Microeconomics-II-English-Version-munotes

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MODULE I

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INTRODUCTION TO GAME THEORY

Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Basic Concepts
1.3 Duopoly Price War
1.4 Alternative Strategies
1.5 Dominent Strategy
1.6 Nash Equilibrium
1.7 A Zero -Sum Game
1.8 A Non -Zero -Sum Game
1.9 Prisoner‟s Dilemma
1.10 Normal form Game
1.11 Extensive Form Game
1.12 Sub-Game Perfections
1.13 Questions

1.0 OBJECTIVES
 To understand the various concepts of games.
 To know the meaning of Prisoner‟s Dilemma.
 To study the concept of duopoly price war.

1.1 INTRODUCTION
In a climate of uncertainty, economic decision making involves strategy.
Every firm needs to find out as to how other firms will react to price and
output decisions. Will there be a price war and if so, would it lead to
losses. Will bargaining with the workers union would end in a stalemate
and strike. The making of the Union budget involves a lot of bargaining
between the various stake holders in the society. The trade unions,
associations of commerce and industry, consumer groups, political parties
and other interest groups get involved in influencing the budget. The study
of economic games that these stake holders play is known as Game
Theory. Econo mic decision making thus involves uncertainty and strategy. munotes.in

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Game theory is an important branch of economic theory and analysis that
provide many insights into the behavior of economic agents in situations
where there is an actual or potential conflict of i nterest. It is an approach
to analyzing rational decision making behavior in interactive or conflict
situations. Game theory analyses the way that two or more players or
parties choose actions or strategies that jointly affect each participant. The
elem ent of game arises because the outcome depends not only on the
choices made by one player but also on what other players choose to do at
the same time. This theory was developed by John von Neumann
(1903 -57) and Oskar Morgenstern in their work “The Theory of
Games and Economic Behavior”. Game theory has been used by
economists to stu dy the interaction of duopoly , monopolistic and
oligopoly firms, union management disputes, trade policies etc.

1.2 BASIC CONCEPTS
According to Walter Nicholson , a game is a situation in which
individuals must make decisions and in which final outcome will depend
on what each person decides to do. In a game , agents aim to maximize
their own pay -off by choosing specific actions but the actual outcome
depends on what all other players do. The game consists of a specified
interactive playing field, a specification of all possible courses of action
and a schedule of the pay -offs to each of the players under all possible
outcomes. Players plan their own courses of action in order to maximize
their expected payoff, under the knowledge that the other players are
trying to do the same. Any game has three basic elements. They are:
the players, the list of possible actions or strategies available to each
player and the payoffs the play ers receive for each possible
combination of strategies. The player in the game theory is the decision
maker. Firms are considered to be players in oligopoly markets. The
number of players is generally fixed throughout the game and some games
have a fixed number of players. Strategy refers to a course of action
available to a player in a game. Generally players do not have too many
options as far as strategy is concerned. Payoffs refer to final outcomes to
the players at the end of the game.

A player‟s str ategy is a complete specification of the actions to be taken in
response to outcomes that are found as the game proceeds. A player‟s pay -
off from choosing a strategy depends on what the other players do but
players cannot make binding agreements with each other. Given the
strategies of all the players, there will be a set of possible outcomes to the
game. These determine the potential pay -offs for each of the players. A
specific outcome is called equilibrium if no player can take actions to
improve his own pay-off while all other players continue to follow
their optimal strategies. In order to select the best strategy, a player must
know what other players will do but they in turn must also know every
player will do. In strategic game, players choose their moves
simultaneously. Whenever the choices are discrete and finite, the game munotes.in

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can be represented in the structure of a table which sets out the outcomes
for each player depending on what the other players do. In an extensive
game, players make moves in some order and hence the analysis of the
game needs a specification of the pay -offs and information at each point in
time. Real business interactions are similar to an extensive game, as firms
interact dynamically over a period of time. However, whenever the p recise
timing of moves is not essential to the outcome, a game can be represented
as a normal game. A game that is played only once is a „one -shot-game‟.
Repeated games open possibilities of learning and of acting in order to
punish or reward the other pl ayers. A super -game is a game that is
repeated many times.

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

1.3 DUOPOLY PRICE WAR
Let us assume that you are the head of Daffodils, a departmental store
whose motto is “We will not be undersold”. Your rival Lilies, runs an
advertisement, “We sell f or ten per cent less”. Figure 1.1 shows the
dynamics of price cutting. The vertical arrows shows Lilies price cuts, the
horizontal arrows shows Daffodils responding strategy of matching each
price cut. Notice that the pattern of reaction and counter -reaction will end
up in a zero price because the only price compatible with both strategies is
a zero price. Lilies ultimately realize that when it cuts its price, Daffodils
will match the price cuts. Now you will begin to ask what Lilies will do if
you charge price A, B, C etc. Once you begin to consider how others will
react to your actions, you have entered the arena of Game Theory.
Fig.1.1 - Price War


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Duopoly is a situati on where the market is supplied by two firms that are
deciding whether to engage in price war and destroy themselves. Let us
assume for the sake of simplicity that both the firms have the same cost
and demand structure. Further, each firm can choose wheth er to charge its
normal price or lower its price below the marginal costs and drive away
the rival. In this duopoly game, the firm‟s profits will depend on its
strategy and that of its rival‟s. The interaction between the two firms or
people is represented by a two -way pay -off table. A pay -off table is a
means of showing the strategies and the pay -offs of a game between two
players. Figure 1 .2 shows the pay -offs in the duopoly price game for our
two stores. In the pay -off table, a firm can choose between th e strategies
listed in its rows or columns. For example, Lilies can choose between its
two columns and Daffodils can choose between its two rows. Here, each
firm decides whether to charge its normal price or to begin a price war by
choosing a low price.

Fig. 1.2 – A Pay -off Table for Price War.


By combining the two decisions of each Duopoly firm gives four possible
outcomes which are shown in the four cells of the table. The number in the
lower left shows the pay -off to Daffodils and the numbers in the upper
right shows the pay -off to Lilies.



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1.4 ALTERNATIVE STRATEGIES
In Game theory, you are required to think through the goals and actions of
your opponent and to make your decisions based on your opponent‟s goals
and actions. While yo u think through your opponents, you must remember
that your opponent will also be trying to outwit you. The following is the
guiding philosophy in Game theory:
“Choose your strategy by asking what makes most sense for
you assuming your opponent is analyzing your strategy and
acting in his best interest.”

Let us apply this philosophy to the Duopoly example. Note that both the
firms have the highest joint profits in outcome A. Each firm earns Rs.10
when both follow a normal price strategy. At the ot her end is price war
where each cuts prices and runs a big loss. Between the two extreme ends,
there are two interesting strategies where only one firm engages in price
war. In outcome C, Lilies follow a normal price strategy while Daffodils
engages in a p rice war. Daffodils take away most of the market but makes
heavy losses because it is selling below cost. Lilies‟ is better -off selling at
normal prices rather than responding and as a result, his loss is only Rs.10
against a loss of Rs.100 made by Daffod ils.

1.5 DOMINANT STRATEGY
To begin with the game, one must know whether each player has a
dominant strategy. This situation arises when one player has a best
strategy no matter what strategy the other player follows. In the price war
game example, cons ider the options open to Daffodils. If Lilies conducts
business as usual with a normal price, Daffodil will get Rs.10 profit if it
plays the normal price and will lose Rs.100 if it declares price war. On the
other hand, if Lilies starts a price war, Daffo dils will lose Rs.10 if it
follows the normal price but will lose more if it also engages in price war
i.e. Rs.50. The same logic holds true for Lilies. Therefore, no matter what
strategy the other firm follows, each firm‟s best strategy is to have the
normal price. Charging the normal price is a dominant strategy for both
firms in the price war game.

A strategy is a dominant strategy for a player if its outcome or pay -off is
most favorable given the available alternative strategies irrespective of
what hi s competitor does. When both players have a dominant strategy, we
say that the outcome is a do minant equilibrium. In Figure 1 .2 above,
outcome A is a dominant equilibrium because it arises from a situation
where both firms are playing their dominant strate gies.

1.6 NASH EQUILIBRIUM Most interesting situations do not have a dominant equilibrium. We can
use our duopoly example to find this out. In a game of rivalry, each firm munotes.in

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considers whether to have its normal price or a monopoly price and earn
monopoly p rofits. The game of rivalry is shown in Figure 1 .3.

The firms can decide on the normal price equilibrium as found in the price
war game or they can raise their price to earn monopoly profits. Notice
that both the firms have the highest joint profits in Cell „A‟ where they can
earn a total of Rs.300 when each follows a high price strategy. Situation
„A‟ can emerge if th e firms collude and set the monopoly price. At the
other extreme is the competitive strategy of normal price where each rival
has profits of only Rs.10. In between the two extremes there are two
interesting strategies where one firm chooses a normal price and the other
one a high price strategy. In Cell „C‟, Lilies follows a high price strategy
but Daffodils‟ undercuts. Daffodils‟ take away most of the market and has
the highest profit from any of t he four situations and Lilies l oses money.
In Cell „B‟, Da ffodils gambles on high price but Lilies normal price means
a loss for Daffodils. In this example, Daffodils has a dominant strategy. It
will profit more by choosing a normal price no matter what Lilies does.
On the other hand, Lilies does not have a do minant strategy because Lilies
would want to play normal if Daffodils plays normal and would want to
play high if Daffodils play high. Lilies‟ has an interesting dilemma.
Should it play high and hope that Daffodils will follow or play safe by
playing norm al.

Fig 1.3 The Game of Rivalry (Should a Duopoly Try the monopoly price)


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By thinking through the pay -offs, it becomes clear that Lilies should play
the normal price. The reason is that Lilies should start by putting itself in
Daffodils‟ shoes. Not ice that Daffodils‟ will play normal price no matter
what Lilies does because that is Daffodils dominant strategy. Therefore
Lilies should find its best action by assuming that Daffodils will follow his
best strategy which immediately leads to Lilies play ing normal. This
illustrates the basic rule of Game theory: “You should set your strategy
on the assumption that your opponent will act in his best interest.”

The solution is called the Nash equilibrium after mathematician John
Nash who developed the conc ept in the 1950s and won the Nobel Prize in
Economics in 1994 for his contributions to the Game theory. A Nash
equilibrium is one in which no pla yer can improve his or her pay -off
given the other player‟s strategy. That is, given player „A‟s strategy,
player „B‟ can do no better and vice -versa. Each strategy is a best
response against the other player‟s strategy. The Nash equilibrium is
called the non -cooperative equilibrium because each party chooses
that strategy which is best for itself without collusio n or co -operation
and without regard for the welfare of society or any other party.
According to Nash theorem, every game with a definite number of players
and a definite nu mber of strategies would at least have one „Nash
equilibrium ‟. However, in order to hold the Nash theorem to be true, the
strategies available must have some random element to them. A strategy
with some random element is known as a mixed strategy. There may be
multiple Nash equilibrium and it may not be clear as to which one will
arise . Further, it is generally true that the Nash equilibrium is not the
global optimum i.e. if players could co -operate they could all become
better off. A game theory framework can help us understand the strategic
choices available but it does not always hel p predict which of many
possible outcomes may occur.

Nash Equilibrium In Pure Strategies :
When a player adopts a single strategy and holds on to it, it is known as a
pure strategy. However, if the player uses two or more strategies in order
to keep his opponents guessing, it is known as a mixed strategy. The
situation of a pure strategy is deterministic because there is no change in
the strategy whereas in the case of a mixed strategy, it is probabilistic
because each strategy from the bundle has a proba bility of being picked
up. On the basis of total gain or total loss, games are classified into zero -
sum and non -zero-sum games. When there are two competitors in a game,
it is called a two -player game and when the number of player are more
than two, it is called a n -player game.

1.7 A ZERO -SUM GAME
In a zero -sum game, one man‟s gain is equal to another man‟s loss i.e. the
sum of a positive number (gain) and that of a negative number (loss) is
equal to zero. The Pay -off Matrix in a zero -sum game of Loca l Body munotes.in

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Elections is presented in Figure 1.4 . Figures in the cells shows pay -offs to
the two candidates Anil and Sunil. Positive signs show gains whereas
negative signs show losses. These two candidates have two strategies i.e.
Social Workers campaigning o r Businessmen campaigning for their
elections. If both the candidates use Social Workers for their campaigning,
the outcome is zero i.e. nobody gains or lo ose as shown in Cell „A‟ . The
top right cell or Cell „B‟ in the matrix shows that Anil‟s pay -off or gain of
votes is 3000 with his strategy of using social workers for the campaign as
against Sunil‟s strategy of using Businessmen. The bottom left and right
cells i.e. Cells „C‟ and „D‟ indicate that Anil‟s pay -off for using the
strategy of Businessmen is -2000 and -1000 i.e. loss of 3000 votes to Sunil
for his strategy of using social workers and businessmen. In this game,
gains made by Sunil are at the expense of Anil i.e. (+3000) + ( -3000) = 0.
In this game, Cell „A‟ shows the dominant strategy equi librium.
Figure No. 1.4 – The Payoff Matrix for a Local Body Elections
(Zero -sum Game) Sunil Social Workers Campaign Businessmen Campaign A 0 B +3000 C -2000 D -1000
1.8 A NON -ZERO -SUM GAME
In a non -zero-sum game, the sum of one player‟s gain and the loss of the
competitor is non -zero. In the Oligop olistic game played in Figure 1.5 , the
outcome is a non -zero-sum outcome. There are two firms, namely:
Daffodils and Lilies. Both the firms have two strategies i.e. no rmal price
and mo nopoly price . If either firm follows a monopoly price strategy, both
gains better pay -offs i.e. from Rs.100 to Rs.600 each, shown in cell „D‟ or
the bottom right cell. Cell „D‟, however, indicates collusive or cooperative Businessmen Campaign Anil Social Workers Campaign munotes.in

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equilibrium. If one of the firms m aintains normal price and the other a
high price, the one who follows a normal price strategy gains Rs.900 i.e.
from Rs.100 to Rs.1000 whereas the one who follow a high price strategy
suffers a loss of Rs.60 i.e. from Rs.100 to Rs.40 as shown in Cell „B‟ . The
sum of the changes in the pay -offs of the two firms is non -zero because
the total profit to be earned is not fixed like the total number of votes in
the game of Local Body elections. Cell „A‟ shows that both the firms have
a dominant strategy to charge a normal price and earn Rs.100 each. Cell
„A‟ also shows Nash Equilibrium given its definition because the
strategies are reciprocal and the pay -offs are equal.

As against a game of rivalry, in a cooperative or collusive game, the
players are assumed to be rational to understand that their mutual interest
is in cooperation and not in competition. In a game of cooperation, at least
one of the players will benefit without causing a loss to the other. In a
non-cooperative game or a game involving rivalry, the players do not
cooperate with each other for want of communication . The prisoners‟
dilemma explained in Table 1.3 is an example of non -cooperative game.

Figu re No. 1.5 – The Payoff Matrix in a Game of Rivalry
(Non -zero-sum Game)
Lilies Normal Price High Price A* Rs.100 Rs.100 B Rs.40 Rs.1000 C Rs.1000 Rs.40 D Rs.600 Rs.600
1.9 PRISONER‟S DILEMMA In the prisoner‟s dilemma, when each player chooses his dominant
strategy, the result is unfavorable to both the players. There are two High Price Daffodils Normal Price munotes.in

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prisoners, Anil and Sunil who are locked up in separate cells for
committing a crime. However, the prosecutor has limited hard evidence to
convict them for a minor offence for which the punishment is one year
imprisonment. Each prisoner is to ld that if one admits while the other
remains silent, the confessor will be let off without being imprisoned and
other one will be jailed for 20 years. If both the prisoners confess, they
will be jailed for only five years. The two prisoners are not allow ed to
communicate with each other. The payoffs to the prisoners are shown in
Figure 1.6 .
Figure No. 1.6 – The Payoff Matrix for a Prisoner‟s Dilemma Anil Confess Remain Silent A 5 Years for each B Zero years for Sunil 20 years for Anil C 20 years for Sunil Zero years for Anil D 1 year for each
In this game, the dominant strategy for both the players is to confess
irrespective of the strategy pursued by the other as shown in Cell „A‟ .
Irrespective of Anil‟s strategy, Sunil will get a lighter sentence by
confessing. If Anil admits to the crime, Sunil will get five years ( Cell „A‟)
instead of 20 (C ell „C‟). If Anil remains silent, Sunil will be let off ( Cell
„B‟) instead of spending a year in jail ( Cell „D‟). As the payoffs are
perfectly symmetric, Anil will also be happy to confess irrespective of
what Sunil does. The difficulty is that when each follows his dominant
strategy and confesses, both will do worse than if each had shown
restraint. When both confesses, each get five years ( Cell „A‟) instead of
the one year they would have gotten by remaining silent ( Cell „D‟). The
choices before the prisoner‟s exemplify a dilemma in which the prisoners
have to make a choice between two evils i.e. to confess or to remain silent.

Oligopoly firms face similar dilemma when they introduce monopoly
price as against the price set by the rival. The oligopoly firms need to
decide as to whether they should compete or cooperate. There is however
differ ence in the situation explained by prisoners‟ dilemma and the
oligopoly situation. The prisoners here have only one chance to choose a
strategy whereas the oligopoly firms have more than one chance to choose Confess Remain Silent Sunil munotes.in

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their strategies. They have the opportunity, lea rn, unlearn and relearn and
hence the probability of collusion or cooperation is high amongst
oligopoly firms. Oligopoly firms may also decide to compete and get
involved in a price war in order to increase their market shares. However,
the existence of a kinked demand curve only proves the existence of price
rigidity or price stability in the oligopoly market. Further, the existence of
Carters and Price Leader firms and price signaling mechanism only proves
that there is a desire for stability amongst the oligopoly firms.

1.10 NORMAL FORM GAME.
A normal form game or a n -player game is any list G = (S1,...,Sn;
u1,...,un), where, for each i ∈ N = {1,...,n}, Si is the set of all strategies
that are available to player i, and ui : S1 × ... × Sn → R is player i‟s von
Neumann -Morgenstern utility function. A player‟s utility depends not only
on his own strategy but also on the strategies played by other players.
Moreover, ui is a von Neumann -Morgenstern utility function so that play er
„i‟ tries to maximize the expected value of ui (where the expected values
are computed with respect to his own beliefs). Here, player i is rational if
he tries to maximize the expected value of ui (given his beliefs). It is also
assumed that it is commo n knowledge that the players are N = {1,...,n},
that the set of strategies available to each player i is Si, and that each i tries
to maximize expected value of ui given his beliefs. When there are only 2
players, we can represent the (n ormal form) game by a bi-matrix as shown
below.



Here, Player 1 has strategies up and down, and player 2 has the strategies
left and right. In each box the first number is 1‟s payoff and the second
one is 2‟s (e.g., u1 (up, left) = 0, u2 (up, left) = 2).

1.11 EXTENSIVE FORM GAMES
The extensive form contains all the information about a game, by defining
who moves when, what each player knows when he moves, what moves
are available to him, and where each move leads to, etc.

A tree is a set of nodes and directed edges c onnecting these nodes such
that 1) for each node, there is at most one incoming edge; 2) for any two
nodes, there is a unique path that connect s these two nodes. Imagine the
branches of a tree arising from the trunk. For example , Figure 1.7 is a tree.

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Figure No. 1.7


However, figure 1.8 shown below is not a tree because there are two
alternative paths through w hich point A can be reached (through B and
through C). So also, the figure is not a tree either since A and B are not
connected to C and D .
Figure No. 1.8


Figure No. 1.9

An extensive form Game consists of a se t of players, a tree, an allocation
of each node of the tree (except the end nodes) to a player, an
informational partition, and payoffs for each player at each end node. The
set of player s will include the agents taking part in the game. However, in
many games there is room for chance, e.g. the throw of dice in
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backgammon or the card draws in poker. One need to consider the
“chance” whenever there is uncertainty about some relevant fact. T o
represent these possibilities a fictional player such as Nature is introduce d.
There is no payoff for Nature at end nodes, and every time a node is
allocated to Nature, a probability distribution over the branches that follow
needs to be specified, e.g., Tail with probability of 1/2 and Head with
probability of 1/2. An information set is a collection of points (nodes)
{n1,...,nk} such that 1) the same player i is to move at each of these nodes;
2) the same moves are available at each of these nodes. Here the player i,
who is to move at the information set, is assumed to be unable to
distinguish between the points in the information set, but able to
distinguish between the points outside the information set from those in it.
For instance, consider the game in Figure 1 .10. Here, Player 2 knows that
Player 1 has taken action T or B and not action X; but Player 2 cannot
know for sure whether 1 has taken T or B. The s ame game is depicted in
Figure 1.11 slightly differently. An information partition is an allocat ion
of each node of the tree (except the starting and end -nodes) to an
information set.
Figure No. 1.10

Figure No. 1.11

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To conclude, at any node, it is well known as to which player is to move,
which moves are available to the player, and which information set
contains the node, summarizing the player‟s information at the node. If
two nodes are in the same information set, the available moves in these
nodes must be the s ame, for otherwise the player could distinguish the
nodes by the available choices. And all these are assumed to be common
knowledge. For instance, in the game in Figure 1 .10, player 1 knows that,
if he takes X, player 2 will know this, but if he takes T o r B, player 2 will
not know which of thes e two actions has been taken. ( he will know that
either T or B will have been taken ).

1.12 SUB -GAME PERFECTION.
A smaller game that is part of an extensive form game is called a sub -
game. When backward induction is restricted to a sub -game, the
equilibrium computed for the main game, remains equilibrium for the sub -
game also. Sub -game perfection generalizes this idea to general dynamic
games. Nash equilibrium is said to be sub -game perfect if it is so in every
sub-game of the game. A sub -game must be a well defined game when it
is considered individually. The sub -game must have an initial node and all
the moves and information sets from that node must remain in the sub -
game.

