ECO 201: Microeconomics II Course Notes (South African HEIs, TVETs & Coursework-Ready Study Guide)

Microeconomics II (often ECO 201 in South African institutions) typically extends Microeconomics I by moving from basic supply–demand mechanics to deeper tools: constrained optimisation, consumer and producer choice, market structure (including oligopoly), general equilibrium intuition, and welfare analysis. It also introduces stronger applications of micro theory to policy, firm strategy, and labour or housing market examples—frequently with emphasis on how assumptions translate into testable predictions. These exam notes are structured to mirror common South African course outcomes and provide worked examples, typical assessment styles, and concept-to-application linkages.

Section 1: Core Micro II Foundations—Optimisation, Preferences, and Cost Curves

Microeconomics II “wins” on tests when you can (1) translate a story into a mathematical problem, (2) solve it correctly, and (3) interpret the result economically. This section builds the baseline toolkit you repeatedly use across consumer theory, production, and market structure.

Consumer Theory Revisited: Utility, Indifference Curves, and Choice

Preferences and Utility

Most ECO 201 syllabi start by refining the language of preferences:

Complete: for any two bundles (A) and (B), the consumer can say whether (A \succeeds B), (B \succeeds A), or is indifferent.
Transitive: if (A \succeeds B) and (B \succeeds C), then (A \succeeds C).
More is better (monotonicity): if a bundle has “more” of at least one good and no less of the other, it is preferred or at least not worse.

A utility function is a convenient representation of preferences. You should be able to recognise when a utility function implies typical indifference-curve shapes.

Indifference Curves and Marginal Rate of Substitution (MRS)

Indifference curve: all bundles that yield equal utility.
MRS: the rate at which the consumer is willing to exchange one good for the other while keeping utility constant.
- For two goods (x) and (y), a generic rule is:
  [
  \text{MRS}_{x,y} = -\frac{dy}{dx}
  ]
  moving along an indifference curve.

Diminishing MRS typically implies convex indifference curves to the origin.

Example: Quasi-linear preferences

Suppose utility:
[
U(x,y)=x+\ln(y)
]
The MRS is:
[
\text{MRS}_{x,y} = \frac{\partial U/\partial x}{\partial U/\partial y} = \frac{1}{1/y} = y
]
Interpretation: when (y) is higher, the consumer is willing to give up more (x) for an extra unit of (y).

The Budget Constraint and Tangency

A consumer faces prices (p_x, p_y) and income (m):
[
p_x x + p_y y = m
]
Optimal choice occurs where:

the budget line is tangent to the highest attainable indifference curve, i.e.
[
\text{MRS}_{x,y} = \frac{p_x}{p_y}
]
This is the interior optimum condition.

Corner solutions

If preferences are such that tangency cannot occur in the feasible region (e.g., perfect substitutes), the optimum may occur at a corner. Recognising corner cases is a frequent exam requirement.

Demand from Optimisation: Substitution and Income Effects

Price changes generate two conceptual effects:

Substitution effect: change in consumption due to relative price changes holding utility constant.
Income effect: change due to real purchasing power changes.

The sign of the income effect determines whether demand is normal or inferior for that good.

Inferior good

If a good’s consumption falls when income rises (real purchasing power increases), it is inferior.

Constrained Optimisation Techniques: Lagrange Method and Comparative Statics

Lagrangian Setup

For general form:
[
\max_{x,y} U(x,y) \quad \text{s.t.} \quad p_x x + p_y y = m
]
Set:
[
\mathcal{L} = U(x,y) + \lambda(m – p_x x – p_y y)
]
FOCs (first-order conditions):
[
\frac{\partial U}{\partial x} – \lambda p_x = 0,\quad \frac{\partial U}{\partial y} – \lambda p_y = 0
]
and the constraint.

A common exam strategy: divide the two FOCs to eliminate (\lambda), giving the tangency condition.

Worked example (Cobb–Douglas)

Let:
[
U(x,y)=x^{a}y^{1-a} \quad (0<a<1)
]
FOCs yield:
[
a\frac{U}{x}=\lambda p_x,\quad (1-a)\frac{U}{y}=\lambda p_y
]
Divide to get:
[
\frac{a}{1-a}\cdot \frac{y}{x}=\frac{p_x}{p_y}
]
Thus demand is:
[
\frac{y}{x}=\frac{1-a}{a}\cdot\frac{p_x}{p_y}
]
Together with the budget constraint, you get standard Cobb–Douglas demands:
[
x^* = a\frac{m}{p_x},\quad y^*=(1-a)\frac{m}{p_y}
]
Interpretation: each good consumes a constant expenditure share.

