2

Words of inspiration
Ours then are everything which we see, all the homes, the fortresses, the cities, all the buildings in the entire world which are so many and such that they seem the work of angels rather than of men. . . .Ours are the pictures, ours the sciences, ours the wisdom.
Giannozzo Manetti1

For "Economics is the study of people in the ordinary business of life."

Alfred Marshall2

my wife

Ammini
as always.

. . . the beginner will

have difficulty in finding a book that leads him straight to the heart of the subject and give him the power to apply it intelligently. He refuses to be bored by diffuseness and general statements which convey nothing to him, and will not tolerate a pedantry which makes no distinction between the essential and the non-essential . . .
Richard Courant3

1.

On the Dignity and Excellence of Man (quote taken from Frederick Hart, Art).

2. 3.

Principles of Economics Differential and Integral Calculus.

Acknowledgements

My professional indebtedness is to my teachers, students and colleagues. Bibliography lists all the scholarly publications I consulted as I was preparing this book. Trained in India, Germany, and the United States, I pay my obeisance to all my teachers. Special mention is due to Ryuzo Sato, my thesis adviser, mentor and my boss in the last eighteen years of my academic career. I was fortunate to start my academic career in the friendly environment of the Sanathana Dharma College. In 1970, I came to Brown University for graduate education just as the excitement over the New Curriculum was at its height. Involvement with undergraduate education for three years as teaching assistant and one year as teaching associate showed me how high one can aim in classroom instruction if it is properly motivated. In addition to carrying that commitment to my courses at Southern Methodist University, I, as director of undergraduate programs in economics, joined a few colleagues in a substantial upgrading and tightening of the program. The enthusiastic support of our students made it a lasting success. In 1987, I moved to Stern School of Business as Associate Director of the Center for JapanU.S. Business and Economic Studies. The School was then formulating a curriculum linking all the core MBA courses. I approached colleagues in various departments asking what I could possibly teach in the core course in microeconomics that would make the link to other core courses explicit. Regrettably I do not have a complete record of all the conversations but there are a few whose advice I sought repeatedly and some of them commented on various versions of my lecture notes. They are: Kimberley Bates, Samuel Craig, Avijit Ghosh, Kose John, Robert Shoemaker, Richard Sylla, and Lawrence White. Outside the Stern School, I am grateful to Charles T. Horngren of Stanford University and late Peter L. Bernstein, author of several books in economics and finance, for reading parts of the notes and giving constructive criticisms. Every teacher is surprised by the ingenuity of the students in misinterpreting what was taught and I am afraid that my colleagues will find me no less creative. For the present book, I drew inspiration from three sources. First is admiration of popular science books that began with reading Lancelot Hogbens Mathematics for the Million early in life. I am also fascinated by the increasing use of computer graphics in recent science books. The one diagram in Dennis Robertsons Lecturers on Economic Principles and the success of Minoo Masanis Our India were early indicators that graphic can be effective in economics also. Next is the recognition, even among mathematicians, of the pedagogic benefits of non-linear presentation which, instead of following the logical order of deduction, brings out the connection between topics and an overview of the whole structure. The spiral method used in this book is adopted from Paul Bamberg and Shlomo Sternbergs A course in mathematics for student of physics. Finally, in two succinct conversations on the teaching of game theory, Adam Brandenburger suggested that I take the first chapter of John von Neumann and economist Oskar Morgensterns

Theory of Games and Economic Behavior seriously and I did. More than others before me, I pursued their suggestion to begin with examination of a primitive economy and made it the foundation of the spiral. I used CorelDraw to prepare the graphics and am grateful to Lisbi Abraham for introducing me to its power and flexibility. I tested an earlier version of some chapters on three non-economists: Raghu Ramachandran, Ashwin Shah, and Venu Venugopal. Their friendly but penetrating criticisms convinced me of the enormity of the task ahead. I was lucky to work with Deborah Emin, publisher of Sullivan Street Press, Inc.; she helped me break away from the academic style of writing though I am sure she would have loved to make me rewrite the current version all over again. Only a reader will know the errors and deficiencies and I appreciate comments and corrections that you can e-mail to me at ramachandran@visualeconomicanaysis.info My wife, Ammini, introduced me to the new trends in publishing industry as she selfpublished her cookbook a few years earlier. I chose internet publishing through Scribd. In 1964, I was leaving home to take my first faculty position, my father, Rama Varma Appan Thampuran who was a professor before moving to educational administration, advised me of goals I should have as a teacher. The rest of my career was a struggle to live up to it. My mother, Padmam Varma, was better at making economic decisions than I ever will be. My nuclear family, Ammini, Raghu, Rama and Jo Ann, who provided loving support through these years, is the joy of my life.

Table of Contents

Chapter 1. Chapter 2. Chapter 3. Chapter 4. Chapter 5. Chapter 6. Chapter 7. Chapter 8. Chapter 9. Chapter 10. Chapter 11. Chapter 11: Chapter 13. Bibliography Index

Individuals in a liberal society. Consumer preferences and choices. From self-reliance to exchange. Choices involving time and uncertainty Let us go shopping. Firms: their role in supplying the market. Monopolist: the sole producer of a product. One product, many prices. Competing with differentiated products. Game theory: the analysis of strategy. The competitive markets. Intertemporal preferences, uncertainty and the financial markets. Firms: Islands of command. 223 229

1 13 27 45 59 75 89 105 119 129 139 157 181

Chapter 1. Individuals in a liberal society.

We have no choice but to choose. Throughout the day, at home and at the office, we confront situations where we have to select one of the options before us. Some choices have ephemeral consequences while others leave a lasting impact on our future well-being. Our education, our job, the place where we live, the way we furnish it, what we eat and our leisure activities are choices we make about our personal lives. In some years, we borrow and accumulate debt; in others, we save to increase our assets. Our current decisions affect our future lifestyle. Our responsibilities at work vary with our station in the corporate ladder. The Chief Operating Officer (CEO) of a manufacturing organization sets the goals for the company. Production is ratcheted up and new plants constructed or workers are laid off and plants closed down to fulfill the goals he sets. The corporate office decides when to raise funds by issuing of bonds and stocks to finance the operations of the company. These decisions are made public in statutory filings and in corporate announcements. The middle management ensures that the decisions made by the corporate office are implemented by the operational units. Their involvement, though not publicized outside the firm, is crucial to its success. At the factory floor, the worker appears to be doing purely repetitive work. Within limits, she can work harder or slow down, and her choice depends on rewards for her productivity. Beyond that, she has an intimate understanding of the operations in her area, and can observe inefficiencies or potential for break-downs in the production process that are not obvious to her superiors. Recognizing the value of the information, many firms offer incentives to employees to alert the management about possible problems and for making suggestions to increase productivity. In retailing, restaurants and airlines, the actions and attitude of the employee who are responsible for delivering the service determine how satisfied the customers are and how willing they are to make repeat purchases. Even those at the bottom level of the corporate organization affect the fortunes of their companies. In democratic nations, we elect the legislators and, in United States, also the President. The budget they enact determines the levels of personal and corporate taxation and the expenditure on public services. They pass laws promoting competition in the market and restricting pollution of air and water. At election time, political parties announce their agenda and we vote for the candidates based on our preferences for their policies. The opportunities we have and our ability to execute our preferred actions depend on decisions made by others. We are able to purchase goods only if firms produce and market them. Decisions of our employers affect our job security and opportunities for advancement. The return and risk on our investments depend on financial and real estate markets. For each to achieve goals that partially depend on actions by others, there has to a mechanism to coordinate the individual choices. One important goal of economic analysis is to determine how well an economy achieves the coordination. Does the organization of economic activity permit consumers to maximize their utility and firms to maximize their profit? Does the

economy maximize social welfare defined in terms of the welfare of the individuals? 1 The general conclusion of modern economics is that a market economy, with caveats stated in later chapters, is more efficient than alternate institutional arrangements. Economic analysis has succeeded in convincing the general public and policy makers of the rigor of its analysis and the relevance of its conclusions. Because of its influence, the trend in western nations over the last two centuries and in developing countries more recently is to increase the choices available to individuals and to allow them greater freedom in making decisions. Deregulation also increased competition in the market and spurred firms to increase their productivity. Economic growth leads to substantial improvement in the standards of living around the world. Yet all is not well. As consumers, investors, employees and executives we are inundated with advice and offers by various groups; they are pushing their products and services. Political parties claim that their programs are based on sound economic principles and beseech us to vote for them. Increased opportunities and freedom to select has not always led to better choices. At individual and national levels, we continue to make mistakes. Why are we not saving enough to sustain us in our retirement? Why are so many of us purchasing houses we cannot afford? Financial institutions, with highly qualified staff, have given out loans that they cannot recover or have made investments that result in massive losses. Nations adopt policies that result in widespread shortages of agricultural and industrial products, economic stagnation and discontent among its citizens. Were those who made these decisions ignoring the lessons of economic analysis and if so, why did they do so? Or is the discipline, in spite of its breadth and depth, lacking in effective guidelines to help us to make proper choices in certain situations? The goal of this book is to explain, in an intuitive manner, the core concepts in economic analysis. Empirical literature is quoted to illustrate potential applications of economic analysis but they are not intended to espouse any policy position. The structures we build. Our scientific knowledge can be compared to a campus with its many structures that differ in style and functions but are dedicated to a common purpose. We have benefited from each of them. Yet their magnificence does not hide the cracks in our knowledge. Consider how the advances in three disciplines - medicine, and economics -- impacted our decisions. The general public holds physical sciences in great reverence. In the seventeenth century Isaac Newton stated the three laws that govern terrestrial and celestial motions. Newton's ability to explain a broad range of phenomena by a few simple propositions fired public imagination and became the model for all scientific endeavors. Technological development went hand in hand with scientific progress. Steam engines developed as thermodynamics provided indices of their efficiency. Internal combustion engines transformed the mode of transportation. Fascination with static electricity branched into the study of currents, electromagnetic induction and radiation and led to the birth of electrical, electronic and communication industries. The analysis of cathode ray led to discovery of electron and then to radioactive decay. The nucleus of atoms was shown to be made up of protons and neutrons. Better understanding of structure of atoms gave
1

Though much debated, there is no consensus on how indices of social welfare are to be constructed from those for individual preferences.

birth to the nuclear industry. No wonder that other disciplines aspire to achieve the theoretical elegance and experimental success of physics. Classical physics precludes electrons within the atom having stable orbits and quantum physics was developed to explain such anomalies. It was soon realized that protons and neutrons are composites of many other fundamental particles. One of them is the neutrino, "the little one," postulated from theoretical considerations by Wolfgang Pauli in 1930. Its existence was empirically verified in 1956 but even now some of its properties baffle physicists. What is unique about neutrino is that tens of thousands of them originating in the Sun pass through our bodies every second. We are not aware of it, anything we do will not affect their course and we do not care about it. The general public can admire the achievements of physics without being distracted by what is not yet known. Contrast this with another discipline that has changed our lives, medicine. Bubonic plague that wiped out a third to half the population in European cities in the fourteenth century is now contained through public policy and medication. Two hundred years ago, Edward Jenner developed vaccination against small pox, but it continued to be a threat in many parts of the world until a sustained drive to vaccinate eradicated it recently. Making the public understand the importance of hygiene has drastically limited contagions like cholera. Antibiotics were an effective antidote to bacterial infections and many new vaccines were developed to provide immunity against viruses. Still newly identified viruses like HIV spread quickly and are infecting millions. Various types of cancers that are known for a long time still lack definitive cures. New medications and medical procedures that are announced as breakthroughs in treating some aliments are soon found to have undesirable consequences. Some diseases show a new surge, but it is not known whether it is due to aging of the population, hereditary factors, environmental changes or recent behavioral patterns. We fear maladies without remedies and our concerns influence the funding of medical research. Given these uncertainties, the doctor and the patient have to agree on a course of treatment when each alternative has some risk. Should the doctor, given his expertise, make the decision or should he inform the patient of her choices and let her make the decision? Can the doctor be depended to recommend the treatment that is best for the patient or will he be influenced by personal or professional considerations to choose another? Many individuals are covered by insurance offered by the private insurance companies or by the state. As the cost of medical procedures increase, can the third parties paying for it -- the insurance companies or government programs -- set criteria for deciding what treatments the patient can have or ask the patient to take increasing share of the cost? Even though each choice has some undesirable consequences, we have to decide on one of them. In the beginning of eighteenth century, the European countries started constructing a new structure in the campus of knowledge. In 1827, Prussia first established chairs to teach General Householding (as economics was then referred to). 1 Those who discussed economic policy whether they were in academics or in government positions were staunch nationalists. They, the mercantilists, emphasized the "civilizing" nature of an authoritarian state and wanted it to be
The title is indicative of the prevailing view that national economy should be looked upon as the household of the nation and managed as households are managed. Magnusson (1992), p.S249.
1

strong enough to take aggressive stand in international conflicts. 1 Economic growth enabled the state to grow stronger and development of local industries under a protectionist trade policy was necessary to assure supply of important industrial commodities in times of war. Nation as much as individuals benefited from having a horde of precious metals (gold and silver) and considered a balance-of-payment surplus that leads to their accumulation beneficial to the nation. This, in spite of the recognition that inflows of gold and silver from South America in the sixteenth century was the source of inflation in Europe and that the inflow of precious metals due to trade surplus can lead to price increases in due course. They did not have a clear conception of the interrelationship between various sectors of the economy. They doubted that individual choices will lead to the development of the productive sector and to the growth of a vibrant market economy. Even if it does, it would take a very long time. "Why allow this to be achieved in a roundabout manner when it can be accomplished directly?" asked the Swedish economist Johan Lastbohm. 2 It is against such views that Adam Smith launched a two pronged attack. He used the philosophical arguments developed in the eighteenth century England and Scotland to argue for the primacy of the individual's interests and rights. In addition he used the vast amount of data he had collected about economic conditions from ancient times to the contemporary England and France to expose in his Wealth of Nations the inequities and inefficiencies of the mercantilist system. Economic policy should promote the welfare of the individual. Instead of emphasizing the role of production in strengthening the state, Smith held that consumption is the sole purpose of production. Commerce and manufacturers will gradually introduce order and good government and a free market would ensure the liberty and security of individuals. Introduction of machinery became possible as the complex work of artisans was divided into many simple operations and each of them was allocated to different workers. The division of work that increases productivity of workers is limited by the size of the market. Smith argued that by eliminating restrictions to internal and international trade, higher rate of economic growth and greater prosperity can be achieved. Smith's stature grew slowly over the next century and he is now regarded as father of modern economics. While attacking specific regulations that hurt national prosperity, Adam Smith was pragmatic than doctrinaire in drawing the boundary between public and private domains. He accepted that the government should take beneficial responsibilities like maintaining law and order, enforcing contracts and in maintaining public institutions. He opposed monopolies, like East India Company, formed under a government charter but supported patent and copyright. Even in international trade, he was willing to agree to restrictions like limiting export of corn under certain conditions. He recommended taxing woolen to give domestic workers an advantage.
1

Schumpeter attributes the aggressiveness of new native states to the breakup of the alliance between the Holy Roman Empire and the Catholic Church. It used to be the only effective international authority in the Medieval Europe. Schumpeter (1954), pp. 145-6.

Magnusson (1992), p.S251. This is a cry echoed in the twentieth century by leaders of the nations embarking on rapid industrialization from Stalinist Soviet Union to democratic India. The belief persists as non-market economies show short periods of high growth rates, generally at the beginning of the development program.

The market price of a product depends on demand and supply. If the price increases, consumers will substitute other products for it and substitution will restrain price increases. Smith went further and claimed that market price will fluctuate around a natural price that is sufficient to cover the cost of production. Instead of building on the discussion of market equilibrium based on consumer substitution and cost of production, the nineteenth century economists followed David Ricardo in claiming that relative values of goods correspond to the labor embodied in them. The labor theory of value was combined by Karl Marx with the exploitive theory of profits to claim that capitalists extract value belonging to laborers. In the middle of the nineteenth century, William Stanley Jevons, Carl Menger and Leon Walras undermined the primacy of cost in determining relative prices or exchange value. They claimed that utility from consumption is the source of value. Alfred Marshall shortly thereafter argued that cost and demand are like the two blades of a scissor and that both are indispensible for the determination of value. The synthesis that Alfred Marshall made of classical economics and the evolving marginal economics provides a bench-mark to measure subsequent progress. It began with the recognition of the complimentary roles of cost and utility in determining relative prices of goods. Central to this analysis is the idea that choice is substitution at the margin. The budget a consumer has is limited and increasing consumption of one product requires a reduction of others. 1 When a consumer values an incremental unit of a product no more than units of others he has to give up, he has no inclination to change his consumption any further. Marshall extended substitution at the margin to inputs in production. Firms choose more or less labor intensive processes and use them with a mix of other inputs to minimize cost of producing the output. The remunerations for inputs are determined by quantities demand and supplied. This approach led him to the idea of the simultaneous equilibrium of all input and output markets (the general equilibrium theory) but Marshall never developed the interrelationship systematically as Leon Walras did. Building on the works of Jevons, Menger and Walras, economic analysis emphasized substitution at the margin as the means to maximize utility of individuals and profits of firms. Antoine Cournot's seminal work in mathematical economics published in 1838 used calculus to analyze individual optimization and market equilibrium. Going beyond market for one product, Leon Walras in 1874 examined how the interactions among the many markets determine the equilibrium of the economy. Both Walras and Vilfredo Pareto studied the efficiency of competitive markets. Alfred Marshall was well trained in mathematics and was aware of Cournot's work but he preferred to suppress the mathematical derivations and presented results only verbally. Economic profession was slow in adopting mathematics as a tool. Even as late as 1940's less than three percent of the pages in American Economic Review, the journal of the American Economic Association, had rudimentary mathematical expressions. 2

Jevons and Menger stated that marginal utility, incremental satisfaction from unit increase in consumption of a commodity decreases as consumption increases. Because of the decrease, a consumer who achieved certain level of consumption of a product will not be willing to incur the cost of purchasing additional units. This determines his demand for the product. Utility analysis was subsequently refined, as discussed in the next chapter, to remove the psychological assumptions in the nineteenth century formulation. 2 Debrue (1991), p.1

Calculus imposes limitations on the type of functions that can be used to model behavior of individuals and firms. Since these restrictions do not always correspond to the opportunities available in an economy, one trend in the economic analysis was to expand the scope and generality of equilibrium analysis by adopting more sophisticated mathematical techniques. 1 Institutional changes and analytical developments influenced each other. The opening of the market spurred organizational innovations. Deregulation of trade increased competition and, to be profitable, firms had to reduce the cost of production by increasing the scale production. It was no longer feasible for the owner to manage the operations and a managerial cadre was created to enable separation of management from ownership. As cost of manufacturing operations increased, pooling of savings by a few investors and loan from a local bank were not enough to finance the plant and its operations. Financial markets developed to channel the saving of different individuals to financial intermediaries and let them invest the funds in different stocks and bonds. Limited liability protected personal assets of shareholders from the creditors of the company in case the firm went bankrupt. Those who invested their savings needed information on the returns they can expect. The firms periodically publish financial accounting statements, and guidelines were set out by regulatory agencies to ensure that they accurately reflect the financials flows of the firm. Finance theory showed how investors can reduce the risk through diversification and hedging. Information technology was used to minimize inventory without disrupting production and to develop cost effective supply chains. Individual disciplines, like human resource and organizational management, finance, accounting and supply chain management focused on specific aspects of the complex operations of the firms. They all aim in guiding the firm to adopt practices that increase its profitability. Shared goal and common methodologies like game theory (study of strategies used in interaction among a small group of decision-makers) and dynamic optimization (optimization over time) links them to economic analysis. Making explicit the links provides a better understanding of the nature of decisions to be made. The success of economics is that, over the two and half centuries, it has grown into a rigorous discipline that uses mathematical and statistical reasoning to substantiate its conclusions. Its belief in individual optimization placed on households and firms the responsibility of making proper decisions. For some decisions, like savings to meet unexpected expenses or for retirement, the individual has to look into the future. Many decisions, like investment in stocks and undergoing some medical procedures, involve risks. Theories that deal with intertemporal decisions and decisions under uncertainty invoke assumptions about the behavior of individuals and firms that are much more complex than those about choice at one point of time. When outcomes differ from what was expected, questions are raised about the validity of these assumptions. Is the low savings rate in the United States due to myopic choices by individuals? Do the current theories about choice under uncertainty underestimate the probability of extreme outcomes? Adam Smith realized that markets may veer away from the competitive ideal. There is a tension between freedom to transact in the market and instituting regulations to ensure level playing field. This comes out in periodic debates about antitrust and financial regulations.
New mathematical methods used include convex analysis, fixed point theorems, linear programming and activity analysis, game theory and non-standard analysis.
1

When an individual or an economy faces a crisis, the question is whether those who made bad decisions ignored the lessons of economic analysis or did economics fail to provide them with clear guidelines? Whatever be the reason, the consequences are important to us and in this economics is like medicine. Developments in both sciences have resulted in improvement over time in the quality of life. 1 However, both have left challenges, some old and other new, unanswered. Public appreciation of sciences. The scientific revolutions of the seventeenth century changed the public perception of the world around them. The Copernican revolution, the calculations of Kepler and the observations of Galileo revolutionized astronomy. William Harvey discovered the circulation of blood in the body and the microscopes of Anton van Leeuwenhoek identified red blood cells and single cell bacteria. The geographical explorations opened up access to new lands and people with strange customs. The climax was the publication of Newton's Principia Mathematica in 1687. The scientific breakthroughs and the controversies they created became part of social discourse and popular science shaped the public opinion in France and England. 2 Even novels and poems referred to them. Realizing the value of convincing a wider audience the validity of various theories, the protagonists solicited public support for them as Voltaire did for Newtonian physics. Louis XV created a post for professor of experimental physics at the College of Navarre for Jean-Antoine Nollet and his lectures, which were free, were popular enough for hundreds to attend them. He wrote books on scientific experiments for the general public. 3 Other scientists gave lectures and demonstrated experiments in different parts of Paris and they were well attended in spite of high entry fees. In United Kingdom, interest in popular science was well established by the eighteenth century. Royal Society was established in 1660 to promote scientific debate and lobby for science. Till 1820 it admitted gentlemen interested in science as its members. At the end of eighteenth century, the Royal Institution was established to promote science and to diffuse scientific knowledge. Christmas lectures by Humphrey Davy and Michael Faraday at the Institution were extremely popular. 4 Scotland, because of its location, had intellectual contacts with European universities and in the seventeenth century many Scots attended Dutch universities. The Union with England in 1707 opened the economy for trade with the British Empire. By the middle of the eighteenth century, Scotland became the tobacco capital of Europe, importing more tobacco from America than even London. Linen industry also benefited from the wider market. The economic prosperity created a cultural revival. A number of societies were organized to propagate literature and the art of speaking. Noble families hired tutors to give lectures at their homes. It is to this Scotland that Adam Smith returned after his six years at Oxford University.
1

In the common preface to Cambridge Economic Handbook, J.M.Keynes expresses that economics is not like physical sciences. See preface in Robertson (1923). 2 Even novels and poems referred to them. Realizing the value of convincing a wider audience the validity of various theories, the protagonists solicited public support for them as Voltaire did for Newtonian physics. 3 Lynn (2006), pp.56-57. 4 Gregory and Miller (1998), pp.20-21.

He was in need of financial support and his well-connected friends arranged for him to give a series of lectures on "rhetoric and belle lettres." He brought a new approach to the subjects, leading the students to develop a style that was expressive but at the same time concise and precise. "Undoubtedly, Smith's lectures on rhetoric and belle lettres delivered in Edinburg marked a clear transition from the earlier well-established academic tradition of formal rhetoric. They were the first of the kind not only at the Edinburg University but also in Great Briton giving to a more practical and creative attitude towards rhetoric." 1 It is not surprising that he carried this style into his magnum opus, the Wealth of Nations. Joseph Schumpeter comments on Adam Smith style: 2 "He never moved above the heads of even the dullest readers. He led them gently, encouraging then with trivialities and homely observations, making them feel comfortable all along. While the professional of his time found enough to command his intellectual respect, the `educated reader' was able to assure himself that, yes, this was so, he too always thought so; while Smith taxed the reader's patience with his masses of historical and statistical material, he did not tax his reasoning power." Many economists consider Schumpeter was condescending in his comments on Smith's contributions. It may be true that individual building blocks of his system were developed earlier by others but he weaved them together into a comprehensive thesis on economics. He never hesitated in expressing his opposition to any institution or regulation that limited competition with and across nations. But Schumpeter was correct is his ability to do all this without talking down to the readers. Even today Smith's homely observations are quoted as of no other economist. Alfred Marshall took a different route. When he began study of economics in 1867, David Ricardo and James Stewart Mill reigned supreme. Writing about the development of his thoughts for a German publication, he said that he began by translating Ricardo's reasoning into mathematics. 3 His first published work, Economics of Industry written with his wife, was meant for the education of the working class. Later he began work on diagrammatic illustrations. His goal was to focus on tools that have universal applicability. "Marshall's mathematic and diagrammatic exercises in Economic Theory were of such character in their grasp, comprehensiveness and scientific accuracy and went so far beyond the "bright ideas" of their predecessors that we may justly claim him as the founder of modern diagrammatic economics." 4 Still he relegated diagrammatic analysis to footnotes, fearing businessmen who read his Principles of Economics will be turned away by it. Even though his literary style had none of the elegance of Smith's rhetoric, the book was received with wide acclaim. The mathematization of economics enabled it to broaden its scope. It can now analyze simultaneous equilibrium of many markets, choice of a diversified portfolio that balances risk and return, strategic interaction among a few competitors and dynamic behavior over time. The cost is that the profession is less committed to the Smith-Marshall tradition of making economic
1 2

Jermolowics (2004), p.204 Schumpeter (1954), p.185. 3 Keynes (1924), pp.328-329. 4 Keynes (1924), p.322.

analysis accessible to general readers. The one concession to non-mathematical readers is the use of graphs but they tend to grow in complexity with the theories they depict and it requires skill to decipher them. Economics is not the only science that strived for mathematical rigor in the twentieth century. Mathematics itself strengthened its foundations with set theory, analysis and topology. There is a steep gradient in the mathematical structure of physical theories from Michael Faraday to James Maxwell to Albert Einstein. Even so, there is a thriving market for popular science books that explain these theories to readers with differing skills and perseverance. In the seventy years since the publication of Lancelot Hogben's Mathematics for the Million and Richard Courant and Herbert Robbin's What is Mathematics, dozens of books for non-mathematicians were published. Some like Rueben Hersh's What is Mathematics Really and Simon Singh's Fermat's Enigma have no or very few equations. Others, including John Derbyshire's Prime Obsession and Mario Livio's The Equation that Couldn't Be Solved, have many. Popular science books in physics show even greater diversity. George Gamov, a nuclear physicist, published sixteen popular science books between 1940 and 1970, including five in the Mr. Tomkin series. Ian Stewart's What Shape is a Snowflake and Stephen Hawking's The Universe in a Nutshell are profusely illustrated. Kip AS. Throne's Black Holes and Time Wraps and Tony Hey and Patrick Walters's The New Quantum Universe require sustained attention from the readers. Economic analysis, like all other disciplines, have many branches, some more mathematical than others. However, there is no ground to believe that anyone of them is more abstract and difficult to comprehend than cosmology, quantum physics or relativity. Consider all the books on economic analysis for the general reader (excluding both textbooks and those that do not explain concepts) and arrange them in the ascending order of effort expected from the reader. How large is the pile? Partha Dasgupta's Economics: A Very Short Introduction, Avinash Dixit and Barry Nalebuff's Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life and John Kay's Why Firms Succeed will be in most lists. If the upper end is stretched, Paul Milgrom and John Robert's Economics, Organization and Management can be added to the pile. As with sciences, the inclusion criteria are fuzzy and, depending on how they are interpreted, different list can be complied. Still it fair to say that, compared to the menu of popular science books, the choice of books on economic analysis for the general reader is sparse. In contrast, there are hundreds of books on economic policies, some proposing the very policies others oppose. If principles of economic analysis have universal applicability, differences in conclusions must be attributed to disagreement on objectives of the policies and assumed differences in the responses of individuals. This is all the more the reason for those who are affected by recommendations to have an understanding of tools used in forming them. It is unfortunate that as choices open to individuals expanded in the second half of the twentieth century, the general public have to, borrowing an analogy from Dennis Robertson, stand outside and bow towards the temple of economic analysis. 1 The plan of this book.
1

Robertson (1958), p.42.

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At the core of economic analysis is the study of markets. While there are a variety of markets, it makes sense, as is usually done, to start with the market where we buy goods for daily use. We have our budgets and, among what we can afford to buy, we select baskets of goods and services based on our preferences. The goods are supplied to the market by the producers who, based on their costs and technology, choose outputs that maximize their profits. Why should the quantities they supply and what we want to buy be the same? If they are not, either there is a shortage that prevents us from buying what we seek or a surplus that cuts into the profits of the firm. For any economy to function without such perturbances, a mechanism to coordinate the decisions of consumers and producers and to nudge the quantities demanded and supplied toward equality, is needed. The thrust of modern economics is that price acting as a signal to consumers and producers is, with caveats discussed in later chapters, the most efficient way to achieve coordination. The coordination problem does not exist or minimal in primitive economies where one or two individuals live in isolation. Their efforts to make the best of their strained circumstances bring out in a very intuitive way the conditions that must be satisfied to achieve efficient use of resources in contemporary market economies. The next three chapters focus on study of isolated societies but there are frequent digressions to consider the light they throw on the working of modern economies. Ability to substitute is what allowed mankind to prosper under varied natural conditions. In modern economies substitution is what empowers consumers as they cut back or reject products that have become expensive or of low quality. Chapter 2 discusses how willingness to substitute is determined by the preferences of the consumers. Chapter 3 starts with the discussion of a sailor stranded in a lush island. He has to direct his efforts to gather food for dinner and he has to consume what he collected. He has to match his ability to produce with his preferences for the consumption basket. His choices reveal how he can achieve an efficient use of his time and resources. Next exchange is introduced by considering two individuals living by themselves. Each of them have in possession one food product - fish with the fisherman and vegetables with the farmer - but they prefer to have both for dinner. They will agree to an exchange only if it benefits both but the distribution of benefit will vary with the rate at which they exchange. This is true for market economies too. Today we purchase many goods at fixed prices. Less frequently when we buy a house or when we negotiate the terms of employment, we bargain the terms. The theory of bargaining based on cooperative game theory is explained and its analysis is applied to negotiations within affluent and subsistence level households. The chapter ends with an examination of the transition from medieval economy with rural self-reliance to urban market economies with retailing at fixed prices. Chapter 4 braces both primitive and market economies. The first part discusses decisions whose costs and benefits are spread over time. We decide on our education when young and, while career changes are possible in the United States, it sets the direction for our professional life. We save during working years as a buffer for unexpected expenses and for a comfortable life after retirement. Future is uncertain and the second part discusses the concept of uncertainty and how two farmers living on opposite sides of a mountain and facing different weather patterns, can sign contracts (similar to derivative contracts in a modern economy) to limit the fluctuations in their consumption.

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The discussion of market economy begins with Chapter 5. Individuals with fixed budgets go to shop in markets where prices are fixed. Among the baskets he can afford, an individual chooses one that maximizes his utility. How a change in the price of one product or the income of the consumer affects the chosen basket is examined. Given the income of consumers and prices of other goods, there is only one price at which the quantities demanded equal that supplied. The internal organization of a firm is the topic of the next chapter. The relation between inputs and outputs is considered. It leads to a discussion of how to account the cost and revenues of the firm and how to measure profitability. In modern economies, it is reasonable to assume that there are a large number of consumers in any market. However, the number of firm producing a product differs from market to market. Next five chapters discuss markets with one to many firms. The numbers affect the output and pricing decisions made by each of the firms. In some markets, a product is sold to all customers at one price while in others different groups of customers pay different prices. Branding of products allows producers to differentiate their products from that of others and charge different prices. Finally, the market where there are many producers and consumers with none having any influence on the market price is discussed; it has a special place in economic theory as it can be shown to achieve efficiency defined in a specific sense. The next chapter develops on the discussion of time and uncertainty in Chapter 4 and introduces financial economics. The final chapter takes a look how the understanding of the functioning of the market provides additional insights into decision making within a firm. Summing up. At least from the time of the Enlightenment movement in eighteenth century Europe, the public has shown an interest in having the contributions of scientific disciplines explained in non-technical language. Experimental sciences enthralled the public by holding demonstrations in various institutions devoted to propagation of science but it was popular science books with colorful graphics that reached a wider audience. To explain economic principles in a nontechnical language with help of computer graphics is the modest goal of this book. 1 Bibliographic Note: Debreu (1991); Devine, Lee and Peden (2005); Gregory and Miller (1998); Jermolowics (2004); Keynes (1924); Lamm (1989);Lothian (1963); Lynn (2006); Magnusson (1992); Robertson (1923); Roberstson (1958); Schumpeter (1954); Stigler (1949); Stigler (1990); Viner (1991).

This effort is not exempt from the mathematical proposition that one point cannot fill in a gap.

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Chapter 2. Consumer preferences and choices.

"We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness--- That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed,..." In declaring that there is no hierarchy among its citizens, that they have natural rights no government can restrict, that they can pursue their worldly welfare and that it is the citizens that empowered the government, The United States Declaration of Independence passed on July 4, 1776 set forth not only the aspirations of a nation about to be born but of all liberal democracies around the globe. At the time of the Declaration, most societies were hierarchical with the king at the top and the serfs at the bottom. An individual's position in this hierarchy was determined at birth and the right to choose one's lifestyle - where to live, what to wear, what to eat and the vocation to follow - that we take for granted did not exist for him or her. The conviction in the Medieval Age was that human beings, though endowed with rationality, were born with weakened will and inclined to sinning. To prevent them from destabilizing the society, they have to be led by divinely ordained rulers. According to an extreme formulation of this view, the theocratic theory, rulers had absolute authority in temporal matters. He had a moral responsibility to care for their subjects, but it was a one-sided obligation that did not allow subjects to judge or bring an action against the ruler. In reality, the feudal system involved some devolution of power and the king's power outside his own estate depended on his ability to form strategic alliances with barons, the territorial magnates. In Europe this relationship began to change by sixteenth century as the rulers expanded their jurisdiction at the expense of the barons and established modern states with centralized administration. Individual rights under the feudalism and absolute monarchy, so far as they existed, did so by the grace of the rulers and were subject to their whims. The Declaration of Independence, in reversing this relation between the ruler and the ruled and by conferring unalienable rights on the citizens and requiring the government to seek the consent of the ruled, proposed a revolutionary agenda that was controversial then and continues to be debated even now. The English philosopher Thomas Hobbes (1588-1679) argued that political power comes from the consent of the governed. The state of nature (society before the establishment of a political authority) was poor, nasty and brutish and the struggle for survival led to violence. To escape from the threat of constant turmoil, a civil society was formed by its members surrendering their rights to a sovereign. The sovereign was vested with power not by divine ordination but by a social contract made by the citizens. John Locke (1632 - 1704) introduced an economic component into the political process when he made hunger the main threat to survival in a state of nature. To alleviate their hunger, individuals gathered food and even cultivated land. For making nature more abundant by his labor, a person earned the right to the land he tills and the harvest he reaps. When individuals came together and began to exchange what their produce using money as a measure of value, two important changes occurred. First a society was created and second the right to property was separated from labor that was embodied in it. Collective life was built on property and as political authority was created by social contract, the authority cannot abridge the individual right to property that pre-existed its formation. The role of justice was to guarantee property. The

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need was to empower the political authority to enforce social contract without giving it too much of power over individuals can be achieved only by creating a representative legislature. By the end of the seventeenth century, the works of Hobbes and Locke brought an awareness of the rights of individuals and the benefits of a democratic form of government. Locke's claim that individuals were vested with natural rights was criticized by Jeremy Bentham (1748-1832). Natural rights, he argued, were based on fictitious image of a primitive society and a hypothetical social contract. It was political institutions that conferred rights on individuals and the rights were justified only if they lead to "the greatest happiness" of the citizens. Today the debate is whether public policies to promote "social justice" infringe on individual rights. Modern welfare theory based on refinement of Bentham's utilitarian philosophy supports redistribution if it raises social welfare, appropriately defined in terms of the utilities of individuals. 1 According to entitlement theory, each household has the right to consume what it produces and any redistribution is unjust. 2 Immanuel Kant (1724-1804) argued that state cannot impose any particular conception of happiness on individuals. Society must treat humanity in each person as an end in itself and freedom, defined as independence from being constrained by another's choice, was an absolute right. Property right was essential for implementation of innate right to one's freedom. His strict definition of property rights denied legitimacy to taxing one person to support another. This, however, did not preclude him from arguing that the state should support the poor; since the state had to raise resources to fund its effort, there is an ongoing debate, whether Kant's positions on absolute property rights and the support of the poor are consistent or not. Scientific breakthroughs culminating in the work of Newton led many intellectuals in the eighteenth century Europe to believe that, through reasoning, the public can be made to reject the superstitions of the medieval age and accept a social order based on reason. Beyond a belief in rational order, there were ideological differences among protagonists; luminaries of Scottish Enlightenment stressed more than their continental counterparts the economic, political and religious freedoms of individuals. 3 Adam Smith was a prominent member of the Scottish circle.

The distinction between the two views of justice can be fudged by adding to rights over and beyond life and liberty to the list that needs to be guaranteed. Critics argue that such addition makes the arguments for rights trivial as anything can be defended. The debate continues. 2 The distinction between the two views of justice can be fudged by adding to rights over and beyond life and liberty to the list that needs to be guaranteed. Critics argue that such addition makes the arguments for rights trivial as anything can be defended. The debate continues. Scottish Enlightenment influenced The Declaration of Independence. Among those associated with Enlightenment, Francis Hutcheson, David Hume, Sir James Steuart and Adam Smith contributed to economic analysis and policy. A comparison of their views brings out the diversity of opinion even within this group. Hutcheson, the teacher of Adam Smith, was a critic of Hobbes views on morality. Hume discussed money, the rate of interest, balance of trade, public finance and population but lacked a unified vision of the economic process. Steuart had a comprehensive theory but it was one based on the earlier Mercantilist views that favored state intervention to support industry. He is said to have influenced Alexander Hamilton in developing the infant-industry argument to justify trade restrictions in newly independent United States. Adam Smith who began his career as a lecturer in moral philosophy disagreed with his teacher Hutchinson. Later he wrote The Wealth of Nations, a systematic exposition of free market economy. In the book, he never mentioned Steuart but opposition to his views are evident in Smith's criticism of Mercantilist doctrines.
3

15

His early works were on rhetoric and moral philosophy but, after a trip to Europe during which he had discussions with French economists, he turned his attention to economics. The Wealth of Nations was the first comprehensive treatise on the economics. Smith collected and analyzed information about agriculture, manufacturing, internal and international trade, taxation and government regulations of commercial activities in British Isles and Europe. He identified many regulations that were hindering the activities of individuals in these sectors and argued for their elimination. Adam Smith went beyond recognizing the rights of individuals and claimed that all activities in an economy must be directed to increase individual welfare. "Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer." 1 Relating the value of a product to its ability to meet the wants of consumers has a long history. The Greek philosopher, Aristotle, wrote of the distinction between value-in-use and value-in-exchange and Scholastic Philosophers of the sixteenth century had a theory of utility. 2 Individuals derived "utility" from the satisfaction of wants but relating utility to demand and relative prices of products required refinements in utility analysis that was developed only in the nineteenth century. Smith related price (at least in the long run) to the cost of production and specifically to one component of it, the labor cost. While he was criticized for his focus on labor cost, he did show awareness that consumers' willingness to substitute one product for another set bounds for their relative prices. The price of wood, he noted, was capped by the possibility of substituting cheaper coal, even though coal was judged inferior to wood by its users. This chapter elaborates the concept of substitution in consumption and explains how it can be quantified. Computer graphics, helpful to represent the substitution by consumers and producers, is developed in next section. Diagrammatic representation of consumer's choice as selection of a basket of goods. A consumer, Emma, has received her weekly paycheck. Part of it she saves and the balance spends on groceries, clothes, toiletries and gas. Her shopping takes her to different stores even though the trend is for each store to broaden the selection of goods. Most of the purchases are made in the weekend, but she does shop on weekdays. While she spreads her purchases over the week, they are part of Emma's budgetary plan for the week. At the store, she places whatever she selects in a basket as is usually done in grocery stores and warehouse clubs (like Costco or Sam's Club). As part of her deliberation on what to purchase, she takes out some items that she placed in the basket and adds others. 3 Each addition or substitution creates a new basket. The choice she has to make in spending her budget wisely is to choose from the many baskets she can afford, the one she prefers to all others.

1
2

Adam Smith (1937), p.62

Schumpeter (1954), pp.1053-1066. The adding and subtracting can be a virtual substitution as she mentally plans her purchases, or she may physically remove and add products to her basket at the store.

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Figure 1. Constructing baskets by substitution of products. Emma buys many goods but to facilitate a pictorial representation, the choice is restricted to two goods. This outwardly absurd simplification does not affect the qualitative nature of the conclusions discussed in this chapter. Using mathematics, the analysis can be extended to purchase of any number of goods. In Figure 1, quantities of the one product, a soft drink, is measured along the bottom or horizontal line and quantities of the second product, milk, is measured along the vertical line. The First Basket has two bottles of soft drink and four cartons of milk and the dot near the left bottom corner of the basket represents the position of the basket. The quantities in the basket are measured by distances of the dot from the vertical line and the horizontal one. By adding four bottles of the soft drink and taking out two cartons of milk, a new basket with six bottles of soft drink and two cartons of milk is created. The Second Basket is further away from the vertical line but at a lower height than the First Basket. Emma can purchase these baskets only if they are within her budget. If her budget for drinks is $15 and if the prices of soft drink and milk are $1.50 and $3 respectively, then both baskets cost $15 and are just affordable. So is the Third, Fourth and Fifth Baskets shown in Figure 2. The points representing the baskets that cost as much as the budget lies along a straight line appropriately known as the budget line. How many such points are there? Products are sold in containers or packages of different sizes; milk can be had in a quart or half quart cartons and gallon jugs; soft drinks are sold in big bottles and small cans. For analytical simplicity, diagrams are drawn under the assumptions that products are divisible into such small quantities that they can be viewed as varying continuously. Then every point on the budget line represents a basket of milk and soft drink that costs $15.

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Figure 2. Budget line. Emma moves up the budget line as she buys more milk and less soft drink. The slope of a curve is, in common usage and mathematics, the ratio of the increase in height to a forward movement horizontally. 1 The economic significance of the slope of the budget line is that it indicates how much more of one product can be purchased with the cost savings from reducing one unit of the other product. Since the budget line is a straight line, its slope can be determined by taking ratio of quantities in the end baskets. These are baskets Emma can purchase by spending the entire budget on one of the products: Third Basket containing five cartons of milk and Fifth Basket containing ten bottles of the soft drink. The ratio of quantities in the two baskets is five-to-ten. Since the quantity of one product increases as the other decreases, the mathematical convention is to making the slope of the line a negative number: (-5)/10 = -0.5. Can Emma buy any basket that is not on the budget line? Sixth Basket with two bottles of soft drink and two cartons of milk costs only $9 and is well within her budget. Any other basket that lies below the budget line costs less than the budget, and Emma can afford baskets on or below her budget line. Which one would she prefer?

Think of bicycling along a road. Slope for the road is how much you climb as you cycle a short distance. In geometry, the slope of a curve at a point is the ratio of the vertical movement to the horizontal one as one traverses along a curve. In general the slope varies along the curve and slope is calculated based on movement between two close points. For a straight line, the slope is the same at all points, and it can be calculated by the ratio of the increase in height to the horizontal distance travelled between its end points.

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Figure 3.Choice reveals unobservable preferences of consumer. Individual preferences expressed by choice Emma living in the United States does not have to fight for survival like those living in primitive societies envisaged by Hobbes and Locke, but she gets hungry and thirsty periodically and needs clothes to wear. In her purchases, she can choose from food products and apparels available in the market. Her selection affects not only her but also the producers of goods and an understanding of her decisions is a prerequisite for an analysis of the market mechanism. Nineteenth century economists, building on the utilitarian philosophy, assumed that any basket of goods provides the consumer, depending on her preferences and the composition of the basket, a level of utility. In addition, they the level was measurable and its changes with quantities of commodities indicated how her preferred basket changed with income and prices. Their analysis was criticized in the beginning of twentieth century for assumptions about an individual's preferences that cannot be verified by observation (Figure 3). A new approach to consumer behavior, instead of claiming to explain choice in terms of utility, made utility a numerical index that reflects the choice. Economic analysis recognizes the diversity of preference among individuals. Two individuals with the same income and paying same prices (in short, having the same budget line) might choose different baskets and their choices demonstrate how their preferences differ. However, consumers in different economies and at different times are observed reducing consumption of products whose prices increased. Income increases lead to choices of bigger baskets with larger quantities of almost all products. Economic analysis has to explain both the diversity in choice among consumers and similarity in their responses to changes in affordability. This is achieved by imposing minimal restrictions on the preferences of all consumers. These restrictions are embodied in the axioms of preference. 1 An axiom is defined in Oxford English Dictionary as "a self-evident proposition, requiring no formal demonstration to prove its truth, but received and assented to as soon as mentioned."

The discussion in the text is based on revealed preference approach of Paul Samuelson and Hendriks Houthakker.

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Figure 4. Two axioms of preference.

The first axiom is that a consumer can express her preference; given any two baskets, she ranks one basket as preferred to the other or ranks them equally (she is indifferent). If this is not true, there is no rational choice. The second axiom is that consumers, at least in the neighborhood of what they have, prefer larger quantities to less of each of the goods. 1 The Basket One in Figure 4 (reproduced from Figure 2), costs less than Emma's budget. If she adds two more bottles of the soft drink to the basket, the cost increases from $9 to $12 and its cost is within her budget of $15. By this axiom of non-satiation, she prefers Basket Two to Basket One. Her budget allows her to keep adding two more bottles of the soft drink to the basket and she will prefer Basket Three (same as Fourth

The purchases are for a period, the week in the example of Emma. She may not want more milk in her cereal as she sits for breakfast one morning, but she will be willing increase her consumption of milk over the week, if changes in income and prices make it possible to consider such an increase. Consumption, in discussion of budget allocation, should not be viewed as an act at one time but as what she would do over the period of allocation. It is in this sense that consumers are assumed to have non-satiation. Though it is easier to visualize local non-satiation, in the theory of consumer choice, it is common to assume non-satiation over the whole consumption set.

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Basket in Figure 2) to Baskets one and two. By extension of this argument, there is a basket of the budget line that is preferred to any basket below it. Baskets on the budget line in Figure 2 differ in having more of one product and less of the other. The third axiom imposes some order in the ranking of such baskets (Panel B of Figure 4). She has to choose from three baskets, and she first considers a choice between Basket 2 to Basket 3 and decides that she prefers Basket 2. Then she compares Basket 2 and Basket 1 and chooses Basket 1. If she is to compare the third possible pair among the baskets, Basket 1 and Basket 3, which one will she prefer? The third axiom states that she must prefer the Basket 1 to the Basket 3. Notice that ordinary numbers satisfy transitivity; 5 is greater than 3, 10 is greater than 5 and 10 is greater than 3. The axioms of preference make utilities reflecting the ranking of baskets to have some of the properties of numbers but not all of them. A person chooses one basket to another. Utility being only an index indicating choice, the preference for a basket over another can be represented by assigning utilities 10 to the first basket and 2 to the second or 35 to the first and 19 to the second. From choice of the baskets alone, it is impossible to decide which of the utility assignments is valid. Much of the controversy in the beginning of twentieth century economics was on this question but there is no need to get into this historic debate. The fourth axiom can be interpreted as excluding what is known as "lexicographic preferences." In a dictionary world are arranged by the first letter, and those words are then ordered by the second letter and so on. "Azure" comes ahead of "baby" even though its second and third letters "z and u" come much behind "a and b" in the ordering of alphabets. The axiom requires that consumers should not rank baskets by the quantity of one product irrespective of the quantities of other products. If enough of the second product is offered, he or she must be willing to accept a reduction of the first. This axiom assures that preference for basket changes continuously with quantities of the product and consumers are willing to substitute one product for another. The abstract formulation of preferences is necessitated by the recognition that only the individual is privy to his or her preferences. Using the four axioms, a measure of the willingness of an individual consumer to substitute is developed in the next section. Consumers' preferences and willingness to substitute one product for another. Innovation and substitution are two strategies vital to the survival of mankind through the millenniums. Human intelligence enabled development of newer technologies to tame the vagaries of nature and improve standard of living. However, shortages arise even today as crops fail or industrial production is disrupted. When it happens, consumers have to adjust their consumption and do it in a way that individual choices add up to the reduction in the availability of the product. One solution is for a central authority to acquire command over the output and apportion it among the consumers. Under rationing of "scare" goods as implemented in many countries, the total output is divided equally among the consumers. 1 Allocation of predetermined
1

In times of food shortage, the state tries to avoid famines by rationing food. Less frequently, other items are also rationed.

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quantities results in consumers having to buy baskets that differ from the one they prefer. Some

Figure 5. Marginal rate of substitution.

are willing to exchange rationed goods for other products while other consumers prefer more of the rationed goods. They circumvent the centralized allocation system by buying and selling in the "black market." 1 The market economy relies on individual's willingness to substitute to achieve a reduction in quantity demanded of the scarce product, and it leads to a better social outcome (in a sense to be discussed in next chapter). Given a basket, the maximum amount of one product the consumer willing to give up for one unit of another is a measure of his willingness to substitute. A consumer, Allen, has to choose one of two baskets offered to him (Figure 5). Basket A has six bottles of soft drink and two cartons of milk while Basket B has two bottles of soft drink and four cartons of milk. If Allen chooses Basket B, he is revealing that having two additional cartons of milk more than compensated him for the loss of four bottles of the soft drink. How much extra milk will just compensate him for the loss soft drink? To determine that amount, gradually reduce the quantity of milk in Basket B (here is where the assumption that quantity changes continuously is needed). Allen will rank the new baskets lower than Basket B but, at least for small reductions, he will continue to prefer them to Basket A. Further reduction in quantities of milk will result in Basket D. It has less of both products than Basket A and must, by axiom of non-satiation, be ranked in his preferences below Basket A.

Feasibility of such exchanges is explained in Chapter 3. Why could not the administrators adjust the baskets even partially to make them closer to individual choices? Bureaucrats managing the rationing system will never be able to obtain enough information about individual preferences to make such adjustments feasible.

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In between Basket B and Basket D, there is a basket that Allen ranks equally as Basket A (he is indifferent between the two). In Figure 5, it is Basket C. Allen's preferences are such that, given Basket A, he is willing to accept one additional carton of milk for four bottles of the soft drink. This rate of exchange is his marginal rate of substitution. Graphically, it is measured by the ratio of the height CD to length of base AD of the triangle ACD. 1 An individual's marginal rate of substitution varies with the baskets. An additional axiom of preference, explained in detail in next chapter, indicates the way the rate changes. Given identical baskets, the marginal rates of substitution will also differ among individuals. If Emma had Basket A, her marginal rate of substitution will be different from that of Allen. Willingness to substitute is important aspect of human behavior and plays a crucial role in the functioning of the economy. Relating preferences to product characteristics. In the last section, consumer's preferences were defined by ranking of baskets of goods. The role of products in the baskets in influencing the consumer was not made explicit. Consumers purchase goods to satisfy wants: they rent or own housing for shelter, purchase food to satisfy hunger and get drinks to quench their thirst. Different goods, in spite of their differences satisfy each of these wants - an individual can alleviate his hunger with vegetables, fish or meat. He can drink water, soft drinks or fruit juice when thirsty. Which one he will choose depends on his preferences for the characteristics of these foods: their tastes and nutritional values, for example. Can the preferences for goods be decomposed into preferences for its characteristics? Product changes in automobile industry provide an example. Shortly after Henry Ford introduced mass production of T Model cars, customization based on a bare chassis began. Many of the independent producers began putting a wooden frame with the interior extended to an almost vertical back. The "station wagons" were used as taxis to transport passengers and their luggage from railway stations to their destination. The idea of a minivan, positioned between the station wagon and light truck, was first put forward at Ford but was shelved due to concern of finance and sales departments that it will cannibalize sales of other models without increasing the total. Around this time, many Ford executives including Lee Iacocca left Ford and joined Chrysler. 1

Reflecting the increase in one product as the other is decreasing, the ratio is negative. The marginal rate of substitution is defined as the negative of a negative number, making the ratio a positive number. In the text, for visual clarity, the marginal rate of substitution is expressed as the ratio of two discrete quantities while mathematically it should be the ratio of two very small changes. If the two baskets, D and E, were brought closer to each other, then the sides of the triangle will get smaller and a smaller and ultimately become infinitesimal quantities. Another approach is to draw a curve through the points representing all baskets that the consumer ranks equally with Basket D (called indifference curve in next chapter) and define the marginal rate of substitution as the slope of the curve at Basket A.

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Chrysler in the early eighties had only one distinctive product, the K-car, and it was marketed in various versions. The Ford expatriates started pushing the idea of a minivan with front-wheel drive. When introduced in 1983 (as 1984 model), the characteristics that made it so popular to families and small businessmen were excellent visibility, seat height and pass through capability from front seats to rear, height low enough to allow parking in home garages, easy entry through sliding door on passenger side and capability to carry loads too wide for a station wagon. In the 1990s and early 2000s, the Sport Utility Vehicles (SUV), descendent of rough terrain vehicles, became popular even among the urban population. With the increase in price of gasoline and the recession of 2008-2009, these vehicles with low mileage became unpopular and hybrid-vehicles that have both internal combustion engine and electric motors entered the market. Consumers purchase products that are cost effective in providing the best combination of characteristics to meet their wants. Preference for characteristics explains why product differentiation - making products of the same class that differ slightly from each other - exists. It provides insights into why new products succeed or fail. As long as products differ only in a few characteristics, it is feasible to decompose the preference for the product into preference for the characteristics. When they differ in many characteristics, the decomposition becomes too complex to be instructive. Changing consumption: what drives it? Consumers add new products to their baskets and stop consuming that they used to. Some of the changes are driven by availability; many customers dropped land phones when cell phones became widely available and their reliability increased. However, all changes are not driven by product innovations or even availability. What we are fed as a child is not what we want to eat as grownups. Even during our adult life we make changes in our lifestyle. The shifts in the consumption ripple through the economy and affect the fortunes of firms. The firms want to understand and anticipate the shifts in demand for their products and to influence the direction of the shift through advertisements and endorsement of actors and athletes. At the societal level, policy makers and social scientists want to examine the impact of such changes on social wellbeing. What generates these changes? Is it information about a product that is new to the consumer that made her change or did her friends and peers have an influence beyond providing information to you? You have walked past a Vietnamese restaurant many times but never gone in and are not sure whether the food meets your established preferences for spicy, sour and sweet dishes. Your colleagues at your new job go to the restaurant for lunch regularly and not wanting to be left out of lunch outings, you agree to go with them. After eating a few times, you develop a liking for Vietnamese food and started eating there on your own. Is your new found love of Vietnamese cuisine the result of information that the cuisine meets your existing preferences for spicy food or did you change your preferences under peer pressure?

Yates (1996), p.5.

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Economics, in the liberal tradition, assume that preferences are specific to individual and others can judge it only through observation of her choices (Figure 3). This limits the ability to judge the sources of change in the observed selection. Firms spend heavily to influence consumers to prefer their product to those of their competitor even as its competitors are doing the same. How productive are these efforts? In United States billions of dollars are spent in advertising. If advertising is providing information to consumers, then the expenditure not only serves the interest of the producer but benefits the consumers also. If advertising works by modifying the preferences of consumers, then it is possible that consumers are influenced to make purchases over and beyond what is socially desirable. Economist Phillip Nelson, in a number of research papers, argues that treating advertisement as providing information not only by their contents but also through their frequency and media choice, leads to conclusions that are consistent with data. 1 Those who focus on the psychological effects of advertising argue that, even if a mental frame to rank preferences exists and satisfies all the axioms stated earlier, it can still be influenced by persuasion by others. There are so many brands that are close to each other in functionality - more than twenty models of midsize sedans available before 2008-2009 downsizing by automobile firms - that no amount of information in itself will convince a customer to prefer one brand to another. Persuasion to change wants, belief and actions dominate social life as individuals seek comfort in being accepted by peer groups. While expressing preferences in terms of characteristics and considering the effect of social factors in the choice are helpful in understanding specific aspects of consumer behavior, rational choice as developed in the neoclassical tradition in economics with fixed preferences is insightful and has generated many verifiable results. It will be the main focus of coming chapters. Summing up. The individual has wants that need to be satisfied and, given the opportunity, will choose the combination of goods among those affordable that he prefers most. The liberal tradition holds that individuals have the right to property and liberty, and he should be able to make the choice that maximizes his welfare without imposition from outside. Any analytical framework to examine consumer choice must accept that individual preferences are not directly observable, that they vary from a person to another and yet individual response to price increases or income changes show a common trend. These requirements have led to an abstract formulation in which those aspects of preferences shared by all individuals are defined by the axioms of preference. One common characteristic of individual preferences is the willingness to substitute. A measure of this flexibility is the marginal rate of substitution, an increase of one product that just compensates for a small decline in the other. The marginal rate of substitution differs from individual to individual and, for each individual, it differs with the composition of the basket he has. Substitution at the margin plays an important role in the functioning of an economy.
1

The arguments for information approach are summarized in Chapter 13.

