Difficulty: Intermediate to Advanced | Prerequisites: Basic microeconomics, familiarity with market structures (see companion notes on Market Structures, Efficiency, and Market Failure).
This set of notes covers four topics that frequently appear on advanced microeconomics exams: strategic decision-making through game theory (Nash Equilibrium), how firms exploit market power through price discrimination, the relationship between tax rates and government revenue (the Laffer Curve), and the effects of globalization on income inequality. These topics span different parts of the course but share a common thread: they all deal with how agents (firms, governments, economies) make choices under constraints, and what happens as a result. You should already be comfortable with basic market structures, supply and demand, and the idea of efficiency before working through this material.
Nash Equilibrium describes stable outcomes in strategic interactions where no player can improve by changing strategy alone. Price discrimination lets firms charge different prices to different buyers for the same good. The Laffer Curve shows that tax revenue rises with tax rates up to a point, then falls. Globalization has mixed effects on income inequality, tending to widen it in developed economies and sometimes narrowing it in developing ones, though with significant caveats.
Nash Equilibrium
A set of strategies, one for each player in a game, where no player can improve their payoff by unilaterally changing their own strategy, given what the other players are doing. Think of it as: everyone is doing the best they can, given everyone else's choices, so nobody wants to deviate.
Dominant strategy
A strategy that gives a player the best payoff regardless of what the other players do. If every player has a dominant strategy, the intersection of those strategies is the Nash Equilibrium.
Prisoner's Dilemma
A standard game-theory setup in which two rational players each have an incentive to defect (not cooperate), even though mutual cooperation would produce a better outcome for both. It illustrates why individually rational behaviour can lead to collectively suboptimal results.
Price discrimination
The practice of charging different prices to different consumers (or groups of consumers) for the same good or service, where the price difference is not explained by differences in cost. In simple terms, it is selling the same thing at different prices to different people based on their willingness to pay.
First-degree price discrimination (perfect price discrimination)
Charging each consumer exactly their maximum willingness to pay. Rarely achievable in practice, but a useful theoretical benchmark.
Second-degree price discrimination
Charging different prices based on quantity consumed or product version (e.g. bulk discounts, economy vs. premium tiers).
Third-degree price discrimination
Charging different prices to different identifiable groups (e.g. student discounts, senior discounts, peak vs. off-peak pricing).
Laffer Curve
A theoretical curve showing the relationship between tax rates and total tax revenue collected by the government. At a 0% tax rate, revenue is zero. At a 100% tax rate, revenue is also zero (because no one would bother earning taxable income). Somewhere in between sits the revenue-maximising rate. In simple terms, raising taxes does not always raise revenue, because at some point higher rates discourage the activity being taxed.
Globalization
The increasing integration of national economies through trade, investment, migration, and technology transfer. It is not a single policy but a broad set of processes that connect markets across borders.
Income inequality
The extent to which income is distributed unevenly across a population. Commonly measured by the Gini coefficient, where 0 represents perfect equality and 1 represents perfect inequality.
Game theory models strategic interactions, situations where the outcome for each player depends on the choices of all players, not just their own.
A Nash Equilibrium is stable: once reached, no player has a reason to change behaviour unilaterally. This does not mean the outcome is efficient or desirable, only that it is self-reinforcing.
The Prisoner's Dilemma is the canonical example. Both players defect in equilibrium, even though mutual cooperation would leave both better off. This result illustrates why cartels (like OPEC) struggle to maintain cooperation: each member has an incentive to cheat.
Nash Equilibrium is central to understanding oligopoly behaviour. In a Cournot model (firms choose quantities) or a Bertrand model (firms choose prices), the equilibrium is a Nash Equilibrium.
A game can have one Nash Equilibrium, multiple equilibria, or (in some cases) none in pure strategies. When there are multiple equilibria, coordination becomes the problem.
Price discrimination requires three conditions: the firm must have some market power (it is not a price-taker), it must be able to identify or segment consumers by willingness to pay, and it must be able to prevent resale (arbitrage) between groups.
