Micro economics II

Course code: Econ 1022

A TEACHING MATERIAL FOR DISTANCE

STUDENTS

Prepared By:

Demilie Basha

Department of Economics

College of Business and Economics

Adigrat University

August, 2015
Adigrat

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Course description

In modern economics the scope of economics can be seen in two broad

categories: 1, Micro economics and 2 Macro economics. Accordingly, this
module mainly focuses on micro economics II in which it deals with issues like
market structures (pure monopoly, monopolistic completion and oligopoly) in
brief, general equilibrium, information asymmetry and moral hazard, game
theory, welfare economics, factor pricing, externalities and public goods.

Course objectives

After completion of this course student:

 Cleary understand, the nature, characteristics, optimization condition of

firms in the case different market structures
 Understand the relationship between information asymmetry and moral
hazard
 Should understand different approaches of welfare economics
 Have to analyze both demand and supply side cases of factor pricing
strategies
 Should grasp issues related with both positive and negative externalities
as well as they are expected to have a good understanding about public
goods

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 Contents of the Module in Brief

Chapter 1, Price and output determination under monopoly Introduction

 Source and Types of Monopoly

 Demand, Marginal Revenue and cost curves under Monopoly

 Short Run Equilibrium of Monopoly

 Long Run Equilibrium of Monopoly
 Types of Monopoly
 Social cost of Monopoly Power
Chapter 2, Monopolistic competition

 Assumptions of Monopolistic Competition

 Product Differentiation and demand curve
 The Concept of Industry and Product "Group”
 Equilibrium Conditions in Monopolistically Competitive Market
 Equilibrium with price competition
 Equilibrium with new firms entering the industry
 Price Competition and free entry/exit
 Excess Capacity and Welfare Loss
Chapter 3, Oligopoly theory

 Characteristics of Oligopoly Market

 Non- Collusive Oligopoly

 The Cournot's Duopoly Model (Output simultaneous game)

 The 'Kinked - Demand ' model

 The Bertrand Model (Price Game)

 The Stackleberg’s Duopoly Model (Output sequential game)

 Collusive Oligopoly
 Cartels
 Price Leadership

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Chapter 4: pricing of factors of production and income distribution

 factor pricing in a perfectly competitive market

 The Demand for Factors of Production
 The Demand for one (Single) variable productive factor(Lr)
 The Demand for a factor (Lr) in case of Several Variable Inputs
 Market Demand for a Factor
 Factor Supply and Factor Price
 The Supply of Labour in short run

 The Market Supply of Labour

 Factor Pricing
Chapter 5: welfare economics, externalities and public goods

 Introduction
 Welfare Economics
 Adam Smith's welfare criterion
 Bentham's criterion
 Pareto's optimality criterion
 Hicks- Kaldor compensation criterion
 Externalities
 Positive Vs Negative Externalities
 Externalities and inefficiency
 public goods
 Asymmetric Information
 Moral Hazard.
 Case Study: Information and Insurance Markets

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 Micro Economics-II

Chapter 1, Price and output determination under

monopoly

Introduction

In a perfectly competitive market each firm's production is such a small

proportion of industry output that an individual firm has to influence on the
market price. As we have seen the competitive firm is a price taker. In this unit
we will see the opposite extreme to a purely competitive firm of pure monopoly
a single seller in an industry. The sources of monopoly, price and output
determination in the short and long run periods, price discrimination by a
monopoly and comparison of the price and output with perfect competition are
some of the points to be discussed in this unit.

Definition

A monopoly is a market structure where there is only one firm that

produces and sells a particular commodity or service and there are
no close substitutes available. Since the monopoly is the seller in
the market, the industry is a single firm industry and it has no
direct competitors. However it does not necessarily mean that it is a
guarantee to get an abnormal profit. Monopoly power only
guarantees that the monopolist can make the best of whatever
demand and cost conditions exist without fear of the entrant of new
competing firms.

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 Source and Types of Monopoly

The rise and existence of monopoly is related to the factors, which prevents the
entry of new firms. The different barriers to entry that are the causes of
monopoly are described below.

i. Legal Restrictions: A monopoly, which are created for the interest of the
public. For example the public utility sectors such as water supply, postal,
telegraph and telephone services, radio and TV services, generation and
distribution of electricity such monopolies are known as public monopolies
ii. Control over key raw materials: some firms may get monopoly power if
they posses certain scarce & key raw materials that are essential for the
production of certain goods or if the supply of a commodity is localized in a
single place. This type monopoly is known as raw material monopoly. For
example India possesses manganese mines, the extraction of diamonds is
controlled by South Africa
iii. Efficiency: A primary and technical reason for growth of monopolies is
economies of scale. The most efficient plant (probably large size firm), which
can produce at minimum cost, could eliminate the competitors by cutting
down its price for a short period and can acquire monopoly power.
Monopolies created through efficiency are known as natural monopolies.
iv. Patent rights: - The government has granted firms a patent right, for
producing a commodity of specified quantity and character so that firms will
have exclusive rights to produce the specified commodity. Such monopolies
are called patent monopolies.

Common characteristics of monopoly

Monopoly markets share the following common characteristics.

1-Single seller and many buyers

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There is a single seller who sells the product to many buyers.

2-Absence of close substitutes

A product produced by a monopolist has no close substitute so that consumers

have no alternative choices to substitute one product for another.

3-Price maker

Dear learner, in perfectly competitive market, we have said that, both sellers
and buyers are price takers. However, the monopolist is a price maker. Facing
a down ward sloped demand curve for its product, the monopolist can change
its product price by changing the quantity of the Product supplied. For
example, the monopolist can increase the price of its product by decreasing
the quantity of supply.

4-Barrier to entry

In monopoly, new competitors cannot freely enter in to the market due to some
barriers which can be economical, technical, legal or other type of barriers.

Demand, Marginal Revenue and cost curves under Monopoly

In the analysis of consumer behavior you have seen that the demand curve is
generally down ward sloping showing inverse relationship between price and
quantity demanded.

In perfectly competitive market the industry faces down ward sloping demand
curve; firms face a horizontal demand curve because of the existence of large
number of producers and homogeneity of the product, the firm cannot exert
power on the total industry supply.

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The monopoly industry on the other hand is a single firm industry. A monopoly
firm therefore faces a down ward sloping demand curve. It implies given the
demand curve, a monopoly firm has the option to choose between prices to be
charged or output to be sold. But he cannot simultaneously control both the
price and the level of output. He can either decide the level of out put, and
leave the price of the out put to be determined by consumer demand or he can
fix the price and leave the level of out put to be decided by the demand for the
product at that price. One of the fundamental differences between a monopolist
and a competitor is there fore the demand (AR) and marginal revenue curves
they face. In the case of perfectly competitive market MR = AR=P=D. But in the
case of down ward sloping demand curve of monopoly marginal revenue curve
falls twice as much as the fall of average revenue curves i.e. the slope of MR is
twice as steep as the average revenue curve. The following figure illustrates this
relationship

D=AR=P

MR
Quantity
0
T M
AR and RM curves for Monopoly

DM is the demand curve and DT is the marginal revenue curve, which bisects
the quantity demanded OM. Thus the distance OT = TM

This can be shown mathematically as follows assuming linear demand function

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 1. The demand function
P = a - bx where a = constant, x=quantity demanded

2. The total revenue is

R = Px

= (a - bx)x = ( substituting P = a -bx)

= ax -bx2

3. The Average revenue

R Px
AR =   P  a  bx
x x

Thus the demand curve is also the AR curve of the monopolist with slope
= -b

4. The marginal revenue (the first derivative of R)

dR d (ax  bx 2 )

dx dx

=a-2bx

That is the MR is a straight line with the same intercept (a) as

the demand curve, but twice as steep ( i.e slope = -2b)

Short Run Equilibrium of Monopoly

In this section, we examine the determination of equilibrium price and output

by a monopolist in the short run. We will also show that a monopolist, like a
perfectly competitive firm, can incur losses in the short run. Finally, we
demonstrate that, unlike the case of the perfectly competitive firm, the
monopolist’s short run supply curve cannot be derived from its short run
marginal cost curve (the supply curve of the monopolist is indeterminate).

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Under monopoly, the firm is a price maker and has a power to alter the level of
output. Thus, profit maximization under monopoly involves determination of
the price and output combination that yields the firm the maximum possible
profit. Price and output combination that maximizes the monopolist profit can
be determined in the similar fashion as that of the perfectly competitive firm.

The profit maximizing level of output is that level of output at which marginal
cost curve cuts the marginal revenue curve from below. The equilibrium (profit
maximum) price is the price corresponding to the equilibrium price from the
demand curve.

Consider the following figure:

P1

P2 SMC

d
P3

b
E

c
DD or AR
Q1 Q2 Q3
MR

Fig. 6.4 Short- run equilibrium of the monopolist: marginal approach.

Equilibrium output is Q2, where MC and MR curves intersect each other and MC
curve is up ward sloping. Equilibrium price is the price corresponding to the
equilibrium quantity, Q2 (i.e. p2).

Note that, a monopolist charges a price which exceeds the MC of production,

unlike the case of the perfectly competitive firm.

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The profit maximizing condition of MR = MC and MC is increasing can be
shown as follows.

∏ = TR – TC
d
0
∏ is maximized dQ when

D dTR dTC
  0
dQ dQ dQ
That is,

 MR – MC = 0

 MR = MC ………………………….. first order condition

The second order condition of profit maximization is

d 2
0
dQ 2

d 2 d 2TR d 2TC
  0
dQ 2 dQ 2 dQ 2  dTR 
That d   is,
2
d TR  dQ  dMR
 
dQ 2 dQ dQ
dMR dMC
 0
dQ dQ
(Because
and the same for MC)

Slope of MR- slope of MC<0

Slope of MC > slope of MR ------- the second order condition

Numerical example

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Suppose the monopolist faces a market demand function given by P=40-Q. The
firm has a fixed cost of $ 50 and its variable cost is given as TVC=Q2
determine:

a) the profit maximizing unit of output and price

b) the maximum profit
Solution

Given: p=40-Q

TFC=50

TVC= Q2

a) equilibrium condition is MR=MC, and slope of MC>slope of MR.

TR=P.Q = (40-Q) Q =40Q- Q2

TC=TFC+TVC =50 + Q2

Now,
dTR d (400  Q 2 )
MR    40  2Q
dQ dQ

dTC d (50  Q 2 )
MC    2Q
dQ dQ

MR=MC 40-2Q=2Q

40=4Q

Q=10
dTR
MR   2
Second order condition: slope dQ of

dMC
MC  2
dQ

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 Slope of
dMC dMR

Thus, the profit maximizing level dQ dQ of output is10 and the
profit maximizing price is obtained by substituting the profit maximizing
quantity (10) in the demand function.

Thus, P = 40 – Q

P = 40 – 10 = 30

b) The maximum profit is the level of profit obtained from selling 10 units at $
30 each.

∏ = TR – TC

But TR = P.Q

= $ 30 * 10 = $ 300

TC = 50 + Q2 = 50 + 102 = $ 150

The maximum ∏ is thus $ 300 - $ 150 = $ 150.

