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Advanced Economic Theory, Semester V – TYBA by Krishnan Nandela, Associate Professor & Head, Department of Economics, Dr. TK Tope Arts & Commerce Night Senior College, Parel, Mumbai – 400 012

SEMESTER – V

THIRD YEAR BACHELOR OF ARTS

BY

KRISHNAN NANDELA ASSSOCIATE PROFESSOR &

HEAD, DEPARTMENT OF ECONOMICS

2


DR. TK TOPE ARTS & COMMERCE NIGHT SENIOR COLLEGE

PAREL, MUMBAI – 400 012

PAPER IV: TYBA.

ADVANCED ECONOMIC THEORY

SEMESTER - V

1. PRICE AND UNDER OLIGOPOLY. [14 lectures]

Features of Oligopoly market, Cournot’s model, Kinked Demand Curve

Hypothesis, Collusion: Cartels and Price Leadership. Game Theory: Nash

Equilibrium and Prisoner’s Dilemma.

2. THEORY OF FACTOR PRICING. [12 lectures]

Factor Pricing in Perfectly and Imperfectly Competitive Markets. Economic Rent.

Wage Determination under Collective Bargaining, Bilateral Monopoly. Loanable

Funds Theory, Risk, Uncertainty and Profits.

3. GENERAL EQUILIBRIUM AND SOCIAL WELFARE. [12 lectures]

Interdependence in the economy, General Equilibrium and its existence. The

Pareto Optimality Criterion of Social Welfare, Marginal Conditions for a Pareto

Optimal Resource Allocation, Perfect Competition and Pareto Optimality.

4. ECONOMICS OF INFORMATION. [12 lectures]

Economics of Search: Search costs. Information failure and missing markets.

Asymmetric Information: The market for Lemons. Adverse selection: Insurance

Markets. Market Signaling. The Problem of Moral Hazard. The Principal-Agent

Problem. The Efficiency Wage Theory.

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References.

1. Dornbusch R S, Fischer and R Startz, Macroeconomics 8e New Delhi Tata Mc Grow Hill

2004 [UNIT- 6].

2. Dwiwedi D N, Principles of Economics, New Delhi, Vikas Publishing House, 2008

(UNIT- 7).

3. Froyen R T Macroeconomics: Theories and Policies, Delhi Pearson Education Asia, 2001

[UNIT- 5].

4. Mankiw N Gregory, Macroeconomics, 6e New York, Worth Publishers 2003, [UNIT-

5,6].

5. Mankiw N G, Principles of Economics, 6e New York, Worth Publishers 2003.

6. Musgrave R A and P B Musgrave, Public Finance in Theory and Practice, 5e New York,

Mc Graw Hill International Edition, 1989 [UNIT- 8].

7. Koutsoyannis, Modern Microeconomics, Macmillan Press Ltd., London.

8. Salvatore D Microeconomics: Theory and Applications, New Delhi Oxford, New Delhi

Oxford University Press 2006 [UNIT- 1-4].

9. Salvatore, D. (1997) International Economics, Printice Hall, New York [UNIT- 7].

10. Sodersten, Bo (1991), International Economics, The Mc Millan Press, London [UNIT- 7].

11. Stiglitz J Economics of Public Sector 3e New York W W Norton and Co 2000, [UNIT-

8].

12. Sujoy Chakravarty, Daniel Friedman, Gautam Gupta, Neeraj Hatekar, Santanu Mitra,

Shyam Sunder (2011) Economic & Political Weekly, August 27- September 2, 2011 Vol

XLVI No. 35 P 39-78.

13. T.N. Hajela (2013): Macroeconomic Theory, 10th ed Ane Books Pvt. Ltd.

14. T.N. Hajela (2013): Public Finance - 3/e, Ane Books Pvt. Ltd.

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No.

Chapter

Pages

Module – I.

1.

Price under Oligopoly. Cournot’s Model, Collusion: Cartels and Price Leadership.

07

2. Game Theory. Nash Equilibrium and Prisoner’s Dilemma, Public Goods Games.

21

Module – II.

3.

Theory of Factor Pricing. Factor Pricing in Perfectly and Imperfectly Competitive Markets, Theory of

Economic Rent, Wage Determination under Bilateral Monopoly and the Role

of Collective Bargaining, Loanable Funds Theory, Risks, Uncertainty and

Theory of Profits.

33

Module – III.

4.

General Equilibrium. Interdependence in the Economy – General Equilibrium and its Existence-The

Pareto Optimality.

Condition of Social Welfare, Marginal Conditions for Pareto Optimal

Resource Allocation,

Perfect Competition and Pareto Optimality; - Kaldor- Hicks Compensation

Criterion - Arrow’s Impossibility Theorem.

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Module – IV.

5.

Economics of Information. Economics of Search: Search Costs, Information Failure and Missing

Markets – Asymmetric Information: The Market for Lemons, Adverse

Selection: Insurance Markets, Market Signaling,

The Problem of Moral Hazard, The Principal-Agent Problem, Efficiency

Wage Theory.

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6. University of Mumbai Question Papers 90

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QUESTION BANK FOR AET – TYBA

SEM - V

Module I - Decision making under Oligopoly.

1. Explain the Cournot Model of Oligopoly.

2. Explain price leadership under Cartel.

3. Write a note on Game theory regarding Prisoners’ Dilemma and Nash equilibrium.

4. Write a note on public goods games.

Module II - Theory of Factor Pricing.

1. Explain the marginal productivity theory of distribution.

2. Explain the factor price determination under imperfect competition.

3. Explain the concept of Economic Rent.

4. Write a note on collective bargaining and wage determination.

5. Explain wage determination under bilateral monopoly.

6. Explain the loanable fund theory of interest.

7. Profit is a reward for risk and uncertainties. Explain.

Module III - General Equilibrium and Social Welfare.

1. Explain the theory of general equilibrium.

2. Explain the Pareto optimality conditions of social welfare.

3. Explain the marginal conditions of Pareto optimality about allocation of resources.

4. Write a note on Pareto optimality and perfect competition.

5. Write a note on Kaldor-Hicks compensation criterion.

6. Write a note on Arrow’s Impossibility Theorem.

Module IV - Economics of Information.

1. Explain the concept of search costs, information failure and missing markets.

2. Write a note on asymmetric information and the market for lemons.

3. Write a note on the problem of adverse selection in the insurance market.

4. Explain the problem of moral hazard in the insurance market.

5. Explain the principal agent problem.

6. Explain the efficiency wage theory.

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QUESTION PAPER PATTERN

SEMESTER - V

Note.

1. All questions carry equal marks.

2. Figures to the right indicate full marks.

Q.1. Module I. (Answer any two) 15

a) Features of Oligopoly, Cournot Model, Kinked Demand Curve.

b) Collusion: Cartels and Price Leadership.

c) Game Theory.

Q.2. Module II. (Answer any two). 15

a) Factor pricing under perfectly and imperfectly competitive markets.

b) Economic rent, wage determination under collective bargaining, bilateral monopoly.

c) Loanable funds theory and risk, uncertainty and profits.

Q.3. Module III. (Answer any two). 15

a) Interdependence in Economy, General equilibrium and its existence.

b) Pareto optimality criterion of social welfare, marginal conditions for Pareto optimality.

c) Perfect competition and Pareto optimality.

Q.4. Module IV. (Answer any two). 15

a) Economics of Search, Search costs, Information failure and missing markets.

b) Asymmetric information, Market for lemons, Adverse selection Insurance Market and

market signaling.

c) The problem of moral hazard, principle agent problem and Efficiency Wage Theory.

Q.5.Modules I to IV. (Answer any three). 15

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UNIT ONE

PREVIEW.

▪ Introduction.

▪ Characteristic Features.

▪ Models of Price and Output Determination under Oligopoly.

▪ Non-collusive Oligopoly Model – Price and Output Determination under Duopoly.

▪ Price Leadership Models (Dominant Firm, Low cost firm and Barometric Price

Leadership).

▪ Collusive Oligopoly: Price and Output under Cartels.

INTRODUCTION

The term ‘Oligopoly’ has been derived from two Greek words, ‘Oligi’ which means ‘few’ and

‘polein’ which means sellers. Thus, oligopoly is an abridged version of monopolistic

competition. It is a competition among few big sellers each one of them selling either

homogenous or heterogeneous products. Each seller under oligopoly competition has a market

share substantial enough to influence the price and output decisions of rival firms. Oligopoly

markets can be classified into two namely pure or homogenous oligopoly and differentiated or

heterogeneous oligopoly.

The Indian market is an ideal example of an oligopoly market. The consumer durable goods

industry manufacturing television sets, washing machines, water purifiers, refrigerators, air

conditioner etc. is an industry consisting of few firms. Similarly, the automobile industry and the

cigarette manufacturing industry also consists few firms. All these industries can be categorized

into differentiated or heterogeneous oligopoly because each one of the firms sells their products

with a different brand name, price and features.

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CHARACTERISTIC FEATURES

Let us now look at the main characteristics of an Oligopoly market structure.

1. Few Sellers: The Oligopoly market is characterized by few large firms or sellers, each

sharing a substantial portion of the total market. The number varying from at least two

sellers to about ten. Since the market shares of individual firms are substantial, changes in

price and output of one firm influences the price and output policies of rival firms.

2. Interdependence amongst the Firms: Because of the fewness of number, the firms are

interdependent in their decision-making about price, production and promotional policies.

The products offered by the firms are close substitutes and hence the cross-price elasticity

of demand is not only positive but also high. Thus, inaction of individual firms in the face

of price reduction or product differentiation would only be at the cost of reduced market

shares. Hence, under Oligopolistic competition, firms react immediately to the changes in

the business policies of rival firms.

3. Selling Costs: Aggressive advertising and sales promotion exercise is an important

characteristic feature of Oligopolistic competition. Since the products are close

substitutes, the only way to retain or enlarge one’s market share is to resort to non-price

competition. Prof. William Baumol in his work ‘Economic Theory and Operations

Analysis’ have rightly remarked that “it is only under oligopoly that advertising comes

fully into its own”. A firm under oligopoly therefore competes by increasing

advertisement expenditure, product quality improvement and other sales promotion

strategies.

4. Group Behavior: The oligopoly market consists of a small group of big sellers who are

extremely interdependent. In determining their price and output policies, their behavior is

found to vary from collusion to competition. If they find that competition is being

stretched beyond the desirable limits, they may enter into tacit co-operation or collusion

and make common cause. Yet at other times, intense cut-throat competition may be

witnessed to retain and expand their market shares. Thus, the behavior of the group under

oligopolistic competition is uncertain and therefore unpredictable.

5. Indeterminate Average Revenue Curve: The average revenue curve or the demand

curve of an oligopoly firm is found to be indeterminate on account of the inability to

predict or foresee the reactions of the competing firms to one’s own business strategies –

particularly the price and output policies. The demand curve therefore loses its

definiteness and determinateness on account of its responsiveness to the changing prices

of substitutes in the market.

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6. Price Rigidity – or Inelastic Price: Heterogeneous Oligopoly is characterized by price

inelasticity or rigidity. It is fixed at a certain level because a movement away from the

fixed price proves to be counter-productive. For instance, if a firm decides to reduce the

price, all the rival firms will follow suit and reduce the price reduction exercise to

meaninglessness. Similarly, if a firm decides to increase the price, none of the rival firms

will follow resulting in loss of market share for the firm which has attempted price risk.

Thus, once the price is fixed at a certain level, it is found to remain constant.

MODELS OF PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY

Different models of price and output determination under oligopoly have been developed based

on the nature of competition. It is found that the competition between the firms in an

oligopolistic market structure assumes three forms, namely:

1. Open competition leading to price war and finally in non-price competition as

exemplified by the Kinked demand curve model.

2. Price leadership model in which larger firms assume market leadership and determine

market prices to be followed by the smaller firms, and

3. Collusive models which shows co-operation or collusion between firms about price

determination and market sharing.

Based on the nature of competition, several attempts have been made to build models explaining

price and output equilibrium under oligopoly. However, because of the indeterminate demand

curve of an oligopoly firm, none of these models have been able to determine a stable

equilibrium in an oligopolistic market structure. None the less, these models are useful in

understanding the nature of problem of price and output determination under oligopolistic

competition. We will discuss these models in the succeeding paragraphs.

NON-COLLUSIVE OLIGOPOLY MODEL: PRICE AND OUTPUT DETERMINATION

UNDER DUOPOLY

The important models of non-collusive oligopoly are (a) Cournot model and (b) Kinked demand

curve model.

COURNOT’S MODEL (DUOPOLY).

Augustin Cournot, a French economist was the first economist to develop a model of oligopoly

in the form of a duopoly model in the year 1838. Cournot made the following assumptions to

explain his model:

1. There are two firms, each one owning an artesian (deep) mineral water well,

2. Both the firms operate their wells at zero marginal cost,

3. Both the firms have a demand curve with constant negative slope, and

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4. Each firm acts on the assumption that his rival will not react to his decision to change his

price and output.

With these assumptions, let us proceed to explain Cournot’s duopoly model as depicted in Figure

1.1 below.

PR

ICE

Y

P2

C

P1

0

OUTPUT

Q

E

K T

M D X

Fig. 1.1: Cournot’s Model: Price and Output Determination under Non-Collusive Duopoly Let us assume that there are only two firms, namely Firm ‘A’ and Firm ‘B’ in the market and in

the beginning, Firm ‘A’ is the only firm selling mineral water in the market. To maximize

profits, Firm ‘A’ sells ‘OQ’ output at OP2 price. At ‘OQ’ output, both MR and MC are equal to

zero. Firm ‘A’, therefore makes total profit equal to the area OP2EQ. Now let us assume that

Firm ‘B’ makes entry into the market and sells his goods in the remaining half of the market.

Note that, Firm ‘A’ caters only to fifty percent of the market (OQ = QD). Firm ‘B’ assumes that

Firm ‘A’ will not change its price and output policy. With the remaining market QD and the

demand curve ED, the firm obtains its marginal revenue curve EM which divides QD into two

equal halves QM and MD. Accordingly, Firm ‘B’ determines OP1 as the profit maximizing price.

Note that QM output is only one fourth of the total market. On account of Firm ‘B’s entry into

the market, the market price falls to OP1 and the total revenue of Firm ‘A’ accordingly falls from

OP2EQ to OP1KQ. Now Firm ‘A’ begins his price and output adjustment with a hope that Firm

‘B’ will not react. Firm ‘A’ believes that Firm ‘B’ will only cater to 25 percent of the market and

that 75 percent of the market is available to him. To maximize his profits, firm 'A’ supplies 50

percent of 75 percent which is 37.5 percent of the market in the new situation, thereby reducing

his market share from the original 50 percent. Now Firm ‘B’ assumes that Firm ‘A’ will continue

to cater to 37.5 percent of the market and now he can cater to the remaining 62.50 percent of the

market. To maximize his profits in the new situation Firm ‘B’ supplies 50 percent of 62.50

percent i.e., 31.25 percent. Now Firm ‘A’ will again react to ‘B’s action and the process of action

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and reaction continues in the successive periods – In which Firm ‘A’ continues to lose his market

share and Firm ‘B’ continues to gain until the market shares of both the firms is exactly equal at

33.33 percent each. Further adjustments after this would produce the same end-result and hence

the firms reach their equilibrium position with each one catering to 3rd of the market share and

leaving the remaining one third uncatered. Cournot, thus provides a stable equilibrium by

assigning one third each of the market share to both the firms leaving one third unfulfilled. The

model can be extended to suit more than two players i.e., an oligopoly situation. For instance, if

there are three firms, each firm will supply to one fourth of the market and leaving the remaining

one fourth unsupplied. Similarly, if there are four firms, each firm will supply to one fifth of the

market, leaving the remaining one fifth unfulfilled. The formula according to Cournot’s duopoly

model for determining the market share of each firm under oligopolistic competition is Q (n +

1) where Q = market size and n = number of firms.

Although, Augustin Cournot’s duopoly model provides a stable equilibrium solution, it is not

found to be free from limitations. The behavioral assumption that rival firm will not react to

one’s own price and output decisions though it had reacted during the previous time period is

unreasonable and irrational. Further, to assume that the cost of production is zero is not only

unrealistic but also unnecessary to prove his case.

KINKED DEMAND CURVE (PAUL SWEEZY’S MODEL).

Paul Sweezy’s model shows stability or rigidity of price and output under oligopolistic

competition through his Kinked demand curve model. This model is known to be as one of the

best models explaining the behavior of oligopoly firms. The model tries to establish that once

price and output are determined, an oligopoly firm will not find it worthwhile to change its price

and output in response to small changes in the cost of p0roduction – because it believes that if it

reduces its price, other rival firms will follow and the price reduction exercise will become

meaningless. Similarly, if the firm increases its price, other firms will not follow such a move.

Rival firms may stick to their prices and may even reduce them. Thus, under both circumstances,

the firms which initiates changes in price stands to lose. This behavioral assumption is made by

all the firms in respect of each other. The Kinked demand curve model is depicted in Fig.1.2

below.

Although the tendency to maintain the status-quo is the conclusive feature of the Kinked demand

curve model, it would be pertinent to analyze other possible actions and reactions of rival firms.

Three possible actions and reactions of the Firms can be stated as under:

1. Both price cut and price rise is followed by the rival firms,

2. Absence of reaction by rival firms to any change in the price policy of a certain individual

firm, and

3. When there is a price cut, rival firms follow suit but do not follow a price hike.

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RE

VE

NU

E/C

OS

T

Y

d

D

P

0

OUTPUT

Q X

K

MR

MR

d

D

MC 2

MC1

Fig. 1.2 – Kinked Demand Curve Model.

In figure 1.2 above, you will notice that price OP is determined at the Kink between the two

demand curves ‘DD’ and ‘dd’. Assuming ‘dd’ as the market demand curve, the price changing

firm will move along the ‘dd’ demand curve if rival firms are found to be following in like

manner i.e., they react according to possible action (1) above. If the rival firms exhibit in action

as according to possible action (2) above, there the price changing firm will move along the

elastic demand curve DD. The demand curve ‘dd’ is relatively inelastic because change in

demand in response to changes in price is limited by the counter moves of the rival firms.