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Marginal rate of substitution, a measure of flexibility in consumer's preferences is a core concept in the economic analysis. Taking a closer look at the role of products in fulfilling wants, preferences for goods can be deduced from preferences for its characteristics, particularly when products differ in a few characteristics. It is useful in examining how consumers respond to new goods. When consumers change their choices even when prices and incomes have not changed, is it due to new information that made them prefer a different product or is it a change in preferences? Economists argue that advertisement convinces consumers by providing information while others attribute it to the power of persuasion. The next chapter considers how trade, instead of being exploitation of one by the other as was widely feared through the ages, can benefit both parties. Bibliographic note. Bagwell (2007); Coleman (996); Finer (1997); Fleishchaker (2004); Manet (1994); Miller and Dagger (2003); O'Shaughnessy & O'Shaughnessy (2004); Schumpeter (1954); Stigler (1987);Waldon (1995); Wenar (2007); and Yates (1996).

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Chapter 3. From self-reliance to exchange.

In subsistence economies in which families live mostly on food produced on their farms, the coordination between production and consumption decisions poses less of a challenge than in modern economies. An individual surviving alone in wilderness and producing what he consumes faces no coordination problem at all but, to make the best of his lonely life, he needs to align his preferences for consumption to his capabilities for production. He loves to eat vegetables but is much better at hunting and fishing than in farming, and he has to decide how much meat or fish he is willing to give up for additional vegetables. He maximizes his utility when he produces the basket of meat and vegetables that he prefers to all others he can produce and the choice identifies a relation between his capabilities and preferences. A market economy must match the preferences of its many consumers and the capabilities of its producers if it is to make best use of its resources and the condition necessary for efficiency of a market economy is a direct generalization of the one for a single person economy. The irony is that our understanding of a market economy is facilitated by first considering an economy where there is none. The saga of a stranded sailor. The story of Alexander Selkirk's survival for four and a half years in a deserted island off Chile was recorded by the captain of the ship that rescued him. Selkirk in interviews he gave back at home in England embellished it and Daniel Defoe did even more so in his novel Robinson Crusoe based on Selkirk. After getting into trouble, Selkirk ran away from his home at the age of 19 and took to the sea. In eight years, he will become the sailing master of a galley, and a year later joined a privateer expedition to the Pacific Ocean. During the first decade of eighteenth century, Austria, England and Netherlands were at war with France and Spain. War was a good excuse for English buccaneers to raid, with the approval of British authorities, Spanish galleons as they were transporting South American gold to Spain. The 1703 expedition to the Pacific was put together by William Dampier, who had a checkered career first as a buccaneer in South America and then as a captain of a Royal Navy ship exploring Australia. Two ships set sail; Selkirk was on a ship commanded by Charles Pickering but the captain died during the expedition and was replaced by Thomas Stradling. In January 1704, the ships rounded Cape Horn at the southern tip of South America and entered the Pacific Ocean. After many chases and battles the ship finally anchored in the only safe haven for British buccaneers in that area, a deserted but hospitable island about 400 miles west of Chile then known as Isla Ms a Tierra. 1

In 1966 Isla Ms a Tierra was renamed Isla Robinson Crusoe.

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Figure 1. Changing production by shifting labor input.

Selkirk felt that the ship needed repairs before continuing the journey but the incompetent Stradling disagreed. In a fit of temper, Selkirk asked to be set ashore with his baggage. He assumed that others will join him in the protest as Stradling did not have good relation with his crew. To his surprise, the ship sailed without him.1 He lived in the island from October 1704 to February 1709. Fortunately, the Island had a flock of goats left over by Spanish settlers who were there for a short time and turnip and green vegetables planted by pirates during their visits to the Island. The biggest problem was isolation, and he diverted himself by reading the Bible and studying the navigation books that were among his processions. He talked aloud to keep his faculty of speech, but even so, it was hard to understand him when he returned to Scotland. Choices for survival. Being alone in the island, Selkirk had to feed himself. Those who saw him at the time of rescue have commented on his ability to chase and catch goats bare-footed. He also set traps for lobsters. Tulip and green vegetables in the plains and fruit from the trees in the mountainous regions of the Island were there to be harvested. Even though he was lucky to be stranded in a

Souhami, ibid, pp.56-85; Severin, ibid, pp.35-42. The ship sank shortly after leaving the Island.

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Figure 2. Selkirk's preference for baskets he can produce. lush island, like all those living in primitive societies, survival was his first concern, and he spent most of his time foraging for food and then cooking a balanced meal of meat and vegetables. 1 The choice before him, as shown in Figure 1 was to divide his time between gathering vegetables and catching goats. The less time he spent gathering vegetables, more time was there for catching goats and the dinner consisted of more meat and less greens. Ratio of the reduction in vegetables he gathered in order to have another pound of meat was his marginal rate of transformation. Economics does not believe in a mantra to recite, a wand to waive or a nose to twitch that will change turnips into a goat. The transformation was not of outputs already produced but outputs that can be produced. In the time, it takes him to gather two pounds of green, he could procure (by catching goats and butchering them) two pounds of mutton. 2 His marginal rate of transformation was 2/2 or 1 and, in the following discussion, the ratio is taken to be constant. 3 Will he prefer to produce and

Though he could have meat, lobsters, fruits and vegetables, his choices are, for sake of drawing diagram, reduced to two: meat and vegetables.

Numerical examples in this section are constructed to illustrate economic concepts and are not based on historical facts about Selkirk's life in the island. Using mathematics, it can be generalized to any number of goods instead of two in the text and diagrams 3 To be mathematically accurate, the changes in quantities in Figure 2 should be very small (infinitesimal). Here, for visual clarity, the liberty of drawing discreet changes is taken and the curves in Figures 2 are slightly distorted to

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consume another basket with more meat and less vegetables to the earlier one? The willingness of a consumer to substitute one product for another - the extra amount of the second product needed to compensate for giving up a unit of the first - is measured by his marginal rate of substitution (Figure 5, Chapter 2). Given Basket A in Panel A of Figure 2, Selkirk needs only 1.5 lbs. of meat to compensate him for the reduction in vegetables; his marginal rate of substitution was 2/1.5 or 4/3. He ranks the two baskets, Basket A and the basket represented by the green dot, equally in his preferences; he is indifferent between the two. 1 With the time saved in gathering 2 pounds less of vegetables, Selkirk can produce the red basket with two more pounds of meat. 2 Since the red basket contains more meat, Selkirk will prefer it to the green basket and Basket A. 3 What if he continues shifting his efforts to catching goats, he will end up with only meat for dinner. He will not go to that extreme as it exposes him to risk of catching scurvy, the sailor's disease, from deficiency of Vitamin C. In that he is like most consumers who are observed preferring diversified baskets of goods. The reason green basket is to the left of the red basket is that, at Basket A, Selkirk's marginal rate of substitution, 4/3, is greater than the marginal rate of transformation, 1. He needed less mutton to compensate him for a reduction of vegetables than what he can produce through a shift in efforts. If the marginal rate of substitution declines as he consumes more mutton and eventually equaled the marginal rate of transformation (as at Basket B in Panel A of Figure 2), he will cease reducing consumption of vegetables. Is there a reason to assume that marginal rate of substitution will decline? A possible argument is that as a consumer has less and less of a product, he will be less willing to reduce it further. This is too vague a statement as it suggests that marginal rates of any two baskets, one of which contains more of a product and the other less of it - the red basket and Basket A, for example - can be compared. Preferences are personal to an individual and the liberal tradition in the economic analysis is to assume the minimum about the consumer's preferences. The four axioms of preference stated in the last chapter led to the definition of the marginal rate of transformation. An additional axiom is needed to specify how the rate changes, but it should only impose minimum restrictions on the preferences. The intuition about how a consumer responds to changes in the baskets is made precise by an axiom: among baskets that any consumer ranks equally (between which he is indifferent), the marginal rate of substitution decreases as the consumer has less and less of a product along the vertical axis (as vegetable in Figure 2). As Selkirk moves from Basket C to the green/red basket along the curve in Pane B of Figure 2, the reduction in meat just

accommodate discrete changes. To avoid clustering the diagram, the basket corresponding to the red dot (and some others) are not drawn. The basket is not drawn to avoid clustering the diagram and the green dot will be referred to as the green basket. Other baskets are represented by dots of different color. 2 If marginal rate of transformation is a constant, all the baskets Selkirk can produce by shifting his efforts will lie along a straight line, the production possibility frontier. If the rate varies with output, the frontier will be a curve. Since increase in output leads to a decline in the other, the ratio of changes is negative but to enable comparison with marginal rate of substitution, the sign is ignore (or formally only the absolute value is considered).
3 1

Notice that this reasoning used both the non-satiation and transitivity axioms stated in last chapter.

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compensates him for the reduction of vegetables. Since he is indifferent between various baskets on the curve, it is one of his indifference curves. 1 By the axiom of diminishing marginal rate of substitution, the slope of the curve which is a measure of the marginal rate of substitution decreases as Selkirk's moves to the right and down the curve and the curve becomes flatter at lower points. To establish that Selkirk will prefer one of the baskets he can produce, it is necessary to show that the marginal rate of substitution and the marginal rate of transformation will equal each other at the one and only one basket that Selkirk can produce or at one point along the line in Panel A of Figure 2. If Panel B of Figure 2 is superimposed on Panel A, the indifference curve will touch the straight line at Basket B. 2The level of utility from other feasible outputs (other points on the straight line) will be less as they lie below the indifference curve. This follows from the shape of the curves. The marginal rate of transformation between the two goods determined the flexibility that nature allows Selkirk in producing meat and vegetables and the marginal rate of substitution measures the flexibility his preference give him in substituting one item of food for another. Equating the two enabled him to match his opportunities with his preferences. Though derived for the case of one individual and two goods, the equality between the two rates is a necessary condition for making the best use of resources, as judged by consumers' preferences, in a market economy with many individuals and many goods. Selkirk decides how long he wants to work. Selkirk, instead of working all day, wants to take some time off to rest in his hut, to study the bible and navigation books, to exercise his vocal codes by talking aloud and to go to the shore to look out for any ship that possibly will come by and rescue him. He has to split his time between these activities. Mathematically speaking, adding leisure as another choice requires only a generalization of the discussion in the last section but for non-mathematical exposition it is preferable to reduce choice back to two by treating mutton and vegetables as one compound product. 3 4Baskets are now made up of two goods, food and leisure.

Other indifference curves will pass through the black and red baskets to the left and right of the indifference curve shown in the diagram. Consumer's preference for various baskets is represented by a set of indifference curves. It is not fortuitous that it did but the result of deliberate choice of the one indifference curve. Existence proof is difficult and is not considered here. They are constructed to show that among the many indifference curves of the individual whose preferences satisfy all the axioms, one and only one indifference curve will be tangent to the budget line. We unconsciously aggregate when we speak of expenditure on food though we spent it on many food products. Economic analysis has derived the conditions under which individual goods can be aggregated to one. Skipping niceties, we assume that they are satisfied in the one-person economy. We unconsciously aggregate when we speak of expenditure on food though we spent it on many food products. Economic analysis has derived the conditions under which individual goods can be aggregated to one. Skipping niceties, we assume that they are satisfied in the one-person economy.
4 3 2

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Figure 3. Selkirk chooses between gathering food and leisure.

The question is whether the extra leisure compensated him for the reduced meal. Treat leisure as an activity that, like consumption of a product, increased his utility. As discussed in the last section, the basket that equated his marginal rate of substitution between leisure and food to the marginal rate of transformation between them maximizes his utility. Choice between leisure and work in a modern economy. Selkirk can decide for himself how long he wants to work. In a modern economy employment is based on a contract between the employer and employee, and its terms depend on the laws of the country, the structure of the industry and the conditions in the labor market. What insight can Selkirk's choice provide on recent trends in working hours? An employee may not be able to alter the hours of work from day to day but over time the employer and employee can renegotiate the workweek. Governments, in response to public demands, introduced first laws restricting child and women labor and then hours of work for male adults. The employers and employees of a firm bargain within the framework of laws and come to an agreement; such agreements, it will be shown in the section on Nash bargaining solution below, reflects the preferences of the parties and the strength of their bargaining positions. Angus Maddison estimates that in 1870 an employed person in the United States worked for an average of 2,964 hours, a total that can be achieved only by working nine and a half hours a day, six days a week, around the year. 1 The labor movement was clamoring for a reduction of hours and many establishments agreed to forty hour workweek by the end of the Second World War. In 1950, employed persons in the United States (including those not working full-time) worked for an average of 1,867 hours while those in Europe worked slightly more hours. By the end of the century further reductions in Western Europe led to an employed person there working fewer hours than his or her counterpart in the United States.
1

Angus Maddison (2001), p.347. In Western Europe hours varied from country to country but were above or close to 2,900 hours.

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Figure 4. Benefits of exchange. The shortening of the workweek resulted in a reduction of annual work-hours until 1970. After 1970, the increases in participation rate (the percentage of population in labor force and the average number of weeks worked) more than balanced the decline in working hours per week. Availability of part-time work and removal of Blue Laws in the United States let those who are not in the market for a fulltime job like students, housewives and retirees take part-time jobs. Since then the growth in participation rate has leveled off but the annual hours worked continued to increase. Among those who have a regular job, a higher percentage was taking a second job. These trends reflect individual choices in working hours. There is no consensus on why work hours in Europe continue to fall; some claim that it reflects the different preferences of European workers for leisure while others argue that it is due to rigidity of labor laws and higher tax rates which reduces the incremental after tax income from additional work. Benefits from exchange. The one-person economy lacks one important facet of market economies, the exchange of goods and services between individuals. Today the percentage of a product consumed directly by those who produce it is very small. Part of income from employment and assets is spent on buying consumption goods produced by others and the rest saved. The simplest economy where exchange can occur is one in which two individuals form an isolated community. In one such economy, two individuals George and Robert, can fish or cultivate vegetables. Unlike Selkirk, they need not necessarily consume what they produced as each can exchange some of his output for that of the other. What advantages does the exchange provide over self-sufficiency? Robert is a better farmer in the sense that by shifting time from fishing to farming, he can harvest more vegetables than George can do with a similar shift. Their marginal rates of transformation between fish and vegetables differ, with Robert having an advantage in farming and George in fishing. The division of labor with Robert concentrating on cultivation and

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Figure 5. Robert benefitted from exchange. George on fishing allows them to produce collectively more vegetables and fish than if each tries to produce both. Nevertheless, production by itself does not make them better off. Robert is not a vegetarian and George does not want to eat fish all the time. Larger outputs benefits them only if both George and Robert can obtain, through exchange, baskets they prefer to what they are can produce themselves. Having specialized in what they are good at, they meet to exchange (Figure 4). George, given his catch, is willing to give up 3 pounds of fish for a pound of vegetables; his marginal rate of substitution is 3. Robert, loaded with vegetables, is amenable to giving up six pounds of vegetables for a pound of fish; his marginal rate of substitution is 1/6. After bargaining, they agree to exchange 1.5 pound of fish for a pound of vegetables. 1 At that exchange rate Robert who was willing to give nine pounds of vegetable for 1.5 pounds of fish had to give up only 1.5 pounds of vegetables and he became better off by the exchange (Figure 5). A similar diagram can be drawn to show that George is better off as he had to exchange only 1.5 pounds of fish for a pound of vegetables. The crucial result is that exchange benefited both. What enabled mutually beneficial exchange is that the rate of exchange, 1.5 to 1, lies between the marginal rates of substitution of George (3/1) and Robert (1/6). If they had agreed on any other rate of exchange that lies in between the two marginal rates of substitution, the exchange at that rate will also benefit both. Having improved their welfare by one exchange, could they do even better with further exchanges? If after the first exchange, the marginal rates of substitution are still different, there are opportunities further exchanges. As they proceed with these exchanges, George has more vegetables and fewer fish while Robert has more fish and fewer vegetables than at the start. As fish in his basket depletes, George will be less willing to part with it and he will offer only smaller amounts of fish for a pound of vegetable. Robert is depleting his vegetables and will offer smaller amounts of it for a pound of fish. 2 The gap what each is willing to offer narrows as
1

Compare the bargaining George and Robert does to what is done now-a-days at a flea market or an oriental bazaar. The bargaining process is not explicitly considered here but an example of it is discussed later in the chapter.

Marginal rate of substitution was defined in this example as (change in quantity of fish/change in quantity of vegetable) as the consumer moves along an indifference curve or as he is as well off before as after. As George becomes less willing to offer fish, his marginal rate of substitution declines from 3/1 to 2.5/1 and lower. As Robert offers less vegetable, the ratio of exchange of fish to vegetables increase (notice the denominator is decreasing) and

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exchange proceeds and when they become equal, opportunity for further trade that improves both is exhausted. 1 Such an economy has achieved an efficient allocation of goods or Pareto efficiency, so named after the Italian economist Vilfredo Pareto (1848-1923) who formulated this definition. The ability of a market to achieve efficient allocation of resources is at the core of the arguments offered by economists to defend free trade. Careful analysis has shown that the market economy must meet certain conditions for exchanges to lead to a Pareto efficient allocation; the conditions pertain to the level of competition among producers and the extent of information flow between consumers and producers. This allows critics of market economy to argue that these conditions are seldom fulfilled in the real world. Distribution of benefits from exchange. Exchange is a game in which both parties win. Just as winners in sports stand on the victory pedestals, winning by exchange can be represented by George and Robert standing on pedestals (Figure 6). Move to a higher pedestal indicates that the new basket is preferred to the earlier one. However, unlike in sports, the height of the pedestal in which George stands cannot be compared to the one on which Robert stands. Robert preferring Basket F to Basket D (Figure 5) is an indication that exchanges increased his utility, but it provides no indication the extent to which his utility increased and whether it was more or less than the change in George's utility. To reflect the limitations on ranking of utilities of different individuals, the red pedestals on which George stands are placed in a row behind the blue pedestals of Robert. Pedestals in one row can be compared with each other but not with those in the other row. An allocation in this two person economy is the division of the total output among George and Robert. Before trade, the allocation to each was he produced. How well they are under this allocation is represented by the left-most pair of pedestals. They begin to trade starting with a rate of 1.5 pounds of vegetables to 1 pound of fish and ends up with a set of baskets that is another allocation. How well they were after trade is shown by the middle pair of pedestal. Both became better as both the blue and the red pedestals in the center are higher than those to the left. 2 But in judging the trading process, economists use a more demanding criterion. Is it possible to have another allocation that will take Robert to a higher pedestal without reducing George's pedestal? If there is one, then trade led to an inefficient allocation, inefficient in the sense that one of the parties could be made better off by a reallocation. If not, then the trade has resulted in a Pareto efficient allocation.
the two ratios converge. The indifference curve with quantity of fish on the vertical line and quantity of vegetables on the horizontal axis becomes flatter as one move down on it due to the rule of diminishing marginal rate of substitution. If Robert is moving down his indifference curve, George is moving up his and naturally slopes of their indifference curves vary in opposite directions. The rates at which the marginal rates of substitution change depend on individual preferences and differ from person to person and basket to basket. Here for verbal exposition, they are visualized as making a sequence of trades. They could bargain till they finally choose the basket at the end of the sequence. If they make a sequence of trades, an additional assumption is necessary that the end baskets under the different trade regimes are the same; it is assumed here.
2

It is clear if one of them become worse off (has to move to a lower pedestal), he will not agree to the trade.

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Figure 6. Distribution of benefits. Demanding as it looks, the criteria is weak in one sense. What if trade began at two pounds of vegetables for a pound of fish? Robert is still better off but the rate moved in favor of George who is receiving a larger amount of vegetables in exchange for the same amount of fish. If the trade continues as they move to an efficient allocation were also better for George, at the end George will have a basket that he would prefer to one under the earlier trade. 1This is represented by the right-most pair of pedestals. George became better off from trade but less so than under the earlier scheme. These results generalize to economies with many individuals and products. An allocation of all the goods produced in the economy among its consumers is Pareto efficient if there is no shuffling of goods among baskets that result in one person having a higher level of utility (a preferred basket) while all others have at least the same level. Just as trade can take George and Robert to one of many allocations, trading among many individuals in a market can be led to one of many Pareto efficient allocations. If the Pareto efficient allocation reached makes one group in the population, the Georges, very poor and the Roberts very rich relative to another Pareto efficient allocation with less disparity, should public policy strive to shift to the second one? Building on the works of Pareto, two important results were derived in the middle years of twentieth century. The first theorem states that market transactions in a competitive economy (the extent of competition to be defined precisely in Chapter 11) will lead to a Pareto efficient
Notice that they have to agree to trade and George cannot unilaterally push Robert to choose the trading favorable to him. Though in the verbal description, the final outcome was presented as the result of a series of trades, George and Robert may have agreed on final baskets before trade. If they make sequential trades, the process must be explicitly modeled as is not done here.
1

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allocation. The second one is about changing from one efficient allocation to another. It states that any of the possible efficient allocations can be achieved by making appropriate changes in the initial allocation of goods among individuals. In the two-person economy, the initial allocation is the fish George caught and the vegetables Robert cultivated. In a monetary economy, the initial endowments are the wealth of citizens. The impact of the second theorem is that, by reallocating the wealth and letting the market operate without interference, any Pareto efficient allocation can be achieved. If, on the other hand, the government tries to interfere in the market in the interest of a "fair allocation"," then, as happened in the communist and other regulated economies, inefficiencies will arise and black markets become common. Even if it is feasible to shift from one efficient state to another, should public policy try to redistribute wealth or income? Redistribution implies taking from Peter and giving it to Paul. 1 The entitlement theory, following the natural rights doctrines of Locke and Kant, claim that individuals have an entitlement to the fruits of their labor, and the state should not deprive them of it. Others use refinements of Jeremy Bentham's utilitarianism to argue that public policies must seek to maximize social welfare (to be defined based on individual preferences) through redistribution. Most public policies - income tax, sales tax, expenditures on education and health and even regulations - involve some redistribution. From time to time, and in different countries, heated debate breaks out on a public policy that is under consideration then and there; much of the current debate is over environment and health. If, going beyond the slogans in which they are presented for public consumption, the sources of disagreement are examined they turn out to be over the distributional consequences of the policy. The debate is sometimes phrased as less government versus more; less government is involved in making such policies, the less is the threat of redistribution. Whether these disagreements are viewed as differences about philosophical, political or economic doctrine, they will continue in the future as changing times and circumstances bring new policy issues into the forefront. Game theory: the logic of interaction among individuals. Instead of bargaining as George and Robert were doing, we make most of our purchases at fixed prices in stores. A customer is among the many in a store and, while the sales associates may help her in finding the product she was looking for, the shop does not negotiate prices or any other aspect of the sale with the shopper. In other types of transactions, we interact with one other person or a small group and each side makes choices based on their belief of how the other side will respond. Such interactions can be classified into two: in the first type of interactions, gains to one party result in loss to the other. Competitive sports like football and basketball are examples. Competition among firms for market share is another example. Such interactions even outside sports are classified as noncooperative games. There is another group of interactions in which both sides benefit if they can come to an agreement on the outcome. George and Robert both benefited when they agreed to trade even though each would like to get more out of the other. In negotiating a job offer, a prospective
Reallocation can affect the incentives of the Georges and Roberts. They may alter their efforts and the economy can end up in an allocation that "trims both pedestals."
1

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employee wants as high a salary as he can obtain but recognizes that his employer wants to keep it low. The applicant who wants the job and the employer who need to fill a position benefit when they agree on the terms of employment. When bidding on a house, a potential buyer has to consider what is acceptable to the seller; it has to be better than other offers and yet one that he prefers to pay than to walk away. Interactions among a small group of individuals where they communicate with each other and come to a binding and mutually beneficial agreement are cooperative games. John von Neumann and Oskar Morgenstern's Theory of Games and Economic Behavior (1944) was the first comprehensive thesis on game theory. 1 They defined a solution concept for non-cooperative games that is independent of the specific nature of the game, its rules and its rewards, as long as it is strictly competitive. The payoffs are in terms of "utility" to the players and utility depends not only on the outcome but also on the risk the players have to take to achieve it. This formulation is now standard in economics and finance. George and Robert, on the other hand, benefited from co-operating. They will continue the exchange until reaching one of many Pareto efficient allocations. John Nash in the 1950s introduced a solution concept to a game where communication and binding agreements among parties are possible and the result of the co-operative game was a specific Nash bargaining solution. He did not consider the process by which the agreement is reached or the mechanism to enforce it but assumed that the outcome of the process will satisfy a set of axioms he postulated. He conjectured that the agreement could be the outcome of a non-cooperative game from which the parties have no interest in diverging. Later developments in game theory showed that Nash bargaining solution can be viewed as the limit of solutions of a non-cooperative game when certain conditions are fulfilled. An example of Nash bargaining solution. George had a basket of fish and Robert a basket of vegetables when they met to trade. They can always consume these baskets, and they will trade only if it procures them baskets, they prefer to the ones they have. The pair of utility levels of baskets they had before trade is the "disagreement point." The first axiom of bargaining theory states that negotiations should lead in a Pareto efficient allocation; it should not be possible to increase the utility of George or Robert without decreasing that of the other. Another axiom goes by a fancy name, "Independence of Irrelevant Alternatives." Just before trading, George and Robert saw some goats on a nearby mountain but both knew that, unlike Selkirk, they do not have the ability to run up and catch them. Then the presence of the goats should not affect their bargaining over fish and vegetables. 2 The increase in utility of any individual due to trade is measured by a difference between the levels of utility indices of baskets before and after trade; call it excess utility. Pareto efficient choices differ in the levels of excess utilities. The Nash Bargaining solution when both parties
Solution to a specific non-cooperative game in which two firms producing identical product compete in the market, was developed in 19th century by Antoine Cournot. 2 This example is trivial but in many applications where the bargaining set (the set of Pareto efficient allocations from which one is chosen as the solution) is complex, it is necessary to preclude choices that are not feasible from affecting the agreement.
1

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have equal bargaining power is the one among them that maximizes the product of excess utilities. Bargaining power depends on the parties relative risk aversion (willingness to forgo gains for reducing uncertainty) and impatience. If bargaining power differs, the solution is obtained by raising excess utilities by appropriate indices to reflect the bargaining power of the parties and then maximizing the product. This solution hides the bargaining process and assumes that somehow it will lead to an agreement. The negotiation itself is a game where parties posture to influence each other. Will the competition modeled as a non-cooperative game lead to the Nash bargaining solution? Consider two persons making offers to each other. Negotiations that lead to sale of a house are of this format. The buyer makes an offer in the first period. In Period 2, the seller can either accept it or reject it. If the offer is rejected, the seller makes a counteroffer. The buyer accepts or rejects seller's revised offer in Period 3. The exchanges continue until, for houses that get sold, one agrees to the offer made by the other. In the end, both parties find that dragging the negotiations is costly; each time an offer is rejected, sometimes is lost in negotiations and there is a cost to the delay. The seller has to pay the mortgage, and the buyer does not have the house he wants. In case of employment negotiations, the worker loses the wage for the period, and the employer loses the incremental profit that can be earned by hiring an additional worker. In commercial transactions, the interest that could be earned during the negotiating period is lost. Such negotiations lead to a bargaining solution that is not necessarily the Nash bargaining solution. However, if the time period between counteroffers becomes smaller and smaller, then solution to the non-cooperative game approaches that of Nash bargaining solution. This validates the insight Nash had in solving the bargaining problem. Bargaining within a family Everyone belongs to many social groups. There are groups of friends, work-groups, political party units, committees, and family. The uniqueness of family is that members interact over long periods in a wide set of issues. Its members who differ in age, sex and preferences have to synchronize their goals and resolve their conflicts. This will require negotiations and concessions, even if it is not as formal or as explicit as in making deal with outsiders. What is being negotiated will depend on the circumstances of the family. The studies of affluent families focus on who makes the decisions to save and to spend. Then the family has to agree on what items the budget will be spent. In development economics the discussion covers the same topics but the stress in on how resources hardly enough for survival are allocated among various members. Concerns include the health of female and children in the family and the education of younger generation. Cooperative game theory provides one perspective to analyze these pressing social issues. The Nash solution, as mentioned in last section, depends on the bargaining power of parties. If the parties cannot come to an agreement, their utilities will depend on what other options they have, the disagreement point. As old social structures break down, as accepted customs are found to be anachronistic and as new opportunities empower the helpless, the bargaining powers of the family members and the cost of disagreement changes. For a married couple, the outside option is divorce. In societies where divorce is difficult or is looked down socially, the aggrieved partner is struck in a dysfunctional marriage. In agrarian economies, children have to help

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parents with the work in subsistence farms. When parents get old and infirm, the children have to take care of them. Their future is tied to the farm. Economic development opens up opportunities for the young to leave home and support themselves; the generations are less bound to each other. The conventional wisdom supported by marketing studies indicates that, in the case groceries, cleaning items and other nondurable goods are the wife's domain. For expensive and complex items like cars, historically men made the choice. When women become earning members, they have more economic independence and, specifically if it is driven by them, women get to choose the car. Manufacturers in designing the vehicle have to consider their relative preferences of female drivers for reliability and safety over acceleration and speed. Economic psychology argues that, instead of focusing on the outcome, the process of arriving at it needs to be explicitly considered. Different members of the family can have more or less an influence on choice that is finally made. One member of the family first recognizes the need for purchase. The severity with which it is felt, the social and economic basis of the power of that member and past bargaining experience all affect the outcome. Thus the one who cooks knows what is needed in the kitchen. Contradictory results are found in the role of members in next stage of gathering information about products and evaluation of alternatives. At the final stage, the spouses jointly decide on the purchase. The husband decides what car to buy while the wife chooses the color and some accessories. 1 In the impoverished families of Asian and African countries, the decision to allocate the food and other collective resources can depend on sex and age with adult male members receiving major shares. Women have fewer chances to work outside the family and earn cash income; when they do work outside, they earn less than men. They also have less access to loans. It has become an article of faith for World Bank and other international organizations that female members tend to allocate more resources to the welfare of the children than men and that, for improving the welfare of children, it is cost effective to direct financial aid to women. One study based on Brazilian data showed that an increase in mother's unearned income increased child's survival probabilities almost 20 times that of a similar increase provided to the father. 2 However, economics warns that such efforts should not lead to even less support from the head of the family. Analysis of negotiations among members provided better understanding of decisions is made within a family. In the western countries, it influenced the development and marketing of goods while in poorer nations it has resulted in the formulation of welfare and development policies. The development of market economy. George and Robert were both producers and consumers, and they traded directly with each other. Today consumers depend on the market to supply most of their needs; wholesalers and retailers separate the producer from the consumer. Trading in a market is more than an exchange of goods (Figure 7). The buyer needs information on the nature of the product offered, its quality and the time of delivery. The seller needs to be assured of the payments promised. The
1 2

Kircher (1988), pp.258-292; Phillip Kotler, p.165 -166. Dasgupta (1993), p.471

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transaction cost is the cost of obtaining information about possible exchanges, negotiating the terms of exchange and enforcing the contract. It has to be added to the cost of producing the good. Growth of demand for the products produced outside the household and lowering of transaction costs leads to the development of market economies. While trading existed in pre-historic times, early trade served a narrow clientele or a government seeking command of the supply of staples. Ancient cities from Babylon onwards relied on the agricultural hinterland and even distant colonies to feed the population in the cities. Transporting over land was expensive and over time maritime trade became prominent. Phoenicians and Greeks established colonies along the Mediterranean coast and actively traded in the region. Romans first and Arabs later mastered the secret of the trade winds and used it to establish trade routes to Asia. In addition to staples and slaves, exotic products from foreign lands, like silk, ceramics and spices that the affluent demanded, were brought through the Silk Road and sea routes. Meanwhile the rural population relied mostly on what they produced and what they obtain by exchange from other villagers. By third century, incursions along the border of the Roman Empire and strife within, led to its economic decline and decay of its cities. The large percentage of the population was impoverished and land was concentrated in few extensive estates. Those living on the land were bound to the estate by law and obligations. That this was true even as late as century is seen from the life of one Bodo as reconstructed from well-preserved archival material of the Monastery of St. German de Press in France. Hakan Lindgren describes it: "Despite his proximity to the city of Paris, Bodo and his family had very little market contact. The network of economic contacts was both limited and unchanging. The people who contributed to his annual consumption overwhelmingly were found in his immediate proximity. More than one-half of Bodo's consumption originated in household production by his wife Ermentrude and his three children, Windo, Gerbert and Hildegaurd. The rest came largely from other households in the same village." 1 A typical peasant market in a village brought farmers and craftsman together. Country fairs are held near churches on Sundays and festival days. 2 There were market squares in towns to which artisans and farmers brought their products. In cities, those selling one product like clothes set shops in one street so that customers can walk around and choose. Even in these markets, most of the sales were by producers to consumers and as late as the sixteenth century

Figure 7. Three types of flows in a market.

1
2

Lindgren (1997), p.28. Sawyer (1986), pp. 59-77

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Italian Renaissance, retail trade where goods were brought by a third party for resale was viewed with suspicion. 1 In the politically fragmented Europe, concern about security along the road, the cost of transportation and the cost of enforcing the contract limited trade across regions. One solution is for a local potentate to assure traders who come to a fair in his territory, safe passage and enforceable contracts. The success of thirteenth century fairs in Champaign located in France is due to the protection to traders and enforceability of contracts (like letters of credit) that the Counts of Campaign offered. It became a premier market for textiles, leather, fur, and spices. At their height, in the late twelfth and the thirteenth century, the fairs linked the cloth-producing cities of the Low Countries (Netherlands and neighboring regions in Germany) with the Italian dyeing and exporting centers. In the sixteenth century, Portugal and Spain embarked on geographical exploration and colonization. Portugal became masters of the Indian Ocean and wrested the spice trade from the Arabs. Spanish colonized Mexico and parts of South America. Netherlands, British and French also embarked on colonial expansion. An early impact of this process was in import of gold and silver into Europe. Soon products like coffee, tea, cocoa, Indian cotton textiles, Chinese porcelain and sugar were imported in larger quantities and became cheap enough to be within the budget of ordinary Europeans. Though by fourteenth century there were stores in most English towns selling products from different regions, retailing in the modern sense began its slow but steady evolution in London of the sixteenth century. London by then became the focal city for internal and international commerce and needed outlets for the products that flowed into the city. In the seventeenth century England, the average consumer began to demand products from foreign countries like coffee and chocolates, and they began to eat out of pottery rather than wooden flatware. This consumption revolution gave a boost to retail. In the middle of the nineteenth century, some retailers selling textile fabrics to the less affluent customers of London saw an opportunity to increase sales by cutting prices; larger volume made up for the lower profit margin. They advertised by distributing handbills and posted fixed price (price-tickets as it was then called) on their windows. 2 Evidently, the shops were successful as the custom spread. After the first department store, Bon March opened in Paris in 1860, the modern concept of shops with fixed prices and large body of salaried personnel became well established. Summing up. The need to make choices on what to produce and what to consume exists in primitive as well as modern economies. Increase in the output of one product can be achieved only diverting resources from production of another. The ratio of the rates of changes of the two products is the marginal rate of transformation. Vilfredo Pareto defined an efficient allocation as one in which, by a reshuffling of goods among consumers, it is impossible to increase the welfare of one person without reducing that of
1 2

Welch (2005), pp.34-41. Davis (1966), pp.258- 261.

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another. In the one person economy of Selkirk, it is achieved by equating the marginal rate of substitution to the marginal rate of transformation. The equality of the two ratios is needed for efficient allocation in a multi-person, multi-product economy. The first theorem of welfare economics states that a competitive economy is Pareto efficient. The second theorem states that, any efficient allocation can be achieved by a reallocation of initial endowment and then let the competitive market function to choose the outputs and prices. Redistribution is always controversial. Some consider it an infringement of property rights. Even in a market economy, there are transactions like setting employment conditions that are transacted between two or a few individuals. The cooperative game theory explains what all influences the agreement. It is then applied to examine the allocation within families and to develop public policies to help those who are impoverished. Selkirk, George and Robert, like all who live in subsistence economies face the risk that their survival can be threatened by forces beyond their control like by bad weather or other natural disasters. They would like, if possible, limit the consequences to them from the worst outcome. The next chapter considers making choices when the outcome is uncertain and possibility of hedging to minimize the adverse consequences.

Bibliographical Note. Binmore (2007); Cameron (1993); Dasgupta (1993); Davis (1996); Dimand and Dimand (1996); Heap and Varoufakis (2004); Kotler (2000); Lindgren (1997); Lundberg and Pollack (1996); Maddison (2001); Motley (1997); Osborne (2004); Schor (1991): Severin (2002); Souhami (2001); Strauss and Thomas (1995); Turner (2002); Prescott (2004); Welch (2005).

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Chapter 4. Choices involving time and uncertainty

The outcome of our decisions can be uncertain when it depends not only on our actions but on events not in our control. It is beyond our resources and knowledge to foresee such events and evaluate their impact. Selkirk looks at the sky, the seas and even the behavior of birds and animals and uses his experience as a seaman to predict Island's weather. His vision is limited to the horizon even though events beyond it will shortly affect the Island's weather. Today, satellites and weather stations collect data around the world and are connected to massive computers that analyze them. The weather forecasters distill the information and make predictions about local weather in the evening news. Nevertheless, the jet stream shifts, fronts stall and the weather surprise us. Are forecasts of weather three or four days ahead less reliable than that for the next morning? It is not necessarily so but instinct and experience makes us believe it is so. Time and uncertainty are intertwined and it is possible that opportunity for events that are beyond our predictive power to occur increases with time lapse. Selkirk when catching goats and keeping them in a pen near his hut was planning his future consumption. Today we can shift consumption over time by adding to our asset through saving or by running it down by outspending our income. Education is an investment in human capital. Early in our lives we choose between continuing our education through college for higher earnings later in life or going to work at a young age. The benefit from postponing consumption is the opportunity it creates to consume a larger basket in the future. However, individuals have time preference; a basket of goods received at a later date is ranked below an identical basket available in the present. The section on intertemporal choices examines this trade off. An individual will choose the time profiles of consumption to maximize intertemporal utility just as each time period she chooses the basket that maximizes her utility. The next section, Decision making when outcomes are uncertain, turns to choice when each decision could lead to one of many possible outcomes. The most promising educational plans can disappoint as the job markets change; new technologies and outsourcing wipes out jobs that looked attractive when we made our educational choices. House prices go up and down and so do the stock market. Some of our investments appreciate in value while others lose theirs. The section begins by describing how "states of nature" (broadly defined as events over which we have no control) intervene to generate uncertainty about outcomes of our actions. We fear that, in some states of nature, we suffer unexpected expenses or a loss of our property. Can we make a deal with someone else to bear such losses, if it occurs, for a payment in advance? An example of two farmers in an isolated community hedging their risk is developed. Each farmer signs a contract that when the other has a poor harvest, he will consign a fixed quantity of his output to the other. Trivial as this example is, the ideas it brings out are central to more complex contracts like insurance and portfolio choice. Intertemporal decisions and time value of money. A high graduate can either start working or go to college. Higher education involves paying tuition and board, and postponing fultime employment for four years.

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Table 1. Calculation of the value of money Panel A. Forward in time: compound interest. Year 0 Capital and interest (1 year investment) Capital and interest (2 year investment) $100 Year 1 $ 110 = $100(1+0.1) $110 = $100(1+0.1) $121 = $100(1+ .1)2 Year 2.

$100

Panel B. Backward in time: present value Year 0 Present value of cash flow one year from now. Present value of cash flow to years from now $100/(1 + 0.1) = $90.90 $100[1/(1+0.1)]2 = $82.65 Year 1 $100 Year 2

$100 [1/(1 + 0.1)] = $90.91

$100

Why does anyone choose to go to college? At the end of twentieth century, the annual earning of a college graduate in U.S. was, on the average, 1.8 times that of a high school graduate. 1 At completion of high school, the student has to decide whether the extra earnings of more than forty years of employment make it worthwhile for him to incur the expenses of college education. 2 If a person goes to a bank and exchange dollars for euros, the exchange occurs instantaneously, and he can compare the euros received to the dollars exchanged. In the case of college education, the expenses are incurred early in life while the salary differences are spread over the working years. Can he add up the extra income from different years and compare it to the cost of education or should he make adjustments for the differences in time between expenses and receipts? Will an individual's lower valuations of future receipts induce him to save less than what is needed to meet unforeseen expenses or to maintain a reasonable standard of
1

The ratio cited is from a July 2002 report by Day and Newberger. The difference in earning between college and high school graduates increased over the last quarter of twentieth century as changes in the job markets in the United States and in most of the western nations reduced job opportunities for the less skilled workers. 2 The analysis assumes that the young high school graduates have funds to pay for the education or have access to credit market to borrow the funds. Even if the student has the intelligence and motivation to go to college, cash constraints can prevent him from doing so. A cash-constrained student is not able to maximize his life-time income.

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living in his old age? Why is there such a striking decline in the personal savings rate in the United States during the last two decades? This section extends the analytical framework of utility maximization at one point of time to intertemporal choices. If the interest rate on safe investments is 10 percent, $100 invested in Year 0 will earn an interest of $10 by Year 1 (Panel A, Table 1). The initial fund is now $110 and if reinvested, earns an interest of $11 in the next year. The fund grows to $121 by end Year 1. The relation between the values of funds in different years can be expressed concisely using a multiplication factor: (1 + interest rate expressed as a fraction). The capital and interest after a year are $100 (1+ 0.1) and after two years $100(1+0.1) The reverse question plays an important role in subsequent discussions: What amount would an individual be willing to pay now for receiving $100 in a year? Since she can earn an interest by investing the amount at the current rate of interest, the most she will advance is an amount if invested will yield $100 a year later Panel B, Table 1). Instead of multiplying by the factor (1 + 0.1), the amount that is to be received in the future is divided by it. She will be willing to advance $100[1/(1 + 0.1)] or $90.90 for receiving $100 a year henceforth. She will advance $100[1/(1 + 0.1)] or $82.65 for $100 two years from now. In general, the present value is found by raising the discount factor, 1/(1 + interest rate expressed as a fraction), to an index equal to the time interval until repayment. 1 Though Table1 considered only loaning and borrowing of funds, the rules for forward and backward shifts over time have general validity. It applies to all comparisons of funds or utility over time. Shifting forward in time requires the amount invested to be multiplied by a compound interest factor and shifting backwards by division by the same factor. In case of utility from consumption in future, the utility received at that date must be divided by, as explained in next section, by a discount factor. To apply it to investment in education take the average of differences in salaries of high school and college graduates in all age cohorts; averaging is necessary due to idiosyncratic variation among individuals. The averages are discounted to the year of high school graduation and then compared to the cost of college education. The study by Barrow and Rose concludes that, for college graduates in the United States, the present discounted value of the earning differential for the first ten years after graduation, using prevailing interest rates, equals the cost of education less any tuition grants they received. 2 Since the working life of a college graduate is four times as long, the discounted value of higher salaries far exceeds the cost of education. Why is it then that some go to college and others do not? Choosing between consumption streams: time preference. Educational choice, by shifting incomes and expenditures over time, affects consumption patterns. Mia by going to college postponed earning for four years, but she earned more after graduation than those who went to work after high school. Figure 1 shows a stylized representation of the consumption streams (consumption over time) of a high school and a

The factor, (1+0.1) was raised is two for repayment two years after the advance. For later repayments, it should be raised to an index equal to the number of years to repayment. 2 Burrow, Lisa and Cecelia Rouse (2005)

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Figure 6. Time preference and intertemporal substitution college graduate. 1 Treating consumption basket for each period as "an item for which the individual has preferences," intertemporal consumption pattern can be viewed as a "superbasket." Choice before Mia and her schoolmates is to choose one or the other of the superbaskets. Irving Fisher (1867-1947), writing in the 1930's, developed an analysis of intertemporal choice that was similar to choice of baskets of goods at one point of time. He asserted that individuals have time preferences for immediate consumption. Given a choice between a basket of goods now and an identical basket next period, all consumers, irrespective of their other differences in preferences, will choose the first. To compensate for time preference, increase the basket for the second period until Mia is indifferent between the two baskets (Figure 2). This suggests a measure of pure time preference: ratio of the quantity in Basket C to that in Basket A = 1 + time preference. If Mia has to choose between any pair of baskets, one in Period 0 or another in Period 1, she will multiply the utility of "Period 1 basket" with discount factor [1/(1+ time preference)] before comparing it to the utility of "Period 0 basket" and choose the one with higher utility. 2

Compare this ratio with discounting future income by discount factor, [1/(1+interest rate)]. In spite of the similarity of mathematical structure, there are serious conceptual differences. Interest rate is observable in the market while the rate of time preference reflects the preferences of individuals. The composition of baskets is assumed not to change over time, enabling each basket to be treated as one commodity in the superbasket. Compare this ratio with discounting future income by discount factor, [1/(1+interest rate)]. In spite of the similarity of mathematical structure, there are serious conceptual differences. Interest rate is observable in the market while the rate of time preference reflects the preferences of individuals.

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Figure 1.A measure of time preference. While earlier chapters focused on choice of a consumption steam with no specific time associated with it. Fisher's approach extends the logic to choice of the consumption stream over two periods with recognition of the time and levels in the two periods. However, it is hard to generalize his approach to many periods as is needed to take decisions about education or savings. In 1937, Paul Samuelson proposed a generalization. He made two crucial assumptions. First, the varied influences that go into intertemporal choice can be represented by a constant discount factor. Second, utility from different periods can be added after discounting. The formal structure is very similar to discounting future income to determine the present value as in Figure 1. The utility of the superbasket (income flow) is equal to the sum of utilities of the smaller baskets (income in each year) discounted by dividing it by (1+time preference) raised to the appropriate power. 1 Even though Samuelson expressed reservations about the intertemporal discounting with constant discount factor, the approach became standard in economics analysis. The differing choices Mia and schoolmates can be explained in terms of intertemporal choices. The discount rate depends on preferences and will vary from individual to another. Even if the income streams from educational choices are the same for two individuals, the one with a higher discount rate will decide not go to college when the other does. Decision making when outcomes are uncertain. Up to now each action taken by an individual, whether acting as producer or consumer, results in one specific outcome. From possible actions open to him, he will choose the one whose outcome he prefers to those of others. Frequently, the best laid plans fail and the outcome of a choice differs from what was expected at the time of decision. Our purchases disappoint and production plans fail. We suffer unexpected losses to our property through accidents, fire and flood. We fall sick and incur unplanned medical costs. Financial losses arise as our assets depreciate. We respond to

Utility of superbasket = [U]+[U/(1+time preference)]+[U/(1+time preference)]. . . .where U's are the utilities of income in the year indicated by the subscript.

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Figure 2. Decision making under certainty and uncertainty. uncertainty by taking insurance or diversifying our portfolio of investments but we can never eliminate it. It is much more difficult to make a choice when the outcome is uncertain than when it is certain, as each action has many consequences. In general the individual will not prefer all possible outcomes of one's decision to those of the other and it is not known at the time of decision which outcome will occur, what rule should the individual follow in making the choice? Nature of uncertainty. Figure 3 illustrates how choice under uncertainty differs from that under certainty. Each begins with a decision to take an action that leads to an outcome. Under certainty, there is only one consequence to that action. When Chloe is in a store, she selects a few goods; her challenge is in deciding what basket of goods she prefers to all others that she can afford. She is sure that she can buy the chosen basket at the counter. (Panel A of Figure 3). Uncertainty arises when each action has more than one outcome. The outcome is determined, in Panel B, not only by Chloe's decision but also by the slot in the roulette wheel into which a ball falls (for the sake of latter diagrams, the slots are grouped into two). The possible outcomes are represented by a super-basket containing one basket for each group of slots (just as a consumption stream over working years was represented by baskets within a super-basket in Figure 1). The individual will, in contrast to intertemporal consumption, obtain only one of the baskets. Chloe is planning to go to a beach for sunbathing. The outcome of a trip depends on the weather; she will get a good tan if it is sunny all day but not if summer showers in the afternoon

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force her to leave early. The weather is the state of nature whose randomness is represented by the roulette wheel in Panel B of Figure 3. Using this analogy, nature is said to intervene between the decision-maker and the outcomes in every situation where uncertainty arises. The states of nature are so enumerated that they are mutually exclusive and exhaustive; any possible outcome is associated with one and only one state of nature. The action together with the state of nature determines an outcome; for Chloe the outcomes contingent on the state of nature are good tan or light tan. Chloe, if she is going to the sea shore, has to leave in the morning; her other choice is to stay at home and watch TV. How can she decide whether to go to beach or not without knowing the afternoon weather? What makes the choice difficult is that her ranking of choice switches with state of nature. In State 1, good weather, she prefers going to a beach but with rain threatening in State 2, she prefers to stay at home. Since the publication of von Neumann and Morgenstern's Theory of Games and Economic Behavior in 1944, economists have developed three approaches to analyze choices under uncertainty. Each involves a reexamination of the elements -- baskets of goods, preference and decision rules -- involved in the choice. Though the three approaches have much in common, this chapter will focus on one developed by Kenneth Arrow and Gerald Debreu. The other two approaches are discussed in Chapter 11. State-contingent commodities and individual choice. Commodities are most obviously distinguished by their physical characteristics. At a grocery store, a shopper has no problem in distinguishing between tomatoes and cabbage. As he gets to the tomato counter, additional distinctions come into focus. Some tomatoes are plucked unripe and ripened in storage while others are vine-ripened. Some are grown using chemical fertilizers and pesticides while others are grown organically. Tomatoes are tagged by the processes used in cultivation and ripening, and these tags are important to some consumers. A product that is currently available should be differentiated from the same product that is available at a later date. A farmer may need wheat now even though he is expecting a bountiful harvest within months. He will seek to exchange wheat available at different dates and even pay premium for immediate delivery. The experience of drinking a cup of hot coffee after being out in the cold is different from that of drinking it on a hot afternoon. Products are tagged by the state of nature in which they are available and each of the tagged commodities is a state-contingent commodity. Individuals have preferences that lead them to exchange one state-contingent commodity for another and, because of such preferences, prices of state-contingent commodities differ even though they are physical identical. When an individual makes a consumption or production decision, the outcome can depend on the state of nature. In Figure 3, each decision has two possible outcomes corresponding to two baskets of state-contingent commodities (for Chloe planning a trip to the beach, the statecontingent commodities are good tan or a light one). The super-basket of state-contingent commodities is more like a magician's hat than a grocery basket: sometimes you pull out one and other occasions another product. The difference is that decision maker, unlike the magician, has no control over the contents. It depends on the state of nature.

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Figure 4.Choice of a superbasket of contingent commodities. Consider an Indian farmer dependent on monsoon making a decision to plant. If he plants early and rains arrive ahead of schedule, he has a good harvest; if the rains come late, the plants whither in the field, and he has a poor harvest. Planting early leads to a super-basket of statecontingent commodities, (good harvest, poor harvest). If he postpones the planting, his harvest will again depend on the onset of rains; if the rains come early, the growing season missed part of the monsoon and the harvest will be poor; if it is late, the harvest will be bountiful. The decision to plant late led to another super-basket of state-contingent commodities (poor harvest, good harvest). He can choose in-between dates but each date to plant corresponds to a superbasket. Another example is an individual investing her savings in bonds and stocks. Bonds offer a fixed interest rate while return on stocks varies with the state of the economy. Consider two states of the economy, a period of expansion and one of recession. When the economy is buoyant, the returns on stocks are higher than that of bonds; in a recession, stocks lose value and returns are low or even negative; on the average, return on stocks is greater than that of bonds. Each allocation of her assets among the two corresponds to a superbasket of returns on assets. 1 In general, the choices open to an individual are limited, and in Figure 4 they are taken to lie along a straight line. Individuals have a preference that ranks the super-baskets off state-contingent commodities. Those that are ranked equally lie on an indifference curve. The marginal rate of substitution is, as in the case of indifference curves of consumption goods, the slope of the indifference curve. Figure 4 shows the indifference curve which is tangent (touches at one point) to the line at the red point. All other available super-baskets lie below the indifference curve and are ranked lower in preference relatively to the red basket. Comparison with Figure 3 of Chapter 3 shows how Arrow-Debreu contingent commodity formulation extended the decision process under certainty to decision making under uncertainty.

Portfolio choice is discussed in Chapter 12.

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So far the discussion proceeded with referring to the probability of events but it is common to associate probability with random events. What is the probability of an event? Probability is an amorphous concept that appears in everyday discussions and in all the sciences. It underlies statistical analysis used in social sciences for verification of results. There is no single system of axioms about probability that is universally accepted and applied in all contexts in which probabilistic judgments are involved. Whatever the interpretation, it should have the property that more probable events should occur more frequently. 1 The concept of probability has its root in gambling. In repeated throws of a fair coin, head tends to appear roughly half the times, and the law of large numbers states that the ratio of heads to total throws tends to 0.5 as the number of throws increases. If a dice is thrown repeatedly, any face will appear on the average one-sixth of the time. From such examples, an intuitive notion of relating probability to relative frequency arose. Once outside the casino halls, the definition of probability as relative frequency raises the question: relative to what? The probability of rain is, by this definition, the percentage of times it rained in the past when similar weather patterns existed. The problem is in defining "similar weather patterns." The more detailed the description of weather patterns the less frequent is their occurrence; if the definition is made less precise, there is no assurance that the events are really repetitive. Without repeated occurrences, probability cannot be defined as limiting value of the ratio of preferred events to the total. Even bigger problem is the critique of induction by the eighteenth century Scottish philosopher, David Hume. What guarantee is that the patterns of the past will be a reliable guide to the future? The problem with inductive interference is that it claims to generalize from a finite number of observations to a general conclusion. The difficulty of going from the specific to the general is not confined to estimation of probability but challenges the very foundation of empirical knowledge. In spite of much debate it has created, there is no convincing resolution of this critique. A common approach to valuation of financial assets is based on the probability of various returns and the extent of their variation around the mean return. Implicit in the estimates are assumptions about the probability of the asset-returns taking values in the range of its variation. Low probability is assigned to extreme values of returns and if and when they occur the analysts and policy makers are taken by surprise. On Black Monday, October 19, 1987, the U.S. stock market crashed. Dow Jones lost 22.6 per cent and S & P 500 lost 20.4 per cent. Jackwerth and Rubinstein have calculated that, using a probability distribution of stock prices that is widely used in financial analysis, the probability of the crash once in 20 billion years, the life of the universe, is extremely low! 2 Measures of probability, imperfect though they may be, provide a guide to making decisions in economics and finance.

Kolmogrov axioms are the ones that have wide acceptance but not all interpretations of probability are consistent with it. 2 Jackwerth and Berstein (1996), p.1611.

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Uncertainty and hedging.

Figure 5. Fluctuations of output of Tim's farm Outcomes of many decisions an individual has to make are uncertain. Some of them like inclement weather on an outing to the beach have a transient impact on the individual while others like a loss of assets have serious consequences. Individuals desire to minimize an unpleasant outcome or to mitigate it. Their preferences show risk aversion or a willingness to take a lower expected income or wealth to avoid large losses. An example is purchase of insurance. The individual pays a premium in all periods and states, reducing his budget for other expenses; in return he is compensated, at least partly, for a loss in one state of nature (as when his car is damaged in an accident or his house by fire or flood). Agreement by one individual, Natalie, to exchange some of her assets for a claim on Pablo's assets in case she suffers a loss is an example of risk sharing that mimics insurance. Pablo, in agreeing to such a contract, will balance the benefits of receiving payments from Natalie with the cost of compensating her loss. The best that the two can do is to come to an agreement, as George and Robert did, that is Pareto efficient in the sense that neither has another choice that benefits him or her without forcing the other to choose one ranked lower. Adam Smith had an idea that markets where many individuals perusing his or her interests will lead to an allocation that is efficient. Two instances of economic activity were considered in Chapter 3. Selkirk was both a producer and a consumer but not involved in trade while George and Robert traded goods in their possession. Adam Smith explicitly included both consumers and producers among those trading in the market. The development of an analytical framework for treating both production and consumption decisions by individuals trading in many markets began with Leon Walras in the third quarter of the nineteenth century and culminated in a rigorous formulation by Kenneth Arrow and Gerald Debreu in the middle of twentieth century. Later Arrow and Debreu extended the analysis to include trade in contingent claims (like Natalie's claim on Pablo's assets if she suffers a loss). The advantage of tagging commodities by time and state of nature is that the analysis of trade at one instant of time, like that between George and Robert, can be extended to trade over time and states of nature. A simple example below shows how trading in contingent claims can be used to hedge against losses.

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Figure 6. Contingent claims.

