CHAPTER ONE

MONOPOLISTIC COMPETITION

Perfect competition and pure monopoly are useful tools of analysis; but neither of the
two depicts the common phenomena of the real world. These real world phenomena are
best analyzed using the market structures that fall between the two extremes –
monopolistic competition and oligopoly.
As the name implies, monopolistic competition is a blend of competition and monopoly.
The competitive element arises because there are many sellers, each of which is too
small to affect the other sellers. Firms can also enter and leave a monopolistically
competitive industry. The monopolistic element arises from product differentiation.
That is, since the product of each seller is similar but not identical, each seller has a
monopoly power over the specific product it sells. This monopoly power, however, is
severely limited by the existence of close substitutes.

1.1 Product Differentiation, the Demand Curve and Costs of the Firm

In response to the rising concern in the 1920s and 1930s that models of perfect
competition and pure monopoly were too extreme to serve as analytical models of
business firms and market behavior, Edward Chamberlin (1933) and Joan Robinson
(1933) contributed the pioneering works on monopolistic competition. [We adopt the
theory of Chambrelin here].
Product differentiation may be attributed to:
-subjective judgment of the consumer,
-quality (durability) of the product,
-characteristics (taste, color, ---) of the product,
-sales promotion, packaging, trademarks, etc.
Product differentiation is generally intended to distinguish the product of one producer
from that of the others in the ‘industryʼ. It can be real or fancied.
Real differentiation – exists when there are differences in the specification of the
products or differences in the factor inputs, or the location of the firm that determines
the convenience with which the product is accessible to the consumer, or the services
offered by the producer.
Fancied (spurious / imaginary) differentiation – exists when the products are basically
the same but the consumer is persuaded, via advertising or other selling activities, that
the products are different. It is established by advertising, difference in packaging,
difference in design, or simply by brand name.
Whatever the case, the aim of product differentiation is to make the product unique in
the mind of the consumer. The effect of product differentiation is that the producer has
some power in the determination of price. The firm is not a price-taker but faces the
keen competition of close substitutes offered by other firms. Hence, product
differentiation gives rise to a negatively sloping demand curve. This demand curve is
less than perfectly elastic.
Chamberlin adopted the shape of costs of the traditional theory of the firm. The AVC,

Micro economics II 1
MC and ATC curves are all U-shaped implying that there is only a single level of output
which can be optimally produced. He introduced the selling costs in the theory of the
firm for the first time. The recognition of product differentiation provides the rationale
for the selling expenses incurred by the firm. He also argued that the selling-costs
curve is U-shaped, i.e., there are economies and diseconomies of scale of advertising
as output changes. The U-shaped selling cost, added to the U-shaped production
costs, yields a U-shaped ATC curve.

1.2 The Concept of Industry and Product Group

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

Heterogeneous products cannot be added to form the market demand and supply
schedules as in the case of homogeneous products. Further, we do not have a single
equilibrium price for the differentiated products, but a cluster of prices.
Under perfect competition, industry was defined as a collection of firms producing
identical (homogeneous) products. But when products are differentiated one cannot
define an industry in this narrow sense. Each firm having a distinct product is, in a
sense, an industry in itself, exactly as a monopolist is. Nonetheless, we can usefully
lump together firms producing very closely related commodities and refer to them as a
‘product groupʼ.

1.3 . Equilibrium of the Firm

The choice - related variables for a monopolistically competitive firm are product
variation, selling expenses and prices. In this section, we examine how a
monopolistically competitive firm determines its best level of output and price in the
short run and long run on the assumption that the firm has already decided on the
characteristics of the product to produce and on the selling expenses to incur.
As for firms under any type of market structure, the best level of output for a
monopolistically competitive firm in the short run is where MR = MC, provided that
price exceeds the AVC.

Micro economics II 2
 $
$ Profit MC AC
MC AC

MR MR d

(a) Excess Profit Q (b) Normal Profit Q

$
MC AC
Loss

MR d
Q
(c) Production at Loss

In the long run, however, the monopolistically competitive firm breaks even. In other
words, production at positive profit or production at loss is unrealistic and doesnʼt exist
because of free entry and exit into and out of the product group. This long run
equilibrium is achieved through price adjustments of the existing firms and by new
firms entering the product group. (Refer Koutsoyiannis: 208-209).

1.4 Excess Capacity and Welfare Loss

The long run equilibrium of the firm is defined by the point of tangency of the demand
curve to the LAC curve. At this point MR = MC and AC = P, but P > MC. As a result
price will be higher and output will be lower as compared with the perfectly competitive
model. There are too many firms in the industry, each producing an output less than
optimal (at the falling part of the LAC) in a monopolistically competitive market. The
difference between the level of output indicated by the lowest point on the LAC curve
and the monopolistic competitorʼs output when in long run equilibrium measures
excess capacity. Excess capacity is the difference between the ideal output
corresponding to the minimum LAC and the output actually attained in the long run
equilibrium.

Micro economics II 3
$

LAC

QA QI Q

Measure of Excess Capacity

According to Chamberlin, however, long run equilibrium under monopolistic

competition does not give rise to excess capacity so long as the market is
characterized by active price competition. In his view, excess capacity arises when free
entry is coupled with the absence of price competition. Under the conditions of free
entry and active price competition, Chamberlin argues that, the equilibrium output will
be close to the minimum cost output, because firms will be competing along their
individual demand curves that are very elastic. Consumers desire variety of products
(product differentiation reflects the desires of consumers who are willing to pay the
higher price in order to have choice among differentiated products). The higher cost,
resulting from producing to the left of the minimum LAC, is thus socially acceptable.
Consequently the difference between actual output QA and minimum cost output QI is
not a measure of excess capacity but rather a measure of the ‘social costʼ of
“ differentness” which is considered a quality of the product. Chamberlin takes QA (in
figure above) as the potential or ideal level of output and any deviation from it as a
measure of excess capacity, which results from absence of price competition. If firms
avoid price competition and instead enter into non-price competition, there will be
excess capacity (restriction of output) and higher prices in each firm and for the
industry. In this event the firm ignores its planned sales curve (dd in the figure below)
and concern itself only with its market share (share - of - the- market curve or actual -
sales curve). In other words, DD becomes the relevant demand curve.

Micro economics II 4
 D
$ Dʼ

LAC

Dʼ D d

Qa QA QI Q

Chamberlinʼs Measure of Excess Capacity

The long run equilibrium (in this case) is reached only after free entry has shifted the
DD curve to a position of tangency with the LAC curve.
In general, the social welfare aspects of monopolistic competition are ambiguous.
Each firm produces less than the socially optimal output (as compared to prefect
competition) and charges P > MC. On the other hand, if each firm were some how
forced to produce this level of output at marginal cost price, private enterprise would
no longer represent a viable economic system because this requires production at loss
which is impossible in the long run. Elimination of private sector by itself represents
loss of social welfare. Thus, the social welfare impacts of the existence of monopolistic
competition are inconclusive.

Micro economics II 5
 CHAPTER TWO

OLIGOPOLY

Oligopoly is the form of market structure in which there are a few sellers of a
homogeneous or differentiated product. The distinguishing characteristic of oligopoly
is the interdependence or rivalness among firms in the industry. There is no widely
accepted theory on oligopoly. This is because:
- Oligopoly involves uncertainty,
- The products may be homogeneous or heterogeneous, and
- Various ways of reaction among competitors exist.
Thus, there are different oligopoly models, each of which is applicable to some specific
situations.
The sources of oligopoly are generally the same as for monopoly but weaker in the
case of oligopoly. In addition, incumbent (existing) firms may take strategic actions to
deter (protect) entry.
The limiting case of oligopoly is duopoly – the market in which two firms compete with
each other.
Firms in oligopolistic market structure may behave independently even though they are
interdependent in the market (non-collusive oligopoly) or may enter into agreements
regarding their decision(s) (collusive oligopoly).

2.1 Non-Collusive Oligopoly

For analytical convenience, we usually assume that the products within

the oligopoly market are identical and there are two firms – duopoly in
most of the forthcoming discussions.

I.COURNOTʼS DUOPOLY MODEL

Cournotʼs model is the earliest duopoly model (developed in 1838). The original
version of the model makes “heroic” assumptions that the duopolists have identical
products and identical costs. He also assumed that the marginal (additional) cost is
zero for both firms and these firms fully know their linear demand curve, and each firm
acts on the assumption that the competitor will not change its output, and decides its
own output to maximize profit.
Assume that firm A is the first to start producing and selling mineral water. It will produce
quantity A and sells at price P1.

Micro economics II 6
P
D

P1 C

P2

Dʼ Q

O A B

MR

Now, firm B assumes that A will keep its output fixed at OA and hence considers that
its own demand curve is CDʼ. It produces AB (=1/2ADʼ) and charges price P2 in order to
maximize profit. Firm A, faced with this situation, assumes that, B will retain its quantity
constant in the next period. Therefore, A will produce ½ of the market that is not
supplied by B [=1/2(1-1/4) ODʼ]. B (again) reacts and will produce ½ of the unsupplied
market [(=1/2(1-3/8) ODʼ]. This action-reaction pattern continues until equilibrium is
reached. At equilibrium, each firm produces one-third (1/3) of the total market.

Firm A Firm B
½ ½ (1-1/2) = ¼

½(1- ¼) = ½ - 1/8 = 3/8 1//2(1-3/8) =1/4+1/16 = 5/16

½(1-5/16) = ½ - 1/8 – 1/32 = 11/32 ½(1-11/32) = 1/4+1/16+1/64 = 21/64

. .
. .
. .

Product of firm A in equilibrium = ½ -1/8-1/32-1/128 - … = ½ - (1/8+1/32+1/128) [This

1 /8
is a geometric progression with ratio r = ¼] and, thus = ½ - [ ] = 1/3.
1 1 / 4
1/4
Product of firm B in equilibrium = ¼+1/16+1/64+1/256+… = [ ] = 1/3.
1 1 / 4
Let us now relax the assumption of zero marginal cost and see the equilibrium of a
duopoly market (Cournotʼs equilibrium) based on the reaction-curves approach.
Reaction curve is a curve that shows the relationship between a firmʼs profit
maximizing output and the amount it thinks its competitor will produce. For instance, if
we have two firms (A&B), firm Aʼs reaction function (curve) shows how much output A
must produce in order to maximize its own profit for every specific level of output of its

Micro economics II 7
rival (B). Consider the following example.
Find the Cournotʼs equilibrium if the market demand and the costs of the duopolists
are:
P =100 – 0.5X where X = X1+X2
C1 = 5 X1
C2 = 0.5 X22
Firm 1ʼs profit is given by П1 = P X1 – TC1
= [100 – 0.5 (X1+X2)] X1 - 5 X1

= 100 X1 - 0.5 X12 – 0.5 X1X2 - 5 X1

= 95 X1 - 0.5 X12– 0.5 X1X2
Firm 2ʼs profit is given by П2 = P X2 – TC2
= [100 – 0.5 (X1+X2)] X2 - 0.5 X22
= 100 X2 - 0.5 X1X2 - 0.5 X22 - 0.5 X22
= 100 X2 - 0.5 X1X2 - X22
Each firm maximizes its own profit (which depends on the output of the other firm as
well).
 1  2
Profit maximization → = 0 and =0
X 1 X 2
 1
= 95 - X1 – 0.5X2 = 0 95– 0.5X2 = X1………….firm 1ʼs reaction function [eq.1].
 
XX1 1

 2
= 100 - 2 X2 – 0.5X1 = 0  X2 = 50 - 0.25X1… firm 2ʼs reaction function [eq.2].
X 2
 X2
Solve equations 1&2 simultaneously to find equilibrium quantities of the two firms.
X1 = 95– 0.5X2
X2 = 50 – 0.25X1

 X1 = 95– 0.5(50 – 0.25X1)

X1 = 95– 25 + 0.125X1
X1– 0.125X1 = 70
0.875 X1 = 70
X1 = 80
And X2 = 50 – 0.25X1 = 50 – 0.25(80) = 50 –20 = 30

The total output in the market is X = X1+X2 = 80+30 = 110.  The market (equilibrium)
price is P =100 – 0.5X = 100 – 0.5(110) = 45. (Check the second order conditions by
yourselves!). Find the profit of each firm.

Critiques of the Cournot Model

1. It is assumed that firms do not learn from past miscalculations of competitorsʼ

reactions.
2. It is a closed model in the sense that entry is blocked. The number of firms assumed
in the first period remains the same throughout the adjustment process.

Micro economics II 8
3. Even if it does not impair the validity of the model, the assumption of zero production
costs is unrealistic.
4. Other variables of competition are not included in the model.

II. THE ‘KINKED - DEMANDʼ MODEL

Paul Sweezy introduced this model in 1939. It attempts to explain the price rigidity that
is often observed in some oligopolistic markets. Sweezy postulated that if an
oligopolist raised its price, it would lose most of its customers because the other firms
in the industry
would not match the price increase. On the other hand, an oligopolist could not
increase its share of the market by lowering its price, since its competitors would
immediately match the price reduction. As a result, oligopolists face a demand curve
that is highly elastic for price increases and less elastic for price reductions. That is the
demand curve faced by oligopolists has a kink at the established price; and, because
of this, oligopolists tend to keep prices constant even in the face of changed costs and
demand conditions (hence, interdependence is recognized).

P
A

H MC2
P* B MC1

O Q* G C Q
The demand curve facing the oligopolist is HBC and has a kink at the prevailing price
P* and quantity Q*. It is more elastic above the kink than below it. The oligopolistʼs MR
curve is HJFG (HJ corresponding to the demand curve above the kink – HB, and FG
corresponding to the part of the demand curve below the kink – BC). It is discontinuous
between J&F. This implies that the oligopolistʼs output and price remain unchanged
even in the face of changing costs (movement of the MC between points J&F, say,
from MC1 to MC2). There is only one case in which a rise in cost will most certainly
induce the firm to increase its price when costs rise, despite the fact that the higher
costs pass through the discontinuity of the marginal revenue curve. This occurs when
the rise in costs is general (for example, imposition of a sales tax) and affects all firms
equally. Under these circumstances the firm will increase its price with the certainty
that the others in the industry will follow, since there costs are similarly affected.
The major weakness of this model is that it cannot explain at what price the kink occurs
and how prices are determined.

