MICROECONOMICS II

LECTURE NOTE
By Yasin Ahmed(MSc)
 CHAPTER 2: OLIGOPOLY

• Oligopoly is a market structure which is dominated by a few large

producers of a homogeneous or differentiated product.

• Crucially, these few firms recognize their rivalry and

interdependence, fully aware that any action on their part is likely
to induce counter-actions by their rivals
.
• This leads us to consider strategies and counter-strategies between
market participants.
 Basic characteristics of oligopoly:

 Few large firms dominate the entire industry

 Either homogeneous or differentiated products

 Interdependence of firms - decisions of one firm affects the

decisions of other firms – potential for collusion or competition

 Substantial barriers to entry: may be due to economies of scale,

patent, mergers, access to resources, etc.

 prices in oligopoly tend to be ‘sticky’ or rigid
• Duopoly: is a special case of oligopoly in which
there are only two firms in the industry.
• In general, oligopoly market is divided in to two:
1. Non-collusive oligopoly
2. Collusive oligopoly
 Types of oligopoly models
• There are different models to explain the behavior of
oligopolistic firms.

• There are non-collusive models and collusive models. .

• When firms enter into some form of agreement as to the price

level they charge or the quantity of output they produce, such
firms are said to be collusive oligopoly.
• On the other hand, if there is no any form of agreement between firms,

firms are said to be non-collusive oligopoly.

A. Non-collusive oligopoly

• In non-collusive type of oligopoly market, there is no collusion - there is

no cooperation among rivals.

• Hence, the common feature of non-collusive oligopoly models is there

is no cooperation among rival firms.

• Thus, under non-collusive oligopoly each firm develops an expectation

about what the other firms are likely to do.

• Since firms are mutually interdependent, a firm expects some reaction

from its rivals when it decides to take a given course of action.

• Fore example, when a firm increases its own output or price, it
expects some reaction from the rivals to its action; increment of
output or price.

• However, the question is ‘what kind of reaction’ does a firm

expect to its action?

• What then is the implication of this expectation on the behavioral

pattern of oligopolists?
 common
non-
collusiv
e
oligopol
T
y
• 1. The Kinked Demand Model
he
se • 2. Cournot's Duopoly Model
ar
e:
models.
• 3. Bertrand’s Duopoly Model
• 4. Stackelberg’s Duopoly Model
Comparison between the three non-collusive models

• In Cournot competition firms simultaneously compete in

terms of quantity supplied to the market.

• In Stackelberg competition one or more firms are able to

initially pre-commit themselves to a particular output level.

• The remaining firms observe this level of output and then

simultaneously determine their own optimal output levels.

• Finally, in Bertrand competition firms simultaneously

compete in terms of the price they charge consumers.

1. Sweezy’s kinked demand curve model of oligopoly
• This model is developed by Paul Sweezy to explain why prices in
oligopoly markets are stable or rigid, even when costs rise.
• If you closely look at the prices of products produced by oligopoly
firms,
• You may easily see that prices are more stable as compared to the
prices of products in other market structures.
 Example, the prices of soft drinks, beer, cigarettes and other
similar products, you come to realize that once price is set it
remains relatively for a long period of time.
 This is because firms come to believe that

 If they cut prices their rivals will follow the price cut and, as a

result, the price cut will not produce much of an increase in sales.

• However, a price increase will not be followed and will, therefore,

result in a significant loss of sales to the firm raising its price.

• As a result, once a price is reached, it tends to remain in effect for

long periods.
• An oligopoly firm will face two demand curves for different

ranges of prices.

• Suppose a firm knows that any time it raises its prices, all other

firms in the industry will do the same.

• In this case it faces AB, which is a relatively inelastic curve.

• If, on the other hand, no other firms follow its changes in prices

the firm will instead find itself on CD, a much more elastic

demand curve.

• If the firm is the only one to raise prices, it will experience a large

drop in sales.
The Kinked Demand Curve
 The Kinked Demand curve
and the corresponding MR curve

P*
MR

D
Q* quantity
 The MC curve intersects the MR curve
in the vertical segment.

$
MC
P*
MR

D
Q* quantity
If costs shift up slightly, but MC still intersects MR in the vertical
segment, there will be no change in price. This price rigidity is
seen in real world oligopoly markets.
$ MC’
MC
P*

D
Q* MR quantity
The ATC curve can be added to the graph. To show positive profits,
part of ATC curve must lie under part of the demand curve.

$
MC ATC
P*

D
Q* MR quantity
 Profit = TR - TC

$
MC ATC
P* profit

ATC*

D
Q* MR quantity
 2. Cournot's Duopoly Model

• Cournot’s model is the earliest duopoly model (developed in 1838).

• The original version of the model makes the following “heroic”

assumptions:

• The duopolists have identical (homogeneous) products and identical

costs,

• The marginal (additional) cost is zero for both firms,

• The firms fully know their linear demand curve, and

• Each firm acts (decides on its own output to maximize profit) on the

assumption that the competitor will not change its output level.
• Assume that firm A is the first to start producing and selling mineral
water (and refer to Figure 2.1 below). It will produce quantity A and
sells at price P1 because MR = MC (= 0) at point A – the mid-way
between O and D'.
• Now, firm B enters into the industry and assumes that A will keep its output
fixed at OA and hence considers that its own demand curve is CD’.

• It produces AB (=1/2AD’) and charges price P2 in order to maximize profit.

• Firm A, faced with this situation, assumes that, B will retain its quantity
constant in the next period.

• Therefore, A will produce ½ of the market that is not supplied by B [=1/2(1-

1/4) OD’].

• B (again) reacts and will produce ½ of the unsupplied market [=1/2(1-3/8)

OD’].

• This action-reaction pattern continues until equilibrium is reached.

• At equilibrium, each firm produces one-third (1/3) of the total market (a

total of 2/3); one – third of the market remains unsupplied.
• Example - Assume the total market demand of mineral water is 100 bottles per

week.

• If firm A is the only firm in the market, it will produce one-half of the total

demand-50 bottles.

• Then, when firm B enters into the industry, it assumes that firm A will keep on

producing 50 bottles and considers that its demand will be the remaining 50

bottle.

• Firm B, facing an unsatisfied market demand of 50 bottles, produces half of this

demand, which is 25 bottles (one-fourth of the total market demand).

• But when firm B enters and starts producing 25 units, firm A will

be forced to revise its previous quantity because now the A’s

market demand is not 100 but it is 100 minus the amount produced

by B.

• Assuming that B will continue producing 25 units and A will fix

its quantity of output based on the amount of demand which is not

supplied by B (1-¼ =¾ of 100 which are equal to 75).

• Then A maximizes its profit by producing one-half of its demand

• In a similar way, firm B will revise its previous decision. In its decision, B assumes that

A will continue producing 37.5 (3/8x100) units and B produces one-half of 62.5 (the

remaining demand) - 31.25 which is ½(1-3/8) = 5/16 of 100.

• The process continues until each firm produces 1/3 of the overall market demand.

• The two firms produce and supply 2/3 of the total market demand which is equal to

66.67 units.

• We can, therefore, generalize that each firm supplies 1/3 of the market demand, at a

common price which is lower than the monopoly price, but above the perfectly

competitive price (which is zero in the Cournot’s example of costless production).

• Thus, the Cournot solution is stable.

• In general terms, if there are n firms in the industry each will

provide 1/(n +1) of the market, and the industry output will then be

n /(n +1) of the total demand.

• Clearly, if four firms are assumed to exist in the industry, the higher

the total quantity supplied and hence the lower the price.

• As more firms are assumed to exist in the industry, the larger the

total quantity supplied and hence the lower the price.

• The larger the number of firms the closer is output and price to the

competitive level.
• Example - Assume there are 10000 firms in the industry.

• The individual supply will then be 1/10001 of the total supply which is very
small proportion as compared to the total supply – the same as in competitive
market.

• In competitive market, the supply of each firm is very small proportion to the
total supply.

• When we see the total supply and price, the total supply of these firms will be
10000/10001 which is nearly equal with the total demand.

• The price in competitive market is equal to the MC. In our example, the MC is
zero.

• The price in this case is also zero because firms supply nearly the total demand –
OD’.

• From the demand curve it can be seen that OD’ can be sold if the price is zero.
• Let us now relax the assumption of zero marginal cost and see the equilibrium

of a duopoly market (Cournot’s equilibrium) based on the reaction-curves

approach.

• Reaction curve is a curve that shows the relationship between a firm’s profit

maximizing output and the amount it thinks its competitor will produce.

• It shows how firm A will determine its output as a reaction to B's decision to

produce a certain level of output.

• For instance, if we have two firms (A&B), firm A’s reaction function (curve)

shows how much output A must produce in order to maximize its own profit for

every specific level of output of its rival (B).

• The reaction functions of firms under Cournot’s behavioral assumption are

downward sloping in a quantity set of axes.

• The Cournout’s equilibrium is determined by the intersection of the two reaction curves

at point e, giving equilibrium outputs of A and Be for firm A and B respectively.

• Provided A’s reaction curve is steeper than B’s reaction curve, then Cournot

equilibrium will be stable in the sense that any departure from it will lead to events that

tend to restore it.

• If A decides to produce quantity A1, lower than equilibrium quantity Ae, firm B will

react by producing B1, given the Cournot assumption that firm A will keep its quantity

fixed at A1.

• However, A reacts by producing a higher quantity of A2, on the assumption that B will

stay at the level B1.

• Now firm B reacts by producing its quantity at B2.

• This adjustment will continue until point e is reached.

 Consider the following numerical example.
• Find the Cournot’s equilibrium if the market demand and the costs
of the duopolists are:

• P =100 – 0.5X where X = X1+X2

• C1 = 5 X1 and C2 = 0.5 X22

• Step 1: Define the profit functions of the two firms.

• Firm 1’s profit is given by π1 = P X1 – TC1

= [100 – 0.5 (X1+X2)] X1 – 5 X1

= 100 X1 – 0.5 X12 – 0.5 X1X2 – 5 X1

= 95 X1 – 0.5 X12 – 0.5 X1X2

• Firm 2’s profit is given by Õ2 = P X2 – TC2

= [100 – 0.5 (X1+X2)] X2 – 0.5 X22

= 100 X2 – 0.5 X1X2 – 0.5 X22 – 0.5 X22

= 100 X2 – 0.5 X1X2 – X22

• Step 2: Maximize the profit function of each firm with respect to its own
output (find the reaction function of each firm).

• Profit maximization Þ ¶Õ1/¶X1 = 0 and ¶Õ2/¶X2 = 0

• ¶Õ1/¶X1 = 95 – X1 – 0.5 X2 = 0

• Þ 95 – 0.5 X2 = X1……………firm 1’s reaction function [eq.1].

• ¶Õ2/¶X2 = 100 – 2 X2 – 0.5X1 = 0

• Þ X2 = 50 – 0.25X1……. firm 2’s reaction function [eq.2].

Step 3: Solve equations 1&2 simultaneously X1+X2 = 80+30 = 110.
to find equilibrium quantities of the two • Þ The market (equilibrium) price is P
firms. =100 – 0.5X = 100 – 0.5(110) = 45.
• X1 = 95 – 0.5X2  The profit of each duopolist is
• X2 = 50 – 0.25X1 Firm 1 profit = R1-C1 = P*X1- 5X1 =

• Þ X1 = 95 – 0.5(50 – 0.25X1) 45*80- 5*80 = 3200

• X1 = 95 – 25 + 0.125X1 Firm 2 profit = R2-C2 = P*X2- 0.5X22 =

45*30- 0.5*302 = 900
• X1– 0.125X1 = 70
Total industry profit = 3200+900 = 4100
• 0.875 X1 = 70
• Note that whether the quantities supplied
• X1 = 80
by the firms are equal or not depends on
• And X2 = 50 – 0.25X1 = 50 – 0.25(80) = 50
whether they face the same cost structure
–20 = 30
or not.
• The total output in the market is X =
 Critiques of the Cournot’s Model

1. It is assumed that firms do not learn from past miscalculations of

competitors’ reactions.