Hedging using contingent claims in an isolated economy. Tim, a subsistence farmer living in isolation, is planting wheat in his farm; for simplicity, it is assumed that he has no choice in what he plants and how he farms. The harvest in good weather is 40 bushels while in bad weather it is only 10 bushels (Figure 5). Since good and bad weather are equally frequent, his average output is 25 bushels. Still he faces periods of famine and feast. Tim, like so many other consumers, prefers lesser fluctuation in his consumption. How can he achieve it? To make a deal, he has to find another party, a wheat farmer Harold, willing to exchange wheat based on states of nature. The two farms are identical except in location and the weather in Tim's farm located on one side of a mountain range is opposite of that in Harold's farm located on the other side. When one produces 40 bushels, the other produces 10 bushels, and this occurs equally often. The average output of each farm is 25 bushels. Unlike George in Chapter 3, exchanging fish for Roberts vegetables, Tim in lean years has nothing at hand to exchange for the wheat he is seeking. The most he can do is to promise to return the wheat next time the harvest is good. What Tim and Harold can do is to trade promises that the one with the good harvest will provide the other with bushels of wheat. The commitments need to be documented. They agree to exchange slips of paper each of which promises to deliver 1 bushel of wheat to the other party if the harvest is low. Tim's green slips are contingent claims that offer one bushel of wheat if the weather is good in his farm while Harold's red slips offer one bushel if weather is good in his (Figure 6). If they can exchange 15 contingent claims both have 25 bushels irrespective of the weather. If both farmers prefer a steady level of consumption to fluctuations, then they have increased their utility levels by this deal. There are two special features of hedging by Harold and Tim that enable them to avoid uncertainty altogether. Why was it possible? Tim and Harold were lucky to have the fluctuation in their harvests cancel each other perfectly. In general it will not occur. If Harold's output in good weather is only 30 bushels with other outputs are as in Figure 6, then the total output of the two farms will fluctuate between 40 (30 in Harold's farm and 10 in Tim's) and 50 (= 10 + 40)

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Figure 7. Ratio of prices of contingent claims and probabilities of states of nature. bushels. There is "systemic risk" (risk of the economy as a whole) and someone has to bear it. One possibility is for one of them to absorb the change in total output. If the agreement is for Harold to trade 10 bushels of his good harvest in return for 10 bushels when his output is low, then his consumption is 20 bushels in both states while Tim's will fluctuate between 20 and 30 bushels. Exchange of contingent claims allowed them to move to a preferred consumption pattern but uncertainty cannot be completely eliminated. In a contemporary world, wage contracts provide examples of arrangements to share systemic risk. A firm has to meet its expenses from its sales revenue and what is left belongs to the owners. Consider the residual after paying all expenses other than wages. What is left is to be divided between workers and owners. This residual amount fluctuates with variations in sales revenue and cost of inputs, and the firm has to agree on an arrangement to share the risk between the workers and the owners. One common arrangement is for workers to get fixed wages while letting owner's income fluctuate. The other is for both to share some risk; bonuses are structured to make the employee remuneration move with profits of the firm. Prices of contingent claims and hedging. Individuals have limited budget and they allocate some of it for risk management. They buy contingent claims to compensate for loses in adverse situations. Those who sell the claims charge a price just as insurance industry changes a premium. The cost of these claims determines the amount and type of claims that an individual can purchase with his budget. Assuming that there are only two types of claims and their prices are fixed, the packets an individual with a budget for hedging can afford are points on a straight line that slopes downward to the right in Figure 7 (which is a reproduction of Figure 4). The slope, how much more one contingent claim can be added by reducing a unit of the other, depends on the ratio of prices. One basket on the line has equal quantities of the two claims. If the indifference curve is tangent to the line at that point, the individual, like Harold or Tim, avoids any fluctuation in their consumption. When will that occur?

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With reinterpretations of the indifference curve as set of (equally ranked) super-baskets of contingent commodities suggests a new definition of the marginal rate of substitution. It differs from the definition in Chapter 2 in that an increase in contingent claims to wheat does not necessarily increase the consumption of the wheat. The change in consumption is contingent upon the state of nature occurring. The potential increase in utility basket must be weighted by the probability of the state occurring. The expected increase in utility is a product of three factors: the increase in quantity of contingent commodity, the increase in utility per unit increase in the commodity (marginal utility) and the probability of the state occurring. This product must equal a similar product for the other commodity for a movement to keep the level of utility remains unchanged. The slope of the indifference curve, marginal rate of substitution, is the ratio of the change in quantities along the curve. If it equals the ratio of the probabilities, then as shown in the footnote, the individual will a super-basket with equal quantities in both states. 1 Harold and Tim were exchanging contingent claims at a ratio of one and the ratio of probabilities of the two states (0.5/0.5) is also one. They choose an exchange that provided them with 25 bushels of wheat in each state. Given another price ratio for contingent claims, they would not have done so. In contemporary world, most individuals do not fully insure their losses from car accidents or fire, agreeing to take part of the loss as deductible in the insurance policy. Efficiency of trade in contingent claims. One justification of market economy is that it allows the economy to reach an efficient state in the sense that no one can move to higher level of utility without decreasing the utility of another. If all those trading in contingent claims paid the same price, every individual sets the marginal rate of substitution of contingent claims to a common price ratio. In the example of Figure 7, there were two states of nature and two contingent claims; the market is said to be complete when the number of contingent claims equals that of the states of nature. The completeness allows the individuals to achieve Pareto efficiency, even if there is uncertainty. Since there are so many sources of uncertainty in a modern economy -- health of individuals, stock prices of companies, weather affecting agricultural output - and each has many states of nature, it looks unrealistic to expect that the number of contingent claims available in the economy equal that of the states of nature. Can such an economy achieve efficiency? Each of the long lived securities -- securities like share that provide returns in different states of nature in different periods -- are equivalent to packet of many contingent claims and they can possibly bridge the difference between number of states and claims. It is an empirical question and depends on the market conditions.

(Probability of state 1)(change in quantity of contingent commodity 1)( marginal utility of the commodity) = (probability of state 2) (change in quantity of contingent commodity 2)(its marginal utility). Hence (change in quantity of contingent commodity 2)/(change in quantity of contingent commodity1) = slope of indifference curve = [(probability of state1)(marginal utility of contingent commodity1)]/[(probability of state 2)(marginal utility of state 2)]. At point of tangency, this equals the ratio of price of contingent commodity 1 to price of contingent commodity 2. If the price ratio equals the ratio of probabilities, then the ratio of marginal utilities must be 1.This will happen only if quantities of wheat are the same or the chosen point, the state of nature does not affect the level of consumption.

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Summing up. Many of the decisions we make in the present affect us in the future. Economic science from the time of Adam Smith on recognized the role of time but the tools to analyze intertemporal decisions when outcomes are uncertain were developed only in the twentieth century. Time preference in one form or another can be traced back to nineteenth century writers had but the precise formulation stated here is from Irving Fisher's Theory of Interest published in 1907. Introduction of uncertainty complicates the decision process as outcomes depend not only on the choice by the decision maker but also on states of nature (defined as a source of randomness). Given his inability to control the outcome, an individual resigns to making choices that maximize the expected utility. Individuals are risk averse and want to avoid losses, even if, on the average the asset has high value; this is shown by purchase of various types of insurance that require payments of premiums even if there is no loss. A rudimentary arrangement to shift risk is by transacting in contingent claims. States of nature intervene between the choice made by the decision maker and the outcome. Incorporating trading in dated commodities and contingent claims into the general equilibrium has provided insights into what is needed to achieve optimal allocations in such economies. Incomplete markets with fewer numbers of contingent claims than states of nature can prevent the economy attaining efficient allocations. Institutional arrangements to cope with trade over time and states of nature reflect the response incompleteness of markets and asymmetric information. Except for the short description of general equilibrium above, analysis of choice was mostly confined to rather primitive and isolated economies. It allowed the core concept in economics to be developed in an intuitive manner. Next chapter explains how the consumption choices of individual consumers lead to market demand for a commodity and how quantity demanded is responsive to changes in the prices of commodities. Producers also respond to price changes. The responses of consumers and producers result in a market moving to a price at which quantity demanded to equal quantity supplied. Bibliographical note. Day and Newberger (2002); Frederick, Loewenstein and Donoghue (2002); Huang and Litzenberger (1998); Herschleifer and Riley (1992); Fisher (1930); Lengwiler (2004),Jackwerth and Rubinstein (1996); Lutz (1967).

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Chapter 5. Let us go shopping.

In modern societies, we rely on others to supply us with goods and service needed to meet our wants. Nothing is more frustrating than not getting a product when we need it. Irritation turns to anxiety, if the unavailable products - grains, milk, or gasoline, for example - are essential for our daily life. In North America and Europe such shortages are rare and transitory but in many parts of the world millions live a life of quiet desperation. Those who supply us rely on sales for their income. If they produce less than what we demand, lost sales cut into their profits. Excess production results in unsold inventory and an inability to recover the cost incurred in their production. Every society - primitive or modern, autocratic or liberal - needs to coordinate production and consumption decisions. Our instincts lead us to believe that such coordination requires conscious efforts by individuals with an oversight over the process. Air traffic controllers use radar to keep our planes flying safely and FedEx and UPS use bar codes and tracking systems to deliver millions of packages to customers across the world on time. Producers use logistic systems to ensure timely delivery of goods to stores. Why not establish a system of controls to manage the economy? Production in anticipation of demand by consumers is intrinsically much harder task than delivering what is ordered. Output of each firm is purchased by thousands of consumers, and stores want to stock their shelves in expectation of sales. Each firm has to decide, without direct information about choices of individual consumers, the quantity of its product that they will collectively demand. Production and pricing strategies of competitors will affect the sales of the firm. When political leaders, either out of idealism or of selfish interest, try to intervene in the market by establishing controls, they end up creating either excess demand or excess supply. Thwarted buyer and sellers try to circumvent the system by dealing in "black markets." Adam Smith is renowned for his exposition of the benefits of free market economy, but it is Frederick von Hayek who emphasized the informational problems in achieving coordination among independent decision makers. 1 He argues that the central problem in economics is not the logistics of implementing what we know needs to be done but knowing what has to be done. Even if those who devise and implement controls have the best of intentions, they are hindered from being effective by the lack of knowledge about quantities demanded and supplied. In addition to the information problem, we now know that there is an incentive problem. Shortages give administrators the power to decide who receives what and experiences of many economies that implemented controls show that administrators resist attempts to deprive them of that power. The market system, Hayek claimed, minimizes the informational requirements. Both consumers and producers observe one signal in the market, the price, and make their decisions independently. Shortage of gasoline leads to an increase in its price and each consumer decides how to respond. Susan is a sales agent whose work involves travel and cutting back on driving will hurt her business. Wong is retired and can substitute sightseeing trips with other leisure activities. As the price of gasoline goes up both Susan and Wong reduce their purchases but by different amounts. No one other than the consumer needs to know how pressing their wants are
1

Hayek (1945), pp.519-530.

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and how willing he or she is to reduce consumption. The price continues to increase until the reductions balance quantities demanded and supplied. The next section considers how a consumer sets his budget for consumption expenditure. Subsequent sections discuss how his purchases depend on the budget and prices. Given the budget, he chooses a basket of goods that he prefers to others that cost as much. Understanding his choice permits examination of how the composition of the basket changes with his income and the prices of goods. An individual demand curve is derived to reflect his responses to price changes. The quantities demanded by individuals at various prices are added to draw the market demand curve. Producers also respond to changes in price. Pending discussion in later chapters on how the production plans of firms depend on their cost structures and the extent of competition in the market, the quantity of a product collectively supplied by all firms is assumed to increase with its price. The market clearing price is the one that equates the quantity demanded to the quantity supplied. Setting the budget. The budget for our shopping depends on our income and our assets. We receive income from our employment, returns from our investments in bonds and stocks, and rents from the properties we own. Some households receive transfer payments include pensions, social security, welfare payments or remittances from family members. 1 Part of the income is spent on consumption and the rest is saved. The Consumer Expenditure Survey conducted by the U.S. Bureau of Labor Statistics reports that of the average-after-tax income of households in 2008 was $61,774 of which they spent $50,486. 2 Some of the consumption expenditure is on goods that last a long time while others are on those meant for immediate use. Among the durable goods that we buy are houses, furniture, cars and computers. We spent on education early in life (and occasionally for short periods later) and enjoy its benefits for the rest of our lives. Purchase of durable goods and services that last a long time should be viewed as investments. 3 Other products like food, toiletries, cleaning supplies are used up quickly as we consume them. We anticipate our need for these products in the near future and, in each of our shopping trips, make purchases for the days ahead. Still the time interval between purchase and use is so short that we can, as an approximation, ignore it.

Transfer payments differ from wages in that no service is done in return for the payment. Pensions and social security are based on work done in the past. Family members support each other. Some welfare payments are made conditional to working but the payments as such is not related to the amount or quality of work.
2 3

Bureau of Labor Statistics, Consumer Expenditure Survey (2008), Table 2. A house is considered an investment. Education should be viewed as investment in human capital.

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Figure 1. A consumer's income, expenditure and assets. We save to make provisions for our retirement and for uncertain contingencies like illness or period of unemployment. We look into the future and timing of our wants enters our decision process in an essential way. The assets that we accumulate through our savings can be compared to water in a tub. Our income is the inflow into it, and our expenses are the outflows (Fig. 1). In the years we earn most, we spent less than our income and add the difference to our assets. In some periods, anticipating higher income in the future or facing unexpected expenses, we borrow and run down our assets. 1 In addition to changes due to savings or borrowings, our wealth can increase or decrease if specific assets appreciate or depreciate in value. If an individual has an income of $50,000 and her house and stocks appreciated from $100,000 to $120,000, then she can consume $70,000 without reducing her wealth from the previous level. 2 In the last decades of twentieth century, there was significant appreciation of the value of stocks and houses. In the ten years to 1999, the wealth of U.S. households, adjusted for inflation, increased by $15 trillion or slightly in excess of 50 per cent. More than 60 per cent of asset growth was due to increases in the value of stock holding; the prices of stocks increased five folds in this period. 3 The stock market began to decline in 2000 but house prices continued to increase. Housing prices peaked in 2007. Between April 2007 and February 2008, OFHEO pricing index put out by the Federal Housing Finance Agency fell by 10 percent. Between May 2007 and May 2009, the S&P500 stock price index fell by 40 percent. Estimates indicate that between the second quarter of 2007 and last quarter of 2008, the total household net worth declined by $12.9 billion (about 20 percent of net worth). 4 When asset prices were increasing, consumers feel less need to save for future and this is offered as an explanation for the decline in the household savings rate in US from around 14 percent from mid- 1980s to zero in 2000. More recently it is increasing, but it is too early to say at what level it will settle. Once the individual chooses the budget for consumption expenditures, the baskets she can afford to buy will depend on the prices of products.

2
3 4

Chapter 11 considers how savings in the present is determined by intertemporal utility maximization. General inflation is assumed to be negligible. Poterba (2000),p.99 Cashell (2009), pp.5-8.

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Figure 2. Budget line. Baskets that are within a consumer's budget. Julia, a consumer with a budget of $300, spends it on buying two products. The price of Product 1 is $4 and of Product 2, $6. Baskets that cost $300 - Baskets A, B and C in the Figure 2 - lie on the budget line. 1 The slope of the budget line at a point is the ratio of the vertical distance to the horizontal distance between two neighboring points on it. Since the budget line is a straight line, the slope is the same at all points on it, and it can be measured by the ratio of the height of the left end of the budget line (the length of the blue arrow) to the distance of its right end from the corner (length of red arrow). The slope, -50/75, has a negative sign indicating that height decreases to the right. It is possible, and in fact helpful, to express the slope as the ratio of two prices. The maximum amount of Product 2 Julia can purchase is (budget/price of Product 2) = $300/$6 = 50. Similarly, the maximum amount of Product 1 she can purchase is (budget/price of Product 1). The ratio of the two with a negative sign added is - (price of Product 1/price of Product 2). While budgets of consumers in a market differ, all of them pay the same prices and budget lines of all consumers have the same slope. Expressing the slope of the budget line in terms of prices enables deriving many important results. Julia chooses a basket. What basket on the budget line will Julia choose? In the case of Selkirk, the loner who had to produce his own dinner, the best he could do was to match his willingness to substitute products in his consumption (his marginal rate of substitution) with his ability to shift production from
It is a straight line as long as prices do not vary with quantities; price discounts with quantity purchased, for example, will put a kick in the line.
1

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Figure 3. The budget that maximizes utility.

one to the other (his marginal rate of transformation). Julia purchases what she consumes and she must equate her marginal rate of substitution to her ability to buy more of one product by reducing the other or to the slope of the budget line. The reasoning to determine Julia's utility maximizing budget is similar to that used to determine Selkirk's choice. Will Julia choose Basket A on the left panel of Figure 3? Starting from that basket she reduces Product 2 by a small amount. The position of the green basket shows how much more of Product 1 is needed for her to feel indifferent to the reduction in Product 2. 1 But the savings on expenditure on Product 2 allows her to buy the red basket on the budget line which she prefers as it contains additional amount of Product 1 and the same amount of Product 2. As she shifts down the budget line, she has less of Product 2, and she will become reluctant to reduce it even more. She needs larger amounts of Product 1 to compensate for further reductions of Product 2. When Julia reaches Basket B, she has no incentive to move down the budget line as the additional quantity of Product 1 that can be purchased just compensates the decrease in Product 2 (the green and red baskets coincide and is shown by the half-green half-red circle). Panel B shows baskets that Julie ranks equally as Basket B; its shape is determined by the axiom of diminishing marginal rate of substitution. If Panel B is superimposed on Panel A, the indifference curve will touch the budget line at Basket B with the rest of the curve will lie above the line. Basket B is the utility maximizing basket that Julie can afford. The discrete changes in quantities in Figure 3 make explicit the substitution process but it takes liberties with the analytical derivation of the results. In a rigorous derivation of the equality between marginal rate of substitution and price ratios, the changes in quantities of goods are made smaller and smaller the limiting process in mathematics makes quantities infinitesimal - until the black and green baskets are almost indistinguishable. Then the indifference curve will be tangent to the budget line as shown in the inset at the upper right hand of Figure 3.

Baskets are represented by dots of the same color.

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Figure 4.Choices of different individuals. Though only one indifference curve is drawn in Panel B, other curves lie above and below it (Basket A lies on one such curve). Irrespective of the position and slope of the budget line, one indifference curve of Julie that will be tangent to it. This is an important result as it enables comparing baskets Julie will choose as her budget line shifts either due to changes in her income or in the prices she pays. Why individuals choose different baskets? Scott is another individual with the same income as Julie and shops in the same market. Since both are also paying the same prices, their budget lines are identical. Still differences in tastes lead them to choose different combinations of the two goods as they maximize their utilities (Figure 4). Since both equate their marginal rates of substitution to the common price ratio, they end up having the same marginal rates of substitution. The equality of marginal rates holds for all the consumers in a market, irrespective of their incomes, as long as they pay the same prices. Once the purchases were made, they have no incentive to make further transactions just as George and Robert exhausted possibilities of trading when their marginal rates of substitution became equal. 1 The equality of marginal rates of substitution is one of the conditions for the economy to achieve an efficient allocation of resources.

Trade between George and Robert was discussed in Chapter 3.

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Consumption changes with increasing affluence.

Figure 5. Proportional increase in expenses on all commodities. Scott had an increase in his income and that leads him to increase his budget for consumption by 20 per cent to $360. He can afford larger baskets and the axiom of non-satiation (preferring more to less) guarantees that he will choose one on his new budget line. One possibility is to increase consumption of all products by 20 percent; the new basket will be Basket B of Figures 5. Other possibilities shown in Figure 6 include spending the additional $60 on one of the goods and ending up with Basket C or Basket D. Scott will choose a basket along the new budget line that equates his marginal rate of substitution to the price ratio. As long as the chosen basket is in the segment between Baskets D and C, he has increased consumption of both products. Other consumers faced with similar budget increases will make their own choices and the aggregate change in quantity demanded of each product will be the sum of the changes in individual demand. The income elasticity of demand of any product is the ratio of the percentage change in the

Figure 6. Shift in budget line. quantity demanded to the percentage change in income. Ernst Engel, a nineteenth century German statistician, observed that the proportion of income spent on food in Germany decreased

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Figure 7. Cost savings from decrease in price of one commodity.

as income of average consumer increased. This relation implies, assuming prices are constant, that the demand for food product does not increase in proportion to income or the income elasticity of food products is less than one. The percentage of income spent on food in United States has declined during the last century. 1 In 1900, the typical American household spent 36 per cent of the income on food but by 1950 it came down to 24 per cent. By 2001 it was 13.5 per cent and of this 5.7 per cent was on food consumed away from home (restaurants and fast food places). In contrast to food, the expense on all types of transportation in United States increased from 4 per cent in 1900 to 13 percent in 1950 to 19.3 percent in 2001. The automobile and airplane made travel easier and Americans are now traveling longer distances and more often than ever before. Effects of change in a price. The effect of a price change on affordable baskets depends on the quantity of the product in the basket. Andrew with a budget of $300 is buying 15 units of Product 1 priced $4 and 40 units of Product 2 priced $6 (Upper basket in Figure 7). As the price of Product 1 falls to $3, the cost of the basket goes down by $15. In contrast, the cost of the lower basket with 30 units of Product 1 goes down by $30. More he consumes the product that has become less expensive the greater is the cost savings. Cost savings indicate how the budget line changes with a reduction in price. If Andrew was spending the entire budget on Product 2, there is no cost savings and top end of the budget line is not affected (Figure 8). If he buys only Product 1, he can buy 100 units instead of 75 and the lower right-hand end of the line moves to the right. The budget line swings outwards.
1

Bureau of Labor Statistics, "100 years of U.S. Consumer Spending: Data for the Nation, New York City and Boston," http://www.bls.gov/oub/uscs/. The decline reflects both the relative change in quantities and prices of food and other items in the basket of a typical consumer.

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Figure 8. Shift in budget line as price of Product 1 decreases. Both before and after the price change, Andrew buys baskets that equate his marginal rates of substitution to the price ratios. He will shift from the basket corresponding to the black dot on the lower budget line to one on the new budget line. It may sound reasonable that consumers will alter their budget allocations to buy more of the cheaper product and less of the other; one such allocation is the red basket on new budget line. However, one of the core assumptions of economics is that individuals differ in their preferences. For general validity, the increase in consumption with price decline must be established, not by vague conjecture, but by deriving it using minimal assumptions about preferences. To simplify the analysis without affecting the core of the reasoning, add another assumption to the axioms of preference: a proportional change in all commodities, as when he

Figure 9.The effect of price decline of Product 1.

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Figure 10. Market demand curve. buys the yellow basket instead of the black, will not affect Andrew's marginal rate of substitution. Andrew will buy a basket on the new budget line and let the one that maximizes his utility be the red basket on Panel B of Figure 9. Consider the indifference curve passing through that basket. Given the assumptions about consumer preference, the curve must lie above the new budget line except at the chosen basket (Curve 2 of Panel B, Figure 9). To determine the relative position of the black and red baskets, increase the quantities in the black basket proportionately to get green basket on Curve 2. By the newly added assumption, the marginal rate of substitution at green basket remains the same. But the budget line has lower slope as see in Figure 8; the lower end has moved out making it flatter. To reduce the rate to equal the lower slope, Andrew must move down the curve or increase quantity of Product 1; this follows from the axiom of diminishing marginal rate of substitution. Andrew's move from the black basket to red basket can be decomposed into two separate ones: proportional expansion to reach the green basket and a slide down the indifference curve to the red basket. The first move increases quantities of both products, and the second move increases the quantity of Product 1 while decreasing that of the other. The two moves jointly increase in the consumption of Product 1 whose price has decreased. Market: the price at which the market clears. Nineteenth century French economist, Antoine Cournot defined market as "the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same good tend to equality easily and quickly." Given that all consumers are paying the same price, the quantities they demand at that price can be added up to equal the quantity demanded in this market. As price decreases, each of them will buy more and the quantity demanded in the market will increase. This is illustrated in Figure 10 for a product.

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Figure 11. Supply curve. As price is reduced from $3 to $2.50 each individual in the market will increase his or her purchases and the total quantity demanded increases from 1,000 bottles to 2,000 bottles. At a still lower price of $2, the quantity demanded will be 3,000 bottles. A demand curve graphically illustrates the relation between prices and the quantities demanded for any product, and it slopes downwards to the right to reflect the increase in quantity demanded at lower prices. Each point on the curve corresponds to one price measured along the vertical line to the left and to one quantity as measured along the horizontal line at the bottom. At any point of time, only one price prevails in the market. The consumers are able to purchase the products only if the producers supply them to the market. The output each producer is willing to produce depends on his costs, the price in the market and the competition he faces from other producers. As price increases, more revenue is generated per unit sold and the firm has an incentive to consider increasing its output. Pending detailed analysis of how incremental cost and revenues determine each firm's response to price changes, the collective output of all firms producing a homogenous product is assumed to increase as its price increases. This is shown in Figure 11; the firms produce 1000 units when price is $2, 2000 units when it is $2.50 and 3000 units when price is $3.00. The table in Figure 12 juxtapositions the quantities demanded by consumers and that supplied by producers at various prices. What stands out is that there is only one price, $2.50, at which the quantity demanded to equal the quantity supplied. The output brought to the market is

Figure 12. Market clearing price.

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sold and shelves in stores are cleared at this market-clearing price. The demand curve of Figure 9 and the supply curve of Figure 10 are drawn together in Figure 12 and they intersect at the market-clearing price. It show that if the price is above the market-clearing price, producers supply more than what consumers are willing to buy. Every fall automobile companies introduce new models. As 2007 models were introduced in the fall of 2006, dealers in the United States could not display the new vehicles as their lots were full of leftovers. The worst hit was Chrysler Corporation. Beginning of November 2006, only half the vehicles in Chrysler dealerships were new models as compared to more than 75 percent in General Motors and Ford dealerships. Chrysler announced an incentive program to move the unsold vehicles. Irrespective of how the program is structured, it is a reduction in what consumers have to pay for their purchase and was intended to increase sales. 1 If the price is below the market clearing price, the quantity demanded will exceeded that supplied and shortage will lead to an increase in price. The periodic increases in price of food product as storms and freezes disrupt the supply of vegetables and fruits are examples of market response to shortages. The price observed in the market at any moment need not be the market clearing price but the surpluses and shortages will move it towards the market clearing level. Prices we see in stores. In the nineteenth century stores in London selling textiles began to post prices instead of bargaining on every item sold. The arrangement was found profitable and soon spread to other stores. Today most of the purchases by individuals in Europe and North America are in stores that sell at "fixed prices." Are they the same as the market clearing prices of Figure 12? If not, will they tend to move towards each other? "Like most marketing decisions," writes Thomas Nagle and Reed Holden, "pricing is an art. It depends as much on good judgment as on precise calculation.... Good judgment requires understanding. One must comprehend the factors that make pricing strategies succeed and others fail" 2There are many consumers in a market and drawing the demand curve requires an estimate not only the quantities they will buy at the current posted price but for a range of prices around it. The supply curve depends on the responses of all producers. It is hard for the marketing officers of a corporation, be it a retailer or the manufacturer, to anticipate correctly the market clearing price of a product and set the price at that level. Consider the experience of the retailer, K-Mart. To attract customers to their stores, they would announce a sale on a Sunday in 2002 but the firm underestimated the demand at the lowered prices. When customers rush to buy, the store had run out of stock on the very day the sale was announced. The frustration of missing the sales turned customers off, and it is considered to be one of the reasons K-mart had to go into Chapter 11 bankruptcy reorganization in 2002. 3

1
2 3

New York Times, November 2, 2006. C.3 Nagel and Holden (1995), p.9 The Wall Street Journal, October 15, 2002. B1& 3

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Absence of precise information leads manufacturers and retailers to seek for guidelines to determine the posted prices. One approach is cost-plus pricing. Internal accounting provides unit cost of the product and the price is set above it to generate targeted profits. The problem with this approach is that it sets price without considering the consumers. They may not be willing to purchase the quantity that maximizes producer's profits at that price. If production is reduced to match the quantity demanded, the unit cost to the manufacturer increase as its plants operate at less than capacity; if price is increased to equal the higher costs, then the sale decreases even more, generating a spiral of increasing costs and decreasing sales. Over time retailers and manufacturers developed sophisticated pricing strategies to assess demand and control inventories at stores but the central issue of understanding the consumer is still there. Changes in quantity demanded as price changes: price elasticity. We are faced with frequent changes in prices as a market adjusts to fluctuations in the quantity supplied. Weather changes lead to bountiful harvest or a crop failure. Shortage of raw materials, breakdown at a major plant, disruption of transportation or political instability affect the supply of industrial products. In 2005, supply disruptions due to Hurricane Katrina that hit the Gulf Coast initially took out 25 per cent of the crude oil production in the United States and 10 to 15 percent of its refining capacity. It created a shortage of gasoline in the country and the shortage together with the increasing crude oil prices in international markets resulted in the gasoline prices rising from $1.78 per gallon on January 3ed to $3.07 on September . 1 Shortages lead to price increase but how much should it increase to balance the market? If demand is elastic - elasticity in the usual sense implies a response to any pressure - then a slight increase in price will lead to a substantial reduction in quantity demanded. Only a small price change is needed to rebalance demand and supply. Demand for gasoline is relatively inelastic in the short run as users cannot reduce their driving or shift to a fuel efficient vehicles with every fluctuation in gasoline prices. The inelasticity resulted in the increase in gasoline prices in 2005. If higher prices persisted over time, the demand for automobiles will shift from gas guzzlers to fuel efficient cars and the demand for gasoline will decrease. Gasoline price begins to fall. The consumer is choosing a utility maximizing basket. If the price of a product changes, he will shift to another basket with different quantities of both goods (as seen by the move the black basket to the red basket in Figure 9). The effect of the change in price of one product on quantity demanded of another is measured by the cross-elasticity of demand. As price of gasoline increased, the demand for new cars declined. Who buys and sells in a market? The English economist William Jevons points out that the institution of markets evolved over time while maintaining their basic function of bringing buyers and seller together: "Originally a market was a public place in a town where provisions and other object were
1

Energy Information Administration, U.S.A

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exposed for sale; but the word has been generalized, so as to mean any body of persons who are in intimate business relations and carry on extensive transactions in any commodity." 1 It is up to the individuals to decide which "body of persons" to join. The decision will be based on the prices in various markets and the convenience of accessing the market. Consumers in medieval villages buy farm products from farmers come to sell their products. To attract the largest number of buyers, village markets of the Medieval Europe were always held near churches, especially on festival days. As communication and transportation improved and as retailing developed individuals were no more restricted to buying locally produced goods or shopping at a local store. They can go to a neighborhood grocery store, a superstore or wholesale food club, or they can order it over the internet for home delivery. Each consumer will go to the market where prices are lowest, given the effort involved in making the purchase. On the supply side, farmers consider the markets where they want to sell their harvest. If their ability to transport the products is limited, they are confined to the nearest one. As packaging, preserving and transportation developed, farmers ship products to distant markets. Today Australian lamb is sold in London and South Asian shrimp in United States. The cost of transportation and price differential between markets determine the choices of the producers. As long as consumers and suppliers brought and sold in the nearest market, it was separated from markets elsewhere. Each commodity has its own demand and supply relations in every market, and they will determine the market-clearing prices. If producers and consumers have the opportunity to switch markets, buyers will move to a market where prices are lower and producers go to the one where it is higher. The shifts in demand and supply will make the prices converge. In spite of geographical separation, there is only one body of persons transacting in the two localities and, from an economic point of view, those who face one price for a product are in one market. This logic was used by George Stigler and Robert Sherwin to examine the wholesale market for flour in Midwest. Analyzing the prices of wheat from 1971 to 1981 in Minneapolis and Kansas City, Missouri, two cities 300 miles apart, they concluded that the differences were not, in a statistical sense, significant. The reason was that the same national bakeries are buyers in both markets. On the supply side, Stigler and Sherwin found that 28 per cent of the flour was being shipped more than 500 miles. Many mills supplying Minneapolis and Kansas City are located in between the two centers, making the distance to the two markets much less than 300 miles. All these factors made the prices in two cities move quickly and easily to equality, making them one market in the sense Jevons. They also examined the co-movement of the prices of flours in Portland, Oregon and Buffalo, New York with those in Minneapolis and Kansas City, Missouri. Their conclusion was: "The direct and reasonable answer is that flour prices in these widely separated cities have a significant measure of independence, but they share all major movements in prices." 2 The geographical extent of a market can be quite large, depending on the price of the product and cost of transportation.

Jevons (1871), p.84 Stigler and Sherwin (1985), p.564.

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Summing up. The separation of consumption decisions made at the household from production decisions taken by the firms necessitated an institutional arrangement for their coordination. The commodity market that allows each participant to take decisions based on a common price signal has, it was argued, many advantages over alternate institutional arrangement. Complementing the separation between production and consumption, two other separations developed in modern industrial economies: separation of ownership from management and savings from investment. As the production activities in pre-industrial households shifted to firms, labor market emerged to match workers with the firms emerged. Labor market directs the service provided by workers to their employers. Selkirk chose how much he works and implicitly how intensively he worked. An employer wants his workers to maximize their effort while workers like to work at a less demanding pace. The conflict between the interest of employer and employees is an example of the agency problem. The price that equates the labor market is wages. The wages has to be related to productivity to induce workers to put their best effort and various forms of incentive pay schemes were developed. Given the size of modern firms, the owners are not able to supervise the workers. They created a cadre, middle management, to ensure that the directives of owners and senior management are implemented by their subordinates. Neither supervision nor the incentive pay can totally eliminate the agency problem as informational limitations and uncertainty limit their effectiveness. It was a common in the past for generations in a family to work at the same plant in their locality. Mobility of workers and pressure on firms facing rapid technological change and foreign competition made frequent turnovers in employment common. Workers had to enter the labor market more than once in their lifetimes. The construction of a plant requires financial resources. Well into the nineteenth century, factories were small enough that a group of entrepreneurs, their friends and local bank could fund it. It was public works like railways and canals that needed massive investments and depended on raising funds by issuing bonds and shares. Development in technologies led to increases in size of factories and the needed funds could only be raised by tapping into the savings of a large number of households. Those who provide the funds do not have control over the operations but they lose their savings if the firm fails. The financial market developed a number of institutions to absorb the savings from households and provide them with a return while reducing their exposure to risk. Banks accept deposits at fixed interest and provide mostly short term loans to firms. Diversification, spreading the savings over many investments, reduces the risk to the investors. Mutual funds have made it easier for individuals to achieve a higher level of diversification than possible if they directly in stocks. The information requirements of modern economies created new activities like marketing to match producers and consumers, and accounting to inform outsiders of the financial conditions of the operations. Inventory control and supply chain management were developed to ensure a smooth flow of inputs into the firm and output from it. Various markets in an economy are interlinked. A reduction of sales leads to cut in employment. The labor market response is increase in unemployment and downward pressure on wages. The reduction in wage income of households forces them to cut consumption

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expenditures and trim savings, sending another shock through commodity, financial and labor markets. The next chapter looks at the inside of a factory as it converts inputs into output. It brings out the involvement of the firm in the three markets. Bibliographical note. Bureau of Labor Statistics (2006); Cashell (2009), pp.5-8; Consumer Expenditure Survey (2008); Energy Administration (2005); Hayek (1945); Jevons (1871); Nagel and Holden (1995), p.9; New York Times, November 2, 2006. p. C3; Stigler and Sherwin, (1985) p.564; The Wall Street Journal, October 15, 2002. B1& 3.

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Chapter 6. Firms: their role in supplying the market.

Even though a few factories existed in the early modern Europe, the shift of manufacturing from households to factories became widespread only in the eighteenth century. Concentration of production in factories enabled introduction of complex machines. In the beginning of industrial revolution, machines were driven by windmills, waterwheels and steam engines; later they were replaced by those relying for energy on internal combustion engines and electricity. Each worker in the factory specialized in one operation and the division of labor increased productivity. Henry Ford introduced assembly line production in his automobile plant. Its adoption in other industries is followed by increased use of automation and robotics. While we tend to associate modern industry with large plants, smaller ones are still common and, indeed, some recent technologies like electric furnaces in steel industry are making smaller plants competitive. About half of the US non-farm output is produced by firms that employ less than 500 persons. Among these firms about half employ 1 to 4 employees. 1 One common factor is that whether the technology is complex or simple and the plants large or small, the underlying economics of these operations - converting some products into others that users value more - is common to all of them. Shifting production away from households created a separation between consumption decisions and production decisions and the coordination between the two was achieved through the commodity market. As firms grew in size and as technology grew in complexity, the capital required for establishing and operating a manufacturing operation exceeded what an individual was able to provide. Financial institutions pooled the savings of individual households and lent parts of the pool to different firms and the growth of financial markets led to separation of savings and investment decisions. Innovations in business organizations, like types of partnerships and joint-stock companies, made it feasible for those not involved directly in the management of the firm to contribute to the equity of a firm without concern that financial problems of the firm will push time to bankruptcy. The management of the firm shifted to the professionals hired by the owners, creating a separation of ownership from management evolved. The three separations have economic consequences that will be discussed in different contexts in following chapters. This chapter introduces the basic structure of firms. Organizing the production. Even now each household is involved to a limited extent in production, preparation of food being an example, for its own consumption. Considering what we do in the kitchen is helpful in understanding of the complex operations of a firm. At the start of the cooking we check that we have the ingredients needed for the dinner. Perishables like meat, milk and vegetables are in the refrigerator and others we store in the pantry. A variety of appliances like food processors, mixers, stoves, ovens and microwaves are in the kitchen to assist us in the preparation of a meal. There are many appliances that are meant for specific uses, like rice cooker, and we had to

SBA Office of Advocacy (1998)

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Figure 1. The firm: an external look. decide which ones to buy, taking into consideration their costs and the space they take in the kitchen-counter. The meat and vegetables we purchase are cleaned, cut and even packaged. Some of it is even precooked, reducing the time and effort needed to incorporate them into the dishes we want to serve. We can avoid cooking altogether by buying pre-cooked dinners or ordering delivery from restaurants. Such outsourcing is not without cost. The preparation may not be to our tastes and the food may not be as fresh as the one we prepare from scratch. In setting up as plant the firm must choose the technology it uses. Is it worth incurring additional investment in complex machinery to save labor cost? How much of the product should be fabricated within the plant and what parts or operations are to be outsourced? Henry Ford chose the vision of an integrated firm. The Rouge River Plant at its peak in the 1920s had the furnaces to produce steel and glass for the cars, a plant to process rubber and produce the tires and even an electricity plant. The raw materials came from forests, mines, and limestone queries the Ford Motor Company owned. Ford even sought to establish rubber plantations in Brazil.1 After the Second World War, the Ford Motor Company shifted its strategy to decentralization and globalization. Today a typical manufacturing firm purchases finished and semi-finished products from suppliers. Some companies, like PC makers, outsource all the production and focus on assembly and marketing of their branded product. 2 At one time or other, we have passed by plants that look from outside like the one in Figure 1. An imposing physical structure is enclosed in to restrict entry. Raw materials and semifinished goods are delivered to the plant by road or rail. We observe workers going in at the beginning of a shift and leaving at the end of it. Output is shipped out to various locations. This external view that excludes all internal operations highlights the core economic function of a firm: converting inputs into output. Modern economics use this view as the starting point for the analysis of the firm. The building and machinery installed in the plant are fixed inputs that cannot be altered in a short period of time. Other inputs like labor hours (number of laborers times hours worked) and quantity of raw materials can be changed much more quickly; they are variable inputs. 3
1 2 3

http://media.ford.com/article_display.cfm?article_id=13884 The distinction between outsourcing and subcontracting for which there is no consensus is ignored.

For exposition using graphs, the number of inputs need is restricted to two. The inputs are then grouped into two: fixed and variable.

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Figure 2. Flow of inputs and output. The firm in Figure 2 is producing four boxes of output using eight boxes of variable inputs. If the firm increased the number of inputs baskets without altering the machinery installed within the plant, will it change its output and by how much? The outcome will depend on the installed technology but there are technologies where some increase in output is to be expected. The output increases per unit increase in the basket of inputs is defined the marginal product of the basket. For the firm in Figure 2, it is half a unit. The marginal product can increase or decrease as the firm keeps increasing the variable inputs. One possibility is that the installed machinery determines the capacity of the plant and until it is reached every basket of variable inputs has a fixed marginal product. Firms with such technology provide a simple framework to derive many results that are valid even if the marginal product is not constant. Some results that crucially depend on an alternate technology are developed in Chapter 11. The use of inputs to produce output sets up a relation between sales revenue and cost of inputs (Figure 3). The difference between the two flows is "the operating income." The "profit of a firm," defined later in the chapter, equals the operating income less cost of funds raised to finance construction and maintenance of the plant. These costs are fixed in the short run. Given variation in cost of production and sales revenues with output, the interest of owners is served by choosing the output that maximizes operating income.

Figure 3. Flow of products and funds.

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Figure 4. Marginal revenue and marginal cost. To get insights into how cost changes with production, consider once again home production. You invited six of your friends to a home-cooked dinner. You have set a budget and purchased the meat, vegetable and wine. Then you learn that a friend you always wanted to invite is in town and you decided to include him. How does it affect the planning and preparation of the meal? You have to spend more time preparing the meal, in setting places and washing dishes but it is a labor of love. All the same the expenses for the dinner will go over your original budget as you need to buy more meat and wine and maybe larger amounts of vegetables. The extra cost you had to incur is the marginal cost of having one more person for dinner; the benefit to you is the fun of visiting with an out-of-town friend. A firm focused on its profitability compares the monetary cost and benefits of increasing its output by a unit. Whether operating income increases or not depends on the relative size of the changes in sales revenue and cost of inputs. The change in input is the reciprocal of the marginal product; if one basket produces 0.5 units, then it takes two baskets to produce a unit. The cost incurred in producing that unit is the cost of purchasing two additional baskets of input: $200 if each basket costs $100. The increase in total cost per unit increase in production is the marginal cost of the product (height of red box in Panel A of Figure 4). If the firm now increases the output by another unit, will the increase in operating expenses for second unit be the same as that for the first unit or will it be different? For this firm that pays fixed price for inputs and has constant marginal product, the marginal cost is a constant. Kalnins provides data on the marginal cost of renting a room (difference in cost to the hotel of having an occupied and an unoccupied room). For economy motels it is $20 per night and for luxury hotels $75 per night. 1 Sales revenue increases as more units are sold in the market. 2 The increase in revenue per unit increase in sales is marginal revenue (height of green box in Panel A of Figure 4). How
Kalnins (2006), p.214. There are circumstances where sales revenue can decrease with output. Then the firm will not increase the output but instead decrease it. The reasoning in the text should be reversed.
2
1

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Figure 5. Gross profit at capacity. marginal revenue changes with output will depend on the extent of competition in the market for the product. Pending detailed analysis of competition in following chapters, it is fixed at the level in Figure 4 in this chapter. For this firm with fixed marginal cost and marginal revenue, an additional unit increases its sales revenue more than by its costs and the difference adds to the operating revenue. Can the firm keep increasing net income by increasing output? It will ultimately run into one or more of three barriers: capacity limit, decreasing marginal revenue and increasing marginal cost. Next few chapters will deal with markets where marginal revenue decrease with output and Chapter 11 will consider firms with increasing marginal cost. In this chapter marginal cost and marginal revenue are taken to be constant at the level in Figure 4 and the firm will keep expanding output until capacity is reached. The sum of differences between marginal revenue and marginal cost, represented by the area of the blue box, is the firm's gross profit (Figure 5). 1 Sales revenue, cost of inputs, and gross profit of public companies are published in their income statements. Economics and financial accounting. Many groups of individuals, within and outside the firm have to make decisions based on financial data like costs, sales revenue, assets and liabilities of the firm. Investors have to choose how much shares of the firm they want to hold in their portfolios. Financial institutions like banks, insurance companies and pension funds provide funds to the firm by loans or through purchases of its bonds and they use accounting information to evaluate the firm's financial condition. Suppliers who sold the company products on trade credit need assurance that they will receive the payment as per schedule. Customers who purchase durables like cars and computers have concerns about after sales service. The allocation of resources in an economy is guided by
1

Fixed cost, like the cost of financing existing plant and paying salaries to employees at the management level, do not change with output and do not enter into marginal cost. The plant has the capacity to produce so many units and dashes are to indicate that marginal cost and marginal revenues of in-between units. The height of the rectangles being the difference between marginal revenue and marginal cost, and the length of the side the number of units sold, their product measures the excess of revenue over cost for capacity output.

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Figure 6. Flow of information, funds and products. accounting data. The demand for financial information by these groups creates a supply. Firms generate financial accounting statements to stakeholders about the performance of its operations. Figure 6 shows the flow of information funds and products. The nature and amount of data supplied to outsiders will depend on the cost of generating and making public the information relative to the benefit from their publication like enhanced credibility with financial institutions and customers. Costs include expenses for collection, collation and distribution of the data. Competitors can use information about the firm to develop strategies that benefit them. Firms want to emphasize favorable information and gloss over unfavorable aspects of their performance. United States and most developed nations have financial agencies that promulgate regulations to ensure that the financial statements meet certain minimum standards. One of the challenges facing financial regulators in this age of global integrations is to make the national reporting requirements consistent with each other. The conventions and rules that are to be followed in the United States are known as Generally Accepted Accounting Principles (GAAP). Though quite elaborate to ensure that financial statements reflect the economic conditions and performance of the companies, GAAP leaves enough discretion to the firms in choosing accounting techniques and procedures that statements should be read with a critical mind. Among financial information released by publically owned companies, the income statement indicates how well the entity performed during a period. Part of the "2005 Income Statement" of the Model Corporation is reproduced in Table 1. 1

Table is constructed by simplifying the "Consolidated Statement of Income" of an American technology company. It illustrates the general format of such statements but specifics will vary among corporations.

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Operating Income of Model Corporation

for year ending in December 2005 Net Revenue Cost of goods sold Depreciation* Gross profit Marketing, general and administrative Research and development Amortization of intangibles Operating expenses Operating income

In millions

$39,000 $16,000 $4,300 $23,000 $5,700 $5,000 $100 $10,800 $12,200

Table 1. Model Corporation, Consolidated Statement of Income, 2005 Annual Report. * Depreciation is from Consolidated Statements of Cash Flows.

The first entry is net revenue defined as total sales revenue less returns by customers. Most sales are not for cash; the sales may occur in December 2005 but the buyer has 30 days to pay and settle the account in January 2006. The sales will be included the Income Statement under net revenues as it was earned in the year; cash will be recorded in the statement of cash flows when it is received. The buyer is allowed to return the product within a period and even if the product is returned in January 2006, it will be recorded as sales the income statement. Every now and then, a firm (or sales employees of the firm without the knowledge of its upper management) will bolster the bottom line in income statements by pushing customers (using their ongoing relations or offering incentives) to purchase more of the product at the end of an accounting period than they would otherwise do, knowing well that a portion of what is sold will be returned soon. By then the accounting period has ended and the sales figures for the past period are inflated by these tactics. Cost of goods sold is the sum of material, labor and overhead costs. The firms are unwilling to reveal detailed breakup of costs as it provides useful information to competitors and the income statement groups them together as cost of goods sold. Some technologies permit substitution of one input for another. In those cases, the firm has the opportunity to minimize costs. This result is examined in Chapter 11; here the technology is assumed to require fixed combination of inputs. Capital equipment wears out with use and becomes obsolete with time. Consider the case of an entrepreneur running a business from home. He purchases a car costing $35,000 for business purposes only. As he drives around to meet his clients, the car gets worn out and he realizes that after five years the car will not meet his needs. If he does not subtract from his revenues an amount to reflect the depreciation of the car, he is underestimating the cost of doing business and overestimating his income. Alternatively, he can estimate that the car will last five years and the end it can be sold for $10,000. The depreciation in the value of the car over five years is $25,000 and he accounts for it by setting aside $5,000 each year and treating depreciation as a cost of doing business. Accounting for depreciation requires a judgment. Instead of depreciating by the same amount per annum he can take a larger depreciation in the first year as cars lose value as soon as they are driven out of the dealership. Depreciation (and

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Net Income of Model Corporation

December 2005 In millions of dollars 12,200 600 11,600 4,000 7,600

Operating income Interest and other, net Income before taxes Provision for taxes Net Income

Table 2. Model Corporation, Consolidated Statement of Income, 2005 Annual Report.

obsolescence) is an estimate and US accounting rules permit the firm to choose from one of four schedules. Because of the special nature of this cost, it is listed separately. A technology oriented firm has to invest heavily in research and development to remain in the forefront; the income statement of the Model Corporation shows that its expense on research and development is one third of the cost-of-goods sold. Patents acquired through its research lose value over time; industrial patents have limited life and new ones makes earlier patents less valuable. Amortization of intangibles is the write down of values of intangibles like patents. All these items add up to operating expenses. The difference between gross profits and operating expenses measure the revenue generated by the operation of the firm and is listed as operating income (also referred to as net operating income). Out of this, the firm must meet the interest cost on loans, payment to bond holders and taxes. The next section considers the different concept of profitability. Measures of profitability. The firm has assets like the plant, inventory of finished and semi-finished products and offices. There is a cost involved in acquiring these assets and it has to be financed either equity of the owners or debt. Those who provided the funds expect payments in return (like interest on loans) and these payments should be treated as cost to the firm. Some assets are financed by debt. In borrowing the firm undertakes a legal obligation to pay fixed amounts at agreed times. Debt includes loans from banks and outstanding bills, notes and bonds issued by the firm and sold in financial markets. These payments take precedence over payments to equity holders. The Model Corporation had a net interest expense of $600 million in 2005 and this was paid out of the operating income (Table 2). On the income after paying interest, a corporation with limited liability like Model Corporation has to pay corporate taxes. The justification for the tax (at least when it was introduced) is that incorporated firms enjoy privileges like being recognized a legal entity separate from its owners and limited liabilities. Since this privilege conferred on it by the state, it should contribute to the state revenue and the Model Corporation has set aside $4,000 million for paying taxes. The balance is net income or accounting profits (as it is referred in economics) and is available for distribution to the owners. Because of the deductions of costs administrative costs and interest, the net income can be

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negative even if gross profit is positive. In that case the output that maximizes gross profit will minimize the loss after these deductions. Economists argue that accounting costs, calculated by deducting the cost of debt but not that of equity, do not reflect the true competitive position of the firm. Those who provided the equity to the firm will consider whether the return they receive from the firm (their share of the distribution of net income) matches what they can earn by investing their funds elsewhere. If the return equaled or exceeds that from other firms, then the investors will maintain their investment or even increase it. If it is lower, they will withdraw their funds; how quickly or easily they can do it depends on the organization of the firm. If the shares of the firm are traded in the stock market, they can sell them and prices of the shares will fluctuate with purchases and sales in the stock market. In a fully rational market, the share price should equal the discounted value of future dividends from the firm. Investor of a privately held firm will find it harder to dispose of the assets but they will seek to exit. Just as interest costs were reduced from operating income, economic analysis suggests that the return funds invested in the firm can earn elsewhere should be treated as a cost and deducted from net income. The difference, economic profit, is what enters into the decisions of the equity holders. In practice, comparison of returns among firms poses many problems. Unlike the interest on debt, return on equity fluctuates due to the conditions the firm faces in the output and input markets. Moreover, returns of some firms fluctuate more than that of others. Investment in them is considered risky. Investors demand a higher return for riskier investments than for those less so and the returns must be adjusted for differences in risk. If accounting numbers are to be interpreted with some caution, measures of economic profit should be viewed even more critically. Still investors have to take decisions about allocating their funds and some measure of economic profit is needed. Professional firms are adjusting accounting data and offering estimates of returns that are comparable. Economic Value Added, developed by a consulting group Stern Stewart & Co has achieved wide recognition. Relating profitability to output. The economic profit is calculated by deducting interest cost and what equity holder can earn elsewhere from the operating income. Even if a firm has a positive operating income, the firm can be functioning at a loss. Operating income and economic profit (or loss) varies with output. Four additional concepts - average revenue, average variable cost, average fixed cost and average cost -- are helpful in bringing out the relation between output and profitability. The total sales divided by units sold is the average revenue at that output; if changes in its output does not affect the price at which the product is sold, average revenue equals price. Cost of inputs like employment and raw materials that varies are with production is the variable cost; variable cost per unit of output is average variable cost. If marginal cost is constant as was for the technology of firms considered in this chapter, then the average variable cost is a constant (Figure 7). Expenses that are not variable with output including interest on debt and competitive return on equity are treated as fixed costs. Average fixed cost, fixed cost divided by output, decreases as output increases; same fixed costs are divided by larger output. The sum of average variable cost and average fixed costs is the average cost. If average revenue is less than the

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Figure 7.Variation of average cost with output average cost, each unit produced is bringing in less sales revenue than the cost of producing it; the firm is running at a loss. Still it may not want to close down production as long as average revenue is greater than the average variable cost; the firm is earning a positive operating income it can use to offset partially the fixed costs like debt payments and plant maintenance that cannot be avoided in short run. A 2006 article in FORTUNE analyzing the problems faced by Ford Motors illustrates how variation of the average cost with output determines profitability. 1 The average variable cost of a Ford vehicle is $15,000. The fixed cost is $57 billion and Ford was selling 6.6 million units. The average fixed cost, given the sales, is $8,636 making average cost $23,636. Price, average revenue, must exceed the average cost if Ford is to make a profit on vehicle sales. Consider what happens if the sales increase to 7 million units, a number close to Ford's output a few years earlier. The average fixed cost declines to $8,125 and reduces the average cost by $500. On sales of 7 million units, it amounts to an increase net income by $3.5 billion dollars. Facing declining sales in the first decade of twenty-first century, Chrysler, Ford and General Motors competed with each other by offering discounts, effectively reducing the average revenue. Since a shift in consumers' preferences resulted in a reduction of sales in spite of incentives, Ford and other automobile companies found themselves in a spiral of increasing average cost (as output decreased) and decreasing average revenue. Is it a wonder that the three companies ran up losses? The solution that was finally adopted was to reduce fixed costs by closing down plants and reducing capacity. Changing capacity If marginal revenue exceeds the marginal cost, the firm will produce at installed capacity as every additional unit adds to its gross profit. If the average revenue exceeds the average cost, then the firm is making an economic profit at capacity output. Why not increase the capacity and
1

FORTUNE (2006), pp.96-100.

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increase even more the profits of the firm? The firm adding to its capacity incurs the cost in the present and the benefit, increases in cash flow after meeting cost of production, is received in the future. Before comparison, the two cash flows must be discounted to the same period. Cash received next year is discounted to the present by multiplying it by the discount factor, 1/ (1 + interest rate expressed as a fraction); if cash is received two years from now, it is multiplied by the square of the discount factor. 1 In general, the discount factor is raised by the number of years before the receipt of the cash. Adding all the discounted cash flow gives the present value of future income flows. If the present value is greater than the cost of investment, then the owners benefit by expanding the firm. To make the calculation, the firm needs estimates of the cash receipts in the future and future cash flow is uncertain. One possibility is to ascertain the expected value for each year and discount it but it involves not only estimating the possible values of cash receipts each year but their probabilities as well. Decision makers frequently use an alternate approach of looking at stock prices of firms that face the same market condition. If the firm used for comparison has a dividend pattern that is similar to the cash flow from the capacity expansion, the price of the stock of the comparison firm will equal the present value of the cash flow of the investment. It can then be compared to the cost of capacity expansion. This assumes that capacity expansion is strictly based on market conditions that are not affected by actions of competitors. If two firms are competing intensively like Boeing and Airbus or Intel and AMD, each firm will respond to expansion by the other by expanding its capacity. Such a situation can be examined using game theory and is discussed in Chapter 12. The organization of the firm. Three considerations determine the organization of the firm: need for funds, ability to sell its products and managing the resources used in production. Organization of industrial activity in years leading up to the eighteenth century industrial revolution can be classified into four categories. 2 In the beginning, there were the tiny family workshops like that of the village blacksmith with the master and three or four others to assist him. Each shared the work without any clear differentiation of responsibilities and they had direct contact with the customers. In the second group are industries, most notably in textiles, individual workshops were liked by a supply chain managed by a merchant entrepreneur. He supplied the raw cotton or wool to the spinner. The spinner supplied yarn to weaver, and the weaver supplied clothes to the merchant-entrepreneur who pocketed the profit from selling the final product. The third group of industries, like in breweries, glass works and tanneries, the manufacturing was localized, in one building. Workers specialized on specific tasks and worked under supervision of owners. There were even small factories like paper-mills and saw-mills where grindstones and bellows were operated mechanically. The fourth group consists of
1

Discounting future cash flows was discussed in Chapter 4. Brudel, (2002), pp.298-302; 433-442.

