Unec 1653752904

Managerial economics
D.J. Reyniers and M. Selvaggi

MN3028
2016
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Professor Diane Reyniers, Professor of Managerial Economics and Strategy, Department of
Management, London School of Economics and Political Science
and
Dr Mariano Selvaggi, Independent Academic Adviser; previously of the London School of
Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
University of London International Programmes

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Published by: University of London

© University of London 2016
The University of London asserts copyright over all material in this subject guide except where
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Contents
Contents
Chapter 1: Introduction........................................................................................... 1
1.1 Road map to the guide............................................................................................. 1
1.2 Introduction to the subject area................................................................................ 1
1.3 Syllabus.................................................................................................................... 2
1.4 Aims of the course.................................................................................................... 2
1.5 Learning outcomes for the course............................................................................. 3
1.6 Overview of learning resources................................................................................. 3
1.7 Examination advice.................................................................................................. 6
Chapter 2: Decision analysis.................................................................................... 9
2.1 Introduction............................................................................................................. 9
2.2 Decision trees......................................................................................................... 11
2.3 Attitude towards risk.............................................................................................. 13
2.4 Some applications.................................................................................................. 16
2.5 The expected value of perfect information............................................................... 18
2.6 Overview of the chapter.......................................................................................... 21
2.7 Reminder of learning outcomes.............................................................................. 21
2.8 Test your knowledge and understanding................................................................. 21
Chapter 3: Game theory........................................................................................ 25
3.1 Introduction........................................................................................................... 25
3.2 Extensive form games............................................................................................. 27
3.3 Normal form games................................................................................................ 29
3.4 Nash equilibrium.................................................................................................... 31
3.5 Prisoners’ dilemma................................................................................................. 35
3.6 Subgame-perfect equilibrium.................................................................................. 37
3.7 Perfect Bayesian equilibrium................................................................................... 39
3.10 Test your knowledge and understanding............................................................... 41
Chapter 4: Bargaining............................................................................................ 45
4.1 Introduction........................................................................................................... 45
4.2 The Nash bargaining solution.................................................................................. 47
4.3 The alternating-offers bargaining game................................................................... 49
4.4 Incomplete information bargaining......................................................................... 52
Chapter 5: Auctions and bidding strategies.......................................................... 55
5.1 Introduction........................................................................................................... 55
5.2 Private and common-value auctions........................................................................ 57
5.3 Private-value auctions and their ‘optimal’ bidding strategies.................................... 59
5.4 Auction revenue..................................................................................................... 64
5.5 Common value auctions......................................................................................... 64
5.6 Complications and concluding remarks................................................................... 66
5.7 Conclusion............................................................................................................. 70
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MN3028 Managerial economics

Chapter 6: Asymmetric information I.................................................................... 73
6.1 Introduction........................................................................................................... 73
6.2 Adverse selection.................................................................................................... 74
6.3 Moral hazard.......................................................................................................... 78
Chapter 7: Asymmetric information II................................................................... 83
7.1 Introduction........................................................................................................... 83
7.2 Signalling and screening......................................................................................... 84
7.3 Principal-agent problems........................................................................................ 88
Chapter 8: Demand theory.................................................................................... 95
8.1 Introduction........................................................................................................... 95
8.2 Reviewing consumer choice.................................................................................... 96
8.3 Consumer welfare effects of a price change.......................................................... 101
8.4 Elasticity............................................................................................................... 103
8.5 Overview of the chapter........................................................................................ 105
8.6 Reminder of learning outcomes............................................................................ 105
Chapter 9: Other topics in consumer theory....................................................... 107
9.1 Introduction......................................................................................................... 107
9.2 State-contingent commodities model.................................................................... 108
9.3 Intertemporal choice............................................................................................. 111
9.4 Labour supply....................................................................................................... 114
9.5 Risk and return..................................................................................................... 118
9.6 Overview of the chapter........................................................................................ 121
9.7 Reminder of learning outcomes............................................................................ 122
Chapter 10: Production and input demands....................................................... 125
10.1 Introduction....................................................................................................... 125
10.2 Production functions and isoquants.................................................................... 126
10.3 Firm demand for inputs...................................................................................... 129
10.4 Industry demand for inputs................................................................................. 136
10.5 Overview of the chapter...................................................................................... 138
10.6 Reminder of learning outcomes.......................................................................... 138
10.7 Test your knowledge and understanding............................................................. 139
Chapter 11: Cost concepts................................................................................... 141
11.1 Introduction....................................................................................................... 141
11.2 Types of economic costs...................................................................................... 143
11.3 From production function to cost function........................................................... 145
11.4 Division of output among plants......................................................................... 146
11.5 Estimation of cost functions................................................................................ 148
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Contents

Chapter 12: Topics in labour economics.............................................................. 151
12.1 Introduction....................................................................................................... 151
12.2 Efficiency wages................................................................................................. 152
12.3 Firm demand for labour...................................................................................... 156
12.4 Internal labour markets....................................................................................... 159
Chapter 13: Market structure and performance................................................. 165
13.1 Introduction....................................................................................................... 165
13.2 Determinants of market structure........................................................................ 166
13.3 Measures of market structure.............................................................................. 171
13.4 Perfect competition............................................................................................. 172
Chapter 14: Monopoly and monopolistic competition....................................... 177
14.1 Introduction....................................................................................................... 177
14.2 Monopoly........................................................................................................... 179
14.3 Monopolistic competition................................................................................... 182
Chapter 15: Price discrimination......................................................................... 187
15.1 Introduction....................................................................................................... 187
15.2 Price discrimination............................................................................................ 188
Chapter 16: Other monopolistic pricing practices.............................................. 201
16.1 Introduction....................................................................................................... 201
16.2 Skimming or intertemporal price discrimination................................................... 202
16.3 Commodity bundling.......................................................................................... 207
16.4 Multiproduct firms.............................................................................................. 211
16.5 Transfer pricing................................................................................................... 214
Chapter 17: Oligopoly theory.............................................................................. 223
17.1 Introduction....................................................................................................... 223
17.2 Symmetric oligopoly models................................................................................ 226
17.3 Strategic asymmetry........................................................................................... 231
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Chapter 18: Cartels and (implicit) collusion........................................................ 237

18.1 Introduction....................................................................................................... 237
18.2 Profit maximisation by a cartel............................................................................ 238
18.3 Tacit (or implicit) collusion................................................................................... 242
Chapter 19: Introduction to corporate governance............................................ 247
19.1 Introduction....................................................................................................... 247
19.2 Directors and their duties.................................................................................... 249
19.3 International corporate governance codes........................................................... 251
19.4 The UK Stewardship Code................................................................................... 255
Chapter 20: Concluding remarks......................................................................... 257
20.1 Overview............................................................................................................ 257
20.2 Associated online material.................................................................................. 257
Appendix 1: Maths checkpoints.......................................................................... 259
1. Functions – a few general remarks.......................................................................... 259
2. Differentiation........................................................................................................ 260
3. Logarithmic functions/properties of In and exp......................................................... 262
4. Integration............................................................................................................. 262
5. Systems of equations/manipulating equations......................................................... 263
6. Uniform distribution................................................................................................ 264
7. Probabilities.......................................................................................................... 264
8. The discount factor ‘δ’............................................................................................. 266
9. The company’s profit function.................................................................................. 267
General suggestions for studying and revising............................................................. 268
Overview and definitions of some important functions................................................. 268
10. A few hints on solving questions........................................................................... 269
iv
Chapter 1: Introduction
1.1 Road map to the guide

Welcome to the subject guide for MN3028 Managerial economics.
This course considers a variety of exciting topics that lie at the intersection
of management and economics. You will learn how economics can provide
a useful framework to think about managerial issues and analyse problems
that businesses and societies commonly face in the real world. We hope
that this knowledge and critical thinking will serve you well in your future
studies and professional career.
This guide will help you to engage actively with the course and develop
a robust understanding of the subject matter. It provides a framework for
covering the topics in the syllabus and directions to the Essential reading.
However, the guide is not a substitute for the careful study of the readings
listed at the beginning of each chapter. For each topic in the syllabus it
is advisable to start with the relevant chapter of the guide, then do the
reading for that particular topic, then come back to the guide and attempt
the sample exercises at the end of the chapter. This will help you check
your understanding of the topic by applying your knowledge to solve
specific problems.
The subject guide is divided into 20 chapters, consisting of an introductory
chapter; five main content blocks covering the syllabus (namely, risk and
information, game theory and strategic behaviour, demand and supply
theory, market structure and competition, and corporate governance); and
a concluding chapter. It aims to:
• provide an effective framework for the study of the subject
• introduce you to the relevant subject material
• present the material in a structured/digestible format
• guide you towards appropriate learning resources
• enable you to approach managerial decision problems using economic
reasoning
• discuss business practice topics using an analytical approach, relying
on equations and numerical insight
• encourage you to take an active approach to learning by reading
recommended material; undertaking learning activities; and
participating in discussion via the virtual learning environment (VLE).
1.2 Introduction to the subject area

This course is intended as an intermediate economics course for BSc
(Management) and BSc (Economics) students. The main objective of the
course is to enable you to approach managerial decision problems using
economic reasoning. As such, it is less theoretical than a microeconomic
principles course and more attention is given to topics that are relevant
to managerial decision making. For instance, business practices such as
price discrimination, transfer pricing, bundling, resale price maintenance
and corporate governance are discussed. Most topics are analysed using
equations and numerical examples – that is, an analytical approach is
used. The theories that are presented are not practical ‘recipes’; they
are meant to give you insight and train your mind to think more like an
1
economist. The emphasis throughout is on the application of knowledge

and problem-solving rather than pure memorising and essay writing.
Why should economics and management students study economics?
The environment in which modern managers operate is an increasingly
complex one. It cannot be navigated without a thorough understanding
of how business decisions are and should be taken. Intuition and factual
knowledge are not sufficient. Managers need to be able to analyse; to put
their observations into perspective; and to organise their thoughts in a
rigorous, logical way. The main objective of this course is to enable you to
approach managerial decision problems using economic reasoning. At the
end of studying this subject, you should have acquired a sufficient level
of model-building skills to analyse microeconomic situations of relevance
to managers. The emphasis is therefore on ‘learning by doing’ rather
than repeating memorised material. You are strongly advised to develop
problem-solving skills using the exercises at the end of each chapter and
past examination papers as well as ancillary material available through the
VLE to complement and clarify your thinking.
1.3 Syllabus
The course covers basic topics in microeconomics such as supply and
demand, consumer theory, labour supply, asymmetry of information,
neo-classical view of the firm, production, costs, factor demands, perfect
competition, monopoly, monopolistic competition, oligopoly, cartels and
tacit collusion. We also analyse some newer material regarding alternative
theories of the firm, internal organisation of the firm, market structure,
efficiency wages, incentive structures, corporate governance as well as
some industrial organisation theories of commonly used pricing practices.
The following topics also form part of the course syllabus:
• individual (one person) decision making under uncertainty, attitudes
towards risk and the value of information
• theory of games and strategic decision making, including
its applications to oligopoly, collusion among firms, product
differentiation, entry deterrence and other market practices
• the effects of asymmetric information in areas such as bargaining,
bidding and auctions, situations of moral hazard and adverse selection
• corporate governance in modern organisations.
Some knowledge of constrained maximisation and Lagrangian functions
would be helpful for students taking this subject, although this is not a
prerequisite.
1.4 Aims of the course

This course has two main objectives, which directly relate to the major
themes that will be emphasised throughout this subject guide. The course
aims to:
• enable students to approach managerial decision problems using
economic reasoning
• present business practice topics using an analytical approach, using
equations and numerical insight.
2
1.5 Learning outcomes for the course

On completion of this course, and having completed the Essential reading
and exercises, you should be:
• prepared for Marketing and Strategy courses by being able to analyse
and discuss consumer behaviour and markets in general
• able to analyse business practices with respect to pricing and
competition
• able to define and apply key concepts in decision analysis and game
theory
• able to confidently analyse different market structures and equilibrium
outcomes in each of them.
1.6 Overview of learning resources

1.6.1 The subject guide
This subject guide has been written in such a way that you can obtain a
good basic understanding of the topics in the syllabus, before going on to
read the various other resources to broaden and deepen your knowledge.
It has been designed to give you a clear indication of the level of analysis
and detail that will be expected of you in the examination. Please note
that although the subject guide provides crucial academic guidance, it
is different from a traditional academic textbook and it is specifically
intended to work alongside the other resources detailed below. We
strongly encourage you to consult all available resources as you progress
with your studies of the subject.
The topics covered in this subject guide are closely aligned with those
taught to second year BSc (Management) students at the London School
of Economics and Political Science (LSE). Particularly:
• basic microeconomics (i.e. consumer theory, labour supply, neoclassical
theory of the firm, factor demands, competitive structure, government
intervention, etc.)
• individual (one-person) decision making under uncertainty and
the value of information; the theory of games. The latter considers
strategic decision making with more than one player and has
applications to bargaining, bidding and auctions, oligopoly and
collusion, the effects of asymmetric information on market outcomes
(one decision-maker has more information than the other) –
particularly situations of moral hazard (post-contractual opportunism)
and adverse selection (pre-contractual opportunism)
• some interesting topics in labour economics such as efficiency wages,
incentive structures and human resource management.
Each chapter of the subject guide contains learning outcomes to help you
check your progress and level of understanding of key topics. Each chapter
also contains worked-out examples throughout and sample exercises at the
end of the chapter. You are strongly encouraged to attempt these exercises
as well as the Sample examination paper on the VLE. Simply reading the
subject guide and the recommended textbooks without trying to solve
exercises on your own will not be sufficient for you to gain benefit from
the subject or prepare you for the examination.
3
1.6.2 Mathematics for managerial economics

The mathematical Appendix 1 in this subject guide gives an indication
of the level of mathematics required for the course. Review it! If you are
having difficulty with the mathematics in this course, you might find the
following textbook useful:
Png, I. Managerial economics. (New York: Routledge, 2016) 5th edition
[ISBN 9781138810266].
The above textbook does not assume a prior knowledge of economics
and offers a less mathematical introduction to managerial economics.
However, it is recommended as preliminary reading only and should not
be used as a substitute for the subject guide. The level of mathematics
it uses is much lower than that required for this course and it does not
cover the topics in detail. The different models are treated in a very basic
way. It can, however, be a useful back-up reference if you don’t have the
basic knowledge required to understand a topic. In particular, if you use
this book, it is recommended that you work through the mathematical
appendices that are provided at the end of each chapter. It is not necessary
to study the entire book in depth.
1.6.3 Essential reading

This guide is intended for an intermediate-level course on economics for
management. It is more self-contained than other subject guides might
be. Having said this, we do want to encourage you to read widely from
the reading list. Seeing things explained in more than one way should
help your understanding. It is therefore vital that you do all the Essential
reading specified at the beginning of each chapter, to complement and
expand the material discussed in the guide.
In addition to studying the material, it is essential that you practise problem
solving. This is important not only to check your own understanding of
the topic, but also to prepare effectively for the written examination. Each
chapter contains some sample questions and working through these and
problems in the recommended texts is excellent preparation for success
in your studies. You should also attempt past examination questions from
recent years; these are also available online on the VLE.
Throughout this guide, we will recommend appropriate chapters in the
following textbook:
Varian, H.R. Intermediate microeconomics: a modern approach. (New York: W.W.
Norton and Co., 2014) 9th edition [ISBN 9780393123968].
Detailed reading references in this subject guide refer to this specific
edition of Varian’s textbook. New editions of this textbook may of course
have been published by the time you study this course. You can use a more
recent edition of any of the books we recommend; use the detailed chapter
and section headings and the index to identify relevant readings. Also
check the VLE regularly for updated guidance on readings.
1.6.4 Further reading

We list a number of journals throughout the subject guide, which you may
find interesting to read. In certain chapters we also list relevant chapters of
the following textbooks:
Allen, W.B., K. Weigelt, N.A. Doherty and E. Mansfield Managerial economics:
theory, applications, and cases. (New York: W.W. Norton and Co., 2013) 8th
edition [ISBN 9780393912777].
Besanko, D., R. Braeutigam and K. Rockett Microeconomics. (Singapore:
John Wiley & Sons, 2015) 5th edition, International Student Version
4 [ISBN 9781118716380].
Besanko, D., D. Dranove, M. Shanley and S. Schaefer Economics of strategy.

(Singapore: John Wiley & Sons, 2013) 6th edition, International Student
Version [ISBN 9781118319185].
Carlton, D.W. and J.M. Perloff Modern industrial organization. (Harlow: Pearson
Education Ltd, 2015) 4th edition, Global Edition [ISBN 9781292087856].
Tirole, J. The theory of industrial organisation. (Cambridge, MA: The MIT Press,
1988) [ISBN 9780262200714].
We strongly encourage you to read those chapters as additional material to
support your studies.
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
1.6.5 Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the virtual learning environment (VLE) and the Online
Library. You should use the Online Library and VLE regularly throughout
your studies to support the learning material included in this subject guide.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at: http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Electronic study materials: All of the printed materials which you
receive from the University of London are available to download, to
give you flexibility in how and where you study.
• Discussion forums: An open space for you to discuss interests
and seek support from your peers, working collaboratively to solve
problems and discuss subject material. Some forums are moderated by
an LSE academic.
• Videos: Recorded academic introductions to many subjects;
interviews and debates with academics who have designed the courses
and teach similar ones at LSE.
• Recorded lectures: For a few subjects, where appropriate, various
teaching sessions of the course have been recorded and made available
online via the VLE.
5
• Audiovisual tutorials and solutions: For some of the first year

and larger later courses such as Introduction to Economics, Statistics,
Mathematics and Principles of Banking and Accounting, audio-visual
tutorials are available to help you work through key concepts and to
show the standard expected in exams.
• Self-testing activities: Allowing you to test your own
understanding of subject material.
• Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library

The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
onlinelibrary@shl.london.ac.uk
1.7 Examination advice

Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations, for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
It is worth emphasising again that there is no substitute for practising
problem solving throughout the year. The best way to internalise the key
concepts of managerial economics is to work through the set problems and
exercises that are included in this guide and also those that are available
on the VLE. It is impossible to acquire a reasonable level of problem-
solving skills while you are revising for the examination. You should
consciously try to solve the exercises presented at the end of each chapter
as well as past examination questions available on the VLE at the same
time as you progress with your studies. This approach will help you test
your true knowledge and understanding of the topic in real time.
The examination lasts for three hours and you may use a calculator.
Detailed instructions are given on the examination paper. Read them
6
carefully! The questions within each part carry equal weight and the
amount of time you should spend on a question is proportional to the
marks it carries. Part A consists of compulsory, relatively short problems
of the type that accompanies each of the chapters in the guide. Part B is
a mixture of some essay-type questions and longer analytical questions.
In part B a wider choice is usually available. Please refer to the VLE for a
Sample examination paper to help you prepare. It indicates the level and
type of questions you should expect. We would strongly advise you to
attempt to complete this paper within the time specified before looking at
the solutions provided in the Examiners’ commentaries on the VLE.
Remember, it is also important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course, which give advice on how each question might best be
answered.
1.7.1 Some advice and ideas on how to study

(This information was originally written by Tell Fallrath as an Appendix to
a previous edition of the guide.)
• Check your understanding of each model in three ways:
1. Can you explain its main arguments in a few simple words?
2. Can you solve a basic model analytically?
3. Can you draw the corresponding graphs?
• Do you understand the models and solutions intuitively?
• What is the overall context of a particular model that you study? How
does it relate to what you already know?
• Try to summarise each topic yourself, perhaps by using mind maps.
Remind yourself of the examples that you have studied and how they
relate to the theory of each chapter.
• Don’t memorise, but understand! There is hardly anything that you
will need to memorise for this course. Instead make sure you feel
comfortable with the exercises.
• Instead of reading the chapter over and over again, practise problem
solving!
• Often students complain that there are not enough practice questions.
You can create an infinite number of questions yourself by changing
given examples slightly (i.e. change a Marginal Cost function from
MC = 10 to MC = 20). Check how the results change and that you
understand why they change in this particular way. For graphical
questions, change an assumption and see how the graph changes.
• Don’t blame any deficits in mathematics on the economics course!
Throughout the year as soon as they arise, address any difficulties you
may have with the mathematics.
• Be curious and get help if you don’t understand something. If you are
studying at an institution, for example, ask for help from your fellow
students, teachers or past-year students.
• Relate the models to your day-to-day experience, which is much
more rewarding and fun. Examples give powerful illustrations of how
economic theory works. After all, economics is not an abstract science,
but models the world around you.
7
Notes
8
Chapter 2: Decision analysis
2.1 Introduction
It seems appropriate to start a course on economics for management with
decision analysis. Managers make decisions daily regarding selection of
suppliers, budgets for research and development, whether to buy a certain
component or produce it in-house and so on. Economics is in some sense
the science of decision-making. It analyses consumers’ decisions on which
goods to consume, in what quantities and when, firms’ decisions on the
allocation of production over several plants, how much to produce and
how to select the best technology to produce a given product. However,
the bulk of economic analysis considers these decision problems in
an environment of certainty. That is, all the necessary information is
available to the agents making the decisions. Although this is a justifiable
simplification, in reality, of course, most decisions are made in a climate
of (sometimes extreme) uncertainty. For example, a firm may know how
many employees to hire to produce a given quantity of output but the
decision of whether or how many employees to lay off during a recession
involves some estimate of the length of the recession. In a similar vein, oil
companies take enormous gambles when they decide to develop a new
field. The cost of drilling for oil, especially in deep water, can be extremely
high (e.g. billions of US$) and the payoffs in terms of the future price of
oil and gas as well as the likelihood of striking significant deposits can be
very uncertain. Investment decisions would definitely be very much easier
if uncertainty could be eliminated. Imagine what would happen if you
could forecast interest rates and exchange rates next year with 100 per
cent accuracy.
Clearly we need to understand how decisions are made when at least
some of the important factors influencing the decision are not known
for sure. The field of decision analysis offers a useful framework for
studying how these types of decisions are made or should be made. It also
provides insight into the cost of uncertainty or, in other words, how much
a decision-maker is or should be prepared to pay to reduce or eliminate
the uncertainty involved in the decision-making process. To illustrate
the concept of value of information, consider the problem of a company
bidding for a road maintenance contract. The costs of the project are
unknown and the company does not know how low to bid to get the job.
An important question to be answered in preparing the bid is whether
to gather more information about the nature of the project and/or the
competitors’ bids. These efforts only pay-off if, as a result, better decisions
are taken in the end.
Decision analysis is mainly used for situations in which there is one
decision-maker whereas game theory deals with problems in which
there are several decision-makers, each pursuing their own objectives. You
will study game theory in the next chapter. In decision analysis any form of
uncertainty can be modelled including that arising from unknown features
of competitors’ behaviour (as in the bidding example). However, when
decision analysis models are used to solve problems with several decision-
makers, the competitors are not modelled as rational and strategic
agents (i.e. it is not recognised that they are also trying to achieve certain
objectives, taking the actions of other players into account). Instead,
decision theory takes the view that, as long as probabilities can also be
9
attached to other decision-makers’ actions, optimal decisions can be

calculated. An obvious objection to this approach is that it is not clear how
these probabilities become known to the decision-maker. Game theory
avoids this problem as it takes a symmetric, simultaneous view. The reason
decision analysis is used in these situations despite these shortcomings
is that it is much simpler than game theory. For this reason and because
some of the techniques of decision analysis (such as representing
sequential decision problems on graphs or decision trees, and solving them
backwards) can also be used in game theory, we study decision analysis
first.
2.1.1 Aims of the chapter

The aims of this chaper are to consider:
• the concept of expected value of perfect information (EVPI) and how
it can be used
• why we may want to use expected utility rather than expected
value maximisation
• the concept of certainty equivalent and how it relates to expected
value for a risk loving, risk neutral and risk averse decision-maker
• the application of decision analysis in insurance and finance.
2.1.2 Learning outcomes

By the end of this chapter, and having completed the Essential reading and
exercises, you should be able to:
• structure simple decision problems in decision tree format and
derive optimal decisions
• explain attitudes towards risk and the way they may impact on optimal
decision-making
• calculate risk aversion coefficients
• calculate EVPI for risk neutral and non-risk neutral decision-makers
• apply the tools of decision analysis to solve new problems involving
uncertainty.

Norton and Co., 2014; 9th edition) Chapter 12: Uncertainty.

You may also find the following book useful as additional reading:
edition [ISBN 9780393912777], especially Chapter 14: Risk analysis.
2.1.5 Synopsis of chapter content

This chapter provides a framework for analysing optimal decision-making
by a single decision-maker in the context of uncertainty about future
outcomes (i.e. risk). It introduces decision trees and the concept of
expected utility, examines rational agents’ optimal decisions as a function
of their risk appetite and presents a way to value perfect information in
environments of uncertainty. A number of applications of the concepts to
real and financial markets are also considered.
10
2.2 Decision trees

A decision tree is a convenient representation of a decision problem
that helps decision-makers visualise their strategic future. It contains all
the ingredients of the problem:
• the possible decisions
• the sources of uncertainty
• the payoffs to the decision-maker for each possible combination of
probabilistic outcomes and decisions.
Drawing a decision tree forces the decision-maker to think through the
structure of the problem faced, thus making the process of determining
optimal decisions easier. It illustrates the various options available and
provides an easy way to compare pay-offs across strategies. A decision
tree consists of two kinds of nodes: decision or action nodes which are
drawn as squares; and probability or chance nodes which are drawn
as circles. The arcs leading from a decision node represent the choices
available to the decision-maker at this point; whereas the arcs leading
from a probability node correspond to the set of possible outcomes when
some uncertainty is resolved. When the structure of the decision problem
is captured in a decision tree, the payoffs are written at the end of the
final branches and (conditional) probabilities are written next to each arc
leading from a probability node. The algorithm for finding the optimal
decisions is not difficult. Starting at the end of the tree, work backwards
and label nodes as follows. At a probability node calculate the expected
value of the labels of its successor nodes, using the probabilities given on
the arcs leading from the node. This expected value becomes the label
for the probability node. At a decision node (assuming a maximisation
problem), select the maximum value of the labels of successor nodes.
This maximum becomes the label for the decision node. The decision
which generates this maximum value is the optimal decision at this node.
Repeat this procedure, moving further to the left along the decision tree,
until you reach the starting node. The label you get at the starting node
is the expected pay-off obtained when the optimal decisions are taken.
The construction and solution of a decision tree is most easily explained
through examples.
Example 2.1
Cussoft Ltd., a firm which supplies customised software, must decide

between two mutually exclusive contracts, one for the government and the
other for a private firm. It is hard to estimate the costs Cussoft will incur
under either contract but, from experience, it estimates that, if it contracts
with a private firm, its profit will be £2 million, £0.7 million, or –£0.5
million with probabilities 0.25, 0.41 and 0.34 respectively. If it contracts with
the government, its profit will be £4 million or –£2.5 million with respective
probabilities 0.45 and 0.55. Which is Cussoft’s optimal decision to maximise
expected profit?
In this very simple example, Cussoft has a choice of two decisions – to

contract with the private firm or to contract with the government. In
either case its pay-off is uncertain. The decision tree with the payoffs and
probabilities is drawn in Figure 2.1. The label of the top probability node is
equal to the expected profit if the contract with the private firm is chosen.
11
The expected profit is the sum of the amount of money gained (or lost) if
each outcome occurs, times the probability of occurrence of the outcome,
which in this case is (0.25)(2) + (0.41)(0.7) + (0.34)(–0.5) = 0.617
(£ million). The label of the bottom probability node is equal to the expected
profit if the contract with the government is chosen, which is (0.45)(4) +
(0.55)(–2.5) = 0.425 (£ million). Working backwards it turns out that the
optimal decision at the decision node is to choose the contract with the
private firm since it generates the biggest expected profit. Optimal decisions
are indicated by thick lines.
0.617 0.25 2
0.41
0.7
private firm
0.34
-0.5
4
0.617
0.45
government 0.425
0.55
-2.5
Figure 2.1: Decision tree for Example 2.1
Example 2.2
Suppose the chief executive officer (CEO) of an oil company must decide
whether to drill a site and, if so, how deep. It costs £160,000 to drill the first
3,000 feet and there is a 0.4 chance of striking oil. If oil is struck, the profit
(net of drilling expenses) is £600,000. If she doesn’t strike oil, the executive
can drill 2,000 feet deeper at an additional cost of £90,000. Her chance of
finding oil between 3,000 and 5,000 feet is 0.2 and her net profit (after all
drilling costs) from a strike at this depth is £400,000. What action should
the executive take to maximise her expected profit? (Try writing down and
solving the decision tree yourself without peeking!)
You should get the following result.
600
168 oil
400
0.4 oil
drill
3000 ft -120 0.2
0.6
no oil drill
5000 ft no oil
168
0.8 -250
don’t drill -120 don’t drill
0
-160
Figure 2.2: Decision tree for Example 2.2
12
2.3 Attitude towards risk

In the examples considered so far we have used the expected monetary
value (EMV) criterion (i.e. we assumed that the decision-maker is
interested in maximising the expected value of profits or minimising
the expected value of costs). In many circumstances this is a reasonable
assumption to make, especially if the decision-maker is a large company.
To examine how risk may affect managerial behaviour, consider a manager
facing the following choice:
1. A certain profit of £1,000,000.
2. A project with a 50:50 chance of a £3,000,000 profit or a £500,000
loss.
The EMV of the project equals:
0.50 (£3,000,000) + 0.50 (£500,000) = £1,250,000
– so to maximise expected profits, the manager should choose the project
because it has a bigger EMV. However, it is reasonable to believe that many
managers may nonetheless prefer the certainty of £1 million to the risky
project. Indeed, this is more likely to be true for relatively small businesses
for which losing £500,000 could be disastrous. Whether decision-makers
will want to follow the EMV criterion in this situation will ultimately
depend on their attitude towards risk. To appreciate that it may not always
be appropriate to use EMV, consider the following story, known as the
St. Petersburg paradox.
I will toss a coin and, if it comes up heads, you will get £2. If it comes up
tails, I will toss it again and, if it comes up heads this time, you will get
£4; if it comes up tails, I will toss it again and, this time, you will get £8
if it comes up heads, etc. How much would you be willing to pay for this
gamble? I predict that you would not want to pay your week’s pocket
money or salary to play this game. However, if you calculate the EMV you
will find:
EMV = 2(1/2) + 4(1/4) + 8(l/8) + ... + 2n(1/2n) +... = 1 + l + 1 + ... = ∞!
Even when faced with potentially large gains, most people do not like to
risk a substantial fraction of their financial resources. Although this implies
that we cannot always use EMV, it is still possible to give a general analysis
of how people make decisions even if they do not like taking risks. As a
first step we have to find out the decision-maker’s attitude towards risk. A
useful concept here is the certainty equivalent (CE) of a risky prospect
defined as the amount of money which makes the individual indifferent
between it and the risky prospect. To clarify this, imagine you are offered
a lottery ticket which has a 50–50 chance of winning £0 or £200. So the
expected payoff of the lottery is £100. Would you prefer £100 for sure to
the lottery ticket? What about £50 for sure? The amount £x so that you
are indifferent between x and the lottery ticket is your certainty equivalent
of the lottery ticket. If your x is less than £100, the EMV of the lottery, you
are ‘risk averse’. In general a decision-maker is risk averse if CE < EMV,
risk neutral if CE = EMV and risk loving if CE > EMV.
Suppose you have an opportunity to invest £1,000 in a business venture
which will gross £1,100 or £1,200 with equal probability next year.
Alternatively you could deposit the £1,000 in a bank which will give you
a riskless return. How large does the interest rate have to be for you to be
indifferent between the business venture and the deposit account? (Namely,
what is your certainty equivalent? Are you a risk lover?) Note that it is
possible to be a risk lover for some lotteries and a risk hater for others.
13
2.3.1 Expected utility

In the presence of uncertainty, we shall assume that rational agents want
to maximise expected utility. A utility function represents the level of
satisfaction (or benefit or welfare) attached to each possible outcome. It
is risk-adjusted, so we can determine a decision-maker’s degree of risk
appetite summarised in their utility function. The expected utility criterion
is convenient because it enables us to still use expected value calculations
but with monetary outcomes replaced by utility values. More specifically,
the expected utility is the sum of the utility of each possible outcome times
the probability of the outcome’s occurrence. For example, consider the
lottery ticket discussed above and suppose the utility of £200 is 10 and the
utility of £0 is 0. In this case the expected utility equals
0.50 (10) + 0.50 (0) = 5.
It is possible to show that, if a decision-maker satisfies certain relatively
plausible axioms, they can be predicted to behave as if they maximise
expected utility. Furthermore, since a utility function U*(x) = aU(x) +
b, a > 0, leads to the same choices as U(x) we can arbitrarily fix the
utility of the worst outcome w at 0(U(w) = 0) and the utility of the best
outcome b at l(U(b) = l) for a given decision problem. To find the utility
corresponding to an outcome x we ask the decision-maker for the value
of p, the probability of winning b in a lottery with prizes b and w, which
makes x the CE for the lottery. For example, if the worst outcome in a
decision problem is £0(U(0) = 0) and the best outcome is £200(U(200)
= 1), how do we determine U(40)? We offer the decision-maker the
choice represented in Figure 2.3 and keep varying p until he is indifferent
between 40 and the lottery.
40
200
p
1-p
0
Figure 2.3: Determining utility
When the decision-maker is indifferent, say for p = 0.4, we have:

U(40) = U(lottery) = pU(200) + (1 – p)U(0) = p = 0.4.
That is, the utility attached to a gain of £40 is 0.4. Utility values can
be obtained in a similar way for the other possible outcomes of the
decision problem. Replacing the monetary values by the utility values and
proceeding as before will lead to the expected utility maximising decisions.
The definition of risk aversion can be rephrased in terms of the utility
function:
• a risk averse decision-maker has a concave utility function
• a risk lover has a convex utility function
• a risk neutral decision-maker has a linear utility function.
14
risk averse neutral risk loving
money
Figure 2.4: Attitudes towards risk

To see why a concave utility function represents risk aversion, consider an
individual who will end up with payoffs £100 or £200 which are equally
likely so that the expected value of the lottery is £150. For an individual
who is risk averse, the CE of this lottery should be less than £150 (you
should understand why)! A concave utility function is drawn in Figure 2.5
where you can read off the expected utility of the lottery EU = 0.5 U(100)
+ 0.5 U(200) at point C on the line connecting U(100) and U(200). The
CE is the amount of money that delivers the same level of utility as the
lottery, i.e. U(CE) = EU. For a concave utility function, we always have
that CE<EU as can be seen in Figure 2.5 and the individual is therefore
risk averse. Following similar steps you should be able to show that
CE>EU when the utility function is convex.
utility
B
EU
C
A
money
100 CE 150 200
Figure 2.5: Concave utility function and risk aversion

It is possible for a decision-maker to be risk averse over a range of
outcomes and risk loving over another range. Indeed, this is how we
can explain that the same people who take out home contents insurance
buy a national lottery ticket every week. An example of a utility function
corresponding to risk loving behaviour for small bets and risk averse
behaviour for large bets is drawn in Figure 2.6.
15
money
Figure 2.6: Risk loving and risk averse behaviour
2.3.2 Measures of risk aversion

For continuous differentiable functions, there are two measures of risk
aversion, the Pratt-Arrow coefficient of absolute risk aversion
determined as – U'' (x)/U' (x) and the Pratt-Arrow coefficient of
relative risk aversion determined as – U′′ (x)x/ U'(x). If U is concave,
then U′′< 0 and hence both these coefficients are positive for risk averse
individuals.1 1
Note that the
coefficient of relative
risk aversion is the
2.4 Some applications negative of the elasticity
of marginal utility of
2.4.1 The demand for insurance income and does not
depend on the units
People take out insurance policies because they do not like certain types in which income is
of risk. Let us see how this fits into the expected utility model. Assume an measured.
individual has initial wealth W and will suffer a loss L with probability p.
How much would she be willing to pay to insure against this loss? Clearly,
the maximum premium R she will pay makes her just indifferent between
taking out insurance and not taking out insurance. Without insurance she
gets expected utility EU0 = pU(W – L) + (1 – p) U(W) and, if she insures
at premium R, her utility is U(W – R). Therefore the maximum premium
satisfies U(W – R) = pU(W – L) + (1 – p) U(W). This is illustrated for a
risk averse individual in Figure 2.7. The expected utility without insurance
is a convex combination of U(W) and U(W – L) and therefore lies on the
straight line between U(W) and U(W – L); the exact position is determined
by p so that EU0 can be read off the graph just above W – pL (the EMV
of this lottery). This utility level corresponds to a certain prospect W – R
which, as can be seen from the figure, has to be less than W – pL (the EMV
of this lottery), so that R > pL. This shows that, if a risk averse individual
is offered actuarially fair insurance (premium R equals expected loss pL),
he will insure.
16
EU0
W–L W–R W–pL W
Figure 2.7: Insurance
Example 2.3
Jamie studies at Cambridge University and uses a bicycle to get around. He

is worried about having his bike stolen and considers taking out insurance
against theft. If the bike gets stolen he would have to replace it which would
cost him £200. He finds out that 10 per cent of bicycles in Cambridge are
stolen every year. His total savings are £400 and his utility of money function
is given by U(x) = x1/2. Under what conditions would Jamie take out
insurance for a year? What if he has utility of money U(x) = ln(x)?
If he takes out insurance he obtains utility U(400 – R) where R is the

premium. Without insurance he gets (0.1)U(200) + (0.9)U(400). Equalising
these expected utilities and substituting U(x) = x1/2, gives:
(0.1)√200 + (0.9) √400 = √400 – R

or
R = 23.09
which means that insuring is the best decision as long as the premium does
not exceed £23.09. Similarly, if U(x) = ln(x), the maximum premium can be
calculated (you should check this!) as £26.79.
2.4.2 The demand for financial assets

Consider the problem of an investor with initial wealth W who wants to
decide on her investment plans for the coming year. For simplicity, let us
assume that there are only two options: a riskless asset which delivers a
gross return of R at the end of the year; and a risky asset which delivers
a high return H with probability p and a low return L with probability
1 – p. It is not difficult to allow for borrowing so that the investor can
invest more than W but, to keep things simple, let us restrict the investor’s
budget to W. The decision problem then consists of finding the optimal
amount of money A(<W ) to be invested in the risky asset. Given A, the
investor gets an expected return of:
EU(A) = pU(R(W – A) + HA) + (1 – p)U(R(W – A) + LA) = pU(RW + (H – R)A)
+ (1 – p)U(RW + (L – R)A)
Maximising EU(A) and assuming an interior solution (i.e. 0 < A < W)
leads to the following (first order) condition:
EU'(A) = pU'(RW + (H – R)A)(H – R) + (1 – p)U'(RW + (L – R)A)(L – R) = 0
17
Note that, if the risky asset always yields a lower return than the riskless
asset (H, L < R), there can be no solution to this condition since U' > 0.
In this scenario the investor would not invest in the risky asset (A = 0).
Similarly, if the risky asset always yields a higher return than the riskless
asset (H, L > R) there can be no solution to this condition and under these
circumstances the investor would invest all of her wealth in the risky asset
(A = W). All this makes economic sense. For the other scenarios (L < R <
H) the first order condition above allows us, for a specific utility function, to
calculate the optimal portfolio allocations.
2.4.3 Insurance in financial markets

Consider an asset manager who holds a portfolio of commercial property
worth £900 million. They estimate there is a 25 per cent chance the real
estate market will worsen next year and the portfolio will be worth only
£400 million. They also think there is a 75 per cent chance that property
values will remain stable. The expected value of their property portfolio is
therefore £775 million.
If the asset manager is risk averse and has utility function U(W) = W1/2,
where W is the portfolio’s worth, the expected utility is given by
0.25(£400 million)1/2 + 0.75(£900 million)1/2 = 27,500.
The CE (that is, the amount of money that would make the manager
indifferent between having that amount for certain and holding the risky
property portfolio) is calculated as follows:
U(CE) = CE1/2 = 27,500
which means that CE = £756.25 million. Suppose a risk neutral insurance
company is willing to provide coverage against drops in property values. If
the policy covers the manager’s entire loss in the portfolio, what premium
should the insurer charge for this policy?
The expected payout is £125 million (0.25 × £500m), so the insurance
company should charge a premium P of at least this amount to break even
on the policy. A higher premium leads to a positive expected profit. The
manager’s CE can in turn be used to calculate the maximum amount she
would be willing to pay to hold such a policy. Specifically:
£900 million – P = CE = £756.25 million.
Hence the asset manager is indifferent between buying the full coverage
insurance policy for £143.75 million and facing the uncertainty in the real
estate market because both provide a similar expected utility of 27,500.
The difference between the minimum premium that the insurance company
is willing to accept (£125 million) and the maximum that the manager
is willing to pay (£143.75 million) represents the risk premium, or the
amount of money the insured is willing to pay above what is actuarially fair
(i.e. the expected value of the loss).
2.5 The expected value of perfect information

In most situations of uncertainty a decision-maker has the possibility of
reducing, if not eliminating, the uncertainty regarding some relevant factor
by obtaining additional information. Typically this process of finding more
information is costly in financial terms (e.g. when a market research agency
is contracted to provide details of the potential market for a new product) or
in terms of effort (e.g. when you test drive several cars before deciding on a
purchase). A crucial question in many decision-making contexts is therefore,
‘How much money and/or effort should the decision-maker allocate to
reducing the uncertainty?’ ‘How much should they be willing to pay to buy
18
such information?’ In this section, we study a procedure which gives an upper

bound (or maximum value) as an answer to this question. This upper bound is
called the expected value of perfect information (EVPI) and is derived
as follows for a risk neutral decision-maker (we will go back to the expected
utility model later). The value of perfect information is defined as the increase
in expected profit if you can obtain completely accurate information concerning
future outcomes.
Assuming you know the outcomes of all probabilistic events in a decision tree,
determine the optimal decisions and corresponding pay-off for each possible
scenario (combination of outcomes at each probability node). Given that you
know the probabilities of each scenario materialising, calculate the expected
pay-off under certainty using the optimal pay-off under each scenario and the
scenario’s probability. This expected pay-off is precisely the pay-off you would
expect if you were given exact information about what will happen at each
probability node. The difference between this expected pay-off under perfect
information and the original optimal pay-off is the EVPI. Since, in reality, it is
almost never possible to get perfect information and eliminate the uncertainty
completely, the EVPI is an upperbound on how much the decision-maker is
willing to pay for any (imperfect) information. Generally better decisions are
made when there is no uncertainty and therefore the EVPI is positive. However,
it is possible that having more information does not change the optimal decisions
and in those cases the EVPI is zero. While the concept of EVPI is extremely useful,
it is really quite abstract and difficult to grasp. So let us look at an example.
Example 2.2a
The notion of perfect information in Example 2.2 translates into the

existence of a perfect seismic test which could tell you with certainty
whether there is oil at 3,000 feet, at 5,000 feet or not at all. Assuming such a
test exists, how much would the chief executive officer (CEO) be willing to
pay to know the test result? The tree in Figure 2.8 represents the (easy)
decision problem if all uncertainty is resolved before any decisions are made.
There are three scenarios: ‘oil at 3,000 feet’, ‘oil at 5,000 feet’ and ‘no oil’
whose probabilities can be derived from the original tree as 0.40, 0.12, and
0.48 respectively. If the CEO is told which scenario will occur, her decision
will be straightforward. Given the optimal decision corresponding to each
scenario and the probabilities of the various scenarios, the optimal pay-off
with perfect information is £288,000. Recall that the original problem had
an EMV of £168,000 and hence EVPI = £120,000. If a perfect seismic test
were available, the CEO would be willing to pay up to £120,000 for it.
600
drill
oil at 3000 ft 600 don’t 0
0.40
400
oil at
5000 ft drill
0.12
288 400 don’t 0
no oil
0.48
0 don’t drill
Figure 2.8: Calculating EVPI
19
If the decision-maker is not risk neutral, a similar method to the one we

have just discussed can be used to evaluate the EVPI in utility terms (i.e.
we calculate EU under the assumption of perfect information and compare
this with the EU in the original problem). However, this does not tell us
how much the decision-maker is willing to pay to face the riskless problem
rather than the risky one! It is in fact quite tricky to determine the EVPI for
an EU maximiser. Consider the simple decision tree in Figure 2.9 where an
individual with money utility U(x) = x 1/2 chooses between a safe and a risky
strategy, say investing in a particular stock or not. In either case there are
two outcomes – O1 and O2 (e.g. the company is targeted for takeover or not)
– resulting in the monetary payoffs indicated on the tree. The probabilities of
the outcomes are independent of the decision taken. Using the EU criterion,
the decision-maker chooses the safe strategy so that EU = 4.
Activity
Explain why the above is the case.
1/3
16
O1
2/3
safe
O2
16
1/3 81
risky O1
2/3
O2 1
Figure 2.9: EU maximiser chooses safe strategy

With perfect information, however, the decision-maker chooses the ‘risky’
strategy if O1 is predicted and the ‘safe’ strategy when O2 is predicted, as is
indicated in Figure 2.10. This gives her:
EU = (1/3) (9) + (2/3) (4) = 17/3.
81
risky
O1 safe
1/3 16
O2 1
2/3 risky
16
Figure 2.10: Optimal choice under perfect information
20
How much is the decision-maker willing to pay for this increase in EU from
4 to 17/3? Suppose she pays an amount R for the perfect information. She
will be indifferent between getting the information and not getting it if
the EU in both cases is equal, or 4 = (1/3)(81 – R)1/2 + (2/3)(16 – R)1/2.
Solving this for R (numerically) gives R as approximately 12.5; hence, the
EVPI for this problem is about 12.5. Note that this last equation can be
solved algebraically.
2.6 Overview of the chapter

This chapter discussed the key concepts of decision analysis, such as: the
construction of decision trees and the way they can help identify optimal
decisions; the way in which attitudes towards risk may affect decision-
making; and common economic measures of risk appetite. A way to value
the access to perfect information in a context of uncertainty has also been
analysed, as well as applications of decision analysis theory to insurance
and financial markets.
2.7 Reminder of learning outcomes

Having completed this chapter, and the Essential reading and exercises,
you should be able to:
• structure simple decision problems in decision tree format and
derive optimal decisions
• explain attitudes towards risk and the way they may impact on optimal
decision-making
• calculate risk aversion coefficients
• calculate EVPI for risk neutral and non-risk neutral decision-makers.
• apply the tools of decision analysis to solve new problems involving
uncertainty.
2.8 Test your knowledge and understanding

You should try to answer the following questions to check your
understanding of this chapter’s learning outcomes.
The VLE also contains additional exercises to test your knowledge of the
content of this chapter, together with their respective solutions, as well as
past examination papers. We encourage you to use the VLE regularly to
support your study of the course material in this subject guide and prepare
for the examination.
1. London Underground (LU) is facing a courtcase by legal firm
Snook&Co., representing the family of Mr Addams who was killed
in the King’s Cross fire. LU has estimated the damages it will have to
pay if the case goes to court as follows: £1,000,000, £600,000 or £0
with probabilities 0.2, 0.5 and 0.3 respectively. Its legal expenses are
estimated at £100,000 in addition to these awards. The alternative
to allowing the case to go to court is for LU to enter into out-of-court
settlement negotiations. It is uncertain about the amount of money
Snook&Co. are prepared to settle for. They may only wish to settle
for a high amount (£900,000) or they may be willing to settle for a
reasonable amount (£400,000). Each scenario is equally likely. If they
are willing to settle for £400,000 they will of course accept an offer
of £900,000. On the other hand, if they will only settle for £900,000
they will reject an offer of £400,000. LU, if it decides to enter into
negotiations, will offer £400,000 or £900,000 to Snook & Co. who will
21
either accept (and waive any future right to sue) or reject and take the
case to court. The legal cost of pursuing a settlement whether or not
one is reached is £50,000. Determine the strategy which minimises
LU’s expected total cost.
2. Rickie is considering setting up a business in the field of entertainment
at children’s parties. He estimates that he would earn a gross revenue
of £9,000 or £4,000 with a 50–50 chance. His initial wealth is zero.
What is the largest value of the cost which would make him start this
business:
a. if his utility of money function is U(x) = ax + b where a > 0
b. if U(x) = x1/2; for x > 0 and U(x) = –(–x)1/2 for x < 0
c. if U(x) = x2, for x > 0 and U(x) = –x2 for x < 0.
3. Find the coefficient of absolute risk aversion for U(x) = a – b.exp(–cx)
and the coefficient of relative risk aversion for U(x) = a + b.ln(x).
4. Find a volunteer (preferably someone who doesn’t know expected
utility theory) and estimate their utility of money function to predict
their choice between the two lotteries in Figure 2.11 below. Payoffs are
given in monetary value (£). Check your prediction.
100
2/3
1/3
200
50
1/3
5/9
150
1/9
300
Figure 2.11: Choice between two lotteries

5. An expected utility maximiser spends £10 on a lottery ticket, with a
chance of 1 in 1 million of £1 million. He takes out home contents
insurance at a premium of £100. His probability of an insurance claim
of £1,000 is 1 per cent. Draw his utility of money function.
6. A decision-maker must choose between (1) a sure payment of £200;
(2) a gamble with prizes £0, £200, £450 and £1,000 with respective
probabilities 0.5, 0.3, 0.1 and 0.1; (3) a gamble with prizes £0, £100,
£200 and £520, each with probability 0.25.
a. Which choice will be made if the decision-maker is risk neutral?
b. Assume the decision-maker has a CARA (constant absolute risk 2
Hint: show that c
aversion) utility of money function U(x) = –a exp(–cx) + b and has to equal 0.00024
her certainty equivalent for a gamble with prizes £1,000 and £0 approximately
equally likely is £470. Which choice will be made?2 for U(0) = 0 and
U(1,000) = 1.
22
7. Henrika has utility function U = M 1/2 for M ≥ 0 and U = –(–M)1/2 for

M < 0, over money payoffs M.
a. Given a lottery with outcomes £0 and £36 with respective
probabilities 2/3 and 1/3, how much is she willing to pay to
replace the lottery with its expected value?
b. Given the table of money payoffs below, which action maximises
her expected utility?
c. How much would Henrika be willing to pay for perfect information
regarding the state of nature?
S1 S2
A1 4 4
A2 9 1
1/3 2/3
23
Notes
24
Chapter 3: Game theory
3.1 Introduction
Game theory extends the theory of individual decision-making to
situations of strategic interdependence: that is, situations where players
(decision-makers) take other players’ behaviour into account when making
their decisions. The pay-offs resulting from any decision (and possibly
random events) are generally dependent on others’ actions.
Strategic interaction can involve many players and many strategies, but to
simplify our analysis most of the examples and applications discussed in this
guide will deal with two-person games with a finite number of strategies.
Whereas it is possible to approach many business situations using decision
analysis by assigning probabilities to uncertain behaviour of rivals, game
theory is a superior methodology for dealing with strategic problems. Rather
than assessing probabilities of players’ actions, game theory starts out with
the assumption that players take actions that promote their self-interest
given the information available to them. The introduction of game theoretic
reasoning in economics has caused dramatic transformations of several fields
of study, most notably – but not exclusively – in industrial organisation.
Game theory can help executives better understand others strategically
by providing a robust framework to analyse economic problems and
anticipate the behaviour of others (e.g. competitors). This ability, in turn,
can increase the payoffs of sound managerial decisions.
A distinction is made between cooperative game theory and non-
cooperative game theory. In cooperative games, coalitions or groups
of players are analysed. Players can communicate and make binding
agreements. The theory of non-cooperative games assumes that no such
agreements are possible. Each player in choosing his or her actions, subject
to the rules of the game, is motivated by self-interest. Because of the larger
scope for application of non-cooperative games to managerial economics,
we will limit our discussion to non-cooperative games.
To model an economic situation as a game involves translating the
essential characteristics of the situation into rules of a game. The following
must be determined in any game:
• the number of players
• their possible actions at every point in time
• the pay-offs for all possible combinations of moves by the players
• the information structure (what players know when they have to make
their decisions).
All this information can be presented in a game tree which is the game
theory equivalent of the decision tree. This way of describing the game is
called the extensive form representation.
It is often convenient to think of players’ behaviour in a game in terms of
strategies. A strategy tells you what the player will do each time s/he has
to make a decision. So, if you know the player’s strategy, you can predict
his behaviour in all possible scenarios with respect to the other players’
behaviour. When you list or describe the strategies available to each
player and attach pay-offs to all possible combinations of strategies by the
players, the resulting ‘summary’ of the game is called a normal form or
strategic form representation. A game in normal form will allow us to
depict it easily using a pay-off matrix, as will be shown later. 25
Players in a game can also have complete or incomplete information. In

games of complete information all players know the rules of the game. In
incomplete information games, at least one player only has probabilistic
information about some elements of the game (e.g. the other players’ precise
characteristics). An example of the latter category is a game involving an
insurer – who only has probabilistic information about the carelessness of an
individual who insures his car against theft – and the insured individual who
knows how careless he is. A firm is also likely to know more about its own
costs than about its competitors’ costs. In games of perfect information all
players know the earlier moves made by themselves and by the other players.
In games of perfect recall, players remember their own moves and do not
forget any information which they obtained in the course of game play. They
do not necessarily learn about other players’ moves.
Game theory, as decision theory, assumes rational decision-makers. This means
that players are assumed to make decisions or choose strategies which will give
them the highest possible expected pay-off (or utility). Each player also knows
that other players are rational and that they know that the other player knows
they are rational and so on. In a strategic situation the question arises whether
it could not be in an individual player’s interest to convince the other players
that one is irrational. (This is a complicated issue which we will consider in the
later sections of this chapter. All we want to say for now is that ultimately the
creation of an impression of irrationality may be a rational decision.)
Before we start our study of game theory, a ‘health warning’ may be
appropriate. It is not realistic to expect that you will be able to use game
theory as a technique for solving real problems. Most realistic situations are
too complex to analyse from a game theoretical perspective. Furthermore,
game theory does not offer any optimal solutions or solution procedures for
most practical problems. However, through a study of game theory, insights
can be obtained which would be difficult to obtain in another way and
game theoretic modelling helps decision-makers think through all aspects
of the strategic problems they are facing. As is true of mathematical models
in general, game theory allows you to check intuitive answers for logical
consistency.

The aims of this chapter are to consider:
• the concept of information set and why it is not needed in decision
analysis
• why it is useful to have both extensive form and normal form
representations of a game
• the importance of the prisoners’ dilemma as a paradigm for many social
interactions
• the concept of dominated strategies and the rationale for eliminating
them in the analysis of a game
• the concept of Nash equilibrium (this is absolutely essential!)
• the concepts of backwards induction and subgame-perfect equilibrium
• the concept of non-credible threats and its application to entry deterrence
problems.

• represent a simple multi-person decision problem using a game tree
26
• translate from an extensive form representation to the normal form

representation of a game using the pay-off matrix
• find Nash equilibria in pure and mixed strategies
• explain why in a finitely repeated prisoners’ dilemma game
cheating is a Nash equilibrium
• discuss the subgame perfect equilibria and explain the chainstore
paradox.

Norton and Co., 2014; 9th edition) Chapter 29: Game theory and Chapter 30:
Game applications.

You may also find the following books and articles useful as additional
reading:
edition [ISBN 9780393912777] Chapter 12: Game theory.
Axelrod, R. The evolution of cooperation. (New York: Basic Books, 1984)
[ISBN 9780465021215].
Kreps, D. and R. Wilson ‘Reputation and imperfect information’, Journal of
economic theory (1982) 27, pp.253–79.
Milgrom, P. and J. Roberts ‘Predation, reputation and entry deterrence’, Journal of
economic theory (1982) 27, pp.280–312.
Nash, J. ‘Noncooperative games’, Annals of Mathematics 54 1951, pp.289–95.
Selton, R. ‘ The chain store paradox’, Theory and Decision (9) 1978, pp.127–59.
Tirole, J. The theory of industrial organisation. (Cambridge, MA: The MIT Press,
1988) [ISBN 9780262200714] Chapter 11: Noncooperative game theory: a
user’s manual.

This chapter provides an introduction to non-cooperative game theory by
discussing simple games of complete information in normal and extensive
form. The concepts of strategic dominance and Nash equilibrium (in pure
and mixed strategies) are discussed in the context of insightful applications
to managerial economics. We then consider sequential games and discuss
the concept of subgame perfect Nash equilibrium as well as some of its
applications to industrial organisation.
3.2 Extensive form games

As mentioned above, the extensive form representation of a game is very similar
to a decision tree although it can be used for several players rather than just
a single decision-maker. The order of play and the possible decisions at each
decision point for each player are indicated as well as the information structure,
the outcomes or pay-offs and probabilities. As in decision analysis, the pay-offs
are not always financial. They may reflect the player’s utility of reaching a given
outcome. A major difference with decision analysis is that in analysing games
and in constructing the game tree, the notion of information set is important.
When there is only one decision-maker, the decision-maker has perfect
knowledge of her own earlier choices. In a game, the players often have to make
choices not knowing which decisions have been taken or are taken at the same
time by the other players. To indicate that a player does not know her position
in the tree exactly, the possible locations are grouped or linked in an information
set. Since a player should not be able to deduce from the nature or number of
27
alternative choices available to her where she is in the information set, her
set of possible actions has to be identical at every node in the information
set. For the same reason, if two nodes are in the same information set, the
same player has to make a decision at these nodes. In games of perfect
information the players know all the moves made at any stage of the game
and therefore all information sets consist of single nodes.
Example 3.1 presents the game tree for a game in which Player 2 can
observe the action taken previously by Player 1. However, Example
3.2 presents the game tree for a game in which players take decisions
simultaneously and therefore Player 2 does not know the exact decision
taken by Player 1. This uncertainty is depicted by Player 2’s information set.
Example 3.1
t 3,0
T 2
3,–2
b
1
t 1,–1
B
2
b 4,2
Figure 3.1: Game tree for a dynamic game
In this game tree Player 1 has two strategies: either T (for Top) or B (for
Bottom). Player 2 in turn can take actions ‘t’ or ‘b’ when it’s his turn to move.
Player 1 makes the first move; Player 2 observes the choice made by Player
1 (perfect information game) and then chooses from his two alternative
actions. The pay-off pairs are listed at the endpoints of the tree. For example,
when Player 1 chooses B and Player 2 chooses t, they receive pay-offs of
1 and –1 respectively. Games of perfect information are easy to analyse.
As in decision analysis, we can just start at the end of the tree and work
backwards (Kuhn’s algorithm). When Player 2 is about to move and he is at
the top node, he chooses t since this gives him a pay-off of 0 rather than –2
corresponding to b. When he is at the bottom node, he gets a pay-off of 2 by
choosing b. Player 1 knows the game tree and can anticipate these choices
of Player 2. He therefore anticipates a pay-off of 3 if he chooses T and 4 if
he chooses B. We can therefore conclude that Player 1 will take action B and
Player 2 will take action b.
Let us use this example to explain what is meant by a strategy. Player 1 has
two strategies: T and B. (Remember that a strategy should state what the
player will do in each eventuality.) For Player 2 therefore, each strategy
consists of a pair of actions, one to take if he ends up at the top node and
one to take if he ends up at the bottom node. Player 2 has four possible
strategies, namely:
(t if T, t if B)
(t if T, b if B)
(b if T, t if B)
(b if T, b if B)
or {(t, t), (t, b), (b, t),(b, b)} for short.
28
Example 3.2
The game tree below is almost the same as in Example 3.1 but here Player 2
does not observe the action taken by Player 1. In other words, it is as if the
players have to decide on their actions simultaneously. This can be seen on
the game tree by the dashed line linking the two decision nodes of Player 2:
Player 2 has an information set consisting of these two nodes. This game (of
imperfect information) cannot be solved backwards in the same way as the
game of Example 3.1.
t 3,0
T 2
b 3,–2
1
1,–1
B t
2 4,2
b
Figure 3.2: Game tree for a simultaneous move game
Note that, although the game trees in the two examples are very similar,
Player 2 has different strategy sets in the two games. In the second game
his strategy set is just (t, b) whereas in the first game there are four possible
strategies.
3.3 Normal form games

A two-person game in normal form with a finite number of strategies
for each player is easy to analyse using a pay-off matrix. The pay-off
matrix consists of r rows and c columns where r and c are the number
of strategies for the row and the column players respectively. The matrix
elements are pairs of pay-offs (pr , pc ) resulting from the row player’s
strategy r and the column player’s strategy c, with the pay-off to the
row player listed first. The normal form representations of the games in
Examples 3.1 and 3.2 are given below.
Player 2
(t, t) (t, b) (b, t) (b, b)
Player 1 T 3,0 3,0 3,–2 3,–2
B 1,–1 4,2 1,–1 4,2
Normal form for Example 3.1
Player 2
t b
Player 1 T 3,0 3,–2
B 1,–1 4,2
Normal form for Example 3.2
29
Example 3.3
Two competing firms are considering whether to buy television time

to advertise their products during the Olympic Games. If only one of
them advertises, the other one loses a significant fraction of its sales.
The anticipated net revenues for all strategy combinations are given in
the table below. We assume that the firms have to make their decisions
simultaneously.
Firm B
Advertise Don’t
Firm A Advertise 10,5 13,2
Don’t 6,7 11,9
If firm A decides to advertise, it gets a pay-off of 10 or 13 depending on

whether B advertises or not. When it doesn’t advertise it gets a pay-off of
6 or 11 depending on whether B advertises or not. So, irrespective of B’s
decision, A is better off advertising. In other words, ‘Don’t advertise’ is a
dominated strategy for Firm A. Firm A has a dominant strategy,
namely ‘Advertise’ because this is its optimal choice of strategy no matter
what Firm B does. Notice that B does not have a dominant strategy because
its optimal choice depends on what A does. Since we are assuming that
players behave rationally, dominated strategies can be eliminated. Firm B
can safely assume that A will advertise. Given this fact, B now only has to
consider the top row of the matrix and hence we can predict that it will also
advertise. Note that both A and B are worse off when both advertise than if
they could sign (and enforce) a binding agreement not to advertise.
Example 3.4
In the pay-off matrix below, only one pay-off, the pay-off to the row player,
is given for each pair of strategies. This is the convention for zero-sum
games where the pay-off to one player is equal to the losses of the other
(and therefore the pay-offs to the players sum to zero for all possible
strategy combinations). Hence, the entry 10 in the (T, L) position is
interpreted as a gain of 10 to the row player and a loss of 10 to the column
player. An application of this type of game is where duopolists compete
over market share. Then one firm’s gain (increase in market share) is by
definition the other’s loss (decrease in market share). In zero sum games
one player (the row player here) tries to maximise his pay-off and the
other player (the column player here) tries to minimise the pay-off.
If we consider the row player first, we see that the middle row weakly
dominates the bottom row. For a strategy A to strictly dominate a strategy
B we need the pay-offs of A to be strictly larger than those of B against all
of the opponent’s strategies. For weak dominance it is sufficient that the
pay-offs are at least as large as those of the weakly dominated strategy. In
our case, the pay-off of M is not always strictly larger than that of B (it is
the same if Player 2 plays R). If we eliminate the (weakly) dominated
strategy B, we are left with a 2 × 3 game in which Player 1 has no
dominated strategies. If we now consider Player 2, we see that C is weakly
dominated by R (remembering that Player 2’s pay-offs are the negative of
the values in the table!) and hence we can eliminate the second column. In
the resulting 2 × 2 game, T is dominated by M and hence we can predict
that (M, R) will be played.
30
Player 2
L C R
Player 1 T 10 20 –30
M 20 10 10
B 0 –20 10
In general, we may delete dominated strategies from the pay-off matrix

and, in the process of deleting one player’s dominated strategies, we
generate a new pay-off matrix which may contain dominated strategies for
the other player which in turn can be deleted and so on. This process is
called successive elimination of dominated strategies.
Activity
Verify that, in the normal form of Example 3.1 above, this process leads to the outcome
we predicted earlier, namely (B,(t,b)) but that, in the normal form of Example 3.2 above,
there are no dominated strategies.
Sometimes, as in the example above, we will be left with one strategy pair,
which would be the predicted outcome of the game but the usual scenario
is that only a small fraction of the strategies can be eliminated.
3.4 Nash equilibrium

Game theory can be used to understand and predict behaviour. Much of
the theory’s predictive power comes from its solution concepts and here
we focus on a particular type of solution concept – Nash equilibrium.
A Nash equilibrium is a combination of strategies, one for each player,
with the property that no player would unilaterally want to change his
strategy given that the other players play their Nash equilibrium strategies.
So a Nash equilibrium strategy is the best response to the strategies that a
player assumes the other players are using.
Pure strategies are the strategies as they are listed in the normal form
of a game. The game below has one Nash equilibrium in pure strategies,
namely (T, L). This can be seen as follows. If the row player plays his
strategy T, the best the column player can do is to play his strategy L
which gives him a pay-off of 6 (rather than 2 if he played R). Vice versa, if
the column player plays L, the best response of the row player is T. (T, L)
is the only pair of strategies which are best responses to each other. It is
worth noting that a game may have no Nash equilibrium or more than one
equilibrium.
L R
T 5, 6 1, 2
B 4, 3 0, 4
In some cases we can find Nash equilibria by successive elimination of
strictly dominated strategies. However, if weakly dominated strategies
are also eliminated we may not find all Nash equilibria of the game.
Another danger of successively eliminating weakly dominated strategies
is that the final normal form (which may contain only one entry) after
elimination may depend on the order in which dominated strategies are
eliminated.
31
Example 3.5: ‘Battle of the sexes’
The story corresponding to this game is that of a husband and wife who
enjoy the pleasure of each other’s company but have different tastes in
leisure activities. The husband likes to watch football whereas the wife
prefers a night out on the town. On a given night the couple have to decide
whether they will stay in and watch the football match or go out. The pay-off
matrix could look like this.
Wife
In Out
In 10, 5 2, 4
Husband
Out 0, 1 4, 8
You should be able to show that this game has two Nash equilibria: (in, in)
and (out, out). Only when both players choose the same strategy is it in
neither’s interest to switch strategies. However, we cannot predict which
Nash equilibrium will prevail from the game description alone. The battle of
the sexes game is a paradigm for bargaining over common standards.
When electronics manufacturers choose incompatible technologies they are

generally worse off than when they can agree on a standard. For example,
Japanese, US and European firms were developing their own versions of
high definition television whereas they would have received greater pay-offs
if they had coordinated. The computer industry, in particular in the area of
operating system development, has had its share of battles over standards.
This type of game clearly has a first mover advantage and, if firms succeed
in making early announcements which commit them to a particular strategy,
they will generally do better.
Example 3.6
This example is typical of market entry battles. Suppose two pharmaceutical
companies are deciding on developing a drug for combatting Alzheimer’s
disease or osteoporosis. If they end up developing the same drug, they have
to share the market and, since development is very costly, they will make a
loss. If they develop different drugs they make monopoly profits which will
more than cover the development cost. The pay-off matrix could then look
like this:
A O
A –2, 2 20, 10
O 10, 20 –1, –1
There are two Nash equilibria in this game: (A, O) and (O, A). Note that there
is a ‘first mover advantage’ in this game. If Firm 1 can announce that it will
develop the drug for Alzheimer’s (i.e. strategy A) then it can gain 20 if the
announcement is believed (and therefore Firm 2 chooses strategy 0). If Firm
2 could do the same, it would also be better off. Firms in this situation would
find it in their interest to give up flexibility strategically by, for example,
signing a contract which commits them to the delivery of a certain product.
In our scenario a firm could, with a lot of publicity, hire the services of a
university research laboratory famous for research on Alzheimer’s disease to
signal its commitment to the rest of the market.
32
The type of first mover advantage illustrated in this example is prevalent in

the development and marketing of new products with large development
costs such as wordprocessing or spreadsheet software packages. The firm
which can move fastest can design the most commercially viable product in
terms of product attributes and the slower firms will then have to take this
product definition as given. Other sources of first mover advantage in a new
product introduction context include brand loyalty (first mover retains large
market share), lower costs than the second mover due to economies of scale
and learning curve effects.
Case study: Airbus versus Boeing
In the early 1990s, Europe’s Airbus Industrie consortium (Airbus) and Boeing were both capable
and committed to developing a large passenger aircraft – a ‘superjumbo’. The rationale for
pursuing such a project was clear at that time. Airports were getting very crowded and, given
the high volume of traffic forecast for the next decades, management predicted that it was
going to become increasingly difficult to find take-off and landing slots. Logically an aircraft
carrying, say, 700 or 800 passengers rather than 500 was likely to increase efficiency. If the
world market has room for only one entrant into the superjumbo segment (predicted sales
were about 500) and both firms start development, they will incur severe losses – to bring a
superjumbo to market could cost €15bn or more according to press reports. Assume the payoff
matrix with strategies ‘develop’ (D) and ‘don’t develop’ (DD) is similar to the one given below.
A/B D DD
D –3, –3 10, –1
DD –1, 10 0, 0
There are two Nash equilibria: one in which Airbus builds the aircraft (and Boeing doesn’t) and
one in which Boeing builds it (and Airbus doesn’t). In this game there is a significant ‘first-
mover advantage’: if we allow Boeing to make a decision before its rival has a chance to make
a decision it will develop the aircraft. (In reality the game is, of course, more complicated and
there are more strategies available to the players. For example, Boeing could decide to make a
larger version of its existing 450-seat 747, which would not be very big but could be developed
relatively quickly and at lower cost. Or it could decide to collaborate with Airbus.)
The role of government regulation is not clear-cut here. On the one hand, governments may
want to prevent the inefficient outcome of both firms going ahead with development but,
on the other hand, the prospect of monopoly (see Chapter 14 of the subject guide) is not
attractive either. Particularly if Boeing and Airbus collaborate, the consequences of what would
be an effective cartel would be disastrous for struggling airlines. Not only would they have to
pay a high price for the super-jumbo but, if they want to buy a smaller aircraft, they would have
to turn to Boeing or Airbus who might increase the prices of these smaller, twin-engined jets to
promote the super-jumbo.
What happened in reality is that both manufacturers developed their own superjumbos
although Boeing, unlike Airbus, did not invest as much. Instead of developing an entirely new
aircraft, it developed the 747-8, which, as its name suggests, is an updated version of Boeing’s
original four-engined 747 jumbo jet. The market for superjumbos turned out to be sluggish and
airlines are not placing as many orders as manufacturers (particularly Airbus) initially expected.
Part of the reason seems to be flawed strategic business planning. Twin-engined planes
improved considerably and became able to fly further and more fuel-efficiently than their
four-engined competitors. The main use for the Airbus A380 is on busy routes or into crowded
airports like London’s Heathrow where landing slots are at a premium, and the only way of
flying in more passengers is to use bigger planes. However, at most of the world’s airports,
landing slots are not necessarily an issue and twin-engined aircrafts are fit-for-purpose. While
33
both companies have order backlogs that will sustain production for a few years, they both
face tough choices if new orders do not come through. No passenger airline placed orders for
Boeing’s 747-8 or Airbus’s A380 in 2014.
One way to avoid the problem of both companies starting development would have been for
the EU to announce that it would give a large subsidy to Airbus if it developed the aircraft,
regardless of whether Boeing also developed it. Then ‘develop’ may become a dominant
strategy for Airbus and one Nash equilibrium would be eliminated. (To see this add 5 to A’s
pay-off if A chooses strategy D.)
Example 3.7
In the pay-off matrix below there is no Nash equilibrium ‘in pure strategies’
(i.e. none of the pairs (T, L), (T, R), (B, L) or (B, R) are stable outcomes).
Consider, for example, (B, L). If the row player picks strategy B then the best
response of the column player is L but, against L, the best response of the
row player is T, not B. A similar analysis applies to the other strategy pairs.
L R
T 10, 5 2, 10
B 8, 4 4, 2
Is it possible to find an equilibrium concept for games such as the one in

