Chapter 2 Competitive markets: Demand and supply
1. Non-price determinants of demand
Income: As China has grown rapidly in the last 25 years, car sales have increased from 250,000/month in 2000 to over 2,500,000/month now, because people earn significantly more.
Tastes & Preferences: Many Android phones offer much better value than iPhones, yet 87% of US teenagers have an iPhone, and Apple has increased its market share worldwide in recent years.
2. Non-price determinants of supply
Changes in Technology: Thanks to advancements in automation, the Tesla factory in Shanghai finishes a new car every 40 seconds. This means the firm can supply more cars now than before.
3. Market mechanisms
London Hotel Price Soars:
The surge in London hotel prices ahead of the Queen's state funeral is a classic example of the market mechanism's signalling and incentive functions in action.
A sudden, massive increase in demand for a fixed supply of hotel rooms sent a powerful price signal of scarcity. This signal informed both consumers and producers about the changed market conditions. In response, the rising prices created a strong price incentive for hotels to increase revenue by raising rates. This incentive function helps ration the limited supply, ensuring rooms go to those with the highest willingness to pay.
4. Consumer & producer behavior (HL only)
Bias
1️⃣ Rules of Thumb
People buy items priced at $9.99 instead of $10 because they follow a simple rule of thumb that “.99” means a better deal.
2️⃣ Anchoring
Car dealers show a high initial price during negotiations so that any later discount seems reasonable, making consumers more likely to accept a higher final price.
3️⃣ Framing
Consumers choose yoghurt labeled “90% fat-free” rather than “10% fat” because the positive framing changes their perception of healthiness.
4️⃣ Availability
After seeing news about plane crashes, some people overestimate the risk of flying because vivid events are easier to recall.
Bounded rationality
Consumers choose the first acceptable phone plan they see rather than comparing all options because decision-making is too complex.
Bounded self-control
Students procrastinate on assignments and end up studying last-minute because they prioritize short-term comfort over long-term goals.
Bounded selfishness
Shoppers voluntarily donate small change to charity at checkout even though it does not benefit them materially.
Imperfect information
Consumers buy used cars without knowing their true condition, leading to poor decisions and potential regret.
Choice architecture
1️⃣ Default Choice
Employees are automatically enrolled into workplace pension schemes unless they opt out, increasing retirement saving participation.
2️⃣ Restricted Choice
Fast-food restaurants provide small menus or limited drink sizes to simplify decisions and encourage healthier or faster choices.
3️⃣ Mandated Choice
Some countries require people to state “yes” or “no” to organ donation when applying for a driver's license, forcing a free but explicit decision.
Firm business objectives
Amazon:
Amazon provides a strong real-world example of how firms may pursue different business objectives over time rather than a single goal. In its early years, Amazon prioritised revenue maximisation and growth maximisation by aggressively reinvesting profits into logistics infrastructure, cloud computing (AWS), and international expansion, often operating with very low or even negative profits. This strategy enabled Amazon to rapidly increase its market share, particularly in e-commerce and digital services, by exploiting economies of scale and network effects. As the firm became more established, certain divisions—most notably Amazon Web Services (AWS)—shifted closer to profit maximisation, generating high and stable profit margins. However, at the firm level, Amazon can be seen as exhibiting satisficing behaviour, where management aims to achieve acceptable profit levels while prioritising long-term objectives such as innovation, market dominance, and sustained growth. This suggests that the assumption of profit maximisation may be unrealistic for large multinational firms, as real-world businesses like Amazon often pursue multiple objectives simultaneously or sequentially depending on market conditions and strategic priorities.
Chapter 3 Elasticities
1. Price elasticity of demand (PED)
Nike Increases Prices On Its Top-selling Sneakers:
(May, 2025) Nike raised prices on its top-selling sneakers, such as the Air Max 270, because it believes demand for these specific products is inelastic. By increasing the price on these popular shoes by $5 to $10, Nike is likely betting that its loyal customer base will continue to buy them despite the higher cost. This strategy is employed to increase revenue and offset rising costs from tariffs, and it is considered effective because the products are inelastic—meaning the quantity demanded doesn't change much when the price does.