Long – run Equilibrium under Monopoly

The monopolist’s long run condition is different from the perfectly competitive
firms’ long run situation in respect of the entry of new firms into an industry.
In perfectly competitive market there is free entry in the long run. Nevertheless,
entrance is barred by several factors in monopoly. More over, we have seen that
a perfectly competitive firm can earn only normal profit in the long run. The
monopolist firm can, however, get a positive profit even in the long run because
there are entry barriers that discourage new firms to enter the industry,
attracted by the positive profit. Let us now examine the long run equilibrium
situation for single plant monopolist. If the monopolist incur loss in the short
run (SAC>P) and if there is no plant size that will result in super normal profit
in the long run given the market size, the monopolist must stop operation (shut

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down). If the monopolist makes (P> SAC) in the short run in a given plant, the
monopolist not only continue its operation but also looks for different plant size
to expand, so that could maximize profit in the long run. But at what output
level the monopolist maximizes its profit? A monopolist maximizes its long run
profit when it produces and sells that output level where LMC = MR , slope of
LMC being greater than the slope of MR at the point of intersection, and the
optimal plant size is the one whose SAC curve is tangent to the LAC at the
point corresponding to long run equilibrium output.

Let’s illustrate the equilibrium situation graphically.

SMC1

P1

C SAC1 LAC

SMC2 LMC

P SAC2 DD
MR

Q
Q1 QE

Fig 6.6 Suppose initially the monopolist builds the plant size having the costs
SAC1 and SMC1 the equivalence of SMC1 and MR leads into producing and
marketing output levels Q1 and P1, making a unit profit of P1 – C, since the
monopolist is making a positive profit, it decide to continue its operation and
looks for a more profitable plant size in the long run. This long run plant is

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attained when LMC = MR, and the corresponding output level and price are Qe
and Pe

respectively.

Finally, it should be noted that there is no certainty in the long run that the
monopolist will reach the optimal plant size (minimum LAC), as in perfectly
competitive case. The monopolist may reach optimal plant size or even may
exceed the optimal size if the market demand allows him (or if there is enough
demand which absorb that level of output).

Types of monopoly

1. The multi- plant monopolist

We have seen that a monopolist maximizes its profit by producing that level of
output where MR equals MC. For many firms, however, production takes place
in two or more different plants whose operating cots can differ. To minimize
transport cost, to approach the consumers or for different reasons a
monopolist may establish more than one plant in different areas. The operating
costs of these plants can also vary due to many reasons such as variation in
prices of raw materials, wage of labors etc. Now let's examine how a monopolist
facing such cases maximizes its profit by taking the following a two- plant
monopoly firm as an example. Data regarding cost and revenue is given in a
table below.

Output and Price Marginal Marginal cost Marginal cost Multi plant
sales revenue
Plant -1 Plant-2 Marginal cost

1 5.0 - 1.92 2.04 1.92

2 4.5 4 2.00 2.14 2.00

3 4.1 3.30 2.08 2.24 2.04

4 3.8 2.9 2.16 2.34 2.08

5 3.55 2.55 2.24 2.44 2.14

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6 3.35 2.35 2.32 2.54 2.16

7 3.2 2.30 2.40 2.64 2.24

8 3.08 2.24 2.48 2.74 2.24

9 2.98 2.18 2.56 2.84 2.32

10 2.98 2.08 2.64 2.94 2.34

Given this information, how can the monopolist decide the total production and
how much of that output each plant should produce?

The logic used in choosing output levels is very similar to that of the single-
plant firm. We can find the answer intuitively in two steps.

Step 1 - Whatever the total output, it should be divided between the two plants
so that marginal cost is the same in each plant. Otherwise, the firm could
reduce its cost by reallocating production. For example, if marginal cost at
Plant-1 were higher than at Plant-2, the firm could produce the same output at
a lower total cost by producing less output at plant -1 and more output at
plant-2. Thus, for equilibrium to occur marginal cost at firm-1 (MC1) must
equal marginal cost at firm- 2 (MC2) i.e. MC1 = MC2

Step-2 We know that the total output must be such that marginal revenue
equals the multi plant marginal cost. Now it is essential to know first how the
multi -plant marginal cost is derived from each plant marginal costs. If the firm
wants to produce the first unit, it should produce it in plant 1 because, the MC
is lower in plant 1 than in plant 2 (i.e. 1.92 < 2.04). Hence, MC of producing
the first unit for the multi –plant monopolist is 1.92. If output is to be two
units or if the firm wants to add one more units, the second unit should also be
produced in plant 1 because the MC of the second unit in plant 1 is less than
MC of producing one unit in plant 2 (i.e. 2.00 < 2.04). Hence, multi-plant
marginal cost for the second unit is $2. If three units are to be produced, plant
2 will enter into production since the MC of producing one unit in plant 2
(2.04) is less than marginal cost of producing the third unit in plant 1, & 2.08.

Hence, multi-plant MC for the third unit is 2.04, the derivation of multi-plant
marginal cost continues in the same manner.

Once, multi-plant marginal cost is derived, the only thing left to obtain
equilibrium total output is equating the multi plant MC with the marginal

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revenue. So in the above table, equilibrium output is 8 units where MC of
multi-plant = Marginal revenue (i.e. 2.24 = 2.24).

Now the remaining issue will be how to allocate the total production between
plants 1 and 2. The multi plant monopolist allocates production in a way that
each plants MC equals common value of multi plant MC and marginal revenue.
The common value of multi plant MC and marginal revenue is 2.24. Thus it
follows that the allocation of production is in a way that MC of plant-1 = 2.24
and MC of plant-2 = 2.24

i.e. Plant 1 produces 5 Units (because at 5 units MC1 = 2.24)

Plant 2 produces 3 units (because at 3 units MC2 = 2.24) In short, the

condition of equilibrium in multi- plant monopolist is: MR = MC of multi plant
monopolist and to allocate the total out put among each plant, the condition
must satisfy:

MC1 = MR = MC of multi plant monopolist

MC2 = MR = MC of multi plant monopolist

MR = MC1 =MC2

2. Price Discrimination
Price discrimination refers to the charging of different prices for the same good.
But not all price differences are price discrimination. If the costs of offering a
certain uniform commodity (service) to different group of customers are
different (say due to difference in transport costs), price of the commodity may
differ for each group owing to this cost difference. But this can not be
considered as price discrimination. A firm is said to be price discriminating if it
is charging different prices for the same commodity with out any justification of
cost differences.

By practicing price discrimination, the monopolist can increase its total

revenue and profits.

Necessary conditions for price discrimination

For a firm to effectively practice price discrimination the following necessary

conditions should be fulfilled.

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1-There should be effective separation of markets for different classes of
consumers, so that buyers of low price market can not resale the
commodity in high price market.

A market is said to be effectively separated if one of the following points is met:

- Geographical variation with high transport cost so that the inter market price
margin is unable to cover the transport expense.

E.g. Domestic Vs international markets.

- Exclusive use of the commodity. For some services resale is inherently

difficult. For example you can not resale Doctor’s services, Entertainment
shows.

- Lack of distribution channels

2. The second necessary condition to successfully practice price

discrimination is that the price elasticity of demand should be different
in each sub market.

For example, a movie theatre knows that college students and old people differ
in their willingness to pay for a ticket and can exercise discrimination by
charging the college students a higher price. This condition can be justified by
using the markup formula. Suppose the firm has a marginal cost of MC and
the price elasticity’s of demand for its product into different markets are ed1
and ed2

Then the price in each market is

MC MC
P1  , and .P 2 
1 1
1 1
ed1 ed 2

If ed1= ed2, P1 will be automatically equal to P2.

Hence, ed1 = ed2 for the prices to differ.

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3- Lastly, the market should be imperfectly competitive. In other words,
the seller of the product should have some monopoly power (it should not be
price taker) to practice price discrimination.

Degrees (types) of price discrimination

The degree of price discrimination refers to the extent to which a seller can
divide the market and can take advantage of it in extracting the consumer
Surplus. In economics literature, there are three degrees of price
discrimination. These are discussed one by one here under.

1-First degree price discrimination (Perfect price discrimination)

This is a price discrimination in which the monopolist attempts to entirely take

away the consumers surplus. Ideally, a firm would like to charge each
customer the maximum price that the customer is writing to pay for each unit
bought. We call this maximum price the consumer’s reservation price and
obviously, the consumers’ reservation prices are different due to the differences
in their economic status or the value they attach to a commodity. The practice
of charging each customer his/her reservation price is called first degree price
discrimination. Note that the consumer’s willingness to pay reservation price
for a given commodity varies with the quantities of the commodity the
consumers own. The law of diminishing marginal utility implies that a
consumer’s willingness to pay for successive units of a commodity declines
because the marginal utilities of these successive units decline. Hence, in the
first degree price discrimination prices differ across customers, and a given
customer may pay more for the initial units than for others (successive units).

First degree price discrimination is the limiting case of price discrimination, the
monopolist, in this case, individually negotiate with each buyer and sell each
unit of the out put at the corresponding price given on the demand curve of the
consumer, then receiving the entire of consumer’s surplus.

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For example, a doctor who knows his patients’ paying capacity charges high
price for the richest patients’ and low price for the poor patients for identical
services.

This is practiced to increase revenue. If the doctor fixes the price at

the richest patients’ level, no poor will afford to pay and the doctor
will not get revenue from the poor. On the other hand, the doctor
would not fix the price at the poorest patients’ level for all patients
because he knows that the rich can pay more and he will exploit the
rich. Lawyers also practice the same discrimination for identical legal
service.

Perfect price discrimination is efficient as it maximizes the total welfare, where

welfare is defined as the sum of consumer surplus and producer surplus. That
is, there is no welfare loss associated with first degree price discrimination
equilibrium. The problem with perfect price discrimination is that it hurts
consumers because the monopolist will take the entire of the consumer
surplus. The other problem with perfect discrimination is that it involves high
transaction costs; it is too difficult and costly to gather information about each
customer’s price sensitively.

2-Second degree price discrimination (block pricing)

Many firms are unable to determine which customers have the highest
reservation prices. Such firms may know, how ever, that most customers are
willing to pay more for the first unit than for successive units. This is due to
the fact the typical customer’s demand curve is down ward sloping. Such a
firm can price discriminate by letting the price each customer pays vary with
the number of units the customer buys. The act of charging different prices for
different quantities of purchases is called second degree price discrimination or
some times called quantity discrimination. In second degree price

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discrimination the price various only with quantity: all customers pay the same
price for a given quantity.

In second degree price discrimination, the monopolist attempts to take the

major part of the consumer surplus instead of the entire of it.

Block pricing can feasibly be implemented where:

-the number of consumers is large and price rationing can be effective e.g.
electricity and telephone services.

-the demand curves of all customers are identical and

-a single rate is applicable for a large number of buyers.

3-Third degree price discrimination (multi-market price discrimination)

Typically, a firm does not know the reservation price for each of its customers.
But, the firm may know which groups of customers are likely to have higher
reservation prices than others. In such a situation the firm may divide potential
customers in to two or more groups and set a different price for each group.
Such an action of charging different prices in different markets is called third
degree price discrimination. All units of the good sold to customer with in a
group (in one market) are sold at a single price, but prices will differ among the
different groups or markets.

For simplicity, let us assume that there are only two markets. To maximize
profits, the monopolist must produce the level of out put (defined by MC=MR)
and sell that out put in the two markets in such away that the marginal
revenue of the last unit sold in each market is the same. This will require the
monopolist to sell the commodity at higher p rice in the market with the less
elastic demand.

