Micro Economics-II

Price and out put determination under monopoly

Introduction
In a perfectly competitive market each firm's production is such a small proportion of the
industry’s output that an individual firm has no influence on the market price. As you
have learned in Microeconomics I, the competitive firm is a price taker. The opposite
extreme to a purely competitive firm is a pure monopoly where only a single seller exists
in the industry. The sources of monopoly, price and out put determination in the short and
long run periods, price discrimination by a monopoly and comparison of the price and out
put with perfect competition are some of the points to be discussed in this unit.
Definition
A monopoly is a market structure where there is only one firm that produces and sells a
particular commodity or service and there are no close substitutes available. Since the
monopoly is the seller in the market, the industry is a single firm industry and it has no
direct competitors. However it does not necessarily mean that it is a guarantee to get an
abnormal profit. Monopoly power only guarantees that the monopolist can make the best
of whatever demand and cost conditions exist with out fear of the entrant of new
competing firms.
Source and Types of Monopoly

The rise and existence of monopoly is related to the factors, which prevents the entry of
new firms. The different barriers to entry that are the causes of monopoly are described
below.

i. Legal Restrictions: A monopoly, which are created for the interest of the public. For
example the public utility sectors such as water supply, postal, telegraph and
telephone services, radio and TV services, generation and distribution of electricity
such monopolies are known as public monopolies
ii. Control over key raw materials: some firms may get monopoly power if they
posses certain scarce & key raw materials that are essential for the production of
certain goods or if the supply of a commodity is localized in a single place. This type
monopoly is known as raw material monopoly. For example India possesses
manganese mines, the extraction of diamonds is controlled by South Africa

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iii. Efficiency: A primary and technical reason for growth of monopolies is economies of
scale. The most efficient plant (probably large size firm), which can produce at
minimum cost, could eliminate the competitors by cutting down its price for a short
period and can acquire monopoly power. Monopolies created through efficiency are
known as natural monopolies.
iv. Patent rights: - The government has granted firms a patent right, for producing a
commodity of specified quantity and character so that firms will have exclusive rights
to produce the specified commodity. Such monopolies are called patent monopolies.

Demand, Marginal Revenue and cost curves under Monopoly

In the analysis of consumer behavior you have seen that the demand curve is generally
down ward sloping showing inverse relation ship between price and quantity demanded.
In perfectly competitive market the industry faces down ward sloping demand curve;
firms face a horizontal demand curve because of the existence of large number of
producers and homogeneity of the product, the firm can not exert power on the total
industry supply.

The monopoly industry on the other hand is a single firm industry. A monopoly firm
there fore faces a down ward sloping demand curve. It implies given the demand curve, a
monopoly firm has the option to choose between prices to be charged or out put to be
sold. But he cannot simultaneously control both the price and the level of out put. He can
either decide the level of out put, and leave the price of the out put to be determined by
consumer demand or he can fix the price and leave the level of out put to be decided by
the demand for the product at that price. One of the fundamental differences between a
monopolist and a competitor is there fore the demand (AR) and marginal revenue curves
they face. In the case of perfectly competitive market MR = AR=P=D. But in the case of
down ward sloping demand curve of monopoly marginal revenue curve falls twice as
much as the fall of average revenue curves i.e. the slope of MR is twice as steep as the
average revenue curve. The following figure illustrates this relationship

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 AR and RM curves for Monopoly

D=AR=P

MR
Quantity
0
T M
DM is the demand curve and DT is the marginal revenue curve, which bisects the
quantity demanded OM. Thus the distance OT = TM
This can be shown mathematically as follows assuming linear demand function

1. The demand function

P = a - bx where a = constant, x=quantity demanded
2. The total revenue is
R = Px
= (a - bx)x = ( substituting P = a -bx)
= ax -bx2
3. The Average revenue

AR =

Thus the demand curve is also the AR curve of the monopolist with slope = -b
4. The marginal revenue (the first derivative of R)

=a-2bx
That is the MR is a straight line with the same intercept (a) as the demand curve,
but twice as steep ( i.e slope = -2b)
Note: - the general relation between P and MR is found as follows
R = Px
(Product rule of differentiation, you have learned in your quantitative for economists I
course)

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 (But is negative due to the inverse relation between demand & price)

P = MR+x

Thus the marginal revenue is smaller than price at all levels of out put.

The nature and shape of cost curves confronting a monopolist are similar to those faced
by a perfectly competitive firm. Because cost depends on the production function and
input prices, irrespective of whether a firm is a monopoly or perfectly competitive

Short Run Equilibrium of Monopoly

As we know, in the short run period the scale of plant is fixed and the firm is unable to
change it. If the monopolist desires to produce more, he can make an intensive use of the
variable input. Since the monopolist has to incur fixed costs in the short run, the
minimum price acceptable by him must be equal to his average variable cost. For this
reason the equilibrium condition is the same as we have explained under perfect
competition i.e. equilibrium occurs when marginal revenue equals marginal cost. But for
the monopolist, MR does not equal price. The short run price and out put determination
under monopoly, and also the firm’s equilibrium are illustrated in the following figure.

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The monopolist firm is in equilibrium at point E where SMC interests the MR curve from

SMC
A
P1

P2 B SAC
E AR=D

MR
0
Qe
below. The profit maximizing (equilibrium) out put is Qe and price is 0P 1. At OQe level
of out put, the average cost is OP2 (or QeB). Thus the monopolist's per unit abnormal
profit is equal to AB, which is the difference between the price OP1, and the
corresponding average cost of production (OP2). The shaded area; P1ABP2 represents the
total monopoly profit.
Total revenue = AR x out put sold
= OP1 x OQe
= Area OP1AQe

Total Cost = AC x out put produced

= OP2 x OQe
= Area OP2 BQe
Profits = TR-TC
= Area OP1 AQe - Area OP2 BQe
= Area P1AB P2
Does a monopolistic firm always earn an abnormal profit? Have you said no? Good. As
we explain in the introduction part a monopolistic position does not guarantee above
normal return always weather the monopolist gets profit or not, depends up on the
conditions of demand and costs. It is possible that his entire short run average cost curve
lies above the demand curve or AR curve so that he has to incur a loss. The following
figure illustrates such a situation.

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 P1 D ATC

P2 B AVC
P3 N

AR=D
Qe
MR
0
As the figure prevails marginal cost equals marginal revenue at point E where Qe level of
out put is produced and OP2 is the equilibrium price. But average total cost is OP1 (or
QeD). Thus
Total revenue = OP2 x OQe Total cost = OP1 x OQe
= OP2BQe = Area OP1 DQe
Total revenue exceeds total cost; hence, the firm makes a loss of P 2 P1DB. The
monopolist would produce rather than shut down in the short run, since price exceeds the
AVC (OP3). If demand decreases so that the monopolist cannot cover all variable cost at
any price, the firm would shut down and lose only fixed cost.

Long Run Equilibrium of Monopoly

Contrary to perfect competition pure economic profit is not eliminated in the long run
under monopoly... As we already discuss a monopoly exists if there is only one firm in
the market. This statement implies that entry in to the market is closed. If a monopolist
should earn a pure profit in the short run, no other producer can enter the market in the
hope of sharing whatever profit potential exists in the long run. Thus a monopolist will
continue to earn abnormal profit even in the long run. The magnitude of the long run
profits will depend up on the cost condition under which he has to operate production and
the demand curve he has to face in the long run.

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If it’s AR> SMC1, it earns a short run profit at out put Oq1 as shown in the following
figure (area P1 P2AB). The firm would therefore not only continue in the business but
would also expand its business to the size that yields maximum profit in the long run (a
plant with SMC2 and SAC2)

Long run Equilibrium of monopoly

As depicted in the figure, the point of intersection between LMC and MR curves
determine the equilibrium out put at Oq2, price Op3. The total long run profit has been
shown by the area P4P3cd (Total revenue (OP3Cq2) - Total cost (OP4Dq2))

Under perfect competition we have seen that in the long run every firm has be of
optimum size where its long run average cost (LAC) is minimum. Does a monopolistic
firm always produce at the optimum size in the long run? In the cost of monopoly, the
equilibrium level of out put (where LMC=MR) may or may not have the lowest long run
average cost. There are three possibilities to exist depending on the cost structure of the
firm and demand for the product.

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i. Under utilization of capacity:- A case in which the market size and cost conditions
lead to maximize profit at lower than optimum size (i.e LMC &MR intersects out
puts less than where LAC is at its minimum
ii. Over utilization of capacity :- A case where in the market is so large that it forces
the monopolist to maximize profit by over utilizing the capacity ( at out puts greater
than where LAC is at its minimum)
iii. Optimum size of the plant: - This is the case in which the market size and cost
conditions allow. The monopolist to maximize long run profit at exactly equal to the
optimum plant.
Types of Monopoly
A) Multi plant monopolist

So far we have analyzed the equilibrium of a monopoly firm which owns and produces
with only one plant. Suppose now a monopolist produces out put in more than one plant,
with different cost strictures. How such a firm would allocate a given level of out put
among these plants to maximize his profit?
In order to produce the profit maximization out put, the monopoly firm will operate each
plant in such a manner that MC in each plant is equal to the common MR .For the sake of
simplicity, we assume
i. The firm has two plants
ii. The firm is aware of its AR and MR curves.
Then how a profit maximizing monopolist determines its total out put and price is
illustrated figure below.

Total Market
Plant A Plant B

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The total MC (indicated in total market) is the horizontal summation of the MC curves of
the individual plants. i.e MC = MCa = MCbi.e, the firm should transfer out put of the
higher cost plant in the lower cost plant . For example, if the last unit produced in plant B
costs birr 10, but one more unit produced in A adds only birr 7 to A's cost, that unit
should be transferred from B to A. this process continuous until marginal cost of A equals
marginal cost of B i.e MCa=MCb

The total profit maximizing out put & is defined by the intersection of MC and MR
curves. And the profit maximizing out put is, there fore can be obtained by drawing a line
parallel to x-axis until it intersects the individual MCa and MC b which is equal to the
common MR (MC=MCa =MCb =MR)

B) Price Discrimination
A producer, mostly likely a monopolist need not always charge a single price to his
customers since he is the only producer in the market, he has a control over the supply of
the product. He can charge different prices to different consumers or in different markets.
Thus when the same product is sold at different price to different consumers, it is called
price discrimination. The two most important points to note about the definition of price
discrimination are: first, exactly the same products must have different prices. A trip from
Bahir Dar to Gondar is not the same as a trip from Bahir Dar to Dessie because
transportation costs are different and this difference raises the price of the trip. Second, in
order for price discrimination to exist, production costs must be equal. If costs are
different, a profit maximizing firm who sets MR=MC will usually charge different price
for a product. This price difference is also due tot cost difference not discrimination.

Consumers are discriminated in respect of price on the basis of their incomes,

geographical location, Age, sex, quantity they purchase, frequency of visits to the shop
etc. For instance, price discrimination on the basis of age in airways, railways, Cinema
shows, Musical concerts, charging lower price for teenagers. Doctors has charged
different price for rich and poor persons. But to implement price discrimination
effectively the following conditions has to be full filled.

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1. There must be separate markets, so that no reselling can take place from a low price
market to a high price market. It is most commonly effective for goods that can not
be easily traded (exchange of services for example, a poor receiving medical care at
relatively low price can not resell his or her operation to another patient, but a lower
price buyer of some raw material could resell it to some one in the higher price
market.
2. Differences in the elasticity of demand. It is the difference in price elasticity that
provides opportunity for price discrimination. If price elasticity of demand in
different markets are the same, price discrimination would not be important (gain
full).
Degrees of price discrimination
The main objective of price discrimination is to maximize profit more than that the firm
could obtain by charging the same price defined by the equation of his MC and MR. The
degree of price discrimination, there fore, refers to the extent to which a seller can divide
the market and can take advantage of it in extracting the consumers surplus. Accordingly
there are three degrees of price discrimination practiced by monopolists
a. First degree price discrimination

The discriminatory pricing that attempts to take away the entire consumer surplus is
called first-degree discrimination. Under first price discrimination, the firm treats each
individual's demand separately and each consumer is assumed as a separate market.

b. Second -Degree price Discrimination.

First-degree price discrimination is expense to implement. Because dealing each

individual demand curve needs vast information and it is costly. Second degree price
discrimination is some what simpler because it requires the firm to consider groups of
consumers. This is discrimination on the basis of quantity purchased and intends to take
only the major part of consumer surplus rather than the entire.

c. Third degree Price discrimination

Selling the same product with different price in different markets having demand curves
with different elasticity is called third degree price discrimination. Profit in each market
would be maximum only when his MR=MC in each market. The monopolist there for
divides his out put between the markets so that in all markets his MR=MC.

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In this case suppose that the monopolist has to sell his product in only two markets A and
B. As a result, the monopolist must allocate out put between the two markets in such
proportion that the necessary condition for profit maximization (i.e. MR = MC) is
satisfied. The equilibrium condition is satisfied i.e. MC=MRa =MRb (common MC equal
individual MR)

Social cost of Monopoly Power

So far we have seen how out put and price is determined in the case of perfect
competition and monopoly. And we have examined the quantity supplied under perfect
competition & monopoly; the price charged by a perfectly competitive and monopolistic
firm. Economists are always criticized monopoly firms in that it is less efficient than
competitive firms and it causes social welfare loss and distortions in resource
allocation.