Example 3.7? Nash (1951) showed that games in which each player has a
finite number of strategies always have an equilibrium. However, players
may have to use mixed strategies at the equilibrium. A mixed strategy
is a rule which attaches a probability to each pure strategy. In other words,
a Nash equilibrium in mixed strategies is an equilibrium in which
each player chooses the optimal frequency with which to play their pure
strategies given the equilibrium frequency choices of the others, and no-
one has an incentive to deviate.
To see why it makes sense to use mixed strategies, think of the game of
poker. The strategies are whether to bluff or not. Clearly, players who
always bluff and players who never bluff will do worse than a player who
sometimes bluffs. The same applies to tennis players who constantly try
to randomise their serve so that opponents cannot easily prepare their
return of serve. Players using mixed strategies are less predictable and
leaving your opponent guessing may pay off. To see how to find a Nash
equilibrium in mixed strategies for a two-player game in which each of the
players has two pure strategies, consider the pay-off matrix of Example 3.7
again in 3.7a below.
Example 3.7a
Suppose the row player uses a mixed strategy (x, 1 – x) (i.e. he plays
strategy T with probability x and B with probability 1 – x) and the column
player uses a mixed strategy (y, 1 – y) (i.e. he plays strategy L with
probability y and R with probability 1 – y). Then the expected pay-offs to the
row and column player are respectively:
πr = 10xy + 2x(1 – y) + 8(1 – x)y + 4(1 – x)(1 – y)
and
πc = 5xy + 10x(1 – y) + 4(1 – x)y + 2(1 – x)(1 – y).
34
The row player chooses x so as to maximise her expected pay-off and the
column player chooses y so as to maximise his expected pay-off. Given y, the
expected pay-off to the row player is increasing in x as long as
y >1/2 and decreasing in x for y < 1/2 (check this by differentiating πr with
respect to x) and therefore the best response to y is x = 0 for y < 1/2,
x = l for y>1/2 and any x is optimal against y = 1/2. Following a similar
derivation for the column player we find that his best response to a given x is
to set y = 0 for x > 2/7, y = 1 for x < 2/7 and any y is optimal against x >
2/7. These best response functions are pictured in bold in Figure 3.3.
L
1/2
R
0 2/7 1
B X T
Figure 3.3: Mixed strategy Nash equilibrium
At a Nash equilibrium the strategies have to be best responses to each

other. Therefore, the point (x = 2/7, y = 1/2), where the response
functions intersect, forms a Nash equilibrium in mixed strategies. We can
then calculate the players’ expected pay-offs by substituting x and y in the
expressions for πr and πc above.
The notion of Nash equilibrium is also very helpful in a negative sense:

any combination of strategies which does not form a Nash equilibrium
is inherently unstable. However, when there is more than one Nash
equilibrium, game theory does not offer a prediction as to which Nash
equilibrium is more likely to be played. A topic of substantial research was
to try to find justifications for selecting particular types of Nash equilibria
– say, the equilibria which are not Pareto dominated – over others. This
type of research could help eliminate some Nash equilibria when there
are multiple equilibria. Nevertheless game theorists have not succeeded
in agreeing on an algorithm which will select the equilibrium that is or
should be played in reality.
3.5 Prisoners’ dilemma

A class of two-person non-cooperative game which has received much
attention not only in economics but also in social science more generally,
is the class of prisoners’ dilemma games. The story the game is meant to
model concerns two prisoners who are questioned separately, without the
possibility of communicating, about their involvement in a crime. They are
offered the following deal. If one prisoner confesses and the other does
not, the confessor goes free and the other prisoner serves 10 years; if both
confess, they each spend seven years in prison; if neither confesses, they
each serve a two-year term. This is summarised in the pay-off matrix below.
35
Confess Don’t
Confess 7,7 0,10
Don’t 10,0 2,2
This game is very easy to analyse: for both players the strategy ‘confess’
is a dominant strategy. (Remember that you want to minimise the pay-
off here!) There is one Nash equilibrium in pure strategies in which both
prisoners serve seven-year sentences. What is interesting about this game
is that, if the prisoners could set up a binding agreement, they would
agree not to confess and serve only two years. (This type of model is used
to explain difficulties encountered in arms control for example, where the
strategy ‘confess’ could be interpreted as ‘deploy a new missile’.)
The typical application of the prisoners’ dilemma to managerial economics
translates the prisoners’ plight into the situation of duopolists deciding
on their pricing policy. If both set a high price they achieve high profits; if
both set a low price they achieve low profits. If one firm sets a low price
and its rival sets a high price the discounter captures the whole market
and makes very high profits whereas the expensive seller makes a loss.
At the Nash equilibrium both firms set low prices and hurt themselves by
doing so although in equilibrium, it is in neither firm’s interest to deviate.
Of course, in reality firms do not interact only once but they interact in
the market over many years and the question arises whether collusive
behaviour could be rationalised in a repeated prisoners’ dilemma game.
When the game is played over several periods rather than as a one-shot
game, players might be able to cooperate (set a high price) as long as their
rival is willing to cooperate and punish when the rival cheats (deviates
from cooperation). This possibility of punishment should give players
more of an incentive to cooperate in the long-term. Axelrod (1984) ran
a contest in which he asked game theorists to submit a strategy of the
repeated version of the prisoners’ dilemma. He then paired the given
strategies (some of which were very complicated and required significant
computer programming) and ran a tournament. The ‘tit-for-tat’ strategy,
which consistently outperformed most of the others, is very simple. This
strategy prescribes cooperation in the first round and as long as the other
player cooperates but deviation as soon as and as long as the other player
deviates from cooperation. In other words, do whatever the other player
did in the last round. The tit-for-tat strategy never initiates cheating, and
it is forgiving in that it only punishes for one period. If two players use the
tit-for-tat strategy, it will be in their own interest to always cooperate.
Let’s think about what game theory can contribute to understanding
players’ behaviour in the repeated prisoners’ dilemma. If the game is
repeated a finite number of times then collusive behaviour cannot be
rationalised. To see this, remember that the only reason to cooperate is
to avoid retaliation by your opponent in the future. However, this means
that, in the last period, there is no incentive to cooperate. But, if both
players are going to cheat in the last period, the next-to-last period can be
analysed as if it were the last period and we can expect cheating in that
period and so on, so that we end up with the paradox that, even in the
repeated prisoners’ dilemma game, cheating is the unique equilibrium. (Of
course we are assuming, as always, that players are intelligent, can analyse
the game and come to this conclusion. If a player is known to be irrational,
an optimal response could be to cooperate.)
36
However, if the prisoner’s dilemma is repeated over an infinite horizon or

if there is uncertainty about the horizon (i.e. there is a positive probability
(< 1) of reaching the horizon), then cooperation can indeed be generated.
What is needed is that the strategies are such that the gain from cheating
in one period is less than the expected gain from cooperation. For
example, both players could use trigger strategies (i.e. cooperate until the
other player cheats and then cheat until the horizon is reached). This will
be a Nash equilibrium if the gain from cheating for one period is smaller
than the expected loss from a switch to both players cheating from then
onwards.
3.6 Subgame-perfect equilibrium

So far, with the exception of Section 3.2 ‘Extensive form games’, we
have considered games in normal form. In this section we return to the
extensive form representation of a game. Consider Example 3.1 and
its normal form representation at the beginning of Section 3.3 ‘Normal
form games’. From the pay-off matrix it is clear that there are three Nash
equilibria: (T,(t, t)), (B,(t, b)) and (B,(b, b)). Two of these equilibria
though, the ones which have Player 2 playing b or t regardless of what
Player 1 plays, do not make much sense in this dynamic game. For
example, (B,(b, b)) implies that Player 2 – if Player 1 plays T – would
rather play b and get a pay-off of –2 than t which gives pay-off 0. The
reason this strategy is a Nash equilibrium is that Player 1 will not play T.
The notion of subgame-perfect equilibrium was developed as a refinement
of Nash equilibrium to weed out this type of unreasonable equilibria.
Basically, the requirement for a perfect equilibrium is that the strategies of
the players have to form an equilibrium in any subgame. A subgame is
a game starting at any node (with the exception of nodes which belong to
information sets containing two or more nodes) in the game tree such that
no node which follows this starting node is in an information set with a
node which does not follow the starting node. Put more simply, a subgame
is defined as being a segment of a larger game. In the game tree in Figure
3.4, a is the starting node of a subgame but b is not since c, which follows
b, is in an information set with d which does not follow b.
1
b 2
1
c
1 2
1
d 1
3 1
a
Figure 3.4: a starts a subgame, b does not

So while (B,(b, b)) is a Nash equilibrium in Example 3.1, it is not
subgame-perfect since it is not an equilibrium in the (trivial) subgame
starting at Player 2’s decision node corresponding to Player 1’s choice of T.
The same applies to Nash equilibrium (T,(t, t)).
37
Example 3.8
t 10,7
T 2
b 3,0
1
7,10
t
B
2
b 1,2
Figure 3.5: Subgame-perfect equilibrium
Consider the game in extensive form depicted in Figure 3.5. Using

backwards induction it is easy to see that the subgame-perfect equilibrium
is (T,(t, t)) as indicated on the game tree. If we analyse this game in the
normal form, we find three Nash equilibria (marked with an asterisk in the
pay-off table). One of these, namely (B,(b,t)) can be interpreted as based
on a threat by Player 2 to play b unless Player 1 plays B. Of course if such
a threat was credible, Player 1 would play B. However, given the dynamic
nature of the game, the threat by Player 2 is not credible since in executing
it he would hurt not only his opponent but himself too (he would get a pay-
off of 0 rather than 7 which he could get from playing t). By restricting our
attention to subgame-perfect equilibria we eliminate Nash equilibria based
on non-credible threats.
Player 2
(t,t) (t,b) (b,t) (b,b)
Player 1 T 10,7* 10,7* 3,0 3,0
B 7,10 1,2 7,10* 1,2
Normal form
Example 3.9 (‘entry deterrence’)
The industrial organisation literature contains many game theoretic

contributions to the analysis of entry deterrence. The simplest scenario
is where the industry consists of a monopolist who has to determine his
strategy vis-a-vis an entrant. The monopolist can decide to allow entry and
share the market with the new entrant, or (threaten to) undercut the new
entrant so he cannot make positive profits. The question arises whether
the incumbent firm’s threat to fight the entrant is credible and deters the
entrant from entering. We can analyse this game using the notion of perfect
equilibrium. On the game tree in Figure 3.6, E stands for entrant and I for
incumbent. The entrant’s pay-off is listed first.
don’t
3,4
enter I
-2,0
E fight
don’t
0,10
Figure 3.6: Entry deterrence
38
It is easy to see that, at the subgame-perfect equilibrium, the entrant enters

and the incumbent does not fight. It is in the interest of the incumbent firm
to accommodate the entrant. There are versions of the entry deterrence
game which result in the incumbent fighting entry at equilibrium. In the
‘deeper pockets’ version, the incumbent has access to more funds since it
is likely to be a better risk than the entrant, and can therefore outlast the
entrant in a price war. In the incomplete information version, the entrant
is not sure about the characteristics or pay-offs of the incumbent (see
Example 3.10). In the ‘excess capacity’ version, incumbent firms make large
investments in equipment which affects their pay-off if they decide to fight
entry. If firms have a large capacity already in place, their cost of increasing
output (to drive the price down) is relatively low and therefore their threat
of a price war is credible. To see this in Example 3.9, find the subgame-
perfect equilibrium if the incumbent’s pay-off of fighting increases to 6 when
the entrant enters.
This example could be extended to allow for several potential entrants

who move in sequence and can observe whether the incumbent (or
incumbents if earlier entry was successful) allows entry or not. It would
seem that, for an incumbent faced with repeated entry, it is rational to
always undercut entrants in order to build a reputation for toughness
and thus deter further entry. Unfortunately, as in the repeated prisoners’
dilemma, this intuition fails. Selten (1978) coined the term ‘chain store
paradox’ to capture this phenomenon. The story is about a chain store
which has branches in several towns. In each of these towns there is a
potential competitor. One after the other of these potential competitors
must decide whether to set up business or not. The chain store, if there
is entry, decides whether to be cooperative or aggressive. If we consider
the last potential entrant, we have the one-shot game discussed above in
which the entrant enters and the chain store cooperates. Now consider the
next-to-last potential entrant. The chain store knows that being aggressive
will not deter the last competitor so the cooperative response is again
best. We can go on in this way and conclude that all entrants should enter
and the chain store should accommodate them all!1 We should remember 1
For an analysis of
that, as for the repeated prisoners’ dilemma, the paradox arises because different versions of
the chain store game
of the finite horizon (finite number of potential entrants). If we assume
in which the paradox
an infinite horizon, predatory behaviour to establish a reputation for is avoided see Kreps
toughness can be an equilibrium strategy. and Wilson (1982) and
Milgrom and Roberts
(1982).
3.7 Perfect Bayesian equilibrium
In games of imperfect or incomplete information, the subgame-perfect
equilibrium concept is not very helpful since there are often no subgames
to analyse. Players have information sets containing several nodes.
In these games an appropriate solution concept is perfect Bayesian
equilibrium. Consider the imperfect information three-person game in
extensive form represented in Figure 3.7. At the time they have to make
a move, Players 2 and 3 do not know precisely which moves were made
earlier in the game.
39
T2 2,0,0
T1 2 0,2,0
T3
B2
1 M1 3 B3
2 0,2,2
T2
T3 2,8,0
B1 3
B2
4,0,0 6,4,0 B3 0,2,6
Figure 3.7: Bayesian equilibrium

This game looks very complicated but is in fact easy to analyse if we use
backwards induction. When Player 3 gets to move, she has a dominant
strategy, B3: at each node in her information set, making this choice
delivers her the highest pay-off. Hence, whatever probability Player 3
attaches to being at the top or the bottom node in her information set, she
should take action B3. Similarly, given Player 3’s choice, Player 2 chooses
B2. The choice of B2 leads to 2 or 4 depending on whether Player 2 is at
the top or bottom node in his information set, whereas T2 leads to pay-
offs of 0 and 2 respectively. So again, independent of Player 2’s probability
assessment over the nodes in his information set, he chooses B2. Player 1,
anticipating the other players’ actions, chooses strategy M1.
In general for a perfect Bayesian equilibrium we require: (a) that the
equilibrium is perfect given players’ assessment of the probabilities of
being at the various nodes in their information sets; and (b) that these
probabilities should be updated using Bayes’ rule and according to the
equilibrium strategies. In other words, strategies should be optimal given
players’ beliefs and beliefs should be obtained from strategies. For the
game represented in Figure 3.7, these requirements are satisfied if we set
the probability of Player 2 being at his bottom node equal to 1 and the
probability of Player 3 being at her bottom node equal to any number in
[0,1].
Example 3.10
Let us return to the entry game of Example 3.9 and introduce incomplete
information by assuming that the incumbent firm could be one of two types
– ‘crazy’ or ‘sane’ – and that, while it knows its type, the entrant does not.
The entrant subjectively estimates the probability that the incumbent is
sane as x. This scenario is depicted in the game tree in Figure 3.8 with the
pay-offs to the entrant listed first. The important difference with the game of
Example 3.9 is that here there is a possibility that the entrant faces a ‘crazy’
firm which always fights since its pay-off of fighting the entrant (5) is higher
than that of not fighting (4). The ‘sane’ firm, however, always accommodates
the entrant. The entrant’s decision to enter or not will therefore depend
on its belief about the incumbent’s type. If the entrant believes that the
incumbent firm is ‘sane’ with probability x then its expected pay-off when it
enters is 3x – 2(1 – x) = 5x – 2. Since the entrant has a pay-off of zero if it
doesn’t enter, it will decide to enter as long as 5x – 2 > 0, or x > 2/5.
40
0,10
don’t enter -2,0
E fight
‘sane’ x enter
I don’t fight
3,4
don’t enter 0,10
1-x -2,5
‘crazy’ E
fight
enter I
don’t fight 3,4
Figure 3.8: Entry deterrence

In this chapter we considered non-cooperative game theory and
introduced the concepts of pay off matrix, dominant strategy and the
important solution concepts of Nash equilibrium and subgame-perfect
Nash equilibrium. Applications of game theory to simple problems
in managerial economics and industrial organisation have also been
examined, as well as the concept of perfect Bayesian equilibrium.

• represent a simple multi-person decision problem using a game tree
• translate from an extensive form representation to the normal
form representation of a game using the pay-off matrix
• find Nash equilibria in pure and mixed strategies
• explain why in a finitely repeated prisoners’ dilemma game
cheating is a Nash equilibrium
• discuss the subgame-perfect equilibria and explain the
chainstore paradox.

1. Consider the following matrix game.
L R
T 2, 5 1, 4
B 5, –1 3, 1
41
Are there any dominated strategies? Draw the pay-off region. Find the
pure strategy Nash equilibrium and equilibrium pay-offs. Is the Nash
equilibrium Pareto efficient? Which strategies would be used if the
players could make binding agreements?
2. Find the Nash equilibrium for the following zero sum game. The
tabulated pay-offs are the pay-offs to Player 1. Player 2’s pay-offs are
the negative of Player 1’s. How much would you be willing to pay to
play this game?
Player 2
–1 2 –3 0
Player 1 0 1 2 3
–2 –3 4 –1
3. At price 50, quantity demanded is 1,000 annually; at price 60 quantity

demanded is 900 annually. There are two firms in the market. Both
have constant average costs of 40. Construct a pay-off matrix and
find the Nash equilibrium. Assume that, if both firms charge the
same price, they divide the market equally but, if one charges a lower
price than the other, it captures the whole market. Suppose the two
firms agree to collude in the first year and both offer a most favoured
customer clause. What is the pay-off matrix for the second year if they
colluded the first year?
4. Find the pure and mixed strategy equilibria in the following pay-off
tables. How might the –100 pay-off affect the players’ actions?
L R L R
T 12, 10 4, 4 T 12, 10 4, 4
B 4, 4 9, 6 B 4, –100 9, 6
5. Students don’t enjoy doing homework and teachers don’t like grading
it. However, it is considered to be in the students’ long-term interest
that they do their homework. One way to encourage students to do
their homework is by continuous assessment (i.e. mark all homework),
but this is very costly in terms of the teachers’ time and the students do
not like it either. Suppose the utility levels of students and teachers are
as in the pay-off matrix below.
teacher
check don’t check
student work 0, -3 0, 0
no work -4, 4 1,- 2
a. What is the teacher’s optimal strategy? Will the students do any
work?
b. Suppose the teacher tells the students at the beginning of the year
that all homework will be checked and the students believe her.
Will they do the work? Is the teacher likely to stick to this policy?
c. Suppose the teacher could commit to checking the homework part
of the time but students will not know exactly when. What is the
minimal degree of checking so that students are encouraged to
do the work? (Namely, what percentage of homework should be
checked?)
42
6. Consider the two player simultaneous move game below where pay-
offs are in £. Find the pure strategy Nash equilibria. How would you
play this game if you were the row player? How would you play this
game if you were the column player?
a b c d
u 100, 3 2, 2 2, 1 0, –500
d 0, –500 3, –500 3, 2 1, 10
7. Two neighbours had their house broken into on the same night and
from each house an identical rare print went missing. The insurance
company with whom both neighbours had taken out home contents
insurance assures them of adequate compensation. However, the
insurance company does not know the value of the prints and offers
the following scheme. Each of the neighbours has to write down the
cost of the print, which can be any (integer) value between £10 and
£10,000. Denote the value written down by Individual 1 as x1 and the
one written down by Individual 2 as x2. If x1 = x2 then the insurance
company believes that it is likely that the individuals are telling the
truth and so each will be paid x1. If Individual 1 writes down a larger
number than Individual 2, it is assumed that 1 is lying and the lower
number is accepted to be the real cost. In this case Individual 1 gets
x2 – 2 (he is punished for lying) and Individual 2 gets x2 + 2 (he is
rewarded for being honest). What outcome do you expect? What is the
Nash equilibrium?
8. Consider the extensive form game below. Find all Nash equilibria. Find
the subgame-perfect equilibrium.
u
2 0,0
U
1 d
3,1
D
1,3
9. Consider the extensive form game below. What are the players’
information sets? Write this game in normal form and analyse it using
the normal form and the game tree.
t 3,2
2
T b 2,1
M t 1,2
1 2 b
1,4
B
t 2,1
2
2,4
b
10. A firm may decide to illegally pollute or not. Polluting gives it an extra
pay-off of g > 0. The Department of the Environment can decide to
check for pollution or not. The cost of this inspection is c > 0. If the
firm has polluted and it is inspected, it has to pay a penalty p > g; in
this case, the pay-off to the Department of the Environment is s – c >
0. If the firm has not polluted and it is checked, no penalty is paid. If
the Department of the Environment does not inspect, its pay-off is 0.
43
a. Suppose that the Department of the Environment can observe

whether the firm has polluted or not before it formally decides
whether or not to check. Draw the game tree. What is the
equilibrium?
b. Now suppose the pollution cannot be observed before checking.
Draw the game tree. Is there a pure strategy equilibrium? Compute
the mixed strategy equilibrium. How does a change in the penalty
affect the equilibrium?
44
Chapter 4: Bargaining
4.1 Introduction
Consider the following situation. Company B wants to acquire Company
S and values it at £1 billion. The current valuation of Company S in
the stock market is £700 million, which is the minimum value at which
Company S’s owners would be willing to sell it. Company B values S
more than its current market value because it believes the companies’
assets are complementary and by combining them in a single entity,
additional value can be created immediately due to strategic synergies.
This additional value represents the gains from trade in this example. If
the acquisition occurs – that is, if Company B acquires company S – at a
price that lies between £700 million and £1 billion, then both companies
(i.e. their respective owners) would be better off. The two groups of
owners therefore have an interest in completing the deal but, at the same
time, they have conflicting interests over the price at which to strike a
deal: S would like a high valuation of its assets while B would prefer a low
valuation. Any exchange situation, such as the one just described, in which
a pair of individuals, groups or organisations can engage in mutually
beneficial trade but have conflicting interests over the terms of that trade
is a bargaining situation.
Generally stated, a bargaining situation is one in which two players
have a common interest in cooperating but, at the same time, also
have conflicting interests over exactly how to cooperate. The players
involved could be individuals, companies or even countries. Many
interesting real-life situations (economic, social and political) involve
some sort of bargaining over a mutually beneficial outcome. Although
many transactions studied in standard microeconomic theory involve
markets where at least one side of the market takes the price as given,
sale agreements often take place between one individual seller and one
buyer. In an industrial context, for instance, this is the case with single
sourcing contracts where a firm commits itself to procure all of its supplies
of a particular input from a single supplier. In such situations there is no
market mechanism to determine the price. Rather than post a price, sellers
bargain with buyers over the division of the gains from trade. The number
of occasions where negotiation rather than the market mechanism is used
is large, and bargaining theory can help us model and analyse outcomes in
those environments.
The literature on bargaining has developed dramatically in the last few
decades due to advances in non-cooperative game theory. For example,
there are multiple applications to political economy, industrial economics,
international trade and political science. Bargaining is an interesting topic
of study because, as mentioned above, it has both cooperative and
conflicting elements. For example, when a seller has a low reservation
price for an object and a buyer has a high reservation price then, clearly,
if the two parties can agree to trade, they will both be better off. So both
have a strong incentive to reach an agreement. On the other hand, conflict
exists regarding the divisions of the gains of trade. Each player would like
to reach an agreement that is as favourable to them as possible. The seller
will naturally prefer a high price and the buyer will prefer a low price.
Bargaining is any process through which the players on their own try to
reach an agreement. Typically this process is not frictionless and a basic
45
cost of bargaining comes from the fact that bargaining is time consuming
and time is valuable to the players. This creates a sort of urgency to reach
an agreement quickly so as to avoid costly delays. Game theory helps us to
model bargaining situations carefully and allows us to check our intuition
regarding, for example, how the outcome of the bargaining will depend on
the parties’ bargaining power and strategies, level of impatience, attitudes
towards risk and so on. Questions in which economists are interested
include:
• conditions under which bargaining will lead to an efficient outcome –
the bargaining outcome is Pareto efficient in the sense that parties do
reach an agreement without any costly delay;
• the distribution properties of the bargaining outcome – how the gains
from trade are divided between the parties;
• what are good bargaining strategies and what determines a player’s
bargaining power?
Bargaining problems arise whenever payoffs have to be shared among
several players. When firms succeed in running a cartel, for example,
agreeing on how to divide cartel profits is a major problem. Managers
are interested in bargaining models for their predictions in the context of
management (e.g. for labour (union) negotiations and strikes). However,
most game theoretic models of bargaining are either very simplistic (and
that is certainly true for the ones we discuss in this chapter) or extremely
complex and unrealistic in their assumptions about players’ ability to
reason and calculate.
In the hope that this does not discourage you too much, let us proceed.

• the most prominent axiomatic and game-theoretic bargaining
solutions used in managerial economics, as well as some of their
applications
• the role of friction and patience in dynamic bargaining
• the cooperative and conflicting aspects of bargaining situations
• the nature of the inefficiencies associated with bargaining in the
presence of incomplete information.

• apply the Nash bargaining solution to economic problems
• analyse alternating-offers bargaining games with finite or
infinite numbers of rounds
• describe the impact of incomplete information on bargaining
outcomes.

Varian, H.R. Intermediate microeconomics: a modern approach. (New York:
W.W. Norton and Co., 2014); 9th edition, Chapter 30: Game Applications,
Section 30.7: Bargaining.
46

Binmore, K. Playing for real: a text on game theory. (Oxford: Oxford University
Press, 2007) [ISBN 9780195300574] Chapter 17: Cutting a deal.
Muthoo, A. Bargaining theory with applications. (Cambridge: Cambridge
University Press, 1999) [ISBN 9780521576475] Chapter 2: The Nash
bargaining solution; and Chapter 3: The Rubinstein model.
Nash, J.F. Jr. ‘The bargaining problem’, Econometrica 18 1950, pp.155–62.
Rubenstein, A. ‘Perfect equilibrium in a bargaining model’, Econometrica 50
1982, pp.97–109.

This chapter examines bargaining models in which players on their own
try to reach an agreement over the partition of certain gains from trade
(i.e. the ‘size of the cake’ to be divided). It introduces the Nash bargaining
solution to a bargaining problem and then considers Rubinstein’s basic
alternating-offers model. The chapter discusses some key features of its
(unique) subgame-perfect equilibrium as well as the concepts of friction
and bargaining power within this model. Finally, the chapter analyses
briefly the possible effects of players’ incomplete information in the
bargaining process and illustrates how inefficiencies may arise in these
(more realistic) situations.
4.2 The Nash bargaining solution

A bargaining solution may be interpreted as a recipe that determines a
unique outcome for a bargaining situation. The Nash bargaining solution
(NBS) is defined by a fairly simple formula. Another attractiveness of the
NBS is that it is applicable to a large class of bargaining problems.1 The 1
NBS and the concept
NBS is rooted in cooperative game theory. It is therefore axiomatic in of Nash equilibrium
studied in Chapter 3
that it is focused on predicting outcomes to bargaining problems based
are unrelated, but John
on some reasonable properties or axioms. While it does not describe the Nash created both
process by which players arrive at the outcome in terms of individual concepts.
strategies, it can be shown that it nevertheless possesses some strategic
foundations: several plausible (game-theoretic) models of bargaining
vindicate their use. Indeed, one such strategic bargaining model that has
been widely used in the economics literature will be studied in Section 4.3.
4.2.1 Bargaining over how to partition a surplus

Here we characterise the NBS of a specific bargaining situation in which
two players, A and B, bargain over the partition of a cake (or ‘surplus’)
of fixed size. This surplus is often also called the gains from trade and
represents the net value the two players generate when they reach an
agreement. For instance, if a buyer and a seller bargain over a mutually
acceptable price to exchange an item (as in the example considered in 4.1
Introduction), the gains from trade are given by the difference between
the buyer’s valuation of the item and the seller’s reservation price. The
gains from trade can be calculated in a similar fashion depending on the
particular problem being analysed.
UA(x) and UB(y) are each player’s utility from obtaining their respective
share of the surplus. For simplicity we assume both utility functions are
strictly increasing and concave. Importantly, if the players fail to reach
agreement then they obtain their respective disagreement payoffs
dA and dB. These payoffs can be interpreted as a fallback position
when bargaining fails. To ensure the existence of a mutually beneficial
agreement, let us assume that UA(x)>dA and UB(y)>dB exist. In other
47
words, there exists a partition of the surplus such that both players are
better off than with their disagreement payoffs.
The NBS of the bargaining situation just described is the unique pair of
utilities that solves the following maximisation problem:
Max (UA – dA) (UB – dB)
where the maximum (UA – dA) (UB – dB), which is the product of the
players’ gains over their disagreement payoff, is referred to as the Nash
product. Under fairly general mathematical conditions, it can be shown
that the above problem has a unique NBS which is the solution to the
following equation:
(UA(xN)–dA)/U’A(xN) = (UB(yN)–dB)/U’B(yN)
where U’ denotes the derivative of U, yN=G–xN is B’s share in the NBS and
G is the total surplus.
Example 4.1
Suppose UA= x and UB= y while the gains from trade are G. Since in this
particular case U’ = 1, applying the above equation implies that the NBS is
characterised by the two payoffs:
xN=(G+dA–dB)/2,
yN=(G+dB–dA)/2.
This particular bargaining outcome is also known as the split-the-difference

rule because these two equations can be rewritten in the following way:
xN=dA+(G–dA–dB)/2,
yN=dB+(G–dA–dB)/2.
The interpretation is as follows. The players agree first of all to give each of
them a share di of the cake (which gives them a utility equal to the utility
they obtain from not reaching agreement), and then they split equally the
remaining cake G–dA–dB. Notice, for example, that player A’s share xN is
strictly increasing in dA and strictly decreasing in dB.
Example 4.2
This example considers how the degree of risk aversion may affect the
players’ share of the cake in the NBS. Specifically suppose UA = xβ and
UB = y, where 0<β<1. Hence A is risk averse while B is risk neutral. If we
also assume that dA = dB = 0, then the NBS is characterised by the following
pair of payoffs:
xN = βG/(1+β),
yN = G/(1+β).
Notice that as β decreases, player A’s degree of risk aversion increases and
her share of the cake shrinks. Player B in turn captures a bigger share of
the cake. So a player’s share of the cake generally decreases as she becomes
relatively more risk averse. At the opposite end of the spectrum, as the value
of β approaches 1, the above payoffs converge to a split-the-difference rule
as both players share the gains from trade equally.
48
4.2.2 An application to crime control

In this section we consider a simple application of the NBS concept to
crime control in the presence of potential bribery.
A criminal decides whether or not to steal an amount of money M>0. If he
steals the money, then with probability σ<1 he is caught by the police who
are potentially corruptible. Concretely if the criminal pays a bribe B, the
policeman will not report the crime to the authorities and the criminal will
walk away free. Let’s call the criminal and policeman, respectively, C and P.
Assume the players’ utility of money is U(x)=x and the disagreement
point (dC,dP)=(Ω,0), where Ω represents the penalty faced by C when he’s
caught and reported to the authorities (the penalty could be monetary or
time spent in prison). This bargaining situation is therefore a special case
of Example 4.1 above and its NBS is given by:
UC=(M + Ω)/2,
UP=(M – Ω)/2.
P’s payoff represents the bribe received. So notice that the potential
penalty Ω influences both players’ payoffs in the NBS even though it is
never paid to the authorities.
Under which conditions would crime be successfully deterred? Notice that
C’s expected utility from stealing is given by:
EUC= σ (M+Ω)/2+(1–σ)M.
Since C’s utility from not stealing the money is zero, the crime will not be
committed so long as:
σ (M+Ω)/2+(1–σ)M<0; or after rearranging
M (2 – σ)+σΩ<0.
Since σ<1, it can be seen from the above condition that crime is always
committed if the penalty matches the crime (i.e. Ω = –M). In effect
penalties are not high enough and can be evaded through bribery.
Activity
Show that when the penalty Ω and detection probability σ are sufficiently large, crime
can be prevented by the effect they have on C’s expected utility and disagreement point
at the bargaining stage.
4.3 The alternating-offers bargaining game

We now move on to analyse the more modern non-cooperative approach
to modelling the bargaining process. The paradigm is Rubinstein’s
model of bargaining (Rubinstein 1982). In this extensive form game,
the players take turns to make offers to each other until agreement is
secured. This model has much intuitive appeal, since making offers and
counteroffers lies at the heart of many real-life negotiations. One intuitive
insight of this model is that some sort of ‘friction’ is essential to motivate
players to reach an agreement. Otherwise there is no meaningful cost of
perpetual disagreement. This friction in the bargaining process is typically
modelled as cost of delay (or cost of haggling), and the players’ respective
degree of impatience may in turn influence their bargaining power.
Rubinstein’s model has been extremely influential and has been adapted
and extended over the last few decades to examine a wide variety of new
economic applications.
49
4.3.1 Rubinstein’s model

In this model two players have to decide on how to divide an amount of
money between them. They alternate in making suggestions about this
division and the game ends as soon as an offer is accepted. An offer is a
proposal of a partition of the money. If a player accepts the offer, then
agreement is struck and the players divide the money according to the
accepted offer. If no offer is accepted, the game goes on forever. However,
as time goes by, the amount of money available shrinks. This cost of delay
represents the ‘friction’ in the bargaining process alluded to above. It turns
out that, at the unique subgame perfect equilibrium of this game, the
players agree immediately.
To see how this conclusion is arrived at, let’s look at a simpler two-period
version of this game. Suppose two players, Bert and Ernie, have a total of
£100 to divide between them. Bert makes an offer first. He might decide,
for example, to keep £70 to himself and offer £30 to Ernie. Ernie will
then either agree to this division or make a counteroffer. If he agrees,
he will get the £30; if he refuses the offer and makes a counteroffer, the
£100 ‘cake’ will shrink to £100δ. The discount factor δ (0 < δ < 1) can be
thought of as a measure of the players’ impatience or more generally
the cost of a delay in reaching an agreement (it may represent the cost
of a strike in the industrial relations context, for example, where potential
output and profit is lost while parties disagree). If the game ends here (i.e.
by Bert accepting or rejecting Ernie’s counteroffer) and we assume that
if no agreement has been reached both players get zero, it is not hard to
see what will happen. (You may want to draw a game tree at this point.)
Assuming Bert and Ernie are like the usual self-interested, non-altruistic
players, then if Ernie decides to make a counteroffer, he will offer Bert
one penny, which Bert will certainly accept. The idea is that Ernie can
offer some arbitrarily small amount to Bert that would make him better
off, and we approximate such an ‘arbitrarily small’ amount by zero. In
this case Ernie ends up with about £100δ. If Bert wants to avoid this
outcome, he will have to offer Ernie this same payoff at the start to make
him indifferent between accepting his offer in period one or making a
counteroffer in the next period. So Bert keeps £100 (1 – δ) for himself. So
at the subgame perfect equilibrium of this two-period game, Bert will offer
£100δ to Ernie at the start and Ernie will accept.
Now consider the same game but with Bert willing to make a second offer
(i.e. the sequence of moves is Bert, Ernie, Bert). By the time Bert makes
his second move, the cake will have shrunk two times to £100δ2. Now Bert
will have the ‘last mover advantage’ and can make a take-it-or-leave-it
offer to Ernie, which he will accept. Ernie will anticipate this and offer Bert
£100δ2 when he has the opportunity, so that he keeps £100δ – £100δ2 =
£100δ (1 – δ) for himself (remember that in the second period the size of
the cake is £100δ). However, Bert can improve on this by offering Ernie
£100δ (1 – δ) in the first move and keeping £100 (1 – δ + δ2) for himself.
You should be convinced by now that the subgame perfect equilibrium
strategy for each player tells him to make an offer which leaves his
opponent very close to being indifferent between accepting the offer
and continuing the game. As a consequence, the first offer is always
accepted and the outcome is efficient.
What happens if we don’t give the players a deadline? Suppose they
can keep making offers and counteroffers for an infinite number of
periods but, as before, the cake shrinks in each period. Since this is an
infinite horizon game, you cannot use the backwards induction method.
50
This artefact also eliminates the ‘last mover advantage’ and we can
look for a symmetric equilibrium (players using the same strategy).
Also, the equilibrium strategy must be stationary (i.e. it should give the
same prescription in each period because, in the infinite version of the
alternating-offers game, when an offer has been rejected, the game is
exactly as it was before the offer was made except for the shrinking).
So, let us assume that Bert offers Ernie £100x and keeps £100(1 – x) to
himself. Ernie will consider accepting £100x or making an offer of £100 δx
to Bert and keeping £100 δ(1 – x). Since he should be indifferent between
these two options we find that δ(1 – x) = x or x = δ/(l + δ). At the
(unique) subgame perfect equilibrium Bert gets £100/(1 + δ) and Ernie
gets £100δ/(1 + δ). In the infinite version of this game, it is an advantage
to be able to make the first move. Again, as in the finite version, the first
offer is always accepted and the outcome is Pareto efficient. Notice that
in contrast to the NBS, in the Rubinstein model, efficiency is a prediction,
not an assumption, of the model.
As the time between offers and counteroffers shortens, the discount factor
δ approaches 1 and the asymmetry, caused by who moves first, disappears.
In this case the equilibrium outcome converges to the split-the-difference
rule and each player obtains one-half of the ‘cake’. It is not very difficult
to extend this analysis to allow for different discount factors for the two
bargaining parties. The conclusion of this modified game is that the
relatively more patient player will get a larger slice of the cake. Hence in
this model a player’s bargaining power is inversely related to her degree
of impatience. Why does being relatively more patient confer greater
bargaining power? Because a player’s ‘cost’ of rejecting an offer is having
to wait until next period to be able to make a counteroffer. This intrinsic
cost of delay decays as the player becomes more patient.
Another important message of the alternating-offers model is that
frictionless bargaining processes are indeterminate. If players do not really
care about the time at which agreement is struck, then there is nothing
to prevent them from negotiating for as long as they wish. There is no
urgency to reach an agreement.
4.3.2 Experimental work

The alternating-offers bargaining game has an elegant and simple
‘solution’ as well as a stark prediction about the duration of the bargaining
(one offer only). However, the game theoretic predictions are not always
replicated when tested in experiments with real subjects. Some years
ago, a group of students at LSE participated in a series of bargaining
experiments. Subjects were paired to an unknown bargaining partner and
could only communicate via a formal computer program with their partner
who was sitting in a different room. Experiments of this type generally
show that ‘real’ players have a tendency to propose and accept what they
consider a fair offer while rejecting what they consider a mean offer even
if this rejection means they will be in a worse position. If you were offered
one penny in the last round of the game in this section, would you accept?
Disgust and an appetite for fairness are certainly not the only reasons why,
in reality, subjects may not behave in accordance with the theory. Some
offers may be fully rational but at the same time violate certain social
norms of behaviour, which in turn induces retaliation by the other player.
Indeed, these social norms may be reflected in significant cross-cultural
differences in behaviour that have been discovered by economists when
conducting experiments on bargaining games.
51
4.4 Incomplete information bargaining

While the alternating-offers bargaining game is economically appealing, it
nevertheless fails to explain many real life bargaining situations in which
disagreement is common and costly negotiations take place over several
weeks or months. In the Rubinstein game, agreement is predicted to be
immediate. It turns out that to generate delayed agreement you have to
assume that the players do not know all the information there is to know
about their opponent (i.e. players have some level of private information).
In particular, players may have private information about their reservation
price (i.e. their maximum willingness to pay) when bargaining over the
sale of an item.
Incomplete information bargaining models are classified according to
which player(s) has private information and which player(s) makes
offers. For example, in a frequently studied bargaining game called the
‘Tunisian Bazaar’, the value to the seller of the good being sold is common
knowledge. The buyer’s reservation price, however, is known to the buyer
but not the seller, who has certain beliefs about the buyer’s reservation
price (modelled as a probability distribution). In each period, the seller
sets a price and the buyer can either purchase at that price or reject the
price offer.
Models of incomplete information bargaining can be extremely complex
and I will not discuss them in general or even give an overview. Instead,
I will show you in a simple example that inefficiencies can occur. This
means that, if it were possible to get both players to reveal their valuations
truthfully, they could both be made better off. It is precisely because
players are hiding their valuations in order to get an advantage that there
are costly delays before an agreement is reached. Consistent with the
theory, experiments with subjects have found that when there is complete
information about the players’ payoffs, bargaining typically leads to quick
efficient agreements, but when there is private information, bargaining
takes longer and often Pareto efficient outcomes are not reached.
4.4.1 A simple example

Consider the following incomplete information bargaining game. There is
a population of buyers and sellers of a good. Half of the seller population
has a reservation price of 1 and the other half has a reservation price of 3.
One-third of the buyer population has valuation of 2 and two-thirds have
valuation of 4. Each player knows his own reservation price or valuation
but the others do not.
Two players, a seller and a buyer, are drawn randomly from each
respective population and try to come to an agreement about the price at
which a good will be sold. We will refer to a player as being of type i if he
has reservation price/valuation i. The seller moves first and offers to sell
for a price of 2 or 4. The buyer always accepts an offer of 2 but may reject
a price of 4. If the buyer rejects, the seller can offer a price of 2 or 4 and
the buyer has another chance to accept or reject. If there is delay any pay-
offs in the second period are discounted using a discount factor ds for the
seller and db for the buyer.
Table 1 contains the possible strategies for each type of player and the pay-
offs corresponding to each possible strategy pair. The first pay-off listed is
the buyer’s. Note that a seller of type 3 will never set the price equal to 2
and that a buyer of type 2 is never willing to buy at price 4. This restricts
the number of strategies we have to consider.
52
Seller type 1 Seller type 3

Always ask 2 Ask 4, then 2 Ask 4, then 4 Always ask 4
Buyer type 2
(0, 2) (0, 2ds) (0, 0) (0, 0)
always rejects 4
Buyer type 4
(2, 2) (2db, 2ds) (0, 4ds) (0, 4ds)
reject 4 once
Do not reject (2, 2) (0, 4) (0, 4) (0, 4)
For a buyer of type 4, rejecting a price of 4 in the first period weakly

dominates accepting price 4 immediately. If we eliminate the last row in
the table then, for a seller of type 1, asking a price of 2 dominates asking
4 first and then asking 2 so that we can eliminate the second column in
the table. Given that the seller of type 1 thinks that the buyer he faces is
equally likely to be of type 2 as of type 4, asking 2 gives him an expected
pay-off of 2 whereas asking 4 twice gives him an expected pay-off of
0(1/3) + (4ds)(2/3). Thus the seller of type 1 asks 2 if 2 > 4ds(2/3) or
ds < 3/4. It follows that, if ds > 3/4, there is no trade, at the equilibrium,
between a seller of type 1 and a buyer of type 2 which is clearly inefficient.
There is also an inefficient delay of the agreement between a seller of type
3 and a buyer of type 4.

The chapter examined bargaining models in which two players try to reach
an agreement over the partition of certain gains from trade. In particular
it considered the (axiomatic) Nash bargaining solution and the dynamic
Rubinstein’s alternating-offers game. It discussed some key features of the
subgame perfect equilibrium of the Rubinstein model and the concepts
of friction and bargaining power. The chapter also considered briefly the
effects of incomplete information on the bargaining process and how
inefficiencies may arise in this context.

• apply the Nash bargaining solution to economic problems
• analyse alternating-offers bargaining games with finite or
infinite numbers of rounds
• describe the impact of incomplete information on bargaining
outcomes.

53
1. Consider the alternating-offers bargaining game over £100, with Bert

making the first offer and Ernie making a counteroffer if he wants to.
Suppose Bert has an outside option of £50, that is, at any point during
the game, Bert can stop bargaining and get £50 (discounted if he gets
it after the first period). If Bert takes his outside option, Ernie gets
zero. How does this affect the equilibrium strategies and payoffs?
2. Consider the following bargaining game. Player 1 offers the division of
a cake of size 1 to player 2. Player 2 can either accept or reject. If he
accepts, the proposed division is implemented. If player 2 rejects, then
player 1 can once more propose a division which player 2 can accept
or reject. If player 2 rejects this second offer, he can propose a division
to player 1 and player 1 can accept or reject. If player 1 rejects, player
2 can make another offer. If player 1 rejects this second offer, the game
ends and both players get zero. Both players discount their payoffs
after each rejection with discount factor δ (0 < δ < 1). What is the
subgame perfect equilibrium of this game?
54
Chapter 5: Auctions and bidding strategies
Chapter 5: Auctions and bidding

strategies
5.1 Introduction
In the models of bargaining analysed in Chapter 4, there was a single
seller of the good and a single buyer who negotiated over the partition
of the gains from trade. Auction theory, in contrast, analyses situations
in which many buyers compete to buy from one seller. Here there is
no bargaining per se but rather a set of bidding rules together with a
mechanism to select the winning bidder. Auctions are a widely used
alternative to the competitive market mechanism (where many sellers
compete to sell) for transferring goods from sellers to buyers. Auctions
are indeed one of the oldest forms of markets. Today, thanks in part to the
pervasiveness of the internet and its auction sites, many sorts of goods and
services are sold every day around the globe using electronic auctions (e.g.
eBay). By studying auctions you will get a better understanding of how
these markets function.
Some of the most prominent examples of the use of auctions in real
markets include the following:
• The governments of the US and UK (among others) regularly auction
off parts of the radio spectrum for use by mobile phones and other
digital communication devices.
• Australia and New Zealand privatised the provision of public services
by auctioning off several government-owned entities such as electricity
plants and telephone networks.
• The US government regularly auctions off the right to drill in coastal
areas that may contain vast amounts of oil.
• In sales of securities and bonds, auction methods are used. In many
countries, the Treasury auctions off government debt issues to financial
institutions such as banks, stock brokerages and insurance companies.
• Companies are sometimes sold through a formal bidding process that
may involve an investment bank acting as the auctioneer.
• Boyes and Happel (1989) report that in the department of economics
at the College of Business, Arizona State University, office space
was auctioned off to the faculty. The proceeds were used to set up
a graduate scholarship fund. (The authors mention that the bidders
didn’t really care where the money went as long as the chairman didn’t
keep it!) Every interested faculty member submitted a sealed envelope
with a bid before an announced deadline. The highest bidder then got
first choice of offices, the second highest bidder could choose from the
remaining offices, etc. Anyone who bid above $75 received a window
office. The highest bid was $500, the next highest $250, and a total of
$3,200 was raised.
• In Singapore prospective buyers of new cars have to bid for a permit
or Certificate of Entitlement (COE) before they make their purchases.
Successful bidders pay the lowest accepted bid price. For example, if
the quota for a particular category of cars (say 1,001 to 1,600 cc.) is
1,000 and the thousandth highest bid is S$600, then every successful
bidder (with a bid in the top 1,000) in this category pays S$600.
55
The exceptions are company vehicles and heavy goods vehicles for
which double the amount in their categories must be paid. There are
exceptions for motorcycles as well. Their owners pay one-third of the
‘open’ category premium if they choose to enter this category (there is
a special motorcycle category). Diplomatic vehicles are unaffected by
the quota system.
In auctions buyers typically bid to purchase items but sellers can also use
auction-type mechanisms to sell the right to provide a product or service.
This is called a reverse auction and it occurs when a party announces the
need for a product or service and buyers bid for the right to provide that
good or service (and the lowest bidder wins the auction in this case).
For example, many governments and large companies purchase almost
exclusively by procurement through competitive bidding. Therefore you
may have to quote a fee as a business or professional services consultant
for particular projects. The analysis of an auction is the same whether
bidders bid to buy or to sell (except that in the latter case the lowest
bidder wins). You should bear in mind though that the purpose of bidding
is not to win at any cost but to maximise your expected gain (i.e. to win
only when you are better off by winning).
To study auctions and optimal bidding strategies, we shall apply some of
the concepts and tools of game theory discussed in Chapter 3. Essentially
we are given a description of the rules of the game (i.e. the auction) and
want to determine what the expected outcome will be. This outcome
will in turn depend on the players’ strategic choices and the equilibrium
concept used.
Given that auctions are so prevalent, we should consider the reasons for
their use and the circumstances under which they are more appropriate
than other methods of sale. Auctions are not typically used to sell
standardised products for which there are competitive markets. The time
and expense needed to organise an auction and gather all the interested
parties in the same place would be wasted since the outcome would
be the same as in the market. However, e-commerce has significantly
reduced some of the organisational costs of bringing bidders together,
which is evidenced by the phenomenal popularity of auction sites on the
internet. Yet auctions are virtually the only mechanism used to sell special,
unique items such as antiques, real estate, art, rare wine, oil drilling
sites and mineral leases. It is very difficult to post a price for such items
because of the uncertainty surrounding the demand for them; there is no
historical data a seller can use to form an estimate about potential buyers’
willingness to pay. Auctions are therefore the mechanism most frequently
used to determine prices for these special objects.

• the difference between private-value auctions and common-
value auctions
• the main types of auction mechanisms and the optimal bidding
strategies for each of them
• the IID assumption on buyers’ valuations
• the effect of the number of bidders on the auction revenue and the
bid’s structure
• how a bidders’ ring works
• the revenue equivalence result
56
• the winner’s curse

• the effect of buyer risk aversion in a first price sealed bid auction
• the effect of seller risk aversion on his preference between first
and second price sealed bids.

• explain why bidding your true valuation is a dominant strategy in
English and in second price sealed bid (or Vickrey) auctions
• derive the optimal bidding strategy in first price sealed bid auctions
with uniformly distributed private values
• discuss the general relationship between the number of bidders and
expected revenues
• analyse simple auctions of the type discussed throughout this chapter.

Norton and Co., 2014; 9th edition) Chapter 18: Auctions.

theory, applications and cases. (New York: W.W. Norton and Co., 2013) 8th
edition [ISBN 9780393912777] Chapter 13: Auctions.
Boyes, W.J. and S.K. Happel ‘Auctions as an allocation mechanism in academia:
the case of faculty offices’, Journal of Economic Perspectives 3(3) 1989,
pp.37–40.
Capen, E., R. Clapp and W. Campbell ‘Competitive bidding in high-risk
situations’, Journal of Petroleum Technology 23(1) 1971, pp.641–53.
Klemperer, P. ‘Auction theory: a guide to the literature’, Economic Surveys 13(3)
1999, pp.227–86.
Klemperer, P. ‘What really matters in auction design’, Journal of Economic
Perspectives 16 2002, pp.169–89.
‘Teetering’, The Economist, 27 August 1994, p.7.

This chapter studies the main type of private and common value auctions
as well as bidders’ optimal bidding strategies using the tools of game
theory. It also explains the important concept of the winner’s curse in
common value auctions.
5.2 Private and common-value auctions

In the theory of auctions a distinction is made between private-
and common-value auctions. It is crucial that you understand this
categorisation! The distinction rests on how the value of the auctioned
object is modelled (i.e. which assumptions are made regarding how the
potential buyers value the object). Take the (unrealistic) extreme case
in which an item to be auctioned has a fixed value which is known to all
bidders (e.g. a £50 note); the item will be sold to the highest bidder who
pays his bid (we will see later that in some auctions the winning bidder
does not pay his bid) and is allocated randomly if there is a tie. Then, of
course, the Nash equilibrium (see Chapter 3 of this subject guide) is for
everyone to bid the known value (make sure you know why) – which
57
is not very interesting! In all real-life auctions there is some uncertainty

either about the value other bidders attach to the item or about the value
of the item itself.
In a private-value auction you know the value to yourself of winning the
item (or the contract in a procurement situation) but you do not know its
value to other competing bidders. Different bidders attach different values
to the item in question. For example, you know that your reservation price
for an antique clock is £12,000; another bidder may value it at £14,000.
When you tender for a contract to build a tunnel you may know from past
experience how much it would cost you to build it but you are unlikely to
know exactly what your competitors’ costs will be. In models of private-
value auctions it is often assumed that the valuations of bidders are
drawn independently from the same distribution: the IID (independently
identically distributed) assumption. In the procurement context this
implies that costs for each company are taken as drawn from a common
distribution. Auctions for artwork are considered private-value auctions
as long as bidders do not intend to buy for investment purposes. If they
buy as an investment with the intention of reselling the item, then, their
private value is not independent of the other bidders’ values because the
latter will affect the resale price.
In a common-value auction you are uncertain about the value of the
object to be auctioned but, whatever the value is, it is the same for all
bidders. This would be the case for an auction for an unknown amount of
money in a sealed envelope. Each bidder forms an estimate of the single
uncertain value of the object. Typical examples of common-value auctions
are auctions in which a government sells the mineral rights to a plot of
land or off-shore drilling rights. When oil field leases or gas drilling rights
are auctioned, a bidder may not know how deep he will have to drill, how
much oil or gas there is, what the future oil and gas prices will be and so
on. However, all these factors will affect the value of the oil field equally
for all bidders and the oil discovered will have the same market value
regardless of who won the auction. US Treasury bills are also sold through
common-value auctions because the participating financial institutions
resell the government debt.
In a procurement context, the common-value assumption is valid if all the
bidders would incur the same costs to do the job but no bidder knows the
precise cost. However, some bidders may have more information about
the object than others: they may have more experience (for example, they
have drilled in an adjacent site to the oil field on auction and can make
assumptions about the site’s characteristics). The important assumption in
models of common-value auctions is that the object has the same intrinsic
value to all; but all bidders form their own estimate of this value.
In reality auctions can be a mixture of private-value and common-value
auctions: the auctioned object will have a common value but it also has
a buyer-specific value. For example, there may be several candidates
interested in buying a particular company. The actual value of the
company’s assets is likely to be relatively objective and the same for all
potential buyers. The company’s activities, however, may offer varying
degrees of strategic synergy, depending on who the buyer is. This leads
to some bidder-specific valuation as well. Current auction theory studies
this type of hybrid scenario with common and private values but the
techniques used are quite advanced and beyond the scope of this subject
guide. In discussing optimal bidding strategies, we shall only refer to
strictly private-value and strictly common-value auctions.
58
5.3 Private-value auctions and their ‘optimal’ bidding

strategies
In this section we discuss some types of auctions that are frequently used
and analyse optimal ways of bidding in them. We will show what the
profit-maximising bidding strategies are and how optimal bids depend on
bidders’ estimates of the valuations and on the number of bidders. Table
5.1 summarises the characteristics of the auction forms discussed in this
section. In all auctions bidders try to choose the best strategy knowing that
their competitors are also rationally trying to optimise. This of course leads
to game theoretic analysis; auctions are very good examples of games of
incomplete information where each bidder has private information about
their valuation of the object being sold.
Private value How bids are What does the Optimal strategy
auctions made? winner pay?
English auctioneer starts with the highest bid stay in the auction
low bid, bidders make until the bidding
increasingly higher process reaches
bids your valuation
Standard (or first bids are submitted the highest bid bid below your
price) sealed bid secretly and valuation
simultaneously
Dutch auctioneer starts with the price at which bid below your
high price and reduces the auctioneer valuation
it gradually until a stopped
bidder stops him
Second price bids are submitted the second highest bid your true
sealed bid secretly and bid valuation
simultaneously
Table 5.1: Summary of private-value auctions
5.3.1 Private-value English auctions

English auctions, or oral ascending bid auctions, are the most commonly
used auction format. Although the term ‘English auction’ may conjure up
images of Christie’s or Sotheby’s salesrooms filled with art connoisseurs
bidding millions of pounds for a Monet, use of this type of auctions is
certainly not restricted to these glamorous settings. Many agricultural
products, fish, repossessed houses and cars are also sold in oral auctions.
These auctions follow a specific format: the auctioneer starts by setting
a low price (also called the reserve price) and asking for bids. As
long as interested bidders remain, the price rises through competitive
and increasingly higher (verbal) bids until there is only one bidder left.
Generally, each bid must exceed the previous bid by some minimal bid
increment. When no participant is willing to increase the bid further, the
highest bidder wins the object. It is important to realise that this highest
bidder pays an amount which is only slightly higher than the last bid made
by the second highest bidder. A Japanese version of this auction involves
an electronic system which displays a rising price. All bidders who remain
interested at the displayed price keep a button pressed. When the price
gets too high for a bidder, he releases the button and, when there is only
one bidder left, the price at which the second to last bidder drops out is
displayed with the identity of the winner.
59
How should you bid in a private-value English auction? Imagine you

are actually in an auction room, bidding for a desired object. You have
a reservation value v – this is your private valuation of the object. You
are indifferent between acquiring the object at a price equal to your
reservation value and not acquiring it. The bidding process starts at a bid
below v. Will you make a bid? Suppose the bidding is quite competitive
and the bid price rises to v. Will you make another bid? The optimal
strategy, which you may have arrived at yourself, is given in the box below.
The optimal strategy in a private-value English auction is to stay in the

auction and continue to bid until your valuation is reached.
In fact, this optimal strategy is dominant: whatever strategies the

other bidders use, you cannot do better than follow the above strategy.
The explanation is as follows. If you win the auction, your pay-off is the
difference between your valuation and your bid; if you do not win, your
pay-off is zero. Your only decision is when to drop out. If you drop out
before the bid price reaches your valuation, you forego the opportunity
of a positive pay-off. If you stay in the auction after the bid price has
exceeded your valuation, you risk obtaining a negative pay-off (if you
win the auction), and the highest pay-off you can get is zero. Therefore
under no circumstances can you improve on dropping out
when the last bid reached your valuation. This points to a possible
explanation for the popularity of English auctions: very little information
gathering and preparation costs are involved since bidders’ optimal
strategies do not depend on how their competitors bid.
From the nature of the optimal strategy it follows that, in an English
auction, the object goes to the person who values it most. He will pay a
price approximately equal to the second highest reservation price since
at this price his only remaining competitor drops out. In reality, the final
price is slightly above the second highest valuation because bids are
raised in discrete steps – the minimal bid increment. In some real-life
auctions the auctioneer determines the next possible bid on the basis of his
perception of the competitiveness of the bidding. The bids may be raised
by pennies or as much as £100,000, depending on the context. (However,
the issue of discrete bid raises is ignored in virtually all auction models.)
5.3.2 Private-value standard sealed bid auctions

In a standard sealed bid auction, bids are invited from interested bidders
and remain secret until a preannounced date on which they are revealed
simultaneously. Typically bidders submit their bid in a sealed envelope
or similar confidential process. In the usual first price version of the
sealed bid auction, the winner is the bidder who bids the highest amount
and he pays the auctioneer the amount he bid. Of course in the case
of procurement or government contracts, where this type of auction is
used almost exclusively, the winner is the one who offers to carry out the
required work at the lowest price. If there is an auctioneer’s reserve price
and all bids are lower than the reserve price, then no one may receive the
item.
How should you bid in a first price sealed bid auction? Obviously, you
shouldn’t bid above your valuation (because you could get a negative
pay-off). If you bid your valuation, your pay-off is zero. It is easy to see
that you can do better if you bid below your valuation. When you bid
below your valuation you are in fact trading off larger potential gains
(valuation minus bid) against a reduced probability of winning the
auction. This implies that there is no dominant strategy here because
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the reduction in the winning probability depends on your competitors’

bids. Your equilibrium bid should take into account your estimate of your
competitors’ valuations and of their bids. The optimal bid is the one which
maximises your expected gain given your probabilistic information about
the equilibrium competing bids. At the equilibrium each bidder shades his
bid below his valuation. It turns out that the general (Nash equilibrium)
rule for private-value standard sealed bid auctions is as follows.
The optimal strategy in an IID private-value, first price sealed bid auction is
to bid the expected value of the second highest valuation among the bidders
assuming your valuation is the highest.
We will not give a proof of this result but we will show you how it works in
the special case of uniformly distributed valuations. Suppose there are two
risk-neutral bidders: you and an opponent. Each of you has a valuation
which is known only to you and which is drawn independently from a
uniform distribution on [0,1]. Your valuation is v1 and you bid b1. Suppose
your opponent’s strategy tells him to bid a fraction f of his valuation v2 (i.e.
b2 = f v2). Would you ever bid above f ? If you bid above f you are sure to
win since b2 < f for v2 < l. If you bid below f your probability of winning is
the probability that the other bid is below yours:
P (win) = P(b2 < b1) = P(f v2< b1) = P(v2 < b1 / f ) = b1 / f.
Hence your expected gain from a bid b1 equals:
(v1 – b1) P(win) = (v1 – b1) (b1 / f ).
Note that there is a trade-off between the probability and the profitability
of winning: if the bid increases, the profit (v1 – b1) decreases but the
probability (b1 / f ) of winning increases. Optimising the expected gain
with respect to b1 gives b1 = v1/2. This optimal bid is independent of the
other bidders’ valuation: an optimal response to any linear bid is to bid
half your valuation. It follows that the strategy pair in which bidders bid
half their valuations forms a Nash equilibrium. How does this relate to the
general rule above? Well, if you assume your value v1 is the highest, then
your expectation of the other bidder’s value is equal to v1/2.
Let us extend the analysis above to a sealed bid auction with n bidders,
each with a valuation drawn from the uniform distribution on [0,1].
Assume you are Bidder 1 and all your opponents use the same linear
bidding strategy: bi = fvi, i = 2,..., n. You win the auction if all of your
rivals’ bids are below yours; that is, when bi = fvi < b1 for all i:
P (win) = P(v2< b1 / f and v3 < b1 / f and ...vn < b1 / f ) = (b1 / f )n–1 .
The above expression uses the fact that the bidders’ valuations are drawn
independently. Hence your expected gain from a bid b1 equals:
(v1 – b1)P(win) = (v1 – b1) (b1 / f )n–1 .
Optimising the expected gain with respect to b1 leads to b1 = ((n – 1)/n)v1.
The equilibrium strategies are therefore to bid (n – 1)/n of your value. You
should now be able to derive the equilibrium bidding strategy for valuations
from a uniform distribution on [L,U]. The answer is b1 = (1/n) L + ((n
– 1)/n)vi. We have of course assumed that each bidder knows how many
bidders there are. This is an unrealistic assumption if the number of bidders
is very large but it is precisely in this case that uncertainty about the number
of bidders is not a serious problem: as the number of bidders increases, the
optimal bidding strategy is to bid close to your valuation.
It is very important that you realise what is meant by an ‘equilibrium
strategy’. As we have seen in the game theory chapter, an equilibrium
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strategy is only optimal against equilibrium strategies. It is the best you

can do if the other bidders play their equilibrium strategies. If you have
reason to believe that your rivals are not using an equilibrium strategy,
your optimal response is likely to differ from the equilibrium strategy. In
general, to find an equilibrium bidding strategy, look for best responses
(i.e. strategies which tell the players what to bid given their valuations and
the other players’ bidding strategies). With IID valuations there is always
a symmetric equilibrium, in which each player bids an increasing function
of his value. As a consequence, the bidder with the highest valuation will
make the highest bid and win the object.
As you can see from the results above, as the number of bidders increases,
each bids a higher fraction of his value and the final price goes up. It
follows from this analysis that it is in the seller’s interest to get as many
bidders as possible since the expected maximum value is increasing in n
and each bidder bids close to his value if n is large.
The general principle is that the expected revenue will keep increasing
as the number of bidders increases, but it will do so at a slower rate. The
effect of the number of bidders on the expected revenue has become a
relevant consideration in determining appropriate antitrust policy with
respect to takeovers and restructuring in the defence industry, since the
government cannot expect to fulfil its military requirements at a low cost if
there are only one or two potential suppliers for any type of weapon.
5.3.3 Private-value Dutch auctions

This type of auction is reportedly used in the Netherlands for selling
cheese and wholesale fresh flowers. In a Dutch auction the auctioneer
starts at a very high price and reduces it gradually by steps until one of
the bidders shouts ‘mine!’. The winning bidder then pays that price. A
mechanical version of the Dutch auction involves a giant clock (called the
Dutch clock) and a switch for each bidder. As the clock ticks, the price goes
down continuously until one of the bidders uses his switch to stop it. This
version of the Dutch auction was also used in Ontario tobacco auctions.
Over the years, the technology of Dutch auction clocks has changed
dramatically. Nowadays the clock is projected overhead at the auction
itself and can also be accessed remotely by computers, so that anyone with
internet connection and a buyer’s licence can bid via computer. The price
and the identity of the winning bidder are then displayed.
The optimal strategy in a private value Dutch auction is the same as for a
first price sealed bid auction.
In essence, the Dutch auction and the first price sealed bid auction
describe the same game. Each player’s strategy consists of a function of his
valuation. The only (immaterial) difference is that, in a sealed bid auction,
the bid is submitted in writing and a Dutch auction is an oral auction. In
a Dutch auction, the bidding strategy can be interpreted as the plan to
claim the item if the bid level goes down to the number predetermined in
the bidding strategy. Notice that a bidder in a private-value Dutch auction
does not gain anything from his presence; he could send an agent to do
the bidding.
Although Dutch and English auctions are both oral auctions, they are
very different from the bidder’s perspective. As mentioned before, in an
English auction, as the price increases, the bidder can assess at any time
whether he can gain by increasing the bid level. In particular, when the
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bid level reaches the bidder’s valuation it is clear that he cannot make a
gain from the auction. In a Dutch auction, the bidder is not certain at any
price (below his valuation) whether he can increase his gain by waiting or
bidding. He knows that he will win the auction if he bids but he could get
a larger surplus (valuation minus bid) if he waits.
5.3.4 Private-value second price sealed bid auctions

We now consider a variant of the sealed bid auction where the winner is
the highest bidder but now she will pay the second-highest price bid. In
other words, the person who bids the most gets the object, but she only
has to pay the bid made by the second-highest bidder. For example, if A
bids £4,000, B bids £5,000 and C bids £6,000, C would be the winner
of both a first price auction and a second price auction. In the first price
auction, C would have to pay £6,000 whereas in the second price auction
he would have to pay £5,000.
The second price sealed bid auction is also known as a Vickrey auction
in honour of William Vickrey, the economist who received the 1996 Nobel
Prize for his pioneering research on auctions. Surprisingly, the second
price sealed bid auction is easier to analyse than the first price sealed bid
auction.
The optimal strategy in a private-value second price sealed bid auction is to

bid your true valuation.
We found before that this is also the optimal strategy in an English

auction. Bidding your valuation is a dominant strategy, as it is for the
English auction. Why? Because what you pay if you win does not depend
on your valuation. Suppose you bid below your valuation. Then you will
get zero if you don’t win. If you win, then you would have won bidding
your true valuation and paid the same amount (the second highest bid).
So, bidding below your valuation is dominated by bidding your valuation
since bidding lower only decreases your chances of winning the auction
and obtaining a positive pay-off. Now suppose you bid above your
valuation. If you lose, you would certainly have lost bidding your valuation
(your bid would have been lower). Hence you did not do better by bidding
higher than your valuation in this case. If you win and the second bid is
above your valuation you will get a negative pay-off. You do worse than
by bidding your valuation. If you win and the second bid is below your
valuation, you would have won bidding your valuation as well. Bidding
above your value is dominated by bidding your value since bidding above
only increases your probability of winning the auction when you don’t
want to win it.
Note that the optimality or dominance of the strategy ‘bid your
valuation’ does not depend on knowing other bidders’ valuations or their
distributions. In other words, whatever the other bidders’ strategies are,
you cannot do better than bidding your valuation. As was mentioned
for the English auction, the dominance of the optimal bidding strategy
makes second price sealed bidding an attractive auction form. Bidders
do not have to gather any information; they do not in fact have to think
strategically. They just have to be rational enough to realise that they
should bid their valuation. An interesting feature of the Vickrey auction is
that it achieves essentially the same outcome as an English auction, but
without the iteration.
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5.4 Auction revenue

An important issue for anyone considering the sale of an object at an
auction is how much revenue can be expected from such a sale and which
type of auction generates the highest revenue. This is particularly relevant
to managers designing auctions, say online, with a goal to maximise
profits. Let us first look at the revenue to the seller from first and second
price sealed bid auctions using the example of independent, uniformly
distributed valuations. We will use the following property of the uniform
distribution. For a uniform distribution on [0,1], the expected value is 1/2;
if you make two independent draws from the distribution, the expected
value of the largest is 2/3 and of the smallest 1/3; in general, if you make
n independent draws, the expected value of the largest is n/(n + l), the
second largest has expected value (n – 1)/(n + l) and so on; the minimum
has expected value 1/(n + 1).
5.4.1 First price sealed bid revenue

Recall that, in the two-bidder uniform valuation case, the expected
winning bid is half the valuation of the highest value (i.e. (1/2)(2/3) =
1/3). In the n bidder case, the expected revenue is a fraction (n – 1)/n of
the winner’s valuation or (n – 1)/n of the expected value of the maximum:
that is, ((n – 1)/n)(n/(n + 1)) = (n – 1)/(n + 1).
5.4.2 Second price sealed bid revenue

What is the expected revenue to the seller if the two bidders bid their
valuation (which they are supposed to do as their optimal strategy) in a
Vickrey auction? The seller gets the lowest bid, so if there are two bidders
with valuations drawn independently from a uniform distribution on [0,1]
he will expect a revenue of 1/3, the same as in a first price sealed bid
auction. For n bidders, he will expect to get (n – 1)/(n + l), the expected
second highest valuation. So the expected revenue is again the same as
for the first price sealed bid auction. In fact, this conclusion holds quite
generally:
The revenue equivalence result: Irrespective of the distribution of

values, in a private values IID auction for the sale of one item and risk
neutral bidders, a first price sealed bid auction (or a Dutch auction) and a
second sealed bid auction (or an English auction) yield the same expected
revenue. The expected revenue in these auctions is the expected second
highest valuation. Each of these auctions is an optimal auction (i.e. it
produces the maximum revenue of all possible auction methods).
5.5 Common value auctions

Recall that in a common-value auction, the good in question is worth
intrinsically the same amount to every bidder, although the bidders may
have different estimates of that common value. We now analyse the
bidders’ optimal strategy in common-value auctions using the bidding
rules discussed above.
5.5.1 Common value English auctions

In a common-value auction, where bidders are uncertain about
the value of the item for sale and where the item has the same value
independent of who acquires it, bidders in English auctions can learn by
observing each other’s behaviour.
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In particular, a bidder can observe how many active bidders there are at
any price and when they drop out. This gives some useful information and
indication of their estimates. Sometimes the identity of the bidders also
conveys useful information. This is the reason why an expert buyer, whose
presence indicates that a particular item is desirable, may want to hire an
agent to do the bidding for him. If he were to bid himself, other bidders
might revise their value estimates upwards and bid more competitively.
Generally there is no dominant strategy for a common-value English
auction and the equilibrium bidding strategy depends on the structure
of the information among the bidders (who knows what?) and the
possibilities for obtaining additional information about the value during
the auction.
5.5.2 Common-value first price sealed bid auctions

In a common-value first price sealed bid auction, as in all common-
value auctions, each bidder has his own estimate of the value. If bidders
bid according to their estimates, then the most optimistic bidder (the one
with the highest estimate) wins the object. However, he is very likely to
have overestimated the value of the object. This is the winner’s curse:
‘If you lose, you lose and if you win you also lose!’ The name refers to
the fact that if you win the auction, it is probably because you have
overestimated the value of the good being sold. You have won because you
were too optimistic.
To avoid the winner’s curse you should bid below your estimate.
The winner’s curse phenomenon is illustrated in Figure 5.1. Assume that

the probability density function of bidders’ estimates has the actual value
of the object as its expected value. This means that bidders’ valuations are
on average correct but half of the bidders overestimate the value. Given
this large probability of overestimation, bidders will be cautious and
reduce their estimates when determining the amount to bid. In the figure
they all reduce their estimate by an amount d. This gives the distribution
of bids on the left in the figure. Depending on the discount d the most
optimistic bidder may still suffer from the winner’s curse. If the discount
is too small the highest bid still exceeds v, as it does in the figure. As d
increases, the bid curve moves further to the left and the chances that the
winner has bid too much become smaller.
bids estimates
v-d v
Figure 5.1
In competitive procurements there are frequent occurrences of the
winner’s curse. If you get the consultancy job you tendered for, you are
likely to have underestimated the costs. In common-value competitive
bidding for, say, an offshore oil lease, you have to correct for the possibility
65
of overestimation. Capen, Clapp and Campbell (1971) analyse bids for

offshore oil tracts, auctioned by the US government in the late 1960s. They
present evidence that the winners may have been cursed! For example,
the winning bid for offshore Texas Tract 506 was US$43.5 million, nearly
three times the second highest bid of US$15.5 million.
If there are many bidders, you have to shade your bid even more in order
to account for the winner’s curse phenomenon. To see this, suppose
each bidder estimates the value as its real value plus some (positive or
negative) error and bids his estimate minus some discount. Then the
probability of the bid of the winner exceeding the value is larger when
there is a large number of bidders since the probability that the maximum
of n IID variables exceeds any number increases in n. This is an interesting
observation because there is a natural tendency to bid more aggressively
when there are many bidders.
Note that we haven’t told you how to bid in a common-value first price
sealed bid auction other than that you should discount your valuation.
This is because no simple optimal bidding strategy exists. How you
should bid depends on the nature of uncertainty about the value and the
information available to the bidders. As for the private-value versions, the
optimal bidding strategy in a common-value Dutch auction is the same as
in a common value first price sealed bid auction.
5.5.3 Common-value second price sealed bid auctions

For the common-value version of a Vickrey auction, the optimal
strategies are different from the English auction. In the English auction
there is an opportunity to learn from observing other bidders, but this does
not exist in a sealed bid auction. You should not bid your expected value
based on your estimate alone (for winner’s curse reasons) and you should
take into account that you win if your estimate is highest. You can expect
higher bids in a second price sealed bid auction because the price that is
paid is lower than the winning bid.
5.6 Complications and concluding remarks

The theory of auctions is a fascinating field which has grown dramatically
over the last few decades, in parallel with the advance of game theoretic
modelling in economic theory. I have tried to give you an introduction
to the more accessible material. In this section we briefly mention some
additional issues which are of relevance to real-life auctions.
5.6.1 Phantom bids

As mentioned above, bidders in common-value English auctions obtain
information by observing who drops out and when. If the number of
active bidders decreases rapidly, bidders are likely to think they have
overestimated the value and revise their estimate downwards. This
explains the temptation by sellers to use agents who keep bidding against
the last bidder. The disadvantages of using agents in this way are that;
(a) the seller incurs a risk of the high bidder dropping out and one of
his agents ‘winning’ the auction; and (b) bidders may account for the
possibility that they are bidding against an agent and shade their bids
accordingly. Clearly, using phantom bids skillfully is an art!
Can the auctioneer use phantom bids profitably in a private-value English
auction? Yes, he can. Recall that the winner pays the second highest
valuation. If the auctioneer takes a phantom bid after all but one ‘real’
bidder have dropped out, he increases the seller’s revenue. The larger the
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difference between the highest and the second highest valuation, the more
profitable the use of phantom bids will be.
In a second price (private- or common-value) sealed bid auction, an
unscrupulous seller could ‘cheat’ by inserting a phantom bid just below the
winning bid, thus increasing the price paid by the winner. This may partly
explain the unpopularity of the second price sealed bid auction. Of course,
the seller could only profitably cheat in this way if the bidders are naive. If
the bidders account for the possibility of a dishonest seller, they will shade
their bids and they will tend to bid as in a first price sealed bid auction.
Activity
Do you know why? Think about what the winner pays if the seller uses a high phantom
bid.
5.6.2 Late bidding

In many auctions, particularly ones on the internet, participants wait until
virtually the last minute to place their bids. This behaviour is somewhat in
conflict with what the standard auction theory would predict since there is
limited learning. Why do we see so many ‘late bids’?
There have been several theories trying to explain this phenomenon. For
certain auctions, people don’t want to bid early to avoid driving up the
selling price. For example, eBay typically displays the bidder identification
and actual bids for items being sold. If you are a serious and frequent
bidder, you may want to hold back your identity until the last minute so
as not to reveal your interest in a particular item. This is another example
where the identity of the bidders conveys valuable information. Late
bidding may also be a way to avoid bidding wars. Bidding high at the
last minute introduces some uncertainty since one of the online bids may
not get through and the winner is likely to end up paying a much lower
price. This may be better in expected terms than bidding up the price to
the point where no bidder expects to get a positive consumer surplus. Late
bidding on the internet is a form of ‘implicit collusion’ among users. There
are also more explicit types of collusion among bidders as explained below.
5.6.3 Collusion
In some auctions it is possible for bidders to collude. For example, a
‘ring’ of bidders in an English auction could agree not to bid against each
other (i.e. not to bid when the current bid was made by one of the ring
members). In this way the ring can buy the object for less than would be
possible without the ring. The object is then sold in the ring to the highest
bidder and the profit is divided among the ring members. Rings are more
likely when bidders know each other. In 1994, property developers in
Hong Kong were accused of collusion in government land auctions. The
US Justice Department also charged Philadelphia antique dealers with
anti-trust violations for their participation in bidding rings, or pools, at
antique furniture auctions.
Although bidders could also collude in sealed bid auctions, the anonymity
of the bidding process makes cheating (i.e. breaking the collusive
agreement) more likely. This may be the reason why sealed bid auctions
are preferred to English auctions in procurement. Collusion is more likely
in auctions which are not one-off events but are repeated very regularly
with more or less the same bidder population (for example, Treasury
auctions). To counteract collusion among bidders it is advisable for the
seller to withhold information such as the identity of the winner and the
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winning bid. This eliminates the possibility of colluders punishing the

cheaters, which in turn increases the probability of cheating. The topics
of cartels and collusion among firms are considered in Chapter 18 of the
subject guide.
5.6.4 Risk aversion

In deriving optimal strategies we have implicitly assumed that bidders are
risk-neutral. Would we find different results if bidders are assumed to be
risk averse? The answer to this question depends on the type of auction
under consideration. In a private-value English or second price sealed bid
auction the dominance of bidding your true valuation still applies. The
argument given for this dominance does not assume anything about the
bidders’ attitude to risk.
However, risk averse and risk neutral bidders do bid differently in a
private-value first price sealed bid auction and a Dutch auction. Because
first price auctions have no dominant strategies, bidders must anticipate
the bids of others and hence can only partially control this uncertainty.
When the clock in a Dutch auction is ticking away, indicating lower and
lower prices, a risk averse bidder will become increasingly nervous as the
price moves below his value. He is likely to stop the clock earlier than a
risk neutral person with the same value. A risk averse person bids higher
because he is willing to pay more to avoid the zero pay-off associated with
losing. This behaviour is a sort of ‘bidding insurance’. If this does not make
sense to you intuitively, think of the auction as a lottery in which there are
two possible pay-offs: a surplus equal to the value of the item minus the
bid if you win and zero if you lose. The probability of winning depends
on your bid. If you are risk averse you may prefer a low positive pay-off
with a high probability to a high positive pay-off with a low probability. It
follows that a (risk neutral) seller can make more revenue in a first price
sealed bid auction than in a second price sealed bid auction if the bidders
are risk averse, hence the qualification referring to risk neutrality in the
revenue equivalence result.
Example 5.1
Consider a private-value first price sealed bid auction with two risk averse
bidders who have identical utility functions U(x) = x1/2 and values drawn
independently from the uniform distribution on [0,1]. Recall that the Nash
equilibrium strategy for risk neutral bidders is to bid half their valuation. As
before, assume Bidder 2 uses a linear bidding strategy:
b2 = fv2. The probability that Bidder 1 wins with a bid b1 , remains b1 /f.
Bidder 1 maximises his expected utility U = (b1 / f )(b1 – v1)1/2 which results
in b1 = 2/3v1. The best response against any linear bid function is b1 =
2/3v1. We have therefore shown that, for risk averse bidders with a square
root utility of money function, bidding 2/3 of their valuation is a Nash
equilibrium strategy. The seller gets 2/3 of the expected maximum valuation
(2/3), that is 4/9, which is higher than the expected revenue of 1/3 in the
risk neutral version.
A risk averse seller will also prefer first price over second price sealed
bid auctions. The reason is that the variance of the winning bid is larger
in the latter auction form. Example 5.2 (which can be skipped if you are
afraid of integrals!) illustrates this.
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Example 5.2
Consider an auction with uniform valuations and risk-neutral bidders. We

know that in a first price auction the winning bid is half the maximum
value. To determine the variance of the winning bid we therefore need to
look at the distribution of the highest value. For any number x in [0,1]:
P(highest value < x) = P(both values < x) = x2.
This implies that the distribution function of the maximum is F(x) = x2 and
its density function is f (x) = 2x. You should check that the expectation of
half the highest value is:
∫ 10(x/2) f (x)dx = 1/3
To find the variance calculate the second moment:

E(x2) = ∫10 x2f (x)dx = 1/2
The variance of the maximum value equals E(x2) – (E(x))2 = 1/18 (since E(x)
= 2/3) and so the variance of the winning bid is Var(x/2) = Var (x)/4 = 1/72.
In a second price auction with two bidders, the winning bid is the
minimum (second highest) value. We therefore have to find the distribution
of the minimum valuation:
P (lowest valuation > x) = P (both values > x) = (1 – x)2
so that F(x) = 1 – (l – x)2 = –x2 + 2x.
The density of the minimum valuation is then f (x) = 2 – 2x and you can
check that the expected minimum valuation is 1/3. This confirms that the
seller expects the same revenue in the private-value second price sealed bid
auction as in the private-value first price sealed bid auction. The variance of
the minimum value can be calculated as:
E(x2) – (E(x))2 = ∫10 x2 f (x)dx – (1/3)2 = 1/6 – 1/9 = 1/18
The variance of the selling price in the second price auction is four times
higher than in the first price auction.
5.6.5 Sequential auctions

In most auction models it is assumed that the sale of an item can be
considered in isolation. In reality however, many auctions are of a
sequential or repeated nature (e.g. the government may have an annual
round of procurement tenders for stationery; several art objects may be
auctioned on the same day). In some procurement auctions the quantity
auctioned is not fixed but can be determined by the buyer (i.e. the buyer
solicits bids and his quantity demanded is given by a demand function
q(p) where p is fixed by the auction). In some share auctions a bidder bids
a price and a quantity he wants to buy. The winner will be the bidder who
offered the highest price, who will get the quantity he bid. If there are any
shares left, the bidder who offered the second highest price will get the
quantity he bid at the price he offered and so on. Bidders in share auctions
may be allowed to submit several price-quantity bids. Conceptually this is
equivalent to submitting a demand curve.
Repeated auctions are more likely to lead to bidder collusion, but there
are also other complications. The value of a good to a potential buyer may
depend on whether he has been able to acquire complementary goods in
an earlier auction. Imagine a property developer interested in purchasing a
substantial chunk of land to build a new entertainment complex. Suppose
the land is sold in relatively small plots. If the bidder is not successful in
69
the early bidding rounds, his valuations for plots coming up for sale later
on may decrease dramatically. In particular, the value of any plot may
depend on whether he is able to acquire the adjoining plots. Similarly,
a construction company, with limited capacity, values winning a road
maintenance contract according to its available capacity which depends on
the number of contracts it has won recently.
Another consideration in sequential auctions is the effect of winning in an
early round on your ability to bid later on. If you have a fixed budget or
are not able to borrow easily, winning the auction for the modem painting
may leave you without enough resource and hence with no chance to win
the silverware auction later on. Other bidders may realise this and may be
able to use this fact to their advantage. By bidding against you to ensure
you pay a large amount of money for the painting, they hope to ensure
themselves a good deal in the silverware auction.
5.6.6 Other factors

Procurement contracts are not always awarded on the basis of price alone.
In many instances a buyer will consider quality issues as well. He could
do this either when the bids are opened (if he has asked bidders to specify
quality variables) or by preselecting the suppliers who are allowed to
tender. For reasons of public accountability, governments and other public
institutions are more likely to use the latter option, especially if quality is
not easily assessed objectively.
Time may be an important consideration in building contracts. When the
Santa Monica freeway was damaged in the 1994 Los Angeles earthquake,
the California Department of Transportation (Caltrans) scrapped its
normal bidding procedures and construction firms were required to bid on
both the cost and the time needed to get the repairs done.
5.7 Conclusion
Above we have only discussed a few types of auctions but many more
exist. For the more advanced and interested reader we recommend
Klemperer (1999) and Klemperer (2002) as further reading. Even for
the auctions described in this chapter there are many variants and the
assumptions which are made to enable us to analyse these auctions
would have to be modified to deal with each variant. For example, it is
quite common for the seller to set a reserve price below which he is not
willing to sell. This reserve could be several millions of pounds for an
Impressionist painting for example. An astute auctioneer or seller may be
able to generate a higher expected revenue by carefully selecting a reserve
price. In the models considered here, the number of buyers is fixed but in
reality it is endogenous because potential suppliers trade off the cost of
preparing a bid (which may include an ‘entry fee’) against their expected
pay-off from participating in the tender. It is fair to say that game theory
has offered significant insights into the mechanisms of auctions and
strategies for rational bidders. At the same time, many practical issues
are ignored in current auction theory which limits its value for real life
bidders.
70

This chapter explained the main types of private- and common-value
auctions and examined bidders’ optimal bidding strategies in each of
them, using the tools of game theory. It also considered the winner’s curse
in common-value auctions and why managers should bid below their
estimate in these situations.

