Game theory and dynamic adjustments[edit]

Cobweb model with stable equilbrium.

Cobweb model with unstable equilibrium.

Later, some market models were built using game theory, particularly
regarding oligopolies, which was being developed by John von Neumann at least
from 1928.[24] Game theory was originally applied to le Her and chess,
both sequential games, economics as developed by Alfred Marshall on other hand,
while adopting the Cartesian coordinate system, considered only static games. This
may seem counterintuitive since Marshall considered that economic behavior might
change in the long run and that "an equilibrium is stable; that is, the price, if
displaced a little from it, will tend to return, as a pendulum oscillates about its lowest
point",[25] Nicholas Kaldor was aware of this problem: economic equilibrium is not
always stable and not always unique since it depends on the shapes of both the
demand curve and the supply curve, he explained the situation in 1934 as follows: [26]
"We shall examine these objections in turn by enumerating, in each case, the
conditions which are necessary to make them inoperative( or in the absence of
which they would be operative). We shall call an equilibrium "determinate" or
"indeterminate" according as the final position is independent of the route followed,
or not; we shall call equilibrium "unique" or "multiple" according as there is one, or
more than one, system of equilibrium-prices, corresponding to a given set of data;
and, finally, we shall speak of "definite" or "indefinite" equilibria, according the actual
situation tends to approximate a position of equilibrium or not."
Regarding price adjustments, he said:
"Finally, we have to take account of the fact that adjustments always proceed at
more or less frequent intervals-that they are more or less continuous. The quantity of
anything demanded or supplied may change once a Day, once a week, a month, or
a year-depending on such factors as the technical period of production, etc. We shall
call an adjustment completely discontinuous, if the full quantitative adjustment to a
given price-change occurs all at once, at the end of a certain period. (E.g. a change
in the price of rubber may not influence the rate of supply for a period of seven
years, at the end of which the full quantitative reaction may take place at once. Or a
change in the price of corn, by inducing farmers to change the area sown, will make
its effect felt a year later when the new harvest comes to the market.) Similarly, we
shall call an adjustment completely continuous, if it proceeds at a steady rate in time,
or if the time-lags between the appearance of successive quantitative changes are
such as can be neglected. The latter will always be the case when the degree of
discontinuity-the length of the "time-lags"-is the same on the demand side as on the
supply side. In the following analysis we shall treat only these two cases of complete
discontinuity and continuity."

Stackelberg competition represented as an extensive form game with infinite action

space, the players payoffs are on the right.
A good example of how microeconomics started to incorporate game theory, is
the Stackelberg competition model published in that same year of 1934,[27] which can
be characterised as a dynamic game with a leader and a follower, and then be
solved to find a Nash Equilibrium, named after John Nash who gave a very general
definition of it. Von Neumann's work culminated in the 1944 book Theory of Games
and Economic Behavior, which was cowriten with Oskar Morgenstern. Regarding the
use of mathematics in economics, the authors had this to say: [28]
"It may be opportune to begin with some remarks concerning the nature of economic
theory and to discuss briefly the question of the role which mathematics may take in
its development. First let us be aware that there exists at present no universal
system of economic theory and that, if one should ever be developed, it will very
probably not be during our lifetime. The reason for this is simply that economics is far
too difficult a science to permit its construction rapidly, especially in view of the very
limited knowledge and imperfect description of the facts with which economists are
dealing. Only those wlio fail to appreciate this condition are likely to attempt the
construction of universal systems. Even in sciences which are far more advanced
than economics, like physics, there is no universal system available at present."
A major problem discussed in this book if that of rational behavior under strategic
situations involving other participants:
"First, the "rules of the game," i.e. the physical laws which give the factual
background of the economic activities under consideration may be explicitly
statistical. The actions of the participants of the economy may determine the
outcome only in conjunction with events which depend on chance (with known
probabilities), cf. footnote 2 on p. 10 and 6.2.1. If this is taken into consideration,
then the rules of behavior even in a perfectly rational community must provide for a
great variety of situations some of which will be very far from optimum.
Second, and this is even more fundamental, the rules of rational behavior must
provide definitely for the possibility of irrational conduct on the part of others. In other
words: Imagine that we have discovered a set of rules for all participants to be
termed as "optimal" or "rational" each of which is indeed optimal provided that the
other participants conform. Then the question remains as to what will happen if some
of the participants do not conform. If that should turn out to be advantageous for
them and, quite particularly, disadvantageous to the conformists then the above
"solution" would seem very questionable. We are in no position to give a positive
discussion of these things as yet but we want to make it clear that under such
conditions the "solution," or at least its motivation, must be considered as imperfect
and incomplete. In whatever way we formulate the guiding principles and the
objective justification of "rational behavior," provisos will have to be made for every
possible conduct of "the others." Only in this way can a satisfactory and exhaustive
theory be developed. But if the superiority of "rational behavior" over any other kind
is to be established, then its description must include rules of conduct for all
conceivable situations including those where "the others" behaved irrationally, in the
sense of the standards which the theory will set for them.
At this stage the reader will observe a great similarity with the everyday concept
of games. We think that this similarity is very essential; indeed, that it is more than
that. For economic and social problems the games fulfill or should fulfill the same
function which various geometrico-mathematical models have successfully
performed in the physical sciences. Such models are theoretical constructs with a
precise, exhaustive and not too complicated definition; and they must be similar to
reality in those respects which are essential in the investigation at hand. To
recapitulate in detail: The definition must be precise and exhaustive in order to make
a mathematical treatment possible. The construct must not be unduly complicated,
so that the mathematical treatment can be brought beyond the mere formalism to the
point where it yields complete numerical results. Similarity to reality is needed to
make the operation significant. And this similarity must usually be restricted to a few
traits deemed "essential" pro tempore since otherwise the above requirements would
conflict with each other.
It is clear that if a model of economic activities is constructed according to these
principles, the description of a game results. This is particularly striking in the formal
description of markets which are after all the core of the economic system but this
statement is true in all cases and without qualifications."
Game theory considers very general types of payoffs, therefore Von Neumann and
Morgestein defined the axioms necessary for rational behavior using utiliy;
Barriers to entry[edit]
William Baumol provided in his 1977 paper the current formal definition of a natural
monopoly where "an industry in which multiform production is more costly than
production by a monopoly" (p. 810):[29] mathematically this equivalent
to subadditivity of the cost function. He then sets out to prove 12 propositions related
to strict economies of scale, ray average costs, ray concavity and transray convexity:
in particular strictly declining ray average cost implies strict declining ray
subadditivity, global economies of scale are sufficient but not necessary for strict ray
subadditivity.
In 1982 paper[30] Baumol defined a contestable market as a market where "entry is
absolutely free and exit absolutely costless", freedom of entry in Stigler sense: the
incumbent has no cost discrimination against entrants. He states that a contestable
market will never have an economic profit greater than zero when in equilibrium and
the equilibrium will also be efficient. According to Baumol this equilibrium emerges
endogenously due to the nature of contestable markets, that is the only industry
structure that survives in the long run is the one which minimizes total costs. This is
in contrast to the older theory of industry structure since not only industry structure is
not exogenously given, but equilibrium is reached without add hoc hypothesis on the
behaviour of firms, say using reaction functions in a duopoly. He concludes the
paper commenting that regulators that seek to impede entry and/or exit of firms
would do better to not interfere if the market in question resembles a contestable
market.