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Figure 8. Liability under partnership and incorporation. manufacturing that uses machinery driven by running water and later by steam engines. They grew into the factories that became widespread in the nineteenth century onwards. In the process of production, costs are incurred and revenues generated. The organization of production should assign the responsibility for its liabilities and the rights to its revenues. From prehistoric times, family members shared the work in the farm and, after giving local barons the share of the harvest those were their due by law and customs, survived on what was left. Small workshops of the village blacksmith, cobbler or lace-maker were run as family enterprises with the family retaining the profits. Merchants involved in maritime trade that was both costly and risky, minimized the burden to each by forming partnerships. The partners contributed fund to host a single voyage in the Mediterranean and later to ports further away. Another innovation by trading companies was that the partnership was structured as unincorporated joint-stock companies in which members had shares in the joint or common stock. Partners could sell or buy the stocks. Manufacturing firms adopted this approach as production became increasingly mechanized and the cost of starting a business increased with the complexity of the technology and size of operations. Well into the nineteenth century most businesses were organized as partnerships; unlike partnership for voyages, it was not time bound. Partners are able to contribute more funds than individual entrepreneurs and the firm in many cases can benefit from the diverse expertise of partners - one good at overseeing manufacturing and other sales. One disadvantage is that the firm has no independent existence and the departure of one partner requires its dissolution and if its operations are to continue, reconstitution as another partnership. Another limitation is unlimited liability is that it puts the entire wealth of all partners at risk. Adrian and Neville are two individuals of unequal wealth who formed a partnership. In Figure 8, the size of their assets is represented by bundles of dollars; part invested in the firm is shaded red. Adrian invested two-thirds of his wealth in the firm. Neville invested only one-fifth of this

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wealth and, in spite of being wealthier, his investment is less than that of Adrian. If the firm is organized as a partnership and runs into financial distress, the creditors can seek to reclaim the losses from the assets of any of the partners. Neville's assets will be the preferred target as it is larger and less impaired by the loss of investment in the firm. He can end of losing his wealth altogether. The experiences of those who subscribed to the syndicates of Lloyd's of London are poignant reminders of the dangers of unlimited liability. Lloyd's is not a firm in the traditional sense; rather it serves as a meeting place where underwriters from syndicates for specific insurance contracts. Individual members known as "Names" commit to back the syndicate with their assets. To be a name was considered both prestigious and profitable and Names did not take the downside risk was not taken seriously. In the 1980s, Lloyd's ran into massive debts ($3.3 billion in 1989), putting the personal wealth of 50,000 names at risk. Many of them ended up in personal bankruptcy or close to it. Individuals will be reluctant to join partnerships for the risk of losing their assets. One solution to the conundrum is to separate the liabilities of the directors from that of other investors. Continental Europe recognized limited partnerships in which some partners were allowed to limit their exposure (to the liabilities of the firm) to the amount they subscribed to its capital, as long as they did not participate in the management of the firm; English law, however, did not recognize limited partnerships. The time was right for the fusion of the corporation and joint-stock company forms of business organizations to achieve first, the transferability of shares, next a separate identity for the business unit, and finally limited liability. In England, the Acts of 1844 made the incorporation of unlimited companies possible by registration, while the Act of 1856 permitted the formation of limited companies. During the nineteenth century other European nations enacted legislation enabling limited liability joint-stock companies. In 1811, New York adopted a general law of incorporation and the competition among states led to its general adoption by other states by the middle of the century. As long as manufacturing firms remained small, the owner or few partners directed and supervised its operation. The development of railways and steamships enlarged the geographical extent of markets and firms located in different cities began to compete with each other. Manufacturing operations grew in size and marketing became more sophisticated. The need for professional management led to the development of the hierarchy shown in Figure 6. Ever since the organizational structure has gone through cycles with the layers increasing some periods and being trimmed down in others Conclusion. Manufacturing plant has installed machinery that it uses to convert baskets of variable inputs like labor hours, energy and raw material into products that it sells. An increase in output for unit increase in a basket of inputs is the marginal product of the basket. Reversing the perspective, consider the increase in the input required to produce an extra unit of output. The cost of that basket of inputs is the marginal cost of the product. When the firm sells the product, the additional revenue it generates is the marginal revenue. As long as marginal revenue is greater than marginal cost, the firm has incentive to increase output. The

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tendency to expand output will be limited by capacity of the plant or by shrinkage of the difference between marginal revenue and marginal cost. In this chapter, marginal revenue and marginal cost will be taken as constants and the capacity is the binding factor in limiting output. Management, investors, financial institutions, suppliers and customers depend on data about the firm to make their decisions. The firm responds to the need by generating and publishing data; the type of data produced and published is determined by cost-benefit considerations. Cost arises from the resources devoted to generating it and from the data revealing the strategies of the firm to its competitors. Benefits arise from convincing the investors and financial institutions to provide funds at attractive rates and by assuring suppliers and customers of the continued solvency of the firm. Financial accounting provides information about the cost of inputs used in production, administrative and marketing expenses, expenses on research, interest payments and provision for corporate income tax. The sales revenue net of these expenses is net income or accounting profit. Those who subscribed to the equity of the firm needs a return that at least equals what they could earn elsewhere. In economics but not in accounting, this return is treated as a cost and economic profit is accounting profit less the required return to equity holders. The difficulty is that the return equity owners expect is not easy to ascertain as they also take into consideration the riskiness of the investment. Some companies are adjusting accounting information to provide investors returns that are comparable across companies. Profitability can be expressed in terms of average revenue and average cost. Average cost includes average variable cost and average fixed cost. If marginal cost is a constant, so will average variable cost but average fixed cost will decline with output. Companies with large fixed cost will run into loss even if their operating income is positive. Partnership provided advantage over individual ownership in being able to pool the financial resources and to benefit from the expertise of different partners. The limitation is that the total assets of each partner are exposed to the liabilities of the firm. Limited partnership limited liability of each partner to the amount subscribed to the capital of the firm. Joint stock companies with limited liability allowed individuals to invest in a firm going strictly by accounting and market information. In subsistence economies, production was within the family and for consumption. Development of factory system led to a separation between production and consumption. The joint stock companies created a separation between management and ownership. In addition to separation between and production, these companies created a separation between management and ownership. Selected Bibliography. Braudel (2002); Ford Corporation; The Economist (1993); Hongren et al (2006); Kalnins (2006): FORTUNE (2006); SBA Office of Advocacy (1998 ); The Wall Street Journal (1995).

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Chapter 7. Monopolist: the sole producer of a product.

The market is defined as an area where buyers and sellers are in such close contact that price of the same product trends quickly to equality. The size of the market (the number of buyers and sellers in it) increased with the improvements in transportation and development in communication technology. Today millions of households in United States who eat cereals at breakfast buy it from three producers: Kellogs, General Mills and Quaker. Does this imbalance in numbers (monopoly is an extreme case with one producer) put the consumers at a disadvantage by tilting the market process towards higher prices for products and higher profits for the producers? What norm is to be used in judging prices as high or low? Does the cost of production provide a benchmark for evaluating fairness of prices in a market? Should the government interfere in the market if prices are judged too high? Should promotion of competition be a goal in itself or are there circumstances that justify creation of monopolies? This chapter considers a market with one producer of a product and many consumers; subsequent chapters will consider those with more producers. Monopoly can prevail only if the firm is able to exclude competitors from the market. Governments through decrees or laws can create a monopoly and government owned or sponsored monopolies were quite common in the past. Among them state monopolies of salt achieved particular notoriety. Daily consumption of salt is a biological necessity and, before modern refrigeration, salting of meat and fish was the only means to preserve them. Since there are no known substitutes for salt, individuals have minimal flexibility in reducing its consumption as the price increases. Governments from France to China were quick to realize that they can exploit the dependence on salt to raise revenues by monopolizing either its production or trade and charging high prices. 1 The price of salt in France in 1630 was 14 times its cost of production; in 1710 it was 140 times the cost! 2 Many of the salt monopolies including those in France and Japan lasted well into the twentieth century but governments having developed other sources of revenue ceased inflating the price of salt to fill their budgetary gaps.

Figure 1. Consumers vs monopolist: the choices they have.

Kurlansky (2002), pp.11-12, 31-35; Laszlo (2001), pp.74-79. Laszlo (2001), p.77.

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Figure 2. Monopolist chooses his profit maximizing output. A market with a monopolist producer and many customers is illustrated in Figure 1. On one side of the market, the supply side, there is only one producer. The lack of competition, it is alleged, prompts him to charge a higher price than he would if he had competitors. While he can set a price, customers decide how much they will buy. It constrains him as his profit depend both on the price and the quantity sold. Each consumer chooses the basket that he prefers among all those he can afford to buy and the amount of a product in it will depend on its price relative to that of other goods. Consumers reduce the amount of a product when it price increases either by reducing its consumption or by substituting other goods that can satisfy the same needs. The sum-totals of the quantities demanded by individuals at various prices generate the market demand curve. The monopolist can choose either the price or the quantity he wants to sell and the demand curve will determine the other variable. He will make the choice that maximizes his profits. While in public discussions it is traditional to focus on the price monopolists charges, in economic analysis it is more intuitive to think of him as choosing the output. Next section analyzes his choice of the price-output combination that maximizes his profit. How it affects the welfare of the consumers and what policies public authorities should adopt in a market with one producer will be discussed in following sections. The choice of the monopolist. The relative levels of marginal revenue and marginal cost will determine the contribution an additional unit of output makes to the profit of the firm. The marginal cost, increase in total cost per unit increase in output, depends on the firm's technology and input prices and here, as in previous chapter, marginal cost is taken to be a constant. Marginal revenue is the increase in sales revenue per unit increase in output and its variation has to be analyzed (Figure 2).

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A decision to increase sales has a two-fold effect of total sales revenue of a monopolist. Additional units sold increases his sales revenue. But to achieve the sales, he has to slide down the demand curve and cut the price on all unit sold and it reduces the sales revenue. A simple example will bring out the principle which is valid in general. A monopolist is selling two bottles when price is $4. The firm, if it wants to increase the sales to three units has to reduce the price to $3.50. While the third bottle brought additional sales revenue of $3.50, the firm received $0.50 less from the sale of the other two. Marginal revenue, the increase in sales revenue, is 3.50 - 1 = $2.50. The price at which he can sell 4 units is $3 and the marginal revenue is $1.50. In Figure 2, Panel A, the heights of the green boxes measure the marginal revenue as output changes in discrete units. The height decreases with output, reflecting the decline in marginal revenue. 1 For continuous variation in output, Panel B shows the marginal revenue curve lying below the demand curve. The shape and position of the marginal revenue curve depend on that of the demand curve; if demand curve is a straight line as in Panel B, then the marginal revenue curve will also be a straight line that is twice as steep. The challenge for the monopolist is to choose the point on demand curve where his gross profit is a maximum. Economists noticed that for analytical purpose it is easier to visualize the monopolist's decision as one of choosing the output. As marginal revenue is decreasing with output, it will ultimately slide below the constant marginal cost and increasing output any further will reduce gross profit. Profit maximizing output for this firm is determined not by plant capacity but by declining marginal revenue. In case of continuous variation as in Panel B, the output is where the marginal revenue curve intersects the marginal cost curve. Normal profit or excess profit? To determine whether the monopolist is earning "excess profit," the distinction between gross profit and economic profit has to be reintroduced. Costs the firm has to incur other than that of inputs include administrative costs and the cost of obtaining funds either as debt or equity. If these costs exceed the gross profit, the firm is having a loss in spite of the surplus from its manufacturing operations. The size of the gross profit depends on the gap between constant marginal cost and price. To ascertain the influence of the demand for the product on this gap, consider the monopolist setting the price equal the marginal cost (zero gross profit); the price and output corresponds to the blue dot in Figure 2. As output exceeds the one that maximizes profit, he will want to reduce sales by increasing the price. The extent of the price increase depends on how sensitive consumers are to its change. 2 The more responsive the consumers are, the smaller will be the gap between price and marginal cost at the profit maximizing output; the gap expressed as a fraction of the price, Lerner's Index, is a measure of monopoly power.
1

Since marginal revenues at various outputs are less than the price at which they are sold, they must all lie below the downward sloping demand curve. This is possible only if they decline in general as output increases, though additional assumptions are needed to ensure that they decrease smoothly at all outputs. 2 The quantitative measure, elasticity (discussed in next section) relates infinitesimal changes in quantity and to infinitesimal changes in prices. Elasticity normally varies along the demand curve. To focus on monopolist's ability to charge a price higher than the marginal cost, it is assumed that elasticity is constant along the marginal revenue curve.

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Eurotunnel has a monopoly in linking British Isles to the Continent by a rail line. The idea of constructing a tunnel under the English Channel was floated more than 200 years ago. Yet concern that it might undermine the security of the United Kingdom held it up until the British and French governments signed an agreement in 1986 to build a 30 mile tunnel from Folkestone, England and Calais, France. The British Government insisted in not providing public funding for the project and a private British-French consortium, Channel Tunnel Group, won the bid to build the tunnel. As an engineering project, it was a major success and was awarded, according to Eurotunnel, the first prize among top ten construction projects of twentieth century. Like so many mega-projects around the world, its capital cost exceeded the original estimate and with it the cost of financing went up with it. 1 More than the cost increase, it was the unexpected low demand for rail transportation that hurt Eurotunnel. The ferries that linked the Island and the Continent cut their fares, shippers who had invested in moving goods through them were unwilling to change and consumers valued other benefits of taking the ferry like availability of duty-free liquor. Rail traffic when operations started in 1994 was half of what was projected and Eurotunnel's profitability was hurt by a shortfall in projected revenue. The resistance of potential customer drove Eurotunnel close to bankruptcy more than once as it was not able to meet its interest obligations much less provide a return to investors. If the firm succeeds in charging a price that ensures it high rate of return on its capital, others will try to enter the market by developing substitutes. Monopoly will last only as long as the firm is able to prevent entry by legal or strategic actions. Historically public policy has swung back and forth from supporting monopolies to restricting them. Governments have used monopolies to raise revenues or provide services that competitive firms will not be able to do. Examples of state conferring such privileges are: (1) the 1670 British Royal Charter to the Hudson Bay Company to explore vast areas of Canada; (2) utility laws that give a utility company monopoly to provide gas and electricity in a city; and (3) patent and copyright laws that confers temporary monopoly to innovators and authors. Periodically governments have responded to public concerns that monopolies are gorging the consumers and have enacted laws against monopolization. Recognizing the value of public policies, firms lobby legislators (in the old days ingratiate themselves to the monarchs) to enacting laws and regulations that protect them from competition. Recent efforts to extend intellectual property rights by allowing patenting of software and genetically engineered organisms are examples of such efforts. Lobbying is not limited to one side. Potential entrants lobby the legislature about the harmful effects of the monopoly enjoyed by the incumbent. Though there is no competition in the product market, there develops a competition in "influence market." In the end when the

Cost overruns are common for big infrastructure projects. An international comparison shows that the cost of bridges and tunnels exceed estimates by 34 per cent. Given the challenging nature of constructing Eurotunnel, the cost overurn of 80 per cent is not out of line. Anyway, it is much less than the other Anglo-French undertaking, the supersonic Concorde. "The cost of borrowing: why do big projects such as Eurotunnel find it difficult to make the numbers add up?" Financial Times, April 10, 1994 and "Eurotunnel shows us how big plans get derailed,: Financial Times, July 27, 2005.

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profits are dissipated though lobbying, neither the consumers nor the producer has benefited by the continuation of the monopoly. The English economist, John Hicks, commented that the best of all monopoly profits is quite life. He is not living every moment wondering what the competitors are planning and fearing that they will wipe out his profits. However the quite life can be for a short period if consumers are able to resist high prices and innovators are able to come with new products that circumvent the barriers to entry. The development of digital photography eroded the monopoly of Polaroid in instant photography. Quantitative measure of consumer responsiveness to price changes. The ability of the monopolist to increase price above the marginal cost depends on how sensitive consumers are to price increases. Given its role, a quantitative measure of consumer response is needed to derive analytical results and to develop appropriate policies. The rate of change of quantity demanded to a change in price suffers from the defect that it depends on units in which the product or price is measured. Consider a product sold in packages of two units. If rate of decrease in sales is 5 unit per dollar increase in price, the rate changes to 0.05 per cent if price is measured in pennies. To avoid the dependence of the response rate on units, both price and quantity changes are measured in percentages and price responsiveness measured as ratio of the proportional change in quantity to percentage change in price. 1 This ratio is known as the price elasticity of demand. Since the quantity demanded changes in the opposite direction to change in price, the ratio will be always negative. A negative sign creates a problem in relating the magnitude of elasticity with the sensitivity of consumers. If elasticity changes from -2 to -3, algebraically it has decreased as (-3) minus (-2) is -1. The consumers though are more sensitive to price increase when elasticity is -3 than when it is -2. Alfred Marshall suggested that the ratio of percentage changes be multiplied by - 1 to make the numbers positive; then higher elasticity indicates greater sensitivity to price. In this book, the Marshallian tradition will be followed though in United States more and more economists keep the negative sign. If price elasticity is greater than 1, the demand is said to be elastic; a reduction in price increases the sales by a higher percentage and the sales revenue will increase. Marginal revenue, the increase in sales revenue per unit increase in sales, is positive. 2 If the elasticity is less than one, the relationship between price change and change in sales revenue is reversed; it is an increase in price that leads to an increase in sales revenue. Though the price elasticity of demand for salt in nineteenth century France is not known, estimates of price elasticities for basic food products, in different countries and at different times, are all well

The demand for a product in the market increases from 2,000 units to 3,000 units when price decreases form $4 to $3. The percentage change in price is 100(3000-2000)/2000 or 50 per cent. The percentage change in price is 25. The ratio is 50/-25 or -2 and elasticity as defined by Marshall is 2. When the monopolist was increasing price above the marginal cost, his sales revenue was decreasing. His cost was decreasing faster (marginal cost was greater than marginal revenue) and his profits increased.
2

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Figure 3. Consumer surplus. below one. The low elasticity of demand is what allowed salt monopolies to raise revenue by increasing the price. Consumer surplus: a measure of benefits to consumer from exchange. When George the fisherman met Robert the farmer, he was surprised that Robert was willing to exchange more vegetables for a pound of fish than the minimum he would have demanded. 1 He was valuing the first pound of vegetables more than what it costs him to get it. The difference is "a surplus" that he obtained from the opportunity to exchange. In a market economy, the consumer exchanges dollars for what she purchases. A consumer, Madison, goes to the store and is surprised by the price of chicken: "Hey that is a bargain and I am going to buy it." The difference between what she was willing to pay and what she paid is a monetary measure of her "surplus." The price is fixed but as she buys more, her valuation of the additional purchases decreases. Still she benefitted from opportunity to trade as she moved to a preferred position. Madison purchases the basket along her budget line at which her marginal rate of substitution (the ratio at which she is willing to exchange one product for the other without affecting the level of her utility) equals the ratio of prices. As the price ratio decreases with a fall in the price of one product, she moves along the new budget line and purchases more of the product to reestablish the equality of the two ratios. Her downward sloping demand curve is shown in Figure 3. Consider discrete changes first. The price in the market was $6 and Madison will not buy the product as her valuation of the first unit is slightly below $6. She makes her first purchase of one unit when price comes down to $5. Though she paid only $5, her marginal valuation of the first unit is close to $6 and the difference is a gain from the trade. A monetary measure of the gain, consumer surplus is $1 times the quantity purchased (the light blue rectangle in Figure 3 on the left). Her marginal valuation of the second unit is slightly less than $5 and it takes another price reduction to $4 to make her buy another unit. Her surplus from the second unit is $1 and her surplus from the first unit increases
1

Chapter 3, Figure 4.

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Figure 4. Deadweight loss under monopoly. by another dollar. Her total surplus is now 2+ 1 = $3 and equals the area of the three blue rectangles. In case of continuous variation, Madison's marginal valuation changes continuously along the demand curve (as with the discrete case, the price at which she buys the last "incremental" quantity is taken as the marginal valuation). To find the total surplus, divide the total quantity purchased at the price shown in Figure 3 into small segments (as between the white lines) and take the area of the strip - the product of the height of the demand curve over price and the incremental quantity - as a measure of the surplus from that incremental change in quantity. Add up the area of all such strips and the area of the blue triangle is a measure of the consumer surplus. The market demand curve is obtained by adding the quantities individual consumers purchase at each of the prices. Does it imply that the surplus under the individual demand curves can be added to measure the consumer surplus generated by the market? There are serious objections to it as each individual surplus is dependent on his or her preferences. The liberal belief is that preferences being specific to individuals, interpersonal comparisons and aggregation across individuals are not admissible. Those involved in policy analysis, like costbenefit analysis of public projects, argue that consumer surplus can be used as an approximation. One application in industrial organization is to evaluate the welfare cost of monopoly. Deadweight loss: cost of monopoly and certain public policies. A monopolist sells the profit maximizing output at a price higher than the marginal cost (Panel B of Figures 2 and 4). The higher price relative to marginal cost has two-fold effect on consumer surplus: it leads consumers to reduce their purchases and the height differences between the price line and demand curve at various levels of output are narrowed.

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This is brought the numerical example of Panel A of Figure 4. If marginal cost to the producer is $4 and price equals marginal cost, Madison will purchase 2 units and the consumer surplus is, as calculated in Figure 3, is $3. If the monopolist increases the price above marginal cost to $5, Madison will reduce her consumption to 1 unit and consumer surplus is only $1. The monopolist will have a gross profit (yellow square) of $1. The reduction of consumer surplus by $2 is not matched by increase in monopolist's profit and the difference (grey square) is a deadweight loss to the society. Continuous variation in price and quantity is shown in Panel B. The monopolist will set the output at the level where marginal revenue equals marginal cost and the price at which he sells it will be higher than marginal cost. The reduction in output is shown in Figure 4 as the distance between sales at marginal cost and at monopoly price. The loss in consumer surplus not matched with increase in monopolist's profit, the deadweight loss, is as in the discrete case is the grey area (a triangle if the demand curve is a straight line). Redistribution from consumers to the producer to be considered unfair on equity grounds but it cannot be approved or condoned on efficiency grounds. A departure from efficiency requires that some are worse off without others being made better off. In the case of monopoly, the increase in profits of the firm is less than the decreases in consumer surplus by the grey triangle. That the difference is a deadweight loss can be made clear by considering a hypothetical negotiation between producer and consumers. Let the monopolist agree to reduce the price to marginal cost on the understanding that consumers will voluntarily transfer the amount equal to the yellow rectangle back to him. Producing a larger output increases his cost of production but it is matched by an increase in sales revenue. The reduction in profits because of lower price is made up by the transfer from consumers. The proposed arrangement neither benefits nor hurts him while consumers find their surplus increasing by the grey area. The cost of monopoly to the society, its deadweight cost, is the grey triangle. Monopoly is not the only source of deadweight loss. The taxes can create a deadweight loss by making consumers pay a higher price than what the producer receives. If a product is sold at the marginal cost of $10 and a tax of 10 per cent is imposed on it, the price consumers have to pay is $11. It reduces their consumer's surplus. The producers are selling less and their profits are reduced. The government raises tax revenue and, even if it is used in most efficient way to promote the welfare of the citizens, there is a deadweight loss due to higher price paid by consumers. This is true when tariffs increases the price consumers have to pay for foreign goods that are imported and leads them to substitute home goods that are more expensive. In the past, the need for income and the belief that the economic and strategic interests of a nation requires protecting its industries were explanations offered as reasons for imposing tariff duties. After the Second World War, the Allied nations did not want to repeat the competitive tariff increases of the interwar years and all industrial economies of Europe and in the United States agreed to reduce tariff under the 1947 General Agreement on Tariffs and Trade. Subsequently the World Trade Organization took the role of making nations agreeing to reduction of barriers to international trade. The calculation of deadweight loss due to tariffs on different goods is complicated as it requires the elasticities of demand for various imported goods. For the United States with its

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large internal economy, the estimates for the economy as a whole are rather low at around 0.1 per cent of the total value of all goods produced (gross national product) in United States. 1 When specific sectors - automobile, computers and textiles are examples - faced severe competition from foreign producers, owners and workers of firms in these industries exerted political pressure on the administration and congress to protect them either through tariffs or quantitative restrictions. The benefits to owners and worker should be balanced against cost to consumers. After the Oil Shock of 1973, consumers started shifting to the smaller Japanese cars with higher mileage. American producers had to cut production, creating excess capacity in the plants and unemployment. Detroit and neighboring areas took the blunt of this downturn. Fear that political pressure is building to impose trade restriction led the Japanese government in March 1981 to announce a voluntary quota on exports of Japanese automobiles to the United States. The quota amounted to a 7.7 per cent reduction over previous levels. The estimated cost to consumers based on various elasticities and on the initial level of demand ranged from $1 to $6 billion. More revealing is that the cost per job saved ranged from $95,000 to $220,000, well above the average income of an American. 2 Those who are hurt by international trade are concentrated in a few industries and regions and they are able to form action groups to pressure politicians to act. Consumers though more numerous are too spread out, have no contact with each other and are not able to organize. Economists argue that cost to consumers should be considered before adopting policy measures that increase price or restrict availability. In United States, the Council of Economic Advisors has acted as a counterweight to pressure groups and has consistently supported freer trade. Instead of conferring such privileges, should the government, given its mandate to promote the welfare of the citizens, enact laws and regulations to prohibit anti-competitive strategies of firms? Patent: monopoly as incentive for innovation. From the dawn of civilization, rulers recognized the value of patronizing arts and sciences. Literature and visual arts were mostly devoted to glorifying them. Success in war required developing new military technology. Agriculture being the main source of income, rules brought new land under agriculture through irrigation system like the one that watered the river valleys of Euphrates-Tigris and Nile. Construction technology developed as state and religion were committed to monumental architecture from pyramids to temples and palace. European courts became even more active in patronage as the pace of innovations increased around the Renaissance. Today universities and research institutes receive grants to undertake research. Another way of rewarding individual innovators is to offer prizes. In 1714, the British Parliament established a prize for one who can devise a way to determine of a ship's longitude with great precision. It was awarded to John Harrison though not without some reluctance as his method differed from what conventional wisdom considered appropriate. 3
1
2 3

Irwin (2010), p.113. Nelson (1996), p.38. Sobel (1995)

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Initially patents were bestowed as special favors by the monarch but criticism that such awards were based on favoritism than on merits led to establishing a formal process for patenting beginning with the Venetian statute of 1474 and the English Statute of Monopolies of 1623. The advantage of patent system over grants and prizes to innovators is that the reward is determined by competition in the market and not by an administrative process. The reward he receives - the profits from exploiting the innovation which he alone is authorized to do - is a cost to the users of the invention and not to the general taxpayer. The reason for bestowing a monopoly on the innovator is that he has to meet the cost of development upfront. Once a new product or manufacturing technique is developed and made public, others can quickly mimic it. The resulting competition brings the price of the product or output of the innovative process down to its cost of production and the investor who incurred the developmental cost has no opportunity to recover it. This happened to two of the eighteenth century pioneers in industrial revolution. Industrial revolution in England began with gradual mechanization of the cotton textile manufacturing. Handlooms needed the weaver to reach for the tread on both sides of the loom and that limited the width of the cloth. In 1733 John Kay invented "the flying shuttle" allowing weaving broader cloths by freeing the weaver from using both hands to pass the tread and more than doubled the productivity of weavers. Though Kay took a patent, the weavers refused to pay him the royalties and the cost of litigation to recover them actually ruined him. He petitioned the British Parliament for an Act to let him recoup his royalties but failing to get the response he expected, went to France where the government awarded him a pension. Faster weaving increased the demand for yarn and there was an urgency to mechanize spinning. Who made the breakthrough is still debated. The accepted version is that John Hargreaves discovered "spinning jenny" which allowed many looms to be worked by one person. The counterclaim is that Thomas High had developed it two years earlier but could not afford to patent it. The introduction of "water frame" by Richard Arkwright, a barber and wigmaker, in 1769 was decisive step in the mechanization of the textile industry. Arkwright's patent was rescinded in 1785 but he was a successful businessman, built many mills and, unlike the earlier inventors, accumulated a fortune. The next major innovation was by Samuel Crompton when he combined elements of the jenny and the frame in his "mule." Crompton was born in a poor family and had to contribute to the support of his family at the age of 15 by working on the spinning jenny. Recognizing that he can improve on it, he worked secretly for five years during which time he financed his experiments by playing violin at a local bar. He was too poor to take out a patent on the machine and even if he had attempted the broad patent that Arkwright had would have involved him in a costly litigation. He tried to raise subscription from those who used the mule but the first effort was a failure though later some Manchester merchants raised 500. He submitted a petition to the British Parliament showing that more than eighty per cent of spindles then in use were based on his mule. The Parliament awarded him a grant of 5,000. His effort to get into business failed and he survived on an annuity his friends brought him without his knowledge. Together the four innovations - flying shuttle, spinning jenny, water frame and the mule - increased the productivity of a labor 25 times. Yet two of the innovators died in penury. The expenditures firms have to incur to remain in the forefront of technological race are increasing over time. The Model Corporation spent $5,000 million on research and development in 2005 and similar expenditure are incurred in other years. In pharmaceutical industry, one

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study estimates the cost of development of a new drug as $403 million (2000 dollars). If the interest cost accumulated on the funds invested during the long interval of time from the early stages of development to approval of a drug is included, it can be as high as $802 million.1 Patent gives the innovator property rights to his innovation. If there is sufficient demand for the new product, the innovator can be either earn monopoly profit as the sole produce or receive royalty by licensing the innovation to others. 2 The higher profit stream last as long as the patent lasts or until newer technologies make the innovation redundant. What is the benefit to the society in creating a temporary monopoly as a matter of public policy? When a new product comes into the market, the consumers who switch to it values it more than the existing products and they are choosing a basket that is preferred to what they had before. This benefit must be balanced against the cost of creating a monopoly. The state must also decide on the "length and breadth" of the patent and consider how the decisions affect future innovations too. In the ending decades of the twentieth century, the United States, concerned with falling behind other nations in technological race, strengthened patent protection. In 1994, it joined other members of the World Trade Organization in signing the "Trade Related Aspects of Intellectual Property Rights" (TRIPS) that set the life of a patent at 20 years. The Hatch-Waxman Act added five year lost in premarket testing and Food and Drug Administration approval process and eliminated duplicative testing of generic drugs. In addition, through court judgments, patents for genetically engineered bacteria and business practices like Amazon's one-click Internet ordering were declared patentable. The United States set up a Court of Appeals of the Federal Circuit to bring specialized expertise and expedite cases about patent validity or infringement. Looking forward, the effect of patent on further innovations must be judged. A broad patent can inhibit others from developing products or processes that are improvements of the current one. A monopolist has the privilege of being the one and only. Yet in a society that promotes technological innovation and economic growth, the peace of mind from monopoly can be fleeting. His life is akin to that of a dictator of a small island who is fighting the erosion of his shores. Competitors are ever threatening him new products and customers take every opportunity to switch to products that offer value. Public resentment of monopoly and antitrust laws. Public policies have supported and opposed monopolies. Having considered the arguments for permitting monopolies, consider the one for limiting them. Opposition to monopolies has a long history. In 81 B.C. the Chinese emperor called on 60 nobles to debate on appropriateness of state owned iron and salt monopolies. The nobles split into two opposing groups. The Confucians argued that charging monopoly prices were not befitting a just state while the
1

Cost of new medicines, DiMasi, Hansen and Grabowski (2003). The data on Model Corporation is from Table 1 on page 81. 2 It is the consumer preference for the product that is the source of profit. In 1975 Sony introduced Betamax, the first home video cassette recorder. Within a year, JVC introduced the VHS format and consumer preference for the longer playing VHS tapes resulted in it becoming the standard in spite of Sony's early introduction, superior technology and patent rights. Licensing is common in some industries like semiconductor and biotechnology.

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legalists considered them necessary for raising revenues needed to maintain a strong state. In the end the monopolies were continued. 1 In his 483 A.D. edict, Zeno, the Emperor of Eastern Roman Empire, banned monopolies even if an Emperor had authorized them in the past. This prohibition Adam Smith was opposed to large state chartered corporations like British East India Company and Hudson's Bay Company that dominated international trade during his time. He made an impassioned plea for freedom in commerce. 2 "A monopoly granted to either an individual or to a trading company has the same effect as a secret in trade or manufactures. The monopolists, by keeping the market constantly under-stocked, by never fully supplying the effectual demand, sell their commodities much above the natural price, and raise the emoluments, whether they consist of wages or profits, greatly above their natural rate. The price of monopoly is every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion, but for any considerable period." A sympathetic reading of this passage in a pioneering work written more than 200 years ago would make natural price equal to cost of production including competitive return to equity investors. The output of the monopolist is less than what would be sold at marginal cost and in that sense he keeps "the market constantly under-stocked." But the claim that monopoly charges the highest price is refuted by Figures 1 and 2. Monopoly is an extreme example of a market with one supplier and many consumers. Even if there are a few producers, the fear is that the imbalance in numbers and ability of a few to form alliances to their benefit will hurt the consumers. Such concerns reached a critical level in the United States at the end of nineteenth century. Around that time, the United States economy was going through a transformation. The development in transportation and telecommunication merged local markets into one large national market. The capital market became capable of raising the required capital to acquire the stocks of other firms while technological changes gave a cost advantage for large scale production. The same factors created price instability. Firms well entrenched in local markets were now exposed to competition from firms far away. Firms around the nation were increasing their installed capacities to make use of the economies of new technologies. Jointly they led to periods of boom and burst in the markets. In railways and oil industry, firms formed cartels - association among firms to maximize their collective profits - to stabilize prices but at the cost to sectors like farmers that use their products and services. Public resentment against cartels become strong enough for the Congress to enact Sherman Act of 1890 and the United States became pioneer in policies to promote competition. The Act prohibits contracts combinations and conspiracies to restrain trade and prohibits monopolization, or attempts to monopolize. A legal nicety that has economic significance is that
1 2

Kurlansky (2002), pp.28-35. Smith (1937), p.61.

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having a monopoly position in itself is not illegal. In the first major decision under this act, the Supreme Court in 1987 ruled the price agreement among 18 railway companies illegal. In 1911, the Court ruled against manufactures requiring sellers to sell above a minimum price. The Standard Oil Trust formed by John D. Rockefeller controlled at the end of nineteenth century 80 per cent of the refining and 90 per cent of the oil pipelines in the United States. 1 There was public hue and cry that it was not only a monopoly but that it was formed by destroying competitors through ruinous price cutting (predatory price cutting) and other unethical business practices. In 1911 Supreme Court issued a decree dissolving the Trust into 38 companies. The Sherman Act did not prohibit companies from merging into a single firm and many cartels circumvented the act by merging. Clayton Act of 1914 was the first of few acts that extended the scope of the laws restricting anti-competitive practices. It prohibited mergers to reduce competition. Subsequently antitrust policies restricted other practices like price discrimination. If a firm discriminates by offering different prices, then there has to be an economic justification like low costs for large orders. Finally it allowed firms hurt by illegal practices to sue for triple damages (three times actual damages plus attorney fees). The Federal Trade Commission established in 1914 by an act of the Congress and the Commission and the Antitrust Division of the Department of Justice are empowered to enforce the antitrust laws. The level of enforcement has varied over time responding to economic and political climates. Developments in economic analysis have refined the understanding of what constitutes anticompetitive practices. In contrast Germany at during the turn of twentieth century was favoring cartels as a way to control instability. The first restrictions were introduced after the hyperinflation following the First World War. It did not limit cartel but only policies that use market power to increase prices. After the Great Depression cartels were made compulsory for firms in many industries and Nazi regime used it as a tool to control nations industries. After the Second World War, the Allies wanted to impose laws against cartels but their enthusiasm faded as a strong Germany was considered a necessary bulwark against the Soviet Union. In 1957, after long debate Germany finally passed a competition law. The Treaty of Paris that created the European Coal and Steel Community in 1951 included a number of pro-competitive measures. The dominant motivation was to diminish German power by making available essential iron and coal to other European nations. The other motivation was recognition that competition is the way to attain efficiency in market allocation of resources. The competition policy of the European Union is built on the same principles. It calls for a system that does not distort internal markets and prohibits discrimination on national grounds. But it exempts cartels formed to eliminate excess capacity in a permanent way. The competition policy gives a favorable treatment to small and medium firms. The subsidies they receive from the state are not considered to affect trade and competition in the Common Market. The early case laws under the Sherman and Clayton tended to judge mergers or pricing policies like volume discount on the intent of the law and not their impact on the welfare of consumers and producers. If merger creates efficiencies by reducing fixed or marginal costs, would it justify the merger? There are two difficulties in using welfare criteria. The first is that
1

Miller (2003), p.267.

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the companies will always claim large efficiencies but they are hard to measure and will only be realized, if at all, only long after the action was approved. Next there is a distributional question whether the gains for producers should be given equal weight as to consumers. If a merger reduces fixed cost by eliminating excess capacity but do not change marginal cost or price, is the increase in profits of the firm a justification for the merger? Two or more firms were competing and pricing their product at marginal cost. Their merger leads to a reduction in marginal cost but it creates a monopoly and price now not only exceeds the new marginal cost but even the old marginal cost (and price), should the merger be approved as increase in profits outweigh the decrease in consumer surplus? Since Williamson (1968) raised these questions they are being debated. Since 1980, the level of economic sophistication in the guidelines issued by Department of Justice and the Federal Trade Commission has increased dramatically. Yet the issues are so complex that the guidelines had to adopt intuitive measures to guide decisions. The European Union guidelines resemble that of U.S. in many respects. Given its origin in fear that a firm or firms will dominate the market, the European Union guidelines place greater emphasize on the market of the merged firm than U.S. guidelines. The cost of challenging the decision by Department of Justice or Federal Trade Commission in U.S. or Competition Director General of European Union in court is so high that few firms pursue it. Summing up. A monopolist, as the sole producer, is constrained by the market demand curve. He can set the price and sell what consumers demand at that price or decide on what he wants to produce and sell and let the market demand curve determine the price. His technology is assumed to be such that the marginal cost is a constant. He has to reduce the price to sell a larger quantity and the marginal revenue lies below the demand curve and, at each output, it is less than the price. He will maximize his profit when he produces an output at which marginal cost equals marginal revenue. The price will exceed marginal cost and the difference will depend on how sensitive consumers are to price increases. A measure, price elasticity of demand is constructed to measure consumer sensitivity to price changes. Consumer surplus is a measure of the benefit from being able to purchase goods. As price increases reduce the quantity purchased, it decreases more than the increase in profits of the producers. The difference is a measure of the deadweight loss due to monopoly. Currently laws allow the innovator to have a monopoly of his product or process. The higher profit is an incentive to innovators. The length and breadth of the patent should balance the cost to the consumer with the benefits of providing incentive to innovators. The public resentment against monopoly has led even ancient monarchs to adopt policies to limit them. Today the antitrust policies in the United States and competition policies of European Union set the model for limiting ability of firms to form monopolies.

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Selected bibliography. Carlton and Perloff (2000); DiMasi, Hansen and Grabowski(2003); Irwin (2010); Kalnins (2006); Kurlansky (2002); Laszlo (2001); McGee (1958); Miller (2003); Motto (2004); Mund (1933); Nelson (1966); Sobel (1995); Smith (1937); Whinston (2007); and Williamson (1968)

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Chapter 8. One product, many prices.

Nothing is more exasperating than to find out that we paid more than others for the same goods. Yet selling a product at different prices is endemic in modern economies. Prices of groceries vary among neighboring stores. When we drive up to gas stations, we find stations within a block charging different prices. Airline fare depends on the time of purchase, the time of travel and the length of the trip and it is not uncommon for passengers sitting next to each other in commercial flights paying very different fares. 1 The 43 million Americans without health insurance and many more whose insurance do not cover drugs try to save by purchasing generic version of drugs but variation in prices from one drug store to the other makes it hard to get the best prices. A Wall Street Journal survey shows that price of 30 tablets of 20 mg Simvastatin, the generic equivalent of the widely prescribed cholesterol reducing medication Zocor, is as high as $89.99 at a drug store and as low as $6.99 at a pharmacy within a wholesale club. 2 Another example is the grey market in electronic goods; products sold at lower price abroad are re-exported to the United States and sold at stores specializing in such goods at prices lower than the same goods directly exported to the United States by authorized retailers. A market, by definition, brings buyers and sellers together and moves the prices of same goods easily and quickly to equality. Why is it that process not working in cases of price discrimination? How can producers segment the market and prevent the price of the same product equalizing across segments? How do producers determine the segmentation of the market? Since producers adopt different strategies to segment the market, depending on the preferences of the consumers and the information they are able to obtain about consumers, a number of specific forms of market segmenting and segment pricing have to be considered separately. Segmenting markets by characteristics of consumers. Consumers make their decisions based on their preferences, their incomes and the prices of goods. Preferences of a consumer are known only to him or her. Firms depend on consumers for their revenue and not knowing price sensitivity is a limitation in planning production and choosing pricing schedules. To obtain additional information on the preferences of consumers, firms adopt one of two strategies. Firms stratify consumers using information about demographics, family status and income obtained from sources like the U.S. Census Bureau and hope that this stratification corresponds to consumers' ability and willingness to pay. The other

The question, "What is a commodity?" has to be addressed. Is a trip between two airports purchased just before the flight the same commodity as one purchased two weeks in advance? Tagging commodities by different characteristics is useful in many contexts but, by common usage and economic analysis, trips in the same class in one plane are not differentiated. The Journal reports that stores were changing prices even as they were being asked about them while denying that the survey prompted the change.

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Figure 1. Observable and unobservable characteristics of consumers. strategy is to develop a schedule of prices that would make consumers with low price sensitivity self-select into groups that pay higher prices. Airlines, in addition to using weekend stay as an observable criterion to distinguish business and leisure travelers, also use how advance of travel booking are made as another observable criterion. Business trips, unlike vacations, are snap decisions made as opportunities arise. Accordingly airlines charge higher fares to those who do not make advance reservations. Following English economist Joan Robinson, the market - group of sellers and buyers - with a higher price is referred to as the strong market and the one with a lower price as the weak market. Firms use a different strategy when they offer a schedule with two or more prices that are so structured as to induce consumers with different price sensitivities to choose one of the pricequantity combinations. One scheme is to charge a lower price for the second unit if purchased together. Another schedule charges a lump-sum charge for every consumer upfront and then a per-unit price; as the lump-sum charge is spread over more units, the average price per-unit price vary with quantities purchased. Under uniform pricing, the monopolist will produce the output at which marginal cost equals marginal revenue and the demand curve will determine the price. If he decides to adopt price discrimination, he has to determine the output in different segments given the demand by consumers in the segments. If more than one firm competes in the segment, each firm has to consider the strategies of its competitors. Each of the sections below will consider one form of price discrimination under monopoly and then examine how it is modified by the existence of competition among firms.

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Price discrimination by observable characteristics of consumers. The demand curve of the monopolist is the demand curve for the product in the market and slopes downwards to the right. The marginal revenue curve lies below it. The technology of the firm is such that the marginal cost, as shown by the height of the horizontal marginal cost curve, is constant for all levels of output. Price is given by the height of the demand curve right above the intersection of marginal revenue and marginal cost curves. Monopoly price, as shown in last chapter, exceeds the marginal cost. The difference between price and marginal cost depends on the sensitivity of consumers to price changes as measured price elasticity (ratio of the percentage change in quantity demanded to percentage change in price). 1 Less responsive the customers are to price increase, the higher is the price that the monopolist finds it profitable to change for his product. Price discrimination based on price responsiveness of consumers. The firm examines the possibility of increasing its profits by dividing the market into two and charging different prices. The first step is to identify the subset of its consumers with low elasticity of demand that can be charged a higher price relative to the constant marginal cost. In this section we will consider firms using observable characteristics of consumers to segment the market. Stores, in giving discounts to students and senior citizens, are assuming that those who are not working and earning an income are more sensitive to price increases. They use student IDs and driver licenses to identify those who are in the "weak market" and prevent those in "the strong market" from crossing over. Having segregated the market, the monopolist has two markets to supply. It must make two interrelated decisions: choose its output and decide how the output is partitioned between the markets. 2 These decisions together with the demand curves in the two markets will determine the prices. Taking division of output first, consider the monopolist shifting one unit of a given output from Market 2 to Market 1. The sales revenue from Market 1 will increase and sales revenue from Market 2 will decrease by the marginal revenues in these markets. If marginal revenues differ, the firm can increases sales revenue by shifting sales to the one with higher marginal revenue. These transfers make the firm slide down the marginal revenue curve in the market to which it transfers the product and up the curve in the other (Figure 2).

Defining price elasticity as the negative of the ratio of proportionate change in quantity to proportionate change in price, the relation between the excess of price over marginal cost is given by the Lerner index: (price - marginal cost)/price = (1/price elasticity). The college student, the pensioner and the employed are all in the same locality. Geographical distance between markets is considered in a later section.
2

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Figure 2. Segmenting markets for price discrimination. Ultimately the two marginal revenues will equal each other, exhausting possibilities for further profitable transfers. Once common marginal revenue is established by the allocation process, choice of output becomes clearer. If the common marginal revenue is greater than the marginal cost, the firm can increase profit by increasing output and allocating the extra output between the markets. The two decision processes together determine the total output and how much of it is sold in each of the two markets. Since the monopolist has the option of charging the same price, it is obvious that he will introduce price discrimination only if it increases his profits. The welfare of consumers may increase or decrease depending on changes in output. Utility maximization leads to consumers equating marginal rate of substitution between any two goods to the ratio of their prices. Take any product other than that of the monopolist that consumers buy. Since the monopolist has divided consumers into two markets and is charging different prices, consumers in each market will equate their marginal rate of substitution to the ratio of the monopolist's price in that market to the price of the other product. The marginal rate of substitution in strong market will be different from that in the weak market. An economy is efficient in the sense formulated by Vilfredo Pareto if two consumers are not able to make an exchange that improves both or at least improve one without hurting the other. Since price ratios between the monopoly product and the other product differ by the segments, there are exchanges that can benefit both. 1 However without the ability to charge higher price in one market, the monopolist may not be willing to serve the weak market; without a higher price for hard bound volumes, publishers will not be able to sell paperbacks. As he withdraws from the weak market, consumers in that market are not able to buy the product. Price discrimination reverses this condition and opens new markets and increases output. Then welfare may increase depending on the specific circumstances prevailing in the markets.

If the marginal rates of substitution of consumers are not the same, Consumer 1 who has Product 1 is willing to give up more of it for a unit of Product 2 than what Consumer 2 demands. They can agree to an exchange that benefits at least one and possibly both.

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Segmenting markets by geographical distance from plant.

Figure 3. Delivered price: mill price plus freight. When an individual order goods over the phone or internet, he is billed for the product and for shipping and freight. Many of the products brought in stores are manufactured at plants far away and have to be transported to the stores. In each of these cases, the consumers are buying not only the product but the transportation service to where the customer is. It is intuitive to think of the delivered price paid by the customer as the sum of two prices: the price of the product and the price of transportation services (Figure 3). Consider a monopolist who has decided on a fixed price at his plant - fob price - and expects the consumer to pay the freight to the place of delivery. In the example, customers are clustered in two locations, the Near Market and Distant Market. In this section, the distance from the plant provides a natural segmentation of consumers. Under the pricing scheme in Figure 3, the firm charges a fixed fob price at the plant and adds the transportation cost to determine delivered price to customers in the two markets. If the firm chooses the price at the plant, then the quantities sold in the two markets are determined by their demand curve and the price the customers have to pay. The customers in Distant Market will have to pay a higher delivered price than those in the Near Market The pricing scheme does not take into consideration the differences in the demand conditions in the two markets. Will smoothen out the price difference, by charging more in the Near Market and less in the Distant Market increase his profits? To reduce costs to the customers in the Distant Market, the firm charges a lower fob price to the shipments there and a higher fob price to the Near Market. Depending on the price sensitivity of the customers in the two markets, the profitability from increased sales in Distant Market can make up for the reduction in the Near Market (Figure 4)

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Figure 4. Price discrimination between geographically separated markets.

Assuming demand curves are identical in both markets and that they are linear, the difference between the delivered prices in the two markets will be half of the additional transportation cost between the two markets. Analysis of efficiency is complicated by the freight charges. Consumers in the two markets adjust the quantity demanded to the delivered prices they have to pay. Equality of marginal rates of substitution among all consumers is not feasible as prices differ with distance from the plant. One conclusion drawn in the literature is that price discrimination by charging different fob prices to different markets is not efficient. Plasterboard in United Kingdom and cement in Belgium are delivered to customers at fixed prices irrespective of how far they are from the plant. Both products have high transportation costs; for plasterboard it is about 13 per cent of the price and for cement it ranges, depending on distance, from 10 to 40 percent of price. The London Brick Company is a monopoly and follows zonal pricing; they charge a uniform prize within zones 5 miles wide. In all the three cases, those close to the plant are subsidizing those further away. 1 Figure 4 made two specific assumptions: consumers are charged freight from the point of production and there is only one firm. When there are more firms, they may agree on pricing scheme that no one benefits from nearness to customers. Under the "Pittsburg plus" pricing that U.S. steel industry, irrespective of where the steel plant serving a customer is located, the price included freight from Pittsburg; a Chicago customer purchasing steel from a local plant was changed "phantom" freight from Pittsburg. The pricing scheme was abandoned in 1924, when U.S. courts ruled against it. The European Coal and Steel Community use multiple base point pricing and the resulting price schedule is very complex.

Phlips (1981), pp.23-30.

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Price discrimination under competition.

Figure 5. Price discrimination in competitive markets. When there is competition, the firms segmenting the market have not only to consider the elasticities in these markets but also the pricing adopted by their competitors. If Firm A and Firm B consider one market to be the strong market the other to be the weak market, both will charge high prices in the first market and low price in the second. Both firms agree that students and senior citizens are in the weak market and those in working years are in the strong market and both offer discounts to the first group of customers. Even though it is not necessarily true, price discrimination can lead to an increase profits. However the strong market for one firm may be the weak market for the other. One possibility is that the location of a firm gives it an advantage in one market. If, in Figure 4, a second firm is located in the right side of Distant Market, then it has an advantage in that market compared to the firm at the left end. The distance, instead of being in geometrical space, can be in characteristic space. American automobile companies dominated the market for large sedans and SUVs preferred by certain buyers; it was their strong market. They were weak in the market for energy-efficient smaller cars where Japanese and other foreign automobile companies had an advantage. But some customers will switch to the small cars if the U.S. car manufactures charge a high price in the strong market. Competition exerts a downward pull on the prices in the strong market. In contrast to price discrimination under monopoly, the competition between the two firms will, if it is intense, lower prices of both products below the uniform prices the two firms would have charged. Profits may be less than under uniform pricing. II. Price discrimination based on unobserved characteristics of consumers. Over and beyond the observable characteristics like age, employment and distance from the plant, consumers have other characteristics that cannot be observed by producers. Yet they provide opportunities for profit-enhancing price discrimination. A firm, even though it cannot observe the price sensitivity of its customers can induce them to self-select into groups according to their price elasticities and charge a higher price to those with relatively inelastic demand.

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Letting consumers who are deal-prone self-select. Manufacturers and stores distribute coupons that offer a discount at time of purchase. They are in advertisements in newspapers; leaflets of coupons are inserted into Sunday newspapers; and they stick out between pages of magazines. An envelope of several coupons appears periodically in mailboxes. Some products purchased in stores have coupons inside the packages while others have it inside; some of them can be used to discount current purchase and others future ones. Stores hand out coupons in their in-house newspapers or have coupon dispensing machines. Customers with loyalty cards receive discounts. Paradoxically, while almost everyone redeems some coupons, most of coupons are thrown away. In 1996, manufacturers of consumer packaged goods distributed 268.5 billion coupons of which 5.3 billion or 2 per cent were redeemed. The average value of coupons redeemed was 69 cents. 1 Why are consumers redeeming only two percent of coupons and discarding the rest? What is the benefit to producers in incurring the cost of printing and in distributing the coupons so few of which are redeemed? Using a coupon requires an effort by the consumer. They have to be cut out, sorted by product categories - breakfast cereals, cooking oil etc - and stored till the next shopping trip. Coupons have expiration dates which could force the consumer to choose between letting them expire or by accelerating purchases. If a coupon is for a different brand in the same product category, a decision has to be made whether to substitute the favored band with the new one or not. Against these costs, the customer benefits from reduction in price and, as with bargaining in a flea market, from the satisfaction of being a smart buyer. Consumers differ in their attitude to seeking lower prices, to changing purchase timing or shifting to a new brand; these preferences cannot directly observed by the producer. The ideal situation for the producer would be for coupons to be redeemed only by those who consider the effort worth the savings. Then the firm has succeeded in making the consumer reveal how elastic their demand is and price their product accordingly. In reality such a clear segmentation of price sensitive and insensitive consumers is not achieved as firms, instead of focusing on one single goal, seek many at the same time. They want to induce consumer to try newly introduced products or brands, make them switch from one existing brand to another, increase sales to meet corporate goals, encourage loyalty to the brand, and defend market share. In view of such variations, overarching conclusions, valid for all consumers and markets, on the effect of issuing coupons are not to be expected. Some results stand out in empirical studies and they are mostly in line with what is to be expected from analysis of consumer behavior. The households that use coupons have, in the aggregate, a higher price elasticity of demand than nonusers. However a loyal consumer who receives a coupon for his favorite brand through one of the channels of distribution will redeem it even if he or she would have purchased the product without the coupon. Studies also indicate that coupons provide a strong inducement to those who do switch, to do so.
1

Nevo and Wolfram (2007), p.319. The average value of non-redeemed coupons need not be the same as that of redeemed coupons but given the low rate of redeeming coupons, recipients ignore much of the potential savings.

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Ready-to-eat breakfast cereal industry is one of the major issuers of coupons. It is an industry dominated by a few firms which compete with each other by selling many brands. Various studies of the industry validate the results stated in the previous paragraph. Among additional results observed is the tendency for a larger percentage of consumers to use coupons for brands with higher prices. Producers of brands facing intense competition from lower-priced generic store brands issue coupons more frequently and conversely producers of generics find that their market shares are lower when brands-name manufactures issue coupons often. Firms use coupons to meet sales goals through a short term boost in sales; between 10 and 15 percent more coupons are issued in the last quarter of the fiscal year of the corporation than in its first. It is not clear that the short spurt in sales increases the firm's profit as much as enabling the employees of the companies to claim that they have met corporate goals. The lack of alignment between the interests of the corporation and of its employees is known as "agency problem." Using pricing to acquire and retain consumers. Thousands of new products are introduced each year. 1 Most of them will not be of interest to any one customer but each time she tries to make a purchase, she finds that some new ones are viable alternatives to what she was buying. For customers the choice arises anytime they have to make a purchase. Some goods like the food are purchased quite often as they are used up in one act of consumption. Others like cars, SUVs, computers or kitchen equipments are durable goods and last longer but still need to be replaced regularly. Producers of existing products want to retain the past customers while innovators offer inducements to switch. A U.S. firm on the average loses annually ten percent of its customers and replacing them is essential for survival. Various studies show that only 10 to 20 per cent of new products survive. The tension between acquisition and retention is seen in pricing policies. Given that only a small percentage of customers on the average switch, its current customers are its strong market and potential customers are weak market. The firm should offer a low introductory price to those who are willing to switch and then start increasing it; such a price schedule is standard in phone and cable industries that offer low prices for a limited period. Some firms post a low price for the basic unit like ink-jet printer or razor and then set a high markup on "follow-on" products like ink and blades that have to be purchased from the firm to assure compatibility. Coupons and inducements for repurchase are used to counter these inducements; airlines offer frequent flyers to accumulate mileages for future upgrades or few tickets. Knowledge of how long the consumer was purchasing the product or how long she was shopping in the store is valuable information for producers and retailers. Developments in information technology have made gathering the information feasible and cost- effective. Loyalty card allow stores to keep track of their purchases. In addition stores can purchase from third parties data bases with purchase history of large groups of customers. Before assuming that the information on purchase history allows sellers to use highly profitable pricing strategies, two limitations of the data must be noted. Consumers make a selection, based on their preferences,
By the end of twentieth century, roughly 25,000 new Uniform Product Code (UPC) or barcodes are issued each year. New UPCs are issued for new sizes and slightest variation in characteristics of the product that is sold separately. Distinct new products (however defined) are fewer in number but still run into thousands.
1

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from what is available to them. Just to know that a consumer purchased a product does not allow any deduction of her preferences without information of what else she could have purchased. The first limitation of purchase histories is that such data is not included in it. The second limitation is that consumers are mobile and available data on each consumer will be valid for a limited period only. In spite of these limitations, one study shows the value of purchase history. Issuing coupons to consumers who had made just one purchase increase the net coupon revenue by 50% over blanketing consumers with coupons and focusing on those with a short history increases it to 250%. 1 So far the discussion has been on charging different prices to different customers. Another pricing strategy is offer discounts for purchasing larger quantities and a customer will end up paying different prices for the different units purchased. Price that varies with consumption - two-part tariff. Amusement parks have an entrance fee and some add additional charges for rides. As soon as a passenger engage a taxi, the meter registers an initial charge to which is added a fare based on distance traveled. In all these cases, the initial fixed charge gets divided among larger number of units as consumption increases and the average cost per unit to the buyer keeps deceasing. The analytical tools developed in last chapter on monopoly enables consideration of how the "two-part tariff" affects the profitability of firms and the welfare of consumers. The individual demand curve of a consumer, Jayden, is also downward sloping. His valuation of marginal units decreases as his consumption of the product increases. In the numerical example of Figure 7, the relation between quantity demanded and price is: price = 16 quantity. Jayden values the first unit in dollar terms at $15, the second at $14 and following units even less until the sixth unit is valued at $10. Consumer's surplus for each unit is its valuation less price and equals the height of the shaded rectangle for that unit. It is $5 for the first unit and $0 for the sixth unit. Adding them all up, the total consumer's surplus is $15. The production technology is such that marginal cost is a constant at $4. The monopolist maximizes his profit by setting marginal revenue (not shown in the figure) equal to marginal cost. For this demand curve and marginal cost, the profit maximizing output is 6 units.2 The product is sold at a uniform price of $10. Gross profits (excess of sales revenue over cost of inputs and labor) is 6 x (10 - 4) = $36. 3

1 2

Rossi, McCulloch and Allenby (1996), p.322.

The discussion in the text is based on discrete changes and it can differ from calculations based on continuous variations. Under discrete changes, the firm finds its marginal revenue of 7th unit, $3, to be less than the marginal cost.
3

Average variable cost equals constant marginal cost.

