a small selection of behavioral economics, which has developed signif-
roscientific methods icantly in recent years.
with questions of
economic science.
Influence of Reference Points and Framing
The standard model of consumer behavior assumes that consumers attach a certain
value to the goods and services they buy according to the utility they can derive from
them. However, behavioral economics shows that the perceived value of a good is influ-
enced by the starting point and the environment of the respective decision situation.
Reference point This is also referred to as the reference point on which the preferences of a consumer
This is the starting are partly based. A simple example of the effect of reference points is the current
point from which an monthly rent paid by a tenant. Take, for example, a person living in the greater Munich
individual makes a area looking for a new apartment in the same city. For that person, 1,300 euros for a
consumption deci- three-room apartment in that market will seem customary. However, 1,300 euros may
sion. seem like usury for somebody from the more rural Mecklenburg-Western Pomerania.
Conversely, the previous monthly rent of 400 euros in Mecklenburg-Western Pomerania
would seem like a bargain to the Munich resident. In this example, therefore, the refer-
ence point of the monthly rent of long-term residents of Munich and Mecklenburg-
Western Pomerania differs (Pindyck & Rubinfeld, 2018).
Behavioral economics has now helped to uncover further points of reference. For
example, people attribute a higher value to a good if they already own it than if they do
not (yet) own it. This example of a reference point is accordingly called the endowment
Endowment effect effect.
The value of a good
is assessed higher The endowment effect can be illustrated by the difference between the price a person
by the owner than is willing to pay for a good they do not yet own and the price at which the person is
willing to sell the good they already own. For example, in an experiment at an American
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Unit 7 121
university, every second student at a lecture was gifted a coffee cup. The selection of by someone who
the students given the coffee cup was random. The students who had been given a cup does not own the
as a gift were then asked for the minimum amount of money they would have to be good.
paid for them to return the cup to the professor. The other group, that had not received
a coffee mug, was asked for the minimum amount of money they would accept instead
of the mug. So, although both randomly selected groups of students were faced with
the same decision (whether they would rather receive a coffee cup or a self-chosen
amount of money), there is a clear difference in the amount of money depending on
the respective reference point. The students who had received a coffee cup as a gift
demanded an average amount of seven dollars for its return. The second group of stu-
dents, those who had not received a cup, accepted an average of only three and a half
dollars as compensation.
This result is a typical example of the endowment effect—the coffee cup simply has a
higher value for the person who already owns it. For more details on this and other
similar experiments, see Kahneman, et al., (1990).
The ownership effect can be explained by the tendency for people to put more empha-
sis on avoiding losses than on making additional gains. This is called loss aversion. Loss aversion
Deteriorations in relation to the reference point are perceived more strongly than An aversion to loss is
improvements. For example, the loss of the cup would hurt those students who had the tendency of indi-
received one more than those who did not. Therefore, the former demand more money viduals to focus
for the coffee cup than the latter are willing to pay for it. Loss aversion is also noticea- more on avoiding
ble in the empirically proven tendency of private investors to be reluctant to sell shares losses than on mak-
with price losses, even if the proceeds of the sale could be invested in other shares ing profits.
that seem more promising to them. Private investors thus place more emphasis on the
loss sustained by selling the share rather than on the potential profit to be gained
through the alternative, lucrative share investment (Pindyck & Rubinfeld, 2018).
In addition to the reference point, the environment (or framework) of a decision situa-
tion also plays a pivotal role. This is called framing. For example, physicians are more Framing
likely to use a risky new drug if it is labeled “saves 90 out of 100 lives” rather than “lets This term refers to
ten of 100 people die,” even though both labels express the same idea (Tversky & Kah- the tendency of peo-
neman, 1981). The fact that people’s decisions also depend on the way the results are ple to rely on the
presented is something that companies take advantage of when advertising. They pay context in which the
close attention to how they present a product, what information they pass on to the alternatives availa-
consumer, and the form that that should take. ble for selection are
described in deci-
sion-making situa-
People Attach Importance to Fairness tions.
Another insight revealed by behavioral economics is that people in economic transac-