For example, suppose that a monopolist has 100 units of a commodity to be

sold in one or both of two sub markets. How should the monopolist allocate the

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100 units between the two markets to maximize its profit? Suppose, initially,
that the monopolist simply sold 50 units in each market and also assume that
the marginal revenue of the last unit sold in market 1 is 5 and the marginal
revenue of the last unit sold in market 2 is 3.

In this case, the monopolist can increase its total revenue by decreasing the
number of units sold in market 2 and increasing the number of units sold in
market 1. Hence, if one less unit is sold in market 2, total revenue falls by $3.
But by selling this unit in market 1 total revenue increases by $5.So, by
reallocating it sales from market 2 to market 1 the monopolist can increase its
total revenue by $2 ($5-3$). Obviously, reallocation of sales will increase the
firm’s total revenue until the marginal revenue of the last unit sold in each
market gets equal.

Thus we can conclude that to maximize the total revenue received from the sale
of a given quantity a commodity, the monopolist should allocate the total
quantity in each sub market in such away that the marginal revenue of the last
unit sold in each sub market is the same. Symbolically, the equilibrium
condition for a third degree price discriminating monopolist is: MC=MR1=MR2.

Social costs of monopoly: the dead weight loss

In a competitive market, price equals marginal cost of production. Monopoly

power, on the other hand, implies that price exceeds marginal cost. Because
monopoly power results in higher prices and lower quantities produced, we
would expect it to make consumers worse off and the firm better off. But
suppose we value the welfare of consumers the same as that of producers. In
aggregate, does monopoly power make consumers and producers better off or
worse off?

To answer this question, suppose an industry operating under perfectly

competitive situation is suddenly monopolized. We can answer the questions
by comparing the consumer and producer surplus that results when a

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competitive industry produces a good with the surplus that results when a
monopolist supplies the entire market. Referring to the following figure,
suppose DD represents the market demand curve, MR represents the
corresponding marginal revenue.

Dead
weight
loss
41 = pm D
MC

A B Ec
Em 25 = pc
C
DD= Price = MR (for perfect competitor)
G Em

0 Qm Qc Q

6 10
Fig.6.8

Here, we use consumers’ and producers’ surplus as a measure of welfare of

each. Consumer surplus is the area between the demand curve and
equilibrium price and producer surplus is the area between the equilibrium
price and marginal cost curve.

- A perfect competitor’s equilibrium occurs when MC equal price or

marginal revenue at Ec and the equilibrium price and quantity are PC
&QC respectively. Here the consumer’s surplus is the area above the
dropped line Pc Ec and below the demand curve i.e. area of  Pc F Ec.

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 On the other hand the producer surplus is the area below the dropped
line PcEc and above the MC curve.
- A monopolist equilibrium occurs when MC = MR i.e. at Em and the
equilibrium price and quantity become Pm and Qm respectively. Hence,
in monopoly lower quantity is sold at higher price. The new consumers’
welfare is the area above the dropped line PmD and below the demand
curve (i.e. area of  PmFD) where as the producers surplus becomes the
area below the dropped line PmD and above MC curve to the left of Qm
(i.e. the area GPm DEm)
- Thus monopoly power reduces the consumers’ surplus by the amount
which equals area A+B. But increases the producers’ surplus by the area
A-C. The net welfare effect (loss) is obtained by deducting the welfare loss
of consumers from the welfare gain of producers i.e.,
Net welfare = Welfare gain by producers – Welfare loss by consumers

= A-C – (A+B)

= A-C – A-B

= -C –B or – (C +B)
Thus monopoly results in a welfare loss which is given by the area ( C+B)

This area is called dead weight loss. It is gained neither by producers nor by
consumers.

The other disadvantage (Social cost) of monopoly is that is discourages

innovations. Monopolist may feel secure and have no incentive to innovate new
product (technology) since there are no competitors.

24
Chapter 2, MONOPOLISTIC COMPETITION

In many industries, the products that firms produce are differentiated.

For one reason or another, consumers view each firm's products as

different from those of other firms. Product differentiation is the

major characteristic of monopolistically competitive market structure.

A monopolistically competitive market combines the characteristics of

competitive and monopoly markets.

Assumptions of Monopolistic Competition:

The assumptions of the monopolistic competition are the same as those of perfect

competition, with an exception of homogeneity of products. That is, monopolistic

competition is a market structure in which a large number of sellers sell

differentiated products, which are close, but not perfect, substitutes for one

another.

One of the assumptions of a perfectly competitive market structure is

firms in the industry produce homogenous products while firms in a

monopolistically competitive market produce a differentiated products

otherwise market structures, perfectly competitive and monopolistic

competition, have the same assumptions.

Specifically, the following are some of the basic assumptions of a

monopolistic competition market:

25
  There is a large number of sellers and buyers in market

 The products of the sellers are differentiated, yet they are close substitutes

of one another.

 There is free entry and exit of firms in the market

 The goal of the firm is profit maximization both in the short run and long

run

 The prices of factors of production (labor, capital, etc) and technology are

given

Product Differentiation

Product differentiation in the monopolistically competitive market

may be based up on certain characteristics of the product itself.

Therefore, demand of a product in this market is determined not only

by the price policy of the firm, but also by the style of the product,

the services associated with it, and the selling activities of the firms.

Thus, the demand curve will shift if:

 The style, or the selling strategy of the firm changes

 Competitors change their price, output, services or selling

policies

 Tastes, incomes, prices or selling polices of products from other

industries change

The Demand Curve

The demand for a product, once preference for a product is created, it

gives rise to a negatively sloping demand curve for the product of the

26
individual firm. That means, since each firm produces a differentiated

product, it holds the monopoly power over its own products and the

firm has some power to influence the market price of its products.

As a result, the demand curve for a product of a firm is downward (or

negatively) sloping, as presented below.

Price

X (quantity of output sold)

x
The demand (dd) curve of a firm for its products in monopolistic

competitive is negatively sloped and highly elastic (or greater than the

monopoly) because of the assumption of a large number of sellers in

the market. In other words, products are close substitutes one to the

other so that a slight change in the price of a firm's product brings

about a larger change in its output quantity demanded. Since

consumers have a large number of alternatives, if a firm increases its

product price (p), customers will shift to the other producers and

hence the demand for a firm's product (x) decreases and vice versa.

The demand is determined not only by the price policy of the firm but

also by the style of the product and other services. Two important

policy variables in the theory of the firm are the product itself and

27
selling activities. Thus the dd curve will shift if all other things (other

than the firm's price of its product) are changed. Variables other than

firm's price can be style, quality, design, advertising, etc. They are

called product and selling activities.

If a firm introduces good quality or design or extensively advertises its

product, the dd curve shifts to the right, implying at that level of price

the quantity demanded (x) increases. However, the change only in

price (other things being constant) leads a movement along the same

dd curve, because p and x are inversely related.

Costs

All cost curves short- run average variable cost (AVC), average cost

(AC),marginal cost (MC) and long- run total average cost (LAC) of a

firm are U- shaped, implying that there is only a single level of

output which can be optimally produced and economies and

diseconomies of scales. So the shape of costs are the same in all

perfectly competitive, monopoly, and monopolistically competitive

markets.

But here, in the monopolistic competitive, a new cost is introduced,

i.e., selling costs. Selling costs are costs incurred on advertisement,

improving the quality and style, etc. of the product. Selling costs help

to alter the position or the shape of the dd curve for a product.

28
Accordingly, selling costs curve is U- shaped, i.e., there are economics

and diseconomies of selling costs. For instance, if we take

advertisement, initially the increment in selling quantity is greater

than the advertisement cost and after a certain point the sales rate

remains more or less constant but the advertisement cost continues to

rise. This leads to a fall in the average selling cost initially and it rises

up as advertisement continues. Hence the selling cost is U- shaped.

The U- Shaped selling cost added to the U- shaped production cost

(APTC), yields a U-shaped ATC curves.

The Concept of Industry and Product "Group”

An industry under perfectly competitive market is defined as a group

of firms that produce homogenous products. However, this definition

cannot be applied in the case of differentiated products. In the case

of homogeneity of products, it is possible to add them horizontally and

get the market demand and supply of the products. But here, in the

case of monopolistic competition, products cannot be added to get

the market demand and supply. For this reason, it is very important to

redefine the industry for analytical purpose. Product differentiation

creates difficulties in the analytical treatment of the industry of

monopolistically competitive market structure. Heterogeneous

products cannot be added to form the market demand and supply

schedules as in the case of homogeneous products. The

29
monopolistically competitive industry is a ' group' of firms

producing a closely related' commodity, referred to as ' product

group'. An operational definition of ‘product group’ is that the

demand of each single product be highly elastic and that it shifts

appreciably when the price of other products in the group changes. In

other words, products, forming ‘the group’ or ‘industry ‘, should have

high price and cross-elasticity.

Product differentiation allows each firm to change different prices.

There will be no unique equilibrium price, but an equilibrium cluster

of prices, reflecting the preferences of consumers for the products of

the various firms in the group. When the market demand shifts or cost

conditions change in a way affecting all firms, then the entire cluster

of prices will rise or fall simultaneously.

Equilibrium Conditions in Monopolistically Competitive Market

This section tries to analyze how a firm in monopolistically competitive

market arrives at its equilibrium in the short and long run. This

equilibrium analysis is very important to determine the optimum or

profit maximizing level of output and price. Further, we will compare

the equilibrium conditions of both monopolistically competitive and

perfectly competitive firms.

Models of Equilibrium

30
In order to be able to analyze the equilibrium of the firm and the

product group (industry) Chamberlin made the following ' heroic

assumption ‘that firms have identical demand and cost curves.

This requires that consumers’ preferences be evenly distributed

among the sellers, and that differences between the products be

such as not to give rise to differences in costs.

The rule of determining profit maximizing level of output is the same

in all market structures, i.e., producing the output at which marginal

revenue (MR) is equal to marginal cost (MC) and at that point MC

TR
must be rising. MR is the slope of total revenue ( ) or the first
Q

derivative of total revenue with respect to quantity produced and sold (

dTR TC
), whereas MC is the slope of total cost ( ) or the first derivative
dQ Q

dTC
of total cost with respect to quantity produced and sold ( ).
dQ

Chamberlin develops three distinct models of equilibrium.

31
 Chamberlin develops three models of equilibrium.

Model 1: Equilibrium with new firms entering the industry

Assumption: Each firm is in short run equilibrium with excess profit.

LMC

dE

Pm LAC

Pe E

d|E d|

Qe Qm Q

MR2 MR1

The firm in the short run is in equilibrium at point C where MC = MR. At

equilibrium point a given firm attains abnormal profit, area of PmCBA. The
excess profit attracts firms to come in to the market with competing brands.
The result of new entry is a downward shift of the demand curve dd’, since the

32
market is shared by a larger number of sellers. The process will continue until
the dd curve is tangent to the average cost curve at its equilibrium. i.e. until
the abnormal profit is eliminated and excess profit is wiped out. In the final
equilibrium of the firm, the price will be Pe and the ultimate demand curve will
be dd|E. In the long run the equilibrium occurs at P=LAC, at this point there
will be neither entry nor exit, and the equilibrium is stable.

Model 2: Equilibrium with price competition

In this model, the number of firms in the industry is assumed to be compatible

with long run equilibrium, so that neither entry nor exit will take place. But
the ruling price in the short run is assumed to be higher than the equilibrium
price.