2. Price elasticity of supply (PES)
Why Computer Chips of TSMC Has Price Inelastic Supply:
-If prices increase, it can take chip manufacturing companies like TSMC up to a decade to build new factories that increase capacity, because of the complexity needed to make these chips; it is very hard to build new capital.
-There is rarely any unused capacity in these factories as the companies try to maximize profits; TSMC, the world's largest chip manufacturer, is fully booked for years to come.
-Chips also update every year, so even though it is easy to store chips for later, there is no point for storage.
3. Income elasticity of demand (YED)
Post-pandemic Surge in Luxury Consumption Due to Increase In Consumer Income:
(February, 2022) In 2021 and 2022, China's luxury market saw a strong recovery, with growth of 36% in 2021 and 48% in 2020, driven by increased consumer income and a shift in spending from international travel to domestic luxury purchases. This pattern demonstrated a high Income Elasticity of Demand (YED) for luxury goods, where demand grew more than proportionally to rising incomes. The case illustrates how high YED can benefit brands during economic upturns but also make them more vulnerable to downturns, making it a critical factor for businesses to consider when making investment decisions in the market.
Chapter 4 Government intervention in microeconomics
1. Subsidy
Subsidy For China's EV:
(November, 2023) Between 2009 and 2022, over RMB 200 billion in subsidies and tax relieves were provided to manufacturers and consumers. This direct government intervention successfully boosted both supply and demand, leading to massive industry growth and making China the world's largest EV market, accounting for half of global sales by 2022.
As the market matured, the policies shifted. Consumer purchase subsidies were fully withdrawn by the end of 2022, and tax exemptions are being phased out. This demonstrates the principle of removing market intervention once an industry becomes competitive.
2. Indirect tax
Increase In Indirect Tax For Cigarette In Minnesota:
(March, 2021) The number of Minnesotans who smoke has fallen nearly 40% over the last two decades. But that decline has slowed in recent years and there are still more than 500,000 smokers in the state. The House Preventive Health Policy Division approved a bill Wednesday that seeks to further reduce those numbers by raising taxes on cigarettes, cigars and tobacco products, and funding new campaigns to help people quit smoking and stop others from starting. Sponsored by Rep. Jennifer Schultz (DFL-Duluth), HF1721 would increase the tax on a pack of cigarettes by $1.50, bringing the total excise tax to $4.54 per pack.
3. Price floor
Minimum Wage In California:
(August, 2025) The minimum wage in California is $16.50 per hour as of January 1, 2025, and will increase to $16.90 per hour on January 1, 2026, which acts as a price floor in the labor market. However, others argue that since this will increase the price of labor, there will be an excess of labor, in other words, more unemployment, because companies won't be willing to pay that much.
4. Price ceiling
Price Ceiling For COVID-19 Swab Test In Indonesia:
(October, 2020) In October, 2020, Indonesia set a price ceiling of Rp 900,000 for COVID-19 swab tests to address cost disparities at private labs. The ceiling, based on government analysis, includes labor and overhead costs. Previously, some hospitals charged over Rp 2.5 million.
Chapter 5 Common pool resources and negative externalities
1. Negative externalities of production
Bełchatów Power Station polluting CO2 for energy production:
A coal power plant in Poland pollutes as much CO2 as the entirety of Switzerland, just as a by-product for energy production. This is an enormous negative externality, as the world has to suffer from tens of millions of tonnes of extra CO2, which is a much higher cost than the power plant operator experiences themselves. (MSC > MPC)
Correcting negative externalities of production: Pigovian tax
UK Landfill tax:
(October, 1996) The UK Landfill Tax is a Pigouvian tax designed to correct a negative externality of production caused by waste disposal. When firms send waste to landfill, they generate pollution, long-term environmental damage, and land-use costs that are not reflected in their private costs. The tax increases the cost of landfill disposal for producers, with the standard rate rising from £10/tonne in 1996 to £126.15/tonne in 2024-25. By making producers internalise these external costs, the government aims to reduce over-production of waste and encourage recycling and cleaner production methods. As a result, landfill volumes have significantly declined over time, showing that the tax has helped align marginal private cost closer to marginal social cost and reduce market failure.