tions value fairness and their sense of justice influences their decision-making behav-
ior. We will now look at the competitive market for snow shovels to further highlight
this point. According to the conventional market model, an overnight snowstorm, which
leads to a rightward shift of the demand curve, actually results in a higher equilibrium
price on the snow shovel market. However, more than 82 percent of those questioned
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122 Unit 7
in one survey regard a price increase from 15 to 20 dollars by a store operator after a
snowstorm as unfair and feel that the store is exploiting the situation (Kahneman et al.,
1986).
The survey results make it clear that companies should also take into account consum-
ers’ ideas of fairness when setting their prices. In this respect, it is also understandable
that, contrary to standard microeconomic theory, companies tend to increase their pri-
ces in response to higher costs rather than to increases in demand (Rotemberg, 2011).
Ultimatum game The ultimatum game provides further evidence of the economic relevance of fairness.
The ultimatum game Two perfect strangers are invited to a game through which they can win a total of 100
is a behavioral sci- euros. To do this, a player must first submit a proposal as to how the 100 euros should
ence experiment to be divided, in whole euros, between the two of them. If the second player accepts the
explore the altruism proposed division, both players receive their share according to the proposal of player
and selfishness of 1. If the second player rejects the proposal, neither of the two players receives any
individuals. money. According to the conventional theory, which assumes a homo economicus,
player 2 should accept every amount of money offered by player 1, as any amount of
money won is better than none (i.e., it gives more utility than zero euros). Thus, if both
players were pure utility maximizers, player 1 could anticipate the behavior of Player 2
and would propose a split of 99 euros for themselves and one euro for the second
player, with the second player actually accepting this proposal.
However, if the ultimatum game is played with real people, the results deviate signifi-
cantly from the predictions of classical theory. The second player will usually refuse a
99-to-1 split, and the first player knows this. Thus, the first player submits what they
consider to be fairer distributions, those which could net the second player 30, 40, or
even 50 euros. Although an allocation of 70 to 30, for example, is still unfair, it is much
fairer than an allocation of 99 to 1. This is why the second player agrees to such an
allocation much more often (Mankiw & Taylor, 2018).
The knowledge gained from the ultimatum game is particularly important for wage set-
ting by companies. If a company makes a high profit in a successful year, employees
could expect to be paid a fair share, even if this is not part of the normal market remu-
neration. As seen with player 2 in the ultimatum game, who renounces money and
harms themselves in order to punish unfair behavior, employees who feel unfairly
rewarded could take measures such as strikes, reduced work performance, or other
actions that are damaging to the company in order to express their sense of justice. In
other words, employees might be willing to suffer a disadvantage themselves in order
to punish their employer for acting unjustly.
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Unit 7 123
Summary
Information economics and behavioral economics both examine the effects on

people’s decision-making behavior when they move away from assumptions of the
standard economic model. While information economics assumes incomplete infor-
mation, behavioral economics abstracts the image of man as a homo economicus
(one who always acts completely rationally).
Incomplete information is problematic if market players are affected to different

degrees, i.e., if asymmetric information is available. Hidden properties can lead to
adverse selection, while hidden actions focus on the problem of moral hazard. The
technical terms signaling and screening describe specific measures taken by mar-
ket players to overcome asymmetric information.
Whereas a lay person might claim that humans have unlimited cognitive abilities,
the economist would instead speak of limited rationality. The endowment effect
and framing illustrate that reference points and the environment or context play a
role in decision-making situations. The ultimatum game reveals that people also
take into account considerations of fairness and justice in economic transactions.
Knowledge Check
learning platform.
Good luck!
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Evaluation 125
Congratulations!
You have now completed the course. After you have completed the knowledge tests on
the learning platform, please carry out the evaluation for this course. You will then be
eligible to complete your final assessment. Good luck!
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Appendix 1
List of References
128 Appendix 1
List of References
Akerlof, G. A. (1970). The market for lemons: Quality, uncertainty and the market mecha-
nism. Quarterly Journal of Economics, 84(3), 488—500.
Alesina, A., & Fuchs-Schündeln, N. (2007). Good bye Lenin (or not?): The effect of com-
munism on people’s preferences. American Economic Review, 97(4), 1507—1528.
Athey, S., & Luca, M. (2019). Economists (and economics) in tech companies. Journal of
Economic Perspectives, 33(1), 209—230.
Bofinger, P. (2015). Grundzüge der Volkswirtschaftslehre [An Introduction to the science