In game theory , a sub-game perfect eq uilibrium is a refinement of a Nash
equilibrium used in dynamic games . A strategy profile is a sub -game
perfect equilibrium if it represents a Nash equilibrium of every sub-game
of the original game. Informally, this means that at any point in the game,
the players' behavior from that point onward should represent a Nash
equilibrium of the continuation game (i.e. of the sub -game), no matter
what happened before. Every finite extensive game with perfect recall has
a sub -game perfect equilibrium. Perfect reca ll is a term introduced by
Harold W. Kuhn in 1953 and "equivalent to the assertion that each player
is allowed by the rules of the game to remember everything he knew at
previous moves and all of his choices at those moves" .

A common method for determini ng sub -game perfect equilibrium in the
case of a finite game is backward induction . Backward induction is the
process of reasoning backwards in time, from the end of a problem or
situation, to determine a sequence of optimal actions. It proceeds by
examin ing the last point at which a decision is to be made and then
identifying what action would be most optimal at that moment. Using this
information, one can then determine what to do at the second -to-last time
of decision. This process continues backwards u ntil one has determined
the best action for every possible situation (i.e. for every possible
information set ) at every point in time. Backward induction was first used
in 1875 by Arthur Cayley , a British Mathematician. Here one first
considers the last a ctions of the game and determines which actions the
final mover should take in each possible circumstance to maximize his/her
utility . One then supposes that the last actor will do these actions, and munotes.in

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considers the second to last actions, again choosing those that maximize
that actor's utility. This process continues until one reaches the first move
of the game. The strategies which remain are the set of all sub -game
perfect equilibrium for finite -horizon extensive games of perfect
information. However, backward induction cannot be applied to games of
imperfect or incomplete information because this entails cutting through
non-singleton information sets .

For example, determining the sub -game perfect equilibrium by using
backward induction is shown below in Figure 1.12. Strategies for Player 1
are given by {Up, Uq, Dp, Dq}, whereas Player 2 has the strategies among
{TL, TR, BL, BR}. There are four sub -games in this example, with 3
proper sub -games.
Figure No. 1.12

A Sub -game Perfect Equilibrium.

Using the backward induction, the players will take the following actions
for each sub -game:
1. Sub-game for actions p and q: Player 1 will take action p with payoff
(3, 3) to maximize Player 1's payoff, so the payoff for action L becomes
(3,3).
2. Sub-game fo r actions L and R: Player 2 will take action L for 3 > 2, so
the payoff for action D becomes (3, 3).
3. Sub-game for actions T and B: Player 2 will take action T to maximize
Player 2's payoff, so the payoff for action U becomes (1, 4).
4. Sub-game for acti ons U and D: Player 1 will take action D to maximize
Player 1's payoff.
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Thus, the sub -game perfect equilibrium is {Dp, TL} with the payoff (3, 3).
1.13 QUESTIONS
Q1. Write a note on Prisoners‟ Dilemma.
Q2. Explain how Nash equilibrium is achieved in pure and mixed
strategies.
Q3. Write a note on normal and extensive form games.
Q4. Write a note on Sub -game Perfection .



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2
RISK AND UNCERTAINTY

Unit Structure
2.0 Objectives
2.1 Introduction
2.2 Uncertainty and Choice under uncertainty
2.3 Measures of Risk Aversion
2.4 Summary
2.5 Questions
2.6 References

2.0 OBJECTIVES
To learn and understand the concept of risk in brief and the concept of
uncertainty in details. In this we will study the behaviour of a rational
consumer under uncertainty and how he makes a choice under
uncertainty. You wil l study the behaviour of risk -avers, risk -neutral
and risk-loving people. You will learn to study the use of tables,
equations and graphs to study this behaviour

2.1 INTRODUCTION
Many of the choices that people make involve considerable
uncertainty. Sometimes we need to choose between risky ventures. For
example, what should we do with our savings? Should we invest in
something safe, such as a bank savings account, or something riskier
but more lucrative, such as the stock markets? Another example is the
choice of a job or a career. Is it better to wor k for a large, stable
company where job security is good but the chances of advancement
are limited, or to join a new venture, which offers less job security but
quicker advancement?

To answer these questions, we must be able to quantify risk so as to be
able to compare the riskiness and alternative choices. We must see
how people can deal with risk or reduce risk — by diversification, by
buying insurance, etc. or by investing in additional information. In
different situations, people must choose the amou nt of risk they wish to
bear. To analyse risk quantitatively, we need to know all possible
outcomes of a particular action and the likelihood that each outcome
will occur.

2.2 UNCERTAINTY AND CHOICE UNDER UNCERTAINTY
Very often we have to select from a number of alternatives which
differ in the risk the consumer has to bear. This is seen in cases like munotes.in

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insurance and gambling. When you take insurance policy (say for a fire
in your house or car theft), you lose your premi um (a small amount) to
avoid the risk of losing your house or a car (a large value). However,
this situation may or may not occur. The loss of say house is probable
and therefore uncertain. But it is certain that you lose your premium
when you have paid it . Here we prefer certainty of small loss to
uncertainty of a large loss.

The risk refers to a situation when the outcome of a decision is
uncertain but whe re the probability of each possible outcome is known
or can be estimated. The greater the variability of possible outcome,
the greater the risk involved in making the decision.

The uncertainty refers to the situation where there is more than one
possible o utcome of a decision but where the probability of occurrence
of each particular outcome is not known or even cannot be estimated.

Many of the choices that people make involve considerable
uncertainty.

Sometimes we need to choose between risky ventures.

For example, what should we do with our savings? Should we invest in
something safe, such as a bank savings account, or something riskier
but more lucrative, such as the stock markets? Another example is the
choice of a job or a career.

Is it better to work for a large, stable company where job security is
good but the chances of advancement are limited, or to join a new
venture, which offers less job security but quicker advancement?

To answer these and such questions, we must be able to quantify risk
so as to be able to compare the riskiness and alternative choices.

People deal with risk or reduce risk — by diversification, by buying
insurance, etc. or by investing in additional information. In different
situations, people must choose the amount of ri sk they wish to bear.
For the quantitative analysis of risk we need to know all possible
outcomes of a particular action and the likelihood that each outcome
will occur. Following methods are used like

Probability:
Probability refers to the likelihood that an outcome will occur. Suppose
the probability that the oil exploration project is successful might be
1/4, and the probability that it is unsuccessful 3/4. Probability could be
objective and subjective. Objective probability relies on the frequency
with which certain events have occurred. Suppose we know from our
experience that, of the last 100 offshore oil explorations, 1/4 have
succeeded and 3/4 have failed. Then the probability of success of 1/4 is
objective be cause it is based on the frequency of similar experiences.

If we toss an unbiased coin, we would obtain two outcomes namely
head and tail. If we toss a coin for quite good number of times there are munotes.in

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say 50% or ½ chances of getting head or 50% or 1/2 chance of getting
tail. Here the sum of the probabilities of all possible outcomes would
be equal to 1. In case of tossing a coin, it is ½ + ½= 1.

In another example, let us assume that a person, from th e shares of a
company, has got 50% dividend in 5% periods, 30% dividend in 60%
periods and 10% dividend in 35 percent periods. Here the three rates of
dividend, 50,30 and 10 are exhaustive. Thus , in this case, the
probability of getting a dividend of 50% i s 5% or1/20, that of getting
dividend of 30% is 60% or 12/20 and the probability of getting a
dividend of 10% is 35% or 7/20, here
1/20+ 12/20+ 7/20 = 1 .

But what if there are no similar past experiences to help measure
probability? In these cases, objective measures of probability cannot be
obtained, and a more subjective measure is needed. Subjective
probability is the perception that an outcome will occu r and the
perception is based on a person’s judgment or experience, but not on
the frequency of outcome observed in the past.

Whatever be the interpretation of probability, it is used to calculate two
important measures that help us describe and compare r isky choices.
One measure tells us the expected value and the other variability of the
possible outcomes.

Expected Value:
The expected value of an uncertain event is a weighted average of the
values associated with all possible outcomes, with the probabilities of
each outcome used as weights. The expected value measures the
central tendency. In the above example, dividend is a variable -its three
values are 50%, 30% and 10% and their probabilities are 1/20, 12/20
and 7/20 respectively. In this cas e the expected value of the dividend is
(1/20×50 + 12/20×30+7/20× 10) % or 24%.

In another example Suppose we are considering an inve stment
proposal in an offshore oil company with two possible outcomes:
success yields a payoff of £40 per share, while failure yields a payoff
of £20 per share.

The expected value in this case is given by:
Expected Value = Pr (success) (£40/share) + Pr (failure) (£20/share)
= 1/4 (£40/share) + 3/4 (£20/share) = £25/share.

More generally, if there are two possible outcomes having pay offs
X1 and X 2, and the probabilities of each outcome are given by Pr and
Pr2, then the expected value E(X) is: E (X) = Pr1X1 + Pr 1 X2 …………..
(1)

Variability:
The variability or dispersion of a variable is the extent to which its
values are dispersed or scattered. For example, if the first set of values
of variable are 30,35,40,45, and 50 and second set of values of munotes.in

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variables are 5,10, 30, 50 and 70. It is clear that the variability of
second set is greater than the first one. Significance of variability,
small or large, is important and is different in different cases. Suppose,
the first set of values is the runs of a particular cricketer in five
different matches and second set of values is runs in five matches of
second cricketer. Here the significance of smaller variability in the first
case and higher variability in the second case is that the first player is
more consistent performer than the second player.

Suppose we are choosing between two sales jobs that have the same
expected income (£1,500). The first is based on commission. The
second job is salaried. There are two equally likely incomes under the
first j ob — £2,000 for a good sales effort and £1,000 for a moderate
effort. The second job pays £ 1510 most of the time, but would pay
£510 in severance pay if the business goes burst.


The two jobs have the same expected income because .5 (£2,000) + .5
(£1,000) = .99 (£1,510) + 0.1 (£510) = £1,500. But the variability of
the possible payoffs is different for the two jobs. The variability can be
analysed by a measure that presumes that la rge differences between
actual payoffs and the expected payoff, called deviations,

Following Table gives the deviations of actual incomes from the
expected income for the two sales jobs:

Table No. 2.1 Deviations from Expected Income £ Job 1 Job 2 Outcome 1 Deviation Outcome 2 Deviation 2,000 500 1,000 500 1,510 10 510 990
In the first job, the average deviation is £500:
Thus , Average Deviation = .5 (£500) + .5 (£500) = £500

For the second job, the average deviation is calculated as:
Average Deviation = .99 (£10) + .01 (£990) = £19.80

The first job is, thus, substantially more risky than the second as the
average deviation of £500 is much greater than the average deviation
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of £19.80 for the second job. The variability can be measured either by
the variance which is the average of the squares of the deviations of the
payoffs associated with each outcome from their expected value or by
the standard deviation (σ2) which is the square root of the variance.

The average of the squared deviations under job 1 is given by:
Variance (σ2) = .5 (£2, 50,000) + .5 (£2, 50,000) = £2, 50,000

The standard deviation is equal to the square root of £2, 50,000 or
£500.

Similarly, the average of the squared deviations under Job 2 is given
by:
Variance (σ2) = .99 (£100) + .01 (£9, 80,100) = £9,900.

The standard deviation (a) is the square root of £9,900 or £99.50. We
use variance or standard deviation to measure risk, the second job is
less risky than the first. Both the variance and the standard deviation of
the incomes earned are lower. The concept of variance applies equally
well when there are many outcomes rather than just two.

Decision -making:
Suppose we are choosing between the two sales jobs described above.
What job should we take? If we dislike risk; we will take the second
job. It offers the same expected return as the first but with less risk.
Now suppose we add £100 to each of the payoffs in the first job, so
that the expected payoff increases from £1,500 to £1,600.

The jobs can then be described as:
Job 1: Expected Income = £1,600 Variance = £2, 50,000
Job 2: Expected Income = £1,500 Variance = £ 9,900

Job 1 offers a higher expected income but is substantially riskier than
job 2. Which job is preferred depends on us. If we are risk -lovers, we
may opt for the higher expected income and higher variance, but a risk -
averse person might opt for the second. We need to develop a
consumer theory to see how people might decide between incomes that
differ in both expected value and in riskiness.

Choice unde r Uncertainty: Preference towards Risk:
We use the above job example to describe how people might evaluate
risky outcomes, but the principles apply equally well to other choices.
Here we concentrate on consumer choices generally, and on the utility
that co nsumers derive from choosing among risky alternatives.

To simplify matters, we will consider the consumption of a single
commodity, say, the consumer’s income. We assume that consumers
know probabilities and that payoffs are now measured in terms of
utility rather than money.

Fig. 5.1(a) shows how we can describe one’s preferences towards risk.
The curve OB gives one’s utility function, tells us the level of utility munotes.in

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that one can attain for each level of income. The level of utility
increases from 10 to 16 to 18 as income increases from £10,000 to
£20,000 to £30,000.

However, the marginal utility diminishes from 10 when income
increases from 0 to £10,000, to 6 when income increases from £10,000
to £20,000, to 2 when incom e increases from £20,000 to £30,000.

Table No. 2.1 Risk Aversion



Now, suppose, we have an income of £15,000 and are considering a
new but risky job that will either double our income to £30,000 or
cause it to fall to £10,000. Each has a probability of 0.5. As Fig. 5.1(a)
shows, the utility level associated with an income of £10,000 is 10
(point A), and the utility level associated with a level of £30,000 is 18
(point B). The risky job must be compared with the current job, for
which utility is 13 (poin t C).

To evaluate the new job, we can calculate the expected value of the
resulting income. Because we are measuring value in terms of utility,
we must calculate the expected utility we can get. The expected utility
is the sum of the utilities associated with all possible outcomes,
weighed by the probability that each outcome will occur.

In this case, expected utility is E(U) = 1/2U (£10,000) + 1/2U
(£30,000) = 0.5 (10) + 0.5 (18) = 14.

The new risky job is, thus, preferred to the old job because the
expected utility of 14 is greater than the original utility of 13. The old
job involved no risk — it guaranteed an income of £15,000 and a
utility level of 13. The new job is risky, but it offers the prospect of
both a higher expected income and a higher expe cted utility of 14. If
we wished to increase our expected utility, we would take the risky
job.

Choice under Uncertainty: Different Preferences towards Risk:
People differ in their willingness to bear risk. Some are risk -averse,
some risk -lovers and some risk -neutral. A person who prefers a certain
given income to a -risky job with the same expected income is known
as risk -averse which is the most common attitud e towards risk.
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Most people not only insure against risks — such as, life insurance,
health insurance, car insurance, etc. but also seek occupation with
relatively stable wages.

Figure 2.1(a) applies to a person who is risk -averse. Suppose a person
can ha ve a certain income of £20,000 or a job yielding an income of
£30,000 with probability 1/2 and an income of £10,000 with
probability 1/2. As we have seen, the expected utility of the uncertain
income is 14, an average of the utility at point A (10) and the utility at
B (18), and is shown at E.

Now we can compare the expected utility associated with the risky job
to the utility generated if £20,000 were earned without risk which is
given by D (16) in Fig. 2.1(a). It is definitely greater than the expected
utility with the risky job E (14).

A person who is risk -neutral is indifferent between earning a certain
income and an uncertain income with the same expected income. In
Fig. 2.1(c) the utility associated with a job generating an income
between £10,000 an d £30,000 with equal probability is 12, as is the
utility of receiving a certain income of £20,000.

Fig. 2.1(b) shows the probability of risk -lover. In this case, the
expected utility of an uncertain income that can be £10,000 with
probability 1/2 or £30, 000 with probability 1/2 is higher than the utility
associated with a certain income of £20,000. As shown:
E(U) = 1/2U(£10,000) + 1/2V(£30,000) = 1/2(3) + 1/2(18) =10.5 >
U(£20,000) = 8.

The main evidence of risk -loving is that people enjoy gambling. But
very few people are risk -loving with respect to large amount of income
or wealth. The risk premium is the amount that a risk -averse person
would be willing to pay to avoid risk taking.

The magnitude of the risk premium depends on the risky alternatives
that the person faces. The risk premium is determined in Fig. 5.2,
which is the same utility function as in Fig. 2.1(a). An expected utility
of 14 is achieved by a person who is going to take a risky job with an
expected income of £20,000.

This is shown in Fig. 2.2 by drawing a horizontal line to the vertical
axis from point F, which bisects the straight line AB. But the utility
level of 14 can also be achieved if the person has a certain income of
£16,000. Thus, the risk premium of £4,000, given by line EF, is the
amount of income one would give up to leave him indifferent between
the risky job and the safe one.
Figure No. 2.2 Risk Premium

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How risk -averse a person is depends on the nature of the risk involved
and on the person’s income. Generally, risk-averse people prefer risks
involving a smaller variability of outcomes. We saw that, when there
are two outcomes, an income of £10,000 and £30,000 — the risk
premium is £4,000.

We now consider a second risky job, involving a 0.5 probability of
receiv ing an income of £40,000 and a utility level of 20 and a 0.5
probability of getting an income of 0. The expected value is also
£20,000, but the expected utility is only 10.
Expected utility = .5U (£0) + .5U (£40,000) = 0 + .5(20) = 10.

Since the utility associated with having a certain income of £20,000 is
16, the person loses 6 units of utility if he is required to accept the job.
The risk premium in this case is equal to £10,000 because the utility of
a certain income of £10,000 is 10.

He can, thus, af ford to give up £10,000 of his £20,000 expected
income to have a certain income of £10,000 and will have the same
level of expected utility. Thus, the greater the variability, the more a
person is willing to pay to avoid the risky situation.

Choice under Uncertainty: Reducing Risk:
Sometimes consumers choose risky alternatives that suggest risk -
loving rather than risk - averse behaviour, as the recent growth in state
lotteries suggest. Nevertheless, in the face of a broad variety of risky
situations, consumers are generally risk -averse. Now we describe three
ways in which consumers can reduce risks diversification, insurance,
and obtaining more information about choices and payoffs.

Choice under Uncertainty: Diversification :
Suppose that you are risk -averse and try to avoid risky situations as
much as possible and you are planning to take a part -time selling job
on a commission basis. You have a choice as to how to spend your
time selling each appliance. Of course, you cannot be sure how hot or
cold th e weather will be next year. How should you apportion your
time to minimize the risk involved in the sales job?

The risk can be minimized by diversification — by allocating time
towards selling two or more products, rather than a single product. For
example, suppose that there is a fifty -fifty chance that it will be a
relatively hot year, and a fifty -fifty chance that it will be relatively
cold.

Gives the earnings you can make selling air-conditioners and
heaters:
Table No. 2.2 Income From Sale of Equipment Hot weather Cold weather Air-conditioner sales £ 30,000 £ 12,000 Heater sales £ 12,000 £ 30,000 munotes.in

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If we decide to sell only air -conditioners or only heaters, our actual
income will be either £12,000 or £30,000 and expected income will be
£21,000 [.5(£30,000) + .5(£12,000)]. Suppose we diversify by dividing
our time evenly between selling air -conditioners and heaters. .

Then our income will certainly be £21,000, whatever be the weather. If
the weather is hot, we will earn £15,000 from air -conditioner sales and
£6,000 from heater sales; if it is cold, we will earn £6,000 from air -
conditioner sales and £ 15,000 from heater sales. In either case, by
diversifying, we assure ourselves a certain income and eliminate all
risks.

Diversification is not always easy. In our example, whenever the sales
of one were strong, the sales of the other were weak. But the principle
of diversification has a general application. As long as we can allocate
our effort or investment funds towards a variety of activi ties, whose
outcomes are not closely related, we can eliminate some risk.

Choice under Uncertainty: Insurance:
We have seen that risk -averse people will be willing to give up income
to avoid risk. If, however, the cost of insurance is equal to the expected
loss, risk -averse people will wish to buy enough insurance to offset
losses they might suffer. The reasoning is implicit in our discussion of
risk-aversion.

Buying insurance means a person will have the same income whether
or not there is a loss, because the insurance cost is equal to the
expected loss. For a risk -averse person, the guarantee of the same
income, whatever be the outcome, generates more utility than would be
the case if that person had a high income when there is no loss and a
low i ncome when a loss occurred.

Suppose a homeowner faces a 10% probability that his house will be
burglarized and he will suffer a loss of £10,000. Let us assume that he
has £50,000 worth of property.

Table 2.3 shows his wealth with two possibilities — to insure or not
to insure:
Table No. 2.3 Decision to Insure Insurance Burglary(Pr=.1) No Burglary(Pr=.9) Expected wealth No £ 40,000 £ 50,000 £ 49,000 Yes £ 49,000 £ 49,000 £ 49,000
The decision to purchase insurance does not alter his expected wealth.
It does smoothen it out over both possibilities. This generates a high
level of expected utility to the house -owner, because the marginal
utility in both situations is the same for the person who buys insurance.
But when there is no insurance, the marginal utility in the event of a
loss is higher than if no loss occurs. Thus, a transfer of wealth from the
no-loss to the loss situation must increase total utility. And this transfer
of wealth is exactly what is achieved through insurance.
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Persons usually buy insurance from companies that specialise in selling
it. Generally, insurance companies are profit -maximising firms that
offer insurance because they know that, when they pool risk, they face
very little risk.

This avoidance of risk is based on the law of large numbers, which
tells us that although single events may be random and difficult to
predict, the average outcome of many similar events may be predicted.
For example, if one is selling automobile insurance, one cannot predict
whether a particular driver will have an accident, but one can be
reasonably sure, judging from past experience, about how many
accidents a large group of drivers will have.

By operating on a large scale, insurance companies can be sure that the
total premiums paid in will be equal to the total amount of money paid
out. In our burglary example, a man knows that there is a 10%
probability of his house being burgled; if it is, he will suffer a £10,000
loss. P rior to facing this risk, he calculated his expected loss of £1,000
(£10,000 x 0.1), but this is a substantial risk of loss.