The most common reason for criticism of monopoly is that price is higher and out put is
lower than in a perfectly competitive market. These fore, we compare the long run price
and out put under monopoly and perfect competition using the following graphical
analysis assuming a constant cost industry ( so that LAC =LMC)
0 q1 q2

LAC=LMC=MR=
AR=DD perfect

Price and out put under monopoly & perfect competition

As it is prevailed in the above figure given the cost and revenue conditions, the perfectly
competitive industry will produce Oq2 at which is LAC = LMC= AR. Its Price will be
OP1.

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On the other hand, the monopoly firm produces an out put where LMC = MR. Monopoly
firm produces Oq1 and charges price OP2. Thus, if both monopoly and competitive
industries are faced with identical cost conditions, the out put under competitive
condition is higher than under monopoly (0q2 >0q1), and price in the competitive
industry is lower than in monopoly (OP1<OP2). Perfect competition is therefore more
desirable from social welfare angle. The loss of social welfare is measured in terms of
loss of consumer surplus. The total consumer surplus equals the difference between the
total utility which a society gains from and the total price which he pays for a given
quantity of goods as you have seen in module one.

 Consumer surplus under competitive market

- The total utility from oq2 = area OALq2
- Total price paid by the society = area OP1Lq2
- Consumer surplus = area OALq2 = area OP1Lq2
= area ALP1
 Consumer surplus under monopoly
- Total utility from Oq2 = area OAJq1
- Total price paid by them society = OP2Jq1
- Consumer surplus = area OAJq1-areaOP2q1
= area AJP2
 Thus loss of consumer surplus under monopoly equals
Area ALP1 -Area AJP2 = P2JLP1

Of this total loss of consumer surplus (P2JLP1), P2JkP1 is extracted by the monopolist as
profit, the remaining JKL goes to none and it is termed as dead weight loss to the society

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 I - MONOPOLISTIC COMPETITION
In many industries, the products that firms produce are differentiated. For one reason or

another, consumers view each firm's products as different from those of other firms. Product

differentiation is the major characteristic of monopolistically competitive market structure.

A monopolistically competitive market combines the characteristics of competitive and

monopoly markets.

Assumptions of Monopolistic Competition:

The assumptions of the monopolistic competition are the same as those of perfect

competition, with an exception of homogeneity of products. That is, monopolistic

competition is a market structure in which a large number of sellers sell differentiated

products, which are close, but not perfect, substitutes for one another.

One of the assumptions of a perfectly competitive market structure is firms in the industry

produce homogenous products while firms in a monopolistically competitive market produce

a differentiated products otherwise market structures, perfectly competitive and monopolistic

competition, have the same assumptions.

Specifically, the following are some of the basic assumptions of a monopolistic

competition market:

 There is a large number of sellers and buyers in market

 The products of the sellers are differentiated, yet they are close substitutes of one

another.

 There is free entry and exit of firms in the market

 The goal of the firm is profit maximization both in the short run and long run

 The prices of factors of production (labor, capital, etc) and technology are given

Product Differentiation

Product differentiation in the monopolistically competitive market may be based up on

certain characteristics of the product itself. Therefore, demand of a product in this market is

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determined not only by the price policy of the firm, but also by the style of the product, the

services associated with it, and the selling activities of the firms.

Thus, the demand curve will shift if:

 The style, or the selling strategy of the firm changes

 Competitors change their price, output, services or selling policies

 Tastes, incomes, prices or selling polices of products from other industries change

The Demand Curve

The demand for a product, once preference for a product is created, it gives rise to a

negatively sloping demand curve for the product of the individual firm. That means, since

each firm produces a differentiated product, it holds the monopoly power over its own

products and the firm has some power to influence the market price of its products. As a

result, the demand curve for a product of a firm is downward (or negatively) sloping, as

presented below.

Price

X (quantity of output sold)

x
The demand (dd) curve of a firm for its products in monopolistic competitive is negatively

sloped and highly elastic (or greater than the monopoly) because of the assumption of a large

number of sellers in the market. In other words, products are close substitutes one to the other

so that a slight change in the price of a firm's product brings about a larger change in its

output quantity demanded. Since consumers have a large number of alternatives, if a firm

increases its product price (p), customers will shift to the other producers and hence the

demand for a firm's product (x) decreases and vice versa.

The demand is determined not only by the price policy of the firm but also by the style of

the product and other services. Two important policy variables in the theory of the firm are

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the product itself and selling activities. Thus the dd curve will shift if all other things (other

than the firm's price of its product) are changed. Variables other than firm's price can be

style, quality, design, advertising, etc. They are called product and selling activities.

If a firm introduces good quality or design or extensively advertises its product, the dd curve

shifts to the right, implying at that level of price the quantity demanded (x) increases.

However, the change only in price (other things being constant) leads a movement along the

same dd curve, because p and x are inversely related.

Costs

All cost curves short- run average variable cost (AVC), average cost (AC),marginal cost

(MC) and long- run total average cost (LAC) of a firm are U- shaped, implying that there is

only a single level of output which can be optimally produced and economies and

diseconomies of scales. So the shape of costs are the same in all perfectly competitive,

monopoly, and monopolistically competitive markets.

But here, in the monopolistic competitive, a new cost is introduced, i.e., selling costs.

Selling costs are costs incurred on advertisement, improving the quality and style, etc. of the

product. Selling costs help to alter the position or the shape of the dd curve for a product.

Accordingly, selling costs curve is U- shaped, i.e., there are economics and diseconomies of

selling costs. For instance, if we take advertisement, initially the increment in selling quantity

is greater than the advertisement cost and after a certain point the sales rate remains more or

less constant but the advertisement cost continues to rise. This leads to a fall in the average

selling cost initially and it rises up as advertisement continues. Hence the selling cost is U-

shaped. The U- Shaped selling cost added to the U- shaped production cost (APTC), yields a

U-shaped ATC curves.

The Concept of Industry and Product "Group”

An industry under perfectly competitive market is defined as a group of firms that produce

homogenous products. However, this definition cannot be applied in the case of

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differentiated products. In the case of homogeneity of products, it is possible to add them

horizontally and get the market demand and supply of the products. But here, in the case of

monopolistic competition, products cannot be added to get the market demand and supply.

For this reason, it is very important to redefine the industry for analytical purpose.

Product differentiation creates difficulties in the analytical treatment of the industry of

monopolistically competitive market structure. Heterogeneous products cannot be added to

form the market demand and supply schedules as in the case of homogeneous products. The

monopolistically competitive industry is a ' group' of firms producing a closely related'

commodity, referred to as ' product group'. An operational definition of ‘product group’ is

that the demand of each single product be highly elastic and that it shifts appreciably when

the price of other products in the group changes. In other words, products, forming ‘the

group’ or ‘industry ‘, should have high price and cross-elasticity.

Product differentiation allows each firm to change different prices. There will be no unique

equilibrium price, but an equilibrium cluster of prices, reflecting the preferences of

consumers for the products of the various firms in the group. When the market demand shifts

or cost conditions change in a way affecting all firms, then the entire cluster of prices will

rise or fall simultaneously.

Equilibrium Conditions in Monopolistically Competitive Market

This section tries to analyze how a firm in monopolistically competitive market arrives at its

equilibrium in the short and long run. This equilibrium analysis is very important to

determine the optimum or profit maximizing level of output and price. Further, we will

compare the equilibrium conditions of both monopolistically competitive and perfectly

competitive firms.

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 Models of Equilibrium

In order to be able to analyze the equilibrium of the firm and the product group (industry)

Chamberlin made the following ' heroic assumption ‘that firms have identical demand and

cost curves. This requires that consumers’ preferences be evenly distributed among the

sellers, and that differences between the products be such as not to give rise to

differences in costs.

The rule of determining profit maximizing level of output is the same in all market structures,

i.e., producing the output at which marginal revenue (MR) is equal to marginal cost (MC)

and at that point MC must be rising. MR is the slope of total revenue ( ) or the first

derivative of total revenue with respect to quantity produced and sold ( ), whereas MC

is the slope of total cost ( ) or the first derivative of total cost with respect to quantity

produced and sold ( ).

Chamberlin develops three distinct models of equilibrium.

a. Equilibrium with price competition

This model assumes that the number of firms in the industry is optimal (no entry or exit) and

long run equilibrium is reached through price adjustment (price competition) of the existing

firms. Remember that the conditions of profit maximizations are different in the short- run

and in the long - run. In the short- run the time is not enough to firms to adjust their sizes and

entry is not possible.

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A firm under monopolistic competition faces two types demand curves as shown in the figure

above. One is a firm's anticipated (or expected) demand curve which shows the inverse

relationship between P and X (curves dd’, d1d’1 and d2d’2). That is, the firm can change the

price of its product but other firms do not make any changes in their prices. The other

demand curve that the firm faces is the actual -sales curve (or share of the market curve) at

each price after all firms change their own product prices. It is labeled as DD' in the above

figure. DD' incorporates the effects of actions of competitors to the price changes by the firm.

Now let us assume that the firm is at the non- equilibrium position at P0 and X0 and let us see

how the firm will reach at equilibrium point using the figure above. The firm to maximize its

own profit reduces price to p1 expecting to sell x’0 quantity outputs .This x’0 is not realized

because all other firms simultaneously reduce their prices to maximize their own profits, so

the actual sale of the firm is not x ’0 but it is x1. That means the actual sale at p1 is x1 which is

less than the expected, x’0. As a result expected demand curve dd’ shifts down to d 1d’1. x’0

would be realized if all other firms have not decreased price to p 1 . Actually, as the firm

decreases its price all other firms simultaneously decrease price then the actual sale turns to

be x1 (of course the quantity sold increases from x 0 to x1 as p0 falls to p1 ) .This process

continues until equilibrium is reached at point e in the above figure.

According to the model the firm can not learn from its past experience, i.e., the firm suffers

from myopia. The firm continues to behave on the assumption that its new demand curve

(d1d’1) will not shift further; the firm lowers its price again from P 1 to P2 expecting to sell x’0

but all other firms also decrease price, as a result, the actual sale of this firm will be x 2 and

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finally the firm reaches at equilibrium (point e) with the equilibrium price and output Pe and

xe respectively. Thus DD' is the locus of points of shifting expected demand curves as

competitors, acting simultaneously, change their price .The DD' is steeper than the

anticipated demand curves, because the actual sales from a reduction in price are smaller than

expected.

The reduction in price continues. The process stops when the expected demand curve as

shifted so far to the left as to be tangent to the LAC at point e. Any further reduction in price

will not be attempted since the LAC would not be covered. At point e the DD' cuts the

expected demand curve, and the equilibrium price and output are pe and xe respectively. It

should be noted that the equilibrium point e lies to the left of the minimum of LAC, and it is

at the falling part of LAC, though, all firms are making zero profit.

b. Equilibrium with new firms entering the industry

In this model the existing firms are assumed to be in the short run equilibrium realizing

abnormal profits; existing firms don’t have any incentive to adjust their price, but long run

equilibrium is attained by new entrants who are attracted by the lucrative (rewarding) profit

margin. Then the market will be shared by firms and the demand of the individual firm will

shift leftwards followed by price adjustments. This will continue until the demand of the firm

is tangent to the long run average cost (LAC) at its equilibrium. At such point, firms just

break even: no incentive to enter as the firms are earning a normal profit (zero profit)

 Profit= TR-TC=(P-AC)Q, Break Even point (when TR=TC or P=AC) and Profit

margin

c. Price Competition and free entry/exit

In actual life equilibrium is achieved both by price competition and by entry and exit of firms

into and out of the industry (or the market). The figure below shows the ultimate equilibrium

under monopolistic competition in the long run.

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Here also, as we looked in the previous model 1, there are two demand curves: price

adjustments are shown along the expected demand curves (dd, d’d’,) while entry and exit

cause shifts in DD curve. Therefore this analysis is based on an integrated analysis of effects

of free entry/exit and price competition.

To see how we arrive at the long run equilibrium points, let us assume that firms are initially

in short run equilibrium at e1 and profits are abnormal. New firms are attracted into the

market by this excess profit. As new firms enter into the market, the market share curve (DD)

shifts to the left until it becomes tangent to LAC at point e2. The left - ward shift of the DD

curve means as new firms join the industry the market share of each firm will fall down, i.e.,

DD shifts to D’D’.

You may think that e2 is long run equilibrium since normal profits are earned. This is

however not the case once the firms reach point e 2, each firm thinks that its demand curve is

dd, not D’D’. Then each firm believes that it can increase its profits by reducing the price and

there by increasing the sales as we discussed in model 1. Therefore, we observe price

competition as individual firm reduces price from p to p’ in order to increase its sales by

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assuming all other firms would not decrease price unfortunately all other firms

simultaneously decrease price to p’ to maximize their own profits .

Still the firm suffers from myopia it decreases price further and the d’d’ curve shifts to d”d”

and all firms make loss as d”d” lies below the LAC. Some firms that can not stand this loss

will exit out of the market. As result the market share of each firm will increase as shown

but the shift of D’D’ to D *D* and at the same time d”d” shifts to the right to d *d* until it

becomes tangent to the LAC at point E. Point E is, therefore, the long run equilibrium, all

firms make zero profit. The equilibrium price and output are p* and X* respectively.

Note that in both models the equilibrium points lie to the left (Falling Part) of the

minimum of LAC though profits are zero or normal.