First-degree (perfect): the firm captures the entire consumer surplus. Every unit is sold at the buyer's maximum willingness to pay. This is mostly theoretical but approximated by individual negotiation (car dealerships, some B2B pricing).
Second-degree: different pricing for different quantities or versions. Bulk discounts, tiered software subscriptions, and economy vs. business class seating all fall here. The consumer self-selects into the pricing tier.
Third-degree: different prices for identifiable groups. Student and senior discounts, matinee vs. evening cinema tickets, and airline pricing by booking date are standard examples. Airlines are the textbook case: the same seat on the same flight sells at vastly different prices depending on when you book, how flexible the ticket is, and which fare class is available.
Price discrimination can increase total output (and sometimes total welfare) relative to a single-price monopoly, because it allows the firm to serve consumers who would have been priced out.
The Laffer Curve is a simple but politically charged idea. It shows that there exists a tax rate that maximises government revenue, and that rates above this point are counterproductive (they raise less revenue, not more).
The curve is bell-shaped (or hump-shaped) with tax rate on the horizontal axis and revenue on the vertical axis.
At the two extremes: 0% tax yields zero revenue, and 100% tax also yields zero revenue (because the tax base disappears). The revenue-maximising rate sits somewhere in between, but the curve does not tell you where.
The practical debate is always about which side of the peak a given economy sits on. If tax rates are already below the peak, raising them will raise revenue. If they are above the peak, cutting them could raise revenue. Empirically, pinning down the peak is difficult, and it varies by tax type and economy.
The Laffer Curve is sometimes conflated with the Phillips Curve (inflation vs. unemployment) in exam questions. They are completely different concepts. The Phillips Curve is a macroeconomics relationship; the Laffer Curve is about fiscal policy and tax design.
Globalization has had different effects on income inequality depending on the type of economy.
In developed economies, globalization has tended to widen income inequality. The mechanisms include outsourcing of manufacturing and low-skill jobs to lower-cost countries, increased competition putting downward pressure on wages for less-skilled workers, and a growing premium on advanced skills and education (those who can compete globally do well; those who cannot fall behind).
In developing economies, the picture is more mixed. Globalization has created jobs, raised incomes, and reduced poverty in many countries (notably China and parts of Southeast Asia). At the same time, it has sometimes led to exploitation of low-skilled labour, environmental damage, and concentration of gains among urban or export-oriented sectors, leaving rural or informal workers behind.
Policy responses to inequality driven by globalization include investment in education and skills training (to help workers adapt), progressive taxation (to redistribute gains), social safety nets (to protect those displaced by trade), and labour standards and environmental regulations (to prevent a race to the bottom).
For essay answers, demonstrate awareness of both sides. Globalization is not uniformly good or bad for inequality. The direction and magnitude of its effects depend on the specific country, its institutions, its trade partners, and the policies in place.
Payoff matrix (Prisoner's Dilemma): a 2x2 grid showing each player's payoff for each combination of strategies. The Nash Equilibrium is the cell where neither player benefits from switching.
Laffer Curve: an inverted-U with tax rate (0% to 100%) on the x-axis and government revenue on the y-axis. Label the peak as the revenue-maximising rate.
Price discrimination diagram: for third-degree discrimination, draw two separate demand curves (one per group) with different elasticities. The firm sets MR = MC in each market, charging a higher price to the less elastic group.
Nash Equilibrium explains why competing firms in an oligopoly often settle on similar prices without explicit collusion. Each firm's pricing is a best response to the other's.
Airline pricing is the go-to real-world example of price discrimination. The same London-to-New York seat can cost £300 or £3,000 depending on flexibility, timing, and fare class.
Students often assume Nash Equilibrium means the best possible outcome. It does not. The Prisoner's Dilemma shows that a Nash Equilibrium can be Pareto inefficient (both players would prefer mutual cooperation, but neither will cooperate unilaterally).
Price discrimination is sometimes confused with price differentiation based on cost. Charging more for a larger size of coffee is not price discrimination if the cost of the larger cup is proportionally higher. Price discrimination requires same cost, different prices.