Micro economics II 9
III. BERTRANDʼS DUOPOLY MODEL

Bertrandʼs duopoly model (which was developed in 1883) differs from Cournotʼs in
that it assumes that each firm expects that the rival will keep its price constant,
irrespective of its own decision about pricing. Each firm is faced by the same market
demand, and aims at the maximization of its own profit on the assumption that the
price of the competitor will remain constant. Like the Cournotʼs model, it applies to
firms that produce the same (homogeneous) good and make their decisions at the
same time. In this case, however, the firms choose prices instead of quantities.
Because the good is homogeneous, consumers purchase only from the lowest-price
seller. Thus, if the two firms charge different prices, the lower-price firm will supply the
entire market and the higher-price firm will sell nothing. If both firms charge the same
price, consumers will be indifferent as to which firm they buy from. And, it is assumed
that each firm will supply half the market.
Consider the following example where the market demand for a good is P = 30 – Q
where Q = Q1+Q2, and both firms have a marginal cost of 3 (MC1 = MC2 = 3).
As long as price is above the MC, there will be an incentive to reduce price and thus,
the equilibrium will be the competitive outcome – where price equals marginal cost.
* Equilibrium price P* = MC = 3.
*Equilibrium quantity Q* is obtained by substitutiting P = 3 into the
market demand: P = 30 – Q  3 = 30 – Q  Q* = 27.
* Each firm supplies 27/2 = 13.5 units (Q1 = Q2 = 13.5).
Bertrandʼs model is criticized on the same grounds as that of Cournot (critics 1,2 and 4
under Critiques of the Cournot Model) and on its assumption of the equal market share
of total sales by the firms. It is more natural to compete by setting quantities rather than
prices when firms produce a homogenized good.
Price competition is more natural when products have some degree of differentiation
than when products are identical. To illustrate this, suppose each of the two duopolists
has fixed costs of 10 and,
*Q1 = 12-2P1+P2 (firm 1ʼs demand function)
*Q2 = 12-2P2+P1 (firm 2ʼs demand function)
* MC1 = MC2 = 3
The equilibrium of the two firms setting their prices at the same time will be as follows:
Firm 1ʼs profit: П1 = TR1 – TC1= P1Q1 – (10 + 3 Q1)
= P1 (12-2P1+P2) – [10+3(12-2P1+P2)]
= 12 P1-2P12+ P1P2 –10 - 3 (12-2P1+P2)
= 12 P1-2P12+ P1P2 –10 – 36 + 6 P1 - 3 P2
= 18 P1-2P12+ P1P2 –46 - 3 P2
 1
П1 is maximized when = 0 18 - 4P1 + P2 = 0 P1 = 4.5 + 0.25 P2… (Eq.1)
P1
[firm 1ʼs reaction function]
Firm 2ʼs profit: П2 = TR2 – TC2= P2Q2 – (10 + 3 Q2)
= P2 (12-2P2+P1) – [10+3(12-2P2+P1)]
= 12 P2-2P22+ P1P2 –10 - 3 (12-2P2+P1)

Micro economics II 10
 2
= 12 P2-2P2 + P1P2 –10 – 36 + 6 P2 - 3 P1
2
= 18 P2-2P2 + P1P2 –46 - 3 P1
 2
П2 is maximized when = 0  18 - 4P2 + P1 = 0 P2 = 4.5 + 0.25 P1… (Eq.2)
P 2
[firm 2ʼs reaction function]
Solving (1) and (2) simultaneously yields: P1 = P2 = 6 and
Q1 = 12-2(6) +6 =6
Q2 = 12-2(6) +6 =6
Find the profit of each firm.

IV. STACKLEBERGʼS DUOPOLY MODEL

This model was developed by Heinrich von Stackleberg and is an extension of

Cournotʼs model. Unlike the Cournotʼs model, where firms are naïve (do not recognize
their rivalness) and where the two firms make their output decisions at the same time,
under Stacklebergʼs model one of the two firms is sufficiently sophisticated to
recognize that its competitor is naïve and thus sets its output before the other.
Consider the example below (which is the same as the example under Cournotʼs
model).
Assume that in a duopoly market the demand function is P =100 – 0.5(X1+X2) and the
duopolistsʼ costs are C1 = 5 X1 and C2 = 0.5 X22.

1. Stacklebergʼs solution with firm 1 being the sophisticated leader:

. Firm 1 knows the reaction function of firm 2, substitutes this reaction function into its
own profit function, and maximizes its profit as if it were a monopolist.
Reaction function of firm 2:
П2 = P X2 – C2
= [100 – 0.5 X1 –0.5X2] X2 - 0.5 X22
= 100 X2 - 0.5 X1X2 - 0.5 X22 - 0.5 X22
= 100 X2 - 0.5 X1X2 - X22
 2
= 100 – 2 X2 - 0.5 X1 = 0.  X2 = 50 - 0.25X1 firm 2ʼs reaction function
X 2
Substitute this into firm 1ʼs profit function and maximize.
П1 = P X1 – C1
= [100 – 0.5 (X1+X2)] X1 - 5 X1

= 100 X1 - 0.5 X12 – 0.5 X1X2 - 5 X1

= 95 X1 - 0.5 X12– 0.5 X1X2
П1 = 95 X1 - 0.5 X12– 0.5 X1 (50 - 0.25X1).
= 95 X1 - 0.5 X12 – 25 X1 + 0.125 X12
= 70X1 – 0.375 X12
 1
 = 70 – 0.75 X1 = 0X1 = 280/3. (Check the second order condition)
X 1
Firm 2 would assume that firm 1 produces 280/3 units; thus substitutes this amount

Micro economics II 11
into its reaction function:
X2 = 50 - 0.25X1 = 50 – 0.25(280/3) = 80/3.
2 2
П1 = 70X1 – 0.375 X1 = 70() – 0.375(280/3) ≈ 3267.
П2 = 100 X2 - 0.5 X1X2 - X22 = 100 (80/3) - 0.5 (280/3)(80/3) – (80/3) 2 ≈ 711.
What is the price charged per unit of output?

2. If firm 2 is assumed to be the Staklebergʼs sophisticated leader:

X2 =35, X1 = 77.5, П2 = 918.75, П1 ≈ 3003.
What is the price charged per unit of output?
In sum, each firm (duopolist) estimates the maximum profit it would earn (a) if it acted
as leader, (b) if it acted as follower, and chooses the behavior which yields the largest
maximum profit.
Determinate equilibrium results if one of the two firms wants to be leader and the other
wants to be follower.
If both firms desire to be followers, their expectations do not materialize. One of the
rivals must alter its behavior and act as a leader, or the Cournot equilibrium will be
reached if each duopolist recognizes that its rival also wants to be follower.
If both firms want to be leaders disequilibrium arises, whose outcome, according to
Stackleberg, is economic warfare. Equilibrium will be reached either by collusion, or
after the ‘weakerʼ firm is eliminated or succumbs to the leadership of the other.

2.2 COLLUSIVE OLIGOPOLY

One way of avoiding the uncertainity arising from oligopoistic interdependence is to

inter into collusive agreements. There are two main types of collusion: cartels and price
leadership. These forms may represent (imply) tacit (secret) agreements or open
collusion.
A.CARTELS

Cartel is an organization of suppliers of a commodity aimed at restricting competition

and increasing profits. There are two typical forms cartels: cartels aiming at joint-profit
maximization, and cartels aiming at the sharing of the market.

1. Cartels Aiming at Joint-Profit Maximization (Centralized Cartels)

In this form of cartel, the aim is to maximize the industry (joint) profit. The situation is
identical with that of a multiplant monopolist who seeks the maximization of his profit.
Consider a pure oligopoly – an oligopoly where all firms produce a homogeneous
product. The firms in the cartel appoint a centralized agency to which they delegate
the authority to decide on:
- The total quantity to be produced by the industry,
- The price at which the output is sold,
- The allocation of production, and
- The distribution of the maximum joint-profit among the members.
To do this the central agency has to assess the cost structure of the industry (and firms)

Micro economics II 12
and the market demand. For the simple case of two firms (duopoly), the equilibrium is
determined as follows:
Given P = f (X)…demand function [where X = X1 + X2]
C1 = f (X1) and C2 = f (X2)…cost functions of the two firms.
F.O.C: MR = MC1 = MC2
 2 1 2 2
S.O.C: < 0 and <0
 X1 X 2
2 2

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

 = 1 + 2
1 2
MC
AC1
MC1 AC
MC2 AC2
P*

D
MR

Q 1* Q2*
Q* = Q1*+ Q2*
Note that: 1) MC is the summation of MC1 and MC2 (but not the simple horizontal
summation).
2) 1 and 2 do not necessarily go to the two firms; the total profit  (= 1 + 2)
could be shared between the two firms on a criterion other than the cost of the firms.

Numerical example
Market demand P =100 – 0.5X where X = X1+X2
Costs of the colluding firms C1 = 5 X1
C2 = 0.5 X22
Maximize П = П1+ П2 = TR1+TR2 – TC1- TC2 = P (X1+X2) - C1 - C1
= [100 – 0.5 (X1+X2)] (X1+X2) - 5 X1 -0.5 X22

= 95 X1+100 X2 - 0.5 X12–X1X2-X22

 1  2
Profit maximization  = 0 and =0
X 1 X 2
 1
= 95 - X1 – X2 = 0  95= X1+ X2 …………(1)
X 1
 2
= 100 -X1- 2 X2 = 0 X1+ 2X2 = 100. …………(2)
X 2
Solving equations 1&2 simultaneously gives: X1 = 90 and X2 = 5

Micro economics II 13
The total output in the market is X = X1+X2 = 90+5 = 95.  The market (equilibrium)
price is: P =100 – 0.5X = 100 – 0.5(95) = 52.5. (Check the second order conditions by
yourselves!). Find the profit of the cartel. {Note that this profit is greater than П1+ П2 if
the firms do not collude}
In practice, however, this monopoly equilibrium (maximization of industry profit) may
not be achieved. In other words, there are factors that militate against achievement of
the joint profit maximization of the cartel. These reasons are:
1.Mistakes in the estimation of market demand and costs.
2.Slow process of cartel negotiations- by the time agreement is reached market
conditions may have changed.
3.Fear of government interference- particularly if the monopoly price yields too
high
profits.
4.Fear of entry – the fear of attracting new firms to the industry by too high profits.
5.Stickiness of the negotiated price, etc.

2. Market – Sharing Cartels

In this type of cartel, firms agree to share the market, but keep a considerable degree
of freedom concerning the style of their product, their selling activities and other
decisions. This type of collusion is more common. There are two basic methods for
sharing the market: non-price competition and determination of quotas.

Non-Price Competition Agreements

The member firms agree on a common price, at which each firm can sell any quantity
demanded. The price is set by bargaining, with the low-cost firms pressing for a lower
price and the high-cost firms for a higher price. The agreed price must be such as to
allow some profits to all members. If all firms have the same costs, the cartel could be
stable. With cost differences, the cartel will be inherently unstable, because the low-
cost firms will have a strong incentive to cheat the other members by cutting their
prices secretly. Thus, this form of cartel is very loose.

Sharing of the Market by Agreement on Quotas

Firms may make agreement on quotas, i.e. the quantity that each firm may sell at the
agreed on price. If all firms have identical costs, the monopoly solution will emerge with
the market being shared equally among the members. If costs are different, the final
quota of each firm depends on the level of its costs as well as on its bargaining skill.
During the bargaining process two main statistical criteria are most often adopted: past
levels of sales and productive capacity.
*Another popular method of sharing the market is the definition of the region in which
each firm is allowed to sell. In this case of geographical sharing of the market, the price
as well as the style of the product may differ.