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Figure 7. Two part tariff In addition to the cost of production, the firm has to incur a fixed cost that includes the cost of funds raised to construct plant. The firm will be profitable only if gross profits exceed fixed cost. If the fixed cost is $45, the firm is not profitable under uniform pricing and will go out of business. Is there a two-part tariff that makes the firm profitable and consumers better off? Let the fixed charge under two-part tariff be $10. Then the firms gross profits, assuming that the expenditure on this product is a small part of the consumer's budget and the fixed charge will not change his demand curve, will increase to $46 and the operation has become profitable. But consumer's surplus is reduced from $15 to $5. It is even possible to increase the fixed charge and reduce the price per unit and increase the total surplus total surplus (consumer's surplus and profits together). Then the possibility arises that producers and consumers can both be made better off. If the monopolist reduces the price to $6, he will sell 10 units and his gross profit is 10 x (6 - 4) or $20. Increase the fixed charge to $27 and the monopolist is now profitable as operating income of $47 exceeds the fixed cost. The consumers surplus for the first unit is now 15 - 6 = $9. The sum of individual surpluses for the ten units sold is $45; after paying the tariff of $27 the surplus of $18 exceeds the one under uniform pricing showing that consumers benefited from the shift. The two-part tariff enabled the firm to reduce the discrepancy between price and marginal cost and both consumer surplus and profits increased. Such a change is an improvement in the sense Pareto defined efficiency and the new outcome is said to be Pareto Superior. The numerical example only shows the possibility of a two-part tariff being Pareto Superior to monopoly pricing; it is not necessarily so. If customers are divided into weak and strong markets, those in the weak market may not be willing to willing to pay the fixed charge and will drop out. Public utilities like electricity, gas and telephone companies which have large fixed cost do not want to exclude many residents in its area of service (it may even be against public utility regulations) from connecting to it by charging a high connecting charge. They charge a

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non-linear tariff where the cost of additional units -- additional kilowatt hours of electricity for example - decreases as more units are consumed. Compared to a uniform price greater than marginal cost, a non-linear tariff can be devised that, by making consumers self-select into groups by choice of their consumption, is Pareto Superior. Bundling: selling two products as a package. It is common for a producer to package two goods together and to sell it at one price. Common examples include fixed price menus at restaurants and vacation packages that include travel, hotel and sight-seeing. Receivers, video players, TVs and speakers are sold separately or packaged into a music system. Computer manufacturers sell PCs as a system and most customers purchase it as such though it is made of components and the customers are allowed to select each component from a menu. 1 Going back to a monopolist, the advantage for bundling comes from the differences in customers' preferences for the products. One vacationer likes to travel in comfort and willing to pay up to $250 while a hotel is for him just as place to sleep that is not worth more than $125. Another customer sees travel as a necessary nuisance and looks for the best bargain. She is not willing to pay more than $200 for air fare but likes nice accommodation that costs as much as $200. If travel agency (with a monopoly in selling trips to this resort) is selling travel arrangements and hotels rooms separately and wants both customers to buy, it can charge only the lowest prices at which both will purchase; $200 for airfare and $125 for hotel and his revenue from a customer is $325. If however he offers a package of comfortable travel and hotel accommodation for $350, both customers will take it. The first customer who would have paid up to $375 earns a consumer surplus of $25 from the package. The second consumer was willing to pay up to $400 and obtains a consumer surplus of $75. The higher revenue adds to the profit of the firm. Bundling can be thought of as a form of non-linear pricing with first element of the bundle charged the same price as if it was brought separately and the second at a discount. Bundling can be either pure bundling or mixed bundling. Under pure bundling, the consumer has no choice but to buy the products together as a bundle. Under mixed bundling, the customers are allowed to purchase the components individually or buy the bundle. Restaurants are offering mixed bundling when they put on the menu fixed price and a la carte meals. Summing up. Every market transaction has two parties, a buyer and a seller. Does the market benefit both of them or are sellers able to exploit the consumers' dependence on them for the products and charge "unfair prices?" Adam Smith writing in the eighteenth century argued that it is the self-interest of the producer to supply the market and their actions not only benefit them but also the consumers. Since then economic analysis has refined this argument and, as in the text, today
Computers are sold with pre-installed "trialware," security software, internet services and other utilities not requested by the buyer. These softwares keep prompting him or her to subscribe to them. Financial Times (2007) reports that commission paid by software vendor to PC manufacturers when customer subscribes is between $10 and $20 per machine, a significant amount in an industry with very narrow profit margin.
1

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apply the yardstick of Pareto efficiency to evaluate on the welfare implications of market systems. In spite of the development and refinement since Adam Smith's time, a consensus on whether the market needs regulation to enforce a level playing ground has eluded us to this day. Pareto criterion is not definitive because of two limitations. From an inefficient position, there is more one movement or change that would improve all parties; these moves differ in that some changes will benefit one party more than the other and no guidance is offered in choosing one over the other. Next, the market system will lead to an efficient allocation of the resources and product (one from which there are no Pareto Superior moves) only if the market satisfies a number of conditions. In policy debates focused on whether that conditions are met by a specific market. One of such conditions is that producers should not be able to set or influence prices and another is that the marginal rate of substitution between two products should be the same for all consumers. In the markets discussed in this chapter neither conditions are satisfied. Should public policy limit price discrimination and enforce conditions on the market that enhances its efficiency? How much would such policies affect the individual freedom to engage in commerce? The anti-trust or competition policies of various nations seek a balance between presumed increases in efficiency of markets and the limitations and distortions to its operations that regulations introduce. The development of transportation systems and the legal environment led to consolidation among manufacturing and transportation companies at the beginning of twentieth century. Concern that these firms were monopolizing segments of industry and trade led to the passing of Sherman Act of 1890 which prohibited such practices. However courts interpreted it as not so much prohibiting monopoly but certain acts by them. The uncertainties created by this interpretation let the passing of Clayton Act of 1914. It prohibited four practices, one of which was use of price discrimination to reduce competition. Section 2 of Clayton Act of 1914 reads: It shall be unlawful for any person engaged in commerce, in the course of such commerce, either directly or indirectly, to discriminate in price between different purchasers of commodities of like grade and quality, . . .and where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy, or prevent competition with any person who either grants or knowingly receives the benefit of such discrimination, or with customers of either of them: Provided, That nothing herein contained shall prevent differentials which make only due allowance for differences in the cost of manufacture, sale, or delivery resulting from the differing methods or quantities in which such commodities are to such purchasers sold or delivered: The first sentence declares price discrimination unlawful while the second sentence conditions it by stating that differentials are allowable as long as it reflects underlying differences in costs. Practitioners of price discrimination can claim that differences indeed reflect differences in cost of production or distribution. The Great Depression together the spread of grocery chains in the 1930s created the suspicion that the buying power of large corporations could allow them to negotiate price concessions that are not extended to small stores and that the cost difference would put independent stores at a competitive disadvantage. The Robinson-Patman Act of 1936 prohibited

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any one engaged in commerce from discriminating in price between different purchasers of commodities of similar grade and quality. As the Supreme Court stated in one of the judgments: "the Robinson-Patman Act condemns price discrimination only to the extent that it threatens to injure competition . . . Congress did not intend to outlaw prices differences that result from or further the forces of competition." There were much litigation under the Act and it is a provision that creates concerns among manufacturers and distributors to this day. The contentious issue is not whether there is price discrimination but whether it injures competition. However the firms that are receiving price breaks maybe passing it on to consumers benefiting them. Is Wall Mart that using its purchasing power to get low prices from its suppliers and passing it on to consumers benefiting the consumers or hurting the market by pushing out competitors? The controversy that frequently surrounds opening of new stores by Wall Mart indicate that the issue is still very emotional. The discussion in this chapter brought out the complexity in analyzing various forms of price discrimination and determining its effects on consumers and producers. The analysis in this chapter shows that a blanket condemnation of price discrimination is not justified as under certain circumstance it can benefit consumers. Since these conditions may not hold in specific instances, it is necessary to be vigilant. This chapter showed that while a market brings together buyers and sellers and establishes a price, the producers may be able to influence who are the buyers in one market. The customers for a product are separated into different markets based on their willingness to pay and charged different prices. In the next chapter, a closer look is made of what a product is and how close it is to other products. Today each of our wants is satisfied by many products; competition in the breakfast cereal market was discussed earlier. What are the differences between the various brands? Are consumers benefiting from the greater choice or is this another way for producers to fragment the market and charge higher prices? Bibliographic note: Acquisti and Varian (2005); Amstrong (2006); Blattberg, Getz and Thomas (2001); Kotler (2000); Blattberg and Neslin (1990); Brown and Sisley, (1986); Carlton and Perloff (2000), pp.274-331; Clark, (1995); Financial Times (July 11, 2007); Hogan and Nagel(1995); Hogan and Nagel (2006); Holmes (1998); Narasimhan (1984); Nevo and Wolfram (2002); Philips (1981); Rossi, McCulloch, Allenby (1996); Stole (2007); Varian (1989); and The Wall Street Journal (March 13, 2007).

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Chapter 9. Competing with differentiated products.

Figure 8. Consumers' preferences for differentiated products.

Depending on the context, commodities are defined broadly or narrowly. We speak of eating cereals for breakfast. When we go to buy them at the grocery store we find not "one cereal" but a whole aisle of breakfast foods with close to one hundred ready-to-eat cereals. The milk we choose can be whole, 2 per cent or one per cent. In general equilibrium analysis -- considering the simultaneous equilibrium of all markets -the refinement of commodities was carried to the extreme with same products tagged not only by characteristics but even by date and state of nature. In spite of the elegance of this approach, a coarser classification is useful in bringing out aspects of competition in the market In the derivation of the demand, consumers were assumed to have preferences for baskets of goods without consideration of the nature of the goods in the basket. Analyses of competition in a market where products are branded require making explicit how consumers differentiate one brand from another. Consumers responses to product differentiation suggest two approaches. In the first, consumers rank brands by levels of specific characteristics. In the case of cereals, the characteristics that influence preference include sweetness, the amount of fiber and the extent to which one serving meet the daily minimum requirement. In automobiles, buyers are interested in acceleration, number of passengers that can be seated comfortably and leg space. Panel A of Figure 1 shows different brands arranged according to one characteristic. Each consumer has one preferred level of the characteristic and will choose the brand that is closest to his preferred position (assuming price differences among similar brands are minimal); among close to forty brands of toothpaste for sale at the grocery store, the consumer chooses the one brand. Since arranging products in a characteristic spectrum has similarity to arranging them in space, this approach is referred to as spatial model of product differentiation. If a new brand is introduced in the market, consumers whose preferred position in the spectrum is closer to it will switch to the new one.

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Figure 2. Customers in geographical space. In the other approach, consumers group products with those belonging to one group viewed as closer substitutes to each other than products in other groups (Panel B of Figure 1). Consumers love variety; in earlier discussion of consumer choosing one of the baskets along his budget line, he preferred a basket with two goods and not one at the end of the budget line. In choice among differentiated goods, consumers allocate their budgets among groups of commodities and, then from each group, choose a combination of brands. Preference to a brand translates to limited substitutability between brands and the low elasticity of demand allows producers to charge a price higher than the marginal cost. Whether it increases his profit will depend on the cost side; fragmentation of demand results in lower output of each brand and it increases average fixed costs of each brands. However the prevalence branding in almost all industries indicates that branding is in general is profitable. Next sections elaborate the model of competition for consumers spread out in space. It provides the intuition to analyze to competition in characteristic space. Competition in geographical space. A plant located as in Figure 2 supplies customers located at equal intervals along a road. The firm sets the price at the plant (fob or mill price) and then adds the transportation costs to determine the "delivered price" to the consumers at different locations. The delivered price increases at uniform rate over distance from the plant as cost per unit distance is a constant. Each consumer buys one unit of the product provided its delivered price is below the "reservation price," the maximum price she is willing to pay for it. 1 In Figure 2, the firm sells to eight customers (blue figures) closest to the plant. The ninth and tenth consumers (red figures) find the delivered price exceeding reservation price.

Here the consumer, instead of changing quantities continuously with price, is assumed to either buy it or not depending on whether the price is below or above the reservation price. It focuses on the role of distance related cost in a very simple framework.

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Figure 3. Firm location and sales region.

A second firm, producing an identical product, has its plant located at other end of a road and is charging the same mill price. The length of the road is thrice the distance to the eight consumer. Because of symmetry in price and cost of transportation, eight consumers in its neighborhood will now purchase from it (Figure 3). Each firm has a monopoly in the market in its neighborhood with the cost of transportation preventing each from competing in the sales region of the other. There is a region in the center with eight potential customers who will not buy from either firm. This configuration encourages a new firm to enter the market and locate at the very center. At worst, it captures the eight customers who were not buying from the other two firms. Given the location of the third firm, some customers of Firm 1 and 2 (seventh and eight from either end) will find that they are closer to Firm 3 and will switch to it. Foreseeing this threat, Firms 1 and 2 will, instead of choosing the two ends of the road, locate closer to each other. Whether that will preclude another firm entering or not depend on the cost structure of the firms; if no firms enter, the established firms were able to use their positioning to limit competition. The central result of this simple model, that firms have choose their locations with consideration to their competitive advantage in potential sales regions, is valid in general. Potential customers instead of being spread out uniformly along a straight road cluster around neighborhoods. Retailers using census and other data try to identify the economic status and tastes of consumers in each neighborhood and locate stores where their goods are most in demand. Customers, for instance, are unwilling to travel a distance to eat at a fast food restaurant. Such restaurants will succeed only if they are located where patrons tend to congregate. Within cities, they choose locations near offices, urban shopping areas and schools; another common location is near highway exists. In contrast shopping malls attract customers even if located away from residential areas as they offer the opportunity to visiting many stores, check out different brands of goods and buy them all at one place. Mall owners provide varied inducements to attract the crowd like having nationally known anchor stores, attractive food

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Figure 4. Product in characteristic space. courts, convenient parking facilities, play area for children and movie theatres. The flow of customers that this aggregation of facilities generates will determine the mall's success. Locating in the characteristic space. Within each commodity group, there are many brands that differ in characteristics. Orange juice in a grocery store is classified as with lot of pulp, with some pulp and no pulp; cars are ranked by their acceleration measured by the time to attain a speed of 30 miles per hour from start. Consumers, based on their preference for the amount of the characteristics, are spread out uniformly in the characteristic space and any consumer further away from the location of the brand bears a "psychic cost" in having to buy a product with characteristics that differs from her preferred combination. The total cost to the consumer, "cost at delivery," of buying a product is the sum of its price and psychic cost. With this interpretation, competition in characteristic space can be related to spatial competition. Firms can compete by positioning brands in different location in the characteristic space. Instead of developing a general analysis of product positioning the rest of the section focuses brand proliferation in the ready-to-eat breakfast cereal industry. Kellogg, General Mills, General Foods and Quaker Oats, the top four of the six firms that practically formed the supply side of the market, accounted for approximately 90 per cent of the sales in the 1960.1 They had a higher rate of profit than other manufacturing industries. Between 1958 and 1970, accounting profits for the four firms and Ralston was 19.8 per cent of assets while the comparable figure for all manufacturing in United States is 8.7 per cent. Still there was no entry of new firms into the industry. In 1972, the U.S. Federal Trade Commission charged the
1

Scherer (1979), pp.113-114. The other two were Nabisco and Ralston-Purina.

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four largest U.S. manufacturers with creating high barriers to entry through brand proliferation, differentiating similar products and promoting trademarks through intensive advertising. In the two decades after World War II, demographic growth and increase in weight for a standard serving of cereal due to sweetening accounted for as much as 57 per cent of the aggregate growth in ready-to-eat cereals. In turn it implies that the sales of new brands came mostly from consumers switching from others. 1 Between 1957 and 197, the six firms introduced 51 new brands of cereals into distribution beyond regional test marketing while withdrawing 22. A total of 67 brands were in distribution in December 1970; few succeeded in reaching a market share of 2 per cent or more. Since the older brands showed considerable staying power, the new brands were being used to cover small niches and to exclude other brands from locating there. No new firms entered the market in this period. The antitrust litigation failed and the industry in the United States continued to be dominated by few firms. The four firms originally listed in the litigation have a market share (by volume sold) of 79 per cent in the last quarter of 1992. The cost of material and labor for the industry is 34.7 per cent as contrasted to 72.2 per cent for all manufacturing firms. The advertising to sales ratio for the industry is high at 13 per cent while for other food industries it is between 2 and 4 per cent. 2 Competition, in so far it exists, is from other forms of breakfast foods. Product characteristics and market power of producers. Just as consumers are clustered in some neighborhoods, products are clustered in characteristic space. In Panel B of Figure 1, consumers consider brands in one group as good substitutes for each other while those in other groups are poor substitutes. The importance of group is brought by the antitrust litigation against Gillette. If the price of a brand increases, consumers will, given the preference for products in the group, substitute another one in it. The producer of the brand has to consider profit reduction from the loss of sales but if he owns other brands in the group, his combined profits suffers less than if consumers shifted to that of another manufacturer. If one producer owns many brands in a group, the only recourse for the consumer against price increases of these brands is to use products outside the group but it forces her to move to a less preferred product group. How should group defined or what brands are to be included in one group? Will a consumer consider only cereals in the breakfast group or will he consider other European and Spanish breakfast foods as potential substitutes. If a group is defined too narrowly, any merger will give appear to give the merged firm a large share of the sales in that group. The antitrust regulations prohibit monopolization and definition of the group influences the judgment whether a firm has gained monopoly power or not. This is brought out by the attempt of the Antitrust Division of the Department of Justice to block Gillette that owned Waterman pen from acquiring Parker Pen. In 1993 Gillette that owned Waterman posted a tender to buy the stocks and options of the Parker Pen Holding Company. The Antitrust Division requested the United States District Court of District of Columbia to issue a preliminary injunction against the acquisition. It was claimed
1 2

Scherer (1979), p.122. Nevo (2001), p.319.

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that consumers would be unwilling to substitute Parker or Waterman for any other pen and the merger would allow Gillette to increase prices. Fountain pens are classified as base, premium or jewelry model. The characteristics that distinguish a premium pen from a base pen are its sold gold nib, gold trim, superior ink filling system and superior resistance to leak. 1 It gives the owner a feeling of status and affluence. The Antitrust Division claimed that choice is dictated by another characteristic: the national origin. Waterman and Parker are quintessential American pens since 1888 and consumers differentiate it even from European premium pen, Schaffer and Montblanc. Gillette Company argued that the Antitrust Department was defining the group narrowly. Those who own premium pens also own base pens, ball point pens, pencils and other writing instruments. A proper definition of market includes all writing instruments and that most customers buy not one of them but a combination. In short, the relevant group of brands is not American premium pens but all writing instruments. Even if Waterman and Parker pens merge, merged companies will face competition from producers of other writing instruments. The Court agreed with this argument and denied injunction. Next section considers markets where consumers purchase a portfolio of differentiated products. Monopolistic competition: between monopoly and competition. As standards of living improved over the last three centuries, consumer purchases reflect ongoing changes in their lifestyle. Instead of consuming what is essential for survival, wearing the roughest garments and confining their activities to their immediate neighborhood, the public wants to try out different cuisines, follow recent fashion in what they wear and travel further and further away. Restaurants offering ethnic foods from various regions of the world are striving and bookstores have a collection of cookbooks that promote exotic, healthy or easy-to make recipes. In cloths, men buy button-down shirts, casual wear of different styles and colors, many ties and belts and a variety of footwear; woman's wardrobe has many dresses, hats and a collection of shoes. The preference for variety is obvious. When consumers buy a portfolio of products, the demand for the individual product has to be distinguished from that of the group. Each firm has a monopoly in its brand and seeks to maximize its profit, recognizing that the demand for its brand is affected by the price and quantity of other products in consumer's portfolios. Edward Chamberlain in 1933 analyzed the price and output of a firm under monopolistic competition and the equilibrium of the market. A rigorous formulation of competition among differentiated products was provided by Avinash Dixit and Joseph Stiglitz in 1977. Differentiation produces a preference for a particular brand and consumers will not be willing to abandon the brand for a slight price difference. The demand curve for the brand is downward sloping and marginal revenue curve lies below the demand curve and is downward sloping (Figure 5). The technology of the firm is such that its marginal cost is constant. An increase in output will increase gross profit (sales revenue minus cost-of goods produced) as long as
1

Jewelry pens are made with lacquer polish and are used more as jewelry than as a writing instrument.

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marginal cost exceeds marginal cost. The firm has to pay the fixed costs (administrative expenses and interest on its debt) out of the gross profit; the residue is the accounting profit reported in income-expenditure statements of companies. 1 The average variable cost equals constant marginal cost. As the fixed cost is spread over larger and larger number of units, the average fixed cost will decrease. Figure 5 shows the average variable cost (AVC) and average fixed cost (AFC) for three outputs. Average cost, being sum of average variable cost and average fixed cost, decreases with output. Price, output and profits of a brand. The firm maximizes its profit by choosing the output at which marginal cost equals marginal revenue and the demand curve for the brand determines the price. Price and average cost determines the profit of the firm. Figure 4 shows revenues and cost of one brand. Given the position of the demand curve before entry, "Output before entry" is such that price exceeds the average cost. 2 The firm earns "excess profit" as it has funds left after paying the market rate of interest to the financial institutions. Since there are no barriers to industry, new firms will enter the product group. Each firm finds that he quantity demanded of its product at any price is decreasing and,

Figure 5. Profit maximization under monopolistic competition.

The assumption is that the firm is fully financed by debt, accounting profit is also economic profit. It assumes that the assumptions of the Modigliani-Miller theorem hold in the financial market. The importance of capital structure will be discussed in Chapter 12.
2

The marginal revenue curve of the demand curve before entry is not drawn in Figure 4. It intersects marginal cost curve at the "Output before entry."

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after enough firms have entered, the demand curve will shift down to the lower curve in Figure 5. Price at the new profit maximizing output will equal average cost; there is no excess profit and new firms have no incentive to enter the industry. Both the firm and the industry are in equilibrium. The analysis of entry depends crucially on comparison of price with a proper measure of average cost. Given the difficulty in estimating it, one possibility is to compare the rate of accounting profit per dollar invested in the firm with the average for the industry or economy. In discussion of ready-to-eat breakfast cereals in last section, the profit rate for four firms in the industry between 1958 and 1970 was 19.8 per cent while that for all manufacturing in United States is 8.7 per cent. There was no entry in spite of the difference in rates of return. One explanation is that the investment in cereal industry is risky and there are other hidden costs. The other possibility is that there are barriers to entry as Federal Trade Commission claimed but the court did not accept it. Is there excess entry? Under monopolistic competition, each firm faces a downward sloping demand curve and price exceeds marginal cost. But there is entry and the demand curve for each brand is pushed down till price is equals average cost. However entry, by fragmenting the market among producers, increases the average cost of a firm. Does brand proliferation that increases cost of product benefit or hurt consumers? Market for many consumer goods show a proliferation of brands. Is there excessive brand proliferation in the sense that reduction improves efficiency in the sense that it benefits some without hurting others? If the preference for variety is ignored, the conclusion of too many differentiated goods than is valid. If consumers do have a preference for variety, Dixit and Stiglitz showed that the outcome is efficient allocation subject to the additional condition that firms recover the fixed and variable costs of production. Conclusion. The concern about monopoly is that the producer has market power to charge a very high price and earn a profit in excess of what is needed to attract investment to the industry. Will entry of competitors with differentiated product limit the power to set prices and reduce the excess profit? How will a producer in such an industry react to entry? The effect of entry depends on (i) the preference of consumers; (ii) how it affects existing producers; and (iii) how affected producers respond. So many are the possible combinations of consumer preferences, cost conditions and manufacturers responses that one framework cannot analyze all of them. The chapter laid out two models that have been found useful in analyzing markets with differentiated products. The location model focuses on one aspect of our preferences. Whenever an individual is shopping for a product, she examines different products for some specific characteristics. If the spatial model, each firm has a lock on consumers whose preferred combination is closest to its product. If the distance between two firms in one-dimensional characteristic space is large enough, a third will enter in the middle. Anticipating challenge by new firms, those in the market will locate close enough to preclude entry.

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The monopolistic competition focuses on another aspect of our preferences: the love for variety. Product fall into groups and, in each group, there are many brands. The brands in a product group are viewed by consumers as close substitutes but not identical. The demand curve for each brand is downward sloping. Each producer sets his output to equate marginal cost with marginal revenue. If the price exceeds average cost, the firm earns a profit is excess of what the resources can earn other investments. It attracts other firms to enter the group and the competition pushes back the demand curve of each firm till price equals average cost. At a social level, the question is whether the monopoly power leads to a proliferation of brands. If consumer prefer variety, the allocation is efficient with the side condition that each firm just covers its variable and fixed costs. Bibliographic note: Dixit and Stiglitz (1977); Freeman and Dungey (1981); Martin(2002); Mazze and Michman (1998); Nevo (2001); Phlips and Thisse (1982); and Scherer (1979).

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Chapter 10. Game theory: the analysis of strategy.

In fall of 1704, after almost one year of sailing around South America, the ship Cinque Ports anchored in a Chilean island Isla Ms a Tierra (now renamed Isla Robinson Crusoe). Alexander Selkirk, sailing master, felt that the ship needed repair before proceeding further but the captain, Thomas Stradling, disagreed. Hoping to force captain's hand Selkirk asked to be set ashore but to his dismay the ship sailed without him.1 Both Stradling and Selkirk had two choices: Stradling could agree to repair the ship before sailing or refuse to do so. Selkirk could remain on the ship or stay at the Island. Since they were making decisions independently, there are four possible combinations. Among them, the combination chosen was for Selkirk to stay on the Island and for Stradling to sail without repairing the ship. The outcomes of their choices were that Selkirk was stranded in the Island for more than four years while the ship sank shortly after it set off. Stradling and the sailors who survived were taken prisoners. As the story is told, the choices seem to be based not on rational calculation of outcomes but on the hatred the two had for each other. To survive alone in the Island, Selkirk built a hut in a meadow less than two miles uphill from the Cumberland Bay, the bay that provided best anchorage of ships visiting the Island. 2 In the thick woodlands to be east of the hut, he also built a hideout on a tree. Selkirk was hoping that one of the many ships that sail by will rescue him. In the spare time he had after gathering food, he would go to a lookout up the hill to watch for ships and, if he saw one, he would try to get its attention by dragging branch of a tree to the sea shore and setting it on fire. One dawn he went to the shore and found a Spanish ship anchored there. Sailors from the ship were rowing to come ashore. Since British buccaneers were praying on Spanish galleons transporting gold, Selkirk was sure that he will be taken prisoner and condemned to the galleys. To escape, he ran towards the protecting trees with the sailors chasing him and firing at him. Difficult as it was, he managed to evade them and climb to the hideout on the tree. The sailors came up to its bottom of the tree but did not notice him. They gave up the chase and went to his hut, butchered and eat the goats there, destroyed the sea chest, the kettle, bedding, books and tools he had forged from items that earlier visitors had left behind. The Spanish sailors stayed for two days during which Selkirk remained in hiding. As they sailed away, they left behind a rusty anchor, a piece of sailcloth, a short length of chain, a coil of worn rope and discarded timber. With them he rebuilt his hut and went on with his life on the Island until his eventual rescue by British ships that anchored in the Bay. 3 Selkirk had two choices: to run to his hut where there is a good chance of being found or to hide in the forest even if it involves hardship. The Spanish sailors could continue to search the forest till Selkirk was captured or they can go to the hut and enjoy the fresh food (vegetables and
1

"The saga of the stranded sailor" in Chapter 3 has details of his life in the Island. Before the ship sailed, Selkirk begged Stradling to take him back on board but was refused. It indicates that Selkirk did not really prefer the option he took. He assumed that his strategy will force Stradling to rethink his decision to sail without repairing it. In this Selkirk misjudged even though the outcome was much worse for Stradling and other sailors than living in isolation.

National Geographic (2004). The National Geographic Society led an expedition to find the spot where Selkirk built the hut. The spot was confirmed when the dug up a navigational divider.
3

Souhami (2001), pp.115-117.

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mutton from goats in the pen). Both parties made rational choices as Selkirk will have a miserable life as a prisoner and fresh food is a premium for sailors sailing in ships without refrigeration. Non-cooperative game theory provides the rationale for analyzing strategic interactions and their outcomes. 1 In a modern society, a monopolist as the sole producer does not have to consider the strategies of any competitor. It is in his interest to make entry into the industry as difficult as possible. Patenting and brand proliferation examined in previous chapters are strategies to extend his position in the market. Depending on cost and market considerations, one or more firms may break though the barrier and, if they did, the incumbent must reconcile to competing with the entrants. Two aircraft manufacturers, Boeing and EADS (producers of Airbus) compete in the market for wide-bodied passenger planes; two semiconductor firms, Intel and Advanced Micro Processors (AMD), compete in computer processors market. Each of them has to consider not only cost of production and market demand but the output and pricing strategies of their competitor. The output of individual firms and the market clearing price will be different when two firms compete in the market (duopoly) from that under monopoly. They can compete by adjusting output, changing prices or establishing capacities. The strategies that they adopt are themselves their choices. Competition on quantities and prices were analyzed even before the development of game theory. As seen from the experiences of Selkirk, different strategies can lead to different outcomes. In the case of duopoly, output and price competition leads to dramatically different results, resulting in much discussion whether one is more relevant than the other. Recent studies consider firms using both strategies in competition. Following sections consider all three cases. The quantum jump from one to two. Two firms managed by Murphy and Zvi are competing in the market. Any action contemplated by a firm to increase its profits will affect the profits of the other firm. The second responds by altering its decisions to make the best of the new situation. Each has to make plans on the basis of his inference of the other's action. There is no more a unique output that maximizes a firm's profit but one for each of the anticipated action of the other. Each firm knows that its price and profits depends on the total output. Since a firm can only choose its output, it has to make a choice of its output based on its anticipation of the output of the other firm. Murphy determines the profit maximizing output for his firm to be 200,000 units, given his conjecture that Zvi will produce 200,000 and the market price is set to clear the market (equate quantity demanded to 400,000 units produced).

Games are classified into cooperative and non-cooperative games. In cooperative game theory, the players communicate with each other and make binding agreements. The theory of negotiations based on cooperative game theory was discussed in Chapter 3. In non-cooperative game theory, players consider that they are competitors. They make independent decisions and do not communicate with each other.

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Figure 1. Nash equilibrium: each chooses the best response to the strategy of the other player. Notice that Murphy is not observing or reacting to a decision by Zvi; he is considering his best response given what he believes Zvi would do. What is Zvi doing as Murphy is forming his conjecture and output decision? He has to make a decision based on his conjecture of what Murphy will do. Consider one possible conjecture and choice: Zvi determines that the profit maximizing output for his firm to be 200,000 units, given his conjecture that Murphy will produce 200,000 units and the market price clears 400,000 units produced. Both made the decisions simultaneously, not in the sense that they were made in the same nanosecond, but did so without any knowledge of the other's choice. In this particular case, their decisions turned out to be felicitous. Each made conjectures that turned out to be accurate neither Murphy nor Zvi has any incentive to change their decisions (Figure 1). When no firm can unilaterally make a change that improves its profit, the strategies of the firms constitute Nash equilibrium, named John Nash. It is great if both firms end up in the Nash equilibrium and coexisted in that blissful state forever. But the analysis as an explanation of business behavior has no credibility if the outcome is not related to demand and cost considerations. Then the mangers understand why there their decisions were consistent optimal decisions and to develop an algorithm to determine achieve it. In retrospect the second turned out to be the harder of the two to achieve. Cournot's model of duopoly. In 1838 monograph, Augustin Cournot analyzed one solution for competition of two firms in a market. The demand for the product is determined by the consumers and the firms take the market demand curve as given to them (prices and quantities that we cite below are from a numerical example given footnote). 1 They have identical cost conditions; the constant marginal
The numerical example is based on a market demand curve,q=680,000-10,000pwhere q is the sum of outputs of the two firms and p is the price at which that output is sold. If one firm has monopoly, the marginal revenue curve will be mr=68-0.0002q and setting it equal to marginal cost of $8, the output of monopolist is seen to be 300,000. The price in the market will then by $38. With two firms, Murphy's marginal revenue is 68-0.0002qM -0.000qZ. If
1

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cost is $8. They make decisions independently of each other and these decisions determine the output and market clearing price. Given the demand curve and a marginal cost, Murphy will produce 200,000 units if he expects Zvi to produce 200,000 units. Given symmetry in costs, Zvi will produce 200,000 units if he expects Murphy to produce 200,000 units. Their assumption match the actual outputs as in Figure 1 but the choice is shown to be the outcome of profit maximization by the two firms, given their expectations of the other firm. Calculation in Footnote 1 of previous page shows that the output if there was only one firm will be 300,000 units and the price $38. Competition increased output and reduced price but the price is still higher than the marginal cost. The downward marginal revenue curve lies below the demand curve of each firm and intersects the constant marginal cost at a lower output. The output has to be reduced from one at which the demand curve and marginal cost intersects to achieve profit maximization and that results in higher price than marginal cost. Murphy's output is based on his conjecture of the output produced by Zvi. Why should Murphy and Zvi have consistent expectations as shown in Figure 1? If Murphy expects Zvi to produce a larger output, he will reduce his output while if the expectation is that Zvi's output is lower, he will produce a higher output. Various outputs will lie along a curve (a straight line for the example) that Cournot called Murphy's reaction curve. Similarly Zvi will have a reaction curve. Cournot argued, under some nave assumptions about their expectations, that the two curves will intersect at the outputs that are consistent. Further, if any firm chooses another output, profit considerations will make it move towards the point of intersection. While Cournot's pioneering work is to be admired, the assumptions are too restrictive to be accepted as realistic. Competing on price - Bertrand's Model. In the case of a monopolist, it does not matter whether the firm chooses the output or the price; one will determine the other along the market demand curve. When there are few firms competing in the market, the choice of the decision variable affects the results. This was brought out by Joseph Bertrand, a French mathematician, in a critical review of Cournot's work. Consider as in the last section, two firms producing a homogeneous product under constant and identical marginal cost. Firms choose prices simultaneously and consumers, who see the output of the two firms as perfect substitutes, choose to buy from the firm that posts the lowest price. If they offer it at the same price, then consumers would split evenly between the two. The two firms have the same marginal cost of $8 and the market demand curve was as in Figure 2. 1 Suppose Firm 1 sets a price of $15. If the other firm also sets the price at $15, they will split quantity demanded at that price, 530,000, evenly. Each unit sold $7 over its marginal cost and the surplus over operating cost of each firm is 0.5 x 530,000 x7 = $1,855,000. Now look what happens if Murphy decides to undercut Zvi by setting the price at $14.50. Since Firm 1 offers a lower price, consumers would buy 535,000 units from it (larger quantity because
Murphy expects Zvi to produce 200,000 units, his profit maximizing output will be 200,000 units. The combined output of 400,000 will be sold at a price of $28.
1

Under the assumptions, average cost equals marginal cost

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of lower price) and, assuming it has the capacity to supply that output, the operating profit of Firm 1 would increase to 535,000 x 6.5 = $3,477,500. Firm 1 has an incentive to act by itself to cut its price below $15 and the pair of prices (15, 15) by the two firms cannot be Nash equilibrium. Firm 2 will respond to Firm 1's action by setting its price even lower. What made unilateral price cutting profitable is that price was above the marginal cost and as long as that is true one firm or the other will cut the price to draw consumers to it. Only the pair of prices ($8, $8) is the Nash equilibrium for the two firms engaged in price competition. The works of Cournot and Bertrand laid the foundation for study of interactions among a few firms. Still the differing results create a dilemma. Do firms use quantity or price competition? Why should a firm confine to one strategy? Why not use both quantity and price strategies in tandem? The result that, under price competition, consumers will switch from one firm to the other at the slightest price reduction is valid only if the two products are considered perfect substitutes. If they are viewed as slightly different - Coke and Dr. Pepsi - the change in the quantity demanded will depend on the marginal rates of substitution of various consumers. The prices will not plunge to the marginal cost. If the reduction in price shifts the demand to one of the two firms, it can profit from it only if it has the capacity to produce the extra output at the same marginal cost. Its output may be constrained not by the demand curve but plant capacity. This suggests that firms compete by both adjusting installed capacity and by the price they charge for the product. Choosing the capacity and setting the price. Capacity takes time to install and is expensive to create. A new part of a town is bringing in businesses and hoteliers anticipate demand for accommodation. Like all constructions, building a hotel involves cost and takes time and, once constructed, it is not easy to change the number of rooms. Its capacity is limited and rigid. But the prices charged for a room per night can changed from day to day. How would hoteliers compete in this market? David Krep and Jose Scheinkman constructed a two-period model to examine competition in capacity and price. In the first period the firms choose, independently and simultaneously, the capacity to produce a homogeneous good. At the beginning of second period, each firm knows the capacity and has to choose the price they are going to charge (Figure 2). Arguing backwards, guess an answer and then see why it can be justified. If the capacity established in first period is what would be produced under one-period Cournot competition, what will be the prices charged in the next period if firms compete on price? The claim is that the common price chosen by both firms will be Cournot prices and not marginal cost as in single-period Bertrand competition. It is obvious that Cournot prices, by definition, will clear the quantities demanded when output equals combined Cournot capacities. Yet the firms setting prices independently could choose another price, if it more profitable. It needs to be shown that there is no such price. First consider one of them choosing a lower price. If it did, consumers who consider the products to be perfect substitutes will want to buy from it. Since its capacity is limited, it cannot increase output and ends up selling the same output at the new lower price. No firm wanting to maximize its profits will do so.

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Figure 2. Sequential decisions: setting capacity and price. The next step is to show that there is no incentive for a firm to increase the price. If Zvi increases his price, all consumers try to shift to Murphy's firm. But Murphy's capacity is limited and he cannot meet the market demand at the price he had set. Zvi's customers who wanted to buy from Murphy but could not, will go back Zvi. Even if the net result is that Zvi sells a smaller quantity, he is selling at a higher price and the possibility exists that the he earns a higher profit. Kreps and Schenkman using some intricate reasoning showed that, if the firms had established Cournot capacities in the first period, then both firms would not depart from the Cournot (market clearing) price. In the first period, firms realize that the prices that both firms will choose next period are the Cournot prices and so they will establish Cournot capacities. In spite of following Bertrand type competition in the second period, the equilibrium that firms find optimal for two periods together coincides, in Krep-Scheinkman model, with the Cournot outcome. Who are the consumers who could not get what they want from Murphy if Zvi charges a higher price? Murphy can "ration" his output in two ways. Knowing that he cannot satisfy each, he could give each the same fraction of demand. 1 According to the numerical example, each firm has a capacity of 200,000. If everyone tries to buy from Murphy, he could sell each half of what they want. The other possibility, "Beckmann rationing," is for Murphy to sell whoever comes first; it is like a sale that last as long as the product is in stock. It has been shown that KrepsScheinkman result holds only if Murphy uses the first type of rationing. Can pursuit of individual betterment be self-defeating? Cournot, Bertrand and two-period games discussed show that the outcome of the strategy one player adopts depends not on the strategy of his competitor.

Governments rationing essential goods in times of scarcity use this type of rationing as they consider it to be fair.

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Figure 3. Persuing individual interests lead to a bad choice for all. Bertrand model with two firms producing identical product showed the possibility that prices can spiral down to marginal cost with firms ending in losses. Airline fares are easy to find out from various websites and price cuts can be easily confirmed. There are periods when one major airline in the United States will cut the fare and then other major lines will match it though all airlines. Then one airline will increase it but others will not match and the airline that increased the fare will have to cancel the fare increase. The competitive cuts in fares end all airlines in losses. The average fare increases by 18.3 per cent from $292 in 1995 to $346 in 2008. The increase was much less than the increase in general price level. When adjusted for inflation, fares actually decreased by 16.2 percent in this period. Due to economizing in travel following the recession of 2007-2008, the airfare fell to $309 in 2009. 1 Consider a duopoly shown in Figure 3. Each firm has two possible strategies: choose a high price or a low price. The profit of each firm is shown by the height of the box of appropriate color. Suppose Firm 1 decides to charge a high price. Firm 2 can charge a high or low price (Panel A) and finds that its profit is higher when it charges a lower price. If Firm 1 selects the lower price for its product, Firm 2 is better off charging a lower price (Panel B). Whatever price Firm 1 charges, Firm 2 is better off charging a low price. When a player in a game has a strategy which it prefer irrespective of what the other player does, it is said to have a dominant strategy. Firm 1 considers how it will respond to strategies of Firm 2. If Firm 2 chooses a high price, then consider the left column in Figure 3, Firm 1's profit is higher if it chooses a lower price. If Firm 2 chooses lower price, the right column shows that Firm 1 is better off by choosing a lower
1

U.S. Bureau of Transportation.

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price. It has a dominant strategy, to charge a lower price. Both firms follow their dominant strategies and end up with profits shown on the lower right side of Figure 3. Comparison of the left top pair of boxes shows that the both firms will have higher profits if they had chosen the higher price. But if one charged the higher price, the other earns a higher profit by charging a lower price and forces the first to move to a lower price. Individual decisions led collectively to a bad choice. If this is just one example of firms choosing price, it could be dismissed as an aberration. But it can arise in any context where individuals interact strategically. A well-known example is of a prosecutor negotiating plea bargaining. John and Matthews are suspected to be partners in a crime. The prosecutor knows that he does not have enough evidence to get a conviction. So he negotiates with them independently. He tells Matthews that if he confesses, he will ask the judge to give him a lenient sentence but if he refuses and John confesses, he will get a very harsh one. Matthews knows that if neither agrees to plea bargain, both of them will go free but he cannot trust John to reject a similar deal that the prosecutor will be offering him. The net outcome is that both confesses and has to do time in jail. From this widely discussed example, self-defeating behavior due to lack of coordination and enforcement of agreements is known as "Prisoner's Dilemma." Thomas Hobbes argued that the "state of nature," or societies without a government are nasty and brutal. Mutual respect of life and property benefits all but each one is tempted to encroach on another for immediate benefit. The result is mayhem. Hobbes made such behavior a justification for a strong government to enforce law and order. One of the contemporary issues is controlling pollution. Equipment to clean effluents adds to the cost of production. Car owners have to pay more for cars with catalytic converters while electric cars are have only limited range. If everyone other than you adopts these measures, you can enjoy the benefits without incurring the costs. Yet if everyone uses that logic, the environment will be polluted and no one benefits. How prevalent is Prisoner's Dilemma? Is it possible that the players will develop enforceable coordination mechanism without it being forced on them? In 2008, airlines in the United States started charging for fee for luggage and no airline tried to undercut the other by abandoning the fees. 1 When players have to interact repeatedly, they will be willing to abide by an understanding, explicit or implicit, to choose what is mutually beneficial. A large number of experiments were conducted to test how people will respond to situations where Prisoner's Dilemma can arise. The results indicate that cooperation is more than what one would expect if everyone was strictly maximizing their utility. On the other hand, a sizable percentage of players depart from the cooperative solution. Whether utility maximization is bound by a commitment for higher morality - as citizens we have to give to charities or blood drives and even agree for tax increase to improve schools even if we have no kids - continues to be debated.

This is true of airlines that introduced the fees. SouthWest Airlines never charged the luggage fees.

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Nash equilibrium. Not every interactive situation has dominant strategies for each player that results in a unique solution. Sometimes one player has a dominant strategy and more commonly none have dominant strategies. In the conflict between Alexander Selkirk and Thomas Stradling on whether Cinque Ports should be repaired before sailing or not, Selkirk did not have a dominant strategy. If the ship was repaired, he had no reason not to sail with it but if it is not repaired and was in danger of sinking (which it did), he was better off being stranded in the lush Island. Whether Selkirk agreed to continue or not, Stradling (as far as the situation can be reconstructed from narratives that are available) was better off repairing the ship than sailing on a worn-eaten one. 1 If Stradling had acted rationally and chosen the dominant strategy, then Selkirk would have gone abroad and the game has a unique solution. In many games, no player has a dominant strategy. Can such games have a solution and will it be unique? John Nash in 1950s extended the concept of solution to many games that could not be solved otherwise. Nash equilibrium is a set of strategies for each player such that it yields him at least as high a reward (in dollars or utility) as any other that he can choose provided all others remain with the strategies they choose. The Cournot and Bertrand equilibrium are the Nash equilibriums of two games. Even if they are the same firms producing the same product, the two equilibriums should be viewed as that of two separate games as the strategies used by firms in competing are different. Many games in which players choose one of many strategies may have no equilibrium solution. A simple example is where two players playing head or tails. If both announce head or tail the second player has to pay the first player a penny (traditionally this game is described for such a small bet). If one player announces head and the other tail, irrespective who announces which, the first player must pay the second a penny. If the first player suspects that the second player will make a call that does not match with his, he will change as he prefers not to lose a penny. If the second player suspects that the first player will match his call, he will change to gain a penny. But the game has equilibrium if each calls head or tail with probability 0.5. In that case, half the time they will match and half the time they will not and each has an expected gain of zero penny but neither has an incentive to change the strategies they have adopted. The contribution of Nash was in showing that any game with finite number of strategies has at least one equilibrium solution if the players switch between strategies with appropriate probabilities. This result considerably expanded the number of games with solutions and made wide use of game theory in economic analysis feasible. The problem is that Nash equilibrium is not unique for many games and subsequent research game theory is to develop criteria to reduce the set of Nash equilibriums for a game. Summing up. The interactions among individuals in a society can take many forms. In some cases, they communicate with each other and arrive at binding agreements. Cooperative game theory
1

The claim that repairing the ship was a dominant strategy implies that Stradling did not act rationally. It is quite possible that Stradling infuriated with a shipmate challenging him acted irrationally. Economic analysis of games assumes that players act rationally

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provides a framework to analyze decisions within a family, negotiations for sale of a house or salary negotiations. In other type of interactions, the parties are competitors. Firms that produce the same product for a market, even if they are willing to communicate, are prevented by antitrust laws from doing so. They have to decide on what output or price will maximize their profit based on what they expect their competitors will do. Cournot considered two firms competing by changing their output and showed that in the duopoly market output will be greater than under monopoly and for prices less, given identical demand curve. Bertrand considered the firms competing by price cutting and concluded that they will cut the prices till both are equal to the common marginal cost. In Kreps-Schenkman model, firms choose the capacities first and then compete on prices. The price that clears the market is the Cournot price. There are circumstances where individuals competing ends up in making a choice that is worse for all than one they could have achieved by coordination. The wide applicability of Prisoner's Dilemma to economic and social decisions has led to extensive debate its logical foundations and for many experiments to test whether players really behave as postulated in the game. There are many games without dominant strategies and, without a method of finding equilibrium strategies, applicability of game theory was limited. John Nash proved that a set of strategies from which no player will unilaterally deviate exists for a wide class of games. Assumptions of rationality includes the question that the outcomes of the game are evaluated on purely what it does to the individual or whether he accepts a moral code that requires consideration of some social benefits. Bibliographic note: Binmore (2007); Kreps and Scheinkman (1983); National Geographic Magazine (2004); Osborne (2004); Shy (1995); Souhami (2001); Triole (1990).

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Chapter 11. The competitive markets.

We join the crowds at open markets, stores or malls to choose from array of products offered for sale there. Each one chooses a few products and each product is brought by many. No one buys a sizable percentage of a product and no customer has the leverage to affect the prices. Can a producer influence price? When we go to a farmers market, we see different sellers selling bushels of corn, tomatoes or potatoes. None can set a higher price on any product than others as all we have to do is to move to the next stall to get an identical product cheaper. When we buy manufactured products at a department store, we do not see different producers selling homogenous products. Products are branded and each band is produced by one producer. Since branding differentiates products, can producers of different brands charge different prices? Discussion of monopolistic competition showed that high prices and profits induce new firms to enter the market and that entry reduces the demand for each of the existing brands at the current prices. Firms adjust output and price to respond to the shift. In this chapter, we consider a case where many producers sell a homogenous product and the competition for consumers is so great that the producers have to accept, like those in the farmers market, the prices that prevail in the market. How common is such conditions? Even though each brand is produced by only one firm, we find in any store many brands of electronic goods of comparable quality. It is different in automobile industry. Showrooms have only car or trucks of one division of General Motors or Ford or Toyota. While side by side comparison of different brands is not possible, a buyer can consult Consumer Report or automobile magazines for comparison. Interned is another source of information. Before the reductions in automobile industry following the 2008- 2009 crisis, there were around twenty models competing in market for family sedans. If the price of one brand was significantly above the average of other brands, consumers will switch and the producer will find that he has to cut prices to regain market share. When a firm introduces an innovative product, it can charge more than products in its group. Responding to this competition, other producers will introduce brands of comparable quality - a process that results in what is known as commodification or commoditization of the product and prices begins to fall. In service industry, airlines in spite of brand names found that their influence in fares is limited; through the last decades of twentieth century, if an airline increases its fares and others did not then the airline is forced to reverse the fare increase. A competitive market is one in which neither individual producers or consumers can affect the price through their decisions. Vilfredo Pareto considered a market to be efficient if the allocation of resources is beyond improvement in a specific sense that none can be bettered while others. It is always possible to rob Peter to pay Paul but if Peter can be made better off without hurting anyone else, why not do so? Paretos argument is that a use of the resources in the economy that does not exploit such an opportunity is inefficient. By exclusion, an efficient economy is one in which such inefficiencies do not exist. One of the achievements of twentieth century mathematical economics is show that an economy in which all markets are perfectly competitive will have a Pareto efficient allocation of its resources. This is reason enough for considering competitive markets.

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Figure 1. Variation of marginal revenue with price. Marginal revenue and marginal costs: guide-posts to profit maximization. The variation of the marginal revenue and marginal cost with output is decisive in determining the profit maximizing output. In earlier chapters on monopoly and monopolistic competition, the technology of the firm was assumed to be such that the marginal cost was a constant. The firm can increase its sales only by reducing the price and the marginal revenue decreases as output increasing. The decreasing marginal revenue provided the constraint as the output where it equals marginal cost is the profit maximizing output. Under perfect competition, each product is produced by many firms. Each firm is so small relative to the market that it can increase its sales without affecting the market price for the product and marginal revenue, as shown below, is constant. If both marginal revenue and marginal cost are constant, they were never (except by accident) be equal to each other. If marginal revenue is greater than marginal cost, the firm can keep expanding as it never reached the profit maximizing output. If it does, it ceases to be one of many firms in the market but more significantly such expansions are not observed in the economy. The constraint has to be come from the cost side. The increasing marginal cost must be forcing the firm to limit output. Marginal revenue. An increase in output by one firm does not lead to a reduction in the price of the product. If thousand units of a product are sold at $3 each, total sales revenue is $3,000. If sales increase to 1,100 units, its sales revenue is now $3,300. Each additional unit increased sales revenue by $3; marginal revenue (increase in total revenue per unit increase in sales) equals price as shown in Figure 1. Even though marginal revenue does not change with output, it will increase or decrease if the market conditions lead to a change in the price of the product. If price increases to $3.50, then the marginal revenue will also increase with it to $3.50. Given the cost structure, every shift in marginal revenue increases or decreases the profit maximizing output.

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Figure 2.Drag and thrust needed to counter it. Marginal cost. Changing the manufacturing facility requires planning ahead, raising finance and ordering capital equipment. The firm cannot change it in the short run. If output is very low, the fixed cost associated with the financing and maintenance of this facility has to be spread over a few units. If, on the other hand, the output is increased beyond a level, the fixed input is strained as it is combined with many units of variable input to increase production. In short, the marginal cost (and average cost) are not constant any more. The justification of variable costs when all inputs are variable is more complex and controversial. Instead of beginning with an abstract discussion of variable costs, the next section summarizes a management accounting study of the cost of flying a plane at various cruising speeds. It brings out how technology determines cost variations and provides an introduction to U-shaped average cost curves. Cost management of aircraft operation A study by Burrows et al focuses on three specific costs - the cost of fuel; salaries of pilots and cabin crews; and cost of maintenance directly related to flight time vary with cruising speed. The following discussion focuses on fuel costs. Isaac Newtons law of motion can be used to analyze the flight dynamics of a plane. There are two forces that impede the flight of steady flight of a plane at fixed altitude. The first one is the drag of the air. When we walk or even run in calm weather, our speed is not enough to make us notice the resistance of air. However if the wind is blowing in our direction, then we have to strain to walk against it. When cycling, the resistance offered the flow of air around us is noticeable. Airplanes flying at great speed have to move large quantities of air around it and it creates a drag that retards the flight (Panel A, Figure 2). There is also friction between air and the surface of the plane. The drag depends on the shape of the plane, its surface, the speed and the properties of air around it and it increases with the speed of the plane. The engines have to generate power, thrust, to push the plane against the drag and the power needed increases quickly with the speed of the plane (Panel B, Figure 2). The second force acting on the plane is gravity which pulls objects towards the earth. Kites were the first heavier-than-air object designed and built to fly and it does so by the using the steady wind above the ground level to counter its weight and the tension of the string that the kite flyer holds. A commercial plane weighs tons and needs more than the lift of the natural air stream. Instead, the forward flight of the plane creates airflow over its wings that provide the lift

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Figure 3. Lift and power required to generate it. (Figure 3). At any speed, the lift depends on area of the shape of the wing, the angle by which the air stream is tuned down, the relative speeds of air above and below the wing (sue to the shape of the wing) and the density of air. When plane flies faster, the airflow increases leading to an increase in the lift. Engines have to strain less against gravity and this leads to saving of the power needed to generate lift. The total power that engines have to generate to keep the plane flying at a constant speed and altitude is the sum of power for thrust and lift and this is obtained in Figure 4 by adding up the two curves in the right hand panels of Figures 3 and 4. As plane accelerates from low speeds, the reduction of power for lift will exceed the increase for thrust and the sum will decrease. At higher speeds the drag of air increases more than the decline needed to generate lift. The total

Figure 4. Total power that engines have to generate at different cursing speeds.

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power that engines of the plane need to generate decreases as speed increases from low level and then increases; this is shown by a U-shaped curve in Figure 4. The total fuel cost of a flight depends on fuel consumption per hour and the time of flight. Calculations using flight management systems show that total fuel cost of a flight by commercial plane as cruising speed is varied has a U-shape. When cruising speed increases from 0.76 Mach (ratio of the speed of plane of to that of sound in the air) to 0.78 Mach, total fuel cost for a flight of 7000 nautical miles of a commercial plane decreases from $25,250 to $25,000. But further increase in speed to 0.8 Mach leads to higher the fuel cost of $25,275. 1 The average cost or cost per mile will also be U-shaped. 2 The airline example is interesting in that cost variation can be explicitly related to the dynamics of flight. In manufacturing firms, the multiplicity of processes and complexities of each prohibit such direct derivation. The current view of the shape of cost curves evolved over hundred and fifty years following the publication of the Wealth of Nations as economists sought to understand the nature of costs. Variable proportion: Explanation for variations in marginal and average costs. It is pressure of population on cultivable lands that led economist to conclude that marginal product (increase in output per unit increase in an input) can vary with output. In any region, the most fertile land will be cultivated first and then, as demand for food increases, the cultivation is extended to less fertile plains. The output per acre will fall. Another possibility to increase output is to cultivate each acre more intensively. This requires application of additional labor (to plow, to weed, to fertilize) and again incremental labor has lower marginal product. Robert Malthus (1766-1834), an English clergyman and writer in economics, claimed that population will periodically outstrip agricultural supply leading to famines and pestilence. Improvements in irrigation, new and better fertilizers and the green revolution have increased agricultural output beyond what could be imagined in the end of eighteenth century. Adam Smith argued that the division of labor in industry will increase the productivity of workers. Marginal product increases with specialization made possible by higher outputs. Alfred Marshall combined the two arguments and attributed both increases and decreases of marginal product to variation in the proportion between inputs. Marginal product and marginal cost. There are inputs like installed machinery that takes time to change while others like employment can be increased much more rapidly. An increase in variable input increases its ratio to fixed input. In the beginning, the better utilization of the fixed input will lead to quick increases in incremental output or marginal product of the variable input. After a limit, the flexibility of the fixed input to combine with ever increasing quantities of the variable input is strained and the growth in output slows down.

The calculation made by Burrows et al is for a hypothetical flight of 370 seat BB-400 plane for 7,000 nautical miles. The price of fuel was set as $0.25 per kilogram. The article notes that while the cost changes look modest, a $150 savings per sector for an airline that serves 20 similar sectors daily will produce an annual savings of $1.5 million. It is a significant number given the razor-thin profit margins in the industry. 2 In the familiar case of driving a car, the miles per gallon decreases with speed and increases gasoline consumption for a trip.