Producer Theory: Production Functions, MRTS, and Cost Minimisation

Production Functions

A production function describes maximum output from inputs:
[
q=f(K,L)
]
In Micro II you often see:

diminishing marginal returns (in at least one input),
isoquants,
marginal rate of technical substitution (MRTS),
cost minimisation.

Isoquants and MRTS

Isoquant: combinations of (K) and (L) delivering the same (q). MRTS is:
[
\text{MRTS}{L,K} = \frac{dK}{dL}\Big|{q}
]
At cost-minimisation, the tangency condition is:
[
\text{MRTS}_{L,K} = \frac{w}{r}
]
where (w) is the wage rate and (r) the rental rate of capital.

Cost Minimisation and Long-Run/Short-Run Distinctions

Short run: at least one input is fixed (often (K)).
Long run: all inputs are variable.

This matters because:

short-run cost curves can be U-shaped due to diminishing marginal returns,
long-run cost curves reflect the ability to re-optimise input mixes.

Short-Run Cost Curves and Their Intuition

Total, Average, Marginal Costs

Define:

Total cost: (TC(q))
Average cost: (AC(q)=\frac{TC(q)}{q})
Marginal cost: (MC(q)=\frac{dTC}{dq}) (in discrete form: (\Delta TC / \Delta q))

Key relationships:

When (MC<AC), average cost falls (adding output increases total cost but less than proportionally to output).
When (MC>AC), average cost rises.

Minimising AC and the MC=AC Condition

If curves are smooth and continuous:

minimum of (AC) occurs where (MC=AC).

Long-Run Cost and Economies of Scale

Economies of Scale

Economies of scale occur when average cost decreases as output increases:

typically associated with large-scale technologies, fixed costs spread, network effects (in some industries).

If average costs rise with output:

diseconomies of scale, often due to managerial complexity, congestion, or inefficiencies.

LRAC as the Envelope

In long run, firms choose the cheapest combination of short-run technologies:

(LRAC) is the lower envelope of all relevant short-run (SAC) curves.

This envelope logic is often tested with diagrams: you should describe it clearly in words even if you cannot draw neatly under exam pressure.

Micro II Exam Skill: Translating Graphs to Sentences

South African exam graders often reward correct interpretation more than perfect diagram art. Practice describing:

“A fall in price shifts the budget line outward/rotates and changes the tangency point.”
“If (MC) crosses (MR) from below, profit maximising output increases.”
“If demand is elastic, total revenue increases with a price decrease.”

These phrasing patterns become scoring tools.

Section 2: Firm Behaviour and Market Outcomes—Perfect Competition, Monopoly, and Price Discrimination

This section covers the classic micro core: competitive equilibrium, monopoly pricing, and how firms’ pricing strategies depend on elasticity and information. You will also see how welfare changes under market power and why regulation matters.

Perfect Competition and Profit Maximisation

Assumptions

Perfect competition typically assumes:

many firms,
identical products,
no barriers to entry,
perfect information,
firms are price takers.

Therefore, each firm faces a horizontal demand curve at the market price (P).

Profit Function

[
\pi(q)=Pq – TC(q)
]
Profit is maximised where:
[
MR=MC
]
In perfect competition:
[
MR=P
]
So the rule becomes:
[
P=MC
]
Profit is positive if:
[
P \ge \text{min }AC
]
otherwise firms exit in the long run.

Shutdown and the AVC Rule

In the short run, if producing is not worth the variable cost:

shut down if:
[
P<AVC
]
where (AVC=\frac{VC}{q}).

This is tested because it connects calculus-free cost curves to practical decisions.

Elasticity and Market Power: Monopoly Pricing and Welfare

Monopoly Characteristics

Monopoly means:

single firm,
barriers to entry,
downward-sloping market demand,
firm sets price, so MR differs from demand price.

Monopoly Revenue: Why (MR<P)

With downward-sloping demand, selling more requires lowering price. Thus:

the additional revenue from increasing quantity is less than the current price.