Correcting negative externalities of production: Tradable permits
UK airline pollution permits:
(June, 2022) In 2021, the UK allocated 4.4 million free permits under the UK Emissions Trading Scheme (UK ETS) to airlines. Tradable permits can efficiently reduce emissions by setting a cap and allowing trading. Thus, airlines may reduce their emissions by selling their leftover permits to other airlines. EasyJet was the biggest beneficiary of the scheme, with permits worth a potential £40m left over at the end of 2021, followed by British Airways with £23.5m worth of permits. However, this is a wrong demonstration of tradable permits, as the UK government overestimates the carbon emissions, and permits distributed are enough for the entire industry to dodge a carbon emissions cap and trade scheme entirely.
2. Negative externalities of consumption
Smoking:
Smoking may result in a significantly higher cost for society than on the person smoking, because it creates discomfort of smell, smoking-related health problems on passive smokers, and put burdens on the national healthcare system as it has to pay for their lung cancer treatment, or other illnesses associated with smoking. (MPB > MSB)
Correcting negative externalities of consumption: Pigovian tax
London Congestion Charge (UK):
(17 February, 2003) On 17 February 2003, the London scheme was introduced: drivers entering a defined central zone during weekdays must pay a daily charge (initially £5) for private vehicles.
This is an example of a pigouvian tax because it charges road users for the negative consumption externalities they produced (congestion, delays, pollution) so that private decisions better reflect social cost.
The result: in the first six months there was about a 20-30% reduction in vehicles entering the zone and traffic speeds improved.
Correcting negative externalities of consumption: Nudge (HL only)
Plain tobacco packaging:
(Originated in 2012, Austrailia) Australia’s 2012 introduction of mandatory plain tobacco packaging serves as a landmark example of using nudge theory to address the negative externalities of smoking. Unlike outright bans or heavy taxes, this policy subtly alters the choice architecture for consumers by removing all branding elements (logos, colors, distinctive fonts) from cigarette packs. Instead, packs feature standardized olive-brown packaging with large graphic health warnings and brand names in a uniform small font.
3. Common pool resources and solutions to the tragedy of the commons
The Darién Gap:
The deforestation of the Darién Gap in Panama is a stark real-world example of the tragedy of the commons. The rainforest is a common pool resource—it is non-excludable (difficult to prevent access) and rivalrous (logging by one group depletes it for others). This leads to a market failure characterized by negative externalities of production, including severe environmental damage, loss of biodiversity, and violent conflict with indigenous tribes.
High profits from illegal rosewood logging (reaching $12,000/m³ in China) create powerful incentives for over-exploitation, as no single entity bears the full cost of the resource's depletion.
Solutions attempted highlight the challenges of resolving this failure:
Collective Self-Governance by indigenous tribes is community-based but lacks resources against armed loggers.
Assigning Property Rights (40% of land granted to tribes) legally empowers owners but is undermined by corruption.
International Agreements (e.g., Interpol seizures) are essential for a global problem but ineffective if not universally enforced.
Chapter 6 Positive externalities, public goods, asymmetric information and inability to achieve equity
1. Positive externalities of production
Hong Kong Metro Expansion:
(1979) The expansion of Hong Kong’s Mass Transit Railway (MTR), starting with the first line in 1979, generated clear positive externalities of production. By investing in rail infrastructure, MTR improved accessibility, reduced travel times, and increased labor mobility, which boosted productivity for businesses near stations. These firms gained more customers and easier employee access without paying for the construction themselves. Property developers and the government also benefited as land and commercial property values rose due to improved transport links. This “Rail + Property” model helped finance further expansion while creating spillover benefits for the wider economy, such as new business growth and reduced road congestion.
Correcting positive externalities of production: Subsidy
Subsidy for R&D development:
Japan offers a subsidy under its “Incentive Programs – Investing in Japan” scheme where companies establishing or expanding factories, production equipment or R&D in specified regions can receive up to ¥3 billion for eligible costs.The subsidy rate varies by company size and region—up to ¾ of eligible expenses for SMEs in certain zones. This intervention reduces private production costs, encourages firms to invest in higher-value activities, and generates spill-over benefits (job creation, technology diffusion) for the wider economy.
2. Positive externalities of consumption
Consumption of fruit:
Goods such as fruits and vegetables create positive externalities, as the healthcare system benefits from you being healthy, avoiding expensive trips to the hospital. As they say, an apple a day keeps the doctor away. (MSB > MPB) However, in the free market, producers can earn more by selling processed foods, and consumers often enjoy the taste of unhealthy goods more.
