Microeconomics-II Year II, Semester II

Chapter one
Monopolistic Competitive Market Structure

1.1. Review of Market Structure

A market is an institution or mechanism that brings buyers and sellers of particular goods, services,
or resources together. It is a set of conditions in which buyers and sellers meet each other for the
purpose of exchange of goods and services for money. Market structure is the interconnected
characteristics of a market, such as the number and relative strength of buyers and sellers and
degree of collusion among them, level and forms of competition, extent of product differentiation,
and ease of entry into and exit from the market.

The market structure in which a firm produces and sells its product is defined by the following
characteristics:
◦ The number of firms in the industry
◦ The nature of the product produced
◦ The degree to which the firm can influence price
◦ Non-price competition
◦ The extent of barriers to entry
◦ The impact on efficiency
Based on these characteristics, markets are classified into:
I. Perfect competitive market: homogeneous products, buyers and sellers are price takers.
II. Imperfect competition market
 Oligopoly: few large sellers who have some control over the prices.
 Oligopsony: few buyers of a product
 Monopoly: single seller with considerable control over supply and prices.
 Monopsony: single buyer with considerable control over demand and prices.
 Monopolistic Competition: many sellers, differentiated products

1.2. Introduction and Basic Features of Monopolistic Competitive Market

The real world is neither perfect competitive nor perfect monopoly. The type of competition found
in the real world lies b/n the two extremes. Monopolistic competition is a market structure in which

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there are many firms selling differentiated products. It is the hybrid of perfect competition and
monopoly, sharing some features of each. The competitive element arises because there are many
sellers, each of which is too small to significantly affect the other sellers. In addition, firms can
enter and leave a monopolistically competitive industry. The monopolist element arises from
product differentiation. It implies, the product of each seller is similar but not identical, each seller
has a monopoly power over the specific product it sells. However, this monopoly power is severely
limited due to the existence of close substitutes. In other word, even if the product of a
monopolistic competitor is unique and this grants the firm some power of price making like a
perfect monopoly, the product has close substitutes unlike that of a pure monopolist which limits
the power of a monopolistic competitor. Examples of monopolistic competition include the
markets of numerous brands of soap and detergents, restaurants, hotels and resorts, clothing
brands, etc.

1.3. Product Differentiation and The Demand Curve

Product differentiation is generally intended to distinguish the product of one producer from that
of the others in the industry. A firms whose product close substitutes (strong competitor) is busily
engaged in trying to make it product better or look better than the substitute products. That is,
monopolistically competitive firms have to secure some market share by making their product
different. This product differentiation might be attributed to:
The subjective judgment of the consumer,
The quality (for instance durability of the product)
The characteristics of the product such as taste, color…
Warranties and guarantees
Sales promotion, packaging, trademarks, etc.

Product differentiation can be real or fancied. Real product differentiation exists when there are
differences in the specification of the product (chemical composition/ingredients), difference in
factor inputs, the location of the firm that determines the convenience with which the product is
accessible to the consumer, or the services offered by the producer during times of sale. Fancied
/imaginary product differentiation exists when the products are basically the same but the
consumer is persuaded, via advertising or other selling activities, that the products are different. It

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is established by advertising, difference in packaging, brand name. Whatever the case, the aim of
product differentiation is to make the product unique in the mind of the consumer.

The Demand Curves:

One major implication of product differentiation is that the producer has some power in the
determination of its product’s price. The firm is not a price-taker but a price-maker even though it
faces the keen competition of close substitutes offered by other firms. Hence, product
differentiation gives rise to a negatively sloping demand curve. This demand curve is less than
perfectly elastic as the firm can alter price, but more elastic than the demand curve a pure
monopolist faces because of the availability of close substitutes in monopolistic competition.
Unlike a wheat-farmer who cannot individually affect the market price of wheat (nearest example
of perfect competitor), the producer of a clothing brand (Nike, Adidas, Puma) can set the price for
its product. However, as opposed to the Ethiopian Telecommunications Corporation (ETC) which
possesses an absolute power to set its price (fare), the extent to which the cloth producer can
choose (and set) price is very limited. This is because while there is no competitor to ETC that
threatens its market share, the cloth producer fears loss of customers to producers of other brands.

We distinguish between two types of demand curves in the theory of monopolistic competition –
the planned sales curve and the actual sales curve.

The planned sales curve – this is a demand curve that shows how much the firm will sell if it
varies its price from the ongoing level under the assumption that other firms maintain their existing
prices. If the firm reduces its price and other firms maintain their prices, the firm can expect a
considerable increase in sales since it will be able to attract buyers away from other firms in the
group (industry) and increase sales to existing customers. If the firm increases its price and other
firms maintain their prices, the firm can expect a considerable decrease in sales since it will lose
business to other firms in the group.
Thus, assuming that each firm expects its actions to go unfelt by the others, each believes its
demand curve to be quite elastic. This demand curve (the planned sales curve) is shown as dd in
Figure 1.1 below. If the firm under consideration charges P 2 per unit, it would sell Q4 units of its
output; similarly, Q* and Q 3 units would be sold at prices P* and P1, respectively. Under the

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assumption we made regarding what this firm thinks about its competitors, the decision of this
firm to change prices implies a movement along the dd curve.

D
d
P2
P*

P1 d

Q4 Q2 Q* Q1 Q3
Figure 1.1. Two kinds of demand curve

The actual sales curve – this is the demand curve based on the supposition that all firms raise or
lower their prices by the same amount as this firm under consideration. This demand curve, also
known as the share-of-the-market curve, is shown as DD in Figure 1.1. If this firm reduces its price
from P* to P1 (on the expectation of raising sales to Q 3) and all other firms reduce their prices to
P1 as well, this firm will sell only Q1 units of output. Similarly, if this firm increases its price to P2
and all other firms increase their prices to P2 as well, this firm will sell Q2 units of output. Thus, if
firms follow both price- rises and price-cuts of a firm, no shift of customers is expected to result
from a price change. The only change that takes place is the change in the quantity consumed of
each firm’s product in a direction opposite the direction of price change. If this is the case, then
the position of the DD curve will be affected only by the entry into or exit out of the particular
market where the market share of each firm is affected.

The actual sales curve (DD) is less elastic than the planned sales curve (dd), since price reductions
by this firm will expand its sales by a greater amount if other firms do not meet the price reduction,
and price rises by this firm will decrease its sales by a greater amount if other firms do not meet
the price increase (than if they do). For example, if other firms do not follow the decision of a firm
to raise price from P* to P2, the firm’s sales will fall from Q* to Q 4, rather than from Q* to Q2 .

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1.4. The Concept of Industry and Product Group

To enhance the comparison of the concept of industry in monopolistic competition to the same
concept in perfect competition and pure monopoly, recall how industry was defined in the latter
two cases. Under perfect competition, an industry encompasses all firms producing exactly
identical (homogenous) products. Under pure monopoly, since there are no two firms which
produce the same product, a given firm is an industry in itself.

When products are differentiated, one cannot define an industry as a collection of firms producing
identical (homogeneous) products. In this narrow sense, each firm having a distinct product is an
industry in itself, exactly as a pure monopolist is. However, unlike the pure monopolist which
produces a completely unique product, in monopolistic competition, there are firms which produce
closely related (or very similar) products that satisfy the same need. Despite some slight
differences among the various brands of soap, soap producers are in keen competition with each
other and their behaviors are very similar (more or less the same). Thus, it helps if we study the
behavior of soap producers in general rather than studying the behavior of the producer of each
brand of soap separately.

However, product differentiation creates difficulties in the analytical treatment of the industry.
Heterogeneous products cannot be added to form the market demand and supply schedules as in
the case of homogeneous products. Furthermore, there isn’t a single equilibrium price for the
differentiated products, but a cluster of prices. That is, although the producers of the various brands
of soap are to be studied together, the equilibrium price of one brand (say, Wabel) is likely to be
different from the equilibrium price of another (say, 777). As such we will have a cluster of
equilibrium prices for soap taken as a single commodity.

Chamberlin was (perhaps) the first economist who tried to define industry in monopolistic
competition by lumping together firms producing very closely related commodities (in terms of
their use). He referred to such group of firms as a ‘product group’. Thus, whenever the term
industry is used in reference to monopolistic competition, it is to mean a product group.

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1.5. Short Run Equilibrium of Monopolistic Competitive Market

In this section, we examine how a monopolistically competitive firm determines its best level of
output and price in the short run and long run on the assumption that the firm has already decided
on the characteristics of the product to produce and on the selling expenses to incur. Once the firm
has decided on product variation and selling expenses, it can choose only the price it charges
(which also implies the level of output chosen). Note that the choice of price automatically
determines the optimal level of output and thus we do not treat price and quantity as two distinct
variables of choice.

As for a firm under any type of market structure, the best level of output for a monopolistically
competitive firm is determined by the equality of marginal revenue and marginal cost (i.e., MR =
MC). In the short run, the firm maximizes its profit at a point where MR = MC provided that price
is at least as high as the average variable cost (i.e., as long as P > AVC). There are three possible
situations (profit levels) for a monopolistically competitive firm in a short run equilibrium:
production at positive profit, production at normal profit, and production at loss.

1. If the price the firm charges per unit of output (P) exceeds the average cost (ATC) at the
equilibrium level of output, then the firm enjoys positive economic profit
(excess/supernormal/abnormal profit). This is because if P > ATC, then the firm receives more
money from the sale of each unit of output than what it incurs to produce and sell a unit on
average.

2. The firm gets only normal or zero profit if P = ATC (if the demand curve is tangent to the ATC
curve) at a point corresponding to the equilibrium level of output. In this case, the firm incurs
a per unit cost (implicit plus explicit costs) that is exactly equal to what the sale of each unit of
output generates.

3. The firm incurs a loss, if P < ATC at equilibrium. Even if the firm incurs a loss, it will continue
to be in business as long as the total revenue generated from the sale of the product, at least,
covers the total variable cost (i.e., as long as TR > TVC or P > AVC). As can be clear from
this case, the total fixed cost does not enter the short run decision of a firm to either shutdown
or continue operation as it could not be recovered (avoided) by closing down. Fixed costs are
incurred whether the firm chooses to produce or to cease operation. Hence, to decide whether

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to shut down or to continue operation, the firm examines whether the revenue from producing
and selling its product can cover its total variable cost or not. Figure 1.2 below depicts the three
possible short run equilibria of a firm in a monopolistically competitive market structure.

Figure 1.2: Short Run Equilibrium of a Firm in Monopolistic Competition

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1.6. The long run equilibrium of Monopolistic Competitive Market

In the long run, however, the monopolistically competitive firm doesn’t have production at positive
profit or production at loss. This is one similarity between perfectly competitive and
monopolistically competitive firms. However, there is a difference between how the two categories
of firms reach this long run equilibrium. While perfectly competitive firms reach the long run (zero
profit) equilibrium as result of free entry and exit, monopolistically competitive firms reach the
long run (zero profit) equilibrium because of two forces:

1. Free entry into and exit out of the product group

 If firms are making losses in short run, they incentive to exit the market, decrease number
of products, increases demand faced by each firm, demand curve shifts right and each
firm’s loss – declines until: zero economic profit.

 When firms earn positive economic profit in the short run, new firms enter due to low
barriers to entry. Entry increases competition, causing the demand curve for existing firms
shift left as customers have more choices. This continues until firms earn zero economic
profit, where Price (P) = Average Cost (AC).