• Firms are assumed so naïve that each assumes that its rival will keep its
output constant from time to time though its assumption doesn’t
materialize.

2. It is a closed model in the sense that entry is blocked.

• The number of firms assumed in the first period (two) remains the same
throughout the adjustment process.

3. Even if it does not impair (take away) the validity of the model, the
assumption of zero production costs is unrealistic.

4. Variables of competition other than quantity are not included in the model.
 3. Stackelberg’s Duopoly Model
• This model was developed by Heinrich von Stackelberg and is an extension of

Cournot’s model.

• Unlike the Cournot’s model, where firms are naïve (do not recognize their

rivalry) and where the two firms make their output decisions at the same time,

under Stackelberg’s model, (at least) one of the two firms is sufficiently

sophisticated to recognize that its competitor is naïve and thus sets its output

before the other.

• Consider the example below (which is the same as the example under Cournot’s

model).

• Assume that in a duopoly market the demand function is P =100 – 0.5(X 1+X2)

and the duopolists’ costs are C1 = 5 X1 and C2 = 0.5 X22.

• 1. Stackelberg’s solution with firm 1 being the sophisticated leader:

• Firm 1 knows the reaction function of firm 2, substitutes this reaction

function into its own profit function, and maximizes its profit as if it
were a monopolist.
• Step 1: Reaction function of firm 2:

• Õ2 = P X 2 – C 2

• = [100 – 0.5 X1 – 0.5X2] X2 – 0.5 X22

• = 100 X2 – 0.5 X1X2 – 0.5 X22 – 0.5 X22

• = 100 X2 – 0.5 X1X2 – X22

• ¶Õ2/¶X2 = 100 – 2 X2 – 0.5 X1 = 0.

• Þ X2 = 50 – 0.25X1 firm 2’s reaction function

• Step 2: Substitute this into firm 1’s profit function and maximize.

• Õ1 = P X1 – C1 = [100 – 0.5 (X1+X2)] X1 – 5 X1

• = 100 X1 – 0.5 X12 – 0.5 X1X2 – 5 X1

• = 95 X1 – 0.5 X12 – 0.5 X1X2

• Þ Õ1 = 95 X1 – 0.5 X12 – 0.5 X1 (50 – 0.25X1).

• = 95 X1 – 0.5 X12 – 25 X1 + 0.125 X12

• = 70X1 – 0.375 X12

• Þ¶Õ1/¶X1 = 70 – 0.75 X1 = 0 ÞX1 = 280/3. (Check the second order condition)

• Step 3: Firm 2 would assume that firm 1 produces 280/3 units; thus substitutes
this amount into its reaction function and produces:

• X2 = 50 – 0.25X1 = 50 – 0.25(280/3) = 80/3 units.

• Þ Õ1 = 70X1 – 0.375 X12

• = 70(280/3) – 0.375(280/3) 2 = 3267.

• Þ Õ2 = 100 X2 – 0.5 X1X2 – X22

• = 100 (80/3) – 0.5 (280/3)(80/3) – (80/3) 2 = 711.

• What is the price charged per unit of output?

• P =100 – 0.5(X1+X2) = 100 – 0.5 (280/3 + 80/3) = 40

2. If firm 2 is assumed to be the Stackelberg’s sophisticated leader:

• X2 =35, X1 = 77.5, Õ2 = 918.75, Ï1 = 3003.

• What is the price charged per unit of output?

• What happens if each firm knows the reaction function of the competitor? In this case,

each firm (duopolist) estimates the maximum profit it would earn (a) if it acted as leader,

(b) if it acted as follower, and chooses the behavior which yields the largest maximum

profit.

 Determinate equilibrium results if one of the two firms wants to be leader and the other

wants to be follower.

 If both firms desire to be followers, their expectations do not materialize.

• One of the rivals must alter its behavior and act as a leader, or the Cournot’s equilibrium

will be reached if each duopolist recognizes that its rival also wants to be follower.

 If both firms want to be leaders disequilibrium arises, whose outcome, according to

Stackelberg, is economic warfare.

• Equilibrium will be reached either by collusion, or after the ‘weaker’ firm is eliminated

or succumbs to the leadership of the other.

 4. Bertrand’s Duopoly Model

• Bertrand’s duopoly model (which was developed in 1883) differs from Cournot’s in

that it assumes that firms choose to compete by setting prices instead of quantities.

• Each firm is faced by the same market demand, and aims at the maximization of its

own profit on the assumption that the price of the competitor will remain constant.

• Like the Cournot’s model, it applies to firms that produce the same (homogeneous)

good and make their decisions at the same time.

• Thus, if the two firms charge different prices, the lower-price firm will supply the

entire market and the higher-price firm will sell nothing.

• Because the good is homogeneous, consumers purchase only from the lowest-price

seller.
• If both firms charge the same price, consumers will be indifferent as to

which firm they buy from.

• And, the model assumes that each firm will supply half the market.

• Consider the following example where the market demand for a good is P

= 30 – Q(where Q = Q1+Q2) and both firms have a marginal cost of 3 (MC1

= MC2 = 3).

• If the two firms charge the same price of 5 Birr, each could get a per unit

margin of Birr 2.

• However, at least one will have the incentive to cut price and undersell the

other.

• This means P = 5 will not be a stable (an equilibrium) price.

• In general, as long as price is above the MC, there will be an incentive
to reduce price and thus, the equilibrium will be the competitive
outcome – where price equals marginal cost.

Ø Equilibrium price P* = MC = 3.

 Equilibrium quantity Q* is obtained by substituting P = 3 into the

market demand.:

• P = 30 – Q Þ 3 = 30 – Q Þ Q* = 27.

 Each firm supplies 27/2 = 13.5 units (Q1 = Q2 = 13.5).

• Bertrand’s model is criticized on the same grounds as that of Cournot’s

(critics 1and 2 under Critiques of the Cournot’s Model) and on its
assumption of the equal market share of total sales by the firms.
• It is more natural to compete by setting quantities rather than prices when firms produce

a homogenized good.

• Price competition is more natural when products have some degree of differentiation

than when products are identical. [Bertrand’s model didn’t go so far to include product

differentiation; this is an extension].

• To illustrate this, assume that the duopolists have fixed costs of 10 and 15 (i.e., TFC 1 =

10 and TFC2 = 15), marginal costs of 3 and 2 (i.e., MC1 = 3 and MC2 = 2), and the

demand functions are given below.

q Q1 = 12 – 2P1 + P2 (firm 1’s demand function)

q Q2 = 24 – 4P2 + 4P1 (firm 2’s demand function)

q MC1 = 3 Þ TVC1 = 3Q1 and MC2 = 2 Þ TVC2 = 2Q2

q Þ TC1 = 3Q1 + 10 and TC2 = 2Q2 +15.

• The equilibrium of the two firms setting their prices at the same time will
be determined as follows:
Step 1: Define the reaction functions of the firms by first defining their
profit functions.

• Firm 1’s profit: Õ1 = TR1 – TC1 = P1Q1 – (10 + 3 Q1)

= P1 (12 – 2P1 + P2) – [10+3(12 – 2P1+ P2)]

= 12 P1–2P12 + P1P2 –10 – 3 (12 – 2P1+ P2)

= 12 P1–2P12+ P1P2 –10 – 36 + 6 P1 – 3 P2

= 18 P1–2P12 + P1P2 – 3 P2 – 46

• Õ1 is maximized when¶Õ1 /¶P1 = 0 Þ18 – 4P1 + P2 = 0

• Þ P1 = 4.5 + 0.25 P2… (Eq.1). [Firm 1’s reaction function]

• Firm 2’s profit: Õ2 = TR2 – TC2= P2Q2 – (15 + 2Q2)

• = P2 (24 – 4P2 + 4P1) – [15 + 2(24 – 4P2 + 4P1)]

• = 24P2 – 4P22+ 4P1P2 –15 – 2(24 – 4P2 + 4P1)

• = 24P2 – 4P22+ 4P1P2 –15 – 48 + 8 P2 – 8 P1

• = 32P2 – 4P22 + 4P1P2 – 8 P1 – 63

• Õ2 is maximized when ¶Õ2/¶P2 = 0 Þ 32 – 8P2 + 4P1 = 0

• Þ P2 = 4 + 0.5 P1… (Eq.2). [Firm 2’s reaction function]

Step 2: Solve the two reaction functions simultaneously.

• P1 = 4.5 + 0.25 P2

• P2 = 4 + 0.5 P1
Þ P1 = 4.5 + 0.25 (4 + 0.5 P1)

Þ P1 = 4.5 + 1 + 0.125 P1

Þ P1 – 0.125 P1 = 5.5

Þ 0.875P1 = 5.5

Þ P1 = 5.5/0.875 = 44/7 » 6.29.

Þ P2 = 4 + 0.5 P1 = 4 + 0.5 (44/7) = 50/7 » 7.14.

Step 3: Substituting P1 = 44/7 and P2 = 50/7 into the demand functions gives:

Þ Q1 = 12 – 2(44/7) + 50/7 = 46/7 and

Þ Q2 = 24 – 4(50/7) + 4 (44/7) = 144/7

• Find the profit of each firm!

• The following figure depicts the reaction curves of the firms and
their equilibrium quantities.
 B. Collusive Oligopoly

• One way of avoiding the uncertainty arising from oligopolistic

interdependence is to enter into collusive agreements.

• There are two main types of collusion:

 cartels and price leadership.

• These forms may represent (imply) tacit (secret) agreements or

open collusion.

• It is usually the case that cartels are overt (open) and formal

while price leadership is tacit.

 1 Cartels
 Cartel is an organization of suppliers of a commodity aimed at
restricting competition and increasing profits.

• It may take open form of collusion, the member firms entering into
an enforceable contract pertaining to price and possibly other
variables.

• On other words, a cartel may be formed by secrete collusion among

sellers.

• There are two typical forms of cartels:

 Cartels aiming at joint-profit maximization, and

 Cartels aiming at the sharing of the market.

A. Cartels Aiming at Joint-Profit Maximization (Centralized Cartels)

• In this form of cartel, the aim is to maximize the industry (joint) profit.

• The situation is identical with that of a multi – plant monopolist who seeks the

maximization of his profit.

• Consider a pure oligopoly – an oligopoly where all firms produce a

homogeneous product. (This is often the case with centralized cartels).

• The firms in the cartel appoint a central agency to which they delegate the

authority to decide on:

- The total quantity to be produced by the industry,

- The price at which the output is sold,

- The allocation of production, and

- The distribution of the maximum joint-profit among the members.

• To do this, the central agency has to assess the cost structure of the
industry (and firms) and the market demand.
• For the simple case of two firms (duopoly), the equilibrium is
determined as follows:

• Given P = f (X)…demand function [where X = X1 + X2]

• C1 = f (X1) and C2 = f (X2)…cost functions of the two firms.

• First Order Condition (F.O.C): MR = MC1 = MC2

• Second Order Condition (S.O.C): ¶2 Õ1/¶ X1< 0 and ¶2 Õ2/¶X2< 0

• Note that these conditions are the same as the conditions for
profit-maximizing multi-plant monopolist.
 Consider the following numerical example.

q Market demand: P =100 – 0.5X where X = X1+X2

q Costs of the colluding firms: C1 = 5 X1 and C2 = 0.5 X22

• Maximize Õ= Õ1 + Õ2 = TR1+TR2 – TC1– TC2 = P (X1+X2) – C1 – C2

= [100 – 0.5 (X1+X2)] (X1+X2) – 5 X1 – 0.5 X22

= 95 X1+100 X2 – 0.5 X12 –X1X2 – X22

• Profit maximization Þ ¶Õ1/¶ X1 = 0 and ¶Õ2/¶ X2 = 0 [Or you may use

the condition: MC1 = MR and MC2 = MR].