Correcting positive externalities of consumption: Education and awareness creation
5 A Day campaigns:
(Originated in 1988, California) In an effort to promote healthy eating, countries like the US, UK and Germany have therefore launched initiatives such as "5 a day", where they try to encourage people to eat at least five portions of 80 g of fruit and vegetables each day. This is a form of education/awareness campaign.
3. Public goods and solutions to the free rider problem (direct provision + contracting out)
Direct Provision: British Lighthouses (19th Century)
(1836, the U.K.) Facing a shortage of lighthouses—a classic public goods due to the free-rider problem—the UK implemented the 1836 Lighthouse Act.
Solution:
The state-owned Trinity House was given a monopoly to build and maintain all lighthouses, funded by a compulsory tax on shipping.
Advantages:
This solved the free-rider problem, ensured universal coverage, and was financially self-sustaining.
Disadvantages:
It potentially led to lower efficiency, with reports of poor maintenance and a lack of innovation over time.
Contracting Out: The US F-35 Fighter Jet Program
Modern fighter jet development, with its immense R&D costs, functions like a public good for national defense. The US government chose to contract this out.
Solution:
The military buys F-35s from the private contractor Lockheed Martin.
Advantages:
This utilizes private sector technical expertise and vast industrial capacity.
Disadvantages: It has been plagued by massive cost overruns (billions of dollars) and chronic delays. This creates a "military-industrial complex," where the lines between corporate profit and public interest can blur.
Conclusion
Both solutions address the market failure inherent in public goods provision. Direct provision ensures equity and solves free-riding, but risks inefficiency. Contracting out harnesses market innovation but can lead to high costs and accountability issues, demonstrating a core trade-off in public policy.
4. Asymmetric information (HL only)
Adverse selection and solution to it (legislation+signalling)
Implement of nutrition facts label:
(1990-1994, the U.S.) Before the mandatory nutrition labelling regime in the United States, many packaged foods lacked full disclosure of calories, fat, sugar and other nutrients — meaning that producers held more information about food quality than consumers did. In this context the market suffered from asymmetric information: consumers could not reliably distinguish between “healthier” and “less healthy” processed foods. This gives rise to adverse selection: because buyers anticipate uncertainty, they are only willing to pay an average price; meanwhile producers of low-quality (high-sugar, high-fat) goods continue supplying them due to profit, while healthier producers either exit or fail to gain any profit. As a result, the market becomes dominated by lower-nutritional‐quality foods.
After the passage of the Nutrition Labeling and Education Act (NLEA) in 1990 and the rollout of the “Nutrition Facts” panel for most packaged foods from around 1994 onward, consumers gained access to standardised nutrition information. This disclosure helps reduce information asymmetry, allowing healthier-food producers to signal their quality and consumers to differentiate. Thus it mitigates the adverse selection problem in the food market. Although labelling does not eliminate all market failures (consumer understanding, lack of incentives, credence goods remain), it is a real world example of regulation addressing adverse selection via increased transparency.
Moral hazard
Global subprime crisis:
(2007-2008, especially the U.S.) The 2007-08 global financial crisis provides a case of moral hazard. Large mortgage company assumed they would be rescued if things went wrong, so they engaged in risk-taking—such as approving mortgages to borrowers with weak credit or packaging these loans for sale elsewhere—knowing they might not personally bear the full cost of failure. Because the originators did not keep the full risk, they had less incentive to check borrower reliability. At the same time, there was significant information failure: lenders, investors and borrowers did not have full, accurate information about how risky the loans actually were, how they were bundled, or what the true exposure of institutions was. The implicit guarantee of “too-big-to-fail” encouraged firms to act recklessly. When the housing bubble burst and loan defaults surged, governments intervened to bail out major institutions—reinforcing the expectation that failure would be socialised while profits were privatised. Thus the crisis shows moral hazard: when agents expect others will absorb losses, they take on excessive risk, which leads to market failure and systemic instability.