Actual Sales curve or share of the Market Curve

d D

LMC

P0

d|1

P1

d||1 LAC

P2

d|2 d

e d|1

Pe

33
 d||1

d|e

X0 X1X2Xe MR Xol

The analysis of this case is done by the introduction of a second demand curve,
labeled DD’, which shows the actual sales of the firm at each price after
accounting for the adjustments of the prices of other firms in the group. DD’ is
sometimes called actual sales curve or share of the market curve. It is a locus
of points of shifting dd curves as competitors change their price.

Assume the firm is at a non-equilibrium position Po and Xo. The firm, in an

attempt to maximize its profit, lower the price to P1 expecting to sell X 'o . This
level of sales is not actually realized because all other firms faced by the same
demand and cost condition have an incentive to act in the same way
simultaneously. Thus, all firms acting independently reduce their price
simultaneously to P1. As a result, the dd curve shifts downward and the firm
instead of selling expected quantity X 'o sales actual quantity X1 (whish is less
than the expected quantity)on the shifted dd curve dd’ along the share curve
DD’.

According to Chamberlin, the firm suffers from myopia and does not learn from
pas experience and may further reduce price expecting that the others will not
react. Thus the firm lowers its price again in an attempt to reach equilibrium,
but instead of the expected sales Xo the firm achieves actual sales of X2,
because all other firms act identically, though independently. The process
stops when the dd’ curve has shifted so far to the left as to be tangent to the
LAC curve. Equilibrium is determined by the tangency of dd’ and the LAC. At
the point of tangency the DD| curve cuts the dd| curve. Obviously it will pay

34
no one firm to cut the price beyond that point, because its costs of producing
the larger output would exceed the price at which this output could be sold in
the market.

Model 3: Equilibrium through Entry and Price Competition.

Chamberlin suggests that in the real world adjustment towards long run
equilibrium takes place through both entry/exit and price competition. Price
adjustments are shown along the dd| curve while entry/exit cause shifts in the
DD’ curve. Equilibrium is stable if the dd| curve is tangent to the AC curve
and expected sales are equal to actual sales, i..e, DD| curve cuts dd| curve at
the point of tangency of dd’ & LAC.

35
 D|

D* D LMC

e2

C d| A

LAC

P1 B

d* e1

X X1 X 2 X* MR*

Let’s start from e1 where there is an abnormal profit. This excess profit attracts
other firms to enter into the market. When they enter in to the market, the
market will be shared by larger number of firms then DD (market share curve)
keeps on shifting left ward until it becomes tangent to LAC, DD|.

Although, firms earn normal profit, e2 does not constitute stable equilibrium,
because the firm believes that dd is its demand curve. By taking dd as its sales
planning function the firm will feel that it can expand sales and earn excess
profit by reducing price to P1. But all the firms will be doing the same thing

36
simultaneously. As price is reduced by all firms dd shifts down to dd| and
each firm realizes a loss of area CABP1 instead of positive profit.

The firm is still in myopia assumption, now also he believes that he can
obtain positive profit by cutting its price. However, all the firms do the same.
One might think that the process would stop when dd becomes tangent to the
LAC, dd*. This would be so if the firm could produce X*. However, there are so
many firms and the share of the firm is only X2. The firm still on the myopia
assumption believes that it can reach X* if he reduces to P*. However, all firms
do the same and dd* falls below the LAC with ever increasing losses. At this
time, the financially weakest firms will leave the market. So that the surviving
firms will have a higher market share then DD| will move to the right with dd | .
Exit will continue until the dd becomes tangent to the LAC curve and the
market share curve, DD, cuts the dd curve at the point of tangency, point E.

Equilibrium is then stable at point E with normal profits earned by all firms
and no entry or exit taking place. The equilibrium price is P*, which is unique
and each firm have a share equal to OX* at E, expected share is equal to actual
sale.

Criticism of Chamberlin’s Large Group Model

1. The assumption of product differentiation is incompatible with the

assumption of independent action and free entry.
2. It is hard to accept the myopic behavior of business men implied by the
model. For sure some firms learn from their past mistakes.
3. The concept of industry was destroyed by the recognition of product
differentiation. Heterogeneous products can not be added to give
industry.
4. The model assumes large number of firms & high cross price elasticities
among the products in the industry but the model does not objectively

37
 define the number of firms and the magnitude of elasticity required to
have monopolistic market structure.
Despite his critics chamberlin’s contribution to the theory of pricing are:

a) Introduction of product differentiation and selling strategy as two

additional policy variables in the decision process of the firm. These
factors are the basis for the non price competition which is a typical
form of competition in the real world.
b) Introduction of the share of the market demand curve as a tool of
analysis.
2.6 Excess Capacity and Welfare Loss
Under perfectly competitive firm MC = MR = LAC = P = AC at the minimum
point of LAC and resources are efficiently allocated. On the other hand, under
monopolistic competition MC = MR and P = AC, but P > MC (because P > MR).
As a result price will be higher and output will be lower in monopolistic
competition as compared to the perfectly competitive market.

In monopolistically competitive market structure there are too many firms in

the industry each producing less than the optimal (at a higher cost) because of:

1. The tangency of the long run average cost and demand occurs at the
falling point of the average cost curve.
2. Firms incur selling cost which is not presented in perfectly competitive
market structure. Therefore, firms in monopolistically competitive
market structure have an excess capacity measured by the difference
between the ideal output (YF) corresponding to the minimum cost level on
the LAC curve and the output actually obtained in the long run (YE).

38
 P
LMC

d Excess
Capacity

Chamberlin argues that the excess capacity and misallocation of resources is

valid only if one assumes that the demand curve of each individual firm is
horizontal. If demand is downward sloping and firms enter into active price
competition and entry is free in the industry. YF cannot be considered as a
socially optimal level of output. Consumers desire a variety of products. And
product differentiation reflects the desire of consumers to pay higher price for
differentiated product. Therefore, the difference between the actual output YE
and the minimum cost output YF is not a measure of excess capacity but rather
a measure of the “social cost of producing and offering the consumers a greater
variety of output.”

39
Chamberlin’s argument is based on the assumption of active price competition
and free entry. He argues that the equilibrium output will be very close to the
minimum cost output, because firms will be competing along their individual
dd curves which are very elastic.

Chamberlin divides the competition into two, price and non-price competition.
If firms avoid price competition and instead enter into a non price competition
there will be an excess capacity in each firm and inefficient product capacity in
the industry and that is an inexhaustible economy of scale for the firms in the
industry. Chamberlin argues “excess capacity in monopolistically

competitive market structure comes because of the non-price

competition coupled with free entry”. Excess capacity is the difference
between YE and Y.

In summary, if the market is monopolistically competitive the output is lower

than society would ideally like it to be (that is, price is higher than MC, but the
socially desired P = MC cannot be achieved without destroying the whole
private enterprise system.

40
Chapter 3, OLIGOPOLY THEORY
Oligopoly is the fourth type of market structure. Oligopoly is a form of

market structure in which a few sellers sell homogeneous or

differentiated products. An oligopoly is an industry with small

number of sellers. How small is small cannot be decided in theory but

only in practice. Nevertheless, in principle, the criterion is whether

firms take in to account their rivals’ actions in deciding upon their

own action or not. In other words, the essence of oligopoly is

recognized interdependence among firms. Coca-Cola considers the

actions and likely future responses of Pepsi when it makes its

decisions (whether concerning product design, price advertising, or

other factors).

It is difficult to fix up definite number of sellers. Any way, if each seller

has command over a sizable proportion of the total market supply

then there exists oligopoly in the market. That means if one seller

increases (decreases) its supply; the market price may decrease

(increase) because the supply of this seller constitutes a significant

proportion in the total market supply.

Characteristics of Oligopoly Market

The basic characteristics of oligopolistic market structure are the

following:

41
A. Keen (or intense) competition between firms: The number of firms is

small enough that each seller takes into account the actions of

other firms in its pricing and output decisions. In other words, each

firm keeps a close watch on the activities of the rival firms and

prepares itself with a number of aggressive and defensive marketing

strategies.

B. Interdependence: the nature and degree of competition makes firms

interdependent in respect of decision making.

C. Barrier to entry: in oligopoly market firms are small enough in

number implies there is barrier for new firms to enter into the

market. Some common barriers to entry are economies of scale,

patent rights, and control over important inputs by existing firms.

In general unpredictable action and reaction will make it difficult to

analyze oligopoly market. Firms may come ‘in collusion with each

other’ or ‘may try to fight each other on the death.’ So accordingly we

can classify oligopoly market structure as:

 Non-collusive Oligopoly and

 Collusive Oligopoly

 Non- Collusive Oligopoly

Oligopoly firms may cooperate (collude) or may not cooperate (no-

collusion) in some activities with respect to their businesses

depending on their interest and agreement. If firms do not

42
 cooperate, their decision-making process is analyzed using the

non- collusive model. Under this model we have the Cournot's

duopoly model, the 'kinked- demand' model, Bertrand Duopoly

model and Stackleberg Duopoly model. We will look how firms

arrive at equilibrium points in each model one by one.

a. The Cournot's Duopoly Model (Out put simultaneous game)

When there are only two sellers of a product, there exists duopoly, a special case of

oligopoly. Augustin Cournot, a French economist, was the first to develop a formal

duopoly model in 1838. To precede our analysis of the model, the assumptions of the

model are the following:

a) There are only two firms, A and B each owing a mineral water wells;

b) Both operate their wells at zero marginal cost of production (MC=0)

c) Both face a down ward sloping straight line demand curve; and

d) Each seller
P acts on the assumption that its competitor will not react to its decision
to change its output and price

MRA MRB

43
 Graphical Presentation of Price and output determination under

Cournot’s Duopoly

Now let us assume that firm A is the first to start producing and

selling mineral water, x. Therefore the market open to A is OD, the

total quantity demanded. The market demand curve for the product is

DD and its respective marginal revenue curve is firm A's marginal

revenue curve ( MRA). Firm A will sell half of the total quantity

demanded OD.

MRA is twice steeper than the DD curve (please try to show how this

holds true) in the imperfect market and it bisects OD at the middle.

Thus firm A will sell OXm amount of X. At point A, firm A is

maximizing its profit because at A, MR=MC= 0. When MR= 0, the

elasticity of demand, ed=1. If we assume the total quantity demanded,

OD is one unit, then firm A will sell ½ (1) = ½ unit of x.

 Show that in imperfect markets, MR=P (1-1/ ed)

Now firm B enters into the market (next to A). The market open to B is

therefore, the remaining half (XmB) out of the total OD. Hence the

demand curve of B is CD and its respective marginal revenue curve is

MRB which cuts XmD at the middle at point B. At point B profit of firm

B is maximum because MRB= MC= 0. Firm B will sell quantity XmB at

44
the Price P. Here we can observe that firm B will supply ¼ X. That

means ½ (½) =¼.

With the entry of B to the market price fall from Pm to P. Firm A

attempts to adjust its price and output to the changed condition. Thus

A assumes that B will not change its output XmB and price P as B is

making the maximum profit and he continues to supply ¼. Then A

has ¾ of the market available to it that is ¾ (1-1/4). To maximize its

profit A will supply ½ (¾) = 3/8 of the market. Now it is B's turn to

react (to move). This action and reaction will continue until both reach

the equilibrium point by supplying 1/3 each.