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2. Price competition of the existing firms

Excess Capacity, Mark Up and Welfare Loss in Monopolistic Competition

As shown in the previous section, the long run equilibrium of a monopolistically competitive firm
is defined by the point of tangency of the demand (DD) curve and the ATC curve. At this point,
MR = MC and ATC = P, but P > MC. As a result, price will be higher and output will be lower as
compared to the long run equilibrium of a perfectly competitive firm. There are also too many
firms in the product group, each producing an output less than the socially optimal level (at a point
on the falling part of the ATC). The difference between the level of output indicated by the lowest
point on the ATC curve and the monopolistic competitor’s output when in long run equilibrium
measures excess capacity. Put differently, excess capacity is the difference between the ideal level
of output corresponding to the minimum ATC and the output actually attained in the long run
equilibrium. Excess capacity suggests that monopolistic competition is costly to consumers.
Monopolistic competitor firms are not productive and allocative efficient. Markup refers the
difference between the price that the firms charge and the marginal cost of production.
 P = MC = min ATC = productive efficiency (least cost method of production)
 P = MC = allocative efficiency (society’s best mix of goods with scarce resources)

Advertising and Monopolistic Competition

Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do. The
goals of advertising are to increase demand and make demand more inelastic. Advertisements costs
are made to persuade consumers to buy a particular good rather than another. Advertising increases
ATC. The increase in cost of a monopolistically competitive product is the cost of “differentness”.
Differentiation exists so long as advertising convinces buyers that it exists. Firms will continue to
advertise as long as the marginal benefits of advertising exceed its marginal costs. The goals of
advertising include shifting the demand curve to the right and making it more inelastic. Advertising
shifts the ATC curve up.

Brand names may signal information regarding the product, reducing consumer risk. It is valuable
to a firm; it makes the demand less elastic and can enable the firm to earn higher profits. Once a
consumer has had a positive experience with a good, the price elasticity of demand for that good
typically decreases—the consumer becomes loyal to the product.

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Chapter Two
Oligopoly Competitive Market
2.1.Introduction and Basic Features of Oligopoly

In this chapter we discuss the characteristics of oligopoly, the types of oligopoly, the various
models of oligopoly behavior, as well as the welfare aspects of the oligopolistic market structure.
The term oligopoly is developed from two Greek words; “oligoi” meaning a few and “pollein”
meaning to sell. Oligopoly is the form of market structure in which there are a few sellers of either
a homogeneous or a differentiated product. With regard to the type of output produced, the
oligopoly market could be similar to perfect competition (producing standardized or identical
products) or to monopolistic competition (producing closely related but not identical products).
The number of sellers is neither as large as that under perfect competition (or monopolistic
competition) nor just one as under pure monopoly. Under monopolistic competition, we saw that
firms do compete on non-price basis, say through spending on selling activities like advertising.
In oligopoly, such competition is generally more severe: firms do fight to reduce the market share
of their competitors to the extent of incurring loss (themselves) so as derive rivals out of market.
They do also exercise various practices to block the entry of potential firms.

Examples of oligopoly market structure in Ethiopia;

Malt industry (two firms)
Cement industry (13 firms)
Brewery industry (15 firms)
Private Banks (15)

Characteristics of Oligopoly

 Presence of market power: In economics, market power is the ability of a firm to profitably
raise the market price of a good or service over marginal cost. In perfectly competitive markets,
market participants have no market power. A firm with market power can raise prices without
losing its customers to competitors. Markets participants that have market power are therefore
sometimes referred to as "price makers," while those without are sometimes called "price
takers." Significant market power is when prices exceed marginal cost and long run average
cost, so the firm makes economic profits.

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The determinants of market power of the firm include:

A. Number of producers/sellers
B. Size of each firms
C. Barriers to entry
D. Availability of substitutes goods/services
 Interdependence among firms: One firm’s choices affect the profit potential of other firms,
which results in strategic interactions among firms. Each firm must take into account the
expected reaction of other firms. The importance of interdependence is that it leads to strategic
behavior. Oligopolistic behavior includes both ruthless competition and cooperation. Strategic
behavior in oligopoly: a firm’s decisions about price and output can affect other firms and
cause them to react. Firm will consider these reactions when making decisions. The policies of
one affect the firms. The demand curves for individual firms are dependent on the pricing and
marketing decisions of competitors. Interdependence in pricing means that price war may be
developed and reduce profit.
 There are few sellers of good or service: Because of being few sellers, the key features of
oligopoly are interdependence between firms and resulting tension between cooperation and
competition.
 Difficult /restricted entry (usually not necessary): the barriers could be legal, minimum
efficient system & strategic behavior. Entry is often limited either by

 Legal restrictions such as patents and copyright (eg. Banking in most of the world),
 A very large minimum efficiency scales (economies of scale; access and complex
technology),
 By strategic behavior (game theory),
 Government regulation favoring existing firms making it difficult for new firms to enter
the market.
 Existence price rigidity: Firms are reluctant to change prices due to potential reactions from
competitors, leading to the kinked demand curve model.

 Product differentiation: products may be homogeneous or differentiated (e.g., automobiles,

smartphones).
 Excessive expenditure on advertisement

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 Oligopoly involves uncertainty: no firm is sure about the future action plans or the response
strategies of its rivals.

As a result, there is no single model describing the operation of an oligopolistic market. In this
market, two to ten firms competing on the basis of price, quality, innovation, marketing,
advertising and regulation. It is the most complex market structure. Generally, firms in
oligopolistic markets may make decisions separately (may behave independently) even though the
decision of one actually affects the other is termed as non-collusive oligopoly. Alternatively,
oligopolistic may enter into tacit (implicit or unspoken) or overt (open or explicit) agreements
regarding their decision(s) referred to as a collusive oligopoly.

2.2.Non-Collusive Oligopoly

In non-collusive type of oligopoly market, there is no collusion (no cooperation) among rival firms.
Thus, under non-collusive oligopoly each firm develops an expectation about what the other firms
are likely to do. Since firms are mutually interdependent, a firm expects some reaction from its
rivals when it decides to take a given course of action. For example, when a firm increases its own
output or price, it expects some reaction from the rivals to its action; increment of output or price.
However, the question is ‘what kind of reaction’ does a firm expect to its action? What then is the
implication of this expectation on the behavioral pattern of oligopolists?

Economists, in their efforts to analyze firms’ behaviors, have developed a number of models which
describe the non-collusive oligopoly. Here, we will look at four popular models of the non-
collusive oligopoly: Cournot’s duopoly model, Bertrand’s duopoly model, Stackelberg’s duopoly
model and the ‘Kinked-Demand Curve’ model. The basic distinctions between the different types
of non-collusive oligopoly models lie on: the assumption as to the kind of action an oligopoly firm
will take; the kind of reaction a firm will expect from its rival as a response to its action; and the
resultant effects of these behavioral patterns (action and reaction) of oligopolists on equilibrium
output and/or price.

2.2.1. The Cournot’s duopoly model

The Cournot-Duopoly model is the earliest and simplest oligopoly model developed in 1838. The
model is based on the following assumes:

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There are two equally positioned firms (duopolies) produce a homogeneous product and
have identical costs;
The marginal (additional) cost of production is zero for both firms;
Both firms have full knowledge of the linear market demand curve they face; and
Each firm acts and decides on its own to determine its profit-maximizing level of output
on the assumption that the competitor will not change its level of output.

A reaction curve is a curve that shows the relationship between a firm’s profit maximizing level
of output and the amount it thinks its competitor will produce. For instance, for two firms (A and
B), firm A’s reaction curve/function shows how much output firm A must produces in order to
maximize its own profit for every specific level of output its rival (firm B) produces. The reaction
functions of firms under Cournot’s behavioral assumption are downward sloping in a quantity set
of axes.

Numerical example: If the market demand for a product supplied by two firms and the costs of
the duopolists are: 𝑃 = 100 − 0.5𝑄 where, 𝑄 = 𝑞1 + 𝑞2 , and, 𝑇𝐶1 = 5𝑞1 and 𝑇𝐶2 = 0.5𝑞2 2 .

A. Find the reaction functions of the two firms.

B. Find Cournot’s equilibrium (the profit maximizing levels of output for the two firms, the
market price they charge, and the profit of each firm).

Solution:
Step 1: Maximize the profit function of each firm with respect to its own output (find the reaction
function of each firm).
Firm 1’s profit is given by:𝜋1 = (100 − 0.5𝑄) 𝑞1 − 5𝑞1
𝜋1 = [100 − 0.5(𝑞1 + 𝑞2 )]𝑞1 − 5𝑞1
𝜋1 = [100 − 0.5𝑞1 − 0.5𝑞2 ]𝑞1 − 5𝑞1
𝜋1 = [100𝑞1 − 0.5𝑞1 2 − 0.5𝑞1 𝑞2 ] − 5𝑞1
𝜋1 = 95𝑞1 − 0.5𝑞1 2 − 0.5𝑞1 𝑞2
𝑑𝜋1 95𝑞1 − 0.5𝑞1 2 − 0.5𝑞1 𝑞2
= =0
𝑑𝑞1 𝑑𝑞1
95 − 𝑞1 − 0.5𝑞2 =0
𝑞1 = 95 − 0.5𝑞2 (1)

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This is firm 1’s reaction function. It gives us the firm’s profit maximizing level of output (q1) for
every level of production by its rival (q2).

Firm 2’s profit is given by: 𝜋2 = (100 − 0.5𝑄) 𝑞2 − 0.5𝑞2 2

𝜋1 = [100 − 0.5(𝑞1 + 𝑞2 )]𝑞2 − 0.5𝑞2 2
𝜋1 = [100 − 0.5𝑞1 − 0.5𝑞2 ]𝑞2 − 0.5𝑞2 2
𝜋1 = [100𝑞2 − 0.5𝑞2 2 − 0.5𝑞1 𝑞2 ] − 0.5𝑞2 2
𝜋1 = 100𝑞2 − 𝑞2 2 − 0.5𝑞1 𝑞2
𝑑𝜋2 100𝑞2 − 𝑞2 2 − 0.5𝑞1 𝑞2
= =0
𝑑𝑞2 𝑑𝑞2
100 − 2𝑞2 − 0.5𝑞1 =0
𝑞2 = 50 − 0.25𝑞1 (2)
This is firm 2’s reaction function. It gives us the firm’s profit maximizing level of output (𝑞2 ) for
every level of production by its rival (𝑞1 ).

Step 3: Solve equations 1and 2 simultaneously to find equilibrium quantities of the two firms.

𝑞1 = 95 − 0.5𝑞2
[ ]
𝑞2 = 50 − 0.25𝑞1
𝑞2 = 50 − 0.25(95 − 0.5𝑞2 )
𝑞2 = 30, 𝑞1 = 80
The reaction function of the two firms and the equilibrium quantities are depicted in the figure
below. 𝑞2
190

50

30 Reaction function of firm 2:𝑞2 = 50 − 0.25𝑞1

𝑞1
80 95 200
Figure 2.1: Reaction Functions and Duopoly Equilibrium under Cournot’s Model

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Once we find the equilibrium quantities of the two firms by solving their reactions functions
simultaneously, the other values are easy to find. The total output in the market is 𝑄 = 𝑞1 + 𝑞2 =
80 + 30 = 110. Then, the equilibrium price is determined by substituting this value (𝑄 = 110)
into the market demand function. Thus, 𝑃 ∗ = 100 – 0.5𝑄 = 100 – 0.5(110) = 45. The profit
of each firm at equilibrium is found by substituting the appropriate values into the profit function
of the firm (П1 or П2) from step 1 above. As an exercise, find the profit of each firm by substituting
the values obtained into the profit functions!

Note that whether the quantities supplied by the firms are equal or not depends on whether they
face the same cost structure or not. Under the initial assumption of identical cost structure (zero
marginal cost for each firm), we found that each firm supplies one- third of the total market.

2.2.2. Bertrand model/ The Bertrand Duopoly Model

Bertrand’s duopoly model (which was developed in 1883) derives from Cournot’s duopoly model
we saw above. It differs from Cournot’s in that this one assumes that each firm expects that the
rival will keep its price constant, irrespective of its own decision about pricing. Each firm is faced
by the same market demand, and aims at the maximization of its own profit on the assumption that
the price of the competitor will remain constant. Like the Cournot’s model, it applies to firms that
produce the same (homogeneous) good and make their decisions at the same time. In this case,
however, the firms choose prices instead of quantities. In short, the difference between Cournot’s
and Bertrand’s models is the difference in the variable of competition – quantity for Cournot and
price for Bertrand.