Now suppose 100 people face this situation and all of them buy
burglary insurance from a company. The insurance company charges
each of them a premium of £1,000 which generates an insurance fund
of £1, 00,000 from which losses can be paid.

The insurance company can rely on the law of large numbers which
assures it that the expected loss for every individual is likely to be met.
Thus , the total payout will be close to £1, 00,000 and the company
need not worry about losing more than that amount.

Insurance companies are likely to charge premiums higher than the
expected loss because they need to cover their administrative costs.
Thus, many people may prefer to self -insurance rather than buy from
an insure company. One way to avoid risk is to self -insure by
diversifying.

Choice under Uncertainty: Value of Information:
The decision a consumer makes when outcomes are uncertain is based
on limited information. If more information were available, the
consumer could reduce risk. Since information is a valuable
commodity, people will be prepared to pay for it. The value of
complete information is the difference between the expected value with
complete information and the expected value with incomplete
information.

To see the value of information, suppose you are a manager of a store
and must decide how many suits to order for the fall season. If you
order 100 suits, your cost is £180 per suit, but if you order 50 suits,
your cost would be £200. You know you will be selling for £300 each,
but you are not sure what total sales would be.

All unsold suits could be returned but for half the price you paid for
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is a 0.5 probability that 100 suits will be sold and a 0.5 probability that
50 will be sold.

Table 2.4 gives the profit that you could earn in each of the two
cases:
Table 2.4 Profits from Suits Insurance Burglary(Pr=.1) No Burglary(Pr=.9) Expected wealth 1. Buy 50 suits £ 5,000 £ 5,000 £ 5,000 2. Buy 100 suits £ 1,500 £ 12,000 £ 6,750
Without more information, you would buy 100 suits if you were risk -
neutral, taking the chance that your profit might be either £12,000 or
£1,500. But if you were risk -averse, you might buy 50 suits for a
guaranteed income of £5,000.

With complete information, you can make the correct suit order,
whatever the sales might be. If sales were going to be 50 suits and you
order for 50, you make a profit of £5,000. On the other hand, if sales
were going to be 100 and you order for 100, you make a profit of
£12,000. Since both outcomes are equally likely, your expected profit
with complete information would be £8,500.

The value of information is:


Thus, it is worth paying up to £1,750.00 to obtain as accurate an
information as possible.

Choice under Uncertainty: Demand for Risky Assets:
People are generally risk -averse. Given a choice, they prefer a fixed
income to one that is as large on average that fluctuates randomly. Yet
many of these people will invest all or part of their savings in stocks,
bonds and other assets that carry some risk.

Why do risk -averse people invest in risky stocks either all or part of
their investment? How do peo ple decide how much risk to bear for the
future? To answer these questions, we must examine the demand for
risky assets.

Choice under Uncertainty: Assets :
An asset is something that provides a monetary flow to its owner. The
monetary flow from owning an asset can take the form of an explicit
payment, such as the rental income from an apartment building.
Another explicit payment is the dividend on shares.

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But sometimes the monetary flow from ownership of an asset is
implicit; it takes the form of an incre ase or decrease in the price or
value of the asset — a capital gain or a capital loss.

A risky asset provides a monetary flow that is in part random, which
means, the monetary flow is not known with certainty in advance. A
share of a company is an obvious example of a risky asset — one
cannot know whether the price of the stock will rise or fall over time,
and one cannot even be sure that the company will continue to pay the
same dividend per share.

Although people often associate risk with the stock mark et, most other
assets are also risky.

The corporate bonds are example of this — the corporation that issued
the bonds could go bankrupt and fail to pay bond owners their returns.
Even long -term government bonds that mature in 10 or 20 years are
risky.

Although it is unlikely that government will go bankrupt, the rate of
inflation could increase and make future interest payments and the
eventual repayment of principal worth less in real terms, and, thus,
reduce the value of the bonds.

In contrast to ris ky assets, we can call an asset riskless if it pays a
monetary flow that is certain. Short -term government bonds — known
as Treasury Bills — are risk -free assets because they mature within a
short period, there is very little risk of an unexpected increase in
inflation.

And one can also be confident that government will not default on the
bond. Other examples of riskless assets include passbook savings
accounts in banks and building societies or short - term certificate of
deposit.

Choice under Uncertainty: Asset Returns:
People buy and hold assets because of the monetary flows they
provide. Assets may be compared in terms of their monetary flow
relative to the price of asset. The return on an asset is the total
monetary flow it provides as a fra ction of its value. For example, a
bond worth £1,000 today that pays out £100 this year has a return of
10%.

When people invest their savings in stocks, bonds or other assets, they
usually hope to earn a return that exceeds that rate of inflation, so that ,
by delaying consumption, they can consume more in the future. Thus,
we often express the return on an asset in real terms which means
return less the rate of inflation. For example, if the annual rate of
inflation had been 5%, the bond would have yielded real return of 5%.
Since most assets are risky, an investor cannot know in advance what
return they are going to yield in future. However, one can compare
assets by looking at their expected returns which is just the expected
value of its return. In a par ticular year, the actual return may be higher munotes.in

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or lower than expected, but over a long period the average return
should be close to the expected return.

Different assets have different expected returns. Table 5.6 shows that
the expected real return on Treasury Bills has been less than 1%, while
the real return for a representative stock on the London Stock Market
has been almost 9%.

Why would a person buy a Treasury bill when the expected return on
stocks is so much higher? The answer is that the deman d for an asset
depends not only on expected return, but also on its risk.

One measure of risk, the standard deviation (σ) of the real return, is
equal to 21.2% for common stock, but only 8.3% for corporate bonds,
and 3.4% for Treasury Bills, as Table 5.6 shows. Clearly, the higher
the expected return on investment, the greater the risk involved. As a
result, a risk -averse investor must balance expected return against risk.

Table No. 2.5 Investment risk and Return Insurance Real Rate of Return (%) Risk (Standard Deviation, σ, %) Common Stock 8.8 21.2 Long term corporate bonds 2.1 8.3 Treasury Bills 0.4 3.4
Choice under Uncertainty: Trade -Off between Risk and Return:
Suppose a person has to invest his savings in two assets — riskless
Treasury Bills, and a risky representative group of stocks. He has to
decide how much of his savings to invest in each of these two assets.
This is analogous to the consumer’s problem of allocating a budget
between two goods x and y.

Let us denote the risk -free re turn on the Treasury Bill by R f, where the
expected and actual returns are the same. Also, assume the expected
return from investing in the stock market is R m, and the actual return is
Ym.

The actual return is risky. At the time of investment decision, we know
the likelihood of each possible outcome, but we do not know what
particular outcome will occur. The risky asset will have a higher
expected return than the risk -free asset (R m > R f) Otherwise, risk -
averse investors would invest only in Treasury Bills and none at all in
stocks.

To determine how much he will invest in each asset, let us assume b is
the fraction of his savings placed in the stock market, and (1 – b) the
fraction used to purchase Treasury Bills. The expected return on his
total portfolio , Rp, is a weighted average of the expected return on the
two assets
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Suppose, the stock market’s expected return is 12%. Treasury Bills pay
4%, and b = 1/2. Then R p = 8%. How risky is this portfolio? The
riskiness can be measured by the variance of the portfolio’s return. Let
us assume the variance of the risky stock market investment is σ2
m and
the standard deviation is σ m. We can show that the σ of the portfolio is
the fraction of the portfolio invested in the risky asse t times the o of
that asset:
σp = bσm……… (3)

Choice under Uncertainty: Investor’s Choice Problem:
To determine how our investor should choose this fraction b, we must
first show his risk - return trade -off analogous to the budget line of a
consumer. To see this trade -off, we can rewrite equation (2) as



The slope of the budget line is R m – R/σm, which is the price of risk as
shown in Fig. 2.3. Three indifference curves are drawn; each curve
shows combinations of risk and return that have an investor equally
satisfied. The curves are upward -sloping because a risk -averse investor
will require a higher expected return if he is to bear a greater amount of
risk. The utility -maximising investment portfolio is at the point where
indifference curve U 2 is tang ent to the budget line.

Fig No. 2.3 Fig No. 2.4
Choosing between risk and return Choice of two different investors


Choice under Uncertainty :Two Different Attitudes to Risk:
Choice under. Two Different Investors Choice with Different
Attitudes to Risk:
Investor A is risk -averse. His portfolio will consist mostly of the risk -
free asset, so his expected return, R A, will be only slightly greater than
the risk -free return, but the risk σ A will be small. Investor B is less risk -
averse. He will invest a large fraction of his funds in stocks. The
expected return on his portfolio, R B, will be larger, but the return will
also be riskier.



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2.3 MEASURES OF RISK AVERSION Fig No. 2. 5

In the above diagram , Left graph : A risk averse utility function is
concave (from below), while a risk loving utility function is
convex. Middle graph : In standard deviation -expected value space, risk
averse indifference curves are upward sloped. Right graph : With fixed
probabilities of two alternative states 1 and 2, risk averse indifference
curves over pairs of state -contingent outcomes are convex.

In economics and finance , risk aversion is the tendency of people to
prefer outcomes with low uncertainty to those outcomes with high
uncertainty, even if the average outcome of the latter is equal to or
higher in monetary value than the more certain outcome. Risk aversion
explains the inclination to agree to a situation with a more predictable,
but possibly lower payoff, rather than another situation with a highly
unpredictable, but possibly higher payoff. For example, a risk -averse
investor might choose to put their money into a bank account with a
low but guaranteed interest rate, rather than into a stock that may have
high expected returns, but also involves a chance of losing value.
Fig No. 2. 6

Utility function of a risk -averse (risk -avoiding) individual








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Fig No. 2. 7

Utility function of a risk -neutral individual

Fig No. 2. 8


Utility function of a risk -loving (risk -seeking) individual

CE – Certainty equivalent ; E(U(W)) – Expected value of the utility
(expected utility) of the uncertain payment W; E(W) – Expected value
of the uncertain payment; U(CE) – Utility of the certainty
equivalent; U(E(W)) – Utility of the expected value of the uncertain
payment; U(W 0) – Utility of the minimal payment; U(W 1) – Utility of
the maximal payment; W0 – Minimal payment; W1 – Maximal
payment; RP – Risk premium

A person is given the choice between two scenarios: one with a
guaranteed payoff, and one with a risky payoff with same average
value. In the former scenario, the per son receives $50. In the uncertain
scenario, a coin is flipped to decide whether the person receives $100
or nothing. The expected payoff for both scenarios is $50, meaning that
an individual who was insensitive to risk would not care whether they
took the guaranteed payment or the gamble. However, individuals may
have different risk attitudes .

A person is said to be:
 risk averse (or risk avoiding ): if they would accept a certain
payment ( certainty equivalent ) of less than $50 (for example, $40),
rather than taking the gamble and possibly receiving nothing.
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 risk neutral : if they are indifferent between the bet and a certain
$50 payment.
 risk loving (or risk seeking ): if they would accept the bet even
when the guaranteed payment is more than $50 (for example, $60).

The average payoff of the gamble, known as its expected value , is $50.
The smallest dollar amount that an individual would be indifferent to
spending on a gamble or guarantee is called the certainty equivalent ,
which is also used as a me asure of risk aversion. An individual that is
risk averse has a certainty equivalent that is smaller than the prediction
of uncertain gains. The risk premium is the difference bet ween the
expected value and the certainty equivalent. For risk -averse
individuals, risk premium is positive, for risk -neutral persons it is zero,
and for risk -loving individuals their risk premium is negative.

Utility of money :
In expected utility theory, an agent has a utility function u(c)
where c represents the value that he might receive in money or goods
(in the above exampl e c could be $0 or $40 or $100).

The utility function u(c) is defined only up to positive affine
transformation – in other words, a constant could be added to the value
of u(c) for all c, and/or u(c) could be multiplied by a positive constant
factor, without affecting the conclusions.

An agent possesses risk aversion if and only if the utility functi on
is concave . For instance u(0) could be 0, u(100) might be 10, u(40)
might be 5, and for comparison u(50) might be 6.

The expected utility of the above bet (with a 50% chance of receiving
100 and a 50% chance of receiving 0) is
𝐸(𝑢)=൫𝑢(0)+𝑢(100)൯2⁄

and if the person has the utility function with u(0)=0, u(40)=5,
and u(100)=10 then the expected utility of the bet equals 5, which is
the same as the known utility of the amount 40. Hence the certainty
equivalent is 40.

The risk premium is ($50 minus $ 40) = $10, or in proportional terms
($50−$40)$40⁄

or 25% (where $50 is the expected value of the risky bet: This risk
premium means that the person would be willing to sacrifice as much
as $10 in expected value in order to achieve perfect certainty about
how much money will be received. In other words, the person would
be indifferent between the bet and a guarantee of $40, and would prefer
anything over $40 to the bet.

In the case of a wealthier individual, the risk of losing $100 would be
less significant, and for such small amounts his utility function would
be likely to be almost linear. For instance, if u(0) = 0 and u(100) = 10,
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The utility function for perceived gains has two key properties: an
upward slope, and concavity. (i) The upward slope implies that the
person feels that more is better: a larger amount received yields greater
utility, and for risky bets the person would prefer a bet which is first-
order stochastically dominant over an alternative bet (that is, if the
probability mass of the second bet is pushed to the right to form the
first bet, then the first bet is preferred). (ii) The concavity of the utility
function implies that the person is risk averse: a sure amount would
always be preferred over a risky bet having the same expected value;
moreover, for risky bets the person would prefer a bet which is a mean -
preserving contraction of an alternative bet ( that is, if some of the
probability mass of the first bet is spread out without altering the mean
to form the second bet, then the first bet is preferred).

Measures of risk aversion under expected utility theory :
There are multiple measures of the risk av ersion expressed by a given
utility function. Several functional forms often used for utility
functions are expressed in terms of these measures.

Absolute risk aversion :
The higher the curvature of (𝑐) , the higher the risk aversion. However,
since expected utility functions are not uniquely defined (are defined
only up to affine transformations ), a measure that stays constant with
respect to these transformations is needed rather than just the second
derivative of (𝑐) . One such measure is the Arrow –Pratt measure of
absolute risk aversion (ARA ), after the economists Kenneth
Arrow and John W. Pratt , also known as the coefficient of absolute
risk aversio n, defined as



Where and denote the first and second derivatives with
respect to c of . For example, if
so and then Note
now does not depend on and so affine transformations
of do not change it.

The following expressions relate to this term:
Exponential utility of the form is unique in
exhibiting constant absolute risk aversion (CARA): is
constant with respect to c.

Hyperbolic absolute risk aversion (HARA) is the most general class of
utility functions that are usually used in practice (specifically, CRRA
(constant relative risk aversion, see below), CARA (constant absolute
risk aversion), and quadratic utility all exhibit HARA and are often
used because of their mathematical tractability). A utility function
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exhibits HARA if its absolut e risk aversion is a hyperbolic function ,
namely

The solution to this differential equation (omitting additive and
multiplicative constant terms, which do not affect the behavior implied
by the utility function) is:
𝑢(𝑐)=(𝑐−𝑐௦)ଵିோ
1−𝑅 ,

where R=1/a and c8= -b/a . Note that when a=0, this is CARA,
as A(c) = 1/b = const , and when b=0, this is CRRA as cA(c) =
1/a=const .

Decreasing/increasing absolute risk aversion (DARA/IARA) is
present if A(c)is decreasing/increasing. Using the above definition of
ARA, the following inequality holds for DARA:
𝜕𝐴(𝑐)
𝜕𝑐=−𝑢ᇱ(௖)𝑢ᇱᇱᇱ(𝑐)−ൣ𝑢ᇱᇱ(௖)൧ଶ
[𝑢ᇱ(𝑐)]ଶ<0

and this can hold only if uˈˈˈ(c) >0 . Therefore, DARA implies that the
utility function is positively skewed; that is, uˈˈˈ(c) >0 . Analogously,
IARA can be derived with the opposite directions of inequalities,
which permits but does not require a negatively skewed utility function
(uˈˈˈ(c)<0 ) An example of a DARA utility function is u(c) = log (c) ,
with A(c)=1/c , while u(c)= C-αc2, with A(c)= 2α/(1-2αc)would
represent a quadratic utility function exhibiting IARA.

Experimental and empirical evidence is mostly consistent with
decreasing absolute risk aversion.

Contrary to what several empirical studies have assumed, wealth is not
a good proxy for risk aversion when studying risk sharing in a
principal -agent setting. Although A(C)= −௨ᇱᇱ(௖)
௨ᇱ௖ is monotonic in
wealt h under either DARA or IARA and constant in wealth under
CARA, tests of contractual risk sharing relying on wealth as a proxy
for absolute risk aversion are usually not identified.

Relative risk aversion :
The Arrow –Pratt measure of relative risk aversion (RRA)
or coefficient of relative risk aversion is defined as

𝑅(𝑐)=𝑐𝐴(𝑐)=−𝑐𝑢′′
𝑢′(𝑐)

Unlike ARA whose units are in $−1, RRA is a dimension -less quantity,
which allows it to be applied universally. Like for absolute risk
aversion, the corresponding terms constant relative risk
aversion (CRRA) and decreasing/increasing relative risk
aversion (DRRA/IRRA) are used. This measure has the advantage that
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it is still a valid measure of risk aversion, even if the utility function
changes from risk averse to risk loving as c varies, i.e. utility is not
strictly convex/concave over all c. A constant RRA implies a
decreasing ARA, but the reverse is not always true. As a specific
example of constant relative risk aversion, the utility function 𝑢(𝑐)=
log(𝑐) implies

RRA = 1. In intertemporal choice problems, the elasticity of
intertemporal substitution often cannot be disentangled from the
coefficient of relative risk aversion. The isoelastic utility function
𝑢(𝑐)=𝑐ଵି௣−1
1−𝑝
exhibits constant relative risk aversion with 𝑅(𝑐)=𝑝 and the
elasticity of intertemporal substitution ∈𝑢(𝑐)=1⁄𝑝 . When
p=1,using l 'Hôpital's rule shows that this simplifies to the case of log
utility, u(c) = log c, and the income effect and substitution effect on
saving exactly offset.

A time -varying relative risk aversion can be considered

Implications of increasing/decreasing absolute and relative risk
aversion :
The most straightforward implications of increasing or decreasing
absolute or relative risk aversion, and the ones that motivate a focus on
these concepts, occur in the context of forming a portfolio with one
risky asset and one risk -free asset. If the person experiences an
increase in wealth, he/she will choose to increase (or keep unchanged,
or decrease) the number of dollars of the risky asset held in the
portfolio if absolute risk aversion is decreasing (or constant, or
increasing). Thus economists avoid using utility functions such as the
quadratic, which exhibit increasing absolute risk aversion, because
they hav e an unrealistic behavioral implication.

Similarly, if the person experiences an increase in wealth, he/she will
choose to increase (or keep unchanged, or decrease) the fraction of the
portfolio held in the risky asset if relative risk aversion is decreasing
(or constant, or increasing).

In one model in monetary economics , an incre ase in relative risk
aversion increases the impact of households' money holdings on the
overall economy. In other words, the more the relative risk aversion
increases, the more money demand shocks will impact the economy.

Portfolio theory :
In modern portfolio theory , risk aversion is measured as the
additional expected reward an investor requires to accept additional
risk. If an investor is risk -averse, they will invest in multiple uncertain
assets, but only when the predicted return on a portfolio that is
uncertain is greater than the predicted return on one that is not
uncertain will the investor will prefer the former. Here, the risk-return
spectrum is relevant, as it results largely from this type of risk
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on investment, i.e. the square root of its variance . In advanced portfolio
theory, different kinds of risk are taken into consideration. They are
measured as the n-th root of the n -th central moment . The symbol used
for risk aversion is A or A n.
𝐴=𝑑𝐸(𝑐)
𝑑𝜎
𝐴௡=𝑑𝐸(𝑐)
𝑑ඥ𝜇௡೙

Limitations of expected utility treatment of risk aversion :
Using expected utility theory's approach to risk aversion to
analyze small stakes decisions has come under criticism. Matthew
Rabin has showed that a risk-averse, expected -utility -maximizing
individual who, from any initial wealth level [...] turns down gambles
where she loses $100 or gains $110, each with 50% probability will
turn down 50 –50 bets of losing $1,000 or gaining any sum of money.

Rabin criticizes this implication of expected utility theory on grounds
of implausibility —individuals who are risk averse for small gambles
due to diminishing marginal utility would exhibit extreme forms of risk
aversion in risky decisions under larger sta kes. One solution to the
problem observed by Rabin is that proposed by prospect
theory and cumulative prospect theory , where outcomes are
considered relative to a reference point (usually the status quo), rather
than considering only the final wealth.

Another limitation is the reflection effect, which demonstrates the
reversing of risk aversion. This effect was first presented
by Kahneman and Tversky as a part of the prospect theory , in
the behavioral economics domain. The reflection effect is an
identified pattern of opposite preferences between negative as opposed
to positive prospects: people tend to avoid risk when the gamble is
between gains, and to seek risks when the gamble is between losses.
For example, most people prefer a certain gain of 3,000 to a n 80%
chance of a gain of 4,000. When posed the same problem, but for
losses, most people prefer an 80% chance of a loss of 4,000 to a certain
loss of 3,000.

The reflection effect (as well as the certainty effec t) is inconsistent
with the expected utility hypothesis. It is assumed that the
psychological principle which stands behind this kind of behavior is
the overweighting of certainty. Options which are perceived as cer tain
are over -weighted relative to uncertain options. This pattern is an
indication of risk -seeking behavior in negative prospects and
eliminates other explanations for the certainty effect such as aversion
for uncertainty or variability.

The initial findings regarding the reflection effect faced criticism
regarding its validity, as it was claimed that there are insufficient
evidence to support the effect on the individu al level. Subsequently, an
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the effect is most prevalent when either small or large amounts and
extreme probabilities are involved.