However, reaction (3) is found to be the most realistic one. Reaction (iii) is described as

asymmetrical behavior of the rival firms because they do not follow suit when there is a price

hike and definitely cuts down their prices when the price changing firm attempts a price cut. This

asymmetrical behavior of the rival firms produces a ‘Kink’ in the demand curves. Thus, only a

part of the demand curve i.e., DK becomes relevant to the firm because when the firm changes

its price i.e., raises its price on demand curve ‘dk’ other firms do not follow the price rise,

thereby forcing down the price changing firm to demand curve ‘DK’. Now when the price

changing firm decides to reduce the price along the demand curve DD, rival firms follow suit

which prevents the price changing firm from taking the advantage of elastic demand on demand

curve DD – and forces him down on the segment Kd of the demand curve which is less elastic

than KD. These two segments, namely, segment DK and segment Kd produces a Kink at point

‘K’ and the relevant demand curve for the firm is obtained as DKd. The marginal revenue curve

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DMR QMR is a discontinuous curve and its two segments DMR and QMR corresponds to the

two segments of the average revenue curve DK and Kd of the Kinked demand curve DKd. The

marginal cost curve MC1 intersects the discontinuous portion of the MR curve and the

equilibrium is established. The oligopoly firm has the freedom to vary its marginal cost between

the points MR and Q and yet maximize profits as you will notice that the change in cost between

these two points does not influence the profitability of the firm. The firm will therefore stick to

OQ level of output and OP price, thus establishing price and output stability.

The Kinked demand curve theory is criticized on the following grounds:

1. The theory explains how price stability is established but it does not explain how price ‘P’ is

determined in the first instance. Prof. Aubrey Silborston, in his work ‘Price behavior of

firms rightly observes: “The most interesting question is not, why prices are sticky in the

short run but who decides what the price is to be and on what principles.

2. The model does not apply to collusive forms of oligopoly which are generally found in

reality.

PRICE LEADERSHIP MODELS

Price leadership under oligopolistic competition may emerge on technical grounds i.e., on

account of technical superiority of an oligopoly firm. It may also emerge out of covert or explicit

agreement between the oligopoly firms. The technical superiority of an oligopoly firm may be

the result of size, efficiency, economies of scale or the ability of the firm to accurately forecast

market conditions.

Price leadership is of various types. The largest firm in the market establishes its dominance and

has a great influence over the market. It assumes leadership in determining prices and the smaller

firms simply follow it. Such a situation is described as price leadership by the dominant firm or it

is known as the dominant firm model. Similarly, a low-cost firm can also assume price

leadership under oligopolistic competition. With the objective of profit maximization, the low-

cost firm sets a lower price than the profit maximizing price of the high cost firms. Thus, the

high cost firms are forced to reduce their prices to the level of the low-cost firm. Yet another

known form of price leadership is known as Barometric price leadership. In this form, the

barometric firm initiates changes in price which is followed by the rival firms. In the succeeding

paragraph, we will discuss the different important types of price leadership under oligopoly.

PRICE LEADERSHIP BY THE DOMINANT FIRM.

Price leadership by a dominant firm is the most common form found under oligopolistic

competition. The firm assumes dominate on account of its largest size and therefore the largest

market share. There are other small firms which accept the leadership of the dominant firm.

Although the dominant firm is capable to drive out the smaller firms from the market by

reducing the price to the extent of being uneconomic to the smaller firms and thereby assume

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monopoly status but on account of laws against monopoly practices, the dominant firm

compromises with the smaller firms.

On account of its market dominance, the dominant firm is aware of the market demand for its

product. He is also aware of the marginal cost curves of the smaller follower firms and thereby

their total market supply at various possible prices. The dominant firm therefore sets its profit

maximizing equilibrium price which is accepted by the smaller firms. The smaller firms behave

like the competitive firms and accept the horizontal demand curves. The price leadership by the

dominant firm and the market sharing with the smaller firm is depicted in Fig. 1.3 below.

PRICE/COST

PRICE/COST

YY

C

A

R

B

F M

S

MD

P2

P2

P3

P3

PP

P1

P1

00

MC

L

MR

L

E

Q

L

DL

OU

TP

UT

X

Fig

. 1.3

: P

rice

lea

ders

hip

by t

he

Dom

inan

t F

irm

15


Panel (a) of Fig. 1.3 above shows the market demand curve MD. The dominant firm must derive

its individual demand curve from the market demand curve MD so that the rest of the market can

be left to the followers. To do this, the dominant firm sets the price and deducts the combined

supply of the follower firms at the given price from the total market demand. Thus, at the price

determined by the dominant firm, its share is equal to the total market demand less the combined

share of the follower firms. Let us now understand the derivation of the demand curve of the

dominant firm. Let us assume that the price set is OP3. At price OP3, the combined supply of the

smaller firms is P3R which is equal to the equilibrium market demand and supply. When the

follower firms cater to the entire market demand, the market share of the dominant firm is nil.

Now when the dominant sets OP price, the total market demand is PB out of which PA is

supplied by the follower firms and the remaining market supply equal to AB is catered to by the

dominant firm. Notice that, when price is further reduced to OP2, the market share of the

dominant firm rises to CF and the follower firms are left with much smaller a share than before.

Further at price P1, the share of the follower firms is reduced to zero and the entire market supply

is catered to by the dominant firm. When we graphically plot the price-output data, we obtain the

downward sloping demand curve of the dominant firm which is shown as P3DL in the diagram.

The marginal cost curve NCL intersects the marginal revenue curve MKL at point ‘E’ and the

equilibrium output OQL is determined. Over the output is determined, the price is determined

according to the demand curve P3DL. Thus, price OP or PQL is determined and the dominant firm

supplies OQL output which is equal to AB. Note that, AB is the difference between market

demand PB and the combined supply of the follower firms PA at price OP which is determined

by the dominant firm (AB = PB - PA). The profit maximizing output and price of the dominant

firm is OQL and PQL. At price PQL or OP, the demand curve of the follower firm is PB.

Similarly, P3R and P2F are the other demand curves of the follower firms. These demand curve

are parallel to the x-axis or horizontal straight lines or they are perfectly elastic because the status

of the follower firms is like that of the competitive firms under perfect competition. The follower

firms are therefore price takers unlike the price making dominant firm. At price OP, the marginal

cost curve of the follower firm MS intersects the AR = NR curves which is PB at point ‘A’. PA

is therefore the profit maximizing output of the follower firms.

The dominant firm model is, however, not free of limitation. The dominant firm, by

nomenclature must be essentially the largest firm in the industry and a firm which can produce

its output at a cost lower than any other firm. Thus, the dominant firm must also be a low-cost

firm. It the price fixed by the dominant firm is not acceptable to the follower firms, they may not

openly challenge the leader but secretively reduce their prices – to increase their market shares.

The follower firms may also resort to non-price competition to increase their market shares.

Thus, the nibbling into the market share of the dominant firm by the follower firms does not

provide a stable equilibrium solution as made to believe by the dominant firm model.

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PRICE LEADERSHIP BY THE LOW-COST FIRM.

The low-cost firm price leadership model under oligopoly can be explained with the following

assumption:

1. There are only two firms with one of them being a low-cost firm.

2. The products produced by these two firms are homogenous. Thus, it is a case of

homogenous oligopoly.

3. Both the firms equally share the market.

With these assumptions, the model can be explained with the help of figure 1.4 below:

RE

VE

NU

E/C

OS

T

Y

P1

P

D

R

E

0

OUTPUT

Q

d

M

MC 2

AC 2

MC 1

AC1

N M

MR

X

Fig. 1.4: Price Leadership by a Low-Cost Firm

You will notice in Fig. 1.4 above that the demand curve Dd is positioned half way between the y-

axis and the market demand curve DM, thus equally dividing the market between the two firms.

Let us assume that these firms are Firm ‘1’ and Firm ‘2’. The marginal revenue curve of each of

these firms is MR. AC1 and MC1 and AC2 and MC2 are respectively the average cost and

marginal cost curves of these two firms. The cost curve of Firm ‘1’ is positioned below the cost

curves of Firm ‘2’, thereby making it obvious that Firm ‘1’ is a low-cost firm. The equilibrium

output of the low-cost firm is determined by the intersection of MC1 with the MR curve at point

‘E’. Accordingly, OM profit maximizing output and OP equilibrium price is determined.

17


However, the profit maximizing output of Firm ‘2’ is determined at point ‘R’ where MC2

intersects the MR curve. Accordingly, ON output and OP1 price is determined. Since, the

products of both the firms are homogenous. Firm ‘2’ cannot change a higher price OP1 and is

therefore forced to reduce its price to OP i.e., accept the price set by the low-cost firm. The low-

cost firm therefore becomes the price leader. Here, Firm ‘1’ is the price leader and Firm ‘2’ is the

price follower.

You may also notice that when the high cost firm is forced to reduce the price to OP, its market

share is equal to OM. Thus, at price OP, the market shares of both the firms are equal and the

sum of their market shares is equal to the market demand OQ (OM + OM =OQ). However, Firm

‘1’ being a low-cost firm has a much larger economic profit then firm ‘2’.

BAROMETRIC PRICE LEADERSHIP.

The firm which is well equipped with market knowledge and can predict market conditions in a

manner more precise than any other firm under oligopolistic competition is known as a

barometric firm. The barometric firm by virtue of its cerebral status initiates changes in the

prices of products produced by it and is followed by other firms both big as well as the small.

The barometric firm is so called because the changes in prices initiated by the firm serve as a

barometer of changes in market condition.

The barometric firm emerges under oligopolistic competition on account of the following

reasons:

1. Sometimes the oligopolistic market may have a few large firms and it may not be

feasible for the constituent firms to accept the price leadership of one of the big firms.

It is therefore found to be more convenient to accept the price leadership of a smaller

firm which has proven analytical and predictive abilities.

2. Not all the firms may have the ability and willingness to undertake market research.

Further, it also makes lot of economic sense to use the research outputs of a firm

which has a proven track record in the field.

COLLUSIVE OLIGOPOLY: PRICE AND OUTPUT UNDER CARTELS

Firms under oligopolistic competition are characterized by extreme interdependence. Price war

and cut-throat competition are other features. To avoid the problems of uncertainty and fruitless

price and non-price competition, the firms under oligopolistic market conditions may enter an

agreement on a uniform price and output policy for the entire industry. Such agreements are

generally tacit or discreet in nature because open agreements may invite legal action from the

government. Collusive oligopoly is said to prevail, when oligopoly firms enter such open or

secretive agreements. The two main types of collusive oligopoly are price leadership and cartels,

of which, we have already discussed price leadership in the previous section. Unlike under price

leadership, the firms constituent of a cartel jointly determine their price and output policy.

18


Cartelization may have legal restrictions domestically. However, internationally, oligopoly firms

seem to be free to form cartels.

A cartel is a union of oligopoly firms formed by an agreement between them. They jointly

establish a cartel organization to determine price and output decisions, to determine production

quotas to each firm and to supervise the market activities of individual firms in the industry.

Cartelization of firms may assume different forms. When member firms agree to completely

surrender their right to determine price and output to a Central administration agency or a Cartel

Board, such a case of collusive oligopoly is known as Perfect Cartel. Under a perfect cartel, the

price and output of the entire industry as well as the individual oligopoly firms is determined by

the board or the central authority so that maximum joint profits are obtained for the member

firms.

To explain the price and output determination under a perfect cartel, let us assume that there are

two firms; Firm ‘A’ and Firm ‘B’ and they have constituted a cartel by an agreement. Let us

further assume that the aim of the cartel is to maximize the joint profits of the two constituent

firms. With these assumptions, we can proceed to explain the price and output determination

under a perfect cartel with the help of Fig. 1.5 below.

In panel (c) of Fig. 1.5 above, the demand curves for the entire industry estimated by the cartel is

DM which is downward sloping. The marginal cost curve of the cartel can be obtained by adding

the marginal costs of the two firms which is depicted by the combined marginal cost curve CMC

(MCA + MCB = CMC). The equilibrium output of the cartel will be determined by the

intersection of marginal revenue curve and the combined marginal cost curve. Such an

equilibrium point is denoted by point ‘E’ in the diagram and the equilibrium output OQ is so

distributed amongst the two firms that their marginal costs are equal. The two firms: Firm ‘A’

and Firm ‘B’ are respectively in equilibrium at points ‘G’ and ‘F’ where their individual

marginal cost curves MCA and MCB intersects the marginal revenue curve which is shown by a

horizontal straight line originating from point ‘E’, which is the equilibrium point of the cartel

(GQ1 = FQ2 = EQ). Price OP = AQ is determined by the cartel and accepted by the constituent

firms ‘A’ and ‘B’. You will notice that the market shares or quotas allotted to the firms are OQ1

for Firm ‘A’ and OQ2 for Firm ‘B’. You may also observe that the sum of the quotas of the two

firms is equal to the equilibrium output of the industry (OQ1 + OQ2 = OQ). At price OP, Firm

‘A’ makes profit equal to the shaded area P1A1B1C1 and Firm ‘B’s’ profit is equal to the area

P2A2B2C2. The sum of the profits made of the two firms is the joint profit made by the cartel

which is also the maximum profits under the given market conditions.

19


YY

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P 1

P 2

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C 2

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20


Cartelization is an example of perfect collusion under oligopolistic market conditions. The

stability of price and output under a cartel will however depend upon the adherence to the

agreement entered by member firms.

Questions.

1. What do you understand by the term oligopoly? Explain the main characteristics of

oligopoly.

2. Explain how price and output is determined under non-collusive oligopoly model put

forward by Augustin Cournot.

3. Critically examine Paul Sweezy’s Model of non-collusive oligopoly.

4. What is price leadership? Explain how the market is shared by the constituent firms under

the dominant firm model.

5. Explain the process of market sharing according to the low-cost firm model.

6. What is barometric price leadership? Account for the emergence of the barometric firm or

barometric price leadership.

7. Explain how price and output is determined under a cartel?

8. Answer in Brief:

(a) What is price rigidity and account for the emergence of price rigidity in Paul Sweezy’s

model of oligopoly?

(b) ‘Asymmetrical behavior of the rival firms produces a ‘Kink’ in the demand curve.

Explain the statement in the context of Kinked demand curve model of oligopoly.

(c) ‘The oligopoly firms have the freedom to vary marginal cost and yet maximize profits.’

Explain the statement in the context of Kinked demand curve model.

(d) What is a cartel? Explain the concept of a perfect cartel.

(e) Explain the difference between collusive and non-collusive oligopoly.

21


UNIT ONE

PREVIEW.

▪ Introduction to Game Theory.

▪ Basic Concepts (Nash Equilibrium).

▪ Prisoner’s Dilemma.

▪ Public Goods Games.

▪ Applications of Game theory.

INTRODUCTION.

In a climate of uncertainty, economic decision making involves strategy. Every firm needs to

find out as to how other firms will react to price and output decisions. Will there be a price war

and if so, would it lead to losses? Will bargaining with the workers’ union would end in a

stalemate and strike. The making of the Union budget involves a lot of bargaining between the

various stake holders in the society. The trade unions, associations of commerce and industry,

consumer groups, political parties and other interest groups get involved in influencing the

budget. The study of economic games that these stake holders play is known as Game Theory.

Economic decision making thus involves uncertainty and strategy.

Game theory is an important branch of economic theory and analysis that provide many insights

into the behavior of economic agents in situations where there is an actual or potential conflict of

interest. It is an approach to analyzing rational decision making behavior in interactive or

conflict situations. Game theory analyses the way that two or more players or parties choose

actions or strategies that jointly affect each participant. The element of game arises because the

outcome depends not only on the choices made by one player but also on what other players

choose to do at the same time. This theory was developed by John von Neumann (1903-57)

and Oskar Morgenstern in their work “The Theory of Games and Economic Behavior”. Game theory has been used by economists to study the interaction of duopoly, monopolistic and

oligopoly firms, union management disputes, trade policies etc.

22


BASIC CONCEPTS.

According to Walter Nicholson, a game is a situation in which individuals must make decisions

and in which final outcome will depend on what each person decides to do. In a game, agents

aim to maximize their own pay-off by choosing specific actions but the actual outcome depends

on what all other players do. The game consists of a specified interactive playing field, a

specification of all choices and a schedule of the pay-offs to each of the players under all

possible outcomes. Players plan their own courses of action to maximize their expected payoff,

under the knowledge that the other players are trying to do the same. Any game has three basic

elements. They are: the players, the list of possible actions or strategies available to each player

and the payoffs the players receive for each possible combination of strategies. The player in the

game theory is the decision maker. Firms are players in oligopoly markets. The number of

players is generally fixed throughout the game and some games have a fixed number of players.

Strategy refers to a course of action available to a player in a game. Generally, players do not

have too many options as far as strategy is concerned. Payoffs refer to final outcomes to the

players at the end of the game.

A player’s strategy is a complete specification of the actions to be taken in response to outcomes

that are found as the game proceeds. A player’s pay-off from choosing a strategy depends on

what the other players do but players cannot make binding agreements with each other. Given

the strategies of all the players, there will be a set of possible outcomes to the game. These

determine the potential pay-offs for each of the players. A specific outcome is called equilibrium

if no player can take actions to improve his own pay-off while all other players continue to

follow their optimal strategies. To select the best strategy, a player must know what other

players will do but they in turn must also know every player will do. In strategic game, players

choose their moves simultaneously. Whenever the choices are discrete and finite, the game can

be represented in the structure of a table which sets out the outcomes for each player depending

on what the other players do. In an extensive game, players make moves in some order and

hence the analysis of the game needs a specification of the pay-offs and information at each point

in time. Real business interactions are like an extensive game, as firms interact dynamically over

a period of time. However, whenever the precise timing of moves is not essential to the

outcome, a game can be represented as a normal game. A game that is played only once is a

‘one-shot-game’. Repeated games open possibilities of learning and of acting to punish or

reward the other players. A super-game is a game that is repeated many times.