of markets] (4th ed.). Pearson.
Bundesregierung. (2019). Eckpunkte für das Klimaschutzprogramm 2030 [Key points for
the climate protection program 2030]. Available online.
Bündnis 90/Die Grünen. (2019). Handeln—und zwar jetzt! Maßnahmen für ein klimaneu-
trales Land [Act—and act now! Measures for a climate-neutral country]. Available online.
Deutsche Post DHL Group. (2020). 2020 Business profile: Investor relations. https://
www.dpdhl.com/content/dam/dpdhl/en/media-center/investors/documents/busi-
ness-profiles/DPDHL-Business-Profile-2020.pdf
European Milk Board. (2019). Was kostet die Erzeugung von Biomilch? [What does the
production of organic milk cost?]. http://www.europeanmilkboard.org/fileadmin/Doku-
mente/Milk_Production_Costs/Updates_DE/BIO/Broschuere_Kostenrechnung_Bio-
Milch_DE.pdf
Federal Network Agency. (2018). 20 Jahre Postgesetz – Bestandaufnahme der Markt-,

Wettbewerbs- und Universaldienstentwicklung [20 years of Postal Act: Stocktaking of
market, competition and universal services]. Available online.
Fossett, J., Gilchrist, D., & Luca, M. (2018). Using experiments to launch new products.
Harvard Business Review.
Galilei, G. (1638). Discorsi e dimostrazioni matematiche intorno a due nuove scienze

[Discourses and mathematical demonstrations relating to two new sciences]. Available
online.
German Council of Economic Experts. (2020). https://www.sachverstaendigenrat-wirt-

schaft.de/en.html
Hermannsen, H. (2019). “Ökolandbau lässt sich nicht verordnen”: Bayerns Agrarminis-

terin Michaela Kaniber möchte Öko nicht gegen Konventionell ausspielen [“Organic
farming cannot be decreed”: Bavaria’s Minister of Agriculture Michaela Kaniber does
not want to play eco against conventional]. Agrarzeitung, 75(25), 10.
www.iubh.de
Appendix 1 129
List of References
Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1986). Fairness as a constraint on profit
seeking: Entitlements in the market. American Economics Review, 76(4), 728—741.
Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment
effect and the Coase theorem. Journal of Political Economy, 98(6), 1325—1348.
Mankiw, N. G., & Taylor, M. P. (2018). Fundamentals of economics (7th ed.). Schäffer-Poe-
schel.
Monopolies Commission. (2019). Die Novelle des Postgesetzes: Neue Chancen für den
Wettbewerb [The amendment to the Postal Act: New opportunities for competition].
Available online.
Pindyck, R. S., & Rubinfeld, D. L. (2018). Microeconomics (9th ed.). Pearson.
Rotemberg, J. J. (2011). Fair pricing. Journal of European Economic Association, 9(5), 952—
981.
Rothschild, E. (1994). Adam Smith and the invisible hand. The American Economic
Review, 84(2), 319—322.
Schwägerl, C. (2019). In conservative Bavaria, citizens force bold action on protecting

nature. YaleEnvironment360. https://e360.yale.edu/features/in-conservative-bavaria-
citizens-force-bold-action-on-protecting-nature
Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of
choice. Science, 211(4481), 453—458.
Vetter, P. (2019). Adidas verschifft seine Zukunft nach Asien [Adidas ships off its future to
Asia]. Welt. https://www.welt.de/wirtschaft/plus203404392/Aus-fuer-Speedfactory-Adi-
das-verlagert-Produktion-nach-Asien.html
Wigger, B. U. (2006). Grundzüge der Finanzwissenschaft [Finance Essentials] (2nd ed.).

Springer.
www.iubh.de
Appendix 2
List of Tables and Figures
132 Appendix 2
Nina's Demand Table

Source: Holzmann (2020).
Demand Curve
Source: Holzmann (2020), based on Pindyck & Rubinfeld (2018).
Shift in the Demand Curve

Source: Holzmann (2020), based on Mankiw & Taylor (2018).
The Mayers’ Supply Table

Supply Curve
Shift of the Supply Curve

Market Equilibrium
Excess Supply and Demand

Price Elasticity of Demand

Winter Holiday in the Low Season

Winter Holiday in the High Season

Selection of Basket of Goods

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Appendix 2 133
Indifference Curves
Display of Indifference Curves That Intersect Each Other