Public understanding and risk in social activities :
In the real world, many government agencies, e.g. Health and Safety
Executive , are fundamentally risk -averse in their mandate. This often
means that they demand (with the power of legal enforcement) that
risks be minimized, even at the cost of losing the utility of the risky
activity. It is important to consider the opportunity cost when
mitigating a risk; the cost of not taking the risky action. Writing laws
focused on the risk without the balance of the utility may misrepresent
society's goals. The public understanding of risk, which influences
political d ecisions, is an area which has recently been recognised as
deserving focus. In 2007 Cambridge University initiated the Winton
Professorship of the Public Understanding of Risk , a role described as
outreach rather than traditional academic research by the holder, David
Spiegelhalter .

Children :
Children's services such as schools and playgrounds have become the
focus of much risk -averse planning, meaning that children are often
prevented from benefiting from activities that they would otherwise
have had. Many playgr ounds have been fitted with impact -absorbing
matting surfaces. However, these are only designed to save children
from death in the case of direct falls on their heads and do not achieve
their main goals. They are expensive, meaning that less resources are
available to benefit users in other ways (such as building a playground
closer to the child's home, reducing the risk of a road traffic accident
on the way to it), and —some argue —children may attempt more
dangerous acts, with confidence in the artificial s urface. Shiela Sage,
an early years school advisor, observes "Children who are only ever
kept in very safe places, are not the ones who are able to solve
problems for themselves. Children need to have a certain amount of
risk taking ... so they'll know how to get out of situations."

Game shows and investments :
One experimental study with student -subject playing the game of the
TV show Deal or No Deal finds that people are more risk averse in the
limelight than in the anonymity of a typical behavioral laboratory. In
the laboratory treatments, subjects made decisions in a standard,
computerized laboratory setting as typically employed in behavioral
experiments. In the limelig ht treatments, subjects made their choices in
a simulated game show environment, which included a live audience, a
game show host, and video cameras. In line with this, studies on
investor behavior find that investors trade more and more speculatively
after switching from phone -based to online trading and that investors
tend to keep their core investments with traditional brokers and use a
small fraction of their wealth to speculate online.

Risk Aversion :
People differ greatly in their attitudes towards r isks. In Bernoullis
hypothesis a person whose marginal utility of money declines will
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the expected vale of income from a gambler = same amount of income
with certainty. The person who re fuses a fair gamble is a risk averse.
Thus, risk averter is one who prefers a given income with certainty to a
risky gamble with the same expected value of income. Risk aversion is
the most common attitude towards risk. It is because of the attitude of
risk aversion that people insure against various kinds of risks such as
burning of house, illness etc.

This attitude of risk aversion can be explained with N -M method of
measuring expected utility. Marginal utility of income of risk averter
diminishes as hi s income increases.
Fig No. 2.9
The Neumann -Morgenstem Concave Utility Curve of a Risk -
Averter



U(I) is the N -M utility function curve. It starts from the origin and has
a positive slope i.e. individual prefers more income to less. The curve
is concave to the origin showing that the marginal utility of income of
a person decreases as his income increases. Therefore, the utility curve
represents the case of risk -averter or the attitude of risk -aversion. For
example, with income of Rs. 2000/ -, the persons utility is 50 which
rises to 70 when his income increases to Rs. 3000/ -. As income rises to
Rs.4000/ -, utility rises to 75.

Now, suppose the person’s current income is Rs. 3000/ -. He is offered
a fair gamble in which he has a 50 -50 chance of winning or loosing Rs.
1000/ - . Thus , the probability of winning is ½ or 0.5. If he wins the
game, his income will rise to Rs. 4000/ - and if he looses the gamble,
his income will fall to Rs. 2000/ -. The expected money value of his
income in this situation of uncerta in outcome is given by: E(V) = 1/2 ×
4000 +1/2 × 2000 = Rs.3000/ -. If he rejects the gamble he will have the
present income (i.e. Rs. 3000) with certainty. Though the expected
value of his uncertain income prospect = his income with certainty, a
risk avert er will not accept his gamble. This is because as he acts on
the basis of expected utility of his income in the uncertain situation
(i.e. Rs. 4000/ - if he wins and Rs.2000/ - if he loses) can be obtained as
Expected Utility(EU) = π U (Rs. 4000 + 1− π U (Rs. 2000). The
diagram shows the utility of a person from Rs. 4000 is 75 (Point B)
and utility from Rs. 2000 is 50 ( Point A), the expected utility from this
uncertain prospect will be
E(U) = 1/2 (75) + 1/2 (50)
= 37.5 + 25 = 62.5
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In N-M utility curve U( I) the expected utility can be found by joining
points A (corresponding to Rs.2000) and point B (corresponding to Rs.
4000)by a straight -line segment AB ---- then reading a point on it
corresponding to the expected value of the gamble Rs. 3000, the
expected value of the utility is M_(2 )D (=62.5) < M_(2 )C or Rs.70
which is the utility of income of Rs.3000 with certainty. Therefore, a
person will not gamble. His rejection of gamble is due to the
diminishing marginal utility of money income for him. The gain in
utility from Rs.1000in case he wins < the loss in utility from Rs. 1000
if he loses the gamble. Therefore, the expected utility from the
uncertain income prospect is less than the utility he obtains from the
same income with certainty.

In case margina l utility of money income decreases a person will avoid
fair gambles. Such a person is called risk averter as he prefers an
income with certainty (i.e. whose variability or risk is zero) to the
gamble with the same expected value (where variability or risk is > 0).
For example, person with a certain income (Y) of Rs. 3000, two fair
gambles are offered to him. First, a 50:50 chance of winning or losing
Rs.1000, as before and second a 50:50 chance of winning or losing
Rs.1500. With the even chance of winning or losing the expected value
of income in the second gamble will be

1/2 (1500) +1/2 (4500) = Rs. 3000. On N -M curve we draw a straight -
line segment GH by joining (G ---Y Rs. 1500 and H ----Y Rs. 4500). It
shows expected utility from the expected money valu e of Rs. 3000
from the second gamble is M_(2 )L < M_(2 )D of first gamble. The
person will prefer the first gamble which has low variability to the
second gamble which has higher degree of variability of outcome.
Risk Aversion and Insurance

A risk averse person is always ready to make some payments in order
to avoid the risk -facing him. It means the risk averter would like to pay
money to someone, say an insurance company, if he is assured a given
income with certainty = the expected to value of the gambl e with
uncertain outcome.

For example, suppose a person has an income of Rs. 1,00,000 from the
house he owns. The risk he faces is that if the house is burnt down by a
fire he will suffer a loss of Rs. 40,000 in his income. Let us further
suppose that th e probability of his house being burnt down is 0.5. This
is explained in the following diagram
Fig No. 2. 10


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If his house catches fire and burns down, his income will be reduced to
Rs 60,000 (W_L). The expected value of the uncertain prospect is ½
(1,00,000 ( W_S)) + ½ (60,000) = Rs, 80,000 (E(W)). A straight lie
segment is drawn between the utility points of the two uncertain
outcomes of Rs. 1,00,000 and Rs. 60,000. Utility of the expec ted value
of Rs. 80,000 is M_(2 )D i.e. line drawn from E(w) or 60 . When we
draw the line from U_c, we find that a certain income= income 70000
i.e. E(c) also yields the same utility as the expected value of the gamble
(Rs. 80,000). This means that a risk averse person will be willing to
pay premium to the insurance comp any up to the maximum of Rs.
30,000 (Rs. 1,00,000 – Rs. 70,000) provides the insurance company
agrees the restore his loss of Rs. 40,000 in case his house catches fire
and burns down. Going in for insurance guarantees a person to have
the sure income wheth er or not there is loss due to fire. Since risk
aversion is the most common attitude, many people buy enough
insurance against various types of risks.

Fig No. 2. 11

Fig No. 2. 11

Recent Analysis of the Speculative Behaviour :
Let us now discuss the behaviour of economic agents such as investors
and producers under the conditions of risk and uncertainty. This relates
to the behaviour in the context of demand for money or liquidity. Here,
let us take an account of the contributio ns of Prof. Baumol and James
Tobin. It will help us to examine how the investors avert or minimise
risk.





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Baumol’s Inventory Demand Analysis :
Transactions Demand: J.M Keynes, in his General Theory analysed
total demand for money under three categories to satisfy transactions,
precautionary and speculative motive. Baumol mainly explained the
transactions motive. It is stated that the demand for m oney is a function
of the income and is directly proportional to the size of the income of
the investor. According to Baumol the transactions demand for money,
though directly proportional to the size of the income, is less than
proportionate to the increm ents in the income. For this Baumol made
use of inventory demand approach.

Inventory Demand Method: On account of transactions demand
investors are required to possess large amount of money in cash or
liquid form. This can be utilised for the payment of labour, raw
material and such other charges. On this account, liquid money assets
become necessary because of different timing of earning income and
its expenditure. However, though holding money is a matter of
convenience, it brings no income and hence/th us it is expensive.
Moreover, large amount of money required to cover the whole volume
of transactions over the entire income earning period is not
immediately required or needed.

The next alternative open to the investors is that of investing part of
their liquid assets in short term bonds or securities and earn interest
income over such investment. Now the question is what proportions of
investment in bonds and withdrawals in cash will be of optimum size
from time to time. For this let us take a numerical example.

Let the total demand for liquid money at the beginning of the period
t_0is Rs. 1,200which is to be carried over till the end of the period or
beginning of the next peri od t_1. In other word the time interval t_0 to
t_1let be of 12 months. Then the investor does not need the entire
amount of Rs. 1200 at t_0 point of time. He can distribute it
conveniently in the three instalments of Rs. 400 each. Therefore, he
possesses Rs. 400 at t_0 period, instalments Rs.400 for 1/3t for four
months and invests remaining Rs. 400 for2/3t or eight months. So that
through out the year he has adequate cash resources and yet receives
interest over Rs. 400 for four months and over Rs. 400 ov er eight
months. The average demand for cash balances or liquid money
sources is ½ M where M is the total annual demand of Rs. 1200. This
is clear since average of the two months is
2
3𝑡+1/3𝑡
2=1
2 𝑀








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Fig No. 2. 12


In the above diagram on the x-axis, we take time or of income earning
period and on the Y axis we take total demand for money OM. Part of
the OM, which is1/3 OM, is invested in bonds for 1/3t or four months
and another 1/3OM invested in bonds for 2/3t or eight months. Now
the next qu estion is what is optimum proportion of investment in bonds
and holding in cash balance?

Variations in Investments: The optimum level of demand for cash
balances is flexible and will depend upon two types of factors.

On the one hand demand for money wil l depend upon b the value of
brokerage charge, administrative expenses etc., of holding bonds
(directly related), and

On the rate of interest or the income to be earned from the investment
in bonds(inversely related).

This can be explained in the form of a function or an equation. Let C
be the total inventory cost of making transactions, b the brokerage
charges percentage, r the rate of interest or return on bonds, M/2 is the
average demand for money, Y is the income of the firm and M the
amount of wi thdrawal from the bonds and hence Y/M is the number
of withdrawals. Then we have
𝑐=𝑟𝑀
2+𝑏𝑌
𝑀

We want to find out optimum value of M which will minimise the
value of C. This can be derived by differentiating C with respect to M
and then setting it equa l to zero.
𝑑𝐶
𝑑𝑀= 𝑑(𝑟𝑚
2)
𝑑𝑀+𝑑(𝑏𝑌
𝑀)
𝑑𝑀

= ௥
ଶ−௕௒
ெమ, setting it equal to zero
= ௥
ଶ−=0, or
𝑀ଶ=ଶ௕௒
௥, or
𝑀= √2𝑏𝑌
𝑟, M 2/3t 1/3t 2/3t 1/3t Time Money/Cash Balances
𝑡1 bonds Bonds munotes.in

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This is called square root formula of determining demand for money.
This explains that (i) M the demand for money depends directly upon b
the brokerage charges. Higher the rate of b lower will be the demand
for bonds and more will be the demand for liquid money assets. (ii)
Demand for M depends inversely on the rate of int erest such that
higher the interest rate more will be the investment in bonds and less
will be the demand for money in cash balances.

Diminishing Proportion: Finally, Baumol has related variations in the
demand for transaction cash balances and changes in the income Y. As
the size of the income Y of the investor goes on increasing, he will no
doubt require more and more cash balances. But he will also be able to
invest more in the bonds. With large amounts of investment in the
value of brokerage cost b will diminish. Therefore, relatively greater
proportion of investment will be attractive, hence the proportion of
cash balance demand will be restricted. Thus, h e states that the
transactions demand for money is no doubt the function of income but
it progressively goes on falling in its proportion. For example, if
transactions demand with Rs. 10,000 income is 10 percent (Rs. 1000)
then with Rs. 50,000 income may b e 8 percent (Rs. 4000) and with Rs.
80000 income may be 6 percent (Rs. 4800). Thus, with growing size of
the income of the investor transactions demand also increases
absolutely but diminishes relatively.

James Tobin and Speculative Demand :
Liquidity Pre ference: Keynes liquidity preference or speculative
demand for money is based on certain assumptions. It depends on

Expectations about future rates of interest are inelastic.

Speculators or individuals like to hold either in cash money assets or
bonds.

James Tobin in his ‘Liquidity Preference as Behaviour towards Risk’
has attempted fresh piece of analysis by removing these limitations of
Keynesian theory

Instead of taking help of elasticity of expectations his theory is based
on the assumption that ex pected value of gains or losses from holding
interest basing assets is always equal to zero

It further assumes that a speculator or investor distributes his assets in
both cash and bonds and not in either of them.

B. Probability under Risk:
In holding cash resources or money no risk is involved. But it brings
no return in the form of interest income. To invest in bonds on the
other hand is attractive activity which brings income but it also
involves risk of capital gains or losses. More of su ch risk goes on
increasing as the amount invested increases. The investors are prepared
to accept such risk only when they are hopeful of adequate returns. If
‘g’ is expected gain or loss from the investment in bonds then investor
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distribution has zero expected value irrespective of the current rate of
interest r on his investment. If M and B are the proportions of
distribution of his assets between money and bonds then the total
return R on his investment will have the value,
R=B (r+g) where O
Tobin then classifies investors into three categories:
The risk lovers who desire to invest all their wealth on bonds and to
maximise their risk. They are gamblers.

The there are plungers who will either invest all their wealth in bonds
or will possess all in cash

Finally, there are risk averters or avoiders. They try to avoid risk
associated with holding bonds rather than cash or money.

Risk Avoidance: It is worth to analyse behaviour of the third category
of investors who are risk avoiders. Some people relate the amount of
risk involved to the expected returns on the investment. Therefore, they
try to distribute their assets both in bonds investment an d money
holding.
Figure No. 2.13

Risk on the X -axis and Returns on the Y -axis. 𝐼𝐶ଵ 𝑎𝑛𝑑 𝐼𝐶ଶare upward
sloping indifference curves of risk -bearing investors. It shows that
investor expects higher and higher returns to undertake more and more
risk. Wealth is measured along OW. Now ON is the budget line of
investor and OC is downward counterpart showi ng proportional
distribution of assets or wealth between bonds and money in
accordance with the degree of risk. The investor is in equilibrium at
point E i.e., tangency between 𝐼𝐶ଵ and budget line ON. A vertical line
is drawn from E to meet OC at point 𝐸ଵthen optimum distribution of
wealth between bonds and money can be determined. At point 𝐸ଵthe
investor prefers to invest OR in bonds and holds remaining amount of
R
W
M
B
E
𝐸1
IC1
IC2
C
Risk
N
X
Wealth and expected Returns munotes.in

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RW in money, thus risk is avoided by diversifying total wealth partly
in bonds and partly in money.

The amount of risk involved is related by them to the expected returns
on the investment. They will therefore appropriately try to distribute
their assets both in bonds investment and money holding. It is then
interesting to find out their pref erences between risk and expected
returns.

Figure No. 2.14
Determination of the optimal portfolio



Risk is shown on the X axis and Return along the Y axis. The expected
return on the portfolio is the interest that can be earned on bonds. This
depends on two things: (i) the interest rate and (ii) the proportion of the
portfolio held in bonds. The total r isk to which an individual is
exposed depends on (i) the uncertainty concerning bond prices — that
is, the uncertainty concerning future movements in market rate of
interest, and (ii) the proportion of the portfolio held in bonds. Let us
denote the expecte d total return by R and the total risk of the portfolio
as a σt. If an individual holds all his wealth (W) in money and none in
bonds, i.e., W = M + 0, both R and σt will be zero, as shown by the
origin (point 0). With an increase in the proportion of bond s, i.e., W =
M + B; as M falls and B increases, R and a, will both rise.

The opportunity line C is a locus of points showing the terms on which
the individual investor can increase R at the cost of increasing σt. A
movement along C from left to right shows that the investor increases
his bond holding only by reducing his money holding.

The lower quadrant alternative portfolio allocations, resulting in
different combinations of R and σt. The vertical axis measures bond
holding. The amount of bonds (B) held in W increases as the investor
moves down the vertical axis to a maximum of W.

The difference between W and B is the asset demand for money (M).
The line OB in the lower part of the diagram shows the relationship
between a, and B. As the proportion o f B in W increases, σt also
increases. This means that as the proportion of bonds in the portfolio
increases, the total risk of the portfolio increases, too.

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2.4 SUMMARY
People differ greatly in their attitudes towards risks. In Bernoullis
hypothesis a person whose marginal utility of money declines will
refuse to accept a fair gamble. A fair game or gamble is one in which
the expected vale of income from a gambler = same amount of income
with certainty. The person who refuses a fair gamble is a risk averse.
Thus, risk averter is one who prefers a given income with certainty to a
risky gamble with the same expected value of income. Risk aversion is
the most common attitude towards risk. It is because of the attitude of
risk aversion that peo ple insure against various kinds of risks such as
burning of house, illness etc.

2.5 QUESTIONS
Q1. Write a note on uncertainty and Choice under Uncertainty.
Q2. Explain the choice under uncertainty
Q3. Write a note on measures of Risk aversion

2.6 REFERENCES
 Gravelle H. and Rees R .(2004) : Microeconomics., 3rd Edition,
Pearson Edition Ltd, New Delhi.
 Varian H (2000): Intermediate Microeconomics: A Modern
Approach, 8th Edition, W.W.Norton and Company
 Gibbons R. A Primer in Game Theory, Harvester -Wheatsheaf, 1992
 Salvatore D. (2003), Microeconomics: Theory and Applications,
Oxford University Press, New Delhi.


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MODULE II

3

OLIGOPOLY MODELS - I

Unit Structure
3.0 Objectives
3.1 The Oligopoly Market: Example, Types and Features
3.2 Cournot’s Duopoly Model
3.3 Bertrand’s Duopoly Model
3.4 Stackelberg’s Duopoly Model
3.5 Questions
3.6 References

3.0 OBJECTIVES
 To explore the knowledge of Oligopoly market and its Various Models
 To understand price and output determinations under Oligopoly
Market.
 To know different types of equilibrium under oligopoly Model.
 To find out of variation in the equilibrium of Oligopoly Theories.

3.1 THE OLIGOPOLY MARKET: EXAMPLE, TYPES AND FEATURES
The Oligopoly Market characterized by few sellers, selling the
homogeneous or differentiated products. In other words, the Oligopoly
market structure lies between the pure monopoly and monopolistic
competition, where few sellers dominate the market and have control over
the price of the product.

Under the Oligopoly market, a firm either produces:
Homogeneous product: The firms producing the homogeneous products
are called as Pure or Perfect Oligopoly. It is found in the producers of
industrial products such as aluminium, copper, steel, zinc, iron, etc.

Heterogeneous Product: The firms producing the heterogeneous products
are called as Imperfect or Differentiated Oligopoly. Such type of
Oligopoly is found in the producers of consumer goods such as
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The term oligopoly is derived from two Greek words: ‘Oligos’ means few
and ‘polis’ means to sellers. Oligopoly is a market structure in which there
are only a few sellers (but more than two) of the homogeneous or
differentiated products. So, oligopoly lies in between monopolistic
competition and monopoly. Oligopoly refers to a market situation in which
there are a few fi rms selling homogeneous or differentiated products.
Oligopoly is, sometimes, also known as ‘competition among the few’ as
there are few sellers in the market and every seller influences and is
influenced by the behaviour of other firms.

3.1.1 Types of Oligopoly:

1. Pure or Perfect Oligopoly :
If the firms produce homogeneous products, then it is called pure or
perfect oligopoly. Though, it is rare to find pure oligopoly situation, yet,
cement, steel, aluminium and chemicals producing industries approach
pure oligopoly.

2. Imperfect or Differentiated Oligopoly:
If the firms produce differentiated products, then it is called differentiated
or imperfect oligopoly. For example, passenger cars, cigarettes or soft
drinks. The goods produced by different firms have their own
distinguishing characteristics, yet all of them are close substitutes of each
other.

3. Collusive Oligopoly :
If the firms cooperate with each other in determining price or output or
both, it is called collusive oligopoly or cooperative oligopoly.

4. Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it is called a non -
collusive or non -cooperative oligopoly.

3.1.2 Features of Oligopoly:
The main features of oligopo ly are elaborated as follows:

1. Few firms:
Under oligopoly, there are few large firms. The exact number of firms is
not defined. Each firm produces a significant portion of the total output.
There exists severe competition among different firms and each firm try to
manipulate both prices and volume of production to outsmart each other.
For example, the market for automobiles in India is an oligopolist
structure as there are only few producers of automobiles.

The number of the firms is so small that an ac tion by any one firm is likely
to affect the rival firms. So, every firm keeps a close watch on the
activities of rival firms.

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2. Interdependence :
Firms under oligopoly are interdependent. Interdependence means that
actions of one firm affect the actions of other firms. A firm considers the
action and reaction of the rival firms while determining its price and
output levels. A change in output or price by one firm evokes reaction
from other firms operating in the market.

For example, market for cars in India is dominated by few firms (Maruti,
Tata, Hyundai, Ford, Honda, etc.). A change by any one firm (say, Tata) in
any of its vehicle (say, Indica) will induce other firms (say, Maruti,
Hyundai, etc.) to make changes in their respective vehicles.