The basic concepts of Game theory are being explained by studying a duopoly price war.

23


Duopoly Price War.

Let us assume that you are the head of Daffodils, a departmental store whose motto is “We will

not be undersold”. Your rival Lilies, runs an advertisement, “We sell for ten per cent less”.

Figure 4.1 shows the dynamics of price cutting. The vertical arrows show Lilies price cuts, the

horizontal arrows show Daffodils responding strategy of matching each price cut. Notice that

the pattern of reaction and counter-reaction will end up in a zero price because the only price

compatible with both strategies is a zero price. Lilies ultimately realize that when it cuts its

price, Daffodils will match the price cuts. Now you will begin to ask what Lilies will do if you

charge price A, B, C etc. Once you begin to consider how others will react to your actions, you

have entered the arena of Game Theory.

Duopoly is a situation where the market is supplied by two firms that are deciding whether to

engage in price war and destroy themselves. Let us assume for the sake of simplicity that both

the firms have the same cost and demand structure. Further, each firm can choose whether to

charge its normal price or lower its price below the marginal costs and drive away the rival. In

this duopoly game, the firm’s profits will depend on its strategy and that of its rival’s. The

interaction between the two firms or people is represented by a two-way pay-off table. A pay-off

table is a means of showing the strategies and the pay-offs of a game between two players.

Figure 4.2 shows the pay-offs in the duopoly price game for our two stores. In the pay-off table,

a firm can choose between the strategies listed in its rows or columns. For example, Lilies can

24


choose between its two columns and Daffodils can choose between its two rows. Here, each

firm decides whether to charge its normal price or to begin a price war by choosing a low price.

By combining the two decisions of each Duopoly firm gives four possible outcomes which are

shown in the four cells of the table. The number in the lower left shows the pay-off to Daffodils

and the numbers in the upper right shows the pay-off to Lilies.

Alternative Strategies.

In Game theory, you are required to think through the goals and actions of your opponent and to

make your decisions based on your opponent’s goals and actions. While you think through your

opponents, you must remember that your opponent will also be trying to outwit you. The

following is the guiding philosophy in Game theory:

“Choose your strategy by asking what makes most sense for you assuming your

opponent is analyzing your strategy and acting in his best interest.”

25


Let us apply this philosophy to the Duopoly example. Note that both the firms have the highest

joint profits in outcome A. Each firm earns Rs.10 when both follow a normal price strategy. At

the other end is price war where each cuts price and runs a big loss. Between the two extreme

ends, there are two interesting strategies where only one firm engages in price war. In outcome

C, Lilies follow a normal price strategy while Daffodils engages in a price war. Daffodils take

away most of the market but makes heavy losses because it is selling below cost. Lilies’ is

better-off selling at normal prices rather than responding and as a result, his loss is only Rs.10

against a loss of Rs.100 made by Daffodils.

Dominant Strategy.

To begin with the game, one must know whether each player has a dominant strategy. This

situation arises when one player has a best strategy no matter what strategy the other player

follows. In the price war game example, consider the options open to Daffodils. If Lilies

conducts business as usual with a normal price, Daffodil will get Rs.10 profit if it plays the

normal price and will lose Rs.100 if it declares price war. On the other hand, if Lilies starts a

price war, Daffodils will lose Rs.10 if it follows the normal price but will lose more if it also

engages in price war i.e. Rs.50. The same logic holds true for Lilies. Therefore, no matter what

strategy the other firm follows, each firm’s best strategy is to have the normal price. Charging

the normal price is a dominant strategy for both firms in the price war game.

When both players have a dominant strategy, we say that the outcome is a dominant equilibrium.

In Figure 4.2 above, outcome A is a dominant equilibrium because it arises from a situation

where both firms are playing their dominant strategies.

Nash Equilibrium.

Most interesting situations do not have a dominant equilibrium. We can use our duopoly

example to find this out. In a game of rivalry, each firm considers whether to have its normal

price or a monopoly price and earn monopoly profits. The game of rivalry is shown in Figure

4.3.

The firms can decide on the normal price equilibrium as found the price war game or they can

raise their price to earn monopoly profits. Notice that both the firms have the highest joint

profits in Cell ‘A’ where they can earn a total of Rs.300 when each follows a high price strategy.

Situation ‘A’ can emerge if the firms collude and set the monopoly price. At the other extreme is

the competitive strategy of normal price where each rival has profits of only Rs.10. In between

the two extremes there are two interesting strategies where one firm chooses a normal price and

the other one a high price strategy. In Cell ‘C’, Lilies follows a high price strategy but Daffodils’

undercuts. Daffodils’ take away most of the market and has the highest profit from any of the

four situations and Lilies loses money. In Cell ‘B’, Daffodils gambles on high price but Lilies

normal price means a loss for Daffodils. In this example, Daffodils has a dominant strategy. It

will profit more by choosing a normal price no matter what Lilies does. On the other hand,

Lilies does not have a dominant strategy because Lilies would want to play normal if Daffodils

26


plays normal and would want to play high if Daffodils play high. Lilies’ has an interesting

dilemma. Should it play high and hope that Daffodils will follow or play safe by playing normal.

By thinking through the pay-offs, it becomes clear that Lilies should play the normal price. The

reason is that Lilies should start by putting itself in Daffodils’ shoes. Notice that Daffodils’ will

play normal price no matter what Lilies does because that is Daffodils dominant strategy.

Therefore, Lilies should find its best action by assuming that Daffodils will follow his best

strategy which immediately leads to Lilies playing normal. This illustrates the basic rule of

Game theory: “You should set your strategy on the assumption that your opponent will act

in his best interest.”

The solution is called the Nash equilibrium after mathematician John Nash who developed the

concept in the 1950s and won the Nobel Prize in Economics in 1994 for his contributions to the

Game theory. A Nash equilibrium is one in which no player can improve his or her pay-off

given the other player’s strategy. That is, given player ‘A’s strategy, player ‘B’ can do no better

27


and vice-versa. Each strategy is a best response against the other player’s strategy. The Nash

equilibrium is called the non-cooperative equilibrium because each party chooses that strategy

which is best for itself without collusion or co-operation and without regard for the welfare of

society or any other party. According to Nash theorem, every game with a definite number of

players and a definite number of strategies would at least have one ‘Nash equilibrium’.

However, to hold the Nash theorem to be true, the strategies available must have some random

element to them. A strategy with some random element is known as a mixed strategy. There

may be multiple Nash equilibrium and it may not be clear as to which one will arise. Further, it

is generally true that the Nash equilibrium is not the global optimum i.e. if players could co-

operate they could all become better off. A game theory framework can help us understand the

strategic choices available but it does not always help predict which of many possible outcomes

may occur.

PRISONER’S DILEMMA.

In the prisoner’s dilemma, when each player chooses his dominant strategy, the result is

unfavorable to both the players. There are two prisoners, Anil and Sunil who are locked up in

separate cells for committing a crime. However, the prosecutor has limited hard evidence to

convict them for a minor offence for which the punishment is one year imprisonment. Each

prisoner is told that if one admits while the other remains silent, the confessor will be let off

without being imprisoned and other one will be jailed for 20 years. If both the prisoners confess,

they will be jailed for only five years. The two prisoners are not allowed to communicate with

each other. The payoffs to the prisoners are shown in Table 1.3.

Table 1.3 – The Payoff Matrix for a Prisoner’s Dilemma

Anil

Confess Remain Silent

5 Years for each

Zero years for Sunil

20 years for Anil

20 years for Sunil

Zero years for Anil

1 year for each

Co

nfe

ss

Re

mai

n S

ilen

t

Su

nil

28


In this game, the dominant strategy for both the players is to confess irrespective of the strategy

pursued by the other. Irrespective of Anil’s strategy, Sunil will get a lighter sentence by

confessing. If Anil admits to the crime, Sunil will get five years (upper left cell) instead of 20

(lower left cell). If Anil remains silent, Sunil will be let off (upper right cell) instead of spending

a year in jail (lower right cell). As the payoffs are perfectly symmetric, Anil will also be happy

to confess irrespective of what Sunil does. The difficulty is that when each follows his dominant

strategy and confesses, both will do worse than if each had shown restraint. When both

confesses, each get five years (upper left cell) instead of the one year they would have gotten by

remaining silent (lower right cell). The choices before the prisoners exemplify a dilemma in

which the prisoners must make a choice between two evils i.e. to confess or to remain silent.

PUBLIC GOODS GAMES.

The public goods game is a standard of experimental economics. In the basic game,

subjects secretly choose how many of their private tokens to put into a public pot. The tokens in

this pot are multiplied by a factor (greater than one and less than the number of players, N) and

this public good payoff is evenly divided among players. Each subject also keeps the tokens they

do not contribute.

RESULTS.

The group's total payoff is maximized when everyone contributes all their tokens to the public

pool. However, the Nash equilibrium in this game is simply zero contributions by all; if the

experiment were a purely analytical exercise in game theory it would resolve to zero

contributions because any rational agent does best contributing zero, regardless of whatever

anyone else does.

In fact, the Nash equilibrium is rarely seen in experiments; people do tend to add something into

the pot. The actual levels of contribution found varies widely (anywhere from 0% to 100% of

initial endowment can be chipped in). The average contribution typically depends on the

multiplication factor. Capraro has proposed a new solution concept for social dilemmas, based

on the idea that players forecast if it is worth to act cooperatively and then they act cooperatively

in a rate depending on the forecast. His model indeed predicts increasing level of cooperation as

the multiplication factor increases.

Depending on the experiment's design, those who contribute below average or nothing are called

"defectors" or "free riders", as opposed to the contributors or above average contributors who are

called "cooperators".

VARIANTS.

Iterated public goods games.

"Repeat-play" public goods games involve the same group of subjects playing the basic game

over a series of rounds. The typical result is a declining proportion of public contribution, from

29


the simple game (the "One-shot" public goods game). When trusting contributors see that not

everyone is giving up as much as they do they tend to reduce the amount they share in the next

round. If this is again repeated the same thing happens but from a lower base, so that the amount

contributed to the pot is reduced again. However, the amount contributed to the pool rarely drops

to zero when rounds of the game are iterated, because there tend to remain a hard core of

‘givers’.

One explanation for the dropping level of contribution is inequity aversion. During repeated

games players learn their co-player's inequality aversion in previous rounds on which future

beliefs can be based. If players receive a bigger share for a smaller contribution the sharing

members react against the perceived injustice (even though the identity of the “free riders” are

unknown, and it’s only a game). Those who contribute nothing in one round, rarely contribute

something in later rounds, even after discovering that others are.

Open public goods games (Transparency)

If the amount contributed isn't hidden it tends to be significantly higher. The finding is robust in

different experiment designs: Whether in "pair-wise iterations" with only two players (the other

player's contribution level is always known) or in nominations after the end of the experiment.

Public goods games with punishment and/or reward.

The option to punish non-contributors and to reward the highest contributions after a round of

the public goods game has been the issue of many experiments. Findings strongly suggest that

non-rewarding is not seen as sanction, while rewards don't substitute punishment. Rather they are

used completely differently to enforce cooperation and higher payoffs.

Punishing is exercised, even at a cost, and in most experiments, it leads to greater group

cooperation. However, since punishment is costly, it tends to lead to (marginally) lower payoffs,

at least initially. On the other hand, a 2007 study found that rewards alone could not sustain

long-term cooperation.

Many studies therefore emphasize the combination of (the threat of) punishment and rewards.

The combination seems to yield both a higher level of cooperation and of payoffs. This holds for

iterated games in changing groups as well as in identical groups.

Asymmetric costs and/or benefits.

Asymmetric cost and or benefit functions have direct influence in the contribution behavior of

agents. When confronted with different payoff returns to their contributions, agents behave

differently though they still contribute more than in Nash equilibrium.

Income variation

A public goods games variant suggested as an improvement for researching the free rider

problem is one in which endowment are earned as income. The standard game (with a fixed

30


initial endowments) allows no work effort variation and cannot capture the marginal

substitutions among three factors: private goods, public goods, and leisure.

Framing.

A different framing of the original neutral experiment setting induces players to act differently

because they associate different real-life situations. For example, a public good experiment could

be presented as a climate negotiation or as contributions to private parties.

The effect of associations (label frame) depends on the experience-pool the player made with

similar real-life frames. This is especially true for one-shot (not iterated) games where players

can only infer others’ behavior and expectations from their life experiences. Therefore, the same

frame can induce more and less contribution, even in similar cultures. Label frames move beliefs

i.e. about other player's behavior, and these beliefs subsequently shape motivation and choice.

Also, the same game structure can always be presented as a gain or a loss game. Because of

the Framing effect players respond completely differently when it is presented as a gain or a loss.

If public good games are presented as a loss, i.e. a player's contribution in a private engagement

diminishes other player's payoff, contributions are significantly lower.

Multiplication Factor.

For contribution to be privately "irrational" the tokens in the pot must be multiplied by an

amount smaller than the number of players and greater than 1. Other than this, the level of

multiplication has little bearing on strategy, but higher factors produce higher proportions of

contribution.

With a large group (40) and very low multiplication factor (1.03) almost no-one contributes

anything after a few iterations of the game (a few still do). However, with the same size group

and a 1.3 multiplication factor the average level of initial endowment contributed to the pot is

around 50%.

Implications.

The name of the game comes from economist’s definition of a “public good”. One type of public

good is a costly, "non-excludable" project that everyone can benefit from, regardless of how

much they contribute to create it (because no one can be excluded from using it - like street

lighting). Part of the economic theory of public goods is that they would be under-provided (at a

rate lower than the ‘social optimum’) because individuals had no private motive to contribute

(the free rider problem). The “public goods game” is designed to test this belief and connected

theories of social behavior.

Game theory.

The empirical fact that subjects in most societies contribute anything in the simple public goods

game is a challenge for game theory to explain via a motive of total self-interest, although it can

31


do better with the ‘punishment’ variant, or the ‘iterated’ variant; because some of the motivation

to contribute is now purely “rational”, if players assume that others may act irrationally and

punish them for non-contribution.

APPLICATIONS OF GAME THEORY.

The principles of Game theory find application not only in Economics but also other social

sciences, business management and everyday life. In Economics, price war and trade wars are

explained by Game theory. It also explains why foreign competition may lead to more price

competition. What happens when a firm from one country enters another country’s market

where firms had tacitly colluded on a price strategy that led to a high oligopoly price? The

foreign firms may refuse to play the game and they may cut prices to gain market shares.

Finally, collusion may break down and give away to price competition. An important element in

a game is the attempt made by players to build credibility. A player is considered credible if he

keeps his promises and carries out threats. However, credibility must be consistent with the

incentives of the game. When Central banks act tough on inflation by adopting politically

unpopular polices, they are trying to build their credibility in the economy. The Central bank

achieves greater credibility when its rules are converted into law. Businesses make credible

promise by writing contracts that impose penalties if they do not perform as promised. When an

army burns its bridges behind it, it is giving the greatest credibility to its promise to fight to the

death by foreclosing the road to retreat.

According to William Barnett (Making Game Theory Work in Practice – The Wall Street

Journal, Feb 13, 1995), game theory helps managers pay attention to interactions with

competitors, customers and suppliers and focus on how near-term actions promote long term

interests by influencing what the players do. The managers must know the industry in which

they are working inside out to make use of the principles of game theory. Industries with four or

less players have the greatest potential for game theory because the competitors are big enough

to benefit more from an improvement in the general conditions in the industry than they would

from improving their position at the expense of others i.e. making the cake bigger rather than

getting a bigger share of a smaller cake. Further, with fewer competitors it is possible to think

through the different combination of moves and countermoves.

Barnett says that small players can take advantage of larger companies which are more

concerned with maintaining the status quo. For instance, Kiwi Airlines with a small share of the

market could cut fares by up to 75 per cent between Atlanta and Newark without a significant

response from Delta and Continental. Large players can create economies of scale or scope such

as frequent flier programs that are unattractive to small airlines. When competitors have similar

cost and revenue structures they often behave similarly. The challenge is to find prices that

create the largest markets and then use non-price competition, distribution and service.

Managers must analyze the nature of demand. The best chances to create value with less

aggressive strategies are in markets with stable or moderately growing demand. Barnett

concludes, “Sometimes (game theory) can increase the size of the pie; on other occasions, it can

32


make your slice of the pie bigger; and sometimes it may even help you do both. But for those

who misunderstand the fundamentals of their industry, game theory is better left to the theorists.”

Questions.

1. What is Game Theory? Write a note on duopoly price war.

2. Explain the concept of Nash Equilibrium.

3. Write a note on Public Goods Game.

4. Write a note on Prisoner’s Dilemma.

5. Explain the applications of Game Theory.

33


UNIT TWO

PREVIEW.

▪ Factor Pricing in Perfectly and Imperfectly Competitive Markets.

▪ Theory of Economic Rent.

▪ Wage Determination under Bilateral Monopoly and the Role of Collective Bargaining.

▪ Loanable Funds Theory.

▪ Risks and Uncertainty Theory of Profits.

FACTOR PRICING UNDER PEFRFECT COMPETITION.

Under the conditions of perfect competition, the wages are determined by the demand for and

supply of labor in an industry. The equilibrium wage rate is determined at the point of

intersection between the demand and supply of labor.

Demand for Labor.

The demand for labor is a derived demand. It increases with the increase in demand for goods

and services. The wage rate is equal to the marginal revenue productivity of labor (MRPL). The

marginal revenue productivity of labor refers to the addition made to the total revenue by an

additional unit of labor employed. The demand curve for labor is the MRPL curve. It shows the

amount of labor the firm would employ at each possible wage rate. The MRPL curve is

downward sloping due to the operation of the law of diminishing marginal productivity.

The Supply of Labor.

The supply of labor refers to the number of workers who would be willing to work at each

possible wage rate. There is a direct relationship between the wage rate and the quantity of labor

supplied. Hence the labor supply curve has a positive slope. Other factors that determine labor

supply are population growth rate, the age and sex distribution of population, working hours,

education and training, labor laws, social attitude towards of employment of women, attitude

towards work and leisure and mobility of labor.