• ¶Õ1/¶X1 = 95 – X1 – X2 = 0 Þ 95= X1+ X2 …………(1)

• ¶Õ2/¶X2 = 100 –X1– 2 X2 = 0 ÞX1+ 2X2 = 100. …………(2)

Solving equations 1&2 simultaneously gives: X1 = 90 and X2 = 5

• The total output of the cartel is X = X1+X2 = 90+5 = 95.

• Þ The market (equilibrium) price is: P =100 – 0.5X = 100 – 0.5(95) =

52.5. (Check the second order conditions by yourselves!).
• Find the profit of the cartel.

• Õ = Õ1 + Õ2 = 95 X1+100 X2 – 0.5 X12 –X1X2 – X22

• = 95(90) + 100(5) – 0.5 (90)2 –90*5 – (5)2 = 9050 – 4525 = 4525

• {Note that this profit is greater than the sum of Õ1 & Õ2 if the firms were
to act independently}.
• In practice, however, this monopoly equilibrium (maximization of
industry profit) may not be achieved.
• In other words, there are factors that militate against the achievement of
the joint-profit maximization of the cartel.
• These reasons include:

1. Mistakes in the estimation of market demand and costs.

• The central agent might commit mistakes while estimating and
aggregating the demands and costs of individual firms.
• Or, the firms may purposely report incorrect figures to influence their
shares of total profit.
• 2. Slow process of cartel negotiations. By the time agreement is reached
market conditions may have changed, and the chosen quantity and price
may no more be those that result in monopoly profit.
• 3. Fear of government interference. The cartel may purposely under
operate not to attract the eyes of the government particularly if the
monopoly price yields too high profits.
• 4. Fear of entry. The fear of attracting new firms to the industry by too
high profits is another reason why monopoly profit may not be realized.
• 5. Stickiness of the negotiated price. Even if the cartel is aware of
changes in market conditions, it needs new negotiation to change the
already agreed on price (and quantity) so that profit deviates from the
monopoly profit.

B. Market – Sharing Cartels

• In this type of cartel, firms agree to share the market, but keep a

considerable degree of freedom concerning the style of their product,

their selling activities and other decisions.

• Thus, this type of collusion is more common than centralized cartel.

• There are two basic methods for sharing the market: non-price
competition and determination of quotas.
i. Non-Price Competition Agreements
• The member firms agree on a common price, at which each firm can sell
any quantity demanded.
• The price is set by bargaining, with the low-cost firms pressing for a
lower price and the high-cost firms for a higher price.
• The agreed on price must be such as to allow some profits to all
members.
• The firms agree not to charge a price below the cartel price, but they are
free to vary the style of their product and/ or their selling activities.
• This form cartel is indeed ‘loose’ in the sense that it is more
unstable than the complete cartel aiming at joint profit
maximization.

• If all firms have the same costs, the cartel could be stable.
• With cost differences, the cartel will be inherently unstable,
because the low-cost firms will have a strong incentive to cheat
the other members by cutting their prices secretly.
ii. Sharing of the Market by Agreement on Quotas

• Firms may make agreement on quotas, i.e. the quantity that each firm may sell at

the agreed on price.

• If all firms have identical costs, the monopoly solution will emerge with the market

being shared equally among the members.

• If costs are different, the final quota of each firm depends on the level of its costs as

well as on its bargaining skill.

• During the bargaining process two main statistical criteria are most often adopted:

past levels of sales and productive capacity.

• Another popular method of sharing the market is the definition of the region in

which each firm is allowed to sell.

• In this case of geographical sharing of the market, the price as well as the style of

the product may differ.

Price Leadership

• Price leadership is a coordinated behavior of oligopolists where one firm

sets the price and the others follow it because,

 It is advantageous to them or

 They prefer to avoid uncertainty about their competitors’ reactions even

if this implies departure of the followers from their profit-maximizing

position.

• Price leadership allows the members complete freedom regarding their

product and selling activities and thus is more acceptable to the

followers than a centralized cartel, which requires the surrendering of all

freedom of action to the central agency.

• The prices charged may differ for different firms (particularly if
the product is differentiated), but the direction of their changes
will be the same.
• There are various forms of price leadership. The most common
types of leadership are:
• A. Low-cost price leadership
• B. Dominant-firm price leadership
• C. Barometric price leadership
A. Low – Cost Price Leadership

• The important condition for this model is that firms have unequal costs.

• It is assumed that there are two firms that produce a homogeneous product
at different costs, which clearly must be sold at the same price.

• Then, the firm with low cost charges a lower price and its price will be
followed by high-cost firm although the price doesn’t maximize the profit
of the follower.

• The follower would obtain a higher profit by producing a lower output and
selling it at a higher price.

• But the follower prefers to follow the leader sacrificing some of its profit in
order to avoid a price war, which would eliminate it if price fell sufficiently
low as not to cover its LAC.
• Although it is stressed that the leader sets the price and the follower
adopts it, it is clear that the firms must also enter a share-of-the-market
agreement, formally or informally.
• Otherwise, the follower could adopt the price of the leader but produce a
lower quantity than the level required for maintaining the price in the
market, and thus indirectly push the leader to a non profit- maximizing
position.
• Consider the following numerical example:

• Market demand: P = 105 – 2.5X; X = X 1 + X2,

• Costs: C1 = 5X1and C2 = 15X2

• The leader will be the low-cost firm, firm 1. Firm 1 assumes that the
rival firm will produce an equal amount of output to its own, i.e., X 1 = X2.
• The relevant demand function to the leader will be:

• P = 105 – 2.5(X1 + X2); but X1 = X2

• P = 105 – 2.5(X1 + X1)

• P = 105 –5X1

• The low-cost leader (firm) will set the price that maximizes its own profit.

• Õ1 = R1 – C1 Þ P X1 – C 1 Þ(105 –5X1) X1 –5X1

• =105 X1–5X12 – 5X1 Þ 100 X1–5X12

• F.O.C: ¶Õ1/¶X1= 100 – 10X1 = 0. Þ100 = 10X1 Þ X1 = 10.

• S.O.C: 2¶ Õ1/¶X1 = –10 < 0

• P = 105 – 5X1 = 105 –5(10) = 55

• The follower will adopt the same price (55) and will sell an equal level of
output (X2 = 10).
• Note that the profit- maximizing output of firm 2 would be X2 = 9 units, and

• it would sell it at P* = 60, which is found by maximizing firm 2’s profit

function if it could act the same way as firm 1.
 The firms may agree that they are going to share the market in constant
proportions in which case we drop our earlier assumption of equal share of the
market.
• Consider two firms with shares k1 and k2.

• k1 = X1/X …………….(1) and

• k2 = X 2/X …………….(2)

• Dividing (1) by (2) gives k1/k2 =X1/X2

Þ X1 = k1/k2 * X2 …………………. Reaction function of firm 1.

Þ X2 = k2/k1 * X1 …………………. Reaction function of firm 2.

• Assume that:

• q k1 = 2/3 and k2 = 1/3………Shares

• q P1=100-2X1-X2…………….firm 1’s demand function

• q C1=2.5X12………………….firm 1’s cost function

• q The firms agreed that firm 1 would be the low-cost leader.

Solution:

• Step 1: p1=R1 – C1 = (100 – 2X1 – X2) X1 – 2.5X12

• Step 2: Substitute the reaction function of firm 2, X 2=

, to obtain the profit function of the leader.

Þp1 = R1– C1 = (100 – 2X1 – 0.5X1) X1 –2.5X12 =100X1 – 5X12

• Step 3: Maximize the leader’s profit:

• ¶Õ1/¶X1 = 100 – 10X1 = 0. Þ100 = 10X1 Þ X1 =10.

• The leader will set the price P1 =100 – 2X1 – X2

• =100 – 2X1 – 0.5X1

• =100 – 2.5X1

• =100 – 2.5(10) =75

• Step 4: The quantity which will be produced by the follower is X2 = 0.5X1 = 5

and he will sell it at the price of the leader P1 = 75.

B. The Dominant – Firm Price Leadership

• In this model, it is assumed that there is a large dominant firm

that has a considerable share of the market, and some smaller
firms, each of them having a small market share.

• It is also assumed that the dominant leader knows the total supply

by the smaller firms at each price (S1 in panel (a) of the figure

below), and the market demand curve D.

• With this knowledge, the leader can obtain his own demand curve

(DL) by calculating the difference between the total demand D

and the total supply by the smaller firms S1 at each price level.
• The dominant firm leader maximizes his profit by equating his MCL to his

MRL (sets price P* and sells quantity X*) - panel (b).

• The smaller firms are price-takers, and may or may not maximize their profits,
depending on their cost structure.

• This model is also called ‘the partial monopoly’ model since the large firm
acts as a monopolist while the small firms are price-takers and act like firms in
pure competition.

• Consider the following numerical example.

• q Market demand: D = 50 - 0.3P

• q Aggregate supply of the smaller firms: S = 0.2P

• q Total cost function of the leader firm: CL = 2X

• Step 1: The demand of the dominant firm: X = D – S

• Þ X = 50 – 0.3P – 0.2P

• Þ X = 50 – 0.5P

• Or P = 100 – 2X

• Step 2: pL =RL – CL = (100 – 2X) X – 2X = 100X – 2X2 – 2X = 98X – 2X2

• Step 3:¶ÕL/¶X = 98 – 4XL = 0. Þ98 = 4XL Þ XL = 24.5.

Þ The leader will set the price P = 100 – 2X = 100 – 2 (24.5) = 51

Þ The total quantity demanded D = 50 – 0.3 (51) = 34.7.

• The leader supplies X = 24.5 out of the total and the smaller firms produce the remainder

(= 34.7 – 24.5 = 10.2). (Alternatively: S = 0.2(P) = 0.2 (51) = 10.2).

• Similar to the low-cost price leader, the dominant firm leader must make sure that the

smaller firms will not only follow his price but also produce the right quantity – the

quantity that will not push him to a non-profit-maximizing position.

• Thus, there should be tight (formal or informal) sharing-the-market agreement between

(among) firms where price leadership is the form of collusion.

• In order to have the power to impose its price the leader must be both a low – cost and a

large firm. Þ the power of the leader depends both on its costs and its size.

• If a firm has low costs but is very small (compared to some other firm –leader), it may

not find it possible to survive a price, or advertising or product – design war that the

dominant firm may start.

• On the other hand, if the dominant firm loses its cost advantage, it loses also its power

to impose an increase in price, since the smaller firms, having lower costs, will

normally not follow it in price increases.

C. Barometric Price Leadership

• In this model it is formally or informally agreed that all firms will follow (exactly or

approximately) the changes of the price of a firm which is considered to have a good

knowledge of the prevailing conditions in the market and

• can forecast the future developments in the market better than others.

• In short, the firm chosen as the leader is considered as a barometer, reflecting the

changes in economic environment.

• Usually it is a firm which has established the reputation of a good forecaster of

economic changes from past behavior.

• A firm belonging to another industry may also be chosen as the barometric leader.

• Barometric price leadership may be established for various reasons.

1) Rivalry between several large firms in an industry may make it impossible to accept one

among them as the leader.

2) Followers avoid the continuous recalculation of costs, as economic conditions

change.