• explain why bidding your true valuation is a dominant strategy in
English and in second price sealed bid (or Vickrey) auctions
• derive the optimal bidding strategy in first price sealed bid auctions
with uniformly distributed private values
• discuss the general relationship between the number of bidders and
expected revenues
• analyse simple auctions of the type discussed throughout this chapter.

content of this chapter, together with their respective solution, as well as
1. A flat which is currently rented is going to be sold. There are two
potential buyers: the current tenant and an outsider. The owner
solicits a price from the outside buyer and allows the tenant to buy the
house if he matches this offer. The buyers and the owner know that
the two buyers’ values for the flat are independent of each other and
that for each buyer the value is drawn from a uniform distribution on
[£100,000; £160,000].
a. How should the tenant decide whether or not to match the outside
offer?
b. What offer should the outside buyer make if her value is £120,000?
What offer should she make as a function of her value v?
c. (Only attempt this part if you feel brave!) What is the seller’s
expected revenue? Assuming there are two bidders, what would
the seller’s expected revenue be under an English auction?
2. In a private value first price sealed bid auction there are two bidders
with values v1 and v2 drawn independently from a uniform distribution
on [0,1]. Assume bidder 2’s strategy is to bid b2 = v21/2. Show that the
optimal response of bidder 1 is to bid b1 = 2/3v1. Do these strategies
form a Nash equilibrium?
3. I have a beautiful picture of the famous ballerina Belle Taper which
I will auction in class. I charge a £2.50 auction entry fee. You cannot
bid unless you pay this fee. You can only see the picture after you
have decided to participate in the auction (and paid!). You should not
71
assume that you will derive any pleasure from seeing the picture, only
from possessing it. After you have seen the picture you will know your
valuation of it. Everyone’s prior distribution of their and any other
bidder’s valuation is uniform on [£0, £15]. The auction will be of the
first price sealed bid type. Would you participate in the auction if one
other bidder participates? What if two other bidders participate? What
if the auction is of the second price sealed bid type?
4. a. ‘A second price sealed bid auction is better for the seller than a first
price auction because in a second price auction the buyer pays less
than his bid and will therefore bid higher.’ True or false?
b. ‘A first price sealed bid auction is better for the seller than a second
price sealed auction because in a first price auction your optimal
bid depends on what your opponent bids. This makes the bidding
more competitive.’ True or false?
5. Suppose there are four bidders, each with a private value uniformly
distributed on [0,1]. What is the expected price in an English auction?
What about a first price sealed bid auction?
6. Steven and Robert are two risk neutral potential buyers of a
dinglehopper. Each buyer values the dinglehopper at an amount
v1 known only to him. This valuation is considered by everyone,
including the seller, to have been drawn from a given distribution,
uniform on [0,10] for Steven and uniform on [10,30] for Robert. The
draws for the two individuals are independent.
a. Who will win in an English auction? What is the expected selling
price?
b. Suppose the seller can impose a minimum bid level of 10. What is
his expected revenue in this case? What if he sets the minimum bid
level at 15? What is the optimal minimum bid level?
72
Chapter 6: Asymmetric information I
6.1 Introduction
The consumer and production theories analysed in the previous chapters
assumed no significant differences in information between the parties
to a transaction. For example, buyers and sellers were assumed to be
perfectly informed about the quality of the good or service being sold.
While this assumption may be adequate in many market situations, it is
certainly less defendable in market interactions where it is very costly (or
impossible) to obtain accurate information about the quality of the good
or service in question. The asymmetry of information may also refer to
certain characteristics of one of the parties. For example, when a person
buys motor insurance online the insurance company provides a quote
even though it has limited information about the driving ability of the
customer. The insurer may have information about the number of years of
driving experience and whether the person has had previous claims, but
arguably these metrics are only an imperfect predictor of driving ability. In
many other transactions such as buying a second-hand car, applying for a
mortgage, buying health insurance or investing in a company’s stock, the
buyer and the seller typically have different information. The party with
the informational advantage may attempt to use it for their own benefit
but, in doing so, the actual feasibility of the market exchange may be
undermined. We would like to understand how these incentives potentially
impact on the orderly functioning of markets.
More specifically, situations of asymmetric information arise when
one party involved in a transaction knows more than the other about
relevant variables. To illustrate, a seller may have more information about
the quality of the product he is trying to sell than the buyer does. With
asymmetric information decisions are taken which would be inefficient
under symmetric information. In extreme cases, markets which would
show vigorous trade under perfect information may collapse completely. It
becomes very difficult under asymmetric information to draw inferences
from people’s behaviour, as they may be trying to fool you. For instance,
when bargaining, a buyer may make a low bid in the hope that the seller
will believe he has a low reservation price. By bluffing in this way he
may increase his expected gain at the expense of an inefficient delay in
reaching an agreement.
This chapter and the next one examine situations of asymmetric
information in different, interesting economic contexts. They are
intertwined and revolve around a common general topic. So you should
study them together when you prepare for the final examination. The
sample exercises to test your knowledge and understanding of the concepts
are therefore included at the end of the Chapter 7 of the subject guide.

• why asymmetric information represents a problem if we are
concerned with efficiency – as epitomised by the ‘lemons’ problem
• how using a ‘deductible’ can overcome moral hazard in the insurance
context
• what market mechanisms can be used to mitigate problems resulting
from asymmetric information.
73

• give examples (preferably your own) of adverse selection and
moral hazard
• discuss how adverse selection in insurance can lead to low risk
individuals being priced out of the market and explain the use of a
partial cover insurance policy in this context
• explain the conceptual difference between pre-contractual
opportunism and post-contractual opportunism
• identify other real-life markets where asymmetric information exists,
and rationalise measures used by market participants to reduce the
effects of information asymmetries on efficient trade.

Norton and Co., 2014; 9th edition) Chapter 38: Asymmetric information.

Akerlof, G.A. ‘The market for “lemons”: quality uncertainty and the market
mechanism’, Quarterly Journal of Economics (85) 1970, pp.488–500.

This chapter revolves around asymmetry of information and studies the
problems posed by adverse selection and moral hazard. Adverse selection
is particularly analysed in the context of the ‘lemons’ problem as well
as through the operation of different insurance markets. The chapter
then examines insurance deductibles as a way to mitigate moral hazard
problems.
6.2 Adverse selection

Economists distinguish between two basic cases of differences in
information between buyers and sellers: (a) where one party knows more
about their attributes or the quality of the good, and (b) where one party
can take unobservable actions that affect the quality of trade. The former
information asymmetry leads to adverse selection problems, while the
latter leads to moral hazard problems. Section 6.2 focuses on adverse
selection and Section 6.3 considers moral hazard. Adverse selection
occurs when less desirable agents are more likely to voluntarily participate
or ‘self-select’ in trade. In adverse selection problems, the type of agent
or quality of the good is not observable by one of the parties
and has to be guessed. This is why adverse selection problems are also
known as hidden information problems. For example, people who
suffer from terminal diseases are more likely than others to want to buy
medical insurance or life insurance. The individuals considering buying life
insurance have better information about their risks and likelihood of dying
than an insurance company does.
As a consequence of this adverse selection problem, the insurance
company cannot use risk estimates from the general population to set
its premiums. The premiums will have to be higher than those based on
the general population. Similarly, if a bank charges the same interest to
low risk and high risk borrowers, the high risk ones will be more likely to
74
borrow. The bank faces an adverse selection of borrowers. If you advertise

a job vacancy at a given wage, you only get people applying who are
willing to work at that wage. From a pool of potential applicants, only the
less desirable workers might apply. Adverse selection can be responsible
for market failure (i.e. there may be no market for a good whereas
profitable transactions between buyers and sellers would be possible if
everyone had full information).
6.2.1 The ‘lemons’ problem

The ‘lemons’ problem, first studied in a seminal paper by the Nobel Prize-
winning economist George Akerlof (1970), provides an excellent example
of an adverse selection problem. The terminology of this problem has
its origins in American slang: used cars are called ‘lemons’ if they are of
bad quality whereas ‘plums’, ‘peaches’ or ‘cherries’ are high-quality cars.
A ‘lemon’ is a used car that turns out to have many faults not apparent at
the time of sale – hence the sour taste. The starting point of the analysis
is a question you may have wondered about: ‘Why are one-year old cars
with low mileage so much cheaper than new cars?’ The answer lies in the
quality of one-year old cars which are offered for sale. Sellers are likely to
know more about the hidden qualities of the cars they are selling because
they have been driving them for a while and therefore know their existing
defects. So they know whether they are selling a lemon or a plum, while
sellers can invest some time in test driving the car, but they are never going
to be as well informed as the seller. For prospective buyers the quality of the
car remains hidden since they do not know whether a particular car is good
or bad. As a result the whole second-hand car market may collapse.
Example 6.1
Suppose one-year old cars of a particular make and model have a quality
or value (to the original buyer) uniformly distributed on the interval from
£10,000 to £20,000. The buyer of a new car only finds out the value the car
will have at age 1 after he has bought the car. He is now considering selling
the car on the used car market. Suppose a used car buyer (there are many
of them) is willing to pay £500 more than the seller’s valuation of the car.
(The reason for this could be that new car buyers do not like driving cars
over one-year old whereas used car buyers do not care much about how new
the car is.) If buyers and sellers had perfect information about quality then
all cars would be sold (for a price that lies somewhere between the seller’s
valuation and the buyer’s valuation) and everyone would be better off. The
market outcome would thus be efficient. Here it is assumed that the seller
knows the quality of the car but the buyer does not. What will the price be?
Because of buyer competition, the price in the market will equal the
(expected) value to the buyers. If the price is p, then all sellers who value
their car at p and below will try to sell their car. So all cars offered for sale
have values (to the seller) between £10,000 and p with an average quality
of (£10,000 + p)/2. Buyers cannot observe the actual quality of the car and
are willing to pay £500 more than the expected average quality value to the
seller i.e. p = (£10,000 + p)/2 + £500 which gives an equilibrium price p
= £11,000. This means that only the lowest quality cars (those with value
below £11,000) are offered for sale. Only 10 per cent of the cars are sold.
You should verify that, if the buyer premium (the excess the buyer is willing
to pay over the value of the car to the seller) is less than £500, even fewer
cars get sold.
75
Although Example 6.1 was phrased in terms of the used car market, the
‘lemons’ problem can occur in any market where buyers and sellers have
different information about the quality of the good being sold. In such
markets there is a tendency for low quality to crowd out high quality. This
effect could be so acute that the whole market may collapse and efficient
trade may not materialise. In Example 6.1, sellers of higher-quality cars
would like to persuade buyers that their car is better than average, but
the problem is that this statement is not credible. Sellers of low-quality
cars would make the statement and buyers would not be able to tell them
apart.
You might think that buyers and sellers should be able to write a contract
stipulating the quality sold, with appropriate penalties if the delivery
is later found to be of low quality. However, writing such contracts is
costly and only makes sense if they can be enforced. It is often very
difficult for a buyer, let alone a court, to assess quality accurately and to
determine whether any defect existed at the time of the sale or was caused
by negligent use. The adverse selection problem can be attenuated if
reputation is important, as is the case when a seller aims to repeatedly sell
to a given buyer, and by the use of warranties.
Example 6.2
Consider the example of home contents insurance. There is a large variance

geographically in burglary rates, even within cities. For concreteness assume
that a fraction ph of potential buyers of insurance expect a loss (which
becomes a claim if they are insured) of £400 per year and the remaining
potential buyers (p1) expect a loss of £100 per year. Since potential buyers
of insurance are risk averse, they are willing to pay a premium R which
is higher than their expected claims. Suppose the high claim individuals
are willing to pay a premium of up to £500 per year while the low claim
individuals’ reservation price is £130 per year. The insurance company tries
to gather personal information about the potential policy holders and does
not know for sure who the high and low claim individuals are. Therefore
we assume it has to set a uniform premium for all customers. Ignoring any
administration costs and assuming everyone is insured, the company has to
set the premium to cover its expected payout:
R ≥ 400ph + 100p1
As long as there are many low claim individuals this premium does not
exceed the low claim individuals’ reservation price:
400ph + 100p1 = 400 (1 – p1) + 100p1 < 130 for p1> 90%.
However, when there are too few low claim individuals, the premium
required by the insurance company to cover its cost would have to increase
to above £130. This implies that only high claim individuals buy insurance
at a high premium R > 400. Note that under perfect, symmetric information
everyone would buy insurance at the appropriate rate for their risk category.
However, because of the asymmetry of information, if the insurance
company continues to set the premium based on the average claim, it will
make losses since only the high-risk properties will be insured. So it must set
the premium based on the high risk clients and only these will be insured.
76
This illustration is another example of a lemons market. Because the

insurance company cannot perfectly discriminate between high and low
claim individuals, they can only offer one type of policy cover that may
appeal only to high-cost customers. Hence an adverse selection of the
population of potential policyholders chooses to purchase insurance. The
low cost customers suffer because they are priced out of the market.
6.2.2 The market for annuities

The market for annuities is another interesting illustration of adverse
selection. An annuity is a popular type of retirement product that converts
a certain amount of money (typically a personal pension fund) into a
constant income stream for the remainder of the individual’s life. The
way it works is that a pensioner gives an annuity provider, usually a life
insurance company, their pension fund accumulated over many years of
contribution to a personal pension plan. The insurance company in turn
promises to pay a fixed amount of money to them monthly for as long as
the person lives. Therefore the person is insured against the risk of living
too long and running out of money in the pension fund.
If the person knows more about their true health status than the insurance
company when they buy an annuity, then adverse selection may occur.
But notice that, from the insurance companies’ viewpoint, the high-risk
customers are those in relatively good health who will live a long time. In
effect, they will end up costing the company a lot of money as the monthly
payments will have to be made over a very long period. To complicate
matters even more, notice that it is generally much more difficult to
identify absence of health problems than to find them. People know a lot
about their own health status and particularly dietary and exercise habits,
whereas the insurance company can only imperfectly predict it through
the observed medical history and one-off health tests. Those individuals in
excellent health find annuities to be a fabulous product but they are the
customers with which the insurance company is more likely to make losses
over the life of the policy. Annuity rates based on the average mortality
rate will be a misleading indication of the actual experience of deaths
among the population of annuitants. This adverse selection problem may
be so severe that it can completely destroy the annuities market.
Problems of adverse selection can sometimes be overcome by compulsory
insurance regulation requiring, for example, everyone to take out medical
insurance or all homeowners to insure their homes. Until 2014 in the
UK market, it was compulsory for people to buy an annuity when they
retired. Some employers insure all their employees as one package to avoid
adverse selection problems. If everyone is insured, the high risk individuals
will be better off since they pay a lower premium. The low risk individuals
are not necessarily better off but they will get the insurance at a lower
premium than when the premium was based on only high risk individuals.
Whether low risk individuals are better off under this scheme depends on
how risk averse they are as the insurance they are offered is not actuarially
fair (premium > expected loss).
As another example of eliminating the adverse selection problem in this
way, consider extended five year or 50,000 miles warranties for cars.
These used to be purchased only by people who were likely to make
extensive use of the warranty. Now some manufacturers give this kind of
warranty as a standard feature and include its cost in the price of the car.
77
Example 6.3
The value of Target Ltd. under its current management is known only to the
current management team. EFM Ltd. is interested in taking over Target and
estimates that Target’s current value is 50, 60 or 75 (£ million) – all equally
likely – whereas, after takeover and under EFM’s management, the value
would be 50, 70 or 85 respectively. The procedure for the takeover bid is
that EFM makes an offer which Target can accept or reject. EFM only gets
one chance to make an offer. How much should they bid? Adverse selection
occurs because, for any bid EFM makes, Target will only be interested if it
has a low value (below the level of the bid). In fact we have an extreme case
of adverse selection here in that it prohibits trade altogether:
•• if EFM offer 50 it cannot make a profit since Target would only sell
if its value was 50
•• if EFM offers 60, Target sells if its value is 50 or 60 which gives an

expected gain to EFM of (1/3)(–10) + (1/3)(10) = 0
•• if EFM offers 75 then Target will accept the offer for sure but EFM
expects a loss: (1/3)(–25) + (1/3)(–5) + (1/3)(10) < 0.
In Example 6.3, a takeover bid is only accepted if the target’s value under
its current management is below it.
Activity
Show that if information were symmetric (i.e. if the bidder had equal access to
information about the target’s value as its current management), the inefficiency
associated with the absence of a takeover could be avoided.
6.3 Moral hazard

Moral hazard is another interesting problem that generally arises in the
insurance industry due to asymmetry of information. It is mainly about
incentive problems where one agent cannot observe the actions
of the other agent. This is why moral hazard problems are also known
as problems of hidden action. In the typical example, being insured
changes an individual’s behaviour. If someone has taken out insurance
for theft or collision he is likely to be more careless than when he was not
insured. People who buy mobile phone insurance are more likely to pay
less attention and forget their devices in a taxi or restaurant. Whereas the
term ‘adverse selection’ generally applies to characteristics or qualities of
one of the parties before a contract is entered into (pre-contractual
opportunism), ‘moral hazard’ describes situations in which one of
the parties misbehaves or takes actions that adversely affect the other
party after a contract is signed (post-contractual opportunism). A
restaurant which offers an all-you-can eat deal gets an adverse selection of
big eaters as its clientele. If a group of people eat out and decide to share
the bill equally, moral hazard implies that they are likely to overindulge.
If a company rewards employees based on seniority rather than
performance, it may get an adverse selection of low-achieving applicants.
When compensation is based on team performance rather than individual
performance, moral hazard leads to reduced individual efforts.
For example, governance weaknesses and moral hazard problems at
banks played a big role in the global financial crisis that began in 2007.
Banks perform a key role in the economy by intermediating funds from
retail savers and depositors to activities that support enterprise and help
78
drive economic growth. Their safety and soundness are key to financial
stability, and failures in the financial system may transmit problems
across the banking sector and the economy as a whole (i.e. they give
rise to externalities). The fact that governments and policymakers across
the globe considered some banks ‘too big to fail’ and stood ready to bail
them out with billions of pounds of taxpayers’ money, if necessary, led
to significant moral hazard on the part of banks. Due to this implicit
guarantee by the government, banks’ senior management did not have
the right incentives to manage their business prudently, maintain a
sound internal control system and avoid excessive risk-taking. Some of
the identified cases of misconduct by banks included the mis-selling of
financial products, misunderstanding of risks in their trading book, lax
credit controls and the manipulation of Libor and foreign exchange rates.
In the context of insurance business, if the insurer can observe the
behaviour of policyholders (e.g. where they park their cars or whether
they lock them – in the case of motor insurance; whether they smoke or
take drugs in the case of life insurance), it could group them in different
risk classes and set a different premium for each class. The problem is that
it is often impossible or very costly to monitor behaviour. Insurers cannot
observe all the relevant actions of those they insure. Therefore the basic
trade-off described above arises: full insurance means too little care will be
undertaken by individuals because they do not face the full costs of their
actions. To counteract the moral hazard problem in insurance, companies
often do not give complete insurance but use instead deductible provisions.
Example 6.4
Elmo wants to insure his car, of value V, against theft. Elmo who has wealth
W (this includes the value of his car) is risk averse and has a strictly concave
utility of money function U. Elmo knows he should really always lock his car
and fix the anti-theft device he keeps in his trunk. However, everything else
equal, he prefers to be lazy and leave the car unlocked. If he is careful his
car gets stolen with probability pf; if he is careless his probability of ending
up carless is p1( p1 > pf). If Elmo does not have insurance he will prefer to be
careful since:
(1 – pf )U(W) + pfU(W – V ) > (1 – p1)U(W ) + p1U(W – V ).
The insurance company is risk neutral and the insurance industry is assumed
to be perfectly competitive. This implies that profits are zero (the premium
is determined as the expected claim) and the insurance company offers Elmo
his utility maximising contract (R, D) where R is the premium and D is the
payment Elmo receives if his car gets stolen. If the insurer could observe
Elmo’s behaviour then it would maximise:
(1 – pi)U(W – R) + piU(W – V + D – R) subject to pi D = R, i = 1, f.
Substituting the constraint for R and setting the derivative with respect to D
equal to zero leads to:
(1 – pi)U′(W = pi D)(–pi) + piU′(W – V + D – pi D)(1 – pi) = 0
so that D = V or, in words, the insurer offers full insurance. (No surprises
here – we’ve seen this in Chapter 2 on decision analysis!) Elmo ends up with
utility U(W – R) and will choose to be careful and pay a low premium.
Assume now that the insurer cannot observe its client’s behaviour. If it offers
full insurance, Elmo is going to be careless given any premium R he is asked
to pay since, once he is insured, his expected utility is U(W – R) whether he
79
is careless or not. The insurance company anticipates this behaviour and

therefore has to set the premium accordingly: R = p1V. Will Elmo accept this
contract? It depends on whether his expected utility without insurance (and
with carefulness) exceeds the expected utility of the insurance contract:
(1 – pf )U(W ) + pfU(W – V ) > = < U(W – p1V )
For example if U(x) = ln(x) then the equation above reduces to:
(1 – pf )ln(W ) + pf ln(W – V ) > = < ln(W – p1V )
For W = 10,000; V = 7,000; pf = 0.01 and pi = 0.015 Elmo would insure.

If p1 = 0.05, Elmo would not insure.
This type of market failure is however easily remedied through the use of a
deductible. If the insurance company does not offer full insurance but sets
D < V, then if Elmo buys insurance his expected utility:
(1 – pi)U(W – R) + piU(W – V + D – R)
is decreasing in pi and Elmo therefore has an incentive to be careful. The

insurance company can now afford to base its premium on anticipated
careful behaviour (i.e. R = pf D). Note that the size of the deductible is
unimportant; in fact, for utility maximisation, we want D as close to V as
possible but not equal to it.
In this insurance example, inefficiency results from the policyholder’s

inability to commit to careful behaviour after he has purchased a full
cover policy. The customer would like to buy more insurance, and the
insurance company would in principle be willing to provide more cover
if the customer continued to take the same amount of care. However, in
the above example this cannot occur because if the customer was able to
insure fully against the loss then they would rationally choose to take less
care.
If the insurance company offers a policy with a deductible then the client
is in some sense worse off because he is risk averse and would rather
ensure 100 per cent. However, the inability to commit to careful behaviour
ceases to be a problem. By altering the insurance contract slightly from the
full cover format, the client’s incentives have changed dramatically and he
is ultimately better off than under the full cover policy! What drives the
change in behaviour is that the policyholder now has some stake in the
game since he’s also directly impacted by a potential theft.

This chapter analysed two basic types of problems that exist in markets
characterised by the presence of asymmetry of information: adverse
selection and moral hazard. We considered the standard ‘lemons’ case and
different insurance markets to illustrate the adverse selection problem. The
problem of moral hazard and the use of insurance deductibles to mitigate
it were then examined.

• give examples (preferably your own) of adverse selection and
moral hazard
80
• discuss how adverse selection in insurance can lead to low-risk

individuals being priced out of the market and explain the use of a
partial cover insurance policy in this context
• explain the conceptual difference between pre-contractual
opportunism and post-contractual opportunism
• identify other real-life markets where asymmetric information exists,
and rationalise measures used by market participants to reduce the
effects of information asymmetries on efficient trade.

You should try to answer the questions at the end of Chapter 7 of the
subject guide to check your understanding of the learning outcomes of the
two chapters on asymmetric information.
81
Notes
82
Chapter 7: Asymmetric information II
7.1 Introduction
This chapter builds on the topic of asymmetric information discussed in
the previous chapter and considers two applications of the hidden action
and hidden information problems: signalling and principal-agent
relationships.
In situations of adverse selection or moral hazard, the informed party
may have an incentive to reveal his information to the uninformed party.
A seller of high-quality used cars could certainly do better if they could tell
potential buyers that their cars are indeed of high quality. However, just
posting a sign saying ‘I sell good cars’ will not achieve very much. For the
customers to believe the seller, the seller has to prove in some way that
their cars are good. They could do this by offering a warranty. Clearly, if
offering a warranty is only profitable when the cars are of good quality
(i.e. a seller of ‘lemons’ would make a loss if they offered a warranty), then
the warranty is a credible signal of good quality.
Similarly, firms which have low costs might want their potential
competitors to know this for entry deterrence purposes. Entry into the
market may only be profitable if the incumbent has high costs. A low-cost
incumbent can signal through limit pricing, which would be unprofitable
for a high-cost incumbent. Advertising can also have a pure signalling
purpose. For some goods, advertisements do not tell customers anything
other than that a good is for sale. The explanation might be that the
seller feels so confident about the quality of the product that they predict
that the customer who tries it will become a regular buyer. Indeed, if
customers do not make repeated purchases, the seller could not recuperate
the advertising expenditure. Generally, the cost of signalling should be
lower for the higher quality parties. It should not pay for the lower quality
parties to pretend to be high quality by imitating the behaviour of high-
quality parties.
Principal-agent relationships are an important class of moral hazard
problems in which one party – the principal – hires another party – the
agent – to take certain valuable actions. The asymmetry arises because the
agent is generally assumed to have more information than the principal.
In particular, the agent knows how much or how little effort he made in
pursuing the principal’s objectives. Since the principal and the agent have
different objectives (i.e. a conflict of interest), the agent has to be given
appropriate incentives to act in the principal’s interest in order to avoid or
limit the moral hazard problem.
One of the most important principal-agent structures encountered in
business is that between the owners of a firm and its managers. The
owners are typically shareholders who are interested in maximising the
firm’s value (i.e. equity price and dividends) but are not directly involved
in the daily running of the company. Managers, on the other hand, are
the ones running the business on a daily basis and may have limited
or no ownership whatsoever of the company stock. The principals are
the shareholders and the agents are the managers. The question that
arises in this context is: ‘Are the managers going to run the business and
make decisions that put shareholders’ interests at the heart of what they
do?’ Rather, managers may be interested in job security, they may be
excessively risk averse to avoid corporate failure or inclined to pursue
83
value-destroying acquisitions to manage a bigger business. These activities

have the potential to destroy shareholders’ value and therefore appropriate
incentive mechanisms need to be created to align the interests of executive
management with those of the owners. Similar principal-agent issues
appear repeatedly in managerial economics and you will come across
several applications of this concept throughout the course.

• the difference between signalling and screening
• the main features of principal-agent relationships in economics
• the relevance of the participation and incentive compatibility
constraints in the principal-agent problem.

• explain Spence’s education as a signal model and work out an
example
• analyse a simple principal-agent problem when effort is not
observable and output is stochastically related to effort
• apply the insights of principal-agent models to other economic
problems.

Norton and Co., 2014; 9th edition) Chapter 38: Asymmetric Information.

Spence, M. Market signalling: informational transfer in hiring and related
screening processes. (Cambridge: Harvard University Press, 1974)
[ISBN 9780674549906].
Rothschild, M. and J. Stiglitz ‘Equilibriun in competitive insurance markets:
an essay on the economics of imperfect information’, Quarterly Journal of
Economics (91) 1976, pp.629–49.

The chapter builds on our discussion of asymmetric information in the
previous chapter by considering signalling and screening models, and the
main differences between these two types of hidden information problems.
It also analyses the case of education as a signal and the principal-agent
problem.
7.2 Signalling and screening

Recall the ‘lemons’ problem discussed in the previous chapter: the owners
of the used cars knew their quality, but the potential buyers didn’t. We saw
that in this context the adverse selection problem may seriously undermine
the number of transactions being made. In extreme situations, the whole
market may collapse, leading to economic inefficiency since socially
valuable trades would not take place. However, the owners of the good
cars certainly have an incentive to try to convey to the potential buyers
the fact that they have a good car. They would like to choose actions that
signal the quality of their car to those who might buy it. As explained
84
in the Introduction, one sensible signal in this context would be to offer

a warranty, which is a promise to pay the purchaser some agreed upon
amount if the car turns out to be a lemon. So long as the owners of lemons
find it prohibitively expensive to provide such a warranty, the signal works
and would make the market perform better.
In hidden information problems, the uninformed party also usually has
an incentive to proactively seek additional information. There are certain
measures the uninformed party can take to alleviate the asymmetric
information problem. When the uninformed party engages in activities to
find out the other party’s private information it is said to be screening. So
the distinction between screening and signalling is that screening is done
by the uninformed party while signalling is done by the informed party.
Banks and insurance companies can try to identify risk classes. Car insurers,
for example, look at a driver’s past record, age and gender, whether the
car owner has a garage, etc. Business premises with fire sprinkler systems
can get a fire insurance policy with a lower premium. Similarly, smokers
pay more for medical insurance. For some policies, potential clients have
to undergo a medical examination and insurance can be refused based
on the outcome of this examination. Banks use sophisticated multivariate
statistics to assess borrowers’ credit histories and predict their probability of
defaulting on a loan. Used car buyers in the UK can get an AA (Automobile
Association) inspector to check the car before purchase.
If characteristics of customers are unobservable, firms can use self-
selection constraints as an aid in screening customers to reveal private
information. For example, consider the phenomenon of rising wage
profiles where workers get paid an increasing wage over their careers. An
explanation may be that firms are interested in hiring workers who will
stay for a long time. Especially if workers get training or experience which
is valuable elsewhere, this is a valid concern. A firm will then pay workers
below the market level initially so that only ‘loyal’ workers will self-select
to work for the firm.
7.2.1 Education as a signal

The classic example of signalling, first analysed by Spence (1974), is
one in which high productivity individuals try to differentiate themselves
from low productivity individuals by investing in education. The firm
cannot distinguish between high and low quality workers but the workers
themselves know their abilities. As we will show in the following example,
good workers can use education as a signal of productivity since only the
most productive workers invest in education. In other words, the signalling
cost to the good workers is lower than to the low productivity workers
and this is precisely what makes the signal credible. Therefore the two
types of workers can be identified because they make different educational
choices and this is observable to the hiring firm – the uninformed party in
this context. The attained educational level allows the firm to distinguish
between the two types.
Example 7.1
When workers enter their first job, it is difficult to estimate their

productivity. Assume that workers know their own productivity but firms
do not and that a high productivity worker is worth £30,000 per year and a
low productivity worker is worth £15,000 per year to the firm. There are as
many high productivity workers as there are low productivity workers.
85
If the labour market is competitive, competition between firms drives up

the wage to:
(0.5) £15,000 + (0.5) £30,000 = £22,500.
High productivity workers would like to convince the firm that they are
indeed worth more than average. An opportunity to do exactly that may
exist if workers can invest in education before they apply for a job. The
employer, if he is convinced that workers who are educated are also
highly productive, will pay £30,000 if the worker is educated and £15,000
otherwise. The cost of a university education to an individual consists of
£15,000 tuition fees and living expenses (in excess of the government
subsidy) plus an opportunity cost of £45,000 (i.e. three years of wages
foregone while studying) plus a cost of effort. (This last cost varies for
high and low productivity individuals.) Let’s say that high productivity
workers are intelligent and actually enjoy studying so that their cost of
effort is zero whereas low productivity workers find studying extremely
strenuous and they value the cost of effort involved in getting a university
degree at £50,000. Hence the total cost of education is £60,000 for a high
productivity worker and £110,000 for a low productivity worker.
For simplicity we assume that university education has no effect on

productivity and we ignore what happens after a worker leaves his first
job. If workers expect to stay in their first job for five years, signalling is
effective. If firms pay university graduates £30,000 and others £15,000,
all high productivity workers get a university degree and none of the low
productivity workers go to university. To check this, we have to show that a
high productivity worker gains from getting a degree (see (a) below) and a
low productivity worker does not (see (b) below):
(30,000) (5) – 60,000 = 90,000 > (15,000) (5) = 75,000 (a)
(30,000) (5) – 110,000 = 40,000 < (15,000) (5) = 75,000 (b)
We have found a separating equilibrium in which the two types of

workers are identified through signalling. In this example, education is
beneficial to the high productivity workers but wasteful for society as a
whole in the sense that, under perfect, symmetric information its cost could
be avoided. It is useful only as a signal here.
You should be able to show that, if the expected tenure for the first job
is less than four years, signalling does not pay and no worker gets a
degree. In this case we find a pooling equilibrium in which the two types
of workers use the same strategy and are paid £22,500. Similarly, if the
expected tenure is long enough, say eight years or more, signalling will not
work because everyone would prefer to get a degree and earn £30,000.
Firms which want to break even cannot pay the high salary to graduates in
this case and as a result nobody gets a degree.
Note that the high productivity workers are negatively affected by the
existence of low productivity workers. Either they have to invest in
signalling (in a separating equilibrium) or they get a wage below their
productivity (in a pooling equilibrium). This type of externality is an
important aspect of the adverse selection problem.
Although the wage differential between university graduates and others

is large in many countries, thus supporting the above model of education
as a pure signal, there may be other valid reasons for the existence of
this differential. Namely, people increase their productivity at university
by learning technical knowledge, social and computer skills valued by
86
employers. At the same time, the sectors of the economy which employ
unskilled workers tend to see fiercer foreign competition from low-wage
countries that drives down wages. There are also other reasons to doubt
that education is just a signal. In reality, education has other social
benefits such as increased productivity, personal satisfaction, formation of
better citizens and the potential to better sort future workers into different
kinds of jobs. Despite all this, the asymmetry of information means that
people may overinvest in their education as a labour market signal.
7.2.2 An insurance menu

Uninformed parties can screen their counterparties by offering a menu
of choices or possible contracts to prospective (informed) trading
partners who ‘self-select’ one of these offerings. This type of screening
was developed in an insurance context by Rothschild and Stiglitz (1976).
They show that, if the insurer offers a menu of insurance policies with
different premiums and amounts of cover, the high risk clients self-select
into a policy with high cover. Example 7.2 illustrates how, in an insurance
market, inefficiency due to adverse selection can be ameliorated through
the insurance company offering clients two contracts: a low premium,
partial cover policy and a high premium full cover policy.
Example 7.2
Assume there are no moral hazard problems (i.e. individuals do not

have any control over their probability of a claim). There are low risk
and high risk individuals (all risk averse) with claim probability pl and ph
respectively. (The insurer knows pl and ph but he does not know who the
low risk and high risk individuals are.) For simplicity we assume that low
risk and high risk individuals are identical with respect to initial wealth W,
size of the potential loss V and utility function U.
If the insurance company offers a policy (R, D) where R is the premium and
D is the payment when the policyholder suffers a loss, then it is possible
that only the high risk individuals are insured (see Example 7.2). Suppose
now that the insurance company offers a menu of two policies, a low
premium policy with a deductible (Rl, Dl) and a high premium policy with
no deductible (Rh , V). The purpose of these two policies is to get clients to
self select such that the low risk group chooses the first policy and the high
risk group the second. Assuming, as before, that the insurance industry is
competitive and therefore profit on any policy is zero, the premiums are set
according to Rl = plDl and Rh = ph V.
Clearly, the low risk group prefers the fair (premium equal to expected
claim) insurance (Rl, Dl) to no insurance. Similarly, high risk individuals
prefer (Rh, V) to no insurance. What is most important though is that the
high risk group prefers (Rh, V) to (Rl, Dl). If it prefers the contract designed
for the low risk group then the insurance company cannot break even. So
we need:
U(W – Rh ) > (1 – ph ) U(W – Rl ) + ph U(W – Rl + Dl – V ). (*)
The left hand side of this inequality is the expected utility to a high
risk individual if he chooses policy (Rh, V) and the right hand side is his
expected utility if he chooses policy (Rl, Dl). Given that Rl = pl Dl and Rh =
ph V, this puts a constraint on the design of the menu of policies in the form
of an upper bound on Dl. The existence of the high risk group imposes a
policy with a deductible on the low risk group. For the parameter values
87
corresponding to the car theft insurance of Example 6.4 (W = 10,000, V

= 7,000), U(x) = ln(x), pl = 0.01 and ph = 0.1, the premiums are Rh =
(0.1)(7000) = 700 and Rl = (0.01)Dl. The inequality (*) for these values
reduces to:
ln(10,000 – 700) > (0.9) ln(10,000 – 0.01 Dl) + (0.1) ln(10,000 – 0.01 Dl + Dl – 7,000)
or
Dl < 1945.
The low risk group cannot be offered more than a 28 per cent
(1,945/7,000) partial cover.
As we have seen in Example 7.2, insurance companies can overcome the

situation in which the bad risks crowd out the good ones, by designing
separate insurance policies for the different risk groups. Although the
insurer cannot prevent a high risk client from buying a policy designed for
a low risk client, it is possible to deter him by choosing the parameters of
the policies carefully, and in particular by using a deductible in the policy
designed for the low risks. Offering partial cover to the low risk group is
only a partial(!) solution to the adverse selection problem since the low
risk group would prefer a full cover policy. The low risk group still suffers
from the existence of the high risk group but at least it is not priced out of
the market anymore.
7.3 Principal-agent problems

We now turn to the study of incentive systems. The question you will
be trying to answer is ‘How can I get someone to do something for
me when that person needs to be given incentives to do so?’ We try to
answer this important question using the specific theoretical framework
of a principal-agent problem. Designing appropriate incentive systems
is of great practical importance. As a result of the global financial crisis
that started in 2007, for instance, the international banking regulators
have approved new governance and capital adequacy requirements
intended to prevent excessive risk-taking in loan and investment activities
by banks. Poorly designed incentive mechanisms and remuneration
practices were considered to be at the heart of the behavioural problems
that led to the financial crisis. But conflicts of interest are not confined
to the financial sector – they typically arise in most professions. Would
doctors, for example, over-prescribe drugs because their income is partly
dependent on prescription? Is it conceivable that primary school teachers
concentrate their effort and attention on gifted pupils to the detriment
of less able ones because their personal appraisals depend largely on
examination results? Will a lawyer be tempted to advise her client to go
to trial (which enhances the visibility of the lawyer) rather than to accept
a good settlement offer out of court? We face such basic conflicts in most
professions.
In the standard context in which the principal-agent problem is studied,
an employer (the principal) hires a worker (the agent) to do a particular
job which results in a benefit to the employer. Generally, the employer
benefits from high effort levels (i.e. the more effort, the more output), but
the worker dislikes providing much effort. The key features of a principal-
agent problem are therefore the following:
• The agent supplies effort in order to produce some valuable output.
• The agent’s effort level typically is not observed by the principal.
88
• The principal pays the agent and receives the output.

• The agent’s pay can be related to output (i.e. performance-related
pay).
A moral hazard problem arises when, if the worker is not monitored or
given appropriate incentives, he will shirk. If the effort was observable by
the principal, the principal could simply require a certain level of effort,
verify that it has been delivered and compensate the agent accordingly.
The problem is that effort is not always observable and measurable. When
the agent’s effort cannot be perfectly monitored, the principal has to
design an incentive mechanism through rewards that align the interests of
the two parties. In this way, even if the principal cannot directly monitor
the agent’s effort level, he knows the agent has an incentive to behave in
the way that it is expected.
7.3.1 Effort can be observed

It may be easier to start the analysis by considering the simpler case where
the agent’s effort level is assumed to be observable by the principal. This is
unrealistic but will nevertheless help us set the scene for the more complex
scenarios.
When the employer can observe the worker’s effort, or when there is
a deterministic relationship between effort and performance, it is not
difficult to find an incentive scheme which motivates the worker to
provide the ‘optimal’ effort. Suppose the worker generates a profit P(e)
for the employer if he works for e hours. The cost (monetary equivalent of
his disutility) to the worker of working e hours is C(e) and, if the worker
does not work for this employer, he can get an alternative job which gives
him a utility (in money terms) of u. The employer chooses the effort he
wants the worker to exert to maximise his profit minus the payment to the
worker, taking into account the worker’s reservation utility u and the fact
that it should be in the worker’s interest to make the effort chosen by the
employer. The following simple payment schemes motivate the worker to
provide the efficient amount of effort.
Payment based on effort

If the principal can observe the effort provided by the agent, the principal
can reward the agent directly in relation to the effort. Specifically if the
worker is paid based on his effort e according to we + K (with w and
K as constants), the employer’s problem is: max P(e) – (we + K). The
employer has to take into account the participation constraint or
the individual rationality constraint (i.e. the worker only works if
he gets at least his reservation utility: we + K – C (e) ≥ u). The employer
has no reason to give the worker more than his reservation utility and so
his objective becomes, after substituting the participation constraint, max
P(e) – (C(e) + u). The employer chooses the optimal effort e* such that the
marginal profit of effort equals its marginal cost: P′(e*) = C′(e*) . The
worker has to be encouraged to provide the optimal effort level which
leads to the incentive compatibility constraint: the worker’s net pay-
off we + K – C (e) should be maximised at the optimal effort , that is
w = C′ (e*). We can conclude that the worker is paid a wage per hour
equal to his marginal disutility of effort and a lump sum K which leaves
him with his reservation utility.
Forcing contract
The employer could propose to pay the worker a lump sum L which gives
him his reservation utility if he makes effort e* i.e. L = u + C(e*) and zero
89
otherwise. Clearly, the participation and incentive compatibility constraints

are also satisfied under this simple payment scheme. This arrangement is
called a forcing contract because the employee is ‘forced’ to make effort
e*. That is, the expected effort level is contractually specified. In ‘payment
based on effort’ and ‘franchise’, the expected effort level is not specified
contractually and the worker can choose how much effort he wants to
exert. The incentive mechanism ensures that it is in the agent’s best
interest to voluntarily choose the effort level that the principal prefers.
Franchise
Suppose the worker keeps the whole profits of his efforts in return for a
certain lump sum payment to the principal. This can be interpreted as a
franchise structure. How should the ‘employer’ set the franchise fee F? The
worker now maximises P(e) – C(e) – F and therefore chooses the same
optimal effort as before: e* such that P'(e*) = C'(e*). The principal can
charge a franchise fee which leaves the worker with his reservation utility:
F = P(e*) – C(e*) – u.
7.3.2 Effort cannot be observed

When the effort can be observed or when output or profit can be observed
and there is a deterministic relationship between effort and output/profit,
the moral hazard problem underlying principal-agent problems is easily
solved, as we have seen above. However, when the employer cannot
observe the agent’s effort the problem becomes much more complicated.
In these cases it is difficult to reward or penalise directly because
principals can only imperfectly infer the level of effort.
Suppose the employer can observe output but output or profit is only
stochastically related to effort. In other words, output could be high due
to high effort or simply good luck. Payment based on effort is out of the
question because effort is not observed by the principal, so what about
payment based on output? The employer could, for example, use the
franchise solution. However, if the worker is risk averse, he will need to
be compensated for taking on risk. Even when he makes a large effort, his
profit could be low if he is a franchisee. The employer, on the other hand,
is more likely to be risk neutral and willing to carry this risk. The franchise
solution is inefficient here. I hope an example will clarify this.
Example 7.3
Assume the agent’s (worker’s) utility, as before, depends on his pay w

and his effort level e. For simplicity let U(w,e) = √w – e. The principal
(employer) is risk neutral. The agent can decide to shirk or not; shirking
corresponds to e = 0 and not shirking corresponds to e = 8. The agent
generates a revenue of £0 or £10,000 for the principal, with probabilities
given in Table 7.1. Thus note that revenue could be high even when the
agent puts in a low level of effort (e.g. a booming economy). You could
think of the agent as a salesperson whose effort is important in getting a
sale worth £10,000.
Revenue for principal

0 10,000
e = 0 (shirk) 1/2 1/2
e = 8 (work) 1/3 2/3
Table 7.1: Probabilities of generating low and high revenue
90
Of course, when the agent is not shirking, the principal’s chance of earning
the £10,000 revenue is higher. Suppose the agent’s reservation utility is u
= 8 then, if the principal could observe the agent’s effort level, how much
would he have to pay to elicit e = 0? For e = 0, the agent’s utility in this
job is √w and for this to exceed u = 8 we need to pay him w ≥ 64. If the
principal wants to elicit effort level e = 8 which gives utility √w – 8 to the
agent he needs to pay w ≥ 162 = 256. You should be able to show that a
risk neutral principal, who can observe effort, will elicit the high effort.
Suppose now that the principal cannot observe effort. An obvious method
to reward the agent is to pay him based on his ‘performance’ (i.e. pay
him x if the revenue to the principal is 0 and y if he secures a revenue of
£10,000). Assume the principal cannot pay a negative amount (x, y ≥ 0).
How should the principal determine the appropriate payment scheme (x,
y) if he wants to make the agent work? First of all, he wants to prevent the
agent quitting his job or, in other words, the participation constraint should
be satisfied:
(1/3)U(x, 8) + (2/3) U(y, 8) ≥ 8, or
(1)
(1/3)(√x – 8) + (2/3)(√y – 8) ≥ 8.
Also, given the compensation scheme (x, y) the agent should prefer
working to shirking (i.e. the incentive compatibility constraint should be
satisfied):
(1/3) U(x, 8)(2/3) U(y, 8) ≥ (1/2) U(x, 0) + (1/2)U(y, 0), or
(2)
(1/3)(√x – 8) + (2/3)(√y – 8) ≥ (1/2) √x + (1/2) √y.
The constraints (1) and (2) can be rewritten as:
√x + 2√y ≥ 48 and – √x + √y – 48 ≥ 0.
respectively. Therefore the area above the upwards sloping line in Figure
7.1 represents the set of feasible compensation schemes.
1/2
y
(2)
48
24
(1)
1/2
48 x
Figure 7.1: Feasible compensation schemes
The risk neutral principal will want to maximise his expected revenue
which, given that the agent works, equals:
(1/3)(0 – x) + (2/3)(10,000 – y).
Maximising this is equivalent to minimising 2y + x which is achieved (over

the region of feasible compensation schemes) at √x = 0 and √y = 48. This
indicates that the principal should pay the agent only when he secures
the £10,000 revenue and then the payment should be 482 = 2,304. The
principal thus expects a net revenue of:
(2/3)(10,000 – 2,304) = 5,130.67
91
which exceeds his expected net revenue of inducing no effort:
(1/2)(0) + (1/2)(10,000) – 64 = 4,936.
The principal will therefore motivate the agent to work.
The agent receives expected utility equal to his reservation utility of 8

when his effort can be observed. When effort is unobservable, his expected
utility is (1/3)(0 – 8) + (2/3)(48 – 8) = 24. His expected wage is also
higher when effort cannot be observed: (1/3)(0) + (2/3)(2304) = 1536
> 256. This higher expected wage is necessary to compensate the agent
for carrying risk. Ideally the principal should carry all risk since he is risk
neutral but, if the agent is paid a fixed wage, inefficiency results due to
moral hazard.

This chapter considered signalling and screening models, the case of
education as a signal in hidden-information problems and the principal-
agent problem.

• explain Spence’s education as a signal model and work out an
example
• analyse a simple principal-agent problem when effort is not
observable and output is stochastically related to effort
• apply the insights of principal-agent models to other economic
problems.

1. The value of a four-year-old Honda Accord to the owner is uniformly
distributed between £3,800 and £5,800. Whatever the value to the
owner is, the car is worth £200 more to a potential buyer. There are
many potential buyers for a four-year-old Honda Accord. Find the
equilibrium price.
2. A travel agent sells holidays to the Cayman Islands. Consumers are
willing to pay £1,400 if the holiday is excellent and £800 if the holiday
is mediocre. The travel agent knows the quality of the holidays he sells
but the consumer does not.
a. If a fraction x of travel agents sell excellent holidays, how much is
a risk neutral consumer willing to pay for a holiday?
b. Suppose it costs a travel agent £1,000 to book a mediocre holiday
and travel agents are perfect competitors. Is there a market
equilibrium in which all holidays are mediocre?
92
c. Suppose it costs a travel agent £1,000 to book a mediocre holiday

and £1,100 to book an excellent holiday. Is there an equilibrium in
which all holidays are excellent?
d. Suppose it costs the travel agent the same amount, £1,000, to book
a mediocre or an excellent holiday. Find the market equilibrium
(equilibria). How much consumer surplus is generated at the
equilibrium (equilibria)?
e. For the scenarios of (c) and (d), if it were possible, would it be
good competition policy to ban the sale of mediocre holidays?
f. How can the inefficiencies resulting from asymmetric information
be avoided in this context?
3. McClean & Co. and McDirty & Co. are in the entertainment business.
McClean is interested in taking over McDirty. It does not know
McDirty’s value v under its current management but believes it to be
between £3 million and £4 million, all values equally likely. The value
v is known only to McDirty’s management team who will decide on
any takeover bid. Whatever the value v is, the company is worth 1.5v –
£1.5 million to McClean.
a. Draw the value to McClean as a function of v and conclude that
McDirty is always worth more in McClean’s hands than under its
current management.
b. McClean has one chance to make a takeover bid p which McDirty
will accept or reject. What is the expected gain to McClean of
offering £3.5 million?
c. What is the optimal takeover bid?
4. Consider Spence’s signalling model and allow workers to choose their
number of years of education before they start working. Eighty per
cent of the workforce is intelligent and highly productive whereas
the remaining 20 per cent is not intelligent and unproductive. The
intelligent workers are worth £50,000 per year to the employer and
the others are worth £20,000 per year, which is what their salary
would be if the employer could tell them apart. The cost of education
is £10,000 per year for an intelligent student and £20,000 per year
for a less intelligent student. You should add the opportunity cost of
not working while studying to these numbers. Assume that the less
intelligent workers decide to get zero education.
a. Ignoring discounting, and assuming the expected length of the job
is four years, how much education should the intelligent workers
get for their education to be a credible signal of their productivity?
b. Show that everyone would be better off without signalling.
5. Martha has a disutility of effort function C(e) = e2/2 (e is the number
of hours she works) and reservation utility u = 0. I am a risk neutral
distributor of Finnish vodka and want Martha to work for me. For
every hour she works, I make a profit of m on average. I can observe
how many hours Martha works and thus pay her based on her effort.
a. What is the optimal wage labour contract w(e) = we + K, where w
is a per hour wage and K is a lump sum.
b. Martha wants to buy the franchise from me. How much could I get
her to pay for it?
c. Next year Martha graduates and she will be able to get a better
job. This will increase her reservation utility to u = 2. How does
that affect the answer to (a) and (b)?
93
6. A risk neutral principal hires a risk averse agent to do a job. The

agent’s utility function is U(w,e) = √w – (e – 1) where e is the agent’s
effort and w is his compensation and the agent has a reservation utility
u = 1. The agent decides to work hard (e = 2) or shirk (e = 1). The
principal’s revenue depends on the agent’s efforts but also on random
factors outside the agent’s control. The probabilities of obtaining
revenue 10 or 30 are as indicated in the table below.
Revenue
R = 10 R = 30
e=1 2/3 1/3
e=2 1/3 2/3
a. Calculate the expected revenue if the agent works hard and if he

shirks.
b. If the principal could observe effort, how much would she have to
pay to get the agent to work hard? To get the agent to make a low
effort? What is her net revenue in either case? What is the optimal
forcing contract?
c. Suppose the principal can only observe revenue, not effort, and
so has to pay the agent more for the high revenue than for the
low revenue if she wants the agent to work hard. Write down the
participation and incentive compatibility constraints. Draw these
constraints and indicate feasible combinations of pay levels for
high and low revenue.
d. Write the principal’s objective function as a function of the pay
levels for high and low revenue. What is the optimal compensation
scheme? Calculate the agent’s expected utility and his expected
wage and make a comparison with (b).
e. Check that motivating the high effort is worthwhile for the
principal.
94
Chapter 8: Demand theory
8.1 Introduction
The objective of this chapter and the next one is to guide you through
some fundamental concepts in the economic theory of demand and
consumer choice. You will have already studied many of the key concepts
of consumer choice in your introductory microeconomics course, so
our treatment of the standard theory here will be brief. The focus will
be mainly on reviewing some key insights of this framework to help us
examine specific applications to demand theory and managerial economics
issues.
Consumer theory deals with individual consumers’ choice of how to
spend their income. The standard model of consumer choice assumes that
consumers have consistent preferences that can be modelled using the
concept of a utility function. They maximise this utility function subject
to a budget constraint, that is, consumers choose their most preferred
bundle of goods from their budget sets. In addition to a brief review of this
standard model, this chapter and the next discuss important applications
of consumer choice to finance, welfare economics, uncertainty,
intertemporal decision-making and labour supply.

• the decomposition of the price effect into income and substitution
effects (Hicks and Slutsky methods)
• the concepts of equivalent variation (EV) and compensating
variation (CV)
• ways to assess the change in consumer welfare as a result of changes
in the price of goods
• the concept of elasticity and the relationship between price elasticity
and the effect of a price change on revenue
• the relationship between price elasticity and the optimal markup.

• derive demand functions given a utility function
• derive the Slutsky equation
• derive Slutsky and compensated demand functions and explain
their use
• analyse qualitative changes in consumer welfare
• calculate elasticities.

Norton and Co., 2014; 9th edition) Chapter 5: Choice, Chapter 6: Demand,
Chapter 8: Slutsky equation, Chapter 14: Consumer’s surplus and Chapter
15: Market demand.
95

Besanko, D., R. Braeutigam and K. Rockett Microeconomics. International
student version. (Singapore: John Wiley & Sons, 2015) 5th edition
[ISBN 9781118716380] Chapter 5: The theory of demand.
Biddle, J.E. and D.S. Hamermesh ‘Sleep and the allocation of time’, Journal of
Political Economy 98(5) 1990, pp.922–43.