Therefore:
[
MR < P \quad \text{for } q>0
]
Graphically, MR lies below the demand curve for linear demand.

Monopoly Output Rule

Profit maximisation:
[
MR=MC
]
Then price is read from the demand curve at that quantity.

Monopoly Outcome Compared to Competition

Monopoly typically produces less output and charges a higher price than competition.
Welfare effects:
- Consumer surplus decreases,
- Producer surplus may increase,
- Deadweight loss arises due to lost mutually beneficial trades.

Deadweight Loss Intuition (Triangle)

Deadweight loss occurs because quantity is restricted below the efficient level (where marginal benefit equals marginal cost).

A high-scoring exam explanation states:

“For units between monopoly quantity and competitive quantity, marginal benefit to consumers exceeds marginal cost to society, so they would create positive net welfare but are not produced.”

Monopoly and Regulatory Tools (Simple Policy Logic)

Price ceilings and their pitfalls

A price ceiling below the monopoly price may increase output but can lead to:

shortages if set too low,
reduced quality or investment,
depending on constraints.

Subsidy/Tax implications

If a government imposes a tax per unit, the firm’s effective marginal cost increases, shifting the MC curve upward. Market outcomes change systematically:

equilibrium quantity falls,
prices for consumers rise (less than full tax if elasticity matters).

Even without heavy algebra, the direction and relative magnitude based on elasticity is often enough for exam marks.

Price Discrimination: When Firms Can Extract More Surplus

Price discrimination means charging different prices to different consumers for the same good based on observable differences.

Conditions for Third-Degree Price Discrimination (Common)

For successful price discrimination:

Market power (firm must be able to set prices).
Ability to separate consumers into groups (e.g., student vs non-student).
Prevention of resale/arbitrage between groups.

Profit-Maximisation Under Price Discrimination

For each group (i):
[
MR_i=MC
]
Equivalently, firms set markups inversely proportional to elasticity of demand:
[
\frac{P_i-MC}{P_i}=\frac{1}{|\varepsilon_i|}
]
So:

group with more elastic demand gets lower markup and often a lower price,
group with less elastic demand pays a higher relative markup.

Worked example: Two groups with different elasticities

Assume constant marginal cost (MC=10). Suppose elasticities are:

group A: (|\varepsilon_A|=2)
group B: (|\varepsilon_B|=5)

Markup rule:
[
\frac{P_i-MC}{P_i}=\frac{1}{|\varepsilon_i|}
]
Rearrange:
[
P_i = \frac{MC}{1-\frac{1}{|\varepsilon_i|}}
]

For group A:
[
P_A=\frac{10}{1-\frac{1}{2}}=\frac{10}{0.5}=20
]

For group B:
[
P_B=\frac{10}{1-\frac{1}{5}}=\frac{10}{0.8}=12.5
]

Interpretation: the more price-sensitive group (B) faces a lower price. This is a standard exam pattern.

Perfect Competition vs Monopoly vs Discrimination: Exam-Grade Comparison Checklist

When asked “compare,” write a checklist-like answer:

Market structure assumptions (price-taking vs price-setting).
Optimal condition: (P=MC) vs (MR=MC).
Elasticity role: in monopoly, markup depends on elasticity; in perfect competition, elasticity is effectively infinite.
Welfare: deadweight loss in monopoly (less in discrimination depending on coverage).
Surplus redistribution: who gains and who loses (consumer vs producer).

Case-Based Thinking for South African Context (Generic, University/TVET Relevant)

South African economics courses often use familiar local settings like:

public transport fare differences,
student discounts,
utility pricing tiers,
mobile data bundles.

Even if your course avoids explicit local case brands, the logic fits:

If the firm can segment by category (student status, income bracket),
it may implement third-degree or similar discrimination.

On exams, you should state:

which discrimination type it resembles,
what assumption about resale holds (usually “imperfect resale”),
why elasticity differs across groups.

Section 3: General Equilibrium, Welfare Economics, Externalities, and Public Policy

ECO 201 often expands from partial equilibrium (one market at a time) to welfare and market failure. You’ll be expected to reason about efficiency, equity (often qualitatively), and policy instruments.

General Equilibrium Intuition: Interdependence of Markets

Partial vs General Equilibrium

Partial equilibrium: focus on one market holding others fixed.
General equilibrium: consider that a change in one market affects incomes, prices, and demands across markets.