Micro economics II 14
B.PRICE LEADERSHIP

Price leadership is a co-coordinated behavior of oligopolists where one firm sets the
price and the others follow it because it is advantageous to them or because they
prefer to avoid uncertainty about their competitorsʼ reactions even if this implies
departure of the followers from their profit-maximizing position. Price leadership allows
the members complete freedom regarding their product and selling activities and thus
is more acceptable to the followers than a centralized cartel, which requires the
surrendering of all freedom of action to the central agency. The prices charged may
differ for different firms (particularly if the product is differentiated), but the direction of
their change will be the same.
There are various forms of prices leadership. The most common types of leadership
are:
1) Low-cost price leadership
2) Dominant-firm price leadership
3) Barometric price leadership

1. Low-Cost Price Leadership

The important condition for this model is that firms have unequal costs. It is assumed
that there are two firms that produce a homogeneous product at different costs, which
clearly must be sold at the same price. Then, the firm with low cost charges a lower
price and its price will be followed by high-cost firm although the price doesnʼt
maximize the profit of the follower. The follower would obtain a higher profit by
producing a lower output and selling it at a higher price. But the follower prefers to
follow the leader sacrificing come of its profit in order to avoid a price war, which would
eliminate it if price fell sufficiently low as not to cover its LAC. Although it is stressed
that the leader sets the price and the follower adopts it, it is clear that the firms must
also enter a share-of-the-market agreement, formally or informally. Otherwise, the
follower could adopt the price of the leader but produce a lower quantity than the level
required for maintaining the price in the market, and thus indirectly push the leader to a
non profit- maximizing position.
Letʼs assume that the market demand is defined by the function P = a – bX; X = X1 + X2,
C1 = f1 (X1) and C2 = f2 (X2) where C1< C2.
The leader will be the low-cost firm, firm 1. Firm 1 assumes that the rival firm will
produce an equal amount of output to its own, i.e., X1 = X2.
The relevant demand function to the leader will be:
P = a – b (X1 + X2); but X1 = X2
P = a – b (X1 + X1)
P = a – 2bX1
The low-cost leader (firm) will set the price that maximizes its own profit.
П1 =R1 – C1
= P X1 – C1
= (a – 2bX1) X1 - C1
 1 R 1 C 1
F.O.C: = - =0
X 1 X 1 X 1

Micro economics II 15
 MR1 = MC1
 2 1 MR 1 MC 1
S.O.C: < 0 or <
X 1
2
X 1 X 1

The solution of this problem yields the price P and output X1 that the leader produces
to maximize his profit. The follower will adopt the same price and will produce X2 (=X1),
but doesnʼt maximize profit.
Numerical example:
Market demand: P = 105 – 2.5X; X = X1 + X2,
Costs: C1 = 5X1and C2 = 15X2
The leader will be the low-cost firm, firm 1. Firm 1 assumes that the rival firm will produce
an equal amount of output to its own, i.e., X1 = X2.
The relevant demand function to the leader will be:
P = 105 – 2.5(X1 + X2); but X1 = X2
P = 105 – 2.5(X1 + X1)
P = 105 –5X1
The low-cost leader (firm) will set the price that maximizes its own profit.
П1 =R1 – C1
= P X1 – C1
= (105 –5X1) X1 - 5X1
=105 X1–5X12 - 5X1
=100 X1–5X12
 1
F.O.C: = 100 - 10X1 = 0. →100 = 10X1 → X1 = 10.
X 1
 2 1
S.O.C: = -10 < 0
X 1
2

P = 105 –5X1 = 105 –5(10) =55

The follower will adopt the same price (55) and will sell an equal level of output (X2 =
10).
Note that the profit- maximizing output of firm 2 would be X2 = 9 units, and it would sell
it at P* = 60, which is found by maximizing firm 2ʼs profit function
**The market sharing firm leader:
In this model, the product is homogeneous and the firms agree that they are going to
share the market in constant proportions.
Consider two firms with shares k1 and k2.
k1 = X1/X and k2 = X2/X
Given that X1 + X2 = X, k1 = X1/(X1+X2) and k2 = X2/(X1+X2)
k1+k2 = 1k2 = 1-k1 or k1 = 1-k2.
k1 = X1/(X1+X2) k2 = X2/(X1+X2)
k1 X1 + k1X2 = X1 k2X1 + k2X2 = X2
k1 X1 – X1= -k1X2 k2X1 = X2 – k2X2
X1 (k1-1) = -k1X2 X2 (1-k2) = k2X1
X1= -k1X2/ (k1-1) X2= k2X1/ (1-k2). …Reaction function
X1 = k1X2/ (1-k1)…. Reaction function of firm 2.

Micro economics II 16
of firm 1.
Assume that: * k1 = 2/3 and k2 = 1/3… Shares
*P1=100-2X1-X2…firm 1ʼs demand function
2
*C1=2.5X1 ….. Firm 1ʼs cost function
**The firms agreed that firm 1 would be the leader.
1=R1-C1 = (100-2X1-X2) X1-2.5X12
۰ Substitute the reaction function of firm 2, X2=(1/3) X1 / (1-1/3) X2=0.5X1, to obtain
the profit function of the leader.
1=R1-C1 = (100-2X1-0.5X1) X1-2.5X12=100X1-5X12
۰ Maximize the leaderʼs profit:
 1
= 100 - 10X1 = 0. 100 = 10X1  X1 =10.
X 1
The leader will set the price P1=100-2X1-X2
=100-2X1-0.5X1
=100-2.5X1
=100-2.5(10)=75
The quantity which will be produced by the follower is X2=0.5X1= 5 and he will sell it at
the price of the leader P1 = 75.

2. The Dominant – Firm Price Leadership

In this model, it is assumed that there is a large dominant firm that has a considerable
share of the market, and some smaller firms, each of them having a small market share.
It is also assumed that the dominant leader knows the MC curves of the smaller firms,
which he can add horizontally and find the total supply by the smaller firms at each
price
(S1 in the figure below). With this knowledge, the leader can obtain his own demand
curve by calculating the difference between total demand D at that price and the total
S1 (because this firm is also assumed to know the market demand).

P P
S1

MCL
P*

D
Supply by the dominant firm DL
Supply by the small firms

X X* MRL X

The dominant firm leader maximizes his profit by equating his MCL to his MRL (set price

Micro economics II 17
P* and sells quantity X*) - panel (b). The smaller firms are price-takers, and may or
may not maximize their profits, depending on their cost structure.
This model is also called ‘the partial monopolyʼ model since the large firm acts as a
monopolist while the small firms are price-takers and act like the firms in pure
competition.
Numerical example:
 Market demand: D = 50-0.3P
 Aggregate supply of the smaller firms: S = 0.2P
The demand of the dominant firm: X = D-S
X = 50-0.3P-0.2P
X = 50-0.5P
Or P = 100-2X
 Total cost function of the leader firm: CL = 2X
ПL =RL – CL = (100-2X) X – 2X = 100X – 2X2 -2X = 98X-2X2
 L
= 98 - 4X1 = 0. 98 = 4X1  XL = 24.5.
X
 The leader will set the price P = 100 – 2X = 100-2 (24.5) = 51
 The total quantity demanded D = 50 -0.3 (51) = 34.7.
The leader supplies X = 24.5 out of the total and the small firms produce the remainder
(= 34.7-24.5 = 10.2). (Alternatively: S1 = 0.2) = 0.2 (51) = 10.2).
Similar to the low-cost price leader, the dominant firm leader must make sure that the
small firm(s) will not only follow his price but also produce the right quantity - the
quantity that will not push him to a non-profit-maximizing position. Thus, there should
be tight (formal or informal) sharing-the-market agreement between (among) firms
where price leadership is the form of collusion.

Micro economics II 18
 CHAPTER THREE

INTRODUCTION TO GAME THEORY

Game theory is the theory that examines the choice of optimal strategies in conflict
situations. Where it is concerned with the general analysis of strategic interactions,
here we apply it to the study of economic behavior in oliogopolistic markets.
The economic games that firms play can be either cooperative or non-cooperative. In
a cooperative game, players can negotiate binding contracts that allow them to plan
joint strategies. In a non-cooperative game, negotiation and enforcement of binding
contracts are not possible. Cartel (centralized cartel) is an example of cooperative
game where as Cournotʼs and Bertrandʼs models are examples of non-cooperative
games.

3.1 The Payoff Matrix of a Game

Payoff is the outcome of a game that generates rewards or benefits for the player. It is
the outcome or consequence of each combination of strategies by the rival firms. The
payoff matrix is a table that gives the payoffs from all the strategies open to the firm
and the rivalʼs responses. Strategic interaction can involve many players and many
strategies (rules or plan of actions for playing a game), but we will limit ourselves to two
persons and finite number of games.

3.2 Dominant Strategy and Nash Equilibrium

Suppose we have two firms, A and B, and a choice of two strategies for each: advertise
or donʼt advertise. Firm A, of course, expects to earn higher profits if it advertises than
if it doesnʼt but the actual level of profits of firm A depends also on whether firm B
advertises or not. Thus, each strategy by firm A can be associated with each of firm
Bʼs strategies. The payoff matrix below illustrates the four possible outcomes from this
simple game.
Firm B
Advertise Donʼt advertise
Firm A Advertise 4,3 5,1
Donʼt advertise 2,5 3,2

In the payoff matrix above, the first number in each of the four cells refers to the payoff
(profit) for firm A, while the second is the payoff (profit) for firm B. What strategy
should each firm choose?
Letʼs consider firm A first:
 Firm A will earn a profit of 4 by advertising if B advertises and a profit of 2 if it
doesnʼt advertise but B advertises.
Firm A should advertise if B advertises (Because 4>2).
 If B doesnʼt advertise, firm A would earn a profit of 5 if it advertises and 3 if it
doesnʼt.
Firm A should advertise (Because 5>3).

Micro economics II 19
Thus, firm Aʼs profits will always be greater if it advertises than if it doesnʼt regardless
of what firm B does.
Now consider firm B:
 If firm A advertises, firm Bʼs profits would be 3 if it advertises and 1 if it doesnʼt.
 If firm A doesnʼt advertise, firm Bʼs profits would be 5 if it advertises and 2 if it
doesnʼt.
Firm Bʼs profits will also be greater if it advertises than if it doesnʼt, regardless of
what firm A does.
In this case, both firms (A&B) will advertise regardless of what the other firm does and
will earn a profit of 4 and 3, respectively (the top left cell in the payoff matrix above).
We say that advertising is the dominant strategy for both firms. Dominant strategy is
the optimal choice for a player no matter what the opponent does. The advertising
solution (the final equilibrium) for both firms holds whether A or B chooses its strategy
first or if both firms decide on their best strategy simultaneously.
However, not all games have a dominant strategy for each player. An example of this is
shown in the following payoff matrix.
Firm B
Advertise Donʼt advertise
FirmA
Advertise 4,3 5,1
Donʼt advertise
2,5 6,2

 If firm A advertises, B chooses ‘Advertiseʼ (because 3>1) and if A doesnʼt

advertise, B chooses ‘Advertiseʼ as well (Because 5>2). Bʼs optimal choice
is to advertise whether A advertises or not. Thus B has a dominant strategy.
 If B advertises, A chooses ‘Advertiseʼ (because 4>2) and if B doesnʼt
advertise, A chooses ‘donʼt advertiseʼ (because6>2). Aʼs choice depends
on whether firm B advertise or not. Thus, A doesnʼt have a dominant
strategy. In order for firm A to determine whether to advertise, it must first
try to determine what firm B will do.
If firm A knows the payoff matrix, it can figure out that firm B has the dominant strategy
of advertising. Thus, when firm Bʼs choice is revealed, firm A will determine its optimal
strategy and this will result in Nash Equilibrium. Nash equilibrium is a situation in which
each player chooses an optimal strategy, given the strategy chosen by the other player.
The Nash equilibrium is a cell whose both entries are chosen. The cell (4,3)-(advertise,
advertise) is the Nash equilibrium of above game.
A pair of strategies is a Nash equilibrium if Aʼs choice is optimal given Bʼs choice, and
vice versa. The Cournot equilibrium examined in chapter 2 is an example of Nash
Equilibrium.
The major problems with Nash equilibrium are:
1. A game may have more than one Nash equilibrium &
2. There are games with no Nash equilibrium.
Examples:

Micro economics II 20
A game with no Nash equilibrium

Player B

Player A Left Right

Top 0,0 0, -1
Bottom 1,0 -1,3

A game with two Nash equilibria:

Player B
Player A Fight Not fight
Fight 350,350 350,300
Not fight 300,300 400,400

 The Nash equilibria are:(fight, fight) and (not fight, not fight)

3.3 Mixed Strategies

If we enlarge our definition of strategies, we can find a new sort of Nash Equilibrium
where we cannot get Nash equilibrium if we have pure strategy. Pure strategy is a
strategy in which each agent makes a specific choice and sticks to it. If the agents are
allowed to randomize their strategies - to assign a probability to each choice and to
play their choices according to those probabilities - we call this strategy a mixed
strategy.
Nash equilibrium in mixed strategies refers to an equilibrium in which each agent
chooses the optimal frequency with which to play his strategies given the frequency
choices of the other agent. Every game with a finite number of players and a finite
number of actions has at least one Nash Equilibrium.
Consider the following payoff matrix for which no Nash equilibrium exists under pure
strategy.
Player B
Player A Left Right
Top 0,0 0, -1
Bottom 1,0 -1,3

Suppose player B plays left with probability b and Right with probability (1-b); player A
plays Top with probability a and bottom with (1-a).
Each player calculates his own expected payoff given the probability with which the
opponent plays the strategies.
The expected payoff of player A is:
i) = 0(the probability that B plays left)+0(the probability that B plays Right)
(b)+0(1-b)= 0 if he plays Top.
ii) = 1(b) +-1(1-b) =2b-1 if he plays Bottom
A will be indifferent between playing Top and Bottom if the expected payoffs from both

Micro economics II 21
strategies are equal i.e., if 0=2b-1  2b=1 b=1/2 ; (1-b) = ½
 A is indifferent between top and Bottom if b=1/2
 Plays Top frequently if b<1/2(because b<1/2 0>2b-1)
 A plays Bottom frequently if B>1/2 because b>1/2 0<2b-1

The expected payoff of player B is:

i) =0(a) + 0(1-a)=0 if the plays left
ii) = -1(a) +3(1-a) =3-4a if he plays right.
B will be indifferent between playing left and Right if 0=3-4a
3=4a  a =3/4; (1-a)=1/4
 B is indifferent between left and right if a=3/4
 B plays Left frequently if a>3/4
 B plays Right frequently if a <3/4.
The Nash equilibrium is when A plays Top with probability3/4 and Bottom with 1/4 and
B plays Left with probability 1/2 and Right with1/2.

3.4 The Prisonerʼs Dilemma and Cartel Cheating

Nash equilibrium may not exist for some games. The other problem with Nash
equilibrium is that it doesnʼt necessarily lead to Pareto efficient outcomes. Oligopolistic
firms often face such a problem the prisonerʼs dilemma. This refers to a situation in
which each firm adopts its dominant strategy, but each could do better by cooperating.
Consider the following situation. Two suspects are arrested for armed robbery; if
convicted each could receive a maximum sentence of ten years imprisonment. Unless
one or both suspects confess, each could receive a maximum sentence of one year in
prison. Each suspect is interrogated separately and no communication is allowed
between the two suspects. Each suspect is promised that he/she will go free by
confessing while the other (who doesnʼt confess) will receive the full-ten-year
sentence. If both suspects confess, each gets a reduced sentence of five years
imprisonment. The payoff matrix is as given below.
Suspect B
Confess Donʼt confess

Suspect A Confess
-5, -5 0, -10
Donʼt confess
-10,0 -1, -1
 If B confesses, A chooses to confess because -5>-10
 If B doesnʼt confess, A chooses to confess because 0>-1.
To confess is the dominant and best strategy for A.
 If A confesses, B chooses to confess because-5>-10
 If A doesnʼt confess, B chooses to confess because 0>-1.
To confess is the dominant and best strategy for B.
With each suspect adopting his/her dominant strategy of confessing, each ends up
receiving a five-year sentence. Only if the suspects can communicate, reach an
agreement not to confess and the agreement could be enforced would each get a one-

Micro economics II 22
year sentence.
The concept of the prisonerʼs dilemma can be used to analyze the incentive to cheat in
a cartel (i.e., the tendency to secretly cut prices or to sell more than the allocated
quota). Consider the following payoff matrix.