If the two firms charge the same price each will get half of the market demand at that price. If one
firm charges more than the other, even just a little bit, then the one with the higher price will sell
nothing and the one with the lower price will have all the demand at that price. Because the good
is homogeneous, consumers purchase only from the lowest-price seller. This is a realistic
assumption if information is perfect; if two firms (A and B) produce and supply the same
commodity to a market and if one of the firms (A) charges Birr 10 per unit while the other (B)
charges Birr 6 per unit, then no one with this information would buy from firm A. If, on the other
hand, both firms charge the same price, consumers will be indifferent as to which firm they buy

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from. And, the model assumes that each firm will supply half the market. Bertrand’s model could
have been better if it considered firms producing a differentiated product.

Numerical example: To illustrate the extension, we proposed to Bertrand’s model, assume that
the two duopolists have total costs of TC1= 10 +3Q1 and TC2= 15+2Q and the demand functions
given by:

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

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

Solution:
Step 1: Define the reaction functions of the firms by defining their profit functions.
Firm 1’s profit:
𝜋1 = 𝑇𝑅1 − 𝑇𝐶1 = 𝑃1𝑄1 − (10 + 3𝑄1 )
𝜋1 = 𝑃 1 (12 − 2𝑃1 + 𝑃2 ) − [10 + 3(12 − 2𝑃1 + 𝑃2 )]

𝜋1 = 18𝑃 1 − 2𝑃12 + 𝑃1𝑃2 − 46 − 3𝑃2

𝑑𝜋1 18𝑃 1 − 2𝑃12 + 𝑃1𝑃2 − 46 − 3𝑃2𝑑𝑦

=
𝑑𝑃1 𝑑𝑃1
𝑃1 = 4.5 + 0.25𝑃2, This is firm 1’s reaction function.

Based on similar step the Firm 2’s reaction function is; 𝑃2 = 4 + 0.5𝑃1
Solve the two reaction functions, we found that 𝑃1 = 6.29, 𝑃2 = 7.14

Reaction function of firm 1

P2

Reaction function of firm 2

P1
4.5
Figure 2.2: Reaction Functions and Duopoly Equilibrium under Bertrand’s duopoly model

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Microeconomics-II Year II, Semester II

2.2.3. Stackelberg’s Duopoly Model

This model was developed by Heinrich von Stackelberg and is an extension of Cournot’s model.
He assumed that firms set the quantity sequentially. Stackelberg’s Duopoly Model assumed that
one firm acts as a dominant firm in setting quantities. Dominance implies knowledge of the way
competitors will react to any given output set by the leading firm (in the Cournot model neither
firm had the opportunity to react). A dominant firm then can select that output which yields the
maximum profit for itself. We can use numerical example to show the welfare outcome under the
Stackelberg’s assumption of one dominant firm and one passive (follower) firm.

Example1: Assume that there are two firms who supply salt in the country Ethiopia and entry to
the market is blocked. Further assume that market demand takes the following form. 𝑃 = 30 −
𝑄, 𝑤ℎ𝑒𝑟𝑒 𝑄 = 𝑄1 + 𝑄2, 𝑎𝑛𝑑 𝐴𝐶 = 𝑀𝐶 = 12. We will assume that Firm 1 is the dominant firm
and thus has prior knowledge of Firm 2s reaction curve. Find the Stackelberg equilibrium quantity,
price and profit for each firms.

Solution: Total revenue of Firm 1 is under Cournot

TR 1  30Q1  Q12  Q1Q2

But Firm 1 knows that Firm 2s reaction curve so

 1  1
TR 1  30Q1  Q12  Q1  9  Q1   21Q1  Q12 Thus, MR 1  21  Q1
 2  2

Which when equated with MC (=12) to find Firm 1s output gives

1
12  21  Q1  Q1  9 & Q 2  9  Q1  4.5.
2
Eqiulibrium price for this combined output is P  30  Q  30  9  4.5  16.5

This result shows that Stackelberg’s assumptions offer better welfare outcomes than Cournot
model.

2.2.4. The Kinked Demand Curve

Paul Sweezy introduced the kinked-demand model in 1939. This model attempts to explain the
price rigidity that is often observed in some oligopolistic markets. Sweezy postulated that if an
oligopolist raised its price, it would lose most of its customers because the other firms in the

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Microeconomics-II Year II, Semester II

industry would not match the price increase. On the other hand, an oligopolist could not increase
its share of the market by lowering its price, since its competitors would immediately match the
price reduction. As a result, oligopolists face a demand curve that is highly elastic (sensitive) for
price increases and less elastic (insensitive) for price reductions. That is, the demand curve faced
by oligopolists has a kink at the established price. Consequently, oligopolists tend to keep prices
constant even in the face of changing costs and demand conditions. Hence, interdependence is
recognized in Sweezy’s model.

$
A

H
MC1
P* B
MC2

Q
O Q* G C
The demand curve facing the oligopolist is HBC with a kink occurring at a point corresponding to
the prevailing price P* and quantity Q*. This demand curve is more elastic above the kink than
below it. In other words, the firm is very likely to lose significantly for raising its price above P*
but very unlikely to gain by cutting its price. The oligopolist’s marginal revenue curve is given by
HJFG (HJ corresponding to the demand curve above the kink – HB, and FG corresponding to the
part of the demand curve below the kink – BC). It is discontinuous between J and F. This implies
that the oligopolist’s output and price remain unchanged even in the face of changing costs.
Particularly, for the movement of the firm’s marginal cost curve between points J and F, say from
MC1 to MC2, the equilibrium price and quantity will not be affected.

There is only one case in which a rise in cost will most certainly induce the firm to increase its
price, despite the fact that the higher costs pass through the discontinuity of the marginal revenue
curve. This occurs when the rise in costs is general (for example, imposition of a sales tax) and

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Microeconomics-II Year II, Semester II

affects all firms equally. Under these circumstances, the firm will increase its price with the
certainty that the others in the industry will follow, since their costs are similarly affected. The
major weakness of this model is that it cannot explain at what price the kink occurs and how prices
are determined. It takes the price as given and explains the rigidity of that given price.

2.3. Collusive Oligopoly

One way of avoiding the uncertainty arising from oligopolistic interdependence is to enter into
collusive agreements. The Collusion model is a model that assumes oligopolistic firms become
collude to have control over quantity supplied or prices to act as a monopoly to maximize their
profit. There are two main types of collision, cartels and price leadership. Each of these forms may
represent either a tacit (secret) agreement or an open collusion. However, it is usually the case that
cartels are overt (open) and formal while price leadership is tacit.

2.3.1. Cartel
A cartel is a group of firms acting together to limit output, raise price, and increase economic
profit. There are two typical forms of cartels: cartels aiming at joint- profit maximization, and
cartels aiming at sharing of the market. These two types of cartel will be discussed below.

A. Cartel aiming at joint profit maximization (Centralized Cartels)

In this form of cartel, the aim is to maximize the joint (industry) profit. The situation of a
centralized cartel is identical with that of a multi-plant monopolist. Just as the multi-plant
monopolist looks for the allocation of production among its plants that maximizes its total profit,
the centralized cartel also seeks the maximization of its total profit via allocating production among
the cartel members (producers). Very often, centralized cartels are pure oligopoly – an oligopoly
where all firms produce a homogeneous product.

The firms in a centralized cartel appoint a central agency to which they delegate the authority to
decide on:
The total quantity to be produced by the industry,
The price at which the output is sold,
The allocation of production among members, and
The distribution of the maximum joint-profit among the members.

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Microeconomics-II Year II, Semester II

The central agency assess the cost structure of the industry (and that of each member firm) and the
market demand for the product. For the simple case of two firms (duopoly) that formed a
centralized cartel, a cartel maximizing the joint-profit, the equilibrium is determined as follows:

Given the market demand function for the product, P = f (X) where X = X1 + X2, and the cost
functions of the two firms, C1 = f (X1) and C2 = f (X2), the cartel maximizes the joint-profit at a
point where the marginal cost of production of each firm equals the common marginal revenue.
That is, maximizing the joint-profit requires that:

MR = MC1 = MC2, the First Order Condition (F.O.C), and

𝜕 2Π1 𝜕 2Π2
< 0, < 0, the Second Order Condition (S.O.C).
∆𝑋12 ∆𝑋22

Note that these conditions are the same as the conditions for a profit-maximizing multi- plant
monopolist.

Example: An industry has two colluding firms, which act so as to maximize total profit in the
industry and then split the profits equally. Firm 1 has cost function 𝐶1=8𝑄1. Firm 2 has cost
function 𝐶2=𝑄22 . Market demand is given by 𝑃=48−Q.

 Determine the profit maximizing industry output and price

Determine the output level produced by each firm at equilibrium.

Solution: Joint profit function

𝜋 = 𝑃(𝑄) − 𝑐1 (𝑄1 ) − 𝑐2 (𝑄2 )
𝜋 = (48 − 𝑄)(𝑄) − 𝑐1 (𝑄1 ) − 𝑐2 (𝑄2 )
𝜋 = (48 − 𝑄1 − 𝑄2 )(𝑄1 + 𝑄2 ) − 8𝑄1 − 𝑄22
𝜋=40𝑄1 +48𝑄2 -𝑄12 -2𝑄22 -2𝑄1 𝑄2 , industry profit function
Take partial derivative of this profit function with respect to 𝑄1 and 𝑄2 and set to zero. 2𝑄1 +2𝑄2 =4
𝑄1∗=16 (low cost firm), 2𝑄1 +4𝑄2 =48 𝑄2∗ =4 (high cost firm), Industry out put Q∗ =16+4=20,
Industry price=48-20=28, Industry profit = π(Q∗1 , Q∗2 )= π (16,4)=416

B. Market sharing cartel

In this type of cartel, firms agree to share the market, but keep a considerable degree of freedom
concerning the style of their product, their selling activities and other decisions. This form of

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Microeconomics-II Year II, Semester II

collusion is very common. They share the market in two different ways; Non – price competition
(advertising, special gifts, packaging, quality, …etc) and determination of quotas.

Market sharing by non-price competition: Firms agree to charge same price, but keep a
considerable degree of freedom to vary the style of their products, quality and selling activities.
The price is negotiated by bargaining with low cost firms asking for a lower price and the high
cost firms asking for a higher price. This form of Cartel is unstable or loose cartel if there is cost
differential between firms in the industry. There is strong incentive for low cost members to break
away from the cartel openly and charge a lower price. This may lead to price war and the fittest
will survive.

Sharing of the Market by Agreement on Quotas: Firms may make agreement on quotas, i.e.,
on the quantity that each firm may sell at the agreed on price. If all firms have identical costs, the
monopoly solution will emerge with the market being shared equally among the members. If costs
are different, the final quota of each firm depends on the level of its costs as well as on its
bargaining skill. During the bargaining process two main statistical criteria are most often adopted:
past levels of sales and productive capacity. Firms with better levels of sales in the past and those
with a potential of expanding production (high productive capacity) are likely to secure more share
of the market.

Another popular method of sharing the market is the definition of the region in which each firm is
allowed to sell. In this case of geographical sharing of the market, the price as well as the style of
the product may differ.

2.3.2. Price leadership model

Price leadership is a coordinated behavior of oligopolists where one firm sets the price and the
others follow it. The other firms follow the price set by the price leader either because that is
advantageous for them or because they prefer to avoid uncertainty about their competitors’
reactions even if doing so may imply departure of the followers from their profit-maximizing
position. The prices charged may differ for different firms (particularly if the product is
differentiated), but the direction of their changes will generally be the same. That is, even though
prices might differ across producers/firms, they do rise and fall together.

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Chapter Three: Factor Prices and Income Determinations

3.1.Introduction
Market is generally categorized in to three types based on the nature of things exchanged. These
are: Product market, Factor market and Money market. In the previous two chapters, we have seen
the product market. In those chapters, the concern has been with the determination of the prices
and quantities of final commodities on the assumption that whatever amount of an input needed is
available for use at a fixed price. However, just like final consumer goods, inputs (resources) have
demanders and suppliers whose interactions determine their prices and quantities. In this chapter,
we turn our face to the factor (resource) market and deal with the determination of prices and
employment of inputs.

Factor market is the market in which resources or factor of productions are bought and sold. A
factor of production is any resource that is used by firms to produce goods and services, items that
are consumed by households. Economists classified factor inputs into four groups: land, labor,
capital, and entrepreneurship. The prices of these factors were called rent, wage, interest and profit,
respectively. In many ways, the determination of input prices and employment is similar to the
pricing and output determination of commodities. That is, the price and employment of an input
are generally determined by the market force of interaction between demand and supply.