Chapter 7 Market power (HL only)
1. Perfect competition
Discogs:
Discogs is an online marketplace where individuals buy and sell physical music products such as CDs. The market is close to perfect competition because many sellers offer homogeneous products, for example the same CD edition. Sellers must display price, condition and images, meaning consumers have near-perfect information and can easily compare options. As there are a large number of sellers, no individual seller has market power, making them price takers. In addition, there are very low barriers to entry, since anyone can create an account and start selling. As a result, the market is relatively efficient, especially for popular CDs, with minimal welfare loss.
2. Monopoly
ASML:
ASML, a Dutch technology firm, holds a global monopoly over EUV lithography machines, which are essential for manufacturing advanced semiconductor chips. This monopoly is protected by extremely high barriers to entry. First, ASML benefits from strong economies of scale, as massive fixed costs in R&D mean average costs fall as output increases. Second, ASML possesses a monopoly resource, since it controls unique EUV technology developed over decades. Third, legal barriers such as patents further prevent entry by competitors. As a result, ASML is a price maker and restricts output, leading to allocative inefficiency. However, the monopoly also improves dynamic efficiency, as large-scale investment enables technological progress that would be impossible for many small firms.
3. Natural monopoly
Shanghai Metro:
The Shanghai Metro is an urban rail system mainly operated by Shanghai Shentong Metro Group, making it a clear example of a natural monopoly. The industry is characterised by very high fixed costs, including the construction of tunnels, tracks and stations, while the marginal cost of carrying additional passengers is relatively low. This means average costs fall as output increases, creating strong economies of scale. As a result, it is more efficient for one firm to supply the entire market rather than having multiple competing providers duplicating infrastructure. Although competition is limited, this structure minimises costs and allows extensive citywide coverage, which is typical of natural monopolies in public transport.
4. Monopolistic competition
McDonald's:
McDonald’s operates in the fast-food industry, which is a clear example of monopolistic competition. There are many firms selling differentiated products, as McDonald’s distinguishes itself through branding, menu design and store experience, despite selling similar food to competitors such as Burger King or KFC. Due to product differentiation, McDonald’s has some price-making power, allowing limited price competition, although close substitutes restrict excessive price increases. At the same time, firms mainly compete through non-price competition, including advertising, brand image and new product launches. Barriers to entry are relatively low, as new fast-food outlets can enter the market, though strong branding gives established firms an advantage. This structure increases consumer choice but leads to allocative inefficiency, as firms operate with excess capacity and prices remain above marginal cost.
5. Collusive oligopoly (informal/tacit)
Government response to abuse of market power (fine)
German carmakers:
In the European automobile market, major German car manufacturers — Volkswagen Group, BMW and Daimler (Mercedes‑Benz) — were found to have colluded to limit the rollout of advanced emissions‑cleaning technology (such as AdBlue systems) between 2009 and 2014, effectively avoiding competition on cleaner engines despite possessing the technology to reduce harmful emissions beyond legal requirements. This behaviour is typical of a collusive oligopoly, where a few large firms cooperate (formally or informally) to reduce rivalry, maximise industry profits and restrict improvements that could otherwise benefit consumers. Because these firms coordinated technical strategies rather than competing independently, consumers were denied better products and the market experienced allocative inefficiency and reduced innovation incentives.
As a government response, the European Commission fined the companies a total of approximately €875 million — with Volkswagen paying around €502 million and BMW around €373 million — for breaching antitrust rules; Daimler avoided a fine by reporting the cartel. This penalty aimed to deter anti‑competitive collusion and restore competitive incentives in the industry, although the fines are relatively small compared with the firms’ overall revenues.
6. Non-collusive oligopoly
Chinese Telecommunications:
China’s telecommunications industry is dominated by three major firms — China Mobile, China Telecom and China Unicom — which together account for over 97% of mobile subscriptions, indicating a highly concentrated oligopoly. The market is non-collusive, as firms do not formally cooperate but instead compete strategically. Price competition occurs through discounted data plans and promotional tariffs, while non-price competition is more significant, including 5G network expansion, service quality improvements and brand differentiation. Due to high fixed infrastructure costs and strong interdependence, each firm’s decisions depend on rivals’ likely responses, reflecting game-theoretic behaviour rather than collusion. This results in continuous competitive pressure without explicit agreements, which is characteristic of a non-collusive oligopoly.