Excess Capacity and Welfare Loss

Now let us compare the long- run equilibrium situations of the perfectly and monopolistically

competitive markets and see how the monopolistically competitive market structure results in

welfare loss.

In the long run, firms both in perfectly and monopolistically competitive markets make zero

profit. However, the equilibrium price is higher and output is lower in monopolistic

competitive as compared to the equilibrium price and outputs of the perfectly competitive.

The equilibrium point in the monopolistic competitive is at the falling part of LAC while in

the perfectly competitive at the lowest point on LAC. That means costs are higher in the

monopolistic competitive than in the perfectly competitive. As a result monopolistic

competition has been attacked on the ground that firms are working with ' excess capacity', as

measured by the difference between ideal out put , X F and the output actually attained in long

-run equilibrium XE in the following figure.

21
As it has been presented above, the output produced in the perfectly competitive ( x F) is

greater than output produced in monopolistic competition (XE) . The distance between XE and

XF, therefore, gives excess capacity, implies that the firm in monopolistic competitive market

is working under capacity, meaning the firm has still an excess capacity that is not used. If it

was used the firm could increase output to the level XF. Thus monopolistically competitive

market results in welfare loss as it works to the left of the minimum of the LAC.

22
 II. OLIGOPOLY THEORY
Oligopoly is the fourth type of market structure. Oligopoly is a form of market structure in

which a few sellers sell homogeneous or differentiated products. An oligopoly is an industry

with small number of sellers. How small is small cannot be decided in theory but only in

practice. Nevertheless, in principle, the criterion is whether firms take in to account their

rivals’ actions in deciding upon their own action or not. In other words, the essence of

oligopoly is recognized interdependence among firms. Coca-Cola considers the actions and

likely future responses of Pepsi when it makes its decisions (whether concerning product

design, price advertising, or other factors).

It is difficult to fix up definite number of sellers. Any way, if each seller has command over a

sizable proportion of the total market supply then there exists oligopoly in the market. That

means if one seller increases (decreases) its supply; the market price may decrease (increase)

because the supply of this seller constitutes a significant proportion in the total market

supply.

Characteristics of Oligopoly Market

The basic characteristics of oligopolistic market structure are the following:

A. Keen (or intense) competition between firms: The number of firms is small enough that

each seller takes into account the actions of other firms in its pricing and output

decisions. In other words, each firm keeps a close watch on the activities of the rival

firms and prepares itself with a number of aggressive and defensive marketing strategies.

B. Interdependence: the nature and degree of competition makes firms interdependent in

respect of decision making.

23
C. Barrier to entry: in oligopoly market firms are small enough in number implies there is

barrier for new firms to enter into the market. Some common barriers to entry are

economies of scale, patent rights, and control over important inputs by existing firms.

In general unpredictable action and reaction will make it difficult to analyze oligopoly

market. Firms may come ‘in collusion with each other’ or ‘may try to fight each other on the

death.’ So accordingly we can classify oligopoly market structure as:

 Non-collusive Oligopoly and

 Collusive Oligopoly

 Non- Collusive Oligopoly

Oligopoly firms may cooperate (collude) or may not cooperate (no- collusion) in

some activities with respect to their businesses depending on their interest and

agreement. If firms do not cooperate, their decision-making process is analyzed using

the non- collusive model. Under this model we have the Cournot's duopoly model, the

'kinked- demand' model, Bertrand Duopoly model and Stackleberg Duopoly model.

We will look how firms arrive at equilibrium points in each model one by one.

a. The Cournot's Duopoly Model (Out put simultaneous game)

When there are only two sellers of a product, there exists duopoly, a special case of oligopoly.

Augustin Cournot, a French economist, was the first to develop a formal duopoly model in 1838.

To precede our analysis of the model, the assumptions of the model are the following:

a) There are only two firms, A and B each owing a mineral water wells;

b) Both operate their wells at zero marginal cost of production (MC=0)

c) Both face a down ward sloping straight line demand curve; and

d) Each seller acts on the assumption that its competitor will not react to its decision to change its

output and price.

24
 P

MRA MRB

Graphical Presentation of Price and output determination under Cournot’s Duopoly

Now let us assume that firm A is the first to start producing and selling mineral water, x.

Therefore the market open to A is OD, the total quantity demanded. The market demand

curve for the product is DD and its respective marginal revenue curve is firm A's marginal

revenue curve ( MRA). Firm A will sell half of the total quantity demanded OD.

MRA is twice steeper than the DD curve (please try to show how this holds true) in the

imperfect market and it bisects OD at the middle. Thus firm A will sell OX m amount of X. At

point A, firm A is maximizing its profit because at A, MR=MC= 0. When MR= 0, the

elasticity of demand, ed=1. If we assume the total quantity demanded, OD is one unit, then

firm A will sell ½ (1) = ½ unit of x.

 Show that in imperfect markets, MR=P (1-1/ ed)

Now firm B enters into the market (next to A). The market open to B is therefore, the

remaining half (XmB) out of the total OD. Hence the demand curve of B is CD and its

respective marginal revenue curve is MRB which cuts XmD at the middle at point B. At point

B profit of firm B is maximum because MR B= MC= 0. Firm B will sell quantity X mB at the

Price P. Here we can observe that firm B will supply ¼ X. That means ½ (½) =¼.

25
With the entry of B to the market price fall from Pm to P. Firm A attempts to adjust its price

and output to the changed condition. Thus A assumes that B will not change its output X mB

and price P as B is making the maximum profit and he continues to supply ¼. Then A has ¾

of the market available to it that is ¾ (1-1/4). To maximize its profit A will supply ½ (¾) =

3/8 of the market. Now it is B's turn to react (to move). This action and reaction will continue

until both reach the equilibrium point by supplying 1/3 each.

Periods Firm A Firm B

I ½ (1) = ½
=

II
=

III

IV

. . .

. . .
N

We observe that the output share of Firm A declines gradually. We may re-write this

expression:

[Product Share of firm A equilibrium] =

= .

The expression in parenthesis is a declining geometric progression with ratio .

Applying the summation formula for an infinite geometric series (where S=sum,

26
a= first term of series, r= ratio) we obtain [Product share of firm A in equilibrium] =

=1/3.

Again we observe that the output of Firm B increasing at decreasing rate. We may re-write

this expression:

[Product Share of firm B equilibrium] =

= .

The expression in parenthesis is an increasing geometric progression with ratio .

Applying the summation formula for an infinite geometric series (where S=sum,

a= first term of series, r= ratio) we obtain [Product Share of firm B in equilibrium] =

=1/3.

The supply by each firm remains 1/3 in the rest of the periods. Consequently, the Cournot

equilibrium is stable equilibrium. The price level in the Cournot models is lower than the

monopoly priced but above the pure competitive price. In general if there are n firms in the

industry each will provide of the market, and the industry output will be

clearly as more firms exist in the industry, the higher 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.

Note that: The Cournot game is also called an out put game as the strategies of firms are

their outputs. Firms are using their outputs as a weapon to win the tough competition among

the firms. Reaction curve Approach

This is based on iso-profit curves of competitor. Assume there are two firms Firm A and B

27
An Iso-profit curve for firm A / Firm B the locus of points defined by different levels of out

put of A / B and his rival B /A which yield to A / B the same level of profit.

Properties of Iso-profit curves

1- For substitutable commodities they are concave to the axis along which we measure

the out put of rival firms.

2- The further the iso-profit curves lie from the axis, there lower is the profit & vice

versa

A1 > A2 > A3 > A4

B1 > B2 > B3 > B4

3- For Firm A / Firm B the highest points of successive iso-profit curves lie to the left /

right of each other.

4- Reaction Curve of Firm A / Firm B: a curve that joins the locus of points of highest

profits that Firm A / Firm B can attain given the level of out put of rival Firm B/Firm

Mathematical Derivation of Cournot’s Duopoly

Let the market demand is given by X = a – b Px for two oligopoly firms (Duopolists)

Where Market Demand = X = X1 + X2, X1 = output of firm 1

28
 X2 = output of firm 2

While C1 = f (X1) and C2 = f (X2)

Profit maximizing rule of the firms are

1st order condition: 1 = TR1 – TC1; 1 = TR1 - TC1

X1 X1 X1

2 = TR2 – TC2; 2 = TR2 - TC2

X2 X2 X2

2nd t order condition: 21 = 2TR1 - 2TC1 < 0 ; 2TR1 < 2TC1

    

22 = 2TR2 - 2TC2 < 0 ; 2TR2 < 2TC2

    

b. The 'Kinked - Demand ' model

This model attempts to explain the phenomenon of price rigidity in oligopolistic firm. It is

the best known model to explain relatively more satisfactory the behavior of the oligopolistic

firm.

If an oligopolistic firm reduces price of its product, it believes that the rival firms will follow

& neutralize the expected gain from price reduction. But if it raises its price, the firms would

either maintain their prices of even make price-cut, so that the price-raising firm would lose,

at least its market share. The oligopoly firm would find it more desirable to maintain the

prevailing price & output.

The analysis:

There are three possible ways in which rival firms may react:

I. Rival firms follow the changes in price, both price hike and price cut

II. Rival firms do not follow the changes in price, both price hike and price cut

III. Rival firms follow the price cut changes but not follow price hike change

29
 If rival firms react in manner (I) and (II) an oligopolistic firm taking lead in changing

prices will face two different demand curves.

dd’ = Which is based on reaction (I) (Follow both hike & cut)

DD’ = Which is based on reaction (II) ( Do not follow both price hike and cut)

 dd’ is less elastic than DD’ because of the changes in dd in responsible to changes in price

are restrained by the counter-moves by the rival firms.

Figure 2.2

The demand curve of the oligopolist has a kink at point E reflecting the following behavioral

pattern. Now let us look how this kink is formed at pint E. Initially the firm is at equilibrium

at point E where the expected sale is equal to the actual sale and the price is P and the output

level is X. If a firm reduces its price, all other firms also follow this action and will reduce

their price. So that, although, the demand in the market increases, the shares of competitors

remain unchanged As a result the demand curve of the firm below price level p is ED'.

In other round, if the firm increases price above P, other firms will not follow this action and

consequently the demand curve of the firm will be dE, implies its sales decreases due to the

shift of some of its customers to the other firms. Thus for price increases above P, the

relevant demand curve of a firm is the section DE of the dd' curve. Finally, the demand curve

of the firm will be dED' which is a ‘'kinked demand’' curve.

Due to the kink in the demand curve of the oligopolist firm, its marginal revenue curve (MR)

is discontinuous at X which corresponds to the kink at E. The MR has two segments:

30
Segment dA corresponds to the upper part of the demand curve, dE while the segments from

point B correspond to the lower part of the kinked- demand curve, ED'.

The gap or the distance between point A and point B increases or decreases depending on the

elasticities (or the slopes) of the segment dE and ED'. The greater the difference of

elasticities of the upper (dE) and lower (ED') parts of the kinked- demand curve, the wider

discontinuity in the MR curve, and hence the wider the range of AB.

Now let us look the behavior of the equilibrium of the firm. The equilibrium of the firm is

defined by the point of the kink at point E because to the left of E, MC is less than MR and

the right of E, MC is greater than MR. Since in the range AB MR is a straight line whatever

be the MC (i.e. whether the MC is Mc1 or MC2 or in between MC1 and MC2) we have always

the equality between MR and MC (MR=MC) implying the firm is maximizing profit by

producing x and charging the price P.

Here you should note that whether the MC increases or decreases (in the range AB) price

remains the same p, i.e. price is rigid or sticky in the oligopoly market. The rigidity of price

is the result of uncertainty the firm faces from its competitors. In other words firms do not

increase price despite the rise in costs to avoid competition of viral firms.

There is only one case in which a rise in cost will most certainly induce the firm to increase

its price. This occurs when the rise in costs is general, example imposition of tax that affects

all firms equally. Under these circumstances the firm will increase its price with the certainty

that the other in the industry will follow. Hence the point of the kink shifts upwards to the

left, and equilibrium is established at a higher price and lower output, x.

c. The Bertrand Model (Price Game)

This model assumes that firms choose price rather than output. The first piece of work in this

line is that of Joseph Bertrand. In a critique of Cournot’s book, Bertrand briefly sketched a

model in which firms make simultaneous price decisions. When firms offer identical goods

31
and have a constant marginal cost, there is a unique Nash Equilibrium when firms choose

price and it entails both firms pricing at marginal cost. The Bertrand model yields the

surprising result that Oligopolistic behavior generates the competitive solution! If firms’

outputs are differentiated, price competition results in similar to those of the Cournot solution:

each firm’s price lies between the competitive price and the monopoly price. One of the most

significant ways in which firms compete is trying to make their product unique relative to the

other products in the market. The reason is that the more differentiated is one’s product; the

more one is able to act like a monopolist. That is, you can set a higher price without inducing

large numbers of consumers to switch to buying your competitors’ outputs. To consider the

role of product differentiation, let us follow the suggestion of Bertrand and assume that firms

make simultaneous price decisions with constant marginal cost –though, of course, we will

assume that firms’ outputs are differentiated. This means that consumers perceive these

products as being imperfect substitutes. That is, there are consumers who are willing to buy

one firm’s output even though it is priced higher than its competitors’. It also typically means

that a small change in a firm’s price causes a small change in its demand.

D. The Stackleberg’s Duopoly Model (Out put sequential game)

This model assumes that one oligopolist is sufficiently sophisticated. That means the

sophisticated Duopolists determine the reaction curve of his rival and incorporate it in his

own profit function which he then proceeds to maximize like a monopolist.