There are several important qualifications (differences), however. Two of these are:

1. Consumers demand commodities because of the utility or satisfaction they receive in

consuming the commodities, firms demand inputs in order to produce the goods and services
demanded by the society. That is, the demand for an input is a ‘derived demand’; it is derived
from the demand for the good or service produced from that resource. For instance; the
demand for land on which to grow corn is derived from the demand for corn and the demand
for labor with which to produce cars is derived from the demand for cars.
2. While consumers demand commodities, firms demand the services of the inputs. That is, firms
demand the flow of input services and not the stock of the inputs themselves.

The pricing of factor of production (inputs) takes place in various markets. We will first examine
the determination of factor prices in perfectly competitive product and input markets. Subsequently
we will relax the assumption of perfect competition and discuss factor pricing in markets with
various degrees of imperfection.

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3.2. Factor pricing in perfectly competitive market

First let as explain some concepts for better understanding of the concept of factor pricing.

Marginal physical product (MPP) or marginal product of the input (MP): The change in
output resulting from the use of an additional unit of a productive factor (input). MPP tells us how
output changes as we change the level of the input by one unit.

𝑀𝑃𝑃 = ∆𝑇𝑃/∆𝐼 where, TP stands for total product and I stand for the units of the input.

The Value of marginal product (VMP): Amount obtained from the sale of additional unit of a
product. It helps in deciding how many units of the factor to hire. It is given as:
𝑉𝑀𝑃𝑖 = 𝑀𝑃𝑃𝑖 . 𝑃𝑋.
Marginal revenue of the product (MRP): The extra income of a firm from the sale of the output
contributed by an additional unit of an input. It is the additional revenue generated by employing
an additional factor (input) unit.
∆𝑇𝑅
𝑀𝑅𝑃𝑖 = 𝑜𝑟, 𝑀𝑅𝑃𝑖 = 𝑀𝑃𝑃𝑖 . 𝑀𝑅𝑥.
∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑝𝑢𝑡

Marginal Factor Cost (MFC): The extra expense a firm incurs to purchase (or rent) an additional
unit of a factor of production.
𝑀𝐹𝐶 = ∆𝑡𝑜𝑡𝑎𝑙𝑓𝑎𝑐𝑡𝑜𝑟𝑐𝑜𝑠𝑡/∆𝑖𝑛𝑝𝑢𝑡𝑙𝑒𝑣𝑒𝑙
Average Factor Cost (AFC): The per unit cost incurred for acquiring a factor of production.

𝑡𝑜𝑡𝑎𝑙𝐹𝑎𝑐𝑡𝑜𝑟𝐶𝑜𝑠𝑡
𝐴𝐹𝐶 = =
𝑡𝑜𝑡𝑎𝑙𝑖𝑛𝑝𝑢𝑡𝑙𝑒𝑣𝑒𝑙
Average Revenue Production (ARP): is the per unit revenue from the sale of additional output
produced by a given input.

𝑡𝑜𝑡𝑎𝑙𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝐴𝑅𝑃 =
𝑡𝑜𝑡𝑎𝑙𝑖𝑛𝑝𝑢𝑡𝑙𝑒𝑣𝑒𝑙

3.2.1. Demand of a firm for a single variable factor in short run: labor

In deriving the short run demand for an input, we assume that the input under consideration is the
only variable factor of production, i.e., the amount used of the other inputs is taken as fixed (cannot
be changed). As discussed earlier, the demand for factor of production is a derived demand. Thus,

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the demand for factor of production depends on the demand for goods and services produced from
that factor. In other words, as demand for a good depends on its utility, the demand for factor
depends on the MRP of the factor.

Note: MRP curve is a derived demand curve from MP and price of the commodity. That is, the
demand for an input will continue to decline as long as its MP is declining even though its price is
constant. So, MRP curve explains (shows) the demand for an input and hence this concept goes
much more beyond than input demand curve which is drawn by plotting input price and quantity
demanded of that input on the x-y plane.

When the firm is a perfect competitor in the product market, its marginal revenue is equal to the
commodity price (MRX = PX). Consequently, the firm’s marginal revenue product equals the
firm’s value of marginal product, i.e., MRPi = VMPi. For concreteness, if the variable input we
are dealing with is labor, then 𝑀𝑅𝑃𝐿 = 𝑀𝑃𝑃𝐿. 𝑀𝑅𝑋 = 𝑉𝑀𝑃𝐿 = 𝑀𝑃𝑃𝐿. 𝑃𝑋. This implies that
VMP as well as MRP curve becomes the demand curve for an input (factor).

The marginal cost on (or the extra cost of hiring) an additional unit of an input (MCi) is equal to
the input price if the firm is a perfect competitor in the input market. Perfect competition in the
input market means that the firm demanding the input is too small to affect the price of the input
significantly by itself. Thus, the firm faces a horizontal or perfectly elastic supply curve (infinitely
elastic) for the input. For example, if the input is labor, this means that the firm can hire any
quantity of labor time at the given (market-determined) wage rate.

𝑀𝐹𝐶 = 𝑃𝑓 = 𝐴𝐹𝐶
Marginal Productivity and Factor Demand employment decision of the firms

What determines how much of a factor a firm will employ to maximize firm’s
profit?
In any kind of market structure, in general, a profit-maximizing firm always tries to maximize her
/his profit by adjusting MFC and MRP (i.e. compare MFC and MRP).
 MRP > MFC: firm should continue to employ more factors.
 MRP = MFC: the profit of the firm’s is maximized (at equilibrium)
 MRP < MFC: firm should reduce the quantity of factors.

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In the case of perfect competitive product and factor markets, a profit maximizing firms employ
each factor of production at a point where 𝑀𝑅𝑃𝑖 = 𝑉𝑀𝑃𝑖 = 𝑀𝐹𝐶𝑖 (𝑃𝑓), where Pf is input price.
That is, the firm will optimize its use of the factors of production when
– Labor is utilized until the MRP of labor = the price of labor (i.e. wage)
– Capital is utilized until the MRP of capital = the price of capital (i.e. interest)
– Land is utilized until the MRP of land = the price of land (i.e. rent)
– Entrepreneurship is utilized until the MRP of entrepreneurship = the price of
entrepreneurship (i.e. profit)

MRP and Wage

e1
W1
e2
W2
e3
W3
MRPL=VMPL

L1 L2 L3 Quantity of labor

Figure 3.1: Equilibrium of a Firm in Perfectly Competitive Product and Input Markets

With reference to Figure 4.1, for a market wage rate of W1, the firm’s optimal point of operation
is at point e1 defined by the condition VMP L = W1. Given W1, if the firm operates at a point to the
left of e1, then we witness that VMP L > W1 (the extra monetary contribution of hiring one more
unit of labor is greater the extra expense on the unit). As a result, the firm would increase its profit
by hiring more labor. The opposite holds for operating at any point to the right of e1. That is, an
additional unit of labor adds more to the cost than it adds to the revenue and thus the firm would
increase its profit by reducing the amount of labor it uses.

3.2.2. Demand of a firm for several variable factors: labor and capital

When there are more than one variable factors of production, the VMPi curve does not represent
the demand for the input. That is, a firm’s demand for labor is no more the same as the VMPi in
long run. This is because, in the long run, various resources are used simultaneously in the

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production process so that a change in the price of one factor leads to changes in the employment
(use) of the other factors as well. For instance, a change in wage rate induces not only a change in
the quantity of labor a firm uses but also changes in the quantities of other factors (of which capital
is one); in the long run, no input is fixed in amount. This change in the amount of other factors in
the production process, in turn, shifts the marginal (physical) product curve of the input whose
price is initially changed. To continue with the example of labor, a change in wage rate results in
changes in the use of labor and capital (all other factors); and the changes in the amounts of these
other factors cause the marginal product of labor to shift.

In general, the firms allocate resource efficiently by choose the level of the inputs which equates
the marginal product per dollar across each of the inputs.

𝑀𝑃𝑃𝐿 𝑀𝑃𝑃𝐾
=
𝑊 𝑟
3.2.3. The market demand for a factor
The market demand curve for an input is derived from the demand curves for the input by
individual firms. Nevertheless, it is not the simple horizontal summation of the demand curves of
the individual firms. This is because when the price of an input (say labor) falls, not only this firm
but also other firms will employ more of this factor and other (complementary) inputs to expand
production. Thus, the supply of the final commodity increases and consequently its price falls.
Since this price is one of the components of the demand curves of the individual firms for the
factor, these curves shift downward to the left.

Figure 3.2A below shows the demand curve d1 of an individual firm for labor. Initially suppose
the wage rate is w1. The firm is at point ‘‘a’’ on its demand curve and employs L1 units of labour.
Summing over all employing firms, we obtain the total demand for the input at the wage rate w1.
Point ‘‘A’’ in figure B is one point on the market demand curve for labor.

If wage rate declines to w2 , and other things being equal, the firm would move along its demand
curve D1, to point bʹ, increasing employed labor to L2. However other things do not remain equal.
When the wage rate falls, all firms tend to demand more labor and increased employment leads to
an increase in total output. The market supply curve for the commodity produced shifts downwards
to the right, and the price of the commodity falls. The decline in the price of the good reduces the

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Microeconomics-II Year II, Semester II

value of marginal product of labor at all levels of employment. In other words, the VMP L curve
shifts downwards in figure A. as D2.

w1 a w1 A

w2 b b’ w2 B B’

D1
D2
L1 L2 L L1 L2 L
Figure 3.2A. single firm’s labor demand Figure 3.2B. Market demand curve for labor

When the wage rate falls to w2 the firm is in equilibrium not at point bʹ but at point ‘‘b’’ on the
new demand curve D2. Summing horizontally over all firms we obtain point B of the market
demand curve. If the fall of the commodity price was not taken into account, we would be led to
over estimation of the demand for labor following a decline in the wage rate. In figure B, point Bʹ
represents the demand for labor in the market with price of the commodity unchanged. This point
does not belong to the market demand curve for labor.

The amount of an input (factor of production) demanded depends on:

The price of the input under consideration: an increase in input price reduces the quantity
demanded of the input, and vice versa. A change in the input’s own price results in a change
in the quantity demanded of the input (movement on a demand curve), and does not change
the demand for the input.
The marginal physical product (MPP) of the factor: if the MPP of a factor increases, more
of the factor will be demanded, and vice versa. A change in the MPP of a factor implies a shift
in the demand for the input either to the left or to the right.
The price of the output (commodity): when the output the firm produces becomes cheaper,
the firm will cut its production and thus demands less of the input used. The opposite happens
when the commodity gets more expensive.

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Microeconomics-II Year II, Semester II

The amount of other factors that are combined with the factor: if, for instance, the amount
of a complementary input rises, the productivity (MPP) and thus the demand for the factor
under consideration will rise.
The price of other factors: increase in prices of complementary inputs reduces the amount of
the complementary inputs to be used with a given amount of a productive factor, and thus
reduces the productivity of (and demand for) the productive factor. An increase in the price of
a substitute, on the other hand, increases the demand for the factor of concern.
Technological progress: technological progress could increase or decrease the demand for an
input depending on whether it increases or decreases the MPP of the factor. A technological
progress that raises the productivity of labor (more than that of capital), will increase the
demand for labor, and vice versa.
3.2.4. Supply of labor by individual worker
The main determinants of the market supply of labor are:
 The price labor (wage rate).
 The tastes of consumers which define their trade-off between leisure and work.
 The size of the population.
 The labor-force participation rate.
 The occupational, educational and geographic distribution of the labor force.
The relationship between the supply of labor and the wage rate defines the supply curve. The other
determinants can be considered as shift factors of the supply curve.

Decisions about labor supply of individual worker result from decisions about time allocation: how
many hours to spend on different activities? It depends on the individual’s preference for work and
leisure. Leisure is time available for purposes other than working to earn income such as time spent
with family, friends. The preference of the individual between leisure and work (work is valued
for and in terms of the income it generates) can be represented by a set of indifference curves. An
indifference curve is a graph of alternative combinations of goods that provide a given level of
satisfaction (utility). The substitutability between income and leisure is assumed imperfect. That
is, the marginal rate of substitution of leisure for income (MRS LY) – the amount of income
sacrificed for an extra unit of leisure, holding utility constant – declines as the individual has more
and more of leisure.