Periods Firm A Firm B

I ½ (1) = ½ 1 1 1
 =
2 2 4
II 1  1 3 1  3 5
1   = 1   
2  4 8 2  8  16

III 1 5  11 1 11  21
1    1   
2  16  32 2 32  64

IV 1 21  43 1 43  85
1    1  
2 64  128 2  128  153

. . .

. . .
N 1  1 1 1  1 1
1    1   
. .2  3  3 .2  3  3

45
We observe that the output share of Firm A declines gradually. We

may re-write this expression:

1 1 1 1
[Product Share of firm A equilibrium] =    ........
2 8 32 128

1 1 1 1 1 1 1 1
=  [  *  * ( ) 2  * ( ) 3  .....] .
2 8 8 4 8 4 8 4

The expression in parenthesis is a declining geometric progression

1
with ratio r  . Applying the summation formula for an infinite
4

a
geometric series S  (where S=sum, a= first term of series, r= ratio)
1 r

1
1 8 =1/3.
we obtain [Product share of firm A in equilibrium] = 
2 1
1
4

Again we observe that the output of Firm B increasing at decreasing

rate. We may re-write this expression:
1 1 1 1
[Product Share of firm B equilibrium] =     ...............
4 16 64 256
1 1 1 1 1 1 1
= [  *  * ( ) 2  * ( ) 3  .....] .
4 4 4 4 4 4 4

The expression in parenthesis is an increasing geometric progression

1
with ratio r  . Applying the summation formula for an infinite
4
a
geometric series S  (where S=sum, a= first term of series, r= ratio)
1 r
1
we obtain [Product Share of firm B in equilibrium] = 4 =1/3.
1
1
4

46
The supply by each firm remains 1/3 in the rest of the periods.

Consequently, the Cournot equilibrium is stable equilibrium. The price

level in the Cournot models is lower than the monopoly priced but

above the pure competitive price. In general if there are n firms in the
1
industry each will provide of the market, and the industry output
( n  1)

n
will be clearly as more firms exist in the industry, the higher the
( n  1)

total quantity supplied and hence the lower the price. The larger the

number of firms the closer is output and price to the competitive level.

Note that: The Cournot game is also called an out put game as the

strategies of firms are their outputs. Firms are using their outputs as

a weapon to win the tough competition among the firms.

Reaction curve Approach

This is based on iso-profit curves of competitor. Assume there are two

firms Firm A and B

An Iso-profit curve for firm A / Firm B the locus of points defined by

different levels of out put of A / B and his rival B /A which yield to A /

B the same level of profit.

Properties of Iso-profit curves

1- For substitutable commodities they are concave to the axis along

which we measure the out put of rival firms.

47
 2- The further the iso-profit curves lie from the axis, there lower is

the profit & vice versa

A1 > A2 > A3 > A4

B1 > B2 > B3 > B4

3- For Firm A / Firm B the highest points of successive iso-profit

curves lie to the left / right of each other.

4- Reaction Curve of Firm A / Firm B: a curve that joins the locus of

points of highest profits that Firm A / Firm B can attain given

the level of out put of rival Firm B/Firm A

b. The 'Kinked - Demand ' model

48
This model attempts to explain the phenomenon of price rigidity in

oligopolistic firm. It is the best known model to explain relatively more

satisfactory the behavior of the oligopolistic firm.

If an oligopolistic firm reduces price of its product, it believes that the

rival firms will follow & neutralize the expected gain from price

reduction. But if it raises its price, the firms would either maintain

their prices of even make price-cut, so that the price-raising firm

would lose, at least its market share. The oligopoly firm would find

it more desirable to maintain the prevailing price & output.

The analysis:

There are three possible ways in which rival firms may react:

I. Rival firms follow the changes in price, both price hike and price

cut

II. Rival firms do not follow the changes in price, both price hike

and price cut

III. Rival firms follow the price cut changes but not follow price hike

change

 If rival firms react in manner (I) and (II) an oligopolistic firm taking

lead in changing prices will face two different demand curves.

dd’ = Which is based on reaction (I) (Follow both hike & cut)

DD’ = Which is based on reaction (II) ( Do not follow both price hike

and cut)

49
 dd’ is less elastic than DD’ because of the changes in dd in

responsible to changes in price are restrained by the counter-moves by

the rival firms.

Figure 2.2

The demand curve of the oligopolist has a kink at point E reflecting

the following behavioral pattern. Now let us look how this kink is

formed at pint E. Initially the firm is at equilibrium at point E where

the expected sale is equal to the actual sale and the price is P and the

output level is X. If a firm reduces its price, all other firms also follow

this action and will reduce their price. So that, although, the demand

in the market increases, the shares of competitors remain unchanged

As a result the demand curve of the firm below price level p is ED'.

In other round, if the firm increases price above P, other firms will not

follow this action and consequently the demand curve of the firm will

be dE, implies its sales decreases due to the shift of some of its

50
customers to the other firms. Thus for price increases above P, the

relevant demand curve of a firm is the section DE of the dd' curve.

Finally, the demand curve of the firm will be dED' which is a ‘'kinked

demand’' curve.

Due to the kink in the demand curve of the oligopolist firm, its

marginal revenue curve (MR) is discontinuous at X which corresponds

to the kink at E. The MR has two segments: Segment dA corresponds

to the upper part of the demand curve, dE while the segments from

point B correspond to the lower part of the kinked- demand curve,

ED'.

The gap or the distance between point A and point B increases or

decreases depending on the elasticities (or the slopes) of the segment

dE and ED'. The greater the difference of elasticities of the upper (dE)

and lower (ED') parts of the kinked- demand curve, the wider

discontinuity in the MR curve, and hence the wider the range of AB.

Now let us look the behavior of the equilibrium of the firm. The

equilibrium of the firm is defined by the point of the kink at point E

because to the left of E, MC is less than MR and the right of E, MC is

greater than MR. Since in the range AB MR is a straight line whatever

be the MC (i.e. whether the MC is Mc1 or MC2 or in between MC1 and

MC2) we have always the equality between MR and MC (MR=MC)

51
implying the firm is maximizing profit by producing x and charging the

price P.

Here you should note that whether the MC increases or decreases (in

the range AB) price remains the same p, i.e. price is rigid or sticky in

the oligopoly market. The rigidity of price is the result of uncertainty

the firm faces from its competitors. In other words firms do not

increase price despite the rise in costs to avoid competition of viral

firms.

There is only one case in which a rise in cost will most certainly

induce the firm to increase its price. This occurs when the rise in costs

is general, example imposition of tax that affects all firms equally.

Under these circumstances the firm will increase its price with the

certainty that the other in the industry will follow. Hence the point of

the kink shifts upwards to the left, and equilibrium is established at a

higher price and lower output, x.

c. The Bertrand Model (Price Game)

This model assumes that firms choose price rather than output. The first piece of

work in this line is that of Joseph Bertrand. In a critique of Cournot’s book,

Bertrand briefly sketched a model in which firms make simultaneous price

decisions. When firms offer identical goods and have a constant marginal cost,

there is a unique Nash Equilibrium when firms choose price and it entails both

firms pricing at marginal cost. The Bertrand model yields the surprising result that

Oligopolistic behavior generates the competitive solution! If firms’ outputs are

52
differentiated, price competition results in similar to those of the Cournot solution:

each firm’s price lies between the competitive price and the monopoly price. One of

the most significant ways in which firms compete is trying to make their product

unique relative to the other products in the market. The reason is that the more

differentiated is one’s product; the more one is able to act like a monopolist. That is,

you can set a higher price without inducing large numbers of consumers to switch

to buying your competitors’ outputs. To consider the role of product differentiation,

let us follow the suggestion of Bertrand and assume that firms make simultaneous

price decisions with constant marginal cost –though, of course, we will assume that

firms’ outputs are differentiated. This means that consumers perceive these

products as being imperfect substitutes. That is, there are consumers who are

willing to buy one firm’s output even though it is priced higher than its

competitors’. It also typically means that a small change in a firm’s price causes a

small change in its demand.

D. The Stackleberg’s Duopoly Model (Out put sequential game)

This model assumes that one oligopolist is sufficiently sophisticated.

That means the sophisticated Duopolists determine the reaction curve

of his rival and incorporate it in his own profit function which he then

proceeds to maximize like a monopolist.

Let firm A and firm B are the two Duopolists.

 If firm A is the sophisticated oligopolist it will assume B will act on

the bases of its ok2wn reaction curve. This will permit A to chose to

set its own out put at the level which maximizes its own profit. This is

point a, which lies on the highest possible iso-profit curve of A,

53
denoting the maximum profit A can attain given B’s reaction curve. So

B produc a level of out put XB at point b.

 Collusive Oligopoly
Sometimes firms form collusion each other in many actions to avoid uncertainty

or competition among themselves. This collusion helps the oligopolist firms to act

like a monopoly. The two main types of collusion, cartels and price leadership.

1-Cartels

Cartels imply direct agreements among the competing oligopolist with the aim of

reducing the uncertainty arising from their mutual interdependence. Based on

this objective, the general purpose of cartels is to centralize certain managerial

decisions and functions of individual firms with a view to promoting commons

benefits.

54
There is one typical example of cartels i.e., OPEC (Oil and Petroleum Exporting

Countries). These countries (or oil producing firms) form the organization called

OPEC and this OPEC acts as decision maker and all firms are governed under it.

The two typical Services of a cartel are

A) Fixing price for joint maximization of firms profit and

B) Market- sharing between its members firms. Now let us look these two

functions one by one

A) Cartels aiming at joint profit maximization

For the purpose of this analysis we concentrate on a homogenous or pure

oligopoly, i.e., all firms produce a homogenous products. The equilibrium analysis

is similar to that of the multi-plant monopolist. The cartel ( the central agency )

acting as a multi- plant monopolist, will set the profit maximizing price defined by

the intersection of the industry MR and MC curves of firms as shown below.

a- Firm 1
b- Firm 1 c- Industry
MR

For simplicity we assume that there are only two firms in the cartel, firm 1 and

firm 2. Given the market demand D in figure c the monopoly solution, which

maximizes joint profits, is determined by the intersection of MC and MR, at point

e. The total output is X=X1 +X2 and sold at price P. Now once the central agency

55
decides these variables (P and X) it allocates the production among firms 1 and

firm 2 as a monopolist would do, i.e., by equating the common MR to the

individual MCs’.

Since all firms have the same price P, their MRs, are also the same. Therefore at

equilibrium points, i.e., at point e, MC=MR and at point e2 MC2=MR. Thus firm 1

produces X1 and B produces X2. The firm with the lower cost produces a larger

amount of output but the distribution of profits is decided by the central agency of

the cartel.

B) Market - Sharing Cartels

As noted above the second service of the cartel is to share the market between its

members. There are two basic methods for sharing the market: non - price

competition and determination of quotas.

Non - price competition agreements: firms agree on a common price, at which

each of them can sell any quantity demanded. The agreed price must be such as

to allow some profits to all members. In this type of agreement firms cannot sell at

lower price but they can use different kinds of selling activities (e.g. changing

style, package, etc). In other words by using these selling activities firms can have

a larger share of the market- called non price competition.

This form of cartel is indeed ' loose', in the sense that it is more unstable than the

cartel aiming at joint profit maximization. Because, since there are cost differences

among firms, the low cost firms will have a strong incentive to break the

agreement and sell at lower price or to cheat the other members by secret price

concessions to the buyers. Then the price war and instability of the agreement

occur.