In general equilibrium, relative prices and incomes are endogenously determined.

Budget Constraints and Arrow–Debreu Logic (Practical)

A common exam learning outcome is to interpret why:

consumers choose optimally given prices and income,
firms choose optimally given technology and input prices,
equilibrium requires markets clear simultaneously.

You might not need formal proofs, but you must understand the relationships:

Excess demand in one market influences price adjustments,
these changes feed back into other markets.

Welfare Theorems (Conceptual Mastery)

First Welfare Theorem

Under conditions (commonly: perfect competition, no externalities, complete markets, rational agents):

competitive equilibrium is Pareto efficient.

A practical translation:

“No other allocation makes someone better off without making someone worse off.”

Second Welfare Theorem

Any Pareto-efficient allocation can be supported by competitive markets through appropriate lump-sum transfers (under strong assumptions).

In exam answers:

emphasise that “equity” depends on transfers, not on changing efficiency.

Externalities and Market Failure

Types of Externalities

Negative externality: third parties bear costs (e.g., pollution).
Positive externality: third parties gain benefits (e.g., vaccination, education).

Social vs Private Costs/Benefits

For a negative externality:

private marginal cost (MPC) is less than marginal social cost (MSC),
optimal output equates marginal benefit (MPB) with MSC, not MPC.

Diagram Logic without Overdrawing

Write directions carefully:

MSC lies above MPC,
market equilibrium sets (MB= M P C),
efficient output sets (MB= M S C),
thus market overproduces relative to efficiency.

Policy Tools: Taxes, Subsidies, and Standards

Pigouvian Tax (Corrective Tax)

To correct a negative externality:

government imposes a per-unit tax equal to marginal external cost.

Effect:

firm’s marginal cost rises by the tax amount,
output falls toward the efficient level.

Exam-grade articulation:

“The tax internalises the externality, aligning private incentives with social costs.”

Emissions standards vs taxes

If the course covers comparing instruments:

standards set quantities (or emissions limits),
taxes set price of emissions.

Key qualitative comparison:

taxes provide flexibility to firms in achieving compliance,
standards can be more administratively direct but may be less cost-effective across heterogeneous firms.

Public Goods and the Free-Rider Problem

Definition

A public good is:

non-excludable (hard to prevent consumption),
non-rival or low rivalry.

Efficient Provision and Summation of Marginal Benefits

Efficiency requires:
[
\text{Sum of marginal benefits} = \text{Marginal cost}
]
Unlike private goods where you use one demand curve, public goods require vertical summation.

Free-rider logic

If one household expects others to contribute, they may free-ride.
This leads to under-provision relative to efficient quantity.

Cost–Benefit Reasoning for Students and Workers

In applied assignments, questions might ask you to evaluate:

schooling investment,
healthcare programmes,
infrastructure projects.

For negative and positive externalities, the “net social benefit” includes:

private benefits/costs,
external benefits/costs.

This is a “must know” approach because it appears across different problem styles.

Section 4: Market Structure Beyond the Basics—Oligopoly, Game Theory Intuition, and Strategic Interactions

Microeconomics II in many SA curricula includes at least an introductory oligopoly/game theory component. Even if the course is not “pure game theory,” you must be comfortable with strategic reasoning: actions by one firm affect payoffs of others.

Oligopoly and Strategic Interdependence

The Core Idea: Interdependence

In oligopoly:

a firm’s profit depends not only on its own price/output decision,
but also on competitors’ responses.

Thus:

best response functions and equilibria matter.

Prisoners of Bribe: Typical Exam Format

Many exam problems use payoff matrices to ask:

identify dominant strategies,
find Nash equilibrium,
determine outcomes under repeated interaction (sometimes).

If your course includes formal games, you need to master terminology even in qualitative form.

Nash Equilibrium and Dominant Strategies

Nash Equilibrium Definition

A strategy profile is a Nash equilibrium if:

no player can improve their payoff by changing strategy unilaterally.

Dominant strategy

A strategy is dominant if it yields a higher payoff than alternatives regardless of the other player’s action.

If a dominant-strategy equilibrium exists, it is a Nash equilibrium.