Let firm A and firm B are the two Duopolists.

 If firm A is the sophisticated oligopolist it will assume B will act on the bases of its own

reaction curve. This will permit A to chose to set its own out put at the level which

maximizes its own profit. This is point a, which lies on the highest possible iso-profit curve

of A, denoting the maximum profit A can attain given B’s reaction curve. So B produc a

level of out put XB at point b.

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 b

 Collusive Oligopoly
Sometimes firms form collusion each other in many actions to avoid uncertainty or competition

among themselves. This collusion helps the oligopolist firms to act like a monopoly. The two main

types of collusion, cartels and price leadership.

1-Cartels

Cartels imply direct agreements among the competing oligopolist with the aim of reducing the

uncertainty arising from their mutual interdependence. Based on this objective, the general purpose of

cartels is to centralize certain managerial decisions and functions of individual firms with a view to

promoting commons benefits.

There is one typical example of cartels i.e., OPEC (Oil and Petroleum Exporting Countries). These

countries (or oil producing firms) form the organization called OPEC and this OPEC acts as decision

maker and all firms are governed under it.

The two typical Services of a cartel are

A) Fixing price for joint maximization of firms profit and

B) Market- sharing between its members firms. Now let us look these two functions one by one

A) Cartels aiming at joint profit maximization

33
For the purpose of this analysis we concentrate on a homogenous or pure oligopoly, i.e., all firms

produce a homogenous products. The equilibrium analysis is similar to that of the multi-plant

monopolist. The cartel ( the central agency ) acting as a multi- plant monopolist, will set the profit

maximizing price defined by the intersection of the industry MR and MC curves of firms as shown

below.

a- Firm 1
b- Firm 1 c- Industry
MR

For simplicity we assume that there are only two firms in the cartel, firm 1 and firm 2. Given the

market demand D in figure c the monopoly solution, which maximizes joint profits, is determined by

the intersection of MC and MR, at point e. The total output is X=X 1 +X2 and sold at price P. Now

once the central agency decides these variables (P and X) it allocates the production among firms 1

and firm 2 as a monopolist would do, i.e., by equating the common MR to the individual MCs’.

Since all firms have the same price P, their MRs, are also the same. Therefore at equilibrium points,

i.e., at point e, MC=MR and at point e 2 MC2=MR. Thus firm 1 produces X1 and B produces X2. The

firm with the lower cost produces a larger amount of output but the distribution of profits is decided

by the central agency of the cartel.

B) Market - Sharing Cartels

As noted above the second service of the cartel is to share the market between its members. There are

two basic methods for sharing the market: non - price competition and determination of quotas.

34
Non - price competition agreements : firms agree on a common price, at which each of them can sell

any quantity demanded. The agreed price must be such as to allow some profits to all members. In

this type of agreement firms cannot sell at lower price but they can use different kinds of selling

activities (e.g. changing style, package, etc). In other words by using these selling activities firms can

have a larger share of the market- called non price competition.

This form of cartel is indeed ' loose', in the sense that it is more unstable than the cartel aiming at joint

profit maximization. Because, since there are cost differences among firms, the low cost firms will

have a strong incentive to break the agreement and sell at lower price or to cheat the other members

by secret price concessions to the buyers. Then the price war and instability of the agreement occur.

Sharing the market by agreement on quotas: if all firms have identical costs, the monopoly solution

will emerge with the market being shared equally among the firms. But if costs are different, the

quotas and shares are determined by bargaining power (or skill) of firms.

2- Price Leadership

Price leadership is another form of collusion. In this form of coordination one firm sets the price and

the other follows it. There are various forms of price leadership .The most common types of

leadership are price leaderships by a low- cost firm and price leadership by a large (dominant)

firm.

a. The model of the Low -Cost Price Leader

Due to economies of scale, efficiency, etc. a firm in the oligopoly market can be a low- cost firm.

Thus this firm takes the lead to charge price of the commodity and other firms will follow the action.

To look the model, let us assume there are two firms, which produce a homogenous product at

different costs. The firms may have equal markets (figure 1) or they may have unequal markets

(figure 2) according to their agreement as shown below.

Figure1 Figure2

35
As you observe in the figures above, firm A is the low- cost firm and it takes a lead to charge price

and the high cost firm (i.e., firm 2) will follow this price. In figure 1 firm A, a leader, determines its

price PA that maximizes its profit at the output level (x 1) where MCA= MR and firm B, the follower

takes this price PA through it does not maximize its profit by producing X2 (at X2, MCB > MRB).

Here you should note that since both firms sell the same amount at the same price, both firms have

the same demand curve d and one marginal revenue curve MR1= MR2 in figure1 above. The market

demand curve is D. In figure1 both firms will sell the same quantity X 1 =X2 at the same price PA.

However, firm B's profit maximizing price and out put would be P B and XBe respectively. At price PA

the market demand is X = X1 + X2.

In figure 2 since both firms have not equal market share their demand and marginal revenue curves

are different. Here also firm A, the leader, decides price P A according to the marginal rule MR A =

MCA, maximizes it’s Profit by selling X A, but firm B taking this price P A will sell XB, not maximizing

profit. As in figure1 firm B could maximize profit if it charged price P B. To avoid price war firm B

accepts the price set by firm A, PA.

b. Price leadership by the dominant firm

In this model it is assumed that there is a large dominant firm which supplies a large proportion of the

total market, and some smaller firms, each of them having a small market share. Thus if this dominant

firm increases or decreases price the other firms will follow it. The dominant firm sets its price so as

to maximize its profit (the point where its MR=MC) but the followers may or may not maximize their

profits depending on their cost structures.

Now let us look a mathematical model how a dominant firm sets its profit maximizing price and

output.

36
Here we represent the market demand by D and the total output that is supplied by the smaller firms

by S then the output sold by the dominant firm will be

X= D - S

Let us assume S= aP and D=b – cP

Using the above function , the dominant firm’s demand function is

X=D-S

X = b - cP - aP

X = b – (c + a)P,

The inverse demand function is

(c + a)P = b - X

P=b–X

(c + a)

Total reevenu of the dominant firm will be: TR = PX = b–X X

(c + a)

If the cost function of the dominant firm is given as C = dx

It will maximizes its own profit as TR - TC

= b–X X _ dx

(c + a)

Then to determine its profit maximizing level of out put the dominant firm will set the first derivative

of its profit function with respect to X must be equal to zero. After determining this level of out put

the dominant firm will set at what price will it sell the product. And the small firms will follow this

desided price by the dominant firm. And this is ca lled pricer leadership by a dominant firm.

37
 III. INTRODUCTION TO GAME THEORY

Introduction

In the oligopoly market we noted that competition is intense. That is, firms must consider the

likely responses of competitors when they make strategic decisions about price, advertising,

and other variables. In other words, the actions and reactions of a firm depend on the move

and countermove of the other firm just like a game. Thus the development and application of

game theory is one of the most exciting areas in microeconomics. This unit explains some of

this theory and show how firms can make strategic moves that give them an advantage over

their competitors.

Definition of a game

Games are played in business, politics, diplomacy and wars. The word game may convey an

impression that the subject is not important in the larger schemes of things –that it deals with

trivial pursuits such as gambling and sports when the world is full of more weighty matters

such as war, business, education, career and relationships. Actually all these weighty matters

are games.

Game theory is a branch of applied mathematics. Game theory is the science of rational

behavior in interactive situation. Game is the science of strategic decision making. Any

situation in which individuals must make strategic choices and in which the final outcome

will depend on what each person chooses to do can be viewed as a game. Game is an action

where there are two or more mutually aware players and the outcome for each depends on the

action of all.

The reason for spending time on game theory is that it is a tool designed for investigating the

behavior of rational agents in setting for which each agent’s best action depends upon what

other agents are expected to do. As a result game theory will prove to be very useful in

investigating firm behavior in oligopolies and more generally, in providing insight

concerning the strategic behavior of firms.

38
The basic elements of a game

The strategic form (normal form) of a game describes an economic setting by three elements:

1. Players: Each decision maker in a game is called a player. These players can be

individuals (poker game), firms (as in the Oligopolistic markets), or entire nation (as

in the military conflict).

2. Strategies: Each course of action open to a player during a game is called a strategy.

Strategy is a decision rule of players. A strategy tells a player how to behave in the

settings being modeled or is a decision rule that instructs a player how to behave over

the course of the game.

3. Payoffs: The final return to the players of a game at its conclusion is called

“payoffs”. Example the Payoffs for the firms can be profit. A player’s payoff

function describes how it evaluates different strategies. That is, given the strategies

chosen by all players, a player’s payoff function tells him his state of well being (or

welfare or utility) from players having played those strategies. It is the objective,

usually numerical, that a player in a game aims to maximize.

Fundamental Assumptions of game

Game theoretic analysis is built on two fundamental assumptions: These are

1. Rationality: game theory assumes that players are interested in maximizing

their payoffs.

2. Common Knowledge: all players know the structure of the game and that

their opponents are rational.

39
Types of Games

The economic games that firms play can be either cooperative or non cooperative. A game is

cooperative if the players can negotiate binding contracts that allow them to plan joint

strategies. A game is non cooperative if negotiation and enforcement of a binding contract

are not possible.

An example of a cooperative game is the bargaining between a buyer and a seller over price

of a commodity. If the commodity costs Birr 100 to produce and the buyer values the

commodity at Birr 200, a cooperative solution to the game is possible, because an agreement

to sell the commodity at any price between 101 and 199 will maximize the sum of the

buyer’s consumer surplus and the seller’s profit, while making both parties better off.

Another cooperative game can be the negotiation of two firms in an industry for a joint

investment to develop a new technology. If the firms can sign a binding contract to divide the

profits from their joint investment, a cooperative out come that makes both parties better off

is possible. An example of a non cooperative game is a situation in which two competing

firms take each other’s likely behavior into account and independently determine a pricing or

advertising strategy to win market share.

Dominant strategies

In any game each player has his own strategy that enables him to win the game. That means

the game’s likely outcome depends on the strategy the player follows. Thus knowing the

strategy help us determine how the rational behavior of each player will lead to an

equilibrium solution.

Before we go to look how a certain game is played we define the concept of a ‘dominant

strategy’. A dominant strategy is that strategy that is optimal for a player no matter what an

opponent does.

The following example illustrates this in a duopoly setting. Suppose firms A and B sell

competing products and are deciding whether to undertake advertising campaigns. Each firm,

40
however, will be affected by its competitor’s decision. The possible outcomes of the game

are illustrated by the payoff matrix in the table below.

Firm B

Advertise Don’t Advertise

Advertise

10,5 15,0

Firm A Don’t Advertise

6,8 10,2

The payoff matrix summarizes the possible outcomes of the game; the first number in each

cell is the payoff to firm A and the second is the payoff to firm B. we can observe from this

payoff matrix that if both firms decide to advertise, firm A will make profits of 10, and firm

B will make profits of 5. If firm A advertises and firm B doesn’t, firm A will earn 15, and

firm B will earn zero.

Firm A If firm B Adv. IIB = 5 Firm A If firm B Adv. IIB = 8

Adv. If firm B Not Adv. IIB = 0 Not Adv. If firm B Not Adv. IIB = 2

Dominant Strategy of firm B is to Advertise

Firm B If firm A Adv. IIA = 10 Firm B If firm A Adv. IIA = 15

Adv. If firm B Not Adv. IIA = 6 Not Adv. If firm A Not Adv. IIA = 10

Dominant Strategy of firm A is to Advertise

Therefore, the equilibrium solution of the above game is (Firm A, Firm B) = (10, 5)

Now let us look the dominant strategy of each firm .First, consider firm A. Firm A should

clearly advertise because no matter what firm B does, firm A does best by advertising (if firm

B advertises, A earns a profit of 10 if it advertises, but only 6 if it doesn’t). And if B dose not

advertise A earns 15 if it advertises, but only 10 if it doesn’t).

41
Thus, advertising is a dominant strategy for firm A. The same is true for firm B; no matter

what firm A does, firm B does best by advertising. Therefore, assuming that both firms are

rational, we know that the outcome for this game is that both firms will advertise. This

outcome is easy to determine because both firms have dominant strategies.

The Nash Equilibrium Concept

Equilibrium Concept: An equilibrium concept is a solution to a game. The equilibrium

concept identifies, out of the set of all possible strategies, the strategies that players are

actually likely to play. Solving equilibrium is similar to making a prediction about how the

game will be played.

The Nash Equilibrium

Although there are several ways to formalize equilibrium concepts in game theory, the most

commonly used approach was originally proposed by Cournot’s in the 19 th century and

generalized in the early 1950s by John Nash. Under Nash’s procedure, a pair of strategies,

say, (a*, b*), is defined to be an equilibrium if a* represents player A’s best strategy when B

plays b*, and b* represent B’s best strategy when A plays a*.

Assuming that players are rational, a player chooses the strategy that gives him his highest

payoff. In deciding which strategy is best, a player must take in to account the strategies that

he expects that other players to choose. To capture this interdependence, the concept of Nash

Equilibrium was developed.

It should be noted that by identifying the dominant strategies it is possible to arrive the

outcome of the game because dominant strategies are stable.