3. Non-Price Competition:
Under oligopoly, firms are in a position to influence the prices. However,
they try to avoid price competition for the fear of price war. They follow
the policy of price rigidity. Price rigidity refers to a situation in which
price tends to stay fixed irrespective of changes in demand and supply
conditions. Firms use other methods like advertising, better services to
customers, etc. to compete with each other.

If a firm tries to reduce the price, the rivals will also react by reducing
their prices. However, if it tries to raise the price, other firms might not do
so. It will lead to loss of customers for the firm, which intended to raise
the price. So, firms prefer non - price competition instead of price
competition.

4. Barriers to Entry of Firms:
The main reason for few firms under oligopoly is the barriers, which
prevent entry of new firms into the industry. Patents, requirement of large
capital, control over crucial raw materials, etc, are some of the reasons,
which prevent new firms f rom entering into industry. Only those firms
enter into the industry which is able to cross these barriers. As a result,
firms can earn abnormal profits in the long run.

5. Selling Costs :
Due to severe competition ‘and interdependence of the firms, variou s sales
promotion techniques are used to promote sales of the product.
Advertisement is in full swing under oligopoly, and many a times
advertisement can become a matter of life -and-death. A firm under
oligopoly relies more on non -price competition. Sellin g costs are more
important under oligopoly than under monopolistic competition.

6. Group Behaviour:
Under oligopoly, there is complete interdependence among different firms.
So, price and output decisions of a particular firm directly influence the
compet ing firms. Instead of independent price and output strategy,
oligopoly firms prefer group decisions that will protect the interest of all
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were a single firm even though individually they retain their
independence.

7. Nature of the Product:
The firms under oligopoly may produce homogeneous or differentiated
product.
i. If the firms produce a homogeneous product, like cement or steel, the
industry is called a pure or perfect oligopoly.
ii. If the firms produce a differentiated product, like automobiles, the
industry is called differentiated or imperfect oligopoly.

8. Indeterminate Demand Curve:
Under oligopoly, the exact behaviour pattern of a producer cannot be
determined with certainty. So, demand curve faced by an oligopolist is
indeterminate (uncertain). As firms are inter -dependent, a firm cannot
ignore the reaction of the rival firms. Any change in price by one firm may
lead to change in prices by the competing firms. So, d emand curve keeps
on shifting and it is not definite, rather it is indeterminate.

3.2 COURNOT’S DUOPOLY MODEL
A model of oligopoly was 1st put forward by Cournot a French economist
in 1838. Cournot’s model of oligopoly is one of the oldest theories of th e
behaviour of the individual firm and relate to non -collusive oligopoly. In
the Cournot model it is assumed that an oligopolist thinks that his rival
will keep their output fixed regardless of what he might do.

Another important model of non -collusive ol igopoly was put forward by
E. H .Chamberlin in his famous work “The theory of Monopolistic
Competition”. Chamberlin made an important improvement over the
classical models of oligopoly, including that of Cournot. In sharp contrast
to Cournot Chamberlin rec ognised is his model that oligopoly firms
recognise their inter -dependence while fixing their output and price.

Cournot’s Duopoly Model Augustine Cournot, a French economist,
published his theory of duopoly in 1838. But it remained mainly unnoticed
till 1880 when Walras called the attention of the economists to Cournot’s
work.

3.2.1 Assumptions :
1) Cournot takes the case of t wo identical mineral springs operated by
two owners who are selling the mineral water in the same market.
Their waters are identical. Therefore, his model relates to the duopoly
with homogeneous products.
2) It is assumed by Cournot for the sake of simplicity that the owners
operate mineral springs and sell water without incurring any cost of
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3) The duopolists completely know the market demand for mineral
water.
4) Cournot assumes that each duopolist believes that regardless of his
actions and their effect on market price of the product, the rival firm
will keep its output constant. .

Actually Cournot illustrated his model with the example of two firms each
owning a spring of mineral water, which is produced at zero costs. We will
present briefly this version, and then we will generalize its presentation by
using the reaction curves approach.

Cournot assumed that there are two firms each owning a mineral well, and
operating with zero costs. They sell their output in a market with a
straight -line demand curve. Each firm acts on the assumption that its
competitor will not change its output, and decides its own output so as to
maximize profit.

Assume that firm A is the first to start producing and selli ng mineral
water. It will produce quantity A, at price P where profits are at a
maximum, because at this point MC — MR = 0. The elasticity of market
demand at this level of output is equal to unity and the total revenue of the
firm is a maximum. With zero costs, maximum R implies maximum
profits, Π. Now firm B assumes that A will keep its output fixed (at 0/1),
and hence considers that its own demand curve is CD’.

Clearly firm B will produce half the quantity AD’, because (under the
Cournot assumption of f ixed output of the rival) at this level (AB) of
output (and at price F) its revenue and profit is at a maxi mum. B produces
half of the market which has not been supplied by A, that is, B’s output is
¼ (= ½. ½) of the total market.
Fig No. 3.1


Firm A, faced with this situation, assumes that B will retain his quantity
constant in the next period. So he will produce one -half of the market
which is not supplied by B. Since B covers one -quarter of the market, A
will, in the next period, produce ½(1 – ¼) = ½ . ¾ = ⅜ of the total market.

Firm B reacts on the Cournot assumption, and will produce one -half of the
unsupplied section of the market, i.e. ½ (1 – ⅜) = 5/16.
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In the third period firm A will continue to assume that B will not change
its quantity, and thu s will produce one -half of the remainder of the market,
i.e. ½ (1 – 5/16).

This action -reaction pattern continues, since firms have the naive
behaviour of never learning from past patterns of reaction of their rival.
However, eventually equilibrium will b e reached in which each firm
produces one -third of the total market. Together they cover two -thirds of
the total market. Each firm maximises its profit in each period, but the
industry profits are not maximised.

That is, the firms would have higher joint profits if they recognised their
interdependence, after their failure in forecasting the correct reaction of
their rival. Recognition of their interdependence (or open collusion) would
lead them to act as ‘a monopolist,’ producing one -half of the total mar ket
output, selling it at the profit -maximising price P, and sharing the market
equally, that is, each producing one -quarter of the total market (instead of
one-third).

1.3.2 The equilibrium of the Cournot firms may be obtained as
follows:
1. The product of firm A in successive period is
Period 1 : 𝟏
𝟐
Period 2 : 𝟏
𝟐ቀ𝟏−𝟏
𝟒ቁ=𝟑
𝟖=𝟏
𝟐−𝟏
𝟖
Period 3 : 𝟏
𝟐ቀ𝟏−𝟓
𝟏𝟔ቁ=𝟏𝟏
𝟑𝟐=𝟏
𝟐−𝟏
𝟖−𝟏
𝟑𝟐
Period 4 : 𝟏
𝟐ቀ𝟏−𝟒𝟐
𝟏𝟐𝟖ቁ=𝟒𝟑
𝟏𝟐𝟖=𝟏
𝟐−𝟏
𝟖−𝟏
𝟑𝟐−𝟏
𝟏𝟐𝟖
We observe that the output of A declines gradua lly. We may rewrite this
expression as follows
ቂ𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝐴
𝑖𝑛 𝑒𝑢𝑖𝑙𝑖𝑏𝑟𝑢𝑚ቃ=𝟏
𝟐−𝟏
𝟖−𝟏
𝟑𝟐−𝟏
𝟏𝟐𝟖……
=𝟏
𝟐−ቈ𝟏
𝟖+𝟏
𝟖−𝟏
𝟒+𝟏
𝟖.൬𝟏
𝟒൰𝟐
+𝟏
𝟖.൬𝟏
𝟒൰𝟑
+⋯቉
The expression in parentheses is a declining geometric progression with
ratio 4=1/4. Applying the summation formula for an infinite geometric
series
න𝑎
1−𝑟
(Where ∫= sum, a= first term of series, r=ratio) we obtain
ቂ𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝐴
𝑖𝑛 𝑒𝑢𝑖𝑙𝑖𝑏𝑟𝑢𝑚ቃ=𝟏
𝟐−𝟏
𝟖
𝟏−𝟏
𝟒=𝟏
𝟐−𝟏
𝟖
𝟑
𝟐=𝟏
𝟐−𝟒
𝟐𝟒=𝟖
𝟐𝟒=𝟏
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2. The product of firm B in successive period is
Period 2 : 𝟏
𝟐ቀ𝟏
𝟐ቁ=𝟏
𝟒
Period 3 : 𝟏
𝟐ቀ𝟏−𝟏
𝟖ቁ=𝟓
𝟏𝟔=𝟏
𝟒+𝟏
𝟏𝟔
Period 3 : 𝟏
𝟐ቀ𝟏−𝟏𝟏
𝟑𝟐ቁ=𝟐𝟏
𝟔𝟒=𝟏
𝟒+𝟏
𝟏𝟔+𝟏
𝟔𝟒
Period 4 : 𝟏
𝟐ቀ𝟏−𝟒𝟑
𝟏𝟐𝟖ቁ=𝟖𝟓
𝟐𝟓𝟔=𝟏
𝟒+𝟏
𝟏𝟔+𝟏
𝟔𝟒+𝟏
𝟐𝟓𝟔
We observe that the output of B increases. But at a declining rate We may
write
ቂ𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝐵
𝑖𝑛 𝑒𝑢𝑖𝑙𝑖𝑏𝑟𝑢𝑚ቃ=𝟏
𝟒+𝟏
𝟒.𝟏
𝟒+𝟏
𝟒.൬𝟏
𝟒൰𝟐
+𝟏
𝟒.൬𝟏
𝟒൰𝟑
+⋯

Applying the above expression for the summation of a declining
geometric series we find
ቂ𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝐵
𝑖𝑛 𝑒𝑢𝑖𝑙𝑖𝑏𝑟𝑢𝑚ቃ=𝟏
𝟒
1−𝟏
𝟒=𝟏
𝟒
𝟑
𝟐=𝟏
𝟑
Thus the Cournot solution is stable. Each firm supplies 4 of the market, at
a common price which is lower than the monopoly price, but above the
pure competitive price (which is zero i n the Cournot example of costless
production). It can be shown that if there are three firms in the industry,
each will produce one -quarter of the market and all of them together will
supply ¾ ( = ¼ . 3) of the entire market OD’.

And, in general, if there are n firms in the industry each will provide n /(n
+ 1) of the market, and the industry output will be n/(n + 1) = 1 /(n + 1) .
n. Clearly as more firms are assumed to exist in the industry, the higher
the 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.
Cournot’s model leads to a stable equilibrium. However, his model may be
criticized on several accounts

The behavioural pattern of firms is naive. Firms do not learn from past
miscalcula tions of competitors’ reactions.

Although the quantity produced by the competitors is at each stage
assumed constant, a quantity competition emerges which drives P down,
towards the competitive level.

3.3 BERTRAND’S DUOPOLY MODEL
Bertrand developed his duopoly model in 1883. His model differs from
Cournot’s in that he assumes that each firm expects that the rival will keep
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Thus each firm is faced by the same market demand, and aims at the
maximization of its own profit on the assumption that the price of the
competitor will remain constant. The model may be presented with the
analytical tools of the reaction functions of the duopolist .

In Bertrand’s model th e reaction curves are derived from iso profit maps
which are convex to the axes, on which we now measure the prices of the
duopolist . Each iso profit curve for firm A shows the same level of profit
which would accrue to A from various levels of prices char ged by this
firm and its rival.

The iso profit curve for A is convex to its price axis (P A). This shape
shows the fact that firm A must lower its price up to a certain level to meet
the cutting of price of its competitor, in order to maintain the level of its
profits at Π A2. However, after that price level has been reached and if B
continues to cut its price, firm A will be unable to retain its profits, even if
it keeps its own price unchanged (at P Ae). If, for example, firm B cuts its
price at P B, firm A will find itself at a lower iso profit curve (Π A1) which
shows lower profits. The reduction of profits of A is due to the fall in
price, and the increase in output beyond the optimal level of utilization of
the plant with the consequent increase in costs. Clearly the lower the iso
profit curve, the lower the level of profits.

Figure No. 3.2

To summaries for any price charged by firm B there will be a unique price
of firm A which maximizes the latter’s profit. This unique profit -
maximizing price is deter mined at the lowest point on the highest
attainable iso profit curve of A. The minimum points of the iso profit
curves lie to the right of each other, reflecting the fact that as firm A
moves to a higher level of profit, it gains some of the customers of B when
the latter increases its price, even if A also raises its price.

If we join the lowest points of the succes sive iso profit curves we obtain
the reaction curve (or conjectural variation) of firm A: this is the locus of
points of maximum profits that A can attain by charging a certain price,
given the price of its rival. The reaction curve of firm B may be derived in
a similar way, by joining the lowest points of its iso profit curves.


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Figure No. 3.3


Bertrand’s model leads to a stable equilibrium, defined by the point of
intersection of the two reaction curves. Point e denotes a stable
equilibrium, since any departure from it sets in motion forces which will
lead back to point e at which the price charged by A and B are P Ae and
PBe respectively. For example, if firm A charges a lower price P A1, firm B
will charge P B1, because on the Bertrand assumption, this price will
maximize B’s profit (given P A1).

Figure No. 3.4


Firm A will react to this decision of its rival by charging a higher price
PA2. Firm B will react by increasing its price, and so on, until point e is
reached, when the market will be in equilibrium. The same equilibrium
will be reached if firms started by charging a price higher than P Ae or P Be a
competitive price cut wou ld take place which would drive both prices
down to their equilibrium level P Ae and P Be.

Note that Bertrand’s model does not lead to the maximization of the
industry (joint) profit, due to the fact that firms behave naively, by always
assuming that their rival will keep its price fixed, and they never learn
from past experience which showed that the rival did not in fact keep its
price constant.

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3.3.1 Bertrand’s model may be criticised on the same grounds as
Cournot’s model:
The behavioural pattern emerging from Bertrand’s assumption is naive:
firms never learn from past experience. Each firm maximises its own
profit, but the industry (joint) profits are not maximized.

The equilibrium price will be the competitive price. (In the example of
costless mineral -water production, the price in Bertrand’s model would
fall to zero. If production is not costless, then price would fall to the level
which would cover the costs of the duopolist inclusive of a normal profit.)
The model is ‘closed’ -does not allow e ntry. The interesting feature of both
Cournot’s and Bertrand’s models is that the limit of duopoly is pure
competition. Neither model refutes the other. Each is consistent and is
based on different behavioural assumptions. We may say that Bertrand’s
assump tion (about the fixity of price of the rival) is more realistic, in view
of the observed preoccupa tion of firms with keeping their prices constant
(except in cost inflation situations).

Furthermore, Bertrand’s model focused attention on price setting as the
main decision of the firm. The serious limitations of both models are the
naive behavioural pattern of rivals; the failure to deal with entry; the
failure to incorporate other variables in the model, such as advertising and
other selling activities, lo cation of the plant, and changes in the product.
Product differentiation and selling activities are the two main weapons of
non-price competition, which is a main form of competition in the real
business world; both models do not define the length of the adjustment
process. Although dealing in terms of ‘time periods,’ their approach is
basically static; both models assume that the market demand is known
with accuracy; both models are based on individual demand curves which
are located by making the conveni ent assumption of constant reaction
curves of the competing firms.

Having discussed the classical duopoly models of Cournot and Bertrand,
we proceed with the development of the traditional models of non -
collusive oligopoly, which apply to market structure s with a few firms
conscious of their interdependence. It is worthwhile pointing out,
however, that both Cournot’s and Bertrand’s models can be extended to
markets in which the number of firms is greater than two.

3.4 STACKELBERG’S DUOPOLY MODEL
This mod el was developed by the German economist Heinrich von
Stackelberg’s and is an extension of Cournot’s model. It is assumed, by
von Stackelberg’s, that one duopolist is sufficiently sophisticated to
recognise that his competitor acts on the Cournot assumptio n.

This recognition allows the sophisticated duopolist to determine the
reaction curve of his rival and incorporate it in his own profit function,
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Assume that the iso profit curves and the reaction fun ctions of the
duopolists are those depicted in following figure. If firm A is the
sophisticated oligopolist, it will assume that its rival will act on the basis
of its own reaction curve. This recognition will permit firm A to choose to
set its own output at the level which maximizes its own profit. This is
point a which lies on the lowest possible iso profit curve of A, denoting
the maximum profit A can achieve given B’s reaction curve.
Figure No. 3.5


Firm A, acting as a monopolist (by incorporating B’s reaction curve in his
profit -maximizing computations) will produce X A, and firm B will react
by producing X B according to its reaction curve. The sophisticated
oligopolist becomes in effect the leader, while the naive rival who acts on
the Cournot assumption becomes the follower.

Clearly sophistication is reward ing for A because he reaches an iso profit
curve closer to his axis than if he behaved with the same naiveté as his
rival. The naive follower is worse off as compared with the Cournot
equil ibrium, since with this level of output he reaches an iso profit curve
further away from his axis.

If firm B is the sophisticated oligopolist, it will choose to produce X’ B,
corresponding to point b on X’s reaction curve, because this is the largest
profi t that B can achieve given his iso profit map and A’s reaction curve.
Firm B will now be the leader while firm A becomes the follower. B has a
higher profit and the naive firm A has a lower profit as compared with the
Cournot equilibrium.

In summary, if o nly one firm is sophisticated, it will emerge as the leader,
and a stable equilibrium will emerge, since the naive firm will act as a
follower.

However, if both firms are sophisticated, then both will want to act as
leaders, because this action yields a g reater profit to them. In this case the
market situation becomes unstable. The situation is known as
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Stackelberg’s disequilibrium and the effect will either be a price war until
one of the firms surrenders and agrees to act as follower, or a collusion is
reached, with both firms abandoning their naive reaction functions and
moving to a point closer to (or on) the Edge -worth contract curve with
both of them attaining higher profits. If the final equilibrium lines on the
Edge -worth contract curve the industry profits (joint profits) are
maximised.

It shows clearly that naive behaviour does not pay. The rivals should
recognise their interdependence. By recognizing the other’s reactions each
duopolist can reach a higher level of profit for himself. If both firm s start
recognising their mutual interdependence, each starts worrying about the
rival’s profits and the rival’s reactions. If each ignores the other, a price
war will be inevitable, as a result of which both will be worse off.

The model shows that a barg aining procedure and a collusive agreement
become advantageous to both duopolist . With such a co llusive agreement
the duopolist may reach a point on the Edge -worth contract curve, thus
attaining joint profit maxi misation.

It should be noted that Stackelb erg’s model of sophisticated behaviour is
not appli cable in a market in which the firms behave on Bertrand’s
assumption. In a Cournot -type market the sophisticated firm ‘bluffs’ the
rival, by producing a level of output larger than the one that would be
produced in the Cournot equilibrium and the naive rival, sticking to his
Cournot behavioural reaction pattern, will be misled and produce less than
in the Cournot equilibrium.

However, in a Bertrand -type market the sophisticated duopolist can do
nothing wh ich would increase his own profit and persuade the other to
stop price -cutting. The most he can do is to keep his own price constant,
that is, behave exactly as his opponent expects him to behave.

A numerical example of Stackelberg’s model
Assume that in a Duopoly market the demand function is
𝑃=100−0.5(𝑋ଵ+𝑋ଶ)
And the Duopolists’ costs are
𝐶ଵ=5𝑋ଵ 𝑎𝑛𝑑 𝐶ଶ=0.5𝑋ଶଶ

The reaction functions are found by taking the partial derivatives of the
duopolists profit functions and equating them to zero:
A numerical example of Stackelberg’s model
Assume that in a duopoly market the demand function is
𝑃=100−0.5(𝑋ଵ+𝑋ଶ)
And the duopolists costs are
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The reaction functions are found by taking the partial derivatives of the
duopolists profit functions and equating them to zero:
𝜋ଵ=𝑃𝑋ଵ− 𝐶ଵ=95𝑋ଵ−0.5𝑋ଵଶ−0.5𝑋ଵ𝑋ଶ
𝜋ଶ=𝑃𝑋ଶ−𝐶ଶ=100𝑋ଶ−𝑋ଵଶ−0.5𝑋ଵ𝑋ଶ
The partial deriva tives are
𝜕𝜋ଵ
𝜕𝑋ଵ=95−𝑋ଵ−0.5𝑋ଶ=0
డగమ
డ௑మ=100−2𝑋ଶ−0.5𝑋ଵ=0
The reaction functions are
𝑋ଵ=95−0.5𝑋ଶ→𝐴ᇱ𝑠 𝑟𝑒𝑎𝑐𝑡𝑖𝑜𝑛 𝑐𝑢𝑟𝑣𝑒
𝑋ଶ=50−0.25𝑋ଵ→𝐵ᇱ𝑠 𝑟𝑒𝑎𝑐𝑡𝑖𝑜𝑛 𝑐𝑢𝑟𝑣𝑒
1] Stackelberg’s solution with A being the sophisticated leader
Firm A will substitute B’s reaction function in its own profit equation
which it will then maximize as if were a monopolist:
𝜋ଵ=𝑃𝑋ଵ−𝐶ଵ=95𝑋ଵ−0.5𝑋ଵଶ−0.5𝑋ଵ𝑋ଶ
Substitute 𝑋ଶ=50−0.25𝑋ଵ
Maximise 𝜋ଵ=70𝑋ଵ−0.375𝑋ଵଶ
First order condition: డగభ
డ௑భ=70−0.75𝑋ଵ=0
This yields Output: 𝑋ଵ= 93ଷଵ
And profit : 𝜋ଵ=70𝑋ଵ−0.375𝑋ଵ=3267
(b) The second order condition for profit maximization is fulfilled.
Firm B would be the follower. It would assume that A would produce
93ଷଵ units; thus B substitutes this amount in its reactio n function
𝑋ଵ=50−0.25𝑋ଵ=26ଷଶ
And its profit would be
𝜋ଶ=100𝑋ଶ−𝑋ଶଶ−0.5𝑋ଵ𝑋ଶ=155.5
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Firm B will substitute A’s reaction function in its own profit function, and
it will proceed to maximize this profit as a monopolist
𝜋ଶ=𝑃𝑋ଶ−𝐶ଶ=100𝑋ଶ−𝑋ଶଶ−0.5𝑋ଵ𝑋ଶ
Substitute 𝑋ଵ=95−0.5𝑋ଶ (i.e., A’s reaction function)
𝜋ଶ=52.5𝑋ଶ−0.75𝑋ଶଶ
a) The first order condition for the maximization of 𝜋ଶ requires
డగమ
డ௑మ=52.5−1.5𝑋ଶ=0
Which yields Output: 𝑋ଶ=35
And Profit: 𝜋ଶ=52.5𝑋ଶ−0.75𝑋ଶଶ=918.75
(b) The second order condition for the maximization of 𝜋ଶ is fulfilled.
The follower is now firm A which will act on the Cournot assumption; it
will assume that the rival will keep his quantity at 𝑋ଶ=35, and will find
its own output by subst ituting this quantity in its reaction function.
𝑋ଵ=95−0.5𝑋ଶ=77.5
And its profit is
𝜋ଵ=95𝑋ଵ−0.5𝑋ଵଶ−0.5𝑋ଵ𝑋ଶ=3003
3) Stackelberg’s disquilibrium
If both entrepreneurs adopt Stackelberg’s sophisticated pattern of
behaviour, each will examine his profits if he acts as a leader and if he acts
as a follower, and will adopt the action that will yield him the greatest
profit.