This chapter uses the consumer theory concepts of utility function
and indifference curves to derive the Slutsky and Hicks approaches to
measuring substitution effects along a demand curve. It also discusses
ways to measure the welfare effects of a change in price and the important
concept of price elasticity of demand.
8.2 Reviewing consumer choice

Make sure you know what is meant by the following terms:
•• utility function and indifference curves
•• normal, inferior and Giffen goods
•• goods that are perfect complements (L-shaped indifference curves)
•• goods that are perfect substitutes (linear indifference curves)
•• goods that are ‘bads’.
8.2.1 Utility, budget constraint and demand

You should know how the budget constraint is affected by taxes, quantity
discounts and vouchers. A voucher is an income transfer which can be
spent on a particular good.
You should remember how demand for a good can be derived from the
utility maximisation problem subject to a budget constraint. For the
two goods case, at an interior solution, the optimality condition for
consumer choice is that the marginal rate of substitution (MRS) equals
the price ratio. The condition that the MRS must equal the slope of the
budget line at an interior optimum implies that the ratio at which goods
can be exchanged in the market coincides with the personal rate at which
the consumer is also willing to exchange them. If this wasn’t the case,
the consumer wouldn’t be at her optimal choice. In a corner solution,
however, one of the goods is not consumed. If the goods are perfect
substitutes you will always find a corner solution unless the price ratio
equals the marginal rate of substitution in which cases, there are many
solutions. You should be able to derive consumer demand algebraically.
The demand function is the function that relates consumers’ optimal
choice – the quantities demanded – to the different values of prices and
income. We recommend you study the derivation of the demand function
for Cobb-Douglas utility U(x1, x2) = x1cx2d in Varian (2014) in Chapter 5,
Choice. The resulting demand functions are given by:
cm dm
x1 = and x2 = , where m is income.
[(c + d ) p1] [(c + d ) p2]
Note that for Cobb-Douglas utility the expenditure shares of each good are
constant (i.e. p1 x1 /m = c/(c + d) and p2 x2 /m = d/(c + d ) do not vary
with prices or income). Empirically this implies that we may be justified
in assuming Cobb-Douglas utility if the fraction of their income which
consumers spend on various products is relatively stable. Once we know
96
a consumer’s utility function we can assess how he is affected by price

and income changes; this is useful in evaluating managerial and policy
decisions regarding pricing and taxation for example.
Once you know how to derive individual demand curves, it is relatively
easy to determine market demand. For any given price, market demand
is the horizontal sum of the individual demands. In other words, to find
market demand add individual demands horizontally.
8.2.2 Slutsky and Hicks

As required background knowledge to understand this section, you should
make sure you know what is meant by:
• normal good (note that a good can be normal at some income levels
and inferior at others)
• inferior good
• Giffen good.
Very often we are concerned with how consumers’ behaviour changes in
response to changes in the economic environment. For example, managers
in the retail sector would like to predict how demand may be affected
by seasonal factors, changes in the macroeconomy, promotional offers
introduced by competing brands or changes in the price of their own
product. In this section we will restrict ourselves to considering the case
of how a consumer’s choice of a good is likely to respond to changes in its
price.
When the price of a good changes relative to prices of other goods, there
are two separate effects on demand. On the one hand is the substitution
effect, which represents the fact that the rate at which you can trade off
the good under study with another good has changed. If, for example,
good 1 becomes cheaper relative to other goods, it means that now you
have to give up less of other goods to purchase good 1. The rate at which
you can substitute other goods for good 1 has changed. On the other hand
is the income effect, which represents the idea that your purchasing
power increases after a price decrease and decreases after a price increase.
As good 1 becomes cheaper, your monetary income hasn’t changed but
your purchasing power goes up because you can now buy the same basket
of goods as you did before the price decrease and still have money left
over to buy more goods. This change in purchasing power affects the
consumer in much the same way as a change in income would – it leads
to a higher or lower level of utility depending on whether prices have
decreased or increased.
Obviously the substitution and income effect occur simultaneously when
the price of a good changes and we only observe the change in consumers’
purchasing behaviour (i.e. the movement of the consumer from the initial
basket to a final basket). For analytical purposes this total change in
consumption can be broken up into its two components – the substitution
effect and the income effect – but it is worth bearing in mind that the
distinction between these two effects is somewhat abstract as in practice
both are intertwined. The income effect accounts for the part of the total
difference in the quantity of the good purchased that isn’t accounted for by
the substitution effect.
Two ways to measure the substitution effect

There are two equally valid versions of the substitution effect. In
the Slutsky version the budget line rotates through the original
consumption bundle until it has the same slope (i.e. relative prices) as the
97
new budget line. The tangency of this rotated budgetline and the highest
possible indifference curve determines the change in consumption due to
the Slutsky substitution effect. It indicates how the consumer ‘substitutes’
one good for the other when a price changes. Since the rotated budget
line passes through the original consumption bundle, the latter is still
affordable and in that sense purchasing power remains constant at the
new relative prices. In the Hicks version of the substitution effect,
the budget line rolls under the original optimal indifference curve until
it has the same slope as the new budget line so that utility rather than
purchasing power is now held constant. The new tangency between the
pivoted budget line and the original indifference curves determines the
change in consumption due to the Hicks substitution effect.
Therefore in both cases the (hypothetical) rotated budget line shows the
new relative prices after the change in price of one of the goods. While
in the Slutsky version the substitution effect is calculated to keep the
consumer’s purchasing power constant at the level of his original basket,
in the Hicks version the substitution effect is calculated to keep the
consumer’s utility constant at the level of this original basket.
The Slutsky demand for a good shows the change in quantity
demanded using the Slutsky version of the substitution effect as the price
of the good changes. It depends on the initial consumption bundle since
we are holding the consumer’s purchasing power constant in the sense that
he can still (just) afford to buy his original bundle. Figure 8.1 illustrates
the Slutsky substitution effect and change in quantity demanded.
x2
A
C B
x1
a c b
Figure 8.1: Slutsky substitution effect

The original budget line leads to a consumer optimum at A. After the
decrease in price of good 1, the optimum shifts to B. The increase in
Slutsky demand due to the price decrease is given by c – a. This represents
the increase in consumption due to pure substitution effect. Point C is the
tangency of a new (higher) indifference and a budgetline corresponding to
the new relative prices drawn through the original bundle A. The further
increase in consumption from c to b represents the income effect.
We will have to introduce some notation now to derive the Slutsky
equation. The original prices for which A is the optimum are p10 and p20
and the quantities consumed at A are x10 and x20. From the figure it is easy
to see that the Slutsky demand (x1s) which is obtained by rotating the
budgetline through A as the price of good 1 decreases and drawing the
relationship between price and quantity, is in fact ordinary demand (x1)
where income is held such that A is just affordable or:
x1s ( p1, p2, x10, x20 ) = x1(p1, p2, m = p1x10 + p2x20 ) (1)
98
To derive the Slutsky equation, we take the derivative with respect to p1:
s
∂x1 ( p1, p2, x10, x20 )/ ∂p1 = ∂x1 ( p1, p2, m = p1x10 + p2 x20)/ ∂p1
0 0
+ (∂x1 ( p1, p2, m = p1x10 + p2 x2 )/ ∂m)x1
which can be rearranged to give:

s
∂x1 ( p1, p2, m = p1x10 + p2 x20)/ ∂p1 = ∂x1 ( p1, p2, x10, x02 )/ ∂p1
(2)
– (∂x1 ( p1, p2, m = p1x10 + p2 x20 )/ ∂m)x10
This last equation decomposes the price effect into the Slutsky substitution
effect and the income effect.
Example 8.1
Assume Cobb-Douglas utility U(x1, x2) = (x1, x2)1/2 and original prices p10 =
p20 = 1 and income m = 100. From the section on ‘Utility, budget constraint
and demand’, we know that the ordinary demands are given by x1 = m/
(2p1) and x2 = m/(2p2) and hence x10 = x20 = 50. From (1) we know that
Slutsky demand is given by:
x1s ( p1, p2, x10 = 50, x20 = 50 ) = x1( p1, p2, m = p1x10 + p2x20 = 50( p1, p2)) =
25( p1+ p2)/p1
This implies that, when the price of good 1 decreases from 1 to 1/2,
ordinary demand for good 1 increases from 50 to 100 whereas Slutsky
demand increases from 50 to 75. The difference between 75 and 100 is due
to the income effect.
Activity
You should check the Slutsky equation (2) for this example:
–75/(2p12) = –25p2 /p12 – 1/(2p1)50 = – 150 for p1 = 1/2 and p2 = 1.
The Hicksian (or compensated) demand shows the response of

quantity demanded to price changes if income is varied so as to keep
the consumer on the same indifference curve (keeping utility constant).
The change in quantity demanded as a result of the price change is thus
based on the Hicks version of the substitution effect. The idea is that the
consumer is being compensated for a price change by having enough
income taken away or given back to keep utility constant at the original
level. As mentioned above, the Slutsky substitution effect revolves around
maintaining the original purchasing power (i.e. old consumption bundle)
after a price change, while the Hicks substitution effect centres on
maintaining the original level of utility (i.e. the old indifference curve).
In Figure 8.2 the derivation of the Hicksian (or compensated) demand
is illustrated. For a high initial price of good x1 the optimal consumption
bundle is at A. If the price of good 1 decreases, so that budget line C
applies, the consumer will choose a point on C. However, we are not
interested in the ordinary demand now; we want to find compensated
demand that only captures the substitution effect. We find the optimal
consumption bundle if the price ratio is as after the price decrease but
the consumer stays on the original indifference curve. In the bottom
figure, Hicksian demand can be drawn simply by plotting the optimal
quantity of x1 as the price ratio changes and drawing the relationship
between price and quantity. You can visualise the budget line rolling
99
around the bottom of the indifference curve. As you can see on the graph,
the optimal consumption bundle is found at the tangency of the budgetline
and the indifference curve, as for ordinary demand. What we are doing
mathematically when we derive the Hicksian demand is that we minimise
expenditure (push the budget line down) subject to the consumer achieving
a given utility level. The Hicksian demand function is thus a function of
prices and utility.
Think of constructing the Hicksian demand curve by adjusting the
consumer’s income as the price changes so as to keep the consumer’s utility
constant. Hence the consumer is ‘compensated’ for price changes and utility
is constant at every point on the Hicksian demand curve. In an ordinary
demand curve, however, the consumer is worse off facing higher prices than
lower prices since, by assumption, income remains constant and purchasing
power varies accordingly. Hicksian demands are useful theoretical tools to
undertake cost-benefit analyses of public policy changes as they can help
come up with estimates of consumer detriment.
x2
A C
B p1
1
x1
p 10
p0
1
p1
1
x1
Figure 8.2: Hicksian demand
Example 8.2
Suppose utility is given by U(x1, x2) = (x1, x2)1/2. What do the compensated
demands look like? The optimisation problem is:
min p1x1 + p2 x2 s.t. U(x1, x2) = u0 .
From the tangency condition we know that the price ratio has to equal the
marginal rate of substitution or:
p1 ∂U / ∂x1 1/2√ x2 /x1 x2 p2x2
p2 = ∂U / ∂x = 1/2 x /x = x1 or x1 = p1
2 √ 1 2
Substitution in the constraint results in the Hicksian demand functions:
p p2
x2 = 1 u0 and x = u
p
√ 2 1 p
√ 1 0
100
You should understand why the substitution effect of a price change

(Slutsky and Hicks) is always negative so that Slutsky and Hicks demand
curves are always downward sloping. The income effect can be positive
or negative so that ordinary demand is not necessarily always downward
sloping, although it is expected to be in most cases. In practice, the income
effect is small unless consumers spend a significant fraction of their
income on the good in question.
8.3 Consumer welfare effects of a price change

Public policy frequently has an effect on relative prices of goods. This is
most obvious in the case of tax policy. If tax on particular commodities
increases or if there is a shift towards excise tax to allow a reduction in
income tax, consumer welfare is clearly affected. One way to measure
this change in the consumer’s well-being would be to compare his utility
level before and after the change. This is problematic because the actual
utility number has no significance. This may not matter if we only want
to know whether the consumer is better or worse off. However, if we
want a more precise measurement or if we want to aggregate the effect
of a policy change over all consumers we need something more precise.
For instance, we could determine how much income the consumer would
be willing to give up to avoid a price increase or how much money the
government would need to give consumers to compensate them for a
policy change which leads to a price increase (e.g. raising VAT on fuel).
Using consumers’ own monetary valuations of price changes allows for this
type of aggregation.
There are several measures which could be used to assess the impact of a
price change on consumers’ welfare. In particular we shall consider two
monetary measures that attempt to answer the following question: what is
the monetary value that a consumer would assign to a change in the price
of a good or service? Economists have developed two equally valid metrics
to answer this question.
8.3.1 Compensating variation and equivalent variation

Compensating variation (CV) is the amount of money which the
consumer requires to compensate him for a price increase or the amount
of money which could be taken away from the individual after a price
decrease to make him as well off as before the price decrease. CV
represents the change in income necessary to restore the consumer to his
original indifference curve, that is, how much extra money the government
would have to give to or take away from consumers if it wanted to exactly
compensate them for a price change.
Equivalent variation (EV) is the amount of money or additional
income the consumer would need before a price reduction, or how much
less income the consumer would need before a price increase, to give him
the level of utility he would have after the price change. EV represents
the income change that is equivalent to the price change in terms of
impact on consumer’s utility.
In graphical terms, the compensating and equivalent variations are simply
two different ways to measure the distance between the initial (before
the price change) and final (after the price change) indifference curves.
You should remember that CV refers to a change in income which takes
you back to the original indifference curve whereas EV refers to a change
in income which brings you to the new indifference curve. CV indicates
the change in income after the price change has taken place whereas EV
101
indicates the change in income before the price change takes place. In
general the amount of money that consumers would be willing to pay to
avoid a price change would be different from the amount of money that
consumers would have to be paid to compensate them for a price change.
At different sets of prices, effectively a pound is worth a different amount
since it will purchase different consumption bundles. Therefore the CV and
EV measures will generally differ.
You will probably need to think about this for a while. Making some
graphs might help. Remember that you can read CV and EV on the vertical
axis if x2 has unit price.
The three measures of changes in consumer welfare due to price changes
(EV, CV and the change in consumer surplus CS) are equal when the
income effect of a price change is zero. This is the case for quasilinear
utility or U(x1, x2) = v(x1) + x2. Note that, on the indifference map
corresponding to this utility function, the vertical distance between two
indifference curves is constant (i.e. it does not vary with x1). CV, EV and
the change in CS are all different except for quasilinear utility where
all three coincide. (It would be a good exercise for you to check this.)
When the income effect is small, the CV and EV tend to be close to one
another and the change in CS is a good approximation (though not an
exact measure) of the monetary value that consumers would assign to the
reduction/increase in the price of a good. This situation is in turn more
likely to arise when expenditures on the commodity as a share of total
income is relatively small.
Example 8.3
Using the same utility function U(x1, x2) = (x1, x2)1/2 and initial prices and
income p1 = p2 = 1, m =100, we can calculate the values of the three
measures of changes in consumer welfare when p1 decreases to 1/2. CV is
the amount of money we can take away from the consumer after the price
decrease to bring him back to his original utility level. To calculate CV we
need to know how optimal utility is affected by a change in price. If we
substitute the demand functions x1 = m/(2p1) and x2 = m/(2p2) into U we
find the indirect utility function:
V = m/(2( p1 p2)1/2)
so that utility after the price change is:
V1= m/(2(1/2.1)1/2) = m/21/2

and utility before the price change is:
V0= m/(2(1.1)1/2) = m/2

CV is the amount of money we can take away from the consumer to
leave him as well off as initially. Hence (m – CV)/2(1/2)1/2 = m/2 or
(100 – CV)/21/2 = 50 which gives CV = 29.3. EV is the amount of money
you have to give the consumer to make him as well off as after the price
decrease. This means that EV is such that:
(m + EV)/2 = m/21/2 or (100 + EV)/2 = 100/21/2
which gives EV = 41.4. The change in consumer surplus due to the price
decrease is the area to the left of demand between the original and the new
price, hence:
1
m
CS = ∫
½
dp = 50(log(l) – log(1/2)) = 34.7
2p1 1
102
8.4 Elasticity
Elasticity is a very important concept in economics. This measure tells
us how responsive demand is to changes in price, income, prices of
substitutes or complements, etc. Whether we look at price elasticity or
income elasticity or cross price elasticity, the measure is always defined
in proportional terms. It tells us what percentage change in demand we
can expect if the other variable changes by one per cent. Mathematically
it is calculated as the ratio of the percentage change in demand to the
percentage change in the other variable of interest (e.g. price). For
example, the price elasticity of demand is given by:
ε=(Δq/q)/(Δp/p).
The sign of the price elasticity of demand is generally negative, since
demand curves typically have a negative slope and changes in quantity
and price have opposite signs. You should be aware that elasticities are
time-dependent. For most products it is unrealistic to assume that the price
and income elasticities will be unchanged over a long period of time. The
simplicity, at least in theory, of calculating values for, say, income elasticity
is misleading. For marketing purposes this figure has to be interpreted
carefully. Let us take the example of Malaysian car sales. A 40 per cent rise
in incomes between 1987 and 1991 was accompanied by a 290 per cent
rise in car sales, giving a rough estimate of income elasticity of 7. Should
the car industry attach much importance to this number? A closer look at
the car market and the market for many goods in fast growing economies
reveals that households do not consume a good when their income is
below a threshold level but as soon as their income reaches the threshold
level they do buy. This means that, even with small increases in per capita
income, large increases in purchases could occur. At the same time, a large
increase in per capita income may not have a significant effect on sales if
the households whose income increased were already above the threshold
level. Clearly, it is more useful to have a good forecast of the growth in
percentage of households above the threshold than of growth in per capita
income.
Whether demand for a good is price elastic depends on several factors
including:
• the number and closeness of substitutes. The elasticity of
demand for a particular brand of cigarettes is large whereas the
demand for cigarettes as a whole is inelastic. The demand for petrol
and salt is inelastic
• the period of time over which the response to a price
change is assessed. For many goods if you study the response
after a longer time period the elasticity will generally be larger
because consumers need some time to adjust their behaviour and
look for substitutes after a price increase. For consumer durables
such as electrical appliances or cars however, the opposite is true. It
appears that if the price of these goods increases people postpone their
purchases and do not buy in the short-term; hence there is a sizeable
short-term response. In the longer term consumers cannot postpone
replacement of their appliance any further which leads to a smaller
long-term response to a price increase
• luxuries versus necessities. The demand for luxury items (income
elasticity > 1) is more elastic than the demand for necessities (income
elasticity < 1) because of their large income effect.
103
8.4.1 The importance of price elasticity of demand

The notion of price elasticity is crucial in pricing decisions. Let us ignore
costs for the time being and just determine how price p should be set if
we want to maximise revenue. Revenue R( p) is the product of price and
quantity demanded at that price: R( p) = pq( p). To see how revenue varies
with chosen price, take the derivative of revenue:
∂R(p)
∂p
=p
∂q(p)
∂p
+ q(p) =
( p ∂q(p)
q(p) ∂p
+1
( q(p) = (1– η) q( p)
where h is the (absolute value of) price elasticity. Therefore revenue is

increasing in p (positive derivative) as long as demand is inelastic (h <
l) and it decreases in price when demand is elastic (h > l). The intuition
behind this result is straightforward. If demand is very responsive to price,
then an increase in price will reduce demand so much that revenue will
fall. If demand is very unresponsive to price changes, then an increase
in price will not change the quantity demanded much, and overall
revenue will increase. A revenue-maximising company sets price so that
demand has unit elasticity. An important consequence is that a profit-
maximising firm will never set price such that demand is inelastic. Why?
If demand is inelastic, an increase in price generates more revenue. At the
same time, because of the increase in price, less is sold and therefore costs
decrease. Revenue increases and costs decrease after a price increase so
profit can be increased by increasing price as long as demand is inelastic.
Price elasticity also determines the optimal level of mark-up over costs. As
you would expect intuitively, if demand is inelastic the markup is higher
than when demand is elastic. To see why this is true, consider the case
of constant marginal cost c and express revenue as a function of quantity
rather than price: R(q) = p(q)q. For profit maximisation we set marginal
revenue equal to marginal cost. Marginal revenue is simply the derivative
of revenue with respect to quantity and so:
∂R
∂q
= p(q) + q
∂p
∂q ( q ∂p
= p 1+ p
∂q
( (
= c or p 1– 1η
( =c
which can be rewritten as:
p=c
( η
η–1
(
η
The optimal markup over cost (for η >1)
(η – 1)
is decreasing in the price elasticity (you should check this) as mentioned

above. In practice constant elasticity demand is often assumed when
estimating demand functions:
q = ap-η mγ tβ (3)
where q is the quantity demanded, p is the price, m is income and t is the
price of a substitute or a complement. Other factors such as demographic
variables are often included. The parameters η, γ and β are the price
elasticity, income elasticity and cross-price elasticity respectively. The
multiplicative functional form (3) assumes that the elasticities are constant
(i.e. they do not vary with values of price, income, etc.). The popularity of
this model can be explained by its ease of use in econometric work (linear
regression can be used after taking logarithms on both sides).
104
Regression analysis and time series analysis are not the only methods you
can use to get information about demand for your product. In fact, in some
cases regression analysis based on historical data is out of the question
because such data is not available (e.g. for a new product). Marketing
managers then resort to consumer laboratories or market experiments. In
a consumer laboratory or clinic, simulations of purchasing decisions take
place. The ‘consumers’ are given a certain budget which they can spend on
the product under study as well as substitute products (other brands) and
other products. The experiments then consist of varying the consumers’
budget and the relative prices. The resulting information is analysed and
elasticities are calculated. In the case of test marketing, the experiment
goes on in the real world. The market for the product is divided into
geographical areas and a different marketing mix (price, advertising, etc.)
is used in each area. Consumers’ responses are measured and demand
information results from analysis of these responses.

In this chapter we showed how to estimate the Slutsky and Hicks demands
and their respective measures of substitution effects as a result of price
changes. The chapter also examined ways to calculate the welfare effects
of a change in price and the important concept of price elasticity.

• derive demand functions given a utility function
• derive the Slutsky equation
• derive Slutsky and compensated demand functions and explain
their use
• analyse qualitatively changes in consumer welfare
• calculate elasticities.

1. Goods x and y are perfect substitutes and consumers have utility
functions of the form U(x, y) = x + y. Consumer i has income mi.
Derive and draw Consumer i’s demand for good x. Derive and draw
the market demand for good x.
2. A university student who loves food has a budget of £100 a month.
Out of that income she buys food x and the rest she spends on
other goods y which have a (collective) price of £10. The student’s
preferences over these two goods are represented by the quasilinear
utility function U(x, y) = 2x1/2+y.
105
a. Suppose that the price of food is £5 per meal. How many meals
and how many units of the other (composite) good y are in the
student’s optimal consumption basket?
b. Suppose the price of food drops to £2 per meal. How many meals
and how many units of the composite good are in the new optimal
consumption basket?
c. What are the substitution and income effects that result from the
decline in the price of food? Try to solve analytically and also
illustrate these effects using a graph.
3. A consumer purchases two goods, food x and clothing y. He has utility
function U(x, y) = xy and an income of £72 a week. The price of
clothing is £1 per unit.
a. If the price of food falls from £9 to £4 per meal, what is the
compensating variation of the reduction in the price of food?
b. What is the equivalent variation of the reduction in the price of
food?
4. True/False. If the income elasticity is positive, the compensated
(Hicks) demand curve is steeper than the ordinary demand.
5. Joanna likes lipstick (x1) and earrings (x2) which give her utility
U(x1, x2) = x1x2. Her pocket money is M per week and lipsticks and
earrings cost p1 = 4 and p2= 1 respectively. Suppose p1 falls to 1. By
how much would her pocket money have had to increase to make
her as well off as after this price change? By how much could her
pocket money be reduced while keeping her as well off as before the
price decrease? Which is the compensating variation? Which is the
equivalent variation? Calculate her increase in consumer surplus due
to the price decrease.
6. The price elasticity of demand for widgets is 1.5. The widget producers
form a cartel (collusive agreement) and agree quotas which will have
the effect of reducing total output such that market price rises by 10%.
What is the effect on total revenue? How does your answer change if
the price elasticity of demand is 0.75?
106
Chapter 9: Other topics in consumer theory
Chapter 9: Other topics in consumer

theory
9.1 Introduction
In the previous chapter, we examined consumer choice in the basic
microeconomic theory of demand. Here, we continue our analysis by
considering several important applications of this framework to topics such
as intertemporal choices, selection of financial assets and labour supply
issues.
More specifically, intertemporal choices refer to consumers’ choices of
consumption over time. We can easily adapt the theory discussed in
Chapter 8 of the subject guide to consider consumers who decide how
much of some good to consume over two time periods. This simple set-
up will allow us to analyse everyday situations such as saving decisions,
consumers’ demand for borrowing and lending money, and the effect of
changes in the interest rate on these economic variables.
In the context of consumers’ choice of labour and leisure, we use the
model of optimal consumer choice to examine individuals’ decisions of
how much to work. We use this framework to discuss individuals’ optimal
responses to wage increases and explain why it may be economically
rational to observe that people reduce the number of hours worked (or
increase the amount of leisure) as wages rise – a phenomenon termed
backward-bending supply of labour.
Finally, we also look at the risk and return characteristics of a combination
of securities and identify the subset of portfolios that will be preferred
by all investors who exhibit some degree of risk aversion and who prefer
more expected returns to less. We delineate the efficient set of portfolios
and examine how it is affected by the presence of risk-free security and the
ability of the investor to lend and borrow funds.

• the role of the income effect in generating backward-bending
labour supply
• the trade-off between risk and return in investment
• the importance of correlation between asset returns for risk
reduction
• why everyone chooses the same portfolio of risky assets when a risk-
free asset is available.

• explain the key features of the state-contingent commodities
model
• set up the intertemporal choice problem and analyse the effect
of changes in the interest rate on the consumer’s choice
• set up a labour supply model
107
• derive the shape of the feasible set of risk-return combinations for

portfolios of two risky assets
• explain graphically the set of efficient portfolios of risky assets.

Varian, H.R. Intermediate microeconomics: a modern approach. (New York:
W.W. Norton and Co., 2014; 9th edition) Chapter 10: Intertemporal choice,
Chapter 12: Uncertainty, Chapter 13: Risky assets.

Battalio, R.C., L. Green and J.H. Kagel ‘Income-leisure tradeoffs of animal
workers’, American Economic Review 71(4) 1981, pp.621–32.
Besanko, D., R. Braeutigam and K. Rockett Microeconomics. International
student version. (Singapore: John Wiley & Sons, 2015) 5th edition
[ISBN 9781118716380] Chapter 5: The theory of demand.
Biddle, J.E. and D.S. Hamermesh ‘Sleep and the allocation of time’, Journal of
Political Economy 98(5) 1990, pp.922–43.
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
Mc-Graw Hill, 2014) 11th global edition [ISBN 9780077151560] Chapter
8: Portfolio theory and the capital asset pricing model.
Elton, E., M. Gruber, S. Brown and W. Goetzmann Modern portfolio theory and
investment analysis. (New Jersey: John Wiley & Sons, 2014) 9th edition
[ISBN 9781118469941] Chapter 5: Delineating efficient portfolios.
Markowitz, H. Portfolio selection: efficient diversification of investments. (Oxford:
John Wiley & Sons, 1991) 2nd edition [ISBN 9781557861085].
‘Risk and return’, The Economist, 19 February 1994, p.137.

This chapter examines applications of demand theory to state-dependent
commodities and intertemporal choices, including savings, consumption
and supply of labour. It also considers the optimal demand of portfolios
of risky financial assets in the presence of uncertain and imperfectly
correlated returns.
9.2 State-contingent commodities model

When we analysed decision-making under uncertainty, we used the
expected utility model. There is an alternative approach to studying
uncertainty: the state-contingent commodities model. This
approach uses standard consumer theory terminology which is why it is
discussed here. Whereas under the expected utility hypothesis any number
of outcomes can be considered, the state-contingent commodities model,
as it relies heavily on graphical analysis, is most useful when there are
only two outcomes.
Assume that the ‘products’ a consumer derives utility from are income or
wealth in two states of the world. The states of the world could be ‘car
is stolen’ and ‘car is not stolen’, for example. Of these states of the world
one and only one will actually occur. This points to a major departure
from standard consumer theory. In the state-contingent commodities
model, only one of the goods is consumed by definition whereas in the
standard consumer theory model, both goods can be (and usually are)
consumed in positive quantities.
Individuals derive utility from income bundles consisting of one income
level for each possible state of the world. If I do not have unemployment
insurance, my income bundle could be (0, m) indicating a zero income
level in the state ‘I lose my job’ and income m in the state ‘I do not lose my
108
job’. If I have unemployment insurance, my income bundle could be (b –

p, m – p), where b is the unemployment benefit the insurance company
pays me when I lose my job and p is the insurance premium. Depending
on the values of b and p and my chance of becoming unemployed, I may
prefer the second bundle to the first. Figure 9.1 shows an indifference map
corresponding to this situation.
employed
450 line
m
m–p
unemployed
0 b–p m–p
Figure 9.1: State-contingent commodities model

The 45 degree line (also called the certainty line) contains income
bundles for which income in both states is equal and hence there is no
uncertainty. The indifference curves are convex for a risk averse individual
because, loosely speaking, such an individual prefers the same income in
both states. Consider an individual at point A on the 45 degree line in Figure
9.2. If this individual were more risk averse she would be willing to trade her
secure position A for fewer income bundles. The income bundles she would
trade for are of course the ones above her indifference curve through A. So
higher risk aversion corresponds to more convex indifference curves.
income in state 2
certainty line
A income in state 1
Figure 9.2: Risk aversion

In general, utility (and thus the position of the indifference curves)
depends on income in both states and the probability (qi) of each state of
the world occurring:
U(m1, m2, q1, q2) .
An example of such a utility function is the expected utility function we
studied before:
U(m1, m2, q1, q2) = q1u(m1) + q2u(m2) (1)
but the state-contingent income approach allows for more general utility
functions. Using the expected utility formulation (1) let’s see how we can
109
determine the certainty equivalent and the risk premium graphically. On

an indifference curve dU(m1, m2, q1, q2) = 0 or, from (1),
q1u′(m1)dm1 + q2u′(m2)dm2 = 0 .
The slope of the indifference curve is thus:
dm2 /dm1 = –q1u′(m1)/q2u′(m2) (2)
which is the marginal rate of substitution between income in the two
states, adjusted by the probabilities of the states occurring. At the
intersection of an indifference curve with the certainty line (where
m1 = m2), the slope is dm2 /dm1 = – q1 /q2.
The iso-expected income line is the locus of income bundles (m1, m2)
which have the same expected value E(m). The equation for the iso-
expected income line for given probabilities (q1, q2) is q1m1 + q2m2 =
E(m). The slope of this line is also – q1 /q2 which implies that the tangency
of an indifference curve and an iso-expected income line occurs at the
intersection of the indifference curve with the certainty line. This is
illustrated in Figure 9.3.
m2
certainty line
B
E
e
c
C iso-expected income line
m1
b c e
Figure 9.3: Certainty equivalent and risk premium

We now want to situate the certainty equivalent of income bundle B
graphically. By definition the individual is indifferent between all points on
his indifference curve and, in particular, he is indifferent between B and C.
At point C the individual gets equal income c in both states. The certainty
equivalent of B is therefore c: the individual is indifferent between getting
c for sure or getting state-contingent income B.
It is straightforward to determine the risk premium graphically. The risk
premium is the difference between the expected value and the certainty
equivalent. Where can we read off the expected value of B? Income bundle
E is on the iso-expected income line through B and therefore has the same
expected value as B, namely q1e + q2e = e. The risk premium therefore
equals e – c.
The state-contingent commodities model has applications in the analysis
of insurance demand.
110
9.3 Intertemporal choice

We strongly recommend that you read Varian’s excellent treatment of
intertemporal choice (Chapter 10) for revision purposes or if you need
some clarification. You should know how to set up the intertemporal
consumption choice problem and derive how saving and borrowing
respond to changes in the interest rate r.
Suppose the consumer has income m1 in period 1 and income m2 in period
2 (the endowment point E in the Figure 9.4 below). He can borrow and
lend at interest rate r. If he does not consume in period 1 then the amount
available for consumption in period 2 equals m2 + (1 + r)m1. Similarly, if
he plans not to consume in period 2, he can borrow an amount m2 /(1 +
r) in period 1 and hence pay back m2 in period 2. In general, consumption
in period 2 will equal income in period 2 plus any savings from period 1 or
minus any repayments of loans from period 1:
c2 = m2 + (1 + r) (m1 – c1) . (3)
Equation (3) is the equivalent of the budget constraint in the standard
consumer choice problem. Note that, as the interest rate r changes, the
budget line rotates through the endowment point E, becoming steeper
with an increase in r and flatter with a decrease in r.
If the individual can borrow but not lend, he has to choose a point on the
line segment to the right of E and, if he can lend but not borrow, he has to
choose a point on the segment to the left of E. If the borrowing and
lending interest rates are different, the budget constraint is piecewise
linear (and concave if the borrowing rate is higher than the lending rate)
with a kink at E.
c2
m2+ lending
(1+r)m1
E
m2
borrowing
c1
m1 m1 + m2/(1+r)
Figure 9.4: Intertemporal choice

The consumer’s preferences over combinations of current and future
consumption can be represented by a utility function U(c1, c2). A
downward sloping straight line, for example, would represent tastes of
a consumer who didn’t care whether he consumed today or tomorrow.
His marginal rate of substitution (MRS) would be constant. If instead we
assumed indifference curves for perfect complements, then this would
indicate that the consumer would like to consume equal amounts today
and tomorrow. In this case the consumer would be unwilling to substitute
consumption from one time period to the other, no matter what. We shall
assume though the more plausible intermediate case of well-behaved
preferences where the consumer is willing to substitute some amount
of consumption in one period for consumption in the other period.
111
Convexity of preferences implies that consumers would rather have an

average amount of consumption each period rather than a lot today and
nothing tomorrow or vice versa. At the optimum bundle of current and
future consumption, the budget line is tangent to the highest possible
indifference curve. The MRS in this context is defined as –(1 + p) where p
(> 0) measures subjective impatience.
Why?
At the optimum the MRS equals the slope of the ‘budget line’ –(1 + r)
which implies that each individual saves or borrows such that the rate r at
which he can trade current for future consumption in the market coincides
with the rate at which he wishes to make these trades.
Using this model, we can derive the amount of saving or borrowing every
individual in the market plans to do, given the interest rate. The market
interest rate can be determined by plotting the total amount of saving and
the total amount of borrowing against the interest rate. You read off the
equilibrium interest rate where the two curves intersect.
Example 9.1
Suppose the consumer has utility function U(c1, c2) = ln(c1) + a ln(c2),
where a (< 1) is a constant. The return on loans to and from the bank
is r and income is m1 in period 1 and m2 in period 2. The consumer’s
optimisation problem is:
Max ln(c1) + a ln(c2) s.t. c2 = m2 + (m1 – c1)(1 + r).
If we substitute the constraint into the objective function we obtain:

ln(c1) + a ln(m2 + (m1 – c1)(1 + r)).
Setting the derivative with respect to c1 equal to zero, we find:

1/c1 + (a/(m2 + (m1 – c1)(1 + r))(–1)(1 + r) = 0
which can be solved for c1:

c1* = (m1 + m2/(1 + r))/(1 + a)
If the consumer can lend but not borrow then the solution remains
unchanged as long as c1*< m1. If c1* > m1 i.e. m2 > a m1(1 + r) then the
consumer would like to borrow but, if he is prevented from doing so, he
will consume his endowment:
(c1, c2) = (m1, m2).
9.3.1 Substitution effect and income effect

As we analysed in the previous chapter, the effect of an interest rate
change (which affects the relative prices of consumption in period 1 and
period 2) can be broken down into a substitution and an income effect.
Using this breakdown it is possible to show, for example, that an increase
in r causes a decrease in c1, for a borrower (i.e. c1>m1) whereas it could
cause an increase in c1, for a lender (i.e. c1<m1).
112
c2 c2
b c
b
c
a aE
E
c1 c1
(a) borrower (b) saver
Figure 9.5: Effect of an interest rate increase

Figure 9.5(a) shows what happens to a borrower’s consumption plans
when the interest rate increases. Initially he is planning to consume at
point a, to the right of his endowment E. After the interest rate increase he
modifies his plans to point c. The thinner line through a has the same slope
as the new budget line (we are using Slutsky substitution here). The move
from a to b is caused by the substitution effect, which always works in the
direction of less c1 if r increases. The move from b to c is due to the income
effect which leads to less c, if c1 is a normal good. Figure 9.5(b) shows the
effect of the same interest rate increase on the saver’s consumption plans.
The substitution effect works in the same direction as for the borrower
but the income effect now works in the opposite direction. If the income
effect is large enough, c1 could increase. Therefore, it is possible to get
a backward-bending supply of savings (i.e. as the interest rate
increases to a high level, savers may reduce their savings!).
Activity
Show that a saver can be made better or worse off by an interest rate decrease. Note that
a saver’s initial consumption plan is not feasible after the interest rate decrease.
Case study: Britain benefits from lower interest rates
When you analyse the effect of interest rate changes on the economy in different countries you
have to take into account the amount of debt at floating rates. Fixed rate debt is by definition
not affected by a change in the interest rate. In an economy with mainly fixed rate debt and
variable rate savings, interest payments on loans will not change much if the interest rate falls
but interest receipts from savings could go down dramatically.
For example in the early 1990s, Britain was an exception among the big economies in the
world in that it was a net debtor if we consider assets and debts held at floating rates by firms
and households. A large majority of British homeowners held variable rate mortgages (90 per
cent versus less than 20 per cent in the USA and 10 per cent or less in Germany, France and
Japan). Also, less than half of British company debt was at fixed rates whereas in the USA,
France and Japan it made up 60 per cent or more.
Since Britain was a debtor, it was better off when the interest rate decreased whereas the rest
of the world could be worse off. Why is that? For a borrower, when the interest rate decreases,
the substitution and income effects reinforce each other and cause him to borrow more.
(Make a graph to see this!) The net borrower ends up on the new budget line to the right of
his original position. The original consumption bundle is still feasible which means that the
borrower is at least as well off as before the fall in interest rate.
113
9.4 Labour supply

The standard consumer choice problem is easily rephrased in the context
of the labour supply decision. The ‘goods’ are leisure l and a composite
good c (with price = 1) which can be interpreted as ‘income available to
spend on consumer goods’. In this context, the term leisure is intended to
include all non-work activities, such as eating, sleeping, entertainment,
etc. The individual earns an income because she works, and this income
is used to pay for the activities she enjoys in her leisure time. Leisure is
desirable but generates no income for the consumer.
The budget constraint indicates how much consumption is possible for
each choice of leisure and its implied choice of work time given a wage
rate w. The worker may have non-labour income M which is taken into
account in the formulation of the budget constraint. In addition to the
monetary constraint, the consumer also faces a time constraint: work time
and leisure time have to add up to 24 hours per day or, more generally,
H hours per time period. The worker’s optimisation problem, represented
graphically in Figure 9.6, is given by: Max U(c, l) s.t. c = M + w(H – l) and
at the optimum the MRS equals the price ratio-w.
C
M+w(H-l)
C*
l
1* H
Figure 9.6: Labour supply

You should know how to modify the model to allow for progressive
income tax. The budget constraint becomes piecewise linear and concave.
Investment in education can be modelled as a decrease in M (fees,
opportunity cost, etc.) and an increase in w (higher wages for the more
educated) so that the budget constraint becomes steeper.
Of course, the basic labour supply model assumes that the worker has
a free choice of working hours or length of working week. In reality
the employer will want to place some restrictions on that choice, often
in the form of a lower bound on the number of hours worked. We can
nevertheless still use the model to study the employee’s reaction to these
restrictions. If workers have a strong preference for working part-time,
then firms which are willing to be flexible rather than insisting on, say, a
40-hour work week can obtain labour at a lower cost. We can show this
by drawing the indifference curve through H – l (hours worked) = 40 and
the corresponding c (point A in Figure 9.7). We can now determine how
much lower the wage rate could be (while keeping the worker as happy
as before) if the worker is allowed to choose the length of the working
week. Rotate the budget line down until you find a tangency (point B)
114
with the indifference curve. At B the worker is as well off as at A although

his income has decreased compared to at A. An interesting statistic in
this context is that Britain’s gender pay gap will leave women effectively
working for free from 9 November until the end of the year, according to
equality campaigners the Fawcett Society. The gender pay gap for median
earnings of full-time employees was 9.4 per cent in 2015, down slightly
from 9.6 per cent in 2014. This is the lowest since the survey began in
1997, although the gap has changed relatively little over the last four
years. A similar picture arises when full-time and part-time employees
are combined. Comparable EU figures show that the average gap within
the EU was 16 per cent, but pay levels throughout the whole of Europe
differed hugely.
C
Figure 9.7: Flexible versus fixed hours
9.4.1 The backward-bending supply of labour

As wages increase, different choices between leisure and work time are
made. This relationship between wage and hours worked is the labour
supply curve. An increase in the wage rate, for example, makes a unit
of the composite good look less expensive. An increase in the wage rate
reduces the amount of work required to buy a unit of the composite good,
and this leads to a substitution effect and an income effect (as we saw
in Chapter 8 of the subject guide). The substitution effect pushes in the
direction of more work – it induces the consumer to substitute more of
the composite good for leisure, leading to less leisure and more work.
However, the income effect has a negative impact on labour supply – it
leads to more leisure and less work if you assume that leisure is a normal
good. If the income effect is large enough, we get a backward-bending
labour supply curve where wage increases result in fewer hours of work.
The labour supply curve slopes upwards over the region where the
substitution effect associated with a wage increase outweighs the income
effect, but may bend backwards over the region where the income effect is
strong and outweighs the substitution effect.
A tax on labour earnings has the same effect as a decrease in wage: the
income and substitution effect counteract each other so that the worker
could end up working more or less whereas a lump sum tax only has an
income effect making the worker work more. As an exercise you could
make a graph illustrating the effect of a fixed rate income tax when the
labour supply curve is backward bending and show that introduction of
the tax reduces labour supply for low wage rates and increases labour
supply for high wage rates. A tax that varies with the amount worked,
115
such as a payroll tax on labour income, would make an individual both

feel poorer (an income effect) and would affect the reward for working
more hours (a substitution effect). In general, the type of taxation applied
in the economy can affect labour supply decisions differently by inducing
only an income effect or both an income and substitution effect. This
differential effect on labour supply decisions can, in turn, affect the overall
social welfare by affecting national earnings and tax receipts.
In line with the mainstream empirical work in this area, Battalio, Green
and Kagel (1981) find evidence of a backward-bending labour supply
curve at high ‘wages’ for pigeons and rats! In their experimental work
they discovered that laboratory animals trade off income for leisure and
that leisure is a normal good. ‘Work’ for pigeons is typically key pecking
or treadle running whereas rats are conditioned to do ‘work’ tasks such as
lever pressing and wheel running. The animals have to perform the task
a certain number of times to get a reward. The authors claim that rats
and pigeons behave as if they were maximising a utility function U(c, l)
and they conclude: ‘Substitutability of income and leisure appears to be a
fundamental, biologically-based, law of behaviour.’
Example 9.2
A consumer has a Cobb-Douglas utility function, U(c, l ) = cαl1–α and budget
constraint c = M + w(H – l). To derive the individual’s labour supply curve,
set the ratio of marginal utilities equal to the slope of the budget constraint:
∂U/∂c αcα–1l1–α 1 αl 1
= α = w or =
∂U/∂l c (1–α)l–α (1–α)c w
Solving this for l gives (*)

(1–α)c
l=
αw
and substituting this expression into the budget constraints gives:

(1–α)c
c = M + w (H– αw ) or c = α(M + wH )
Substituting this expression for c into (*) leads to:
(
l = (1-α) H +
M
w
(
and the labour supply curve is therefore:
H – l = αH – (1–α) M .
w
The number of hours worked H – l, is increasing in w and hence, for this
particular utility function, the labour supply curve is not backward bending.
The simple model discussed above can be used to analyse many interesting
questions. Suppose the government pays a fixed amount in welfare benefit
for unemployed workers (i.e. if they work zero hours they get the benefit
but if they work at all, they do not).
You should be able to show that this provides an incentive to be idle especially if the
wage rate is low.
116
In many countries, welfare or unemployment benefit is withdrawn

completely as soon as the recipient enters the labour market. This ‘welfare
trap’ has detrimental effects on work incentives. Contrast this with the
Canadian province of Newfoundland, which in the 1990s introduced a
plan to avoid the problem of sudden cut-off of benefit. Every individual
was guaranteed a basic income if he did not work. Rather than losing
this welfare payment when people started working they in fact received a
higher payment in the form of a work subsidy. The income supplement
then levels off and eventually decreases to zero at an income of C$42,500
for a family of four. You should be able to show graphically that this plan
reduces voluntary unemployment and that it may be possible to reduce
total welfare payments (by substituting wage subsidies for unemployment
benefit) without making the recipients worse off.
In another paper, Biddle and Hamermesh (1990) tackle a subject which has
long been ignored not only by economists but by social scientists in general:
the demand for sleep. Given that when asked most survey respondents state
that they sleep more hours than they work, understanding the demand
for sleep seems crucial for developing a model of allocation of time by
consumers. Biddle and Hamermesh suggest that there are three approaches,
or hypotheses, to incorporating the demand for sleep in the standard leisure-
consumption tradeoff model we have worked with in this chapter.
1. The minimum amount of sleep an individual needs is assumed to be
biologically determined and consumers do not derive utility from
sleep. Under this hypothesis, an individual sleeps according to his
biological minimum and we can set the amount of time an individual
has available for work and leisure, H, equal to 24 hours per day minus
the amount of sleep.
2. A more plausible hypothesis is that the individual derives utility from
hours spent sleeping as he derives utility from leisure hours in general.
In terms of the labour supply model, the question arises whether we
make a mistake by bunching sleeping with other leisure activities.
3. There is some evidence that sleep affects productivity and hence
wage. Clearly, if we are going to take this hypothesis seriously, our
labour supply model has to be revised rather dramatically. The wage
rate becomes endogenous as it is affected by the consumer’s choice
of sleeping time: w = we+ wsts where we is the exogenous part of the
wage rate and ws measures the sensitivity of productivity or wage
to time spent asleep ts. Total time H is made up of working, waking
leisure and sleeping: H = tw + tl + ts. The consumer’s problem can thus
be written as:
Max U(c, ts, tl )s.t. c = M + (we + wsts) (H – ts tl ).
Biddle and Hamermesh come up with the following empirical findings:
• people with higher wages sleep less
• if the wage rate increases, the number of hours men work does not
increase but sleeping time is reduced in favour of leisure time
• consistent with prior research, men’s supply of work hours is much less
sensitive to changes in the wage rate than women’s. The labour supply
elasticity is measured as –0.021 for men and 0.191 for women
• sleeping time seems to be a normal good: in a sample of economies, a
higher GNP is associated with significantly longer sleep duration.
117
9.5 Risk and return

In the chapter on decision analysis, we touched on the subject of investment
choice between risky assets. Suppose you are offered two alternative
investment opportunities each with a given set of uncertain outcomes and
a probability distribution over these outcomes. A straightforward approach
would be to use the expected utility model (i.e. calculate a weighted sum
of utilities of each outcome, with the weights equal to the probability of
the outcome materialising) and choose the asset which delivers the highest
expected utility. Although this approach is valid, major progress in financial
economics was made by using an alternative assumption to simplify this
process. Harry Markowitz (1991) who, in 1990, was awarded the Nobel
Prize in Economics jointly with William Sharpe and Merton Miller, proposed
a model of choice among risky financial assets where utility depends on
expected return and standard deviation (i.e. risk) of income only rather
than on the entire probability distribution of outcomes.
When risk averse investors decide on their investment in a financial asset
they consider not only expected return (dividend or interest receipts
plus capital gain or loss) but also the risk involved. When given a choice
between investment A which gives a return of 10 per cent for sure
and investment B which gives five per cent or 15 per cent with equal
probability, A is chosen. The reason is that investment B offers the same
expected return but is more risky. In general, it is reasonable to assume
that an investor is only willing to take on higher risk when there is a
compensating increase in expected return (i.e. his indifference curves
in the risk-return plane are upward sloping: expected return is a ‘good’
whereas risk is a ‘bad’). The level of risk associated with an investment
is usually measured as the standard deviation of the return on the
investment. (This may be a good time to look for your statistics notes!)
Everything else being equal, portfolios with larger standard deviations
have to be rewarded by greater expected returns if investors are going
to hold them in equilibrium. For example, average annual returns for
US government bonds (which are a relatively low risk asset) between
1985 and 2009 was about 12 per cent and the standard deviation in the
returns was 10 per cent, while stocks included in the S&P 500 averaged a
return of 17 per cent over the same period and a correspondingly higher
standard deviation of 18 per cent (see Elton et al. 2014). These statistics
are consistent with an equilibrium in which a higher investor risk is
compensated with higher investor expected return.
Given an investor’s preferences we could predict which of a list of assets,
with given risk and return, he would invest in. In reality, however, the
investor is not restricted to investing his entire budget in one asset. He
could invest in several assets or a portfolio of assets. Investing in
several assets reduces risk when the returns on the assets are not perfectly
positively correlated. We will come back to this property later. For the time
being, let us turn to a simple example illustrating the role of correlation
between asset returns first. Suppose you can invest in a business selling
umbrellas and/or a business selling ice cream. The profitability of these
businesses depends on the weather. Assume you have an investment
budget of £10,000 and your net pay-off from investing £1 in either
business is according to the table below.
118
weather umbrellas ice cream probability

good –1 10 1/2
bad 10 –1 1/2
If you invest your £10,000 only in umbrellas, your expected pay-off is
£45,000 and if you invest only in ice cream, your expected pay-off is
also £45,000. In both cases there is also a downside risk that you lose
all your investment. However, suppose you invest £5,000 in each of
the two businesses. Then, when the weather is good, you gain £45,000
for sure and, when the weather is bad, you gain £45,000 for sure.
Your investment is effectively ‘hedged’ against weather conditions! In
other words, rather than running considerable risk by investing in only
one business, you can significantly reduce risk (and in this case indeed
eliminate it) without reducing your expected return by diversifying your
portfolio of investments.
The reason why you were able to completely hedge in the above example
is that the two investments were perfectly negatively correlated – their
returns moved perfectly together but in exactly opposite directions.
Before you get too excited about this result, it is worth remembering that
in practice it is nearly impossible to find two stocks which have perfect
negative correlation and so you have to settle for some uncertainty. Yet by
choosing a portfolio carefully this uncertainty (i.e. risk) can be reduced.
Let us see how that works practically by considering two assets A and B
with expected returns rA and rB and standard deviation of the returns σA
and σB. Empirically it turns out that the normal distribution works well to
describe the volatility of returns but we do not have to make any specific
assumption about the distribution here. Assume rA < rB and σA < σB
otherwise we could do no better than invest in the asset with the highest
return and lowest risk. Thus asset B promises a higher expected return but
it involves more risk. If of every £1 in my budget I invest a share α in asset
A and the remaining share (1 – α) in asset B, the expected return and risk
of my portfolio are given by:
rp = αrA + (1–α) rB (4)
and
Varp = α2 σA2 + (1–α)2 σB2 +2α (1–α) ρσA σB (5)
where ρ is the correlation coefficient between the returns of assets A and
B. This means that, by varying the share of my budget I invest in A, it is
possible to attain the combinations of expected return and risk given by
(4) and (5). Remember that the standard deviation is the square root of
the above expression for the variance of the return on the portfolio.
Consider the (easier) case of ρ = 1 first. This means there is a perfect
positive correlation between assets A and B. For ρ = 1 we have that,
Varp = (α σA + (1–α) σB)2 or σB = α σA + (1–α) σB
which combined with (4) implies that the portfolio’s expected return and
standard deviation (σp, rp) lie along a straight line between (σA, rA) and
(σB, rB) as is shown in Figure 9.8. In the case of perfectly correlated assets,
the return and risk on the portfolio of the two assets is a weighted average
of the return and risk on the individual assets. There is no reduction in risk
from investing in both assets and therefore no diversification benefits.
119
r
B
ρ <1
r ρ =1
A
σ σ
A B σ
Figure 9.8: Portfolio consisting of assets A and B

For ρ < 1, the correlation between asset returns is not perfectly positive
and σp < ασA + (1 – α)σB. Hence the combinations of risk and expected
return which are feasible will be to the left of the upward sloping line
segment in Figure 9.8. The smaller the value of the correlation coefficient,
the lower the risk of the portfolio. Ideally the two assets in the portfolio
should have negative correlation but, as mentioned before, in practice
finding stocks which are negatively correlated is difficult. When the
correlation between asset returns is perfectly negative, as in the example
above, a zero-risk portfolio exists that entails a combination of the two
assets.
We could extend our exercise to more than two assets and determine the
possible risk – expected return combinations which are possible by varying
the shares of the budget allocated to each asset. The set of these feasible
combinations could look like the figure below with each x representing
expected return – risk combinations for portfolios of many individual
assets. Given this feasible set which portfolio would you choose? Of
course it will depend on how risk averse you are but whatever your utility
function is, we can slim down the choice set using a dominance argument.
Given two portfolios with the same σ, you would never rationally choose
the one with the lower r because it is dominated by the portfolio which
has the same risk but offers a higher expected return. So, for each possible
risk level σ, we need only consider the portfolio which gives the highest
expected return. Similarly, given two portfolios with the same r, you would
always prefer the one with the lower risk. Hence, for portfolios with a
given level of r, the portfolio with the lowest s dominates the others. The
portfolios which are not dominated in this sense are called efficient and
are on the curve between A and B in Figure 9.9. The line connecting the
efficient portfolios is called the efficient frontier in finance theory.
Along this frontier, expected return can only be increased at the price of
higher portfolio risk – the risk-return trade-off. There are computer
programs available which calculate the set of efficient portfolios given the
risk and expected return of each available asset.
120
r
B
C
x
x
x
xx
x
xx
x x x
r x
f xx
xx
x
x x x
xx
x
Figure 9.9: Efficient portfolios
9.5.1 The efficient frontier with riskless lending and borrowing

Now suppose we have a risk free asset (e.g. a Treasury bill) available to
invest in addition to our collection of risky assets. The risk-free asset gives
a return rf and (by definition) risk σf = 0. If we invest a share α in the risk-
free asset and the remaining in a portfolio (σp, rp) then we know from (4)
and (5) that our investment will have an expected return of r = αrf +
(1 – α)rp and a variance of Var = (1 – α)2σp2 (remember that ρ = 0 in this
case). This means that, by varying the share α invested in the risk free
asset, we can attain all points on the line between (0, rf ) and
(σp, rp ). We could do this for any portfolio in the feasible set but of course
the portfolios on the efficient frontier are more desirable and, of those, the
portfolio at which the highest line from (0, rf ) is tangent to the efficient
frontier is the optimal one to combine with investment in the risk-free
asset (point C in Figure 9.9). You can see graphically that the portfolios
that combine portfolio C and the risk-free asset achieve a higher return for
a certain level of risk than any other feasible portfolio.
In fact, not only points between (0, rf ) and C are feasible but points to the
right of C as well. By borrowing money at interest rate rf and investing
it in the optimal portfolio we can extend our ‘budget line’ to the right
of C. Clearly, investors should choose a point on this budget line and
lend or borrow money at fixed interest according to whether they pick
to the left or the right of C. Exactly which combination of risk-free and
risky investment is chosen depends on the investor’s utility function, as
represented by the indifference curve in the figure above. It is not difficult
to derive the equation for the budget line through (0, rf ) and (σp,rp),
which is given by r = rf + ((rp – rf )/σp)σ. The slope of this line (rp – rf )/σp
is the price of risk which at the investor’s optimum equals his marginal
rate of substitution (i.e. it is tangential to the indifference curve).

This chapter analysed applications of demand theory to models involving
state-contingent commodities and intertemporal choices. It also explained
the typical risk-return trade-off in securities markets and derived the
portfolios along the efficient frontier line of modern portfolio theory.
121

• explain the key features of the state-contingent commodities
model
• set up the intertemporal choice problem and analyse the effect
of changes in the interest rate on the consumer’s choice
• set up a labour supply model
• derive the shape of the feasible set of risk-return combinations for
portfolios of two risky assets
• explain graphically the set of efficient portfolios of risky assets.

1. Using the state-contingent commodities model, show graphically
that, for full insurance, a risk averse individual is willing to pay an
insurance premium which is higher than his expected loss.
2. Given an interest rate for one year of r, draw a graph representing the
possible consumption choices, ct, for a consumer in each year
t = 1 and t = 2 for a consumer who earns m1 in year 1 and m2 in year 2
(and has no money left at the end of year 2).
a. Draw an indifference curve derived from a utility function U(c1, c2)
over consumption in years 1 and 2 for a consumer who maximises
their utility by neither borrowing or lending in year 1.
b. The interest rate is fixed for the rest of the question, as are
preferences. The total income of the consumer remains the same
over the two-year period, but it is now divided differently between
year 1 and year 2. On a new graph, show the consumer’s utility
maximising consumption choices in year 1 and 2, based on the
same utility function and interest rate. For what division of total
income between years will this consumer be a lender in year 1 and
for what division of total income will the consumer be a borrower?
3. A consumer lives for two periods and receives income 100 in each
period. In the first period he can invest some of his income in a
stock which has a return r of 10% or 20%, each equally likely. His
utility function U(c1, c2) is a function of his consumption levels in
both periods: U(c1, c2) = c12 + 0.7 c22 for c1, c2 ≥ 0. Find the optimal
consumption plan.
4. A worker can choose the fraction of a day, y, that he is not working
(so he works a fraction 1 – y of a day). He derives utility from
consumption goods c (assumed to have price = 1) and leisure y
according to U(c, y) = c4y2. He has a fixed nonlabour income of M per
day and the wage rate is w per day. Write his budget constraint and
derive his labour supply curve. Is it backward bending at high wages?
122
5. Empirical studies show that: (a) for male employment small changes
in the wage rate do not affect the number of hours worked; and (b)
the number of hours women work increases when taxes fall because
of their increased labour market participation. Explain these findings
graphically.
6. Portfolio theory assumes that investors care about expected return
and risk. Draw indifference curves for a risk neutral investor.
7. The return on stock A will be –10% or +20%, each with probability
0.5. The return on stock B will be –5% or +15%, with probabilities 0.3
and 0.7 respectively. The correlation coefficient between the returns of
the two stocks is 0.6. Calculate the expected return and the variance of
the return for each stock. Calculate the covariance between the returns
of the stocks. Can you decrease your risk by investing in a combination
of these two stocks rather than in either of the stocks?
8. Suppose the risk-free rate of return is 5% and you consider investing
in a risky asset with r = 10% and σ = 4%. Show all combinations of
risk and expected return which are feasible if you invest in a portfolio
consisting of the risk-free asset and the risky asset. If you are willing to
carry a risk of 3% but not more what is the best portfolio?
9. If you invest £100 now in Arnold’s ice, in one year you will get back
£(30+T) where T is the average temperature during the next summer.
If you invest £100 now in Bertha’s Brollies, in one year you will
get back £(180–T). The expected value of T is 70 and the standard
deviation of T is 10.
a. Draw a graph showing the combinations of expected return and
standard deviation that you can achieve by dividing £100 between
stock in Arnold’s ice and stock in Bertha’s Brollies.
b. What is the expected value and standard deviation of the safest
investment strategy?
c. What is the highest expected value you can achieve?
10. During the past six years the returns on Air Angleterre and French
Airways have moved as follows:
Year 1 2 3 4 5 6
AA 25 –16 18 5 13 2
FA 10 –3 15 3 20 8
Calculate all the parameters you need to derive the locus of feasible
expected return-risk combinations if you invest a share of your budget
in AA and the remainder in FA.
123
Notes
124
Chapter 10: Production and input demands
Chapter 10: Production and input

demands
10.1 Introduction
This chapter and the next one revolve around the ‘supply side’ of the
market and the economic decisions that underpin it. Specifically, here we
will focus on the topics of production functions and firms’ demand for
inputs. In the next chapter, we then analyse the economics of productive
costs. The theories and concepts discussed in these two chapters attempt
to explain how firms can – and do – make internal decisions about the
amount of input demanded and output produced irrespective of the
structure of the market in which they sell their products or services. They
explain the general behaviour of the firm’s costs and how they vary with
the amount of output it produces. In later chapters we shall also consider
different market structures and the way they affect the firm’s ultimate
productive decisions.
In the neoclassical theory of production considered here, the mechanics
of the firm’s decision process is very similar to the discussion of consumer
choice examined in the previous chapters. Firms maximise their output
level subject to certain budgetary constraints. Production is essentially
seen as a process (e.g. mechanical, physical, intellectual) that somehow
transforms inputs into outputs – in very much the same way as the utility
function related consumption to utility. A production function is
the specific mathematical relationship by which these inputs (or factors
of production) are combined to produce final output. The production
function embodies some level of underlying technology that transforms
ingredients (e.g. labour, capital, entrepreneurship) into the final product
or service. In a sense, a production function is not very different from a
cooking recipe. It lists the ingredients that need to be used and the way
they should be combined to get a perfect dish.
The material covered in this chapter typically goes under the heading
of ‘theory of the firm’ or ‘theory of production’ in most microeconomics
textbooks. However, over the last decades, there has been a growing
interest in what determines the boundaries of the firm, how firms are
organised internally, how their organisational design can be explained in
terms of efficiency and so on. All of these topics are elements of a ‘theory
of the firm’. The neoclassical view of the firm as a black box, hiring or
buying inputs, transforming inputs into outputs and selling these outputs
so as to maximise profits has ceased to be the only theory of the firm
worth studying. This is not to say that traditional neoclassical economics
has nothing to contribute to our understanding of how firms operate. It
in fact complements the new organisational theories in that it emphasises
the technical relationships within the firm and its market interactions.
Furthermore, just as the theory of the consumer is used to derive market
demand, the neoclassical model of production provides a building block in
the determination of market supply.

• how the smooth isoquants continuous production model relates to the
linear production model
125
• the difference between conditional and unconditional input demands

• the problems involved in estimating production functions
• the MRP = ME rule for determining unconditional input demands
• why imposition of a minimum wage may increase employment in a
monopsony
• why the industry demand for an input is not necessarily the horizontal
sum of firm demands.

• derive the conditional and unconditional input demands
• explain how the concept of elasticity of substitution measures the
firm’s input substitution opportunities
• be able to determine whether a production function exhibits
increasing, constant or decreasing returns to scale
• derive unconditional input demands for a monopsony, monopoly
and perfectly competitive market
• apply the inverse elasticity pricing rule for monopsony.

Norton and Co., 2014; 9th edition) Chapter 19: Technology, Chapter 20:
Profit maximization.

‘The trade unions scent a victory’, The Economist, 3 September 1994, pp.27–28.
10.2 Production functions and isoquants

The theory of production is very similar to the theory of the consumer.
The same type of reasoning is used, for example, to find conditional input
demands (amount of input used to produce a given level of output) as
to determine the consumer’s optimal consumption bundle. Isoquants
are (mathematical) contour lines of the production function whereas
indifference curves are contour lines of the utility function. Given this
similarity and that you have studied this material in your introductory
microeconomics course, we will only give a brief review here. Although the
models in this chapter are presented in terms of the firm producing one
output using one or two inputs, most of the analysis can be generalised
straightforwardly to multiproduct firms using many inputs.
It is important to realise that a production function f(x1, x2) indicates the
technically maximum amount of output which can be produced for the
given quantities of inputs x1 and x2. Similarly, any input bundle (x1, x2) lies
on the isoquant corresponding to the highest level of output which can
be achieved using these levels of inputs. To derive input demands we will
need to know the slope of the isoquants. Since output is constant on the
isoquant, using total differentiation we have:
∂f (x1, x2) ∂f (x1, x2)
df (x1, x2) = dx1 + dx2 = 0
∂x1 ∂x2
so that the slope of the isoquant or the marginal rate of technical

substitution (MRTS) equals the ratio of marginal products:
126
∂f (x1, x2) ∂f (x1, x2)

dx2 / dx1 = – / ≡ – MP1/MP2
∂x1 ∂x2
The MRTS is the counterpart of the MRS in consumer theory. It shows the
rate at which one input can be substituted for another while maintaining
the same output level. The MRTS measures how steep an isoquant is.
For convex isoquants, the MRTS decreases in x1 which means that if
a large quantity of x1 (and hence a relatively small quantity of x2) is
used, we can reduce the amount of x1 significantly while increasing the
level of x2 slightly and still produce the same amount. This property is
known as diminishing marginal rate of technical substitution.
A production function can show diminishing MRTS without having
diminishing marginal products of the underlying inputs. A problem with
the MRTS is that it is sensitive to the scale of measurement which is why
the elasticity of substitution is sometimes used to measure the curvature of
the isoquant. Specifically the elasticity of substitution is defined as:
σ = % change in the input ration x2 / x1 (1)
% change in MRTS
Intuitively, the elasticity of substitution measures how quickly the MRTS

changes as we move along an isoquant. In Figure 10.1, the change in the
input ratio corresponds to the difference in slope of rays OA and OB and
the change in the MRTS corresponds to the difference in slope of the lines
a and b tangent to the isoquant. Clearly, if for the input ratios determined
by A and B, the change in MRTS is larger, then the isoquant is more convex
and σ is smaller. The extreme values for σ are 0 for perfect complements
(L shaped isoquants) and ∞ for perfect substitutes (linear isoquants).
Activity
Why? Convince yourself by drawing a graph.
x2 B
a
0 x1
Figure 10.1: Elasticity of substitution

To justify the assumption of smooth continuous isoquants it is useful to
think of production processes (or production activities) represented by a ray
from the origin. The angle of the ray indicates in which fixed proportions
the inputs have to be combined in that particular production process.
Suppose that using production process 1 (PP1) you can produce 100 units
of output using 10 man-hours and 50 units of capital; using production
process 2 (PP2) you can produce 100 units of output using 100 man-hours
and 10 units of capital. For both production processes output increases and
decreases proportionally with increases and decreases in inputs. If you want
to produce 100 units you have a choice between using exclusively PP1 or
PP2 or a combination of the production processes. For example, you could
127
produce 50 units using PP1 (employing five man-hours and 25 units of

capital) and 50 units using PP2 (employing 50 man-hours and five units of
capital). If you combine the production processes, the combination of the
total amount of inputs used will be on the straight line AB in Figure 10.2.
capital
PP1
50 A
PP2
B
10
man-hours
10 100
Figure 10.2: The linear model

Although the linear model of production discussed above is appealing, it
is not convenient to work with mathematically. The assumption of smooth
convex isoquants, which are convenient, can be seen as a reasonable
approximation to the linear model when there are many possible
production processes.
10.2.1 Returns to scale versus diminishing marginal returns

Students often get confused about the difference between ‘diminishing
returns’ and ‘decreasing returns to scale’. Whereas the first expression refers
to decreasing marginal product of one input, the latter refers to what
happens to the level of output if all input levels increase by the
same proportion (e.g. for a production function f of two inputs x1 and
x2, f (αx1, αx2) < αf(x1, x2) for α > 1 indicates decreasing returns to
scale). When the firm’s total output exhibits decreasing returns to scale,
a proportionate increase in all input quantities results in a less than
proportionate increase in output. Note that it is possible for a production
function to have increasing returns to scale for some output levels and
decreasing returns to scale for others. You should be able to show that
the Cobb-Douglas production function f (x1, x2) = ax1b x2c has decreasing,
constant or increasing returns to scale depending on whether b + c < = > 1.
The notion of decreasing returns to scale is difficult to understand in a
realistic setting. If we can produce 100 units with a given set of inputs
why can’t we just duplicate the set of inputs to produce 200 units?
It must be that we are not really able to duplicate all inputs and we
are therefore keeping some inputs constant. Maybe it is impossible to
duplicate the entrepreneurial input or the R&D effort without loss of
quality. Increasing returns to scale can arise for example when an increase
in man-hours allows for specialisation. Also inventories of spare parts and
back-up equipment may not have to increase with an increase in output.
Sometimes a basic engineering relationship is responsible for generating
increasing returns to scale. Think of the output of an oil pipeline as
the amount of oil which flows through per time unit. This output is
proportional to the square of the radius r of the pipeline (the cross section
has area πr2) whereas the input in terms of materials is proportional
to the radius (the circumference is 2πr). Ignoring other inputs such as
horsepower needed to create a flow, output is a quadratic function of
input. In real world industries, production characterised by constant
returns to scale or close to constant returns seems the norm.
128
10.2.2 Technological progress

The production function reflects the current state of technology; if there
is technological progress, the production function changes. The notion of
technological progress encapsulates the idea that production functions
can shift over time and a firm can achieve more output from a given
combination of inputs – or, equivalently, achieve the same amount of
output with fewer inputs.
If you consider a production function with one variable input, say labour,
then the effect of technological progress is to shift the production function
up: with the same amount of labour, a higher level of output can be
achieved. For two variable inputs, the effect of technological progress
can be visualised on the isoquant map: isoquants shift inwards towards
the origin. For example, in the steel industry, American and Japanese
‘mini-mills’ – which are a quarter of the size of giant European firms (and
involve a quarter of their capital investment) – use cheap scrap rather
than iron ore and coke. To make a tonne of steel they use a quarter of the
labour needed in the European firms.
Neutral technological progress involves shifts inwardly of an isoquant
that leaves the MRTS unchanged along any ray from the origin. When the
inward shift on an isoquant also involves a change of MRTS along any
ray from the origin, the technological progress is called labour-saving or
capital-saving, depending on whether the marginal product of capital or
labour increases more rapidly after the technological progress takes place.
Empirical estimation of production functions is not easy. One popular
approach is to use statistical techniques such as regression analysis on
time series or cross section data (data on inputs and outputs for several
firms or plants in the industry) to estimate a specific functional form. The
Cobb-Douglas specification plays a role which is similar to the constant
elasticity demand function in consumer theory because of its mathematical
convenience: the parameters are estimated directly in linear regression.
When cross section data are used to estimate production functions the
implicit assumption is made that the same technological possibilities
are available to all firms in the industry and hence the same production
function applies to all of the firms. Similarly, when using time series data,
it is assumed that the state of technology is stable over the period under
study. Apart from measurement problems (it is difficult to determine
precisely the amount of all inputs used) there is the problem of whether
the observations reflect efficient production, which is what the production
function should describe. An alternative to using existing data is of course
to create new data through experiments.
10.3 Firm demand for inputs

It is important to make a distinction between the following two questions:
1. Given that the firm wants to produce a given level of output, what is
the optimal choice of inputs?
2. What are the firm’s profit maximising input demands and hence what
is the firm’s optimal level of output?
The answer to the first question gives the conditional input demands
(i.e. the amount of inputs the firm demands conditional on the level of
output it produces). The conditional input demands are used to determine
the cost function as we will see later on. The answer to the second
question gives the unconditional input demands (i.e. the amount of
inputs the firm hires or buys to produce the optimal level of output).
129
Clearly the optimal level of output is determined by the structure of the

market in which the firm operates. As we will see, there are two avenues
to determining the firm’s unconditional demand for inputs. We can find
the optimal output level first and then set demands for input equal to
the conditional demands for this optimal output level. Alternatively,
we calculate unconditional demands directly and the optimal output is
determined as the maximum output level the firm can produce given these
levels of inputs.
10.3.1 Conditional demand

Let us start by deriving the conditional input demands. The easiest
scenario to analyse is the case of a firm which is a price taker on the two
input markets. For such a firm the locus of points with equal expenditure
E on inputs is a straight line, an isocost line (p1 x1 + p2 x2 = E), the
analogue of the budget constraint for the consumer. Given the input prices
and the output level it wishes to produce with corresponding isoquant I
(see Figure 10.3) the firm wants to minimise expenditure by finding the
lowest (furthest to the south-west) isocost line tangent to the isoquant I.
The graph looks the same as for the consumer problem.
x2
isocost line
x2*
0 x1
x1*
Figure 10.3: Optimal input mix

At the optimum (minimum cost) solution (if it is not a corner solution),
the slopes of isoquant and isocost line are equal, hence:
p1 / p2 = MRTS = MP1/MP2 .
This implies that, at the optimum, the elasticity of substitution, defined in
(1) equals:
σ = % change in the input ration x2 / x1
% change in p1 / p
Hence, at the optimum, the input ratio changes significantly when the
input price ratio changes if the inputs are substitutes (σ large) whereas, for
complementary inputs (with σ small), the input price ratio has to change
dramatically to have an effect on the combination of inputs used.
For more than two inputs the optimality condition for cost minimisation
subject to an output constraint generalises to ‘the ratio of MP to price is
equal for all inputs which are actually used’. The intuition behind this
result is easy to grasp. If it were the case that the MP-price ratio of input
1 was higher than that of input 2 then, by diverting some money from the
budget for input 2 to that for input 1, you could increase output or you
could keep output constant and reduce total expenditure. It is important
to remember that the input levels which satisfy the tangency conditions
are the input demands for the given level of output. We can determine
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what happens to these input levels when the output level q changes. The
relationships we find then are precisely the conditional input demands
x1(q), x2(q). Clearly these conditional input demands depend on the prices
of the inputs and the substitutability of the inputs.
Using this simple model of conditional input demands, we can make some
interesting predictions. When the interest rate (cost of capital) falls, firms
tend to invest in labour-saving equipment. If labour costs differ between
economies, economies with relatively cheaper labour will tend to use
labour intensive production processes, even when they have the same
technological knowledge.
Example 10.1
The production function is given by q = f (x1, x2) = a x11/2 x21/2. To determine

the optimal use of inputs, set the MP-price ratio’s equal:
(a/2)(x2 /x1)1/2 /p1 = (a/2((x1/x2)1/2 /p2 .
This can be simplified to:

x1/x2 = p2/p1 or x1 = x2(p2 /p1).
Using the production function we can substitute x2 = (q/a)2 /x1 :
x1 = (q/a)2 ( p2 /p1)/x1.
The conditional input demands are:
x1 = (q/a) (p2/p1)1/2 and x2 = (q/a) (p1 /p2)1/2
We are now in a position to discuss the abuse of labour productivity

measures to construct arguments about technological change and to make
international comparisons. To view an increase in labour productivity as
technological progress is clearly wrong when the increase could be due
to a rise in wages which affects labour’s MP-price ratio so that less labour
will be used. If less labour is used then, because of the law of diminishing
return, its MP has to increase. When international comparisons regarding
productivity are made, what is often ignored are the differences in capital
intensity between production techniques used in different countries. If
Germany uses relatively capital intensive production methods (maybe
because of its high wage costs), then its labour productivity will be higher
than elsewhere.
10.3.2 Unconditional demand

Suppose we want to determine how much of each input to use while at the
same time deciding how much output q to produce. Assume there is only
one variable input labour L with unit cost w. (The model generalises easily
to any number of inputs.) We will first consider the relatively simple case
where the firm is a price taker in the input and output markets. The firm’s
problem is to use the amount of input necessary to maximise profit:
max p f (L) – w L
where p is the price per unit of output. Let us assume that the second
order condition is satisfied. The solution to the maximisation problem is
obtained by setting L such that:
p f ' (L) = w, where f ' = df /dL.
The marginal return from labour should equal the marginal expenditure
on it. This implicitly gives the unconditional demand for labour:
L = f ' –1 (w/p), where f ' –1 is the inverse function of f '.
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Of course we still have to check that positive profits are made at this
solution. Substitute p f ' (L) = w in the profit function to get:
p f (L) – p f ' (L) L
which is positive when:
f (L)/L > f '(L)
(i.e. when average product of labour (AP) exceeds marginal product of
labour (MP)). We therefore have to qualify our result by saying that the
unconditional demand for labour is:
L = f ' –1 (w/p) when AP > MP and zero otherwise.
Example 10.2
A competitive firm sells its output at price p and has production function q =
L1/2. To calculate the unconditional labour demand set
p × MP equal to w:
p (1/2 L–1/2) = w or L = (p/2w)2 .