34


The Determination of Wage Rate by the Industry and the Firm.

The wage rate in an industry will be determined at the point of intersection between the demand

and supply curves of labor. In Panel (A) of Figure 3.1 below, the determination of equilibrium

wage rate of an industry is shown. The equilibrium wage rate is OW and the equilibrium

employment of labor is OL. An increase in the demand for labor in the short run will shift the

demand curve to the right and accordingly at a higher wage rate OW1, a larger quantity of labor

OL1 will be employed. Similarly, if the demand for labor decreases in the short run, the demand

curve will shift to the left and a lower quantity of labor OL2 will be employed at a lower wage

rate OW2. However, the long run equilibrium employment and wage rate would be OW and

OL.

The firm under perfect competition is a price taker. The firm therefore must accept the wage rate

determined by the industry. The supply curve of labor for the firm is therefore perfectly elastic

at the given wage rate. The equilibrium point for the firm is where the MRPL curve intersects the

horizontal supply curve. Since the wage rate remains constant at any given point of time, the

supply curve which indicates average wages also indicates marginal wages. Thus, at the

equilibrium point ‘E’, OW wage rate is equal to the average and marginal wages (OW = AW =

MW). This is shown in panel ‘B’ of the figure 3.1.

At point E, the firm achieves the condition of grand equilibrium where the wage rate OW is

equal to the average and marginal revenue productivity of labor (MRP = MW = AW = ARP). At

a lower wage rate OW2, the firm will be making super normal profits because the wage rate is

below the ARP and at a higher wage rate OW1, the firm will be making losses because the wage

is higher than the ARP. However, the long run equilibrium of the firm will be determined at the

point of intersection between the MRPL curve and ARPL curve where the AW = MW curve or

the supply curve of labor is tangent at point E. When wage rate is higher than ARP, loss making

firms will leave the industry and the surplus labor will pull down the wage rate to the equilibrium

level. Similarly, when the wage rate is lower than ARP, new firms will be attracted to the

industry and they will raise the demand for labor. Higher demand for labor will push the wage

rate upwards until AW becomes equal to ARP. Thus, the wage rate under perfect competition is

always equal to the marginal and average revenue product of labor.

35


Y DL1 SL Y

DL

E1 E1 AW1=MW1

W1

DL2 E E AW=MW=ARP=MRP

W

E2 E2 AW2=MW2

W2

MRPL

ARPL

O X O X

L2 L L1 L1 L L2

Fig. 3.1 – Equilibrium Employment in the Industry and the Firm.

FACTOR PRICING UNDER IMPERFECT COMPETITION.

Both product and factor markets are imperfect. The demand and supply of labor is influenced by

the actions of trade unions, governments and monopsony firms. The intervention by trade unions

and governments and the presence of monopsonists in the labor market creates market

imperfections. Two imperfections in terms of competition in the factor market are as follows:

1. Perfectly competitive factor market and monopolistic competition in the product market.

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

Competitive Factor Market and Monopolistic Product Market.

In a competitive factor market, (see Fig. 3.2) the factor prices are determined by the market

forces of industry demand and supply. The supply curve of factor services slopes horizontally

and hence average factor cost is equal to marginal factor cost (AFC = MFC). Due to the

presence of monopolistic product market, the Marginal Revenue Product curve is positioned

below the Value of Marginal Product curve (MRP < VMP). The equilibrium of the firm is

determined at the point of equality between MRP and MFC. At the equilibrium point ‘E’, the

firm employs OQ units of factor service at OP price. The VMP being OP1, it can be seen that

factor service is paid less than the value of marginal product by PP1. Further, less units of factor

service are employed at the equilibrium point ‘E’ where MRP = MFC whereas the firm could

have employed OQ1 units of factor service if equilibrium is determined at the point of

intersection between VMP and MFC. Thus, when there is perfect competition in the factor

36


market and monopolistic or imperfect competition in the product market, factor prices are less

than the value of marginal product and less units of factor inputs are employed.

Monopsony Factor Market and Competitive Product Market.

A monopsony firm is a single buyer of a particular factor service in the factor market. A larger

quantity of factor service will be supplied only a higher price and hence the factor supply curve

Average Factor Cost is upward sloping from left to right (See Fig.3.3). The Marginal Factor

Cost (MFC) is placed above the AFC because of rising marginal factor cost. The firm is in

equilibrium at point ‘E’ where the MRP curve intersects the MFC curve from above.

Accordingly, the firm employs OQ units of factor service and pay OP price which is equal to

AFC at point ‘A’. The monopsony firm determines the price P = AFC at point ‘B’ and enjoys

supernormal profits equal to the area PABC . The factor service is paid only OPAQ which is

less than MRP. The difference between the MRP and AFC is AE (QE – QA) which is

monopsony exploitation per unit of factor service.

P1 A

P E E1 (AFC = MFC)

MRP VMP

O Q Q1

Units of Factor Service Employed

Fig.3.2 Competitive Factor Market and Monopolistic Product Market.

VM

P, M

RP

an

d C

ost

37


THE THEORY OF ECONOMIC RENT.

Classical economists regarded rent as the return to land as a factor of production. David Ricardo

defined rent as “that portion of the produce of the earth which is paid to the landlord for the

original and indestructible powers of the soil” (Principles of Political Economy and Taxation by

David Ricardo). However, according to the modern economists rent can accrue to any other

factor input as in the case of land. Modern economists like Joan Robinson considered rent as a

surplus over transfer earnings (The Economics of Imperfect Competition by Joan Robinson).

Kenneth Boulding defined economic rent as any payment to a unit of factor input which is in

excess of the minimum amount necessary to keep that factor in its present occupation (Economic

Analysis by Kenneth Boulding).

Rent is a surplus over transfer earnings. Transfer earnings mean the amount of money which any

particular unit could earn in its next best alternative use. The minimum payment that must be

made to a particular factor of production to retain it in its present use is known as transfer

earnings. Rent is the difference between the actual earning of a factor of production and its

transfer earning. Thus, Rent = Present Earnings – Transfer earnings. Suppose a piece of land

under rice is yielding Rs. 20 thousand and its next best use bajra fetches Rs. 15 thousand. The

transfer earnings are Rs. 15 thousand and, therefore, in its present use it is giving a surplus of Rs.

Five thousand. Thus Rs. Five thousand is the rent.

MFC

C B

E

AFC

P A

ARP

MRP=VMP

O Q


Fig. 3.3 Monopsony Factor Market and Competitive Product Market.


Fig. Competitive Factor Market and Monopolistic Product Market.

PR

ICE,

CO

ST &

REV

ENU

E

38


Rent in the sense of surplus arises when the supply of land, or for that matter that any other

factor service, is less than perfectly elastic.

Elasticity of supply and Rent.

Economic rent depends upon the elasticity of supply of a given factor.

1. Perfectly Inelastic Supply. The supply may be perfectly inelastic, which can be shown

as a vertical straight line, as in Fig.3.4. This is possible when the factor of production has

a specific use. In this case, the transfer earnings or opportunity cost is zero and hence the

entire earnings of the factor can be considered as economic rent. In Fig. DD is the

demand curve and SM is a vertical straight line fixed supply curve. They intersect at E.

Here OM is the quantity of land which is fixed in supply. OR is the rent per unit and the

total earnings are OMER. Since land is fixed in supply and cannot be transferred to any

other use, its transfer earnings are zero. Hence its entire earnings OMER are rent as

surplus over transfer earnings. For the economy land has no alternative use at all. Hence

the transfer earnings of land, from the point of view of economy are zero and all the

earnings are rent.

2. Perfectly Elastic Supply. The supply of land may be perfectly elastic. This is shown in

Fig.3.5 by a horizontal straight line. When the supply of land is perfectly elastic, there

will be no surplus and the actual earnings and transfer earnings will be equal. For

example, for an individual firm or farmer, the supply of land is perfectly elastic.

S D R E D O M

Demand and Supply of Land

Fig. 3.4 The entire income OMER is economic rent.

Ren

t

39


In Fig.3.6, the supply curve RS of land is a horizontal straight line which is perfectly

elastic. DD is the demand curve. The two intersect at E. In this case, OM land is put to

use. The rent per unit is OR and the total earning is OREM. The transfer earning is also

OREM. If the firm does not pay OR rent, the land will be transferred to some other use.

Since transfer earnings and actual earnings are equal, there is no surplus or rent.

3. Relatively Elastic Supply. When the supply of land is relatively elastic as shown in Fig.

then a part of income from land is rent.

D R E S

D O M


Fig. 3.5 The entire income OMER is transfer earnings.

Ren

t

40


In Fig.3.6, SS supply curve is relatively elastic. It intersects DD demand curve at E. In

this case, OM land is used and the rent per unit is OR. The total earnings are OMER and

the transfer earnings are OMES. If we deduct transfer earnings OMES from the actual

earnings OMER, we get RES. Area RES is the surplus or rent.

BILATERAL MONOPOLY AND WAGE DETERMINATION.

Trade Unions are organizations that seek to represent workers in the industry. Labor is said to be

organized when they are represented by a trade union. In the absence of a trade union, labor

cannot bargain with the employer in the matter of fixing wages and other working conditions.

Through collective bargaining, the trade unions can perform the following role in the labor

market:

1. Increase the wages of the workers.

2. Improve working conditions.

3. Maintain pay differential between skilled and unskilled workers.

4. Fight job losses.

5. Provide a safe working environment.

6. Secure additional working benefits, and

7. Prevent unfair dismissals.

D S R E

S D O M


Fig.3.6 A part of the income of the factor is rent and a part

is transfer earning. OMES is the transfer earning and RES

is the rent.

Ren

t

41


The main function of a trade union is to raise wages and to improve the working conditions of its

members. It replaces individual bargaining by collective bargaining and makes the wage rates

uniform for the same category of workers in a given industry.

Bilateral monopoly is a situation in which there is a single buyer (monopoly) and a single seller

(trade union). In the labor market, the monopoly firm is the single buyer and the trade union is

the single seller. Wage determination under bilateral monopoly is depicted in Fig.3.7.

Equilibrium employment is determined at the point of intersection between MRP and MW

curves at point ‘E’. Accordingly, OL employment and OW2 wage rate is determined. However,

the actual wage rate (OW) is determined at point ‘R’ where the AW curve intersects the

perpendicular EL. Thus, in the absence of collective bargaining, labor is exploited and the firm

makes super normal profits equal to the area WREW2.

When collective bargaining is introduced, the supply curve of labor (AW) becomes a horizontal

straight line (AW1 = MW1) because the wage rates are fixed by the trade union. The MRP curve

now intersects the AW1 = MW1 curve at point E1 and accordingly OW1 wage rate is determined.

According to the new equilibrium point E1, both the wage rate and the level of employment goes

W2 E AW2 = MW2 W1 E1 AW1 = MW1

W R ARP MRP O L L1

Employment Fig. 3.7 Wage determination under Bilateral Monopoly

Wag

es/

Pro

du

ctiv

ity

42


up from OW to OW1 and from OL to OL1. Under bilateral monopoly, both employment and

wage rates are higher than under a monopoly situation in which the firm is a single buyer.

If the trade union is strong, the wage rate can go up to OW2 (MRP = MW) with the original level

of employment OL. However, the actual wage rate and employment will be determined by the

relative strength of the trade union and the firm between OW and OW2. If the trade union is

stronger than the firm, the wage rate will be nearer OW2 and if the firm is stronger than the trade

union, the wage rate will be nearer OW. In both the cases, level of employment and wage rate

would be higher than in the case where there is no trade union and collective bargaining.

LOANABLE FUNDS THEORY OF INTEREST.

The loanable fund theory or the neo-classical theory of interest was developed by Wicksell,

Robertson, and Davonport. Ohlin, Myrdal, and Viner also contributed to the theory. This theory

is a revised version of the classical theory in which along with the real factors, monetary factors

have also been included. According to this theory, rate of interest is determined by the demand

for and supply of loanable funds. The theory is illustrated in Figure.3.8.

Demand for Loanable Funds.

Factors determining demand for loanable funds are as follows:

1. Investment Demand (ID). Investment refers to increase in the productive capacity of the

economy or capital formation. Both public (government) and private entrepreneurs

generate investment demand. The establishment of a new factory or business, the

expansion of existing business, installation of new machinery constitutes investment.

Investment is determined by the marginal efficiency of capital and the rate of interest.

MEC remaining constant, a lower rate of interest will lead to a higher level of investment

and vice versa. Thus, there is an inverse relation between the rate of interest and

investment. The Investment demand curve (I) is negatively sloped.

2. Demand for Dis-savings (DS). Loans for consumption purposes are demanded for

purchasing durable consumer goods like cars, scooters, refrigerators, television sets,

houses, etc. The demand for loans for consumption is met through past savings and hence

it is known as demand for dissaving. Demand for consumer loans also has an opposite

relationship with the rate of interest. The demand for dis-savings or consumption demand

for loans is denoted by a downward sloping curve (DS).

3. Demand for Hoarding (DH). Demand for hoarding money arises because of people's

preference for cash balances. This is the asset demand for money. Savers can lend their

savings to others or they can invest their savings in real estate or purchase shares and

stocks. However, they may also keep their savings in idle cash balances. Other things

remaining constant, at higher rates of interest, inducement to hoard is less because people

will like to lend their savings to take advantage of the high interest rate. It follows that at

lower rates of interest, inducement to hoard is more since the loss by way of interest is

43


small. Therefore, the demand for hoarding money has an opposite relationship with the

rate of interest. The demand for hoarding is denoted by the DH curve which is also a

negatively sloped curve.

The factors that determine the demand for loanable funds are interest elastic and have an

opposite relationship with the rate of interest. The lateral summation of the curves representing

demand for loanable funds gives the aggregate demand for loanable funds denoted by DL(∑D) in

the figure.

Supply of Loanable Funds.

Supply of Loanable funds is determined by the following factors:

1. Savings (S): Savings made by households and firms out of their incomes. Households

saving depend upon their level of income and corporate savings in the form of

undistributed profits depends upon profits. Savings are therefore the major source of

loanable funds. Given the level of income/profits, a higher rate of interest is expected to

increase savings. Thus, the relationship between the rate of interest and savings is the

same as in the classical theory i.e. the saving curve is positively sloped and it is rising

upwards from left to right. It is denoted by ‘S’.

2. Dishoarding (DH): Dishoarding means to bring out hoarded money into use. The people

may resort to dishoarding of idle cash balances which they might have held in the past.

At a lower rate of interest, there is not enough of inducement to lend and, therefore,

hoarding is encouraged. But as the rate of interest rises, people are encouraged to

dishoard their idle cash balances. The DH curve is positively sloped and is denoted by

‘DH’.

3. Bank Money (BM): Commercial banks supply bank money in the form of loans and

advances to entrepreneurs. At higher rate of interest, banks lend more and less at lower

rates. The supply curve of bank money also has a positive slope and is denoted by BM.

All the curves representing the supply of loanable funds are positively sloped i.e. they are

interest elastic. The lateral summation of these curves yields the aggregate supply curve of

loanable funds. This aggregate supply curve is also positively sloped and is shown as SL (∑S).

Determination of Equilibrium Rate of Interest.

The rate of interest is determined at the point of intersection of the two curves i.e. the supply of

loanable funds curve (SL) and the demand for loanable funds curve, DL. Fig. shows that the

equilibrium rate of interest is EM at which the demand for loanable funds is equal to the supply

of loanable funds i.e. OM.

44


Critical Evaluation:

The criticisms of the loanable fund theory are as follows:

1. Indeterminate Theory. Hansen has pointed out that the theory is indeterminate, that is, it

cannot determine interest. The supply of loanable funds consists of savings, dishoarding

and bank money. However, the supply of savings changes with the level of income. If

the income level is not known, the interest rate cannot be determined.

2. Cash Balances not Elastic. According to the theory, the supply of loanable funds can be

increased by releasing cash balances of savings and decreased by absorbing cash balances

into savings which means that cash balances are elastic. However, the total cash balances

with the people are fixed and equal the total supply of money at any given time.

Variations in cash balances occur due variations in the velocity of circulation of money

and not in the amount of cash balances with the people.

3. Savings are interest inelastic. The theory gives undue importance to interest rate in

determining the supply of savings. However, people save to satisfy the precautionary

motive to hold active cash balances. Precautionary demand for money is interest

inelastic.

H DS DI DH DL (∑D) SL (∑S)

BM

S

R A B

E

R1 E1

O M

Demand and Supply of Loanable Funds.

Fig.3.8 – Loanable Fund Theory.

O M

Fig. Demand and Supply of Loanable Funds.

Interest rate

45


4. The theory is Unrealistic. The theory combines monetary and real factors without

factoring changes in the level of income. Savings and investment are real factors

whereas bank credit and dishoarding are monetary factors. These two factors cannot be

combined without bringing in changes in the level of income. The theory is therefore

unrealistic.

5. Unstable Equilibrium. It may be noted that at the equilibrium rate of interest where

aggregate demand for and supply of loanable funds are equal, planned savings and

planned investment may not be equal. In Fig.3.8, at OR rate of interest, savings are equal

to RB and planned investment is equal to RA. Planned savings exceeds planned

investment. Therefore, OR cannot be a stable rate of interest. Planned savings and

planned investment are equal at point E1 where the rate of interest is lower at OR1.

Given these limitations, the loanable fund theory marks an improvement on the classical theory

in the following respects.

1. The loanable fund theory assigns an active role to monetary factors in the determination

of rate of interest, whereas the classical theory treats money as a passive factor. With the

inclusion of real and monetary factors, the loanable funds theory becomes superior to the

classical theory.

2. The loanable fund theory is more realistic because it includes bank credit as an important

determinant of rate of interest.

3. The loanable fund theory considers the influence of hoarding. Hoarding is a factor

influencing demand for loanable funds and hence the theory becomes more realistic and

brings closer to the liquidity preference theory of Keynes.