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Microeconomics-II Year II, Semester II

A change in wage has two effects in the labor supply market: the substitution effect and the
income effect. Consider a rise in the market wage rate.

As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher wage,
individuals consume less leisure time and spend more time at work. This is the substitution effect
resulting from a higher wage. In short, an increase in wage rate leads an individual to work more,
i.e., substitution effect renders wage rate and hours of work to be directly related. Thus, the
substitution effect of the wage increase always operates to make the individual’s supply of labor
curve positively sloped.

An increase in the wage, however, also raises an individual's real income. This leads to an increase
in the consumption of all normal goods. Assuming leisure to be a normal good, a higher wage will
generally induce individuals to consume more leisure time (and reduce hours of work). Individuals
who receive a higher wage can afford to take more time away from work. This is the income effect
resulting from a wage increase. If the income effect dominates, a rise in the wage rate can actually
cause the individual labor supply curve to slope downward. It can also be backward bending.

Figure 3.3: The Supply of Labor by an Individual

The pattern of response to higher wage rates produces a backward bending supply curve for labor
in the figure 3.3 above. The reason for which an individual’s supply of labor may be backward
bending can be explained by separating the substitution effect of wage rate change from the income
effect. Both the substitution and income effects operate over the entire possible wage rates. While
the substitution effect generally overwhelms the opposite income effect at lower wage rates, the

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negative income effect overwhelms the positive substitution effect at higher wages implying a
backward bending supply of labor curve.

3.2.5. The Market Supply of Labor

The market supply of labor is the horizontal summation of the individual supply of labor in that
market. Although there is a general agreement that the supply curve of labor by single individuals
exhibits the backward bending pattern, it is usually the case that the market supply is upward
sloping (not backward bending). This is because, even if some people prefer to work for fewer
hours at higher wage rates, some new workers will also be attracted to the market by the higher
wages. While the workers attracted could be from a different local labor market (assuming labor
mobility) in the short run, population growth also increases the number of individuals entering the
labor market in the long run.

3.3. Factor Pricing in Imperfectly Competitive Markets

3.3.1. Monopolistic power in the product market and perfect competitive in factor market

Under perfect competitive factor market firms are price taker of that factor. Assume that the firm
uses a single variable factor – labor – whose market is perfect. That is, the wage rate is given and
thus an individual firm faces a perfectly elastic supply of labor (i.e. 𝑊 = 𝑀𝐹𝐶 = 𝐴𝐹𝐶). However,
the firm has monopolistic power in the product market. This implies that the demand curve for the
product of the firm is downward sloping and the marginal revenue curve lies below the demand
curve at all levels of output. Consequently, the MRP curve will lie below the VMP curve.
𝑀𝑅𝑃 < 𝑉𝑀𝑃 ⟺ 𝑀𝑅. 𝑀𝑃𝑃𝐿 < 𝑃. 𝑀𝑃𝑃𝐿 , 𝑠𝑖𝑛𝑐𝑒 𝑀𝑅 < 𝑃

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Figure 3.4. Monopolistic exploitation of a firm

When a firm possesses a monopolistic power in the product market, the factor is paid its MRPi,
which is smaller than VMPi (what the input could have been paid if this firm were a perfect
competitor). This effect is called monopolistic exploitation. It represents the difference between
the amount a factor is paid under perfect competition and the amount the same factor is paid under
imperfect competition. In such a situation the firm will be in equilibrium where MRP=MFC at
point E (figure 4.4). The firm employs ON quantity of factor at OP price (factor cost). Here the
MRP of employing ON quantity is EN which is less than RN (the VMP). Thus, from this, we can
observe that the factor of production gets less than the value of its marginal product by RE amount
(the level of monopolistic exploitation by the firm) and this is the influence of imperfect product
market even though the input market is competitive.

3.3.2. Monopolistic in the output market and monopsony in factor market

A monopsony in factor market means that there is only one firm which buys the factor of
production. Hence if the monopsonist decreases his factor employment (decreases its demand for
factor), then it can lower the price of the factor and if it increases its factor employment (increases
its demand for factor), it can raise the price of the inputs. Therefore, it can be deducted that the
supply curve of factor or average factor cost curve that the monopsonist will face is a raising/
positively sloping supply curve. Unlike the perfect competitive factor market, the monoposonist
supply curve of the factor (average factor cost) is less than the marginal factor cost (i.e.

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MFC>AFC) for any level of employment. As discussed in the previous section, in the monopolistic
competitive product market, he MRP curve will lie below the VMP curve. MRP<VMP since
MR<P (in the imperfect product market, both AR & MR curves slope downward).

From the above analysis that when there is Monopsony in the factor market and monopolistic in
the product market, the equilibrium point will hold when VMP>MRP= MFC>AFC.

Figure 3.5: Monopsonistic Exploitation

As shown in the figure above, the equilibrium point is E where MRP curve cuts MFC curve from
above and equals to it. Factor price (Pf)<MRP. The firm employs ON units of the factor at OP
(TN) price which is less than NE (MRP). The gap ET is due to the existence of Monopsony in the
factor market and is the level of monopsonic exploitation of the factor. The gap between VMP &
MRP (SE) is due to the existence of imperfect competition in the product market and is the level
of monopolistic exploitation of the factor. Thus, the total exploitation is ST (area of PRST). We
conclude that, in the case of Monopsony in the factor market and monopolistic in the product
market, the factor employed in production by the firm is exploited from both sides. The effect of
monopolistic exploitation is a lower level of employment at lower factor price (e.g. wage for labor).

In several variable inputs, If the input markets are perfectly competitive, a firm minimizes its cost
(subject to an output constraint) or maximizes its production (subject to a cost constraint) by using
the factor combination at which, 𝑀𝑃𝑃𝐿 / 𝑀𝑃𝑃𝐾 = 𝑤/𝑟 𝑜𝑟 𝑀𝑃𝑃𝐿 / 𝑤 = 𝑀𝑃𝑃𝐾 /𝑟. If the factor
markets are monopsonistic, however, changes in the amounts of factors employed cause changes
in factor prices. That is, as the amount of labor (L) and/or capital (K) used in the production process
change, both wage rate (w) and rental price of capital (r) do change. Thus, w and r are not constants.

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Consequently, a monopsonist who uses several variable factors will use the input combination at
which the ratio of the MPP to the MFC is equal for all variable inputs. In our simple setting of two
𝑀𝑃𝑃𝐿 𝑀𝑃𝑃𝐾
variable factors (L and K), the equilibrium of the firm is given by: =
𝑀𝐹𝐶𝐿 𝑀𝐹𝐶𝐾

3.3.3. Monopsony in the factor market and perfect competition in the product market

A monopsony in factor market means that there is only one firm which buys the factor of
production. Hence if the monopsonist decreases his factor employment (decreases its demand for
factor), then it can lower the price of the factor and if it increases its factor employment (increases
its demand for factor), it can raise the price of the inputs. Therefore, it can be deducted that the
supply curve of factor or AFC curve that the monopsonist will face is a raising/ positively sloping
supply curve. But the MRP and ARP curve will assume their usual shape since perfect competition
in the product market.

The firm will be in equilibrium by employing quantity factor where MRP=MFC.

As can be seen, the firm employs ON quantity of factor at OP price (factor cost). Since there is
monopsony in the factor market, it gets super normal profit equivalent to the area RPST. In other
words, the factor is being paid NT(OP) price while its average revenue product is SN. The
difference (TS) between them is called monopsonic exploitation per unit of factor of production.
Total exploitation is given by RPST.
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3.3.4. Bilateral monopoly

Bilateral monopoly is a model in which the participants are two monopolies, one on the supply
side and one on the demand side. Bilateral monopoly arises when a single seller (a monopolist)
faces a single buyer (a monopsonist). In this model, we assume that:
 All firms are organized in a single body that acts like a monopsonist (the only buyer of labor);
 All laborers are organized in a labor union that acts like a monopolist (a single seller of labor).

Unlike the previous models we examined, market forces do not determine the equilibrium wage
rate and the equilibrium level of employment. The model gives only the upper (the monopolists
lower price and lower limits (the monopsonist’s low pric) within which the wage rate will be
determined by bargaining. The outcome of the bargaining cannot be known with certainty. It will
depend on the bargaining skills, the political and economic power of the labor union and the firms
(or the firms’ union), and on many other factors.

3.3.5. Competitive buyer and monopoly union

This situation occurs when:
 The labor market is dominated by a single, powerful labor union (monopoly supplier of labor).
 Firms compete for labor in a perfectly competitive market (wage takers).
The monopoly union sets a higher a higher wage than the perfect competitive market wage by
restricting labor supply. The competitive firms accept the wage rate and hire workers as long as
their marginal revenue product (MRP) ≥ wage. It implies that, the wage rate is higher than in a
competitive labor market, but fewer workers may be hired.

3.4. Elasticity of Factor Substitution, Technological Progress and Income Distribution

3.4.1. The elasticity of input substitution and the shares of factors of production
The theory of income distribution is the study of determination of the share the factor of production
in the total output produced during a given period of time. Factor shares refer to the proportion of
total income that goes to different inputs—typically labor and capital. The shares of the factors of
production depend upon the relative factor prices and state of technology. Their shares are defined
as:
𝑤𝐿 𝑟𝐾
𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟 = , 𝑡ℎ𝑒 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 =
𝑃𝑄 𝑃𝑄

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𝑠ℎ𝑎𝑟𝑒 𝑜𝑓𝑙𝑎𝑏𝑜𝑟 𝑤𝐿 𝑃𝑄 𝑤𝐿 𝑤⁄
𝑟
Thus, the relative factor shares is: = ∗ = = 𝐾⁄
𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑃𝑄 𝑟𝐾 𝑟𝐾 𝐿

Assume it is possible to substitute labor for capital and capital for labor. Under this assumption
when factor prices change, a profit-maximizing firm substitutes the cheaper factor for the more
expensive one. This response/behavior of profit maximizing firms, induced by changes in factor
prices, will result in a change of the K/L ratio. The change in the K/L ratio implies a change in the
relative shares of the factors. This is measured by elasticity of factor substitution (et). The elasticity
of substitution between inputs (such as capital and labor) measures how easily one factor can
replace another in production. It is the percentage change in the capital-labor ratio to the percentage
in the MRTS under perfect competitive input market; MRTS LK is equal to the ratio of factor prices.
The elasticity of factor substitution is defined as:
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒𝑖𝑛 𝑡ℎ𝑒 𝐾 𝐿 𝑟𝑎𝑡𝑖𝑜 ∆(𝐾⁄𝐿 )/ 𝐾⁄𝐿
𝑒𝑡 = =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑀𝑅𝑇𝑆𝐿𝐾 ∆(𝑀𝑅𝑇𝑆𝐿𝐾 )
⁄𝑀𝑅𝑇𝑆
𝐿𝐾

∆(𝐾⁄𝐿 ) 𝑤⁄𝑟 𝑤
𝑒𝑡 = ∗ , ℎ𝑒𝑛𝑐𝑒 𝑀𝑅𝑇𝑆 =
∆(𝑤⁄𝑟) 𝐾⁄ 𝑟
𝐿
Note that the sign of 𝑒𝑡 is always non-negative. Why? This is because the K/L ratio and w/r ratio
move in the same direction. For instance, a rise in (w/r) ratio implies that labor becomes more
expensive. As a result, firms will substitute capital for labor (labor by capital), and this raises the
(K/L) ratio in production. This shows that (w/r) and (K/L) ratios are positively related.

The relationship between elasticity of substitution and the relative factor shares can be summarized
as follow:
 If 𝑒𝑡 = 0, then it is impossible to substitute labor for capital or vice versa. Such a situation is
exemplified by the Leontief type production functions, where inputs are used in fixed
proportions and cannot be substituted for one another.
 If 0< 𝑒𝑡 < 1 implies an inelastic substitutability: a percentage change in (w/r) ratio brings about
a less than proportionate change in (K/L) ratio.
 If 𝑒𝑡 = 1 implies a unitary substitutability: a percentage change in (w/r) ratio brings about a
proportionate change in (K/L) ratio.