Cournot and Bertrand: Two Common Oligopoly Models

Cournot Competition (Quantity setting)

each firm chooses quantity,
market price determined by total quantity.

In Cournot:

MR and reaction functions determine equilibrium.

Qualitative exam points:

more firms → more competition → lower price → output closer to marginal cost scenario.

Bertrand Competition (Price setting)

firms choose prices,
demand splits by relative price.

Key exam intuition:

with identical products and constant marginal costs,
- Bertrand equilibrium often leads to (P=MC) (price competition drives profits to zero in the simplest case),
with differentiated products or increasing marginal costs,
- results differ.

Make sure you can explain why the “zero profit” outcome arises in the simplest Bertrand model:

if one firm sets a higher price, it loses all demand to the lower-priced competitor.

Collusion, Cartels, and the Incentive Problem

Why Cartels May Form but Struggle

Cartels aim to behave like a monopoly (higher prices, lower quantities).
But individual firms face incentives to undercut the agreed price/quantity.

This is usually explained with:

“cheating” incentives,
enforcement difficulty.

Repeated Games (If Included)

In repeated interaction, cooperation may persist because:

cheating can trigger punishment strategies (e.g., “grim trigger”).

Exam outcomes:

cooperation is more likely if future is sufficiently valuable (high discount factor).

You should be able to explain the logic without heavy equations if not required.

Oligopoly Predictions and Elasticity Interpretation

Even without full game theory, some courses connect oligopoly behaviour to elasticity:

firms with greater market power face more inelastic demand,
strategic pricing decisions reflect the responsiveness of quantity demanded to price changes.

A strong exam answer:

combines model-specific predictions (Cournot vs Bertrand) with general intuition about elasticities and markups.

Numerical Mini-Example Style (How to Show Work)

If an exam question gives a simplified inverse demand and cost for two firms in Cournot, a typical approach:

derive each firm’s profit function (\pi_i(q_i,q_j)),
take derivative w.r.t. (q_i),
set best response: (\frac{\partial \pi_i}{\partial q_i}=0),
solve reaction functions simultaneously.

Even if you cannot compute quickly, the “show steps” pattern earns partial marks.

Section 5: Labour Markets, Asymmetric Information (If Covered), and Exam Mastery—How to Build High-Scoring Answers

Many ECO 201 Micro II courses include labour economics beginnings (imperfect competition, bargaining) and sometimes basic information economics (adverse selection, moral hazard). Even when not deeply formalised, these topics usually appear in either problem sets or essay questions. This final section consolidates those “often tested” areas and provides an answer strategy that matches South African exam marking.

Labour Markets: Wage Setting and Market Power

Perfect competition benchmark

In competitive labour markets, wages reflect marginal productivity and labour supply/demand intersection.

But Micro II often asks: what if the market is not perfectly competitive?

Monopsony (Single buyer of labour)

A monopsony employer faces the labour supply curve, meaning:

to hire more, it must raise wages for all hired workers.
Thus the wage paid is typically below the marginal revenue product (in monopsony logic).

Exam consequences:

monopsony can lead to lower wages and lower employment than a competitive benchmark.

Trade unions and bargaining (Qualitative)

If unions have bargaining power, they can influence wages above the competitive level.
But real outcomes depend on:

bargaining strength,
elasticity of labour demand,
ability of firms to substitute capital for labour.

Your exam essay should show you can balance:

“unions can improve worker outcomes,” against
“wage increases may reduce employment if labour demand is elastic.”

Asymmetric Information: Adverse Selection and Moral Hazard (Intro Level)

If included in your course, expect conceptual multiple choice and short responses.

Adverse selection

Occurs when:

one party knows more than the other before a transaction.
Example archetype:
health insurance: high-risk people more likely to buy.

Market implication:

insurers may respond with higher premiums,
leading to “lemons” problem and possible market failure.

Corrective tools:

screening (signal requirements),
mandates (forcing participation),
regulation.

Moral hazard

Occurs after a transaction when:

one party changes behaviour because they are insulated from some cost.

Example archetype:

insurance reduces incentives to avoid risk.
Corrective tools:
monitoring,
deductibles,
co-payments.

Even if your exam doesn’t require diagrams, you should describe:

timing (before vs after),
incentive problem,
policy response.