Firm A calculates its profits both as a leader and as a follower:
If A is the leader his profits are 3267
If A is the follower his profits are 3003
Clearly firm A will prefer to act as the leader.

Firm B similarly, calculates its profits as a leader and as a follower:
If B is the leader his profits are 918 -75
If B acts as the follower his profits are 155 -50
Thus firm B will also choose to act as the leader.

With both firms acting in the sophisticated way implied by Stackelberg’s
behavioural hypothesis both will want to act as leaders. As they attempt to
do so they find that their expecta tions about the rival are not fulfilled and
‘warfare’ will start, unless they decide to come to a collusive agreement.
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We may now summarise Stackelberg’s model. Each duopolist estimates
the maximum profit that he would earn ( a) if he acted as leader, (b) if he
acted as follower, and chooses the behaviour which yields the largest
maximum.

Four situations may arise:
(1) Duo polist A wants to be leader and B wants to be follower.
(2) Duopolist B wants to be leader and A wants to be follower.
(3) Both firms want to be followers.
(4) Both firms desire to be leaders.

In situations (1) and (2) the result is a determinate equilibrium (provided
that the first - and second -order conditions for maxima are fulfilled).
If both firms desire to be followers, their expectations do not materialize
(since each assumes that the rival will act as a leader), and they must
revise them. Two behavioural patterns are possible. If each duopolist
recognises that his rival wants also to be a follow er, th e Cournot
equilibrium is reached. Otherwise, one of the rivals must alter his be -
haviour and act as a leader before equilibrium is attained.

Finally, if both duopolist want to be leaders disequilibrium arises, whose
outcome, according to Stackelberg’s , is economic warfare? Equilibrium
will be reached either by collusion, or after the ‘weaker’ firm is eliminated
or succumbs to the leadership of the other.

3.5 QUESTIONS
Q1. Explain the meaning and features of oligopoly.
a) Types of Oligopoly Market.
Q2. Describe the Cournot’s Duopoly Model
Q3. Bertrand’s Duopoly Model
Q4. Stackelberg’s Duopoly Model

3.6 REFERENCES
 H.L AHUJA, Modern Microeconomics, Delhi, S Chand Company Ltd.
 A. Koutsoyiannis (1979), Modern Microeconomics, London – 0-333-
77821 -9, Macmillan Press Ltd.
 Walter Nicholas & Christopher Snyder, (2008) Micro Economic
Theory – Basic Principles and Extension, USA – 10:0-324-42162 -1,
Thomson South – Western.



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4

OLIGOPOLY MODELS - II

Unit Structure
4.0 Objectives
4.1 Oligopoly: Repeated games
4.2 Comparison with monopoly
4.3 Limit Pricing and Entry Deterrence in Monopoly
4.4 Legalities of Monopolies Vs. Oligopolies
4.5 Examples of Monopolies and Oligopolies
4.6 Limit Pricing and Entry Deterrence In Monopoly
4.7 Questions
4.8 References

4.0 OBJECTIVES
 To understand Game theories and its Policies.
 To understand profit maximisation under imperfect competitions.
 To understand the differences in Monopoly and Oligopoly

4.1 OLIGOPOLY: REPEATED GAMES
In game theory , repeated games, also known as super games, are those that
play out over and over for a period of time, and therefore are usually
represented using the extensive form . As opposed to one -shot games,
repeated games introduce a new series of incentives: the possibility of
cooperating means tha t we may decide to compromise in order to carry on
receiving a payoff over time, knowing that if we do not uphold our end of
the deal, our opponent may decide not to either. Our offer of cooperation
or our threat to cease cooperation has to be credible in order for our
opponent to uphold their end of the bargain. Working out whether
credibility is merited simply involves working out what weighs more: the
payoff we stand to gain if we break our pact at any given moment and gain
an exceptional, one off payoff , or continued cooperation with lower
payoffs which may or may not add up to more over a given time.
Therefore, each player must consider their opponent’s possible
punishment strategies.

This means that the strategy space is greater than in any
regular simultaneous or sequential game . Each player will determine their
strategies or moves taking into account all previous moves up until that
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they will play the game based on the behaviour of the opponent, and
therefore must consider also possible changes in the behaviour of the latter
when making choices.

Repeated ga mes provide different payoffs at each repetition, depending on
each player’s moves. Since these payoffs are given at different points in
time, in order to analyse repeated games, we must compare each player’s
discounted sum of payoffs, which for infinite r epetitions and finite
repetitions are calculated using the following formulae:


Where: -P: the discounted sum of payoffs;
-t: the number of the repetition being considered;
-n: the total number of repetitions for finite repeated games;
-pt: the payoff at the repetition being considered;
-r: the discount rate.

4.1.1 Repeated Prisoner’s dilemma:
In the game known as the Prisoner’s dilemma , the Nash equilibrium is
Confess -Confess (defect -defect). In order to see what equilibrium will be
reached in a repeated game of the prisoner’s dilemma, we must analyse
two cases: the game is repeated a finite number of times and the game is
repeated an infinite number of times.

When the prisoners know the number of repetitions, it’s interesting to
operate a backwards induction to solve the game. Consider the strategies
of each player when they realise the next round is going to be the last.
They behave as if it was a one -shot game, thus the Nash equilibrium
applies, and the equilibrium would be confess -confess, just like in the one -
time game. Now consider the game before the last. Since each player
knows in the next, final round they are going to confess, there’s no
advantage to lie (cooperate with each other) on this round either. The same
logic applies for prior moves. Therefore, confess -confess is the Nash
equilibrium for all rounds.

The situation w ith an infinite number of repetitions is different, since there
will be no last round, backwards induction reasoning does not work here.
At each round, both prisoners reckon there will be another round and
therefore there are always benefits arising form t he cooperate (lie)
strategy. However, prisoners must take into account punishment strategies,
in case the other player confesses in any round.

4.1.2 Collusion agreement games:
If we assume the game can be played ad infinitum, we can apply it in
a collusion agreement game, where two firms collude, forming a cartel.
Consider two firms (a duopoly ) that may either behave as Cournot
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duopolist earning profits π Cournot each, or collude and act as a cartel,
earning π Cartel each, which correspond to the profits of a monopoly divided
into the number of firms colluding (two in our example).

In this case, we simply need to apply the formula for calculating an
infinite sequence and a discount factor to compensate for the fact that the
gains to be derived are over time (accounting for impatience, inflation ,
loss of interest, etc.):
∏



The left hand side represents the payoff derived from collusion, which can
be held infinitely over time, with δ being the discount factor to bring
future benefits forward to the present. For our threats or offers to be
credible, this left hand side must be greater than the right hand side, which
represents the one off payoff to be gained from deviating and breaking our
cartel . The higher δ is, the higher the value assigned to future benefits and
therefore the greater the chances of collusion. It is worth reminding here
that fair competition is regulated in almost all countries, with cartels being
banned, so most markets that l end themselves to reduced competition and
price fixing are closely monitored.

Although this example is widely used in game theory and for the analysis
of market structures , it can be easily see n that it does not represent a real
situation. Let’s consider the same example: any of the colluding firms
might deviate, in order to dump more output in the market at lower prices,
in order to gain market share. This move will allow that firm to sell more
products than the other firms, which directly contradicts Cournot ’s
premise that each duopolist will produce the same quantity. Therefore,
considering a Stackelberg duopoly might seem more realistic. This would
obviously change the analysis and outcome of the game.

4.2 COMPARISON WITH MONOPOLY
A monopoly and an oligopoly are market structures that exist when there
is imperfect competition. A monopoly is when a single c ompany produces
goods with no close substitute, while an oligopoly is when a small number
of relatively large companies produce similar, but slightly different goods.
In both cases, significant barriers to entry prevent other enterprises from
competing.

A market's geographical size can determine which structure exists. One
company might control an industry in a particular area with no other
alternatives, though a few similar companies operate elsewhere in the
country. In this case, a company may be a monop oly in one region, but
operate in an oligopoly market in a larger geographical area.
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Monopoly :
A monopoly exists in areas where one company is the only or dominant
force to sell a product or s ervice in an industry . This gives the company
enough power to keep competitors away from the marketplace. This could
be due to high barriers to entry such as technology,
steep capital requirements, government regulation, patents or high
distribution costs.

Once a monopoly is established, lack of competitio n can lead the seller to
charge high prices. Monopolies are price makers. This means they
determine the cost at which their products are sold. These prices can be
changed at any time. A monopoly also reduces available choices for
buyers. The monopoly becom es a pure monopoly when there is absolutely
no other substitute available.

Monopolies are allowed to exist when they benefit the consumer. In some
cases, governments may step in and create the monopoly to provide
specific services such as a railway, public transport or postal services. For
example, the United States Postal Service enjoys a monopoly on first class
mail and advertising mail, along with monopoly access to mailboxes.

4.3 OLIGOPOLY
In an oligopoly, a group of companies (usually two or more) controls the
market. However, no single company can keep the others from wielding
significant influence over the industry, and they each may sell products
that are slightly different.

Prices in this market are moderate because of the presence of com petition.
When one company sets a price, others will respond in fashion to remain
competitive. For example, if one company cuts prices, other players
typically follow suit. Prices are usually higher in an oligopoly than they
would be in perfect competition .

Because there is no dominant force in the industry, companies may be
tempted to collude with one another rather than compete, which keeps
non-established players from entering t he market. This cooperation makes
them operate as though they were a single company.

In 2012, the U.S. Department of Justice alleged that Apple ( AAPL ) and
five book publishers had engaged in collusion and price fixing for e -
books. The department alleged that Apple and the publishers conspired to
raise the price for e -book downloads from $9.99 to $14.99. A U.S. District
Court sided with the government, a decision which was upheld on appeal.
In a free market, price fixing —even without judicial intervention —is
unsustainable. If one company undermine s its competition, others are
forced to quickly follow. Companies that lower prices to the point where
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of this, members of oligopolies tend to compete in terms of image and
quality rather than price.

4.4 LEGALITIES OF MONOPOLIES VS. OLIGOPOLIES
Oligopolies and monopolies can operate unencumbered in the United
States unless they violate anti -trust laws. These laws cover unreasonable
restraint of trade; plainly harmful acts such as p rice fixing, dividing
markets and bid rigging; and mergers and acquisitions (M&A) that
substantially lessen competition.

Without competition, companies have the power to fix prices and create
product scarcity, which can lead to inferior products and services and
higher costs for buyers. Anti -trust laws are in place to ensure a level
playing field.

In 2017, the U.S. Department of Justice filed a civil antitrust suit to block
AT&T's merger with Time Warner, arguing the acquisition would
substantially lessen competition and lead to higher prices for television
programming. However, a U.S. District Court judge disagr eed with the
government's argument and approved the merger, a decision that was
upheld on appeal.

The government has several tools to fight monopolistic behaviour. This
includes the Sherman Antitrust Act , which prohibits unreasonable restraint
of trade, and the Clayton Antitrust Act , which prohibits mergers that
lessen competition and requires large c ompanies that plan to merge to seek
approval in advance. Anti-trust laws do not sanction companies that
achieve monopoly status via offering a better product or service, or though
uncontrollable developments such as a key competitor leaving the market.

4.5 EXAMPLES OF MONOPOLIES AND OLIGOPOLIES
A company with a new or innovative product or service enjoys a
monopoly until competitors emerge. Sometimes these new products are
protected by law. For example, pharmaceutical companies in the U.S. are
granted 20 years of exclusivity on new drugs. This is necessary due to the
time and capital required to develop and bring new drugs to market.
Without this protected status, firms would not be able to realize a return on
their investment , and potentially beneficial research would be stifled.

Gas and electric utilities are also gra nted monopolies. However, these
utilities are heavily regulated by state public utility commissions. Rates are
often controlled, along with any rate increases the company may pass onto
consumers.

Oligopolies exist throughout the business world. A handful of companies
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names include The Walt Disney Company ( DIS), Viacom CBS ( VIAC )
and Comcast ( CMCSA ). In the music business, Universal Music Group
and Warner Music Group have a tight grip on the market.

4.6 LIMIT PRICING AND ENTRY DETERRENCE IN MONOPOLY
Limit Pricing is a pricing strategy a monopolist may use to discourage
entry. If a monopolist set its profit maximising price (where MR=MC) the
level of supernormal profit would be so high it attracts new f irms into the
market. Limit pricing involves reducing the price sufficiently to deter
entry. It leads to less profit than possible in short -term, but it can enable
the firm to retain its monopoly position and long -term profitability.

4.6.1 Profit maximisa tion in the short run :
In the short -run, a firm may set price using usual profit maximisation rules
(where MR=MC ). This could lead to a price of P1.

Figure No. 4.1

If the new firm produces at Q1, with a market price of P1, that is higher
than its average costs – so it is profitable for a new firm to enter.

4.6.2 Limit pricing :
Therefore, rather than encouraging a new firm to enter, the monopolist
may decide to set a p rice below this profit maximising level, but still high
enough to enable it to make higher profits than in a competitive market.

For limit pricing to be effective, the monopolist needs to decrease the price
to the point where a new firm will not be able t o make any profit on
entering the market.



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Figure No. 4. 2


By reducing the price to P2 it sacrifices supernormal profit in the short -
run. But, the price is low enough to discourage a new firm entering. At P2,
a new firm faces average costs higher than the market price.

By discouraging entry, the incumbent firm is guaranteed an ‘easy life’ and
guaranteed high profits. The monopolist may also build excess capacity as
a threat that if firms enter, it will reduce the price even further.

4.6.3 Evaluation o f limit pricing :
 A large multinational may be willing to enter a market – even if it is
unprofitable in the short -term. The large multinational can use its
reserves and profit elsewhere to subsidies a loss -making entry. For
example, Google entered the mark et for mobile phones – despite no
experience. Limit pricing is not effective if new firms have the capacity
to absorb losses.
 Rather than limit pricing, a firm may set the profit maximising price,
but then react when a new firm enters. If a new firm enters , it lowers
price to make it difficult. It could go to an extreme and engage in
predatory price – setting the price below average cost to force the rival
out of business. Predatory pricing is illegal, which is a reason to choose
limit pricing instead.
 Limi t pricing will be more effective in industries with substantial
economies of scale – for example, industries, such as steel and
aeroplane manufacture. It gives an advantage to the incumbent and
disadvantage to potential new firms. For industries, with few
economies of scale, such as restaurants and bars, limit pricing will not
be effective




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4.7 QUESTIONS
Explain
1. Oligopoly: Repeated games.
2. Repeated Prisoner’s dilemma.
3. Comparison with monopoly.
4. Limit Pricing and Entry Deterrence in Monopoly

4.8 REFERENCES
 H.L AHUJA , Modern Microeconomics, Delhi, S Chand Company
Ltd.
 A. Koutsoyiannis (1979), Modern Microeconomics, London – 0-333-
77821 -9, Macmillan Press Ltd.
 Robert Pendyck & Daniel Rubinfeld, 2017, Microeconomics , 13 -
978-9332585096, Pearson Publication.
 Andreu, Michael & Jerry, 2012, Microeconomic Theory, Oxford
Publication.


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MODULE III

5

MORAL HAZARD AND ADVERSE
SELECTION -I

Unit Structure
5.0 Objectives
5.1 Moral Hazard
5.2 Adverse Selection
5.3 Market for Lemons.
5.4 Principal Agent Models
5.5 Efficiency Wage/Effort Model.
5.6 Questions

5.0 OBJECTIVES
 To understand the concepts of moral hazard and adverse selection.
 To know the market for lemons
 To understand the principal agent models
 To understand the efficiency wage/effort model.

5.1 MORAL HAZARD
If a person is not insured for life or property, he w ould be more careful
with his life and property and avoid taking risks with his life and property.
However, when he ensures his life and property, his behavior becomes
more risky, thereby exposing him to premature death or loss of property.
The tendency of insured persons to be more prone to risk and thereby
increasing the probability of the insured event happening is known as
moral hazard. A person who has insured his house against fire and theft
would be less careful about his property. Similarly, a p erson who has
insured his car against theft would not think twice before parking his
vehicle in a public place. He may also have no incentive in obtaining a car
park in his residential premises. Further a person whose car is stolen
would not make all the necessary efforts to obtain his car back for he is
sure that the value of the car would be paid to him by the insurance
company. These are all examples of moral hazard and it is because of the
problem of moral hazard that insurance companies do not offer insurance
premiums at fair odds. The insurance companies would try to reduce the
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the insurance company may cover a residential house or a firm’s premises
only if fire detection and fire fighting system is installed. In case of health
insurance, the insurance company insists on medical check -up for
identifying any pre -existing diseases and any such disease is not covered
by the policy. In this way, the insurance companies are able t o charge
small premiums and reduce claims.

The insurance companies need to find out the optimal combination of
premium and risk covered. Let us assume that a person who insures his
house against fire. The value of his house is W and if fire occurs the v alue
of his house will be reduced to W 2 (W 2 = W – D, here D = debris). The
individual insures his house against fire by paying a premium ∞ 1. The
house is insured against fire for amount equal to ∞ 2. If there is no fire, his
wealth is W 1 = W – ∞1 and if there is fire his wealth is W 2 = W - d + ∞2.

Figure No. 5.1
The Problem of Moral Hazard.


Fig.5.1 - The Problem of Moral Hazard.

Insurance companies expose themselves to lesser risks and hence offer
less favorable odds to their customers. By offering less favorable odds,
insurance companies are also able to reduce the problem of moral hazard.
This is shown in Figure 5.1 Let us begin with point P which represents the
value of the house of the person. In the absence of insurance, the value of
his house will be reduced to OF in the event of fire. Let us also assume
that the probability of ‘no fire’ is three times the probability of the house
going on fire i.e. 3 to 1. This is shown by the slope of the person’s budget
line B 1 whose slope is 1/3 indicating 3 to 1 odds. Let us now assume that
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the householder insures his house against fire. Assuming that a fire occurs
with probability of 1 to 3, he chooses point E where his budget line B 1 and
indifference curve I 1 are tangent. Point E is the risk free point for the
householder which is along the 45o line because by paying ∞ 1 = NN 1
insurance premium his wealth remains W 1 = W - ∞1 or ON 1 = OF 1
whether there is fire or no fire. Therefore, he will not take precautions
against fire and hence a fire is most likely to occur. You may note that
along the 45o line, W 2 =W or W – d + ∞2 = W 1 - ∞1. Hence the payment
by the insurance company just covers the loss of house in case of a fire.
The insurance company will therefore not offer 3 to 1 odds. Being a risk -
averse organization, it will sell the insurance policy at much less than the
full value of the house to safeguard itself against loss due to moral hazard
and also laying down certain conditions in the policy. This situation is
shown in Fig.3.8 whe re the householder’s equilibrium point is R where his
budget line is B 2 and the indifference curve I 2 are tangent to each other.
At point R, the householder is paying the same premium NN 1 but in case
of fire, he will be paid the insured sum OF 2 instead of OF 1 of the earlier
insured amount.

5.2 ADVERSE SELECTION
Adverse selection takes place when customers know more than the
insurance company about the probability of an event happening. For
instance, in the market for individual health insurance, the person who
seeks a health insurance cover knows more about his health issues than the
insurance company. In order to cover the risk of inadequate information,
the insurance company will charge a premium based on the national
average. This will dissuade healthy persons from taking up health
insurance cover because th ey think that the premium is unreasonably high
and more unhealthy persons will buy insurance cover because they think
that the premium is low. As a result, high -risk individuals are more likely
to buy insurance than low -risk individuals. This problem is known as
the problem of adverse selection. Adverse selection has the potential to
bankrupt an insurance company and hence insurance companies may hike
the premium to a level such that even unhealthy persons may not buy
insurance cover. Insurance companie s solve the problem of adverse
selection by charging different premiums for different age groups and
occupation based on the nature of risk in each group. Thus low risk
groups would be charged low premiums and high risk groups would be
charged high premiu ms. Persons in different age groups are charged
different rates of premium depending on the length of the period of
insurance and the risk involved.