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 If 𝑒𝑡 > 1 implies an elastic substitutability: a percentage change in (w/r) ratio brings about a
more than proportionate change in (K/L) ratio.
 If 𝑒𝑡 = ∞, then there is a perfect substitutability between factors. An example of this is the
linear production function, where one input can be traded for another at a constant rate.

There is an important relationship between the values of 𝑒𝑡 and the distributive shares of factors.

An increase in the w/r ratio will cause the share of labor (relative to that of capital) to:
– Increase if 𝑒𝑡 < 1;
– Decrease if 𝑒𝑡 > 1; and
– Remain the same if 𝑒𝑡 = 1.
A decrease in w/r ratio will have the opposite effects: the relative share of labor
– Decrease if 𝑒𝑡 < 1,
– Increase if 𝑒𝑡 > 1, and
– Remain unchanged if 𝑒𝑡 = 1.
3.4.2. Technological progress and income distributions
So far, we have assumed that technology is fixed in production analysis period. As knowledge of
new and more efficient methods of production become available, technology changes. That means,
technological progress does occur continuously and this shifts the production function. The change
in production function in turn causes change in the K/L ratio and the elasticity of substitution.
Technical progress is usually classified into neutral, labor saving, or capital saving technical
progress.
1. Neutral technological progress: both the capital-labor ratio & the w/r are unchanged hence
relative shares of factors remain unchanged. The share of capital and labor is constant. It
means the increase of the productivity of L and K in the same proportion, so that K/L remains
the same after the neutral technical progress as it was before at unchanged relative factor
prices (w/r). This happens is that a given output can now be produced with less L and less K.
2. Capital deepening or Capital-saving technical progress: when at a constant capital-labor
ratio, the MRTSLK declines. That means MP K increases relative to MP L. The share of capital
increases while the share of labor decreases. The increase of the productivity of L
proportionately more than the productivity of K. As a result, L is substituted for K in

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production and L/K rises at unchanged w/r. It means the more used L per unit of capital, this
is called capital saving.
3. Labor deepening/Labor-saving technical progress: when at a constant capital-labor ratio,
the MRTSLK increases. That means MP L increases relative to MP K. The share of labor
increases while the share of capital decreases. The increase of the productivity of K
proportionately more than the productivity of L. As a result, K is substituted for L in
production and K/L rises at unchanged w/r. It means the more used K per unit of labor, this is
called labor saving. With a given output, the fewer units of L and K used and higher K/L.

In summary: -
– The relative share of labor increases and that of capital decreases if technological progress
is labor deepening;
– The relative share of labor decreases and that of capital increases if technological progress
is capital deepening; and
– The relative shares of both labor and capital remain unchanged if technological progress is
neutral

Chapter four: Market Failure and the Role of Government

4.1.Concepts of market failures
A market failure is a situation in which the market fails to achieve an efficient allocation. Market
failure is the economic situation defined by an inefficient distribution of goods and services in the
free market, leading to a net loss in social welfare. Economists use the term market failure to refer
to a situation in which the market on its own fails to allocate resources efficiently.

4.2.Why market fails and the role of governments

The main causes of market failure are:

1. Imperfect competition (Market power) 3. Public goods
2. Externalities 4. Asymmetric information
1. Imperfect competition:
Imperfect competition occurs when individual firms have market power, allowing them to set
prices above marginal cost, leading to inefficiency and reduced consumer surplus (welfare loss to
the society). The ability of a single economic actor (or small group of actors) to have a substantial

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influence on market prices e.g. patent right, economies of scale etc may give a firm a market power.
Example: Monopolies: A single seller dominates, leading to high prices and restricted output.
Monopolistic Competition: Many firms compete but with differentiated products, leading to excess
capacity and higher-than-efficient prices. Oligopolies: A few firms control the market, reducing
competition.
2. Externalities
Externality is a cost or benefit resulting from some activity or transaction that is imposed or
bestowed upon parties outside the activity or transaction. It is a cost or benefits of a market
transaction borne by 3rd party, sometimes called spillovers or neighborhood effects. Externality
exists when the action of one economic agent hinders the utility or production of another economic
agent. An externality is present when the activity of one entity (person or firm) directly affects the
welfare of another entity in a way that is outside the market mechanism. It is source of market
failure. Because externalities are not reflected in market price, these prices provide misleading
information for an optimal allocation of resources.

Externalities may be classified as consumption externalities and production externalities. Each of

these types may be negative (external costs) or positive (external benefits). Let us see examples
for the different categories of externalities.
A. Negative consumption externalities (external diseconomies of consumption) – refer to
uncompensated costs imposed on others (consumers) by the consumption or production
activities of some individuals or firms. Examples: pollution produced by local automobiles, a
smoker smoking a cigar next to an individual dining in a restaurant, and playing a loud music
in one’s neighborhood. The pollutants (the users of automobiles, the smoker and the one
playing a loud music do not pay compensation for the victims (those who suffer the
consequences of the activities).
B. Positive consumption externalities (external economies of consumption) – refer to
uncompensated benefits conferred on others (consumers) by the increased consumption or
production of a commodity by some individuals or firms. Example; pleasure from observing
a flower garden of neighbor. You do not pay for enjoying your neighbor’s flower garden.
C. Negative production externalities (external diseconomies of production) – refer to
uncompensated costs imposed on others (producers) by the expansion of consumption or
production by some individuals or firms. Example; water pollution by a steel industry for a
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fishery down the stream. If a steel industry disposes its wastes to a river, this will damage the
school of fish in the stream and consequently affect people living on fishing or the fishing
industry at large.
D. Positive production externalities (external economies of production) – refer to
uncompensated benefits conferred on others (producers) by raised consumption or output
expansion of some individuals or firms. An example for such an externality is an orchard
(land area of fruit trees) located next to a beekeeper. This example reflects a bi-directional
externality where both the beekeeper and the owner of the orchard benefit. The beekeeper
would benefit since the orchard is a source of ingredients for the production of honey. On the
other hand, the bees would help the pollination (reproduction) of the flower trees.

Perfect competition leads to a Pareto optimum outcome only when private costs equal social costs
and private benefits equal social benefits. However, if there are externalities, there is divergence
between private and social benefits and/or private and social costs. For a private decision-maker,
the optimality (equilibrium) condition is given by the equality of marginal benefit and marginal
cost of the agent. That is, optimal decision of a private agent requires the condition MPB = MPC
(where MPB = marginal private benefit and MPC = marginal private cost). For the society at large,
on the other hand, an efficient allocation requires that MSB = MSC, (where MSB = marginal social
benefit and MSC = marginal social cost).
External costs in production – where MSC = MSB – MPC or MSC=MPC+MEC
External benefits in production – where MSC < MPC or MSB=MPB+MEB
External costs in consumption – where MSB < MPB.
External benefits in consumption – where MSB > MPB.
In general, External costs– socially efficient output is less than current output. External benefits-
socially efficient output is greater than current output. Socially efficient output is where MSC +
MPC = MSB + MPB

The Role of Government for market failure (externality)

Government can correct the over allocation of resources by designing a method of internalize the
external cost, i.e. make the offending firm pay the costs rather than shift them to the society. This
can be done by direct and indirect regulation.

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Microeconomics-II Year II, Semester II

Indirect regulation

Subsidy: is a payment by the government to private producers (in cause of positive externality in
production). The government can induce private decision makers to consider external benefits by
making the subsidy depend on the level of output. If the government pays the producer an amount
equal to the marginal external benefit for each unit produced, the quantity produced increases to
that at which marginal cost equals marginal social benefit—an efficient outcome.

Voucher: the government provides to households, which can be used to buy specified goods or
services (positive externality in consumption). A school voucher allows parents to choose the
school their children will attend and to use the voucher to pay part of the cost. The school cashes
the voucher to pay its bills.

Taxes: in cause of negative externality in production the government can set a tax equal to the
marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal
to marginal social cost. This tax is called Pigovian Tax. Imposing taxes would increase the private
marginal cost of the agents thereby making them internalize the effects of their actions and
rendering a lower level of production/consumption to be optimal.

Emissions Charges: the government sets a price per unit of pollution, so that the more a firm
pollutes, the higher are its emissions charges.

Marketable Permits: Each firm is assigned a permitted amount of pollution per time period, and
firms trade permits. The market price of a permit confronts polluters with the social marginal cost
of their actions and leads to an efficient outcome.

Direct regulation: directly limiting the level of consumption and production. As an example for
the direct control, pollutants might be forced to produce a lesser amount of pollution than they
could do if based on their (private) marginal benefits and costs.

The Coase Theorem (property rights): government need not be involved in every case of
externality. Coase theorem states that assignment of clearly defined and transferable property
rights could avoid externalities (and promote economic efficiency). According to the Coase
theorem, well-defined property rights will work in one of the following two ways. If the property
right is granted to the firm producing an externality, then the victims will pay the firm in order to

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avoid the external cost (Firms have the right to pollute and consumers must pay to the firms to stop
doing it). On the other hand, if the property right is granted to the consumers, then the firm
producing the externality will compensate the victims (consumers) (Firms have no right to pollute
and must pay to consumers for doing it). The outcome of both approaches will be the same – the
externality will be internalized. The allocation of legal rights determines gains and losses among
the parties, but does not affect the action taken.

In summary, Positive externalities lead to underproduction and public provision, subsidies,

vouchers, and patents can achieve a more efficient outcome. Negative externalities lead to
overproduction and property rights, emission charges, marketable permits, and taxes can be used
to achieve a more efficient outcome.

3. Public goods
Another possible cause of market failure is public goods. Public goods (social or collective goods)
are goods that are non-rival in consumption and/or their benefits are non-excludablity (impossible
to exclude anyone from consuming the good).

Non-rival: One individual’s consumption of the good does not affect any other individual’s
consumption of the same unit of the good. The marginal cost of provision to an additional
consumer is zero. That is, once provided (made available), the addition of consumers up to capacity
constraint does not reduce the availability of the good. Examples of public goods are national
defense, law enforcement, national TV, streetlights, sidewalks, etc.

Public goods have characteristics that make it difficult for the private sector to produce them
profitably. Because people can enjoy the benefits of public goods whether they pay for them or
not, thus, they are usually unwilling to pay for them. This is referred to as the free-rider problem.
A free rider is a person who receives the benefits of a good but avoids paying for it. This action
prevents private markets from supplying public goods. Government can decide to provide the
public good if the total benefits exceed the costs. Thus, the government can make everyone better
off by providing the public good and paying for it with tax revenue to solve the free rider problem.

4. Imperfect (Asymmetric) information

Asymmetric information: is a situation in which one side of the market—either buyers or
sellers—has better information than the other. For example, Labor is assumed to be a homogeneous

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factor in almost all cases we referred to it. For instance, in Chapter three, we assumed that everyone
had the same "kind" of labor and supplied the same amount of effort per hour worked. In reality,
it may be very difficult for a firm to determine how productive its employees are. On the other
hand, each employee has a better (or full) knowledge of his/her own labor quality. Similarly, when
a consumer buys a used car, it may be very difficult for him/her to determine whether the car is a
good car or a poor quality or defective one (a lemon). By contrast, the seller of the used car possibly
has a pretty good idea of the quality of the car.

Asymmetric information may cause significant problems to the efficient functioning of a market.
In the presence of asymmetric information, there may be too few transactions and/or transactions
may completely fail. Here, we will discuss two common problems associated with asymmetric
(imperfect) information: adverse selection and moral hazard.

Adverse Selection (The hidden information problem): is the situation where low-quality
products drive high-quality products out of the market because of the existence of asymmetric
information between buyers and sellers. It arises when one side of the market cannot observe the
type or quality of the goods on the other side of the market.