3) The barometric firm usually has proved itself as a ‘reasonably’ good forecaster of

changes in cost and demand conditions in the particular industry (or the

economy as a whole), and by following it the other firms can be ‘reasonably’

sure that they choose the correct price policy.

• According to empirical studies, barometric price leadership occurs frequently as

a response to a period of violent price fluctuation and cutthroat competition in an

industry, during which many firms suffer and greater stability is widely sought.
 Contestable Markets
• According to the theory of contestable markets developed during the 1980s, even if

an industry has only a few sellers (or perhaps only one),

 it would still operate as if it were perfectly competitive if entry is “absolutely free”

(i.e., if other firms can enter the industry and face exactly the same costs as

existing firms) and

 if exit is “entirely costless” (i.e., if there are no sunk costs so that the firm can exit

the industry without facing any loss of capital).

• Firms will sell their products at a price that only covers their average total costs (so

that they earn zero economic profit) even if there are only a few firms in the market.
• The firms in a contestable market, like those under perfect competition, will

produce at minimum cost.

• If they produce at more than minimum cost, firms will enter the industry,

produce at lower costs than the existing firms, undercut the existing firms’

price, and make a profit.

• Thus, costs will be pushed down to the minimum level.

• Also price cannot exceed marginal cost.

• If existing firms are charging a price in excess of marginal cost, it is profitable

for an entrant to undercut the price of the existing firms.

• Thus, for an equilibrium to occur price cannot exceed marginal cost.

• The existing firms do not collude to push up price because they know that new

firms would enter the market very quickly and undercut their price.
 CHAPTER TWO: PRICING OF FACTORS OF
PRODUCTION AND
INCOME DISTRIBUTION

• In this chapter, we turn our focus to the factor (resource) market and

deal with the determination of prices and employment of inputs, and

relatedly the distribution of income to their owners.

• In many ways the determination of input prices and employment is

similar to the pricing and output determination of commodities.

• That is, the price and employment of an input is generally determined

by the interaction of the forces of market demand and supply.

• The factor of production are categorized into four groups:
land, labor, capital, and entrepreneurship.

• The prices of these factors were called rent, wage, interest and
profit respectively.

• The determination of wages and other factor earnings in a

market economy is analytically identical to the determination
of product prices.

• Firms have a demand for factor inputs because of what they

can produce.

• The demand for factors of production is a derived demand.

• The determination of factor prices differs from one to

another market structure.

• As a result, we will first examine the determination of

factor prices in perfectly competitive product and input

markets and imperfect markets.

• Note that to simplify our analysis we take only labor

and the analysis represents other inputs.

2.1. Factor Pricing Under Perfect Competition

• determining input price and employment when both factor (input)

and product (output) markets are perfectly competitive.

• In a perfectly competitive product and input markets price is

determined by the interaction of demand and supply (market

forces).

• The interaction market demand for and the market supply of an

input determine the input’s price and level of employment.

2.1.1 The Demand for Factors of Production

i. The Demand of a Firm for One Variable Productive Factor

• The demand for an input by a firm shows the quantities of the input that

the firm would hire at various alternative input prices, ceteris paribus.

• Here, we assume that only one input is variable (i.e., the amount used

of the other inputs is fixed and cannot be changed).

• According to the marginal concept, a profit-maximizing firm will

continue to hire an input as long as

 the extra income (receipt) from the sale of the output produced by the

input is larger than the extra cost of hiring the input.

• The extra income is given by the marginal (physical) product (MPP) of the

input times the marginal revenue (MR) of the firm.

• This is called the marginal revenue product (MRP). That is, MRP = [Link].

• When the firm is a perfect competitor in the product market, its marginal

revenue is equal to the commodity price.

• In this case the marginal revenue product MRP = MPP. P = VMP (the value of

marginal product).

• If the variable input is labor, MRPL = MPPL. P = VMPL.

• The extra cost of hiring an input or marginal expenditure (ME) is equal to the

price of the input if the firm is a perfect competitor in the input market.
• Perfect competition in the input market means that the firm demanding

the input is too small, by itself, to affect the price of the input.

• In other words, each firm can hire any amount of the input (service) at the

given market price for the input.

• Thus, the firm faces a horizontal or infinitely elastic supply curve for the

input.

• For example, if the input is labor, this means that the firm can hire any

quantity of labor time at the given wage rate.

• Thus, a profit-maximizing firm should hire an additional unit of labor as

long as the MRPL exceeds the marginal expenditure on labor or wage rate

(w).
• Profit is maximized at a point where MRP L (= VMPL in this case) =

MEL (= w in this case).

• Mathematically, max p = R – C where R = PX. X and

C = wL + F; F = fixed cost.

Þ dp / dL = d(PX .X - w. L - F)/dL

= PX*dX /dL – w* dL/dL = 0. Þ PX . MPPL = w . ÞVMPL = w.

• A rational firm operates in the second stage of production where the

MPPL is declining but positive.

• Multiplying this MPPL by a fixed output price gives a downward

sloping MRPL curve as in Figure below.

• Given this MRPL and the equilibrium condition MRPL = VMPL = w, the

firm hires L1 units of labor if the wage rate is w1.

• Similarly, L2 units of labor will be hired at w2 and L3 at w3.

• At e1, VMPL = w1. Þ The firm’s profit is at the maximum for wage rate

w1.

• To the left of e1, VMPL > w1. Þ The firm would increase its profit by
hiring more labor.

• The opposite holds to the right of e1. That is, the firm would increase its
profit by reducing the amount of labor it uses.
• The graph that shows this relationship between the wage rate (input price)
and the quantity demanded (hired) of labor (input) is the demand curve
(Figure below).
• Thus, the demand for a single variable input is the value of marginal
 ii. The Demand of a Firm for a Variable Factor when there are Several

Variable Inputs

• When there are more than one variable factors of production, the VMP curve

of an input is not its demand curve.

• This is because various resources are used simultaneously in the production

process so that a change in the price of one factor leads to changes in the

employment (use) of the other factors.

• This in turn shifts the marginal (physical) product curve of the input whose

price is initially changed.

• Let’s assume that the price of labor (the wage rate) falls.

• Then this has three effects: a substitution effect, an output effect, and a
• Initially, the firm produces a profit – maximizing output X1 with a

combination of L1 and K1, given factor prices w and r whose ratios are
defined by the slope of the iso-cost line BC (Figure 4.3).
• When wage rate falls the iso-cost BC changes to BC* and this new iso-
cost (BC*) is tangent to the iso-quant corresponding to output level of
X2 at e2. K2 units of capital and L2 units of labor are used.

• This movement from e1 to e2 can be split into two: substitution effect

and output effect.
• To see the substitution effect draw an iso-cost line (B*C**) parallel to
the new iso-cost line (BC*) but tangent the old iso-quant (X1).

• The movement from e1 to a is the substitution effect.

• This shows that the firm substitutes the cheaper labor for the relatively

more expensive capital even if it were to produce the original level of

output (X1).

• Thus, the employment of labor will rise from L1 to L1*.

• But when wage rate falls, the firm can hire more of the two factors (L

and K) with the same expenditure.

• Hence, the firm produces higher level of output with more labor and

capital (L2 and K2) and, therefore, the movement from a to e2 is the

output effect.

• Point e2 is not the final equilibrium of the firm because keeping the total

cost /expenditure constant doesn’t maximize its profit.

• The fall in wage rate results in a shift in the marginal cost curve downward
to the right (from MC1 to MC2) and the profit maximizing output of the firm
increases from X' to X".
• Thus, the isocost line BC* must shift upward parallel to itself.
• So, the final equilibrium is when isocost bl is tangent to the highest possible
isoquant (X3) at point e3. The movement from e2 to e3 is the profit effect (or the
profit-maximizing effect).
• The substitution effect of a decline in wage rate causes a decline in the marginal
physical product of labor (as it increases the units of L and reduces that of K).
• The output and profit effects result in rise in the amounts of both labor and capital
used.

• Both effects cause the MPPL to shift upward and to the right (increase the MPPL
at a given level of employment).
• The output and profit effects more than offset the substitution effect so that the
final result of a fall in wage rate is an increase (and rightward shift of) the MPP L
(curve).
• Given the price of the final commodity PX, the VMPL also shifts to the
right as depicted in Figure 4.5 below.
• At the initial wage rate w1, L1 units of labor are employed (which is

determined by the intersection of VMPL 1 and the supply w1).

• The new equilibrium demand for L (when wage rate falls to w 2) is at point

B on VMPL2.

• If w further declines to w3, the new equilibrium will be at point C.

• The locus of points A, B and C is the demand curve for labor by the firm

when several variable factors are used.

• In this case, the demand for an input is not the same as its VMP curve, but

derived from changing (shifting) VMP curves.

Demand for a variable factor depends on:

§ The price of the input – increase in input price reduces the quantity

demanded of the inputs services, and vice versa.

§ The marginal physical product of the factor – if the MPP of a factor

increases, more of it will be demanded, and vice versa.

§ The price of the output (commodity) – when the output the firm produces

becomes cheaper, the firm will cut its production and thus demands less of

the input used. The opposite happens when the commodity gets more

expensive.
§ The amount of other factors which are combined with the factor

§ The price of other factors – increase in prices of complementary

inputs reduces the amount of the complementary inputs to be used

with a given productive factor, and thus reduces the productivity of

(and demand for) the productive factor.

§ Technological progress – technological progress could increase or

decrease the demand for an input depending on whether it increases

or decreases the MPP of the factor.

iii. The Market Demand Curve for an Input

• The market demand curve for an input is derived from the individual firms’

demand curves for the input.

• But it is not the simple horizontal summation of the individual firms’

demand curves for the input.

• This is because when the price of an input (say labor) falls, not only this

firm but also other firms will employ more of this factor and

other(complementary) inputs to expand production. Thus, the supply of the

final commodity increases and its price falls (See Figure 4.6).
• If the input price (say wage rate) falls and more of it is used, the supply of the

commodity increases (shifts from SX1 to SX2).

• This derives down the equilibrium price of the product from P X* to PX**.
• Since the MRPL = MPL times MR (which is here equal to the

commodity price), the reduction in commodity price will cause each

firm’s MRP and demand curves for the input to shift down or to the left.

• The market demand curve for an input is then derived by the horizontal

summation of the individual firms’ demand curves for the input after the

effect of reduction in the commodity price has been considered. [See

Figure 4.7 below].

• If the fall in commodity price were not taken into account, it would led

to an overestimation of the market demand for labor (which joins points

A and B’).
 2.1.2 Factor Supply

i. The Supply of Labor

• Here we assume that labor is a homogeneous factor: all labor units are

identical.

• The main determinants of the market supply of labor are:

a) The price of labor (wage rate)

b) The tastes of consumers, which define their trade – off between leisure and

work

c) The size of population

d) The labor force participation rate

e) The occupational, educational and geographical distribution of the labor force.

• The relationship between the supply (decision) of labor and the wage rate defines

the supply curve.

• The other determinants (b – e above) can be considered as shift factors of the

supply curve.

• Since the market supply is the summation of the supply of labor by individuals, we

begin by the derivation of the supply of labor by a single individual.

A. The Supply of Labor by an Individual

• Labor is not (usually) owned by a business firm. It is provided by individuals.

• These individuals can use their labor either for working or for leisure.

• Hence, the supply of labor by an individual depends on the individual’s preference

for leisure and work.

• The preference of the individual between leisure and work (Þ income) can be
• The slope of the budget line represents wage rate per hour.

• When the wage rate is w1, the individual is in equilibrium by working AZ

hours(leisuring OA hours), earning AA’ income.

• If the wage rate increases to w2 the individual will work more hours (BZ > AZ), will

earn a higher income (BB’) and will have less hours (OB < OA) for leisure.