Interpreting Demand Elasticity in Strategic Contexts

Across market structures, elasticity frequently drives results:

Perfect competition: firms are price takers → effectively infinite elasticity for each firm.
Monopoly and oligopoly: markups relate to elasticity and competitive pressure.
Price discrimination: different elasticities across segments lead to different prices.

A strong exam strategy:

in any “what happens if demand becomes more elastic?” question, immediately connect it to:
- lower markup in monopoly,
- stronger competitive pressure in oligopoly,
- more nuanced welfare implications when elasticities vary by group.

Writing High-Scoring Answers: South African Exam Techniques

The “Model → Condition → Result → Interpretation” template

For almost any quantitative problem, write:

Model (e.g., perfect competition, monopoly, Cournot),
Condition (e.g., (MR=MC) or (P=MC)),
Result (e.g., output/price),
Interpretation (welfare, efficiency, deadweight loss, incentives).

This structure helps markers see you understand more than one dimension of the question.

The “directional reasoning” rule

If a question asks “what happens to price and quantity when policy X occurs?” but exact numbers are not possible, you still can score by stating:

“Price rises/falls because marginal condition shifts up/down.”
“Output moves opposite to the shift in marginal cost relative to demand.”
“Welfare increases/decreases depending on externality internalisation or distortion.”

Common mistake: mixing up short-run and long-run logic

A common exam penalty is using long-run zero-profit logic in short run, or vice versa.
Remember:

short run: firms may earn positive or negative economic profit but can still produce (unless shutdown).
long run: entry/exit tends to push economic profit to zero under perfect competition.

Practice Set: Typical ECO 201 Micro II Question Types and What Markers Want

1) “Derive demand” question

What markers want:

correct optimisation setup,
correct derivative/FOC,
correct substitution into the budget constraint,
a final demand function expressed clearly in terms of (m, p_x, p_y).

For Cobb–Douglas:

you should know shares: (x^*=a m/p_x).

2) “Compare welfare” essay

What markers want:

deadweight loss explanation,
surplus changes (consumer/producer),
clear statement of efficiency in terms of marginal benefit/cost,
if asked, link to remedies and why remedies work.

3) “Policy instrument” externality question

What markers want:

identify external cost/benefit,
say whether MPC/MB or MSC/MC should be equated,
explain how a tax/subsidy shifts curves and changes outcomes,
if comparing instruments, include cost-effectiveness or informational issues.

4) “Oligopoly equilibrium” payoff matrix or Nash equilibrium

What markers want:

correct identification of dominant strategies (if any),
correct Nash equilibrium location,
explanation of why equilibrium is stable against unilateral deviations.

Mini Diagram Descriptions (Exam-Ready Wording)

If you can’t draw precisely, you can still earn marks by describing carefully:

Monopoly: “MC intersects MR at a lower quantity than where demand intersects MC under competition. Price is higher because the monopoly price is read from demand at that lower quantity.”
Externality correction: “MSC lies above MPC; the competitive equilibrium equates MB and MPC but the efficient equilibrium equates MB and MSC. A Pigouvian tax increases the firm’s perceived marginal cost, shifting private incentives to match the social optimum.”

These sentences translate directly into what most graders look for.

Institution-Focused Alignment: South African Universities & TVETs Course-Style Notes

Different institutions emphasise different depth levels, but the core marks are consistent. Typical ECO 201 assessments in South Africa often include:

University: higher algebra/graphs; sometimes formal derivations of demand, cost relationships, and welfare triangles.
TVET: strong conceptual reasoning, practical interpretation, and diagram-based explanations; may still include calculations but with clearer scaffolding.

To maximise your grade, ensure your revision covers:

optimisation steps and FOCs,
correct marginal conditions,
elasticity interpretations,
welfare and policy instruments.

Conclusion: The Micro II “Essentials Stack” for Exam Success

ECO 201 Microeconomics II is not just a list of topics—it is a set of repeated logical moves. Those moves are: set up the decision problem (optimisation), find the correct marginal condition (e.g., (P=MC), (MR=MC), or welfare rule (MB=MSC)), translate shifts into market outcomes, and then interpret welfare and incentives. If you master those moves with the specific models covered here—consumer choice, cost curves, perfect competition, monopoly with price discrimination, externalities and public goods, and introductory oligopoly—your answers will look like “complete solutions,” which is exactly what South African marking guidelines reward.