Firm B
Firm A Cheat Donʼt cheat
Cheat 2,2 5,1
Donʼt cheat 1,5 3,3

* The two firms adopt the dominant strategy of cheating and earn a profit of 2 units
each. But by not cheating each member of the cartel would earn the higher profit of 3.
The carter members then face the prisonerʼs dilemma. Only if cartel members do not
cheat will each share the higher cartel profit of 3. A carter can prevent or reduce the
probability of cheating by monitoring the sales of each member and punishing
cheaters. However, the larger the cartel and the more differentiated the product, the
more difficult it is for the cartel to do this and prevent cheating.

3.5 Repeated Games and Enforcing a Cartel

In the preceding section, the players (agents) met only once and played the prisonerʼs
dilemma game. However, the situation is different if the game is to be played
repeatedly.
Two firms facing the prisonerʼs dilemma can increase their profits by cooperating.
Such cooperation, however, is not likely to occur in the single-move prisonerʼs
dilemma games. Cooperation is more likely to occur in repeated or many-move games,
which are more realistic in the real world. In such games (repeated games) the best
strategy is that of tit-for-tat. Tit-for-tat behavior can be summarized as follows: do to
your opponent what he/she has just done to you. That is, begin by cooperating and
continue to cooperate as long as your opponent cooperates. If he/she betrays you the
next time you betray him/her back.
For an optimal tit-for-tat (for firms to cooperate), there must be a hope that
cooperation will induce further cooperation in the future. Among other conditions, it
must be assumed that the game is repeated indefinitely, or at a least a very large and
uncertain number of times. If the game is played for a finite number of times, each firm
has an incentive not to cooperative in the final period because it cannot be harmed by
retaliation. Each firm knows this and thus will not cooperate on the next-to-the last
move. Indeed, in an effort to gain a competitive advantage by being the first to start
cheating, the entire situation will unravel (there will be no confusion) and cheating
begins from the first move.
The following conditions should be met (other than infinite number of games) for an
optimal tit-for-fat (cooperative game):
 Stable set of players for the cooperative behavior to develop.
 A small number of players to keep track of what each is doing.
 Each firm can quickly detect (and is willing and able to quickly retaliate for)
cheating by other firms

Micro economics II 23
  Demand and cost conditions must be relatively stable.

3.6Sequential Games and a Game of Entry Deterrence

The games considered so far are games in which both agents (players) act
simultaneously. But in many situations one player gets to move first, and the other
player responds. An example of this is the Stackleberg model, where one player is a
leader and the other player is a follower.
Suppose player A chooses top or bottom in the first round, player B gets to observe the
first playerʼs (Aʼs) choice, then chooses left or right. The payoff matrix is given as
follows.

Player B

Player A L R
T 1,9 1,9
B 0,0 2,1

 Nash equilibria (if it were a simultaneous game): (T, L)& (B, R).

Note that there are two Nash equilibria if it were a simultaneous game. However, this
normal form presentation of the game cannot be used to analyze the real outcome of a
sequential game. Sequential game is thus analyzed using an extensive form
presentation.
Extensive form is the way to represent the game that shows the time pattern of the
choices.
(1,9)
Right
Player B
Top (1,9) Left (1,9)
Player A (2,1)
Right
Bottom Player B
(2,1) (2,1) Left
(0,0)

The way to analyze this (sequential) game is the backward induction method.
Suppose that player A has already made his choice and we are sitting in one branch of
the game tree. If player A has chosen top, then it doesnʼt matter what player B does,
and the playoff is (1,9). If player A has chosen bottom, then the sensible thing for
player B to do is to choose right, and the payoff is (2,1). Now think about player Aʼs
initial choice. If he chooses top, the outcome will be (1,9) and thus he will get a payoff
of 1. But if chooses bottom, he gets a payoff of 2. So the sensible thing for him to do is
to choose bottom. Thus, the equilibrium choices will be (B, R) with the payoff (2,1).
From Bʼs point of view this is rather unfortunate since he ends up with a payoff 1 rather
than 9. What might he do about it? He can threaten to play left (L) if player a plays

Micro economics II 24
bottom (B). If player A thought that B would actually carry out this threat, he would be
well advised to play top. Because top gives him1, while bottom- if B carries out his
threat-will only give him 0. In this case, however, the threat is not credible (or it is an
empty threat).
One important strategy that an oligopolist can use to deter market entry is to threaten
to lower its price and thereby impose a loss on the potential entrant. Such a threat,
however, works only if it is credible s. Suppose the entrant decides whether or not to
come into the market, and then the incumbent decides whether or not to cut its price in
response.

Fight (-2,4)
Incumbent
Enter (2,7) Donʼt fight (2,7)

Entrant Fight (0,6)

Stay out Incumbent

(2,7) (0,10) Donʼt fight (0,10)

The Nash equilibrium of this sequential game is (enter, donʼt fight). The incumbent firm
may threaten the entrant that it will fight if the potential entrant enters. But, this threat
is not credible because the incumbent will not carry out this threat as 7>4. (Note that
the incumbent can make a credible commitment to fight entry at the expense of
profits).
The incumbent could make a credible threat by expanding its capacity before it is
needed (i.e., to build excess capacity). When the incumbent invests in extra capacity
the payoff is changed as follows.
Fight (-2,4)
Incumbent
Enter (-2,4)
Entrant Donʼt fight (2,3)

Fight (0,6)
(0,8)
Stay out Incumbent
(0,8) (0,6)
(0,8)
Donʼt fight

The profits of the incumbent firm are now lower when it doesnʼt fight (charges the high
price) because idle or excess capacity increases its costs, without increasing its sales.
On the other hand, fighting (charging a lower price) would allow the firm to increase
sales and utilize its newly built capacity, so that costs and revenues increase; thus, it
can be assumed that the firmʼs profit will be unchanged.
The Nash equilibrium of this sequential game is that the potential entrant stays out
which means that the threat is credible. But this means that the incumbent will not use
the extra capacity. Despite this, the investment in excess capacity is worthwhile
because the incumbent firm has signaled to the potential entrant that it would be able

Micro economics II 25
to successfully defend his market.

CHAPTER FOUR

PRICING OF FACTORS OF PRODUCTION AND

INCOME DISTRIBUTION

4.1 FACTOR PRICING IN A PERFECTLY COMPETITIVE MARKET

4.1.1 The Demand for Factors of Production

A firm demands an input in order to produce a commodity demanded by consumers.

Thus the demand for an input is a derived demand – derived from the demand for the
final commodities that the input is used in producing. The demand for an input by a
firm shows the quantities of the input that the firm would hire at various alternative
input prices.

The Demand for One Variable Productive Factor

Here, we assume that only one input is variable (i.e., the amount used of the other
inputs is fixed and cannot be changed). According to the marginal concept, a profit-
maximizing firm will hire an input as long as the extra income (receipt) from the sale of
the output produced by the input is larger than the extra cost of hiring the input. The
extra income is given by the marginal product (MP) of the input times the marginal
revenue (MR) of the firm. This is called the marginal revenue product (MRP). That is,
MRP = N MP.MR. When the firm is a perfect competitor in the product market, its
marginal revenue is equal to the commodity price. In this case the marginal revenue
product MRP = MP. P = VMP (the value of marginal product).
If the variable input is labour, MRPL =MPL. P = VMPL. The extra cost of hiring an input or
marginal expenditure (ME) is equal to the price of the input if the firm is a perfect
competitor in the input market. Perfect competition in the input market means that the
firm demanding the input is too small, by itself, to affect the price of the input. In other
words, each firm can any amount of the input (service) at the given market price for the
input. Thus, the firm faces a horizontal or infinitely elastic supply curve for the input.
For example, if the input is labour, this means that the firm can hire any quantity of
labour time at the given wage rate. Thus, a profit-maximizing firm should hire labour as
long as the MRPL exceeds the marginal expenditure on labour or wage rate (w). Profit is
maximized at a point where MRPL (= VMPL in this case) = w.
Mathematically, max  = R – C where R = PX. X and C = w L + F; F = fixed cost.
L

Micro economics II 26
 d d(P X) dX
 = 0.  . MPL = w . 
X
= = P X - w P X
VMPL = w .
dL dL dL

a rational firm operates in the second stage of production where the MPL is declining
but positive. Multiplying this MPL by a fixed output price gives a downward sloping
MRPL curve as in the figure below.

MRPL e1
w w1
e2
w2
e3
w3
MRPL = VMPL

L
L1 L2 L3
Given this MRPL, the firm hires L1 units of labour if the wage rate is w1. Similarly, L2 units
of labour will be hired at w2 and L3 at w3.
At e1, VMPL = w1.  The firmʼs profit is at the maximum for wage rate w1. To the left of
e1, VMPL > w1.  The firm will increase its profit by hiring more labour. The opposite
holds to the right of e1.
The graph which shows this relationship between the wage rate (input price) and the
quantity demanded (hired) of labour (input) is the curve. Thus, the demand for a single
variable input is the value of marginal product (VMP) of the input under the perfectly
competitive markets.

dL = MRPL = VMPL

L
The Demand for A Variable Factor When There Are Several Variable Inputs

When there are more than one variable factors of production, the VMP curve of an
input is not its demand curve. This is because various resources are used
simultaneously in the production process so that a change in the price of one factor

Micro economics II 27
leads to changes in the employment (use) of the other factors. This in turn shifts the
marginal (physical) product curve of the input whose price is initially changed.
Letʼs assume that the price of labour (the wage rate) falls. Then this has three effects:
- a substitution effect
- an output effect, and
- a profit effect

K
b

B e3

K3
B* e2 X3
K2
K1 e1
a X2
K 1*
X1

L1 L1* L2 L3C C** C* l L

Initially, the firm produces a profit – maximizing output X1 with a combination of L1 and
K1, given factor prices w and r whose ratios are defined by the slope of the isocost lines.
When wage rate falls the new isocost (BC*) is tangent to the isoquant corresponding
to output level of X2 at e2. K2 units of capital and L2 units of labour are used this
movement from e1 to e2 can be split into two: substitution effect and output effect.
To see the substitution effect draw an isocost line (B*C**) parallel to the new isocost
line (BC*) but tangent the old isoquant (X1). The movement from e1 to a is the
substitution effect. This shows that the firm substitutes the cheaper labour for the
relatively more expensive capital even if it were to produce the original level of output
X1. Thus, the employment of labour increases from L1 to L1*. But when wage rate falls,
the firm can hire more of the two factors (L and K) with the same expenditure. Hence,
the firm produces higher level of output with more labour and capital (L2 and K2) and,
therefore, the movement from a to e2 is the output effect. e2 is not the final equilibrium
of the firm because keeping the total cost /expenditure constant doesnʼt maximize its
profit. The fall in wage rate results in a shift in the marginal cost curve downward to the
right (MC1 to MC2) and the profit maximizing output of the firm increases to X3.

P
MC MC1
MC2

Micro economics II 28
 P

X1 X2 X
Thus, the isocost line BC* must shift upward parallel to itself. So, the final equilibrium is
when bl is tangent to the highest possible isoquant (X3) at point e3. The movement
from e2 to e3 is the profit effect.
The substitution effect of a decline in wage rate causes a decline in the marginal
physical product of labour (as it increases the units of L and reduces that of K).
The output and profit effects result in rise in the amounts of both labour and capital
used. Both effects cause the MPPL to shift upward and to the right (to increase at a
given level of employment).
The output and profit effects more than offset the substitution effect so that the final
result of a fall in wage rate is an increase (and rightward shift of) the MPPL (curve).
Given the price of the final commodity PX, the VMPL shifts to the right.

w
VMPL

w1 A

B
w2

w3 C

VMPL1 VMPL2 VMPL3

L1 L2 L3 L

At the initial wage rate w1, L1 units of labour are employed (which is determined by the
intersection of VMPL1 and the supply w1). The new equilibrium demand for L (when
wage rate falls to w2) is at point B on VMPL2. If w further declines to w3, the new
equilibrium will be at point C. The locus of points A, B and C is the demand curve for
labour by the firm when several variable factors are used. This is called the long run
demand for labour by a firm.
Demand for a variable factor depends on:
- the price of the input
- the marginal physical product of the factor
- the price of the output (commodity)
- the amount of other factors which are combined with the factor
- the price of other factors

Micro economics II 29
 - Technological progress.

The Market Demand Curve for An Input

The market demand curve for an input is derived from the individual firmsʼ demand
curves for the input. But it is not the simple horizontal summation of the individual
firmsʼ demand curves for the input. This is because when the price of an input (say
labour) falls, not only this firm but also other firms will employ more of this and other
(complementary) inputs. Thus, the supply of the commodity increases and price falls.