• The supply of labor will also increase when wage rate rises to w3. However, at some

higher wage rate the hours offered for work may decline.

• For example, if the wage rate rises to w4, the individual will work for DZ hours, which

is less than the supply at w3 (CZ) – panel (a).

• This pattern of response to higher wage rates produces a backward bending supply
• The reason that an individual’s supply of labor may be backward bending can

be explained by separating the substitution effect of wage rate change from the

income effect.

• Substitution effect: an increase in wage rate leads an individual to work more,

i.e., to substitute work for leisure.

• Thus, the substitution effect of the wage increase always operates to make the

individual’s supply of labor curve positively sloped.

• Income effect: an increase in wage rate raises the individual’s income, and

with a rise in income, the individual demands more of every normal good,

including leisure (i.e., supplies fewer hours of work).

• Thus, the income effect the wage increase always operates to make the

individual’s supply of labor curve negatively sloped.

• The substitution and income effects operate over the entire possible wage

rates, and

• the substitution effect overwhelms the opposite income effect at lower

wage rates while the negative income effect overwhelms the positive

substitution effect at higher wages implying a backward bending supply

of labor curve.

• Since individuals’ tastes differ, the wage rate at which an individual’s

supply curve of labor bends backward is likely to differ from individual

to individual.
• B. The Market Supply of Labor

• The market supply of labor is the summation of individual supplies

of labor.

• Although there is a general agreement that the supply curve of

labor by single individuals exhibits the backward bending pattern,

• but the market supply curve is usually not backward bending.

• This is because higher wage rates, even if induce some people to

work fewer hours, will also attract new workers into the market

and there is population growth (in the long run).

• ii. The Supply of Other Factors

• The supply of an input other than labor, say a raw material

or an intermediate good, is derived on the same principles
as the supply of any commodity.
• For example, the supply of capital is derived in much the
same way as the supply of maize – both are determined by
cost of production.
• Where the supply of an input to individual firm is infinitely
elastic, the market supply is not perfectly elastic even under
perfectly competitive market structure.
 4.1.3 Factor Pricing
• Given the market demand and the market supply of an input, its price is
determined by the intersection of the two curves.
• The equilibrium wage rate is w* and the employment level is L*.
 2.2. Factor Pricing in Imperfectly Competitive Markets

2.2.1. Monopolistic Power in the Product Market

• Assumptions:

• 1. The input market is perfect: the wage rate is given and the supply of labor to

the individual firm is perfectly elastic.

• 2. The firm has monopolistic power in the output market.

• This implies that the demand for the product of the firm is down –ward sloping

and the marginal revenue curve lies below the demand curve (MR < P) at all

levels of output.
• MRX < PX Þ MRX . MPPL < PX. MPPL Þ MRPL < VMPL
i. Demand of the Firm for a Single Variable Input

• The firm maximizes its profit with respect to the units of labor it employs.

• Given demand function PX = f1 (Q) and production function QX = f2 (L, K ),

where k is fixed.

• p = TR – TC Þ p = PX .QX – ( w . L+F)

• max p: F.O.C. dp/ dL = 0. Þ d (PX QX)/dL - d(w.L + F)/dL = 0 Þ MRPL –

w = 0 Þ MRPL = w

• S.O.C.: d2p/dL2 < 0

• So the firm maximizes its profit when it employs labor in such a way that
MRPL = w (i.e., l1e units of labor at wage rate w1, l2 e at w2, and l3 e at w3 in
the figure below).
 ii. Demand of the Firm for a Variable Factor when there are Several
Variable Factors
• When more than one variable factors are used in the production process the
demand for a variable factor is not its MRP curve, but it is formed from points of
shifting MRP curves. Consider Figure 4.12 below

• When the wage rate is w1, the equilibrium is at point A.

• If wage rate falls from w1 to w2, the firm moves from A to A’ along MRPL1 if every
thing remains constant.
• However, other things do not remain constant. The fall in wage rate has
substitution, output and profit effects.

• The net result of these effects is a shift in MRPL curve to the right which leads to
equilibrium at B. so, line AB is the demand for labor in case of several variable
factors.
• If the firm is a pure monopolist (the only seller for its product), then the

price of the final commodity is likely not to be affected, and in such cases

the market demand curve is the simple horizontal summation of individual

demand curves.

• The market supply is not affected by the fact that firms have monopolistic

power.

• Thus, the market supply of labor is the summation of the supply curves of

individuals, as derived earlier.

• The market price of the factor is determined by the intersection of the

market demand and the market supply.

 iv. Factor Pricing

• When firms have monopolistic power, the factor is paid its MRP, which is

smaller than the VMP. This effect is called monopolistic exploitation.

• It represents the difference between the amount a factor is paid under

perfect competition and the amount the same factor is paid under the

imperfection introduced here.

• If firms under the two scenarios have to use the same amount of labor (L2

in panel (a) of Figure 4.13) the firm in perfect competition pays a wage

rate of w1 while the other firm pays w2.

• w1 - w2 measures the level of monopolistic exploitation by the firm. The

same concept is depicted in panel (b),but at the market level.

 Monopsonistic Power in the Factor Market

• Assuming the only variable input to be labour, the demand for

labour by an individual firm is given by MRPL.

• However, the supply of labor to the individual firm is not

perfectly elastic, because the firm is large in this case.

• Suppose that the firm is the only buyer of the input (a

monopsonist).

• The supply of labor has a positive slope: as the monopsonist

expands the use of labor he/she must pay a higher wage.

• The supply of labor shows the average expenditure or price that the

monopsonist must pay at different levels of employment.

• Its slope is dw/dL which is greater than zero (dw/dL > 0).
• Multiplying the price of input by the level of employment gives the
total expenditure of the monopsonist for the input (TE L = w. L).

• TEL = w. L

• Þ AEL = TEL/L = w*L/L = w.

• Þ w = AEL = f (L)…………The supply of labor the monopsonist faces.

• The relevant magnitude for the equilibrium of the monopsonist is the
marginal expenditure of purchasing an additional unit of the factor.
q Since dw/dL > 0, L> 0 and w >0, it follows that MEL > w for any level
of employment (supply).

 The MEL has also a steeper slope than the supply curve – w (SL).
Assuming linear functions,
 The firm is in equilibrium when it equates the ME on labour to its MRP.

• Profit is maximized by employing Les units of labor for which MEL =

MRPL.
• The wage rate that the firm will pay for the Les units of labor is we –
defined by the supply curve.
• The wage rate and the employment of labour are lower than that of
perfect competition as well as that of monopoly market.
Ø wc = wage rate paid under perfectly competitive product and factor
markets.
Ø wm = wage rate paid under perfectly competitive factor market and
imperfectly competitive product market.
Ø ws = wage rate paid under imperfectly competitive product and factor
markets.
· wc > wm > ws (and Lc > Lm > Ls)
· wc – wm is monopolistic exploitation
· wc – ws is monopsonistic exploitation (wc – wm due to monopolistic
power in the product market and wm – ws solely due to monopsonistic
power in the factor market).
 Bilateral Monopoly

• Bilateral monopoly arises when a single seller (monopolist) faces a single buyer

(monopsonist).

• In this model, we assume that all firms are organized in a single body that acts like a

monopsonist, while the labor is organized in a labor union that acts like a monopolist (a

model in which the participants are two monopolies, one on the supply side and one on

the demand side).

• The solution to a bilateral monopoly situation is indeterminate.

• The model gives only the upper and lower limits within which the wage rate will be

determined by bargaining.

• The outcome of the bargaining cannot be known with certainty.

• It will depend on bargaining skills, political and economic power of the labor union and

the firms, and on many other factors.

• The monopsonost’s demand curve is Db, which is the MRPL.

• From the point of view of the monopolist (labour union) this curve represents its

average revenue curve (ARs).

• The seller’s (union’s) marginal revenue, MRs, is derived from the ARs and lies

below it.

• The supply of labour facing the monopsonist is the upward sloping curve, SL.

• This shows the average expense (average cost) of labour to the monopsonist.

Corresponding to this average cost curve is the marginal expenditure (MEL) curve.

• From the point of view of the monopolist (labour union), the MCs may be

considered its supply curve (assuming that it behaves as if it were a perfectly

competitive seller – it charges a single price for a given level of labour service).
• The monopsonist maximizes its profit at point F, where its

marginal expense on labour (MEL) is equal to the marginal

revenue product of labour (MRPL).

• Thus, the monopsonist desires to hire LF units of labour and to

pay a wage rate equal to wF.

• The monopolist (labour union), on the other hand, maximizes its

gains (profits) at point U, where its marginal cost (MCs) is equal

to its marginal revenue (MRs).

• Thus, the monopolist will want to supply LU units of labour and

to receive a wage rate equal to wU.

• The price desired by the monopsonist is the lower limit and

the price desired by the monopolist is the upper bound.

• The actual wage is between wF and wU, which is determined,

based on the bargaining skills (power) of the two parties.

• The stronger the monopolist, the closer the actual wage rate is

to wU; and the stronger is the monopsonist (the firms’

organization), the closer the actual wage rate is to wF.

 Income Distribution

• Income distribution is the study of the determination of the shares

of the factors of production in the total output produced in the

economy over a given time period.

• If, for simplicity, we assume that there are two factors of

production, L and K, their shares are defined as:

• Share of labour = w.L/X

• Share of capital =r.K/X

 Chapter 3: Market failure and the role of
government
3.1. Concept of market failure
• Market failure is a situation where an (idealized) market equilibrium
model appears to generate inefficiencies, so the welfare of some
economic agents can be improved without reducing the welfare of others.

• It occurs when the invisible hand pushes in such a way that individual
decisions do not lead to socially desirable outcomes.
• It was concluded that all competitive equilibria are Pareto-efficient, that
all welfare maxima are competitive equilibria, and that every competitive
equilibrium is a welfare maxima for some welfare function.
• Either the self-interest of the individual economic agents results in the

maximum social welfare or redistribution of economic resources via non-

distortional mechanisms results in a fair allocation given perfectly competitive

markets.

• However, the prerequisites for perfect competition are unlikely to hold in the

real world.

• At least some firms in an economy may (and do usually) have market power

and/or there usually exists a problem of asymmetric information.

• Market fails to produce the right amount of the product

• Resources may be

• Over-allocated

• Under-allocated

• Even a perfectly competitive market may fail because of externalities and/or public goods.

• Thus, markets generally fail for four reasons:

 market power

 public goods

 externalities

 incomplete information
 3.2. Causes of market failure
A. Externalities

• An externality is defined as the uncompensated impact of one person’s

actions on the well being of another who is not involved in the activity.

• Externality is said to exist when the production/consumption activities

of one party enter the production /consumption activities of other party,
without any payment for the effect.

• The market system (mechanism) is capable of achieving Pareto-

efficient allocations when there are no externalities.

• In the presence of externalities, however, market prices do not reflect

the activities of either producers or consumers.
• Externalities may be classified as consumption externalities and production
externalities.
• Each of these types may be negative (external costs) or positive (external
benefits).
• If the impact on the bystander is adverse, it is called a negative externality. If it
is beneficial, it is called a positive externality.
• Examples:

i. Negative consumption externalities (external diseconomies of consumption) –

uncompensated costs imposed on others by the consumption expenditures of
some individuals.

q Pollution produced by local automobiles,

q A smoker smoking a cigar next to an individual eating in a restaurant,

q Playing loud music in a neighbor hood, ---

ii. Positive consumption externalities (external economies of consumption) –
uncompensated benefits conferred on others by the increased consumption of a
commodity by some individuals.
q Pleasure from observing your neighbor’s flower garden
q Pleasure from listening to a slow music from your neighbor.
iii. Negative production externalities (external diseconomies of production) –
uncompensated costs imposed on others by the expansion of output by some firms.
q Water pollution by a steel industry for a fishery down the stream.
iv. Positive production externalities (external economies of production) –
uncompensated benefits conferred on others by the expansion of output by some
firms.
q An apple (a flower) orchard located next to a beekeeper – a bi-directional
externality where both the beekeeper and the owner of the orchard benefit.
• The crucial feature of externalities is that there are goods people care about that are

not sold on markets.