Perfect Substitutes and Perfect Complements

Possible Combinations of Food and Clothing

Budget Line
Influence of an Income Increase on the Budget Line

Influence of Price Increases on the Budget Line

Budget Optimum
Influence of an Increase in Income on Consumption

Derivation of the Individual Demand Curve

Pricing of CO2 and Fuel Consumption

Pricing of CO2 and Increase of the Commuter Allowance

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134 Appendix 2
Pricing of CO2 and Increase of Commuter Allowance for High Income

The Production of Sports Footwear with Two Variable Production Factors

Isoquants
Production Costs as a Function of Factor Input

Production of a Given Output at Minimum Cost

Expansion Path
Total Cost Curve

Average and Marginal Cost Curve

Profit Maximum of a Company with Complete Competition

Graphical Representation of the Profit of a Company with Full Competition

The Marginal Cost Curve as an Individual Supply Curve in Full Competition

Loss Case with a Market Price below the Average Cost Curve
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Appendix 2 135
Long-Term Zero Profit on Market Entry and Exit and Full Competition
Change in Cost-Minimizing Output Due to Wage Changes

Demand Curves of the Polypolist and the Monopolist

Total, Average, and Marginal Revenue of a Monopolistic Pharmaceutical Company

Monopoly Demand and Marginal Revenue Curve

Profit Maximization of a Monopolist

Profit Maximization in the Face of Monopolistic Competition

Monopolistic Competition in the Long Run

Monopolistic Competition between Full Competition and Monopoly

Demand for Drinking Water

Payout Matrix for a Promotional Game

Modified Advertising Game

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136 Appendix 2
Product Selection Game (I)

Prisoner’s Dilemma
Balance of Terror
Prisoner’s Dilemma in Business Practice (Profit in Thousands of Euros)

Product Selection Game (II)

Product Selection Game in Extensive Form

Empty Threat in the Market Entry Game

Market Entry Game in Extensive Form

Credible Commitment in the Market Entry Game

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COURSE BOOK

© 2021 IU Internationale Hochschule GmbH

Mr. Simon has been a professor in business administration at IU

Mr. Simon received his PhD in business administration with a focus

His research focuses on capital market research and the intersection

1.2 How Do Economists Think? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

2.2 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

3.2 Willingness to Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

5.2 Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

6.2 Simultaneous Games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

6.3 Sequential Games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

7.2 Behavioral Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

Signposts Throughout the Course Book

The Managerial Economics course provides an overview of the fundamentals of economics.

On completion of this unit, you will have learned …

… what economic theory entails.

… the central concepts of economics.

… the two major branches into which economics can be divided.

… how economists think and what methods they use.

… why economists often come to different conclusions.

As a graduate engineer lacking a comprehensive education in economics, Mr. Schmidt

1.1 Definition of Terms and Subjects of Economics

Scarcity of Resources as a Starting Point of Economics

• Which goods and services should be produced?

Economics as the Study of Markets

The distinction between microeconomics and macroeconomics is particularly impor- Macroeconomics

Explanations and forecasts in economics are based on scientific theories, as is common

Furthermore, it is difficult to keep everything constant when using observational data

As scientists, economists often use models to illustrate their theories. A model is an

Economists as Political Consultants

numerous corporate insolvencies. On the other side of the debate, proponents of a

Economics is concerned with the management of scarce social resources, particu-

Economics can be roughly divided into macroeconomics and microeconomics.

Explanations and predictions in economics are based on academic theories

With the exception of laboratory experiments in microeconomics, controlled experi-

Did you understand this unit?

On completion of this unit, you will have learned ...

… upon what supply and demand in a market depends.

… the role the prices of goods play in a competitive market.

… how balance is achieved in a competitive market.

… what the invisible hand of the market entails.

… what an economist means when talking about elasticities.

2. The Invisible Hand of the Market

2.1 Supply and Demand

The Demand Curve as a Relationship Between Price and Level of Demand

The Invisible Hand of the Market

The Invisible Hand of the Market

• Consumer preferences: One example of this would be an increase in environmental

The Mayers’ Supply Table

The Invisible Hand of the Market

2.2 Market Equilibrium

Interaction of Supply and Demand on a Competitive Market

The Invisible Hand of the Market

The Invisible Hand of the Market

The Assumptions of the Market Model

The Invisible Hand of the Market

The Invisible Hand of the Market

Supply and Demand During Winter Holidays

Elasticities in Winter Holidays

The Invisible Hand of the Market