RISK-BEARING AND PROFITS

The risk bearing theory was developed by the American economist Prof. FB Hawley in his book

Enterprise and productive process (1907). According to him, profit is the reward for risk-taking

or risk bearing. Profit is the residual income which the entrepreneur receives for taking risks.

Profit is an excess of payment above the actual value of risk. Hence the reward for risk taking

must be higher than the actual value of the risk.

Some risks are inherent in every business because all businesses are more or less speculative.

The essential function of the entrepreneur is risk taking because he or she cannot delegate this

function to anybody else. The entrepreneur alone must bear the risk and profit is the reward for

risk taking. The degree of risk varies in different business. According to Hawley there is a

positive relationship between risk and profit. Higher the risk greater is the possibility of profit

and smaller the risk, lower is the possibility of profit. A risk avoiding entrepreneur is no

entrepreneur. If he or she transfers risk to an insurance company, the insurance company will

receive profit. The reward of the insurance company is not the premium received but the

46


difference between the premium and the actual loss. Hence profit is the reward for risk tasking

or risk bearing.

CRITICISMS.

The risk bearing theory has been criticized on the following grounds:

1. Meaning of Risk is not clear. FB Hawley does not explain the meaning of risk.

According to Knight, risks are of two types, insurable and non-insurable. Insurable risks

cannot lead to profits because the risks are covered by the entrepreneur by giving the

insurance premium. Risks which cannot be insured give rise to profits and these risks

constitute uncertainties. Uncertainties such as changes in demand and changes in

government policy or competition cannot be insured. Hence according to Prof. Knight,

profit is the reward for uncertainty bearing.

2. Profit is the Reward for Entrepreneurial Ability. Profits are due to the entrepreneur

for organizational and coordinating abilities. These abilities reduce the average cost of

production and increase the level of profits.

3. Profit is the Reward for Avoiding Risks. According to Carver, profit is the reward for

avoiding risks. More the risks are avoided, greater will be the profits.

4. Profit is not proportionate to Risks. If profits were proportionate to risks,

entrepreneurs would take more and more risks to earn more and more profits.

UNCERTAINTY-BEARING AND PROFIT

Prof. Knight made improvement in Hawley’s risk bearing theory of profit. According to Prof.

Knight pure profits are related to uncertainty and risk bearing. He classifies risk in to

INSURABLE RISKS AND NON- INSURABLE RISKS. Some risks are predictable because

they are certain and hence are insurable for example fire, theft, accident etc. The entrepreneur

must bear non-insurable risks to earn profits. There are some risks in business which are

uncertain and non-insurable. Such risks being unpredictable, no insurance company would be

willing to cover them. For example, fluctuations in demand, trade cycle, technological changes,

changes in degree of competition, changes in govt. policies etc.

According to Prof. Knight, all these risks are uninsurable and uncertain. Every business involves

uncertainty. It is the main function of the entrepreneur to bear all such uncertainties of business.

Thus, profit is an exclusive reward for the entrepreneur, for making business decision under

unpredictable and uncertain economic conditions.

47


Criticisms.

Knight’s theory of uncertainty bearing is criticized on the following grounds:

1. The Theory is Unrealistic. Uncertainty bearing is considered as the only function of the

entrepreneur. In modern business, corporate ownership is separate from control.

Decision making is done by salaried managers whereas ownership is with the

shareholders who bear the uncertainties of business. Knight has not been able to separate

management from ownership and hence theory becomes unrealistic.

2. Absence of Empirical Evidence to measure Uncertainty Bearing. There is no way

how uncertainty can be measured. The cause of profit cannot be measured and hence the

consequence remains indeterminate.

3. Confusion between Macro-economic Variables and Micro-economic Entity. The

firm is a micro-economic entity. Changes in population and capital can be predicted for

the whole economy and not for a single firm.

4. Profit is not a residual income. According to JF Weston, the ultimate decision makers

in a firm need not be compensated as residual income receivers. Judgement is an

economic service and is available for a price.

5. Monopoly Profits are not explained. The theory does not explain monopoly profits.

Monopolists do not face any uncertainty and yet makes super normal profits.

Questions.

1. Explain the determination of factor prices in a competitive market.

2. Explain the determination of factor prices under imperfect competition.

3. Explain the theory of economic rent.

4. Explain the role of collective bargaining and determination of wage rates under

bilateral monopoly.

5. Explain the loanable fund theory of interest.

6. Explain the risk and uncertainty bearing theories of profit.

48


UNIT THREE

PREVIEW.

▪ Interdependence in the Economy – General Equilibrium and its Existence.

▪ The Pareto Optimality Conditions of Social Welfare.

▪ Marginal Conditions for Pareto Optimal Resource Allocation.

▪ Perfect Competition and Pareto Optimality.

▪ Kaldor- Hicks Compensation Criterion

▪ Arrow’s Impossibility Theorem.

INTERDEPENDENCE AND EXISTENCE OF GENERAL EQUILIBRIUM.

Equilibrium exists when the demand and supply curves intersects at a positive price which is

called the equilibrium price. The equilibrium price is the price at which there is neither excess

demand nor excess supply. At the equilibrium price, excess demand is zero. Symbolically,

Where ED refers to excess demand, QD is the quantity demanded and QS is the quantity supplied.

There are two conditions for the existence of a stable general equilibrium at a positive price:

1. At the equilibrium price, consumers maximize their utility and producers maximize their

profits.

2. Both the product and factor markets clear at the equilibrium price.

Figure 4.1 shows the existence of general equilibrium in the economy when the demand curve

intersects the supply curve at point ‘E’. Accordingly, OP positive price is determined. The

market clears with OQ quantity demanded and supplied. This demand and supply model applies

to both factor and product markets. KJ Arrow and G Debreu in their work “Existence of an

Equilibrium for a Competitive Economy” Vol.22, 1954 observed that general exists in the

economy when there are no discontinuities and non-increasing returns to scale in perfectly

competitive markets.

There is stability in the general equilibrium when the market forces of demand and supply push

the price towards the equilibrium point. Geometrically, the equilibrium is stable when the

demand curve intersects the supply curve from above. Assuming the price falls from OP to OP2,

ED = QD – QS = 0

49


the quantity supplied will be P2C and the quantity demanded would be P2D. CD will be the

excess demand. Excess demand will increase competition amongst the buyers and push the price

towards the equilibrium price OP. Conversely, when the price rises to OP1, there is excess

supply equal to AB. Now producers will compete amongst themselves to sell more at a lower

price until once again equilibrium price OP is reached. In this way, the equilibrium point ‘E’ and

price OP shows stability of the equilibrium.

.

Unstable Equilibrium.

An unstable equilibrium is a situation in which the equilibrium is not restored once it is

disturbed. Geometrically, when the demand curve intersects the supply curve from below, the

equilibrium is unstable (See Figure 4.2). The demand curve is upward sloping and intersects the

supply curve from below at point ‘E’. However, when the price rises to OP1, the demand is found

to be greater than supply. Rising demand with rising prices will never eliminate excess demand

and equilibrium will never be attained. The same will be true when the price falls to OP2. Thus,

equilibrium point ‘E’ is unstable and will not be restored once it is disturbed.

50


Multiple Equilibria and Stable/Unstable Positions.

Alfred Marshall considered a number of stable and unstable equilibrium positions with unusual

demand and supply curves as shown in Fig. 4.3. There are three equilibrium points on the

demand and supply curves DD and SS. Points ‘A’ and ‘C’ are stable equilibrium positions

whereas point ‘B’ is an unstable equilibrium position. If the price rises above OP3, there will be

excess supply and competition amongst the sellers will restore the equilibrium at point ‘A’.

Similarly, if the price falls below OP1, competition amongst the buyers will restore the

equilibrium at point ‘C’. However, when price rises above P2, excess demand will only push the

prices up endlessly without restoring the equilibrium at point ‘B’. Point ‘B’ is therefore an

unstable equilibrium position.

51


THE GENERAL EQUILIBRIUM MODEL.

The general equilibrium analysis explains the existence of simultaneous equilibrium in different

markets. In each market, total demand is equal to total supply. The price mechanism is the link

between the two markets i.e., the product and the factor markets. According to Prof. Stigler,

general equilibrium refers to inter-relationship among all parts of the economy. Different

variables, such as prices, demand for and supply of goods and factors are interdependent and

interrelated. A change in price of one good will affect other prices in the economy. The general

equilibrium analysis is based on the following assumptions:

1. Income, taste, habit and preferences of the consumers are given and constant.

2. There is perfect competition both product and factor markets.

3. There is perfect occupational and geographical mobility of factors.

4. There are constant returns to scale.

5. Both products and factors are homogenous.

6. Consumers aim at utility maximization and firms aim at profit maximization.

7. There is full employment in the economy and technology is constant.

With these assumptions, general equilibrium can be explained with the help of Figure 4.4 below.

52


General equilibrium in a perfectly competitive economy can be explained in terms of consumer’s

equilibrium, firm’s equilibrium, full employment, Pareto efficient resource allocation and

equilibrium in demand and supply of goods and services.

1. Consumer’s Equilibrium. In figure 4.4, at point ‘E’, the indifference curve IC is

tangent to price line PL. Tangency between the price line and the indifference curve is

the condition of consumer equilibrium according to JR Hicks. The consumer gains

maximum satisfaction at point ‘E’ because the at this point the slope of the price line PL

is equal to the slope of the indifference curve IC and the marginal rate of substitution of

good X for Y is equal to the price ratio Px/Py. Symbolically, MRSxy = Px/Py.

2. Equilibrium of the Firm. At point ‘E’, the competitive firm is in equilibrium because

the production possibility curve CF is tangent to the price line PL. The firm makes

maximum profits at point ‘E’ because at this point the marginal rate of technical

substitution of labor for capital is equal to the ratio capital and labor ΔK/ΔL.

53


Symbolically, MRTSLK = ΔK/ΔL. Further, at point ‘E’, the slope of the price line PL is

equal to the slope of the production possibility curve CF.

3. Full Employment. At equilibrium point ‘E’, all the resources in the economy are fully

employed to produce the maximum quantities of goods X and Y, here, cars and food.

Point ‘E’ is on the production possibility curve CF.

4. Pareto Efficiency. The tangency between the production possibility curve CF and the

indifference curve IC ensures Pareto efficient allocation of resources because at point ‘E’,

the slope of the production possibility curve is equal to the slope of the indifference curve

IC and the marginal rate of technical substitution between two factors labor and capital is

equal to the marginal rate of substitution between two goods X and Y, here, cars and

food.

5. Equilibrium in Demand and Supply. At point ‘E’, the firms in the economy produces

OC1 of Cars and OF1 quantity of food which is also the combination of goods demanded

by consumers. Hence at point ‘E’, total demand is equal to total supply of goods.

DISEQUILIBRIUM.

If the production possibility curve CF is not tangent to the price line PL and the indifference

curve IC at the same point ‘E’, there will be disequilibrium in the economy. A situation of

disequilibrium is shown in Figure 4.5. In this figure, the firm operates at point A on the PPF and

the consumer is in equilibrium at point B where the price line PL is tangent to the indifference

curve IC. Clearly points ‘A’ and ‘B’ show disequilibrium between demand and supply of the

two goods, here, cars and food. The supply of cars OC1 is greater than the demand for cars OC2

and the supply of food OF1 is less than the demand for food OF2. Thus, the price of cars will fall

and that of food will rise until equilibrium is restored at point ‘E’ as shown in Figure 4.4.

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ASSESSMENT.

The theory of general equilibrium has its benefits and limitations. The theory is useful in

explaining the operations of a free market capitalist economy. The theory explains the

interdependence between various sectors in the economy and shows the complexities involved in

a free market economy.

PARETO OPTIMALITY CONDITIONS OF SOCIAL WELFARE.

Modern welfare economists like Hicks, Lerner, Lange and others have laid down the Pareto

optimality conditions of social welfare. According to Pareto, social welfare is maximum when it

is not possible to make anyone better off without making anybody else worse off. Prof. Hicks

has laid down the marginal conditions. Prof. Reder in his ‘Studies in the Theory of Welfare

Economics’, laid down seven marginal conditions of optimum social welfare. These conditions

are also known as the first order conditions of maximum social welfare. These conditions are

based on the following assumptions:

1. Individuals have freedom of choice given their ordinal utility functions.

2. Firms are independent in making their decisions.

3. Technical knowledge is constant and production function of each firm is given.

4. Products are divisible and consumers buy some quantity of each good to maximize their

satisfaction.

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5. Firms minimize their cost and maximize their profits, and

6. Productive factors are perfectly mobile.

The conditions of optimum social welfare are as follows:

1. The Optimum Condition of Exchange.

The marginal rate of substitution between any two products must be the same for every

individual who consumes both i.e. MRSxy = Px/Py. The optimum condition of exchange is

explained with the help of a box diagram in Figure 4.6. There are two individuals ‘A’ and ‘B’

who possess two goods X and Y in fixed quantities. Oa and Ob are the points of origin for each

of the two consumers. The vertical sides represent commodity ‘Y’ and the horizontal sides

represent commodity ‘X’. The indifference map of consumer ‘A’ is represented by indifference

curves A1 to A3 and that of consumer ‘B’ is represented by ICs B1 to B3. Any point within this

box represents a possible distribution of two goods between the two consumers. At point ‘E’, the

two ICs A1 and B1 intersect with each other. Accordingly, ‘A’ possesses OaYa units of Y and

OaXa units of X and ‘B’ possesses ObYb units of Y and ObXb units of X. Since the slopes of the

two indifference curves are not similar at point ‘E’, the MRS of two goods is not equal to their

price ratios. Point ‘E’ is therefore not the point of optimum exchange of two goods between the

two consumers. If the two consumers move from point ‘E’ to a higher point R on a higher IC A3,

Consumer A gets more of X by sacrificing some Y and B gets more of Y by sacrificing some X.

There is no improvement in B’s position because he is on the same IC i.e. B1. However, ‘A’ is

better off because of his movement on a higher IC i.e. A1 to A3. The opposite will hold true if

the two consumers move from point ‘E’ to point ‘P’. ‘Q’ is the only point when both the

consumers would be moving on to a higher IC leading to a higher level of satisfaction for both.

Points P, Q and R are the three possible points of exchange. Joining the locus of these points of

tangency, the contract curve CC is obtained. At these points, the MRSxy = Px/Py for both the

consumers and thus satisfies the optimum condition of exchange. However, a movement along

the contract curve tends to make one consumer better off at the expense of the other and hence

the real optimum point of social welfare remains indeterminate. If both the consumers

compromise at position ‘Q’, a determinate point of maximum social welfare can be achieved.

However, such a compromise involves value judgment.

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2. The Optimum Condition of Factor Substitution.

The optimum condition of factor allocation is that the MRTS between any two factors must be

the same for any two firms using both these factors to produce the same product. The MRTS at

any point on the isoquant is the rate of substitution of one factor for another to maintain a given

level of output as shown in Figure 4.6 above. In the above figure, X and Y are the two factor

inputs and ‘A’ and ‘B’ are the two firms.

The isoquant map of firm ‘A’ is represented by isoquant curves A1 to A3 and that of firm ‘B’ is

represented by IQs B1 to B3. At point ‘E’, the two IQs A1 and B1 intersect with each other.

Accordingly, ‘A’ uses OaYa units of Y and OaXa units of X and ‘B’ uses ObYb units of Y and

ObXb units of X to produce A1 and B1 units of goods respectively. Since the slopes of the two

isoquant curves are not similar at point ‘E’, the MRTS of two factors is not equal. The MRTSxy

for both the firms is equal only on the points of tangency between the two isoquants or on the

contract curve CC.

Points P, Q and R are the three possible points of optimal allocation. However, a movement

along the contract curve tends to make one firm better off at the expense of the other and hence

the real optimum point of factor allocation remains indeterminate.

3. The Condition of Optimum Degree of Specialization.

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The marginal rate of transformation between any two products must be same for any two firms

that produce both. The MRT between any two products is the rate at which one product would

have to be sacrificed to produce more of the other product with the same quantity of resources.

The MRT is measured on the PPF or the production possibility frontier. Optimum degree of

specialization is achieved when the two products are produced in such combinations that the

slopes of transformation curves are equal.

TA and TB are the production transformation curves of the two firms ‘A’ and ‘B’. Firm ‘A’

produces OD of X and DC of Y and firm ‘B’ produces OF of X and FE of Y. These total

amounts of goods X and Y are show in Figure 4.8 by superimposing Panel ‘B’ over Panel ‘A’.

The point of tangency between the two transformation curves is point ‘R’ which is the point of

optimum degree of specialization because the slope of the transformation curves at the point of

tangency is equal.

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At point ‘R’, both the firms together produce KS of product ‘X’ and MN of product ‘Y’. If the

two transformation curves intersect at any point, the slopes of the two curves will not be equal at

the point of intersection and hence any such point cannot be the point of optimum degree of

specialization. Further, a larger quantity of two goods will be produced at the point of tangency

than at the point of intersection between the two curves.

4. The Condition of Optimum Factor-Product Utilization.

According to the condition of optimum factor-product utilization, the marginal rate of

transformation between any factor and any product must be the same for any pair of firms using

the factor and producing the product. In other words, the marginal productivity of any factor in

producing a particular product must be the same for all firms. If the marginal productivity of a

factor is low, the total product would increase by transferring some units of the factor to the high

productivity firm. This is shown in Figure 4.8 where OA and OB are the transformation curves

of firms A and B respectively. Curve OB is superimposed on curve OA. Product Z is produced

by the two firms and is measured on the vertical axis whereas factor input L is measured on the

horizontal axis. Point F is not an optimum position because two transformation curves are not

tangential to each other. To achieve the optimum position, the OB curve should be shifted

upwards so that it becomes tangential to the OA curve. Curve O1B1 is tangent to OA at point E

which is the point of optimum product-factor utilization because the slopes of the two

transformation curves are equal and the product is now increased from DC to KH.

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5. The Optimum Condition of Product Substitution.