PX SX1

SX2
PX*

PX**

dX

If the input price (say wage rate) falls and more of it is used, the supply of the
commodity increases (shifts from SX1 to SX2). This derives down the equilibrium price of
the product (from PX* to PX**).
Since the MRPL = MPL times MR (which is here equal to the commodity price), the
reduction in commodity price will cause each firmʼs MRP and demand curves of the
input to shift down or to the left. The market demand curve for an input is then derived
by the horizontal summation of the individual firmsʼ demand curves for the input after
the effect of reduction in the commodity price has been considered.
w w

w1 a Old equilibrium w1 A

New equilibrium

w2 b bʼ w2 B Bʼ

d1
d2 DL

L L
ʼ ʼ
l1 l2 l2 L1 L2 L2
Firmʼs demand curve market demand curve

Micro economics II 30
If the fall in commodity price were not taken into account, it would led to an
overestimation of the market demand for labour.
4.1.2 Factor Supply and Factor Pricing

The Supply of Labour

Here we assume that labour is a homogeneous factor: all labour units are identical. The
main determinants of the market supply of labour are:
a) the price of labour (wage rate)
b) the tastes of consumers, which define their trade – off between leisure and
work
c) the size of population
d) the labour - force participation rate
e) the occupational, educational and geographical distribution of the labour force.
The relationship between the supply (decision) of labour and the wage rate defines the
supply curve. The other determinants (b – e) can be considered as shift factors of the
supply curve.
Since the market supply is the summation of the supply of labour by individuals, we
begin by the derivation of the supply by a single individual.

A. The Supply of Labour By An Individual

Labour is not (usually) owned by a business firm. It is provided by individuals. These

individuals can use their labour either for working or for leisuring. Hence, the supply of
labour by individual depends on the preference for leisure and work. The preference of
the individual between leisure and work (income) can be represented by indifference
curves.
The horizontal axis measures hours available for leisure and work over a given period of
time. On the vertical axis, the money income is measured. The slope of the budget line
represents wage rate per hour.
Wage
Money rate
Income SL
w4 w4
1
w3 w3
1 Dʼ
w2 Cʼ IC4 w2
1 IC3
W1 Bʼ IC2 w1
1 Aʼ IC1

A BDC L
O CDB A Z

Panel (a) Panel (b)

Labour hours of work

Micro economics II 31
Labour hours of:
Work
Leisure

When the wage rate is w1, the individual is in equilibrium by working AZ hours (leisuring
OA hours), earning AAʼ income. If the wage rate increases to w2 the individual will work
more hours (BZ > AZ), will earn a higher income (BBʼ) and will have less hours (OB <
OA) for leisure. The supply of labour will also increase when wage rate rises to w3.
However, at some higher wage rate the hours offered for work may decline. For
example, if the wage rate rises to w4, the individual will work for DZ hours, which is less
than the supply at w3 (CZ). This pattern of response to higher wage rates produces a
backward – bending supply curve for labour (panel (b) in the figure above).

B. The Market Supply of Labour

The market supply of labour is the summation of individual supplies of labour. Although
there is a general agreement that the supply curve of labour by single individuals
exhibits the back – bending pattern, the market supply is not back – bending. This is
because higher wage rates induce some people to work fewer hours, but will also
attract new workers into the market and there is population growth (in the long run).

The Supply of Other Factors

The supply of an input other than labour, say a raw material or an intermediate good, is
derived on the same principles the supply of any commodity. Where the supply of an
input to individual firm is infinitely elastic, the market supply is not perfectly elastic even
under perfectly competitive market structure.

Factor Pricing

Given the market demand and the market supply of an input, its price is determined by
the intersection of the two curves.

SL

w*

DL

L
L*

Micro economics II 32
The equilibrium wage rate is w* and the employment level is L*. This is the same as the
determination of price for a commodity. The difference between commodity pricing
and factor pricing lies in the determinants of the demand for variable factors and the
method used to derive the supply of labour. The demand for factors is a derived
demand, in the sense that the demand for the services of the factors is based on the
demand of the commodities in whose production the factors are used. Unlike the
supply of commodities, the supply of labour is not cost determined, but involves the
attitudes of individuals toward work and leisure.

4.2 Factor Pricing in Imperfectly Competitive Markets

4.2.1 Monopolistic Power in the Product Market

Demand of the Firm for a Single Variable Input

Assumptions:
1. The firm uses a single variable factor – labour – whose market is perfect: the
wage rate is given and the supply of labour to the individual firm is perfectly
elastic.
2. The firm has monopolistic power in the output market. This implies that the
demand for the product of the firm is down –ward sloping and the marginal
revenue curve lies below the demand curve (MR < P) at all levels of output.

PX VMPL
MRX MRPL

dX MRPL VMPL
QX L
MR

MRX < PX  MRX . MPPL < PX. MPPL

 MRPL < VMPL

The firm maximizes its profit with respect to the units of labour it employs.
Given demand function PX = f1 (Q) and production function QX = f2 (L, K ),

Micro economics II 33
 = TR – TC
 = PX .QX – (w. L+F)
d d ( PX Q X ) d ( wL F )
max : F.O.C. = 0.  - =0
L dL dL dL
d (Q X ) d ( PX ) d ( TR ) d ( PX Q X )
 PX +Q X -w=0 MRX = X
=
dL dL dL dL
dQ dP X dQ d (Q X ) d ( PX )
 PX
X
+Q X . X
=w = PX +Q X
dL dQ X
dL dQ X
dQ X

dQ dP X
 X
( PX +Q X )=w MRX= P X + Q X
dP X
dL dQ X
dQ X

MPPL . MRX =w

 MRPL = w

d
2

S.O.C. 2
< 0.
dL

So the firm maximizes profit when it employs labour in such a way that MRPL = w.

w
e1
*
w SL = MCL = w*
e2
w2 SLʼ
e3
w3 SL”
MRPL

L
l1e l2e l3e

Joining the equilibrium points e1, e2 and e3 (at different wage rates) gives MRPL as a
demand curve that relates wage to labour employment.

Demand of the Firm for a Variable Factor When There Are Several Variable Factors

When more than one variable factors are used in the production process the demand
for a variable factor is not its MRP curve, but it is formed from points of shifting MRP
curves.

Micro economics II 34
 w
MRPL
A SL1
w1

Aʼ B
w2 SL2
MRPL1
MRPL2 dL

When the wage rate is w1, the equilibrium is at point A. if wage rate falls from w1 to w2,
the firm moves from A to Aʼ along MRPL1 If every thing remains constant. However,
other things do not remain constant. The fall in wage rate has substitution, output and
profit effects. The net result of these effects is a shift in MRPL curve to right which
leads to equilibrium at B. so, line AB is the demand for labour in case of several variable
factors.

Market Demand and Supply of Factors

The market demand for a factor is the summation of the demand curves of the
individual monopolistic firms. In the aggregation, however, we must take into account
the shift of the individual demand curves as the price of the factor falls (because of the
fall in commodity price). The derivation is similar to the case under perfect competition.
The only difference is that the individual demand curves are based on MRP (and not on
VMP).
The market supply is not affected by the fact that firms have monopolistic power. Thus,
the market supply of labour is the summation of the supply curves of individuals, as
derived earlier. So does the market supply of any other factor.
The market price of the factor is determined by the intersection of the market demand
and the market supply.
When firms have monopolistic power, the factor is paid its MRP, which is smaller than
the VMP. This effect is called monopolistic exploitation.

Micro economics II 35
 w w
Monopolistic
Monopolistic Exploitation
Exploitation
SL
wc

wm f(  VMP )
MRPL
f(  MRP )

L2 L1 L Lm Lc L

(a) Firm (b) Market

4.2.2 Monopsonistic Power in the Factor Market

Here we will examine the case of a firm that has monopolistic power in the product
market and monopsonistic power in the input market.

A Monopsonist Using a Single Variable Factor

Assuming the only variable input to be labour, the demand for labour by an individual
firm is given by MRPL (the same as that under section 4.2.1). However, the supply of
labour to the individual firm is not perfectly elastic, because the firm is large.
Suppose that the firm is the only buyer of the input (a monopsonist). The supply of
labour has a positive slope: as the monopsonist expands the use of labour he/she must
pay a higher wage.
The supply of shows the average expenditure or price that the monopsonist must pay
at different levels of employment. Its slope is dw which is greater than zero ( dw >
dL dL
0).
w MEL
MRPL
SL

Micro economics II 36
 MRPL

TEL = w. L
TE
 AEL = L
= wL = w.
L L
 w = AEL = f (L)
Multiplying the price of input by the level of employment gives the total expenditure of
the monopsonist for the input (TEL = w. L). The relevant magnitude for the equilibrium
of the monopsonist is the marginal expenditure of purchasing an additional unit of the
factor.
d ( TE ) d ( wL ) dL
MEL = L
= = w. + L dw
dL dL dL dL

 MEL = w + L dw
dL

Since dw > 0, L> 0 and w >0, it follows that MEL > w for any level of employment
dL
(value of L).
The MEL has a steeper slope than the w (SL). Assuming linear functions,
*The slope of the supply function is dw > 0.
dL
* The supply of the MEL curve is:
d ( ME L ) d w  L dw 
= dL
dL dL
d L dw 
= dw + dL
dL dL

2
= dw + ( L .d w + dw . dL )
dL dL
2 dL dL

2
= dw + dw + L .d w
dL dL dL
2

2
= 2 dw + L .d w
dL dL
2

2 2
 2 dw + L .d w > dw (since L .d w = 0 for a linear function).
dL dL
2 dL dL
2

The firm is in equilibrium when it equates the ME on labour to its MRP.

Micro economics II 37
 MEL AEL
w

e
SL

we

MRPL
L
Les

Profit is maximized by employing Les units of labour for which MEL = MRPL. the wage
rate that the firm will pay for the Les units of labour is we.
The wage rate and the employment of labour are lower than that of perfect competition
as well as that of monopoly market discussed earlier.

MEL
SL

wc C A

wm B
ws
VMPL
MRPL
Ls Lm Lc L

 wc > wm > ws
 Lc > Lm > Ls
 wc – wm is monopolistic exploitation
 wc – ws is monopsonistic exploitation (wc – wm due to
monopolistic power in the product market + wm – ws due to
monopsonistic power in the factor market).

Micro economics II 38
Micro economics II 39
 A Monopsonist Using Several Variable Factors

If the input markets are perfectly competitive the firm minimizes its cost by using the
MPP w MPP MPP
factor combination at which L
= or L
= K
.
MPP K
r w r
If the factor markets are monopsonistic, changes in the amount of factors employed
causes changes in the prices of factors. Thus w and r are not given. The monopsonist
who uses several variable factors will use the input combination at which the ratio of
the MPP to the ME is equal for all variable inputs.
Assume that the demand for the product of the monopolistic firm is PX = f1 (QX), the
production function is QX =f2 (L, K) and the supply functions of the factors for the
monopsonist are w = f3 (L) and r = f4 (K).
The firm maximizes the profit function  = PXQX – wL – rK.
 Q P Q X L w
F.O.C: = PX X + QX X - [w +L ] = 0.
L L Q X L L L
 Q P Q X K r
= PX X + QX X - [r +K ] = 0.
K K Q X K K K

Q X P w
Rearranging, [PX + QX X ] = w + L
L Q X L

MPPL MRX MEL

Q X P r
[PX + QX X ] = r + L
K Q X K

MPPL MRX MEL

MPPL. MRX = MEL ……………….. (a)

MPPK. MRX = MEK………………...(b)
MPP ME MPP MPP
 Dividing (a) by (b), L
= L
or L
= K
.
MPP K
ME K
ME L
ME K

4.2.3 Bilateral Monopoly

Bilateral monopoly arises when a single seller (monopolist) faces a single buyer
(monopsonist). In this model, we assume that all firms are organized in a single body
which acts like a monopsonist, while the labour is organized in a labour union which
acts like a monopolist (a model in which the participants are two monopolies, one on
the supply side and one on the demand side).
The solution to a bilateral monopoly situation is indeterminate. The model gives only
the upper and lower limits within which the wage rate will be determined by bargaining.

Micro economics II 40
The outcome of the bargaining cannot be known with certainty. It will depend on
bargaining skills, political and economic power of the labour union and the firms, and
on many other factors.

MEL

wU
F SL = AEb = MCs
wU >wF

wF
U
Db = MRPL =ARs
LU LF L

MRs
The monopsonostʼs demand curve is Db which is the MRPL. From the point of view of
the monopolist (labour union) this curve represents its average revenue curve (ARs).
The sellerʼs (unionʼs) MRs is derived from the ARs and lies below it.
The supply of labour facing the monopsonist is the upward sloping curve SL. This
shows the average expense (average cost) of labour to the monopsonist.
Corresponding to this average cost curve is the AEL curve. From the point of view of
the monopolist (labour union), the MCs may be considered its supply curve (assuming
that it behaves as if it were a perfectly competitive seller).
The monopsonist maximizes its profit at point F, where its marginal expense on labour
(MEL) is equal to the marginal revenue product of labour (MRPL). Thus the
monopsonist desires to hire LF units of labour and pay a wage rate equal to wF.
The monopolist (labour union), on the other hand, maximizes its gains (profits) at point
U, where its marginal cost (MCs) is equal to its marginal revenue (MRs). Thus, the
monopolist will want to supply LU units of labour and receive a wage rate equal to wU.
The price desired by the monopsonist is the lower limit and the price desired
monopolist is the upper bound. The actual wage is between wF and wU which is
determined based on the bargaining skills (power) of the two parties.

4.3 Elasticity of Factor Substitution, Technological Progress and Income Distribution

A. Elasticity of Factor Substitution and the Shares of Factors of Production

As factor prices change, the firm will substitute a cheaper input for a more expensive
one. This profit maximizing behaviour will result in a change of the K/L ratio, and hence,
to a change in the relative shares of the factors. The size of this effect depends on the
responsiveness of the change of the K/L ratio to the factor price changes. A measure
of this responsiveness is the elasticity of substitution (σ).

Micro economics II 41
 percentage changein the K / L ratio
σ=
percentage change in the MRTS L, K

d (K/L)
(K / L) d (K/L) MRTS
= = .
L, K

d (MRTS L, K ) dMRTS L, K (K/L)

( MRTS L, K )
In perfect input markets the firm is in equilibrium when it chooses the input
combination at which MRTSL, K = w/r.
d (K/L) MRTS
 σ= .
L, K

dMRTS L, K (K/L)

The sign of σ is always non – negative because the K/L ratio and w/r ratio move in the
same direction: (w/r) ↑  labour is more expensive.  Capital is substituted for
labour.  (K/L) ↑.
 σ is non – negative.
 σ = 0  It is impossible to substitute labour for capital or vice versa. E.g.
Leontief
type production functions.
 σ = ∞  Perfect substitutability between factors. E.g. Linear production
function.
 σ > 0 (but finite)  Factors are substitutes to a limited degree (extent). E.g.
Cobb -
Douglas type production functions (σ =1).