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Figure 5. Changes in output as employment increases. Confining for ease of discussion to the case of two inputs and one output, consider the increase in output of a small workshop as more laborers are hired ( Figure 5). With the hiring of the first employee, the firm produces 5 units. When the second employee is added, the output increases to 12, making the incremental output after hiring the second employee or marginal product of second employee, 7. Marginal product is measured by changes in total output as production is the result of cooperative action by the fixed and variable inputs in the plant. The second employee did not produce 7 units; rather the two employees together produced 7 more units than the first employee. Still the marginal product defined as increase in total output for unit increase in input increased from 5 to 7. The output when three employees work in the plant is 16; the marginal product of labor declined to 4. The switch from increasing returns to diminishing returns was attributed to the ratio of variable input to fixed input exceeding a limit and the two cases were subsumed under what came to be known as law of variable proportions. The cost of production will depend on the price and productivity of inputs. The costs incurred in financing maintaining the fixed input is the fixed cost and that from variable inputs is variable cost. Marginal cost is calculated from the variable costs. Take a wage rate of $14 per hour or $112 for an eight hour day for the laborers in Figure 6. The first employee produced 5 units or the marginal cost of producing any one of the five units is 112/5 = $22.40. After hiring the second employee total wages doubled to $224. For an additional cost of $112, the firm was producing 7 more units and the marginal cost fell to $16. The third employee increased wages by another $112 and output by 4. The marginal cost is now $28. Marginal cost decreased when marginal product of labor increased and it increased when productivity decreased. The average variable cost will also vary with output and its variation can be related to marginal cost. When only one person was employed, average variable and marginal cost were both $22.40. With an additional employee, marginal cost declined to $16 and average variable cost to 224/12 = $18.67; notice, for contrast with next change in output, that marginal cost at the new output is less than average variable cost. When one more employee was added, marginal cost increased to $28 and average variable cost went up to $21; marginal cost is now greater than

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Figure 6. Marginal and average variable cost average variable cost. For simplicity in calculations, these examples considered discrete changes in variable input and output. The relation between the two costs can be precisely stated when variable input and output are changing continuously. Average variable cost will decline with increases in output if marginal cost is less than the average and increase when marginal cost exceeds average variable cost. The intuition is that new unit costs less than the average cost of earlier ones and addition pulls down the average. This result can hold only if marginal cost curve intersect average variable cost at its lowest point; outputs for which marginal cost is less than average variable cost lies to one side and those for which average variable cost exceeds marginal cost to the other (Figure 6). 1 Output of a competitive firm in the short run: Profit maximization requires marginal revenue to equal marginal cost. The marginal revenue of the firm is the price and as price changes, the firm will change its output till marginal cost is equal to the new marginal revenue (Figure 7). This relation permits drawing the individual supply curve of the firm which relates quantities supplied by the firm at various prices. At the price , the firm will produce an output determined by the intersection of price line and the marginal cost curve. As price declines to , the price line shifts down and the new and lower output is given by its intersection with the marginal cost curve. In general, as price varies, the output corresponds to points along the marginal cost curve making it the individual supply curve of the firm with one caveat. The supply curve (not marginal cost) is truncated at the lowest point of the average variable cost. If the price is below the minimum average variable cost, then the revenue from any unit sold is less than the cost of variable inputs like labor used to produce it. The firm is better off by not incurring these costs. Firing all the laborers, the firm will shut down the plant. The individual supply curve is the marginal cost curve above the average variable cost.

While U-shape of the average variable cost curve and its relation to its marginal cost curve are derived from increasing and decreasing returns, the specific shape and position of the curve will depend on the technology used and input prices.

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Figure 7. Individual supply curve of a competitive firm. In the market, there are many firms. The output of each firm at any price is determined by its individual supply curve. The total quantity supplied to the market at any price is the sum of the outputs of individual firms at that price. Figure 8 shows adding up of the outputs of two firms for two prices. At price the quantity supplied by the first firm is Q and that of second firm is Q. The total output is Q + . At the lower price, the output of first firm is q and that of second is q, making total output q + . The market supply curve can be obtained by following this procedure to add up the individual supply curves of all firms in the market. Market supply curve and market clearing price. In the market, the quantities demanded by consumers at different prices are represented by the market demand curve reproduced in Figure 9. 1 Matching this with quantities supplied as represented by the market supply curve of Figure 8, the relative quantities of the product demanded and supplied at various prices can be compared. As shown in Figure 8, at high price the firms supply a quantity in excess of what is demanded and there is excess supply. The unsold inventory leads to price cutting. At low price, there is shortage as quantity demanded exceeds quantity supplied. The price

Figure 8. Market supply curve with two individual supply curves.

1

The market demand curve was discussed in detail in Chapter 5.

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Figure 9. Market clearing price in a competitive market. begins to increase. Given smooth demand and supply curves, there is only one price at which the quantity supplied equals the quantity demanded. Whatever the producers bring to the market is cleared. Another perspective is that if this price prevails in the market, no producer or consumer will have any incentive to change the production or consumption decision and, in this sense, it is the market equilibrium price. The buildup of inventory when price is high or shortages when price is low does not imply that the market will not move instantaneously to the market clearing price. The adjustment process depends on behavioral and institutional factors. Any time, the price prevailing in the market may differ from the equilibrium price for any number of reasons. Either the demand or the supply curve could have shifted in the recent past. Such shifts occur as changes in tastes and income of consumers shifted the demand curve or as entry or exit of sellers shifted the supply curve. Depending on the market response, the price instead of moving quickly to a market clearing price instantaneously frequently fluctuates around it. Producers devote considerable resources and efforts to make more realistic estimate of demand for future. Products can be stored in inventories and firms can test the market by starting with a high price and then discounting. Still it is not possible to correctly predict prices and quantities demanded. In recent years, there have been frequent shortages of electronic goods as demand was underestimated. Prices of agricultural crops go up as soon as crop damage due to climatic conditions is predicted only to fall back when the loss estimate was found to be too large. The fluctuations continue even as more sophisticated methods are developed to predict future demand. Long run: marginal cost when all inputs are variable. The increase in marginal cost as output increases was attributed to the variation in the ratio of the fixed and variable inputs. Given enough time fixed inputs like manufacturing plants can be changed, adding capacity if there is demand for the output and downsizing or closing if demand is decreasing. If all inputs are doubled, will not output double? If the input market is competitive

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and demand by one firm do not affect prices, the doubling of the quantities of all inputs will double the cost but average cost will remain constant and marginal cost will equal it. What limits the output of a firm in the long run? One possibility is that as firms become large, the constraint comes not from production technology but from ability of the management to supervise the firm. How small or large the firm, it has only one chief executive officer (CEO) and his time and capabilities are stretched as the operations within the firm becomes extensive. He can delegate some of the responsibilities and the development of middle management in large corporations is a sign of it. It however increases the coordination problem among decision makers. American industries go through the cycles. In one phase, the firms go on an acquisition binge claiming that it will reduce costs through synergy among the merged firms. It is followed by another phase where the firms sell off many divisions to concentrate on core competence. Managerial ability seems to be as binding a factor as technological ones. Over time technological changes increases productivity of inputs and reduces cost. Adam Smith argued that factory operations that breaking manufacturing into small repetitive operations that are supported by machinery increases workers productivity. In recent years computers and robotics are at the forefront of enhancing productivity and reducing costs. The discussion shows many possibilities in the long run when firms have wider choice of technologies but there are no clear indications that one of these factors has a dominant influence. Entry and exit of firms into a competitive industry. In a competitive market, by definition, firms are free to enter or exit; any market where it is not so is not a competitive market. Differing for a moment why firms enter, consider the effect on market supply curve as new firms enter. The output of the new firms at various prices must now be added to the output of firms; instead of two firms in Figure 8, now there are three firms and the individual supply curve of the entrant should be added to those of the market demand curve obtained by adding the other two (Figure 10). It shifts the supply curve to the right and, if there are no changes in the demand for the product, the new market clearing price will be lower but the market clearing quantity will be greater as shown in the diagram. The motivation for entry or exit is the profitability of firms in the industry. The profit is sales

Figure 10 . Entry of new firm and effect on market clearing price and

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revenue minus total cost. The total cost incurred by the firm has two components: (i) the fixed cost are cost that do not vary with output and includes administrative overheads and the providing a competitive return for the finance provided to construct and maintain the plant and its operations; and (ii) the cost of purchasing variable input like labor and raw materials. Dividing these costs by output, the average cost can be written as sum of average fixed cost and average variable cost. Comparing price with average cost at the profit maximizing output, there are three possibilities each of which need consideration: (i) average cost is less than price; (ii) average cost is less than price; and (iii) price equals at average cost. If average cost is less than price, then the owners or shareholders of the firm is earning a return in excess of the what they could have earned in alternate investment (as the cost of obtaining the financing for the firm is already included in the fixed cost); they are making an above normal returns. This will motivate others to enter the industry and as shown in Figure 10, price will fall. If price is below average cost, the owners are making a return less than that in other industries or even making a loss. They will get out of the industry and the dropping of each firm shifts the market supply curve to the left (reversing the process in Figure 10) and prices will increase. Entry or exit will cease when the price equals average cost. 1 A quick note on the efficiency of competitive economies: Two results under perfect competition stands in direct contrast to those of monopoly or monopolistic competition. First entry and exit ensures that price equals average cost and that the owners or investors of the plant are not earning a return on their investment that exceeds that they could have earned elsewhere. Second price equals marginal cost; the cost to consumer of an additional unit is the cost to producer of producing that unit. If this relation did not hold, there is a reallocation that makes consumers and producers better off. To get an intuitive idea of the reasoning, consider the firm selling another unit at a price between marginal cost and the current price without changing the price of other units (like airlines discounting the fare on an empty seat closer to the flying time). Firm is better off as its operating income increased by the difference between the discounted price and marginal cost. The consumers are better off as one consumer who was not buying it is consumes it (the price now is not greater than what she is willing to pay for it). However this is a very partial view of changes that affect the welfare of individuals. Increasing the output of one product requires the firms to use resource that could have been used to produce other outputs. This changes the composition of outputs and the use of inputs that are provided by household to firms. They earn their income by providing labor services to firms and letting firms use their assets like their savings. Both firms and households transact in two sets of markets, in one as buyers and in another as sellers. This double interaction has important consequences to the economy. Pareto efficiency requires that the multi-person economy is allocating resources so efficiently that no further improvement is possible; there is no reallocation that can make one better off without hurting another. Looking beyond changes in one output to the economy as a whole, an allocation is Pareto efficient only if the answers to the following three questions are all negative: (1) Can a reallocation of existing products among different consumers make some consumers
1

Over the long run, firms can change plant, adding or reducing capital. This changes the shape and location of average cost curves. The complex reasoning is avoided in this presentation. The bottom line remains that price will tend to minimum average cost showing that the product is produced in the most cost effective manner.

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better off without hurting anyone else? (2) Can a reallocation of inputs among firms producing the same product increase the output of one firm without reducing that of another? and (3) Is it possible to increase the output of one industry by diverting inputs to it from other industries and allocating the changed outputs of industries among consumers make some consumers better off without hurting anyone else? These questions suggest that the condition for attaining Pareto efficiency is very difficult to achieve. One of the achievements of modern economics is in showing that if all markets - input and output - are perfectly competitive, the resulting allocation in Pareto efficient. This result sets a benchmark to evaluate the markets that prevail in different economies at different times. As a prelude to discussion the efficiency of an economy, the next section takes a look at the structure of input markets. Review of input markets. For bringing out the central characteristics of input markets without too much complexity, they are grouped into two: labor market and capital market. Labor markets. The most striking characteristic of labor market is that what are sold are the services of individuals whose welfare is the goal of liberal societies. The diversity of individual preferences that influence the purchases of products also influences the sale of services in the labor market. A bag of potatoes does not care whether it is baked or boiled or where it is transported. We have preferences for the work we do; we have invested in the education and training that qualified us for the work and our skills improve with practice. We expect salaries that are commensurate with our skills and the difficulties of the work we do. We care for environment in the work place; we are very responsive to incentives and sensitive to how we are treated by our colleagues and superiors. We also reluctant to move from the community we are living as breaking social connections impose a personal cost on us. In the end, the goal of a liberal and democratic society is to maximize the welfare of individuals and economic institutions and social policies have to accommodate our work preferences as much as our consumption preferences. While these considerations are true at individual level, we see economic opportunities direct individuals to industries where there is a demand for labor. Adam Smith wrote: If in the same neighborhood, there are any employment more or less advantages than the rest, so many people will crowd into it in the one case, and so many others would desert it in the others, that its advantage would soon return to the level of other employments. 1 (Wealth of Nations, p.111). As an industry whether information technology, oil or real estate becomes profitable and expand, there is a rush to be trained in the professions that provide entry into them. The extent of international migration shows that individuals are willing to move to areas where opportunities exist. In the beginning of twenty-first century, United Nations estimates that 175 million people are living in countries other than where they were born. 2 Shortages will bring about an increase in labor force, though the adjustment may be more painful than in the commodity market. This provides a justification for assuming that firms can hire employees at the current wages. Capital markets. We finance the purchase of a house partly with our savings and the rest (generally the larger fraction) with a mortgage loan. To establish manufacturing plants, retails stores, centers that provide services - health care centers and telecommunication facilities, for example - firms need to invest in physical capital. This is financed by past profits retained by the
1 2

Wealth of Nations, p.111. United Nations (2002), p.1

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Figure 11. Financial intermediation. firms, additional loans from financial institutions or through issue of new equity; the percentage of funds from different sources varies with industries, with countries and over time. Considerations that go into the choice of the mix between loans and equity will be discussed in Chapter 11; till then it is assumed for simplicity that firms raise all the needed funds through loans. What is the source of funds for the mortgage company that gives us the loan to buy the house? It may have issued complex securities to other financial companies but these companies need to generate funds to purchase the securities. Going down the chain, however long that is, it ends in the households who have savings to lend or invest. 1 Through deposits in banks or mutual funds and through purchase of securities, household savings get transmitted through the financial system to make investments in physical capital. This process is known as financial intermediation. In short mortgage industry is fully financed by our savings though our individual house is financed mostly by savings others. Just as laborers are attracted to industries with higher wages until the difference evaporates, so funds will flow into industries that earn an above-normal profit; here normal profit is defined as what investors could earn in alternate investments. The funds that flow into the industry can be used either to finance expansion of existing firms or start new ones. Either way the industry increases the absorption of inputs and adds to its output. As inputs, labor and capital, moves from one industry to another, it changes the outputs of those industries. It could also have an effect on wages and returns to equity. Interactive equilibrium of the three markets. We set explicitly or implicitly budget for our purchases for the coming week or month and we make our purchases in the commodity market. Our budget for purchases is closely related to our earning which is based on our income from employment and our earnings from our assets. In any period, our expenses though it may be less or more than our earnings. If our expenses are less than our income, the savings are invested in the financial markets though banks and other financial institutions; if expenses exceed income, then we borrow to bridge the gap. Every one of us is to a greater or less extent transacting in product, labor and capital markets.

Technically retained earnings of a company belong to its shareholders. Because of separation of ownership and management, the decision not to distribute the profits but plough it back is generally made by the upper management.

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Figure 12. The flow of goods and funds between sectors. Starting from the bottom of the figure, we see two types of flow through the commodity market. The black arrow from the factories to the commodity market indicates the goods and services producers supply the market. 1 The black arrow emanating from the commodity markets to the left indicate what is sold to the households. The payments by households for their purchases are shown by a green arrow directed to the commodity market. The funds are transmitted to the suppliers who record it as their sales revenue. This pattern will be repeated in the other two markets also: there is a flow of services or assets in one direction and a reverse flow of payments for them.

The commodity market groups together all the markets for individual products that are bought and sold in this economy. This is an expedient to show the interrelationship between the three groups of markets. While only production of goods by the factories is visually represented in the diagram. The symbol for factories should be interpreted to stand for institutions like universities, theatres and hospitals that provide services that consumers want to purchase.

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Each market has characteristics that separate it from others. Commodity market was discussed in detail in earlier chapters and labor market and financial market will be discussed in in coming chapters. Even though all flows into the market and from the market are funds measured in dollars, the flow from the households to financial institutions and from them to the firms are shown as orange arrows while the interest and dividends that firms pay are shown as green arrows. Figure 12 shows that though there are different markets and there are many flows thorough each of them, they all begin or end at two foci: the household and firms. Any change in any one of the flows will bring about responses from household and firms and that will affect other markets. If firms hire more laborers, then the income of household from offering labor services increases. Part of the increased income would be spent on buying goods and services, part on savings; the split will depend on individual preferences. The increased demand for goods and services in turn leads to a higher level of sales, higher sales revenue and increased profits. Part of the increased income of households that is saved increases the flow of funds into financial institutions which are then willing to lend more to other households and firms. The Japanese economy suffered a long recession partly due to lack of consumer demand around the same time when consumer demand was a source of strength for the U.S. economy; the crisis in mortgage lending in 2007 brought with it the treat of recession. Consideration of the interaction among markets, known as general equilibrium analysis, contrasts with the partial equilibrium analysis of earlier chapters which focused on one product. The analysis was developed in the third quarter of the nineteenth century by Leon Walras and refined by Kenneth Arrow and Gerald Debrue in the twentieth century. Still partial equilibrium approach continued to be the dominant paradigm in economics due to its ability to derive results like the ones in early chapters. The two approaches are consistent if the effect of changes in one market on others can be neglected or if the price ratio between any two other products is not affected by changes in the market. The first theorem of welfare economics states that if all the markets in the economy (markets for different products, for different types of labor services and loans of different maturities and risks) are all perfectly competitive, then the market system brings about an allocation of resources in the economy that is Pareto efficient. Efficiency of competitive equilibrium. In Chapter 3, the exchanges between Robert the farmer and George the fisherman, living by themselves, was considered. Robert and George exchanged at a price ration that lies between their marginal rates of substitution. As exchange continues their marginal rates of substitution will converge due to the rule of diminishing marginal rate of substitution. When the two are equal, there is no further opportunity to exchange that benefits both of them. However, given the initial difference in the marginal rate of substitution, there are many possible exchanges that will equate the marginal rates of substitution of the two but at different values. Modern general equilibrium analysis establishes the efficiency of competitive economy without any restrictions on the number of types of individuals or the number of goods. Can the reasoning about George and Robert be extended to exchanges involving many consumers and many products? In a competitive economy, no individual has influence on the prices of goods as his or her demand is an infinitesimal part of the total output of each product. When the consumer

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Figure13. Condition for cost minimization in a competitive market. chooses the preferred basket, she equates the marginal rate of substation between any two goods to their price ratios. Since all consumers pay the same prices for goods in the market, the marginal rate of substitution between the two goods for all consumers will equal the common price ratio. The equality of marginal rates of substitution between any two goods among the many consumers assures that there is no possibility of additional exchanges that are mutually beneficial. The analysis assumed that the products to be reallocated were already produced. In an economy, the firms can change output and even if they are producing the same output, they can change the input basket used to produce it. Because of the interdependence depicted in Figure 12, any change in one sector affects others. Selkirk the stranded sailor changes what he has for dinner by shifting time spent gathering vegetables and meat. Any change in the output in a modern economy also requires a reallocation of inputs among firms. An efficient allocation in an economy requires not only allocation of outputs among consumers but allocation of inputs within a firm and among firms. If the choice of inputs like labor and capital do not minimize the cost of production of an output, then a reallocation will increase the profit of the firm or leads to a reduction in the price of the product. The reallocation made either the owners of the firm or the consumers of the product better off and the original allocation is inefficient. If shifting inputs from one industry to another, the economy can produce an output basket that consumers prefer to the earlier one (reminiscent of Selkirk reallocating his labor), then the earlier allocation is inefficient. Given the complexity of the process, an indirect approach that provides intuition to the conditions for efficiency is adopted. Two types of changes in inputs that jointly represent all possible changes are taken one by one and the condition first efficiency identified. Finally it will be shown that all the conditions are satisfied in a competitive economy. First, consider one firm purchasing two inputs in competitive input markets where input prices are not affected by its actions. To focus on inputs, assume that the firm is considering changes in input baskets that produce the same output. 1 If there is a change in input basket of the firm that reduces the cost, the cost reduction can benefit the owners by increasing profits or the firms competitively reduce prices and it benefits the consumers. In either case someone benefits. What basket of inputs among those that produce an output will minimize costs? A numerical example brings out the condition needed to minimize costs. The marginal product of capital - the increase in total output as one additional capital is employed - in an industry is 60 and the cost of capital for it is $120. One unit of labor costs $40 and its marginal product is 10. If the firm fires
1

Just as in discussion of consumption, baskets of goods between which the consumer is indifferent were considered in determining the marginal rate of substitution.

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six employees, then output is reduced by 60 units and cost by $240. By hiring another unit of capital at the cost of $120, it can restore the output to the previous level while reducing cost by $12. An economy is efficient only if all such shifts are precluded; either the price of the input or the marginal product should adjust. The ratio of marginal product is the ratio at which inputs need to be changed to keep output the same; it is the marginal rate of transformation. Selkirk has to equate his marginal rate of substitution to the marginal rate of transformation to make the best use of his resources. Firms in markets where they can purchase inputs at fixed prices in the input market will minimize their costs for producing an output (necessary for maximize their profits) when the ration of marginal products equal the ratio of input prices (Figure 13). 1 For another industry, the product is different and the increase in output as a unit of input is increased is different. However the ratio of marginal product of capital to that of labor will equal, under cost minimization, to the price ratio of inputs. Next consider changes in output of two industries as an input is shifted from one to the other. Consumption baskets must reflect the change in output. Will consumers prefer the new baskets to the old? Competitive firms produce an output that equates price to marginal cost (Figure 7). One laborer moves from Industry 2 to Industry 1. In Industry 2, the marginal product of labor is 15 units; the loss of laborer reduces output by 15 units. The marginal product of labor in Industry 1 is 10 units and, with the addition of a laborer output increases by 10 units. The ratio of output changes, the marginal rate of transformation, in 1.5 and the original allocation is efficient if consumers prefer 1 unit of Product 1 to 1.5 units of Product 2. The wage of the laborer is $40 and, the marginal cost in Industry 1 is 40/15 or $2.66 and that in Industry 2 is 40/10 or $4. Under perfect competition, marginal costs are equal marginal costs and the ratio of prices will be the same as ratio of marginal costs, 1.5. Consumers equate their marginal rate of substitution (how much they are willing to give up one product for another and still prefer the baskets before and after change equally) to the price ratio. As a result all consumers in the economy will equate their marginal rates of substitution to the price ratio of products and consumers are neither made better off nor worse off by a small change in outputs through reallocation of inputs (Chapter 3). In the section, A quick note on the efficiency of competitive economies, it was argued that three questions must be answered in the negative if the economy is to achieve Pareto efficiency. The section showed that it is indeed so for a competitive economy and provides an intuitive understanding of the first theorem of welfare economics. Summing up. The first theorem of welfare economics provides a vindication to Adam Smiths claims that self-interest will lead to an efficient allocation of resources in an economy. It also brings out that many restrictive conditions must be satisfied if the economy if the theorem is to hold. The output of any firm is such a small fraction of the total market demand that a change made by one producer should not the price of the product. The marginal revenue of the firm equals the price and is a constant as long as market conditions keep the price at the current level. For the firm to achieve profit maximization at an output, either reduction in marginal revenue or increase in marginal cost must make it unprofitable to expand beyond that output. In previous

The reasoning behind this relation is given in Chapter 13.

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chapters where the firm had market power, the reduction in marginal revenue limited the expansion of output. In competitive economies, the constraint has to come from the cost side. The study of cost fuel at various speeds of flight of an airplane showed that the average variable cost can be U-shaped with marginal cost rising to intersect the average variable cost at its minimum point. In manufacturing industries, the existence of some inputs that cannot be varied in the short run is offered as an explanation for rising marginal cost. When all inputs are variable in the long run, the deciding factor is the ability of the management. The firm maximizes its profit when the rising marginal cost equals the marginal revenue. As price and marginal revenue varies, the outputs of an individual firm at different prices are given by the marginal cost curve. The marginal cost curve is the individual supply curve and the market supply curve is the sum of individual supply curves. The intersection of market clearing price and demand curve determines the equilibrium price and quantity as the market participants have no incentive to change once it is attained. But the price at any time can differ from the equilibrium price due shocks on the supply side or unexpected changes in demand. The convergence to equilibrium can involve fluctuations over time. Just as for output, there are markets for inputs. Individuals invest in education to provide them with skills that are in demand. Firms hire laborers are long as the remuneration is less than the sale of their marginal product. The savings of households are transferred to financial institutions that then lend to firms and individuals who are in need to borrow funds. Funds flow to firms that has a profit rate in excess of other uses of funds with equal risk attracts funds and they expand. Entry of new firms and expansion of existing firms shift the supply curve to the right and that affects the equilibrium price. The input and output markets are interlinked. The general equilibrium theory examines the simultaneous equilibrium of all markets. One of the achievements of the general equilibrium approach is the formulation and derivation of the first theorem of welfare economics. It shows that a competitive economy achieves Pareto efficiency. Bibliographical note: Burrows et al (2001); Stigler (1987); Tremblay and Tremblay (2005); United Nations (2002);
Yntema (1941).

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Chapter 11: Intertemporal preferences, uncertainty and the financial markets.

In choosing between decisions that generate different inflows and outflows of cash, comparisons should be made only after discounting the flows to the same period using interest rate (Chapter 4). In comparing alternate steams of consumption, utilities must also be discounted using time preference; utility from a basket of goods received in future is less than one received in the present. The incentive to save in spite of this temporal preference is the return to our investments; it allows us to buy a lager basket in the future than what an individual gave up in the present. If the sum of discounted values of future utilities exceeds the reduction in that from present consumption, then savings lead to a net gain in utility. Paul Samuelson proposed a rule for discounting of utilities over many periods that closely followed the rule for discounting future cash flows. The challenge is to explain the sudden decline in savings rate in United States starting in the 1990s. While aware of long term need to save, individuals seem to fall for the temptations to consume in the present. This creates an inconsistency in each period between what they planned to do and what they do. New Year resolutions seldom last a quarter. Recent researches model explain such behavior by assuming that time preference for immediate future to be greater than for later periods. In addition institutional changes, like second and reverse mortgage, have made it easier to spend out of past savings or take more credit. The next section examines these arguments. Choice when outcome is certain involves selecting one that maximizes utility. When uncertainty is involved, the outcome is not known when the decision is being made. Preferences and the decision rule need to be redefined. In Chapter 4, commodities were tagged by the state of nature and each decision lead to a basket of state-contingent commodities. The decision rule is to choose the basket that maximizes utility. Another approach examined in this chapter views choice as selecting from lotteries each of which promise a specific outcome in each state of nature. A preference over lotteries is defined and the individual chooses the lottery that maximizes expected utility. The analysis is then used to understand the peculiarities of insurance market. Well-known results in financial analysis are derived by assuming that preferences take a special form; individual ranks financial assets in terms of their expected return (sum of returns weighted by their probability) and a measure, variance, of how much the actual return vary around the mean. Variation of returns is a risk that investors prefer to minimize and by diversification they can create portfolios with lower variance than individual assets. Many individuals with different preferences trade in the financial market and, for the market to be in equilibrium, the demand for individual assets should equal their supply. Capital asset pricing model examines the market equilibrium and derives a relation between expected return of an asset and its riskiness relative to a market portfolio (a diversified portfolio of all assets), given yield of a riskless asset like treasury bill. The chapter concludes with an introduction to market for derivative securities, securities whose value depends on the price of some underlying assets. An intuitive explanation of Fisher Black and Myron Scholes derivation of the price of options (right to purchase or sell at a fixed price on or before an agreed date) follows. Options provide buyers new opportunities to hedge

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Figure 1.Discounting of utilities from future consumption. against risk and from 1970s option trading grew at an astonishing rate. Unfortunately, in a less regulated market than insurance, riskiness of some positions in the derivative markets was ignored and the market achieved notoriety for their presumed role in financial market crisis of 2008. Intertemporal decisions Choosing between consumption streams. The principle of utility maximization under certainty requires the marginal rate of substitution between the two goods to be set equal to the price ratio. Irving Fisher in the beginning of twentieth century extended the analysis to savings decisions of an individual. The decrease in consumption necessary for saving in Year 0 reduces Mias utility. The savings earns interest and next year she has (1 + interest rate) to spend for every dollar saved this year. The relative price of dollar next year to one this year (what is needed to receive one dollar next year) is [1/(1+interest rate)] and this should equal the marginal rate of substitution between consumption in present and one in future. Because of time preference, the marginal rate of substitution between consumption today and an equal quantity next year is not 1 but the discount factor, [1/(1+time preference)]. Utility is maximized when relative price equals marginal rate of substitution or interest rate equals time preference. Paul Samuelson extended the analysis to many periods assuming that the discount factor is a constant and discounted utilities in different periods can be added up. If the level of utility of current basket is indexed as 100 and taking the discount factor as 0.944 as in Panel A of Figure

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1, , the level of utility of next years basket (identical to one this year) is 94.4. 1 The level of utility of a basket received 9 years from now is 59.3. This can be graphically depicted using a technique from painting. Euclids Optics used purely geometrical arguments to prove that, if we look at two objects of equal size, the one further away from the viewer will seem to be smaller as the rays from its edges to his eyes will make a smaller angle than the one from nearby object of equal size. Beginning with century, this principle was used to depict depth in paintings. 2 The investment Andrei was making in Year 0 yields a constant return for 11 years as represented by baskets in Figure 1. Even though they are of equal, the discounted utilities of baskets decreases with time. The left side shows the utilities when discount factor is a constant. Andrei will save now and invest if the sum of discounted utility is greater than the reduction in utility in Year 0. The assumption of constant discount factor has the advantage dynamic consistency; plans made in Year 0 for the tenth year will not be changed when Andrei is in Year 9. In spite of its analytical convenience, even Samuelson had doubts about the descriptive realism of this model. Under present-based discounting, the Andrei is even more relectant to forego consumption in the present though he values future consumption. His discount factor, instead of being constant, decreases over his time horizon; for simplicity, the discussion here assumes a high discount factor in the present and a constant discount factor for all future years. If change reduces the valuation of future benefits and Andrei and other like him will save less. The decline in personal savings rate around 7 per cent during early 1990 to around 0.4 percent by 2006 has serious consequences for individuals as the savings is a buffer to meet unexpected expenses or shortfalls in income. It has consequences for the economy as it is an accounting identity that investments equal savings. Short falls in savings either require borrowings from abroad or reduction in investments that hurt the economy in future. An understanding of the reasons for the fall in personal savings rate Table 1. Personal savings as percentage of U.S. personal disposable income. Year Savings rate Year Savings rate 1988 7.3 1998 4.3 1989 7.2 1999 2.4 1990 7.0 2000 2.3 1991 7.3 2001 1.8 1992 7.7 2002 2.4 1993 5.8 2003 2.1 1994 4.8 2004 2.1 1995 4.6 2005 0.5 1996 4.0 2006 0.4 1997 3.6 2007 0.4

Source: U.S. Department of Commerce, Bureau of Economic Statistics, Personal Income and Its Disposition. March 27, 2008.

1 2

The discount factor is from Angelletos et al ((2001). In Byzantine painting, the sizes of figures were based on their theological or social importance. It is Florentine architect and sculptor Filippo Brunelleschi (1377-1446) who developed the rule of perspectives but the first formal thesis on perspectives was written by Leon Battista Alberti (1404-1472). Field (1997), pp.20-42.

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is a necessary to develop policies to restore savings rate to its historic levels. The disappearing personal savings: Even though Table 1 indicates a decline in personal savings rate, the numbers require careful analysis as there are many conceptual issues in estimating savings rate. National income is compiled from administrative data collected from different sources and they differ in degrees of precision. Should expenses for purchasing of durable goods be accounted as a current expense or as an investment to be depreciated over years of use? Should an increase in value of assets due to increase in prices of stocks or of houses be added to savings or excluded as they arise not from disposition of current income? Is downward drift in personal savings rate an illusion generated by the measurement problems? After many studies reworked the data, the consensus is that the decline in real. Is this decline compensated by changes in business savings and government savings? Private savings rate - the sum of personal and business savings rate - used to be 11 per cent for a long period but declined to 4 percent by 2000. The third component of national savings is government savings but in a modern democracy, governments cannot be expected to have substantial savings over long periods of time; the politicians will feel the pressure either to increase social expenditure or cut taxes. In U.S., after many years of deficit, the budget was in surplus during the last few years of the twentieth century and then turned negative again. Neither business nor government savings increased to compensate for decline in personal savings rate. Since savings by an accounting identity should equal investment in the economy, United States investment is sustained by foreign savings. 1 Partially yielding to temptation: present-based discounting. One explanation for the low savings rate is temporal inconsistency in our preferences. There are obvious instances of such behavior. It is common to make New Year resolutions to quit smoking and cut credit card debts, yet most find the temptation to light another cigarette and to splurge at the next sales irresistible. The same shortsighted can lead to inadequate savings. After looking ahead, Andrei sets a goal to save during our working years and build a targeted level of assets before retirement. But he fails to put aside what he planned to save this year, promising to begin next year. When that year comes, it is the new first year and he and so many others like him procrastinate once more. The temptation for immediate gratification is modeled by replacing constant time preference in exponential discounting with declining time preference; the name present-based discounting for it comes from it favoring gratification in the present. The Angeletos et al (2001) models declining discount factors in an analytically tractable way by setting the discount factor for first year equal to 0.6699 and for subsequent years at 0.957 and presents simulation of the intertemporal decisions of high school graduates in the United States. 2 They provide evidence that their simulations fit the data better than the constant discount model though the fit is far from perfect.

U.S. Department of Commerce, Bureau of Economic Analysis, National Income Accounts, provides statistics on income and savings. 2 Simulations are a way of making computer models to make predictions about a physical or social system and are used when the system is too complex to be solved by analytically. The inputs are chosen as closely as possible to reflect realistic values, some randomness in the process is admitted and the outcomes, the values of variables that are being studied, are made to depend on both the deterministic and random variables. The computer is used to simulate the model many times to generate different values of the outcomes and their values are averaged to make a possible prediction of the variables.

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Institutional explanations. Another set of explanations attribute the trend in savings rate to institutional changes. Two of them that gained currency in public discussion, aging of population and growth in financial and real estate wealth, looked credible but careful statistical analysis brought out facts that contradicted them. As the population ages, it is argued, older persons save less or even use up their savings and national savings rate will decline. If this is true then the savings of those in lower age groups should have remained the same during these years but data shows that all age groups are saving less in the last two decades. Further the savings rate must change slowly with the age structure of the population while there is a perceptible break in the 1990s. Another claim is that the feeling of increased wealth due to stock market boom and housing bubble motivated the consumers to increase their consumption and reduce savings. If this is true, then the fall in savings rate should be only among those who benefited from the prices of assets. Only half the population holds stocks and slightly more owns houses but all cohorts of households showed a decline in savings. Also why did the savings rate fall even after the stock market burst of 2001-2002 when billions of dollars of unrealized gains were lost? Another explanation focuses on financial innovation that allowed consumers to gain credit easily and to convert illiquid assets like house equity into cash by taking second mortgages. Coincidently the household debt doubled during the last two decades. Once households have easy access to liquid assets, it was used to finance current consumption above the level that would not otherwise be possible. This explanation for the trend in savings has found support in many studies. The fourth explanation focuses on the nature of individual risks in the society. Part of the savings of households is to tide over unforeseen contingencies. Government transfer programs like Social Security and Medicare generated a confidence that less reliance need to be placed on personal savings to meet age related disabilities. Risks to individuals from general economic trends like inflation and depression became less common when macroeconomic policies were able to achieve what is known as the Great Moderation; before 2008, business cycles were believed to be damped and both inflation and unemployment rates were steady at low levels. Collectively they created in individuals a lower preference for savings or a lower discount factor. Statistical studies show that the explanation is consistent with observed changes not only of savings rate but also of interest rate. How far do the new theories explain the decline in savings rate? At the social level, trends arise from the confluence of individual actions and the outcome is influenced by income patterns among individuals, attitudes to risk, institutional constraints and the costs and benefits of holding various classes of assets. Given that they are all changing as economy evolves, the time span of data available for statistical analysis is limited and short time span affects the reliability of results. A review of recent empirical studies suggests that, in spite of the progress in analysis of intertemporal decisions, the decline remains a puzzle.1 Decision making when outcomes are uncertain. Individual choosing a basket of consumption goods will, knowing that he can buy it with certainty, will choose the combination that maximizes his utility. If there is uncertainty in
1

Guidolin and La Jeunesse (2007), p.512.

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Figure 2. Choice of portfolios. outcome, it seems natural to assume that his goal to be maximization of expected utility? Intuitive as such an extension is, the claim has to be justified by reexamining and justifying the decision process (Figure 2). John von Neumann and Oskar Morgenstern in their book Theory of Games and Economic Behavior assumes that choices are over lotteries with each lottery delivering a prize - a basket of the commodities or returns for financial securities- in each state of nature. Preferences for lotteries are based on the prizes they offer. The individual whose preferences satisfy the axioms of choice they formulated will choose the lottery that maximizes his expected utility. Expected utility maximization. Chloe wants to invest her savings in an asset or assets that earn a good return. Returns on her portfolio (even if it has only one asset) vary with the profitability of the industries and state of the economy. Every portfolio is a lottery offering a prize in each state of nature. She cannot choose a return but must confine herself to choosing one of the portfolios costing $1,000. Panel A of Figure 2 shows a portfolio with two states of nature. An investment of $1,000 in the portfolio earns a return of $100 if State 1 occurs and $30 if State 2 occurs; the probabilities of these states occurring are 0.7 and 0.3 respectively. She expected return is [(0.7 x 100) + (0.3 x 30)] = $79. 1 Other portfolios that require same investment will provide different returns in the two states (states of nature and their probabilities of remain same as they are not affected by portfolio choice). How should Chloe decide which portfolio to choose? One rule that she can
1

The states of nature are limited to two only to make to simplify the diagram; in a mathematical formulation, the analysis can be extended to any number of states. Taking a frequency interpretation of probability, Chloe over a period of time receives $100 seventy percent of the time and $30, thirty per cent of the time.

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Figure 3. Example of compound lottery. use is to compare expected returns of different portfolios and choose the lottery with highest expected return. She prefers for good reasons not to do so. Consider a portfolio she could choose that yields $0 in State 1 and $300 in State 2. Even though the expected return is $90 is greater, it has no return in the state with high probability and Chloe prefer a less skewed distribution of prizes. She may decide to consider the worst outcomes ($30 and $0) and choose the lottery for which it is higher. Among these and other possible rules, the one proposed by von Neumann and Morgenstern is considered by economists to provide a better understanding of individual choices involving uncertainty. 1 It makes a distinction between preferences for prizes and preference for lotteries. The ranking of prizes is represented by a utility function that satisifes the axioms of preference stated in Chapter 2. Tese rules are not enough to rank lottery. An individual can prefer a low prize with a high probability to a large prize with low probability even if the expected values are the same. von Neumann and Morgenstern developed a set of axioms according to which lotteries are ranked by expected utilities; expected utility of an asset is the sum of utilities of prizes weighted by probabilites of their occurance. A conceptual difficulty in defining expected utility is that the prize for a lottery may itself be another lottery. The challenge facing a farmer provides an example (Figure 3). Kevin, a commercial farmer in Iowa, chooses his planting of corn knowing that the crop will depend on temperature and rainfall during the season. Assuming two states of nature, he will have a good or bad harvest. Being a commercial farmer, he is not interested in the quantity of corn harvested but the income from its sales. The income depends not only on the harvest but the prices at which it can be sold. So his desired outcome depends on a compound lottery with the prize of the first, the harvest, being another lottery whose prizes are prices. Each choice he makes at planting leads to one compound lottery. Kevin whose preferences satisfy the von NeumannMorgenstern axioms will rank compound lotteries by their expected utilities and chose the one that maximizes it.
1

Experiments offering a set of individuals (students are often used in experiments) choices show a sizable minority breaking von Neumann-Morgenstern axioms. Choices that are identical but posed differently resulted in different selections. This suggests that the selections they made were sensitive to how the choices were presented to them.

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Figure 4. Utilities of returns and of lotteries. Going back to Chloes choice of portfolios, the distinction between return and utility of return is brought out in Figure 4. Panel A shows utility from the return on the portfolio; it is her level of utility when she has realized a particular return on her portfolio. If the return was $30, the utility is marked as U($30). As the return increases to $100, the utility increases along the curve to U(100). Of interest is the shape of the curve which reflects Chloes preferences. She values an additional dollar more when the return is less and the curve of utilities has a steeper slope at lower returns than at higher ones. Panel B shows the expected utilities of three lotteries chosen specifically to analyze Chloes preferences. The first corresponds to a portfolio, a time deposit with a 3%, interest that pays the same return of $30 in each state (black dot). Since it offers the return do not vary with state of nature, its expected utility equal utility of $300 in Panel A. Another portfolio pays $100 in each state (grey dot). The lotteries corresponding to these portfolios (black and grey lotteries) are degenerate in that they pay the same prize in each state of nature and there is no uncertainty. The portfolio in Figure 2 can be viewed as a compound lottery that offers black lottery as prize with probability 0.3 and grey lottery with probability 0.7. Its expected utility (red dot) is the weighted average of the expected utilities of the black and blue lotteries with weight 0.3 and 0.7 and lies along a straight line joining the expected utilities of the other two lotteries. Figure 5 by superimposing Panel B of Figure 4 on Panel A brings out one important consequence of Chloes preferences. The utility of a portfolio with a constant return of $79 (green point) is greater than the expected utility of a lottery with expected return of $79 (red point) and Chloe will prefer the first portfolio over the second. Individuals who like Chloe prefer the fixed income over equal expected income are risk averse. Risk aversion induces individuals to seek ways to reduce fluctuations in their income and wealth and the financial market has responded by developing many products like insurance and financial derivatives to facilitate individuals to transfer risk. Risk premium. The horizontal line from the red point to the utility curve shows that the expected utility of the lottery in Figure 2 equals utility of a fixed return of $60. The risk premium is the maximum difference between expected return of a lottery and return of a riskless asset that leaves an individual indifferent between the two. For Chloe and for this lottery, it is $19.

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Figure 5. Risk aversion and risk premium. If she is able to exchange the lottery for a portfolio with a fixed return greater than $60, she is better off. Why should another person or institution want to accept the lottery in such an exchange? The preferences of individuals differ and the utility curve of another individual can have a different curvature, even if U($30) and U($100) are the same. A special case is where the utility curve of an individual, Ennio, is a straight line. For him, the red and green spots coincide and the expected utility of the lottery equals the utility of $79. An individual or institution with straight-line utility curve has no risk-premium and is risk-neutral. If he purchases the lottery from Chloe for a price between $60 and $75, like $68, Chloes is better off as she values a sure payment of $68 over the lottery while the risk-neutral buyer is also better off as he is getting a lottery that he values as $75 for $68. Insurance industry. Insurance industry exploits the mutual benefit of shifting risk between those with differing risk premiums. For an individual, the damage to his house from fire, claims from a car accident or illness requiring expensive treatment can result in a substantial loss to the value of his assets and being risk-averse, is willing to pay a premium to an insurance company to hedge against such losses. 1 Insurance firms with a wide and diversified portfolios are risk neutral or substantially less risk averse than individuals. Within a small group of drivers, the percentage of drivers involved in accident can vary from 1 to 100 per cent, but within a large group of drivers, all making independent trips, the percentage involved in accidents tends to be stable. Many drivers make no accident and the loss per accident also averages out to a stable number.

Insurance premiums refers to amounts one is willing to pay insurance companies to insure against loss and is distinct from risk premium which is a reduction over expected wealth that the consumer is willing to accept to avoid uncertainty. Figure 5 gives a graphical measure of risk premium and Figure 6 compares it to the insurance premium.

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Figure 6. Principle of setting insurance premium The estimate of loss per person is crucial for determining the insurance premium. The insured pays the premium whether she had a loss or not and a numerical example can be constructed to bring out the principle in setting a premium. The probability that Ashanti, owner of a car worth $30,000, having an accident that results in damage of $5,000 is 0.02; her assets are either $30,000 or $25,000. The expected value of car is $29,900 and the expected loss is $100 (Panel A, Figure 6). Ashanti is risk averse and to her the utility of even $29,500 with certainty is greater the expected utility of having the uncertain value of car. To avoid the risk of loss, she is willing to pay an insurance company a premium higher than the expected loss, as long as the excess is less than her risk premium (Panel B, Figure 6). 1 The insurance company will not be willing to insure the car for a premium less than the expected loss. A higher premium will let it earn an operating profit. A premium greater than expected loss and expected loss plus risk premium benefits both of them. Going beyond one individual, the differences in preferences of individuals buying insurance and competition of insurers restrict even more the bounds for insurance premium. Risk premiums of individuals differ with their risk aversion and those with low risk premiums will not be willing to pay the insurance premium acceptable to others. There are two additional considerations in designing the insurance contract. The individual driver or household taking insurance has limited ability to control losses to his assets. This has a two-fold effect on the insurance industry. Driving at low speeds is safer but increases commuting time; the driver is impatient and tries to overtake others on the road and his weaving through traffic increases the probability of accident. In principle such drivers should be charged a higher premium but the insurance company cannot keep track of how each of the insured drivers acts on the road. He avoids the incremental cost of driving defensively but is able pass the cost of the
1

Panel B magnifies the right end of Panel A.

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accident to the insurance company. The temptation to exploit informational asymmetry to act in manner that differs what was explicitly or implicitly assumed when the insurance was purchased is known as moral hazard. The insurance industry counters it by setting a deductible; the insurer has to pay part of the cost of accident. The industry divides the insured into groups that have different expected loss and charge different rates; rates differ by age as young drivers are, in a statistical sense, more accident prone. Insurance companies refuse to cover drivers with bad record. The insurance company depends on customers buying insurance. Since a premium has to be paid even when there is no loss, those who know that they have low probability of loss will avoid it while those prone to losses will have an incentive to seek more insurance. The young and the healthy do not want to pay the health insurance premiums that they suspect is subsidizing those who are sick and elderly. If each individual is allowed to take insurance, the insurance company will find that they are stuck with a pool of insured prone to running up medical bills. This is an example of adverse selection, adverse for the insurance company as it losses increases. 1 To compensate for adverse selection, the company can increase premium for those who are insured but then high premiums will make those with lower risk within the group drop the insurance, making the pool even smaller and expected loss possibly even larger. Offering health insurance collectively to employees of a large organization with young and old employees avoids adverse selection. The burning issue in health reform is whether the society has an interest and obligation to offer health insurance to all citizens and how the cost is to be covered and adverse selection avoided. Some countries have national health insurance programs where Unites States insurance is mostly through employers. While major employers are able to negotiate insurance premiums that they can agree to pay themselves or more often share with the employees, small companies and self-employed face very high premium. Many millions are left without insurance. Any choice whether to leave the system as is or to modify it to create insurance pools to those who are currently left out involves decisions about distribution about cost and benefits among the population and, as noted in earlier discussions of Pareto efficiency, it involves moral, social and political values that are beyond what can be discussed in terms of economic analysis. 2 The expected loss is only an estimate and actual losses can differ from year to year. Insurance is only a transfer of risk from the insured to the insurer and while aggregation over individuals smoothens out the fluctuations in payouts, there is always a risk that in one period it will spike. This is particularly true for property insurance. Hurricane in Golf Coast, tornadoes in Mid-West and flooding in any part of the country can be financial disaster for the insurance companies. The financial institutions that provide loans to the insurance companies and the individuals who purchase the stocks of the company are concerned about the solvency of the company and its future dividends. If they feel that the company can be under financial stress due to the risks it insured, they will demand a higher return. The company has to consider the risk it is facing and its cost of funds in pricing its products. It charges a premium more than the
1 2

This has become a controversial issue in the health reform passed in United States in 2009. John Locke and Immanuel Kant (sixteenth and eighteenth century philosophers) stressed the rights of individuals to the fruits of their work and argued against the society depriving him or her of any part of it to meet social goals. Jeremy Bentham in eighteenth century stressed the welfare of the society as a whole. (Chapter 2 has a short description of their positions). There are a group of economists, Amartya Sen being prominent among them, who argue that criteria beyond those used in defining Pareto efficiency is needed to address social issues.

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Figure 7. Judging portfolios by their mean and variance. expected loss but as it increases premium, more and more buyers of insurance will find that it exceeds the maximum premium many they are willing to pay. Other insurance companies will come up with rate structures to attract dissatisfied customers of their competitors. An insurance company has to balance between its financial need and the desirability of having a large pool of insured. Financial Economics. In the analysis in the last section, the individuals response to variations of returns with states of nature determined the shape of her utility curve. A person is risk averse if utility of prizes increase less than proportionately with the value of the prize. It created a gap between utility of expected return and expected utility and gives rise to a measure of risk aversion, the risk premium. Irving Fisher in 1906 proposed using variance, a statistical measure of fluctuations around the mean (expected value), as a measure of risk. Harry Markowitz in 1952 paper quantified the reduction of risk from diversification of investments and developed the idea that investors want to maximize expected portfolio return while minimizing its variance. James Tobin (1958) derived an important result that reduced the combination of assets that individuals need to consider in choosing the preferred one. He showed that, if there is one riskless asset and many risky assets, risk-averse individuals restrict their choices to combinations of the risk-less asset and one specific portfolio of all the risky assets. What varies among individuals is the proportion of the two in their portfolios. Still determining the benefit of diversification remained difficult as it required knowing the covariance of returns (intuitively the extent to which returns of stocks vary together) of every pair of stocks. 1 The Capital Asset Pricing developed by William Sharpe and John Lintner showed that, instead of knowing covariance of returns among all stocks, all that is needed to determine the return of any risky asset like a share of a company is its covariance with the market portfolio (a portfolio in which the stock are held in the same ratio as their market value to the total value of all shares sold in the market). 2

Stocks and shares both refer to certificates that provide ownership of a fraction of the equity of a firm but shares usually refers to certificates of a firm while stocks refers to such certificates in general. Covariance is positive if both shares have higher return in the same state. It is negative if one has a higher return in the state where the other has low return and the reverse in the other state. In a portfolio of the two stocks, the high return of one will balance the low return of the other and the portfolio will have lower variation that individual returns. 2 Jack Treynor and Jan Mossin are now listed as co-founders in light of the papers they published around the same time.

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Figure 8. Calculation of variance of the share of High Risk Company. Mean and variance of shares and portfolios. Elijah could invest his assets in a bond or Treasury bill. They provided a fixed return and have no variance. 1 If Elijah invests in shares of companies, he has the right to receive a share of the profits, the fraction being proportional to the ratio of shares he has to number of shares of the company that are outstanding with other investors. Profit of a company fluctuates with changes in consumers taste, their purchasing power and with the extent of competition in the market. Table 2. Mean, standard deviation and covariance of two shares. High Risk Company Mundane Corporation Portfolio (50% invested in each share) 9.5% 7% 8.25% 1.5625 (SD = 1.25%)

Return in state of nature (probability = 0.5) Return in state of nature (probability = 0.5) Mean return Variance

16% 4% 10% 36 (SD = 6%)

3% 10% 6.5% 12.2 (SD = 3.5%) -20.5

Covariance
1

Uncertainty about inflation is a problem and the rate has to be adjusted for expected rate of inflation. Inflation depends on monetary policy and state of the economy and, to exclude economy level issues, all returns are assumed adjusted for inflation.

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To simplify the discussion, the profit in examples of portfolio choice is made to depend on two states of nature only. If Elijah purchases for $100 a share of the High Risk Corporation at the beginning of the period and at the end it is worth either $116 or $104 with probabilities 0.5. Since no dividends are paid on this stock in this period, the return is 16% or 4%. The mean or the expected return is 0.5 x 16 + 0.5 x 4 =10%. Since actual returns in both states differ from the mean, a measure of the variation is needed to determine how risky the stock is. One measure is be to add up the differences between mean and return in each state of nature. The difference is +6% in one state and -6% in the other and they will cancel each other and the measure suggests that there was no fluctuation! This paradox can be avoided by squaring the differences, multiplying them with probabilities of the states and adding then up (as done in the last line of Figure 8). 1 The sum, variance, is a measure of risk in holding a stock or a portfolio and Table 2 gives the variance for shares of two companies and a portfolio. The positive square root of variance, standard deviation, also is a measure of variation and is used in in graphic presentation of the relation between return and risk. In Table 2 standard deviations (SD) are given in parenthesis. If in one state of nature the return of one stock is above its mean and that of the other below its mean, then the differences offset each other at least partially. While it is in line with the old sayings, do not put all your eggs in one basket, Markowitz showed that, while variance of portfolios can only be minimized for each level of return or mean return maximized for each level of variance, risk cannot be completely eliminated. This is brought out by estimates by Andre` Perold of variances of portfolios of stocks in various financial markets. 2 Taking data from 1994 to 2003, Pernold compared the standard deviations of 24 stock markets round the world. Each market can be thought of as a portfolio consisting of all stocks traded there and the aggregate of them as an international portfolio. The capitalization (value of stocks outstanding) of all stock markets was $29,870 billion dollars and standard deviation 15.3 per cent. U.S. stock market with half the total capitalization has a standard deviation of 16.1 percent; standard deviation of the next largest, Japan with about 10 per cent of total capitalization, is 22.3 per cent. United Kingdom, third in capitalization, has a lowest standard deviation at 14.3 per cent while Russia with a capitalization 0.7 per cent has a standard deviation of 76.9 per cent. The standard deviation of the international portfolio of all stocks is lower than that of portfolios of stocks in any of the markets except United Kingdom but still significantly different from zero. Elijah has three securities to choose from: a risk free bond and shares of two corporations. He examines investing his assets in a portfolio consisting only of the bond and shares of the Mundane Corporation. If he invests all the assets in bond, the return will be the risk free interest rate, 3 per cent and standard deviation will be zero. As he shifts his investment to the shares of High Risk Company, the return will increase in proportion to the percentage of shares in the portfolio; if Elijah holds 50 per cent of his assets as shares, the expected return will be 6.5 per cent. The variance will also increase in proportion to the share in the portfolio, as bond has no variance.
1

It is accident of numbers chosen that the two factors, (16 10)2 and (4 10)2 in calculation of variance are the same. Variance has some nice statistical properties that make it the preferred measure of fluctuations around the mean. 2 Perold (2004) pp.3-24. Table on market capitalization and historic risk estimates is on page 8.

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Figure 9. Mean and variance of portfolios.

Compare choices Elijah makes as an investor with that as a consumer. As a consumer, he has a budget which determines the baskets he can afford. The budget line slopes downwards to the right; any increase in the purchase of one product requires a reduction in the other to remain within the budget. He will pick a basket on the budget line where his marginal rate of substitution equals the slope of the budget line; the indifference curve is tangent (touches at one point) to the budget line at that basket. As an investor in a bond and a stock, the combinations of mean and standard deviation that Elijah can attain is determined by mean-variance frontier, a straight line in Panel A of Figure 9. It slopes up as higher expected return can be attained only by portfolios with greater risk. Turning to his preferences, Elijah sees a tradeoff between risk and return. The combination between which he is indifferent is shown by the curve marked I-I. It slopes upwards to the right as he is willing to take greater risk only if rewarded with higher expected return. Among the combinations that lie along the straight line frontier, he will choose the one that equates his marginal rate of substitution between return and risk to the slope of the line or where one of his indifferences curve for return and risk is tangent to the line. The portfolio chosen will depend on Elijahs preferences. If he is very risk averse, the point of tangency will be to the left and he will hold most of his assets as bonds; if his preferences are to take risk for higher expected returns, he will move up the line and may even go to the dashed part where he invests more than his assets in stocks by borrowing in the financial market. If Elijah invests his assets in shares of the two companies, expected return will increase as the proportion of shares of High Risk Company (the one with a higher expected return) increases. The variance of portfolio will also increase as the variance of returns of High Risk

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Figure 100. Risk and return for portfolios with many shares and a bond. Company is greater than that of Mundane Corporation but, due to negative covariance, the increase will be less than proportional to the change in share ratios. 1 Risk and return with many shares and bonds. Having appreciated the advantages of adding the share of a second share to his portfolio, Elijah can diversify even further by investing in more of shares traded in the stock market. Increasing diversification allows him to attain higher returns at the same level of risk. Confine to shares only, the curve relating risk to return in Panel B of Figure 9 opens up to the tilted U-shape of the red curve in Figure 10. The portfolios that achieve the highest return for a given level of standard deviation are efficient and they form the efficiency frontier (the upward sloping part of the cure in Figure 10). The shape and position of the curve depends only on the means, standard deviations and covariances of the shares and is independent of the preferences or assets of the investors; this property is important in establishing market equilibrium. In addition to stocks, Elijah has a choice of investing part of his assets in a risk free asset and it offers portfolios that offer better trade-off than the shares-only portfolios. If he invests his assets in the risk free asset and the shares of Mundane Corporation, they will lie along the straight line of Panel A of Figure 9. It will intersect the red curve as the portfolio has less diversification than those on the curve. Elijah can form a portfolio with more shares which has higher return for any given level of variance. As more stocks are added, the line from risk-free return has swung up (Portfolio P is one of them). Diversification reduces the relative price of risk and return and the line swings upwards. 2

Negative covariance implies that when one has low return, the other has a high return and the returns of the portfolio varies less that of individual stocks. 2 As relative price decreases, the budget line of a consumer swings outwards. The objects of choice are different and the derivation of results needs to be done afresh. Elijahs choice of a portfolio of investments involves choosing the preferred basket given the constraints imposed by his resources and opportunities in the market.

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Figure 11.Efficiency frontiers in capital asset pricing model. Ultimately the line will touch the red curve (frontier for portfolios only shares) at the point M. Combinations along the blue line provides a higher return for a given level of risk than any other portfolio available to Elijah. Marginal risk of a stock for Elijah: The riskiness of a share is measured by its variance or its square root, the standard deviation. Investors expect to be compensated for higher risks of their investment by a higher return. Going back to the case of a share and a bond (Panel A of Figure 9), as the share is added to the portfolio, the standard deviation of returns and excess return (mean of portfolio over that of bond) increased in proportion to the share of the stock. Yet as a share with high standard deviation is added to a portfolio with less risky shares, the incremental risk to a portfolio from the stock purchase depends not on stocks variance but covariance with the portfolio. Realizing this, an investor like Elijah considering purchasing a share is not judging its riskiness by its variance but with its covariance with his portfolio. This suggests a distinction between average risk and marginal risk parallel to the distinction between average and marginal cost in the market for goods. Under competition the price of a product equals the marginal cost, not average cost. The excess return (difference between expected return and return on risk-free asset) he expects for adding a stock depends on its covariance and not variance. When market equilibrium is examined in next section, the portfolio against which the riskiness of individual stock is judged is the market portfolio. Market equilibrium: capital asset pricing model. The discussion of individual decision to invest in a portfolio assumed that the expected return and variance of various assets are known to the decision maker. The returns in the one-period model depend on the end-of-the-period price of the assets (Figure 8) which an individual observer takes as determined in the financial markets. The prices of financial, like all prices, are determined by the demand and supply for them. The Capital Asset Pricing Model (CAPM) developed in the 1960s uses parsimonious assumptions to develop an explanation of financial market equilibrium. It establishes a relation between riskiness of individual assets and their expected returns.