Sharing the market by agreement on quotas: if all firms have identical costs, the

monopoly solution will emerge with the market being shared equally among the

56
firms. But if costs are different, the quotas and shares are determined by

bargaining power (or skill) of firms.

2- Price Leadership

Price leadership is another form of collusion. In this form of coordination one firm

sets the price and the other follows it. There are various forms of price leadership

.The most common types of leadership are price leaderships by a low- cost firm

and price leadership by a large (dominant) firm.

a. The model of the Low -Cost Price Leader

Due to economies of scale, efficiency, etc. a firm in the oligopoly market can be a

low- cost firm. Thus this firm takes the lead to charge price of the commodity and

other firms will follow the action. To look the model, let us assume there are two

firms, which produce a homogenous product at different costs. The firms may

have equal markets (figure 1) or they may have unequal markets (figure 2)

according to their agreement as shown below.

Figure1 Figure2
As you

observe

in the

figures

above,

firm A

is the

low-

cost firm and it takes a lead to charge price and the high cost firm (i.e., firm 2) will

follow this price. In figure 1 firm A, a leader, determines its price PA that

57
maximizes its profit at the output level (x1) where MCA= MR and firm B, the

follower takes this price PA through it does not maximize its profit by producing X2

(at X2, MCB > MRB).

Here you should note that since both firms sell the same amount at the same

price, both firms have the same demand curve d and one marginal revenue curve

MR1= MR2 in figure1 above. The market demand curve is D. In figure1 both firms

will sell the same quantity X1 =X2 at the same price PA. However, firm B's profit

maximizing price and out put would be PB and XBe respectively. At price PA the

market demand is X = X1 + X2.

In figure 2 since both firms have not equal market share their demand and

marginal revenue curves are different. Here also firm A, the leader, decides price

PA according to the marginal rule MRA = MCA, maximizes it’s Profit by selling XA,

but firm B taking this price PA will sell XB, not maximizing profit. As in figure1

firm B could maximize profit if it charged price PB. To avoid price war firm B

accepts the price set by firm A, PA.

b. Price leadership by the dominant firm

In this model it is assumed that there is a large dominant firm which supplies a

large proportion of the total market, and some smaller firms, each of them having

a small market share. Thus if this dominant firm increases or decreases price the

other firms will follow it. The dominant firm sets its price so as to maximize its

profit (the point where its MR=MC) but the followers may or may not maximize

their profits depending on their cost structures.

Now let us look a mathematical model how a dominant firm sets its profit

maximizing price and output.

58
Here we represent the market demand by D and the total output that is supplied

by the smaller firms by S then the output sold by the dominant firm will be

X= D - S

Let us assume S= aP and D=b – cP

Using the above function , the dominant firm’s demand function is

X=D-S

X = b - cP - aP

X = b – (c + a)P,

The inverse demand function is

(c + a)P = b - X

P=b–X

(c + a)

Total reevenu of the dominant firm will be: TR = PX = b–X X

(c + a)

If the cost function of the dominant firm is given as C = dx

It will maximizes its own profit as TR - TC

= b–X X _ dx

(c + a)

Then to determine its profit maximizing level of out put the dominant firm will set

the first derivative of its profit function with respect to X must be equal to zero.

After determining this level of out put the dominant firm will set at what price will

59
it sell the product. And the small firms will follow this desided price by the

dominant firm. And this is ca lled pricer leadership by a dominant firm.

CHAPTER 4, PRICING OF FACTORS OF PRODUCTION AND

INCOME DISTRIBUTION

- Economic resources can be grouped into labour, land, capital, and

entrepreneurship. They are also called factors of production or simply

factors. These factors are supplied by households and purchased by

firms.

- Factor Prices together with factor employment determines the share

of each market in the national income. Ex- The share of labour income

in the national income equals the average wage rate multiplied by the

number of workers.

- This implies that theory of factor pricing also explains how national

income is distributed among the various factors of production. Hence

the other name of this theory is Theory of distribution.

-A- FACTOR PRICING IN A PERFECTLY COMPETITIVE MARKET

A perfectly competitive factor market is one in which there are a large

number of sellers and buyers of the factor of production. Because

no single seller or buyer can affect the price of the factor, each of

them is a price taker. The mechanism of determination of factor prices

does not differ fundamentally from that of prices of commodities.

60
Factor prices are determined through the forces of demand and

supply. The difference lies in the determinants of the demand and

supply of productive factors.

A.1. the Demand for Factors of Production

Given that labor is the most important input or factor, we will usually

speak of the “demand for labor” or “the supply of labor” but it

should be interpreted as the “demand for a productive factor” and

the “supply of a productive factor.” Following the methodology of

earlier units, we will develop first the demand for labor by a single

firm. Here we will examine the demand for labor in two cases: A) where

labor is the only variable factor and B) when there are several variable

factors. Then, we will derive the market demand for a factor.

Derivation of demand curve for factor of production is based on

(dependent on) MP concept. In other words demand for a factor is

derived demand; it is derived from its MP. Marginal productivity

concept states that at equilibrium each factor is paid in

accordance with its marginal productivity.

i.e. payment made to a factor = the value of its MP o

or wage rate (w) = MPLr x Price of the product = VMPLr

This means that for a  maximizing firm it employs an additional

labour so long as the value of its product is greater than its cost.
A.1.1 The Demand for one (Single) variable productive factor(Lr)

61
We derive the demand for labour by a single firm when labor is the only variable

factor in the production process. The following assumptions underlie our analysis:

i) A single commodity x is produced in a perfectly competitive market. Hence

Price of x ( Px) is given (constant) for all firms in the market

ii) The goal of the firm is profit maximizations

iii) Technology is given

iv) The market of labour is perfectly competitive, i.e., the price of labor services

is given for all firms. This implies that the supply of labour to the individual

firm is perfectly elastic as shown below. At with the firm can employ any

amount of labor it wants.

Since labor is the only

variable factor in

production of commodity x,

the shape of the production

function is 'S' shape due to

the law of diminishing

marginal returns of the

variable factor Labour (L).

b) The marginal physical product and the
Figue1
value of marginal product of labor (MPPL
a) The total Product curve (TP) and VMPL)

X MPPL

X= f(Lr) VMPL

Lr MPPL VMPL= MPPL (Px)

62
 Lr

The slope of the production function X = f (Lr) is the marginal product

of labor (MPL) becomes zero when TP is maximum. Since the rational

producer chooses to operate in stage II i.e., the point where APL

maximum and TPL maximum. In other words, this stage II- the

feasible production range- can be presented by the downward slopping

MPL curve in figure b above. Now let us derive the equilibrium of the

firm in a factor market.

As mentioned above, the slope of the production function X = f (L) is

dX
= MPL, i.e., the additional output x produced by and additional
dL

labor. MPL is measured in terms of physical quantity. It can be

kilogram or litter, etc. When we multiply MPL by its Price Px in terms of

money, we get the value of the marginal product of labor (VMPL)

expressed in terms of money, birr. Since Px is constant and MPL is

downward sloping, automatically, the VMPL curve is down ward

slopping and lies above the MPL curve in figure b above.

Using the marginal value, profit is maximized when the marginal cost

of a factor (MCL) is equal to the value of its marginal product (VMPL) in

a perfectly competitive market. Since total production cost (c) is the

sum of variable and fixed costs, i.e., C=  .L + F, the extra cost

63
incurred as a firm employ an extra labour is the marginal cost of labor

(MCL)
dc
MCL=   . Thus profit maximizing firm will hire (employ) a resource
dL

(L) up to the point at which MCL= VMPL which implies  =VMPL which

is an equilibrium point. This equilibrium implies labor in a perfectly

competitive market is paid its value of marginal product.

The mathematical derivation of the equilibrium of the firm is as

follows.

The production function is X= f (L), all other things are constant.

The total cost is C= TVC + TFC =  . L + F

The revenue of the firm is R= P x.X = P x [f (L)]

Profit of the firm is П= R - C = P x. X -  .L- F

To find the maximum profit the first derivative of П with respect to L

d dX
must be zero, that is,  Px   0
dL dL

dX
P x MPL-  = 0, since is MPL
dL

VMPL =  , which is an equilibrium condition as indicated above.

At the same time the VMPLr which is the Value of the additional labor

product is the same as MRPLr which is the additional total revenue as

a result of additional labour.

64
To Prove this:  VMPLr = MPL x Px

= MPL x MR, P = MR in Perf. Comp. market

=  TR
 Lr

 MRPLr = MR x MPL

=  TR x  Q
Q  Lr
=  TR
 Lr

This equilibrium of the firm can be shown using graph. To show the

equilibrium Point using graph, we simply combine the labour supply

(SL) curve drawn under the assumption number (iv above) and the

VMPL curve drawn in figure 1b above.

(a) (b)

65
Point e in the first figure denotes the equilibrium of the firm. At point e the MCL =

 =VMPL. That means at the market wage rate  the firm will maximize its profit
by hiring L* units of labour

Now let us consider figure b. At point e the wage rate is  and the quantity of

labour employed in production is L*. If wage increases from  to  1, the

equilibrium shifts to e1. That means as wage increases to maximize profit the

quantity labor demanded by the firm decreases from L* to L1. To the contrary, if

 falls to  2, the quantity of labor demanded increases from L* to L2. Thus it

follows from the above analysis that the demand curve of a firm for a single

variable factor (L) is its value of marginal product (VMPL) curve and is

downward sloping. The VMPL shows an inverse relationship between  and L.

A.1.2 The Demand for a factor (Lr) in case of Several Variable Inputs

Now we are going to derive the demand for a factor (L) when there are several

variable factors in the production process. When there are more than one variable

factors of production the VMP curve of an input is not the demand curve of a firm

anymore. This is so because the various resources are used simultaneously so

that a change in the price of one factor leads to changes in the employment (use)

of the others. The latter, in turn, shifts the VMP curve of the input whose price

initially changed.

To see this, now let us assume that Lr and K are the two factors of production

existing and again assume that the wage rate falls down cause we are about to

derive the demand of the firm for Lr input. The change (the fall) in the wage rate

affects not only the demand for labour but also the demand for capital through

three effects: i) a substitution effect, ii) an output effect, and iii) a profit -

66
maximizing effect. We will look these three effects using the Isoquant-Isocost

analysis and we derive the demand for labour from these three effects.

For simplicity assume i) only two variable factors

ii) Initial price of Labour (wage) is w1 and that of capital is

r1

iii) Initial Isocost is AB and that of Isoquant is X1

Figure 1

A’’
K1

K2 E1

 Suppose the firm initially was in equilibrium at point e1 where it demand

OL1 Labour and OK1 capital at Isocost AB and indifference curve X1.

 Now let the wage rate of Lr fall from w1 to w2 and hence the new Isocost

become AB’ and the new equilibrium become point e2 at Isocost X2. Here

labour demand has increased by L1L2 and this increase in labour use is as a

result of substitution and out put effect.

 To decompose the two effect we draw an ideal Isocost curve A’’ which is

parallel to AB’ and tangent to the original Isoquant X1. And this A’’ will

remove the output effect of the fall in wage rate and specify the substitution

effect.

 Therefore, from point e1 to E1 is substitution effect. The firm substitute K2K1

demand for capital by L1E1 demand for labour.

67
  And the remaining i.e. L1L2 – L1E1, a movement from point E1 to e2 is an out

put effect.

 Since the firm will ultimately settle at point e2 it will use more Lr and capital.