 σ = 1 unitary substitutability
 σ < 1 inelastic substitutability
 σ > 1 elastic substitutability
There is an important relationship between the values of σ and the distributive shares
of factors. If, for simplicity, we assume that there are two factors of production, L and K,
their shares are defined as:
w.L
o share of labour =
X
r .K
o share of capital =
X
Where w = wage rate
r = rental of capital
L = quantity of labour employed
K = quantity of capital used
X = value of output produced in the economy.
The factor shares depend on the state of technology which defines the production
function, and on the relative factor prices.
Share of labour wL / X wL w/r
Relative factor shares = = = =
Share of capital rK/X rK K/L

Micro economics II 42
If σ < 1, a given percentage change in w/r ratio results in a smaller percentage change
in K/L ratio, so that the relative share expression increases. Thus, if σ < 1, an increase
in w/r ratio increases the distributive share of labour.
E.g. assume that σ = 0.5. A 10% increase in w/r ratio results in a 5% increase in K/L
ratio.
The new relative shares are: [(wL) / (rK)]* = [(w/r) / (K/L)]*
= [(w/r)(1+ 0.10) / (K/L(1+0.05)]*
= [1.1(w/r) / 1.05(K/L)] > (w/r) / (K/L)
(New relative shares ratio) > (Initial relative shares ratio).
If σ >1, a given percentage change in w/r ratio results in a greater percentage change
in K/L ratio, so that the relative share of labour decreases.
E.g. assume that σ = 2. A 10% increase in w/r ratio results in a 20% increase in K/L
ratio.
The new relative shares are: [(wL) / (rK)]* = [(w/r) / (K/L)]*
= [(w/r)(1+ 0.10) / (K/L (1+0.20)]*
= [1.1(w/r) / 1.2(K/L)] < (w/r) / (K/L)
(New relative shares ratio) < (Initial relative shares ratio).
If σ =1, a given percentage change in w/r ratio results in an equal percentage change
in K/L ratio, so that the relative share of labour remains unchanged.
In general, an increase in the w/r ratio will cause labourʼs share, relative to capitalʼs, to:
1) increase if σ <1
2) decrease if σ >1
3) remain the same if σ >1.
A decrease in w/r ratio will have the opposite effects.

B. Technological Progress and Income Distribution

A given production function was assumed up to now. However, technological change

takes place continuously, and this shifts the production function, leading to changes in
the K/L ratio and the elasticity of substitution.
Technological progress can be:
1. Neutral
2. Labour – deepening (capital - saving)
3. Capital – deepening (labour - saving)
Technological progress shifts isoquants downwards, given that the same level of
output can be produced with smaller quantities of factor inputs s technological
progress occurs.
(a) Technological progress is neutral if, at a constant K/L ratio, the MRTSL, K remains
unchanged. Since MRTSL, K = w/r in equilibrium, it follows that when technological
progress is neutral both the K/L ratio and w/r ratio are unchanged. Consequently, the
relative shares of factors remain unchanged.
(b) Technological progress is capital - deepening if, at a constant K/L ratio, the MRTSL,
K declines. This implies that at equilibrium the w/r ratio declines, that is r declines
relative to w, while K/L ratio remains the same. Consequently, the ratio of factor shares

Micro economics II 43
declines:
(New factor share ratio) = [(w/r)/(K/L)]* < (Initial factor share ratio) = [(w/r)/(K/L)]
This is similar to saying that the share of labour decreases and the share of capital
increases.
(c) Technological progress is labour - deepening if, at a constant K/L ratio, the MRTSL,
K increases. This implies that at equilibrium the w/r ratio increases while K/L ratio
remains the same. Consequently, the ratio of factor shares increases:
(New factor share ratio) = [(w/r)/(K/L)]* > (Initial factor share ratio) = [(w/r)/(K/L)]
This is similar to saying that the share of labour increases and the share of capital
decreases.

K K

R
R
a
X a
b X
c Xʼ b
c Xʼʼ Xʼ

O L
(a) Neutral technical progress O L
(b) Capital – deepening technical progress

a
X
b
c Xʼ
Xʼʼ

O L
(c) Labour – deepening technical progress
In each case:
 OR is a ray whose slope shows a constant K/L ratio.
 Points a, b and c show points of production at the given constant K/L ratio
as technical progress takes place.
In summary, the relative share of labour:
a) Increases if technical progress is labour – deepening
b) Decreases if technical progress is capital – deepening
c) Remains unchanged if technical progress is neutral.

Micro economics II 44
The opposite is true for the relative share of capital.
CHAPTER FIVE

GENERAL EQUILIBRIUM ANALYSIS AND WELFARE ECONOMICS

5.1 GENERAL EQUILIBRIUM ANALYSIS

5.1.1 Partial versus General Equilibrium Analysis

Partial equilibrium analysis studies the behavior of individual decision-making units and
individual markets, viewed in isolation. Egs:
 how an individual maximizes satisfaction subject to his income,
 how a firm minimizes its costs of production and maximizes profits under various
market structures,
 how the price and employment of each type of input is determined.
In doing so, we have abstracted from all the interconnections that exist between the
market under study and the rest of the economy. In short, the basic characteristic of a
partial equilibrium approach is the determination of the price and quantity in each
market by demand and supply curves drawn on the ceteris paribus assumption. Only
when an industry (or a market) is small and has few direct links with the rest of the
economy is partial equilibrium analysis appropriate.
However, a fundamental feature of any economic system is the interdependence
among its constituent parts. The markets of all commodities and all productive factors
are interrelated, and the prices in all markets are simultaneously determined. For
example, consumersʼ demands for various goods and services depend on their tastes
and incomes.  In turn, consumers' incomes depend on the amounts of resources
they own and factor prices.  Factor prices depend on the demand and supply of the
various inputs.  The demand for factors by firms depends not only on the state of
technology but also on the demands for the final goods they produce.  The demands
for these goods depend on consumers' income.  There is circular interdependence
of activities within an economic system.
These effects are studied by general equilibrium analysis. General equilibrium studies
the interdependence or interconnections that exist among all markets and prices in the
economy and attempts to give a complete, explicit, and simultaneous answer to the
questions of what, how and for whom to produce. General equilibrium analysis is not
used all the time because dealing with each and all industries in the economy at the
same time by its very nature is very difficult, time consuming and expensive.
General equilibrium is a state in which all markets and all decision - making units are in
simultaneous equilibrium. A general equilibrium exists if each market is cleared at a
positive price, with each consumer maximizing satisfaction and each firm maximizing
profit.
The first and simplest general equilibrium model was introduced in 1874 by Leon
Walras In the Walrasian system, all prices and quantities in all markets are determined
simultaneously through their interaction with one another (by the solution of the
system of equations). Thus the first task in establishing the existence of a general

Micro economics II 45
equilibrium is to describe the economy by means of a system of equations: the number
of unknowns should be equal to the number of equations. In the Walrasian system one
of the equations is a redundant (not an independent) equation and deprives the system
of a solution since the number of independent equations is less than the number of
unknowns. In this model, the absolute level of prices cannot be determined. General
equilibrium theorists have adopted the device of choosing arbitrarily the price of one
commodity as a numeraire (or unit of account) and express all other prices interims of
the price of the numeraire. With this device each price is given relative to the price of
the numeraire. Even if there is equality of independent equations and unknowns there
is no guarantee that a general equilibrium solution exists. Leon Walras was never able
to prove the existence of a general equilibrium.
In 1954 Arrow and Debreu provided a proof of the existence of a general equilibrium in
perfectly competitive markets, in which there are no indivisibilities and no increasing
returns to scale. In 1971 Debreu and Hahn proved the existence of a general
equilibrium for an economy with limited increasing returns and monopolistic
competition, with out indivisibilities. There is no proof so far that shows the existence
of a general equilibrium in oligopoly and monopoly markets.
Apart from the existence problem, two other problems are associated with equilibrium:
the problem of its stability and the problem of its uniqueness.

5.1.2 General Equilibrium in a Two-Factor, Two-Commodity, Two-

Consumer (2x2x2) Economy
Assumptions of the 2x2x2 model

1. There are two factors of production (Land K) whose quantities are given
exogenously. These factors are perfectly divisible and homogeneous.
2. Only two commodities (X and Y) are produced. Technology is given. The
isoquant maps have the usual properties (smooth and convex to the origin
implying diminishing MRTS between factors along any isoquant).Each
production function exhibits constant returns to scale. The two production
functions are independent (no externalities in production).
3. There are two consumers in the economy (A&B) whose preferences are
represented by ordinal indifference curves, which are convex to the origin,
exhibiting diminishing MRS between commodities. Consumersʼ choices are
independent (no externalities in consumption).
4. The goal of each firm is profit maximization and that of each consumer is utility
maximization.
5. The factors of production are owned by the consumers.
6. There is full employment of factors of production, and all incomes received by
their owners (A&B) are spent.
7. There is perfect competition in both commodity and factor markets.
Consumers and firms face the same set of prices (Px, Py, w, r).
In this model a general equilibrium is reached when the four markets (two
commodity and two factor markets) are cleared at a set of equilibrium prices (Px,
Py, w, r) and each participant economic agent (two firms and two consumers) is

Micro economics II 46
 simultaneously in equilibrium.

Three static properties are observed in a general equilibrium solution, reached with
a free competitive market:
a. Efficient allocation of resources among firms (equilibrium of production)
b. Efficient distribution of commodities between the consumers (equilibrium of
consumption)
c. Efficient combination of products (simultaneous equilibrium of production
and consumption)

5.1.2.1. Equilibrium of Consumption (Efficiency in Distribution)

Given the total quantities of X and Y to be distributed between A&B, there will be an
infinite number of Pareto optimal equilibria of distribution. Any point on the Edgeworth
contract curve of consumption is Pareto optimal.

X B

Y
B1
G

Z A5

B2 F

B3
A4
Y B4 E
D
B5 C
A3
A2
A1

XA
Edgeworth box of consumption

Any point in Edgeworth box of consumption shows six variables: X, Y, XA, XB, YA&YB.
However, not all distributions are Pareto-optimal. A Pareto - efficient distribution of
commodities is one such that it is impossible to increase the utility of one consumer
with out reducing the utility of the other. Only points of tangency of the indifference
curves of the two consumers represent Pareto - efficient distributions. The locus of
these points is called the Edgeworth Contract Curve of Consumption. At each point on

Micro economics II 47
 A .B.
this curve MRSxy =MRSxy Point Z (or any point off the Edgeworth contract curve
of consumption) is a point of inefficient consumption because it is possible to increase
the utility of at least one consumer without making the other worse off (consider
movement to E, to F or to any point between E and F on the contract curve).
Of the infinite number of points where the condition MRSxyA =MRSxy.B holds, only one
PX
point is realized in perfect competition. This point is where MRSxyA = MRSxy.B = .
PY

5.1.2.2 Equilibrium of Production (Efficiency in Factor Allocation)

The joint equilibrium of production of the two firms in our simple model can be derived
by the use of the Edgeworth box of production

L OY

K
Y1
Q

R X4

Y2 P

Y3
X3
K B4 N

Y4 M
X2
X1

OX
L
Edgeworth box of production

The size of the box refers to the total amount of Land K available to the economy. Any
point inside the box indicates how the total amount of the two inputs is utilized in the
production of the two commodities. If this economy was initially at point R, it would not
be maximizing its output of commodities X and Y because, at point R, MRTSLKX 
MRTSLKY. The economy can move from point R to point N and increase its output of Y
without reducing its out put of X. Alternatively, it can move to point P increasing its
output of X without reducing its output of Y. At points M, N, P and Q, an X isoquant is
tangent to a Y isoquant so that the MRTSLKX = MRTSLKY.

Micro economics II 48
Curve OXMNPQOY is the Edgeworth contract curve of production. It is the locus of
X Y
tangency points of the isoquants for X and Y at which MRTSLK = MRTSLK . The
general equilibrium of production occurs at a point which satisfies this Pareto
optimality criterion of efficiency in factor substitution. Since this occurs at any point
along the Edgeworth contract curve of production, there is an infinite number of
possible Pareto-optimal production equilibria. However, with perfect competition, one
w
of these equilibria will be realized, the one at which the MRTSLKX = MRTSLKY = .
r
In a general equilibrium, the amounts of X and Y which maximize the profits of firms
must be equal to those which consumers want to buy in order to maximize their utility.
Consumers decide their purchases on the basis of commodity prices, PX & PY. Thus, in
order to bring together the production side of the system with the demand side, we
must define the equilibrium of the firms in the product space.
From each point of the Edgeworth contract curve of production, we can read off the
maximum obtainable quantity of one commodity, given the quantity of the other. The
locus of all the Pareto-efficient outputs (or of all the minimum attainable combinations
of the two commodities) given the resource endowment K and L ) and the state of
technology is the P``roduction possibility frontier (PPF/PPC.)