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The model adds two assumptions to the mean-variance analysis of last section. First, it assumes that the mean and variance of all the assets are known publically and agreed upon by all those who are in the market. Mean and variance are the properties of the stocks but investors obtain their estimates from statistical analysis of stock market data. Statistical estimates can differ depending on data used and estimating techniques. This assumption assumes unanimity. Second, capital asset pricing mode assumes that there is a risk free asset and further the borrowing and lending rate of that asset is same for all individuals and is independent of the amount borrowed or loaned. This also is a strong assumption as rates differ and there are limits to borrowing. Simplifying assumptions can get to the core of a complex problem and the judgment on the model has to be based on how well it describes real-world stock markets. The benefit of diversification is that it provides a better tradeoff between risk and return. Consider all the portfolios that can be formed with the shares traded in the stock market and the ones that provide the best return will lie along the red curve in Figure 11. If there is a risk free asset as assumed in Capital Asset Pricing Model, it is possible to form combinations of the risk free and a portfolio on the frontier of portfolio with shares only (red curve). These portfolios fall on straight lines from the risk free asset to points on the red curve and one of them will be tangent (touch at one point) the red curve. A particular portfolio plays a special role in the Capital Asset Pricing model. To identify it, first define the value of any share as the number of shares outstanding (and held by various individuals and institutions) times the current price of the share. The ratio of the value of a share to the value of all shares in the market is the weight of each share in the market capitalization. A market portfolio includes all risky assets in proportion to their weights. First important conclusion of the Capital Asset Pricing Model is that the market portfolio, M of Figure 11, is on the efficiency frontier of all risky assets. This is a condition for market equilibrium as otherwise there is a change which will benefit the investors. The market will clear - or the quantity demanded of each asset will equal the quantity supplied - only if the market portfolio is on the efficiency frontier. The next important result is that the straight line efficiency frontier with bond and stocks is tangent to the efficiency frontier for stocks at M. All investors will choose portfolios on the line where their marginal rates of substitution between risk and return equal the slope of this line. Relatively more risk-averse investors will choose portfolios that have a higher fraction of the risk-free assets like bonds and earn a lower mean return while less risk-averse investors will choose one further out on the line that has higher risk and higher return. Relation between return and riskiness of assets. Risk-averse individuals will hold risky assets in their portfolios only if the expected return is greater than that of risk free assets. Diversification can reduce the riskiness of portfolios but, as Markowitz showed, cannot eliminate it. Even a portfolio of all shares traded in 24 major stock markets around the world has a standard deviation of 15.3 per cent. 1 The return on market portfolio in a financial market also must exceed the return on risk free asset to compensate for the risk. There are three returns to be considered: risk free return, the expected return on market portfolio and the expected return on individual assets. The capital asset pricing model establishes a relation between the three by deriving a relation between two differences among the three returns. Excess return of any share or market portfolio is the excess of its expected return over that of risk free asset. The difference
1

Perold (2004), p.8.

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between expected return of market portfolio and return of risk free asset is one component of the relation. An investor can avoid part of the risk of holding an individual stock by adding it to the portfolio and knowing that it can be diversified, the market will not reward the investor for bearing the variance of that stock; the return in a competitive financial market is for the risk that cannot be diversified. The expected return of a stock over that of market portfolio depends on its riskiness relative to that of market portfolio and that is measured by covariance between the two. In the capital asset pricing model, the covariance is divided by the variance of market portfolio and the ratio is known as beta. Since the denominator of beta is common to all stocks, the differences in betas of different stocks are due to differences in covariance. The beta of the riskless asset as it does not vary and covariance is zero. The beta of the market portfolio is one as covariance with itself is its variance. Other stocks can have higher or lower beta depending on their covariance with market portfolio. The capital asset pricing model is expressed by the relation: The excess return of any asset = (beta of the asset) times (the excess return of the market portfolio). The model has many intuitive conclusions. The expected return of an asset depends not on its total variance but on that part of its variance that cannot be diversified away. Holding assets in any two shares will not lead to reduction of riskiness. Only if they have negative covariance will there be a reduction in risk. This has important implications for company policies. Every now and then there is a merger mania; company executive claim synergy and go on an acquisition spree. The market is skeptical that riskiness is reduced and stocks of the acquiring company frequently falls. An individuals assets include human capital and real estate but in practice data availability has forced users to take a portfolio of stocks as a proxy for market portfolio. One of the assumptions of the model is that market prices the stocks using all the information available to those trading in it and critics argue that there are episodes of mispricing. Additional variables like book-to-market ratio (the ratio of the firms historical cost to the valuation of the firm in stock market) and size of the firm are included to increase the explanatory power of the model but there is resistance to addition of variables without theoretical underpinning. Beta of stocks is still widely uses as a practical measure in making financial decisions. 1 The uncertain future As we make decision about the future, we have to consider both the lapse of time till we reap the benefits and the uncertainty of the outcome. Previous sections considered them separately. Time preference explains our unwillingness to postpone gratification and the greater is our time preference, more inclined we are to prefer the present gratification over the future. The oneperiod models of uncertainty provide us an understanding of the financial markets. Today there is a class of financial - forward and futures contracts, and options - that are extensively used to hedge against risk that arise over time. They are collectively known as derivatives as their prices are based on, derived from, that of other assets. The next subsection examines one of them, the options and the principle of pricing options.
1

The empirical evidence for Capital Asset Pricing Model is not very strong but it is valued as a framework for thinking about risk, return and diversification.

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Options. Price of crude oil rose from $52 a barrel in January 2007 to $80 per barrel in October 2007 and then to about $147 in July 2008. 1 Southwest Airlines had options to purchase oil at $51 per barrel for most of its oil and price difference between market price and the option price made the option contract worth $2 billion for the Airline. For whatever reasons, other airlines did not take options on aviation fuel. Meanwhile for American Airline, the price difference amounted to annual cost increase of $3 billion. As the price of derivatives of crude oil responded to the price increase, users of oil or its products suffered a cost shock. Next year as prices increased to $147, Southwest Airlines pinned its cost to $62 per barrel. The airline industry was in utter turmoil but Southwest Airlines used options to cushion its costs and continued to be profitable. Option in its simplest form is a right to purchase (call option) or sell (put option) a specified asset at a fixed price by a certain date; the buyer of an option can but is not obliged to exercise the option. 2 The call option is exercised only if the one who holds it finds it beneficial to do so. If an individual or institution has a call option for aviation oil at a price of $61 per barrel when the price in the market is it is selling in the market for $126, the buyer saved $65 per barrel while the one who sold the option suffers loss of $65. 3 Option like insurance shifted the risk from one party to the other. To purchase this privilege, the buyer of the option must pay a price to the one who writes the option. If the price in the market at the time the call option has to be exercised is less than the option price, the buyer will forgo the option and purchase oil in the open market. The price he paid to buy the option is a loss. This example illustrates that derivatives like option only transfers risk; someone has to bear the risk that price of the underlying asset like oil or stocks in open market differs from the price in the option contract The option premium, the price that the one who transfers the risk by purchasing the option, must compensate the writer for the risk. If risks are underpriced, it will be like low insurance premiums and create serious financial problems for those who wrote it. Finally, option premiums are much less than the price of the assets, options give the buyer potential command over quantities of assets at low cost; the fear is that it gives opportunities for manipulating the market for the underlying asset. Evolution of option trading. Trade in futures on rice in Japan and options on tulip bulbs in Holland go back to seventeenth century. These contracts were individually negotiated and the one who sells it practically draws up the contract and the term writer is still used to one who sells an option. Negotiations of a contract are time consuming, negotiated prices are not public information and cannot be compared with prices of similar options traded. Finally there is no secondary market where one who has a position in the option market can unwind it. Due to lack of transparency there was widespread concern that options were being used to manipulate the market and studies indicate that there was an element of truth to the allegation.

An Airline Shrugs at Oil Prices, New York Times, November 29, 2007; Southwest boosted by clever fuel hedges Financial Times, July 24, 2008. 2 The subsequent discussion of option pricing is restricted to call options; the price of put options is related to it by the call-put parity. 3 Writers of option hedge against such losses. Hedging which is integral to option pricing will be discussed later in this section.

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In the early decades of the twentieth century, option pools were formed in Unites States to obtain from major shareholders call options on up to 20 percent of outstanding stocks of companies. There was concern that the options were used to manipulate prices. In 1973, the Chicago Board Option Exchange began trading in standardized stock options and the transparency inspired confidence in the working of the market. In the same year, Fisher Black and Myron Scholes published a paper that analytically derived the price of the option based on the strike price (price of the stock for one who exercises the option), expiry date and volatility of the stock. Now traders in the option market could decide whether the option is mispriced or not. The benchmark inspired confidence in the market and there was explosive growth in options market. Pricing of a call option on a stock. The price of a call option on a stock depends on the movement of stock prices, the profitability to the holder of the option if he exercises it, the hedging by the writer of the option to protect against loses and an appropriate rate of interest to discount to the present. An intuitive understanding of the option price formula can be obtained by considering components separately and then linking them together in the Black-Scholes formula. Pricing just before the expiration date. Consider an option that gives you the right to purchase a stock price at $100 on May 30, 2008. The price is known as expiration price or strike price. The date on which the option can be exercised is the expiration date, exercise date or maturity. American options, allow the holder to exercise it any time up to and including the expiration date while European options can be exercised only on the expiration date. Most options traded are American option but European options are easier to analyze and once European options are understood, the analysis can be generalized to include American options. The discussion below is confined to European call option. Consider a time just before the expiry of the option. Albert has an option to purchase a stock at $100 on a specific expiration date. The price of the stock in the market at that expiration date is $102 and if Albert exercises the option he can then sell it in stock market and make a profit of $2. Recognizing it others will be willing to buy the option from Albert near the expiration date and the price of option will be bid up to $2. If the price of stock was $103, the option price will be $3. This leads to the first of the results needed to build a general theory of option pricing: if stock price is above the strike price, option price close to the expiration date will increase dollar per dollar for every increase in stock price. On the contrary if the stock price just before expiry was $95, the option to buy it at $100 is worthless and price of option will be $0. Even if price of stock changes marginally from that price, it has no effect on the price of option. The jump in option prices complicates the relation between the two. The fluctuations of stock price. The price of High Risk Company in Figure 8 was assumed to fluctuate between $116 and $104 with equal probability. In stock markets, stock prices change by smaller amounts and over a wider range. The return on the stock held for a period of time depends on how the price changed. When the stock of High Risk Corporation increased from $100 to $110, the return was 10 per cent. If the price was $104, the return will be 4 per cent. In stock markets, the stocks take many prices and there is one rate of return for each price (relative to the price in previous period). The assumption used in option theory is that rates of return vary according to a distribution, Normal

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Distribution that occurs frequently in statistical analysis. It places highest probability at the mean value and probability tapers off symmetrically in either direction. The probability of any other return depends on the distance from the mean and the standard deviation of the distribution. Reversing the calculation of returns from prices earlier, the distribution of stock prices can be calculated from the distribution of returns. In addition to distribution of stock prices at an instant of time, how this distribution moves over time must also be defined. This can be illustrated by assuming discrete changes in prices and, for minimizing computation, assuming mean to be constant. Assume that the stock price was $100 at Period 0. The price in Period 1 depends on one of two states of nature; in one state it is $101 with a probability of 0.5 and in the other it is $99, each with probability 0.5. The mean price is $100 (to keep the numerical example simple, the drift of the mean is ignored). The variance is 1 percent. Next period the price moves from the previous position, moving up or down by 1 percent with equal probability. If the price in Period 1 was $101, then the price next period is $102.01 or $99.99. Since the probability of price in Period 1 being $101 is 0.5, the probability of it being $102.01 or $99.99 will be 0.25. If price was $99 in Period 1, the next period it will be $99.99 or $98.01 with probability 0.25. There are three possible prices, $102.01, $99.99 and $98.01 with probabilities 0.25, 0.5 and 0.25. The mean is $100 and variance 2 per cent and variance increases over time. Given the assumed distribution of returns, the movement of stock price follows Brownian motion which, because of its frequent occurrences in physical sciences, is well understood. Modeling stock price movement as Brownian motion and deriving option prices involved many conceptual challenges that were solved by Fisher Black and Myron Scholes. Option pricing. The four variables that influence the option pricing are current stock price, the strike price of option, the variance of the stock under Brownian motion and time to expiration date. Because of the complexity of the process the equation relating these variables to the option price is very involved. Still it has a simple structure and consists of the sum of two factors. The first one is current price of stock multiplied by a probability that depends on a function of the four variables. Second one is the discounted value of strike price multiplied by probability that depends on another function of the four variables. 1 Hedging: Southwest Airlines brought options to purchase aviation fuel at $52 per barrel when the current price of fuel was $51 per barrel. It was betting that price will increase. If price increased as it did $80 by October 2007, those who wrote the options will suffer a loss of $28 per barrel. The same will happen to those who write options on stocks. If the price of stock at the expiry date exceeds the strike price, the difference is a loss to the writer who has to give the stock at a lower price to the one who holds the option. The writer of option, faced with this risk, can hedge against possible loss by using a strategy of buying the stock on which the option is written and financing it with the price of option and selling a bond short. 2 The writer did not have to commit any of his other funds to form this portfolio.
1

The strike price is the price at which option can be exercised at the time of expiry option. It presents value at any time before the time of expiry is obtained by discounting it for the time difference. 2 Selling short is selling an asset that the individual do not own. Sometimes the person shorting the asset borrows it from another individual to whom he has to return it at the specified date. If price of the asset has fallen in between, the person who shorts it makes a profit. Such transactions are common in markets where seller is sure that he can purchase the financial asset in the market if he has to deliver it to the buyer. Hedging is the defraying the cost of one investment by another.

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The terms in the brackets will change with stock prices, time to expiration and variance. Another part of the complex proof of option pricing is to show that on the net the changes in the value of stocks and bonds will cancel each other and the writer will have no cost in maintaining the hedge during the life of the option; in the terminology of option price is a self-replicating. At the time of expiration, the writer following this ever changing hedge portfolio will be left with enough stock to meet the demand by those who brought the option if price of stock exceeds strike price. Since the buyer will exercise the option, the writer can pass the stock to him without additional costs. If the stock price is less than the strike price, the hedging would end up with no stock but then the holder of option is not exercising it. The hedge eliminates the risk of loss to the writer but he makes no profit from it; it is like an insurer who offers a fair gamble to the insured. The buyer of the option has to pay the price of the option and it could be viewed as a premium for avoiding purchasing the stock at a higher price than the strike price. Though the hedging explained after stating the Black-Scholes option pricing formula was stated, the ability of the writer to use dynamic hedging to protect himself from any loss from the option was used in deriving the formula. Mathematically all the arguments in different sections in which options were discussed are interconnected. Assessment of option pricing. The Black-Scholes pricing rule was instrumental in the growth of option markets and still widely used in pricing options. It is a rational pricing formula if the assumptions underlying it are valid. Yet they are frequently violated. The model assumes that the writer can hedge by buying stocks and selling bonds at current prices. If the market is thin relative to the trade by option dealers, the price will change as trade occurs. The model also assumes that there is no transaction cost for these trades which is not true and these costs limit the ability of the writer to trade hedge continuously as required by the formula. The interest rate will not remain constant during the life of the option. Finally the probability distribution of stock prices may differ from what is assumed in the formula. Option pricing formula is another example of how simplification leads to a fundamental insight but once it is obtained, it is necessary to strive to adjust for complexities excluded. Much of the work in option pricing is directed at this goal. Conclusion. Many of the decisions we make in the present affect us in the future. Economic science from the time of Adam Smith on recognized the role of time but the tools to analyze intertemporal decisions when outcomes are uncertain were developed only in the twentieth century. Time preference in one form or other can be traced to nineteenth century writers but the precise formulation by Irving Fisher stated here is from his Theory of Interest published in 1906. Von Neumann and Morgensterns work on utility maximization under uncertainty was published in 1944 and Leonard Savage work on subjective utility in 1954. The mean-variance theory was developed in the fifties by Harry Markowitz and James Tobin. The rest of the analysis of financial markets in this chapter was developed in the last half century. The impact these theories had in their short lives is evident from the dramatic development of the financial markets. Theoretical developments were crucial for the broadening of the market. Until mean-variance theory and capital asset pricing model were developed the concept of risk was not well understood and the cost of equity capital was related to growth rate of the firm which is very subjective. New theories enabled innovation in portfolio management and

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corporate finance. The derivative market, though traced back to seventeenth century, came into its own only after the option price formula was developed. The theories clear were based on simplifying assumptions that were necessary to bring out the role of risk and reward. The result was an analytical foundation that is well understood and a host of empirical results that provide general support to its conclusions. But the fit has not been perfect and ongoing research while questioning and extending the models has not led to a new and widely accepted analytical framework. The assumption of stock prices are rational in the sense that it incorporates all the information about the firm as of that moment is one of the hotly contested assumptions. Behavioral finance argues that the internet bubble, the 1987 stock market crash, the large variance of stock indices and the tendency of stock prices to follow a trend set in past indicate that the assumption of rational expectation need to be modified. The 2008 financial crisis is bound to add to this debate. Bibliographic note: Akerlof (1991); Bailey (2005); Bosworth (2005); Burrow and Rouse (2005); Browning and Lusanrdi (1996); Chabis, Laibson, Schuldt (?); Chriss (1997); Danthine and Donaldson (2002); Day and Newberger (2002); Eichenberger and Harper (1997); Fama and French (2004); Field (1997), Financial Times (July 24, 2008); Fisher (2006); Shane, Loewenstein and ODonoghue (2002); Grinblatt and Titman (1998); Herschleifer and Riley (1992); Huanf and Litzenberger (1998); Hull (1993); Laibson (1997); Lentwiler (2004); Lutz (1967); Machina (1987); Mass Colell, Whinston and Green (1995); Option Insitute (1999); Parker (200); Perold (2004); Shiller (2003).

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Chapter 13. Firms: Islands of command.

The English economist Dennis Robertson described firms in a market economy as islands of conscious power in this ocean of unconscious cooperation, likes lumps of butter coagulating in a pail of buttermilk. 1 The ocean is the competitive market where firms compete with each other for sales to customers. The islands are the firms in which employees are required to take directions from their administrative superiors. Instead of pursuing their individual interests, employees are expected to take actions judged to be in the best interest of the organization. The paradox is that these islands of conscious power were not imposed on the economy - as planning was imposed on the Russian economy after the Soviet Revolution - but arose out of the churning of the competitive markets. Each one of us, even when swimming in the markets, has to interact with the command structures as consumers, investors of our savings, and as employees. Decisions made within it has affects us. Yet there is aura of mystery as the firms are guarded in what they reveal. Even if we are working in the firm, what we know is restricted to what we have to do. Yet actions within the firm affect us by affecting our career opportunities, the value of our savings and the choices in the product market. In the interrelationship in an economy, the two foci are the consumer and the producer. All other institutions play a supporting role in the relations between the two. This chapter takes a peek at the mysterious islands. The shifting of production from cottages to factories occurred when new technologies gave a competitive advantage to mass production using of machines driven by water or steam power. Adam Smith in his Wealth of Nations uses the process of producing pins to illustrate the enhanced productivity from division of labor. 2 A single craftsman, if he tries to make pins by himself, can at most produce ten pins per day. In the factories he visited, Adam Smith noted that the production of pins was broken down into eighteen distinct operations and ten persons manage them (with some doing more than one of the operations). The output of the plant is forty-eight thousand pins or four thousand and eighty pins per worker per day. The boundaries between its internal operations and the markets where they transact are changes over time. The Rouge River Complex of Ford Motor Company grew over time to include almost all stages in the manufacturing of a car; it had its own blast furnace and steel mill, glass manufacturing, tire plant and assembly line to put it all together. Today it is common for a firm to purchase many components of its products from other firms; a computer manufacture purchases semiconductors, plastic cover of the central processing unit and even the keyboard from other firms. Instead of producing something internally while buying rest from outside, why not carry the breakup the manufacturing process to the level of individual operation and let a market transaction intervene between them? In pin making, let each of the eighteen operations be done by different firms with the firm that did the first operation selling the semi-finished good in the market to the one doing the second and so go on till at the end of eighteen operations, are done and the finished product can be sold in the consumer goods market. This limit of fragmentation is never reached and firms that internalize production coexist with markets for parts and semi-finished goods.
1 2

Robertson (1923), p.85 Adam Smith (1904), p.5

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Figure 1. The organizational chart of a firm.

The rise of the industrial corporation. Till the middle of nineteenth century, manufacturing except in armories and textiles, were conducted at the smallest level. Most American firms relied on human, water or animal power to run the simple machines made out of wood; many were put together locally but some were imported from England. The overwhelming majority of enterprises listed in McLane Report has assets only of a few thousand dollars and employed at the most ten or dozen people. 1 Given their sizes and organization, the need for capital was limited and met from the savings of the owner, his partners and the local bank. In the transition from household production to factories, consumer industries in England went through an intermediate stage of proto-industrialization or putting-out system. An urban entrepreneur provided workers at home with raw materials and then took back the processed good and sold them in the market. In United Sates, a few industries - cotton (for a short period), textile, shoes, chairs - used the putting-out system but it never became widespread here as in England. Since the most common primary production units of production are a small factory, there was no need for complex organizational structure. The owners relied on direct supervision to manage the laborers and their activities. This delayed use of accounting system to assess the

McLane Report is a 1932 survey of American manufacturing authorized by the Secretary of the Treasury. Alfred D. Chandler (1977), p.60.

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efficiency of operations; later double-entry bookkeeping was used to record of financial transactions. 1 As the size of firms grew with technological change, with improvements in transportation opening distant markets and with mergers of firms in the same industry (horizontal mergers), the owners had to delegate decisions to others. In United States, the railways faced the challenge of coordinating movement of goods and passengers over long distances. In the case of manufacturing industries, technological innovations increased the size and output of firms and they had to develop capabilities to sell the output over a wide geographical region. Firms created a middle management staffed with professionals specialized in management, accounting, sales to supervise the operations (Figure 1). 2 In England, the early industrialization and smaller geographical area with more concentrated population had the opposite effect as opening of markets in the United States; the management continued to be in the hands of entrepreneur or his family and professional management structure as in the United States did not develop till the twentieth century. In the entrepreneurial firms, the top management consisted of the founder/owner or his partners. With the growth of firms, decentralization even at the top level became imperative. The firms that raised funds in capital market had to provide representation to those who provided it with funds. The shareholders of firms (that have issued stocks in financial markets) are the nominal owners of the firms but diffused ownership of stocks makes it impractical for them to participate actively in the management. This responsibility is delegated to the board of directors who are elected by the shareholders. The board appoints the chief executive officer (CEO). The chief executive office is assisted by the chief financial officer and executive vice presidents for operations, marketing and personnel in developing competitive strategy and policies of the firm. They evaluate how well the policies set by them are implemented by the middle management and operating units. Decisions relating to operating unit. Operating units position at the bottom of the command structure (Figure 1) belies its economic significance. The profitability of the firms is determined mostly by the cost of inputs into its processes and by the sales revenue of its output. The economic justification for the superstructure is its role in directing the operating unit to meet the goal of maximizing profits. Management that fails to meet this goal come in for criticism and is under threat of being replaced. The operating unit is only one segment of a longer supply chain that begins with consumers at one end and ends with producers of the most basic inputs at the other. Its operations must be tuned to the demand for the firms output which depends on the needs of the consumers and the extent of competition in the market. For any level of output, the management must minimize the cost of production by choosing a basket of inputs that is appropriate for its technology and the current cost of inputs. While the production process differs from industry to industry, in general it can be depicted, as in Figure 2, as the transformation of raw materials into finished product.
1 2

Accounting systems were introduced earlier in England due to prevalence of putting-out system there. The distinction between line and staff positions was carried over from the railways. The line positions, from general manager to foreman, form the hierarchy for the control of the product or service while staff positions are provide advisory and support responsibilities like accounting, finance and research.

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Figure 2. Cross-section of a firm The profit maximizing output will vary with the changing conditions in the product market and the operating unit must respond by changing the input basket to achieve cost minimization at the new level of production. The adjustments will depend on the technology and the speed with quantities of inputs can be changed. From outside, a modern factory is an imposing structure and the management, out of concern that information about its operations will give away its competitive advantages, limits access to its plants. One familiar exception to this inaccessibility is small restaurants where as diners we can observe the meals being prepared. Viewed in abstract as a transformation of raw food products into a meal their operations parallel that of other industrial units. In addition a restaurant is a retailer and its choices throw light on how it links food preparation to marketing. Choices made by a restaurant. The physical space of the restaurant includes dining area, the bar, kitchen and storage area. The dining area has its chairs, tables, lightning and music system. The bar is stocked with beer, wine and liquor. The kitchen is equipped with appliances, cutlery and crockery to prepare and serve food. The two common sources of energy are electricity and gas. The restaurant employees cooks, assistants in the kitchen, bartender and the waiters. If it is an up-scale restaurant that only serves dinner from 6:00 p.m. to 10 p.m., the food preparation starts around noon and the last employee leaves around midnight. The limited hours of operation creates an asymmetry in its cost structure. The employees are paid for the hours they work and the electricity and gas charges depend on usage. Whether it is used or not, the physical capital - space and equipment - is there all the time and the owners have to pay interest on the cost of the capital even though it is used only half the time. 1 . The capacity of the restaurant is based on an expectation how many customers will come for dinner on an average day but the number fluctuates from day to day. If unexpectedly large number of customers comes on a day, the restaurant needs extra tables and chairs to sit the guests and the kitchen has to be equipped to prepare additional dinners. The restaurant must have at
1

Most firms use a mix of equity and loans to fianc their investment in physical capital. The implication of using the mix will be discussed later in the chapter but here, for simplicity, the investment is assumed to be financed by loans only.

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hand enough groceries to prepare the extra meals. Each choice has its costs. If the restaurant maintains a capacity well above what it uses in general, it adds to the cost of capital of the firm. Some food items become stale quickly and if purchased in excess will have to be thrown out. If some guests are denied seating, he or she will most likely go to another restaurant. Not only has the firm lost revenue from the sale of dinners on that day, those who went away may not return in future. In choosing capacity, the restaurant seeks a balance between the fixed cost of capital and the loss of profits from lost sales. The owners can increase utilization of the physical capital by serving lunch. The wage cost will increase in proportion to hours employees worked and the energy bill will go up. Additional grocery need to be purchased. In terminology used in earlier chapters, these are the variable costs. The cost of capital that does not change with increased utilization - ignoring additional tare and ware - is the fixed cost. The decision to serve lunch is economical if the additional sales revenue exceeds incremental variable cost. If one evening more than normal diners are served, would the rushed preparation to use more of the ingredients per additional meal? Will extra activities in the kitchen create distract kitchen staff and add to the labor time needed to prepare each additional meal? If so, the cost of additional meal, the marginal cost goes up with the number of meals. If the prices of entries in the menu are fixed, then it is also the marginal revenue and there is a level of service at which marginal revenue equals marginal cost. As discussed in earlier chapters, this is the level at which restaurant maximizes its profit. The decision whether to serve lunch or not is an example of the choice the owners have to make about the strategic fit of the restaurant in the supply chain. It must decide on: the quality of the product, the price, the level of service, the speed of delivery and addition of new items in the menu. Some diners go to fast food restaurant seeking quick service and low prices but are willing to give up the service in an upscale restaurant. Others choose chain restaurants with sit-down service, bar serving beer and wine, and better choice of foods; the prices exceed those of fast food restaurants. Still others seek upscale restaurant with full bar, a gourmet meal served with individualized attention that takes more time and cost more. The strategic fit requires that the production end - the chef who prepares the food, the waiting staff if any and the setup of the kitchen - should match the marketing strategies like the ambiance of the restaurant, the speed of service and the pricing. The next section considers how the quantitative relation between inputs and output is determined by the technology. Input choices and production management. The production process in a plant being a transformation of inputs into output, the quantity of output can be related to the quantities of inputs and production function is an expression of this relationship: quantity of output = a function of the quantities of (machine hours, labor hours, raw material and energy). 1

The relation between the speed of plane and use of fuel is an example of such quantitative relation between inputs and outputs (See Chapter 11).

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Certain technologies require that the inputs be combined in fixed proportion. Such is the case of an industry that requires a fixed amount of steel, so many hours of machining, labor hours and a given quantity of energy. 1 If the capacity of the plant is not fully utilized, then a proportional increase in the other (variable) inputs will increase the output in the same proportion. The cost of variable inputs, given fixed prices, will also increase in the same proportion, making marginal cost, the cost of an incremental unit of output, constant till capacity. This is one justification for the constant marginal cost assumption in Chapters 6 to 10. If the technology permits combining inputs in different proportions, then output can be increased by increasing anyone of the inputs. Can the production process have such flexibility? It is widely accepted that in agriculture the proportion of inputs can be varied. Without changing the amount of seeds, a farmer can increase the output through better irrigation, use of fertilizer or careful tending of crops. Does such flexibility exist in industries? Possibly there are workers in a plant who have to switch from one job to the other and the switching time was reducing their productivity. If new workers are added, the jobs can be separated and together they can produce a larger output. Examples apart, whether individual inputs can be varied depends on the technology and this was debated at length in the second half of nineteenth century. Now it is widely accepted that such variation, at least within limits, is feasible. Once the variation of input proportions is admitted, certain marginal concepts that are useful in analysis of firm and of the input markets can be developed. 2 Changing output through change in variable inputs. Based on their marketing studies, the upper management asks you, the production manager of a plant, to increase the output. What are your choices and how should you go about doing it? If inputs can be varied individually, you can increase one of the inputs; let it be energy. For unit increase in the energy, the output of the firm will increase by the marginal product of energy. The marginal product is a derived concept from the increase in total output for unit increase in the quantity of the input; the temptation to think of marginal product as the output produced by the last unit of the input should be resisted as all units of inputs are identical and there is no identification of any unit of output with anyone unit of input. Your decision affects both the cost and the revenue of the firm. An additional unit of energy hour increases the cost by cost of energy but the sales revenue also increases as the additional output is sold. If the price is 10 cents for kilowatt hour and the marginal product is 0.05, then producing an extra unit would cost the firm $2 and that is the marginal cost. In general marginal cost is (price of input)/marginal product. If the increase in sales revenue, marginal revenue, is greater than the marginal cost, the profit of the firm has increased. You will then be justified in hiring more of the input.
1

Another way of stating this relation is that the ratio of any one of the inputs to the output, the coefficient of production for that input, is a constant. 2 George Stigler, an eminent economist and historian of economic thought, succinctly summarizes the debate: By 1900 most economists used universal variable production coefficients. In recent years there has been a revival of fixed coefficients, in connection with so called input-output and linear programming analysis. The question is mostly one of fact, and of a kind of fact not easily enumerated in a census. Moreover, while it is easy (I conjecture) to show that every important production coefficient has varied since 1925, only those variations that occurred in the absence of technological progress are in question, and they do not carry separate labels. Theory of Price p.124.

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Figure 3. The marginal rate of technical substitution. When will increasing energy cease to be profitable? The answer is jointly determined by the manufacturing technology and the market for the product. The output of a firm is constrained by one of the three conditions: the firm reaches capacity, marginal revenue decreases to the level of constant marginal cost, or marginal cost increases to the level of marginal revenue. Once marginal cost exceeds marginal revenue, the firm cannot add to profit by increasing output. Should you have increased another variable input than energy? The increase in profit for one additional unit of output will be the difference between the marginal revenue and marginal cost. Since marginal revenue is determined by the output market, it will be the same irrespective of the input used to increase output. The differences in profit from using different inputs depend only on marginal product of an input and its price. If you are asked to increase the output, your responsibility as the production manager is to choose the input that adds most to the profit of the firm. When will a substitution of inputs reduce the cost and increase the profits of the firm? What basket of inputs will produce the current output at minimal cost? What is the condition for cost minimization? How to choose the basket of inputs that minimize cost. The firm in Figure 2 is considering substituting some of its labor intensive operation with one that uses more energy without changing in output. The contribution to output by additional energy must match the decline due to reduced labor hours. It suggests that that the rate of substitution will depend their marginal products. The conditions that neither output nor cost be affected by small changes imply that ratio of marginal products of the two inputs, defined as the marginal rate of technical substitution, equals the ratio of their prices (Figure 3). 1 If the change in input basket had
1

The output is constant if (marginal product of labor) times (change in labor) equal (marginal product of energy) times (change in energy). Hence (marginal product of energy)/(marginal product of labor) = (change in labor)/(change in energy). Since the changes in the quantities of inputs are such as to keep output constant, it is defined as the marginal rate of technical substitution (along the lines of defining change in quantities of consumer goods that keep level of utility constant as the marginal rate of substitution). Constancy of cost requires (change in

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reduced costs, then the firm was not minimizing cost. This condition is reminiscent of the rule in consumer choice that marginal rate of substitution should equal the price ratio. Is there a combination of inputs that minimize cost and if so is there only one such combination? The condition necessary is that as more and more labor is added, the reduction in energy input needed to keep output constant must decrease; the marginal rate of substitution must decrease as more energy is substituted for labor. Marginal product and marginal cost curve. Going back to input use in agriculture, an increase in fertilizer (or irrigation) increases the yield from the land. In those regions of the world where cultivation was primitive, applying fertilizers led to a substantial increase in the output of the farm. The first dose of fertilizer has a high marginal product. But experience suggests that as more and more fertilizer is added, the land gets saturated and output ceases to increase; the law of diminishing marginal product is a formal statement of the principle that output cannot be increased indefinitely by adding one input while others are constant. As marginal product decreases, the cost of producing an additional unit with additional employment of this input whose price is constant increases. The technology of an industrial unit determines whether output changes with one input and also how the marginal product varies. In marginal product is constant, marginal cost will be constant (assuming input price is constant). In the complex environment in which a plant operates, it is not generally feasible to change one input alone. Given the absence of experimental verification, one approach is to statistically analyze the cost data of the firm and derive the cost curve. Another approach is to interview managers and obtain estimates. Such studies suggest that marginal cost is constant up to an output which was defined as the capacity of the plant and it is assumed to be so in discussions in many models of industrial organization, management accounting and operations research. Most discussions of price theory - the branch of economics that discusses how prices are determined - still favors the assumption that marginal cost is increasing. Perturbations in the supply chain. Changing output. The fluctuations in the demand force every producer to face choices similar to that of the restaurateur in responding to them. Too much of capacity leads to redundancy and the high fixed costs can result in loss as happened to the U.S. automobile industry in 2008. Compared to the previous year, the sales of the Big Three automobile companies, GM, Ford and Chrysler, saw their sales decline by 22.6 per cent, 20.1 per cent and 30 per cent respectively. 1 In mid-December GM announced that it will idle 30 per cent of its North American assembly plant volume. 2 In contrast any firm that underestimates demand will lose sales. Though publishers and booksellers suffered a decline in sales in 2008, Amazon faced a shortage in one of its products. In November 2007, Amazon introduced Kindle, a paperback sized wireless portable reading
labor) times (wage rate) = (change in energy) times (price of energy) and this leads to the condition that (price of energy)/(wage rate) = (change in labor)/(change in energy). The right hand side of the two equalities are the same and so (marginal product of energy)/(marginal product of labor) = (price of energy)/(wage rate). The left hand side of this equality is defined as the marginal rate of technical substitution, leading to a relation that at profit maximization, it must equal the ratio of input price. 1 Los Angeles Times, January 6, 2009. 2 The Wall Street Journal, January 5, 2009

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device into which a large number of e-books could be downloaded. The sudden surge in sales after it was featured in a popular TV in October 2008 resulted in it being out of stock by end of the year and was expected to remain so till the next February. It allowed competitor Sony to promote its Reader device during the gift-buying Christmas season. 1 The ideal is for a firm to adjust its output with sales but such close tracking may be too costly to be profitable. A study of the automobile industry in US by Timothy Bresnahan and Valerie Ramey identifies different ways of adjusting output in the short run. 2 The industry pioneered use of assembly line for mass production; it reduces average cost by spreading the fixed cost of the plant among large number of units and by increasing productivity of workers who repeat the same operation. The output can be varied in response to demand changes by altering the hours of operation of the line and the labor input measured in the work hours will change with it. Labor hours can be increased by making workers on a shift do overtime, by increasing the line speed and by adding more shifts. 3 Overtime achieved by adding an hour or two per day or, more commonly, by an eight hour shift on Saturday requires that the workers be paid a premium of 50 per cent for hours worked in excess of 40 hours a week. Increasing the speed from 70 cars to 80 cars require requires hiring more laborers per shift as it involves reorganizing the assembly line and redefining jobs. If a second shift is added, the workers in that shift receive 5 percent wage premium. The marginal cost of the product depends on how the labor hours were increased. Output reductions are achieved by shutting the plant for at least a day, shut-down for a week, reducing the number of shifts and reducing the line speed. Looking at the reasons plants were closed down, Bresnahan and Ramey notes that 35 per cent of the days the plants are shutdown is for model changeover, 25 per cent for reducing inventory and 7 per cent due to supply disruptions including strikes. The different methods of changing output have different costs due to overtime pay. If higher sales are expected for long time, the firm increases capacity leading to higher fixed cost but not much change in marginal cost. For the duration of the change in output is longer, it will prefer a change in work schedule with larger fixed cost but lower increase in marginal cost; in case when duration is expected to be shorter, it will prefer the change in operations with a smaller increase in fixed cost and high marginal cost. In any case, the nature of costs make the changes in production rate vary, as measured by variance, more than the fluctuations in sales. An inventory of final products permits the firm to meet fluctuating demand by drawing on it when demand exceeds output and adding to it in times of slack sales. Inventories however can be costly. The firm has incurred costs in producing the items in inventory and they were finances from the working capital for which the firm must pay an interest. The cost of the storage facility and the salaries of personnel that manage it are other expenses. Over time part of the inventory

The New York Times, December 24, 2008. A1. Bresnahan and Ramey (1994) pp. 593-624. 3 The data for this study is from 50 automobile plants over 626 weeks from 1972 to 1983. The wage rates and work rules are those that prevailed during this period. Among these plants, 6 produced only one model and that enabled identifying work hours with the specific output.
2

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Figure 4.Multi-stage processing and flow of inputs through the plant. gets spoiled and parts become redundant as new products produced either by the firm or its competitors. 1 Today firms strive to minimize inventory. Managing the flow of inputs. In most manufacturing operations, the inputs that are brought into the firm (Figure 1) are transformed into the output by a multistage production process; Figure 4 shows a simple two-stage process. The modern automobile has many parts made out of different materials. Its production involves fabrication of many parts and then assembling them together. Some are produced in the plant itself while others are provided by its suppliers. In a sequential multi-stage process, output of one process is input to a subsequent process in the operation and demand for it depends on the production schedule of the latter. It would be ideal if inputs can be produced just when there is a demand for it but it is not practical for many reasons. The time involved in production of components differs and machinery at one station in the plant may have to be used for fabrication of different parts. All plants, in spite of differences of in their outputs and technologies, face the problem of ensuring a smooth flow of work-in- process through the manufacturing process. There is a fundamental difference between meeting internal demand for work-in-process and meeting the demand for the product in the market. The buyers makes decisions based on their wants and the producer can provide incentives like price discounts but have no quantitative control. Within a plant both the units producing the components and the ones using them are within the command structure of the firm. The firm can choose how workers operating each unit are informed and motivated to produce the parts in quantities as needed while minimizing cost of production and cost of holding inventory. Should the operating units have freedom to communicate directly with each other and schedule the production or should they be asked to follow a master plan made by the management? The two paradigms for production planning that were widely adopted in the later decades of twentieth century differed substantially in the degree of decentralization.

Thread separation in the tires made by Firestone for Ford SUVs at the Decatur plant resulted in death in early 1990s due to rollovers of the vehicles. One alleged quality control problem that led the separation was that rubber used in manufacture of tires was allowed to sit too long. New York Times, September 15, 2000.

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Just-in-time production. The first approach, developed by Toyota Motor Corporation, focused on inventory reduction by producing what is used just as it is needed. As this paradigm was emulated by other firms, it came to be known as just-in-time production system. Lean production, popularized by MITs International Motor Vehicle Program can be viewed as a refinement and broadening of just-in-time approach. 1 The decision process under just-in-time production hinges on communication between operating units. Consider a processing unit producing a component in small batches and placing it in bins with green cards bearing the identification number of the part. The next processing unit takes them out of the bin when needed and, as each unit is taken out, replaces a green card with a red card. When most of the green cards are replaced by the red ones, the first unit produces another batch of the part. 2 Once a part is placed in the bins, it remains there till the next stage withdraws it: the supervisor has to take responsibility for it and not hide overproduction by shifting the inventory to other units. The just-in-time production is characterized as a pull system as signals from the next stage of production, the pull, determines the operations of each unit. Elementary as the process is, its efficiency derives in localizing and simplifying decisionmaking. For the system to succeed, some complementary changes in the operations of the plant are needed. A processing unit that manufactures any part in small batches will have to switch to production of other parts if its equipments are not to remain idle for long periods of time. Minimizing the labor cost and minimizing the downtime of the machinery are essential if the process is to be economic. Toyota separated the operations for the change-over into those that can be done when the unit is still producing from those that requires shutting down the unit and used the separation to reduce change over time. This is embodied in its philosophy of single minute exchange of dies. The lean production system allowed Toyota to respond to the consumers by offering more choices in any model of the vehicle and even from shifting from production of one model to another than American automobile companies that remained with mass production systems. Toyota developed two other programs - total quality management in 1960s and total productive maintenance in 1970s - that complemented the just-in-time production developed in 1950s and enhanced the competiveness of the company in terms of quality, cost and delivery. Total productive maintenance program seeks to achieve greater customer satisfaction by involving the employees at various stages in the development and production of the product. Its philosophy is that quality of the product is built in the process and any problems should be detected in the process and corrected than after the production of the defective product. The total productive maintenance focuses on the involvement of employees in maximizing the overall effectiveness of the equipments through reduction of downtimes due to repair, resetting or workrelated to losses. Though the goals of these programs are commendable and the evidence of success of companies that have effectively implemented them is convincing, any firm that tries to introduce them must consider the cost of the complex organizational changes they require, including investment in retraining of employees and schemes to motivate them to follow its demanding
1 2

Enkawa and Schvandeveldt (2001) pp. 551-555. This is a simplified representation of signaling the use of parts known as kanban system, kanban being Japanese for cards. The green cards are production kanbans and the red ones are withdrawal kanbans.

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requirements. Experience shows that it is advisable not to introduce the system simultaneously as the cost involved will have no return in the immediate future. Managing flows of inputs from suppliers. Most manufacturing plants purchase many finished, semi-finished and raw materials from other suppliers. In placing orders with suppliers, the firm had to ensure sure that they are capable of producing the product in quantities required to the specifications given and on schedule. The time and effort the firm spends on comparing potential suppliers and choosing between them imposes a cost on it, the transaction cost. If their flow does not match with their use internally, either excess inventory will accumulate at the input end (Bin 1 of Figure 4) or production will be disrupted by shortages. Any bilateral relation is open to opportunistic behavior; the supplier can ask for price increases price beyond that warranted by cost changes as it knows that the firm will have difficulty in changing over to another one. The manufacturing firm can also be opportunistic in pressuring the suppliers as they would suffer serious loss from the redundancy of the investment to produce the part. 1 The Japanese manufacturers minimized such costs and risks by maintaining a close link with a limited number of suppliers and getting them involved in the model design and manufacture. John McMillan argues that the long-term relationship between the firm and its supplier can be viewed as a repeated game which reduces the incentives to take opportunistic action.2 Manufacturers in other industries and other countries have adopted just-in-time production and supplier relations developed by Toyota. McMillan points to the example of Xerox which cut the pool of suppliers from 5,000 to 400. Recent growth of e-commerce reduces the transaction cost of searching and placing an order for parts and how it affects the balance between long-term contracting and market transactions is to be seen. Limitations: In spite of the contribution of the just-in-time programs to efficiency of the production process, it has the limitation that it is reactive than proactive to changes in market conditions. The demand schedule is liable to change with seasons and over the life of a product. Just-in-time production is best suited to high volume and repetitive manufacturing processes. As market trends pressures firms to produce a larger variety of products in smaller quantities, the kanban system loses its ability to minimize inventory. On low volume items, Toyota itself has gone to schedule-initiated production. An alternative system: material requirements planning. Another approach to planning the operations that was extensively used in the second half of twentieth century begins by forecasting demand for the product during a pre-determined planning period. Once the projections are made, a production schedule of each component is prepared. As first developed in the 1960s, material requirement planning (MRP) was found to be too narrow in its scope and newer programs, manufacturing resource planning (MRP II) and Enterprise Resource Planning (ERP), addressed the deficiencies of material requirement planning, by encompassing all operations of the firm, from processing of materials to distribution of the final product. In contrast to the localization of decisions under just-in-time production, these complex computerized systems centralized the information in large data bases and used them to check inventories and order deliver of parts. It is a push system that manufactures parts to a centralized schedule than based on the pull from the next processing systems.
1 2

Game theory discussed in previous chapter provides the logic and the possible solution to such behavior. Mcmillan (1990).

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These push systems require expensive computer systems and once established takes too much of computer time to run the schedule once. It assumes that lead time, time taken to produce a product from time of order is fixed and provides no incentive to workers in the plant to reduce it as exists under just-in-time systems. Being data intensive, it is sensitive to the accuracy of the data and workers have to go through extensive training in inputting shop-floor data into the computer. Also the program cannot respond to frequent changes in data as it is not economic to run the program frequently. Uday Karmarkar points out that the planning system should be tailored to the nature of production process. 1 Instead of viewing pull and push programs as substitutes, they should be used complimentarily with the first promoting shop floor efficiency and the other responsiveness to market conditions. How does your employer treat you? About seventy percent of the aggregate income of individuals in western economies is employment compensation. Each one of us spent the better part of the day during our working years at the job and how enthusiastic we are and how much effort we put into it depends on how the employer and coworkers treat us and how your efforts are recognized and rewarded. For the employer, the compensation paid as wages, bonus or benefits is a cost to be recovered from the sales revenue generated by the efforts of the employee. If the outcome of his effort can be identified either by direct supervision of his work or if the firm can identify what part of the output is due to his effort , then the compensation as with a piece rate or commission for sales for example - can be related to his productivity. Output can depend on group activity or may vary with random factors and the employee can claim that they do not measure his effort well. Close supervision is not possible if the employees have to work are geographically dispersed; it is not practical to closely supervise a sales person is travelling in his region or an airline attendants flying around the country. Knowing that the employer cannot ascertain how diligent he is in his work, the employee, preferring less effort to more, will shirk his responsibilities. Most of us have met at stores, restaurants, in planes or in public offices, employees who seem indifferent to providing you the service that they are supposed to do. We are upset at the employer for not supervising or motivating the employee and even if we do not walk out, we promise never to return. Losing a customer costs the firm current or future profits. The challenge for an employer is to devise a compensation scheme and other human resource policies that motivates the employees to increase their effort at job. Hiring of employees. The crux of recruiting is matching the skills of a recruit with the needs of the employer. The matching is facilitated if the qualifications required of the expected recruit are fairly standard and there are a large number of applicants with identical qualifications; this situation is discussed below. If each vacancy can be filled only by individuals with specific skills and it is not obvious who has it, the matching of the applicant and the job becomes a challenge. Functioning of a labor market where a large number of identical individuals (as far as job qualifications are concerned) compete for many jobs is similar to that of a commodity market in which many consumers purchase identical products from many firms. The market clearing wage is determined by equality of the number of offers to the number of job seekers.
1

Karmarkar (1989).

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Figure 511. Labor market: market clearing wage rate and employment. In contrast to the commodity market, buyers in labor market are the firms while sellers of labor service are the individuals who seek work as a source of income. This reversal necessitates fresh explanation of the response of the buyers and sellers to changes in the price. An individual in a modern economy, like Alexander Selkirk in a deserted island off Chile, has a choice between work and leisure. It is true that the hours of work are standard in many jobs but even so an individual can choose to work more or less. In factories and stores, she can work overtime or take a second job. At managerial level, there are choices between jobs that require long hours and pay more and those that provide more leisure. Her preference is reflected in her marginal rate of substitution between work and leisure. As the work hours lengthen, the individual will be reluctant to give up additional hours of leisure or the marginal rate of substitution will decrease. To induce the employee to give up more leisure, real wages (wages adjusted for price changes of commodities purchased with it) must increase. This leads to the upward slope of the supply curve Figure 5. 1 The cost of hiring worker for an additional hour is the wage rate. Increase in labor hours increase output by the marginal product of labor. This output is sold at a fixed price (in a competitive market for the product) and the extra income for the firm from one additional hour of work is marginal product of labor times the price. As long as the incremental sales revenue exceeds wages, the firm can increase profits by increasing labor input. If production is subject to diminishing returns, increases in labor input without a change in the plant leads to a reduction in the marginal product labor. Assuming the latter, the firm ceases hiring more employees when the extra sales revenue (marginal product times price of product) equals wages. Only a reduction in wages will induce the firms to add more employees. The demand curve for labor slopes
1

To focus on the labor market, this section assumes that the prices of products are constant and real wages change with money wages. Changes in labor input can be either through employees working longer hours or through new hires. The substitution between leisure and work was used to justify rising supply curve in the text but a similar reasoning shows that offer of higher wages is required to attract those not willing to work at the current wages (a housewife who finds cost of child care makes it unprofitable to work at current wages would be an example).

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downwards to the right. Where the two curves intersect is a point on both curves showing that, at the corresponding wage (showing on the vertical line on the right), the quantity of labor supplied equals what is demanded. At this wage, the labor market clears. The demand-and-supply diagram provides insights into the wage-price spiral and unemployment. Firms produce is to sell and it is the demand for the product that generates the demand for labor input; the demand not only for labor but for any input is a derived demand. Another way of expressing the condition for clearing the labor market is that marginal product of labor must equal (wage rate/ price of product). If money wages increase, profits and employment are not affected if price of the product increases proportionately. In times of wage-price spirals, employees demand higher wages and firms pass it on to the customers. In contrast, in recessionary times like 2008-2009, the firms will cut down the employment at any given wage level. This corresponds to a shift of the demand curve to the down and left; though not drawn in Figure 5, it is clear that such a shift will move the point of intersection to the left along the supply curve of labor and employment will fall. If those willing to work have not changed in the short run, the reduction will lead to an increase in unemployment. 1 If individuals differ in skills and if the job for which the firm is recruiting has specific requirements, the recruiting process must be match the candidate with the job. The manager who is making the selection process has to content with the problem of asymmetric information. The individual knows more about his abilities and skills than he does. Recruit wants to signal the employer how suitable he is for the job. One signal is his level of education. According to one view of education, the human capital approach, individuals learn skills in the process of education and the recruiter considers the level of education of the applicant. Another theory argues that it is the innate skills of the individual that matters and that education does not add to it. But one with better abilities will find education less demanding that another with less ability and so the former will have a higher level of education. In this view education is a signal that tells you about his innate abilities. Either way, a good education is asset to a job seeker. Motivation and retention of employees. In the United States, employment is on at will basis which either the employer or the employee can terminate without notice or cause; employment will last only as long as both parties feel that the benefits of continuation exceeds that of termination. An employee will remain with his present employer only as long as his remuneration exceeds what other companies are willing to offer him. The firm desires to keep the employee as long as his productivity earns them a profit. The problem for the employee and the employer is to make the judgment whether it is worth continuing the present contract. An employee productivity varies with her effort. The employer wants her to exert maximum effort at work while she, for physical and psychological reasons, prefers less effort to more. The agency problem arises as when the interests of the employer and employee are not aligned. Given the difficulties in estimating individual productivity mentioned earlier, it is as if she works behind a screen that allows her, at least to an extent, to pursue her interest than that of the firm
1

A full explanation of when wage-price spiral or unemployment can occur and how they can be rectified is in the realm of macroeconomics and is not considered here.

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Figure 6. Agency problem in employer-employee relation. (Figure 6). The firm tries to develop compensation scheme that encourages the employee to align her interests with that of the firm. One method that has a long history is to pay workers a fixed rate per piece produced. Agricultural workers get paid by the amount harvested. Before the development of factories, master craftsman assigned his juniors work they have to finish at home; later garment workers worked at workshops set up for them. They were all paid piece rate for work done. In spite of the opportunity to earn more by increasing their income by producing more, workers on piece rate system were seen to hold back fearing that higher output in one period will lead to employers reducing the rate in future. To eliminate this perverse incentive and to spare the workers from the idiosyncrasies of the supervisor, Frederick Taylor, in the end of nineteenth century, proposed setting up piece rate on a scientific basis. Each task was broken into component part and carefully analyzed to determine the time required to complete it in the most efficient way. These time-motion studies were used to determine the norm that the employees

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have to meet. To encourage employees to produce as much as they can the piece rate for output in excess of norm was set higher. 1 Lincoln Electric, a successful manufacturer of arc welding equipment, is known for its commitment to Taylors scientific management. Piece rates were determined on the basis of time-motion studies and a worker who produced the norm will earn competitive wages. The norm was revised only when new machinery or methods are introduced and workers are allowed to ask for new studies to adjust the rates. Commitment to fix rates till a change in production process assures workers that such opportunistic policy to decrease piece-rate whenever output increases will not be adopted. Do monetary incentives induce employees to increase their productivity? If so, do firms devise compensations schemes to align their interest in higher productivity with that of workers? To identify the response to incentive pay, it is necessary observe the productivity of the same workers under the hourly rates and piece rate. In 1994 Safelite Glass Corporation, the largest installer of automobile glass in the United States changed over from hourly rate to piece rate. They had a sophisticate computerized information system that kept the number of units installed by each worker. Edward Lazear used the data to examine the productivity of workers before and after the change over and concludes that output per worker increased in the range of 40 per cent. 2 Incentive pay draws skilled workers to the company and made them work hard; those who are less productive find their wages falling behind what their colleagues are earning and tend to leave. Lazear estimates that half the increase in productivity at Safelite was due to workers responding to the incentive system and the rest to retention of more productive workers. The gains from increase in productivity were split between firm and the employees; workers compensation increased by 10 per cent. Whether following Taylor nor not, the system of enforcing strict targets on workers who are assigned narrowly defined job was widely adopted in the United States in and around the First World War. Federal Governments procurement policies during the Second World War accelerated its diffusion in the US industries. By 1980, the trend reversed. Considering the success of Japanese firms like Toyota Motors in the 1970s, American companies moved away from the rigid management to innovative systems that empowered the workers on the shop floor. In many activities the difficulty in introducing incentive pay is in developing appropriate measures of output. Profitability depends not just on the quantity of output but on bundle of characteristics associated with production and delivery of the product. Lincoln Electric found that paying crane operators by the number of loads moved created safety problems. A sales person who seeks quick sales by pressuring customers to buy or misrepresents the product will antagonize them and lose the opportunity to repeat sales. Incentives and risk sharing. In devising incentive pay schemes, the differing attitude of employers and the employees to risk needs to be considered. Since output is affected by random shocks, her employment income will fluctuate even if she maintains the same level of effort. The employee whose main source of income is company compensation is risk averse and even
1

Some recent studies claim that there was nothing scientific in Taylors work as many parameters were set arbitrarily. 2 Lazear (2000), pp. 1341-1361.

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though he has an opportunity to earn higher income though his efforts, he will shun it unless he is offered a risk premium in the form of higher average salary and bonus. 1 The owners of the firm are assumed to be risk neutral; one justification for it is that part of the income is from assets. His budget is not subject to pressures from one source of income. Given the preferences of the employer and the employee, an efficient allocation of risk is for the employer to absorb all the fluctuations of income from the operation and offer the employee a fixed wage. It destroys the incentive to work harder. A contract that reverses the roles in risk sharing is common in the taxi industry in New York City. The owner of the taxi charges the driver a fixed rent and let him collect as many fares as he can get. He hustles for passengers but he takes the risk that the fares collected differ from day to day. Most compensation schemes try to balance between the need to create incentives to employees and to share the risk; they also consider other goals of the firm like maintaining the reputation for quality and for good consumer relations. Those who fail repeatedly to meet the norm that includes quality are liable to be terminated. When Lincoln Electrics shifted to piece rate, they offered $20 per unit installed with a guarantee that they can earn approximately $11 per hour; to prevent employees from doing shoddy work, as they strive to install more windshields, the company tracks who installed each one and if one cracks, the employee has to fix it at his own time. More than seventy per cent of those involved in sales of industrial products, industrial services, office products and office services are on salary and commission. Interestingly the highest percentages of those on either fixed salary (27 per cent) or commission only (17 per cent) are in consumer services industry. 2 Involving employees in decisions. The management system that evolved with the birth of modern corporations at the end of nineteenth century stressed the command structure. The organizational structure prescribed the responsibilities of each individual within the organization and they were expected to follow rigid rules made by the management. Those in the lower ranks, the blue color workers in the operating unit specifically, were placed under strict supervision, tight quotas and were given no voice in the decision making. Scientific management devised by Frederick Taylor refined this approach by redesigning work and using time-motion study to set production goals. The decline productivity growth in the 1970s and competition from foreign firms led to a rethinking of the management practices of US firms. The success of Japanese firms created interest not only on their inventory management but about their human resources policies. Japanese firms were viewed as encouraging worker participation; joint consultation between management and labor which takes place at many levels and with varying degrees of formality. At the corporate level it is a formal meeting between management and labor union leaders. 3 At the other end are discussions taking place at workshop level about the day-to-day operations and issues about worker concerns. In addition the life-time employment system of major corporations
1

Consider an employment that offers $40,000 with probability 0.5 and $30,000 with probability 0.5. The expected income from this employment is $35,000. An individual is risk-neutral if he is indifferent between this wage offer and one that offers a fixed income of $35,000. He is risk averse if he rejects the offer for a job that pays a lower fixed wage. The reduction that he is willing to accept depends on his degree of risk-aversion. 2 Johsnton and Marshall (2006), p.337. 3 Japanese labor unions are mostly company unions.