• It is this lack of markets for externalities that causes problems.

• Perfect competition leads to Pareto optimum only when private costs equal social

costs and when private benefits equal social benefits.

• However, if there are externalities, there is divergence between private and social

benefits and costs.

• The equilibrium condition for the private decision-maker is MPB = MPC (where

MPB = marginal private benefit and MPC = marginal private cost).

• For the society at large, an efficient allocation requires that MSB = MSC, (where

MSB = marginal social benefit and MSC = marginal social cost).

• Consider the case of positive externality in production as an example (where MPC =

MSC but MPB < MSB) – Figure below.

• The firm’s equilibrium is at point A where MPB = MPC (= MSC). Q P units of

output are produced and a price of PP is charged.

• If the uncompensated benefit the producer confers on others is to be taken

account of, the extra benefit is larger than the extra cost (MSB > MSC) at this
equilibrium level of output.
• The distance from A to C measures the marginal external benefit (MEB). Since
MSB (= MPB + MEB) > MPB at this point, output should be expanded to the
level where MSB = MSC (to point B) – where QS units are produced each to be

sold at PS.

• However, the firm is concerned only with its (private) marginal benefits and
costs. As MPC > MPB at QS, it will not expand output to this level and only QP is
produced.
• Thus, the commodity will be undersupplied in the presence of positive externality.
• Similarly, if a man takes an action that contributes to society’s welfare but

which results in no payment for him, he is certainly likely to take his

action less frequently.

• But, if the production of a certain good is responsible for external

diseconomies, more of this good is likely to be produced than is socially

optimal.

• Similarly, if a man takes an action that results in costs that he is not forced

to pay, he is certainly likely to take his action more frequently than is

socially desirable.
• In general, external economies (positive externalities) result in

production or consumption of commodities to a level less than socially

optimal, and

 external diseconomies (negative externalities) result in production or

consumption of commodities to a more than socially optimal level.

• With external diseconomies of consumption and production,

governments might try to intervene by directly limiting the level of

consumption and production (direct control) or with a tax on

consumers and producers ).

• On the other hand, with external economies of production and consumption,

Pareto optimum in production and consumption would require a subsidy on

producers and consumers.

• But the corrective tax or subsidy may have some unintended side effects that

lead to inefficiency.

• Alternatively, assignment of clearly defined and transferable property rights

could avoid externalities (and promote economic efficiency) – Coase theorem.

• According to Coase theorem, if property rights are well defined, one party (say

a firm – the producer of the externality) will compensate the victims

(consumers) in order to avoid the external cost.

• But this solution to externalities requires zero (or insignificant) transaction

costs.
 B. Public Goods
• Public Goods are goods that are available for all to consume, regardless of who pays
and who does not.

• Example: National Defence (pure public good), national TV, streetlights, sidewalks,
etc.

• All public goods must exhibit two characteristics:

– Non-rivalry

– Non-excludability

• Non-rivalry means that one person’s consumption of the good does not limit the
ability of someone else to consume the good.

– Example: A TV Show

• Non-excludability means that you can’t keep anyone from consuming the good.

• it is technically difficult to exclude others or the exclusion cost is very high.

– Example: Police Protection

• In such situations, usually, people are attempting to free ride on each other.

• The free-rider problem arises when a consumer or producer doesn't pay for a

non-excludable good in the expectation that others will.

• Consider cleaning your room (dormitory). Each of you may prefer to see the

living room clean and willing to do your part.

• But each may also be tempted to free - ride so that no one ends up cleaning

the room, with the result being messy room.

• This letting the other guy do it may be optimal from an individual point of

view, but it is Pareto – inefficient from the viewpoint of society at large.

 What is Special about Public Goods?

• The problem with public goods is getting people to fund them.

• Imagine if we expected everyone who wanted national defence to pay
for it.
• You might be tempted to let other people chip in for it and you get the
benefit.
• This behavior is called “free riding” and is endemic to the provision of
a Public Good
Free Rider Solutions
• Often we let the government provide public goods because they can
force people to pay for it via taxes
• Find ways to exclude people (scramble TV signals, private police, etc.)
 3. Market Power

• Market power: the ability of a firm to manipulate the price of a good in the market.

– Thus, the firm can restrict supply in order to maximize profits rather than produce

society’s desired mix of output.

• Imperfect information can lead to resource misallocation eg. firm does not accurately

determine price of key input (oil)

• Monopoly prices above those in competitive markets

– Loss of consumer surplus

– Output below competitive equilibrium level

– Loss of allocative & productive efficiency

• Government role

– Restrict market power.

– Promote more competition.

 Monopoly Power: Good or Bad?

• Monopolists may waste scarce resources

– High levels of advertising and marketing to increase brand

loyalty and build entry barriers

• Monopoly power can bring economic benefits:

– Exploitation of economies of scale

– Higher profits used to fund research & development, leading to

faster pace of innovation & gains in dynamic efficiency

– Greater ability to compete internationally as many domestic

markets have become more contestable

 D. Asymmetric Information

• Asymmetric information is a situation in which a buyer and a seller possess

different information about a transaction.

• There are certainly many markets in the real world in which it may be very costly or

even impossible to gain accurate information about the quality of the goods being

sold.

• e.g., When a consumer buys a used car it may be very difficult for him to determine

whether or not it is a good car or a poor quality or defective one (a lemon).

• By contrast, the seller of the used car probably has a pretty good idea of the quality

of the car.

• It may cause significant problems with the efficient functioning of a market.

• Adverse selection and moral hazard are the results of information asymmetry.
Adverse Selection (The Hidden Information Problem)

• Adverse selection is the situation where low-quality products drive high-quality

products out of the market as a result of the existence of asymmetric information

between buyers and sellers.

• It arises when one side of the market cannot observe the type or quality of the goods

on other side of the market.

• The problem of adverse selection could arise in all markets characterized by

asymmetric information like the market for defective products such as used cars and

all insurance markets.

• Equilibrium in a market involving hidden information will typically involve too little

trade taking place because of the externality between the "good'' and "bad" types.

The equilibrium will be inefficient relative to the equilibrium with full information.
• Market signaling is the process by which sellers send messages (or

signals) to buyers conveying information about the quality of goods and

services.

• If sellers of high-quality products can somehow inform or send signs of

their superior quality

• then Individuals would be able to identify high-quality products

• In general, a firm can signal the higher quality of its products to potential

customers

– by offering guarantees and warrantees,

– by a policy of exchanging defective items,

– by adopting brand names

 Moral Hazard (The Hidden Action Problem)

• Moral hazard refers to a situation where one side of

the market cannot observe the action of the other.

• E.g., It exists when an insured party whose actions

are unobserved can affect the probability or

magnitude of a payment associated with an event.

• Examples of information asymmetry =>When a lender wants to provide

credits to the borrowers, he faces certain problems.

1. It is costly (or impossible) for the lender to know whether a borrower is able to

repay his debt, i.e., whether he is a hard-working person or not – adverse

selection.

2. It is costly to monitor the borrower on what is being done with the loan.

• The borrower might use the money borrowed for consumption (or unproductive

activities), which is not easily transferred into monetary repayment.

• Or, he might use it in risky activities such as gambling – moral hazard.

 Taxation

Establish
Property Public Provision
Rights

Types of
Government
Intervention
Subsidies Regulation

Education and
Transfer social
Payments marketing
campaigns
 CHAPTER 4: GENERAL EQUILIBRIUM ANALYSIS AND WELFARE
ECONOMICS

4.1 General Equilibrium Analysis

Partial versus General Equilibrium Analysis

• Partial equilibrium analysis studies the behavior of individual decision-

making units and individual markets, viewed in isolation. Egs:

© how an individual maximizes satisfaction subject to his income,

© how a firm minimizes its costs of production and maximizes profits

under various market structures,

© how the price and employment of each type of input is determined.

• In doing so, we have abstracted from all the interconnections that exist

between the market under study and the rest of the economy.

• In short, the basic characteristic of a partial equilibrium approach is the

determination of the price and quantity in each market by demand and supply

curves drawn on the ceteris paribus assumption.

• However, a fundamental feature of any economic system is the

interdependence among its constituent parts.

• The markets of all commodities and all productive factors are interrelated, and

the prices in all markets are simultaneously determined.

• For example,

• consumers’ demands for various goods and services depend on their tastes

and incomes.

® In turn, consumers' incomes depend on the amounts of resources they own

and factor prices.

® Factor prices depend on the demand and supply of the various inputs.

® The demand for factors by firms depends not only on the state of technology

but also on the demands for the final goods they produce.

® The demands for these goods depend on consumers' income.

Þ There is circular interdependence of activities within an economic system.

Þ These effects are studied by general equilibrium analysis.

• General equilibrium studies the interdependence or interconnections that exist among all

markets and prices in the economy and

 attempts to give a complete, explicit, and simultaneous answer to the questions of what, how

and for whom to produce.

• General equilibrium analysis is not used all the time because dealing with each and all

industries in the economy at the same time by its very nature is very difficult, time

consuming and expensive.

• It is a state in which all markets and all decision - making units are in simultaneous

equilibrium.

• It exists if each market is cleared at a positive price, with each consumer maximizing

satisfaction and each firm maximizing profit.

 The theory was first proposed by French economist Leon Walras in

the 1870s,

 while the modern concept of general equilibrium was developed

jointly by Arrow, Debreu and McKenzie in the 1950s.

 From the 1970s onwards, technological advances and increases in

computing power made it possible to develop models for national

economies and attempt empirical solutions for general equilibrium

prices and quantities.

 General Equilibrium in a Two-Factor, Two-Commodity, Two-
Consumer (2x2x2) Economy

• Assumptions of the 2x2x2 model

1. There are two factors of production (Land K) whose quantities are given

exogenously. These factors are perfectly divisible and homogeneous.

2. Only two commodities (X and Y) are produced. Technology is given. The

isoquant maps have the usual properties (smooth and convex to the origin

implying diminishing MRTS between factors along any isoquant).

 The two production functions are independent (no externalities in production).

3. There are two consumers in the economy (A&B) whose preferences are represented by

ordinal indifference curves, which are convex to the origin, exhibiting diminishing

MRS between commodities.

• Consumers’ choices are independent (no externalities in consumption).

4. The goal of each firm is profit maximization and that of each consumer is utility

maximization.

5. The factors of production are owned by the consumers.

6. There is full employment of factors of production, and all incomes received by their

owners (A&B) are spent.

7. There is perfect competition in both commodity and factor markets. Consumers and

firms face the same set of prices (Px, Py, w, r).

• In this model a general equilibrium is reached

 When the four markets (two commodity and two factor markets) are cleared at a set of

equilibrium prices (Px, Py, w, r) and

 Each participant economic agent (two firms and two consumers) is simultaneously in

equilibrium.

 Three static properties are observed in a general equilibrium solution, reached with a

free competitive market:

a. Equilibrium in production (Efficiency in resource allocation)

b. Equilibrium in consumption (Efficiency in distribution)

c. Efficient combination of products (simultaneous equilibrium of production and

consumption)
a. Equilibrium of Consumption (Efficiency in Distribution)

• Given the total quantities of X and Y to be distributed between A&B,

there will be an infinite number of Pareto optimal equilibria of

distribution.