Labour demand is increasing in price of output and decreasing
in the wage rate. We have to check that no losses are incurred which
is the case since:
AP > MP (1/L1/2 > (1/2) L –1/2) .
Now let us consider the more complicated case of a firm which is not a
price taker. In the output market this means that the market price of the
firm’s output depends on how much it decides to sell. In the input market
similarly it means that the price the firm pays per unit of input depends
on the quantity it buys. As an example consider a university which is the
only employer of cleaners in a small town. If the university wants to hire
10 cleaners it can offer a wage of £7 per hour. However, if 11 cleaners are
needed, the wage has to rise to £7.50 per hour (the supply of cleaners
is upward sloping). If the university cannot discriminate between the
workers, the marginal cost of the 11th worker is not just his salary of
£7.50 but also the increase in the other workers’ salary: £7.50 + £0.50*
10 = £12.50. Intuitively we can deduce that, if a firm is not a price
taker, it will hire fewer people because it takes into account the effect of
its demand on the wage level whereas a price taking firm ignores this
externality.
10.3.3 The case of a monopsony

A monopsony market is a market consisting of a firm which is the only
buyer in a market with many sellers who take the market price as given.
This single firm is called a monopsonist. A monopsonist can be an
individual or organisation that is the only buyer of an input, a finished
product or services. For example, until 1976, major league baseball
players in the USA were not allowed to bargain with more than one
team simultaneously. Hence each baseball team was a monopsonist in
the baseball players’ market. Similarly, governments tend to behave as
monopsonist in the market for national military equipment.
A monopsony could also be a monopoly or it could sell its output in a
competitive market. In some countries farmers have to sell their produce
to a national marketing board which (if the domestic market is isolated)
operates as a monopoly or sells the produce on the international market
at the world price (in this case price taking is likely if the country does
not represent a large share of the world market). Let us now consider the
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most general case of the unconditional input demand model (assuming

there is only one variable input L), the profit maximisation problem for the
monopsonist – monopolist:
max p(f (L)) f (L) – w(L) L.
The monopsonist explicitly takes into account the labour supply function
w(L) rather than taking the prevailing wage as given. This labour supply
curve tells us the wage that is necessary to induce a given amount of
labour to be offered in the market. In other words, the monopsonist knows
that if he wants to hire more workers he has to offer a higher wage. The
first-order condition for the optimisation problem is:
p' f ' f(L) + p f ' (L) – w(L) – L w' (L) = 0
or
( p'f(L) + p) f ' (L) = w(L) + L w' (L).
The left-hand side of this equation is the marginal return from L or
the marginal revenue product (MRP) of labour. It represents the
additional revenue that the firm gets when it employs an additional unit
of labour. Since we are assuming that the firm is not a price taker in its
output market, the MRP also takes into account the effect of additional
output on the market price. The right-hand side of the above equation
is the marginal expenditure (ME) on L. It represents the rate at
which the firm’s total cost goes up, per unit of labour, as it employs more
labour. The ME is larger than the wage as long as the supply of labour
is upward sloping (w' > 0) to capture the extra cost that comes from
having to raise the wage for all units of labour already employed by the
firm (the monopsonist cannot wage discriminate). The rule MRP = ME
captures the demand for inputs in the most general setting; it is applicable
to any combination of market power or price taking behaviour in the
input and output market. The model of course reduces to the simple case
we analysed above: for a firm that is a price taker in both the input and
output markets, marginal revenue equals price and marginal expenditure
equals wage. Figure 10.4 illustrates how the monopsonist’s demand for
labour is determined. Since ME equals MRP and it exceeds the wage, we
are justified in saying that a monopsonist pays workers below the value of
their marginal product.
ME
w*
MRP
L
L*
Figure 10.4: The MRP rule – monopsony
Many textbooks make comparative statements of the type ‘since marginal
revenue is less than the price for a monopolist, a monopolist uses less
input than a competitive firm’. The implicit assumption here is that a
competitive firm operates with the same production function as the
monopoly. Also it seems necessary to assume that it is the only firm in the
industry because, otherwise, would it not be more interesting to compare
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the industry demand with the monopoly demand? However, if the firm is
the only firm in the industry, assuming price taking behaviour is not very
realistic.
Example 10.3
The demand in an industry is given by p = 100 – 2Q, where Q is industry

output. The production function for each firm in the industry is q = f (L)
= 2 L and the wage rate is fixed at w = 4. If the industry consists of one
monopolistic firm, we determine its labour demand from MRP = ME.
Marginal revenue equals MR = 100 – 4 q = 100 – 8L and MP = 2. The
optimality condition thus reads (100 – 8L) 2 = 4 or = L* = 98/8 which
results in output of q* = 98/4. If the industry consists of a number of
competitive firms, then each firm will set MRP = p MP equal to w, or 2p =
4. At the optimum, p has to equal 2 so that industry output equals Q = (100
– 2)/2 = 98/2 (from the demand function). This requires L* = 98/4 units
of labour. (Since each firm uses q/2 units of labour, the industry demand for
labour is Q/2.)
The inverse elasticity pricing rule for a monopsony

The monopsony equilibrium condition, MRP=ME, gives rise to a useful
inverse elasticity pricing rule. The metric of interest in this case is the
elasticity of labour supply, denoted by εL, which represents the percentage
change in labour supplied per a 1 per cent change in the wage. The pricing
rule is:
(MRP – w) / w = 1 / εL
which says that the percentage deviation between the MRP and wage
is inversely related to the elasticity of labour supply. That is, the more
elastic the labour supply curve the closer the equilibrium wage is to the
marginal revenue product. In a monopsony market the firm faces the
industry labour supply, which is typically upward sloping, and therefore
the equilibrium wage is less than the marginal revenue product of labour.
The amount by which the wage falls short of the MRP is determined by the
inverse elasticity of labour supply.
Case study: monopsony and minimum wages
An important objection to minimum wage policy is that it tends to create rather than solve
problems for the people it is trying to help because of its effect on unemployment. This
argument is very compelling: increase the wage rate and you will reduce the demand for
labour, creating unemployment; at the same time a higher wage induces more people to enter
the labour market, thereby further increasing unemployment. Surprisingly, the unemployment
effect of introducing a minimum wage in a sector differs according to whether or not the sector
is a monopsony. Figure 10.5a represents a labour market with firms acting as price takers. The
equilibrium wage w* and employment L* are determined by the intersection of labour supply
and demand. Imposition of a minimum wage wmin above w* is equivalent to making the supply
curve horizontal at wmin up to where the horizontal line intersects the original supply curve. No
labour is available at wages below wmin and, at wages above wmin, labour supply is unchanged.
In a market for labour that is perfectly competitive, the introduction of a binding minimum
wage results in unemployment as more people are willing to work at the prevailing wage than
there is demand for them. The level of unemployment corresponds to the distance AB. Also note
that the equilibrium level of employment has decreased from L* to L’.
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ME
w(L) MRP
supply
demand w(L)
A B
wmin
w* w*
L' L* L L* L' L
(a) Price takers (b) Monopsony
Figure 10.5: Minimum wages
Figure 10.5b represents the situation in a monopsony market for labour. The effect of the
minimum wage on the labour supply curve is as for the price taking sector. However for the
monopsonist this has a dramatic effect on ME.
The firm can now hire as many people as are willing to work for the minimum wage without
driving wages up. His ME curve is now horizontal at wmin, up to the intersection with the supply
curve at L from where it coincides with the original ME curve since the expenses on labour are
E = wmin L for L < L and w(L)L otherwise. The monopsonist ends up employing L workers so
that employment has in fact increased! The reason is that an unregulated monopsony market
results in an underemployment of the input (in this case, labour) and low wages relative to
the competitive market outcome. In the case of a monopsony, the introduction of a binding
minimum wage can help mitigate some of this underemployment problem.
Empirical studies suggest that minimum wages do not automatically reduce employment.
Consider for example the rise in employment in New Jersey’s fast-food industry during the
1990s. In 1992 New Jersey had raised its minimum wage from $4.25 per hour to $5.05 per
hour whereas neighbouring Pennsylvania stuck to $4.25. Employment in New Jersey rose by 13
per cent more than it did in Pennsylvania. Forecasts in Britain suggested that a minimum wage
equal to half male median earnings at the time (£4 per hour) would have had no significant
impact on jobs if it did not apply to young workers under 21 years of age (see ‘The trade unions
scent a victory’).
The model of unconditional input demands is interesting because it

provides a link between input and output markets. It allows us to predict
the effect of changes in the output market, such as moves towards more or
less concentration, on the input market. Price wars in the PC market have
the effect of reducing the MRP of microprocessors putting pressure on
microprocessor prices. Similarly, fare wars in the airline industry have an
effect on the aircraft market.
The model of unconditional input demand summarises the firm’s problem.
Once we have determined the unconditional demand for inputs for a firm
we have solved the problem of how much to produce (i.e. the maximum
amount which can be produced given the inputs available) and what price
to charge (this can be read off the demand curve given the output level).
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10.4 Industry demand for inputs

In the consumer theory chapter we concluded that the market demand
curve is simply the horizontal sum of individual demand curves. The
situation is not quite as simple here. Of course, if the industry is a
monopoly we have no aggregation problem: the industry demand is the
firm demand. So let us consider the case of demand for an input, say
labour, by a competitive industry. Each individual firm in the industry
takes the input price or wage w as given and determines its requirement
from MRP = p MP = w where p is the output price. Now suppose the wage
decreases from w0 to w1. Each firm, given p, wants to hire more workers.
However, p is not fixed in the sense that when all firms in the industry
start hiring more workers and producing more output, the output price
falls (if the demand curve does not shift). When the output price falls,
each individual firm’s demand for labour, and hence the horizontal sum of
the demands ∑MRP, shifts to the left, as is indicated on Figure 10.6 for a
drop in price from p0 to p1. We conclude that the industry demand (in bold
on the figure) is steeper or less elastic than the sum of firm demands.
There are alternative possible scenarios however. In the analysis above
we have ignored the effect of entry and exit in the industry. If the lower
wages lead to positive profits, new firms will enter the industry with two
counteracting consequences:
• these new firms help to increase total industry output and hence
depress output price but
• there are now more individual firm demands to sum horizontally.
Depending on which of these effects is strongest, the industry demand
could be more-or-less elastic than ∑MRP. This analysis has a mirror image
in the determination of market supply.
w0
w1
∑ MRP (p0)
∑ MRP (p1)
Figure 10.6: Industry demand for inputs
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Example 10.4
In Example 10.2 we determined the demand for labour by a competitive firm

with production function q = L1/2 as L = (p/2w)2. Suppose there are 100
identical firms in this industry and industry demand is given by
p = 50 – Q/50 where Q is total industry output (Q = 100q). Applying
p MP = w for each firm but now taking the effect of industry output on price
(via the demand function) into account, we find:
(50 – 2q)(1/2)L–1/2 = w
and after substituting the production function, we have that:
(50 – 2L1/2)/(2L1/2) = w or L = (25/(w + 1))2 .
The industry demand for labour is thus 100(25 / (w + 1))2 rather than the
sum of firm demands 100(p/2w)2.
Case study: A worked out example of the effect of industry

concentration on input price
It is often argued that competition among buyers should be encouraged if the objective is to get a
good deal (a high price) for input producers. Concentrated industries are said to be mean buyers
of inputs. This argument has been used to abolish state marketing boards for agricultural products
for example, and in the same sector, to promote competition among food processing plants. The
reasoning is intuitively appealing. When firms act as price takers, they will demand more inputs
since they do not worry about the effect of their demand on the input price. Also, a competitive
industry is likely to produce more output than a monopoly which again should increase demand
for inputs and hence their price. What we want to show you in this example is that, although
there may be very good arguments to promote competition in an industry, it is not necessarily
always the case that more competition leads to higher input prices.
For simplicity we look at an industry with only one input, labour. The supply of labour is given by
w = 1 + L. The production function is q = L1/2 for each firm in the industry and market demand for
the output is given by Q = 2 – p, where Q is total industry output and p is output price.
Monopoly
Let us consider first what happens if the industry consists of one firm, a monopoly – monopsony.
Its total expenditure on labour equals Lw = L (I + L) so that marginal expenditure equals ME =
1 + 2L. Marginal revenue for the monopolist is MR = 2 – 2q = 2 – 2L1/2 and MP = (1/2) L–1/2.
Applying the rule MRP = ME, (and doing some numerical work because this equation cannot be
solved analytically), gives an unconditional input demand of L* = 0.18. The corresponding wage
can be found from the labour supply function as w = 1.18. Given its demand for labour, we know
from the production function how much output the monopolist produces: q = 0.42, and hence
final product price (from the demand function) is p = 1.58.
Perfect competition
Now let us see what happens if a number of (identical) firms in this industry behave as price
takers in input and output markets. Each firm sets MRP = p MP equal to ME = w or p /(2L1/2) =
w. To determine the industry demand for labour we cannot just add these individual demand
curves as we have seen above. We need to take the output price effect of increased input demand
into account. The optimality condition for the firm becomes (2 – nq)/(2L1/2) = w, where n is the
number of firms in the industry or, after substituting for q, (2 – nL1/2)/(2L1/2) = w. We can solve this
latter equation for L and find L = (w + n/2)–2 as the amount of labour used by each firm. The total
demand for labour in the industry is n times this amount: L = n (w + n/2) –2 = 4n(2w + n)–2. The
equilibrium wage is such that demand and supply of labour are equal: 4n(2w + n)–2 = w – 1. This
equation cannot be solved analytically. The table below gives the equilibrium wage (rounded to
two decimal places) for some specific values of n. It is not difficult to show that the limiting value
of w, as the number of firms n increases, equals 1.
137
number of firms equilibrium wage w

5 1.34
10 1.26
20 1.16
100 1.04
1000 1
At first sight we have a counterintuitive result. The more competitive the industry (the larger
n) the lower the equilibrium wage. Also, when the number of firms is large, the competitive
industry pays lower wages than a monopsonist! To see what is happening here look at the
table below which gives the values of the key variables for a monopsonist, a competitive
industry with n = 10 firms and a competitive industry with n = 20 firms. L* is total labour
demand in the industry and Π is profit per firm.
w L* q Q p Π
monopsony 1.18 0.18 0.42 0.42 1.58 0.45
n = 10 1.26 0.26 0.16 1.6 0.4 0.03
n = 20 1.16 0.16 0.09 1.79 0.21 0.01
If you compare the monopsony with the competitive industry with n = 10 firms, you notice
that total output Q is larger in the competitive industry and the demand for labour is higher,
hence the higher wage rate. However, as the number of firms in the industry increases from
10 to 20, more output is produced with significantly less labour and, as a consequence, the
wage rate drops. The explanation for this phenomenon is the decreasing returns to scale
production function. An industry consisting of many small plants can produce the output
more efficiently than one consisting of a few large plants. This makes the example rather
artificial since if there are decreasing returns to scale, the monopsonist could operate several
small plants rather than one large operation. However the analysis above was carried out for
zero fixed or sunk costs. If a sunk cost is incurred when a plant is put into operation, there is
a tradeoff between efficiency of production and setup costs. (It is a good exercise for you to
check how the assumption of positive sunk cost would affect the analysis.) The purpose of
this example was to show you that you should analyse an industry and its related industries
in detail before you can make general statements.

This chapter discussed the concept of marginal rate of technical
substitution in the production process, the firm’s (conditional and
unconditional) demand for inputs and the case of a monopsony.

• derive the conditional and unconditional input demands
• explain how the concept of elasticity of substitution measures the
firm’s input substitution opportunities
• be able to determine whether a production function exhibits
increasing, constant or decreasing returns to scale
138
• derive unconditional input demands for a monopsony, monopoly

and perfectly competitive market
• apply the inverse elasticity pricing rule for monopsony.

1. Draw an isoquant map representing increasing returns to scale up to
some output level and then decreasing returns to scale.
2. You can cook meals from ‘scratch’ using fresh ingredients or you can
buy frozen dinners. Draw an isoquant assuming the only inputs in
meal production are time and money.
3. For the linear version of the production model where every production
process is characterised by a ray through the origin in the isoquant
plane, show (graphically) the effect of technological progress which
enables the same production levels as before with less labour input.
4. In many less developed countries, production is constrained by the
availability of capital. Show graphically (on an isoquant map) how the
cost function reflects this constraint on the amount of capital available.
How would you find the cost function analytically?
5. A firm’s production function is given by q(K, L) = K1/3 L2/3 and it faces
fixed input prices r (for capital) and w (for labour).
a. Derive the conditional input demands.
b. If the demand function is given by q = (21 – 4p)/8, w = 1 and r
=1/2, what is the firm’s optimum output level? At this output level
how much capital and how much labour is used?
c. Suppose the wage increases from w = 1 to w = 8. If the firm
continues to produce the output level in (b) what is its new
demand for labour i.e. what is the substitution effect of the
change in input price?
d. Given the wage increase in (c), what is the new optimal output
level and its associated demand for labour? What is the output
effect of the change in input price?
6. A monopsonist’s only factor of production is labour and its production
function is Q = 2L, where L is the quantity of labour. The labour
supply curve is w = 2 + L and the monopsonist can sell all the output
it wants at a market price of $10. How much labour would the firm
hire to maximise profit, and what would be the resulting equilibrium
wage in the monopsony market?
7. A large department store behaves as a monopsonist in the market for
retail employees in a small town. At its profit-maximising demand for
labour services, the elasticity of labour supply is +0.8. What does this
tell you about the magnitude of the MRP of labour relative to the wage
that the firm is currently paying its employees?
139
8. A firm’s output, Q, is sold in a perfectly competitive market at p=10.

The firm is a monopsonist in the labour market and its production
function is given by Q(L)=L. Labour is supplied competitively and
everywhere along the supply curve the elasticity of supply is 1.5. How
much lower is the wage paid by the monopsonist than the wage the
firm would pay if it faced intense competition in the labour market?
9. True/false
a. The industry demand for an input is less elastic than the horizontal
sum of the marginal revenue product curves if the industry is
perfectly competitive.
b. Same question if the industry consists of local monopolists with
independent markets.
140
Chapter 11: Cost concepts
11.1 Introduction
In the last chapter we considered firms’ production functions and their
optimal demand for inputs when they operate in a competitive market and
a monopsony. Here, we study costs and the cost minimisation problem. As
we shall see, the latter is closely linked to the conditional input demand
functions studied in the previous chapter. These demand functions answer
the question of how much of each input the firm would use if it wanted to
produce a given level of output in the most economical way. The answer
typically depends on the desired level of output and input prices (as
opposed to the price of output).
The concept of cost applied in managerial economics is broader than
that used in other subjects. For example, it goes beyond the definition of
accounting cost included in the monetary expenses of a company’s income
statement or in the items of a governmental annual budget. Economists
essentially define cost as the value of sacrificed opportunities when one
specific course of action is chosen. This is called opportunity cost.
So cost in managerial economics is not necessarily synonymous with
monetary outflows. For instance, the economic cost of setting up your
own business includes not only the set-up costs and operating expenses,
but also the alternative income that you forego by dedicating yourself to
running your business rather than working somewhere else and earning a
salary. Note that the latter cost represents a lost opportunity, not a direct
financial outlay, but from an economic perspective it should nevertheless
be included as a cost of running your business because it is sacrificed
income. If you didn’t include it you could be underestimating the true cost
of your venture. A similar reasoning can be applied to almost any other
economic decision so long as the relevant resource (in this example, your
time) is scarce.
Another important distinction in managerial economics is between
sunk and non-sunk costs. Simply put, costs that have already been
incurred in the past and cannot be recovered in the immediate future
are considered to be sunk. Therefore they are irrelevant to the decision
maker. As you will see in later chapters of this guide, the existence of sunk
costs can have important implications for the degree of competition in an
industry because they give rise to strategic asymmetries between firms.
For example, certain costs such as an advertisement can be sunk and
irrecoverable and an incumbent firm will not take them into consideration
when making pricing decisions. However, the same cost can be non-
sunk for another firm that is considering entering into that market. The
incumbent firm can use this fundamental asymmetry in cost structure
strategically to deter competitive pressure from potential entrants.
More generally, the intrinsic structure for firms’ costs matters because it
has direct implications for the structure and competitive environment of an
industry. In effect, industries characterised by the presence of significant
economies of scale tend to be highly concentrated because large firms
can achieve relatively lower average costs per unit of production. In these
industries, large firms can enjoy significant market power. The extreme
illustration of this behaviour is, of course, a natural monopoly where unit
cost continuously falls along all the relevant output range. The so-called
economies of scope can also lead to economic efficiencies when firms
141
produce more than one main product. When economies of scope are
prevalent, productive variety is more efficient than extreme specialisation:
firms that produce several products can manufacture and take them to
the market at a lower total cost than stand-alone firms. Marketing is
an important source of economies of scope because companies with a
well-established brand can leverage their reputable name and previous
customer experiences for the introduction of new products at a lower cost.

• the cost minimisation problem
• the different types of costs that are relevant to managerial
economics
• economies of scale and economies of scope
• the problems involved in estimating cost functions
• why MR should equal MC in each producing plant of a multiplant firm.

• solve a firm’s cost minimisation problem
• correctly apply different economic concepts of cost such as fixed and
sunk costs
• distinguish between economies of scale and diseconomies of
scale
• explain the meaning of economies of scope and their potential
impact on market structure
• solve the problem of which plants(s) to operate, and at what level, for
a two plant firm given the plants’ cost functions and the demand
function.

Norton and Co., 2014; 9th edition) Chapter 21: Cost Minimization.

Besanko, D. and R. Braeutigam Microeconomics. (Singapore: John
Wiley & Sons, 2015) 5th edition, international student version
[ISBN 9781118716380] Chapter 7: Costs and cost minimization, and
Chapter 8: Cost curves.
(Singapore: John Wiley & Sons, 2013) 6th edition, International student
version [ISBN 9781118319185], particularly Economics primer: basic
principles, and Chapter 2: The horizontal boundaries of the firm.

This chapter discusses the firm’s cost minimisation problem and other
relevant topics in the economic theory of costs.
142
11.2 Types of economic costs

We mentioned in the introduction to this chapter that economists think
of cost as the value of sacrificed opportunities. This notation is based on
the concept of opportunity cost, which is a term you should be already
familiar with from your introductory economics courses. The opportunity
cost of a particular alternative is the payoff associated with the best of the
alternatives that are not chosen. Opportunity cost is a forward-looking
concept since it considers what is sacrificed by the decision-maker at the
time the decision is made and beyond. Historical accounting costs are not
necessarily appropriate for decision-making inside a firm. Economic costs,
based on the concept of opportunity cost, turn out to be more relevant to
managerial decision-making because they reflect the full value of foregone
opportunities as a result of the firm’s chosen production activities.
Economists also distinguish among other types of costs that are important
for the study of market structure and strategy, particularly rivalry among
firms as well as entry and exit decisions from markets. Some of these cost
concepts are discussed below. They will play a role when you analyse
strategic interactions and competition between firms in later chapters of
this guide.
11.2.1 Sunk costs

Managers should only consider those costs directly affected by the
alternative chosen when they make a decision. Sunk costs are those
costs that must be incurred by the decision-maker no matter what and
therefore should be ignored in the decision-making process. They are
unavoidable. The opposite of sunk costs is avoidable costs. Nonsunk
costs are costs that will be incurred only if a particular decision is made,
and are relevant to the decision-maker. This distinction is illustrated in the
following example.
Example 11.1
Consider a sporting goods firm that manufactures running and athletic

shoes. The shoe factory cost £2 million to build and is so highly specialised
that it has no alternative uses. Thus, if the sporting goods firm shuts the
factory down and produces nothing, it will not recover any of the £2 million
it spent on building the factory. Notice the following distinction between
avoidable and unavoidable costs:
•• The £2 million is a nonsunk cost if the relevant decision is whether

or not to build the factory, because the investment can be avoided if
management decides not to build the factory.
•• The £2 million is a sunk cost once the shoe factory has been built and
should not be taken into account when deciding whether to operate the
factory or shut it down.
•• If some of the £2 million investment could be recovered by selling the

factory then some of this cost would be avoidable and therefore relevant
when deciding whether to operate the factory or shut it down.
Example 11.1 illustrates the notion that whether or not a cost is sunk
depends entirely on the decision and timing being considered. The same
type of cost could be sunk in one context and avoidable in another. The
key to identifying what costs are sunk is to ask yourself if it can be avoided
should you choose a particular course of action.
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Variable costs are always nonsunk because (by definition) they are
completely avoidable if the firm produces no output. However, you
shouldn’t confuse fixed costs with sunk costs. Fixed costs are not
necessarily sunk. For example, a railway operator serving the line from
London to Cambridge needs a locomotive and crew whether the train
is formed of four or eight coaches. Some of these costs are therefore
fixed but not necessarily sunk because the locomotive and staff could
be redeployed to another route if the operator discontinues its London
to Cambridge service. These fixed costs would be avoidable if the firm
decided to stop this service. Note that fixed and sunk costs are both output
insensitive and unavoidable, even if the firm produces no output.
11.2.2 Economies of scale and economies of scope

Economies/diseconomies of scale refer to the behaviour of the
average cost as the level of output increases. Particularly, a firm enjoys
economies of scale in a situation where the average cost declines when
output goes up. On the contrary, a firm suffers from diseconomies of
scale in a situation where average cost increases when output also goes
up. Economies of scale are fundamental to business strategy because they
are a key determinant of a firm’s horizontal boundaries, that is, the size
of its operations. Some industries such as microprocessors and airframe
manufacturing are characterised by the presence of significant economies
of scale in production and as a result a few huge firms dominate. These
relatively large firms can achieve significant cost advantage.
A good understanding of the sources of economies of scale in a market
is critical for understanding competition and market structure. The most
commonly observed sources of economies of scale include the following:
• spreading fixed costs over an increasing volume of output, which leads
to decreasing average costs over the relevant range of output
• production technologies that are capital intensive and therefore give
rise to substantial indivisibilities in the production process (indivisible
inputs are available only in a certain minimum size and cannot be
scaled down as the firm’s output goes to zero)
• physical properties of the production (e.g. cube-square rule)
• economies of scale due to more effective advertising.
While economies of scale may arise in firms that produce a single product,
the concept of economies of scope is only applicable to multiproduct
firms (i.e. firms that produce more than one product). For simplicity’s
sake, let us focus on the simplest case in which the firm produces two
products. A two-product firm is said to achieve economies of scope if
it can manufacture and market its products at a lower cost than two
single-product firms. Let TC (Q1,Q2) denote the total cost to a single firm
producing Q1 units of product 1 and Q2 units of product 2. Mathematically,
a production process exhibits economies of scope if:
TC (Q1,Q2) < TC (Q1,0) + TC (0,Q2).
The above expression captures the idea that it is cheaper for a single firm
to produce both products than for one firm to produce product 1 and
another to produce product 2. Therefore variety turns out to be more
efficient than specialisation. Economies of scale exist if it is less costly for
a firm to add a product to its existing product line given that it already
produces another product.
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Why would economies of scope arise? A common reason is a firm’s

ability to leverage a common input or capability across more than one
product. For example, a satellite television company can use the same
satellite to broadcast news, sports and movie channels and thus save a
substantial amount of money in satellite equipment when compared to
a firm broadcasting stand-alone channels. Apple’s core competency in
engineering and innovation also allows it to make and market popular
mobile phones, tablets and laptops. Marketing can also be a powerful
source of economies of scope.
11.3 From production function to cost function

This section considers the firm’s cost minimisation problem and revisits
some of the concepts discussed in Chapter 10 of the subject guide.
Whereas the production function gives the maximum amount of output
which can be produced as a function of the level of inputs, the cost
function gives the least cost at which a given level of output can be
produced. If there is only one variable input, it is very easy to derive the
cost function from the production function. For a production function q =
f (L), the input requirement for production of q units is L = f –1 (q) and the
corresponding cost function C(q) = w f –1 (q). If there are several variable
inputs, the problem is a bit more involved. By definition of the cost
function, we have to determine, for each output level, the cheapest way to
produce it. For each output level q we have to find the best combination
of inputs. But this is exactly the problem we solved when we determined
conditional input demands! The procedure to find the cost function
corresponding to some production function is thus to find the conditional
input demands and then determine the budget necessary to cover these
requirements.
Example 11.2
In Example 10.1 of Chapter 10 we showed that the conditional demands for

the production function:
q = f(x1, x2) = ax11/2x21/2 are x1 = (q/a)(p2/p1)1/2 and x2 = (q/a)(p1/p2)1/2.
The cost function is therefore:

C(q) = p1x1 + p2x2 = (q/a)(p2/p1)1/2p1 + (q/a)( p1/p2)1/2p2) = (2q/a)( p1p2)1/2.
In the example above we had a constant returns to scale production function

and a linear cost function. In fact, this observation holds more generally
whenever the firm behaves as a price taker in its input markets. Similarly,
increasing (decreasing) returns to scale production functions lead to cost
functions which are less than (more than) linearly increasing.
Activity
Show that the cost function corresponding to the Cobb-Douglas production function:
f (x1, x2) = ax1bx2c
is
C(q) = k p1b/(b+c)p2c/(b+c)q1/(b+c)
where k is a constant depending on a, b and c.
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11.4 Division of output among plants

Suppose a firm operates or is considering operating several plants
or establishments from which it serves the same market. A natural
managerial planning question that arises is: ‘How much output should
each plant produce?’ Intuitively, we could say that, if several plants are in
operation, the marginal cost (MC) in each plant should be equal otherwise
the firm could produce the same amount of output at lower cost by
transferring output from a plant with high MC to a plant with lower MC.
Also, the MC in each plant should equal marginal revenue (MR). To show
this mathematically, assume I produce a total output q, q1 in plant 1, q2
in plant 2 (q1 + q2 = q) and the demand curve is given by p(q). My profit
maximisation problem is:
max П = p(q1 + q2)(q1 + q2) – C1(q1) – C2(q2).
q1, q2
The first order conditions for an interior solution ∂π/∂q1 = ∂π / ∂q2 = 0
result in:
MR(q1 + q2) = MC1 (q1) = MC2 (q2)
which confirms our intuition. We can represent the multi-plant problem,

and the optimality condition that MR equals MC at each plant, graphically
as is done in Figure 11.1. Suppose there are two plants with increasing MC
and MC1(0) < MC2(0). Clearly, if the firm’s total output is less than q’ where
MC1(q’) = MC2(0), then only Firm 1 should be used. As output increases
beyond q’ the firm should start to use Plant 2, adding units of output to
the plant with minimal MC. In other words, the firm’s aggregate marginal
cost curve is the horizontal sum of the plants’ MC curves. The firm’s
optimal output level q is determined by the intersection of this aggregate
MC curve with the MR curve. We can trace back from this intersection to
the individual plants’ MC curves to find the optimal output level for each
plant.
MC1 MC2
∑ MC
MR
q' q*1 q1 q*2 q2 q' q* q
Figure 11.1: Division of output among plants

The optimality condition above is only valid for an interior solution
(i.e. a production plan in which the firm actually produces positive
output in both plants). In general we have to compare the profit obtained
with such a plan with profit obtained by operating one plant only. If, for
example, the fixed costs of Plant 1 are high, it may be better to produce
only in Plant 2 even if Plant 2 is less efficient in the sense that its MC is
higher. Example 11.3 shows how fixed costs determine where production
should take place.
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Example 11.3
A firm which faces a demand curve p(q) = 50 – 10 q is considering whether

it should operate from two establishments and, if so, how much to produce
in each. The cost functions associated with the two plants are: C1(q1) = F1
+ 10q1 + 10q12 and C2(q2) = F2 + 5q22 respectively, where F1 is fixed cost in
Plant 1, so that MC1(q1) = 10 + 20 q1 and MC2(q2) = 10q2.
Let us first check the interior optimum by setting MR(q1 + q2) = MC1(q1) =
MC2(q2). The marginal revenue corresponding to the demand curve is MR(q1 +
q2) = 50 – 20 (q1 + q2). Setting this equal to MC1(q1) = 10 + 20 q1 and solving
for q1 gives q1 = 1 – q2/2(*). Setting MR(q1 + q2) equal to MC2(q2) = 10q2 and
substituting (*) for q1 results in q20 = 3/2 and, using (*) again, q10 = 1/4. You
should check this result by calculating the marginal revenue and marginal cost
functions at q10 and q20. You should also check that if we had MC2(q2) = 60 +
10q2 instead of the original MC function at Plant 2, there is no interior solution
i.e. under these conditions it does not pay to produce at Plant 2.
Even when we obtain an interior solution, we have not necessarily identified

a profit maximising production plan. The profit level corresponding to
(q10, q20) is calculated as:
П = (50 – 10(7/4))(7/4) – F1 – 10(1/4) – 10(1/4)2 – F2 – 5(3/2)2 = 42.5 – F1 – F2 .

We compare this to the maximum profit attainable if we operate a single plant.
If only Plant 1 is in operation (q2 = 0), its optimal output level is such that MR
= MC1 or 50 – 20 q1 = 10 + 20 q1 such that q1 = 1. The corresponding profit
level is Π1 = (40)(1) – F1 – 10 – 10 = 20 – F1. Similarly, operating just Plant
2 (q1 = 0) leads to 50 – 20q2 = 10q2 or q2 = 5/3 and corresponding profit
level Π2 = (50 – 10 (5/3))(5/3) – F2 – 5(5/3)2 = 41.67 – F2. Depending on
whether Π, Π1, or Π2 is largest, we should produce at both plants, at Plant 1
only or at Plant 2 only. Clearly, which is optimal depends on the fixed costs as
is summarised in the figure below. For example, Π is largest if 42.5 – F1 – F2
> 20 – F1 and 42.5 – F1 – F2 > 41.67 – F2 which implies that operating both
plants (the interior solution) is profit maximising if F1 < 0.83 and F2 < 22.5.
You should check that Π1 is largest when F2 > max(21.67 + F1, 22.5) and Π2 is
largest when F1 > 0.83 and F2 < 21.67 + F1. The north-east corner of Figure
11.2 corresponds to the scenario where fixed costs are too large at both plants
so that it is impossible for the firm to make positive profits.
F2
just plant 1 shut down

41.67
22.5
21.67 just plant 2

both
0.83 20 F1
Figure 11.2: Fixed costs and mulitplant firms
147
The example above shows how firms can decide whether to operate one or
two manufacturing plants. Using this type of reasoning we can explain why
real-life firms shift production from one plant to another due to exogenous
cost shocks. Hoover, the domestic appliance maker, shut down its plant
in Dijon thereby ending 600 jobs in France in January 1993. It decided
to concentrate vacuum-cleaner production in Scotland, creating 400 new
jobs at its plant near Glasgow. By shifting its production, Hoover slashed its
costs by a quarter, partly due to economies of scale (all production in one
plant) and the rest from lower wages and non-wage costs such as health
insurance which are a lower percentage of overall wages in Britain than in
France. The French have accused Britain of ‘social dumping’.
11.5 Estimation of cost functions

Our analysis of how firms decide on optimal output levels and how they
allocate production between plants rests heavily on the firm’s knowledge
of its cost function. How do firms obtain this knowledge? One approach
is to use econometric analysis, using time series and/or cross section data
(for several firms or plants in the same industry at a particular point in
time). Using regression analysis the relationship between cost and output
level, input prices, plant size, and so on can be calculated.
As in other applications, we have to decide which functional form to
use that relates the dependent variable of interest (total cost) to the
independent variables being used. Is the cost function linear, quadratic or
cubic in output or does a Cobb-Douglas function give a reasonable fit to
the data? As we have seen before, the Cobb-Douglas specification, which is
very popular, takes the form:
C(q) = k pLα pKß pEγ qδ,
where pL, pK, and pE are labour, capital and energy (or other input) prices
and α, β, γ, δ are the parameters to be estimated.
In practice however, estimating cost functions is problematic. To
start with, there are serious problems with the availability of suitable
data. Expenditures on capital are difficult to measure. Most firms are
multiproduct firms and it is difficult to isolate cost-related data for a single
product. Accounting data reflect various ways of allocating overheads over
products and may hide important factors such as economies of scope (i.e.
the scenario in which it is cheaper to produce several products together
rather than separately).
Using time series data leads to additional problems. To get reliable results,
we need a reasonable sample size of, say, 40 observations. Ideally we
should use monthly observations; it is unreasonable to assume that firms
are using the same production technology (and hence operate according
to the same cost function) over a period of 40 years! In agriculture, for
example, mechanisation has dramatically changed the labour intensity of
many production activities over timespans of 10 or 20 years.
Remember that in the definition of the cost function it is assumed that
firms are using the most efficient combination of inputs. If the real life
firms in the sample are not operating efficiently, the estimated cost
function will be biased. In fact, we cannot expect firms to be operating
‘efficiently’ at all times; this would require perfect foresight and
immediate adaptation of scale of inputs to changed market environments.
An alternative method which is used to estimate the cost function is the
engineering approach. Engineers are asked to estimate the quantity of
inputs such as plant size and machinery required for given levels of output.
148
To estimate the cost function, these requirements are simply multiplied by

the price of the inputs. Because of the technical nature of this exercise, the
costs of controlling and managing are often overlooked.

This chapter examined the cost minimisation problem and other topics in
the economic theory of costs such as sunk costs, economies of scale and
scope, and the division of output among several plants.

• solve a firm’s cost minimisation problem
• correctly apply different economic concepts of cost such as fixed and
sunk costs
• distinguish between economies of scale and diseconomies of
scale
• explain the meaning of economies of scope and their potential
impact on market structure
• solve the problem of which plants(s) to operate and at what level for
a two plant firm given the plants’ cost functions and the demand
function.

1. Suppose that the total cost of providing broadcasting television
services is as follows:
TC(Q1,Q2) = 0 if Q1= Q2= 0, TC(Q1,Q2) = 100 + 2Q1 + 3Q2 otherwise.
Does the provision of broadcasting services exhibit economies of
scope?
2. What is the difference between economies of scale and economies of
scope?
a. Is it possible for a single-product firm to enjoy economies of scope
but not economies of scale?
b. Is it possible for a two-product firm to enjoy economies of scale but
not economies of scope?
c. Do economies of scope depend on the level of output being
produced?
3. Find the cost function corresponding to the following production
functions:
a. the inputs are perfect complements: q(x1, x2) = min (x1, x2)
b. the inputs are perfect substitutes: q(x1, x2) = x1 + x2.
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Notes
150
Chapter 12: Topics in labour economics
12.1 Introduction
The previous chapters have provided all the ingredients of the traditional
neoclassical model of the labour market. The supply of labour is derived
from individual utility maximising decisions regarding consumption of
leisure and other goods. The demand for labour by a firm is derived from
the marginal revenue product rule which says that firms hire an amount
of labour such that the marginal return (the marginal revenue product
or MRP) equals the marginal expenditure. The total demand for labour
(as for other inputs) is obtained by summing the firms’ demands taking
into account any effects of this aggregation on the marginal revenue
of output (see Chapter 10, section 10.4 ‘Industry demand for inputs’).
The equilibrium employment and wage levels are determined by the
intersection of supply and demand.
Although the traditional neoclassical framework summarised above is
undoubtedly an elegant construction which provides a wealth of testable
predictions, as it stands, it is neither realistic nor a great help to managers.
For a start, the model cannot explain involuntary unemployment. If
there is unemployment (labour demand less than labour supply), wages
simply adjust downwards until an equilibrium is reached. This ignores,
among other things, the effect of minimum wage regulations, welfare
payments and union power. Furthermore, downward pressure on wages
can only exist if the pool of unemployed workers is available where they
are needed; if they are in a geographically different location they may
face prohibitive moving costs. Also, the theory predicts that wages should
be continually adjusted to reflect a worker’s productivity whereas in
practice wages are fairly stable and are almost never adjusted downwards.
Similarly, firms are assumed to adjust the size of their workforce
continually in response to changes in demand conditions whereas in
practice labour turnover, at least in Europe, is limited.
The MRP rule is hardly a practical guideline for managers making hiring
decisions and setting wage levels. At the time a worker is hired, there
is uncertainty about his productivity. This problem is likely to be worse
for skilled or professional workers for whom, even after they have been
hired, it is difficult to measure performance or productivity. Managers do
not treat workers like other inputs. In addition to making decisions about
how many workers to hire and how much to pay them, there are the
important problems of whom to hire, whether and how to train them and
how to motivate them. To explain certain features of the internal labour
market such as promotions, life-time employment with the same company,
increasing wages over a career path, etc., different models or at least
variations on the conventional framework are needed.

• the role of unemployment both as a consequence and a necessary
condition in efficiency wage theory
• the dependence of the efficiency wage on the size of a potential
gain from cheating, the probability of being caught and unemployment
benefit
151
• why an individual firm’s demand for labour could increase when

it introduces efficiency wages
• why we observe long-term employment
• the role of promotions in the internal labour market.

• discuss the difficulties in attempting to apply standard neoclassical
models of labour supply and demand to internal labour markets
• analyse a simple efficiency wage model
• set up and solve the minimum cost implementation problem
• give explanations for increasing wage profiles
• discuss Frank’s theory of wage compression.

Shapiro, C. and J.E. Stiglitz ‘Equilibrium unemployment as a worker discipline
device’, American Economic Review 74(3) 1984, pp.433–44.
Yellen, J. ‘Efficiency wage models of unemployment’, American Economic
Review, Papers and Proceedings 74(2) 1984, pp.200–08.

Frank, R.H. ‘Are workers paid their marginal products?’ American Economic
Review 74(4) 1984, pp.549–71.
Lazear, E.P. ‘Agency, earnings profiles, productivity, and hours restrictions’,
American Economic Review 71(4) 1981, pp.606–20.
Malcomson, J.M. ‘Work incentives, hierarchy, and internal labour markets’,
Journal of Political Economy 92(3) 1984, pp.486–507.

The main purpose of this chapter is to discuss the efficiency wage model
as an alternative to the standard microeconomic model of labour markets,
the characteristics of an internal (i.e. corporate) labour market and
reasons why wages may rise over an individual’s career path.
12.2 Efficiency wages

Standard labour economics models assume that labour is of uniform
quality and that this quality can be observed by the employer. Indeed,
the employer is assumed to base the worker’s reward on his quality or
productivity. In reality of course employers do not have perfect information
about workers’ quality or (lack of) effort. If the employer cannot detect
‘cheating’ such as entertaining friends instead of customers on the business
expense account, selling company secrets, taking bribes, working less than
contracted for, etc. then workers will cheat. Even when an employer can
detect these activities, the possibilities for punishment are limited beyond
dismissal.
In many cases, the only means of disciplining a worker is to fire him or
her. No further disciplinary action is available. However, if the terminated
worker can immediately find a new job at the same wage (there is
no unemployment) and there are no reputational effects, then even
termination is not an effective punishment and hence threat of termination
152
will not necessarily induce good behaviour. Only when workers fear
that they will not be able to find a job or at least not as good a job, are
they deterred from cheating by the threat of termination. The question
then arises whether by paying workers a wage premium in the form of
an efficiency wage, the employer can induce good quality work. Note
that ‘good quality work’ can have many interpretations ranging from
higher productivity and better attitudes towards customers to reduced
absenteeism and staff turnover rate. The basic insight is that if workers are
paid a wage higher than the prevailing market wage for similar positions,
they incur a real penalty when they are fired. This question was examined
by Shapiro and Stiglitz (1984) in their seminal paper on efficiency wages.1 1
Yellen (1984) provides
Shapiro and Stiglitz focused on the consequences of payment of efficiency a good overview of
efficiency wage models.
wages on unemployment. If firms find it profitable to pay higher wages,
the argument goes, then the demand for labour decreases which creates
unemployment. Furthermore, unemployment is not only a byproduct of
efficiency wages, it is a necessary ingredient in the efficiency wage model.
If there is full employment, as mentioned above, the threat of termination
is not effective. Unemployment is a worker discipline device.
12.2.1 A simple efficiency wage model

Let us look at a simple version of the efficiency wage model. Suppose the
employee gains g from cheating if undetected. If the market wage is w0 and
there is no unemployment, firing is not a threat because a fired worker
can get another job at the same wage w0. Having a pool of unemployed
workers in a labour market serves to provide incentives for those who
are employed because being fired is more economically painful. If being
fired means taking a less attractive job (or worse, a long and costly spell
of unemployment), the prospect of being caught shirking provides an
incentive to work hard.
It is important in this model that there is no stigma attached to being fired.
All workers are assumed identical and equally likely to misbehave given
the same circumstances. This implies that it is not rational for an employer
to discriminate against workers fired from a previous job. Given that
termination is not a punishment, all workers cheat and firms do not spend
any resources stopping them. Workers get a payment w0 + g per period; w0
from the employer and g as a bribe for example.
Now consider the problem of an employer who is willing to pay a higher
wage w to induce workers to be honest. How much does he have to pay?
The employer will monitor workers and catch cheaters with probability
p. Let’s just look at one period and assume that cheaters are caught (and
fired) at the beginning of the period. If a worker is fired, he receives
unemployment benefit b. We assume here that the higher wages lead to
unemployment. A risk neutral worker cheats if the expected benefit from
doing so exceeds his wage:
(w + g)(1 – p) + bp > w or w < b + g(1 – p)/p ≡ w1 . (1)
The efficiency wage is w1; it is the lowest wage the employer can pay
if he wants the workers to be honest. Specifically, the employee will
work hard if the expected cost of shirking is greater than the cost of
working hard. The efficiency wage is increasing in the gain the worker
gets from cheating. If the temptations to cheat are large then so must be
the compensation for refraining from cheating. A rise in unemployment
benefit also drives up the efficiency wage because it lowers the
punishment value of getting fired. If workers are not likely to be caught
(p low) the efficiency wage has to be relatively higher than when the fine
can detect cheating easily. This last relationship illustrates the trade-off a
153
firm faces if it can determine the probability p, through appropriate choice

of monitoring intensity, as well as the wage w1. Either the firm pays high
wages to raise the expected cost of shirking and does little monitoring or it
monitors seriously and can get honesty for lower wages. This is illustrated
in Figure 12.1 below. All combinations to the north-east of the curve
ensure that workers are honest. Generally, monitoring activities designed
to increase the detection probability p are costly. This implies that a cost
minimising firm chooses a combination of p and w on the curve.
p(w)
w
b
Figure 12.1: Monitoring-wage tradeoff

Suppose the firm can fix p by allocating resources to monitoring and
incurring a monitoring cost M(p) per worker. If the firm minimises
total wage and monitoring expenditure per worker subject to inducing
honest behaviour, its problem, which is known as the minimum cost
implementation problem is:
min w1(p) + M(p) = b + g(1 – p)/p + M(p).
Assuming an interior solution and assuming the second order condition is
satisfied, we find:
p2 M' (p) = g. (2)
If M' (p) > 0 and not decreasing in p, (2) implies that, if the gain to the
worker is high, it is in the firm’s interest to devote a significant resource to
monitoring.
For the firm, the move from paying w0 and suffering dishonesty to the
efficiency wage scenario is profitable if:
w0 + C > w1 + M(p) (3)
where C is the cost to the firm caused by the worker’s cheating. Hence,
the model does not predict that efficiency wages are paid by all firms
in all circumstances. It is quite possible for an employer to be better
off permitting bad behaviour than punishing it if the necessary rise in
wage and monitoring cost is high. For example, restaurant owners often
allow staff to ‘steal’ meals or snacks. Many business employees ‘cheat’ by
inflating their business travel expenses.
We have determined the wage w1 the firm would have to pay to keep a
worker who joins the firm from cheating. We still have to check that the
firm can actually attract or retain workers at this wage. If the alternative
for the worker is to stay at wage level w0, it has to be the case that:
w1 > w0 + g. (4)
Clearly, C has to be larger than g; the cost to the firm due to the worker
shirking has to be larger than the gain to the worker for both condition
154
(3) and condition (4) to be satisfied. If these conditions are satisfied, the
move to an efficiency wage situation constitutes a Pareto improvement:
both the firm and the workers are better off. Efficiency is increased hence
the terminology ‘efficiency wages’! The efficiency wage is higher than the
original market wage w0 and, if the MRP is unaffected, the demand for
labour decreases and unemployment is generated. In this simple model, a
rise in unemployment benefit is likely to increase the efficiency wage and
hence increase unemployment.
Real-life firms and some enlightened management consultants know
that being nice to workers may pay off. In the efficiency wage model, it
is shown that it may be possible to increase the quality of work, reduce
staff turnover or eliminate unproductive behaviour by paying higher
wages. Nordstrom, an American department store chain, pays its sales
staff materially more than the industry average in the hope of attracting
and retaining good workers. Clearly similar arguments could be made for
non-pecuniary rewards for workers. It may be more profitable (less costly)
for a firm to increase job satisfaction than to increase wages. Employees
may appreciate non-monetary aspects of their jobs such as company
cars, training programmes, pride in their work, more responsibility and
autonomy. When firms create a worker-friendly environment, the effect on
monitoring costs is equivalent to that of an increase in wage. If firms are
nice to workers, their trade-off between wage and detection probability
(see Figure 12.1) can be shifted to the left so that, for the same amount of
monitoring, firms can pay a lower efficiency wage or, for the same wage,
they can do less monitoring. Within organisations, the latter possibility
creates conflict as the reliance on middle managers to do the monitoring is
diminished.
Case study: Politicians, sleaze and efficiency wages
Politicians regularly exploit an efficiency wage argument to award themselves salary increases.
In theory at least, paying a cabinet minister or any other government official a high wage
should make him think twice about accepting bribes and getting involved in corruption and
other scandals. In 1994 government ministers in Singapore saw their salaries increase by about
25 per cent. The Singapore government argued that high wages for officials have ensured that
Singapore, as one of very few Asian countries, does not have a corruption problem. The starting
pay for a cabinet minister in Singapore was at the time $419,285 a year. The annual salary of
the prime minister was $780,000, a very nice reward indeed compared to the $200,000 Bill
Clinton had to get by on or the measly $122,000 for John Major, the former UK prime minister.
We can offer at least a partial explanation for these differences in pay in terms of our simple
model of tradeoff between monitoring and wage. In most western democracies, politicians
are monitored by the media. The more intrusive the media, the lower the efficiency wage!
Singapore, for example, would not tolerate a press as aggressive as the British press.
In the United States scandals involving politicians are relatively rare compared to Europe. This
is even more surprising when one considers the enormous efforts of the American lobbying
industry to influence politics. The US offered its elected representatives a salary of about
$140,000, nearly three times the amount a British Member of Parliament was paid at the time.
12.2.2 Efficiency wages and minimum wages

It is possible to discuss minimum wage legislation in the simple efficiency
wage framework outlined above. Suppose the initial situation is as
above with all firms paying low wages w0, all workers cheating and no
unemployment. The workers receive a pay-off of w0+ g and the cost per
worker to the firm is w0 + C. Assume this is an equilibrium (i.e. it is not
155
in any firm’s interest to deviate by paying a higher (efficiency) wage).

If a firm considers paying an efficiency wage w1, then to induce honest
behaviour w1 has to satisfy:
(w1 + g) (1 – p) + (w0 + g)p < w1 or w1 > w0 + g/p
where the first term in the first inequality represents the pay-off
corresponding to cheating and not being caught and the second term
represents the pay-off corresponding to cheating, being caught and getting
a job elsewhere at the low wage w0. Suppose the solution to the firm’s
minimum cost implementation problem is the wage w1 and detection
probability p(w1). Hence the firm would incur a total cost of w1 + M(p(w1))
per worker. It is not profitable for the firm to implement this solution
when this cost exceeds its original cost (i.e. when w1 + M(p(w1)) > w0 + C).
Only an employer who incurs a high cost of worker misbehaviour would
find it profitable to pay the high wage w1.
However, if all firms paid a higher wage and this leads to unemployment
then the worker’s fall back position is lowered to the unemployment
benefit. The resulting efficiency wage (see (1)) w1 is now lower:
w1 > g(1 – p)/p + b.
Suppose the solution of the minimum cost implementation problem is w'
and p(w' ) and the cost per worker is lower than the original cost:
w' + M(p(w' )) < w0 + C. This means that, if all firms could coordinate
their employment policies and offer the efficiency wage w', they would
all be better off. They are in fact stuck in a low pay–low worker quality
equilibrium from which unilateral deviations are not profitable. The
government can facilitate firms’ coordination by setting a minimum wage
level at w'. If it becomes illegal to offer wages below w', all firms will pay
w' and no firm has difficulties attracting workers. Do any welfare gains
result from the introduction of the minimum wage legislation? It turns
out that, as long as the monitoring costs are not too high, there may
be welfare improvement. Total welfare is initially g – C and, after the
minimum wage, ignoring unemployment, it is –M(p(w' )) which represents
an increase if M(p(w' )) – C < – g. The minimum wage legislation could
improve welfare if the monitoring costs are low relative to the cost of
shirking and if the worker’s gain from shirking is not too large. Of course,
unemployment increases and so the net welfare effect of introducing a
minimum wage is ambiguous.
Are the workers better off when the government introduces minimum
efficiency wages? The answer is ambiguous. The workers who keep their
jobs are now receiving w' = g(1 – p)/p + b compared to w0 + g. Given b < w0,
workers are likely to be worse off unless p is low which it would be if firms
face high costs of monitoring. Of course the workers who lose their jobs are
worse off. The move to efficiency wages cannot be a Pareto improvement.
12.3 Firm demand for labour

Let us return now to efficiency wage theory and see if we can model the
effect of the introduction of an efficiency wage on the firm’s demand for
labour. We already know that, for the efficiency wage theory to work,
there should be some unemployment. However, this is not to say that
each firm should reduce its labour demand. Suppose workers choose a
low or high effort level eL or eH which gives them a disutility of cL and cH
respectively and delivers an expected output of qL or qH respectively.
It is important that an individual worker’s output cannot costlessly be
observed by the firm. However, if the firm monitors the worker, it can gain
156
information about whether the worker is working hard (eH) or not (eL). In
particular, if the worker is shirking (eL), he has a chance p of being caught.
The firm decides on p and incurs a monitoring cost M(p) per worker. All L
workers are identical and, if they all work hard, the expected output is LqH
whereas, if they shirk, total expected output is LqL. Both the workers and
the firm are risk neutral.
If it is impossible for the firm to monitor workers, workers have no
incentive to work hard since their shirking is not detected. The firm thus
determines its demand for labour from:
max LqL P(LqL) – w L
L
where P(Q) is the firm’s demand function (i.e. the price the firm can
charge if it sells Q units of output) and w > cL is the wage rate. The result
of this optimisation problem is the familiar MRP = ME condition:
(P(Lq ) + ∂Q∂P Lq ) q = w.
L L L (5)
Now suppose it becomes possible for firms to monitor. Consider the

problem of a firm wishing to pay an efficiency wage. Assume the market
wage is 100 (i.e. a worker has a choice between working for the market
wage w and shirking or working for the efficiency wage w' at a high effort
level). The firm, when it detects shirking, fires the worker and pays him
zero. A shirking worker who is not caught gets the same wage w' as a non-
shirker. Workers are therefore attracted to the firm (anticipating that they
will have to work hard there) if:
w' = cH > w – cL . (6)
Once they join the firm, they work hard if the pay-off of working hard
exceeds the expected pay-off of shirking:
w' – cH > (1 – p)(w' – cL) . (7)
It is assumed in (7) that firms detect worker shirking before workers have
suffered the disutility and that a worker who is caught shirking cannot
start working elsewhere at wage w immediately. The two conditions
(6) and (7) which are very similar to the participation and incentive
compatibility constraints in principal–agent problems, are represented
graphically in Figure 12.2. Note that (7) can be rewritten as:
w' > (cH – (1 – p) cL) /p = (cH – cL)/p + cL .
w' A
join and
don’t cheat
join and
cheat
don’t join
B
w + cH – cL
c
(cH – cL)/p + cL
don’t join
H
0 p′ 1 p
Figure 12.2: Conditions on the efficiency wage
157
Now the firm maximises total profit subject to conditions (6) and (7):
max LqH P(LqH) – w' L – M( p) L (8)
w', p, L
s.t. w' > w + cH – cL and w' > (cH – cL) / p + cL .
The feasible set of combinations of w' and p is the ‘join and don’t cheat’
area in the figure above.
Define p' as the minimum detection probability necessary to induce honest

behaviour if the firm pays the minimum wage w + cH – cL which attracts
workers.
We can find p' at the intersection of the curves corresponding to conditions

(6) and (7) as p' = (cH – cL)/(w + cH – 2cL). Clearly it can never be optimal
for the firm to set p higher than p' because it can guarantee that the
worker does not shirk at any wage above w + cH – cL with a lower detection
probability p. The solution to the firm’s problem therefore has to be a point
on the curve AB. In addition, at the optimal solution of (8), the MRP = ME
rule has to hold:
MRPH = MR(qHL) qH = w' + M(p) (9)
where MR(Q) is the marginal revenue function. This is of course very
similar to the optimality condition (5) before the introduction of an
efficiency wage which can be rewritten as:
MRPL = MR(qLL) qL = w. (10)
MR MRP
MRPH
w′ + M(p)
MRPL
xq
x H
qLL0 qHL0 L0 L
Q
(a) Marginal revenue (b) Marginal revenue product
Figure 12.3: Effect of efficiency wage on firm demand for labour

To keep things simple, let us assume the MR function is linear and set
qL = 1 and qH > 1. Figure 12.3a represents the MR function. Figure 12.3b
gives the corresponding MRP functions before (MRPL) and after (MRPH) the
introduction of the efficiency wage. These curves are derived from the MR
curve as follows. Consider MRPL first. From (10) we know that:
MRPL (L) = MR(L) for qL = 1.
Hence for L = 0, MR(L) is given by the intercept in Figure 12.3a. For
L = L0, we can read MR(L0 ) on Figure 12.3a. These two points are sufficient
to draw MRPL in Figure 12.3b. Now consider MRPH. For L = 0, MRPH =
MR(0)qH which gives us the intercept for MRPH in Figure 12.3b. For L = L0,
we see that MR(qHL0) = x in Figure 12.3a which gives MRPH(L0) = qH x in
Figure 12.3b.
158
Conditions (9) and (10) tell us that the firm demand for labour is
determined by the intersection of MRPL and w and the intersection of
MRPH and w' + M(p) respectively.
Activity
Show that if the initial wage w is relatively high as on the figure and if the efficiency
wage and monitoring costs are not too high, the firm’s demand for labour could increase
when it starts paying efficiency wages!
12.4 Internal labour markets

Real-life companies often have employment and compensation policies
which seem to bear no resemblance to the neoclassical result that labour
should be hired and paid according to the MRP rule. Workers are not laid
off whenever there is a temporary shift in marginal revenue; wages are
often determined according to a fixed scale and the generally low variance
in wages does not seem consistent with workers being paid the value of
their marginal product in each period. Many employees are in an internal
labour market and move up the hierarchy inside an organisation. Mobility
in and out of the internal labour market is limited so that conditions in
the external market have only a limited effect on the internal market.
This is especially true for white collar jobs, professionals and managers or
primary sector workers. The internal labour market is insulated to some
extent from the external labour market except at a few entry points such
as the hiring of graduates where firms compete with other employers.
Workers may have outside options during their careers and firms may hire
from outside for higher level jobs. Only in these situations is a firm forced
to pay market wages. In this section we look at some of these features of
employment policies in organisations and discuss alternative explanations
economists have put forward.
12.4.1 Why do wages rise over a career path?

In most jobs employees are paid a relatively low wage when they
start work and the wage gradually increases with years in the job or
seniority. We could explain this phenomenon by referring to the higher
value of more senior workers because of their acquired (firm-specific)
human capital which means the knowledge and skills that determine
productivity. More senior workers have had more formal training as well
as on-the-job experience which is likely to make them more productive
relative to job entrants. Certainly, in some situations this explanation is
valid but overall it does not seem reasonable to maintain that the most
senior workers are the most productive. Wages generally rise faster than
productivity, although this pattern is by no means applicable to every
single industry or economic sector.
In some circumstances, human capital theory offers an explanation for
increases in wages. Firms investing heavily in training, which increases
the worker’s value not only in their current job but elsewhere as well, tend
to pay new trainee employees a low wage. This wage is increased after the
training is completed. Examples of this are found in accountancy (e.g. the
Big 4 firms), law and architecture. The reason for the jump in wage is that,
while the employee is developing marketable skills at the firm’s expense,
he pays for this training by working at a low wage. As soon as the training
phase ends and outside offers would be forthcoming, the firm is in a position
to offer a higher wage and retain the trained workers. What is harder to
explain is that older workers are paid more than younger and sometimes
more productive workers with the same training and qualifications.
159
Lazear (1981) uses an efficiency argument to explain such rising wage

profiles. Workers are paid less than their MRP early in their careers and
more than their MRP later in their careers so that over their lifetime
they are getting the value of their marginal product. Given this wage
profile it is obviously painful for a worker to lose his job after he has
worked with a firm for a few years: he loses his ‘investment’ in the form of
larger wages later on. Therefore workers with rising wages are more likely
to work hard and avoid being fired whereas workers whose wages do not
increase do not have the same incentive to put in high effort. By offering
increasing wages the employer can succeed in making both the worker
and himself better off because higher efforts by the worker lead to higher
productivity. The increased cost of shirking leads to a Pareto improvement.
Because workers are paid very high wages when they are older, mandatory
retirement is necessary otherwise workers would prefer to continue
working after they had been paid their lifetime value to the firm. Also,
there has to be some mechanism to prevent the firm from firing workers
(without cause) before it has paid them the higher wages to which they
are entitled. If firms care about their reputations, they will not renege on
the (implicit) agreement to pay the workers their lifetime productivity
value by firing them early because then they will not be able to attract
workers in the future.
The efficiency explanation above rests on the idea of using rising wages as
an incentive mechanism. In jobs where the employer can easily monitor
whether the worker is performing adequately or where alternative
incentive mechanisms such as piece-rates or commissions can be used,
we would not expect to see wages rise much with seniority. Conversely, in
large organisations where monitoring costs are high, rising wage profiles
are likely.
Efficiency wage theory can also explain why wages rise over a career
path up to a point where they exceed marginal revenue product. Initially
employees are usually offered low responsibility jobs which are easier
to monitor. In terms of the minimum cost implementation problem, this
implies that the firm can set a high detection probability p at low cost M(p)
which in turn leads to a relatively low wage. Later on, when the employee
has more responsibility, the monitoring cost increases so less monitoring
will be done and a higher wage results.
Firms also offer seniority-based pay for jobs where it is important to retain
people. Paying a low salary initially and compensating later screens for
loyalty in the sense that only workers who intend to stay with the firm
over a longer period find this an attractive proposition. Firms also use
‘golden handcuffs’ such as deferred compensation and unvested pensions
as screening devices. For example, Bell South, an American regional
telephone company, used to encourage employees to put up to 25 per cent
of their pay in a special account. The company augments this contribution
and, when they retire, the employees get more than twice the normal
market interest whereas, if they quit, they just get the market interest.
When an employer hires a new worker neither she nor the worker knows
for sure how productive the worker will be. Workers are typically risk
averse and would prefer a contract which offers them a secure job at a
wage which corresponds to average productivity to a contract offering
them a wage corresponding to their actual productivity. However, if a firm
pays a wage equal to the value of the average productivity it will make
a loss: the low productivity workers will stay and the highly productive
workers will leave for better outside offers. To guard against this, the firm
160
has to start everyone at a low wage and increase wages of workers who
turn out to be productive. The difference between the low initial wage and
MRP for the productive workers is like an insurance premium they pay at
the time when they do not know their productivity.
Finally, in cross section data, wages can show positive correlation with
seniority even if individual workers do not experience rising wage
profiles. There are several explanations for this. Firstly, workers who are
productive in their jobs are highly paid and are likely to stay whereas
workers who are not productive and get low pay tend to leave. As a
consequence, we find that the highly paid workers have higher seniority.
Efficiency wage theory offers an alternative explanation: firms which pay
efficiency wages have low turnover which means that workers in these
higher paying firms have higher seniority again generating the positive
correlation.
12.4.2 Why is there long-term employment?

In contrast to the assumption of perfect mobility of labour underlying the
neoclassical model, firms do not lay off workers when there is a temporary
reduction in demand and they do not start hiring immediately when
demand for their products increases. Workers similarly do not usually
change jobs when slightly higher wage offers are made. Apart from the
obvious explanations of moving costs for workers and legal impediments
and costs of firing workers, are there other reasons for the firm-worker
relationship to be permanent?
One reason for long-term employment is the existence of firm-specific
human capital. Employees may acquire knowledge and skills which
increase their productivity as long as they stay in the same job but which
are not useful for other jobs. From an efficiency point of view then, long-
term commitment is necessary for the firm and/or the worker to have an
incentive to invest in firm-specific human capital.
Sometimes it is necessary to offer a long-term contract to ensure that
the employee’s incentives are aligned with the firm’s long-term
objectives. If the employee’s horizon is one year away, he may not care
about the firm’s profitability several years into the future. It may also be
difficult to judge an employee’s performance in the short-term if the effect
of his work is not felt until much later. This is likely to be the case for
managerial jobs.
Some versions of efficiency wage theory can also explain long-term
employment. If workers are not offered job security they are more likely to
shirk because the punishment of losing their job is not as severe.
12.4.3 What is the role of promotions?

Generally promotions help to assign people to jobs where they are most
productive. However, promotions are also used as rewards to provide
incentives for good performance.
A problem arises when these two goals are in conflict. Good performers at
one level of the hierarchy may not be very productive when promoted to
a higher level. This is especially likely when the nature of the job changes
dramatically after promotion. To avoid the problem of good technical
employees (engineers and researchers) becoming mediocre supervisors
and managers, companies such as IBM and 3M use separate career ladders
for scientists and managers.
Promotion is a reward not only because it brings with it a higher salary
but it also gives the worker a chance to compete in the next round to
161
get promoted further. Since the 1980s, firms have eliminated levels of
management and, as a consequence, promotion is less of an incentive:
at any level there are more candidates and hence a lower probability of
getting promoted. Using promotion as a reward is not entirely harmless.
When workers are involved in team work, rewards based on relative
performance may lead to reduced cooperation. Another problem which
can arise when relative performance assessment is used is that of worker
collusion.
Malcomson (1984) proposes an interesting moral hazard explanation
for promotions. The starting point is that workers are paid more after
promotion. In many situations, especially when a substantial amount of
team work is involved, the employer cannot assess absolute individual
performance accurately. Relative performance is easier to judge. If the
employer would promise to pay according to individual performance,
workers may doubt his honesty. There is a moral hazard problem on the
part of the employer in that he could claim that no workers performed
up to the standard. The workers anticipate that the employer will
misbehave in this way and are not encouraged to work hard. If instead
the employer promises to reward relative performance by promoting the
top 10 performers, workers can easily check that the promise was kept. Of
course it is then in the employer’s interest to select the best performers to
encourage all workers to work hard.
Usually workers at higher levels of a firm’s hierarchy have been promoted
from within the firm. There are only a few ports of entry where outsiders
may be recruited. This is consistent with firms ignorant of individual
abilities paying low wages for young workers of mixed productivity and
screening them to learn which are best. This points to a reason for the firm
to delay promotion whenever it can. Promotion makes an employee more
attractive to outside firms because it acts as a signal of worker quality.
Higher wages have to be offered after promotion to prevent the worker
taking up attractive outside offers.
12.4.4 Wage compression

Another feature of internal labour markets is that within firms there seems
to be less variability in wages than in productivity. An explanation for this
fact could be that it is just too difficult to measure individual productivity
especially where team work is involved. A more interesting explanation is
given by Frank (1984) in terms of status. The starting point is the idea that
people care about their position in the income hierarchy of the firm and
they care more the more they interact with their co-workers. Employees
are willing to sacrifice some income if they can be the highest paid in the
firm and conversely they need to be compensated for being the one with
the lowest pay. This is illustrated in Figure 12.4. The three lines crossing
the 45 degree line represent wage schedules for three firms. An individual
with marginal productivity x could choose to work in Firm A where he is
near the top of the salary scale and enjoy relatively high status. He would
then pay a price ab in terms of the difference between his wage and his
marginal productivity. If he does not care at all about relative status the
individual with marginal productivity x could earn a wage premium bc by
working for Firm C near the bottom of its salary scale.
162
wage 45 degree line

C
c
B
b
A
a
marginal product
Figure 12.4: Status and wage compression

This chapter examined the efficiency wage model as an alternative to the
neoclassical framework for the labour market, and considered reasons
why wages may rise over an individual’s career path in the presence of an
internal labour market.

• discuss the difficulties in attempting to apply standard neoclassical
models of labour supply and demand to internal labour markets
• analyse a simple efficiency wage model
• set up and solve the minimum cost implementation problem
• give explanations for increasing wage profiles
• discuss Frank’s theory of wage compression.

Review the minimum cost implementation problem for efficiency wages
and use this framework to argue the case for whether efficiency wages will
be higher or lower than in the standard model if:
a. workers dislike monitoring
b. workers incur a large psychological cost when they are unemployed
c. workers are risk averse
d. monitoring is very costly
e. workers have high switching costs (moving expenses, loss of firm
specific human capital) when they lose their jobs.
163
Notes
164
Chapter 13: Market structure and performance
Chapter 13: Market structure and

performance
13.1 Introduction
Industries differ in the way they are structured. An important defining
characteristic of market structure is the number of firms serving the
market. However, it is certainly not the case that we can predict how firms
will behave just on the basis of how many firms there are in the industry.
The presence of barriers to entry also plays a crucial role in maintaining
market structure. It is generally believed that, when entry is easy, firms are
disciplined in their pricing policies even when the industry is concentrated.
Empirically, high entry barriers coincide with high profit margins.
Economists classify industries according to the degree of market power
firms have (i.e. do they behave as price takers or price makers?), whether
firms behave strategically and whether the product is homogenous
or differentiated. For example, in a competitive industry all firms are
assumed to be price takers; in an oligopoly there is strategic interaction
between firms.
The traditional structure-conduct-performance literature in
industrial economics concentrates on the relationship between market
structure and market performance. These studies attempted to answer
the following question empirically: what are the major factors that
determine market power? Market structure typically consists of those
factors that determine the competitiveness of a market or industry while
market performance refers to the degree of success of a market or
industry in producing benefits for consumers (e.g. the prevailing market
price is near the firms’ marginal cost). The underlying assumption is that
market structure determines the behaviour or conduct of firms in the
marketplace, which in turn affects market performance.
While the structure-conduct-performance studies have provided many
valuable insights, their empirical approach and (most importantly)
underlying theoretical foundations have been severely challenged
by the modern game-theoretic models of competition and strategic
behaviour. Perhaps the most significant criticism is that concentration
itself is determined by the economic conditions of the industry; it is not
an exogenous industry characteristic that can be used to explain pricing
or other conduct by firms. Moreover, very concentrated markets may
nonetheless deliver relatively competitive market outcomes when entry
barriers are not too high because the threat of potential entrants will
discipline the incumbent firms. The modern frameworks of market
interaction and strategy behaviour are more firmly based on game-
theoretic insights. They show that relations between concentration and
market power is much more elusive than previously argued.
This chapter starts with a summary of the determinants of market
structure and then discusses the metrics most commonly used to measure
it. Entrants into an industry threaten incumbents (i.e. firms that are
already operating in the market) and the potential market performance
because entry often intensifies competition. Therefore we begin by
examining some of the main factors that affect entry and consequently
market structure. The chapter then examines the performance and extent
of market power of a perfectly competitive market as a benchmark for
165
comparison as less competitive market structures are considered in later

chapters.

• the importance of entry barriers as determinants of market
structure and firm behaviour
• the concepts of concentration curve, CRm, HHI and Lerner
index
• why in a perfectly competitive industry the supply curve is not
necessarily the horizontal sum of individual firm supply curves.

• describe the important factors in the determination of market
structure giving (preferably your own) examples
• calculate the market structure measures
• derive perfectly competitive firm and industry supply.

Norton and Co., 2014; 9th edition) Chapter 23: Firm supply.

(Singapore: John Wiley & Sons, 2013) 6th edition [ISBN 9781118319185]
Chapter 6: Entry and exit.
Sutton, J. Sunk costs and market structure. (Cambridge, MA: The MIT Press,
1992) [ISBN 9780262193054].