Not every game has a dominant strategy for each player. If we change the payoff (10, 2) in

the bottom right - hand corner into (20, 2) in the above table, firm A will not have a dominant

strategy but B does have. A's optimal decision depends on what firm B does. If B advertises,

then A does best by advertising; but if B does not advertise, A does best by not advertising.

42
Since firm B has a dominant strategy- advertises, A concludes that B will advertise then a

will advertise.

The equilibrium is again that both firms will advertise. It is the logical outcome of the game

because firm A is doing the best it can , given firm B's decision; and firm B is doing the best

it can , given firm A's decision, this is called Nash equilibrium.

Firm B

Advertise Don’t Advertise

Advertise

10,5 15,0

Firm A Don’t Advertise

6,8 20,2

Firm A If firm B Adv. IIB = 5 Firm A If firm B Adv. IIB = 8

Adv. If firm B Not Adv. IIB = 0 Not Adv. If firm B Not Adv. IIB = 2

Dominant Strategy of firm B is to Advertise

Firm B If firm A Adv. IIA = 10 Firm B If firm A Adv. IIA = 15

Adv. If firm B Not Adv. IIA = 6 Not Adv. If firm A Not Adv. IIA = 20

Firm A has no Dominant Strategy to maximize its payoffs.

But in many games one or more players do not have a dominant strategy. We therefore need

a more general solution concept the Nash equilibrium. Nash equilibrium again is a set of

strategies (or actions) such that each player believes (correctly) that it is doing the best it can,

given the actions of its opponents. Since each player has no incentive to deviate from its

Nash strategy, the strategies are stable. In the example shown in table above, the Nash

equilibrium is that both firms advertise.

43
If you remember in Cournot’s equilibrium, each firm sets output or price while taking the

output or price of its competitors as fixed. Once the firms have reached Cournot’s

equilibrium, no firm has an incentive to change its output or price unilaterally because each

firm is doing the best it can given the decisions of its competitors. Therefore, Cournot’s

equilibrium is also Nash equilibrium. Note that dominant strategy equilibrium is a special

case of Nash equilibrium.

The Prisoners’ Dilemma

A classic example in game theory, called the prisoners’ dilemma, illustrates the problem

oligopolistic firms’ face. It goes as follows: two prisoners have been accused of collaborating

in a crime. They were in separate jail cells and cannot communicate with each other. Each

has been asked to confess to the crime. The payoff matrix in table below summarizes the

possible outcomes.

Table showing the pay-off matrix for prisoners’ dilemma

Person B

Confess Don’t confess

Confess -5, -5 -1, -10

Person A

Don't Confess -10, -1 -2, -2

The payoffs are negatives because they show the number of years one will spend in prison.

Obviously, in numeric example -1 is greater than -10 (i.e,-1> -10) implies spending one year

in prison is preferred to spending 10 years in prison.

Pri. A If Prisoner B Confess, -5 Pri. A If Prisoner B Confess, -1

Conf. If Prisoner B Don’t Confess, -10 Don’t Conf If Prisoner B Don’t Confess, -2

Dominant Strategy of Prisoner B is to Confess

Pri. B If Prisoner A Confess, -5 Pri. A If Prisoner B Confess, -1

Conf. If Prisoner A Don’t Confess, -10 Don’t Conf If Prisoner B Don’t Confess, -2

44
 Dominant Strategy of Prisoner A is to Confess

Now let us look the game.

If both prisoners confess, each will receive a term of five years. On the other hand, if one

prisoner confesses and the other does not, the one who confesses will receive a term of only

one year, while the other will go to prison for ten years. If you were one of these prisoners,

what would you do- confess or not confess? It is very difficult to determine.

As the table shows these prisoners face a dilemma. If they could only both agree not to

confess, then each would go to jail for only two years. But they can't talk to each other, and

even if they could, can they trust each other?

If prisoner A does not confess, s/he risks being taken advantage of by his/her former

accomplice. After all, no matter what prisoner A does, prisoner B comes out ahead by

confessing. Similarly, prisoner A always comes out ahead by confessing, so prisoner B must

worry that by not confessing, s/he will be taken advantage of. Therefore, both prisoners will

probably confess, and go to jail for five years.

Oligopolistic firms often find themselves in a prisoner's dilemma. They must decide whether

to compete aggressively, attempting to capture a larger share of the market at the competitors'

expense, or to "cooperate" and compete more passively, i.e. they can set high prices and

limiting output, they will make higher profits than if they compete aggressively. Let us look

the following game that is played by firm 1 and firm 2.

Firm 2

Charge Birr 4 Charge Birr6

Charge Birr 4 12,12 20,4

Firm 1 Charge Birr 6 4,20 16,16

Now let us assume that both firms have reached the agreement to cooperate by charging birr

6 for a product they sell and each one will receive birr16 Profits. However, if one firm cheats

45
the other by charging 4 (the other charged as before 6) it would increase its profit while the

profit of the other will fall down. That is, if firm 1 charge 4 and firm 2 keeps its promise

(charging 6) firm 1 will increase its profit from 16 to 20.

On the other round, if firm 2 cheats firm 1 by charging 4 it increases its profit from 16 to 20

while the profit of firm 1 falls down from 16 to 4. Since both have the strong incentive to

cheat the other, the final outcome will be to charge 4 and both will have a profit of 12 which

is less than the cooperative profits, 16. Have you noted that the result of this game is similar

to the prisoners’ dilemma?

IV-PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION

- Economic resources can be grouped into labour, land, capital, and entrepreneurship. They

are also called factors of production or simply factors. These factors are supplied by

households and purchased by firms.

- Factor Prices together with factor employment determines the share of each market in the

national income. Ex- The share of labour income in the national income equals the average

wage rate multiplied by the number of workers.

46
- This implies that theory of factor pricing also explains how national income is distributed

among the various factors of production. Hence the other name of this theory is Theory of

distribution.
-A- FACTOR PRICING IN A PERFECTLY COMPETITIVE MARKET

A perfectly competitive factor market is one in which there are a large number of sellers

and buyers of the factor of production. Because no single seller or buyer can affect the

price of the factor, each of them is a price taker. The mechanism of determination of factor

prices does not differ fundamentally from that of prices of commodities. Factor prices are

determined through the forces of demand and supply. The difference lies in the determinants

of the demand and supply of productive factors.

A.1. The Demand for Factors of Production

Given that labor is the most important input or factor, we will usually speak of the “demand

for labor” or “the supply of labor” but it should be interpreted as the “demand for a

productive factor” and the “supply of a productive factor.” Following the methodology of

earlier units, we will develop first the demand for labor by a single firm. Here we will

examine the demand for labor in two cases: A) where labor is the only variable factor and B)

when there are several variable factors. Then, we will derive the market demand for a factor.

Derivation of demand curve for factor of production is based on (dependent on) MP concept.

In other words demand for a factor is derived demand; it is derived from its MP. Marginal

productivity concept states that at equilibrium each factor is paid in accordance with its

marginal productivity.

i.e. payment made to a factor = the value of its MP o

or wage rate (w) = MPLr x Price of the product = VMPLr

This means that for a  maximizing firm it employs an additional labour so long as the

value of its product is greater than its cost.

A.1.1 The Demand for one (Single) variable productive factor(Lr)

47
We derive the demand for labour by a single firm when labor is the only variable factor in the

production process. The following assumptions underlie our analysis:

i) A single commodity x is produced in a perfectly competitive market. Hence Price of x ( P x) is

given (constant) for all firms in the market

ii) The goal of the firm is profit maximizations

iii) Technology is given

iv) The market of labour is perfectly competitive, i.e., the price of labor services is given for all

firms. This implies that the supply of labour to the individual firm is perfectly elastic as

shown below. At with the firm can employ any amount of labor it wants.

Since labor is the only variable

factor in production of commodity x, the shape of the production function is 'S' shape due to the law

of diminishing marginal returns of the variable factor Labour (L).

Figue1 b) The marginal physical product and the

value of marginal product of labor
a) The total Product curve (TP) (MPPL and VMPL)
X MPP L

X= f(Lr) VMPL

Lr MPPL VMPL= MPPL (Px)

Lr

The slope of the production function X = f (Lr) is the marginal product of labor (MP L)

becomes zero when TP is maximum. Since the rational producer chooses to operate in stage

48
II i.e., the point where APL maximum and TPL maximum. In other words, this stage II- the

feasible production range- can be presented by the downward slopping MP L curve in figure b

above. Now let us derive the equilibrium of the firm in a factor market.

As mentioned above, the slope of the production function X = f (L) is = MPL, i.e., the

additional output x produced by and additional labor. MPL is measured in terms of physical

quantity. It can be kilogram or litter, etc. When we multiply MP L by its Price Px in terms of

money, we get the value of the marginal product of labor (VMP L) expressed in terms of

money, birr. Since Px is constant and MPL is downward sloping, automatically, the VMPL

curve is down ward slopping and lies above the MPL curve in figure b above.

Using the marginal value, profit is maximized when the marginal cost of a factor (MC L) is

equal to the value of its marginal product (VMPL) in a perfectly competitive market. Since

total production cost (c) is the sum of variable and fixed costs, i.e., C= .L + F, the extra

cost incurred as a firm employ an extra labour is the marginal cost of labor (MCL)

MCL= . Thus profit maximizing firm will hire (employ) a resource (L) up to the point

at which MCL= VMPL which implies =VMPL which is an equilibrium point. This

equilibrium implies labor in a perfectly competitive market is paid its value of marginal

product.

The mathematical derivation of the equilibrium of the firm is as follows.

The production function is X= f (L), all other things are constant.

The total cost is C= TVC + TFC = .L+F

The revenue of the firm is R= x.X = x [f (L)]

Profit of the firm is П= R - C = x. X- .L- F

49
To find the maximum profit the first derivative of П with respect to L must be zero, that is,

x MPL- = 0, since is MPL

VMPL = , which is an equilibrium condition as indicated above.

At the same time the VMP Lr which is the Value of the additional labor product is the same as

MRPLr which is the additional total revenue as a result of additional labour.

To Prove this:  VMPLr = MPL x Px

= MPL x MR, P = MR in Perf. Comp. market

=  TR
 Lr

 MRPLr = MR x MPL

=  TR x  Q
 Q  Lr
=  TR
 Lr

This equilibrium of the firm can be shown using graph. To show the equilibrium Point using

graph, we simply combine the labour supply (SL) curve drawn under the assumption number

(iv above) and the VMPL curve drawn in figure 1b above.

(a) (b)

50
Point e in the first figure denotes the equilibrium of the firm. At point e the MC L = =VMPL. That

means at the market wage rate the firm will maximize its profit by hiring L* units of labour

Now let us consider figure b. At point e the wage rate is and the quantity of labour employed in

production is L*. If wage increases from to 1 , the equilibrium shifts to e1. That means as wage

increases to maximize profit the quantity labor demanded by the firm decreases from L * to L1. To the

contrary, if falls to 2 , the quantity of labor demanded increases from L * to L2. Thus it follows

from the above analysis that the demand curve of a firm for a single variable factor (L) is its value

of marginal product (VMPL) curve and is downward sloping. The VMP L shows an inverse

relationship between and L.

A.1.2 The Demand for a factor (Lr) in case of Several Variable Inputs

Now we are going to derive the demand for a factor (L) when there are several variable factors in the

production process. When there are more than one variable factors of production the VMP curve of an

input is not the demand curve of a firm anymore. This is so because the various resources are used

simultaneously so that a change in the price of one factor leads to changes in the employment (use) of

the others. The latter, in turn, shifts the VMP curve of the input whose price initially changed.

To see this, now let us assume that Lr and K are the two factors of production existing and again

assume that the wage rate falls down cause we are about to derive the demand of the firm for Lr

input. The change (the fall) in the wage rate affects not only the demand for labour but also the

demand for capital through three effects: i) a substitution effect, ii) an output effect, and iii) a

profit - maximizing effect. We will look these three effects using the Isoquant-Isocost analysis and

we derive the demand for labour from these three effects.

For simplicity assume i) only two variable factors

ii) Initial price of Labour (wage) is w1 and that of capital is r1

iii) Initial Isocost is AB and that of Isoquant is X 1

Figure 1

A’’

51
 K1

 Suppose the K2 E1 firm initially was in equilibrium at point e 1 where it

demand OL1 Labour and OK1 capital at Isocost AB and indifference curve X1.

 Now let the wage rate of Lr fall from w 1 to w2 and hence the new Isocost become AB’ and the

new equilibrium become point e2 at Isocost X2. Here labour demand has increased by L 1L2

and this increase in labour use is as a result of substitution and out put effect.

 To decompose the two effect we draw an ideal Isocost curve A’’ which is parallel to AB’ and

tangent to the original Isoquant X 1. And this A’’ will remove the output effect of the fall in

wage rate and specify the substitution effect.

 Therefore, from point e1 to E1 is substitution effect. The firm substitute K2K1 demand for

capital by L1E1 demand for labour.

 And the remaining i.e. L1L2 – L1E1, a movement from point E1 to e2 is an out put effect.

 Since the firm will ultimately settle at point e 2 it will use more Lr and capital.

 The third effect is profit effect which arises from a down ward shift in the MC curve due to a

fall in wage rate. On figure 2 below at price OP the initial profit maximizing out put was OX 1

at equilibrium point H and suppose it is represented by X 2 Isoquant on figure 1 where the

marginal cost was MC1.