The optimum condition of product substitution is achieved when the marginal rate of substitution

between any pair of products for any person consuming both must be the same as the marginal

rate of transformation (for the community) between them. It means MRSxy between two

products must equal the MRT between them. This is shown in Figure 4.9 where AB is the

transformation curve between two products X and Y. The indifference map of the individual

consists of two indifference curves IC1 and IC2 with O1X1 and O1Y1 as the two axes. Let us

suppose that at point L the community produces ON of X and NL of Y and the consumer buys

O1M of X and ML of Y. However, L is not the socially optimum point because the MRT does

not equal the MRS as the two curves AB IC1 are not tangential to each other at point L. A

movement from L to E represents an optimum position both for the producer and the consumer

because at point E, MRSxy = MRTxy. At point E, the rate at which consumers are willing to

substitute X for Y is equal to the rate at which producer can transform X into Y.

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6. The Optimum Condition for Intensity of Factor Use.

The optimum condition for intensity of factor use or the optimum allocation of a factor is

achieved when the MRS between the rate of reward for work and leisure is equal to the MRT

between hours of work and the resulting product. A person is faced with the problem of

choosing between work and leisure in a given time period. If he enjoys more leisure, he receives

less income and vice versa. Since leisure and income are inversely related, he has an

indifference map indicating various combinations of leisure and income. Each point on the IC

shows the MRT between hours of work and the product. If the MRT between work and product

is greater than the MRS between leisure and work, the product can be increased by transferring a

factor unit’s time from leisure to work. The optimal position is achieved when the reward paid

to a factor owner equals the value of marginal productivity of the factor. This is shown in Figure

4.9 where TC is the transformation curve between work and product. The factor units are

measured horizontally from right to left taking C as the point of origin. The product units are

measured on the vertical axis. The concavity of the TC indicates diminishing MRT between

work and product. The indifference curves IC1 and IC2 indicate various combinations of income

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and leisure. Income is measured on the horizontal axis and leisure is measured on the vertical

axis. The convexity of the IC indicates diminishing MRS between income and leisure. The

marginal condition is satisfied at the point where the transformation curve and the indifference

curve are tangential to each other i.e. their slopes are equal. AT point L, the optimum position is

not achieved because IC1 is intersecting the TC curve. When the individual moves on a higher

IC which is tangential to TC at point P, the MRS between income and leisure equals the MRT

between work and product.

7. The Optimum Inter-temporal Condition.

The optimum inter-temporal condition is achieved when the marginal temporal rate of

transformation between every pair of factors and products as well as the marginal temporal rate

of substitution between every pair of factors and between every pair of products is equal to the

rate of interest on riskless securities. This condition relates to borrowing and lending between

producers in the absence of risk or uncertainty. It implies that the rate of interest at which an

individual producer is willing to lend a given amount of capital must equal its marginal

productivity to the borrowing producer. This is shown in Figure 4.9 where the horizontal axis

measures money as income and the vertical axis measures purchasing power. I1 and I2 are the

time indifference curves of the individual lender pertaining to different income levels. Every

point on a time IC indicates diminishing MRS between present and future incomes which means

that the individual places higher premium on every unit of income he forgoes for future use. TC

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is the time production possibility curve of the individual borrower. Every point on this concave

curve indicates diminishing marginal productivity of capital through time. This condition is

satisfied when the time IC and the time PPC are tangential to each other. Point P indicates

optimum position because the TC and I2 curves have the same slope at this point.

To conclude, between any two products and factors, the MRS must equal their MRT and their

price rations must equal each other.

PERFECT COMPETITION AND PARETO OPTIMALITY.

The marginal conditions of Pareto optimality are fully satisfied under the conditions of perfect

competition. Product prices are equal to marginal costs and factor prices are equal to their

marginal productivity and hence product and factor prices are uniform in the entire economy.

Buyers and sellers cannot influence market price because there are large number of buyers and

sellers in the market. They have perfect knowledge about the market, returns to scale are

constant and there is perfect mobility of factor inputs. Firms make normal profits. Since the

conditions of Pareto optimality are found in perfect competition, a perfectly competitive

equilibrium is known to be Pareto optimum.

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Conditions of Pareto Optimality.

An allocation is Pareto optimal if it is not possible to reallocate resources without making at least

one person worse off. The conditions of Pareto optimality are related to efficiency in exchange

(or consumption), efficiency in production and overall Pareto efficiency (or efficiency in both

consumption and production.

Efficiency in Exchange.

The first condition of Pareto optimality is concerned with efficiency in exchange. The MRSxy is

same for every consumer who consumes both i.e. MRSxy = Px/Py. Assuming that there are two

consumers A and B who buy two goods X and Y and each faces the price ration Px/Py,

consumer A will choose X and Y such that AMRSxy = Px/Py. Consumer B will choose X and Y

such that his BMRSxy = Px/Py. The condition for efficiency in exchange is therefore AMRSxy =

BMRSxy = Px/Py. This is shown in Figure 4.11 which explains the optimum condition of

exchange.

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There are two individuals ‘A’ and ‘B’ who possess two goods X and Y in fixed quantities. Oa

and Ob are the points of origin for each of the two consumers. The vertical sides represent

commodity ‘Y’ and the horizontal sides represent commodity ‘X’. The indifference map of

consumer ‘A’ is represented by indifference curves A1 to A3 and that of consumer ‘B’ is

represented by ICs B1 to B3. Any point within this box represents a possible distribution of two

goods between the two consumers. At point ‘E’, the two ICs A1 and B1 intersect with each other.

Accordingly, ‘A’ possesses OaYa units of Y and OaXa units of X and ‘B’ possesses ObYb units of

Y and ObXb units of X. Since the slopes of the two indifference curves are not similar at point

‘E’, the MRS of two goods is not equal to their price ratios. Point ‘E’ is therefore not the point

of optimum exchange of two goods between the two consumers. If the two consumers move

from point ‘E’ to a higher point R on a higher IC A3, Consumer A gets more of X by sacrificing

some Y and B gets more of Y by sacrificing some X. There is no improvement in B’s position

because he is on the same IC i.e. B1. However, ‘A’ is better off because of his movement on a

higher IC i.e. A1 to A3. The opposite will hold true if the two consumers move from point ‘E’ to

point ‘P’. ‘Q’ is the only point when both the consumers would be moving on to a higher IC

leading to a higher level of satisfaction for both.

Points P, Q and R are the three possible points of exchange. Joining the locus of these points of

tangency, the contract curve CC is obtained. At these points, the MRSxy = Px/Py for both the

consumers and thus satisfies the optimum condition of exchange. A movement along the

contract curve tends to make one consumer better off at the expense of the other and each point

on the contract curve represents optimum social welfare.

Efficiency in Production.

The second condition for Pareto optimality refers to efficiency in production. Under perfect

competition, there are allocation rules for establishing efficiency in production. The first rule

relates to optimum allocation of factors. Accordingly, the MRTS between any two factors must

be the same for any two firms using these factors to produce the same product. Let us suppose

that there are two firms A and B that use two factors: labor (L) and capital (K) and produce one

product. Given the prices of the two factors, a firm is in equilibrium when the slope of an

isoquant equals the slope of the iso-cost line. The slope of an isoquant is the MRTS of labor and

capital and the slope of the iso-cost line is the ratio of prices of labor and capital. The condition

of equilibrium of firm A is AMRTSLK = PL/PK and that of firm B is BMRTSLK = PL/PK. The rule

for efficiency in production is thus AMRTSLK = BMRTSLK = PL/PK.

The second rule of efficiency in production states that the MRT between any factor and any

product must be same for any pair of firms using the factor and producing the product. In other

words, the marginal productivity of any factor in producing a particular product must be the

same for all firms. A firm under perfect competition will employ a factor of production up to the

point at which its marginal value product (VMP) equals its price. If MPP is the marginal

physical product of factor L (Labor) in the production of good X in firm A, then its VMP is the

MPP multiplied by the price of X that is VMP = AMPXL.PX. The price of labor (PL) in firm is:

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PL = AMPXL.PX Or PL/PX = AMPXL …………. (1)

Similarly, in firm B, the price of labor is:

PL = BMPXL.PX Or PL/PX = BMPXL …………. (2)

Since the price of the product (PX) and the price of labor (PL) are the same in both the firms,

each firm will equate its MPP to PL/PX. Thus, from equations (1) and (2), we have:

AMPXL = BMPXL = PL/PX.

In the equilibrium condition, each firm has the same MPPL in producing the same product X.

The third rule related to efficiency in production is that the MRT between any two products

must be the same for any two firms that produce both. Accordingly, if there are two firms A and

B and both produce two products X and Y, then AMRTXY = BMRTXY. A profit maximizing

firm will be in equilibrium when the iso-revenue line is tangent to its transformation curve. It

means the MRT between two products X and Y must equal their price ration i.e. MRTXY = PX/PY.

The third rule of efficiency in production is explained in Figure 4.12.

The MRT between the two products is measured by the slope of transformation curve TC at any

given point. IR is the iso-revenue curve whose slope shows PX/PY. At point P, the slopes of the

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TC and IR curves are equal so that MRTXY = PX/PY. At this point, firms maximize their output

by producing and selling OX1 of and OY1 of commodities X and Y respectively. At point P, the

MRTxy = MCx/MCy i.e. the marginal rate of transformation of commodity X for commodity Y

is equal to the ratio of marginal cost of commodity X to the marginal cost of commodity Y.

Thus for each firm in the industry, Px = MCx and Py = MCy. Hence, MCx/MCy = Px/Py.

Efficiency in Exchange and Production (Product Mix).

In order to achieve Pareto optimality under perfect completion, the MRSxy must equal MRTxy

which is achieving simultaneous efficiency in consumption as well as production.

The price ratios of two products X and Y to consumers and firms are the same under perfect

competition. Hence, the MRS of all consumers will be equal to MRT of all firms. Symbolically,

MRSXY = PX/PY and MRTXY = PX/PY. Therefore, MRSXY = MRTXY. This is shown in Figure

4.13. TC is the transformation curve for products X and Y. Any point on the TC curve shows

MRT between X and Y. It also shows the relative opportunity cost of producing X and Y i.e.

MCx/MCy. I1 and I2 are the indifference curves which represent consumer tastes and

preferences for these two goods. The slope of ICs at any point shows the MRSxy. Pareto

optimality is achieved at point P where the slope of the transformation curve TC and the

indifference curve I2 are equal. This equality in slope is shown by the price line cc which

indicates that at point P, MRSXY = MRTXY = PX/PY or MUx/MUy = Px/Py.

Point Q on I1 indicates inefficient production because it is below the TC curve. Point R is on the

TC curve but it is on a lower indifference curve I1 where the consumer satisfaction is not

maximized. Therefore, Pareto optimality exists only at point P where there is efficiency in both

consumption and production when the society consumes and produces OX1 of commodity X and

OY1 of commodity Y.

The conditions necessary for achieving Pareto optimality therefore relates to efficiency in

consumption, efficiency in production and simultaneous efficiency in both consumption and

production. These Pareto optimality conditions will be achieved if second order conditions are

satisfied for each consumer and producer, no consumer is satiated, there are no external effects

either in consumption or production, there are no indivisibilities and there are no imperfections

in factor and product markets.

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KALDOR-HICKS COMPENSATION CRITERIA.

The compensation criteria developed by Hicks, Kaldor and Scitovsky is known as new welfare

economics. These economists accepted Pareto’s ordinal measurement of utility and the absence

of interpersonal comparison and went on to demonstrate that social welfare could be increased

without making value judgments.

Assumptions of Kaldor-Hicks Compensation Criteria.

The compensation criteria are based on the following assumptions:

1. Everyone’s satisfaction is independent from the others so that he is the best judge of his

welfare.

2. There is absence of external effects in production and consumption.

3. The taste of everyone is constant.

4. It is possible to separate the problems of production and exchange from the problem of

distribution.

5. It is assumed that utility is ordinal and interpersonal comparison is impossible.

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The First Compensation Criteria or the Kaldor-Hicks Criterion.

According to Kaldor, the test of increase in social welfare is that if some people are made better

off and others worse off, the gainers from the change could more than compensate the losers and

yet be better off themselves. The actual payment of compensation is regarded as a political or

ethical decision. According to Hicks, if A is made so much better off by the change that he

could compensate B for his loss and still have something left over, then the reorganization is a

clear improvement. The Kaldor-Hicks criterion shows that if an economic change leads to the

production of more goods and services they can be so distributed as to make some people better

off and none worse off. Actual redistribution being a political or ethical issue need not happen.

This criterion is depicted with the help of Samuelson’s utility curves for two individuals in

Figure 4.14. If ‘A’ and ‘B’ are two individuals, each utility possibility curve represents the locus

of all combinations of their utility levels. Each curve is related to a given fixed bundle of goods

and the various points on each curve are obtained by costless lump-sum redistribution of a fixed

commodity bundle.

Let ‘X’ and ‘Y’ be the two bundles of goods represented by the utility possibility curves B1A1

and B2A2 respectively. Let us begin with Q2 bundle of goods. In terms of Pareto’s criterion that

any change which leads to a movement to any one of the points C, D or E is a Pareto

improvement on the B1A1 curve because it makes both individuals better off or at least one better

off without making the other worse off. But any movement outside C and E to Q1 cannot be

evaluated in terms of Pareto’s criterion because it improves A’s welfare at the expense of B.

However, a move from Q2 to Q1 can be evaluated in terms of the Kaldor-Hicks criterion by

asking ‘B’ as to how much he would be willing to pay to B to forego it. If (ii) > (i), the change

increases welfare because A would compensate B for his loss and still be better off at Q1 than at

Q2. The test for an improvement in welfare is that the initial bundle should lie below the utility

possibility curve representing the new bundle. Thus, a move from Q2 to Q1 satisfies the Kaldor-

Hicks criterion because Q2 lies below the utility possibility curve B1A1 of the final bundle Q1. A

move to Q1 can be desired to generate the point ‘D’ on the same utility possibility curve B1A1

which is clearly better than Q2. Once compensation is made, ‘A’ can move from D to Q1.

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Critical Evaluation.

Scitovsky, Baumol, Samuelson and others have criticized Kaldor-Hicks compensation criteria on

the following grounds:

1. It Ignores Distribution of Income. According to IMD Little, the compensation criteria

is only a definition and not a test of increase in welfare because it ignores income

distribution. The problem of distribution is inseparably connected to the problem of

productive efficiency. To say that one bundle of goods is greater than the other is useless

without making a reference to income distribution. Comparison of two bundles of goods

involves their money values at their market prices.

2. It Measures only potential Welfare. By separating production from distribution, the

Kaldor-Hicks criterion confuses potential welfare with actual welfare. Actual welfare

depends both upon production and distribution.

3. It does not have a Common Standard of Value. Prof. Baumol says that when more

than two commodities are involved, optimum production is not possible unless there is a

common standard of value for measuring different commodities. The common standard

of value depends upon income distribution which is neglected by Kaldor and Hicks.

4. It is not free from interpersonal Comparisons. Kaldor and Hicks have failed in

finding out a value free criteria. Their criterion assumes that the social value of money is

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the same in the hands of both the rich and the poor. Further, money remains with the

better off. Thus, this criterion involves interpersonal comparisons of utility.

5. It is based on long run Welfare Adjustments. Little and Scitovsky criticized Hicks for

suggesting long run welfare adjustments which would have insignificant real income

distribution effects. Further, the effects would be random and will cancel out in the long

run.

6. It does not involve Actual Compensation. Kaldor-Hicks criterion does not consider

actual compensation but only potential compensation. Actual increase in welfare cannot

be measured with the help of potential compensation.

7. It does not have Universal Validity. Kaldor said that the State is responsible for

maintaining equitable distribution of income and unequal distribution of income is

corrected through compensations. However, such corrections and distributions are likely

in a socialist economy according to Scitovsky. In a free enterprise economy, the effects

of reorganization on efficiency and equity cannot be separated because compensation

payments are not politically possible. The criteria therefore do not have universal

validity.

ARROW’S IMPOSSIBILITY THEOREM.

Bergson in his social welfare function showed that a social ranking of alternative economic

situations can be made only by making interpersonal comparisons of utility that are included in

such a function. However, the question is whether the social welfare function reflects the tastes

of the society or the tastes of dictator. KJ Arrow in his ‘Social Choices and Individual Values’

has proved the impossibility of obtaining social welfare function even when individual

preferences are consistent. The five criteria suggested by Arrow for social choices to reflect

preferences of individuals are as follows:

1. Collective Rationality.

Social choices must be rational and alternative choices must be available. The rule for making a

social choice can be derived from an ordering of all possible alternatives open to society. This

ordering must satisfy the conditions of consistency and transitivity. Consistency refers to the

requirement that individuals have preferences that are fully defined or ranked. Social choices

must satisfy the condition of transitivity i.e. if an individual prefers X to Y and Y to Z then he

must prefer X to Z. Social preferences like individual preferences must be completely ordered.

2. Responsiveness to Individual Preferences.

Social choices must be directly related to individual preferences. It means that social choices

must change in the same direction as individual choices. Individual choices must be derived

within the society. However, it is not possible to derive alternatives which affect socially

desirable alternatives.

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3. Non- imposition.

Social choices must not be imposed by customs or from outside the society. It must be derived

from individual preferences. For example, if most of the individuals do not prefer A to B then

the society should not prefer A.

4. Non-dictatorship.

Social choices must not be dictatorial. They must not be imposed by one individual within the

society.

5. Independent of Irrelevant Alternatives.

Social choices must be independent of irrelevant alternatives i.e. if any one alternative is

excluded, it will not affect the ranking of other alternatives.

Arrow shows that it is not possible to satisfy all the five conditions and obtain a transitive social

choice for each set of individual preferences without violating at least one condition. Social

choice is inconsistent or undemocratic because no voting system allows these five conditions to

be satisfied. Such a situation is known as Arrow’s Impossibility Theorem.

ILLUSTRATION.

Let us assume that there are individuals A, B and C in a society. They are asked to rank three

alternative situations X, Y and Z. They vote by writing number 3 for their first choice, number 2

for their second choice and number one for their third choice. Suppose the voting pattern is as

shown in Table 4.1.