Consider the used-car market example mentioned earlier. In this market, sellers of used- cars know
exactly the quality of the cars they are selling while prospective buyers do not. As a result, the
market price for used-cars will depend on the quality of the average used- car available for sale.
The owners of “lemons” would then tend to receive a higher price than their cars are worth, while
the owners of high-quality used-cars would tend to get a lower price than their cars are worth. The
owners of high-quality used cars would therefore withdraw their cars from the market. This
withdrawal of high-quality cars, in turn, lowers the average quality and thus the price of the
remaining cars available for sale. Subsequently, sellers of the now above-average quality cars
would withdraw their cars from the market, further reducing the quality and price of the remaining
used-cars offered for sale. This process continues until only the lowest-quality cars remain in the
market, to be sold at the appropriate very low prices. Thus, the ultimate outcome of the process is
that low-quality cars drive high-quality cars out of the market.

Moral Hazard (The hidden action problem): a situation where one side of the market cannot
observe the action of the other side. It exists, for instance, when an insured party whose actions

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are unobserved can affect the probability or magnitude of a payment associated with an event.
Moral hazard arises when one party to a contract passes the cost of his or her behavior on to the
other party to the contract. When a lender wants to provide credits to the borrowers, he/she faces
certain problems. These problems include:

 It is costly (or impossible) for the lender to know whether a borrower is able to repay his/her
debt, i.e., whether the borrower is a hard-working person or not. This is the problem of adverse
selection.
 It is costly to monitor the borrower on what is being done with the loan. The borrower might
use the money borrowed for consumption (or unproductive activities), which is not easily
transferred into monetary repayment. Alternatively, the borrower might use the loan in risky
activities such as gambling. This refers to the problem of moral hazard.

Market signaling: can overcome the problem of asymmetric information. Market signaling is the
process by which sellers send messages (or signals) to buyers conveying information about the
quality of their goods and services.

When information is very costly for individuals to collect and disperse, it may be cheaper for
government to produce it once for everybody.

Chapter Five
Game Theory

5.1.Game theory and strategic behavior: concepts and definitions

A game is any situation in which players (participants) make strategic decisions – i.e., decisions
that take into account each other’s actions and responses. A strategy is a rule or plan of action for
playing the game. Strategic behavior has been analyzed using the mathematical techniques of game
theory. Game theory is a method of analyzing strategic behavior. Examples of games include
firms competing with each other by setting prices, or a group of consumers bidding against each
other at an auction for a particular commodity. A key objective of game theory is to determine the
optimal strategy for each player. For our price setting firms, a strategy might be: “I will keep my
price high as long as my competitors do the same, but once a competitor lowers her price, I will
lower mine even more”.

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Strategic decisions result in payoffs to the players: outcomes that generate rewards or benefits to
players (the score of each participant). The score is measured in terms of the goal of a firm (i.e.,
profit maximization, market, etc). A payoff is the outcome of each combination of strategies by
the rival firms. In general, the payoff of a strategy is the net gain it will bring to the player for any
given counterstrategy of the competitor(s). The optimal strategy for a player is the one that
maximizes his/her expected payoff. Payoff matrix: is a table that shows the strategies the firms
may choose and the resulting payoffs. A payoff matrix is a box that contains the outcomes of a
strategic game under various circumstances. Equilibrium is a stable state where players have no
incentive to deviate unilaterally.

Game theory can be classified as zero-sum game and non-zero-sum game.

A zero-sum game is one in which the gain of one player comes at the expense of, and is exactly
equal to, the loss of the other player. In this game the gain of one firm is considered as a loss to
the other firm. An example of this occurs if firm A increases its market shares at the expense of
firm B (say, by increasing its advertising expenditure in the face of unchanged state of advertising
by firm B), ceteris paribus. In such a zero-sum game, the gains of one player equal the losses of
the other in magnitude so that total gains plus total losses sum to zero. A nonzero-sum game is
one in which the gains of one firm (player) do not come at the expense of an equal benefit of the
other. In a nonzero-sum game, even though the gains of one firm (player) may come at the expense
of the opponent’s, the gain of one and the loss to the other are not equal in magnitude.

5.2.Dominant strategy and Nash equilibrium

The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen
by the other players. The dominant strategy will maximize the expected payoff of the player no
matter what the other player does. When both firms have dominant strategies; the outcome of the
game is called equilibrium in dominant strategies.

Suppose firm A and firm B sell competing goods. Firm A has a choice of two promotion strategies
(advertise or not advertise) while firm B has a choice of two pricing strategies (high price or low
price). We get four possible combinations of strategies for the two firms.

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The first number in each cell is the payoff to firm A and the second is the payoff to firm B. What
strategy should each firm choose? Advertise is the dominant strategy for firm A while the low
price strategy is the dominant strategy for firm B.

Table 5.1: A Payoff Matrix of a Game

Firm B
High price Low price
Firm A Advertise 12,0 17,6
Not advertise 8,4 0,10

Nash equilibrium is a situation in which each player chooses an optimal strategy, given the
strategy chosen by the other player. Nash-equilibrium is a set of strategies (actions) such that each
player is doing the best it can given the action of its opponents. Since each player has no incentive
to deviate from its Nash strategy, the strategies are stable. A Nash equilibrium occurs when firm
A’s choice is optimal given firm B’s choice, and firm B’s choice is optimal given firm A’s choice.
A game may have one or more Nash equilibrium or it may not have Nash equilibrium at all. In the
case of the Table 5.2 below, the set of strategies (S1, S3) and (S2, S4) are Nash equilibrium.
Note that all dominant strategy equilibria are Nash equilibria; but not all Nash equilibria are
dominant strategy equilibria.

Table 5.2: payoff matrices of the game

Firm B
High price Low price
Firm A Advertise 12,0 17,6
Not advertise 8,4 0,10

5.3.Prisoners Dilemma

The prisoners’ dilemma game is a non-cooperative type of game where two prisoners who have
been caught committing a petty crime were questioned for more serious crime in separate room.
The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why
cooperation is difficult to maintain even when it is mutually beneficial.

Suppose two friends are suspected of committing robbery, and are placed in separate prisons so
that they cannot communicate with each other. The only proof the investigator has is what he/she
can get out of the prisoners. Each prisoner is told that he/she is suspected of robbery and has two

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choices, i.e., either confess or deny. If convicted, each could receive a maximum sentence of ten
years’ imprisonment. Unless one or both suspects confess (i.e., if both deny), each could receive a
maximum sentence of one year in prison. Each suspect is promised that he/she will go free by
confessing while the other (who doesn’t confess) will receive the full ten-year sentence. If both
suspects confess, each gets a reduced sentence of seven years’ imprisonment. Therefore, the
outcome in which both prisoners confess is a unique Nash equilibrium. Confess isn’t only Nash
equilibrium but also equilibrium in the dominant strategies. The ideal strategy is (deny, deny)
where the term of prison is 1 years to each prison rather than 3 years (confess, confess) strategy.
Prisoners, the equilibrium of the game with each confessing is not the best outcome (i. e., it is
Pareto inefficient). The prisoners are indeed in dilemma. On the other hand, each prisoner knows
that if they trust each other not confess, then, the best strategy is (deny, deny) which is Pareto
efficient. However, as there is an incentive for confessing each suspects the other to confess. This
makes confess the rational strategy for each prisoner. Stolen
Table 5.3: The Prisoner’s Dilemma
Suspect B
Confess Deny
Suspect A Confess -3, -3 0, -10
Deny -10, 0 -1, -1

Oligopoly firms often find themselves in a prisoner’s dilemma. The concept of the prisoners’
dilemma can be used to analyze the incentive to cheat in a cartel (i.e., the tendency to secretly cut
prices or to sell more than the allocated quota). Suppose two firms in a centralized cartel face the
following situation. At one end, if both firms cheat (say, each firm chooses to secretly cut the price
it charges), each would earn a profit of 8 thousand Birr. If one cheats and the other sticks to the
agreed on price, the cheater would enjoy a profit of 20 thousand Birr and the other a profit of 2
thousand Birr. At the other end, if both firms stick to their agreement, each would enjoy a profit
of 12 thousand Birr. The payoff matrix below summarizes this information. (All figures in the
table are in thousands of Birr).

Table 5.4. The Prisoners’ Dilemma Applied to Cartel Members

Firm B
Cheat Don’t cheat
Firm A Cheat 8, 8 20, 2
Don’t cheat 2, 20 12, 12

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What is the Nash equilibrium of this game? Cheat is the dominant strategy of each firm.
Consequently, each firm would decide to adopt its dominant strategy of cheating and end up in
earning a profit of 8 thousand Birr each. But, by choosing not to cheat (by sticking to the
agreement), each member of the cartel would earn the higher profit of 12 thousand Birr. Hence,
the outcome – (cheat, cheat) – is sub-optimal (Pareto inefficient), i.e., the firms could have done
better. The cartel members then face the problem of prisoners’ dilemma. Only if cartel members
do not cheat would each earn the higher cartel profit of 12 thousand Birr.

5.4.Repeated Game

In the prisoner’s dilemma discussed above, the players were assumed to meet only one time and
play single game. Although, some prisoners may have only one chance in life to commit crime
and hence play the game, most oligopoly firms play repeated games. By virtue of this, the real
world oligopolists might find way of learning to cooperate so that their efforts to collude are more
effective. If the game is played repeatedly by the same players, strategies can become more
complex because there are new strategic possibilities open to each player. In repeated games, the
“tit-for-tat” strategy works. In the tit-for-tat strategy one player responds to another player’s
previous behavior.

“Tit-for-tat” Whatever your rival does in one round (whether renege or cooperate), you do in the
following round. That is, begin by cooperating and continue to cooperate as long as your opponent
cooperates. If he/she betrays you, you betray him/her back the next time (you play the game).
Repeated games classified into finite repeated game and infinite repeated game. In finite repeated
game: it is likely that each player chooses the equilibrium in dominant strategy and cheats. An
indefinitely repeating game, each participant cooperates because it hopes that cooperation induces
further cooperation. The cooperation, of course, maximizes the joint profit at each play of the
game. Hence, in an indefinitely repeating game, the tit-for-tat strategy works very well because it
offers an immediate punishment for the previous bad behavior (i.e., cheating). That is to say, the
tit-for-tat strategy keeps both players cooperating and earning monopoly profit. Firms that care
about future profits will cooperate in repeated games rather than cheating in a single game to
achieve a one-time gain.

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5.5.Sequential games

The games considered so far are games in which both agents (players) act simultaneously. But in
many situations one player gets to move first, and the other player responds. An example of this is
the Stackelberg’s duopoly model, where one player is a leader and the other player is a follower.
Another example is that of price leadership where a firm sets a price (or announces a price change)
and the others adopt (or follow) this price (or price change). These games are best represented
using game trees, which show the sequence of decisions, possible actions, and resulting payoffs.

We use the backward induction method to analyze sequential game. The name backward induction
is an indication that we begin the analysis from the right most tails of the game tree and sequentially
go back to the starting point. Put differently, the backward induction method entails starting from
the possible responses of the follower and going back to the decision of the leader. Let us take our
analysis of sequential games and the nature of possible threats that could be forwarded from
followers to the oligopoly market. Recall the factors that make entry to an oligopolistic market
difficult. One important strategy that an oligopolist can use to deter (prevent) market entry is to
threaten to lower its price and thereby impose a loss on the potential entrant. Such a threat,
however, may or may not be credible and works only if it is credible.

In this situation, the time sequence of the game is that, first, the entrant decides on whether to enter
the market or to stay out, and then the incumbent (the existing firm) will decide on its response,
i.e., whether to fight (cut its price) or not. In short, first, the potential entrant decides, and then the
incumbent makes its decision. The payoffs of this game to the two firms are summarized as
follows.
Table 5.5. The normal form representation of sequential game between entrant and incumbent firm
Potential Entrant
Enter Stay Out
Fight 4, -2 6, 0
Incumbent Don’t Fight 7, 2 10, 0

As you might now be familiar with, the first step to analyze a sequential game is to set up the
extensive form representation of the game. The first-mover occupies the starting point of the game
tree.

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From the game tree in figure 5.1. below, the incumbent firm charges a high price if the potential
entrant stays out as 10 > 6. Similarly, if the potential entrant chooses to enter, the incumbent firm
will prefer to continue charging the same price (i.e., not to fight) because 7 > 4. This implies that
the final outcome would be either (2, 7) or (0, 10). With the knowledge that the final outcome
would be either of (2, 7) or (0, 10), the potential entrant chooses to enter. Thus, the Nash
equilibrium of this sequential game is: (enter, don’t fight).