5.3 THE MARKET FOR LEMONS
Real life is imperfect and full of uncertainties. Uncertainties involve risk s.
There are political, social, economic and natural uncertainties.
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can be prevented from happening. These uncertainties are not factored in
the basic economic theories. All unit s in an economy have to confront
uncertainties. The households, the firms and the government constitute the
three basic units of the macro -economy. Households worry about future
income flows, wages and employment. They may worry about the return
on their i nvestments in financial markets. The employment market and the
capital market trends particularly the stock market trends cannot be
accurately predicted. The labor skills demanded in future may be entirely
different from the kind of skills imparted and acq uired by students in our
colleges and universities. The stock market may be rising in a sustained
manner but suddenly may fall like a pack of cards and the wealth owned
by a large number of people may evaporate overnight. The study of
unforeseen factors is known as the economics of uncertainties and
risk.

Asymmetric information explains situations in which not all individuals
involved in a potential exchange are equally well informed. Generally, the
seller of a product or a service has more knowledge abou t the quality of
the product or the service than the potential buyers. Asymmetric
information prevents mutually beneficial exchange in the markets for high
quality goods because buyers do not have adequate information to select
high quality goods and hence they are not willing to pay a fair price.
Asymmetric information and other communication problems between
potential exchange partners can be generally solved through the use of
signals that are costly or difficult to fake. For instance, product warranti es
are such a signal. The seller of a low quality product would not offer a
product warranty because it would prove costly to him. Buyers and sellers
may react to asymmetric information by attempting to judge the qualities
of products and people on the ba sis of the groups to which they belong.
For example, a young taxi driver knows that he is a good driver but the
insurance company would still charge him a high premium because the
taxi driver is a member of a group that is frequently involved in accidents .

The Problem of Asymmetric Information :
Sandeep has a well maintained Maruti Baleno Car and now he decided to
buy a trendy car. He wants to sell his car. The current market price for
2013 Maruti Suzuki Alto car is Rs. Two lakh sixty five thousand but
Sandeep wants to sell his car for Rs.Three lakhs because he knows that his
car is in good condition. Sanjay wants to buy an old Maruti Suzuki Alto
Car and wou ld be willing to pay Rs.Three lakh fifty thousand for a car in
good condition but only Rs. Two lakh seventy five thousand for a car in
not so good condition. Sandeep can hire a mechanic to assess the
condition of the car. However, not all the faults can b e detected by a
mechanic. Will Sanjay buy Sandeep’s car? Because Sandeep’s 2013
Maruti Alto looks no different from other similar cars, Sanjay is not
willing to pay Rs.Three lakhs. Sanjay can buy another 2013 Maruti Alto
only for Rs.Two lakh fifty thousand which according to him is as good as
Sandeep’s car. In this situation, Sanjay will buy someone else’s car and
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is not efficient. If Sanjay had bought Sandeep’s Maruti Alto for Rs.Thr ee
lakhs his surplus would have been Rs. Fifty thousand and Sanjay would
have got a fair price for his car. But Sanjay goes ahead and buys a Maruti
Alto for Rs.Three lakh twenty five thousand. Sandeep’s car remains
unsold and Sanjay gets only Rs.25 thousa nd as surplus.

The Lemons Model :
It is difficult to conclude that the car that Sanjay ends up buying will be in
worse condition than Sandeep’s car because anybody else may have a
better car than Sandeep and yet may not find a buyer to pay a fair price.
However, the economic incentives created by asymmetric information
suggest that most used cars that are put up for sale will be of low quality.
This is because people who ill -treat their cars or had purchased a not so
good car are more likely to sell them than others. Buyers also know from
their experience that cars for sale on the used car market are more likely to
be ‘lemons’ than cars that are not for sale. This realization on the part of
buyers causes them to bargain a used car at a lower reservation price.
Further when the prices of used cars fall in the market, the owners of cars
that are in good condition will not offer their cars for sale. This causes the
average quality of the cars offered for sale on the used car market to
decline further. George Akerlof, a Nobel laureate economist from
Berkeley , was the first to explain the logic behind such a price fall.
Economists use the term ‘lemons model’ to describe Akerlof’s
explanation of how asymmetric information affects the average quality of
the u sed goods offered for sale.

The lemons model has important practical implications for consumer
choice. These implications are exemplified in the following illustrations.

Should you buy your friend’s car? :
You want to buy a used Hyundai Accent (GLE). Y our friend buys a new
car every three years and he has a three year old Hyundai Accent (GLE)
which he wants to sell. Your friend says that his car is in good condition
and he is willing to sell it to you for Rs.3.5 lakhs which is the average
market price for three year old Accents. Should you buy your friend’s
car? Going by the Lemons Model, it would make little sense to buy a used
car because used cars offered for sale in the market are of lower quality
than those cars of the same vintage not offered fo r sale. If your friend’s
claim regarding the condition of the car was to be believed then buying a
car at an average price will certainly be a good deal for you because the
average price is always a price for a lower quality car than what is claimed
by th e owner. Illustrations 3.3 and 3.4 will help you understand the
conditions under which asymmetric information about the quality of
product results in a market in which only poor quality products or lemons
are offered for sale.

What price will an innocent buyer pay for a used car?
Let us consider a market with only two kinds of cars: lemons and good
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potential buyers can in no way distinguish between the lemons and good
ones. Ninety per cent of the new cars are good but ten per cent of them
turn out to be lemons. Used but good cars are worth Rs. Five lakhs but
lemons are worth only Rs. Three lakhs. Let us consider an innocent buyer
who thinks that the used cars for sale have the same quality distribution as
new cars. Assuming that this buyer is risk -neutral, what price will he be
willing to pay for a used car? It is a gamble to buy a car of unknown
quality. However, a risk -neutral buyer will be willing to play the gamble
if it is a fair gamble. The buyer here is not able to distinguish between
lemons and good cars. Yet, given the distribution of good cars and lemons,
the buyer has a 90 per cent cha nce of buying a good car and a ten per cent
chance of buying a lemon. Given the prices that he is willing to pay for
the two types of car, his expected value of the car he buys will thus be
0.90(Rs.5 Lakhs) + 0.10(Rs.3 Lakhs) = Rs.4.8 lakhs. The buyer is a risk -
neutral person and hence his reservation price for a used car will be Rs.4.8
Lakhs.

Who will sell a used car for a price that an innocent buyer is willing to
pay?
If you are the owner of a used good car, at what price would you be
willing to sell your car? Would you sell it to an innocent buyer? What if
your car turns out to be a lemon? You know that your car is good and
hence it is worth Rs.Five lakhs to you but an innocent buyer will be
willing to pay only Rs.4.8 lakhs. Hence, neither you nor anybody else
who owns a good car will be willing to sell it for that price. If you had a
lemon, you will be all the more happy to sell it to an innocent buyer
because Rs.4.8 lakhs that the buyer is willing to pay is Rs.1.8 lakhs more
than the lemon’s wor th to you. Hence only used cars for sale will be
lemons. In due course of time, buyers will revise their optimistic beliefs
about the quality of the used cars for sale. Finally, all used cars will sell
for a price of Rs. Three lakhs and all will be lemo ns. However, in
practice, it does not mean that all cars offered for sale are lemons because
the owner of a good car may sell it at an average price under compelling
circumstances. The lemons model explains the frustration of such owners.
When you buy a used car that is sold for reason that has nothing to do with
the condition of the car for an average price, you are actually beating the
market i.e. you are buying a good car for the price of a lemon.

The Problem of Credibility in Trading :
It is diffi cult for a seller to convince the buyer about the good quality of
the car that he has offered for sale. This difficulty is due to the conflicting
interests of the buyers and the sellers. Sellers of used cars have an
economic incentive to overstate the qu ality of their products and buyers
have an incentive to understate the amount they are willing to pay for used
cars and other products. There is a tendency amongst people to interpret
ambiguous information in such a manner that it promotes their self
interest. However, both buyers and sellers can gain if they can find some
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Credible manner in which the good quality of the car can be signaled
(The Costly -to-fake Principle) :
Sandeep knows that his car is in good condition and Sanjay would be
willing to pay much more than his reservation price for a good car. What
kind of signal about the car’s quality would Sanjay find credible? The
potential confl ict of interest between Sandeep and Sanjay shows that mere
statements about the quality of the car may not persuade Sanjay to buy the
car. Let us suppose that Sandeep offers a warranty under which he agrees
to repair any defects the car develops over the next one year. Sandeep can
afford to offer such a warranty because he knows his car is unlikely to
need expensive repairs. In contrast, the person who knows his car would
need extensive repairs would never extend such an offer. The warranty is
a credibl e signal that the car is in good condition. It enables Sanjay to buy
the car with confidence and both Sandeep and Sanjay would gain in such a
deal.

Illustration 3.5 exemplifies the costly - to-fake principle. This principle
suggests that if parties whos e interests potentially conflict are to
communicate credibly with each other, the signals they send must be
costly to fake. Warranties cannot be faked because bad quality products
would impose heavy costs on the seller to offer warranties.

5.4 THE PRINCI PAL AGENT PROBLEM
The principal agent problem is a situation where the principal due to want
of knowledge cannot ensure his best interest is served by the agent. For
example, in a class room setting, the students are the principal and the
teacher is the agent. Due to want of information, the students are not in a
position to know if the teacher is doing his best to serve their interests. In
a corporate setting, the principal is the owner and the agent constitutes the
managers. The managers may pursue t heir own goals rather than pursuing
the goals of the owners. The principal agent problem is due to the problem
of asymmetric information. An agency relationship comes into existence
when there is an arrangement in which one person’s welfare depends upon
what other person does. The agent is the person who acts and the principal
is the party whom the action affects. A principal – agent problem arises
when agents pursue their own goals and not the goals of the principal.

In a modern economy, principals have to employ agents to carry out their
tasks. Whether it is firms or companies and their employees, sick persons
and medical doctors, students and teachers, principals and agents have to
come together to satisfy their goals. However, due to asymmetric
inform ation, it is difficult for the principle to judge in whose interest the
agent is operating. The medical doctor may prescribe unnecessary medical
examinations or tests, the teacher may not cover the portion entirely and
source his information from the presc ribed reference books and employees
in a firm may shirk from performing expected tasks.

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Measures to Reduce the Principal Agent Problem.

1. Performance Monitoring : The principals must monitor the
performance of their agents. In corporate settings, the performance of the
employee is monitored and evaluated by the human resource department.
Annual increments, promotions and demotions are awarded on the basis of
perfo rmance evaluation of the employees.

2. Incentives for Agents : The principals in any setting must create a
system of incentives and disincentives. While incentives will motivate the
agents to perform according to the expectations of the principles,
disincentives will dissuade the agents from shirking or working below
their natural potential.

5.5 EFFICIENCY WAGE/EFFORT MODEL
According to efficiency wage hypothesis, in some markets, wages are
determined by factors other than the market forces of supply and
demand . Managers pay their employees more than the market -
clearing wage in order to increase their productivity or efficiency which in
turn compensates for the higher wages . Since workers are paid more than
the market clearing or equilibrium wage, there will be unemployment .
Efficiency wages are therefore a market failure explanation of
unemployment which is in contrast to theories which emphasize
government intervention such as minimum wages . The idea of efficiency
wages was expressed as early as 1 920 by Alfred Marshall . Efficiency
wage theory is especially important in new Keynesian economics .
Theories which explain as to why managers pay efficiency wages are:

1. Avoiding Shirking . If it is difficult to measure the quantity or quality
of a work er's effort and systems of piece rates or commissions are
impossible. There may be an incentive for the employee to ‘shirk’ i.e. to
do less work than agreed. The manager thus may pay an efficiency wage
in order to create or increase the opportunity cost, w hich gives the threat
of firing. This threat can be used to prevent shirking (or moral hazard).

2. Minimizing Turnover : The worker's motivation to leave the job and
look for a job elsewhere will be reduced due to efficiency wages.
Efficiency wages makes e conomic sense because it is often expensive to
train replacement workers.

3. Adverse Selection : Firms with higher wages will attract more able job -
seekers. An efficiency wage means that the employer can choose the best
workers among applicants, thus elim inating the problem of adverse
selection.

4. Sociological Theories : Efficiency wages may result from
traditions. According to Akerlof’s theory, higher wages leads to high
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5. Nutritional Theories . In developing countries , efficiency wages may
allow workers to eat well enough to avoid illness and to be able to work
harder and more productively.

The Theory :
According to the Efficiency Wage theory, firms willing to pay higher than
equilibrium wages to workers do so to incentivize them to avoid shirking.
It is impossible to monitor workers’ productivity correctly. Firms therefore
face a principal -agent problem caused by asymmetric information. Since
there is no involuntary unemployment at the equilibrium wage rate,
workers who are fired for shirking will easily find re -employment. Hence,
by paying an efficiency wage which is higher than the equilibrium wage,
the firm can induce workers to work without shirking and with greater
effort and productivity. There is always a n opportunity cost in losing a
high paying job. Further, at efficiency wage rates, there is substantial
involuntary unemployment and if workers shirk at efficiency wage rate,
they will be fired with no chances of being reemployed at higher than
equilibrium wage rates. The theory can be explained with figure 5.2
below.

In Figure 5.2, D L is the demand curve for labor by the firm and S L is
assumed to be perfectly inelastic labor supply curve at the equilibrium
wage rate determined at point ‘E’ which is the intersection point between
the downward sloping demand curve and the vertically sloping supply
curve of labor. Here, OW is the equili brium wage rate and OL is the
equilibrium de mand and supply of labor. At Rs.240/ - per day wage rate,
there is no involuntary unemployment and is equal to mar ginal
productivity of labor (Rs.240 = MP L). However, at Rs.240 wage rate,
workers have a tendency t o shirk. In order to prevent shirking, firms will
have to pay a wage rate which is higher than the equilibrium wage rate .
The higher the efficiency wage, the smaller is the level of unemployment.
This is shown by the no -shirking constraint (NSC) curve. The NSC curve
shows the minimum wage that workers must be paid for each level of
unemployment to avoid shirking. For instance, at the efficiency wage of
Rs.240 , the number of unemployed workers would be EA. When the
efficiency wage is raised to Rs.480 per day, the number of workers
unemployed is only BE* and when CF workers are unemployed the
efficiency wage is Rs. 960/- per day. The NSC curve is positively sloped
i.e. smaller the level of unemployment, higher will be the efficiency wage.
The NSC curve will neither intercept nor intersect the S L curve because
there will be some unemployment at the efficiency wage. The intersection
point between D L and NSC is point E* where the efficiency wage
determined is Rs.480 per day. At this wage rate, the firm empl oys 400
workers and 200 workers remains unemployed. Unemployment of 200
workers is considered enough prevent shirking amongst the employed
workers at the wage rate of Rs.480 per day. At a lower efficiency wage
rate of Rs.240 per day, the number of workers required to be unemployed
is 300 (EA). However, at this wage rate, the unemployment is zero (point
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Conversely, at Rs.960 per day wage rate, only 100 workers need to be
unemployed (FC) but the actual unemployment is of 350 workers (FG).
Hence, the equilibrium wage rate must be lower. The efficiency wage is
Rs.580 because at the wage rate, the number of unemployed worker s (200)
is just good enough to prevent the employed workers from shirking.

Fig.No. 5.2 - Efficiency Wage and Unemployment (Shirking Model).


The Carl Shapiro & Joseph Stiglitz Model Of Efficiency Wages :
In the Shapiro -Stiglitz model workers are paid at a level where they do not
shirk. This prevents wages from dropping to equilibrium or market
clearing levels. Full employment cannot be achieved because workers
would shirk if they were not threatened with the possibility of
unemployment. According to the shirking model, complete contracts do
not exist in the real world. This implies that both parties to the contract
have some discretion, but frequently, due to monitoring problems, it is the
employee’s side of the bargain which is subject to the most discretion.
Methods such as piece rates are impracticable because monitoring is too
costly or inaccurate. Such methods may be based on measures too
imperfectly verifiable by workers, creating a moral hazard problem on the
employer’s side. Thus the payment of a wage in excess of market -clearing
may provide employees with cost -effect ive incentives to work rather than
shirk.

In the Shapiro and Stiglitz model, workers either work or shirk and if they
shirk they have a certain probability of being caught with the penalty of
being fired. As a result, at the point of equilibrium there is unemployment.
Unemployment is generated because firms try to push their wages above
the market average to create an opportunity cost to shirking. This creates a
low, or no income alternative which makes job loss costly, and serves as
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an instrument of disci pline for the workers. Unemployed workers cannot
bid for jobs by offering to work at lower wages, since if hired, it would be
in the worker’s interest to shirk on the job, and he or she has no credible
way of promising not to shirk. Shapiro and Stiglitz po int out that their
assumption that workers are identical (e.g. there is no stigma to having
been fired) is a strong one – in practice reputation can work as an
additional disciplining device.

The shirking model does not predict that the bulk of the unemployed at
any one time are those who are fired for shirking, because if the threat
associated with being fired is effective, little or no shirking and sacking
will occur. Instead the unemployed will consist of a rotating pool of
individuals who have qu it for personal reasons, are new entrants to the
labor market, or who have been laid off for other reasons. Pareto
optimality , with costly monitoring, will result in some unemployment,
since unemployment plays a socially valuable role in creating work
incentives. But the equilibrium unemployment rate will not be Pareto
optimal, since firms do not take into account the social cost of the
unemployment they help to create.

However, the efficiency wage hypothesis is criticized on the ground that
more sophistic ated employment contracts can under certain conditions
reduce or eliminate involuntary unemployment. Lazear demonstrates the
use of seniority wages to solve the incentive problem, where initially
workers are paid less than their marginal productivity , and as they work
effectively over time within the firm, earnings increase until they exceed
marginal productivity. The upward bias in the age -earnings profile
provides the incentive to avoid shirking, and the present value of wages
can fall to the market -clear ing level, eliminating involuntary
unemployment. Lazear and Moore find that the slope of earnings profiles
is significantly affected by incentives.

However, a significant criticism is that moral hazard would be shifted to
employers, since they are responsible for monitoring the worker’s effort.
Incentives would exist for firms to declare shirking when it has not taken
place. In the Lazear model, firms have incentives to fire older workers
(paid above marginal product) and hire new cheaper workers, c reating a
credibility problem. The seriousness of this employer moral hazard
depends on the extent to which effort can be monitored by outside
auditors, so that firms cannot cheat, although reputation effects may have
the same impact.

5.6 QUESTIONS
Q1. Write an explanatory note on moral hazard and adverse selection.
Q2. Write a note on the market for lemons.
Q3. What is the Principal Agent problem? How the problem is solved by
the Efficiency Wage model?
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6

MORAL HAZARD AND ADVERSE
SELECTION -II

Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Screening
6.2.1 Screening Techniques in Labour Market
6.2.2 Screening Techniques in Insurance Market
6.2.3 Other Techniques
6.3 Market Signalling
6.4 Summary
6.5 Questions
6.6 References

6.0 OBJECTIVES
 To help the learner with the clear understanding of the concept of
Screening and signalling.
 How these two concepts are used at different cases such as the
selection procedure of the candidate or the labourer, his promotion
etc.
 Student will also learn that how these concepts are used by the
insurance companies.

6.1 INTRODUCTION
Asymmetric information exists when one party in a transaction possesses
better information than the other party. In certain industries, some parties
in a transaction are bound to know more than other parties in the same
transaction.

For example, in a sale transaction, sellers are bound to have more
information than the buyers, since dealing with the same product or a
range of products gives them greater knowledge of the product compared
to the knowledge that some buyers have.

Screening and Signalling is used when asymmetric information may lead
to a moral hazard or adverse selection due to information imbalance.
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6.2 SCREENING
Screening in economics refers to a strategy of combating adverse selection
– one of the potential decision -making complications in cases of
asymmetric information – by the agent(s) with less information.

Screening refers to a strategy that is used to combat adverse selection by
filtering out false information and retaining only the true information.
Screening is used in contemporary markets where the products being
released into the market are getting increasingly complex for an ordinary
consumer to comprehend.

For the purposes of screening, asymmetric information cases assume two
economic agents, with agents attempting to engage in some sort of
transaction. There often exists a long -term relationship between the two
agents, though that qua lifier is not necessary. Fundamentally, the strategy
involved with screening comprises the “screener” (the agent with less
information) attempting to gain further insight or knowledge into private
information that the other economic agent possesses which i s initially
unknown to the screener before the transaction takes place. In gathering
such information, the information asymmetry between the two agents is
reduced, meaning that the screening agent can then make more informed
decisions when partaking in the transaction.

Screening is applied in a number of industries and markets. The exact type
of information intended to be revealed by the screener ranges widely; the
actual screening process implemented depends on the nature of the
transaction taking place. Often it is closely connected with the future
relationship between the two agents.

The concept of screening was first developed by Michael Spence (1973)

Fig. No. 6.1

For example, in the auto industry, non -specialist buyers rely on the
information provided by the seller when evaluating the type of car they
want to buy. Since the specialist seller possesses more information than
the buyer, he or she may give false inform ation about a product in order to
convince the buyer to purchase that item instead of another. Screening is
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employed in various areas, such as insurance, job markets, and
management, where the problem of asymmetric information exists.

6.2.1 Screening Tech niques in Labour Market :
Screening theory provides an alternative with regard to education,
production and wages. As hypothesized by Spence (1973), Arrow (1973),
and Stiglitz (1975), it proclaimed education to be an essential screen or
signal to productivity. According to Brown and Sessions, higher education
is viewed as an endorsement to perform higher -level jobs yielding higher
wages. Proponents of the screening theory maintain that it provides the
optional explanation that links organizational behaviors with the labor
market .

Screening theory addresses the selection needs of organizations in order to
make ideal hiring decisions that yield desired production requirements.
Thus, the theory considers the function that education plays in
communica ting necessary information to organizations and assumes that
employers first establish the required education levels that classify job
applicants. Education acts as a screening mechanism that signals an
individual’s capabilities. Completion of education a nd training programs
are often requirements or prerequisites to promotions and other personnel
decisions. Degrees and diplomas indicate employee production potential.
Organizations can obtain education information in a low -cost manner to
use in hiring decisions.

Employees with higher levels of education have certain characteristics that
include favorable attendance records and less likelihood of engaging in
unhealthy habits such as smoking, excessive drinking, and illicit drug use.
screening theory acknowl edges the positive correlation between education
and wages. The screening theory argues that employers operate in
imperfect labor markets and employees utilize the various general and
specific skills during the process of performing the duties and expectat ions
required by organizations.