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guaranteed the worker the job. The seniority based salary is a form of deferred payment and the incentive effects were cited in previous section. Whether out of deference to the Japanese system or as a result of internal evolution, managements in United Sates started encouraging employee involvement. At the same time it was recognized that the agency problem will not go away just through consultation and what was efficient was a policy that incorporated supervision, incentives and participation. Paul Milgrom and John Roberts argue that not just the piece-rate but a set of complementary policies that made the system succeed. Workers at Lincoln are guaranteed that they will be able to work for 30 hours and there were no general layoffs since the company was started. 80 percent of the company is owned by direct stock holding and employee stock ownership plans. The bonuses offered are very important part of the total compensation of employees and is decided by supervisors based on employees quality of work and cooperation. The recession of 2008 tested their policy. They left go 50 temporary workers and a number of employees with poor performance and less than three years of service. 1 The role of complementarily is brought out by the problems the company had when it started plants abroad. Beginning in 1987 it rapidly established plants in as many as 15 foreign countries and even though it had planned to establish the Lincoln system abroad, the company had to accept that it underestimated the problem of transplanting the culture and the company ran into losses. Casey Ichniowski, Kathryn Shaw and Giovanna Pernnushi did a study of 36 steel finishing lines owned by 17 companies. 2 The sample consisted of high and low performers and a wide range of human resources environments. The choice of specific process, engineering information about it and data collected from visits made allowed the evaluation of the effects of the effect of complementarities on productivity. From the literature on human resources they identified 13 policies like incentive pay, high screening at recruiting, job security and teamwork. The human resources practices of the companies were classified into four systems based on which combinations of the 13 characteristics they had. System 1 was the most innovative and companies that adopted incentives pay based on evaluation of employee contribution in many dimensions including job duties covering wide range of tasks and high level of employee involvement in problem-solving teams. System 2 has most of the practices but miss a few like job rotation or extensive evaluation of employees efforts. System 3 has even fewer of the practices while System 4 is the typical hierarchical management system. Data showed that not only were companies using more innovative human resources system has higher productivity, changing over to System 1 or 2 from System 3 increased productivity. The study supports the view that more than individual innovative practices, it is complementarity among the various measures that increases productivity.

1 2

Milgrom and Roberts (1995);199-205. Ichniowski, Shaw, Prennushi (1997), pp. 291-313.

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Wage distribution in the economy. So far the focus was on how an employee can be motivated and how the agency problem influences the compensation scheme. Going beyond one employer and employee, consider the income from employment of the working population. Three facts stand out: average compensation increases with education; with experience and seniority; and if employees are divided by ethnicity or sex, certain segments of employees who have outwardly similar characteristics as others are earning less. Education and wages. The increase in earning with educational attainment is dramatic. Average salary of a high school graduate in 2007 was $26,894; in the same year a college graduate earned 75 percent more and one with advanced degree, 30 percent more than the college graduate or 127 percent more than high school graduate. 1 Distribution of earning with age and experience. Whether the employee is a high school graduate, a college graduate or a postgraduate, the annual income from employment increases roughly up to the age of 50, then flattens out and finally starts declining around the age of 60. One explanation for this trend is that human capital that is acquired through education and training, depreciates over time. In the early years, the individual and the employer invests on improving skills as the higher productivity over a long working life provides a high return on the investment. As the employee approaches the end of working years, the return for further investment decreases and depreciation of human capital leads to a decline in wages. Another explanation is that employers defer payments. Given that the employer cannot verify whether the employee is shirking, the employer offers a wage that increases with seniority. It provides the employee an incentive to work hard and be retained by the firm. This is beneficial to the employer as it increases the output and reduces turnover. Another reason for avoiding turnover is that the cost of replacement is about 27 percent of the annual salary. 2 Discrimination at workplace. Competition in the labor market, it was claimed in earlier, sets wages equal to the revenue generated by the employee. Competition among firms in the labor market will result in the wages of employees with the same skills and productivity being the same in all industries. Perfect competition in commodity and labor markets together provide precise relation between wages and productivity. Now consider the converse question. The employees are divided into different groups based on ethnicity or sex. The average income of one group exceeds that of the other. Are the observed differences between the groups due to individual choices of the employees or are they due to discrimination preventing them from making choices that would have increased their earnings? It is a historic fact that the opportunities to people of color and women were limited. Social norms put additional constraints on all minorities and women. Recently the laws are leaning towards affirmative action in labor market and competition in product market. How can discrimination be defined in such a society? Are the current differences due to discrimination social factors or to individual choices about education and training? An economic definition of discrimination is employees with the same productivity receiving different wages. The rest of the section focuses on the analytical implications of this definition and a way of measuring the sources of variation in wages.
1

The data is median earning of workers aged 25 or over from Current Population Reports of US Census Bureau (2009) 2 Don Hellriegel et al, p.448.

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Figure 7. Explaining the gap between average male and female Gary Becker argues in his The Economics of Discrimination (1957) that discrimination cannot prevail for a long run in a competitive economy as the firm that discriminates will be at a cost disadvantage. Non-discriminating employers can employees in the discriminated group, women for example, at lower wages and reduce the cost of production. The resulting competition in the product market will reduce demand for higher paid employees and bring down their wages. However such frictionless adjustment may not occur. Workers may refuse to work with those belonging to another ethnic group or sex; technically an employer can get around only employees who are in the shunned groups. Then competition will reduce demand for higher paid workers. Consumers can be the source of discrimination if they refuse products made by minority workers. There is record of firms in meat industry not employing blacks fearing that consumers would object to meat processed by persons of color. Hiring higher paid workers increases the cost of production. Discrimination will continue as long as consumers are willing to pay the higher price. If the competition in the labor market is less than perfect, firms hiring minority employees will not be able to break into the product market and the discriminating firms can continue to operate for a long time. Today the United States laws promote equal opportunity in the labor market and competition in the commodity market. Why then the gaps in the incomes of different groups of workers persist even in the twenty-first century? In 2007, the average earning of white employees, $43,732 exceeds that of black employee by 26 percent and of Hispanics by 46 percent. 1 As shown in Figure 7, female employees earn 31
The average used in the study is the median income, which as the name suggests lies in the middle. Half the employees earn more and the other half earns less. It is one of the averages used in statistical studies. Source: Median Earnings for Full-time, Year-Round Worker (in 2007 Inflation -Adjusted Dollars, Current Population Reports, US Census Bureau, January 2009.
1

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percent less than their male counterparts. Are the differences in average earning due to discrimination or productivity differences? Unfortunately, for reasons discussed earlier, employers are not able to observe the effort made by employees and even what they know it, they consider it as proprietary information and an analysis by third party the reasons for wage difference is not possible. An indirect approach begins by identifying attributes like education that are known to affect the productivity of employees and measuring the differences in these attributes among the groups. One among the many measures of education is the percentage with college degrees. 29.6 percent of US born white workers have college degrees as compared to 16.2 percent of the blacks and 15.9 percent of the Hispanics. There are other attributes that also affect compensation levels. Salaries levels differ among professions and, if those in different groups cluster in industries, their income levels will reflect the industry differences. Until recently women showed preferences for being teachers, clerical workers or librarians and the low level of salary in these professions reduced their average salary. The level of unionization reduces the spread of salaries. If a person temporarily drops out of the labor market for personal reasons, as when a female employee takes a break when children are small, it is possible that the salary levels on reentry will be less than that of other workers in the same age group or years of work experience. Statistical analysis is used to decompose the income gap into components that are attributable to different characteristics. The residue can then be taken as a measure of discrimination (Figure 7). Various studies have explained only one-third of their earning differential and the debate continues whether there is persistence of discrimination against women. Employment compensation is on the average close to 70 percent of the income of individuals and for those in the minorities, it is close to 100 percent. Low relative earning hurts the selfrespect of the employee at work. The economic importance and social significance jointly has to a lively and even passionate argument on the sources of discrimination and their continuance. Connecting with the consumer In the end of all activities in a firm there has to be sales. Only through sales can a firm recover the costs incurred in purchase of raw materials and energy, payment of salary to employees and the interest on its loans. Sales depend on the choice of consumers who select the basket of goods and services that they prefer among those within their budgets. A firm has to understand the preferences of the consumers and choices that are available to them and position its product - its characteristics and price so as to meet its revenue goals. An artisan in the medieval village sells to customers he knows for most of his life. They come to him for repeated purchases and he makes the products to order or he produces what his customers have purchased so many times in the past. His direct contract with customers facilitates the marketing of his products. Mass production that came into existence after the Industrial Revolution of late eighteenth century necessitated creating an extensive customer base. Understanding the consumers is a challenge that the firm has to meet if it is to be successful in the market.

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The creation of a sales or marketing group within manufacturing corporation coincided with development of middle management. 1 James Buchanan Duke pioneered the manufacturing and marketing of cigarettes. His success led other cigarette manufactures to join with him in 1890 to form the American Tobacco Company. Cigarettes used to be hand rolled till Duke introduced the continuous-rolling Bonsack machine that could produce about 70,000 cigarettes a day. He established selling and distribution offices in all major commercial centers; each had a salaried manager, a salesman for the city, another to travel to outlying areas and clerical staff. Matching production with distribution and sales was important as cigarettes, before wrapping in cellophane was introduced, tends to become dry and bitter in a few days. This coordination was managed a central office in New York City which controlled the flow 3 to 5 billion cigarettes. The company had leaf department to purchase, dry and cure the tobacco leaf gave it control of the other end of the supply chain and the firm became an integrated manufacturing enterprise. Issac Singer introduced the first commercially successful sewing machine and with his partner Edward Clark form I. M. Singer & Co (today Singer Corporation). Clark took initiative in replacing the independent distributors with internally managed sales operation. Customers were willing to buy the machine if credit was offered and if they could get the machines serviced. Singer innovated in making them the function of sales division. Both American Tobacco and Singer divided their sales operation on a regional basis. Armour was selling meat, hog, poultry, laboratory byproducts, fertilizers and consumer products like glue and soaps. It organized itself on product lines with a general manager for each division. Each division had a sales manager. Today corporations produce many products and sell then nationally and internationally and the sales organization is structured on regional or product line or on a hybrid of the two depending on their assessment of marketing needs. Functions of marketing and sales divisions. The marketing group in the firm has the responsibility of connecting with the consumer and making choices that satisfies the goals of the consumers and firms. The broad responsibilities of marketing group includes identifying the wants of the consumers, working with the research and production divisions to make marketable products, pricing them, and marketing them through advertisements and promotions. The corporate organization sets up a sales group either within the marketing department or as a separate entity focuses on selling the product; its responsibility is in helping an individual consumer choose a product of his firm. Marketing. A marketing manager of a manufacturing firm or a retailer needs to know the consumers and has to let them know of firms products. Choices made by consumers, given the options, provide explicit indications of their preferences. This limited information is not adequate for developing firms marketing strategy as it needs to know not just how they respond to the current environment but to changes in their incomes, in the price of your product (the price elasticity of demand) and how changes in prices of other products will affect their decisions. Product innovations will change the characteristics of products and marketing manager is concerned how they affect demand for his products. Corporations suffer severe economic losses if they either overestimate or underestimate demand for their products.

Chandler (1977), pp.381-414.

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Figure 8. Facing the competition. In addition to selling to your existing customers, the firm wants to extend its geographical reach by introduce it in a new region of the home country (introducing a product popular in New England to the South-West region of US) or in new countries (extend marketing to developing economies of South and Southeast Asia). The marketing manager has to evaluate the income and tastes of the potential customers in markets that the firm wants to enter and estimate the demand at various prices. The task becomes even more challenging if the product is new. Customers do not ask for them; the demand for very successful products from Sonys cassette recorder to Apples I-phones arose from the vision of the firm that saw the technological possibilities and marketing opportunities. The head of sales division must judge how enthused customers will be of a product that is new to them. The firm obtains information about consumers from two types of sources: secondary data that is already collected and collated by someone else and primary data it collects. Secondary data, in spite of the diminutive name, is cost effective provided that they have the needed information. The Bureau of Census is the largest source of secondary data in the United States. The Census of Population is conducted once every ten years. One of the innovations of 1990 Census that is of great value to the marketing is TIGER (Topographically Integrated Encoding and Referencing). It provided detailed information about clusters as small as 100 individuals. In addition, the Bureau provides Census of Manufactures, Census of Wholesale Sales and Census of Retail Sales and Census of Retail Sales. Other sources of information are trade magazines like Advertising Age and Sales and Marketing Management. Data are collected and sold by private information companies; Scantrack has information on products and brands sold through retail outlets. In addition the marketing department has the choice of collecting information on its own. It can organize focus groups where a small group is invited to discuss either an existing product or one the firm is planning to produce. The discussion in the group is discretely monitored. The firm gathers information from those who brought the product by filling up information as they register their product. Turning to informing the customer of the product, the firm can use different channels. It can establish a direct marketing group that contacts customers over mail, contact through social groups (Mary Kay and Tupperware) or internet. It can arrange for news items or articles to be

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Figure 9. Nature of product and how it determines the type of advertisements. published; while they are inexpensive, but the firm has no control on what gets written up. Personal selling is another form of marketing that provides feedbacks but it is very expensive. With the development of modern technology, there is a proliferation of commercial message sent out. Each consumer receiving on the average 1,600 commercial messages, of which 12 provokes some reaction. 1 The goal is to maximize the response as the firm is incurring cost in sending out these messages. Advertising allows the firm to control the message and at the same time reach a large audience. It can even choose the placement to advertisement to target specific groups; an advertisement placed in a magazine or TV show that is popular with the teenage crowd is focused on that group. Advertising is costly but because of the ability to reach a large audience is cost effective and widely used. Advertising campaigns must consider what consumers know of the goods and how much they rely on advertising and other sources for additional information before making a choice (Figure 9). In the 1970s, Phillip Nelson introduced the distinction between search and experience goods and argued that type and frequency of advertisements will depend on whether consumers can determine the quality and other characteristics before purchase or not. For a product like clothing, a buyer can feel the fabric and check whether it fits him before purchase, advertisements provide information about the characteristics of the product percentage of natural and synthetic fibers, color and cut - and about the stores where it is sold and the price. Advertisements interest consumers by being informative. By comparing information about competitive products, consumers can deliberate decision on what stores to visit and what dresses or suites to try on. When considering new soft drinks that have come to the market, a consumer can decide which one he or she likes only by tasting them; some factual information about calorie contents or main ingredients can be published but there is no way to communicate to the consumer the
1

Kotler (2000)p.551

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taste sensation he or she would have when drinking it. Producers resort to persuasive advertisements - relating it to lifestyles, endorsements by film or sports stars - to catch the attention of potential consumers. The consumers, he argues, look to persuasive advertisements not for factual information but some signals about the quality of the product. How they interpret and respond to the advertisements determine how worthwhile it is for the producers to spend on placing them in various media. Consumers cannot be sure of a product till they make their first purchases but their experiences will decide whether they buy again. The power of consumers in the market comes from their control of the repeat purchases. A producer of quality product expects a higher proportion of their first-time customers to buy again and they will increase the volume of advertising to bring in more first time buyers. The customers sense this rationale and will relate quality to volume of advertising. Experience goods are advertised more on national media than local and more of the advertisements are on TV than on newspapers. Producers who have better information about the product than the consumers know that their product matches with the tastes of a segment of the population. They target their advertisement at the group that will provide the best yield and the customers take the channel as an indication on they should try the product. Recent studies using scanner data from stores and various measures of exposure to advertising bring out the interplay between persuasion and experience in consume choice. These studies concentrate on convenience goods of low unit prices that are frequently purchased (Figure 9). A consumer who has purchased a brand of a product (one brand of cereal or coffee) knows its characteristics while potential customers lack such information. The general conclusion of these studies is that repeat purchases are determined by prior experience of the product and current price. Customers tend to be risk averse and prefer to stick with the satisfying experience provided by a familiar brand. Consumers looking for a new brand are more responsive to advertisements. Pricing the product. Most of the products that we buy are sold at fixed prices at stores, or on internet. Who determined these prices? Why did they choose these prices? Economic analysis of the market gives a simple and precise answer as to what the price should be. Take the demand curve for your product and determine at each level output, marginal revenue or the increase in sales revenue for unit increase in quantity sold. For the same level of output, determine the marginal cost or the increase in total cost for unit increase in output. Compare the marginal costs and marginal revenues for various levels of output and choose the one at which they are equal. Then find from the demand curve, the price at which the profits of the firm will be a maximum, given cost and demand conditions. Fine as the advice is, those who make the decisions within the firm do not have adequate information about the demand curve to implement it. Compared to demand conditions which depends on its customers choices, the firm has better information from its internal reports about its cost of production. The temptation is to use the cost as the base for determining the price. Taking the marginal cost of the product (if taken to be constant, it is also the average variable cost) and adding a markup to provide a return on its capital seems the sensible approach to determining price and cost-plus pricing is historically the most common approach. The excess of sales revenue over costs, net income in the incomestatement of firm, will them be mark-up times unit sold. This gives the illusion that by increasing the mark-up the firm can earn a higher profit and finance division in management will press for

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it. The fallacy in the argument is in ignoring the demand side. When mark-up is increased, the price will increase, leading to a reduction in the sales. The effect of reduced sales can, in specific instances, overwhelm the increase in margin and profits of the firm can decrease. The marketing department will push for price reduction and increase in sales. In this case, it is the reduction of margin on each unit sold that can, in specific circumstances, lead to a reduction in profits. It sounds paradoxical to claim that both increase and decrease in margin can lead to reduction of profits. The resolution for this paradox is in comparing current price to profit maximizing level. Any movement of the price whether it be an increase or a decrease to price at which profit is maximized, will increase profit and any movement away from the latter will decrease it. In short, no rule can ignores demand however difficult it is to estimate it. This is seen from the experience of Wang Laboratories. 1 It introduced the first word processors in 1976 with great success. By 1980s, the competition from personal computers with word processing software cut into its sales. Instead of competing on price, Wang Laboratories took a cost based approach and decided to recover its fixed cost from lower volume of production by increasing the markup. Higher markup led to higher prices that cut into sales even more and soon Wang discontinue the product. In retrospect Wang seems to have adopted an inane policy but such errors in subtler versions were subsequently committed by many other firms with equally disastrous results. As marketing manager has to convince the customers that the product is suits their needs better than that of its competitors and that it is competitively priced. He has to work with the engineering department to avoid engineers and product designers adding features that are technologically interesting even though customers are not willing to pay for. He has to assure the treasurer of the company that the sales plan will yield desired returns on capital invested. All this require that pricing should not be seen in isolation but should be an integral part of the competitive strategy of the firm and success in marketing depends on whether the upper management has the necessary vision. Financing the operations of the firm When we purchase a house, we finance it through a mortgage. We take a loan to buy a car and change many items we buy in stores to our credit cards that give the flexibility of paying it off over months. The firm incurs upfront expenses in constructing a plant, months before it starts operating. The firm has inventories of raw materials and semi- finished products that cost the firm to acquire and store. There is one difference between individual and the firm. While we make our purchases of a house or a car for the satisfaction from its use, the firm incurs costs in advance to make profits in the future. The costs have to be judged in terms of the profits that it generates. The chief financial officer is responsible for cash management, raising funds through equity and loans and preparing financial statements and tax documents. Based on these records, he reports regularly to the Chief Executive Office and the Board of Directors on the financial health of the company and alert them about potential problems. He has to get involved in determining whether the company benefits by discontinuing some operations or adding others. His financial evaluations bring him into conflict with those in charge of production, marketing or human resources who will be promoting other goals. He has to be in contact with the bankers and with
1

Nagel and Holden (1995), p.3.

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investment banks to explore the possibility reducing the cost of funds and adding to the profits of the firm. The flexibility that financial innovations since deregulation have given added to the power and influence of chief financial officer. Some of them have taken risks under optimistic assumptions about future or even hidden the consequences from the shareholders and regulators and have ended in seriously undermining the financial stability of their institutions.1 Investing in new projects. To exploit the opportunities offered by the market, the firm must periodically consider whether to increase its output beyond existing capacity or establish plants to produce new line of products. To create that capacity, the firm incurs now the cost of establishing it while the income it generates is in the future. Because of the lag in receipt of revenues, the firm has to take into account the time value of money. Compound interest rate and discounting. Table 1 from Chapter 4 summarizes the discussion Table 1. Calculation of the value of money Panel A. Forward in time: compound interest.

Year O Capital and interest (1year investment) Capital and interest (2 year investment) $100 $100

Year 1 $ 110 = $100(1 + 0.1) $110 = $100(1 + 0.1)

Year 2.

$121 = $100 x(1 + 0.1)2

Panel B. Backward in time: present value Year 0 Present value of cash flow one year from now. Present value of cash flow to years from now $100/(1 + 0.1) = $90.90 Year 1 Cash flow in Year 1 = $100 Present value in Year 1 = $100 [1/(1 + 0.1)] = $90.91 Year 2 None

Present value in Year 0 = $100[1/(1+0.1)]2 = $82.65

Cash flow in Year 2 = $100

on compound interest and discounting. The familiar rule of compound interest rate Table 1: Panel A).

An individuals opportunity to finance his house purchase used to be restricted to 30-year fixed interest mortgages with a minimum of five or ten percent down payment. With financial innovations, he can get loans with interest rate base on LIBOR (London Interbank Offer rates at which banks lend to each other) or with minimal monthly payments followed by a balloon payment later. This has induced some take mortgages beyond their ability to pay and have got themselves and mortgage banks into financial trouble as during the subprime crisis of 2007-2008.

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Figure 10. Net present value of an investment Going backward in time, how much should an individual loan at 10% interest rate now to get back $100 one year later? Not $100 as previous calculation shows that it will grow to $110. To find this amount, reverse the calculation. The end payment is divided (1 + interest rate expressed as a fraction) or multiplied by (1/(1+interst rate) raised to the time interval(Table 1: Panel B). The calculation determines the present value of future income. Cash flows of the project. Establishing the additional capacity envisaged under the project requires an outflow of cash in Year 0. Over the life of the project, it produces an output that generates revenue from the sales and incurs cost for inputs used in production. The difference between the two is the free cash flow that the project generates and it is what must be discounted. 1 Present value = [First year cash flow/ (1 + interest rate)] + + [Second year cash flow/(1 + interest rate)2] + - -

The concept of cash flow is in principle simple: cash in minus cash out. Accountants start with this number but make many changes to fit the reports they generate to be according to prevalent accounting principles. While these rules have their justification, it clouds the economic and financial significance of cash flows. It is assumed, for simplicity, in Figure 10 and subsequent discussion that construction of the project took only one year and that the firm started generating cash flows (even if it is negative) from next year onwards.

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Figure 11. Will shareholders with diverse preferences agree on a project with positive net present value? + [Last year cash flow / (1 + interest rate)Life of the project]. Under discounting, the cost of investment and the cash flow are both valued in the year the project was started and it makes it feasible to compare the two. The difference between the two is the net present value of the investment (Figure 10). It is the net gain to the investor from investing in this project over the prevailing rate of interest. Project finance when interest rate and profits are known with certainty. There is one difference between any of us investing in our education and a chief financial officer investing for the company. When we are young we decide on the level of education and incur the cost of acquiring it knowing the type of career that we can have with that education. The cost and the benefits come to the same person. The shareholders are the owners of a modern corporation and they benefit or loss from changes in its value. They have, in law if not in practice, the right to approve or reject the project chosen by the management. When the chief financial officer recommends an investment decision, he is doing it for hundreds or even thousands of shareholders. Given the differences in individual preferences, how can she be sure that shareholders agree with his decision? From the production point of view, the project is an increment to the productive capacity of the firm. From a financial point of view, the firm is a hub of cash flows - inflows and outflows and a value can be assigned for the firm based on these flows. The project makes incremental changes to these flows. What Figure 10 shows is that, if the net present value is positive, the investment had earned the shareholders a return in excess of the market rate of interest and has increased the value assigned to the firm. What is their alternative if the shareholders overrule the recommendation to invest in the project and force the management to distribute the amount as dividends? They can invest the distributed funds themselves in the market and earn the market rate of interest but the present value of the earnings will be less than that from the project by its net present value. Since increased resources benefits any shareholder irrespective of his or her preferences, each of the shareholders will implicitly support the chief finance officers recommendation. There is unanimity among shareholders in spite of their differing preferences (Figure 11)!

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The uncertain future and choice of projects. Future is never known with certainty and the uncertainty in the future cash flows has a two-fold effect on the calculation of net present value of a project. The cash flows in Figure 10 are replaced by their expected values for each of the years. Next the discount factor should not be risk free interest rate but adjusted to compensate the individuals for the risk they are taking in choosing the cash flow from the project. The rate used for should have a premium over riskless rate. Ideally the discount rate should be the return of a portfolio of traded securities that has the same risk as the project. In reality, chief financial officer will be hard pressed to come up with such a portfolio as the project has many unique features. The mean-variance approach in finance measures the riskiness of an asset by the variance of its rate of return; variance is a statistical measure of how much the observed rates fluctuate around its mean, taking into consideration the probability of each value occurring. The project is adding to the existing assets of the firm and the riskiness of the project is reduced as the fluctuation the return of firm assets is less than that of individual projects. Competition among buyers will reduce the premium to reflect only the riskiness of asset that is not diversified away. This is the principle underlying Capital Asset Pricing Model which is widely used in determining the discount rate applicable to project financing. The Chief Financial Officer has to use his judgment in determining the appropriate discount rate. Some guidance is given by: (1) the cost of equity for the firm or a similar group of firms; (2) overall cost of capital to these firms when some of the funds are not raised as equity but as debt (bonds and other sources of finance); and (3) the riskiness of the project relative to the overall riskiness of the firm or firms. Ways the firm finances its assets. Once a decision is made to go with the project, chief financial officer has to choose between financing it by issuing shares or bonds. 1 The company has outstanding mix of equity and debt from financing of its existing assets and the new project is an opportunity for management to determine not only how it is financed but also whether the current mix should be changed. The firm is at the nexus of different cash flows. The inflow of cash arises from sales and some of the outflow from purchase of inputs. Their difference, the free cash flow, is what is available to distribute to those to bonds or shareholders. Free cash flow differs from net operating income (profits in accounting sense); one distinction is that depreciation which is treated as a cost in calculation of profits as assets suffer wear and tear but is included in free cash flow as unlike wages or other payments to inputs, it is not paid out in any specific time to an outside party. The value of the free cash flow is obtained by discounting the future payments and it is the value of the firm. The total value of bonds and shares is equal to the discounted values of the free cash flow. It is also the value of the firm. However those who purchased the bonds or equity have made funds available to the company in return for future payments. But bondholders and shareholders do not have the same rights to future cash flows. Characteristics of debt and equity. In issuing a bond, the firm commits to repay the principal with interest by a series of fixed payments up to the expiration date of the bond. The
1

In modern financial literature, stocks and shares are used interchangeably to refer to certificates testifying to ownership share in a corporation. Equity is the total investment in a business by its owners.

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schedule of payments is announced as the bonds are offered to the public and they take precedence over any payments to the shareholders; if the free cash flow in any period is not enough for payouts to bondholders, the firm is in bankruptcy and will have to be either liquidated or the payment schedule restructured with the consent of the bondholders. In contrast to these benefits, the bondholders, unlike shareholders, do not have the right to participate in the management of the company or to benefit financially from the growth of the firm. A shareholder has an ownership interest in the firm, in proportion to the fraction of shares he or she owns. As part owner, the shareholder can vote in the election of the board of directors and require them, at least in principle, to promote the shareholder interest by maximizing the value of the firm. 1 The shareholders have a right to residual of the free cash flow over and above what is owned to bondholders. This amount may be distributed as dividends or a part held within the firm as retained earnings for future investments. Since shareholders have legal right to the retained earnings, the price of the share will, in a well-functioning financial market, reflect this right. If the firm falters, the share prices will fall and dividends will be reduced or even eliminated. Capital structure of a firm is the ratio of debt to equity and equals the ratio of the value of company bonds to that of company stocks in the financial market. The firm can change its structure by issuing bonds to finance purchase of stocks, issuing stocks to purchase the bonds or financing the new project by issuing bonds and stocks in a different proportion to current capital structure. Will changing the ratio affect the value of the firm which was defined as the sum of the values of bonds and stocks? One reads in newspapers of how share purchases or other changes resulted in spectacular increases in the value of a company. Finance textbooks up to the middle of twentieth century sought to prescribe desirable debt-equity ratios for various industries. The conventional wisdom about capital structure was challenged by Franco Modigliani and Merton Miller in 1958. They claimed that value of a firm is unaffected by changes in capital structure. What made this very surprising is that the cost of debt, the return needed to induce individuals to own debt, was much lower than that of equity. In 1950s, the interest rate on corporate debt was between 3 and 5 percent while the cost of equity was between 15 and 20 percent. Why cant a firm reduce the cost of financing its assets by substituting debt for equity? Modigliani and Miller used an argument to show that firms with the same free flow of cash should have the same value, irrespective of how it is divided between shareholders and bondholders. They showed that any difference in values will induce arbitrage: some profit seekers will buy more shares and debt of the firm with lower value and sell that of the other until the two values are equal. Consider two firms generating the same free cash flow that is fully distributed (no increments to retained earnings). The first firm is financed by equity alone and the second by half equity and half debt. An outside individual can replicate 10 percent of the capital structure of the second firm by buying 10 percent of the stocks of the first firm and borrowing to the extent of 10 percent of the outstanding bonds of the second firm; though he gets 10 percent of the free cash flow of the first he has to pay interest on the funds he borrowed to buy the bonds and the difference will equal the dividends from investing in 10 percent of the second firm. 2 If the values of the firm are not the same, then speculators will invest in the cheaper one and earn the same income as
1 2

Corporate governance is discussed in next section. This follows from the fact that both firms have the same free cash flow.

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investing in the other and the demand will push up the value of the firm till it equals that of the other. This proposition can then be used to explain the difference between the cost of equity and debt. Since bond holders of a firm has to be paid in full before dividends to shareholders are declared, any fluctuation in free cash flow of the firm must be absorbed as changes in the dividends. The shares of firm with higher debt-equity ratio are riskier than that of one with lower ratio and a premium has to be paid to the owners of these shares. The lower cost of using cheaper debt is negated by the higher cost of equity. Modigliani and Miller showed the average cost of the two will be the same across firms. That is consistent with the conclusion that the firms with the same free cash flow (with the same risk of fluctuations) will have the same value. To emphasize the role of assets in determining the value of a firm, Modigliani and Miller simplified the financial environment in which the firm operates. They assumed that the firm does not pay corporate taxes, its bonds have no risk, the interest rate is risk free rate and individuals also can borrow at that rate. Subsequent work by them and others explore the effect of replacing these assumptions with others that are better approximations to the market conditions. As Miller wrote in an article commemorating the anniversary of the Merton-Miller propositions: showing what doesnt matter can also show, by implication, what does. 1 First taxation of income from bonds differ from taxation of dividend from shares. For the privilege of incorporating as a limited liability corporation, the state charges a corporate income tax on such corporations. But the rules have a twist that the interest on debt can be deducted from the income of the corporation to determine the taxable income. The bond holders then pay taxes on their income some of which comes from interest on bonds and the rest from other sources. Those who own stocks have first to pay corporate tax out of their share of corporations taxable income and then pay taxes on their individual income which includes the dividends. The net result is that dividends are taxed at corporate and individual levels while interest on debt is taxed only at individual level. This difference is partly compensated by lower tax rate on capital gains. Since most corporations retain a sizable part of the free cash flow as retained earnings, shareholders do not have to pay income tax on them as they are accrued. The growth in retained earnings result in growth in share but the shareholders have to pay only capital gains tax on it. It moderates the cost of double taxation. Next, the firm has a legal obligation to pay interest on debt. If free flow of income is not enough to pay it, the firm is in default and is in danger of bankruptcy. Dividends are rights to profit and if profits is low or there is none, the shareholders have no right to claim payments, Higher debt by making a larger commitment on cash flow increases the probability of bankruptcy during a downturn and this ought to be a consideration in limiting the debt/equity ratio. The managers have information about the firm that outsiders do not have. When in need of new funds, they will choose the method where the difference is information matters least. Investors fear that managers issue new stocks only when they feel that stocks are overvalued and are unloading them. Those who buy debt tend to be better informed about value of the firm and this belief lead to smaller change in stock prices when new debt is issued.

Miller (1988), p.100

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The Modigliani-Miller theory proposed a challenge but a single alternative explanation of capital structure is not yet known and the search for one, given the differences among firms arising from market opportunities they have, the uncertainties they have to consider and the scale of operations, may be futile. [ Corporate office and corporate governance When one individual entrepreneur owns and manages a firm, he controls its operations and directs them to fulfill his goals. However, even when firms were small as most were till the middle of nineteenth century, few entrepreneurs could provide the entire equity of their firm from their own savings. He chose his friends as partners and took loans from the local bank. The small number of partners from the same neighborhood enabled, though not always, achieving agreement on the decisions. The equity of a modern corporation is provided by many shareholders while the management is in the hands of professionals who may own some shares. In law the shareholders are the legal owners of the firm but their interests in the use of funds and in the risks firm takes can differ from that of the management. The goal of corporate governance is to develop a set of procedures and rules to resolve this conflict. Whenever a group of individuals, principals, hires others, agents, to undertake some actions, there is the possibility that the self-interest of agents will make them take actions that differ from those most beneficial to the principals. An employee may not work as hard as the employer was expecting him or her to do. Human resources policies of firms provide a combination of in-house supervision and productivity incentives to motivate the employee. What makes corporate governance different from other instances of agency problem in firm? The principals in this case are shareholders who are numerous and, unlike factory supervisors, have no direct participation in the decision making of the firm. The chief executive officer (CEO) knows that he is responsible to the shareholders to maximize their value but they have no voice in the day-to-day decisions that he make. He to report periodically to the Board of Directors but the Board is composed of those who are friendly with the CEO; he may even be the chairman of the Board. In principle the Board is elected by shareholders at the annual meetings but the management presents a slate and shareholders and the rules are such that it is difficult to elect dissident members to the Board. Chief executive officers compensation is determined by the Compensation Committee but he influence who is on it. When profit is high, it is the glory of the management; when low it is due to forces beyond their control. Chief Operating Officer is like an agent without a principal. The companies are competing in the market and firms with efficient corporate governance should be able to out-compete those with inefficient governance. A serious discussion of corporate governance should examine why an outwardly inefficient system continue to exist, why different corporate governance systems coexist across the world and what the instruments there are to alleviate the agency problem. In addition it must be asked why the agency problem came into focus in public policy debate in the last two decades. Growth of interest in corporate governance. Public awareness of the importance of corporate governance was triggered by (1) a series of losses incurred by major corporations due to poor internal controls, outright manipulation by management or failure of management to take

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appropriate decisions; (2) the rise of pension and mutual funds as vehicles for channeling of private savings; and (3) deregulation and globalization of economies. Financial institutions have shown vulnerability to employees taking risks beyond what they are authorized to do and running up large loses. The rogues gallery includes Nick Leeson at Baring Bank whose attempts to hide small mistakes he made in trades led to a loss of 827 million and bankrupted his firm that was in operation for 233 years; Yasuo Hamanaka whose manipulations of copper market resulted in a loss of $2.6 billion for his employer, Sumitomo Corporation; and Jerome Kerviel whose unauthorized positions at the trading desk of Soicete Generale resulted in a loss of 4.9 billion. 1 Loses at Enron and WorldCom were due to fraud committed by management. Enron had two set of operations. One was selling electricity and natural gas. Enron used the sophisticated techniques involving unconventional interpretation of its income from trade in energy futures and shifting of losses to offshore units. 2 From early 1999 to middle of 2002 WorldCom understated its costs and overstated its income by much more obvious process of treating some current expenses as non-recurring expenses. Executive compensations in both companies were set to their hypothetical profits. The problems of General Motors and Chrysler in manufacturing and Citicorp and Bank of America in 2008/2009 are not due to fraud but bad judgment. The automobile companies were way off in their estimate of demand for various models of vehicles and did not control their costs to make them competitive with foreign car makers. 3 Deal making and acquisitions by the Chief Executive Officer, Sanford I. Weil to make Citigroup a global supermarket for financial services left it with an unwieldy structure and with many dodgy assets that threatened its solvency during the recession of 2008/2009. Bank of America acquired a real estate lender, CountryWide Financial, in 2008 and an investment bank, Merrill Lynch, in 2009 and their losses forced Bank of America to rely on the rescue package offered by the U.S. government. 4 The question is why the governance system of these companies failed to protect their shareholders. Institutional investors like insurance companies, mutual funds, pension funds, and hedge funds pool together savings of individuals and invest it in a diversified portfolio of stocks and bonds. The individual saver benefits from the expertise of the institutional investor and obtains a better return for the level of risk than through individual investment. Institutional investors in U.S. have slightly more than 50 percent of the assets under management of which a significant portion is pension funds. Pension funds are obliged by the Employee Retirement Income Security Act of 1974 (ERISA) to vote their shares responsibly and though they limit the amount of shares of a corporation they hold, still their holdings is large enough to have an impact. Their focus on corporate governance is another reason why it is now much discussed researched topic.

1 2

, Financial Times ( 2009), pp.1-2. Dharan and Bufkins, (2004), pp.97-112. 3 Labor cost, due to union contract and unfunded pension commitment, was way above that of foreign producers. Some aspects of the wage structure in automobile industry in the seventies was discussed in p.189-190 4 The purchase of Merrill Lynch was part of the rescue effort of distressed financial institutions under Federal Reserve and Treasury program and there is a question whether the Bank was steamrolled into it.

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Figure 12. Firm as a nexus of contractual obligations Globalization and integration of financial markets allowed companies to raise funds in international markets and increased awareness of the comparative strengths and weaknesses of various corporate governance regulations. Vigorous discussion by policy makers and research by scholars have identified what could contribute to better governance but each of them could also create conditions that go against the interests of the shareholders. A better understanding has not led to identifying one superior system of corporate governance. Given the broad sweep of the subject, covering corporations of various sizes and organizations in different economies, lack of unanimity should not be surprising. Governance mechanisms to reduce misalignment of interests. International comparison of practices shows that some institutional arrangements contribute to the management being more responsive to the interests of the shareholders. An individual or an institutional investor

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who owns a large block of shares of corporation has an interest in monitoring the management and using the voting power that the block gives to put pressure on management if it takes actions not in the interests of the shareholders (Figure 12). Executive compensation schemes can be designed to reward the management when they promote the interest of the investors. Corporate raiders have interest in taking over firms with inefficient management. Each of these arrangements unfortunately has the potential of introducing misalignments of their own. Monitoring by shareholders. Monitoring of a corporation is time consuming and expensive. If a shareholder owns only a few shares tries to monitor the management, he bears all the costs while he gains a very small share of the benefits of better management. A large shareholder captures a larger share of benefits from monitoring and will have more inclined to do monitoring on an ongoing basis. Stocks of American companies are generally dispersed and there is no dominant shareholder while a study of companies in France, Germany Italy and Sweden showed that more than half of them had one controlling owner. 1 Monitoring will not affect corporate policies unless those monitoring have control. An individual or institution that holds 10 to 20 percent of the shares may be able to convince other shareholders to join in influencing the policies and, if the management is not amenable, to host a proxy fight. The ability to do so depends on the cost of communication and coalition building. Proxy fights are important in the United States but not in European countries and Japan. A large shareholder may have no interest in monitoring if it is possible for her to exist. This occurs when there is an active market for shares as in United States and United Kingdom. A measure of the relevance of stock market is its capitalization (the number of shares outstanding times their prices) relative to the size of the economy (measured by gross national product, the value of all goods and services produced in an economy). The capitalization of stock markets in the two countries have about the same value as their respective national incomes while many continental European countries it is around 50 percent of gross national product. The depth of the stock market can contribute to the dispersal of ownership. When a large shareholder is able to sell the shares at current prices, she has less interest in monitoring. If she is not satisfied by the performance, it is cost effective to exit. This suggests that international differences in stock ownership and between equity and debt financing may be the result of differences in costs of monitoring, cost of displacing management by takeovers and of selling off the stocks. Having a large shareholder need not result in better performance. She is able to appoint her nominees to the Board of Directors and through them induce the management to take actions that beneficial to her but not to others. Instead of value maximization that creates unanimity, the large shareholder appropriates some of the gains at the cost to others. Out of this concern, corporate law and securities regulation imposes restrictions on the right of a large shareholder. The limitations imposed vary among jurisdictions. Monitoring by the board of directors. In principle, the corporate chapters envision a democracy with shareholders electing the board of directors, the board acting as legislative branch appointing and monitoring the chief executive officer (CEO). The responsibilities of the board include approving issue or purchase of stocks, mergers and acquisitions and setting the compensation of the chief executive officer. In the reality the Board fails in its monitoring of the
1

Jean Triole (2006) pp.39-40.

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management. The shareholders are, by rules, forced to elect a board from a panel submitted to the shareholders at the annual meeting and substitution is very difficult if not impossible. In United States, chief executive officer is commonly the chairman of the board. Many members have links with the company other than being a member of the board; they either are employees or past employees or suppliers to the firm. They feel obliged to the chief executive officer and will not be inclined to critically examine his decisions. The independent members - those who have no other relation with the company - even if they are willing to be critical, are handicapped as they are not familiar with the industry and have less information about the corporation than inside members; when financial firms like Bank of America and Royal Bank of Scotland became financially distressed in 1009 and questions were raised about the decisions of their chief operating officers, it was found that the boards that approved these decision had few independent members knowledgeable about banking. Most members of the board prefer to be reappointed and are unwilling to confront the chief executive officer who de facto makes that decision. One criticism is that the board has managerial and supervisory responsibilities and it is desirable to separate the two functions as is done with the two-tier boards of German corporations. The management board (its members are appointed by the supervisory board) has functions similar to that of the upper management of an American corporation. In addition to managing the corporation and setting policies like risk management, they represent the corporation to third parties. The members of the supervisory board are elected; half the members are elected by the shareholders while the other half is elected by the workers. The chairperson is appointed by the representatives of the shareholders, giving the shareholders a marginal advantage in the Board. German companies have two boards: supervisory board and management board. The supervisory board members are elected by shareholders and workers and the board then elects the members of the supervisory board. The method of co-determination which was considered to be a major strength of the German corporate governance is now criticized for promoting gloating over differences among board members rather than undertake a critical review even when a decision has serious consequences for the corporation. Another problem is that the supervisory board is dependent on the management board for information and when management feels that the workers representatives in the supervisory board could object to a proposal, they tend to hold it back till the last minute. The two-board system is not exempt from informational limitations of unitary boards. Proposals for reform of the boards of Anglo-American corporation seek to separate the offices of the chief executive officer and the chairman of the board and to appoint knowledgeable and to appoint more independent or non-executive directors to the board. Unfortunately no robust relation between the composition of the board and the companys performance is seen in the empirical studies. Setting executive compensation to align the interests of shareholders and management. The chief executive officer and senior management are agents expected to promote the interest of the shareholders (with due consideration, in some governance systems, to the interest of other stakeholders). Their self-interest will not match with that of the shareholders and the agency problem arises. In early 1990s, many studies argued that the chief executive officer is not offered compensation that is responsive to the effort he put in increasing the value of the company and it creates serious agency problem. Stock options were promoted as a way to correct the lack of incentives.

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A stock option allows an employee to purchase the stock of the company within a period, the life of the option, at a price specified exercise price when the option is granted. The exercise price is the price of the stock on the day of the option is granted. The option can be exercised only after a specified time; at that time the option is said to be vested. If the exercise price is $10 and the price of the stock increases to $15 at the time of vesting, the employee gains $5 by exercising the option and selling the stock in the market; the option is said to be in money. If the stock price falls to $8, there is no sense in exercising the option which is said to be out of money. While the employee does not benefit from having received the stock option, he does not lose either while if he had owned the stock, as under the du Pont plan, he would have lost $2 per stock. The stock options offered to chief executive officers of S& P 500 firms increased nine-fold from an average $800,000 in 1992 to &7.2 million in 2000. The compensation to chief executive officers increased in inflation adjusted dollars from $3.5 million in 1992 to $14.7 million in 2000. 1 In 1970, the compensation of an average chief executive officer of S&P 500 was 30 times the pay of an average production worker; by 2002 the ratio of compensations was 90. 2 The sensitivity of executive pay to performance was 2 to 10 times higher in 1994 than in 1980. 3 The differential growth in compensation was criticized both on grounds of equity and efficiency. Focusing on efficiency arguments, the criticism is that stock options created distortions of their own. An efficient scheme of compensation should be based on outcomes that arise from the efforts of the employee. Much of the returns from stock options is due to the stock market boom of 1990s and unrelated to the efforts made by the management. A compensation scheme is efficient only if the cost of the stock option to the corporation equals the value of the option to the recipient. The cost to the corporation is equated to what it would have to pay the outside investor to accept the liabilities (commitment for payments) under the option and this can be determined by the Black-Scholes formula for options. The employees are receiving an uncertain cash flow. Being risk averse, his preference is for cash or diversified portfolio and the stock option based on stock will be valued lower by the compensating differential for bearing risk. The efficiency condition is not met. The two main arguments for stock options, that it alleviates agency problem and that is it an efficient form of compensation, have limitations. Another claim is that it allows companies, particularly those like Silicone Valley startups, to offer attractive compensation packages without straining their cash balances. The evidence is inconclusive as statistics indicate that stock options were more add-ons than substitute for salary and companies that cash rich like Microsoft and Intel are generous with stock options. There are many incentives that the firm can offer to induce employees to remain with the company. A salaries profile that starts below marginal product and then rise over years to above the marginal product is one of them. The problem with options that become vested some years later is that the employee has incentive only if stock prices are above the exercise price. A serious criticism is that when stock prices fall below the exercise price companies are resetting the strike price and, in some cases, changing the dates on which the option was granted
1 2

Hall and Murphy (2003), p.51 ibid. p.63 3 Becht, Bolton, and Roell (2003). p.75.

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to make it more favorable. While stock options have made executive compensation sensitive to the stock performance, it creates its own distortions. Takeovers. When internal controls fail to discipline the management, outside groups move to displace the management and gain control of the firm and its cash flows. This sets up a market for managerial services, with those who claim that they can increase its value of a firm challenging current management. The economic benefit of the takeover is measured by the increase in the sum of values of the acquired and acquiring firm. If the sum increased after the hostile takeover, what is the source of the increase? How is the incremental value divided among the shareholders of the two firms? The management reacts to the threat of a hostile takeover by either finding a friendly group to take-over the firm or by introducing measures that make its harder for the outside group to get the control. How do these measures affect the shareholders? In addition to hostile takeovers, managements arrange for merger or acquisitions of other firms. Are they in the interest of the shareholders or are the managements increasing the sizes of firms expecting that such increases will also increase their compensation and benefits? Changing technologies and market conditions require major restructuring of an industry with closure of facilities, changing product lines, and developing new marketing strategies. Managements that spent years developing and implementing the current strategies will have difficulty in abandoning them and make arguments for their continuation even when they are not viable any more. An interesting example is oil industry since the oil crisis of 1970s. The oil price increases increased the cash flow of major oil companies; in 1984 cash flow of ten largest oil companies was 28 percent of the cash flow of 200 firms in Dunns Business Month. 1 An opportunities for investment in exploration and expansion of refineries were dying up. Instead of returning the free cash flow to the shareholders and letting them invest it, the management tried to acquire unrelated businesses. Mobile purchased retailer Montgomery Ward, Exxon purchased a manufacture of electric motors, Reliance Electric and an office equipment company Vydec, BP entered animal food by purchase of U.S. Purnia Mills and Gulf Purchased Ringling Brothers. With the then shocking attempt by T. Boone Pickens of Mesa Petroleum, a small oil company, for a hostile takeover of a major oil company, the Gulf, the downsizing and reorganization of the oil industry began. The economic environment was favorable for takeovers. Under Regan Administration many industries were deregulated and antitrust enforcement relaxed. A financial innovation, introduction of junk bonds enabled the acquiring companies to raise funds quickly. 2 A striking fact is that for the first time, small companies made hostile offers for larger corporations. Takeovers are not as widespread as the publicity that hostile takeovers generated in 1980s would suggest. Even at its peak takeover rates rarely exceeded 1.5 percent and it declined thereafter before reaching a new peak in 1998-2001. While classifying takeovers as friendly or

1 2

Andrei Shleifer and Robert W. Vishny (1988 p.33. Junk bonds can be thought of as commercial loans resold in financial market and rated below investment grade by rating agencies. While such bonds were issued earlier, the bonds issues up to the early years of twentieth century, it gradually dried up. The first issue in many decades was in 1977 when Bear Sterns underwrote an issue; Michael Millikan of Drexel Burnham became the leader in underwriting junk bonds. He financed deals like T. Boone Pickens attempt at hostile takeover of Gulf Oil.

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hostile poses many problems, only 40 of the 3336 transactions in 1986 can be considered hostile; with the takeover defenses introduced in the late 1980, hostile takeovers died out. 1 Does takeover creates increases in the value of the firms? Various event studies show that target shareholders of hostile takeovers in U.S. receive a sizable premium of 24 per cent. When all takeovers are considered, the shareholders of bidder companies have collectively not received any observable gain. Studies in U.S. and U.K fail to substantiate that hostile takeovers are targeting firms with poor performance relative to their peers. 2 Then where does the value increase arise? It could be due to transfer of wealth from employees (tougher wage negotiations or reduction of health benefits and pensions) or bondholders. Whether such transfers are a rectification of inefficient allocation or not depends on the initial position. If the stakeholders had bargained unjustifiable terms from the pre-takeover management, takeover is a mechanism to correct the misallocation. 3 While event studies show that stock market responds favorably to the announcement, event studies focus on short run. Studies considering value change over longer period show that it is negative. The creation of conglomerates in the 1960 and 1970s were well received then but later were recognized as failures and were undone by divestiture. The effect of introducing takeover defense depends on what the management does with it. Some boards use to entrench the management while others have used it to negotiate Summimg up. Consumers and producers are the two foci of the economic system. The liberal society recognized the individuality of each consumer and claimed that he or she has the right to maximize utility based on preferences known only to the individual. The consumers make public their preferences when they make choices in the market. In contrast to the consumers, the preference of producers was taken to be known and it is to maximize the profits. Achieving it requires that many individuals that participate in the production process. This is achieved in principle by a command process in which the top management fixes the goal and then directs all others to act to fulfill them. In reality, corporations are a nexus of contracts and each of them the contracting party has incentives to take opportunistic actions. The challenge for the firm is to develop policies to minimize if not eliminate such actions. Such policies were discussed in this chapter. Bibliographic Note: Becker (1957); Becht (2003); Blinder (1973); Brealey and Myers (2003); Chandler (1997); Breshnahan and Ramsey (1994); Copeland and Weston (1992); Enkawa and Schvaneveldt (2001); Hall, and Murphy (2003); Holden (2005); Ichniowski et al (1997); Financial Times (2009); Holden (2005); Karmarkar (1989); Los Angles Times (2009); Lazear (2000); McMillan (1994); Milgrom and Roberts (1995); Nagel and Holden (1995); New York Times (2000); New York Times (2008);Scherer (1988); Shleifer and Vishny (1988); Smith (1937); Sterndhal and Craig (1982); Stigler (1987); Triole (2006); US Census Bureau (2009); Wall Street Journal (2009).
1 2

M. Becht et al (2003), pp.50-51; Triole (2006), pp.43-44. M. Becht et al (2003), pp. 53-54. 3 F. M.Scherer (1988),pp.70-71.

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Index
Aging population 161 Adverse selection 167 Advertising, 24 Agency problem 197 Asset boom 161 Arrow, Kenneth 51, 54, 153 Average cost 83 Average fixed cost 83 Average revenue 83 Average variable cost 83 Axioms of preference 18ff, 31 Becker, Gary 202 Bentham, Jeremy 14 Bertrand, Joseph 132ff

Discrimination at workplace 202 Dixit, Avinash 9, 124, 126 Delivered price 120 Deadweight loss 95, 96 Deal prone consumer 112 Derivative securities 157 Debreu, Gerard 5, 51, 54, 153 Declaration of Independence 13 Declining savings rate 159ff Defoe, Daniel 27 Delivered price 109 Discount factor 47ff, 158ff Division of labor 33 Dixit, Avinash 9 Duke James Buchanan 204 Duopoly 130ff Economic profit 83 Economic value added 83 Enron 216 Engle, Ernest 66 Enlightenment, Europe 11 Enterprise resource planning 193 Entitlement theory 14 Exchange, benefits 33 Expected utility maximization 162 European Union Antitrust policies, 101 Eurotunnel 92 Experience good 206 f.o.b. 109 Fixed cost 185 Fisher, Irving 48, 58, 158, 168 Ford, Henry 76 GAAP 80 Game theory, cooperative 11

Beta 175 Black, Fisher 157, 178 Breshnahan, Timothy F. 189

Budget line 16, 17, 37, 60ff Bundling 116 Capacity of a firm 133 Capital Asset Pricing model (CAPM) 168, 173ff Cartels 101 Chief executive officer 208 Clayton Act 101, 117 Competitive markets 139ff Compound lottery 163 Contingent claims 55, 157 Consumer surplus 94ff Coordination 10, 27 Coupons 112ff Cournot, Antoine 68, 131ff Covariance 168 Customer retention 113 Dasgupta, Partha 9

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Gillette Company 123, 124 German supervisory board 218 Gross profit 79, 91 Hatch-Waxman Act 99 Hedging 55ff Hicks, John 93 Hobbes, Thomas 13, 18, 136 Holden, Reed 70 Houthakker, Hendriks 18 Hume, David 53 Ichniowski, Casey 199 Income elasticity of demand 66 Income statement 81 Indifference curve 31ff Jermolowics, 8 Jevons, William 5 Justin-time production 191 Kalnins, Arthur 76 Kant, Immanuel, 14, 37 Kay, John, 9 Keynes, John 8 Kreps, David 133 Lastbohm, John 4 Lazear, Edward P. 198 Leisure, choice of, 32ff Lincoln Electric 197ff Locke, John 13, 18, 37 Maddison, Angus 32 Magnusson 3 Malthus 143 Marginal cost 78, 91 Marginal rate of substitution 22, 52, 63ff Marginal rate of transformation 28ff Marginal product 77 Marginal rate of technical substitution 187 Marginal revenue 78, 90, 140ff, 185ff Marginal risk of stock 173 Market, strong and weak 106 Market clearing price 69, 70 Markowitz, Harry 168, 179 Marshall, Alfred 5, 8, 9, 93 Mean-variance analysis 157 McLane Report 182 Menger, Carl 5 Milgrom, Paul 9, 199 Mill price 109 Monopolist 89ff Moral hazard 167 Morgenstern, Oskar 38, 51, 179 Nagle, Thomas 70 Nalebuff', Barry 9 Nash, John 38, 131 Nash equilibrium 137 Nash bargaining solution 38ff Nelson, Phillip 24, 206 Net income 82 Net present value 209 Newton, Issac 7, 142 Normal distribution 178 Operating income 77 Options 176ff Outsourcing 76 Pareto, Vilfredo 34ff, 108 Pareto efficient 35, 54 Parker Pen Holding Company 123, 124 Patent 97ff Pernnushi, Giovanna 199 Portfolio diversification 157 Preference 18ff Present Based discounting 160 Price discrimination 106 Price elasticity 71 Probability 53 Production function 185

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Proto-industrialization 182 Prisoners dilemma 135ff Product characteristics 22ff Product group 119ff Property rights 14 Psychic cost 122 Ramsey, Valeriw A. 189 Repeat purchase, 207 Reservation price 120ff Ricardo, David 5 Roberts, John 9, 199 Robertson, Dennis 9, 181 Robertson Patman Act Robinson, Joan 106 Safelite Glass Corporation 197 Salt tax 89 Sales region 121 Search goods 206 Self-replicating portfolios 179 Samuelson, Paul 18, 49, 157,158,159 Scholes, Myron 157, 158, 177 Schumpeter, Joseph 8, 15 Segmenting of markets 105 Selkirk, Alexander, 27ff, 129, 130 Scheinkman, Jose 133, 134 Shaw, Kathryn 198 Sherman Act 101 Sherwin, Robert 73 Singer, Issac 204 Smith, Adam 4, 8, 9, 14, 15, 54, 59, 100, 117, 140, 150, 155, 181 Spatial model of price discrimination 109ff Sport utility vehicle (SUV) 23 Standard deviation 170 State of nature 45 State contingent commodities, 51ff Stigler, George 73, 186 Stiglitz, Joseph 124, 126 Stock option 219 Stradling, Thomas 27ff, 129, 130 Strike price 177 Super-baskets 48 Transaction cost 4, 192 Time preference 45, 48 Tobin, James 168, 179 Two-part tariff 114ff TRIPS 99 Utilitarianism 14 , 18 Utility 15 Variable proportion 143, 185 Variance 170ff Von Hayek, John 59 von Neumann, John 38, 51, 179 Walras, Leon 5, 54, 153 Wang Laboratories 208 Williamson, Oliver 102 Welfare economics, theorems 37