This chapter analyses topics in industrial economics such as the main
determinants of market structure and the measures typically used to
quantify market concentration. It also discusses the paradigm of a perfectly
competitive market.
13.2 Determinants of market structure

The question of why real-life industries are structured the way they are is
very difficult to answer. There are a multitude of factors which contribute
to the likelihood of one or the other market structure evolving.
Barriers to entry are one important determinant of market structure
because they insulate incumbent firms from competitive forces and allow
them to earn higher economic returns by making it unprofitable for
newcomers to enter the industry. Corporate managers must understand
the number and magnitude of entry barriers to effectively assess entry
conditions and carry out strategic business planning. Entry barriers can
be divided into structural and strategic. Structural entry barriers
are not directly driven by the incumbent’s response to competition and
are often determined by the environment in which the firm operates
(e.g. regulation, patents). Strategic entry barriers result when the
incumbent proactively takes certain actions to deter entry. The following
list of structural and strategic barriers to entry is not exhaustive.
166
13.2.1 Structural entry barriers
Economies of scale and scope

Globally, syringes are the most frequently used medical devices, their major
users being the medical professsion, followed closely by diabetes patients,
and an increasing population of drug abusers. The USA is one of the ten
largest syringe markets geographically, others being China, the UK, Japan,
Germany and India. The market is dominated by a few large companies
such as Johnson & Johnson, Abott Laboratories and Covidien. This is due
to acquisition of smaller firms by the larger ones, which in turn gave them
a technological and strategic edge. There are significant economies of
scale in this industry: the production technology is such that, as output
increases, average costs fall dramatically. The source of economies of scale
may be large setup or fixed costs (e.g. R&D and marketing costs).
In extreme cases the presence of significant economies of scale leads to
a ‘natural monopoly’ which refers to the situation where average costs
decrease beyond the output level corresponding to market demand. In
such cases it is obviously cheaper for one firm to satisfy market demand.
The natural monopoly argument has been used as an argument against
privatisation of the Royal Mail in Britain. Local newspapers are also
characterised by significant economies of scale so that often there will be
just one local newspaper in a town.
The size of the market relative to the degree of economies of scale
seems a relevant predictor of market structure. A useful concept in this
context is the minimal efficient scale (MES) of an establishment in
the industry. It is usually defined as the output level at which long-run
average cost (LRAC) is minimised. An alternative definition of MES is
‘the output level beyond which further increases in output would lead to
a reduction in LRAC of no more than 10 per cent’. In practical terms this
means it is the output level where the LRAC curve begins to flatten out.
If we know the MES for a given production technology and we know the
total consumption in the market, we can calculate how many firms can
be accommodated in the industry. For instance, if the MES for commercial
aircraft manufacturing corresponds to 10 per cent of the US market, then
there is room for 10 fans to serve this market. If the MES is large relative
to the size of the market, the industry is likely to be concentrated.
The importance of economies of scale as a determinant of market
structure is made evident by the changes in structure after technological
innovation. The beer industry, for example, used to be fragmented and
consisted of thousands of local breweries. Beer was unpasteurised and had
to be kept cold so it could not be transported far. With the introduction
of bottling, however (a process which has significant economies of scale),
the number of beer producers decreased dramatically, mainly through
takeovers, and a handful of large companies dominated the industry.
Scope economies (discussed in Chapter 11 of the subject guide) may also
drive incumbents’ cost advantage. Market and umbrella branding, whereby
a firm sells different products under the same brand name, can give rise to
extremely powerful economies of scope in many consumer product markets.
An incumbent’s reputable brand image can significantly reduce the sunk
costs associated with introducing a new product line vis-à-vis the entrants.
The ready-to-eat breakfast cereal industry in the USA is also a well-studied
example of the presence of scope economies. For several decades, the
industry has been dominated by a few firms (e.g. Kellogg, Quaker Oats) that
consistently enlarged their product range while new entrants have had a
difficult time capturing market share from these established brands.
167
Control of essential resource

An obvious instance of market structure determined by entry barriers
is when incumbents control a special non-replicable resource such as
mineral deposits. Alternatively, an incumbent is also protected from entry
if it controls a critical channel in the vertical chain. The control of critical
resources such as these is an entry barrier because it prevents potential
entrants from acquiring the necessary inputs to produce or successfully
get their products to market. Some well-known examples are De Beers
in diamonds, the Organisation of Petroleum Exporting Countries (OPEC)
and French Champagne. Take-off and landing slots at airports are also
very important resources without which entry into the airline industry is
impossible. In the same industry, the practice at most airports of long-term
leasing of gates represents an entry barrier.
There are, however, limits to the market power which derives from owning
a special resource. OPEC found that, when they raised the price of oil
too much, other countries started searching for oil. The oil crisis of the
early 1970s was largely responsible for the exploration of oil fields in
the North Sea. Substitutes can emerge and they can open channels. For
example, Canada’s diamond production somewhat loosened De Beers’ grip
on the worldwide diamond market. Entry barriers can also be erected by
obtaining patents to key products and production processes, but entrants
may find ways to copy without infringing existing property rights or
inventing around existing patents to secure a toehold in the market.
Patents and other legal controls

Governments clearly influence the structure of some industries by setting
up legal barriers to entry. Taxi drivers in many cities have to obtain a
license before they are allowed to establish themselves. In New York the
powerful taxi industry lobby has been able to keep the number of licences
(‘medallions’) unchanged for many decades. Every taxi must have a New
York City-issued licence, known as a taxi medallion, which is literally
attached to the hood of the car. Medallion prices have skyrocketed in
recent years, up 50 per cent between 2009 and 2014, to a high of more
than $1 million each. However, the price of these medallions has recently
taken a hit as Uber cars from the new online taxi company flood the city.
The most recent sale price was just $740,000, down nearly 40 per cent
from last year. There are 13,600 yellow taxis in New York City. But the
competition from 20,600 Uber cars that can be easily summoned has cut
sharply into the taxis’ customer base.
On a similar vein, governments normally decide which airlines are allowed
to fly a certain route. By taking protectionist measures, governments can
make or keep domestic industries concentrated. The industries of countries
with very high import tariffs tend to contain a few major players. Patent
law, which grants monopoly rights for a specified period of time, is used to
encourage innovation by granting market power.
Cost advantage and first mover advantage

In many industries the firms which entered first have a significant
advantage in terms of entrepreneurial skills and/or technological know-
how. Late entrants tend to have a cost disadvantage especially when
learning curve effects are important (i.e. average production cost
decreases with cumulative output). Sunk costs are also a source of cost
advantage as they are only incurred on entry.
Incumbents may also enjoy cost advantages by being able to negotiate
better terms in the vertical chain due to the existence of a track record.
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Effectively, distributors and retailers have had experience dealing with

the incumbent’s product and are therefore more likely to devote scarce
warehousing and shelf space to its products. They may also be more willing
to offer credit and better commercial terms to trustworthy incumbents that
appear as counterparties with relatively low credit risk.
Capital requirements
Large capital requirements can be a source of a cost disadvantage for a
potential entrant. Entrants are usually perceived as riskier prospects by
banks and other lenders. This is not without reason as in many industries
entrants are much more likely than established firms to go out of business.
They therefore pay a higher risk premium. Large sunk costs (investments
such as R&D which cannot be recuperated upon exit from the market) make
the entry decision particularly risky. They are sources of barriers to entry in
for example car manufacturing, defence industries, oil refining, deep sea
drilling, chemicals, electronics, aerospace, pharmaceuticals, etc.
Empirically it is found that, the larger an industry (in sales), the larger
the number of firms, but this is not true for markets with high advertising
and R&D costs.1 Large fixed costs even when they are not entirely sunk 1
Sutton (1992).
make entry more difficult. Capital requirements are obviously larger if the
industry is vertically integrated and it is impossible to enter unless you
enter all layers of the industry. The computer industry used to be vertically
integrated with computer manufacturers making most of the parts as well
as the software in-house. They used to do most of their own marketing,
distribution, sales and service as well. There were few independent
suppliers of parts. Currently, PCs are assembled from readily available parts
used to supply the consumer electronics industry. Most PC makers were
never vertically integrated. Barriers to entry in the computer industry are
much lower than they used to be and there is more competition in every
layer of the industry.
13.2.2 Strategic entry barriers: entry deterrence

Market structure and the presence of entry barriers undoubtedly affect the
behaviour of established or incumbent firms in an industry. Conversely,
incumbents may engage in activities designed to maintain the existing
market structure or alter it in their favour. This would be the case if either:
• the incumbent makes higher profits currently than it does in a more
fragmented market, or
• the incumbent’s behaviour is expected to change the entrant’s view
about the nature of post-entry competition.
In this section we briefly discuss ways in which an incumbent may try to
keep entrants out of its market.
Limit pricing
Limit pricing refers to the situation where a monopolist, rather than
maximising short-run profits, sets prices at such a level that it is not
possible for an entrant to make a profit at the current price. The rationale
is that if the incumbent sets the price low enough, the entrant will conclude
that there is no way that post-entry profits will cover the sunk costs of entry,
and it will therefore stay out. The incumbent must in turn believe that it
is better to be a monopolist, even when charging a non-profit maximising
price, than sharing the market at a duopoly equilibrium price.
Game theoretic models of price competition, however, have raised the issue
of whether limit pricing is really rational. We will not go into the technical
169
details of this discussion here, but suffice it to say that the incumbent’s
behaviour in the standard limit-pricing model may not be a subgame
perfect Nash equilibrium. The limit pricing argument is typically based
on a non-credible post-entry threat because the incumbent’s prescribed
strategy is not rational when one considers the full game tree and applies
backwards induction.
Predatory pricing
Another example of limit pricing is predatory pricing, where a firm
sets a low price (often below cost) in order to drive a rival out of business.
The purpose of predatory pricing is twofold: to drive out current rivals
and to make future rivals think twice about entry. The latter is obviously
reminiscent of limit pricing.
The failure of the intuition-supporting limit pricing also applies to
predatory pricing when it comes to the analysis of game-theoretic models.
We have seen an example of this discussion in the chain store paradox
analysed in Chapter 3 of the subject guide. However, game theorists have
shown that predatory pricing may be rational (i.e. profitable) if there is
some degree of uncertainty and the entrants are not completely sure about
the incumbent’s type or market conditions. If the entrant is uncertain
about the exact reasons behind the incumbent’s pricing strategy, then
the incumbent may keep the entrant out of the market by engaging in
predatory pricing.
Other non-pricing strategies

Firms have instruments other than prices at their disposal when trying to
drive competitors out of business. For example, after the deregulation of
buses in some British cities, some bus companies tried to organise their
timetables so that they would pick up passengers a few minutes before
their rivals. Note that limit pricing and predatory pricing are only possible
if the incumbent has a cost advantage. In some cases a monopolist does
not have to set a low price to deter entry. The threat to retaliate and flood
the market when a competitor enters may be sufficient. Such a threat can
be made credible if the monopolist has excess capacity so that increasing
output (after entry) is not very costly.
Incumbent firms manipulate dealer relationships to shut out competition.
An extreme case is that of exclusive dealership where a manufacturer or
wholesaler agrees to supply retailers only if they do not sell any of their
competitors’ products. Supermarkets typically carry a fairly limited number
of brands of consumer goods. Manufacturers negotiate deals which involve
the supermarkets allocating them a certain amount of shelf space. Some
PC makers sell their machines with a copy of MS-DOS or Windows already
installed. Airlines have developed computer reservation systems for use
by travel agents. Of course those flights by the airline which developed
the system are more prominently displayed and easier to book than others
and, once travel agents have invested in learning how to use such a
system, they are ‘locked in’.
Incumbent firms often try to erect entry barriers by heavily advertising and
promoting their products. This is effective in industries where customer
loyalty is important or where buyers prefer established brands so that it
becomes very difficult for an entrant to convince consumers to try their
product. Large advertising budgets also increase an entrant’s capital
requirements. Companies can increase customer loyalty by offering loyalty
rebates. Airlines’ frequent flyer programmes are a good example of this.
170
13.3 Measures of market structure

Given the complexity of real industries and the many factors which
determine how firms behave in these industries, we cannot expect that a
simple measure of market structure paints the entire picture. Nevertheless,
a summary measure of how many firms there are and their market share
can convey useful information. The concentration curve represents
a complete statistical summary of the number of firms and their market
shares. On the X-axis the firms are listed starting with the largest in terms
of market share. Market share can mean percentage of sales or assets or
employment in the industry. On the Y-axis cumulative market share is
measured so that by definition the concentration curve is concave.
The most commonly used variable to measure the market structure of
an industry is the concentration ratio. Concentration ratios (CRm)
give the total market share (i.e. share of industry sales) accounted for
by the largest m firms in the industry. UK official sources use CR3 and
CR5 whereas, in the US, CR4, CR8 and CR12 are used. If there is only one
firm in the industry the concentration ratio is 1. When there are n firms
of equal size the concentration ratio is m/n which is close to 0 if n is
large. Empirically it is found that concentration ratios are similar across
industries from one country to another (e.g. consumer durables industries
– electrical appliances, washing machines, refrigerators – tend to be
concentrated CR5 = 95%; for salt, CR4 = 99.5% in UK, 93% in Germany,
98% in France). Most manufacturing industries have CR4 < 50%.2 Roughly 2
Sutton (1992).
speaking, an industry is classified as a monopoly if CR1 > 90% and as
perfectly competitive when CR4 < 40%. Monopolistic competition and
oligopoly correspond to CR4 > 40%.
13.3.1 The HHI Index

The Herfindahl-Hirschman-Index (HHI), like the concentration curve,
uses information about all the firms in the industry. It is defined as the
sum of the squared market shares of each firm in the industry:
n
Σ
HHI = i = si 2
If there is only one firm in the industry then HHI = 1 and if there
are many firms with equal market share, HHI is close to 0. Typically,
empirical studies produce similar results for both the HHI and a four-firm
concentration index.
The HHI has the interesting property that its inverse corresponds to the
number of equally sized firms which would give this value of HHI. For
example, if the HHI is 0.25, the industry is as concentrated (according
to HHI) as an industry consisting of four firms each with market share
25% since 4(0.25)2 = 0.25. The advantage of the HHI is that it uses
information on all firms in the industry. This is important when analysing
the evolution of industries through merger activity for example. Whereas
the CRm does not change after a merger unless the very largest firms in
the industry are involved, HHI always increases by 2sisj where si and sj are
the market shares of the merged firms. (Make sure you know why!) The
HHI is used in the US Department of Justice Merger Guidelines to indicate
when a merger is likely to be opposed. For example, a guideline might be
formulated as ‘a merger which increases HHI by x when HHI is currently
over y will be opposed.’
As we mentioned before, these measures only give a very crude idea of
what an industry is like and they have to be interpreted with care. For
a start, CRs are usually measured at national level. This leads to two
171
important distortions. Firstly, it ignores imports and this may lead to

overestimation of concentration in the domestic industry. Secondly, the
relevant market may be regional due to high transportation costs or other
factors.
Although there may be many cement and sugar producers nationally,
within a region in which these goods are normally distributed there may
be only two or three firms. Similarly, there are many local newspapers in
Britain but in each town only one or two are usually distributed. National
CRs are therefore meaningless in this market. The definition of the product
or the market is also very important when considering competition policy
issues. In antitrust cases the defendants often claim that the market should
be defined more widely to include substitute products. If we consider the
computer industry, for example, we find different concentration levels
depending on whether we just consider laptop manufacturers or we
include mainframes, desktops and workstations. In the pharmaceutical
industry concentration may be relatively low if we consider the market
for ‘drugs’ whereas, if we define the market as ‘drugs for gout’ it may
be highly concentrated. Given the importance of barriers to entry for
firms’ behaviour in an industry, the simple measures of concentration
have to be supplemented by further analysis. In particular the evolution
of concentration measures may give an indication of whether firms in
an industry compete fiercely. If the shares are relatively stable, this may
indicate the absence of competition.
There are some measures which, unlike CRs, are not officially published
but can be constructed from industry data. The Lerner monopoly
index (or price-cost margin) measures the wedge between price and
marginal cost as a fraction of the price:
L = (p – MC)/p.
The price-cost margin for a profit-maximising firm equals the negative of
the reciprocal of the elasticity of demand, ε, facing the firm:
(p – MC) / p = – (1/ε).
The Lerner index is meant to give an indication of market power and
entry barriers. Because a marginal cost measure is rarely available,
many researchers use the price-average cost margin instead of the more
appropriate price-marginal cost margin. When an industry is concentrated
and has low entry barriers, the concentration ratio is high, while the
Lerner index would be expected to show evidence of limit pricing.
Alternative measures of market power are cross-elasticities. Firms
producing a good which has many close substitutes (large positive cross
elasticity) have less market power than those producing goods with very
few and distant substitutes.
13.4 Perfect competition

In a perfectly competitive market there are many buyers and sellers who
act independently (non-strategically) and have perfect knowledge of the
market and in particular of the price charged by all sellers. The product is
homogenous so that firms do not engage in non-price competition. There
is no point in advertising, for example, if consumers are perfectly informed
and all products are identical. This also means that there is no price
dispersion (i.e. there is a unique market price at which everyone buys and
sells). No firm has control over this market price. It is often also assumed
172
that all firms have access to the same technology and this assumption,
combined with the fact that firms face the same input prices, implies
that the firms will have identical LRAC curves. Inputs are assumed to be
perfectly mobile and responsive to monetary incentives and there are no
barriers to entry in the long-run. Entry then occurs until economic profit
(of the marginal firm if they are not all identical) is zero. Zero economic
profit of course allows for a risk-adjusted normal rate of return on equity.
As a result of these assumptions, a firm in a perfectly competitive market
behaves as if the demand for its product is horizontal. Clearly the firm is
in a sense making a mistake here: when it decides to increase its supply,
the price of output is affected because the industry demand curve is
downward sloping. The same comment applies to consumers. If any
consumer increases his consumption of the good, he has a (very small)
effect on price since industry supply is upward sloping. The idea that
competitive firms and consumers ignore their effect on output price should
be seen as a convenient simplification. The assumptions of the perfect
competition model may seem unrealistic but there are several real world
industries which conform relatively closely to the competitive framework.
Markets for some agricultural products operate in a competitive fashion as
do financial markets for savings and stocks. The packaged tour business is
also very competitive with operators regularly going out of business. There
are virtually no barriers to entry in this business. Chartering aircraft or
setting up a travel agency does not require major capital investment.
13.4.1 From cost function to supply function

Competitive firms are assumed to maximise profits which, given their price
taking behaviour, means:
max pq – C(q) (1)
q
where q is the firm’s output level, p is the market price and C is the firm’s
cost function.
The first order condition for (1) is:
p = MC(q) (2)
which means that the firm chooses its output level so that its marginal cost
equals the market price. The firm’s supply curve therefore coincides with
its MC curve. We need to qualify this to ensure that the firm is not making
negative profits. If the best output level according to (2) leads to losses,
the firm should shut down (set its supply q = 0). The shutdown conditions
are as follows:
1. In the short-term, if revenue exceeds variable costs, the firm should
continue to produce since positive revenue contributes to the partial
recovery of fixed production costs.
2. In the long-term, if revenue does not cover all costs (i.e. variable plus
fixed costs), the firm should shut down and exit the industry.
These conditions imply that the firm’s supply function is only a section of
the MC curve, the section above average variable cost for short-run supply
and the section above average cost for long-run supply. Short-run supply
coincides with the short-run marginal cost curve (some inputs are held
fixed) and long-run supply with the long-run marginal cost curve.
173
Case study: Competition in the insurance industry
In many countries the insurance industry is fiercely competitive. The ‘insurance cycle’ is a
well-documented phenomenon. During such a cycle the industry goes through a phase of
underwriting overcapacity, excess of capital and price wars. This leads to losses which cause
the marginal (usually smaller) firms to exit. Historically when the industry has been free of
price wars for a short period of time a natural catastrophe such as Hurricane Katrina has struck
eliminating the need for a price war to rid the industry of the weaker players. In any case a
new equilibrium settles in with fewer firms and higher premiums and profits start to appear,
encouraging new entry and the build-up of excess capacity. A typical cycle lasts three to five
years.
13.4.2 From firm supply to industry supply

As a first approximation for industry supply we could sum up the
individual firm supply curves horizontally. That is, for each price we
determine (using the MC curve) how much each firm is willing to supply
and we add these output levels to find industry supply at that price.
Example 13.1
Suppose the annual market demand for wild pasta is given by

D(p) = 100 – 5p and there are 10 firms in the industry, each with
production function q = (LK)1/2 where L is water and K is wheat. In the
short-run the amount of wheat is fixed at 1 unit. The input prices are r = 2
for wheat and w = 1 for water. Since q = L1/2 in the short-run (K = 1) each
firm’s requirement of water is L = q2 so that the cost function is given by
C(q) = q2 + 2 (since w = 1, K = 1 and r = 2). Each firm’s supply function
is thus p = MC = 2q or q = p/2. We do not have to worry about shutdown
here since MC always exceeds average variable cost. The industry supply
curve or the sum of the individual supply curves is then Q = 10(p/2) = 5p
and we find the equilibrium in this industry by equating demand and
supply: 100 – 5p = 5p which results in a market price of p = 10 and
quantity Q = 50. At the market price of 10 each firm wants to produce five
units and makes a profit of (10)(5) – C(5) = 50 – 25 – 2 = 23.
Activity
As an exercise you should check how many firms could enter this industry and still make
3
Hint: Let the total
a profit.3
number of firms be
n and calculate the
equilibrium market
The distinction between short and long-term is also important for industry
output and price as a
supply. Long-run supply is more elastic than short-run supply because all function of n. Then find
inputs are variable and there is entry and exit. Sometimes the notion of the maximum n for
intermediate run is used meaning the period of time in which existing which profit is positive.
firms can adjust most or all of their inputs whereas in the long-run market
entry and exit can take place. If all firms are identical the entry and exit
process ensures that each firm produces the output level at which its LRAC
is minimised (i.e. at its efficient scale) and price equals LRAC. Why is this
so? Clearly price cannot go below minimum LRAC or nothing would be
produced. If it is above LRAC then firms can, by choosing their output
level carefully, make positive profits which would induce entry. Note that,
if firms are not identical, long-run supply is no longer constant but upward
sloping. At the equilibrium in such an industry only the ‘marginal’ firms
make zero profits; the other firms make positive profits.
174
p
∑ MC ∑ MC
1 0
p
1
p
0
Figure 13.1: Input price effect on industry supply

Recall the derivation of industry demand for inputs where we concluded
that the output price effect of a change in input price meant that we
could not simply sum individual firm demands for the input to obtain
industry demand. A very similar story can be told here. As the output price
increases the demand for inputs will shift out which will cause input prices
to rise (see Figure 13.1). At the changed input price, each firm’s marginal
cost or supply curve will shift inwards which makes industry supply less
elastic than the horizontal sum of firm supply curves. This input price
effect of a change in output price is likely to be significant when the
industry is a large user of any of its inputs.
It is very difficult to assess the size or the significance of the input price
effect. In some cases it may be counteracted by new entry into the industry
as higher product prices lead to (temporary) larger profits. When industry
output increases there may be some positive externality effects as well,
such as technological improvements through learning by doing, for
example, or improved support services. These factors would tend to make
industry supply more elastic than the horizontal sum of MC curves.

We analysed the main determinants of market structure and the most
commonly used measures of market concentration. The concepts of perfect
competition and industry supply were also discussed.

• describe the important factors in the determination of market
structure giving (preferably your own) examples
• calculate the market structure measures
• derive perfectly competitive firm and industry supply.

175
1. The market demand for a product is as indicated in the table below.
The industry is perfectly competitive and the second table gives each
firm’s long-run total cost. Each firm can produce only integer numbers
of units of output. How many firms will be in the industry in the long-
run?
price (£) quantity demanded
30 200
20 300
10 400
5 600
3 800
output total cost (£)
1 10
2 12
3 15
4 30
2. Mickey Mouse Publishing Ltd. is a price-taking firm in the market for
microeconomics textbooks. It produces books with total cost function
C(q) = 3q2 + 6q + 3. What is its short-run supply function? What is its
long-run supply function?
3. Suppose an industry’s concentration ratios are based on a firm’s share
of domestic production. What is the effect of increased international
trade and imports on the level and meaningfulness of such ratios over
time?
176
Chapter 14: Monopoly and monopolistic competition
Chapter 14: Monopoly and monopolistic

competition
14.1 Introduction
In this chapter we consider two non-perfectly competitive market
structures: monopoly and monopolistic competition.
A firm is a monopolist if it faces little or no competition in its output
market. Certain competition may exist in a monopoly but the key feature
is that it comes from fringe firms that collectively capture a small share of
the market (typically less than 30 to 40 per cent). Importantly, these firms
cannot threaten to erode the monopolist’s market share. A monopolist
faces a downward-sloping demand, which implies that the quantity
demanded falls as the price goes up. However, the distinguishing feature
of a monopoly is not the fact that it faces a downward-sloping demand
curve, but rather that when choosing the optimal market price it can safely
ignore how other firms will respond. It is this lack of strategic interaction
between firms in the market, rather than the fact that it faces a downward-
sloping demand curve, that sets a monopoly apart from other market
structures. A monopoly sets its price without fear that it will be undercut
by a rival firm.
Since the elasticity of demand faced by a monopolist typically is finite,
the Lerner Index studied in Chapter 13 of the subject guide implies
that the monopolist will introduce a positive price-cost margin and enjoy
market power. That is, the optimal price set by a monopolist will exceed
its marginal cost, output will fall short from the socially optimal level and
society will suffer a deadweight loss. The extent of the monopolist’s
market power will obviously depend on the price elasticity of market
demand.
The concept of monopolistic competition was introduced by Chamberlin
(1933) to capture markets where there is significant competition but
also some scope to differentiate a firm’s product from those of its close
competitors. Monopolistically competitive markets present two main
features:
• There are many sellers, and each seller reasonably assumes that
its actions will have a very limited effect on the behaviour of others.
However, no single firm has a sufficiently large market share to
be considered a monopoly. For example, there are thousands of
retailers and department stores in London’s Oxford Street. If the UK’s
department store John Lewis were to lower its prices for some product
lines, it is unlikely that smaller retailers or peers like Selfridges would
react, despite the fact that they may experience a small drop in sales.
They would probably not alter their prices just to respond to a single
competitor. The same argument probably applies to food shops and
restaurants.
• The reason why sellers may choose not to match a competitor’s
discount is because, in monopolistic competition, firms offer
differentiated products. In essence, two products are
differentiated from the consumers’ viewpoint if, at the same price,
some consumers will prefer to purchase product A, while others
will prefer product B. This captures the notion that products are not
177
perfectly substitutable and consumers make choices among competing

products on the basis of factors other than just price (e.g. tastes for
fashion, peer pressure, etc.). The corollary is that a differentiated
seller that raises its price will not lose all its customers as in a perfectly
competitive market.
Economists distinguish between vertical product differentiation
and horizontal product differentiation. In vertical product
differentiation, products differ in terms of intrinsic quality features and
they can be ordered objectively and unambiguously from better to worse.
For example, most people would agree that a Mercedes Benz is a superior
car to a Citroen within a given model or product range. A product is
horizontally differentiated when only some consumers prefer it to a closely
competing product (holding price equal). For instance, some people may
prefer Adidas’s shoes to Nike’s even when quality is comparable and Nike
offers a slightly cheaper product range. Monopolistic competition involves
horizontally differentiated products.

• the concept of monopoly
• why we may not observe MR = MC in a monopoly
• the concept of monopolistic competition
• the Dorfman-Steiner model.

• find profit maximising price and output for a monopoly
• explain the deadweight loss of monopoly
• describe the main features that characterise monopolistic competition
• explain short-run and long-run equilibrium in a monopolistically
competitive industry.

Norton and Co., 2014; 9th edition) Chapter 25: Monopoly.

[ISBN 9781118716380] Chapter 4: Monopolies, monopsonies and
dominant firms, Chapter 11: Monopoly and monopsony, and Chapter 13:
Market structure and competition.
Carlton, D. and J. Perloff Modern industrial organization. (Essex: Pearson
Education Ltd, 2015) 4th edition, global edition [ISBN 9781292087856]
Chapter 7: Product differentiation and monopolistic competition.
Chamberlin, E.H. The theory of monopolistic competition. (Cambridge: Harvard
University Press, 1933).
Dorfman, R. and P.O. Steiner ‘Optimal advertising and optimal quality’,
American Economic Review 44 1954, pp.826–36.

This chapter considers two market structures that differ from perfectly
competitive markets: monopoly and monopolistic competition. It discusses
178
the optimal pricing decision made by a monopolist and some key factors
that may help create or maintain a monopoly. The chapter then describes
the key features that characterise monopolistic competition and the long-
term equilibrium in this market. Finally, a simple model of advertising in a
differentiated product market is analysed.
14.2 Monopoly
A monopoly is an industry consisting of one firm. Apart from state owned
or heavily regulated industries such as electricity, there are not many
markets which conform to this extreme market structure. In practice
however, we assume that a firm will behave as a monopolist when it
is has a dominant market share of, say, 60–70 per cent and there is no
major rival. Microsoft and Intel for example have large market shares
in operating software and microprocessor chips for PCs, respectively.
Monopolies are also relatively common in emerging economies and former
communist countries because of protectionist measures and the lack of
antitrust legislation. There are several ways in which a firm may become
and remain a monopoly. One obvious way is that the most important
industry players merge (combine into a single firm) to create a large single
firm with no real competitive pressure in the horizon. For example, South
African Breweries controls 98 per cent of South Africa’s beer sales and was
formed by a merger of two major competitors in 1979. At the time South
Africa had no antitrust laws to prevent this degree of market concentration
(see Carlton and Perloff, 2015). We address this possibility in more detail
in Chapter 18 of the subject guide. Here we examine other prominent
reasons why a firm may be able to create and maintain a monopoly.
14.2.1 Advanced knowledge and patents

A firm may be a monopoly because it is the only one that knows certain
production techniques or processes that enables it to produce the same
product at much lower cost than other firms. Or it may be able to invent
a new product or service that cannot be copied easily by competitors. For
example, a laboratory may combine ingredients in an innovative way to
invent a new drug used to treat a fatal disease. Firms will typically try to
keep secret its special knowledge so as to prevent rivals from imitating
it (e.g. Coca Cola). When firms invent a new product or process they are
entitled by patent law to have temporary exclusive rights to market or
license this innovation. In most countries the law on intellectual property,
in particular the patent law, grants a legal monopoly to a firm that has
discovered a new product or technique. The firm can obtain a patent on
its discovery that prevents any other firm from copying its product and
competing with it for a fixed number of years. Companies such as Polaroid
and Xerox were in the fortunate position of building up a significant
first mover advantage due to patenting. In the pharmaceutical industry
each new drug is also patent protected. When such a patent expires,
competition from generic drugs cuts the price dramatically.
14.2.2 Government-created monopolies

In addition to patent laws, governments can create monopolies by granting
a government franchise or ‘sole rights’ to operate a certain business. This
way the government protects the monopolist from entry by other firms. In
1994 the British government awarded Camelot, a consortium of several
companies, the contract to run the national lottery as a monopoly for a
seven-year period. This license has been reawarded on several occasions,
most recently in 2012. Other firms are prohibited from running a lottery
179
with the exception of clubs, charities and local councils and then only if
the turnover is small (less than £5 million a year). This setup mirrors what
goes on in other European countries. In Sweden alcohol stores are state-
owned (Systembolaget) and have a monopoly on the sale of liquor. These
are the only retail stores allowed to sell alcoholic beverages that contain
more than 3.5 per cent alcohol by volume. However, private import for
own consumption is allowed and other companies can sell directly to
restaurant and bars (based on EU rules). An 1874 law established the
US Postal Service monopoly on mail delivery. The agency’s monopoly
on urgent mail was partly broken in 1979. This resulted in more intense
competition from private providers (e.g. Federal Express) and by 1994, the
Postal Service’s share of the express mail market had fallen significantly.
Other government regulations may also lead to monopoly. For example, in
some countries someone wishing to build an in-patient medical practice
needs to obtain an authorisation certificate by demonstrating that a
new facility is actually needed. An early entrant into this market could
make further entry by potential competitors difficult by strategically
overcrowding towns with redundant medical centres. Similarly, trade
barriers can be used to prevent entry. Import tariffs and outright bans help
insulate national monopolies from foreign competition in their domestic
market.
14.2.3 Utilities
A natural monopoly occurs when average costs fall constantly over the
relevant production range and it is therefore more efficient for only one
firm to produce all of the output. In effect total production costs would be
higher if two or more firms shared the market instead of having a single
large firm. The crucial factor is the minimum efficient scale – the level
of total output that minimises average cost, relative to the size of market
demand.
Many utilities (e.g. electricity and gas suppliers, sewerage, telephone
companies) can be characterised as natural monopolies because of the
existence of relatively high fixed costs, such as creating and maintaining
pipes, and the constant (and often very low) marginal cost of supplying
the service. As a result, average cost tends to fall continuously as output
increases. To achieve the cost efficiency of a natural monopoly while
also limiting the market power that results from having only one firm
in the market, most natural monopolies are regulated or operated by
governments. For example, public utility regulators may set the prices that
the company is allowed to charge, which ideally should allow the company
to supply all who are willing to pay for the service at the prevailing price
and also make the required return on its capital (to avoid direct subsidies).
Another solution would be to nationalise the public utility and let the
(central or local) government operate it.
Activity
Can you identify other industries that behave as natural monopolies?
14.2.4 Profit maximisation

The standard monopoly model is very simple. Industry demand equals
firm demand and, although we could make a distinction between short-
and long-term with respect to the monopolist’s cost function, there is no
entry or exit. The profit maximisation problem can be stated in terms of
price or quantity. Both formulations give the same result, of course. Using
180
the quantity formulation leads to the familiar ‘marginal revenue equals

marginal cost’ result. If we think of the monopolist’s problem as one of
choosing an optimal price, we have:
max pq(p) – C(q(p))
p
The first order condition is:
Pq' (p) + q(p) – MC(q(p)) q' (p) = 0.
With some algebraic manipulation this can be rewritten in terms of the
price elasticity as:
(p – MC)/p = 1/η or p = (η/(η – 1)) MC.
The markup η/(η – 1) clearly depends on how price elastic demand
is. For example, for the constant elasticity demand curve q = ap–2, the
markup equals 2 so that the optimal price is double the marginal cost:
p = 2 MC. This result also shows that, if the firm is profit-maximising, the
Lerner index is the inverse of price elasticity.
The markup formula bears a strong resemblance to the popular practice
of cost-plus pricing. Many pricing decisions are made using the rule
of thumb that you should take an estimate of average variable cost, add
a charge for overhead and a profit margin. If the profit margin reflects
market conditions (price elasticity) and if economic costs (i.e. opportunity
costs rather than accounting costs) are used, there is not too much
wrong with this. The main problem is the overhead charge. For profit
maximisation only marginal cost is relevant, not average cost.
The simple monopoly model is not very interesting and there are several
reasons, such as regulation, why we do not observe the behaviour it
predicts. The really interesting questions arise when we consider how
a monopoly is formed and how a firm can stay a monopoly. Unless the
barriers to entry are very high or the monopolist has a significant cost
advantage, potential entrants are attracted by juicy monopoly profits. If
the monopolist is not prepared or forced to share the market, how can he
discourage entry?
If the monopolist engages in limit pricing, we would not observe MR =
MC. If he has a cost advantage, he could threaten to flood the market
when entry occurs. If this threat is credible the monopolist may use the MR
= MC rule. It is likely, however, that the threat is not credible (subgame
perfect) as it may be more profitable to accommodate the entrant. If
the incumbent could commit to a ‘fighting’ strategy by announcing or
advertising that he is willing to match or undercut any price offered
elsewhere, entry can be deterred. Similarly, if the monopolist can obtain
some large long-term contracts from major buyers he is more likely to
be in a position to discourage entry. We will return to these issues later
when we have looked at oligopoly. At this point these questions are hard
to tackle because we have to model what happens after entry to decide
whether it is worthwhile to try to deter entry, for example.
Another reason why we may not observe the MR = MC rule in real-life
monopolies is that some of these monopolies operate in contestable
markets. Such markets have very low entry and exit barriers and the
reason they are monopolies is usually due to economies of scale. Average
cost decreases over the relevant output range so that only one firm can
survive but many firms may compete to be the single supplier. Contestable
markets are markets in which sunk costs are low. A frequently cited
example is that of an airline route between two small cities. Entry is easy
for anyone who has planes available (on other less lucrative routes) and
exit is easy because planes can be sold or leased or switched to other
181
routes. In these circumstances, a monopolist cannot exercise his market

power because, if he did, he would be replaced by a willing and able
entrant. In fact monopolists may even behave as if they were in a perfectly
competitive industry if the market is contestable.
14.3 Monopolistic competition

Monopolistic competition is the market structure which emerges if we
relax the assumption of homogenous goods in the perfect competition
model. There are many sellers producing a differentiated product. For
example, in the beer industry, each brewery markets a unique product
(although it has many close substitutes). The main consequence of
relaxing the assumption of homogeneity of products is that some forms of
non-price competition such as advertising and providing different types of
service can be profitable.
A monopolistically competitive market has three distinguishing features:
1. Fragmentation – there are many buyers and sellers.
2. Free entry and exit – there are no significant sunk costs or any
other entry/exit barriers.
3. Horizontal differentiation – consumers view firms’ products as
imperfect substitutes of each other.
What distinguishes monopolistic competition from perfectly competitive
markets therefore is the existence of product differentiation. This
differentiation could be ‘real’ (e.g. proximity to the consumer’s home)
or the result of physiological elements affecting demand that are not
necessarily related to the product’s physical features. Monopolistic
competition also differs from a differentiated products oligopoly by the
fact that there is free entry.
Monopolistic competition is associated with industries of firms with large
advertising budgets. Many ‘fast moving consumer goods’ (FMCG) sectors
fall into this category. Firms make enormous efforts to convince their
consumers that the washing powder they market, for example, is not
identical to the one marketed by their rivals. You could say that advertising
is necessary in monopolistic competition to ensure that buyers and sellers
have perfect information about the market, which is what we continue to
assume. Apart from advertising, there are many other methods firms use
to create some differentiation of their product. The following list contains
a few examples:
• packaging: two chemically identical dishwasher detergents are
perceived as different by consumers if one is packaged in a plastic
bottle and the other in a cardboard box
• product design: shampoo and conditioner are sold separately and
combined
• type of service: in the PC industry, it is becoming increasingly
difficult to produce a differentiated product. The same components
are used in the assembly of most PCs. Almost all PCs use Intel’s
microprocessors
• location: supermarkets and restaurants, even when they offer the
same range of products, are differentiated by their location. It is
unrealistic to assume that, if a supermarket charges a penny more for
butter than the supermarket at the other end of the high street, it will
lose all its business, or conversely that, when it undercuts its rival by a
small amount, it captures the whole market.
182
14.3.1 Short-run and long-run

A crucial assumption in the monopolistic competition model is that, as
in perfect competition, firms do not act strategically when formulating
price and output decisions. They do not take potential rivals’ responses
into account and they do not collude. This also distinguishes monopolistic
competition from differentiated oligopoly.
Whereas perfectly competitive firms are forced to sell at the market price,
in the monopolistic competition model, a firm does not lose all of its sales
if it prices slightly above its competitors. This implies that each firm faces a
downward sloping demand curve that is highly but not completely elastic.
Each firm has some monopoly power. Indeed one of the reasons to engage
in non-price competition such as improving service is that a firm that
produces a differentiated product does not have to cut its price whenever a
rival cuts his price.
The short-run monopolistic competition model is in fact exactly the
same as the monopoly model with firms setting output levels such that
MR = MC. As in perfect competition there are no or low barriers to
entry so that in the long-run entry and exit ensure that profits are zero.
The long-run equilibrium conditions for a monopolistically competitive
industry are as follows:
• at the optimal output level q* for each firm, price should equal average
cost (AC) so that profit is zero
• at its optimal output level each firm maximises profit and hence MR =
MC at q*.
From the long-run equilibrium conditions we know that, for the optimal
output level q*, MR intersects MC. The price corresponding to q* can be
read off the demand curve and has to equal AC as is illustrated in Figure
14.1. This leaves the possibility of demand intersecting AC rather than
being tangential to it at q*. However, this would mean that there are
output levels for which the firm could make a positive profit contradicting
the fact that q* is profit maximising. The figure shows that, at any output
level other than q*, the firm makes a loss. Because demand has to be
tangent to AC at the long-run equilibrium, firms operate at output levels
to the left of the efficient AC minimising level. Output is lower and price
higher than those that would be chosen by a firm operating in a perfectly
competitive market.
If firms could increase their output, their AC would decrease and profits
would increase but in the longer term this would induce entry into the
market. The cost of this ‘excess capacity’ in monopolistically competitive
markets is often referred to as the price of variety. Consumers are willing
to pay a premium, so the argument goes, to have a choice between
differentiated products. When, during your weekly or annual Christmas
food shopping, you have to find your way through the enormous variety of
products for sale in the shops and on the supermarket shelves you may be
forgiven for being sceptical about this.
183
p
MC
AC
p*
D
MR
q* q
Figure 14.1: Monopolistic competition – long-run equilibrium

Many industries satisfy the assumptions of the monopolistic competition
model although inevitably there are entry barriers because of large
advertising budgets, for example. In such cases the analysis is still valid
but we cannot insist on zero profits at the long-run equilibrium.
Because of product differentiation it is generally not easy to define a
monopolistically competitive industry. For example, does the market for
soap include liquid soap or can we restrict it to soap bars? Whereas
a perfectly competitive industry consists of firms producing perfect
substitutes, in monopolistic competition products are close but not
perfect substitutes. What ‘close’ means in practice is difficult to say and
always entails some arbitrary decisions. In empirical work a judgement
has to be made when specifying demand functions as to which cross price
effects to estimate and which to ignore.
14.3.2 Advertising and the Dorfman-Steiner model

Advertising plays a major role in monopolistically competitive industries.
This gives us an opportunity to look at a model of advertising expenditures
here. Even when two shampoos are chemically identical their demand
curves are not perfectly elastic as in the perfect competition model so
long as one is advertised by a top model and the other by someone totally
unknown to the public. In general, advertising a product has the effect
that consumers consider fewer products as good substitutes for that
product. Advertising has the power to shift the demand curve and change
price elasticity. Analytically this implies that the decisions of how much to
advertise and which price to set cannot be taken in isolation.
Deriving the optimal advertising budget and price is not hard if we know
how demand responds to changes in price and advertising. Let q(p, a) be
the demand function. Then the firm’s profit function is:
π = pq(p, a) – C(q(p, a)) – a.
The first order conditions are:
∂π ∂q(p,a) ∂C ∂q(p,a)
=p + q(p,a) – =0 (1)
∂p ∂p ∂q ∂p
and
∂π ∂q(p,a) ∂C ∂q(p,a)
=p – –1=0 (2)
∂a ∂a ∂q ∂a
After some algebraic manipulation, we can rewrite these conditions in
terms of the price and advertising elasticity of demand:
184
η = p / (p – MC) (3)
and
∂q(p,a) a a
α≡
∂a q = q(p – MC) . (4)
Equation (3) is the familiar markup formula for monopoly pricing. From
equation (4) we deduce that advertising increases with the responsiveness
of demand to advertising, the output level and the profit margin. At the
optimum, the ratio of advertising expenditures to sales revenue equals the
ratio of advertising and price elasticities (divide (4) by (3)):
a / (pq) = α/η (5)
This result was first shown by Dorfman and Steiner (1954) and has
generated a huge literature in the field of marketing models. In empirical
studies, it is found that the advertising–sales ratio is positively related to
price–cost margins which confirms the Dorfman-Steiner result (substitute
(3) into (5)) since price elasticity is negatively correlated with the price
cost margin. Of course this simple model does not capture all of the
interesting aspects of the advertising decision. For example, it ignores
dynamic effects of advertising. A company’s current advertising budget is
unlikely to just affect current sales. By advertising now a stock of goodwill
is built up which leads to higher sales in the future as well.

This chapter considered monopoly and monopolistic competition by
analysing their main features, the firms’ profit-maximising pricing
decision, market outcomes and long-term equilibrium. A simple model of
advertising in a differentiated product market was also discussed.

• find profit maximising price and output for a monopoly
• explain the deadweight loss of monopoly
• describe the main features that characterise monopolistic competition
• explain short-run and long-run equilibrium in a monopolistically
competitive industry.

1. The demand for a textbook is given by p = 20 – 0.0002q. The
publisher’s marginal cost function is MC = 6 + 0.00168q. The author
of the textbook gets a royalty of 20% of total revenue. Suppose the
publisher decides on the price. What is his preferred price-quantity
pair? Suppose the author could decide on the price. What is her
preferred price-quantity pair? In the first scenario (the publisher
185
setting the price), how much would the publisher offer the author as
a lump sum payment in return for the author giving up the royalty?
Should the author accept?
2. The Seow Food Corporation has bought exclusive rights to sell
chocolate bars at Wembley arena. The fee it paid for the concession
was £1000 per event. The cost (excluding this fee) of obtaining and
marketing each candy bar is 10 pence. The demand schedule for candy
bars in the arena is as indicated in the table below. Prices must be in
multiples of five pence. What price should Seow charge for a candy bar
and what is the maximum amount that it should pay for a concession
for a single event?
Price per candy bar (pence) Thousands of candy bars sold per game
20 10
25 9
30 8
35 7
40 6
45 5
50 4
3. Demand for a monopolist’s goods is given by q = S/p0 if p ≤ p0 and

q = 0 if p > p0. S is a constant. What is the monopoly price?
4. Consider a monopolistically competitive market. Explain why in
a long-term equilibrium the firm’s demand curve is tangent to its
average cost curve. What would happen in the long run if the demand
curve cut through the average cost curve at the prevailing price?
186
Chapter 15: Price discrimination
15.1 Introduction
In our discussion of monopoly pricing (Chapter 14 of the subject guide)
we found that the monopolist sets price such that marginal revenue
equals marginal cost. We implicitly assumed that the monopolist had
no option but to set a single price, the same for all buyers, independent
of the quantity they buy, whether they buy any other products from the
monopolist, etc. In reality, sellers often have the opportunity to market
their products at different prices (price discrimination) or sell them as part
of a package (commodity bundling). Firms typically have some degree of
discretion over their strategic pricing policies. For example, they may use
non-uniform pricing. This is a practice whereby consumers are charged
different prices for the same product. It is not uncommon to observe that
different people paid different prices for comparable seats in an airplane
flight or for the same holiday package. Price discrimination is a form
of non-uniform pricing.
As we shall see, price discrimination allows the monopolist to increase
its profits. This is why the practice is so pervasive. Price discrimination
is profitable because the firm can charge a higher price to consumers
who value the good the most, thereby capturing some of their consumer
surplus. This redistribution of surplus (from consumers to the firm)
may paradoxically give rise to overall improvements in Pareto efficiency
because it encourages the monopolist to expand output, which in turn
reduces the deadweight loss associated with a monopoly. Depending on
the type of price discrimination analysed, the welfare effect can be positive
although consumers are typically poorer than they are under competition.
To understand why price discrimination improves profits, remember that
when a monopolist faces a downward sloping demand curve and drops
its price to increase sales, part of the current revenue falls because all
existing output must now be sold at a lower price. This is always the case
in the presence of a unique, uniform monopoly price. However, price
discrimination can be seen as an attempt by the monopolist to reduce
this effect on marginal revenue from expanding sales. Effectively it allows
the firm to expand sales by lowering the price to new consumers without
necessarily having to simultaneously offer the same discount to all current
consumers. The impact on profits is clearly positive.
This chapter deals with some simple types of price discrimination while
Chapter 16 of the subject guide examines other, more complex, types of
monopolistic (pricing) practices such as two-part tariffs, bundling and
quantity discounts.

• the differences between first, second and third degree price
discrimination
• why under first degree price discrimination all consumer surplus can
be extracted
• why under two part pricing, at least for identical consumers, unit price
should be set equal to marginal cost
• the relationship between price in a market and its price elasticity when
third degree price discrimination is practised. 187

• give (your own) examples of price discrimination
• derive the optimal take-it-or-leave-it-offer in first degree price
discrimination
• derive the optimal two-part pricing scheme
• derive optimal prices and quantities in third-degree price
discrimination (analytically and graphically) and determine the
optimal price and quantity when the monopolist faces two demand
curves and is not allowed to price discriminate.

Norton and Co., 2014; 9th edition) Chapter 26: Monopoly behaviour.

Chapter 9: Price discrimination.
Oi, W. ‘A Disneyland dilemma: two-part tariffs for a Mickey Mouse monopoly’,
Quarterly Journal of Economics 85 1971, pp.77–90.

This chapter discusses non-uniform pricing and particularly the three types
of price discrimination that are frequently observed in a monopoly. It also
analyses the conditions under which price discrimination can occur.
15.2 Price discrimination

Of all pricing practices, monopolistic or otherwise, price discrimination
in its many forms is certainly the most visible. Price discrimination occurs
whenever the same good or service (i.e. a good or a service produced at
identical cost) is sold at different prices. More generally, we can say that,
when price differences between consumers are larger than is warranted
by cost differences, there is price discrimination. For example, British Gas
and other public utilities offer a reduction on your bills if you pay by direct
debit. To the extent that collecting revenue by direct debit is less costly
than by alternative methods, the discount is not an indication of price
discrimination. It is more difficult to argue that price differences between
first and second class on trains, or business and economy on planes, are
justifiable on the basis of cost differences. There is something else going
on here.
For a firm in a perfectly competitive industry it is not possible to indulge
in price discrimination. If such a firm sets a price above the prevailing
market price, it loses all of its customers. Some degree of market power
is necessary to enable a firm to price discriminate. It is easiest to analyse
price discrimination by a monopolist although in reality it occurs mostly
in oligopolies. It is easy to understand the attraction of charging different
prices for the same good. Clearly, profits cannot decrease as a consequence
of price discrimination since one option is to set the same price in all
markets. In general, although not necessarily in all theoretically possible
cases, profits increase if price discrimination is possible.
188
Why is price discrimination more common in the sale of services than

manufactured goods? The main reason is that for services, resale is
generally not possible. I cannot get a haircut or a massage and sell it to
you, for example. Utilities such as telephone and electricity companies
often successfully use price discrimination. This is because customers
cannot resell their services to other people.
When resale is possible, price discrimination may not succeed because
of arbitrage. The term arbitrage is used when it is possible for buyers
who buy the product at a low price to resell it to those facing a relatively
high price, thus making a profit. If a wholesaler offers quantity discounts
to retailers, he has to ensure that it is impossible for a retailer to buy a
very large quantity taking advantage of the discount and then resell the
product to the wholesaler’s other customers. Similarly, when a Japanese
car manufacturer wants to charge different prices in Europe and in the
US, the potential price differential is limited by transportation costs. If the
price difference is too large (e.g. when Japanese cars in the US are much
cheaper than in Europe), they will be shipped from the US to Europe (in
the absence of quotas, etc.). Resale defeats the attempt by the monopolist
to charge different prices. Manufacturers’ warranties that become (null
and) void if the product is resold illustrate a way to make resale more
difficult for consumers.
Economic theory classifies price discrimination practices according to
how much information the monopolist has, whether consumers can
choose from a price menu (e.g. when quantity discounts are offered), and
whether markets are isolated (no arbitrage possibility) so that consumers
in each market or market segment are quoted a segment specific price.
15.2.1 First degree price discrimination

Remember that the main purpose of price discrimination is to capture
additional consumer surplus through sophisticated non-uniform pricing.
Perfect price discrimination, or first degree price discrimination,
occurs when a monopoly is able to charge the maximum amount each
consumer is willing to pay for each unit of the product. This is virtually
never possible to do in practice but it nonetheless offers a useful
theoretical benchmark against which other more imperfect forms of price
discrimination can be compared.
Suppose a consumer with income m derives utility from widgets x and
income remaining y after paying for the widgets. A seller of widgets who
knows the utility function can offer the consumer a take-it-or-leave-it
deal. She can determine the maximum amount the consumer is willing to
pay by comparing the utility of consuming widgets and paying a certain
amount P, to the utility without widgets. You can think of the seller
choosing a point on the consumer’s indifference curve through (0,m) as is
illustrated in Figure 15.1. If the seller asks for a payment P* in return for
x* widgets, the consumer will just about accept this offer. If the seller asks
for more than P* or offers less than x* in return, the consumer rejects the
offer.
189
m- P*
x
x*
Figure 15.1: First degree price discrimination
Example 15.1
A consumer with income m derives utility from a good x produced by a

monopolist and from his remaining income y according to utility function
U(x, y) = x1/2 y + y. Hence his utility is U(x, m – P) = x1/2 (m – P) + (m – P)
when he buys x units and pays the monopolist P and utility U(0, m) = m
if he goes without product x. The monopolist who knows the consumer’s
utility function is able to make a take-it-or-leave-it offer, that is, he says ‘I will
give you x units if you give me £P; if you refuse, you will get nothing’. The
consumer accepts such an offer if U(x, m – P) > U(0, m):
( m –PP ) .
2
x1/2 (m – P) + (m – P) ≥ m or x ≥ (1)
Assume the monopolist has constant marginal costs c. To determine his

offer P optimally he maximises his profit P – cx subject to (1). Clearly he
is not going to give the consumer more than is necessary to make him
accept the offer. This implies that he sets x = (P/(m – P))2. His problem
then becomes one of finding the optimal payment P:
( ).
2
P
Max = P – cx = P – c m – P (2)
The first order condition corresponding to (2) is:

P
(
1 – 2c m – P ) ( (m –mP) ) = 0;
2
which can be rewritten as:

1 = Pm . (3)
2c (m – P) 3
You should check that the second order condition is satisfied for P < m.
The optimality condition (3) does not have an analytical solution but
given any values of m and c we can solve for P. If marginal cost is
c = 4/3 and income m = 3, then the monopolist should set P = 1 and
x = (P/(m – P))2 = 1/4, i.e. he should make an offer of 1/4 unit at a
payment of 1. We can check in (1) that the consumer will just accept this
offer: (1/2)(3 – 1) + (3 – 1) = 3. The monopolist, who is in the most
enviable position of knowing the consumer’s utility function, gets profit
π = 1 – (4/3)(1/4) = 2/3. You should check that, when the monopolist
is restricted to setting a fixed unit price, his optimal profit would be less
than 2/3.
190
There is an alternative way to analyse the problem of first degree price

discrimination. It starts out with a consumer’s demand function rather
than the utility function and uses the idea that the area under the demand
curve (consumer surplus) represents ‘willingness to pay’ or a monetary
equivalent of the utility a consumer derives from consuming the good.
However, this interpretation is only valid for special classes of utility
functions such as quasi-linear utility. A utility function of type U(x, y)
= v(x) + y, where x is the quantity of widgets produced by the monopolist
and y is remaining income, is quasi-linear. For such a utility function, the
indifference curves in the x – y plane are vertically parallel and hence the
income elasticity of widgets is zero. When we can use consumer surplus
as a measure of how much consumption of a good is worth to a consumer,
the monopolist’s problem can be illustrated as in Figure 15.2. For each
choice of x, the monopolist knows how much the consumer is willing to
pay, for example, for x = x′, the seller can demand the consumer surplus
represented by the area ab x′ 0. His costs are cd x′ 0 so that his profits are
abdc. Profits are maximised when the monopolist offers to sell x* units
and demands payment of the entire consumer surplus. In other words, the
monopolist is selling each unit at the highest possible price the consumer
is willing to pay. Although we have concentrated on the idea of the
monopolist offering take-it-or-leave-it deals to individual consumers, we
can think of D as the market demand curve. The same conclusion holds
in that the monopolist will sell the quantity which maximises consumer
surplus minus costs and demand payment of the entire consumer surplus
which is the sum of individuals’ consumer surplus. Note that the total
output produced by the monopolist coincides with that of a perfectly
competitive market and efficiency is therefore maximised.
Perfect price discrimination could also be achieved if the monopolist
charged an optimal two-part tariff, where each consumer pays a
different lump-sum fee for the right to purchase and a per-unit charge of c.
The lump-sum fee must be set so as to capture all the consumer surplus.
Under first degree price discrimination, assuming constant marginal cost, the
seller deals with each consumer and determines individual take-it-or-leave-it-
offers. The offer (P, x) varies from person to person. Of course this is all quite
unrealistic. In practice you might come reasonably close to the situation
described above when there are few buyers and the seller has individual
contact with each of them. For example, a car dealer may have some idea of
how much a potential customer is willing to pay. Doctors in remote villages
may also be able to successfully price discriminate if they can identify the
wealthy people in the area and charge higher rates accordingly. In any case,
the perfect price discrimination model provides a useful benchmark.
p
a
D
b
c
d
x
0 x′ x*
Figure 15.2: Extraction of consumer surplus
191
15.2.2 Second degree price discrimination

Second degree price discrimination is also referred to as
nonlinear pricing or block pricing. Under this scheme, the seller
offers consumers a menu consisting of prices corresponding to different
quantities. Usually price is lower if a higher quantity is bought (quantity or
bulk discount). Foods and drinks are often sold at lower per unit prices in
‘family’ packs. This is price discrimination unless the price difference with
single item sales can be justified by differences in distribution or packaging
costs. Utilities (gas, electricity, water, telephone) also offer price menus on
which price decreases with the number of units bought. In theory a seller
could offer a price menu with prices increasing when larger quantities are
bought. In practice consumers would buy small quantities several times
rather than a big quantity unless of course the seller can keep track of all
this by making sure that sales are not anonymous. Indeed, for bank loans
where price (interest) increases with quantity, buyers (borrowers) are not
anonymous.
In contrast to first degree price discrimination, under second degree price
discrimination every individual who buys the same quantity pays the same
price. In a sense consumers self-select to pay different average prices
through their choice of consumption quantity.
A frequently used special case of nonlinear pricing is two-part pricing.
Consumers pay a uniform lump sum ‘entry fee’ which gives them the
right to purchase the good plus a regular price per unit. Therefore the
actual unit price decreases with the quantity bought. Of course, as with
other forms of price discrimination, this type of pricing is only possible
if customers cannot resell (to customers who did not pay the fixed fee).
One of the first papers on two-part pricing quotes Disneyland amusement
park which used to charge per ride in addition to the entrance fee (see Oi,
1971).
The following can all be interpreted as two-part pricing:
• most telephone, electricity and gas companies charge a fixed rental fee
plus a price per unit
• nightclubs use entry fees in addition to a fixed price per drink
• for products which need complementary inputs or replacement
parts such as cameras and shavers, the price of the product is like
an entrance fee and in addition the consumer pays a fixed price per
memory card or per blade
• taxis often charge a fixed fee plus a price per distance travelled.
In some cases, there is a cost based justification for two-part pricing.
For example, for telephones there is a connection cost and printing jobs
involve setup cost so that larger batch sizes are less costly per unit.
As an illustration of two-part pricing in the same framework as first degree
price discrimination, consider the problem of the monopolist who knows
an individual’s utility function. He offers the individual a combination of
a fixed fee F and a unit price p. Figure 15.3 shows that this problem is
equivalent to the one we encountered in first degree price discrimination.
The seller can in fact choose any point on the indifference curve through
(0, m) by an appropriate choice of F and p. The entry fee F determines the
intercept of the consumer’s budget line whereas p determines its slope.
192
m-F
a
x
x* (m-F)/p
Figure 15.3: Two-part pricing

If we analyse the problem in terms of the demand function (which we are
allowed to do only if the income effect is negligible), then for any price
p the seller charges, the maximum fee is the consumer surplus at price p.
Again the best the monopolist can do leads to the same result as in the
take-it-or-leave-it scenario, discussed above, where the entire consumer
surplus was captured. Here, price is set equal to marginal cost and F is
the consumer surplus corresponding to p = c. This result is not dependent
on the assumption of constant marginal costs. The seller’s optimisation
problem is:
max p(q)q – C(q) + CS(q) = max p(q)q – C(q) + ∫q0 p(t)dt – p(q)q
where CS(q) is the consumer surplus of consuming q units. The solution to
this maximisation problem is to set p equal to marginal cost.
The two-part pricing problem becomes more realistic and more interesting
but also much more complicated when the seller does not know individual
utility functions or demand curves. Suppose the seller knows there are
two types of consumers out there with demand functions q1(p) and q2(p)
respectively but he cannot distinguish between them. He also knows the
fraction of consumers belonging to each of these groups. The seller has
to offer the same two-part pricing offer (F, p) to all consumers. How is he
going to determine the best (F, p) offer? A first consideration is whether
the seller should aim to sell to both groups. It may be that one of the
groups has very low willingness to pay for the product and is not worth
trying to sell to. If we assume that both groups are served, then we could
determine the optimal F for any price p. It will be the minimum of the
consumer surplus at p for a Type 1 and a Type 2 consumer. (Remember
that we want both groups to buy.) This implies that the seller does not
succeed in extracting all consumer surplus. One group will enjoy positive
consumer surplus whereas the other’s will be zero. Average profit per
consumer consists of this fee F plus the profit margin times the average
demand (at price p), which is dependent on the relative size of the groups.
Although all consumers will be offered the same deal, the two groups end
up paying different average prices (F + pq)/q = F/q + p because their
quantity choice differs.
15.2.3 Third degree price discrimination

The monopolist may not have sufficiently detailed information to identify
each consumer and determine their willingness to pay so as to perfectly
price discriminate. However, the firm may have enough information
to partition customers into specific groups of consumers who share
193
similarities within the group but differ across groups. If the demand curves
(e.g. price elasticity) of each group differ, the monopolist may find it
profitable to set different prices for the separate groups.
Third degree price discrimination is ‘group’ price discrimination.
Different people pay different prices according to which group they belong.
Typically they cannot change their membership status. For example,
hairdressers often give a significant discount to elderly customers. It is
important to highlight that it is impossible or unprofitable for low-price
buyers to resell to potentially high-price buyers. This is why third degree
price discrimination is most frequently used when selling services. Usually
in third degree price discrimination schemes you pay the same price
for each unit you buy (i.e. there are no quantity discounts). (In theory
you could combine second and third degree price discrimination.) The
following list gives a few examples of third degree price discrimination
practices (we strongly encourage you to think of others):
• senior citizen discounts for movies and buses; student discounts for the
theatre; children’s discounts for the zoo
• academic journals which can be three times more expensive for
libraries than for individuals
• seasonal pricing at resorts
• some restaurants which offer the same menu for lunch and dinner but
dinner prices could be double the lunch prices
• afternoon and evening performances at the theatre may differ in price
• trade-in discounts are offered for many appliances
• fare classes on trains (first and second class) and planes (first, business
and economy class)
• companies with large travel budgets are given corporate discounts by
airlines and hotel chains.
Some of the above examples involve exploiting consumer flexibility
(seasonal pricing) or differences in the value consumers place on time
(afternoon versus evening performances). The analysis of third degree
price discrimination is similar to that of division of output between
plants. Indeed, you could analyse the (realistic) scenario of a company
manufacturing a product in several plants and selling in several markets in
this same framework. For simplicity we will focus on price discrimination
here and assume that everything is produced in one plant with cost
function C(q). The seller can charge different prices, p1 and p2, in his two
markets with demand functions p1(q1) and p2(q2).
The seller’s profit maximisation problem is:
max П = p1(q1)q1 + p2(q2)q2 – C(q1 + q2)
q1, q2
with first order conditions:

MR1(q1) = MC (q1 + q2)
MR2(q2) = MC (q1 + q2). (4)
The intuition behind this result is straightforward: you should always

allocate a unit of output to the market where it will have the highest
revenue. If you supply both markets, their marginal revenue should be
equal. Furthermore you should only sell another unit if its MR exceeds
its MC. You could decide not to sell at all in one market. This means that
the MR in the market which is not supplied is always below the MR in the
market which is supplied and is below MC at the optimal output level.
194
It is very important to realise that the marginal cost should be measured at

the total output q1 + q2. When MC is constant it obviously does not matter
where it is measured but in the general case of increasing MC it does.
Figure 15.4, which illustrates the solution we have just discussed, is similar
to the ‘division of output’ figure. The intersection of the horizontal sum
of the marginal revenue curves with the marginal cost curve determines
optimal total output. We can then trace back to the individual MR curves
to determine how much is sold in each market. The optimal prices are read
off the demand curves. If marginal costs are sufficiently high (MC ′), only
the ‘high willingness to pay market’ (Market 1) will be supplied.
p2
p1
p1' MC'
D1 Σ MR
p1*
MC
MR1 p2* D2
D
MR2
q1*+ q2* = q0
q1* q 0 q2* q2 q
q1' q0 q1 2
1 q1' + q2'
Figure 15.4: Third degree price discrimination

Figure 15.4 also illustrates the monopolist’s pricing problem when he
is prevented from price discriminating between the two markets. In
this case, his demand curve is the horizontal summation of the market
demands D = D1 + D2 and optimal output q0= q01+ q02 is determined
where MC intersects the MR corresponding to D. Since D is kinked, the
MR (the bold lines) is not continuous. In the figure, because the demand
functions are linear and it continues to be optimal for the monopolist to
serve both markets, the optimal output is unchanged. Of course the prices
in the two markets are different: the low price is increased and the high
price is reduced. In general, when price discrimination is not allowed,
the new common price should be between the two previous prices so that
consumers in the previously high price market benefit at the expense of
consumers in the previously low price market. For instance, distillers had
a dual pricing system in the 1970s. Whisky exported to the continent
was more expensive than that sold in the domestic UK market. When
this was ruled to be illegal by the EU Commission, prices in the UK rose
considerably for brands such as Red Label.
When price discrimination is not allowed, a monopolist is more likely not
to serve the low willingness to pay market.
Activity
Can you draw a MC curve on Figure 15.4 for which the monopolist only sells in both
markets when he is allowed to charge different prices?
Generally, output is lower when price discrimination is not allowed. If the

monopolist is constrained to charge the same price in all markets, he may
not want to expand production since it would lower the price of all output
195
but if he can price discriminate he can expand sales in one market without
hurting revenue in another. This is why the welfare effects of third degree
price discrimination are ambiguous. Generally, some consumers gain and
others lose; the monopolist, of course, always gains.
Example 15.2
The domestic and foreign annual demands for a textbook entitled Pricing
for monopolists are pd = 100 – 15qd and pf = 60 – 2.5qf respectively where
p is the price in dollars and q is the number of copies sold (in thousands).
Any copy of the textbook can only be sold in the country to which the
publisher has consigned it (i.e. re-export is illegal). The publisher’s annual
production costs for this textbook are:
C(q) = 10.8 + 20q + 0.1q2.

The MR curves corresponding to the two demand functions are:
MRd = 100 – 30qd
and
MRf = 60 – 5qf .
The optimality condition (4) implies that these two expressions are set
equal to:
MC(qd + qf ) = 20 + 0.2 (qd + qf ).
Solving for qd and qf results in:

qd = 2.6 and qf = 7.6
which suggests (use the demand functions) prices:

pd = 61 and pf = 41.
At output qd + qf = 10.2, MC equals 22 which is also the marginal revenue

in both markets for these sales levels. Profit equals:
П = (2.6)(61) + (7.6)(4l) – 225.2 = 245 or $245,000 per year.
Now suppose the publisher is accused of dumping (i.e. selling at a lower

price abroad than domestically) and is forced to sell the textbook at the
same price domestically and abroad. Assuming the publisher still finds it
profitable to sell in both markets, he faces a total demand:
q = qd + qf = (100 – p)/15 + (60 – p)/2.5.
The publisher’s profit maximisation problem can be expressed with price as
the decision variable:
max П = pq( p) – C(q( p)) .
p
The optimality condition is:
( p – ∂C∂q ) ∂q∂p = – q. (5)
If we substitute the total demand q in (5), and solve for p we find

p = 43.83. At this price 3,740 copies (qd = 3.74) are sold on the domestic
market and 6,470 (qf = 6.47) are sold on the foreign market. The no
dumping restriction hurts the publisher’s profit which is now
П = (43.83)(10.2) – (10.8 + 20(10.2) + 0.1(10.2)2) = 221.9
so that profit has fallen to $221,900 annually.
196
Price discrimination and elasticity of demand
Rewriting the optimality conditions (4) in terms of elasticity of demand

allows us to explain some features of third degree price discrimination in
practice. At the optimum, we find:
( )
η1
p1 =
η1 – 1 MC(q1+ q2) and
p =(
η – 1 ) MC(q + q ) .
η 2
2 1 2
2
Since η1 η2 when η < η , higher price will be set in the market

> 1 2
η1 – 1 η2 – 1
with the least elastic demand. Every day, you can see applications of this
principle. People are charged more when they want to have things done in
a hurry (their demands are likely to be inelastic): for example, one-hour
versus 24-hour photo processing. This type of price discrimination based
on urgency of service also applies to same day versus same week dry-
cleaning, shirt pressing, etc.
When the car manufacturer Mercedes-Benz introduced the 190 sedan to
the USA, the same model (selling for €26,000 in the USA) was available
for around €12,000 in Germany, where presumably the demand for
domestic cars is more elastic. In the USA, Mercedes-Benz is seen as a
premium European brand and demand is rather inelastic. Businesses
often use observable characteristics, such as age, employment status
or nationality, as a screening mechanism to price discriminate more
effectively. Most students and senior citizens have more elastic demands,
so managers often set lower prices for these consumer segments. Some
people may see the practice as social sensitivity but, in fact, it is a
profitable way to price discriminate.
Because the income effect of a price change is likely to be larger for poor
customers, their demands are generally more elastic. In many instances we
do observe that poorer customers are charged lower prices. Now you know
that this may have nothing to do with charity as it can be explained by
pure profit maximising behaviour on the part of the seller. It is rational for
doctors and dentists to charge poor people a lower fee. Often geographical
proxies are used in the sense that everyone in a generally poorer area
benefits from lower prices and conversely everyone in a relatively richer
area is asked to pay more. For example, Keith Fisher, the director of Royal
Mail International, points out in a letter to The Economist of 1995 that
the Royal Mail charged a developing country one penny to deliver an
incoming letter whereas a developed country paid 16 pence. He pointed
out the need to avoid abuse by ‘remailers’ who essentially arbitrage by
shipping bulk mailings to developing countries.
Marketing managers use various devices to discriminate between segments
of the market. Although grocery coupons have other uses such as
gathering information on demand by experimenting with the price, it
seems that sellers may be trying to discriminate between people who
collect and redeem coupons and those who do not bother. The assumption
is that the redeemers have more elastic demand. Coupons are used for
many fast-moving consumer goods such as breakfast cereals. Similar
reasoning applies to price matching, which refers to the practice of
offering to match any lower price the consumer can find. Usually an
advertisement of the lower price has to be presented. Again there are other
197
explanations for this marketing practice but, since very few customers
collect on price guarantees, price matching is an easy way to discriminate
between customers with low search costs (for lower prices) and those
with high search costs. It can be argued that the latter have more inelastic
demands.

This chapter explained the reasons why a monopolist may want to
engage in non-uniform pricing and the necessary conditions for price
discrimination to occur. It discussed the three types of price discrimination
that are often observed in a monopoly as well as the welfare effects of
price discrimination.

• give (your own) examples of price discrimination
• derive the optimal take-it-or-leave-it-offer in first degree price
discrimination
• derive the optimal two-part pricing scheme
• derive optimal prices and quantities in third-degree price
discrimination (analytically and graphically) and determine the
optimal price and quantity when the monopolist faces two demand
curves and is not allowed to price discriminate.

1. Consider the following offer by the UK telecommunications company
BT:
‘We work out the cost of each call individually, and measure the call in
whole units. Each unit buys a period of time. (The basic unit currently
costs 4.935p including VAT.) The length of time given for each unit
depends on when and where you are phoning from, and where your
call is to. (The unit rate may vary depending on how many calls you
make... We have introduced three ‘Customer Options’ which give
discounts on the basic unit rate depending on the number of calls you
make:
Standard Personal: A 5% discount is automatically given on an
evening call you make over £58.75 in one quarter. This discount
increases to 8% on calls made over £293.75 in a quarter. (A quarter is
an average of 91 days.)
Option 15: For a £4 quarterly charge you can apply for our new
high-value scheme which offers a 10% discount on all evening calls at
the basic unit rate. You will benefit from this if your call charges are
consistently more than £40 per quarter including VAT.
198
Supportline: If you make very few calls (less than 125 units per
quarter) you can get: half-price standard rental and the first 30 units
free. On the next 120 units per quarter, you pay a rate which is higher
than the standard unit rate. After you have used 150 units the price
falls to the standard unit rate.’
a. Draw budget lines corresponding to each of the three ‘Customer
Options’. The x-axis is the number of units per quarter and the
y-axis is remaining income. Remember the rental.
b. If my current phone bill is less than £40 per quarter, it does not
make sense for me to go for Option 15. True or false?
c. Why does BT offer these options?
2. In 1979 the Belgian government forced BMW to charge a low price for
cars sold in Belgium (price ceiling). BMW attempted to ban its dealers
from exporting the cheaper cars, offered for sale in Belgium, to other
countries. The European Commission condemned these bans. Show
the possible effect of the Commission’s decision by graphing BMW’s
price-discriminating strategy (selling at price ceiling in Belgium and at
higher price elsewhere) and graphing the non-discriminating scenario.
Show that BMW might decide to quit the Belgian market altogether or
alternatively, charge the Belgium controlled price throughout the EEC.
3. Due to increased awareness of the dangers associated with a high-
fat diet, the demand for skimmed milk has increased. Assuming milk
products are sold through a monopoly distributor (a milk marketing
board), what is the effect of this shift in demand on the price of
cream?
4. Harry enjoys conversations about economics with Sally and wants her
to be his tutor. Sally does not enjoy tutoring but she enjoys getting
paid. She knows that Harry has utility function U(x, y) = x2 + y, where
x is number of hours of tutoring per week from her and y is income
remaining after paying for tutoring. She also knows that he has an
income m per week. Sally’s disutility associated with tutoring (or, to be
precise, the monetary equivalent of her disutility) is given by C(x) =
x3/3.
a. Because of her monopoly power, Sally can make Harry a take-it-or-
leave-it offer (P, x), which means she offers x hours per week for a
fee of P. Determine the optimal offer.
b. Harry’s friends get to hear about Sally. Now Larry, Barry and Terry
are also interested in economics tutoring. If each has the same
utility function as Harry, what offer or offers should Sally now
make? [Hint: she does not have to tutor all of them.]
199
Notes
200
Chapter 16: Other monopolistic pricing practices
Chapter 16: Other monopolistic pricing

practices
16.1 Introduction
In Chapter 15 we analysed the three basic types of price discrimination
that can be used by a monopolist to increase its profits. This chapter
considers more complicated methods of non-uniform pricing such as
intertemporal price discrimination, tie-in sales (i.e. commodity bundling)
and pricing for multiproduct firms. These pricing practices do not
require that the monopolist has substantial insights into its customers
and the degree of consumer information required is typically less than
that required to implement some of the pricing mechanisms discussed in
Chapter 15 of the subject guide. The monopolist’s objective is nonetheless
the same – to take advantage of the opportunity to capture more consumer
surplus from its client base.
Many firms are structured as multidivisional organisations with one
division buying goods from another division within the firm. For instance,
car companies often purchase inputs from their components’ divisions to
produce vehicles. In this context, transfer pricing policies that determine
the (internal) price at which goods are sold between divisions of an
integrated entity, are of crucial importance for the profitability of the
multidivisional firm. If selling divisions are rewarded on the basis of their
divisional profit, they will tend to set the transfer price too high, which
is detrimental to overall profitability. Clearly, transfer prices have to be
determined centrally in such situations. In this chapter we also turn our
attention to these types of pricing problems.

• intertemporal price discrimination and the Coase conjecture
• the peak-load pricing model
• the difference between pure and mixed commodity bundling
• the concepts of loss leaders, cannibalisation, joint products and
economies of scope
• the joint products model and why a monopolist might waste rather
than sell some of his output
• the issue of optimal transfer pricing.

• solve a simple two period skimming model with myopic consumers
• solve a simple peak-load pricing problem
• solve a simple bundling problem
• show graphically how consumers with different reservation prices
distribute themselves over the various options in commodity bundling
• for a multiproduct firm derive prices and quantities for two products
when:
201
each product is handled by a separate division and divisions act

noncooperatively and
when the decisions are taken to maximise firm profit
• solve a joint products problem
• determine optimal transfer prices in the absence and presence of an
external market for the input.

Norton and Co., 2014; 9th edition) [ISBN 9780393123968] Chapter 26:
Monopoly behavior.

Adams, W. and J. Yellen ‘Commodity bundling and the burden of monopoly’,
Quarterly Journal of Economics 90 1976, pp.475–98.
Allen, W. B., N. Doherty, K. Weigelt and E. Mansfield Managerial economics.
(London: W.W. Norton & Company, 2013) 8th edition, international student
version [ISBN 9780393912777] Chapter 10: Bundling and intrafirm
pricing.
[ISBN 9781118716380] Chapter 12: Capturing surplus.
Chapter 10: Advanced topics in pricing.
Schmalensee, R. ‘Gaussian demand and commodity bundling’, Journal of
Business 57(1, 2) 1984, S211–S230.
Stigler, G.J. ‘United States v. Loew’s Inc: A note on block booking’, Supreme
Court Review (1963) pp.152–57. Reprinted in Stigler, G.J. The organisation
of industry. (Homewood, IL: Richard Irwin, 1968).
‘Taxing questions’, The Economist, 22 May 1993, p.83.
Van Ackere, A. and D.J. Reyniers ‘A rationale for trade-ins’, Journal of Economics
and Business 45 1993, pp.1–16.
Van Ackere, A. and D.J. Reyniers ‘Trade-ins and introductory offers in a
monopoly’, RAND Journal of Economics 26 1995, pp.58–74.