Table 4.1 – Ranking of Alternative Situations

Individuals Alternative Situations

X Y Z

A 3 2 1

B 1 3 2

C 2 1 3

The table shows that everyone has consistent preferences. A prefers X to Y, Y to Z and hence X

to Z. B prefers Y to Z, Z to X and hence Y to X. C prefers Z to X, X to Y and hence Z to Y. But

the majority voting leads to intransitive social patterns. Two individuals A and C prefer X to Y.

Two individuals A and B prefer Y to Z. However, B and C prefer Z to X. Hence the majority

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prefers X to Y and Y to Z but it also prefers Z to X. This is shown in Figure 4.15 which shows a

multiple peaked pattern. This explains the paradox of the majority rule which is inconsistent

with those of individuals composing the majority. In this way, Arrow shows that the use of

democratic process of voting leads to a contradictory welfare criteria. According to Musgrave,

this voting paradox explained by Arrow comes as shock to believers in electoral democracy. The

paradox, however, does not imply that democracy does not work or that the majority rule cannot

work. The conclusion is that for majority rule to give non-arbitrary results, the preference

structure of individuals must be typically single peaked i.e. a situation where there no extremist

preference patterns.

Critical Evaluation of Arrow’s Impossibility Theorem.

Samuelson, Little and other welfare economists have made the following criticisms:

1. The Theorem is not related to Social Welfare Function.

According to IMD Little, Arrow’s negative conclusions have no relevance in welfare economics.

His impossibility theorem relates to a decision-making process and not to a social welfare

function.

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2. The Theorem does not provide solution to Interpersonal Comparisons.

Arrow fails to solve the problem of interpersonal comparison of utility in his search for a

satisfactory social welfare function. His method of majority rule involves interpersonal

comparisons. If a majority prefers X to Y, then the majority decision in favor of X means that X

is preferred to Y only if the aim is to maximize utility and the choice of one individual has equal

utility with that of another.

3. Social Choice is not the only Alternative.

According to WJ Baumol, Arrow’s requirements are stricter than what they appear to be.

Inconsistent or undemocratic social choice making is not the only alternative.

4. Majority Voting Pattern is Unrealistic.

The Arrow theorem is based on the assumption of a majority voting pattern which does not take

into consideration the possibility of a voting system that requires unanimity and permits buying

and selling of votes.

JM Buchanan says that the alternative to majority voting may be failure to make collective

choices and there is no reason to believe that this is a preferred course of action. Decisions

reached by majority action may be reversed by a subsequent reconsideration of the issue. Voting

is a means by which collective choices are made and imperfections in the voting mechanism

cannot be a reason to discard the system.

Questions.

1. Explain interdependence, general equilibrium and its existence in the economy.

2. Explain the Pareto Optimality Conditions of Social Welfare.

3. Explain the Marginal Conditions for Pareto Optimal Resource Allocation.

4. Explain the existence of Pareto optimality under Perfect Competition.

5. Explain Kaldor- Hicks Compensation Criterion.

6. Explain Arrow’s Impossibility Theorem.

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CHAPTER 5

PREVIEW.

▪ Economics of Search: Search costs.

▪ Information failure and missing markets.

▪ Asymmetric Information: The market for Lemons.

▪ Adverse selection: Insurance Markets.

▪ Market Signaling. The Problem of Moral Hazard.

▪ The Principal-Agent Problem.

▪ The Efficiency Wage Theory.

ECONOMICS OF SEARCH & SEARCH COSTS.

I wanted to buy a pair of sandals. I thought that I would get a good bargain in the street footwear

market. I looked at the pair of sandals that I thought I would buy and decided to pay Rs.200 for

the pair (consumer’s surplus is the difference between the price that a consumer is willing to pay

and one that the consumer actually pays). I asked the seller for the price. The seller quoted the

price as Rs.400. I bargained and quoted the price that I was willing to pay. The seller began to

make faces and brought down the price to Rs.375 as if he was giving me a discount of Rs.25. I

remained stuck to my buying price and after some haggling over the price, the seller decided to

part with the pair of sandals at Rs.200. Now the question is whether Rs.200 is the correct price

for the pair of sandals. The fact that the seller agreed to sell at Rs.200 means that he still made

some profit even after the selling the pair at half the price quoted in the beginning. For an

ordinary consumer like me and many others, it is difficult to get at the correct price because

adequate information is not available. Information does not come for free. There is a price

associated with information. The price of information in economics is known as Search Cost.

Markets are imperfect and both buyers and sellers do not have perfect knowledge about the

market. Prices are haggled out and more often than not equilibrium prices err on the side of the

buyers leaving a part of the consumer surplus for the sellers to enjoy. What is true for a pair of

sandals is also true for all the goods and services that consumers buy from the market.

THE OPTIMAL AMOUNT OF INFORMATION.

When information is being gathered, the cost of information in the beginning is less and grows

overtime as more and more information is gathered and the value of information begins to

decline after a point. Because of the low-hanging fruit principle, in the beginning, people tend to

gather information from the cheapest sources and may resort to more expensive sources if the

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information gathered is not adequate or satisfactory. Thus, the marginal cost increases whereas

the marginal benefit from an additional amount of information declines.

The Cost-Benefit Principle.

According to the Cost-Benefit principle, a rational consumer will continue to gather information

as long as its marginal benefit exceeds its marginal cost. This is illustrated in Figure 5.1 where

units of information are measured on the horizontal axis and the marginal cost of information is

measured on the vertical axis. The MCI curve rises gradually and after a point rises rapidly.

Conversely, the MBI curve declines gradually and after a point, the decline is more rapid for

reasons explained earlier. A rational consumer will acquire OI units of information because the

marginal benefit of OI information is equal to its marginal cost. The MCI and MBI curves

intersect at point ‘E’ and equilibrium quantity of information OI is established.

Knowing something means also not knowing something. Figure 5.1 shows the optimal level of

ignorance also. A rational person will not acquire more information if the cost of additional

information is greater than its benefit. People will be better off in remaining ignorant than being

informed if the cost of information is greater than the benefit from information.

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Illustration.

The search for low prices come to an end at the point of equality between marginal cost of

information and marginal benefit from information (MCI = MBI). The process of searching for a

low price can be illustrated with the following example.

Prateek wants to buy a Samsung Smart phone. Other things pertaining to the smart phone is

assumed to be similar and only the price varies. The different prices quoted by Smart Phone

retailers are Rs.10,000/-, Rs.11000/-, Rs.12000/-, Rs.13000/- and Rs.14000/-. Given these

prices, the average price of a smart phone turns out to be Rs.60000/5 = Rs.12000/-. Given the

average price, Prateek can decide to buy the smart phone for Rs.12000/-. Alternatively, he may

continue his search for a lesser price. Prateek continues to search to find the lowest price to be

Rs.10000/-. The marginal decline in the price found by Prateek at every search is the marginal

benefit derived by Prateek by going in for additional search. According to the cost-benefit

principle, Prateek will continue his search until the marginal cost of search becomes equal to the

marginal benefit derived from search (MCI=MBI).

The minimum expected price with every additional search can be found by using the following

formula:

𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 = 𝐿𝑜𝑤𝑒𝑠𝑡 𝑃𝑟𝑖𝑐𝑒 + 𝑃𝑟𝑖𝑐𝑒 𝑅𝑎𝑛𝑔𝑒

𝑁𝑜. 𝑜𝑓 𝑆𝑒𝑎𝑟𝑐ℎ𝑒𝑠 + 1

When Prateek completes his first search, the minimum expected price will be:

= 10000 + 4000

1 + 1= 𝑅𝑠. 12000

There is a direct relationship between the minimum expected price and the number of searches

undertaken. More the number of searches, lesser will be the minimum expected price. The

minimum expected price for successive searches with the marginal benefit derived from

successive searches is given in Table 5.2

Table 5.1 shows that the marginal benefit derived from each additional search is diminishing

whereas the marginal cost is rising. When the fourth search is undertaken, the marginal benefit

of search is equal to the marginal cost. Thereafter, it does not make sense to undertake

additional search because the marginal cost is higher than marginal benefit.

The searches undertaken by a person depends upon the level of price and the price range. Higher

the price and the price range, greater will be the number of searches. For example, the rent for a

1000 square feet apartment in Suburban Mumbai City varies from Rs. One Lakh at Bandra West

to Rs.30000/- in Borivili with the average rent being Rs.65000/-. Rent for similar apartments in

Thane City varies from Rs. 15000 to Rs.30000/- with the average rent being Rs.22, 500/-. A

rational person is more likely to spend more time in searching for an apartment because he or she

is more likely to find an apartment towards the lower end of the price range. However, the

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person will spend more time in searching for an apartment in Suburban Mumbai because rents

are higher and are spread over a broader range and the expected saving from further time spent

searching will be greater than in Thane City. One should search for information in case of

expensive things than cheap things. Too many rounds of search in finding the right price of a

bicycle would entail very little or no benefit but spending more time in searching the right price

of a car would definitely derive a greater benefit.

Table 5.1 – Optimal Amount of Information

Search Number Minimum Expected Price Marginal

Benefit

Marginal

Cost

1 10000 + 4000

1 + 1= 𝑅𝑠. 12000 - -

2 10000 +

4000

2 + 1= 𝑅𝑠. 11333.33

666.67 100

3 10000 + 4000

3 + 1= 𝑅𝑠. 11000 333.33 120

4 10000 + 4000

4 + 1= 𝑅𝑠. 10800 200.00 200

5 10000 + 4000

5 + 1= 𝑅𝑠. 10666.66 133.40 300

ASYMMETRIC INFORMATION.

Real life is imperfect and full of uncertainties. Uncertainties involve risks. There are political,

social, economic and natural uncertainties. Uncertainties are always unforeseen and there is no

way that uncertainties can be prevented from happening. These uncertainties are not factored in

the basic economic theories. All units in an economy must confront uncertainties. The

households, the firms and the government constitute the three basic units of the macro-economy.

Households worry about future income flows, wages and employment. They may worry about

the return on their investments in financial markets. The employment market and the capital

market trends particularly the stock market trends cannot be accurately predicted. The labor

skills demanded in future may be entirely different from the kind of skills imparted and acquired

by students in our colleges and universities. The stock market may be rising in a sustained

manner but suddenly may fall like a pack of cards and the wealth owned by a large number of

people may evaporate overnight.

Natural calamities like flood, earthquakes and Tsunami can devastate a whole lot of people

including firms and the government. The rivers Kosi in north Bihar and Brahmaputra in Assam

are known as the sorrows of the land in which they flow. The floods in Bihar in August 2008

had caused widespread destruction of life and property. Millions of people were displaced by the

floods. The Government of India had to announce immediate relief measures amounting to

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Rs.1010 crores. Recall the turmoil caused by heavy rains in Mumbai on 26th July 2005 which

brought the city down on its knees, causing widespread destruction of life and property. You

may also recall the devastating consequences of Tsunami felt by the countries of India, Sri

Lanka, Indonesia and Thailand on 26th December, 2004. According to official estimates more

than 10,000 people were killed by the Tsunami. About four million people were directly

affected by the Tsunami in India. Indonesia suffered a Tsunami attack once again in October,

2010. Political instability both existing and dormant, terrorist and separatist movements, local

mafia and its nexus with the power brokers, bribery, uncertain fiscal and monetary policies of the

government and other factors contribute to a climate of uncertainty.

You may also recall the protest launched by Miss. Mamata Banerjee, leader of Trinamool

Congress against the Tata Nano factory at Singur, West Bengal and the threat to relocate the

factory issued by Mr. Ratan Tata, the Chairman of the Tata Group of Companies in August,

2008. Greater the factors contributing to uncertainty, greater will be the risk involved in

undertaking any enterprise. The study of unforeseen factors is known as the economics of

uncertainties and risk.

Asymmetric information explains situations in which not all individuals involved in a potential

exchange are equally well informed. Generally, the seller of a product or a service has more

knowledge about the quality of the product or the service than the potential buyers. Asymmetric

information prevents mutually beneficial exchange in the markets for high quality goods because

buyers do not have adequate information to select high quality goods and hence they are not

willing to pay a fair price. Asymmetric information and other communication problems between

potential exchange partners can be generally solved through the use of signals that are costly or

difficult to fake. For instance, product warranties are such a signal. The seller of a low-quality

product would not offer a product warranty because it would prove costly to him. Buyers and

sellers may react to asymmetric information by attempting to judge the qualities of products and

people based on the groups to which they belong. For example, a young taxi driver knows that

he is a good driver but the insurance company would still charge him a high premium because

the taxi driver is a member of a group that is frequently involved in accidents.

The Problem of Asymmetric Information – Illustration 3.1.

Sandeep has a well maintained Maruti Baleno Car and now he decided to buy a trendy car. He

wants to sell his car. The current market price for 2013 Maruti Suzuki Alto car is Rs. Two lakh

sixty-five thousand but Sandeep wants to sell his car for Rs. Three lakhs because he knows that

his car is in good condition. Sanjay wants to buy an old Maruti Suzuki Alto Car and would be

willing to pay Rs. Three lakh fifty thousand for a car in good condition but only Rs. Two lakh

seventy-five thousand for a car in not so good condition. Sandeep can hire a mechanic to assess

the condition of the car. However, not all the faults can be detected by a mechanic. Will Sanjay

buy Sandeep’s car? Because Sandeep’s 2013 Maruti Alto looks no different from other similar

cars, Sanjay is not willing to pay Rs. Three lakhs. Sanjay can buy another 2013 Maruti Alto only

for Rs. Two lakh fifty thousand which according to him is as good as Sandeep’s car. In this

situation, Sanjay will buy someone else’s car and Sandeep’s car will remain unsold. The

outcome of this potential exchange is not efficient. If Sanjay had bought Sandeep’s Maruti Alto

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for Rs. Three lakhs his surplus would have been Rs. Fifty thousand and Sanjay would have got a

fair price for his car. But Sanjay goes ahead and buys a Maruti Alto for Rs. Three lakh twenty

five thousand. Sandeep’s car remains unsold and Sanjay gets only Rs.25 thousand as surplus.

The Lemons Model.

It is difficult to conclude that the car that Sanjay ends up buying will be in worse condition than

Sandeep’s car because anybody else may have a better car than Sandeep and yet may not find a

buyer to pay a fair price. However, the economic incentives created by asymmetric information

suggest that most used cars that are put up for sale will be of low quality. This is because people

who ill-treat their cars or had purchased a not so good car are more likely to sell them than

others. Buyers also know from their experience that cars for sale on the used car market are

more likely to be ‘lemons’ than cars that are not for sale. This realization on the part of buyers

causes them to bargain a used car at a lower reservation price. Further when the prices of used

cars fall in the market, the owners of cars that are in good condition will not offer their cars for

sale. This causes the average quality of the cars offered for sale on the used car market to

decline further. George Akerlof, a Nobel laureate economist from Berkeley, was the first to

explain the logic behind such a price fall. Economists use the term ‘lemons model’ to describe

Akerlof’s explanation of how asymmetric information affects the average quality of the used

goods offered for sale.

The lemons model has important practical implications for consumer choice. These

implications are exemplified in the following illustrations.

Should you buy your friend’s car? – Illustration 3.2.

You want to buy a used Hyundai Accent (GLE). Your friend buys a new car every three years

and he has a three-year-old Hyundai Accent (GLE) which he wants to sell. Your friend says that

his car is in good condition and he is willing to sell it to you for Rs.3.5 lakhs which is the

average market price for three-year-old Accents. Should you buy your friend’s car? Going by

the Lemons Model, it would make little sense to buy a used car because used cars offered for

sale in the market are of lower quality than those cars of the same vintage not offered for sale. If

your friend’s claim regarding the condition of the car was to be believed, then buying a car at an

average price will certainly be a good deal for you because the average price is always a price for

a lower quality car than what is claimed by the owner. Illustrations 3.3 and 3.4 will help you

understand the conditions under which asymmetric information about the quality of product

results in a market in which only poor quality products or lemons are offered for sale.

What price will an innocent buyer pay for a used car? - Illustration 3.3.

Let us consider a market with only two kinds of cars: lemons and good ones. The owner of a car

certainly knows the quality of his car but potential buyers can in no way distinguish between the

lemons and good ones. Ninety per cent of the new cars are good but ten per cent of them turn

out to be lemons. Used but good cars are worth Rs. Five lakhs but lemons are worth only Rs.

Three lakhs. Let us consider an innocent buyer who thinks that the used cars for sale have the

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same quality distribution as new cars. Assuming that this buyer is risk-neutral, what price will

he be willing to pay for a used car? It is a gamble to buy a car of unknown quality. However, a

risk-neutral buyer will be willing to play the gamble if it is a fair gamble. The buyer here is not

able to distinguish between lemons and good cars. Yet, given the distribution of good cars and

lemons, the buyer has a 90 per cent chance of buying a good car and a ten per cent chance of

buying a lemon. Given the prices that he is willing to pay for the two types of car, his expected

value of the car he buys will thus be 0.90(Rs.5 Lakhs) + 0.10(Rs.3 Lakhs) = Rs.4.8 lakhs. The

buyer is a risk-neutral person and hence his reservation price for a used car will be Rs.4.8 Lakhs.

Illustration 3.4 - Who will sell a used car for a price that an innocent buyer is willing to

pay?

If you are the owner of a used good car, at what price would you be willing to sell your car?

Would you sell it to an innocent buyer? What if your car turns out to be a lemon? You know

that your car is good and hence it is worth Rs. Five lakhs to you but an innocent buyer will be

willing to pay only Rs.4.8 lakhs. Hence, neither you nor anybody else who owns a good car will

be willing to sell it for that price. If you had a lemon, you will be all the more happy to sell it to

an innocent buyer because Rs.4.8 lakhs that the buyer is willing to pay is Rs.1.8 lakhs more than

the lemon’s worth to you. Hence only used cars for sale will be lemons. In due course of time,

buyers will revise their optimistic beliefs about the quality of the used cars for sale. Finally, all

used cars will sell for a price of Rs. Three lakhs and all will be lemons. However, in practice, it

does not mean that all cars offered for sale are lemons because the owner of a good car may sell

it at an average price under compelling circumstances. The lemons model explains the

frustration of such owners. When you buy a used car that is sold for reason that has nothing to

do with the condition of the car for an average price, you are actually beating the market i.e. you

are buying a good car for the price of a lemon.