 The third effect is profit effect which arises from a down ward shift in the

MC curve due to a fall in wage rate. On figure 2 below at price OP the initial

profit maximizing out put was OX1 at equilibrium point H and suppose it is

represented by X2 Isoquant on figure 1 where the marginal cost was MC1.

 Now when the wage rate falls the MC shifts to the position of MC 1' and the

new equilibrium point becomes G and the profit maximizing out put

increases from OX1 to OX3. Now the firm has expanded its output by X1X3

and this expansion requires additional expenditure on labour and capital.

The increase in expenditure (cost) will shift Isocost AB’ to A’B’’ and the firm

will finally be at equilibrium at point e3 at X* Isoquant on figure 1. And the

total demand for labour is OL3 for which L2L3 is the profit effect additional

labour demand.

Figure 2

 The output and profit effect both being positive will lead to additional

employment of capital. Thus the employment of both Lr and K increases as

a result of output and profit maximization effect. This will ultimately lead to

68
 an increase in the value of MPLr. Finally the decrease in wage rate will shift

the VMPLr curve right ward.

 Now we can easily derive demand for labour when other factor say capital is

variable.

When wage rate decreases from

w1 to w2

- if Lr was the only variable

E
input the demand for Lr

w1 would have increased from

OL1 to OL2

- but here k is also variable and

E’
as w from w1 to w2

w2 VMPL shifts from VMPL0 to

VMPL1 & the new

VMPL0 VMPL1 DDLr equilibrium will be E’ & dd for Lr

increases from

O L1 L2 L3 OL1 to OL3

And by joining the initial anf final equilibrium points(E and E’) we arrive at the

dd curve for the variable input Lr as DDLr

A.1.3 Market Demand for a Factor

The derivation of the market demand for a factor is different from that of the

commodity. The market demand for a commodity is a simple horizontal summation

of each individual's demand for a commodity. But the market demand for an input

is not the simple horizontal summation of the demand curves of individual firms.

This is due to the fact that as the price of the input falls all firms (In market)

will seek to employ more of this factor and expend their outputs. As output

69
(supply) all firms in the market increases price of the output (Px) falls down.

Since this Px is one component of the VMP of a factor (i.e., VMPL= Px. MPL), as Px

falls the VMPL decreases or shifts down to the left from d1 to d2 as shown below.

=VMPL1
=VMPL2

Figure a) Demand of a single firm for labour b) Market demand for

labor

Initially the firm is at point a employing OL1, at wage rate w1 in the figure above.

Then aggregating OL1 of all firms at w1 we get the market demand for labour OL1

at point A in figure b. Now assume wage falls from w1 to w2. Other things being

constant the firm would move along d1 to point b' employing OL '2 . However, other

things do not remain constant (as mentioned above as w1 falls to w2, VMPL or d1

shifts to d2 the new demand curve will be d2.) This is because as each firm uses

L2L '2 additional unit of labour their supply of commodity increase  a price fall of

the commodity will occur  lead to a fall in VMPL (VMPL = MPL x P)  a

downward shift in the demand for Lr from d1 to d2. At w2 the firm is in equilibrium

not at point b' but at point b on d2 and employing L2 not L'2. And market demand

at this point will be multiplying OL2 by the number of labour employing firms and

it is the point B on figure b not B’. Finally the market demand is given by line AB

70
and is negatively sloped showing an inverse relation ship between w and L in

figure b.

A.2. Factor Supply and Factor Price

Under this section we are going to look at how the supply curve of a variable factor

is derived and combining this supply curve with the demand curve of a factor we

determine the market equilibrium price of that factor. As we did in the previous

section, here also we concentrate on the labour input.

A.2.1 The Supply of Labour in short run

To begin the derivation of labour supply, we assume that labour is a homogenous

factor: all labour units are identical .The supply of labor by an individual can be

derived by indifference curves analysis. The indifference curves represent the

preferences of the individual between leisure and income. These curves are called

as Leisure-Income Indifference curves. The negative slope of the indifference

curve shows substitution between leisure and income such that worker's total

satisfaction remains the same.

Y2

Y1

71
There are of maximum hours in a day (24 hrs), which an individual can use for

leisure or for work or for both. The slope of a line from z to any point on the

vertical axis represents the wage per hour. For example, if an individual work all

hours and earn 0Y0 total income, the income per hour (or the wage rate) will be w0

oY0 oY2
 = Slope of zy0 line. Similarly, w2= = slope of zy2.
oz oz
Thus as we move up from the origin the wage rate increases, i.e., w0 > w1 > w2

because the slope of the line increases as we move from zy0, to zy1 to zy2, the

steeper the line the higher the wage rate. Accordingly as we move up from the

origin the level of satisfaction or utility of the individual increases, i.e., III > II >I

When the wage rate is w0, the individual is in equilibrium at point A by working

AZ hours earning AA income and spending OA hours of leisure. If wage increases

to w1 the individual work more hours BZ and will earn a higher income BBand

will have less OB for leisure. That means, as wage increases the individual works

more hour by decreasing his leisure time. In other words, as wage (income)

increases the supply of labour by individual increases. The locus of points of A,

B, C can be plotted as the supply

curve of labour which shows a positive

relationship between wage (w) and

labour (L) as follows.

72
Do you think that the supply of labor increases indefinitely as wage (income)

increases? Please imagine the amount of hours a typical rich person may work in

a day. Have you tried? As we observe from the above graph as wage increases the

supply of labour increases. However, at some higher wage rate the hours offered

for work may decline. This is so because higher wages (incomes) create incentive

for increasing hours of leisure ( by decreasing hours of work).That means, as the

wage rate increases, The individual's income increases and this enables the

workers to have more leisure activities. Hence beyond a certain level of the wage

rate, the supply of labour decreases as the person prefers to use his income on

more leisure activities (e.g. tourists),

Up to a certain wage level the labor supply increases as wage increases this is

Income or Substitution effect. However, the supply of labor decreases beyond

the some wage level i.e., as income increases the person becomes richer then he

works less and spends more of his time for leisure this is Wealth effect. As a

result the supply curve bends backward after a certain level of wage. The supply

curve has both a positive (the rising parts) and a negative (the bending parts)

slopes, or the supply curve for labour in the short run is ‘backward bending’.

A.2.2 The Market Supply of Labour

Different shapes have been suggested for short and long run market supply curve,

depending on the occupational mobility, and the type of labour used and level of

economic growth. In general, however, the backward bending labour supply curve

is a phenomenon of the short run but in the long run the supply curve must have

a positive slope, since young people will be attracted to the market.

73
The market labor supply curve is the sum of individual labour supply curves.

Even if higher wages may induce some people to work less hours, in the long run

as more young people will be attracted to the market, the market supply of labor

is positively slopped,

A.3 Factor Pricing

The equilibrium price and quantity of a factor employed in productions

determined at the intersection of the market demand and market supply curve of

a factor as shown below.

The equilibrium wage is we and employment level is Le. The market model is valid

for the determination of the equilibrium price of a commodity or a production

resource. The difference between commodity pricing and factor pricing lies

in the determinants of the demand for variable factors and the method used

to derive the supply of labour. The demand for factors is a derived demand

(i.e., based on the demand of the commodities produced by the factor). The supply

of labor is not cost determined like the supply of commodities, but involves

the attitudes of individuals toward work and leisure.

74
 CHAPTER 5, WELFARE ECONOMICS, EXTERNALITIES AND
PUBLIC GOODS
Introduction

In the previous units, we have mainly concentrated on the analysis of different

market structures. But, each economic situation in each market structure has its

own implications on the well- being of the society. So, we will examine some

criteria to evaluate the implications of these economic situations on welfare

or social well- being. Besides, we will analyze how markets fail in the presence of

asymmetric information, externalities and public goods.

The price system works efficiently because market prices convey information to

both producers and consumers. Sometimes, however, markets prices do not

reflect the activities of either producers or consumers. There is an

externality when a consumption or production activity has an indirect

effect on other consumption or production activities that is not reflected

directly in market prices. The impact of externalities and public goods will be

analyzed in the second section of this unit.

If consumers do not have accurate information about market prices or product

quality, the market system will not operate efficiently. Asymmetric information

causes inefficiency which will be seen in the final section.

A.1. Welfare Economics

In this section, you will learn about

 Adam smith's welfare criterion

 Bentham's Criterion

75
  Pareto's optimality Criterion

 Hicks- Kaldhor criterion

Welfare economics is concerned with the evaluation of alternative

economic situations, on the basis of their implication for social

well-being. It evaluates alternative economic situations and

determines whether one economic situation yields greater welfare

than others.

The term ' welfare' has been defined in diverse ways, because it is difficult to give

it a precise meaning. What is the basis to evaluate whether a given economic

situation improves welfare or not? Yes, to evaluate alternative economic

situations, we need some criteria of social well- being or welfare. And various

criteria of social welfare have been suggested by economists at different times.

A.1.1. ADAM SMITH'S WELFARE CRITERION

According to Adam Smith, the final aim of all production is to make goods and

services available for consumption and increase in consumption results in increase

in the level of satisfaction. Therefore, increase in the level of national output

leads to increase in the level of satisfaction of a society.

Adam Smith considered growth in National Physical product as the main

determinant of welfare.

But growth in Gross National Product (GNP) doesn't necessarily guarantee an

increase in welfare. So, his welfare criterion assumes existing income distributions

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as just and fair. However, growth in national income with greater income

inequalities may reduce social welfare.

A.1.2. BENTHAM'S CRITERION

Jeremy Bentham argued that welfare is improved when the greatest good is

secured for the greatest number. Welfare is the sum total of utility (welfare) of

all individuals in a society. According to this criterion, if say the society is

composed of three individuals, A, B and C

The total Welfare W is W= UA + UB+ UC where

UA = utility of individual A

UB = utility of individual B

UC = utility of individual C

And, welfare is improved as long as change in: - W (W) which is UA+ UB+ UC

should be greater that 0 (i.e. W>0), where = Change. But, this criterion has

serious shortcomings. Because:

 It is difficult to measure and add the utilities of individuals to obtain the

social welfare

 The welfare of most individuals may be negatively affected while change in W

is positive. Example, if UA and UB decrease and UA increase. But (UA+ UB <

UC), W will be greater than 0 while two out of three individuals are

relatively affected.

A.1.3. PARETO'S OPTIMALITY CRITERION

According to this criterion, any change which makes at least one individual

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 better off and no one worse off is an improvement in social welfare.

That is, social welfare is at its optimum when it is impossible to

make even a single person better off by reallocating productive

resources and consumers goods and services, without making

some one else worse off.

To understand this criterion is an easy, take the following simple example.

Suppose there are 3 individuals. Take you and two of your friends. To say welfare

is improved, at least the welfare of one of you should be improved and there

should be no one negatively affected. If two of you have gained and one lost, we

can't say that welfare is improved. This criterion is related to the concept of general

equilibrium of production and exchange. Let's see the following two cases.

A.1.4. HICKS- KALDOR COMPENSATION CRITERLON

In reality it may be difficult to improve the welfare of someone without affecting

the other. So, we may question the applicability of Pareto-optimality criterion to

the reality. To correct that, we introduce this compensation criterion.