Externalities and market failure[edit]

Ronald Coase analyzed transaction costs, externalities and is also rembered for

the Coase conjecture.
In 1937, "The Nature of the Firm" was published by Coase introducing the notion
of transaction costs (the term itself was coined in the fifties), which explained why
firms have an advantage over a group of independent contractors working with each
other.[31] The idea was that there were transaction costs in the use of the market:
search and information costs, bargaining costs, etc., which give an advantage to a
firm that can internalise the production process required to deliver a certain good to
the market. A related result was published by Coase in his "The Problem of Social
Cost" (1960), which analyses solutions of the problem
of externalities through bargaining,[32] in which he first describes a cattle herd
invading a farmer's crop and then discusses four legal cases: Sturges v
Bridgman (externality: machinery vibration), Cooke v Forbes (externality: fumes
from ammonium sulfate), Bryant v Lejever (externality: chimney smoke), and Bass v
Gregory (externality: brewery ventilation shaft). He then states:
"In earlier sections, when dealing with the problem of rearrangement of legal
rights through the market, it was argued that such a rearrangement would be made
through the market whenever this would lead to an increase in the value of
production. But this assumed costless market transactions. Once the costs of
carrying out market transactions are taken into account it is clear that such
rearrangement of rights will only be undertaken when the increase in the value of
production consequent upon the rearrangement is greater than the costs which
would be involved in bringing it about. When it is less, the granting of
an injunction (or the knowledge that it would be granted) or the liability to pay
damages may result in an activity being discontinued (or may prevent its being
started) which would be undertaken if market transactions were costless. In these
conditions the initial delimitation of legal rights does have an effect on the efficiency
with which the economic system operates. One arrangement of rights may bring
about a greater value of production than any other. But unless this is the
arrangement of rights established by the legal system, the costs of reaching the
same result by altering and combining rights through the market may be so great
that this optimal arrangement of rights, and the greater value of production which it
would bring, may never be achieved."
This then becomes relevant in context of regulations. He argues against
the Pigovian tradition:[33]
"...The problem which we face in dealing with actions which have harmful effects is
not simply one of restraining those responsible for them. What has to be decided is
whether the gain from preventing the harm is greater than the loss which would be
suffered elsewhere as a result of stopping the action which produces the harm. In a
world in which there are costs of rearranging the rights established by the legal
system, the courts, in cases relating to nuisance, are, in effect, making a decision on
the economic problem and determining how resources are to be employed. It was
argued that the courts are conscious of this and that they often make, although not
always in a very explicit fashion, a comparison between what would be gained and
what lost by preventing actions which have harmful effects. But the delimitation of
rights is also the result of statutory enactments. Here we also find evidence of an
appreciation of the reciprocal nature of the problem. While statutory enactments add
to the list of nuisances, action is also taken to legalise what would otherwise be
nuisances under the common law. The kind of situation which economists are prone
to consider as requiring Government action is, in fact, often the result of Government
action. Such action is not necessarily unwise. But there is a real danger that
extensive Government intervention in the economic system may lead to the
protection of those responsible for harmful being carried too far."