 Now when the wage rate falls the MC shifts to the position of MC and the new equilibrium

point becomes G and the profit maximizing out put increases from OX 1 to OX3. Now the firm

has expanded its output by X1X3 and this expansion requires additional expenditure on

labour and capital. The increase in expenditure (cost) will shift Isocost AB’ to A’B’’ and the

firm will finally be at equilibrium at point e 3 at X* Isoquant on figure 1. And the total

demand for labour is OL3 for which L2L3 is the profit effect additional labour demand.

52
 Figure 2

 The output and profit effect both being positive will lead to additional employment of capital.

Thus the employment of both Lr and K increases as a result of output and profit

maximization effect. This will ultimately lead to an increase in the value of MP Lr. Finally the

decrease in wage rate will shift the VMP Lr curve right ward.

 Now we can easily derive demand for labour when other factor say capital is variable.

When wage rate decreases from w1 to w2

- if Lr was the only variable input the demand for Lr

E
w1 would have increased from OL1 to OL2

- but here k is also variable and as w from w1 to w2

E’
w2 VMPL shifts from VMPL0 to VMPL1 & the new

VMPL0 VMPL1 DDLr equilibrium will be E’ & dd for Lr increases from

O L 1 L2 L3 OL1 to OL3

53
And by joining the initial anf final equilibrium points(E and E’) we arrive at the dd curve for the

variable input Lr as DDLr

A.1.3 Market Demand for a Factor

The derivation of the market demand for a factor is different from that of the commodity. The market

demand for a commodity is a simple horizontal summation of each individual's demand for a

commodity. But the market demand for an input is not the simple horizontal summation of the demand

curves of individual firms. This is due to the fact that as the price of the input falls all firms (In

market) will seek to employ more of this factor and expend their outputs. As output (supply) all

firms in the market increases price of the output (Px) falls down. Since this Px is one component of

the VMP of a factor (i.e., VMPL= Px. MPL), as Px falls the VMPL decreases or shifts down to the left

from d1 to d2 as shown below.

=VMPL1
=VMPL2

Figure a) Demand of a single firm for labour b) Market demand for labor

Initially the firm is at point a employing OL 1, at wage rate w1 in the figure above. Then aggregating

OL1 of all firms at w1 we get the market demand for labour OL1 at point A in figure b. Now assume

wage falls from w1 to w2. Other things being constant the firm would move along d 1 to point b'

employing OL . However, other things do not remain constant (as mentioned above as w 1 falls to

w2, VMPL or d1 shifts to d2 the new demand curve will be d 2.) This is because as each firm uses L 2L

additional unit of labour their supply of commodity increase  a price fall of the commodity will

occur  lead to a fall in VMPL (VMPL = MPL x P)  a downward shift in the demand for Lr from

d1 to d2. At w2 the firm is in equilibrium not at point b' but at point b on d 2 and employing L2 not L'2.

And market demand at this point will be multiplying OL2 by the number of labour employing firms

54
and it is the point B on figure b not B’. Finally the market demand is given by line AB and is

negatively sloped showing an inverse relation ship between w and L in figure b.

A.2. Factor Supply and Factor Price

Under this section we are going to look at how the supply curve of a variable factor is derived and

combining this supply curve with the demand curve of a factor we determine the market equilibrium

price of that factor. As we did in the previous section, here also we concentrate on the labour input.

A.2.1 The Supply of Labour in short run

To begin the derivation of labour supply, we assume that labour is a homogenous factor: all labour

units are identical .The supply of labor by an individual can be derived by indifference curves

analysis. The indifference curves represent the preferences of the individual between leisure and

income. These curves are called as Leisure-Income Indifference curves. The negative slope of the

indifference curve shows substitution between leisure and income such that worker's total satisfaction

remains the same.

Y2

Y1

There are of

maximum hours in a day (24 hrs), which an individual can use for leisure or for work or for both. The

slope of a line from z to any point on the vertical axis represents the wage per hour. For example, if

an individual work all hours and earn 0Y 0 total income, the income per hour (or the wage rate) will be

w0 = Slope of zy0 line. Similarly, w2= = slope of zy2.

55
Thus as we move up from the origin the wage rate increases, i.e., w 0 > w1 > w2 because the slope of

the line increases as we move from zy 0, to zy1 to zy2, the steeper the line the higher the wage rate.

Accordingly as we move up from the origin the level of satisfaction or utility of the individual

increases, i.e., III > II >I

When the wage rate is w 0, the individual is in equilibrium at point A by working AZ hours earning

AA income and spending OA hours of leisure. If wage increases to w 1 the individual work more

hours BZ and will earn a higher income BBand will have less OB for leisure. That means, as wage

increases the individual works more hour by decreasing his leisure time. In other words, as wage

(income) increases the supply of labour by individual increases. The locus of points of A, B, C can

be plotted as the supply curve of labour which shows a positive relationship between wage (w) and

labour (L) as follows.

Do you think that the supply of labor increases indefinitely as wage (income) increases? Please

imagine the amount of hours a typical rich person may work in a day. Have you tried? As we observe

from the above graph as wage increases the supply of labour increases. However, at some higher

wage rate the hours offered for work may decline. This is so because higher wages (incomes) create

incentive for increasing hours of leisure ( by decreasing hours of work).That means, as the wage rate

increases, The individual's income increases and this enables the workers to have more leisure

activities. Hence beyond a certain level of the wage rate, the supply of labour decreases as the person

prefers to use his income on more leisure activities (e.g. tourists),

Up to a certain wage level the labor supply increases as wage increases this is Income or Substitution

effect. However, the supply of labor decreases beyond the some wage level i.e., as income increases

56
the person becomes richer then he works less and spends more of his time for leisure this is Wealth

effect. As a result the supply curve bends backward after a certain level of wage. The supply curve

has both a positive (the rising parts) and a negative (the bending parts) slopes, or the supply curve for

labour in the short run is ‘backward bending’.

A.2.2 The Market Supply of Labour

Different shapes have been suggested for short and long run market supply curve, depending on the

occupational mobility, and the type of labour used and level of economic growth. In general,

however, the backward bending labour supply curve is a phenomenon of the short run but in the long

run the supply curve must have a positive slope, since young people will be attracted to the market.

The market labor supply curve is the sum of individual labour supply curves. Even if higher wages

may induce some people to work less hours, in the long run as more young people will be attracted to

the market, the market supply of labor is positively slopped,

A.3 Factor Pricing

The equilibrium price and quantity of a factor employed in productions determined at the intersection

of the market demand and market supply curve of a factor as shown below.

The equilibrium wage is we and employment level is Le. The market model is valid for the

determination of the equilibrium price of a commodity or a production resource. The difference

between commodity pricing and factor pricing lies in the determinants of the demand for variable

factors and the method used to derive the supply of labour. The demand for factors is a derived

demand (i.e., based on the demand of the commodities produced by the factor). The supply of labor

is not cost determined like the supply of commodities, but involves the attitudes of individuals

toward work and leisure.

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 IV-GENERAL EQUILIBRIUM ANALYSIS

Introduction

Here, we will attempt to show how economists have attempted to form an integrated model

of the economy as a whole.

In this unit, we will try to have a brief introduction to general equilibrium analysis, the

branch of micro - economics that deals with the interrelations among various decision-

making units and various markets.

A. Partial versus General Equilibrium analysis.

Our analysis in previous units has focused on a single market, viewed in isolation. That is,

we have examined

 how an individual maximizes satisfaction subject to his/her income constraint

 how a firm minimizes its costs of production and maximizes profit under various

market structures and

 how the price and employment of each type of input is determined

In short, we have shown demand and supply in each market determine the equilibrium price

and quantity in that market, and these demand and supply curves are drawn on the

assumption that other prices are given, that is, each market is regarded as independent and

self contained for all practical purposes.

In particular, it is assumed that changes in price in one market do not have significant

repercussions on the prices existing in other markets. But this assumption in reality may be

seriously wrong. No market can adjust to a change in conditions with out there being a

change in other markets.

58
That is, change in any market has spillover effects on other markets and the change in these

other markets which, in turn, have repercussions or feed back effects on the original market.

These are studied by general equilibrium analysis: an analysis that takes account of the

inter relationships among prices.

A change in demand and price for domestically produced clothes will immediately affect the

demand and price of cotton, thread and other (the inputs of clothes as well as the demand,

wages, and income of textile workers). The demand and price of other farm products (other

than cotton) and of other products (as well as the wages and income of workers in these

sectors) are also affected. These affected sectors have spillover effects on other sectors, until

the entire economic system is more or less involved and all prices and quantities are

affected. Finally, the effect of this change in the textile industry has on the rest of the

economy will have repercussion (through changes in relative prices and incomes) one the

textile industry itself.

So, these repercussions or feed back effects are likely to significantly modify the original

partial equilibrium conclusions (price and output) reached by analyzing the textile industry

in isolation.

Finally, both kinds of analysis are very useful, each being valuable in its way.

 Partial equilibrium analysis is perfectly adequate in cases in which the effect of a

change in market condition in one market has little repercussion on prices in other

markets other wise; a general equilibrium analysis may be required.

With this background, let’s see the conditions required for the economy to be in general

equilibrium of production, exchange, and of production and exchange simultaneously.

59
A.1 GENERAL EQUILIBRIUM OF EXCHANGE
In this section, you will learn about.

1. The conditions for general equilibrium of exchange

2. The contract curve for exchange

We discuss the concept of general equilibrium of exchange in a very simplified model. That

is, we assume a very simple economy composed of

 Only two individuals ( A &B)

 Only two commodities ( X and Y) and

 No production

This allows us to present the general equilibrium of exchange graphically which is called the

Edge worth diagrams for exchange.

The Edge worth box diagram for exchange below shows the indifference curves of individual

A, Convex to the origin OA given by A1, A2 and A3 and, the indifference cures of individual

B, convex to the origin OB, given by B1, B2, and B3.

The dimension of the box is given by the total amount of the two commodities (10 X and 8Y)

owned by the two individual together

60
 Contract curve
for exchange

Fig. Edge worth Box for Exchange

Some of the basic Characteristics of indifference curve are:

 Along the same indifference curve, utility is the same ( example, along A1, either at

point C or D, Utility is constant)

 As we go further from the origin, utility increases (example for individual a, utility

from A3> A2> A1 and for individual B, B3>B2>B1)

 The slope of an indifference curve is Marginal Rate of Substitution and at a point, it

can be measured by the slope of a tangent line at that particular point.

Having these characteristics in your mind, let’s now proceed to our discussion.

 At point C, individual A is represented by A1 and individual B by B1. Then A has 3x and

6y while individual B has 7x ad 2y for the combination total of 10X and 8Y (the dimension

of the box). Starting at point C, individual A is willing to forgone 4 units of Y to increase the

amount of X by one unit by moving to point D on the same indifference curve (on A1). But,

61
individual B is willing to accept only 0.2y to decrease 1x and exchange with A by moving

from C to H on the same indifference curve ( on B1).

i.e. MRS MRS

Since A is willing to give up much more Y than necessary to induced B to give up 1x, there

is a basis for exchange that will benefit either or both individuals. This is true whenever, as at

point C, the MRSxy for the two individual differs

There is a basis for exchange as long as the MRSxy for the two individual differs i.e

MRS MRS

Example: When A and B move from point C to D, individual B receives all of the gains

from exchange (i.e. utility increases from B1 (at c) to B3 (at D)). While individual A gains or

loses nothing (since A remains on the same indifference curve on A1 either at C or D).

At point D, since A1 and B3 are tangent, so that their slopes (MRS XY) are equal, there is no

further basis for exchange. What do you think is the reason? Yes, because at point D, the

amount of Y that A is willing to give up for 1x is exactly equal to what B requires to give up

1x. Any further exchange would make either individual worse off than he or she is at point

D.

 Alternatively, if individual A exchanged 1y for 5x with individual B, individual A would

move from point C or A 1 to point F on A3, while individual B would move from point C to

point F along B1. Then, A would reap all if the benefits from exchange while B would neither

gain nor lose. At point F, MRsxy for A equals MRsxy for B and there is no further basis for

exchange.

 Finally, if A exchanges 3y for 3x with B and gets to point E, both individual gain from

exchange since point E is on A2 and B2. Thus, starting from point C, which is not on line

62
DEF, both or either of the two individuals can gain through exchange by getting to a point on

line DEF. Curve OA DEFOB is called the contract curve for Exchange.

Contract curve for exchange is the locus of tangency points of the indifference curves of

the two individuals.

 That is, along the contract curve for exchange, MRS XY is the same for individuals A and B,

and the economy is in general equilibrium of exchange.

The two individuals are in general equilibrium of exchange if MRS = MRS

 Starting from any point not on the contract curve, both individuals can gain from exchange

by getting to a point on the contract curve. Once on the contract curve, one of the two

individuals cannot be made better off without making the other worse off.

Example, movements from point D (on A1 and B3) to point E ( on A2 and B2) makes

individual A better off but individual B worse off.

Generally, for an economy composed of many consumers and many commodities, the

general equilibrium of exchange occurs where the MRS between every pair of

commodities is the same for all consumers consuming both commodities.

A.2 General Equilibrium of Production

In the previous section, we examined general equilibrium in a pure exchange economy with

no production. In this section, we will examine

 Conditions for general equilibrium of production in a simple economy

 The contract curve for production.

63
 To examine general equilibrium of production, we deal with a very simple economy that

 Produces only two commodities: Consumer goods e.g. corn and wine

 Uses only two production inputs: Labor and capital

 The production inputs are substituted for each other; workers can move from wine

industry to corn and vice versa.