The Problem of Credibility in Trading.

It is difficult for a seller to convince the buyer about the good quality of the car that he has

offered for sale. This difficulty is due to the conflicting interests of the buyers and the sellers.

Sellers of used cars have an economic incentive to overstate the quality of their products and

buyers have an incentive to understate the amount they are willing to pay for used cars and other

products. There is a tendency amongst people to interpret ambiguous information in such a

manner that it promotes their self-interest. However, both buyers and sellers can gain if they can

find some means to communicate their knowledge truthfully. This is described in the following

illustration.

Illustration 3.5 – Credible manner in which the good quality of the car can be signaled (The

Costly-to-fake Principle).

Sandeep knows that his car is in good condition and Sanjay would be willing to pay much more

than his reservation price for a good car. What kind of signal about the car’s quality would

Sanjay find credible? The potential conflict of interest between Sandeep and Sanjay shows that

mere statements about the quality of the car may not persuade Sanjay to buy the car. Let us

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suppose that Sandeep offers a warranty under which he agrees to repair any defects the car

develops over the next one year. Sandeep can afford to offer such a warranty because he knows

his car is unlikely to need expensive repairs. In contrast, the person who knows his car would

need extensive repairs would never extend such an offer. The warranty is a credible signal that

the car is in good condition. It enables Sanjay to buy the car with confidence and both Sandeep

and Sanjay would gain in such a deal.

Illustration 3.5 exemplifies the costly- to-fake principle. This principle suggests that if parties

whose interests potentially conflict is to communicate credibly with each other, the signals they

send must be costly to fake. Warranties cannot be faked because bad quality products would

impose heavy costs on the seller to offer warranties.

INFORMATION FAILURE AND MISSING MARKETS.

A significant market failure is the failure to produce some goods and services, despite being

needed or wanted. Markets can only form under certain conditions, and when these conditions

are absent markets may struggle to exist. The most extreme case of a missing market is the case

of public goods.

Public goods provide benefits to the consumers, but, for several reasons, are unlikely to exist in a

market economy. Examples of public goods include national defense, the police service, street

lighting etc. Markets for these goods are not likely to form or come into existence. Hence, they

are called missing markets and are considered a special case where demand exists, but supply

does not exist.

PUBLIC GOODS.

The market mechanism is likely to fail to supply public goods because entrepreneurs are unlikely

to enter the market, given the impossibility of charging consumers at the point of

consumption. Public goods have the following characteristics:

Non-excludable.

When a public good is supplied, it is impossible to exclude other individuals from deriving a

benefit. For example, once street lighting is made available in an area, all passers-by can benefit,

and no one can be denied access to it.

Indivisible or Non-rival in Consumption.

When a pure public good, such as street lighting, is consumed by one individual, the stock

available for others does not diminish, as it would in the case of a private good. A pedestrian

passing under a street light has no effect on the supply of lighting whatsoever. Indivisibility is

also known as the principle of non-rivalry. The stock of a public good does not fall with more

consumption. Consumers, therefore, do not need to compete to get access to them. Hence, public

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goods are non-rival in consumption. For instance, individuals do not need to queue to get access

to street lighting.

Non-rejectable.

Unlike a private good, consumers cannot reject a public good, and are forced to consume it. An

individual cannot reject being defended by the armed forces of a country, nor can they reject the

benefit of street lighting.

When combined, these three characteristics deter potential suppliers because it would be

impossible to charge users at the point of use.

The Problem of Charging the Consumers.

Suppliers cannot charge at the point of consumption or use because of the free-rider problem.

No one would pay because the first person to pay for supply creates a free supply for everyone

else. No one can be excluded from the market and prevented from consuming, and hence they

are encouraged to become free-riders.

Due to the problem of free riding, suppliers are not able to generate any revenue, or make a

profit, so a necessary condition for the formation of a market is absent, namely the absence of a

profit incentive. With no incentive, entry into the market is deterred, resulting in a missing

market.

SOLUTIONS TO MISSING MARKETS.

If we assume there is a limit to the formation and completion of markets, and a high probability

that some markets might not exist at all, policy makers need to consider how demand can be

satisfied. One of the roles of government is to allocate scarce resources to satisfy demand for

public goods. There are several ways governments can do this, including the following:

1. A government can take complete control over the initial planning, funding and operation

of public goods like defense, policing and street lighting. Government can impose general

taxes to pay for these services, rather than try to charge consumers directly.

2. With transport services, government can fund the building of the infrastructure, and

contract-out the running and maintenance of the service to private firms, as with bridges,

tunnels, motorways, and airports. Government is likely to fund the initial investment out

of taxation, and it may be possible to charge consumers, if the free-rider problem can be

solved. For example, tolls can be used to charge drivers wishing to use a motorway, and

airports can charge landing fees to private airlines.

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MARKET SIGNALLING AND THE PROBLEM OF MORAL HAZARD.

If a person is not insured for life or property, he would be more careful with his life and property

and avoid taking risks with his life and property. However, when he insures his life and

property, his behavior becomes riskier, thereby exposing him to premature death or loss of

property. The tendency of insured persons to be more prone to risk and thereby increasing

the probability of the insured event happening is known as moral hazard. A person who has

insured his house against fire and theft would be less careful about his property. Similarly, a

person who has insured his car against theft would not think twice before parking his vehicle in a

public place. He may also have no incentive in obtaining a car park in his residential premises.

Further a person whose car is stolen would not make all the necessary efforts to obtain his car

back for he is sure that the value of the car would be paid to him by the insurance company.

These are all examples of moral hazard and it is because of the problem of moral hazard that

insurance companies do not offer insurance premiums at fair odds. The insurance companies

would try to reduce the problem of moral hazard by offering conditional coverage. For instance,

the insurance company may cover a residential house or a firm’s premises only if fire detection

and firefighting system is installed. In case of health insurance, the insurance company insists on

medical check-up for identifying any pre-existing diseases and any such disease is not covered

by the policy. In this way, the insurance companies can charge small premiums and reduce

claims.

The insurance companies need to find out the optimal combination of premium and risk covered.

Let us assume that a person who insures his house against fire. The value of his house is W and

if fire occurs the value of his house will be reduced to W2 (W2 = W – D, here D = debris). The

individual insures his house against fire by paying a premium ∞1. The house is insured against

fire for amount equal to ∞2. If there is no fire, his wealth is W1 = W – ∞1 and if there is fire his

wealth is W2 = W - d + ∞2.

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Insurance companies expose themselves to lesser risks and hence offer less favorable odds to

their customers. By offering less favorable odds, insurance companies are also able to reduce the

problem of moral hazard. This is shown in Figure 3.8. Let us begin with point P which

represents the value of the house of the person. In the absence of insurance, the value of his

house will be reduced to OF in the event of fire. Let us also assume that the probability of ‘no

fire’ is three times the probability of the house going on fire i.e. 3 to 1. This is shown by the

slope of the person’s budget line B1 whose slope is 1/3 indicating 3 to 1 odds. Let us now

assume that the householder insures his house against fire. Assuming that a fire occurs with

probability of 1 to 3, he chooses point E where his budget line B1 and indifference curve I1 are

tangent. Point E is the risk-free point for the householder which is along the 45o line because by

paying ∞1 = NN1 insurance premium his wealth remains W1 = W - ∞1 or ON1 = OF1 whether

there is fire or no fire. Therefore, he will not take precautions against fire and hence a fire is

most likely to occur. You may note that along the 45o line, W2 =W or W – d + ∞2 = W1 - ∞1.

Hence the payment by the insurance company just covers the loss of house in case of a fire. The

insurance company will therefore not offer 3 to 1 odds. Being a risk-averse organization, it will

sell the insurance policy at much less than the full value of the house to safeguard itself against

loss due to moral hazard and laying down certain conditions in the policy. This situation is

shown in Fig.3.8 where the householder’s equilibrium point is R where his budget line is B2 and

the indifference curve I2 are tangent to each other. At point R, the householder is paying the

same premium NN1 but in case of fire, he will be paid the insured sum OF2 instead of OF1 of the

earlier insured amount.

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ADVERSE SELECTION AND INSURANCE MARKET.

Adverse selection takes place when customers know more than the insurance company about the

probability of an event happening. For instance, in the market for individual health insurance,

the person who seeks a health insurance cover knows more about his health issues than the

insurance company. To cover the risk of inadequate information, the insurance company will

charge a premium based on the national average. This will dissuade healthy persons from taking

up health insurance cover because they think that the premium is unreasonably high and more

unhealthy persons will buy insurance cover because they think that the premium is low. Thus,

high-risk individuals are more likely to buy insurance than low-risk individuals. This problem

is known as the problem of adverse selection. Adverse selection has the potential to bankrupt

an insurance company and hence insurance companies may hike the premium to a level such that

even unhealthy persons may not buy insurance cover. Insurance companies solve the problem of

adverse selection by charging different premiums for different age groups and occupation based

on the nature of risk in each group. Thus, low risk groups would be charged low premiums and

high risk groups would be charged high premiums. Persons in different age groups are charged

different rates of premium depending on the length of the period of insurance and the risk

involved.

THE PRINCIPAL AGENT PROBLEM.

The principal agent problem is a situation where the principal due to want of knowledge cannot

ensure his best interest is served by the agent. For example, in a class room setting, the students

are the principal and the teacher is the agent. Due to want of information, the students are not

able to know if the teacher is doing his best to serve their interests. In a corporate setting, the

principal is the owner and the agent constitutes the managers. The managers may pursue their

own goals rather than pursuing the goals of the owners. The principal agent problem is due to

the problem of asymmetric information. An agency relationship comes into existence when

there is an arrangement in which one person’s welfare depends upon what another person does.

The agent is the person who acts and the principal is the party whom the action affects. A

principal – agent problem arises when agents pursue their own goals and not the goals of the

principal.

In a modern economy, principals must employ agents to carry out their tasks. Whether it is firms

or companies and their employees, sick persons and medical doctors, students and teachers,

principals and agents must come together to satisfy their goals. However, due to asymmetric

information, it is difficult for the principle to judge in whose interest the agent is operating. The

medical doctor may prescribe unnecessary medical examinations or tests, the teacher may not

cover the portion entirely and source his information from the prescribed reference books and

employees in a firm may shirk from performing expected tasks.

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Measures to Reduce the Principal Agent Problem.

1. Performance Monitoring. The principals must monitor the performance of their agents.

In corporate settings, the performance of the employee is monitored and evaluated by the

human resource department. Annual increments, promotions and demotions are awarded

based on performance evaluation of the employees.

2. Incentives for Agents. The principals in any setting must create a system of incentives

and disincentives. While incentives will motivate the agents to perform according to the

expectations of the principles, disincentives will dissuade the agents from shirking or

working below their natural potential.

EFFICIENCY WAGE/EFFORT MODEL.

According to efficiency wage hypothesis, in some markets, wages are determined by factors

other than the market forces of supply and demand. Managers pay their employees more than

the market-clearing wage to increase their productivity or efficiency which in turn compensates

for the higher wages. Since workers are paid more than the market clearing or equilibrium wage,

there will be unemployment. Efficiency wages are therefore a market failure explanation of

unemployment which contrasts with theories which emphasize government intervention such

as minimum wages. The idea of efficiency wages was expressed as early as 1920 by Alfred

Marshall. Efficiency wage theory is especially important in new Keynesian economics. Theories

which explain as to why managers pay efficiency wages are:

1. Avoiding Shirking. If it is difficult to measure the quantity or quality of a worker's

effort and systems of piece rates or commissions are impossible. There may be an

incentive for the employee to ‘shirk’ i.e. to do less work than agreed. The manager thus

may pay an efficiency wage to create or increase the opportunity cost, which gives the

threat of firing. This threat can be used to prevent shirking (or moral hazard).

2. Minimizing Turnover. The worker's motivation to leave the job and look for a job

elsewhere will be reduced due to efficiency wages. Efficiency wages makes economic

sense because it is often expensive to train replacement workers.

3. Adverse Selection. Firms with higher wages will attract more able job-seekers. An

efficiency wage means that the employer can choose the best workers among applicants,

thus eliminating the problem of adverse selection.

4. Sociological Theories. Efficiency wages may result from traditions. According to

Akerlof’s theory, higher wages leads to high morale and high productivity.

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5. Nutritional Theories. In developing countries, efficiency wages may allow workers to

eat well enough to avoid illness and to be able to work harder and more productively.

The model of efficiency wages based on shirking, developed by Carl Shapiro and Joseph E.

Stiglitz is prominent amongst the many models.

Shirking.

In the Shapiro-Stiglitz model workers are paid at a level where they do not shirk. This prevents

wages from dropping to equilibrium or market clearing levels. Full employment cannot be

achieved because workers would shirk if they were not threatened with the possibility of

unemployment. The curve for the no-shirking condition (NSC) goes to infinity at full

employment as shown in the following figure.

According to the shirking model, complete contracts do not exist in the real world. This implies

that both parties to the contract have some discretion, but frequently, due to monitoring

problems, it is the employee’s side of the bargain which is subject to the most discretion.

Methods such as piece rates are impracticable because monitoring is too costly or inaccurate.

Such methods may be based on measures too imperfectly verifiable by workers, creating a moral

hazard problem on the employer’s side. Thus, the payment of a wage in excess of market-

clearing may provide employees with cost-effective incentives to work rather than shirk.

In the Shapiro and Stiglitz model, workers either work or shirk and if they shirk they have a

certain probability of being caught with the penalty of being fired. Thus, at the point of

equilibrium there is unemployment. Unemployment is generated because firms try to push their

wages above the market average to create an opportunity cost to shirking. This creates a low, or

no income alternative which makes job loss costly, and serves as an instrument of discipline for

the workers. Unemployed workers cannot bid for jobs by offering to work at lower wages, since

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if hired, it would be in the worker’s interest to shirk on the job, and he or she has no credible way

of promising not to shirk. Shapiro and Stiglitz point out that their assumption that workers are

identical (e.g. there is no stigma to having been fired) is a strong one – in practice reputation can

work as an additional disciplining device.

The shirking model does not predict that the bulk of the unemployed at any one time are those

who are fired for shirking, because if the threat associated with being fired is effective, little or

no shirking and sacking will occur. Instead the unemployed will consist of a rotating pool of

individuals who have quit for personal reasons, are new entrants to the labor market, or who have

been laid off for other reasons. Pareto optimality, with costly monitoring, will result in some

unemployment, since unemployment plays a socially valuable role in creating work incentives.

But the equilibrium unemployment rate will not be Pareto optimal, since firms do not consider

the social cost of the unemployment they help to create.

However, the efficiency wage hypothesis is criticized because more sophisticated employment

contracts can under certain conditions reduce or eliminate involuntary unemployment. Lazear

demonstrates the use of seniority wages to solve the incentive problem, where initially workers

are paid less than their marginal productivity, and as they work effectively over time within the

firm, earnings increase until they exceed marginal productivity. The upward bias in the age-

earnings profile provides the incentive to avoid shirking, and the present value of wages can fall

to the market-clearing level, eliminating involuntary unemployment. Lazear and Moore find that

the slope of earnings profiles is significantly affected by incentives.

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However, a significant criticism is that moral hazard would be shifted to employers, since they

are responsible for monitoring the worker’s effort. Incentives would exist for firms to declare

shirking when it has not taken place. In the Lazear model, firms have incentives to fire older

workers (paid above marginal product) and hire new cheaper workers, creating a credibility

problem. The seriousness of this employer moral hazard depends on the extent to which effort

can be monitored by outside auditors, so that firms cannot cheat, although reputation effects may

have the same impact.

QUESTIONS.

1. What is Economics of Search? Explain the cost-benefit principle of determining

optimal information.

2. Write a note on the theory of missing markets.

3. Illustrate the concept of asymmetric information with the market for lemons.

4. Explain the problem of adverse selection regarding insurance markets.

5. Write a note on the problem of moral hazard.

6. Explain the principal-agent problem.

7. Write a note on the Efficiency Wage theory.

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UNIVERSITY QUESTION PAPERS

OCTOBER, 2013.

1. Answer in brief any two of the following: 15

a) Show Cournot’s duopoly equilibrium with the help of a diagram.

b) Explain the dominant firm price leadership model.

c) Write a note on Public Goods Games.


a) Factor price determination under perfect competition in factor market and

imperfect competition in the product market.

b) Loanable Funds Theory of interest.

c) Describe Knight’s views on profit.


a) General equilibrium of exchange.

b) Pareto’s marginal conditions for efficiency in production.

c) Kaldor-Hicks compensation criterion of social welfare.


a) The concept of search costs.

b) The problem of adverse selection in the context of market for credit.

c) Efficiency Wage Theory.

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APRIL, 2015


a) Explain price output determination under centralized cartel.

b) Discuss the dominant firm price leadership model.

c) Explain the prisoner’s dilemma.


a) Explain the factor price determination under imperfect competition in

commodity as well as factor market.

b) Discuss the modern theory of rent.

c) “Profit is a reward for risk and uncertainty bearing”. Explain.


a) Discuss simultaneous general equilibrium in consumption and production.

b) Explain Pareto optimality marginal conditions of efficiency in exchange.

c) Show the relationship between marginal conditions of Pareto optimality and

perfect competition.


a) What is search cost? Explain the process of search cost.

b) What is adverse selection? Explain how market signaling can be used to

overcome this problem.

c) Discuss the efficiency wage theory.

5. Write short notes on any three of the following: 15

a) Cournot’s model of oligopoly.

b) Wage determination under bilateral monopoly.

c) Arrow’s Impossibility Theorem.

d) Principal Agent problem.

e) Public Goods Game theory.

semester v third year bachelor of artstktopenightcollege.in/wp-content/uploads/2019/02/...2. explain...

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