Fight (-2, 4)
Enter

Not fight (2, 7

Potential Entrant

Fight (0, 6)

Stay out
Not fight (0, 10)

Figure 5.1. A Sequential Game tree between a Potential Entrant and an Incumbent Firm

Chapter Six:
6. General Equilibrium and Welfare Economics

6.1.Introduction to general equilibrium

Partial equilibrium: Partial equilibrium analysis studies the behavior of an individual decision-
making unit and a particular market, viewed in isolation. It can be characterized by in “ceteris
paribus” assumption. The partial equilibrium analysis is confined to only one element of the
economy. Examples of such an analysis include the study of:
– how an individual maximizes satisfaction subject to his/her income constraint,
– how a firm minimizes its costs of production and maximizes profits under various market
structures,
– how the price and employment of each type of input is determined.
Partial equilibrium neglects the way in which changes in one market affect other (product/factor)
markets. But the real world market system is interlinked. In other words, in reality a fundamental

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feature of any economic system is interdependence among its constituent parts. The markets of all
commodities and all productive factors are interrelated, and the prices in all markets are
simultaneously determined. For example, consumers’ demands for various goods and services
depend on their tastes and incomes. In turn, consumers' incomes depend on the amounts of
resources they own and factor prices. Factor prices depend on the demand and supply of the various
inputs. The demand of firms for factors depends not only on the state of technology but also on
the demands for the final goods they produce. The demands for these goods depend on consumers'
income. The message is that there is circular interdependence of activities within an economic
system.

Such interrelated economic variables and multi-directional effects are studied in general
equilibrium analysis. General equilibrium studies the interdependence or interconnections that
exist among all markets and prices in the economy and attempts to give a complete, explicit, and
simultaneous answer to the basic economic questions of what, how and for whom to produce.
General equilibrium is an attempt to assess the demand and supply situations of several markets to
determine the prices of many goods. General Equilibrium analyses the way in which the choices
of economic agents are co-ordinated across all product and factor markets. General equilibrium is
a state in which all markets and all decision-making units are in simultaneous equilibrium. A
general equilibrium exists when all economic units maximize their respective objective function
(each consumer maximize satisfaction and each firm maximize profit) and all markets are cleared
at a positive price.

6.1.1. General Equilibrium in a Two-Factor, Two-Commodity, Two- Consumer Economy

To facilitate the discussion and understandability of a general equilibrium analysis, let us construct
a simple model/abstraction.

1. There are two factors of production (L and K), whose quantities are given exogenously. Both
of these factors are homogeneous and perfectly divisible. Homogeneity indicates that all units
of labor are identical, and so are the units of capital. Perfect divisibility of factors means that
any factor of production could be supplied and used in whatever fraction desired.
2. Only two commodities (X and Y) are produced. The technology of production is given. That
is, production at the currently existing technology is considered. The isoquant maps have the
usual properties (smooth and convex to the origin implying diminishing marginal rate of

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technical substitution, MRTS, between factors along any isoquant). Each production function
exhibits constant returns to scale. The two production functions are independent (no
externalities in production). That is, the production process of good X does not influence that
of Y, and vice versa.
3. There are two consumers in the economy (A and B) whose preferences are represented by
ordinal indifference curves, which are convex to the origin, exhibiting diminishing marginal
rate of substitution, MRS, between commodities. Consumers’ choices are independent (no
externalities in consumption).
4. The goal of each firm is profit maximization and that of each consumer is utility
maximization.
5. There is full employment of factors of production, and all incomes received by their owners
(A and B) are spent. Note an implicit assumption in this assumption: the factors of production
are owned by the consumers.
6. There is perfect competition in both commodity and factor markets. Thus, both consumers
and firms face the same set of prices (PX, PY, w, r).

In this model, a general equilibrium is reached when:

– The four markets (two commodity and two factor markets) are cleared at a set of
equilibrium prices (P X, PY, w, r); and
– Each economic agent (two firms and two consumers) is simultaneously in equilibrium.

Three Conditions for general equilibrium

Three static properties are observed in a general equilibrium solution, reached with a freely
competitive market:

1. Efficiency in production/efficiency in factor allocation (Efficient allocation of resources

between firms or goods)

Recall from the previous chapter that a perfectly competitive firm maximizes its profit at a point
where the marginal rate of technical substitution between factors equals the input price ratio (i.e.,
𝑋
when (𝑀𝑅𝑇𝑆𝐿𝐾 = 𝑤/𝑟 ). Also, remember that MRTS LK is the slope of an isoquant in absolute
terms. Now, we will extend this same condition to the simultaneous analysis of two firms, each

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trying to maximize its own profit. The joint equilibrium of production of the two firms in our
simple model can be derived by the use of the Edgeworth box of production.

L
OY

OX

L
Figure 5.1. Edgeworth box of production

If this economy was initially at point R, it would not be maximizing its output of commodities X
𝑋 𝑌
and Y because, at point R, 𝑀𝑅𝑇𝑆𝐿𝐾 ≠ 𝑀𝑅𝑇𝑆𝐿𝐾 . As the rate at which labor and capital can be
substituted for each other differ for the production of the two commodities, this economy is not
making the best out of its resources (at point R). The economy can move from point R to point N
and increase its output of Y (from Y2 to Y3) without reducing its output of X (from X2).
Alternatively, it can move to point P thereby increasing its output of X (from X2 to X3) without
reducing its output of Y. At points M, N, P and Q, an X-isoquant is tangent to a Y-isoquant (X and
𝑋 𝑌
Y isoquants have the same slopes) so that 𝑀𝑅𝑇𝑆𝐿𝐾 = 𝑀𝑅𝑇𝑆𝐿𝐾 . The curve O XMNPQOY is the
Edgeworth Contract Curve of Production. It is the locus of tangency points of the isoquants for
𝑋 𝑌
X and Y (or the locus of points at which 𝑀𝑅𝑇𝑆𝐿𝐾 = 𝑀𝑅𝑇𝑆𝐿𝐾 ). Any point on this contract curve
is Pareto efficient (optimal) in the sense that the production of one of these goods cannot be
increased without reducing that of another.

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The general equilibrium of production occurs at a point that satisfies this Pareto optimality
criterion of efficiency in factor substitution. Since this occurs at any point along the Edgeworth
contract curve of production, there is an infinite number of potential Pareto-optimal production
equilibria. However, with perfect competition, one of these equilibria will be realized, and this
𝑋 𝑌 𝑤
equilibrium is the one at which 𝑀𝑅𝑇𝑆𝐿𝐾 = 𝑀𝑅𝑇𝑆𝐿𝐾 = . If, for instance, this happens at point P
𝑟

in the diagram above, then the economy will produce X3 units of X and Y2 units of Y.
Correspondingly, OXLP units of labor and TKP units of capital will be used in the production of
X while LPT units of labor and OYKP units of capital will be used in the production of Y.

The above discussion is about the production side only. This would enable us to define the
equilibrium of production in the input space. However, in a general equilibrium, the amounts of X
and Y which maximize the profits of firms must be equal to those which consumers want to buy
in order to maximize their utility. Besides, consumers decide their purchases based on commodity
prices, PX and PY. Thus, in order to bring together the production side and the consumption side
of the system, we must define the equilibrium of the firms in the product space.

From each point on the Edgeworth contract curve of production in Figure 5.1, we can read off the
maximum obtainable quantity of one commodity, given the quantity of the other. For instance, the
economy can produce a maximum of X2 units of X if it produces Y3 units of Y. Similarly, it can
produce a maximum of X1 units of X for Y4 units of Y.

The locus of all the Pareto-efficient outputs (or the locus of all the maximum attainable
combinations of the two commodities, given the resource endowment K and L, and the state of
technology) is the production possibilities frontier/curve (PPF/PPC). At any point on the curve, all
factors are optimally (efficiently) employed. Any point inside the curve is technically inefficient,
implying unemployed resources. Points above the curve are unattainable with the currently
existing resources and technology. They could be made attainable only if additional resources or
a new technology or both are found.

The PPF is also called the product transformation curve because it shows how a commodity is
transformed into another, by transferring some factors from the production of one commodity to
the other. The negative of the slope of the PPF is called the marginal rate of product transformation

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(𝑀𝑅𝑃𝑇𝑋𝑌 ) and it shows the amount of Y that must be sacrificed in order to obtain an additional
𝑑𝑦 𝑃𝑋
unit of X, keeping efficiency in production. That is, 𝑀𝑅𝑃𝑇𝑋𝑌 = − =
𝑑𝑥 𝑃𝑌

2. Efficiency in exchange/Equilibrium of consumption

The joint equilibrium of exchange (consumption) of the two consumers in our simple model can
be derived by making use of the Edgeworth box of consumption. Given the total quantities of X
and Y to be distributed between A and B individuals, there will be an infinite number of Pareto
optimal equilibria of distribution. A Pareto-efficient distribution of commodities is one such that
it is impossible to increase the utility of one consumer without reducing the utility of the other.
However, not all distributions (all points in the Edgeworth box) are Pareto-optimal. Only points
of tangency of the indifference curves of the two consumers represent Pareto-efficient
distributions. The locus of these points is called the Edgeworth Contract Curve of Consumption.
𝐴 𝐵 𝑃𝑋
At each point on this curve,𝑀𝑅𝑆𝑋𝑌 = 𝑀𝑅𝑆𝑋𝑌 = . X
𝑃𝑌
OB
Y

OA X
3. Efficiency in Product-Mix (simultaneous equilibrium of production and consumption)
The general equilibrium of the system as a whole requires the fulfillment of the condition:
𝐴 𝐵
𝑀𝑅𝑆𝑋𝑌 = 𝑀𝑅𝑆 𝑋𝑌 = 𝑀𝑅𝑃𝑇𝑋𝑌 . That is, the rate at which the consumers are willing to exchange
one good for another (MRS XY ) must be equal to the rate at which a good can be transformed into
another in production (MRPT XY).

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In perfect competition this condition is satisfied since:

𝐴 𝐵 𝑃𝑋
 𝑀𝑅𝑇𝑋𝑌 = 𝑀𝑅𝑆 𝑋𝑌 = (equilibrium of consumption/efficiency in exchange)
𝑃𝑌
𝑃𝑋
 𝑀𝑅𝑃𝑇𝑋𝑌 = (equilibrium of production)
𝑃𝑌
𝐴 𝐵 𝑃𝑋
 The logically follows the two points above that 𝑀𝑅𝑇𝑋𝑌 = 𝑀𝑅𝑆 𝑋𝑌 = = 𝑀𝑅𝑃𝑇𝑋𝑌 .
𝑃𝑌

6.2. WELFARE ECONOMICS

Welfare economics studies the conditions under which the solution to the general equilibrium
model can be said to be socially optimal. It examines the conditions for economic efficiency in the
production of output and the exchange of commodities and equity in the distribution of income.
welfare economics points out that the maximization of the society’s well-being requires not only
efficiency in production and exchange but also equity in the distribution of income.

The Two Fundamental Theorems of Welfare Economics

The first theorems: any competitive equilibrium leads to a Pareto-efficient allocation. The fact
that perfect competition leads to economic efficiency (Pareto optimality in production and
exchange) proves Adam Smith’s famous law of the invisible hand. Smith’s law postulates that in
a free market economy, each individual by pursuing his/her own selfish interests is led, as if by an
invisible hand, to promote the well-being of society more so than he/she intends or even
understands.

The second theorem of welfare economics postulates that any Pareto-efficient allocation can be
achieved via redistribution and market mechanisms. When indifference curves are convex to their
origins, every efficient allocation (every point on the contract curve for exchange) is a competitive
equilibrium for some initial allocation of goods or distribution of inputs (income). The significance
of the second welfare theorem is that the issue of equity in distribution is logically separable from
the issue of efficiency in allocation. This means that whatever redistribution of income that society
wants would lead to the exhaustion of all possible gains from exchange under perfect competition.
Therefore, Pareto optimality does not imply equity. Society can use taxes and subsidies to achieve
what it considers as a more equitable distribution of income.

GOOD LUCK
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