To see this, we shall construct an Edge worth box diagram for production from the Isoquant

for commodities corn and wine in a manner similar to the Edge worth box diagram for

exchange, in such a way that the size of the box refers to the total amount of labor and capital

available to the economy (12 labor (L) and 10 capital (k)).The Edge worth production box

identifies all the ways in which Labor (L) and Capital (k) can be allocated between the two

production activities.

Corn
production

Contract curve
for production
Capital
(K)

Wine
Labor (L)
Production
Fig. Edge worth Box for production

64
Have you observed? Yes. The differences here are that of Isoquant and inputs. Since we talk

about production, we have inputs (L and K) and output .It is represented by Isoquant W 1, W2

and W3 for wine and C1, C2 and C3 for Corn.

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

production of the two commodities. For example, point R indicates that 3L and 8K are used

in the production of (W1) of commodity W (wine) and the remaining 9L and 2K are used to

produce C1 of corn (C) please note that three of the Isoquants of commodity wine (convex to

origin OW) are W1, W2 and W3. Three of Isoquants of corn (convex to the origin OC) are C 1,

C2 and C3.

Now, our attention is to find the general equilibrium that is to know the allocation of the (12 L

and 10K) among the production of the two goods and how much outputs of the two commodities is

produced by every combination and where the economy can maximize its output of corn and wine.

 Suppose this economy were initially at point R, it wouldn't be maximizing its output

of corn and wine, because at point R, the marginal rate of technical substitution of

labor for capital ( MRTSLK) in the production of Wine exceeds the MRTS LK for corn

i.e.
MRST MRTS
>

 By simply transferring 6k from the production of wine to the production of corn and

1L from the production of corn to the production of wine, the economy can move

from point R (on C1 and W1) to point J (on W1 and C3) and increase its output of corn

(from C1 to C3) and maintain the out put of wine constant (along the same W1)

65
 Can you think of any other alternative to increase the out put of either/ both commodities

with out reducing the other?

 Yes. The economy can move from point R to point N (and increase its output of wine

from W1 to W3, without reducing the output of corn).

 Again, by transferring 4k from the production of wine to the production of corn and

4L from corn to wine this economy can move from R (on, W 1 ,and C1) to M ( on W2

and C2) and increase its output of both wine and corn .

At points J, N and M, wine Isoquant is tangent to a corn Isoquant so that the MRSTS LK in the

production of Wine equals MRTSLK in the production of Corn i.e. MRTS = MRTS

 Curve OWJMNOC is the contract curve for products

Contract curve for production is the locus of tangency points of the Isoquant for W and C at

which MRTSLK in the production of W and C are equal. That is the economy is in

general equilibrium of Production when

W C

MRTS = MRST

Thus, by simply transferring some of the given and fixed amount of available L and K

between the production of W and C, this economy can move from a point not on the contract

curve for production to a point on it and increase its output of either or both commodities.

But, once on its production contract curve, the economy can only increase the output of

either commodity by reducing the output of the other.

Please consider the following example.

Example - By moving from point J (on W1 and C3) to point M (on W2 and C2), the economy

increase its output of commodity W (W1 to W2) but its out put of corn falls (C3 to C2).

66
Generally for an economy of many commodities and much input, the general equilibrium of

production occurs where the MRTS between any pair of inputs is the same for all commodities

and producers using both inputs.

A.3 Derivation of production possibility Frontier.

The production possibility Frontier or PPF transformation curve shows the various combinations

of commodities X and Y (two good) that the economy can produce by fully utilizing of the fixed

amount of resources in the best technology available.

We derive the PPF from the contract curve for production. Since the production contract

curve shows all points of general equilibrium of production, so does the Production

Possibility Frontier. The corresponding PPF can be derived by simply plotting the various

combinations of out puts directly. For our discussion please refer to the Edge worth box for

production given in the previous section.

For Example - If Isoquant W1 referred to an output of 4 units of commodity wine and

Isoquant C3 refereed to an output of 13 units of commodity corn, we can go from point J (W 1,

W3) to point J on the PPF (4W, 13C). And by repeating the same procedure for other points,

and joining them, we derive the PPF of W for C.

14-

13- J(W1,C3)

12-

Corn

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 10-

8- M(W2,C2)

6-

4- R(W1,C1) N(W3,C1)

2-

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Wine
The production possibility Frontier

Thus, the production possibility Frontier is obtained by simply mapping or transforming the

production contract curve from input space (L and K) to output space (W and C).

The PPF shows the maximum amount of either commodity that the economy can produce,

given the amount of the other commodity that the economy is producing.

Take the following example, given that the economy is producing 10W, the maximum

amount of commodity C that the economy can produce is 8C (point M in the figure and vice

versa)

We can identify the following similarities

 A point inside the production possibilities frontier corresponds to a point off the

production contract curve and indicates that the economy is not in general equilibrium

of production, and it is not utilizing its input of Labor and Capital most

efficiently( Inefficiency).

Example: Point R inside PPF corresponds to point R in the Edge worth production box at

which Isoquant W1 and C1 intersect. By simply reallocating some of its inputs between the

production of W and C, this economy can increase its output of C only (and move from point

68
R to J) or it can increase its output of W only and move to N or it can increase its output of

both W and C and move to M.

 Once on the PPF or the contract curve, the output of one commodity cannot be

increased without reducing the other.

Example: A move from pt J to M will increase W by C must be reduced.

Let’s now introduce the concept of marginal Rate of transformation (MRT)

MRTWC is the amount of commodity C that the economy must give up, at a particular point on the PPF,

so as to release just enough Labor and Capital to produce one additional unit of commodity W.

This is given by the absolute value of the slope of PPF at that point.

For example, at pt M on the PPF, it MRT WC is 3/2 or 1.5 (The absolute value of the slope of

the tangent line to the PPF at Pt M). It implies that 3/2 of C must be given up to produce one

additional unit of W.

 As we move down the PPF (and produce more W and less C), the MRT WC increases,

indicating that more and more C must be given up in order to produce each additional

unit of W.

A.4 General Equilibrium of Production and Exchange

Up to now we have seen the conditions of general equilibrium of production and exchange

separately. We now combine the results of the previous three sections and examine how a

simple economy composed of

 Two individuals (A and B)

 Two commodities (W and C) and

 Two inputs (Labor and Capital) can reach simultaneously general

equilibrium of production and exchange. This shown below. First

consider the following graph

69
 Fig. General equilibrium of production and exchange

The slopes at each point on the contract curve and PPF are given. Suppose the MRS WC at D,

E and F are 3, 3/2 and 1/2 respectively and MRT WC at M is 3/2.

Suppose that this economy Produces 10W and 8C, given by point M on the PPF, we can

construct the edge worth box diagram for exchange between individual A and B by dropping

perpendiculars from point M to both axes. Given the indifference curves of individual A and

B and the output of 10X and 8Y, we derive a contract curve O A DEFOB for exchange (please

once refer to the Edge worth box for exchange). Every point on the contract curve for

exchange is a point of general equilibrium of exchange.

 Thus, every point on PPF is a point of general equilibrium of production, and every point

on the contract curve for exchange is a point of general equilibrium of exchange.

 However, in order the economy to be simultaneously in general equilibrium of exchange

and production, the marginal rate of transformation (MRT) of commodity W for

commodity C in production must be equal to the marginal rate of substitution of

commodity W for C in consumption for individual. A and B.

i. e. MRTWC= MRS = MRS

70
Geometrically, this corresponds to the point on the contract curve for exchange at which the

common slope of indifference curve of individual A and individual B equals to the slope of

PPF at the point of production. This occurs at point E where

MRS = MRS = MRTWC = 3/2

When producing 10W and 8C (at Pt M on the PPF), this economy is simultaneously in

general equilibrium of production and exchange when individual A consumes 6W and 3C

(point E his/her indifference curve A2) and individual B consumes the remaining 4W and

5C (point E on his/her indifference curve B 2). If this condition did not hold, the economy

would not be simultaneously in general equilibrium of production and exchange.

For Example, suppose that individuals A and B consumed at point D on the contract curve

for exchange rather than at point E. At point D, the MRS WC (the common absolutes value of

the slope of indifference curves A1 and B3) is 3. This means that individuals A and B are

willing (indifferent) to give up 3C to obtain one in additional unit of W. Since in production,

only 3/2c needs to be given up to produce an additional 1 unit of W, society would have to

produce more of W and less of C to be simultaneously in general equilibrium of production

and exchange (and move from point M to point N).

To put in another way if MRSWC= 3, this society would not have chosen to produce at pt M,

but would have produced at point N (12W and 4C), where MRSWC = MRTSC= 3. The opposite

is true at point F. That is at point F MRSWC = 1/2. Since MRTWC= 3/2 at point M (the point of

production, more of C needs to be given up in production to obtain one additional unit of

production, more of C needs to be given up in consumption.

If this were the case, this society would have chosen to produce at point J (4W and 13C),

where MRSWC= MRTWC= 1/2 rather than at point M. only by consuming at point E will

71
MRTWC= MRSWC for both individuals, and society will be simultaneously in general

equilibrium of production and exchange when it produces at point M.

V- WELFARE ECONOMICS, EXTERNALITIES AND PUBLIC GOODS

Introduction

In the previous units, we have mainly concentrated on the analysis of different market

structures. But, each economic situation in each market structure has its own implications on

the well- being of the society. So, we will examine some criteria to evaluate the implications

of these economic situations on welfare or social well- being. Besides, we will analyze how

markets fail in the presence of asymmetric information, externalities and public goods.

The price system works efficiently because market prices convey information to both

producers and consumers. Sometimes, however, markets prices do not reflect the activities

of either producers or consumers. There is an externality when a consumption or

production activity has an indirect effect on other consumption or production activities

that is not reflected directly in market prices. The impact of externalities and public goods

will be analyzed in the second section of this unit.

If consumers do not have accurate information about market prices or product quality, the

market system will not operate efficiently. Asymmetric information causes inefficiency

which will be seen in the final section.

A.1. Welfare Economics

In this section, you will learn about

 Adam smith's welfare criterion

 Bentham's Criterion

 Pareto's optimality Criterion

 Hicks- Kaldhor criterion

72
Welfare economics is concerned with the evaluation of alternative economic situations, on

the basis of their implication for social well-being. It evaluates alternative economic

situations and determines whether one economic situation yields greater welfare than

others.

The term ' welfare' has been defined in diverse ways, because it is difficult to give it a

precise meaning. What is the basis to evaluate whether a given economic situation improves

welfare or not? Yes, to evaluate alternative economic situations, we need some criteria of

social well- being or welfare. And various criteria of social welfare have been suggested by

economists at different times.

A.1.1. ADAM SMITH'S WELFARE CRITERION

According to Adam Smith, the final aim of all production is to make goods and services

available for consumption and increase in consumption results in increase in the level of

satisfaction. Therefore, increase in the level of national output leads to increase in the level

of satisfaction of a society.

Adam Smith considered growth in National Physical product as the main determinant of welfare.

But growth in Gross National Product (GNP) doesn't necessarily guarantee an increase in

welfare. So, his welfare criterion assumes existing income distributions as just and fair.

However, growth in national income with greater income inequalities may reduce social

welfare.

A.1.2. BENTHAM'S CRITERION

Jeremy Bentham argued that welfare is improved when the greatest good is secured for the

greatest number. Welfare is the sum total of utility (welfare) of all individuals in a society.

According to this criterion, if say the society is composed of three individuals, A, B and C

The total Welfare W is W= UA + UB+ UC where

73
 UA = utility of individual A

UB = utility of individual B

UC = utility of individual C

And, welfare is improved as long as change in: - W (W) which is UA+ UB+ UC should

be greater that 0 (i.e. W>0), where = Change. But, this criterion has serious shortcomings.

Because:

 It is difficult to measure and add the utilities of individuals to obtain the social

welfare

 The welfare of most individuals may be negatively affected while change in W is

positive. Example, if UA and UB decrease and UA increase. But (UA+ UB < UC),

W will be greater than 0 while two out of three individuals are relatively affected.

A.1.3. PARETO'S OPTIMALITY CRITERION

According to this criterion, any change which makes at least one individual better off and no

one worse off is an improvement in social welfare.

That is, social welfare is at its optimum when it is impossible to make even a single person

better off by reallocating productive resources and consumers goods and services, without

making some one else worse off.

To understand this criterion is an easy, take the following simple example. Suppose there are

3 individuals. Take you and two of your friends. To say welfare is improved, at least the

welfare of one of you should be improved and there should be no one negatively affected. If

two of you have gained and one lost, we can't say that welfare is improved. This criterion is

related to the concept of general equilibrium of production and exchange. Let's see the

following two cases.

a) Pareto - Optimality in exchange

We can say that a distribution of the given commodities X and Y between the two consumers

is optimal if it is impossible by a redistribution of goods to increase the utility of one

individual without reducing the utility of the other.

74
Please refer back to the general equilibrium of exchange in the previous unit. As we

discussed in general equilibrium of exchange, a movement from a point off the contract

curve results in an improvement at least in the utility of one individual without reducing the

other. Hence, it is possible to improve welfare by moving to a contract curve.

 Points off the contract curve are not optimal (efficient) because welfare can still be

improved (they are not maximum points), i.e. take the movement from A to B, C or D.

 But, points on the contract curve for exchange are Pareto- optimal since it is

impossible to further improve welfare by redistributing X and Y.