• Any point on the Edgeworth contract curve of consumption is Pareto

optimal.

• A Pareto – efficient distribution of commodities is one such that it is

impossible to increase the utility of one consumer with out reducing the

utility of the other.

• Only points of tangency of the indifference curves of the two consumers represent

Pareto - efficient distributions.

 The locus of these points is called the Edgeworth Contract Curve of Consumption.

 At each point on this curve MRSxyA = MRSxyB.

 Point Z (or any point off the Edgeworth contract curve of consumption) is a point of

inefficient consumption because it is possible to increase the utility of at least one

consumer without making the other worse off (consider movement to E, to F or to any

point between E and F on the contract curve).

• Of the infinite number of points where the condition MRSxy A = MRSxyB holds, only

one point is realized in perfect competition.

 This point is where MRSxyA = MRSxyB =PX/PY.

b. Equilibrium of Production (Efficiency in Factor Allocation)

• The joint equilibrium of production of the two firms in our simple model can be derived

by the use of the Edgeworth box of production

• The size of the box refers to the total amount of Land K available to the economy.

• Any point inside the box indicates how the total amount of the two inputs is utilized in the

production of the two commodities.

• The economy can move from point R to point N and increase its output of Y without

reducing its out put of X.

• Alternatively, it can move to point P increasing its output of X without reducing its output

of Y. Therefore, point R is not pareto-effiicient.

• At points M, N, P and Q, an X isoquant is tangent to a Y isoquant so that the MRTS LKX =

MRTSLKY and it is not possible to increase production of either of the products without

reduction in the production of the other product.

• Edgeworth contract curve of production is the locus of tangency points

of the isoquants for X and Y at which MRTSLKX = MRTSLKY .

• The general equilibrium of production occurs at a point which satisfies

this Pareto optimality criterion of efficiency in factor substitution.

• Since this occurs at any point along the Edgeworth contract curve of

production, there is an infinite number of possible Pareto optimal

production equilibria.

• However, with perfect competition, one of these equilibria will be

realized, the one at which the MRTSLKX = MRTSLKY =w/r.

• In a general equilibrium, the amounts of X and Y which maximize the profits of

firms must be equal to those which consumers want to buy in order to maximize

their utility.

• Consumers decide their purchases on the basis of commodity prices, P X & PY.

• Thus, in order to bring together the production side of the system with the

demand side, we must define the equilibrium of the firms in the product space.

• From each point of the Edgeworth contract curve of production, we can read off

the maximum obtainable quantity of one commodity, given the quantity of the

other.

• The locus of all the Pareto-efficient outputs (or of all the minimum attainable

combinations of the two commodities) given the resource endowment K and L

and the state of technology is the Production possibility frontier (PPF/PPC.)

• At any point on the curve all factors are efficiently employed.

• Any point inside the curve is technically inefficient, implying unemployed resources.

• Points above the curve are unattainable, unless additional resources or a new

technology or both are found.

• The PPF is also called the product transformation curve because it shows how a

commodity is transformed into another, by transferring some factors from the

production of one commodity to the other.

• The negative of the slope of the PPF is called the marginal rate of product

transformation (MRPTXY) and it shows the amount of Y that must be sacrificed in

order to obtain an additional unit of X.

 C. Simultaneous Equilibrium of Production and Consumption (Efficiency in
Product-Mix)

• The general equilibrium of the system as a whole requires the fulfillment of the

condition: MRPTXY = MRSXYA = MRSXYB.

• In perfect competition, this condition is satisfied since MRPT XY=PX/PY

(equilibrium of production), MRSXYA = MRSXYB =PX/PY (equilibrium of

consumption) and

• it follows that, MRPTXY = MRSXYA = MRSXYB =PX/PY .

• Only when the rate at which the consumers are willing to exchange one good

for another (MRSXY) equals the rate at which a good can be transformed into

another in production (MRPTXY) the production sectors’ plans are consistent

with the household sectors’ plans, and the two are in equilibrium.
• The economy is in equilibrium of production producing Xe units of X and Ye units

of Y where the slope of PPF (=MRPTXY) equals the commodity price ratio (PX/PY}

at point T.

• Given the Xe and Ye amounts of the commodities, we can draw the Edgeworth box

of consumption with the dimensions OAYe and OAXe.

• Then, the consumers will have an efficient distribution of X and Y between them

along the contract curve.

• The unique equilibrium (of consumption) will be at a point of tangency of the X

and Y isoquants with the common slope equal to the slope of the PPF at point T.

• If this happens to be at point C, A maximizes his/her utility by consuming OAG

units of X and OAH units of Y.

• Individual B maximizes utility, consuming GXe units of X and HYe units of Y.

• Divergence between MRSXY and MRPTXY implies disequilibrium of the economy

• Suppose that the MRPTXY=2Y/X while MRSXY=Y/X.

• This conveys that the economy can produce two units of Y by sacrificing one unit

of X,

• While the consumers are willing to exchange one unit of X for one unit of Y.

• This means firms produce a larger quantity of X and a smaller quantity of Y

relative to the preferences of the consumers.

• Firms must reduce X and increase the production of Y for the attainment of

general equilibrium
 4.2. Welfare Economics

 Welfare Economics is concerned with economic efficiency and equity.

 It examines the conditions for economic efficiency in the production of

output and the exchange of commodities and equity in the distribution

of income.

 Note that the above definition points out that the maximization of

society’s well – being requires not only efficiency in production and

exchange but also equity in the distribution of income.

 Utility Possibility Frontier/Curve (UPF/UPC)

• The UPF shows the various combinations of utilities received by

individuals A and B (i.e., UA and UB) when our simple economy

is in general equilibrium or Pareto optimum in exchange;

• It is the locus of maximum utility for one individual for any given

level of utility for the other individual.

• UPF UM’UM’ shows the various combinations of utilities

received by individuals A and B (i.e., UA and UB) when the

economy composed of individuals A and B is in general

equilibrium or Pareto optimum in exchange.

• The frontier is obtained by mapping consumption contract (OC)

in the Edgworth box of consumption from output or commodity

space to utility space.

• Note that UPF is associated with Pareto efficient allocations given

equilibrium of production (i.e., given a point on PPF where MRPT X Y

=PX /PY ).

• This means we have another UPF for any other point on PPF.

• In general we can have as many UPFs as there are points on PPF.

• Given UPF of the above sort, in order to determine the Pareto

optimum point in production and exchange at which social welfare is

maximized, we need a social welfare function.

 Social Welfare Function

• Social welfare function would be a statement of those factors that determine social
welfare.
– Eg.

– Total quantity of goods and services(Q)

– The way in which goods and services are distributed(D)

– Health of the community(H)

– Amount of leisure(L),

– Pollution, Rain, Sunshine, etc. It becomes more subjective.

• Social welfare could also be the sum of the utilities who make up society.
• So we could either have
• SW = ʃ (Q, D,H, L, Z) where Z is all other relevant factors

• Or SW = ʃ (U1, U2,…….Un) where U1,U2….Un represents the utilities of the N

persons in the society.
• Given the welfare function defined as above, we can construct
iso-welfare curves as shown below.
• Iso-welfare curves show those distributions of utility that have constant

welfare.

• The allocation that maximizes social welfare can then be obtained by bringing

together our UPF and the iso-welfare curves.

• Social welfare is maximized when UPF is tangent to the highest possible iso-

welfare curve.

• The economy maximizes social welfare when it achieves general equilibrium

at an allocation which generates U 1* and U2* levels of utility to consumer 1

and consumer 2 respectively

The fact that the optimum lies on the utility possibility frontier means that
all of the necessary conditions for efficiency must hold at the optimum.
 Fair Allocations, Envy and Equity

• The welfare function approach is a very general way to describe social welfare.

• But because it is so general it can be used to summarize the properties of many

kinds of moral judgments.

• On the other hand, it isn’t much use in deciding what kinds of ethical judgments

might be reasonable ones.

• Another approach is to start with some specific moral judgments and then

examine their implications for economic distribution.

• This is the approach taken in the study of fair allocations.

• Suppose that we were given some goods to divide fairly among n

equally deserving people.

• How would you do it? It is probably safe to say that in this problem

most people would divide the goods equally among the n agents.

• One appealing feature of this equal division is that it is symmetric.

• Each agent has the same bundle of goods; no agent prefers any other

agent’s bundle of goods to his/her own, since they all have exactly the

same thing.
• Unfortunately, an equal division will not necessarily be Pareto efficient.

• If agents have different tastes they will generally desire to trade away

from equal division.

• Let’s suppose that this trade takes place and that it moves us to a Pareto

efficient allocation.

• The question that arises is: is this Pareto efficient allocation still fair in

any sense?

• Does trade from equal division inherit any of the symmetry of the

starting point?
• The answer is: not necessarily. Consider the following example.

• We have three people, A, B, and C.

• A and B have the same tastes, and C has different tastes.

• We start from an equal division and suppose that A and C get

together and trade.

• Then they will typically both be made better off.

• Now B, who didn’t have the opportunity to trade with C, will envy A

– that is, he/she would prefer A’s bundle to his/her own.

• Even though A and B started with the same allocation, A was luckier in

his/her trading, and this destroyed the symmetry of the original allocation.

• This means that arbitrary trading from an equal division will not

necessarily preserve the symmetry of the starting point of equal division.

• Is there any way to get an allocation that is both Pareto efficient and

equitable (symmetric) at the same time?

• An allocation is said to be equitable if no agent prefers any other agent’s

bundle of goods to his/her own.

• If some agent i does prefer some other agent j’s bundle of goods,

we say that i envies j.

• If an allocation is both equitable and Pareto efficient, we will say that it is a

fair allocation.

• Instead of just any arbitrary way to trade, if we use the special mechanism of

the competitive market, a trade away from equal division will result in a

Pareto efficient allocation.

• It is also impossible for A to envy B in these circumstances.

• A competitive equilibrium from equal division must be a fair allocation.

• Thus the market mechanism will preserve certain kinds of equity: if the

original allocation is equally divided, the final allocation must be fair.

 Chapter 5: Game Theory
• Game theory is the theory that examines the choice of optimal

strategies in conflict situations.

• It attempts to study decision-making in situations where there is a

mixture of conflict and cooperation as in oligopoly.

• In short, game theory shows how an oligopolistic firm can make

strategic decisions to gain a competitive advantage over its rivals or

how it can minimize the potential harm from strategic moves by a rival.
 Some Basic Concepts

• A game is a competitive situation where two or more persons (agents)

pursue their own interests and no person can dictate the outcome.

• A game is described in terms of the players, the rules of the game, the

payoffs of the game, and the information conditions that exist during

the game.

• These elements, common to all conflict situations, are the fundamental

characteristics of a game.
 Cooperative vs. Non-cooperative games

• The economic games that firms play can be either cooperative or non-

cooperative.

• In a cooperative game, players can negotiate binding contracts that allow

them to plan joint strategies.

• In a non-cooperative game, negotiation and enforcement of binding

contracts are not possible.

• Cartel (centralized cartel) is an example where a cooperative game is played

while Cournot’s and Bertrand’s models are examples of situations of non-

cooperative games.
 Zero sum vs. Non-zero sum games
 A zero-sum game is one in which the gain of one player comes at the expense and is

exactly equal to the loss of the other player.

• An example of this occurs if firm A increases its market share at the expense of firm B by

increasing its advertising expenditure (in the face of unchanged advertising by firm B).

 the gains of one player equal the losses of the other so that total gains plus total losses sum

to zero.

 A nonzero-sum game is, on the other hand, one in which the gains or losses of one firm

(player) do not come at the expense of or provide equal benefit to the other firm.