Y
OXʼ
Y4 Mʼ

Nʼ
Y3

Y2 Pʼ

Qʼ
Y1 ÓYʼ

X1 X2 X3 X4 X

At any point on the curve all factors are optimally (efficiently) employed. Any point
inside the curve is technically inefficient, implying unemployed resources. Points
above the curve are unattainable, unless additional resources or a new technology or
both are found.
The PPF is also called the product transformation curve because it shows how a
commodity is transformed into another, by transferring some factors from the
production of one commodity to the other.
The negative of the slope of the PPF is called the marginal rate of product

Micro economics II 49
transformation (MRPTXY) and it shows the amount of Y that must be sacrificed in order
to obtain an additional unit of X.

dY
MRPTXY= - by definition
dX
dMC
MRPTXY = X
.
dMC Y

dTC dTC
Proof: MCX= X
& MCY= Y

dX dY
MC dTC dY
X
=( X
). ……………..(1)
MC Y
dTC Y
dX

Because TCx = w.LX + r.KX and TCY= w.LY + r.KY and w&r are given,
d(TCX) = w.(dLX)+ r.(dKX) ........................(2)
d(TCY) = w.(dLY)+ r.(dKY) ........................(3)
Substituting (2) & (3) into (1) gives,
MC X dTC X dY w.(dL X )  r.(dK X ) dY
=( ). = . ………………(4)
MC Y dTC Y dX w.(dL Y )  r.(dK Y ) dX
Movement on a given PPF (or full employment of resources requires that the factors
released from the decrease in commodity Y must be equal to the factors absorbed by
the increase in the production of X, i.e.,
dLX = - dLY and dKX = - dKY…………………..(5)
Substituting (5) into (4) yields,
MC X w.(dL X )  r.(dK X ) dY dY dY
= . = -1. =- = MRPTXY
MC Y w.(-dL X )  r.(-dK X ) dX dX dX
In perfect competition the profit maximizing producer equates the price of the
commodity produced to the marginal cost of production: MCX=PX and MCY=PY.
MC PX
MRPTXY= X
=
MC Y
PY
Assuming that the market prices of the commodities define the slope of line AB (in
figure below), the general equilibrium of production is given by point T. The two firms
are in equilibrium producing the levels of output Ye and Xe.

Micro economics II 50
 Y
A

F
T
Ye
PX
Slope = -
PY

Xe Fʼ B X

*Equilibrium of Production
5.1.2.3 Simultaneous Equilibrium of Production and Consumption (Efficiency in
Product-Mix)

The general equilibrium of the system as a whole requires the fulfillment of the
condition: MRPTXY = MRSXYA = MRSXYB.
PX
In perfect completion, this condition is satisfied since MRPTXY= (equilibrium of
PY
PX
production), MRSXYA = MRSXYB = (equilibrium of consumption) and it follows that,
PY
PX
MRPTXY = MRSXYA = MRSXYB = .
PY
Only when the rate at which the consumers are willing to exchange one good for
another (MRSXY) equals the rate at which a good can be transformed into another in
production (MRPTXY) the production sectorsʼ plans are consistent with the household
sectorsʼ plans, and the two are in equilibrium.

Micro economics II 51
 Y
A

F
T OB
Ye
PX
Slope = -
PY

H C

OA
G Xe Fʼ B X

*Equilibrium of Production
The economy is in equilibrium (of production) producing Xe units of X and Ye units of Y
where the slope of PPF (=MRPTXY) equals the commodity price ratio (PX/PY} at point T.
Given the Xe and Ye amounts of the commodities, we can draw the Edgeworth box of
consumption with the dimensions OAYe and OAXe. Then, the consumers will have an
efficient distribution of X and Y between them along the contract curve. The unique
equilibrium (of consumption) will be at a point of tangency of the X and Y isoquants
with the common slope equal to the slope of the PPF at point T. If this happens to be at
point C, A maximizes his/her utility by consuming OAG units of X and OAH units of Y.
Individual B maximizes his/her utility, consuming GXe units of X and HYe units of Y.
Divergence between MRSXY and MRPTXY implies disequilibrium of the economy.
2Y Y
Suppose that the MRPTXY= while MRSXY= . This conveys that the economy can
X X
produce two units of Y by sacrificing one unit of X, while the consumers are willing to
exchange one unit of X for one unit of Y. This means firms produce a larger quantity of
X and a smaller quantity of Y relative to the preferences of the consumers.
Firms must reduce X and increase the production of Y for the attainment of general
equilibrium (see the figure below).

Micro economics II 52
 Y

2Y
d MRPTXY = - X

O
X

After determining the equilibrium quantities of the inputs and the commodities, the
next step is to determine the prices (PX, PY, w and r].
From the Walrasian general equilibrium framework, we have the following equations
MRTSLKX = w/r = MRTSLKY --------------------------------------------1
w = MPPLX.PX = MPPLY.PY----------------------------------------------2
r = MPPKX.PX = MPPKY.PY----------------------------------------------3
MRSYXA=MRSYXB=PY/PX----------------------------------------------- 4

w (MPP .P X ) (MPP .P Y )
Dividing (2) by (3) gives = LX
= LY

r (MPP KX
.P X ) (MPP KY
.P Y )

which is identical to equation (1). There are only 3 independent equations with
four unknowns. There will be no unique solution. We choose one of the prices as
a numeraire (unit of account) and express the other prices in terms of (relative to) the
numeraire. Let the numeraire be PX.
From (1), w = r.MRTSLK------------------- (5)
From (3), r = MPPKX.PX -------------------(6)
Substituting (6) in to (5), w = MPPKX.PX. MRTSLK----------------- (7)
From (4), PY = PX. MRSYX--------------- (8)
We can derive the relative prices from (6), (7) and (8):
w
i. = MPP K X
MRTS LK
PX
r
ii. = MPP K X
PX
PY B
iii. = MRS Y X
PX

Micro economics II 53
Note that the change of numeraire leaves the relative prices unaffected.
At its present stage, general equilibrium theory is largely non-operational and
unrealistic. But, by viewing the economy as a vast system of mutually interdependent
markets, it makes the student aware of the complexity of the real world. Moreover, the
solution which exists under certain assumptions and its optimality properties can be
used as a norm to judge the significance and implications of deviations of the various
markets from this ideal state of equilibrium.

5.2 WELFARE ECONOMICS

5.2.1 Definition of Welfare Economics

Welfare Economics studies the conditions under which the solution to the general
equilibrium model can be said to be optimal. It examines the conditions for economic
efficiency in the production of output and the exchange of commodities and equity in
the distribution of income.
Note that the above definition points out that the maximization of societyʼs well – being
requires not only efficiency in production and exchange but also equity in the
distribution of income.

5.2.2 Utility Possibility Frontier/Curve (UPF/UPC) and

Grand Utility Possibility Frontier (GUPF)
The UPF shows the various combinations of utilities received by individuals A and B
(i.e., UA and UB) when our simple economy is in general equilibrium or Pareto optimum
in exchange; it is the locus of maximum utility for one individual for any given level of
utility for the other individual.
UB
U Mʼ

UPF

U Mʼ

UA
UPF UMʼUMʼ shows the various combinations of utilities received by individuals A and B
(i.e., UA and UB) when the economy composed of individuals A and B is in general
equilibrium or Pareto optimum in exchange. The frontier is obtained by mapping
consumption contract (OC) in the Edgworth box of consumption (on page 8) from
output or commodity space to utility space.
Note that UPF is associated with Pareto efficient allocations given equilibrium of

Micro economics II 54
 PX
production (i.e., given a point on PPF where MRPTX, Y = ). This means we have
PY
another UPF for any other point on PPF. In general we can have as many UPFs as there
are points on PPF.
GUPF is the envelope of these UPFs associated with Pareto optimum points of
production and exchange.

UB
G

Eʼ
U Mʼ
GUPF
U Nʼ

Hʼ

U Mʼ U Nʼ G

UA

UMʼUMʼ is UPF drawn when the economy is in production equilibrium at point e as

shown on page 8. UNʼUNʼ is another UPF drawn on the assumption that the economy is
in equilibrium of production at point d on its PPF. By joining points Eʼ, Hʼ, and other
points of equilibrium similarly obtained, we can derive GUPF which is curve GEʼHʼG in
the above diagram.
The GUPF indicates that no reorganization of the production – exchange process is
possible that makes someone better off without, at the same time, making someone
else worse off. Given GUPF of the above sort, in order to determine the Pareto
optimum point in production and exchange at which social welfare is maximized, we
need a social welfare function.

5.2.3 Social Decision Mechanisms

The only way we can decide which of the Pareto efficient points on the GUPF
represents the maximum social welfare is to accept the notion of interpersonal
comparison of utility. Before we investigate the implications of this concept, it is
worthwhile considering first how one might go about bringing together the individual
consumerʼs preferences to construct some kind of “social preferences”. Two
approaches that are of major interest are:
a) Majority voting approach

Micro economics II 55
 b) Rank – order voting approach

A) Majority voting approach (MVA)

Majority voting approach is one way to aggregate individual preferences. In this form of
aggregation, allocation X is said to be preferred to allocation Y if a majority of the
individuals prefer X to Y. For example, in an economy consisting of three individuals, if
two of them prefer X to Y and one of them prefers Y to X, using majority voting
approach we conclude that the society prefers X to Y.
However, there is a problem with this method in that it may not generate transitive
social preference ordering. Suppose we have the following voting result.

Choice Person Person Person

A B C
1st X Y Z
2nd Y Z X
3rd Z X Y

The table shows that

 Persons A and C prefer X to Y and person B prefers Y to X. Hence X > Y.
 Persons A and B prefer Y to Z and person C prefers Z to Y. Hence Y > Z.
If this social preference ordering were transitive we could conclude that X > Z.
However, from the table we know that persons B and C prefer Z to X implying that Z >
X.
Since the preferences are not transitive, there will be no “best” alternative from the set
of alternatives (X, Y, Z). Which outcome society chooses will depend on the order in
which the vote is taken. That is, for example, if the three people vote first on:
 X versus Y and then vote on the winner of this contest versus Z, the best
alternative will be Z.
 Z versus X and then vote on the winner of this contest versus Y, the best
alternative will be Y.
 Y versus Z and then vote on the winner of this contest versus X, the best
alternative will be X.
Therefore, majority vote can be manipulated by changing the order in which things are
voted so as to yield the desired outcome.

B) Rank–Order Voting Approach (RVA)

Here each person ranks the allocations according to his preferences and assigns a
number that indicates its rank in his ordering. Consider the following table.

Allocations Person Person Sum of the

A B ranks
X 1 2 3
Y 2 1 3

Micro economics II 56
Since the sum of the ranks is equal for both alternatives, the society is indifferent
between X and Y.
Rank order voting has also a limitation. It can be manipulated by introducing new
alternatives that change the final ranks of the relevant alternatives. For example,
consider the following table.

Allocations Person Person Sum of the

A B ranks
X 1 3 4
Y 2 1 3
Z 3 2 5

Note that the introduction of a new alternative (i.e., alternative Z) resulted in Y being
preferred to X despite our earlier conclusion that the society is indifferent between X
and Y when alternative Z was not introduced.
To summarize, both majority voting and rank – order voting have limitations in that their
outcomes can be manipulated by astute agents. The question that normally follows is
“Are there other social decision mechanisms, apart from majority voting and rank –
order voting, that are immune to the limitations of these two voting approaches?” In
other words, are there other social decision mechanisms that satisfy the following
properties?
a) Given any set of complete, reflexive, and transitive individual preferences, the
social decision mechanism should result in social preferences that satisfy the
same properties.
b) If everybody prefers alternative X to alternative Y, the social preferences should
rank X ahead of Y.
c) The preferences between X and Y should depend only on how people rank X
versus Y, and not on how they rank other alternatives.
It can be quite difficult to find a mechanism that satisfies all the above properties. In
fact, Kenneth Arrow has proved the following remarkable result which is known as
Arrowʼs Impossibility Theorem.
“If a social decision mechanism satisfies properties a, b and c, then
it must be a dictatorship: all social rankings are the rankings one
individuals.”
Arrowʼs impossibility theorem shows that three very plausible and desirable features of
a social decision mechanism are inconsistent with democracy. That is under
democratic system, there is no perfect way to “aggregate” individual preferences to
make one social preference. If we want to find a way to “aggregate” individual
preferences to form social preferences, we will have to give up one of the properties of
a social decision mechanism described in Arrowʼs impossibility theorem.
Suppose we drop property (c). If we do that, certain kinds of rank – order voting
become possibilities as discussed in the following sub – section.

Micro economics II 57
5.2.4 Social Welfare Function
A social welfare function is just some function of individual utility functions:
W (U1 (X), …,Un (X))
It gives a way to rank different allocations that depends on the individual preferences.
In the above definition, Ui (X) is each individual iʼs preference over the allocations that
summarize the individualʼs value judgments about the allocations. For example, person
i prefers X to Y if and only if Ui (X) > Ui (Y).
There are different ways of formulating social welfare function from individualsʼ
preferences, some which are:
a) By adding the individual utilities and use the resulting number as a kind of social
welfare function. That is,
n

W (U1 (X), …,Un (X)) = U

i 1
i
(X ) .
This is sometimes known as classical utilitarian or Benthamite welfare function. In
this form of social welfare function, we say allocation X is socially preferred to
n n

allocation Y if 
i 1
U i(X ) > U
i 1
i
(Y ) .
A slight generalization of the utilitarian welfare function is the weighted sum - of
- utilities welfare function.
n

W (U1 (X), …,Un (X)) = a U

i 1
i i
(X ) .
Where the weights a1, …,an , are supposed to be numbers indicating how
important each agentʼs is to the overall social welfare.
b) Considering the welfare of the worst off agent as the that affects the social
welfare
of an allocation. That is:
W (U1 (X), …,Un (X)) = min U1 (X), …,Un (X)
Given the welfare function defined as above, we can construct isowelfare curves as
shown below.

U2

W3

W2
W1

U1

Micro economics II 58
Isowelfare curves show those distributions of utility that have constant welfare.
The allocation that maximizes social welfare can then be obtained by bringing together
our GUPF and the isowelfare curves.
Social welfare is maximized when GUPF is tangent to the highest possible isowelfare
curve.

U2

U 2* e

W2
W1

U1
U1*
The economy maximizes social welfare when it achieves general equilibrium at an
allocation which generates U1* and U2* levels of utility to consumer 1 and consumer 2
respectively.