On the other hand, a movement from a point on the contract curve to a point off the contract

curve decreases social welfare.

While points on the contract curve are Pareto -optimal, points off the contract curve are

not maximum (optimal) since it is possible to improve welfare.

X OB

Y
C

Y B
A3

A2 B1

B3 A 1 B2

OA X

OACDO= contract curve of exchange. At any point on the contract curve MRS =MRS

therefore B, C and D are Optimal

75
b) PARETO- OPTIMALITY IN PRODUCTION

What criterion (condition) should be fulfilled to say that a given distribution of inputs is

Pareto- optimal? One can say that a redistribution of the given inputs (i.e L and K) is Pareto-

optimal if it is impossible by a redistribution of factors of production to increase the

amount of one output without reducing the amount of the other.

L OY

A Contract curve

for production.
D

Capital C k

(K) B
x3

x2 y1

y3 x1 y2

MRTS = MRTS
Ox Labour(L)

At points B, C and D

 Point off the production contract curve are inefficient because reallocation of the

given K and L between the production of the two outputs increase the amount of at

76
 least one commodity without reducing the other to reach points on the contract curve

of production.

 Therefore, a movement from off the production contract curve to it results in an

increase in welfare and points on the contract curve are Pareto-optimal. We call them

optimal points because there cannot be further reallocation of inputs which improves

the output of at least one commodity without reducing the other.

For instance, a movement from point A to B, C or D can improve at least the output of

one commodity without reducing the other (as result point A is not maximum (optimal)

point. But, a movement from B, C or D to any other point can't result an improvement

(they are maximum (optimal) point).

A.1.4. HICKS- KALDOR COMPENSATION CRITERLON

In reality it may be difficult to improve the welfare of someone without affecting the other.

So, we may question the applicability of Pareto-optimality criterion to the reality. To correct

that, we introduce this compensation criterion.

 According to this principle, the person who benefits from an economic policy or

reallocation of resources must be able to compensate the person who becomes

worse- off due to this policy, and yet remain better off. The compensations should,

however, not exceed his benefit. To understand this idea, assume that a change in the

economy is being considered which will benefit some (gainers) and hurt others

(losers). So,

If the amount of money of the ' gainers' is greater than the amount of the 'losers', the change

constitutes an improvement in social welfare. Those who could benefit from it could compensate

those who are hurt, and still be left with some ' net gain'

77
 Please take the following example: If a road is constructed in your surrounding there will

be some gainers and losers. To say that the construction of the road improve welfare,

those who gain (benefit) from the construction could compensate the losers and still

remain beneficial.

A.2 Externalities

Externalities are the effects of production or consumption activities that are not directly

reflected in the market.

 impose cost or benefits on external body but they are not taken into account

when decisions are made

 can arise between producers, between customers, or between consumers and

producers

 externalities can be divided into positive and negative

A.2.1. Positive Vs Negative Externalities

Positive externalities - arise when the action of one party benefits another party.

Example- Suppose- you are a florist (keeps a flower garden) and your neighbor is a

Beekeeper (has a beehive). You know that Bees use flowers as a feed. In this case, you

benefit the Beekeeper in your neighborhood. Yet, your decision about flowering did not take

the benefits for the beekeeper in to account. That is, you are not paid for the benefits you

provided.

The benefits are positive externality.

 If a road is constructed in a given area, House holds residing around that road will

benefit yet they don't pay for the benefits they get. This is another case.

78
Negative Externalities- arise when the action of one party imposes costs on another party.

Example- Suppose there is a steel plant (factory) in a given area. And there are fishermen

down stream that depend on the river for their daily catch. If the steel plant dumps its waste

into the rivers, the fisher men will be affected. It results a decrease in the production of fish

because of the waste.

The negative externality arises because the steel firm has no incentive to account for the

external cost that it imposes on fisher men when making its production decision.

Let me add you one

 If there is a night club in your surrounding, the noise will disturb (put external

cost) people in that area during the night.

 Externalities and inefficiency

Since externalities are not directly reflected in the market and not considered when decisions

are made, they affect efficiency. Let's see the effects of positive and negative externalities

one by one.

 Positive Externalities and inefficiency

Please consider the above example of the florist and beekeeper. Given the demand curve of

the florist (private Benefit) and marginal cost, the marginal social benefit (MSB) is above the

marginal Private benefit (MPB). MSB=MPB + MEB

MEB= Marginal External
Benefit
MC= Marginal cost of the florist
MPB= Marginal private benefit of the
florist
MSB= Marginal Social
Benefit

79
 P

MEB
P1
MSB MC

D=MPB
Q

O q1 q*

 From the side of the florist, since it doesn't consider the external benefit when decision is

made, it equates its private benefit with its cost. That is, using Marginality rule (MR=

MC), MPB=MC and it chooses to produce q1.

 But, this florist generates external benefits to the neighbors, as the marginal external

benefit (MSB) curve show. From the side of the society, by including all benefits (MPB

+ MEB), what is important is MSB. Then, by equating MSB = MC, the society chooses

to produce q*.

Now, why the inefficiency arises? It is because the florist doesn't capture all the benefits of

its investment in flowering. As, a result it is producing only q1 while it had to produce q*.

So, the under production (q*-q1) is the cause of the inefficiency.

 Negative Externalities and Inefficiency

Once again consider the above example of the steel plant and the fishermen.

Given the following graph, MC is the marginal cost of the steel plant which doesn't include

the external cost. But, the cost of producing steel to the society (including fishery) is greater

than the cost of the private firm i.e. the Marginal social cost of steel production is greater

than the marginal cost (MC) of the firm.

MC= Marginal private cost

of the plant
MSC= Marginal social cost
which considers the external
cost
80
 Price

cost MSC MC

MEC

MR
B A

P Q (output)

O qs qf

Suppose the production decision of the steel plant is in a competitive market and remember

also equilibrium occurs when marginal cost equals marginal revenue. (MC = MR)

Now, from the side of the firm, equilibrium is at A when MC=MR and maximizes profit by

producing qf. But, from the side of the society, MC is not the only cost MSC includes both

MC and the external cost on fishermen.

MSC = MC =MEC MEC= marginal External cost

So, qs - is the socially efficient output that could be produced including all costs ( production

cost + external cost).

qf - is the profit maximizing output for the firm .

What do you observe from the above analysis?

 While it should be produced qs amount of output by considering all costs, the firm is

producing qf amount of output by simply considering only its own production cost.

 From the side of the society, too much output is produced.

The economic inefficiency is the excess production that causes too much out put.(qf - qs ) is

the excess production due to negative externality i.e. by imposing cost and ignoring it

when production decision is made.

81
A.3 PUBLIC GOODS

Public goods are goods characterized by non- rivalry and non - excludability in

consumption or use.

 A good is non- rival if providing it to an additional consumer doesn't affect the amount

available for others.

Example: The use of a high way (road) during a period of low traffic. In this case, adding

more cars up to capacity will not reduce what is available for others.

 A good is non- excludable if it is difficult or impossible to exclude some one from

using it, once the good is made available.

Example: Once a nation has provided for its national defense, all citizens enjoy its benefits

i.e. you can't be excluded from getting defense service.

 While some of public goods are pure others are not.

A good is pure public good if it is both non- rival and non - excludable in its nature at

the same time.

 But, there may be public goods which are not- rival but exclusive, non-

excludable but rival.

The problem of Public Goods:

If a good can't be excluded, can you enforce payment? No. For instance, take street lighting.

Any one can't be excluded from using it so that you can't charge payments. In this case,

private investors get it unprofitable because they can't charge prices so; public goods must

either be provided by the government or subsidized by the government.

 This is the reason why road, street lighting, defense, etc services are provided by the

government.

A.4 Asymmetric Information

In this section, we will discuss

 What asymmetric information is

82
 The problems caused by asymmetric information.

In our previous discussions, we have implicitly assumed symmetric information that

consumers and producers have complete information about the economic variables that are

relevant for the choices they face.

Asymmetric information arises when some parties know more than others.

 It is simply unequal access to information. You can guess what does

Symmetric information mean. It is the opposite of asymmetric information

In a number of markets, the sellers know much more about the quality of a good than the

buyers do. When the concerned parties have differential access to information, we say the

market is subject to asymmetric information.

What do you think is the effect of asymmetric information in the market?

Information asymmetry can cause serious problems to the efficiency with which the market

system operates. Under asymmetric information, decisions will involve uncertainty that lead

to market failure. At this level, to see how asymmetric information can cause market failure,

let us take two problems A) Adverse selection and B) Moral Hazard.

A) Adverse Selection

In some markets, because of asymmetric information, the bad quality products drive good

quality out of the market. This scenario is called adverse selection. Let's take an insurance

market.

Suppose

 There is asymmetric information in insurance i.e. people who buy insurance know much

more about their general health than any insurance company can hope to know, even if it

insists on a medical examination. Then what will happen?

 Yes, because unhealthy people are more likely to want insurance, the proportion of

unhealthy people in the pool of insured people increases.

83
 This forces the price of insurance to rise, so that more healthy people, realizing their low

risks, choose not to be ensured.

 This further increases the proportion of unhealthy people, which forces the price of

insurance up more, until nearly all people who want to buy insurance are unhealthy.

 Thus, selling insurance becomes unprofitable. So, adverse selection makes the operating

of insurance markets problematic.

B) Moral Hazard.

This is the other effect of asymmetric information. Let's again take the case of insurance

market.

 If the customer can influence the probability of occurrence of the insured incident, the

insurance market can be a victim of the problem of moral hazard.

 Moral Hazard arises when the customer changes his/her behavior after purchasing

insurance.

Example-1-: Please take your self. Suppose you bought insurance for your property (House).

And, compare the amount of care you give for your property before and after you buy the

insurance. In most of the cases, you put less effort in caring for the property after you buy

because you feel insured i.e. your behavior changes. As a result, the insurance company

might have to pay higher compensations than expected because your behavior has changed.

But, what would be the case if these were equal information (that is, if there is symmetric

information)? It might give compensations for those who care for the property. In the

absence of equal information, the insurance company is affected because of Moral Hazard.

Example-2-: Take the workers’- managers’ relationship. Usually, the manager can't perfectly

monitor the behavior of workers (asymmetric information). Then, because they are not

monitored, their behavior may change and creates a problem in their relationship.

C) Case Study: Information and Insurance Markets

84
The market of insurance is characterized by a number of informational asymmetries.

Most of these arise from differences between buyers and sellers of insurance in their

information about the uncertain event being insured against. Because buyers of insurance

directly face these uncertainties, they are often in a better position to know the true

likelihood of their occurrence and are frequently able to take actions that may affect that

likelihood. A car owner in urban area, for example, knows whether he or she is parking in

an area where cars are likely to be stolen and could, possibly at some cost, choose to park

in a safer place. Automobile insurance firms, on the other hand, find it prohibitively

costly to discover how each policy holder parks and must instead base rates on an

assumed average behavior. This type of situation is not unique to insurance markets, but
characterizes a large number of transactions involving informational asymmetries. The concept of

“moral hazard” and “adverse selection” are perhaps the most important discoveries of modern

information theory.

Moral Hazard: individuals can take a variety of actions that may influence the probability that a

risky event will occur. Homeowners contemplating possible losses from fire, for example, can

install sprinkler systems or fire extinguishers at convenient locations. Similarly, people may buy

antitheft devices for cars or keep physically fit in an attempt to reduce the likelihood of illness. In

these activities, utility maximizing individuals will pursue the risk reduction up to the point at

which the marginal gains from additional precautions are equal to the marginal cost of these

precautions.

In the presence of insurance coverage, however, this calculation may change. If a person is fully

insured against losses, he or she will have a reduced incentive to undertake costly precautions and

may therefore increase the likelihood of a loss occurring. In the automobile insurance case, for

example, a person who has a policy that covers theft may park in less safe areas or refrain from

installing antitheft devices. This behavioral response to insurance coverage is termed as “ Moral

Hazard.” Moral Hazard is then the effect of insurance coverage on individuals’ decisions to

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undertake activities that may change the likelihood of incurring losses. It is a situation of

information asymmetry where one player’s actions are not directly observable to others.

Adverse Selection: A second, related way in which informational asymmetries may affect

market transactions arises when different individuals may have different probabilities of

experiencing unfavorable outcomes. It is a form of information asymmetry where a player’s type

(available strategies, payoffs…..) is his private information, not directly known to others. For

example when people buy car insurance, the insurance company doesn’t know all the details

about the car but the owner almost knows it (at least better than the insurance company). So when

the insurance company sells its policy to the car insurance buyers, it may select those car owners

whose car has a lot of problems. As a result the company will have so many troubles in managing

these kinds of policy holders. This type of game theoretic concept is called an adverse selection.

If (as in the moral hazard case) individuals know the probabilities more accurately than do

insurance providers, insurance markets may not function properly because providers may not be

able to set premiums based on accurate measures of expected loss. The resulting equilibrium may

be undesirable for many market participants. That is generally to say, if an insurance company

cannot know as much about the risks (say, of health) as do the insured , then those people who

faces the worst risks may choose to insure more, thereby worsening the average risk pool and

raising premiums for all; and this game theoretic concept is adverse selection. To cope with

these problems, insurance companies usually provide only partial insurance, requiring the policy

holder to bear part of the loss. To solve this challenge insurance companies have to use a

screening mechanism.

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