 According to this principle, the person who benefits from an economic

policy or reallocation of resources must be able to compensate the

person who becomes worse- off due to this policy, and yet remain

better off. The compensations should, however, not exceed his benefit. To

understand this idea, assume that a change in the economy is being

considered which will benefit some (gainers) and hurt others (losers). So,

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 If the amount of money of the ' gainers' is greater than the amount of the 'losers',

the change

constitutes an improvement in social welfare. Those who could benefit from it

could compensate

those who are hurt, and still be left with some ' net gain'

Please take the following example: If a road is constructed in your surrounding

there will be some gainers and losers. To say that the construction of the road

improve welfare, those who gain (benefit) from the construction could

compensate the losers and still remain beneficial.

A.2 Externalities

Externalities are the effects of production or consumption

activities that are not directly reflected in the market.

 impose cost or benefits on external body but they are not taken into

account when decisions are made

 can arise between producers, between customers, or between

consumers and producers

 externalities can be divided into positive and negative

A.2.1. Positive Vs Negative Externalities

Positive externalities - arise when the action of one party benefits another

party.

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Example- Suppose- you are a florist (keeps a flower garden) and your neighbor is

a Beekeeper (has a beehive). You know that Bees use flowers as a feed. In this

case, you benefit the Beekeeper in your neighborhood. Yet, your decision about

flowering did not take the benefits for the beekeeper in to account. That is, you are

not paid for the benefits you provided.

The benefits are positive externality.

 If a road is constructed in a given area, House holds residing around that

road will benefit yet they don't pay for the benefits they get. This is

another case.

Negative Externalities- arise when the action of one party imposes costs on

another party.

Example- Suppose there is a steel plant (factory) in a given area. And there are

fishermen down stream that depend on the river for their daily catch. If the steel

plant dumps its waste into the rivers, the fisher men will be affected. It results a

decrease in the production of fish because of the waste.

The negative externality arises because the steel firm has no incentive to account

for the external cost that it imposes on fisher men when making its production

decision.

Let me add you one

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  If there is a night club in your surrounding, the noise will disturb (put

external cost) people in that area during the night.

 Externalities and inefficiency

Since externalities are not directly reflected in the market and not considered

when decisions are made, they affect efficiency. Let's see the effects of positive and

negative externalities one by one.

 Positive Externalities and inefficiency

Please consider the above example of the florist and beekeeper. Given the demand

curve of the florist (private Benefit) and marginal cost, the marginal social benefit

(MSB) is above the marginal Private benefit (MPB). MSB=MPB + MEB

MEB= Marginal External

Benefit
P
MC= Marginal cost of the florist

MPB= Marginal private benefit of the

florist

MSB= Marginal Social

P1 Benefit
MEB

MSB

MC Q

D=MPB

O q1 q*

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 From the side of the florist, since it doesn't consider the external benefit when

decision is made, it equates its private benefit with its cost. That is, using

Marginality rule (MR= MC), MPB=MC and it chooses to produce q1.

 But, this florist generates external benefits to the neighbors, as the marginal

external benefit (MSB) curve show. From the side of the society, by including

all benefits (MPB + MEB), what is important is MSB. Then, by equating MSB =

MC, the society chooses to produce q*.

Now, why the inefficiency arises? It is because the florist doesn't capture all

the benefits of its investment in flowering. As, a result it is producing only q1

while it had to produce q*. So, the under production (q*-q1) is the cause of the

inefficiency.

 Negative Externalities and Inefficiency

Once again consider the above example of the steel plant and the

fishermen.

Given the following graph, MC is the marginal cost of the steel plant

which doesn't include the external cost. But, the cost of producing

steel to the society (including fishery) is greater than the cost of the

private firm i.e. the Marginal social cost of steel production is greater

than the marginal cost (MC) of the firm.

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 MC= Marginal private cost of
Price the plant

cost MSC MSC= Marginal social cost

which considers the external
MC cost

MEC
MR

P B A

O qs qf
Q (output)

Suppose the production decision of the steel plant is in a competitive

market and remember also equilibrium occurs when marginal cost

equals marginal revenue. (MC = MR)

Now, from the side of the firm, equilibrium is at A when MC=MR and

maximizes profit by producing qf. But, from the side of the society, MC

is not the only cost MSC includes both MC and the external cost on

fishermen.

MSC = MC =MEC MEC= marginal External cost

So, qs - is the socially efficient output that could be produced including all costs (

production cost + external cost).

qf - is the profit maximizing output for the firm .

What do you observe from the above analysis?

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 While it should be produced qs amount of output by considering all costs, the

firm is producing qf amount of output by simply considering only its own

production cost.

 From the side of the society, too much output is produced.

The economic inefficiency is the excess production that causes too much out

put.(qf - qs ) is

the excess production due to negative externality i.e. by imposing cost and

ignoring it

when production decision is made.

A.3 PUBLIC GOODS

Public goods are goods characterized by non- rivalry and non -

excludability in consumption or use.

 A good is non- rival if providing it to an additional consumer doesn't

affect the amount available for others.

Example: The use of a high way (road) during a period of low traffic. In this case,

adding more cars up to capacity will not reduce what is available for others.

 A good is non- excludable if it is difficult or impossible to exclude some

one from using it, once the good is made available.

Example: Once a nation has provided for its national defense, all

citizens enjoy its benefits i.e. you can't be excluded from getting

defense service.
 While some of public goods are pure others are not.

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 A good is pure public good if it is both non- rival and non - excludable in

its nature at the same time.

E.g. National defense

 But, there may be public goods which are not- rival but exclusive,

non- excludable but rival.

The problem of Public Goods:

If a good can't be excluded, can you enforce payment? No. For instance, take

street lighting. Any one can't be excluded from using it so that you can't charge

payments. In this case, private investors get it unprofitable because they can't

charge prices so; public goods must either be provided by the government or

subsidized by the government.

 This is the reason why road, street lighting, defense, etc services are provided

by the government.

A.4 Asymmetric Information

In this section, we will discuss

 What asymmetric information is

 The problems caused by asymmetric information.

In our previous discussions, we have implicitly assumed symmetric information

that consumers and producers have complete information about the economic

variables that are relevant for the choices they face.

Asymmetric information arises when some parties know more than others.

 It is simply unequal access to information. You can guess what does

Symmetric information mean. It is the opposite of asymmetric

information
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In a number of markets, the sellers know much more about the quality of a good

than the buyers do. When the concerned parties have differential access to

information, we say the market is subject to asymmetric information.

What do you think is the effect of asymmetric information in the market?

Information asymmetry can cause serious problems to the efficiency with which

the market system operates. Under asymmetric information, decisions will involve

uncertainty that lead to market failure. At this level, to see how asymmetric

information can cause market failure, let us take two problems A) Adverse

selection and B) Moral Hazard.

A) Adverse Selection
In some markets, because of asymmetric information, the bad quality products

drive good quality out of the market. This scenario is called adverse selection.

Let's take an insurance market.

Suppose
 There is asymmetric information in insurance i.e. people who buy insurance

know much more about their general health than any insurance company can

hope to know, even if it insists on a medical examination. Then what will

happen?

 Yes, because unhealthy people are more likely to want insurance, the

proportion of unhealthy people in the pool of insured people increases.

 This forces the price of insurance to rise, so that more healthy people, realizing

their low risks, choose not to be ensured.

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 This further increases the proportion of unhealthy people, which forces the

price of insurance up more, until nearly all people who want to buy insurance

are unhealthy.

 Thus, selling insurance becomes unprofitable. So, adverse selection makes the

operating of insurance markets problematic.

B) Moral Hazard.
This is the other effect of asymmetric information. Let's again take the case of

insurance market.

 If the customer can influence the probability of occurrence of the insured

incident, the insurance market can be a victim of the problem of moral hazard.

 Moral Hazard arises when the customer changes his/her behavior after

purchasing insurance.

Example-1-: Please take your self. Suppose you bought insurance for your

property (House). And, compare the amount of care you give for your property

before and after you buy the insurance. In most of the cases, you put less effort in

caring for the property after you buy because you feel insured i.e. your behavior

changes. As a result, the insurance company might have to pay higher

compensations than expected because your behavior has changed. But, what

would be the case if these were equal information (that is, if there is symmetric

information)? It might give compensations for those who care for the property. In

the absence of equal information, the insurance company is affected because of

Moral Hazard.

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Example-2-: Take the workers’- managers’ relationship. Usually, the manager

can't perfectly monitor the behavior of workers (asymmetric information). Then,

because they are not monitored, their behavior may change and creates a problem

in their relationship.

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Assignment:

Maximum weight: 40%

1. Discus the factors responsible for existence of pure monopoly

2. How monopolist firms maximize its profit in the short run?
3. Discuses the digress of price discrimination activities of a monopolist
4. Why firms in pure monopoly exercise price discrimination?
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5. Suppose the monopolist faces the market demand function given by Q  .The
P2
AVC of the firm is given as AVC = Q ½ and the firm has a fixed cost of $ 5
a. determine equilibrium P&Q
b. determine the maximum profit
6. Assume a firm engaging in selling its product and proportional activities in
monopolistic competition face short run demand and cost function of Qd = 20 −
0.5P and TC = 4Q2 − 8Q + 15 respectively. Then:
a. Determine the optimum level of output and price in the short run
b. Calculate the optimum profit(loss) the firm will earn(incur)
7. If the inverse demand function of a monopolist firm be given by p = 30 − 5Q and
also its average cost be: ATC = 20⁄Q + 4Q − 6. Then:

a. Compute the optimum level of output and price in the short run
b. Calculate the optimum profit
8. How collusive oligopoly differs from non-collusive oligopoly?
9. Graphically derive the equilibrium condition of Bertrand and Stackleberg’s Duopoly
model
10. Discuses types of collusive oligopoly market strictures
11. Explain the process by which economic profits are eliminated in a monopolistically
competitive market as compared to a perfectly competitive market.
12. What is the essential difference between the Cournot and Stackelberg models
13. Assume that a two-firm duopoly dominates the market for spreadsheet application
software, and that the firms face a linear market demand curve of P = 1,250 – Q
where P is price and Q is total output in the market (in thousands) . Thus Q = QA +

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 QB. For simplicity, also assume that both firms produce an identical product, have no
fixed costs and marginal cost MCA = MCB = 50. Then,
a. Derive the output reaction curves for Firms A and B.
b. Calculate the Courtnot market equilibrium (price-output solutions).
14. Derive mathematically the relationship between MPPL and VMPL(single-variable
case)
15. Suppose the monopolist faces a market demand function given by P=10-Q The firm
has a total cost of TC=4 Q2 + 10 and determine:
a. The profit maximizing unit of output and price
b. The maximum profit
16. If the total cost function of a firm is given by C = 200 + 10Q + 5Q2 – 2Q3 and the
market clearing price be 100 Br per unit of output the find
A, the level of output that maximizes firm’s profit
B, the shutdown level of output
C, what shall do the firm if the price falls to 50 Br per unit of output?
17. What is the difference between monopolistic completion and perfect completion
market structure?
18. Show mathematically that MR is below the demand curve in the case of pure
monopoly
19. Suppose the cost of production for a firm be given by: 𝐶 = 11 − 2𝑄 + 5𝑄 2
where, C & Q stands for cost and level of output respectively. Then,
a. what will be the level of output that maximizes the firm’s profit if market price for the
good be 28 units
b. compute the total profit at this optimum output level
20. If the cost function of perfectly competitive firm is given by: C= a + bQ –cQ2
then the firm will enjoy maximum profit if it sales ----- amount of Q at price p =
1
b.
2

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