5.2.5 Fair Allocations, Envy and Equity

The welfare function approach is a very general way to describe social welfare. But
because it is so general it can be used to summarize the properties of many kinds of
moral judgments. On the other hand, it isnʼt much use in deciding what kinds of ethical
judgments might be reasonable ones.
Another approach is to start with some specific moral judgments and then examine
their implications for economic distribution. This is the approach taken in the study of
fair allocations.
Suppose that we were given some goods to divide fairly among n equally deserving
people. How would you do it? It is probably safe to say that in this problem most people
would divide the goods equally among the n agents. Given that they are equally
deserving, what else could you do?
One appealing feature of this equal division is that it is symmetric. Each agent has the
same bundle of goods; no agent prefers any other agentʼs bundle of goods to his/her
own, since they all have exactly the same thing.
Unfortunately, an equal division will not necessarily be Pareto efficient. If agents have
different tastes they will generally desire to trade away from equal division. Letʼs
suppose that this trade takes place and that it moves us to a Pareto efficient allocation.
The question that arises is: is this Pareto efficient allocation still fair in any sense? Does
trade from equal division inherit any of the symmetry of the starting point? The answer
is: not necessarily. Consider the following example. We have three people, A, B, and C.
A and B have the same tastes, and C has different tastes. We start from an equal

Micro economics II 59
division and suppose that A and C get together and trade. Then they will typically both
be made better off. Now B, who didnʼt have the opportunity to trade with C, will envy A
– that is, he/she would prefer Aʼs bundle to his/her own. Even though A and B started
with the same allocation, A was luckier in his/her trading, and this destroyed the
symmetry of the original allocation.
This means that arbitrary trading from an equal division will not necessarily preserve
the symmetry of the starting point of equal division. Is there any way to get an
allocation that is both Pareto efficient and equitable (symmetric) at the same time?
An allocation is said to be equitable if no agent prefers any other agentʼs bundle of
goods to his/her own. If some agent i does prefer some other agent jʼs bundle of goods,
we say that i envies j. If an allocation is both equitable and Pareto efficient, we will say
that it is a fair allocation.
Instead of just any arbitrary way to trade, if we use the special mechanism of the
competitive market, a trade away from equal division will result in a Pareto efficient
allocation. It is also impossible for A to envy B in these circumstances. A competitive
equilibrium from equal division must be a fair allocation. Thus the market mechanism
will preserve certain kinds of equity: if the original allocation is equally divided, the final
allocation must be fair.

Micro economics II 60
CHAPTER SIX

MARKET FAILURE

It was concluded that all competitive equilibrium are Pareto - efficient, that all welfare
maxima are competitive equilibrium and that all competitive equilibrium are welfare
maxima for some welfare function. Either the self-interest of the individual economic
agents results in the maximum social welfare or redistribution of economic resources
via non-distortional mechanisms results in a fair allocation given perfectly competitive
markets.
However, the prerequisites for perfect competition are unlikely to hold. Competitive
markets fail for four reasons:
i. market power
ii. public goods
iii. externalities
iv. incomplete information

6.1 Market Power

Inefficiencies arise when a producer (supplier) of a commodity has market power. If
there is, for example, a monopoly power in one of the sectors, the quantity of output
produced will be at a point where MR=MC (and P>MR) and sells less output at a higher
price than in perfect competition. If this industry is industry X, MCX=MRX < PX. If
another industry, say industry Y, is perfectly competitive, it will produce where MCY =
MRY = PY. Thus, MRPTXY= MCX/MCY < PX / PY, and so this economy doesn't reach
Pareto- optimum.
Similarly, if the labor market is perfectly competitive while the capital market is
imperfectly competitive, the least-cost input combination in production is given by:
MPP MPP
L
= K
; MEL = w and MEK > r
ME L
ME K

MPP ME w w
L
= L
< MRTSLK ≠ and so this economy doesn't
MPP K
ME K
r r
reach Pareto – optimum.
6.2 Public Goods
Public goods are goods that are non-excludable and non-rival: the marginal cost of
provision to an additional consumer is zero and people cannot be excluded from
consuming it.
Non-excludability - it is technically difficult to exclude others or the exclusion cost is
very high.
Non-rival in consumption - once available, the addition of consumers up to capacity
constraint doesn't reduce the availability of the good.

Micro economics II 61
Because there is non-rivalry in consumption (the marginal cost of the additional
consumer is zero), there is welfare improvement if people are added to the
consumption of the good. In such situations, usually, people are attempting to free ride
on each other. The free rider problem arises when a consumer or producer doesn't pay
for a non-excludable good in the expectation that others will.
Examples of public goods include national defense, national TV, streets and sidewalks.
Consider cleaning your room (dormitory). Each of you may prefer to see the living room
clean and is willing to do his part. But each may also be tempted to free - ride so that
no one ends up cleaning the room, with the result being untidy room. This letting the
other guy do it may be optimal from an individual point of view, but it is Pareto -
inefficient from the viewpoint of society at large.

6.3 Externalities

The market system (mechanism) is capable of achieving Pareto - efficient allocations

when there are no externalities. In the presence of externalities, however, market
prices don not reflect the activities of either producers or consumers. Externality is
said to exist when the production/consumption activities of one party enter the
production /consumption activities of other party, without any payment for the effect.
Externalities may be classified as consumption externalities and production
externalities. Each of these types may be negative or positive.
Examples:
i. Negative consumption externalities:
- pollution produced by local automobiles,
- a smoker next to an individual in a restaurant smoking a cigar,
- playing loud music in a neighbor hood,---
ii. Positive consumption externalities:
- pleasure from observing your neighbor's flower garden
iii. Negative production Externalities:
- water pollution by a steel industry for a fishery down the stream.
iv. Positive production externalities
- an apple orchard located next to a beekeeper.
The crucial feature of externalities is that there are goods people care about that are
not sold on markets. It is this lack of markets for externalities that causes problems.
If there are externalities, there is divergence between private and social benefits and
costs.
The equilibrium condition for the pirate decision-maker is MPC=MPB, (M=marginal,
P = private, C = cost and B= benefit).
For the society at large, an efficient allocation requires that MSC = MSB, (S=social).
If, for instance, there is positive externality in production the firm(s) produce at point
where MPB = MPC. But this is different from the socially efficient level as MSB (=
MPB+MEB) > MPB, (E=External).

6.4 Asymmetric Information

Asymmetric information is a situation in which a buyer and a seller possess different

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information about a transaction. There are certainly many markets in the real world in
which it may be very costly or even impossible to gain accurate information about the
quality of the goods being sold. For example, labor was assumed to be a
_
homogeneous factor everyone had the same" kind" of labor and supplied the same
amount of effort per hour worked. In reality, it may be very difficult for a firm to
determine how productive its employees are. Similarly, when a consumer buys a used
car it may be very difficult for him to determine whether or not it is a good car or a
lemon. By contrast, the seller of the used car probably has a pretty good idea of the
quality of the car. This asymmetric information may cause significant problems with
the efficient functioning of a market. In the presence of asymmetric information, there
may be too few transactions or transactions may fail at all. Adverse selection and
moral hazard are the results of information asymmetry.

6.4.1 Adverse Selection (The Hidden Information Problem)

It refers to a situation where one side of the market cannot observe the type or quality
of the goods on other side of the market. Equilibrium in a market involving hidden
information will typically involve too little trade taking place because of the externality
between the "good'' and "bad" types. The equilibrium will be inefficient relative to the
equilibrium with full information.
Consider an example from the insurance industry. Suppose that an insurance
company wants to offer insurance for bicycle theft. In some areas there is a high
probability that a bicycle will be stolen, and in other areas thefts are quite rare.
Suppose that the insurance company decides to offer the insurance based on the
average theft rate. Who is going to buy the insurance at the average rate? Not the
people in the safe communities _ they don't need much insurance anyway. Instead the
people in the communities with a high incidence of theft will want the insurance _ they
are the ones who need it. But this means that the insurance claims will mostly be made
by the consumers who live in the high-risk areas. The insurance company will not get
an unbiased selection of customers; rather it will get an adverse selection. Thus, if
insurance companies must charge a single premium because they can't distinguish
between high - risk and low - risk groups (individuals), more high – risk groups
(individuals) will insure, making it unprofitable to sell insurance.
In fact there are social institutions that help to solve this market inefficiency. It is
commonly the case that employers offer health plans to their employees as part of the
package of fringe benefits (in case of adverse selection health insurance). The
insurance can base its rates on the average over the set of employees and is assured
that all employees must participate in the program thus eliminating the adverse
selection. Or, it is generally possible to require the purchase of insurance that reflects
the average risk in the population by everyone - compulsory purchase plan.

6.4.2 Moral Hazarded (The Hidden Action Problem)

Moral hazard refers to a situation where one side of the market cannot observe the
action of the other. It exists when an insured party whose actions are unobserved can
affect the probability or magnitude of a payment associated with an event.

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Consider the bicycle theft insurance market again and suppose for simplicity that all of
the consumers live in the areas with identical probabilities of theft, so that there is no
problem of adverse selection. On the other hand, the probability of theft may be
affected by the actions taken by the bicycle owners.
If it is impossible to buy bicycle - theft insurance, consumers have an incentive to take
the maximum possible amount of care. In this case the individual bears the full cost of
his actions and accordingly he wants to "invest” in taking care until the marginal
benefit from more care just equals the marginal cost of doing so. But if the consumer
can purchase bicycle - theft insurance, then the individual's incentive to take care will
be less. If the amount of care is observable, then there is no problem because the
insurance company can base its rates on the amount of care taken. But insurance
companies can't observe all the relevant actions of those they insure. Therefore, a
trade-off will be involved: too little insurance means that people bear a lot of risk, too
much insurance means that people will take inadequate care. The fact that the
consumer can choose the amount of care he takes impels that the insurance company
will not allow the consumer to purchase as much insurance as he wants if the company
cannot observe the level of care.
The amount of a good traded in a competitive market is determined by the condition
that demand equals supply - the marginal willingness to pay equals the marginal
willingness to sell. In the case of moral hazard, a market equilibrium has the property
that each consumer would like to buy more insurance and the insurance companies
would be willing to provide more insurance if the consumers continued to take the
same amount of care --- but this trade can't occur because if the consumers were able
to purchase more insurance they would rationally choose to take less care.

6.4.3 Signaling

Signaling is the process by which sellers send messages (or signals) to buyers
conveying information about product quality. Recall our example of the used-car
market: the owners of the used car knew the quality but the purchaser had to guess at
the quality. We saw that this asymmetric information could cause problems in the
market; in some cases, the adverse selection problem would result in too little
transactions being made. However, the owners of the good used-cars have an
incentive to try to convey the fact that they have a good car to the potential purchasers.
They would like to choose actions that signal the quality of their car to those who might
buy it.
One sensible signal in this context would be for the owner of a good used-car to offer a
warranty. This would be a promise to pay the purchaser some agreed upon amount if
the car turned out to be a lemon. Owners of the good used-cars can afford to offer
such a warranty while the owners of the lemons can't afford this. This is a way for the
owners of the good used-cars to signal that hey have good cars. In this case signaling
helps to make the market perform better.

6.4.4 Information Asymmetry, Monitoring Costs and Microfinance

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When a lender wants to provide credits to the borrowers, he faces problem(s) of
asymmetric information: adverse selection and/or moral hazard.
Lenders have limited information about the credit worthiness of their borrowers. This is
because:
1. It is costly (or impossible) for the lender to know whether a borrower is able to
repay his debt, i.e., whether he is a hard-working person or not.
2. It is costly to monitor the borrower on what is being done with the loan. The
borrower might use the money borrowed for consumption (or unproductive
activities), which is not easily transferred into monetary repayment. Or, he
might use it in risky activities such as gambling.
* These two reasons result in involuntary default.
3. If enforcement (of the court procedure) is costly, the borrower may voluntarily
default.
For big financial banks (say CBE), verifying the borrowers credit worthiness is very
costly, especially for a large number of small-scale borrowers. As a result formal banks
do not provide credit for small borrowers (say farmers) because of adverse selection,
moral hazard and huge transaction costs. However, social welfare can be increased if it
is possible to provide credit for those who demand it.
Village Money Lenders - village money lenders have a comparative advantage in
these small-scale loans for several reasons:
1. They can deal with small scale lending more effectively - less costs of
transaction.
2. They have better access to information about who are good and bad credit
risks than outsiders.
3. They are in a better position to monitor the progress of the loan repayments to
insure repayment.
This means that the village money lenders are in a better position in dealing with the
problems of returns to scales, adverse selection and moral hazard. The problem with
these village money lenders is that they have limited funds and can provide credit for
limited number of people. This results in a very high interest rate. This implies that
there will be many profitable projects that won't be undertaken by the peasants.
Improved access to credit could lead to a major increase in investment, and a
corresponding increase in the standards of living (social welfare).
Muhammed Yunas an American-trained economist from Bangladesh has developed
an institution known as the Grameen Bank (village Bank) to address some of these
problems. This kind of village bank is widely known as microfinance institution.
In the Grameen plan, entrepreneurs with separate projects get together and apply for
loan as a group. If the loan is approved, two members of the group get their loan and
commence (start) their investment activity. If they are successful in meeting the
repayment schedule, two more members get loans. If they are also successful the last
member, the group leader, will get a loan. In doing so, the Grameen Bank avoids the
problems of formal banks and local money lenders (at least partially):
i. The interest rate is much lower than that of local money lenders implying more
investment.
ii. Since the quality of the group influences whether or not individual members will

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 get loans, potential members are highly selective about whom they will join with.
(Problem of adverse selection is avoided to some extent).
iii. Since members of the group can only get loans if other members succeed in
their investments, there are strong incentives to help each other out and share
expertise. This way they avoid the problem of moral hazard.
iv. These activities of choosing candidates for loans and monitoring the progress
of the repayments are all done by the peasants themselves, not directly by the
loan officers at the bank. This way, microfinance institutions reduce the
transaction costs of selecting and monitoring.
The Grameen bank has been very successful in encouraging investment and raising
the loan-recovery rate (from 30-40% to 98% in Bangladesh as an example).

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