 An example of this might arise if increased advertising leads to higher profits of both

firms – a positive-sum game, or

 if increased advertising raises costs more than revenues and the profits of both firms

decline – a negative-sum game.

• Basic elements of games

– A. set of players

– B. strategies

– C. payoff

• Each decision maker in a game is called a player

• =>Can be an individual, a firm or an entire nation.

• Each course of action open to a player is called strategy

• It is a complete specification of what a player will do in the playing of the game.

• Simply, a strategy is a rule or plan of actions for playing a game.

• A Payoff is the outcome of a game that generates rewards or benefits for the player.

• It is the outcome or consequence of each combination of strategies by the rival firms.

• It is measured in terms of the goal(s) of the player.

 Dominant Strategy and Nash Equilibrium

• Dominant strategy is the optimal choice for a player no matter what the

opponent does.

• Nash equilibrium is a situation in which each player chooses an optimal

strategy, given the strategy chosen by the other player.

• Suppose we have two firms, A and B, and a choice of two strategies for each:

advertise or don’t advertise.

• Firm A, of course, expects to earn higher profits if it advertises than if it doesn’t,

but the actual level of profits of firm A depends also on whether firm B

advertises or not.

• Thus, each strategy by firm A can be associated with each of firm B’s strategies.
 The payoff matrix

Firm B
Advertise Don't Advertise
Advertise
Firm A 4, 3 5, 1

Don't Advertise 2, 5 3, 2

• In the payoff matrix above, the first number in each of the four
cells refers to the payoff (profit in this case) for firm A,
 while the second is the payoff (profit) for firm B.

• What strategy should each firm choose?

• Let’s consider firm A first:
· Firm A will earn a profit of 4 by advertising if B advertises and a
profit of 2 if it doesn’t advertise but B advertises.

Ø Firm A should advertise if B advertises (because 4 > 2).

· If B doesn’t advertise, firm A would earn a profit of 5 if it

advertises and 3 if it doesn’t.

Ø Firm A should advertise (because 5>3).

• Thus, firm A’s profits will always be greater if it advertises

than if it doesn’t regardless of what firm B does.
• Now consider firm B:

Ø If firm A advertises, firm B’s profits would be 3 if it advertises and 1 if it

doesn’t.

 If firm A doesn’t advertise, firm B’s profits would be 5 if it advertises and 2 if

it doesn’t.

• Firm B’s profits will also be greater if it advertises than if it doesn’t, regardless of

what firm A does.

• both firms (A&B) will advertise regardless of what the other firm does and will earn

a profit of 4 and 3, respectively.

• advertising is the dominant strategy for both firms.

• The advertising solution (the final equilibrium) for both firms

holds whether A or B chooses its strategy first or

• if both firms decide on their best strategy simultaneously.

• This solution or equilibrium where each firm has a dominant

strategy is called dominant strategy equilibrium.

• However, not all games have a dominant strategy for each

player.
 Example

Firm B
Advertise Don't Advertise
Advertise
Firm A 4, 3 5, 1
Don't Advertise 2, 5 6, 2

• If firm A advertises, B chooses ‘advertise’ (because 3 >1) and if

A doesn’t advertise, B chooses ‘advertise’ as well (because 5 >

2).

• B’s optimal choice is to advertise whether A advertises or not.

• Thus B has a dominant strategy.

• If B advertises, A chooses ‘advertise’ (because 4 > 2) and if B doesn’t advertise, A

chooses ‘don’t advertise’ (because 6 > 2).

• A’s choice depends on whether firm B advertises or not.

• Thus, A doesn’t have a dominant strategy.

• In order for firm A to determine whether to advertise or not, it must first try to

determine what firm B will do.

• If firm A knows the payoff matrix, it can figure out that firm B has the dominant

strategy of advertising.

• Thus, when firm B’s choice is revealed, firm A will determine its optimal strategy and

this will result in Nash Equilibrium.

• The Nash equilibrium is a cell whose both entries are chosen.

• The cell (4,3)-(advertise, advertise) is the Nash equilibrium of the above

game.

• A pair of strategies is a Nash equilibrium if A’s choice is optimal given

B’s choice, and vice versa.

• The Cournot’s equilibrium examined is an example of Nash equilibrium.

• Two of the major problems with Nash equilibrium are that:

 · A game may have more than one Nash equilibrium &

 · There are games with no Nash equilibrium.

• Examples:
a. A game with no Nash equilibrium
Player B
Left Right
Top
Player A 0, 0 0, -1
Bottom 1, 0 -1, 3
b. A game with two Nash equilibria:

Player B
Fight Not fight
Fight
Player A 350, 350 350, 300
Not fight 300, 300 400, 400
 Ø The Nash equilibriums are:(fight, fight) and (not fight, not fight)

The Prisoners’ Dilemma and Cartel Cheating

• Prisoner dilemma: A game in which the optimal outcome for the players is not

Pareto efficient.

• An outcome (or a situation) is said to be Pareto efficient (Pareto optimal) if it is

impossible to make one better off without, at the same time, making another worse

off.

• Oligopolistic firms often face such a problem – the prisoners’ dilemma.

• This refers to a situation in which each firm adopts its dominant strategy, but each

could do better by cooperating.

 Example

 Two players, prisoners 1, 2

 Each has two strategies.

 Prisoner 1: Don't Confess, Confess

 Prisoner 2: Don't Confess, Confess

 Payoff consequences quantified in prison years.

• fewer years = greater satisfaction.

 Prisoner 1 payoff first, followed by prisoner 2 payoff.

 Prisoners’ Dilemma Game
Prisoner 2’s Strategies
Confess Do not Confess

Prisoner Confess (5,5) (0,10)

1’s
strategy Do not Confess (10,0) (1,1)

• Each suspect is interrogated separately and no communication is allowed

between the two suspects.
Each suspect is promised that he/she will go free by confessing while the
other (who doesn’t confess) will receive the full-ten-year sentence.
If both suspects confess, each gets a reduced sentence of five years custody.
209
Ø If B confesses, A chooses to confess because 5<10

Ø If B doesn’t confess, A chooses to confess because 0<1.

Þ To confess is the dominant and best strategy for A.

Ø If A confesses, B chooses to confess because 5<10

Ø If A doesn’t confess, B chooses to confess because 0<1.

Þ To confess is the dominant and best strategy for B.

• With each suspect adopting his/her dominant strategy of confessing,

each ends up receiving a five-year sentence.

• Only if the suspects can communicate, reach an agreement not to

confess, and the agreement could be enforced would each get a one-
year sentence.
• In fact, if both prisoners decide to confess, they will reach not only

at Nash equilibrium but also at dominant strategy since each

prisoner has the same optimal choice independent of the other.

• But, if both prisoners decide not to confess, they would be better off!

The strategy (don’t confess, don’t confess) is Pareto efficient.

• There is no other strategy that makes both prisoners better off.

• Thus, the strategy (confess, confess) is Pareto inefficient.

• The problem is that there is no way for the two prisoners to

coordinate their actions.

• If each could trust the other, then they could both be made better off.
• The concept of the prisoners’ dilemma can be used to analyze the
incentive to cheat in a cartel (i.e., the tendency to secretly cut
prices or to sell more than the allocated quota).
• Consider the following payoff matrix.
• The two firms adopt the dominant strategy of cheating and earn a profit

of 2 units each.

• But by choosing not to cheat (sticking by the agreement), each member

of the cartel would earn the higher profit of 3.

• The cartel members then face the problem of prisoners’ dilemma.

• Only if cartel members do not cheat will each earn the higher cartel

profit of 3.

• A cartel can prevent or reduce the probability of cheating by monitoring

the sales of each member and punishing cheaters.

 Repeated Games and Enforcing a Cartel

 In the preceding section, the players (agents) met only once and played

the prisoner’s dilemma game.

 However, the situation is different if the game is to be played repeatedly.

 Two firms facing the prisoners’ dilemma problem can increase their

profits by cooperating.

 Such cooperation, however, is not likely to occur in single-move

prisoners’ dilemma games.

 Cooperation is more likely to occur in repeated or many-move games,

which are more common in the real world.

 In such games (repeated games) the best strategy is that of tit-for-tat.

 Tit-for-tat behavior can be summarized as follows: do to your opponent what

he/she has just done to you or called equivalent retaliation.

 That is, begin by cooperating and continue to cooperate as long as your opponent

cooperates.

 If he/she betrays you, you betray him/her back the next time.

 For an optimal tit-for-tat (for firms to cooperate), there must be a hope that

cooperation will induce further cooperation in the future.

 Among other conditions, it must be assumed that the game is repeated

indefinitely, or at least for a very large and uncertain number of times.

 If the game is played for a finite number of times, each firm has an incentive not

to cooperative in the final period because it cannot be harmed by retaliation.

 Each firm knows this and thus will not cooperate on the next-to-the last move.
 Sequential Games
 The games considered so far are games in which both agents (players) act

simultaneously.

 Games where players choose actions in a particular sequence are sequential move games

 In many situations one player gets to move first, and the other player responds.

 An example of this is the Stackleberg model, where one player is a leader and the other

player is a follower.

 Suppose player A chooses top or bottom in the first round, player B gets to observe the

first player’s (A’s) choice, then chooses left or right.

 The payoff matrix is given as follows.

 Nash equilibria (if it were a simultaneous game): (T, L)& (B, R).

 Note that there are two Nash equilibria if it were a simultaneous game.

 However, this normal form presentation of the game cannot be used to

analyze the real outcome of a sequential game.

 Sequential game is thus analyzed using an extensive form presentation.

 Extensive form is the way to represent the game that shows the time

pattern of the choices.

Extensive form of sequential games
 Suppose that player A has already made his choice
 If player A has chosen top, then it doesn’t matter what player B does, and
the playoff is (1,9).
 If player A has chosen bottom, then the sensible thing for player B to do is
to choose right, and the payoff is (2,1).
 Now think about player A’s initial choice.
 If he chooses top, the outcome will be (1,9) and thus he will get a payoff
of 1.
 But if chooses bottom, he gets a payoff of 2. So the sensible thing for him
to do is to choose bottom.
 Thus, the equilibrium choices will be (B, R) with the payoff (2,1).
 Game of Entry Deterrence

 One important strategy that an oligopolist can use to deter market

entry is to threaten to lower its price and thereby impose a loss on

the potential entrant.

 Such a threat, however, works only if it is credible.

 Suppose the entrant decides whether or not to come into the

market, and then the incumbent decides whether or not to cut its

price in response.
 When the outcome of the threat is not credible
Incumbent
Fight Not fight
Enter
Entrant -2, 4 2, 7
Stay out 0, 6 0, 10
 The Nash equilibrium of this sequential game is (enter, don’t fight).

 The incumbent firm may threaten the entrant that it will fight if the

potential entrant enters.

 But, this threat is not credible because the incumbent will not carry out this

threat as 7>4.

 Note that the incumbent can make a credible commitment to fight entry at

the expense of profits.

 The incumbent could make a credible threat by expanding its capacity (i.e.,

to build excess capacity).

 When the incumbent invests in extra capacity the payoff is changed as

follows.
 When the outcome of the threat is credible

 The profits of the incumbent firm are now lower when it doesn’t
fight (charges the high price) because idle or excess capacity
increases its costs, without increasing its sales.
 On the other hand, fighting (charging a lower price) would allow the firm to

increase sales and utilize its newly built capacity, so that costs and revenues

increase;

 thus, it can be assumed that the firm’s profit will be unchanged.

 The Nash equilibrium of this sequential game is that the potential entrant stays out

which means that the threat is credible.

 But this means that the incumbent will not use the extra capacity.

 Despite this, the investment in excess capacity is worthwhile because the

incumbent firm has signaled to the potential entrant that it would be able to

successfully defend his market.