This chapter examines certain advanced topics in monopolistic and non-
monopolistic pricing practices such as intertemporal price discrimination,
bundling, optimal pricing strategies for multiproduct firms and the issue of
(internal) transfer pricing within a multidivisional firm.
16.2 Skimming or intertemporal price discrimination

Many services are sold at different prices, depending on the season, the
time of day or the elapsed time since the produce was introduced. A
frequently observed pricing practice is that firms set a relatively higher
price early in the life of a product while the price then falls over time.
In this section we explain why this behaviour may be due to price
discrimination and an attempt to maximise revenues.
To illustrate this idea, suppose a monopolist wants to market a new
durable good such as a given model of a smart phone, the type of product
that, within a horizon comparable to its lifecycle, a consumer buys at
most once. A frequently observed pattern for these types of goods is
that they are initially sold at extremely high prices. After a few years
these innovative goods become more affordable. This pricing pattern
202
of decreasing prices over time is referred to as intertemporal price

discrimination. It is in fact a form of third-degree price discrimination in
the sense that consumers who buy later pay a lower price than those who
buy early on. At the same time you could argue that rational consumers
can predict that prices will decrease in the future and can therefore ‘self-
select’ when they will buy, which makes intertemporal price discrimination
more like second-degree price discrimination.
Price decreases over time are the norm in publishing. Publishers are in
fact monopolists since each book is sold by only one publisher. Although
there are some cost differences between hardbacks and paperbacks, it
is difficult to justify the price differences on a cost basis. An example of
market skimming, where price cuts are not disguised by quality differences
is provided by Intel. Until Intel lost its monopoly (when AMD (Advanced
Micro Devices) entered the market), its pricing strategy was to keep new
microprocessor prices very high and ease them down slowly over time.
Sometimes intertemporal and third degree price discrimination are
used simultaneously. Tickets for the Kasparov-Short chess championship
in London, in 1993, one of the most controversial matches in chess
history, were initially offered at up to £150. When they did not prove
popular and very few seats were sold, prices were reduced down to £20
(intertemporal price discrimination) and readers of The Sun (a
London daily newspaper) were offered tickets for £10 (third-degree
price discrimination). The frequently used marketing practice of
offering a ‘trade-in discount’ on goods such as vacuum cleaners and other
domestic appliances can be explained as an attempt to price discriminate
both intertemporally and between customers who have bought before and
those who have not (see Van Ackere and Reyniers, 1993 and 1995).
If we assume that consumers are myopic, which means that they do not
think ahead and hence do not anticipate price changes, price skimming
is easy to model. The population of buyers and their willingness to pay
can be represented by a demand curve p(q), as in Figure 16.1. If the
monopolist can costlessly change the price he ends up with the entire
consumer surplus (above marginal cost c). He ‘skims’ the market by using
time (early sales) as a screening mechanism, selling at a high price to the
most eager (or rich) consumers with very high willingness to pay first and
then gradually moves down the demand curve selling to consumers with
lower and lower reservation prices. In reality, of course, durable goods
prices do not change every hour. The monopolist may have to keep the
price constant for a given period of time, for example, because the price
may have appeared in a printed advertisement or a catalogue. In that case
we would expect the price to jump from period to period. As in Figure
16.1, during the first year, the price may be p1 and q1 units are sold. At
the beginning of the second year, since all consumers with reservation
price above p, have left the market, the monopolist faces a new residual
demand curve representing consumers still in the market (line AB in
Figure 16.1). He then picks a new (lower) price p2 and sells q2 – q1 units at
this price and so on. Clearly, a larger fraction of the consumer surplus can
be captured in this way than with a single, uniform price.
203
A
p1 p(q)
p2
p3
c q
q1 q2 q3 B
Figure 16.1: Market skimming
Example 16.1
A monopolist seller of microprocessors has a horizon of two years. Any
microprocessor not sold after two years is considered obsolete and is
scrapped. The demand for this durable product is given by p(q) = 1 – q.
Consumers are myopic and buy a microprocessor at most once. The
production costs are negligible. Assuming the seller can set different prices
in year 1 and in year 2, what is his optimal pricing strategy?
As we know from Figure 16.1, the price set in the first period determines
second period demand. The easiest way to deal with this analytically
is to work out what the seller should do in period 2 when he has set a
price p1 in year 1. When we have worked out this problem, we can solve
the problem of setting p, optimally. In year 2, the (residual) demand is
p2(q) = p1 – q or q = p1 – p2 so that period 2 price is determined by
max П2 = p2( p1 – p2) .
The optimal second period price is half the first period price:
p2 = p1/2 and П2 = p12/4 .
In year 1, the monopolist who foresees what will happen in year 2, sets the
price to maximise total discounted profits:
max П1 + dП2 = p1(1 – p1) + dp12/4,

where d is the discount factor. The optimal first period price is thus
p1 = 1/(2 – d/2). If the seller is patient and does not discount the second
year (d = 1), the price path is p1 = 2/3 and p2 =1/3. A more impatient (d
< 1) seller sets higher prices.
So far we have discussed the price skimming problem assuming

consumers do not think ahead. If consumers are rational and forward-
looking, the problem becomes much more complicated. A consumer,
anticipating a lower price in the future, may decide to postpone his
purchase unless he is very impatient. This has a moderating effect on the
monopolist’s skimming plans. However, as long as prices cannot change
instantaneously, there will be some intertemporal price discrimination
with eager consumers buying earlier and paying more than others.
When prices can change instantaneously, consumers anticipate a very
rapid decline in price which means that they will refuse to buy until the
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price is very low (equal to marginal cost). This is the essence of the Coase
conjecture: a durable goods monopolist who can change price instantly
loses all his monopoly power when faced with rational consumers.
When consumers are rational, a seller who can commit to keeping the
price up may be better off than a seller who cannot make such a (credible)
commitment. It is not easy for a firm to make such a commitment and
convince consumers that it will not drop its price in the future. Suppose
the monopolist charges the one period monopoly price in the first period.
Given that not everyone buys at this price, there is a very tempting residual
demand to be satisfied in period 2. Generally, consumers will not believe
that the seller will be able to resist the temptation to lower the price later
on. If, however, a most-favoured customer clause is used so that the
monopolist has to compensate earlier buyers if he ever lowers the price
later on, the commitment to keep prices up may become credible. The
reason is that the cost of dropping prices increases because the monopolist
has to compensate early buyers, and this effect could more than
compensate the benefit of intertemporal price discrimination. (Models of
these phenomena involve consumers forming rational expectations about
future price movements and are outside the scope of this course.)
Case study: Yield management
Airlines are champions of intertemporal and third degree price discrimination. It is relatively
rare to find more than a handful of passengers on a plane who have actually paid the same
fare. The number of tickets differentiated by a myriad of restrictions is overwhelming. The
Saturday night stopover requirement is an attempt by airlines to steer business travellers away
from cheap fares offered to tourists. The practice vanished for a few years due to competition
from low-cost carriers that commonly do not impose this rule and often sell one-way fares only.
However, the practice of pricing according to Saturday night stay reappeared in 2008. The price
difference is usually so large that it makes sense to buy two restricted tickets with a Saturday
night stopover, one starting when you want to leave and the other returning when you want
to return, and just use the outgoing part of the first one and the return part of the second one.
In trying to squeeze as much revenue as possible out of certain classes of passengers, airlines
sometimes create what seem absurd pricing patterns. It is not uncommon for a return ticket to
be cheaper than a one-way ticket, for example. Holiday packages including a flight and self-
catering accommodation are sometimes cheaper than the flight only.
Due to computer reservation systems (CRS) it has become feasible to change fares
instantaneously in response to rivals’ price changes or demand predictions. Travel agents use
a CRS to check which flights are available, at which fare and to make bookings. A CRS may
be owned by one airline (e.g. the Sabre network belongs to American Airlines) but most are
operated by groups of airlines. Amadeus – which was launched in 1987 by a consortium led by
Lufthansa, Air France and Iberia – also has links with American and Asian airlines.
In addition to the CRS, which is publicly accessible, airlines run their own sophisticated
programs aimed at maximising revenue from each flight. A revenue management system
(RMS) has as its objective to sell each seat and to obtain the maximum fare possible. The RMS
checks several times a day on how forthcoming flights are filling up and updates its predictions
accordingly. If bookings are coming in quickly, the number of low fares on offer is reduced; if
it looks like the plane may not be full, more cheap seats are offered. Some full fare seats are
always held back until close to take-off for late booking business passengers or passengers
who connect to other (long-haul and more profitable) flights.
Airlines now even have flexibility with respect to the proportion of seats allocated to first,
business and economy classes. The Boeing 777 airliner uses quick changing bulkheads so that
these proportions can be changed rapidly.
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Although yield management is mainly associated with the airline industry, hotels face very
similar problems and use similar revenue maximising techniques. Discounts for guests booking
in advance, differential pricing between weekdays and weekend nights, loyalty bonuses and
quantity discounts (e.g. 50 per cent off for a two-night stay) are just a few of the marketing
ploys characterising this business.
16.2.1 Peak-load pricing

For many goods and services, demand fluctuates with the seasons or time
of day so that the seller faces several demand curves. The demand at these
different times is satisfied by a common facility but typically different
prices are charged for peak and off-peak use. The demand for electricity
peaks in the morning and the evening and there is seasonal variation
because of heating and air conditioning. Telephone companies have lower
rates for long-distance calls in the evenings and at weekends. Health clubs
sometimes offer off-peak membership at a lower fee. Hotels are cheaper
off-season when they have spare capacity.
Charging different prices at different times of day is not really price
discrimination if costs vary with output because of overtime or use of
less efficient production methods when demand is high. Often marginal
cost is constant until a critical capacity is reached. Electricity generating
companies use technologically efficient methods for lower levels of
output but when these are exhausted they have to use older technologies
which could be ten times as expensive per unit of output (Kilowatt hour).
The same is true for airlines that charge high fares in times of peak
demand when older and less fuel-efficient planes have to be brought into
operation. It is not always easy to establish whether a price difference
can be justified by a cost difference. In many instances, demand in the
peak period is less elastic and therefore, even if costs were the same, a
monopolist would charge a higher price to maximise profits.
In its most general form, peak-load pricing is not easy to model. We
should really start out with a model of consumers deciding whether they
want to consume in the peak or off-peak period depending on the relative
prices. However, we will skip this step here and take the demand functions
which would result from such a process as given. Let us look at a simple
model of peak-load pricing in which the peak (Dp( p)) and off-peak (D0( p))
demands have the same elasticity so that the standard third degree price
discrimination argument would give identical prices. An example of such
a situation is when, for every possible price, peak demand is a multiple of
off-peak demand: Dp( p)= mD0( p), where m is a constant. Assume further
that the cost of providing the service, ignoring capacity costs, is C(q), the
same for both periods. The same capacity K is used in peak and off-peak
periods. The opportunity or investment cost per unit of capacity is constant
at c per unit. The profit maximisation problem is:
max П = pp(qp) qp + p0 (q0)q0 – C(qp) – C(q0) – cK (1)
subject to qp , q0 ≤ K, where qp and q0 are the units sold in peak and
off-peak periods respectively. There are two cases we need to consider.
The first case is when capacity is fully used in the peak period only
(q0 < qp = K). Optimal prices are derived by rewriting (6) as:
max П = pp(qp) qp + p0 (q0)q0 – C(qp) – C(q0) – cqp
for which the first order conditions are:
MRp(qp) = MC(qp) + c (2)
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and
MR0(q0) = MC(q0).
The other case we need to consider is when capacity is fully used in both
periods (q0 = qp = q = K). This leads to rewriting (1) as:
max П = pp(q) q + p0(q) q – C(q) – C(q) – cq
which leads to the following result:
MRp (q) + MR0 (q) = 2MC(q) + c. (3)
In either case, the optimality conditions (2) and (3) determine quantity
sold in each period, which by substitution in the demand functions gives
the optimal prices. To determine whether it is best to set prices so that
capacity is only binding in the peak period or whether the seller should
attempt to equalise demand in both periods, profit has to be calculated for
both cases.
16.3 Commodity bundling

Sellers sometimes offer special deals when goods or services are bought
in packages and cannot be bought separately. For example, when you
subscribe to cable television, you typically have to buy a default package of
channels together, rather than subscribing to those channels individually.
Similarly, it is often cheaper to buy a holiday package which includes
flight, accommodation and meals than to buy these items separately. PCs
are often sold in a package with peripherals. Many durable goods sellers
offer financing with their products. Luxury cars may be sold with leather
seats, sunroof, wooden dashboard, GPS and driver and passenger airbags
included at no extra cost. Again this marketing practice can be explained
in terms of price discrimination but, as it is rather special, it deserves a
special section.
Commodity bundling is sometimes used when the seller has to offer all
buyers the same deal because explicit price discrimination is impossible or
illegal. Bundling can increase profits when customers have different tastes
(i.e. different willingness to pay) and when the monopolist cannot price
discriminate. As for most forms of price discrimination, there may be cost-
based justifications for offering discounts when a bundle of products is
bought. An example is a restaurant which offers set meals, which reduces
waste of perishable items.
Commodity bundling, also called joint purchase discounts, was first
analysed by Adams and Yellen (1976) although the idea that bundling can
be used to extract consumer surplus first appeared in a paper by Stigler
(1963) who discusses the case of ‘block booking’ by the American film
industry. Monopoly producers used to (before it was ruled illegal) bundle
films when offering them to theatres. Theatres could not buy the film they
were interested in if they were only interested in one film; they had to buy
the bundle or nothing.
16.3.1 Types of bundling

Economists differentiate between pure and mixed bundling. Pure
bundling refers to the situation in which the goods in question are
only available as part of the package or bundle; they cannot be bought
separately. A newspaper may sell advertising space in the morning paper
only if an advertisement is also placed in the evening edition. Many
professional societies and charities sell journals or magazines to their
members. Often membership ‘includes’ subscription to these publications
and members are not allowed to opt out and just pay a membership fee.
207
Mixed bundling, on the other hand, allows for goods to be sold

separately as well as in a bundle. For example, we can purchase a
computer from Dell with or without a monitor. Theatre groups and concert
organisers usually sell separate tickets for individual performances as
well as season tickets. Airlines sell one-way as well as round-trip tickets.
A restaurant may offer dishes which feature in the day menu on the à la
carte menu as well. An interesting marketing practice, which is equivalent
to mixed bundling, consists of offering customers discount coupons for
another product in the seller’s range.
16.3.2 Profitability of bundling

To illustrate how bundling can be profitable, let us consider the pricing
problem of a cafeteria manager who sells apple pie and cappuccino. He
figures that 50 per cent of his customers are mainly thirsty and the other
50 per cent are mainly hungry. A thirsty customer is willing to pay up to £2
for a cappuccino and up to £2 for a slice of apple pie. A hungry customer
is willing to pay up to £1 for a cappuccino and up to £3 for the apple pie.
For simplicity we will ignore costs. (You should, after reading this, be able
to repeat the analysis taking costs into account.) If the manager aims to sell
apple pie to both groups of customers, he cannot charge more than £2 per
slice. This is of course better than just aiming to sell to hungry customers
since that would result in expected revenue of £1.50 per customer. Similarly,
if the manager wants everyone to buy cappuccino, he should charge £1,
which gives him the same revenue as selling to thirsty customers only at
a price of £2. Using this pricing strategy, the manager gets an (expected)
revenue of £3 per customer. Now let’s see how bundling can make him
better off. For each customer, the sum of reservation prices for cappuccino
and apple pie is £4. This means that, if the two items are offered in a bundle
at £4, revenue per customer increases from £3 to £4.
The groups of customers in this example have negatively correlated

reservation prices for the two items. In other words, a thirsty customer
is willing to pay more than a hungry customer for a cappuccino, while
a hungry customer is willing to pay more than a thirsty customer for
an apple pie. This feature makes the bundling very profitable since the
alternatives of either selling to the high willingness to pay group only, for
each item, or charging low prices so everyone buys, are not attractive.
Activity
Construct an example showing that it is not necessary for reservation prices to be
negatively correlated for bundling to be profitable.
Schmalensee (1984) points out that pure bundling reduces buyer diversity
in the sense that the standard deviation of reservation prices for the
bundle is always smaller than the sum of the standard deviations of
reservation prices for the goods which compose the bundle. Let σ1 and
σ2 be the standard deviations of reservation prices r1 and r2 for potential
consumers of goods 1 and 2. The correlation between the reservation
prices is ρ. If consumers’ reservation price for the bundle is the sum of the
reservation prices for the product (i.e. rb = r1 + r2) then
Var(rb ) = σ12 + σ22 + 2Cov(r1, r2) = σ12 + 2ρ σ1σ2 < (σ1 + σ2 )2 .
The lower the correlation between reservation prices, the greater the
reduction in heterogeneity achieved by bundling. Reduced diversity allows
for more efficient extraction of consumer surplus and hence increased
profits.
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16.3.3 Illustrating pure and mixed bundling

Figure 16.2 illustrates pure and mixed bundling for consumers with
independent demands for two goods. Each consumer is represented by a
point in the square OABC, marking the pair of reservation prices for both
goods. Consumers buy at most one unit of each product and a consumer’s
reservation price for the bundle equals the sum of his reservation prices for
the two goods. Consumers cannot resell goods. If goods are sold separately
(unbundled sales) then all consumers with reservation prices above the set
prices p1 and p2 buy Product 1 and Product 2 respectively (see Figure 16.2a).
C
r B
2
Buy 2 Buy
only both
p
2
Buy Buy
neither 1 only
r
0 1
p A
1
Figure 16.2a: Unbundled sales

If the seller only offers the goods as a bundle, then only consumers whose
reservation price for the bundle exceeds the bundle price (r1+ r2 ≥ pb) will
buy (see Figure 16.2b).
r
2
Buy
bundle
p
b
Don’t
buy
r
p 1
b
Figure 16.2b: Pure bundling

In the case of mixed bundling, the seller offers the individual components
of the bundle as well as the bundle. Obviously the individual products
are priced such that their prices add up to more than the bundle price,
otherwise nobody would ever buy the bundle.
In the presence of mixed bundling, consumers have four options:
• Option (a): buy nothing
• Option (b): buy Product 1 only
• Option (c): buy Product 2 only
• Option (d): buy the bundle.
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Consumers will make their choice according to which option gives

them the highest consumer surplus, that is, according to max
(0, r1 – p1, r2 – p2, r1 + r2 – pb). On Figure 16.2c, the consumers who buy
nothing are in area OABCD and the consumers who prefer option (b) are
in area DCEF since there:
r1 > p1, r2 < r1 + p2 – p1 and r2 < pb – p1.
The first two inequalities are intuitive while the third one states that in
region DCEF, a consumer who is already buying Product 1 will not switch to
the bundle because the additional benefit (r2) is smaller than the extra cost
(pb – p1). Similarly, consumers in area AHGB prefer option (c) since there:
r2 > p2 , r2 > r1 + p2 – p1 and r1 < pb – p2 .
This leaves consumers in area GBCE to buy the bundle.
p –p
b 2
r
2 G r +p – p
H 1 2 1
p
b
B
p A
2
C E p –p 1
D F b
0 p r
p 1
1 b
Figure 16.2c: Mixed bundling

Firms may also use bundling for other strategic reasons. For example,
when a good for which the seller is a monopolist is bundled with goods
which are sold competitively, the monopolist may be trying to extend
his monopoly power. Microsoft has been accused of doing just that. By
bundling software packages with the operating system it makes PC buyers
who get this software installed ‘for free’ reluctant to buy a package from
one of Microsoft’s rivals. Several firms which used to sell programs to do
tasks now performed by Windows, Microsoft’s operating system, have gone
out of business. Similarly, if the seller is part of an oligopolistic market, he
may bundle products to gain an advantage over his competitors.
16.3.4 Tied sales

The term tied sales is often used to describe a marketing practice that
is related to commodity bundling. Whereas in commodity bundling the
proportions of the items in the bundle are fixed (e.g. one bar of soap and
one towel), under tied sales, the consumer can decide on the quantities
in the bundle. Under tied sales, a manufacturer refuses to supply a
product for which he has a monopoly unless the consumer agrees to
also buy some (complementary) product from the manufacturer. When
this complementary product is available in a competitive market, tying
sales can be seen as an attempt to extend monopoly power. Usually there
is another reason to tie sales, namely to discriminate between types of
customers. As part of their standard leasing arrangement for photocopiers,
Xerox used to insist that customers bought Xerox paper. This allowed
it to price discriminate between high intensity and low intensity users
210
by charging a high paper price. If higher use of paper indicates a higher

willingness to pay for the photocopier lease then customers reveal their
type through the amount of paper they use. Tied sales is a mechanism to
extract more consumer surplus from the keener users. Of course, Xerox
could have negotiated different rentals with low and high intensity users
but this leaves the problem of identifying which class any user belongs to.
Manufacturers who supply replacement complementary goods to the
durable good they sell may be tempted to design their products so
that only products in their range are compatible. This constitutes a
technological tie. For example, a printer manufacturer could design
his products so that only cartridges from the same make can be used.
Camera manufacturers design lenses and camera bodies so that they have
limited compatibility – usually only within the brand name – and often
there is incompatibility between successive generations of products. In
the US there have been several lawsuits concerning technological ties and
designed incompatibility.
16.4 Multiproduct firms

In mainstream microeconomic models the firm is usually modelled as a
single product manufacturer. In our discussion of production and pricing
we have focused on the case of a firm producing a single output. This is
done for convenience, of course, as we know that practically all firms are
multiproduct firms. In fact some of the most interesting pricing questions
arise when firms have to take into account that their pricing policy for
one of their products has significant implications on the demand and
profitability of another. Generally, when pricing and marketing decisions
for individual products are not coordinated the firm does not perform
as well as it could. Particularly, a company structure in which separate
divisions are given responsibility for the profitability of an individual
product can be undesirable.
Example 16.2
Noindent, a company which markets game computers and videogames, has

set up two divisions. The hardware division has responsibility for pricing
the game machines whereas the software division is in charge of pricing
the game cartridges. The demand functions for hardware and software
respectively are as follows:
ph = 1000 – 30qh + 2.5qs
ps = 2.5qh + 500 – 20 qs
where ph and ps are the prices and qh and qs the quantities (in thousands)
demanded per week at these prices. Clearly, the two products are
complements and increases in the demand for one have a positive effect on
the demand for the other. Game computers and video game cartridges are
produced at constant marginal cost of £100 and £50 respectively.
The hardware division of Noindent maximises its profits, taking the

software division’s pricing as given. In game theory terms, we will be
looking for a Nash equilibrium. Profit from selling game computers is:
Пh = (900 – 30qh + 2.5qs) qh
which is maximised (set the derivative with respect to qh equal to zero) for:
qh = 15 + qs /24. (4)
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Substituting this expression for qh in the demand function results in:

ph = 550 + 1.25qs (5)
We can do a similar exercise for the software division with profits:

Пs = (2.5 qh + 450 – 20qs)qs
maximised at:
qs = 11.25 + qh /16. (6)
Substitution in the demand function gives:

ps = 275 + 1.25 qh (7)
Solving (4) and (6) for qh and qs gives qh = 15.509 and qs = 12.219 so that
the prices set by the divisions are determined by (5) and (7) as ph = 565.27
and
ps = 294.39. The maximum profit when divisions act separately can be
calculated for these results as Пsep= 10,202.
Suppose Noindent restructures so that hardware and software pricing

decisions are made within one division or profit centre. Such a division has
incentives to take demand interactions into account by maximising overall
profit:
П = (900 – 30qh + 2.5qs)qh + (2.5qh + 450 – 20qs)qs

Setting derivatives with respect to qh and qs equal to zero and solving for
qh and qs gives qh = 16.105 and qs = 13.263 so that the profit maximising
prices are determined by (5) and (7) as ph = 550 and ps = 275. The
maximum profit when the software and hardware pricing decisions are
made together is Пlog = 10,232. Prices are set lower when the demand
complementarity between products is taken into account. When divisions
only care about their own profitability, they tend to set prices too high
because they ignore (i.e. do not internalise) the externality effect of their
pricing decision on the other division’s profitability.
Firms selling complementary goods often price one product at or below

marginal cost in order to stimulate demand (at high prices) for the other
products. The cheap products are loss leaders aimed at attracting
customers for more profitable goods or services. For example, engine
manufacturers may sell engines rather cheaply and charge a lot for service
and spare parts. Airlines sometimes take a loss on certain routes because
some passengers on these routes connect to profitable flights. In extreme
cases, companies offer gifts of free products to build market share for
other products.
An important issue for many multiproduct firms is that of
cannibalisation. When firms add new products or new varieties of
existing products to their range, they may hurt their own sales. Whenever
Intel introduces a new generation of microprocessors, or Apple launches
a new iPhone version, it competes against its own previous generation
of products. Firms are sometimes multiproduct firms not by choice but
because of technological reasons. This is the case when they create
valuable by-products in the course of manufacturing some other product.
There are many examples of such joint products in the agriculture and
chemical industries. When raising cattle for beef, the farmer also produces
leather. Shell creates propylene basic ingredient in polypropylene, as a
byproduct when it makes ethylene. In contrast to the other situations
described in this section, joint products are related in production rather
212
than consumption. The joint product scenario forms an extreme case of

economies of scope which refers to a production technology whereby
it is cheaper to produce two products together than separately (see
Chapter 11 of the subject guide). For example, it is relatively cheap for a
company laying cables for cable television to add a telephone connection.
16.4.1 The case of joint products

Let us focus on a monopolist manufacturing and marketing joint products.
Each ‘unit’ consists of a unit of Product A and a unit of Product B. If you
find this too abstract, think of the ‘unit’ as an egg: Product A is egg yolks
(which could be used by a mayonnaise manufacturer) and Product B is
egg whites (sold to a manufacturer of low cholesterol egg substitutes). If
we know the cost function of the ‘composite good’ (eggs) and the demand
functions of Product A and Product B, how much should be produced?
Note that the quantity produced of A always equals that of B. Intuitively
we can deduce that production should be increased until the marginal cost
exceeds the sum of the marginal revenues for A and B. To derive this rule
mathematically, write the profit function as:
П = pA(qA)qA + pB(qB )qB – C(q), q = max (qA > qB) (8)
where qA and qB are the quantities of A and B sold and C(q) is the cost
of producing q units of A and of B. If we assume that everything which
is produced will be sold (see below for reasons why this is not always
optimal), then we can set q = qA = qB. Optimising (8) then gives the
following result:
MRA(q) + MRB(q) = MC(q). (9)
When the seller is a monopolist an interesting problem can arise. A
monopolist’s marginal revenue decreases in output and may tend to
zero for large enough output levels. It is thus possible that, while MR for
Product A is still positive and above marginal cost, MR for Product B is
negative. Of course a firm never sells at negative MR since it can avoid this
by selling up to zero MR and wasting the excess production. We will see
exactly how this works in an example but, before tackling the example,
let’s think about why this type of waste does not occur for joint products in
a perfectly competitive market. In such markets, MR equals price which is
positive (as long as the good is a ‘good’ and not a ‘bad’!) and a competitive
firm does not need to worry about selling so much that it drives marginal
revenue down. Of course there may be waste in a competitive market if
the price net of transportation costs is not high enough. Gas which is
released when drilling for oil is often burnt because its transportation cost
from remote oil fields is too high.
Example 16.3
A pineapple grower in the Bahamas produces cans of sliced pineapples and
cans of pineapple juice. The demand functions for cans of pineapples and
cans of juice are respectively:
qp = 80 – 5 pp
and
qj = 50 – 5 pj .
At a cost of C(q) = 25 + 8q + 0.05q2, the production process produces q

cans of pineapple slices and q cans of pineapple juice. Applying rule (9) to
this problem gives:
(80 – 2q)/5 + (50 – 2q)75 = 8 + 0.1q
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so that q = 20 pineapple cans and juice cans should be produced. Figure

16.3 shows how to find the optimal quantity graphically by adding the
marginal revenue curves vertically and identifying the intersection of this
sum with marginal cost. Note that we assume that the seller does not sell
at negative marginal revenue and hence for q > 25 the sum of marginal
revenues coincides with the marginal revenue curve for pineapple cans.
This intersection is at 20 units and the prices can be read off the demand
curves for q = 20 as pp = 12 and pj = 6. At 20 units of output, marginal
revenue is positive for both products.
26
∑ MR
16 MC
10
8 MC ′
D D
j p
25 40 q
50 80
Figure 16.3: Joint products
Now suppose the cost function is C(q) = 25 + q2/35 and there is free
disposal (i.e. it is costless to discard excess pineapple juice). Note in Figure
16.3 that marginal cost (MC' ) now intersects the sum of the marginal
revenue curves where marginal revenue of juice would be negative if all
of the juice produced is sold. The profit maximising producer should set
MRp(qp) = MC' (qp) or (80 – 2q)/5 = 2q/35 which implies production of
qA = 35 cans of pineapple. Rather than selling 35 cans of pineapple juice,
the seller should restrict sale of juice to the level where marginal revenue is
zero (i.e. qj = 25 cans).
16.5 Transfer pricing

A transfer price is the price which is charged when one division of
a vertically integrated firm (say the production division) sells an
intermediate good or service to another division (say the marketing
division). When such internal sales take place, maybe in addition to sales
of the intermediate good on the external market, the determination of
the internal transfer price is important for the firm’s profitability. This
is called intrafirm pricing. At first sight the issue of intrafirm pricing
may puzzle you: why should it matter what price GM’s parts division
charges to its assembly plants? By definition, the payment for parts is
an internal transfer of resources; it is like moving money from your left
pocket into your right pocket. The reason transfer pricing policies
are important is that they are used to provide proper incentives for
individual divisions to take actions which maximise multidivisional
firm profit. Many large-scale enterprises have a decentralised structure
consisting of semi-autonomous profit centres. Such stand-alone divisions
are often established to avoid excessive communication and coordination
214
costs in large firms. Since in this scenario (upstream and downstream)

divisions are rewarded on the basis of their individual performance, the
selling and buying divisions have opposing interests in the determination
of the transfer price. The selling division has an interest in setting the
transfer price high, whereas the buying division prefers a low transfer
price. If transfer prices are not set properly or if the transfer price is left to
negotiation between divisions, total firm profits may suffer.
In what follows we will develop the analysis for three scenarios
distinguished by whether there is an outside or external market for the
intermediate good in question and if there is, whether this market is
competitive or not. Note that when there is a market outside the firm for
the input transferred from one division to the other, the output levels of
the downstream and upstream divisions need not be equal. To simplify
the analysis we assume that units are defined so that one unit of the final
good requires one unit of intermediate good. We also assume that there
are no technological synergies between the production and the marketing
division (i.e. the cost function for either division is not affected by the
output of the other).
16.5.1 Scenario 1: No external market for the intermediate good

The simplest scenario is that of a vertically integrated firm which does
not sell or buy the intermediate good on the external market. There may
be several reasons for this arrangement. An important consideration is
that of transaction costs the firm incurs when it deals with the external
market. Further, a firm may be vertically integrated to assure the supply
of important inputs, to internalise externalities or to avoid government
price controls, taxes and regulations. It could also be an important strategic
decision not to have a market for the intermediate good. IBM’s bad fortune
in the early 1990s has been blamed on its decision to buy the essential
components for its personal computers from the outside market. Instead of
using its own microprocessor chips and software, it bought chips from Intel
and operating system software from Microsoft. This allowed standardisation
in the PC market and made IBM machines very easy to clone.
In what follows we use subscripts f, i and e to denote variables related
to the final good, the intermediate good and the external market for the
intermediate good. Since, in this first scenario, the firm does not buy or
sell the intermediate good externally, the final good quantity qf equals the
quantity of the intermediate good produced. Given the demand function
pf(qf) this quantity qf is the only decision variable. The integrated firm’s
problem is simply to maximise revenue on the final good market minus the
costs incurred by the two divisions:
max pf (qf )qf – Ci (qf ) – Cf (qf ).
For profit maximisation the firm should produce a quantity q f such that
the marginal revenue equals total marginal cost:
MRf(qf ) = MCi(qf ) + MCf(qf ).
This result is illustrated in Figure 16.4 where ∑MC is the vertical
summation of the marginal cost curves. The intersection of ∑MC and MR,
the marginal revenue for the final good, determines optimal output. Of
course this analysis also applies when the firm sells the final good in a
perfectly competitive market. The only difference there is that marginal
revenue is horizontal at the market price.
215
p, MC
∑ MC
p
f MCi
MCf
p
t
D
MR
q
f q
Figure 16.4: No external market

Given this determination of the optimal output level, the firm has to find
a way of implementing a suitable transfer pricing scheme. If the marginal
cost curves are known, the transfer price should be set at pt in Figure 16.4,
such that pt = MCi(qf). With this transfer price rule in place, the firm can
then instruct both divisions to maximise profit subject to this restriction
and this will lead to the desired result: the manufacturing division
produces the output qf for which marginal cost equals ‘marginal revenue’
pt and the marketing division wants to use exactly what is supplied by the
manufacturing division since at output qf its marginal cost, pt + MCf(qf),
equals marginal revenue.
However, we have really only solved the problem for an ideal world where
the cost functions are known and where managers do not try to negotiate
‘a better deal’ for their division. In practice, when the headquarters does
not know divisions’ marginal cost functions, the divisions may not find it in
their interest to volunteer this information or to give accurate information
about costs. Especially when conditions are such that one of the divisions
is making very low profits, managers will try to bargain to increase or
decrease the transfer price. For example, when the manufacturing division
has constant marginal costs, its profits are zero under the optimal transfer
price rule. If costs are known it may be better in terms of providing
incentives to make such a division a cost centre with rewards tied to cost
reductions rather than reward it on the basis of profitability.
16.5.2 Scenario 2: Perfectly competitive external market for the

intermediate good
In this scenario the output of the production division need not be equal
to the output of the final product. If there is excess demand the firm buys
on the external market and if there is excess supply it sells on the external
market. In addition to the assumptions of scenario 1, we assume demand
independence between the production and marketing division (i.e. sale
of an extra unit by either division does not affect demand for the other).
This is a strong assumption since generally when the firm sells more
of the intermediate good we would expect that less of the final good is
demanded and vice versa. This is obviously the case when the firm sells
the intermediate product to its competitors in the final goods market.
Therefore demand independence is only realistic if the intermediate good
is sold to an industry which produces an imperfect substitute or better, a
product unrelated to the final good.
216
It is useful to consider the situation in which the firm sells to the external
market first. The firm now has to make two decisions: how much of the
intermediate good and of the final good to manufacture. It maximises
revenue from the final good and from the intermediate good minus costs:
max pf (qf ) + peqe – Ci(qf + qe) – Cf (qf ).
Since the intermediate good market is perfectly competitive, the firm takes
the price on that market pe as given. For profit maximisation we thus have:
MRf (qf ) = MCi (qf + qe) + MCf (qf )
and
pe = MCi (qf + qe).
p, MC
MCf + p
p e
f MCi
p =p
t e
MCf
D
MR
q q
f i q
Figure 16.5 Competitive external market

Figure 16.5 illustrates these results graphically. To determine the amount
of final good to produce, the firm sets marginal revenue equal to the
sum of marginal costs at the optimum output levels for final and
intermediate goods. The optimal output level for the intermediate good
qi = qf + qe is determined where its marginal cost MCi equals the market
price pe The quantity of the final good produced is then found at the
intersection of MCfc + pe and MR. The external market price represents
the opportunity cost of using a unit of the intermediate good internally.
Of course the same analysis applies when the final good is sold in a
competitive market so that its MR curve is horizontal at the market price.
If the firm is a net buyer of the intermediate good, its optimisation
problem becomes:
max pf (qf )qf – pe qe – Ci (qf – qe ) – Cf (qf )
which results in
MRf (qf) = MCi(qf – qe) + MCf (qf )
and
pe = MCi (qf – qe).
This situation could be illustrated graphically as in Figure 16.5 but with
MCi and pe intersecting to the left of the optimal output level for the final
good.
When there is an external market, profit maximisation generally calls
for the vertically integrated firm to use it. The optimal quantities of
intermediate and final good produced are not equal. As a consequence,
when the divisions are prevented from using the external market,
217
profitability suffers. For example, a cement producer cannot increase

profitability when he buys a ready-mix-concrete firm with the sole
intention of using it as a captive customer.
The proper transfer price when there is a competitive external market
is the external market price. This will induce both divisions to produce
the optimal quantities if they are instructed to maximise profit. This
transfer price rule is also intuitively appealing to managers of the separate
divisions. The manufacturing division would not want to sell below the
market price and forego a more profitable outside sale and the marketing
division does not want to pay more than the market price. Head office,
when setting the transfer price in this scenario, does not need any cost
information. Because of its simplicity the rule of equating transfer price to
external market price is used almost without exception in practice.
Note that the marketing division does not benefit from being vertically
integrated with the manufacturing division. It could buy the intermediate
good under the same conditions on the external market. There is no
rationale for the vertically integrated structure under this scenario. We
obtain this rather surprising result because of the assumption of demand
independence. In the more realistic setting, when an increase in the
quantity of the intermediate good sold on the outside market has a
depressing effect on the demand for the final good, we would expect that
the firm sets the transfer price below the external market price. On the
other hand, when demand dependence and technological dependence
are negligible, there is a case to be made for ‘outsourcing’ or spinning off
a manufacturing division which operates in a competitive market. This
process has been taking place in the computer industry which used to
have a multi-layered vertical structure. Most PC makers in fact restrict
themselves to little more than contracting with electronics suppliers,
assembling and marketing their machines. Several of these electronics
manufacturers arose from restructuring in computer companies which
spun off some of their production capacity.
The issues of make-or-buy decisions and demerger are however very
complex and we cannot hope that a simple transfer price model like
the one outlined in this section will give us all the answers. Arguments
in favour of outsourcing have to be balanced with the firm’s product
differentiation strategy for example. Consumer perceptions and hence
valuations of a product may be determined to a larger or lesser extent by
what is outsourced. Consumers may not care whether a part in a domestic
appliance engine is made in-house. They may, however, due to Intel’s
advertising campaigns, care about which microprocessor is built into their PC.
16.5.3 Scenario 3: Imperfectly competitive external market for the

intermediate good
The last scenario we consider is the one in which the firm has monopoly
power in both of its markets. It sells the intermediate good internally at
a transfer price and externally according to a downward sloping demand
curve pe (qe ). Hence its profit maximisation problem is:
max pf (qf )qf + pe(qe)qe – Ci(qf + qe) – Cf (q),
which results in the following optimality conditions:
MRf (qf ) = MCi (qf + qe ) + MCf (qf ) (10)
and
MRe (qe ) = MCi (qf + qe ). (11)
218
These conditions are similar to the conditions for optimal third degree
price discrimination. The manufacturing division sets its marginal cost
MCi(qf + qe) equal to marginal revenue in the external market MRe (qe)
and to net marginal revenue in the final good market MRf (qf) – MCf (qf).
Figure 16.6 shows graphically what is going on. The left panel represents
conditions in the external market for the intermediate good. The middle
panel shows the derivation of the net marginal revenue curve NMR as
the vertical distance between MRf and MCf . In the panel on the right the
manufacturing division sets its output level where marginal cost intersects
∑MR, the horizontal sum of the NMR and MRe curves. Again, the analysis
for a firm which sells its final product in a competitive market is very
similar.
p
e
∑ MR
De
p* Df
e
p* MCi
f
MCf
MRe NMR MRf
q* q* q q
e q f f q* i
e i
Figure 16.6: Imperfectly competitive external market

The optimal transfer price rule consists of selling internally at a price equal
to marginal revenue on the outside market. Because price on the outside
market exceeds marginal revenue, the internal division gets a discount
(i.e. the intermediate good is sold for less internally). The intuitive reason
for this is the double marginalisation problem, which would occur if the
manufacturing division used its monopoly power internally.
Example 16.4
Siemips, a major producer of microprocessor chips for telecommunications

equipment, sells these chips on the outside market as well as internally. It
has monopoly power in the chips market as is reflected in the downward
sloping external demand pe = 1200 – 0.8 qe. The demand for Siemips’
final good is pf = 1200 – 0.625qf. Each unit of the final good requires one
microprocessor chip. Since Siemips has a policy of only supplying chips to
manufacturers it is not in competition with, there is demand independence
between the chips and equipment divisions. The equipment division has
marginal cost MCf (qf ) = 20 + 0.025qf and the chips division has marginal
cost
MCi(qi) = 200 + 0.375qi = 200 + 0.375 (qf + qe).
To determine the optimal output level on the final good market, we use
(10) and set marginal revenue equal to the sum of marginal costs:
1200 – 1.25qf = 200 + 0.375(qf + qe) + 20 + 0.025qf . (12)
Siemips acts as a monopolist on the external market and sets marginal
revenue equal to marginal cost as in (11):
1200 – 1.6qe = 200 + 0.375(qf + qe). (13)
219
Rewriting (12) and (13) gives

qf = 593.93 – 0.227 qe and (14)
qf = 2666.67 – 5.267 qe. (15)
Equating these two and solving for qe results in qe = 411.27 and hence from
the demand function pe = 871. Substituting into (14) or (15) gives us the
optimal output level for equipment qf = 500.6. The transfer price is set equal
to marginal revenue in the external market 1200 – 1.6 qe = 541.95 which
means that the internal division gets a discount of about 330 on a chip.
In all three scenarios we have considered, the transfer price should be set
equal to marginal cost. In scenario 1, marginal cost corresponding to the
optimal output level of the final good is relevant; in scenario 2, the market
price is used but this is equal to marginal cost when the manufacturing
division maximises profits; and in scenario 3, marginal cost corresponding
to total production (for internal and external use) is the valid price. In
practice, because it is convenient to set transfer price equal to market
price, mistakes are made when market conditions are as in scenario 3.
More complicated scenarios can be modelled for firms in different market
structures and where the assumptions of demand independence and
technological independence do not hold. This is however beyond the scope
of this subject guide.
Case study: Transfer pricing and taxation
Taxes may also encourage vertical integration. Tax rates differ by state as well as by country,
and depending on where divisions are located they may be subject to different taxes. A
vertically integrated firm may therefore be able to shift profits from one location to another by
changing the transfer price at which it sells its internally produced intermediate goods from one
division to another. By shifting profits from a high tax jurisdiction to a low tax jurisdiction by
manipulating its transfer pricing policy, a vertically integrated firm can increase its profits.
Multinational enterprises manipulate their transfer pricing systems in order to redistribute

profits between countries so as to minimise their overall tax liability. If country A has lower
profit tax than country B then the transfer price will be set low in B so that profits are realised
in A. This is illegal but it is very difficult to monitor especially if there is no external market. If
there is an external market, the price on the external market can in some cases be used as an
estimate of the proper transfer price. In the early nineties the US International Revenue Service
investigated American subsidiaries of foreign firms, especially Japanese ones, on the suspicion
that they had underpaid US corporate income taxes by as much as $12 billion.
A 1999 survey by the professional services firm EY suggested that the number one international
tax issue for multinationals was transfer pricing. For example, firms were concerned with
double taxation and onerous penalties for noncompliance. Many countries have enacted
legislation enabling their tax agencies to intensify their transfer pricing inquiries and regulation
enforcement. Items included in transfer pricing are goods, services, property, loans and leases.
Most countries tax multinationals based on the profits that the firm earned within their borders
as if it had made those profits as a stand-alone business at arm’s length from the parent
company (the arm’s length system). Firms are expected to use proper transfer prices which,
in many cases, means the prices they would pay if they had to buy the internally transferred
goods and services from outside. This is of course problematic when there is no outside market.
For many intangibles there is no comparable external market. The advantage of the arm’s
length system is that profits are normally taxed only once.
220

This chapter built on some of the topics discussed in Chapter 15 of
the subject guide to analyse advanced topics in monopolistic and non-
monopolistic pricing practices such as intertemporal price discrimination,
pure and mixed bundling, optimal pricing for multiproduct firms and the
issue of (internal) transfer pricing within a multidivisional firm. In the
case of transfer pricing, we showed that the firm’s optimal decision varies
depending on whether or not an external market for the intermediate
product exists.

• solve a simple two period skimming model with myopic consumers
• solve a simple peak-load pricing problem
• solve a simple bundling problem
• show graphically how consumers with different reservation prices
distribute themselves over the various options in commodity bundling
• for a multiproduct firm derive prices and quantities for two products
when:
each product is handled by a separate division and divisions act
noncooperatively and
the decisions are taken to maximise firm profit
• solve a joint products problem
• determine optimal transfer prices in the absence and presence of an
external market for the input.

1. Off-peak demand for a service is given by q1 = 100 – 2p1 and peak
demand is q2 = 300 – p2. Marginal cost per unit is c = 10 and capacity
cost g = 90 per unit. Find the optimal peak and off-peak price.
2. The Croucher Corporation which is in the woolly hat industry is
composed of a marketing division and a production division. The
marginal cost of producing a woolly hat is £10 per unit and the
marginal cost of marketing it is £4 per unit. The seasonal demand for
woolly hats is p = 100 – 0.01q. There is no external market for the
woolly hats Croucher produces (they look rather odd and are basically
worthless unless properly marketed which requires special skills only
Croucher’s own marketing division can provide).
a. How many woolly hats are sold each season?
b. What is the price of a woolly hat?
c. How much should the production division charge the marketing
division for each hat? 221
3. Hummer & Co has two divisions. Division 1 produces cotton which

is used by division 2 in the manufacture of bandages. The market for
cotton is competitive and the price is pe = $350 per unit. One unit of
bandages can be produced from one unit of cotton. The marginal costs
for the two divisions are MC1= 200 + 0.375q and MC2 = 100 + 0.5q.
Demand for the company’s bandages is given by: p = 1000 – 0.625q.
a. Determine the optimal quantity and price for bandages and the
transfer price for cotton. How much cotton is bought or sold on the
external market?
b. Suppose now that Hummer & Co has market power in the external
market for cotton. It cannot buy cotton from the external market,
but it can sell cotton according to an external demand function
pe = 358 – 0.09qe. Determine the optimal quantity and price for
bandages, and how much cotton (if any) is sold on the external
market and, if any is sold, the transfer price.
4. Suppose Gillette knows it has two types of customers: about 50% are
of Type 1 and 50% are of Type 2. A Type 1 customer is willing to pay
up to £1 for a razor and up to £1.50 for a package of 10 razorblades.
A Type 2 customer is willing to pay up to £0.80 for a razor and up to
£1.70 for a package of 10 razorblades. The marginal cost of razors is c1
per unit and a package of 10 razorblades costs c2 to produce.
a. Given that Gillette has to charge the same prices to all customers,
what is the best pricing policy? How does it depend on c1 and c2?
b. What is the best pricing policy if Gillette sells its products as a
bundle consisting of a razor and 10 blades, and the individual
products are not on sale?
c. If it uses mixed bundling how should it price the bundle and the
individual products?
222
Chapter 17: Oligopoly theory
17.1 Introduction
Market structures differ in terms of number of firms operating in the
market and the nature of product differentiation. In terms of number of
firms, oligopoly is an intermediate market structure between the monopoly
and perfect competition. An oligopolistic industry consists of a few firms
that act independently but at the same time recognise their strategic
interdependence. This strategic interaction, rather than the actual number
of firms in the industry, defines oligopoly.
In this chapter we consider homogenous (i.e. identical) products
oligopoly models where a small number of firms (typically two) sell
products that have virtually the same physical attributes. For example,
in the global market for titanium dioxide (an inorganic pigment used
to whiten products such as paint and plastics), several large firms such
as DuPont, Millennium Inorganic, Huntsman and Tronox sell products
that are virtually identical chemically. Similarly the global market for
accounting and auditing services is dominated by the Big-4 auditing firms:
Deloitte, EY, KPMG and PwC. Their auditing services are seen as very
close substitutes by most large multinational firms, investors in the capital
market and accounting regulators.
The simple oligopoly models analysed also make the following simplifying
assumptions:
• Consumers are price takers.
• Consumers perceive no difference among firms’ products.
• There is no entry into the industry, so the number of firms is constant
over time.
• Firms have market power (they can in principle set price above
marginal cost).
• Each firm only sets its price or output, and other choice variables such
as advertising are irrelevant (i.e. there is no horizontal or vertical
differentiation).
Whereas monopoly, monopolistic competition and perfect competition
could be analysed from an optimisation perspective, oligopoly requires a
game theory framework. This is because a key feature of oligopoly markets
is competitive interdependence. Actions taken by each firm (choice of
price or output level) have implications for the pay-offs of all firms in the
market and therefore individual firms cannot ignore the effect of their
actions on their rivals’ behaviour. All the oligopoly models examined here
are examples of non-cooperative game theory (see Chapter 3 of the subject
guide) where the specific games analysed share the following common
elements:
1. There are at least two players.
2. Each player (firm) attempts to maximise its payoff (profits) given the
actions taken by others.
3. Each player (firm) recognises the impact of other players’ actions on
her payoff (profits).
The third element above is truly distinctive. In perfectly competitive and
monopoly markets, firms do not have to worry about their rivals – in a
223
monopoly market there isn’t any, while in a perfectly competitive market

each seller has a negligible competitive impact on its rivals. In oligopoly
markets, by contrast, the decision of every firm has the potential to
significantly affect the profits of competitors.
In contrast with monopoly and perfect competition, there is no unified
theory of how oligopolies behave. Furthermore, the predictions of
the various models diverge enormously and depend on exactly which
assumptions are made regarding decision variables and strategic symmetry
(firms making decisions simultaneously) or asymmetry (leader-follower
models). The diversity of models and their predictions correspond to
the diversity of real-life behaviour patterns of oligopolistic industries. To
decide which model is appropriate, the particular industry under study has
to be analysed carefully. There is an abundance of industries which could
be described as oligopolies. For example, in the world market for memory
chips, Samsung’s profits partly depend on the decisions made by its main
competitors such as NEC and LG.
In this chapter we restrict ourselves to homogenous good industries.
Oligopoly models can be classified on the basis of their assumptions
regarding the toughness of price competition in the industry, on the
basis of whether sequential (strategic symmetry) or simultaneous moves
(strategic asymmetry) are assumed and according to which variable(s) are
used as the decision variable(s). The models we discuss in this chapter are
listed in Table 17.1.
Tough price Sequential/ Decision

competition simultaneous variable
Cournot (section 17.2.1) Intermediate Simultaneous Quantity
Bertrand (section 17.2.2) Yes Simultaneous Price
Stackelberg (section 17.3.1) No Sequential Quantity
Dominant firm (section 17.3.2) No/Yes Sequential Price
Table 17.1 Oligopoly models

Given that in pure oligopoly the product is homogenous, there is an
industry demand curve, relating price and total market demand. If firms
choose output levels then the price they obtain is determined from this
market demand function. When quantity is the decision variable, firms
are not making any choices regarding price. Price is determined by the
demand curve. This seems unrealistic in that it is hard to imagine how
real-life firms can operate without posting prices or publishing price
lists. But remember that in the study of monopoly the same problem is
encountered and the monopolist’s optimal quantity decision generally has
to be ‘translated’, using the demand curve, into a pricing policy to become
operational. There is no reason why the same method of analysis cannot
also be applied to oligopoly.
Each oligopolist could determine its own and rivals’ ‘optimal’ or
equilibrium production quantities and infer the price from the demand
function. You may wonder how price could be a decision variable for
firms selling a homogenous product. Surely they will all have to charge
the same price? Without running too far ahead let us think of an industry
consisting of two firms, A and B, and assume A charges a lower price than
B (pA < pB). If A has sufficient capacity, it can serve the entire market (i.e.
the quantity demanded at pA according to the demand function). If A has
limited capacity, however, A sells up to its capacity and B faces the residual
demand. When A is capacity-constrained it is not a priori impossible for B
224
to charge a different (higher) price. In all of these scenarios we can model

firms as taking decisions with respect to the quantity or the price variable,
the other one being determined through market demand. Firms choose
price in the Bertrand model and quantity in the other one-period models
we will discuss.
In practice, there are several factors determining whether price or quantity
is used as the decision variable in a particular industry. For strictly
homogenous goods it is generally accepted that there are no price choices
to be made by individual firms. The price is determined by the market
(demand function) and quantity is therefore the strategic variable. For
heterogeneous goods (not considered in this chapter), price is more likely
to be the decision variable but firms could also compete on advertising,
capacity investments, service, etc. If the firms in a particular industry
customarily print catalogues which list prices, then price is likely to be the
strategic variable. Production is adjusted to meet short-term variations
in demand when the production process allows for quick changes in
the rate of production. Alternatively, inventories are used to deal with
variable demand. If the firm has high inventory costs and/or has to plan
production ahead of time, it is likely to consider quantity as its strategic
variable and deal with any situations of demand shocks by adjusting its
pricing policy. An easy way to adjust pricing in the short term is through
offering discounts from a book price, which is set as the maximum the
firm would consider charging. In the car industry, quantity is the strategic
variable since dealer discounts are adjusted more easily than production
schedules. Also when firms are operating close to capacity and changing
capacity is costly, a model with quantity as the decision variable is likely to
be a good approximation. In this case capacity choice is really the strategic
decision. In more sophisticated dynamic models, firms can choose price
and quantity and if the chosen price output combination does not lie on
the demand curve, inventory is used to absorb the difference between
supply and demand.
For convenience, in the remainder of the chapter we will focus on the two
firm or duopoly case. However, most of the analytical tools and results
discussed are applicable to the more general case in which there are more
than just two firms.

• the different homogenous products, oligopoly models and the
conditions that characterise them
• the differences in assumptions with respect to decision variables
and strategic (a)symmetry between the various oligopoly models
discussed
• the (Nash) equilibrium of each oligopoly model.

• solve the Cournot, Bertrand and Stackelberg oligopoly models
• discuss the solutions of the different models and explain how they
compare with each other as well as against the monopoly and perfectly
competitive outcomes (e.g. revenue destruction effect)
• solve a dominant firm model analytically and graphically.
225

Norton and Co., 2014; 9th edition) Chapter 28: Oligopoly.

Bertrand, J. Book review of ‘Théorie Mathématique de la Richesse Sociale’ and
of ‘Recherches sur les Principes Mathématiques de la Théorie des Richesses’,
Journal des Savants 68 1883, pp.499–508.
Wiley and Sons, 2015) 5th edition, international student version
[ISBN 9781118716380] Chapter 13: Market structure and competition.
Education Ltd, 2015) 4th, global edition [ISBN 9781292087856] Chapter
6: Oligopoly.
Cournot, A.A. Recherches sur les Principes Mathématiques de la Théorie des
Richesses. (1838) English edition, Bacon, N. (ed.) Researches into the
Mathematical Principles of the Theory of Wealth. (New York: Macmillan,
1897).
Kreps, D.M. and J.A. Scheinkman ‘Quantity precommitment and Bertrand
competition yield Cournot outcomes’, Bell Journal of Economics 14(2) 1983,
pp.326–37.

This chapter considers well-established models of oligopoly where a
small number of firms, acting independently but aware of one another’s
existence, compete in the market for a homogenous product. It studies
game-theoretic situations where firms’ strategic decisions are either output
level or price. The models also differ in terms of whether firms make these
decisions simultaneously and sequentially.
17.2 Symmetric oligopoly models

There are several different economic models of oligopoly based on
different assumptions. This section analyses two of the most frequently
used (single-period) oligopoly models in which the firms make
simultaneous decisions: the Cournot model and Bertrand model. For
simplicity we will focus on a duopoly market: a market in which there
are just two firms. These models assume strategic asymmetry in the sense
that no firm has an informational or strategic advantage over the others.
The next section considers models involving strategic asymmetry among
firms.
17.2.1 Cournot
The origins of this model can be traced back to Cournot (1838). The
only decision each firm needs to make is how much to produce. In game
theory terminology, the duopolists are engaged in a non-cooperative game
and we are interested in the Nash equilibrium of this game (i.e. a pair of
quantity choices such that it is in neither firm’s interest to alter its choice
unilaterally). These strategies are consistent in the sense that no firm has
ex post regret when it observes its competitor’s quantity decision. The
good produced by the Cournot duopolists is homogenous and therefore
the price is determined by the total quantity supplied: p(q1 + q2). To find
the Nash equilibrium, we find best response functions (i.e. we find the
best quantity choice of Firm 1(2) as a function of Firm 2(1)’s quantity
choice). The intersection of these best response functions gives the Nash
equilibrium. Mathematically this means that for Firm 1 we solve:
226
max p(q1 + q2) q1 – c1(q1)

q1
and find q1 = f1 (q2) and for Firm 2 we find q2 = f2(q1) similarly. The Nash
equilibrium is then found by solving q1 = f1( f2(q1)).
Example 17.1
Demand in an industry consisting of two firms is given by p = 24 – q1 – q2.

Firm 1 has constant marginal costs of 8 per unit; Firm 2 has constant
marginal costs of 4 per unit. The firms’ profits can then be written as
π1 = (24 – q1 – q2 – 8)q1 and π2 = (24 – q1 – q2 – 4)q2. The first order
conditions lead to the response functions q1 = f1(q2) = (16 – q2)/2 and
q2 = f2(q1) = (20 – q1)/2. Note, for example, that when Firm 1 chooses its
optimal level of output it takes the output level of its rival as given. These
response functions are drawn in Figure 17.1. The unique Nash equilibrium
is at the intersection where q1 = 4 and q2 = 8. Hence, the Cournot model
predicts a price of 12.
q
2
16
10
8
f
2
q
f 1
1
4 8 20
Figure 17.1: Cournot response functions
Example 17.2
Consider an industry consisting of n identical firms with constant marginal

cost c and demand function p(Q) where Q is total industry output. Firm i’s
profit function is given by:
i = p(Q)qi – cqi
Its optimal quantity decision given the other firms’ quantity choices is
determined by the first order condition:
∂p
p(Q)+qi –c=0
∂Q
Since all firms are identical we look for a symmetric Nash equilibrium in
which all output decisions are identical i.e. qi = Q/n so that the condition
above can be rewritten as:
p+ n ()
Q ∂p
∂Q
= c,
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which, using the definition of demand elasticity, reduces to:

p
p – nη = c
or
p–c 1
.
p = nη
The left-hand side of the above equation is the Lerner Index. We conclude
that, at the Cournot solution, each firm’s monopoly power, measured as
its markup-price ratio, varies inversely with the demand elasticity and the
number of firms in the industry. If the number of firms n is very large, the
Cournot solution approximates the equilibrium of a perfectly competitive
industry and market power vanishes.
Revenue destruction effect

Cournot oligopolists do not maximise industry profits because they choose
an aggregate output that exceeds the monopoly quantity. This is actually
a common feature of oligopolistic industries and an illustration of the
prisoners’ dilemma (see Chapter 3 of the subject guide): by pursuing
their individual self-interest, the firms in an oligopoly fail to maximise the
profits of the group as a whole.
In the Cournot model, this revenue destruction effect is due to the
following reason. When one of the firms expands its output and thus
reduces the market price, it bears only part of the reduction in revenue
from all the customers who would have purchased the product at the higher
price. In effect, this burden is partly shared with its rival(s). A monopolist,
however, bears the full burden of this revenue destruction effect. As a
result firms in the Cournot model have an incentive to expand output more
aggressively than if they were a monopolist because they do not internalise
the negative externality created on their rivals. As a result the oligopoly
price is below the monopoly price and industry profits are not maximised.
This revenue destruction effect helps explain why relatively small firms in
oligopolies tend to be the most willing to disrupt the status quo: they can
capture relatively more market share but they bear a relatively smaller
revenue destruction effect, which is mainly borne by their bigger rivals.
17.2.2 Bertrand
In the Cournot model, each firm chooses a quantity to produce and
the market price is ultimately determined by the resulting total output.
Bertrand (1883) challenged Cournot’s assumption of quantity-taking
behaviour and thought that oligopolists would collude rather than
compete. He argued that a model of oligopoly where each firm chose a
price, taking as given the prices of other firms, was more plausible. To
demonstrate how unrealistic Cournot’s description was, he developed
a model in which the decision variable is price. The basic assumption is
that once firms choose and commit to their prices, they will then adjust
their production to satisfy all the demand that comes their way. Bertrand
showed how Cournot’s way of thinking leads to the implausible result that
in a duopoly the perfect competition price is charged.
We can think of the Bertrand model as a non-cooperative game in which
each firm decides on price, taking the other prices as given. We then look
for a Nash equilibrium as in the Cournot model. The assumptions of the
Bertrand model are that the product is homogenous, consumers have
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complete information and there are no search or transport costs so that they
buy from the firm charging the lowest price. If firms charge the same price
they are assumed to share the market and have identical market shares (e.g.
consumers are randomly allocated to each duopolist).
Assume firms have identical and constant marginal costs and unlimited
capacity. Under these assumptions we find the very striking result that
there is a unique Nash equilibrium in which both firms set price equal to
marginal cost. Why is this the only Nash equilibrium? Clearly, price could
not be below marginal cost since then firms would be making losses. Price
cannot be above marginal cost since then one of the firms could reduce
its price by a very small amount, capture the whole market and make a
positive profit. If firms differ in (constant) marginal costs, then the low
cost firm can set its price just below the second lowest marginal cost at
equilibrium unless that price is above the monopoly price.
Example 17.3
Assume the same data as in Example 17.1. We look for a Nash equilibrium
in prices. For any price at or above Firm 1’s MC, Firm 2, which has the
lower MC, can undercut Firm 1 and capture the whole market. At the Nash
equilibrium Firm 1 charges p1 = 8 and Firm 2 charges p2 = 8 – ε so that Firm
2 is the sole supplier. Note that Firm 2 is not charging the monopoly price
at equilibrium (you should check that a monopolist would charge p = 14)
since that would induce Firm 1 to undercut it and capture the whole
market. So Firm 2 would not be using a best response to Firm 1’s strategy.
The Bertrand model thus predicts a price of 8 – e and a quantity of 16 + ε.
Compare this to the predictions of the Cournot model in which the high
cost producer, because of the lower intensity of the price competition,
obtains a 1/3 market share.
So in Bertrand’s model with firms producing identical products,

aggressive price rivalry between just two firms can result in the perfectly
competitive outcome. This is a remarkable result. When firms’ products
are differentiated, as in monopolistic competition (see Chapter 14 of
the subject guide), price competition is less intense. In the presence of
material sunk costs to do business, Bertrand competition can also be
destabilising because firms are left with no additional revenue to cover
their sunk costs. This effect can create a strategic asymmetry between a
firm already operating in an industry (with many costs being considered
sunk) and a potential entrant for which the same costs will instead be non-
sunk and recoverable.
The assumption of consumers buying from the firm charging the lowest
price, even if the price difference is very small, is quite restrictive and
justifiable only when the goods are very close substitutes. In fact,
oligopolists strategically differentiate their products to reduce tough price
competition. When products are differentiated, a firm can charge a higher
price than its rival without losing all its business. Even when the good is
homogenous, it is not realistic to assume that all demand goes to the lower
price firm. If some customers do not care about small price differences or
firms know only their own costs and have imperfect information about
rivals’ costs, firms may set their prices above marginal cost in equilibrium
and make positive sales even when they are not the lowest price firm.
It is difficult to think of situations in which the Bertrand model is a
reasonable approximation of reality. The scenario which fits the original
Bertrand model best is maybe that of firms submitting sealed bids for a
229
procurement contract where the contract is awarded to the firm quoting

the lowest price. However, even in these circumstances, firms find ways
to avoid tough price competition. In the 1950s, General Electric and three
other firms rotated sealed bid business for circuit breakers. They held
secret meetings to decide market shares in advance.
The Bertrand model is most applicable to markets in which capacity is
sufficiently flexible so that firms can meet all of the existing demand at the
prevailing prices. For example, during economic downturns airlines tend
to have substantial excess capacity and because many consumers perceive
different airlines as very close (if not perfect) substitutes, each airline can
fill empty seats by undercutting rivals’ prices. The resulting fierce price
competition can resemble Bertrand’s solution and has in fact led to larger
losses in the industry. During economic booms, on the contrary, airlines’
spare capacity is minimal, price competition less intense (there’s no point
in stealing rivals’ customers if you cannot serve them) and profits more
common.
17.2.3 Cournot versus Bertrand

The two models discussed above make dramatically different predictions
about the quantities, prices and profits that will result from oligopoly
competition. In the Cournot model, firms typically retain market power
and the equilibrium price is generally above marginal cost while in the
Bertrand model, competition between just two firms is sufficient to deliver
an outcome in line with the perfectly competitive equilibrium.
Since the predictions of Bertrand and Cournot are very different, it is
important to decide whether price or quantity is the strategic variable. In
a much quoted paper, Kreps and Scheinkman (1983) allow duopolists to
use both variables. In a first stage, ‘capacity’ is chosen which limits each
firm’s output in the second stage. In this second stage, firms set prices. The
firm which sets the lowest price can produce and sell up to its capacity
whereas the high price firm is left with any residual demand. Kreps and
Scheinkman show that, at the unique subgame perfect equilibrium of this
game, the capacities chosen in the first stage are the Cournot equilibrium
quantities and in the second stage firms choose (identical) prices such that
demand equals joint capacity.
As an example, think of airlines offering scheduled flights between London
Heathrow and New York JFK. In the short-run at least, an airline cannot
change the number of seats available on the route (unless the flight
frequency is increased which is problematic because of a shortage of take-
off and landing slots). If price is set equal to marginal cost, there may be
excess demand. When this is the case, both firms pricing at marginal cost
and making zero profit is not an equilibrium. One firm could increase price
slightly and make positive profits. Of course, customers would prefer to
buy from its rival (pricing at marginal cost) but they are rationed there.
The Cournot model has been used more often in practice because it can
be modified quite straightforwardly to accommodate different parameters
of the model and recalculate equilibria to forecast new market outcomes.
For example, in competition policy one can obtain analytical predictions
of the welfare effects of a merger of two large rivals or the impact of new
technologies on market price. Cournot’s model also provides a theoretical
justification for the use of the HHI measure (see Chapter 13 of the subject
guide) in antitrust cases to predict the effects of a merger on pricing.
230
17.3 Strategic asymmetry

In this section we study models in which firms, for whatever reason, do not
make their decisions simultaneously. Simultaneity in this context does not
necessarily have a chronological meaning. In game theory ‘simultaneous
decisions’ refers to the situations in which players make decisions ignorant
of the decisions taken by the other players. In sequential models there is
a ‘leader’ who makes a first move, after which the ‘followers’ make their
decisions. This type of analysis is obviously only appropriate when there is
an industry leader and it is clear which firm assumes the leadership role.
17.3.1 Stackelberg
In the Cournot model, firms are assumed to make output decisions
simultaneously. In certain situations where there is a clear market
leader, however, this assumption is not very realistic, particularly if we
think of output as levels of production capacity. Effectively capacity
expansion decisions tend to be made slowly by management and firms
often behave sequentially.
In the Stackelberg model, firms continue to choose output levels but one
firm acts before the others. More specifically, suppose the ‘leader’ (Firm 1)
makes a quantity decision, which can be observed by the ‘follower’ (Firm 2)
who in turn decides on quantity. Price depends on total output and the exact
relationship between output and price is given by the market demand curve
p(q1 + q2). Let’s use backwards induction and consider the follower’s problem
first. The follower has to determine an optimal output level q2 given that the
leader has chosen q1. Hence, Firm 2’s optimisation problem is:
max p(q1 + q2) q2 – c2(q2).
q2
The result (i.e. the optimal choice of q2) will generally depend on
q1: q2 = q2 (q1). The leader can anticipate the follower’s choice of quantity
and its dependence on his own quantity decision and therefore the leader’s
problem is given by:
max p(q1 + q2(q1))q1 – c1(q1).
q1
Example 17.4
Demand in an industry consisting of two firms is given by p = 24 – q1 – q2.

Firm 1 is the leader and has constant marginal costs of 8 per unit; Firm 2
is the follower with constant marginal costs of 4 per unit. Given q1, Firm 2
determines its optimal quantity by maximising:
(24 – q1 – q2) q2 – 4 q2.
From the first order condition we find q2=10 – q1/2. Firm 1 can anticipate
this dependence of q2 on q1 and maximises (24 – q1 – 10 + q1/2)q1 – 8q1
which leads to a quantity choice of q1 = 6. So the Stackelberg model
predicts q1 = 6, q2 = 7 and p = 11 for this industry. The profits are 18 and
49 for Firm 1 and Firm 2 respectively.
Compared to the Cournot model, the Stackelberg model predicts a higher

output for Firm 1 (the leader) and a lower output for Firm 2 (the follower).
Firm 1 has higher profits and Firm 2 has lower profits than in the Cournot
model. These conclusions hold generally, not just for this example. In the
Stackelberg scenario, the leader has the opportunity to select a high output
to induce the follower to cut back his production. In the Cournot model this
is not possible because firms take output decisions simultaneously and Firm
1 has no strategic advantage.
231
Activity
Make sure you can explain why in the Stackelberg model the leader generally has higher
profits.
If we interpret quantity choice as capacity choice, it may be easier to

find situations in which the Stackelberg model is empirically plausible. It
would mean that the firm which invests first acts as the leader. With this
interpretation, one could argue that IBM historically had a leader’s role in
the mainframe computer market.
17.3.2 Dominant firm markets

The dominant firm model applies to industries in which there is one large
firm (or a cartel, see Chapter 18 of the subject guide)) acting as a price
leader and several small firms. The small firms in the industry (the fringe)
act as competitive firms in that they take the price set by the dominant firm
as given and they supply all they want at this price. In other words, they
maximise their profits by determining their supply quantity as the quantity
for which marginal cost equals the given price. In contrast to the perfectly
competitive model there is no condition of zero profits. The dominant firm
supplies the residual demand. As in the Stackelberg model, the dominant
firm acting as the leader has the advantage of influencing the fringe firms’
or followers’ quantities supplied, in this case by imposing the price they
have to sell at.
Figure 17.2 illustrates how the price decision is made. For any price, the
dominant firm can determine how much will be sold by the fringe firms
by horizontally adding their MC curves. This is indicated by the SMC (sum
of marginal cost) curve. The horizontal difference between the industry
demand curve D and the SMC is the residual demand (RD) faced by the
dominant firm. Profit maximisation by the price leader requires setting
marginal revenue (MR) corresponding to the residual demand equal to the
firm’s marginal cost (MC). This leads to an output of q* by the dominant
firm. The optimal price can be read from the residual demand curve as p*.
Fringe firms supply q' at price p*.
SMC
p*
MC
RD D
MR
MC
q
q* q′
Figure 17.2: Dominant firm model
232
Note that when the dominant firm has a significant cost advantage as
indicated by MC' in Figure 17.2, it finds it optimal to set the price below
the fringe firms’ marginal cost SMC. The fringe firms therefore do not
produce and the dominant firm is the monopoly producer. In practice, a
dominant firm may decide not to undercut the fringe firms even when
that would deliver the highest profit. The reason is that refusing to
accommodate the fringe firms or taking over some of them may provoke
legal action due to antitrust policy.
If there are no barriers to entry and the small firms are making positive
profits, entry will occur, shifting the SMC curve to the right and lowering
the dominant firm’s market share. For example, US Steel’s market share
decreased from 75 per cent in 1903 to less than 25 per cent in the 1960s.
American Can which used to supply 90 per cent of the tin market in 1901,
saw its market share decrease to 40 per cent by 1960. Such market entry
may alter the way in which the industry operates. The dominant firm may
not be willing to tolerate a very large fringe sector.
Theoretically, for the dominant firm model to apply, the dominant firm
should be powerful so that it can credibly threaten to punish fringe firms
if they do not accept its price leadership. This punishment would take
the form of driving the fringe firms out of business through a price war.
Therefore the dominant firm should have low costs, substantial market
share and large production capacity to force the other firms in the industry
to set the same price. Examples of industries for which the dominant firm
model may be plausible include (dominant firms in brackets):
• the European soft drinks industry (Coca-Cola)
• Microsoft (PC operating system market in EU)
• the US airline industry (American Airlines)
• photocopiers (XEROX)
• the UK e-book market (Amazon)
• cameras and film (KODAK).
The reasons why particular firms get to be leaders may be related to size,
management style or they may be historical. For example, Coca-Cola was
exempt from sugar rationing during the war in return for supplying cheap
Coke to American troops in Europe. This gave Coca-Cola a significant
advantage over Pepsi Co at least in the European market. Federal Express,
probably because of first mover advantages, is seen as the price leader in
overnight delivery.
The dominant firm model can be modified to allow for several large firms
dominating the market. These market leaders can be modelled as joint
profit maximisers (a cartel) in which case our analysis above is basically
unaltered or they may be assumed to behave in Cournot fashion with
respect to residual demand. Industries with a few (rather than one) major
players are empirically important. Consider, for example, the dominance of
the Big-4 professional services firms (i.e. Deloitte, EY, KPMG and PwC) in
the global auditing market.
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Example 17.5
Assume industry demand is given by p = a – bQ, where Q is total industry

output. There are n identical small firms in the industry with cost function
C(qs) = csqs2. The dominant firm has constant marginal costs cd and
produces an output qd so that Q = nqs+ qd. Suppose the dominant firm sets
a price p.
The small firms set marginal cost equal to p so that p = 2csqs or qs = p/(2cs).
Hence, residual demand for the dominant firm is given by:
qd = Q – nqs = (a – p)/b – np/(2cs).
This can be rewritten as:
p = (a – bqd)/(1 + bn/(2cs)).
The dominant firm sets marginal revenue corresponding to this demand

equal to its marginal cost:
cd = (a – 2bqd) /(1 + bn/(2cs)).
which results in:

qd = (a – (1 + bn/(2cs)) cd)/(2b).
The optimal price set by the dominant firm can be found by substituting qd
in the residual demand curve, which gives:
p = cd / 2 + csa/(2cs + bn).
For n = 0 this reduces to p = (cd + a)/2, the monopoly price. The optimal
price is decreasing in the number of fringe firms.

This chapter examined the predictions of the most prominent economic
models of oligopoly markets where firms produce homogeneous products.
We considered symmetric (i.e. Cournot, Bertrand) and asymmetric (i.e.
Stackelberg, dominant firm) frameworks. The equilibrium outcomes
of these models can be easily compared against the solutions of the
monopoly and perfectly competitive market studies in previous chapters of
this subject guide.