The Laffer Curve does not imply that cutting taxes always raises revenue. It only says that at some sufficiently high rate, further increases reduce revenue. Where that threshold sits is an empirical question, not a theoretical certainty.
Students sometimes conflate globalization with free trade. Globalization is broader: it includes capital flows, migration, technology transfer, and cultural exchange, not just the removal of tariffs.
⚠️ Nash Equilibrium is tested through payoff matrices. Practise identifying the equilibrium in a 2x2 matrix, including games with no dominant strategy.
⚠️ Know all three degrees of price discrimination and be ready to give a real-world example of each. Airlines come up constantly.
⚠️ The Laffer Curve is a frequent multiple-choice trap. Do not confuse it with the Phillips Curve, and do not overstate its policy implications.
⚠️ The globalization essay is a standard long-answer question. Structure your answer around developed vs. developing economies, name specific mechanisms (outsourcing, skill premium, job creation), and propose policy responses. Examiners reward balanced analysis.
True or false: In a Nash Equilibrium, every player is maximising their payoff regardless of what others do.
Fill in the blank: Price discrimination requires market power, the ability to segment consumers, and the prevention of ________.
True or false: The Laffer Curve suggests that a 100% tax rate would generate maximum government revenue.
Fill in the blank: Third-degree price discrimination charges different prices to different identifiable ________.
True or false: Globalization has uniformly reduced income inequality in developing economies.
Answers: 1. False (each player is maximising given the others' strategies, not regardless of them; "regardless" describes a dominant strategy). 2. Resale (or arbitrage). 3. False (100% yields zero revenue). 4. Groups. 5. False (effects are mixed).
Q: What is a Nash Equilibrium? Is it always the best outcome for the players involved?
A: A Nash Equilibrium is a set of strategies where no player can improve their payoff by unilaterally changing their strategy. It is not always the best outcome; the Prisoner's Dilemma shows that a Nash Equilibrium can leave both players worse off than mutual cooperation would.
Q: Define price discrimination and give a real-world example.
A: Price discrimination is charging different prices to different consumers for the same product, where the price difference is not based on cost differences. A common example is airline pricing, where passengers on the same flight pay different fares depending on booking time, flexibility, and demand.
Q: What does the Laffer Curve illustrate, and what is its key policy implication?
A: The Laffer Curve illustrates the relationship between tax rates and government revenue. It shows that revenue increases with the tax rate up to a point, then decreases. The key implication is that there is a revenue-maximising tax rate, and setting rates above it is counterproductive.
Q: Discuss how globalization affects income inequality in developed versus developing economies.
A: In developed economies, globalization tends to widen inequality by outsourcing low-skill jobs and increasing the premium on education and advanced skills. In developing economies, it can reduce inequality by creating jobs and fostering growth, but it can also widen it through exploitation of low-wage labour and uneven distribution of gains. Policy responses include education investment, progressive taxation, and social safety nets.
Nash Equilibrium is the analytical engine behind oligopoly models (Cournot, Bertrand, Stackelberg). Understanding it is essential for any market-structure question involving strategic interaction.
Price discrimination connects to consumer surplus and welfare analysis. Perfect price discrimination eliminates consumer surplus entirely, transferring it to the producer.
The Laffer Curve sits at the intersection of microeconomics (incentive effects of taxation) and public finance. It connects to discussions of tax incidence, deadweight loss from taxation, and optimal tax theory.
Globalization and inequality connect to trade theory (comparative advantage, Heckscher-Ohlin), labour economics, and development economics.
Nash Equilibrium, game theory, dominant strategy, Prisoner's Dilemma, payoff matrix, Cournot model, Bertrand model, strategic interaction, price discrimination, first-degree price discrimination, second-degree price discrimination, third-degree price discrimination, consumer surplus, market power, arbitrage, Laffer Curve, tax revenue, revenue-maximising tax rate, Phillips Curve, globalization, income inequality, Gini coefficient, outsourcing, skill premium, progressive taxation, social safety nets, trade liberalisation, comparative advantage, welfare economics