• solve the Cournot, Bertrand and Stackelberg oligopoly models
• discuss the solutions of the different models and explain how they
compare to each other as well as against the monopoly and perfectly
competitive outcomes (e.g. revenue destruction effect)
• solve a dominant firm model analytically and graphically.
234

1. Let the inverse demand curve for a homogenous product be p = 70
– Q. Suppose there are two firms in the industry, each with constant
marginal costs of 10. Assuming they behave as Cournot duopolists,
what will be the price and output? What price and output levels does
the Stackelberg model predict? What price and output levels does the
Bertrand model predict?
2. An industry consists of two firms, each of which produces output at a
constant unit cost of 10 per unit. The demand function for the industry
is Q = 1,000,000/p. Find the Cournot and Stackelberg equilibrium
price and quantity.
3. An industry consists of one dominant firm and five small (fringe)
firms which behave competitively, taking the price set by the dominant
firm as given. Industry demand is Q = 10 – p. The fringe firms have
identical cost functions C(q) = q2 and the dominant firm has constant
marginal cost of 1 per unit. Derive the dominant firm’s residual
demand and corresponding marginal revenue. Illustrate all your
derivations on a graph. What price will the dominant firm set? At
this price, how much does it supply and how much is supplied by the
fringe firms?
4. Demand is given by p = 1 – Q and production costs are zero. Find
Cournot, Bertrand and Stackelberg price, output and profit levels.
Suppose Firm 2 (which is the follower in the Stackelberg game) has a
fixed cost F. How does this change your answers?
235
Notes
236
Chapter 18: Cartels and (implicit) collusion
Chapter 18: Cartels and (implicit)

collusion
18.1 Introduction
The models of oligopoly examined in Chapter 17 of the subject guide
(e.g. Cournot, Bertrand and Stackelberg) characterise different situations
with regard to the competitive variables chosen by the firms (e.g. output
versus price) and the timing of their choices (e.g. simultaneous versus
sequential). However, they share the common feature that total industry
profits are less than what they would be if firms maximised profits as a
single entity, choosing the monopoly price and output. In other words,
these models assumed that oligopolists could not behave like a cartel.
A cartel comprises a group of firms that collusively determine the price
and output in a market. One of most notorious international cartels is the
Organization of Petroleum Exporting Countries (OPEC), whose members
include some of the world’s largest oil producers such as Iran, Saudi
Arabia and Venezuela. The goal of the cartel, if it works as its members
intend, is to act as a single monopoly firm and choose the output level
that maximises total industry profits. By coordinating production and
restricting competition among its members, the cartel exercises joint
monopoly power. This chapter analyses the way in which a cartel should
allocate total output across individual producers to maximise profits.
A typical problem faced by cartels is to determine and enforce the
allocation of individual output and total profits across individual members.
This is by no means easy to implement in practice, which is possibly one of
the reasons why very few industries have managed to operate successfully
as cartels. Other factors that conspire against a cartel are that individual
members may find it in their own interest to deviate from the agreed
quota and secretly expand their output, and that agreements among
firms to eliminate competition are often considered violations of antitrust
legislation (i.e. illegal). In the European Union and USA, for example,
antitrust laws prohibit open agreements whose sole purpose is to fix prices
or restrict output, and colluding companies face hefty penalties.
In the presence of antitrust laws, managers may try to use less open/
explicit ways to coordinate and restrict total output. The second part of
this chapter explores conditions under which firms, acting only in their
own self-interest, may nonetheless sustain collusive outcomes when
anticompetitive agreements cannot be written or enforced. We use the
tools of non-cooperative game theory to characterise the subgame-perfect
equilibria where implicit (or tacit) collusion and decentralised
cooperative pricing may emerge.

The aima of this chapter are to consider:
• the concept of a profit possibility frontier
• why the division of profits can be problematic in a cartel
• some of the factors that may facilitate or hinder collusion
• the nature of regime-switching models, the role of uncertainty in these
models and their predictions about price wars.
237

• explain the emergence and intrinsic instability of a cartel
• discuss the concept of implicit collusion and cooperative pricing
behaviour in the context of dynamic games
• demonstrate why in a repeated Bertrand model cheating is more likely
when there are many firms that are impatient.

Norton and Co., 2014; 9th edition] Chapter 28: Oligopoly.

Wiley and Sons, 2015) 5th edition, international student version
[ISBN 9781118716380] Chapter 11: Monopoly and monopsony.
Chapter 5: Cartels.
Green, E.J. and R.H. Porter ‘Non-cooperative collusion under imperfect price
information’, Econometrica 52(1) 1984, pp.87–100.

This chapter studies firms’ incentives to form a cartel by means of an
explicit price-fixing or output agreement whose main purpose is to
eliminate competition among oligopolists. It also considers facilitating
practices to achieve the monopoly outcome. The chapter then explains
that when explicit collusion is not possible, firms may nonetheless be able
to sustain collusive market outcomes as a non-cooperative equilibrium of
dynamic oligopoly games.
18.2 Profit maximisation by a cartel

Chamberlin was one of the first economists (after Adam Smith) to suggest
that oligopolistic sellers would form a cartel and cooperate to set joint
profit maximising price and output levels. Cartels were common before
the antitrust laws were passed. Currently, in most countries, the norm is
that collusion is illegal although some cartels have and are sanctioned
by governments. For example, Germany, Japan and the UK allowed
the formation of cartels that the government believed would promote
efficiency. Both Germany and Japan allowed for cartelisation so that firms
could reduce capacity during periods of excess capacity. The International
Air Transport Association, consisting of American and European airlines
flying transatlantic routes, used to set uniform fares for transatlantic
flights. The US allowed agricultural committees to determine prices and
production quotas for some products. Sometimes collusion between firms
in the domestic market is explicitly forbidden but governments allow
firms to participate in international cartels. The European steel industry
operated as a price fixing cartel until 1988 and was fined in 1994 by the
European Commission.
Because price fixing is illegal, there are not many open cartels but firms may
nevertheless find ways to cooperate at the expense of customers. Powerful
firms use the media to announce price changes which are followed by the
other firms in the industry. All firms in the industry use the leader’s price
238
as a focus point and the risk of ‘misunderstandings’ is minimal. This is a

form of implicit or tacit collusion. Trade associations or professional
associations that represent firms in similar businesses can sometimes be
vehicles for collusion. Most of the time, trade associations fulfil the value
purpose of implementing industry-wide lobbying strategies on behalf of its
membership and collect and disseminate valuable aggregate statistical data.
However, on occasions, trade associations can also serve as the vehicle by
which cartel members communicate and agree anticompetitive behaviours.
For this reason, industry bodies normally forbid discussions on price or
other market sensitive information during committee meetings or member
companies to avoid violating competition laws.
Technically, the problem a cartel faces in allocating output levels across its
members is at first sight identical to that of a monopoly operating several
plants. The optimal output is found by horizontally summing marginal cost
curves and determining the intersection of this cartel marginal cost curve
with the industry-wide marginal revenue curve (or the horizontal sum of
the marginal revenue curves if there are several markets). The output is
allocated to individual producers such that marginal cost is equal in all
firms and equal to marginal revenue. For joint profit maximisation, it is
necessary to allocate high output quotas to low cost firms and low quotas
to high cost firms which may even be required to shut down if they are too
inefficient.
In an oligopoly, finding the optimal output division between cartel
members is only a first step. An important but often ignored problem is
how to divide the cartel profit. If firms can bargain over sidepayments,
it is not as difficult to agree on optimal quotas as when no sidepayments
are allowed. By definition of the collusive solution (i.e. that it is the
solution which maximises joint profits) it is always possible to make all
cartel members better off than they would be in a non-cooperative setting
such as Cournot. This is not to say that the division of profits is trivial
when side payments are possible but it seems that the bargaining among
members should not be too difficult. Because of the problems associated
with divisions of profits, as well as uncertainties about market demand,
output allocations are often clearly suboptimal in real life cartels. When
there are no sidepayments, each cartel member wants a large share of the
output. Production allocations may be based on past sales, capacity or a
geographic segmentation of the market (‘market sharing cartels’). In these
situations, having the most skilled negotiator may be more important than
relative production efficiency.
Usually cartel members do not make contractual agreements about
sidepayments or redistribution of profits since this would be evidence of
(illegal) collusion. In this case (if firms are not identical), some firms may
be better off at the Cournot solution than at the joint profit maximising
solution. This is illustrated for a duopoly in Figure 18.1 where a profit
possibility frontier is drawn. By definition, all combinations of profits
under this curve can be attained by a suitable choice of q1 and q2. The
curve itself is derived by solving:
max λπ1 + (1 – λ) π2
q1, q2
for all values of the parameter λ between 0 and 1. The point which
maximises joint profits corresponds to the solution to the optimisation
problem for λ = 1/2. NE in Figure 18.1 indicates the Nash equilibrium
(i.e. payoff pair) of the corresponding Cournot game. By moving from
NE to the point (max) where joint profits are maximised, firm 2’s profit
decreases.
239
profit 2
NE o max
profit 1
Figure 18.1: Profit possibility frontier

Mathematically, a cartel maximises joint profit:
max π = p(Q)(q1+ q2 ) – c1(q1 ) – c2(q2)
q1, q2
where Q = q1 + q2. The first order conditions are:
∂π = ∂p
× (q1+q2 ) + p(q1+q2 ) – MC1(q1 ) = 0
∂q1 ∂Q
and
∂π = ∂p
× (q1+q2 ) + p(q1+q2 ) – MC2(q2 ) = 0
∂q2 ∂Q
which gives the result mentioned above: marginal revenue equals each
firm’s marginal cost at its optimal output level.
We can use this analysis to show that, for cartel members, since they
are playing a prisoners’ dilemma game, there is always a temptation to
cheat by overproducing. Given that firms, even when they have formally
agreed to collude, have no recourse to a court of law (assuming collusive
agreements are illegal), this temptation is very real. Consider firm l’s profit
given that firm 2 produces the joint profit maximising quantity q2*:
π1 (q1, q2*) = p(q1 + q2*) q1 – c1 (q1).
If firm 1 assumes that firm 2 is going to stick to q2* it finds its optimal
output level q1* by differentiating this function with respect to q1 which
gives:
∂p ∂c
p(q1+ q2* ) + q1 – 1.
∂Q ∂q1
The resulting quantity will typically be different from the one that
maximised joint profits. This indicates that Firm 1 can increase its profits
by increasing output if Firm 2 keeps output constant at the ‘collusive’
amount. The intuition for this is that marginal revenue for the cheater is
close to the cartel price whereas his marginal cost equals marginal revenue
and is thus lower than the cartel price.
Even when cartels can monitor and enforce prices effectively, cartel
members may engage in non-price competition by offering free extras such
as after-sale service or free delivery and installation. Airlines offer better
meals, free in-flight entertainment etc., in order to lure customers away
from other cartel members. This type of non-price competition can be
interpreted as cheating but it is not as easily detected as price cutting.
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Case studies: OPEC

The following brief cases illustrate relatively well-known cartels.
As mentioned in the Introduction, the standard example of an international cartel is OPEC

which restricts oil output by its members so as not to spoil the market. OPEC’s history has
repeatedly illustrated the difficulties of maintaining a cartel and avoiding cheating by cartel
members. Within OPEC there is tension between the rich countries with large oil reserves and
a small population (e.g. Kuwait and Saudi Arabia, which alone accounts for a third of OPEC’s
output) and relatively poor countries with small oil reserves and a large population (e.g. Libya
and Indonesia). The countries with large reserves want a low price since they are concerned
about the long-term effect of high oil prices: customers may start switching to other energy
sources and alternative technologies (e.g. fracking) and there may be market entry in the form
of non-OPEC exploration and production such as in the North Sea. Countries with low reserves
do not worry so much about the long-term effects and, since short-term demand elasticity for
oil is low, they argue for a high price. The poor OPEC countries have consistently overproduced
their quotas. Indeed several studies have concluded that OPEC consistently produces at higher
output levels and lower prices than if it were a pure monopoly due to each nation’s incentives
to grab as large a share of the cartel’s output and profits as possible.
Diamonds
When industries succeed in filtering sales through a common distributor, collusion is not an
unlikely mode of behaviour. The Central Selling Organisation (CSO), a subsidiary of De Beers
(the diamond group of companies), aims to control the world wholesale market in rough
diamonds and has been the largest-selling agent of most of the world’s diamonds throughout
the 20th century. However, even this seemingly cosy cartel arrangement has had problems.
Russia agreed in 1990 to sell 95 per cent of its output through the CSO for a period of five
years but it is unlikely that this agreement was honoured. The breakup of the Soviet Union
threatened the stability of the arrangement. De Beers has had to buy this leaked output to keep
control of the flow of diamonds on to the market and hence their price. As new mines were
developed, De Beers gave them sufficient market share so that they agreed to sell through the
CSO and accept its production control system. When Tanzania decided to act independently,
De Beers depressed the price for the quality of stones sold by Tanzania, forcing it to rejoin the
cartel.
18.2.2 Facilitating practices

Given the cartel members’ incentive to overproduce, managers have used
several mechanisms to detect and prevent cheating (e.g. forcing firms
to publicise prices). Firms may adopt ‘facilitating practices’ to try and
eliminate the incentive of cartel members to engage in secret price cutting
or output expansion that undermines the cartel’s profits. Some of the most
commonly observed facilitating practices include the following:
• Divide the market: Some cartels succeed in preventing cheating
by assigning each firm certain buyers or geographic areas. This type
of market allocation scheme enhances the cartel’s ability to detect
cheating.
• Fix market shares: So long as market shares are relatively easy
to observe and monitor, firms will have less incentive to cut prices
because their market shares would increase and industry peers would
see this. Significant volatility of demand would make shares more
unstable, which would in turn undermine the effectiveness of this
mechanism.
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• Most favoured customer (or nation) clause (MFC): In this

case firms promise their customers that if they ever lower prices,
they will offer a rebate, equal to the difference between the price
customers pay now and the new price. This rebate mechanism means
that deviating from the collusive outcome by cutting the price is less
profitable because of the compensation that would have to be paid to
all previous customers.
• Meet or release clause: In relatively long-term supply contracts,
such a clause guarantees the customer that if she finds a lower price
offered by another supplier, the original seller will match it or release
the customer from the obligation to buy. This type of legal provision
makes it more difficult for a firm to cheat because the cartel will know
quickly of lower prices existing in the market.
18.3 Tacit (or implicit) collusion

Collusive outcomes do not always involve the existence of enforceable
anticompetitive agreements. When firms in an oligopoly are able to
coordinate their actions despite the lack of an explicit cartel agreement,
economists refer to the resulting coordination as tacit (or implicit)
collusion. The reason is that firms can sustain the monopoly outcome
without an explicit collusive agreement.
The models of oligopoly that we have discussed in Chapter 17 of the
subject guide were static: firms play a one-shot game and there is no
possibility of responding in the future to price reductions by rivals. More
realistic models assume a dynamic setting (e.g. infinitely repeated games)
and in particular the repeated prisoner’s dilemma provides a natural
framework within which to study the sustainability of monopoly pricing as
a non-cooperative equilibrium.
In fact, there is a well-known property of dynamic games called the folk
theorem: if firms expect to interact indefinitely and have sufficiently low
discount rates, then any price between the monopoly price and marginal
cost can be sustained as an equilibrium. This implies that cooperative
pricing behaviour is a possible outcome in an oligopolistic industry even if
all firms act in their own interest (they use best responses to their rivals’
strategies). Such a collusive equilibrium is sustained by players’ threats
to retaliate (i.e. to revert to the non-cooperative Nash equilibrium of the
underlying one-shot game as soon as one player deviates).
18.3.1 Infinitely repeated oligopoly games

To illustrate this idea consider a simple infinitely repeated Bertrand game.
All n firms are identical and the price which maximises joint profit is
pm, the monopoly price. If all firms charge pm each makes a profit equal
to a share 1/n of the monopoly profit Пm. If one of the firms undercuts,
however, it captures the whole market. Assume prices are perfectly
observable by all market participants. Although repetition of the one-
period Bertrand solution with all firms pricing at marginal cost in each
period is indeed an equilibrium of this game, there may be a subgame-
perfect equilibrium in which all firms collude and charge pm. Suppose firms
use trigger strategies of the following type: collude (i.e. set price pm)
until at least one firm deviates; when one or more firms deviate in a given
period, set price equal to marginal cost from the next period onwards. For
this combination of trigger strategies to form an equilibrium it should be
the case that it does not pay for any firm to do something else assuming
all the other firms are sticking to their trigger strategies. Note that if a firm
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decides to deviate by marginally undercutting its rivals, it gains:

Пm – Пm/n = Пm (n – 1)/n
immediately as it can serve the whole market (it becomes a monopoly
for one period). Its losses, compared to the collusive outcome, due to
retaliation from the next period onwards are represented by:
(Пm/n)(δ + δ2 + ...) = (Пm/n) (δ/(1 – δ))
where δ is a discount factor. The reason is that profits are zero from the
next period onwards as a result of Bertrand competition and the infinite
price war. Hence the firm cheats if the gain exceeds the loss or when:
δ < 1 – 1/n .
This proves that, at least in this simple pricing model, cheating is more
likely when the number of firms in a cartel is large. When n = 50, a
discount factor above 0.98 is needed to sustain collusion whereas for
an industry with n = 2 firms, a discount factor above 0.5 is sufficient.
The dependence on the discount factor is clear: when firms are patient
(high δ), they evaluate their future losses more highly and this deters them
from cheating.
We have analysed repetition of the Bertrand pricing game here but a
similar story can be told about repeating the static Cournot game. The
trigger strategies there involve playing the Cournot equilibrium output
forever as soon as cheating occurs. In contrast to the Bertrand situation
where you don’t sell at all when someone cheats, firms in a Cournot
industry may not be able to observe cheating immediately but maybe two
or three periods after it has taken place. Cheaters could get away with
earning profits above their share of the collusive profit for several periods.
Detection lags therefore make cheating more tempting.
Activity
Show that a trigger strategy involving repetition of the Cournot game can also sustain
collusion.
When demand fluctuates and there is a lot of uncertainty, there is larger

scope for misunderstanding moves which merely reflect changed demand
conditions as attempts to cheat. This observation has formed the basis
for recent game theoretic work on dynamic oligopoly. To illustrate the
main ideas here, let’s assume a homogenous oligopoly with identical
firms. The time horizon is infinite or there is a chance, in each period,
that the game ends. Firms decide on output levels and they observe only
their own output level and the market price (which, as always, depends
on total industry output). Each firm uses these observables to deduce
whether a rival has defected from the (tacitly) collusive arrangement
(i.e. when the market price is low, overproduction, compared to the joint
profit maximising output, has taken place). So far, we are describing a
repeated Cournot game. The ingredient which has to be added to generate
equilibrium price wars is uncertainty. The relationship between industry
output and price is stochastic so that a low price can be caused by a rival
flooding the market or an exogenous fall in demand.
Green and Porter (1984) show that, when there is uncertainty, there is an
equilibrium in which firms periodically revert from the collusive solution
to static Cournot output levels for a few periods, after which they return
to the collusive output levels. At this equilibrium, firms are using trigger
strategies which tell them to start behaving non-cooperatively when price
falls below a given level. The non-cooperative punishment phases are
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called price wars. What is interesting in this and other regime-switching

models is that no firm ever defects at this type of equilibrium yet price
wars do and have to occur to sustain the equilibrium. In other words, if
there is no trigger in terms of a low price level setting off a price war, it
would not be in any individual player’s interest to continue to collude.
Paradoxically, price wars can be seen as evidence of collusion. If firms
act non-cooperatively (play static Cournot in each period), there is no
reason for them to revise prices periodically and consequently price and
output are stable. However, when they try to collude, punishment periods
are necessary. In the Green-Porter model, the ‘collusive’ output is not the
output a monopolist would set. When determining output, firms have
to take into account that when a low output level is set, the temptation
to cheat is higher and in order to sustain the collusive equilibrium the
punishment periods would have to be longer.
In terms of empirical predictions from this type of model, we should
expect to observe price wars in recessionary periods when there is surplus
capacity. There is some casual evidence for price wars triggered by an
exogenous fall in demand. There are also models that reach exactly the
opposite conclusion to Green and Porter, namely: that cartels are less
stable during expansionary periods because this is when firms have less
capacity or inventories to punish the cheaters. Further the gains from
cheating are larger when there is a boom in demand.

This chapter analysed firms’ incentives to form a cartel by means of
an explicit price-fixing or output agreement whose main purpose is to
eliminate competition among oligopolists and achieve the monopoly
outcome. We also examined the sustainability of tacit collusion as a
noncooperative equilibrium of dynamic games using as an example grim
trigger strategies (i.e. the threat of an infinite price war to keep firms from
cheating).

• explain the emergence and intrinsic instability of a cartel
• discuss the concept of implicit collusion and cooperative pricing
behaviour in the context of dynamic games
• demonstrate why in a repeated Bertrand model cheating is more likely
when there are many firms that are impatient.

1. Consider Exercise 1 in Section 17.6 of Chapter 17. What is the
collusive price and output level? Now assume the firms interact during
244
each period and the time horizon is infinite. For which values of the
discount factor is there a collusive equilibrium sustained by trigger
strategies if firms play Cournot forever after cheating has occurred?
What if they play Bertrand forever after cheating?
2. PowerGen and National Power are the only two electricity generating
companies in the UK. The demand for electricity is p = 580 – 3q.
The total cost function of PowerGen is TCP = 410qP and the total cost
function of National Power is TCN = 460qN.
a. If these two firms collude to maximise their combined profits, how
much will each firm produce?
b. How will they divide profits?
245
Notes
246
Chapter 19: Introduction to corporate governance
Chapter 19: Introduction to corporate

governance
19.1 Introduction
Corporate governance failure has been at the centre of many prominent
corporate collapses or scandals such as those experienced by Enron
(2001), Lehman Brothers (2007) or VW (2015) to name just a few.
The global financial crisis that started in 2007 has also revealed severe
shortcomings in corporate governance. When most needed, existing
standards failed to provide the checks and balances that companies need
in order to cultivate sound business practices.
Broadly speaking, corporate governance consists of the collection
of control mechanisms through which corporations and their senior
management are controlled by shareholders (or owners in the case of
private companies) and other stakeholders. Its main purpose is to facilitate
effective and prudent management that can deliver the long-term success
of the company. Corporate governance involves a set of relationships
between a company’s management, its board, its shareholders and other
stakeholders. It also provides the structure through which the objectives
of the company are set, and the means of attaining those objectives and
monitoring performance. How well companies are run ultimately affects
their performance, market confidence and private sector investment.
Theoretically, the need for good corporate governance rests on the basic
agency problem (see Chapter 7 of the subject guide) that arises
because of the separation that exists between the ownership of a company
(typically large, publicly listed) and its management. To lessen the
potential negative effects of the principal-agent relationship, some type of
control or monitoring system has to be put in place in the organisation.
The first version of the UK Corporate Governance Code, produced in 1992,
contained what continues to be a classic definition of the substance of the
Code:
Corporate governance is the system by which companies are
directed and controlled. Boards of directors are responsible for
the governance of their companies. The shareholders’ role in
governance is to appoint the directors and the auditors and to
satisfy themselves that an appropriate governance structure is
in place. The responsibilities of the board include setting the
company’s strategic aims, providing the leadership to put them
into effect, supervising the management of the business and
reporting to shareholders on their stewardship. The board’s
actions are subject to laws, regulations and the shareholders in
general meeting.
Corporate governance is therefore about what the board of a company

does and how it sets the values of the company. It is to be distinguished
from the day-to-day operational management of the company by full-
time executives. At a minimum, the monitoring system contributing to
a company’s corporate governance consists of a board of directors to
oversee management and an external auditor to express an opinion on the
reliability of the financial statements and accompanying attestations.
247
The Organisation for Economic Cooperation and Development

(OECD) recognizes that sound corporate governance is seen as an essential
element for promoting capital-market based financing and unlocking
investment, which are keys to boosting long-term economic growth. Good
corporate governance is not an end in itself. Rather it is a means to create
market confidence and business integrity, which in turn is essential for
companies that need access to equity capital for long-term investment. Some
of the most topical issues in corporate governance include the following:
• Structure, responsibilities and effectiveness of the board of directors (e.g.
role of the chairman, independence, number of non-executive directors,
proportion of female directors).
• Level and composition of top executives’ compensation and incentives.
• Importance of stakeholders in the corporate governance system.
• Antitakeover defenses, shareholder protection and voting rights.
• Role and behaviour of institutional investors.
While there is no single and universally agreed-upon model of good corporate
governance, there exist some common elements and standards that people
believe characterise sound corporate governance. These common elements
are typically incorporated into Principles or national Codes of corporate
governance. The remainder of this chapter will discuss in some detail the
OECD Principles of Corporate Governance and the UK Corporate Governance
Code as examples of international best practice. The OECD Principles are
particularly relevant internationally and widely used as a benchmark for best
corporate governance practice by countries around the world and influential
multilateral organisations such as the Financial Stability Board, the World
Bank and the International Monetary Fund.

• the concept of corporate governance
• the key elements of a sound corporate governance framework
• some international differences in corporate governance practices.

• recognise the importance of good corporate governance
• describe the OECD Principles of Corporate Governance and the UK’s
Corporate Governance Code
• explain the main responsibilities and duties of the Board of directors
• discuss the concept of stewardship as it applies to institutional investors.

Financial Reporting Council The UK Corporate Governance Code. (London: FRC,
2014) Retrieved 8 December, 2015; www.frc.org.uk
G20/OECD Principles of Corporate Governance. (Paris: OECD, 2015) Retrieved
8 December, 2015; www.oecd.org/daf/ca
OECD Corporate Governance Factbook. (Paris: OECD, 2015) Retrieved
8 December, 2015; www.oecd.org/daf/ca
248

You may also find the following book and corporate governance code useful
as additional reading:
Larcker, D. and B. Tayan Corporate Governance Matters. (New Jersey: Pearson FT
Press, 2015) 2nd edition [ISBN 9780134031569].
Financial Reporting Council The UK Stewardship Code. (London: FRC, 2012)
Retrieved 8 December, 2015; www.frc.org.uk

This chapter provides an introduction to the topic of corporate governance. It
discusses the structure of corporate boards and the main duties of directors,
and illustrates some of the principles and best-practice codes of corporate
governance that are in place internationally. The concept of stewardship as it
applies to institutional investors is also examined.
19.2 Directors and their duties

The board of directors is a major component of the corporate governance
system of any public company because it lies at the intersection of senior
management and shareholders. The board is a governing body elected to
represent the interests of shareholders. At the centre of good governance is
an effective board. For example, failures of governance or the understanding/
management of key risks by boards have been a key factor in many of the
major financial sector failures experienced during the global financial crisis
that started in 2007.
Board members as a group of individuals share collective responsibilities and
are expected to provide both advisory and oversight functions. A common
root cause of corporate mismanagement is the failure by the board to rein in
management and provide sufficient independent challenge to the executives.
In its advisory capacity, the board typically consults with management
regarding the strategic and operational direction of the company. The
board should bring deep relevant business knowledge to help establish
a clear strategy, articulate a robust risk appetite to support that strategy
and support its delivery. In its oversight capacity, the board is expected to
monitor management and ensure that it is acting diligently in the interests of
shareholders. The board should oversee an effective risk control framework
and have the experience and confidence to hold executive management
rigorously to account for delivering the corporate strategy and managing the
business within the agreed risk appetite.
19.2.1 Types of directors

Unitary boards (e.g. those that exist in the UK, US and the majority of other
countries) are generally composed of the following directors.
1. Non-executive directors (NEDs). In most developed countries
regulations and best practice mandate that publicly listed companies have
a majority of NEDs sitting on the board. NEDs do not have a reporting line
to the company’s management. They are expected to challenge and oversee
management showing a certain degree of independence in the way they
discharge their duties. In many jurisdictions the chairman, who presides
over board meetings and provides general leadership, must be a NED.
a. Independent non-executive directors (INEDs). This category
includes NEDs who are also considered to be independent according
to laws, regulations or codes of best practice. Independence
essentially means having no material relationship with the
company, either directly or as an owner or officer of an entity that
249
has a relationship with the company. In practice, the test for

independence typically includes issues such as whether the
individual has been an employee of the company in the recent
past, whether it had material (direct or indirect) business
relationships with the firm, or whether the person has close
family ties with employees of the firm or represents a significant
shareholder.
b. Senior independent director (SID). Some jurisdictions
require the appointment of one of the NEDs as a SID. In the UK,
for instance, the board should appoint one of the INEDs to be the
SID to provide a sounding board for the chairman and to serve as
an intermediary for the other directors when necessary. The SID is
also available to shareholders to hear and channel their concerns
where appropriate.
2. Executive directors. These directors are also part of the executive
management and full-time employees of the company. Senior
managers who sit on the board generally include the chief executive
officer, chief financial officer, chief risk officer, chief operations officer
and head of internal audit, although the exact composition may
change across industries and jurisdictions.
Two-tiered board structures also exist in a minority of countries
including Germany, Argentina and others (see OECD Corporate
Governance Factsheet, 2015). In this model, the management
board is responsible for making business decisions on such matters as
strategy, product development, manufacturing, finance and so on. The
supervisory board in turn oversees the management board and is
responsible for appointing members of the management board, approving
financial statements and making other major financial decisions. No
managers are allowed to sit on the supervisory board.
EU regulation, for example, offers the choice of the two systems (i.e.
unitary versus two-tiered board) for European public limited-liability
companies (Societas Europaea) and some EU countries have established a
framework that gives domestic listed companies the choice.
19.2.2 Legal obligations of directors

In most jurisdictions directors must act in what they consider to be the
best interests of the company, consistent with their legal or statutory
duties. This is referred to as their fiduciary duty to the company (and its
shareholders).
Generally the fiduciary duty of the board includes the following elements:
• A duty of care – directors must make decisions with due deliberation
and sound business judgment. They must act in the way they consider,
in good faith, would be most likely to promote the success of the
company.
• A duty of loyalty – directors must proactively address and avoid
conflicts of interest. They must exercise sound independent judgment.
• A duty of candour – directors must inform shareholders of all
information that is important to their evaluation of the company
and its management. They must exercise reasonable care, skill and
diligence.
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19.3 International corporate governance codes

The governance system that a company adopts is not independent of the
business and cultural environment in which it operates. Particularly the
following factors may help shape and determine a company’s governance
system:
• The legal system, tradition and degree of protection provided to the
shareholders.
• The maturity and efficiency of the domestic capital market.
• The robustness and reliability of the accounting standards.
• The degree of supervisory oversight and regulatory enforcement.
• The societal and cultural values (e.g. corruption, individualism).
During the late 1990s and early 2000s, there have been significant research
efforts and policy initiatives to set out common features that characterise
good corporate governance frameworks. In this section we consider
two of the specific set of recommendations that are frequently used as
international benchmarks of sound corporate governance principles.
19.3.1 The G20/OECD Principles of Corporate Governance

The OECD Principles (the ‘Principles’) were originally developed in
1999, updated in 2004 and more lately reviewed in 2015. This latest
review benefited from the input of experts from recognised international
standard-setters such as the Basel Committee, the Financial Stability
Board and the World Bank Group. Regional Corporate Governance
Roundtables in Latin America, Asia and the Middle East and North Africa
also contributed actively to the review to reflect the reality of corporate
governance practices in those regions.
The revised Principles, published in 2015, maintain many of the
recommendations from earlier versions and continue to be non-binding;
that is, they are not detailed prescriptions for national legislation. Rather
they set out elements of best practice that national legislation may follow.
The Principles are most relevant to large companies listed on stock
exchanges although, of course, smaller and unlisted ones can also choose
to adhere to its corporate governance recommendations in a proportionate
manner. The Principles also recognise the interests of employees and other
stakeholders and their important role in contributing to the long-term
success and performance of the company.
The 2015 OECD Principles provide guidance through recommendations
and annotations across six chapters:
1. Ensuring the basis for an effective corporate governance
framework. The chapter emphasizes the role of corporate
governance frameworks in promoting transparent and fair markets,
and the efficient allocation of resources.
2. The rights and equitable treatment of shareholders and
key ownership functions. The chapter identifies basic shareholder
rights, including the right to information and participation through the
shareholder meeting in key company decisions. The chapter also deals
with disclosure of control structures, such as different voting rights.
3. Institutional investors, stock markets and other
intermediaries. This new chapter addresses the need for sound
economic incentives throughout the investment chain, with a
particular focus on institutional investors acting in a fiduciary capacity.
251
4. The role of stakeholders in corporate governance. The

chapter emphasises the importance of recognising the rights of
stakeholders established by law or through mutual agreements. The
group of stakeholders with an interest in the company’s governance
system includes employees, customers, suppliers, regulators, analysts
and creditors among others.
5. Disclosure and transparency. The chapter identifies key areas
of disclosure, such as the financial and operating results, company
objectives, major share ownership, remuneration, related party
transactions, risk factors, board members.
6. The responsibilities of the board. The chapter sets out key
functions of the board of directors including the review of corporate
strategy, risk management, selecting and compensating management,
overseeing major corporate acquisitions and divestitures, and ensuring
the integrity of the corporation’s accounting and financial reporting
systems.
The Principles are intended to help national policy makers evaluate and
improve the legal, regulatory, and institutional framework for corporate
governance.
The OECD believes that corporate governance matters because it affects
the cost for companies to access capital and reassures those that provide
capital – directly or indirectly – that their rights are protected. The OECD
also thinks that corporate governance rules and practices matter at a
broader macroeconomic level because they help bridge the gap between
household savings and investment in the real economy.
19.3.2 The UK Corporate Governance Code

The British model of governance shares many similarities with that of the
US and is generally referred to as the Anglo-Saxon model. It is largely
shareholder-centric, that is, it considers that the primary responsibility
of the company is to maximize shareholder wealth (as opposed to the
wellbeing of the broader community of stakeholders). Corporate actions
intended to support or safeguard the interest of other stakeholders (e.g.
employees, suppliers) are also seen as desirable but to the extent that
they are consistent with improving the long-term financial performance
of the firm. However, in regulated financial industries such as insurance,
for example, the protection of policyholders is also a key component of an
insurer’s system of governance.
The first version of the UK Corporate Governance Code (the ‘Code’) was
produced in 1992 by the Cadbury Committee. The last update of the Code
by the UK’s Financial Reporting Council was done in September 2014. All
companies with a Premium Listing of equity shares in the UK are required
under the Listing Rules to report on how they have applied the Code.
The British corporate governance system is based on a comply-or-
explain approach to governance standards by which companies have
the option not to comply with a principle as long as they can provide a
robust explanation for noncompliance. Listed companies are required
to report on how they have applied the main principles of the Code,
and either to confirm that they have complied with the Code’s more
specific provisions or – where they have not – to provide an explanation.
Companies are expected to provide clear explanations when they choose
to deviate from the Code, so that their shareholders can understand the
reasons for doing so and make their own analysis. The UK’s trademark
252
comply-or-explain approach has been adopted by many other jurisdictions

globally and is also reflected in the OECD Principles discussed above.
In providing an explanation for non-compliance, the company should
aim to illustrate how its practices are consistent with the relevant Code
principle and describe any mitigating actions taken to address any
additional risk and maintain conformity with the principle.
The main corporate governance principles of the Code revolve around the
following themes:
1. Leadership. The board is at the head of the company and is
collectively responsible for its long-term success. The board should be
led by the chairman, who is also responsible for its effectiveness. Non-
executive directors should constructively challenge and help develop
proposals on strategy; however, it is the responsibility of the executive
management to run the company’s business.
2. Effectiveness. Board directors should have the right balance of
skills, experience, independence and knowledge to discharge their
duties and responsibilities effectively. All directors should be appointed
to the board in a transparent manner and the company should run
appropriate induction programmes for all new directors. The board
should undertake a formal and rigorous annual board effectiveness
assessment. All directors should be submitted for re-election at regular
intervals, subject to continued satisfactory performance.
3. Accountability. The board are ultimately responsible for risk
management and for maintaining sound internal control systems
that ensure the integrity and transparency of the company’s financial
reporting. The board should also develop risk appetite statements
and determine the principal risks it is willing to take in achieving its
strategic objectives. The board should also maintain an appropriate
relationship with the company’s auditors.
4. Remuneration. The remuneration of executive directors should
be transparently linked to corporate performance and incentivise the
long-term success of the company. No director should be involved in
deciding his or her own remuneration.
5. Relations with shareholders. The board should collectively
encourage open and transparent dialogue with shareholders as well
as with the broader community of investors through the company’s
annual general meetings.
19.3.3 Corporate governance principles in other countries

According to the OECD, countries around the globe use different
approaches to corporate governance. Some have opted to support their
corporate governance framework with formal legal and regulatory
instruments while others rely more heavily on non-compulsory codes and
good practice principles.
Figure 19.1 shows that the ‘comply or explain’ system is the most common
internationally and that it is ensured either by laws and regulations
or by contracts between the listed companies and the stock exchange.
Mandatory market disclosure – regarding adherence to the codes – is
also prevalent and is part of the annual reporting requirements for listed
companies in most countries.
253
Jurisdiction Key national corporate governance codes and principles Implementation mechanism
Approach Disclosure Basis for Surveillance

framework
C/E: comply in annual R: regulator
or explain company L: Law or S: stock exchange
B: Binding report regulation P: private
R: Listing institution
rule
Argentina Corporate Governance Code C/E Required L R

Australia Corporate Governance Principles and Recommendations C/E R S
Austria Austrian Code of Corporate Governance C/E Required L
Belgium The 2009 Belgian Code on Corporate Governance C/E Required L R
Brazil Code of Best Practice of Corporate Governance No – –
Canada Corporate Governance: Guide to Good Disclosure C/E Required L
Chile Practices for Corporate Governance of Rule N° 341 C/E*1 Not Required L R
Czech
Corporate Governance Code based on the OECD Principles C/E Required – –
Republic
Denmark Recommendations on Corporate Governance C/E Required L&R S
Estonia Corporate Governance Recommendations C/E Required L
Finland Finnish Corporate Governance Code 2010 C/E Required R S
France Corporate Governance Code of Listed Corporations C/E Required L P
Germany German Corporate Governance Code C/E Required L
Greece Hellenic Corporate Governance Code For Listed Companies C/E Required L
Hong Kong,
Corporate Governance Code (Appendix 14 of the Listing Rules) C/E Required R S
China
Hungary Corporate Governance Recommendations C/E Required L
Iceland Corporate Governance Guidelines C/E Required L S
India Clause 49 of the Equity Listing Agreement B Required R R&S
Indonesia Good Corporate Governance Code No – – –
Irish Stock Exchange Listing Rules applying UK Corporate
Ireland C/E Required R –
Governance Code with Irish Annex
Companies Act B
Israel Required L R
(including the code of recommended corporate governance) C/E
Italy Corporate Governance Code C/E Required L
Japan Principles of Corporate Governance for Listed Companies No *2
– R S
Korea Code of Best Practices for Corporate Governance No -
Luxembourg Ten Principles of Corporate Governance C/E Required R S
Mexico Code of Corporate Best Practice
Netherlands Dutch Corporate Governance Code C/E Required L R
C/E Required R
Corporate Governance Best Practice Code (Appendix 16 of the R
New
Listing Rules)
Zealand
Corporate Governance in New Zealand Principles and Guidelines –
– –
Norway Norwegian Code of Practice for Corporate Governance C/E Required R
Poland Code of Best Practice of WSE Listed Companies C/E Required L S
CMVM 2013 Corporate Governance Code C/E Required L R
Portugal
The Corporate Governance Code of IPCG C/E
Saudi Arabia Corporate Governance Regulations B Required L
Singapore Code of Corporate Governance C/E Required R
Slovak
Corporate Governance Code for Slovakia C/E Required L
Republic
Slovenia Corporate Governance Code for Listed Companies C/E Required L
Spain Unified Good Governance Code C/E Required L R
Sweden Swedish Corporate Governance Code C/E Required R S&P
254
Switzerland Swiss Code of Best Practice for Corporate Governance C/E*3 – –

Turkey Corporate Governance Principles B & C/E Required L R
United
UK Corporate Governance Code C/E Required R R
Kingdom
United NASDAQ Listing Rules
B Required L&R R&S
States NYSE Listed Company Manual
*1 In Chile, listed companies are obliged to perform a self-assessment with regard to the adoption of the good practices of corporate governance,
and report on a ‘comply or explain’ basis.
*2 In Japan, the Financial Services Agency and Tokyo Stock Exchange published in 2014 a draft Corporate Governance Code under the ‘comply or
explain’ framework.
*3 In Switzerland, the Code states that it uses the ‘comply or explain’ principle, but it does not indicate where the company has to explain if a
company’s corporate governance practices deviate from the recommendations.
Figure 19.1: International codes and principles (OECD).
19.4 The UK Stewardship Code

The first UK Stewardship Code was published in 2010 and subsequently
revised in 2012. It aims to enhance the quality of engagement between
asset managers and companies they invest in to help improve long-
term risk-adjusted returns to shareholders. The Stewardship Code is
complementary to the UK Code and also operates on a ‘comply or explain’
basis. Since December 2010, all UK-authorised asset managers are
required by the Financial Conduct Authority (the UK’s financial conduct
regulator) to sign up to the Stewardship Code or explain why it is not
appropriate to their business model.
The Stewardship Code attempts to address the concern that institutional
investors hold significant shares of publicly listed companies on behalf
of their clients but do not always vote in the annual general meetings or
actively engage with the company. This failure to exercise their rights on
behalf of clients could in turn result in poor company oversight and a loss
to the investor. In effect stewardship codes support the effectiveness of
the entire corporate governance framework because company oversight
depends on institutional investors’ willingness and ability to make
informed use of their shareholder rights. For capital market participants
acting in a fiduciary capacity, such as pension funds, asset managers,
collective investment schemes, the right to vote is part of the value of
the investment being undertaken on behalf of their clients and should be
exercised appropriately.
Among other important things, institutional investors are required to
monitor the corporate governance of companies in their portfolio, have
policies and procedures to govern and disclose their voting activity,
manage effectively any conflicts of interest in relation to stewardship, and
explain how they will discharge their stewardship responsibilities.
The FRC expects signatories of the Stewardship Code to disclose publicly
how they met its key principles or explain why they have decided not
to comply with certain elements. This enhanced disclosure is expected
to make the market for investment mandates operate more efficiently
because it will equip ultimate investors with better tools to evaluate
the activities and behaviours of their institutional asset managers, thus
reducing monitoring costs.
255

The chapter considered topics of corporate governance such as board
structure and composition, and fiduciary duties of the directors. The
corporate governance principles published by the G20/OECD and
UK’s Financial Reporting Council were also analysed as examples of
international best practices.

• recognise the importance of good corporate governance
• describe the OECD Principles of Corporate Governance and the UK’s
Corporate Governance Code
• explain the main responsibilities and duties of the Board of directors
• discuss the concept of stewardship as it applies to institutional
investors.

understanding of this chapter’s learning outcomes. The VLE also contains
additional exercises to test your knowledge of the content of this chapter,
together with their respective solutions, as well as past examination
papers. We encourage you to use the VLE regularly to support your
study of the course material in this subject guide and prepare for the
examination.
1. What is the comply-or-explain approach to corporate governance?
Give arguments in favour and against the comply-or-explain approach
versus other more prescriptive systems, bearing in mind possible
cultural, legal or other relevant differences across countries.
2. Identify international best practices in relation to board composition,
responsibilities of directors and creation of dedicated committees.
256
Chapter 20: Concluding remarks
Chapter 20: Concluding remarks
20.1 Overview
This subject guide has covered basic topics in management and
microeconomics such as decision analysis, bargaining, game theory, auctions,
demand theory, asymmetry of information, neoclassical theory of the firm
and market structure and performance (e.g. perfect competition, monopoly,
monopolistic competition, oligopoly, cartels and tacit collusion). It also
examined topics in optimal pricing and an introduction to best-practice
corporate governance standards.
We hope the guide has helped you to engage actively with the course and build
a solid knowledge of the subject matter. As mentioned in the Introduction,
the best way to study and prepare for the examination is to read the guide
consciously and make sure you understand the topics by trying the exercises
included at the end of each chapter. However, the guide is not a substitute for
the careful study of the Essential reading listed throughout. For each topic in the
syllabus, it is advisable to start with the relevant chapter of the guide, then do
the recommended reading for that particular topic, then come back to the guide
and attempt the sample exercises at the end of each chapter. This way you will
be able to check your understanding of the topic by applying your knowledge to
solve specific problems.
To get a higher grade and a really thorough understanding of the subject, it
is important that you go beyond just the subject guide and Essential reading
by also actively consulting the Further reading. Although you are
not necessarily required to do all of the Further reading, reading widely and
selecting particularly relevant chapters of key textbooks will help you to
develop a deeper understanding of the subject, which typically translates into
a better mark in the examination.
20.2 Associated online material

In addition to this subject guide and the Essential and Further reading, it is
crucial that you take advantage of the study resources that are available for this
course online, in the virtual learning environment (VLE) and the Online Library.
You should use the Online Library and VLE regularly throughout your studies to
support the learning material included in this subject guide.
The VLE
This online tool is highly complementary to this guide and has been designed
to help you with your studies and enhance your learning experience by
providing additional support and a sense of community. The VLE contains
helpful ancillary material such as the course information sheet, reading lists,
exercises with suggested solutions, as well as past examination papers and
Examiners’ commentaries.
You should visit the VLE regularly to look for additional resources such as:
• Self-testing activities: these will help you to test your understanding
of the material in the subject guide.
• Discussion forum: this is an open space where you can discuss
interests and experiences, seek support from your peers, ask questions
about material in the guide and work collaboratively to solve problems
and discuss subject material.
• Recorded sessions: audio-visual tutorials and exercise work-throughs.
257
Notes
258
Appendix 1: Maths checkpoints
This appendix was written by Till Fellrath and first appeared as an

appendix to the subject guide in 2000.
This course does not require any advanced maths skills. You are, however,
expected to have a good working knowledge of some main concepts,
all of which were introduced in the first year Mathematics courses. It is
absolutely vital that you are completely familiar with these before you
start this course and if you encounter any mathematical problems you
should address them immediately. In particular, you are strongly advised
to check critically your understanding in the areas listed below.
1. Functions – a few general remarks

Functions indicate a relationship between two or more variables. They
are one of the central tools in applied economics and are used throughout
the subject guide. For instance, a demand function models the relation
between price and quantity within a particular market. It indicates the
demand for a particular good at any given price.
If q(p) = 100 – 4p, we can see that the market demand q at a price p = 10
will be q = 100 – (4 × 10) = 60. In this function, quantity is the explained
variable, with the price being the explaining variable. This function
answers the question: What is the market demand at a price p?
Inverse:
Any function can be expressed in its inverse form by changing the
explained and the explaining (endogenous) variable. Mathematically this
means solving the equation for the other variable. Formally the inverse of
a function f is indicated as f –1.
For the above demand function we get:
4p = 100 – q
p(q) = 25 – (¼)q.
We can see that for a market demand q = 60, the resulting market price
p = 25. (1/4 × 60) = 10. Of course the relation between the two variables is
still the same, but the logic is now reversed. This function now answers
the question: What is the price p that could be charged (i.e. by a company)
for a specific market demand q?
Very often it is necessary to find the inverse of the demand function
in order to calculate a company’s revenues. Similarly to calculate the
marginal revenue product function (refer to section 5 of this appendix)
the inverse of the Production function needs to be derived (subject guide
reference: Chapter 10, Section 10.3, Firm demand for inputs).
Variables and constants:

It is important to distinguish between variables and constants. For a cost
function C(q) = 100 + aq, the figure 100 indicates a level of fixed cost. It
is a constant and occurs regardless of the production level q. The letter ‘a’
represents a constant exogenous factor. Although we do not know how
large ‘a’ is, we cannot influence or choose its level. The letter ‘q’ denotes
the explaining variable. The company can choose its production level
q. Functions are sometimes written down as q(p), stating the explaining
variable(s) in brackets. Often, this is omitted. For any function, students
259
should check that they understand what the explaining and the explained
variable is, distinguishing them clearly from any constants.
General suggestions for studying and revising:

The following suggestions might be useful for students who are uncertain
about the idea of a function. They might facilitate a general understanding
and avoid confusions when attempting to solve sample questions.
• Translate the function in plain English. For example a demand function
q(p) = 100 – 4p could be read as follows: The market demand ‘q’ for a
particular good equals a constant factor 100 minus 4 times its market
price ‘p’.
• Distinguish between the explained variable, the explaining variable(s)
and constant factors. It might be a good idea to clearly write this
down, or to at least spot the explaining variables where this is not
stated explicitly.
• Check if you understand how this function works by substituting some
simple values for the explaining variable(s).
• Where a function includes some unknown constants, i.e. if q(p) =
100 – ap, simplify this function for study purposes by substituting the
constant for a particular value, i.e. a = 3, so that the function reads as
q(p) = 100 – 3p.
• Illustrate a function graphically if you are uncertain about its form.
2. Differentiation
Students are expected to be able to differentiate functions of several
variables. Typically this is done to find the maximum value a function can
reach and to identify the corresponding value for its explaining variable(s).
For example, a company’s profit function can be maximised to find the
profit optimising output quantity (see section 9). Below is a summary
of the main rules and the derivatives of some specific functions. Partial
derivatives are found by treating the other variables as a constant.
Main rules:
Constant factor y = a.f (x)y' = a.f '(x)
Example: y = 5x5
a = 5 and f(x) = x5
y' = 5x 5x4 = 25x4
Summation y = f(x) + g(x) y' = f '(x) + g'(x)

Example: y=x +x7 5
f(x) = x' and g(x) = x5
y' = 7x6 + 5x4
Products y = f(x) . g(x)

y' = f '(x) . g(x) + f(x) . g'(x)
Example: y = x2(x3 + 7x – 1) f(x) = x2 and g(x) = (x3 + 7x – 1)
y' = 2x(x3 + 7x – 1) + x2(3x2 + 7)
= 5x4 + 21x2 – 2x
260
Fractions y = f(x)/g(x)
y' = [ f '(x).g(x) – f(x).g' (x)] / [g(x)]2
Example: f(x) = x3 and g(x) = x2 – 7
y' = [3x2 (x2 – 7) – x3 (2x)]/[(x2 – 7)2]
= (x4 – 21x2)/(x2 – 7)2
Chain rule y = f(g(x)) y' = f ' (g(x)).g'(x)'

Example: y = (x – 7x )
2 3 21
f(u) = u21 and g(x) = x2 – 7x3

y' = 21(x2 – 7x3)20 (2x – 21x2)
Derivatives of some main functions

y = c (constant) y' = 0
y = xn y' = nxn–1
y = x½ [= √x] y' = ½x(–½) [= ½(1/√x) = 1/(2√x)]
y = ex y' = ex
y = ax y' = ln a.ax [e.g. y = 2x y' = ln 2.2x]
y = ln x y = 1/x
y = alog x y' = 1/(ln a) . 1/x
Formal notations:
Differentiations can be expressed in several ways, all meaning exactly the
same. For example, for a cost function C(q):
C'(q) Typically used for functions with one variable
∂C(q)/∂q Often used for partial differentiations of functions with
two variables
MC(q) MC = Marginal Cost, implies the differentiation of a total cost
function C(q)
Some applications in the subject guide:

Chapter 3, Game Theory, Example 3.7 (mixed strategy equilibrium)
Chapter 5, Auctions and bidding strategies (optimal bid V)
Chapter 8, Demand Theory (Slutsky equation)
Chapter 10, Production and input demands (Monopsony)
Chapter 14, Monopoly and monopolistic competition (Dorfman-Steiner model)
Chapters 15 and 16, Price discrimination and Monopolistic pricing practices (virtually in
every model)
Chapter 17, Oligopoly theory (all models)
The concept of differentiating a function is used very frequently
throughout the subject guide and the cited applications are just a few
examples. Students are expected to be at ease with this fundamental
concept of calculus (check previous examination papers for the level of
difficulty that is expected). Anyone who does not feel comfortable with
differentiation should revise the relevant material of their first year course
in Mathematics or check out any calculus book.
261
3. Logarithmic functions/properties of In and exp.

log uv = log u + log v Example: ln(2x) = ln 2 + ln x
log u/v = log u – log v Example: ln(2/x)= ln(2) – ln(x)
log un = n. log u Example: log 2x = x. log 2
log ul/n = (1/n).log u Example: log x1/2 = (1/2). log x
(remember that √x = x1/2)
Although these rules are not central to the understanding of the unit,
it might be necessary to apply these rules in order to simplify given
functions, for instance in order to differentiate a logarithmic function, or
to solve a system of equations.
Some applications in the subject guide

Chapter 2, Decision analysis, Section 2.8, exercise 6 (risk attitude)
Chapter 6, Asymmetric information I (utility curves)
Chapter 9, Other topics in consumer theory (utility curves)
4. Integration
To calculate the area under a function, which can for instance represent
consumer surplus, students need to understand integration as the
‘opposite’ of differentiation. Integration is used to calculate the area below
a function, for instance, to find the consumer surplus. In general, integrals
between the borders a and b can be calculated as follows:
b
∫
a
f(x) dx = F(b) – F(a)
for any integral function.
Example:
Demand is given by a function D: q (p) = 100 – 2p. The consumer surplus
equals the area between the price and the demand curve. For price 40,
consumer surplus is represented by the area below the demand curve and
above p = 40. At the price of 40, the market demands a quantity q = 20.
50
∫ (100 – 2p) dp = [100p – p ]

40
2 50
40
= (100 × 50 – 502) – (100 × 400 – 402)

= 2500 – 2400
= 100
What is the gain in consumer surplus if the price p drops from 40 to 30?
The new consumer surplus at p = 30, where quantity demanded equals
q = 40, can be calculated as
50
∫ (100 – 2p) dp = [100p – p ]

30
2 50
30
= (100 × 50 – 502) – (100 × 30 – 302)

= 2500 – 2100
= 400
262
Thus, the gain in consumer surplus equals the difference between

400 – 100 = 300. Alternatively it can directly be calculated as:
40
∫ (100 – 2p) dp = [100p – p ]

30
2 40
30
= (100 × 40 – 402) – (100 × 30 – 302)

= 2500 – 2100
= 300
For linear functions, it might be easier to use simple geometry to calculate
the integral. For example, the consumer surplus at price p = 30 could be
calculated as the triangle under the demand function and above the price.
At the ‘y’-axis we get the length of (50–30). At the ‘x’-axis the demanded
quantities at the two prices equal q = 0 for p = 50 and q = 40 for p = 30, thus
we get the length (40 – 0). The area of this triangle can now be calculated
as (50 – 30) × (40 – 0) × ½ = 400.
Example:
If a firm’s marginal cost function is given as MC (q) = 10, it is clear that
marginal cost (or the incremental production cost for the next unit)
is a constant 10 for any given production unit. Thus, total cost can be
calculated as the product of 10 times the level of production, or 10q, plus
any fixed cost F which occurs regardless of the level of production. The
total cost function equals C (q) = 10q + F, which is the integrated marginal
cost function or ∫MC. And marginal cost is the differentiated total cost
function. (See for instance Chapter 17, Oligopoly theory).
Similarly, if MC (q) = 10 + 4q + 6q2, then ∫MC =∫(10 + 4q + 6q2) dq = C(q) =
10q + 2q2 + 2q3 + F

Chapter 5, Auctions and bidding strategies (variance of winning bids)
Chapter 8, Demand theory (consumer surplus)
5. Systems of equations/manipulating equations

To find a maximum of a function with two variables, partially differentiate
with respect to each variable and set the results equal to zero. These two
optimality conditions have to be satisfied at the same time. Thus, they
represent a system of two equations with two variables. The values for
each variable can be found for example by substituting one equation
into the other. Students are expected to be comfortable with algebraic
manipulation of equations.

Chapter 2, Decision analysis, Section 2.8, exercise 6 (utility curves)
Chapter 11, Cost concepts (division of output among plants)
Chapter 15, Price discrimination (price discrimination)
Chapter 18, Cartels and (implicit) collusion (collusion)
263
6. Uniform distribution
The concept of uniform distribution is used in Chapter 5, Auctions and
bidding strategies. It describes the way in which a sample of data is
distributed within a certain interval.
Example:
What are the expected valuations of bidders in an auction, if we know the
number of bidders as well as the interval from which their valuations are
drawn?
If the valuation of n bidders is uniformly distributed on [0,1] we can make
the following predictions:
n = 1, expected valuation: ½ (middle of the interval)
n = 2, expected minimum and maximum valuations: 1/3 and 2/3
n = 3, expected minimum, middle and maximum valuations: ¼, ½ and ¾
Thus, when n > I the expectation of the valuation of the highest bidder can
be calculated as (n)/(n + 1), of the second highest as (n – 1)/(n + l), and so
on.
If the distribution is not normalised, for instance for an interval [0, 5]
the expected valuations of 4 bidders would be at equal distances on the
interval [0....v1....v2.... v3….v4….5], or 1, 2, 3, and 4 respectively. The highest
valuation can be calculated as
(n)/(n + 1) × 5 = (4)/(4 + 1) × 5 = 4
For uniformly distributed valuations between [10, 15], the expected
valuations of 4 bidders are expected to be at equal distances on the
interval
[10.... v1….v2.... v3.... v4.... 15] or 11, 12, 13, 14 respectively.
Thus, the expected highest valuation can be calculated as
10 + (n)/(n + l) × 5 = 14
In general for n bidders with uniformly distributed preferences on [L,U]
the expected highest valuation equals
L + (n)/(n + 1) . (U – L)

Chapter 5, Auctions and bidding strategies (auction revenue)
Chapter 5, Auctions and bidding strategies, sample exercises 1, 5, and 6.
7. Probabilities
Probabilities are often denoted by the variable ‘p’ which represents a
number between 0 and 1. If a decision maker faces two (or more) possible
scenarios, which he cannot influence, assumptions could be made about
the likelihood of each outcome. The probabilities of all outcomes must add
up to 1 (representing 100%). Suppose one in ten bikes gets stolen each
year. Outcome 1, bike gets stolen, occurs with probability p = 0.1 (equal
to 10%) and outcome 2, bike does not get stolen, occurs with probability
(1 – p) or (1 – 0.1) = 0.9 (equal to 90%).
264

Chapter 2, Decision analysis, Example 2.1 and 2.2 (decision tree)
Chapter 3, Game theory, Example 3.7 (mixed strategy equilibrium)
Chapter 6, Asymmetric information I, Example 6.4 (demand for insurance)
Chapter 9, Other topics in consumer theory (state-contingent commodities model)
Chapter 12, Topics in labour economics, Section 12.2 (efficiency wage model)
To understand Chapter 5, Auctions and bidding startegies, students need

to be able to perform basic probability calculations, which go back to the
concept of the uniform distribution.
Example:
One bidder wants to buy a rare painting which he values at $400,000.
He does not know what the value is to the owner, but he knows that it is
uniformly distributed between $100,000 and $500,000. The bidder can
only make one offer, which the owner can either accept or reject. What is
the optimal offer that the bidder should make?
The owner’s valuation is said to be uniformly distributed, meaning that
any point in the interval [U, L] = [100,000; 500,000] is equally likely to be
the valuation. The painting will only be sold if the submitted bid exceeds
the owner’s valuation, otherwise the owner would consider the bid to be
too low. If the bidder offers $500,000 he would definitely win the auction,
but his ‘gain’ would be a negative $100,000 as the bid would be above
his own valuation. Thus, the bidder faces a basic trade-off between the
potential gain and the likelihood of the painting being sold. He can lower
his bid, but at the same time the probability of his bid being larger than
the owner’s valuation decreases and he becomes less likely to win the
auction. The bidder’s expected gain can be calculated as the gain from
buying the painting multiplied with the probability of winning.
(v – b) . P(win)
(v – b). [(b – L) /(U – L)]
(400,000 – b) . [(b –100,000) / (500,000 – 100,000)]
To understand the transformation of the owner’s distribution to the
probability values, consider a few examples:
Probability of
Bid Gain Expected gain
winning
500,000 -100,000 1 -100,000
400,000 0 0.75 0
300,000 100,000 0.5 50,000
200,000 200,000 0.25 50,000
100,000 300,000 0 0
By interpreting the above equation as a function of the variable b, we can
calculate the optimal bid by differentiating the function with respect to b.
Expected gain (b) = (400,000 – b) . [(b – 100,000) / 400,000]
∂Expected gain / ∂b = –1[(b – 100,000)/400,000] + (400,000 – b).(1/400,000)
(product rule!)
Set equal to 0 and solve for b to find optimal bid
– 1/400,000. b +1/4 + 1 – (1/400,000 . b) = 0
5/4 = (1/200,000) . b
265
b = 250,000
For the optimal bid of 250,000 the expected gain equals 56,250.
8. The discount factor ‘δ’

The discount factor δ represents the value of money over time. As used
in this subject guide δ equals any number between 0 and 1. Given the
alternative between either accepting $100 now, or waiting for the same
amount for another year, an individual would most likely take the money
now. But the same individual might accept $125 in the following year,
rather than $100 now. If this individual would be exactly indifferent
between $100 now, or $125 one year later, we can calculate his personal
discount factor δ as 100/125 = 0.8. In other words, money loses its value
by 20% each year. To be compensated for the wait, this consumer would
want to receive $125 which equals in ‘today’s money’ $125 x 0.8 = $100.
Thus, a large discount factor close to 1 represents a rather small discount
and money retains a high proportion of its value in subsequent periods.
Similarly, a small discount factor close to 0 indicates a very large discount
in that money loses its value very rapidly.
It is possible to calculate the present value of future payoffs. Suppose that
the individual receives $100 every year for a very large number of years.
How much would this be worth in today’s money? If one does not account
for the value of money over time, the answer would simply be $100
multiplied by the number of years. But if one includes a discount factor in
the analysis, e.g. δ = 0.8, the result changes as follows:
Discounted Value Sum of discounted

Year Face Value $
δ=0.8 values
1 100 100 100
2 100 100δ = 80 180
3 100 100δ2 = 64 244
4 100 100δ = 51.2
3
295.2
5 100 100δ4 = 40.96 336.16
6 100 100δ = 32.768
5
368.928
Converges to 100 x 1/
∞ 100 100δ∞ = 0
(1 – δ) = 500
In general: 1 + d + d2 + d3 + ... = 1/(1 – d) (to aggregate all periods including
period one)
d + d2 + d3 + ... = d (1 + d + d2 + d3 +...) = d/(1 – d) (to aggregate from period
two onwards)
The discount factor can be interpreted in several ways, such as the rate of
inflation, the interest rate for outside investment, or simply the patience of
an individual.

Chapter 4, Bargaining, Exercise 1, Section 4.7 (alternating offers bargaining)
Chapter 16, Other monopolistic pricing practices, Section 16.2 (skimming)
Chapter 18, Cartels and (implicit) collusion, Section 18.3.1 and Section 18.6, Exercise 1.
266
9. The company’s profit function

Chapters 10–16 in the subject guide consider a company’s decision
problems from various angles. The basic assumption is that a company
wants to maximise profits. On the one hand the company receives
revenues for the products it sells in the market. On the other hand it faces
costs which typically increase if the level of production is increased. The
company’s profits can therefore be expressed by a profit function as the
difference between revenues (typically as a function of the production
level q) and costs (typically also as a function of production level q). Thus
profits depend on the production level:
П(q) = Revenues(q) – Costs(q)
If revenues exceed costs, the company makes a profit. Should cost be
larger than the revenues, the company makes a loss.
In order to find the optimal production level, we need to find the
function’s maximum value. Thus, we can differentiate this function with
respect to q.
∂П/∂q = ∂Revenues/∂q – ∂Costs/∂q
set this derivative equal to zero
∂Revenues/∂q – ∂Costs/∂q = 0
or Marginal Revenue (q) = Marginal Cost (q)
or MR= MC
and solve for the profit optimising value of the variable q. Any problem
can thus either be solved by differentiating a (total) profit function or by
directly applying one of the commonly known optimality conditions, such
as Marginal Revenue = Marginal Cost. It is important, however, never to
confuse the two levels of analysis, i.e. total or marginal (differentiated)
values.
Example:
If demand function is given as D: q = 100 – 4p
Marginal cost = 12q
(i) starting with the firm’s profit function П(q) = Revenue(q) – costs(q)
Revenues: Total Revenues TR (q) = price x number of units sold, or p.q, or
(25–1/4q) .q or 25q – ¼q2
Costs: Marginal Cost MC = 12q (given), Total Cost C(q) = ∫MC = 6p2 + F
П(q) = Revenues (q) – Costs (q)
П(q) = 25q – ¼q2 (6q2+F)
П(q) = 25q – 6.25q2 – F
∂П/∂q = 0
25 – 12.5q = 0
q=2
Thus, the firm should produce 2 units, which gives it a maximum profit of
П(q) = 25q – 6.25q2 – F
П(2) = (25 × 2) – 6.25(2)2 – F
П = 50 – 25 – F
П = 25 – F
267
The market price can be found by substituting q back into the (inverse)
demand function
p = 25 – (¼)q
p = 25 – (¼ × 2)
p = 24.5
(ii) applying the optimality condition ‘MR = MC’
MR: Derive Marginal Revenue from the Demand function
- Find the inverse demand curve as p = 25 – (¼)q
- Total Revenue (TR) = price x number of units sold, or p.q, or (25 – (¼)q) . q or
25q – (¼)q2
- Marginal Revenue (MR) = ∂TR/∂q (25–q (¼)q2) = 25 – (½)q
MC: Given as 12q
MR = MC
25 – (½)q = 12q
q=2
General suggestions for studying and revising

• Check the models in Chapters 10–16 and study the way in which they
modify this basic example.
• Check whether you are able to understand both the profit function and
the optimality condition for each model.
• Be absolutely certain what variable(s) you are solving for in each
model, for example input ‘L’ or outputs ‘q1’ and ‘q2’.
• Check whether an inverse function needs to be found, typically for
marginal revenue or marginal revenue product curves.
• Check whether you understand all of the curves listed below and how
they relate to one another.
Overview and definitions of some important functions

П Profits The difference of TR and TC.
TC Total Cost Includes all Cost Factors.
MC Marginal Cost Incremental cost of one additional unit

differentiation of TC.
AC Average Cost Average total cost to produce one unit, TC
divided by output, MC intersects AC at its
minimum.
FC Fixed Cost Independent of level of production,

constant factor of TC.
VC Variable Cost Increases with output, variable fraction of
TC.
AVC Average Variable Average variable cost per unit, VC divided
Cost by output.
TE Total Expenditure Cost of one particular input factor, e.g.
labour.
268
ME Marginal Incremental expenditure if one additional

Expenditure input unit (e.g. one worker) is demanded,
differentiation of TE, increasing for
monopsonist, constant (e.g. wage) for
competitive input market.
TR Total Revenue Number of units sold multiplied by the

price.
MR Marginal Revenue Incremental revenue if one additional unit

is sold, differentiation of TR with respect
to quantity, decreasing for monopolist,
constant (price) for competitive firm.
MP Marginal Differentiation of production function

Productivity with respect to input, typically decreasing,
e.g. productivity of labour.
MRP Marginal Revenue MR x MP, could be constant, typically

Product decreasing, used to solve input problems
such as monopsony model.
10. A few hints on solving questions

Very often students find it difficult to understand sample questions and to
relate them to the existing theory. The following example gives a few ideas
on how a question can be attempted in a structured manner. Secondly, it
shows that very often there is more than one way to arrive at the correct
solution. As long as the reasoning and the results are correct, students are
free to choose any alternative that suits them best.
Example
Tom, Dick and Harry manage a company which markets balloons. The balloon market is
perfectly competitive and the price of balloons is $5 per unit. The amount of capital is
fixed and the investment in capital can be considered a sunk cost. The cost of material
inputs is negligible but labour is expensive. Tom has asked Dick to gather some data on
the productivity of labour. Dick presents him with the figures in the middle of the table
below. Meanwhile Tom has asked Harry to get some information about labour costs.
Harry told him that these costs would depend on how many workers were employed, as
indicated in the table below on the right. Tom now has to decide how many workers to
hire. What should he do and what will the wage rate be?
Number of Total number of Wage
workers balloons per hour rate
0 0 10
1 10 11
2 15 12
3 19 15
4 21 17
5 22 20
6 20 25
Step 1
Read the question carefully!
Step 2
Write down the most important information.
269
•• Company wants to maximise profits.

•• Output market for balloons: Perfect Competition, p=5 per unit.
•• Input market for balloons: number of workers drives the wage rate up, thus the
company is a monopsonist (it is the only buyer of labour).
•• Cost other than labour can be neglected.
Step 3
Relate it to the studied material.
•• Company is a Monopsonist facing perfect competition in its output market.
•• Chapter 10, Production and input demands, Sections 10.3 and 10.4.
Step 4
Solve the question
•• Plan ahead and be certain about what you are looking for. Here we need to find the
optimal number of workers, variable ‘L’ (explicitly asked in the question)!
•• Remind yourself of the analytical steps required to solve the question.
Solution Alternative 1:
Solve in Total Values, finding maximum profit
L Total Revenue (p.q) Total Expenditure (L.w) Profits II
p q Rev. L w Exp. (Rev – Exp.)
0 5 0 0 0 10 0 0
1 5 10 50 1 11 11 39
2 5 15 75 2 12 24 51
3 5 19 95 3 15 45 50
4 5 21 105 4 17 68 37
5 5 22 110 5 20 100 10
6 5 20 100 6 25 150 –50
Answer: Hiring two workers and paying them a wage of 12 gives the maximum profit
of 51.
270
Solve in Marginal Values, applying MRP = ME rule (company should continue to expand
the workforce as long as the additional worker’s revenue contribution is larger than the
incremental expenditure).
Marginal Revenue Product Marginal Expenditure

L
(Marginal Revenue x Marginal Productivity) (additional expenditure)
Total Marginal Total Additional Profit

MR MRP ME
Productivity Productivity Expenditure (MRP-ME)
0 5 0 0 0 0 0 0
1 5 10 10–0 = 10 5x10=50 11 11–0=11 50–11= 39
2 5 15 15–10 = 5 5x5=25 24 24–11=13 25–13= 12
3 5 19 19–15 = 4 5x4=20 45 45–24=21 20–21= –1
4 5 21 21–19 = 2 5x2=10 68 68–45=23 10–23= –13
5 5 22 22–21 = 1 5–32= –27
6 5 20 20–22 = -2 5x(–2)= –10 –10–50= –60
Answer: Workers are hired as long as MRP is larger than ME. Thus, two workers should
be hired at wage 12. (If the third worker would be hired, MRP would be very close to ME.
But since ME exceeds MRP by exactly 1, total profits would be driven down by 1 if the
company hires worker number 3.)
It is also possible to derive the actual functions from the data in the table and to proceed
analytically. Clearly this would be more complicated than the two ways suggested
above. If a table lists a limited number of possibilities, it is usually quicker to check each
alternative to find the optimal solution.
271
Notes
272
Notes
Notes
273
Notes
274

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Managerial economics

D.J. Reyniers and M. Selvaggi

University of London International Programmes

Published by: University of London

5.8 Overview of the chapter.......................................................................................... 71

11.6 Overview of the chapter...................................................................................... 149

Chapter 18: Cartels and (implicit) collusion........................................................ 237

1.1 Road map to the guide

1.2 Introduction to the subject area

economist. The emphasis throughout is on the application of knowledge

1.4 Aims of the course

1.5 Learning outcomes for the course

1.6 Overview of learning resources

1.6.2 Mathematics for managerial economics

1.6.3 Essential reading

1.6.4 Further reading

Besanko, D., D. Dranove, M. Shanley and S. Schaefer Economics of strategy.

1.6.5 Online study resources

• Audiovisual tutorials and solutions: For some of the first year

Making use of the Online Library

1.7 Examination advice

1.7.1 Some advice and ideas on how to study

Chapter 2: Decision analysis

attached to other decision-makers’ actions, optimal decisions can be

2.1.1 Aims of the chapter

2.1.2 Learning outcomes

2.1.3 Essential reading

2.1.4 Further reading

2.1.5 Synopsis of chapter content

2.2 Decision trees

Cussoft Ltd., a firm which supplies customised software, must decide

In this very simple example, Cussoft has a choice of two decisions – to

Figure 2.1: Decision tree for Example 2.1

You should get the following result.

don’t drill -120 don’t drill

Figure 2.2: Decision tree for Example 2.2

2.3 Attitude towards risk

2.3.1 Expected utility

Figure 2.3: Determining utility

When the decision-maker is indifferent, say for p = 0.4, we have:

risk averse neutral risk loving

Figure 2.4: Attitudes towards risk

Figure 2.5: Concave utility function and risk aversion

Figure 2.6: Risk loving and risk averse behaviour

2.3.2 Measures of risk aversion

W–L W–R W–pL W

Figure 2.7: Insurance

Jamie studies at Cambridge University and uses a bicycle to get around. He

If he takes out insurance he obtains utility U(400 – R) where R is the

(0.1)√200 + (0.9) √400 = √400 – R

2.4.2 The demand for financial assets

2.4.3 Insurance in financial markets

2.5 The expected value of perfect information

such information?’ In this section, we study a procedure which gives an upper

The notion of perfect information in Example 2.2 translates into the

oil at 3000 ft 600 don’t 0

Figure 2.8: Calculating EVPI

If the decision-maker is not risk neutral, a similar method to the one we

Figure 2.9: EU maximiser chooses safe strategy

Figure 2.10: Optimal choice under perfect information

2.6 Overview of the chapter

2.7 Reminder of learning outcomes

2.8 Test your knowledge and understanding