Screening techniques are employed within the labour market during the
hiring and recruitment stage of a job application process. In brief, the
hiring party (agent with less information) attempts to reveal more about
the cha racteristics of potential job candidates (agents with more
information) so as to make the most optimal choice in recruiting a worker
for the role.

There are several techniques that employers use to address the problem of
asymmetric information among interview candidates. Screening
Techniques Used in the Labor Market are:
1. Application Review: The hiring party initially screens applicants by
undertakin g a review of their application submission and any responses
received, including an evaluation of their resume and cover letter to
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2. Aptitude Tests and Assessment: Aptitude tests are one of the most
popular s creening techniques that employers use to select high -quality
candidates from a pool of job seekers. Aptitude tests are usually in the
form of specialized tests that are used to test a candidate’s productivity
and their knowledge of specific subjects. The hiring party may require
applicants to undertake a range of testing exercises (either online or in -
person) to reveal academic or practical abilities
3. Quality of College or University: Employers also use the candidate’s
school affiliation to shortlist candid ates. They assume that the top -tier
colleges and universities produce high -quality candidates who are
likely to outperform candidates from the other colleges.
4. Grade Point Average (GPA): The average grade points achieved
during the years spent in school ca n also be used to screen potential
employees. The top performers who have performed consistently well
in school will have high averages compared to students who have had
varied performances during their years in school.
5. Interviews: Candidates are often req uired to undertake an interview
with a representative(s) from the hiring party to reveal a range of
factors such as personality traits, verbal communication ability and
confidence level .

There are many examples of screening in employment decisions.
Employ ers give aptitude tests and check letters of recommendation. The
existence of "old -boy" networks is the result of a screening process. If a
person wants to hire someone, he will ask those he trusts (the "old boys")
for recommendations. Because recommending someone who is
unqualified will lower his prestige in the eyes of the other "old boys,"
there is an incentive for a person to only recommend qualified applicants.1
Also, part of the enthusiasm that employers have for graduates of
prestigious MBA programs is that the schools are selective about who they
let in. They try to select only those students who have the right
combinations of intelligence and personality traits to ensure success in the
business world. Thus, prestigious MBA programs act as a screenin g
agency for business. This, as much as what they teach their students, may
account for the high salaries their graduates command.

6.2.2 Screening Techniques in Insurance Market :
The best known theoretical explanation is that of competitive screening,
put out by Rothschild and Stiglitz in 1977, in their article “Equilibrium in
Competitive Insurance Markets”, which shows how insurance companies
can get around the people taking advantage of adverse selection by
offering different types of insurance options w hich will attract only the
risk adverse. This is covered in more detail in insurance models, which are
covered by the field analysing risk and uncertainty.

There are two basic types of screening: in the first, the ‘victim’ of
asymmetric information simply sets about finding out as much as possible
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offering health insurance, or running a background check before offering a
job. This, aside from verging on the morally questionable, is ofte n highly
regulated in many countries. The second option is using game theory to set
up the terms of a contract so that they only interest the cherries. Something
as simple as copayment in case of a claim (for example, paying a small
percentage of the claim amount in case a car is damaged) can help to weed
out those who are not risk adverse.

The process of screening customers is highly applicable in the market for
insurance. In general, parties providing insurance perform such activities
to reveal the overa ll risk level of a customer, and as such, the likelihood
that they will file for a claim. When in possession of this information, the
insuring party can ensure a suitable form of cover (i.e. commensurate with
the customer’s risk level) is provided. Asymmet ric information also exists
in the insurance industry, and it often leads to moral hazard among the
insured persons. Some of the techniques that insurance companies use
include:

1. Historical record :
Insurers look at the past behavior of its insurance clients to determine their
level of risk and the possibility that they will engage in risky behavior in
the future. Background check is undertaken by the party providing
insurance to obtain information about the customer such as their cr iminal
history, credit rating and previous employment to reveal past behaviors.
For example, if a client has a history of multiple car accidents in the past,
there is a likelihood that the client will still get involved in an accident in
the future. It ma kes the insurance company aware of the level of risk that it
is subjecting itself to by providing insurance coverage to the risky client.

2. Health condition :
When providing life insurance coverage to a client, the insurer will be
interested in knowing the health condition of the client and the kind of
illnesses that the person has. Clients with terminal illnesses or other long -
term illnesses are usually categorized as risky and are, therefore, charged
different premiums compared to clients with no histo ry of illnesses.

3. Demographic Characteristics or Provision of Demographic Information
Another consideration that insurance companies make is looking at the
demographic characteristics of its new clients. The party providing
insurance obtains information about the customer such as their age, gender
and ethnicity to reveal their type When selling auto insurance, younger
clients in the 13 - to 20 -year-old bracket are considered risky compared to
the clients in the 40 - to 50 -year-old age bracket. On the other hand, older
clients aged above 60 years old are considered risky compared to younger
clients aged 30 to 40 years old in life insurance.

Other information gathered by insurance parties during a screening
process is usually specific to the type of insuranc e the customer is seeking.
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health insurance will require provision of health condition and previous
illnesses, and so on.

When there is asymmetric information in the market, screening can
involve incentives that encourage the better informed to self -select or self -
reveal. For example, a job with a low -paying probationary period will
discourage those who know they are not well -suited for the position from
applying. People who are confide nt that they will survive the probationary
period are more likely to find the offer attractive than those who doubt
their ability. A lender who demands collateral for a loan discourages
applications from those who doubt their ability to repay. (Collaterali zed
loans do more than screen, but screening is one of their functions.) People
who expect to use insurance find deductibles more of a burden than those
who do not expect to make claims. Hence, insurance companies use
deductibles to sort policyholders into different risk classes and charge
accordingly.

6.2.3 Other Techniques :
Second degree price discrimination is also an example of screening,
whereby a seller offers a menu of options and the buyer's choice reveals
their private information. Specifically, s uch a strategy attempts to reveal
more information about a buyer’s willingness to pay. For example, an
airline offering economy, premium economy, business and first class
tickets reveals information regarding the amount the customer is willing to
spend on their airfare. With such information, firms can capture a greater
portion of total market surplus.

In contract theory, the terms "screening models" and "adverse selection
models" are often used interchangeably. An agent has private information
about his t ype (e.g., his costs or his valuation of a good) before the
principal makes a contract offer. The principal will then offer a menu of
contracts in order to separate the different types. Typically, the best type
will trade the same amount as in the first -best benchmark solution (which
would be attained under complete information), a property known as "no
distortion at the top". All other types typically trade less than in the first -
best solution (i.e., there is a "downward distortion" of the trade level).

Optimal auction design (more generally known as Bayesian mechanism
design) can be seen as a multi -agent version of the basic screening model.
Contract -theoretic screening models have been pioneered by Roger
Myerson and Eric Maskin. They have been extended i n various directions.
For example, it has been shown that, in the context of patent licensing,
optimal screening contracts may actually yield too much trade compared
to the first -best solution. Applications of screening models include
regulation, public pr ocurement, and monopolistic price discrimination.
Contract -theoretic screening models have been successfully tested in
laboratory experiments and using field data.

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6.3 MARKET SIGNALLING
Signalling theory is fundamentally concerned with reducing information
asymmetry between two parties. In contract theory, signalling is the idea
that one party (termed the agent) credibly conveys some information about
itself to another party (the principal). Although signalling theory was
initially developed by M ichael Spence based on observed knowledge gaps
between organisations and prospective employees, its intuitive nature led
it to be adapted to many other domains, such as Human Resource
Management, business, and financial markets.

In Spence's job -market si gnalling model, (potential) employees send a
signal about their ability level to the employer by acquiring education
credentials. The informational value of the credential comes from the fact
that the employer believes the credential is positively correlat ed with
having the greater ability and difficulty for low ability employees to
obtain. Thus, the credential enables the employer to reliably distinguish
low ability workers from high ability workers. The concept of signalling is
also applicable in competit ive altruistic interaction, where the capacity of
the receiving party is limited.

Signalling started with the idea of asymmetric information (a deviation
from perfect information), which relates to the fact that, in some economic
transactions, inequalities exist in the normal market for the exchange of
goods and services. In his seminal 1973 article, Michael Spence proposed
that two parties could get around the problem of asymmetric information
by having one party send a signal that would reveal some piece of relevant
information to the other party. That party would then interpret the signal
and adjust his or her purchasing behaviour accordingly —usually by
offering a higher price than if she had not received the signal. There are, of
course, many problems that these parties would immediately run into.
 How much time, energy, or money should the sender (agent) spend on
sending the signal?
 How can the receiver (the principal, who is usually the buyer in the
transaction) trust the signal to be an hone st declaration of
information?
 Assuming there is a signalling equilibrium under which the sender
signals honestly and the receiver trusts that information, under what
circumstances will that equilibrium break down?

Suppose that Jeevan wants to sell a car that he values at Rs.50000/ -. Hari
is looking for a car and would consider Jeevan's car worth Rs.60000/ - if he
knew as much about it as Jeevan knows. An exchange would benefit both
Hari and Jeevan but it might not take place because of an information
probl em. Jeevan probably knows a variety of things about his car that
might not be obvious to a buyer. But how can Hari trust Jeevan to tell him
all that he knows when Jeevan has the incentive to misrepresent the
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Economists say that the pote ntial transaction described above has the
problem of asymmetric information, which simply means that the
information available to buyers is different than the information available
to sellers. They are interested in this problem because they see it in many
different situations and because it may lead to a market failure, a case in
which a market is economically inefficient. However, when there is
unexploited value, buyers and sellers have an incentive to find ways to
capture that value. Sellers with high qu ality products need ways to signal
the quality of their products so that buyers can distinguish between high -
quality and low -quality products. Buyers must find ways to screen out
erroneous information but allow in truthful information. These problems
do no t exist in markets in which products are simple and easily evaluated.
There is little need for this behavior in many agricultural markets, for
instance.

One way a seller can signal the quality of its product is by offering
guarantees or warranties. If a f irm offers a warranty on a poor product, it
will suffer a loss. Therefore, it is in the firm's interests to only offer a
warranty on a quality product. The warranty tells potential buyers that the
firm will stake money on its belief that it has a good -quality product.

Another way a firm can signal quality is by building a brand name. A
brand name is valuable only if consumers associate it with quality, and the
firm can build this association only with time and resources. Once a brand
name is established, i t is in the interests of the firm to protect it by not
offering a poor -quality product with its brand name. When a firm with an
established brand name does offer a poor -quality product, it usually puts a
different name on the product so as not to endanger the public's perception
of its brand name.

Signalling plays an important role in the labor market. An employer has
little information about a prospective employee, and cannot expect truthful
answers if he asks whether the applicant is intelligent, has lea dership
qualities, and is responsible. Instead, the applicant must try to prove that
he has these qualities. A college education is a way of signalling
intelligence and perseverance. Leadership can be signalled by
extracurricular activities. (As a result, some students seek leadership
positions primarily for their value as ways to signal leadership to future
employers.) The purpose of a resume is to list those activities that will
signal attractive qualities to potential employers.

The fact that a college education can signal qualities to employers has
raised some interesting questions about why people get college educations.
A popular answer among economists has been that education builds
human capital, that is, it is a way of investing in people to increa se their
productivity. More recently some economists have suggested that this
view is wrong or at best only partly true, and that college education mostly
serves as a way of signalling to future employers. If education is merely a
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who are not intelligent and do not have perseverance, then the social
usefulness of college education may not be very great. From the viewpoint
of the student, it does not matter --the benefits are the same e ither way.
Although most economists believe that education both builds human
capital and acts as a signal, the relative importance of these two functions
is still disputed.

Signalling is an action by a party with good information that is confined to
situa tions of asymmetric information. Screening, which is an attempt to
filter helpful from useless information, is an action by those with poor
information.

Michael Spence considers hiring as a type of investment under uncertainty
analogous to buying a lottery ticket and refers to the attributes of an
applicant which are observable to the employer as indices. Of these,
attributes which the applicant can manipulate are termed signals.
Applicant age is thus an index but is not a signal since it does not ch ange
at the discretion of the applicant. The employer is supposed to have
conditional probability assessments of productive capacity, based on
previous experience of the market, for each combination of indices and
signals. The employer updates those assess ments upon observing each
employee's characteristics. The paper is concerned with a risk -neutral
employer. The offered wage is the expected marginal product. Signals
may be acquired by sustaining signalling costs (monetary and not). If
everyone invests in the signal in the exactly the same way, then the signal
can't be used as discriminatory, therefore a critical assumption is made: the
costs of signalling are negatively correlated with productivity. This
situation as described is a feedback loop: the emplo yer updates his beliefs
upon new market information and updates the wage schedule, applicants
react by signalling, and recruitment takes place. Michael Spence studies
the signalling equilibrium that may result from such a situation.

He began his 1973 mode l with a hypothetical example: suppose that there
are two types of employees —good and bad —and that employers are
willing to pay a higher wage to the good type than the bad type. Spence
assumes that for employers, there's no real way to tell in advance whic h
employees will be of the good or bad type. Bad employees aren't upset
about this, because they get a free ride from the hard work of the good
employees. But good employees know that they deserve to be paid more
for their higher productivity, so they desi re to invest in the signal —in this
case, some amount of education. But he does make one key assumption:
good -type employees pay less for one unit of education than bad -type
employees. The cost he refers to is not necessarily the cost of tuition and
living expenses, sometimes called out of pocket expenses, as one could
make the argument that higher ability persons tend to enroll in "better"
(i.e. more expensive) institutions. Rather, the cost Spence is referring to is
the opportunity cost. This is a combinat ion of 'costs', monetary and
otherwise, including psychological, time, effort and so on. Of key
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"good" and "bad" workers. The cost of obtaining identical credentials is
strictly lower for the "good" employee than it is for the "bad" employee.
The differing cost structure need not preclude "bad" workers from
obtaining the credential. All that is necessary for the signal to have value
(informational or otherwise) is that the group w ith the signal is positively
correlated with the previously unobservable group of "good" workers. In
general, the degree to which a signal is thought to be correlated to
unknown or unobservable attributes is directly related to its value.

The result :
Spence discovered that even if education did not contribute anything to an
employee's productivity, it could still have value to both the employer and
employee. If the appropriate cost/benefit structure exists (or is created),
"good" employees will buy mor e education in order to signal their higher
productivity.

The increase in wages associated with obtaining a higher credential is
sometimes referred to as the “sheepskin effect”, since “sheepskin”
informally denotes a diploma. It is important to note that this is not the
same as the returns from an additional year of education. The "sheepskin"
effect is actually the wage increase above what would normally be
attributed to the extra year of education. This can be observed empirically
in the wage differences between 'drop -outs' vs. 'completers' with an equal
number of years of education. It is also important that one does not equate
the fact that higher wages are paid to more educated individuals entirely to
signalling or the 'sheepskin' effects. In reality, e ducation serves many
different purposes for individuals and society as a whole. Only when all of
these aspects, as well as all the many factors affecting wages, are
controlled for, does the effect of the "sheepskin" approach its true value.
Empirical studi es of signalling indicate it as a statistically significant
determinant of wages, however, it is one of a host of other attributes —
age,sex, and geography are examples of other important factors .

The Model :
To illustrate his argument, Spence imagines, for simplicity, two
productively distinct groups in a population facing one employer. The
signal under consideration is education, measured by an index y and is
subject to individual choice. Education costs are both monetary and
psychic. The data can be summar ized as:
Table No. 6.1

Data of the Model Group Marginal Product Proportion of population Cost of education level y I 1 y II 2 y/2 munotes.in

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Suppose that the employer believes that there is a level of education y*
below which productivity is 1 and above which productivity is 2. His
offered wage schedule W(y) will be:

Working with these hypotheses Spence shows that:
1. There is no rational reason for someone choosing a different level of
education from 0 or y*.
2. Group I sets y=0 if 1>2 -y*, that is if the return for not investing in
education is higher than investing in education.
3. Group II sets y=y* if 2 -y*/2>1, tha t is the return for investing in
education is higher than not investing in education.
4. Therefore, putting the previous two inequalities together, if 1then the employer's initial beliefs are confirmed.
5. There are infinite equilibrium values of y* belonging to the interval
[1,2], but they are not equivalent from the welfare point of view. The
higher y* the worse off is Group II, while Group I is unaffected.
6. If no signalling takes place each person is paid his unconditional
expected marginal prod uct. Therefore, Group, I is worse off when
signalling is present.

In conclusion, even if education has no real contribution to the marginal
product of the worker, the combination of the beliefs of the employer and
the presence of signalling transforms the education level y* in a
prerequisite for the higher paying job. It may appear to an external
observer that education has raised the marginal product of labor, without
this necessarily being true.
Another model

For a signal to be effective, certain condit ions must be true. In equilibrium,
the cost of obtaining the credential must be lower for high productivity
workers and act as a signal to the employer such that they will pay a
higher wage.
Fig. No. 6 .2


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In this model it is optimal for the higher ability person to obtain the
credential (the observable signal) but not for the lower ability individual.
The table shows the outcome of low ability person l and high ability
person h with and without signal S*:


The structure is as follows: There are tw o individuals with differing
abilities (productivity) levels.
• A higher ability / productivity person: h
• A lower ability / productivity person : l

The premise for the model is that a person of high ability (h) has a lower
cost for obtaining a given level of education than does a person of lower
ability (l). Cost can be in terms of monetary, such as tuition, or
psychological, stress incurred to obtain the credential.
• Wo is the expected wage for an education level less than S*
• W* is the expected wa ge for an education level equal or greater than
S*


Thus, if both individuals act rationally, it is optimal for person h to obtain
S* but not for person l so long as the following conditions are satisfied.

note that this is incorrect with the example as graphed. Both `1` and `h`
have lower cost than W* at the education elevel. Also, Person (credential) and
Person (no credential) are not clear.

note that this is ok as for low type "l": and thus, low type will choose Do
not obtain credential.

For there to be a separating equilibrium the high type 'h' must also check
their outside option; do they want to choose the net pay in the separating
equilibrium (calculated above) over the net pay in the pooling equilibrium.
Thus, we also need to test that: Otherw ise high type 'h' will choose Do not
obtain credential of the pooling equilibrium.
Summary of the outcome for l and h with and without S* Person Without Signal With Signal Will the person obtain the signal S*? l Wo W* - C'(l) No, because Wo > W* - C'(l) h Wo W* - C'(h) Yes, because Wo < W* - C'(h)
For the individual: Person(credential) - Person(no credential) ≥ Cost(credential) → Obtain credential Person(credential) - Person(no credential) < Cost(credential) → Do not obtain credential munotes.in

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For the employers:

In equilibrium, in order for the signalling model to hold, the employer
must recognize the signal and pay the corresponding wage and this will
result in the workers self -sorting into the two groups. One can see that the
cost/benefit structure for a signal to be effective must fall within certain
bounds or else the system will fail.

Costly signalling:
In foreign policy, it is common to see game theory p roblems such as the
prisoner’s dilemma and chicken game occur as the different parties both
have a dominating strategy regardless of the actions of the other party. In
order to signal to the other parties, and furthermore for the signal to be
credible, str ategies such as tying hands and sinking costs are often
implemented. These are examples of costly signals which typically present
some form of assurance and commitment in order to show that the signal
is credible and the party receiving the signal should a ct on the information
given. Despite this however, there is still much contention as to whether,
in practice, costly signalling is effective. In studies by Quek (2016) it was
suggested that decision makers such as politicians and leader don't seem to
interpret and understand signals the way they that models suggest they
should.


Sinking costs and Tying hands :
A costly signal in which the cost of an action is incurred upfront ("ex
ante") is a sunk cost. An example of this would be the mobilization of an
army as this sends a clear signal of intentions and the costs are incurred
immediately.

When the cost of the action is incurred after the decision is made ("ex
post") it is considered to be tying hands. A common example being an Person(credential) = E(Productivity | Cost(credential) ≤ Person(credential) - Person(no credential)) Person(no credential) = E(Productivity | Cost(credential) > Person(credential) - Person(no credential))
Prisoners Dilemma B Cooperate B Defect A Cooperate 3,3 0,5 A Defect 5,0 1,1 Chicken's Game B Swerve B Don't Serve A Swerve 0,0 -1,1 A Don't Swerve 1,-1 -5,-5 munotes.in

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alliance made which doesn' t have a large monetary cost initially however,
it does tie the hands of the parties as they are now reliant on one another in
a time of crisis.

Theoretically both sinking costs and tying hands are valid forms of costly
signalling however they have garner ed much criticism due to differing
beliefs regarding the overall effectiveness of the methods in altering the
likelihood of war. Recent studies such as the Journal of Conflict
Resolution suggest that sinking costs and tying hands are both effective in
increasing credibility. This was done by finding how the change in the
costs of costly signals vary their credibility. Prior to this research studies
conducted were binary and static by nature, limiting the capability of the
model. This increased the validity of the use of these signalling
mechanisms in foreign diplomacy.

Conclusion :
Individuals may also serve as their own insiders when signalling about
themselves (e.g., in the job market). Signals about investments are also
common, but we combine these with organizational signals. Signalling
theory focuses mainly on costly signals, scholars have also extended
research on information asymmetries to include less costly forms of
communication. For example, Farrell and Rabin (1996), in an article titled
“Cheap Talk,” provided an influential analysis of how insiders
communicate cost -less i nformation.

Screening is one of the main strategies for combating adverse selection. It
is often confused with signalling, but there is one main difference: in both,
‘good’ agents (the cherries of this world) are set apart from the ‘bad’
agents, or lemon s, which are weeded out. In signalling, it is the
uninformed agent (the victim of asymmetric information) who moves first,
and comes up with a strategy to weed out the lemons. In signalling,
however, it is the cherries, the informed agents, who make the fi rst move
to set themselves apart.

6.4 SUMMARY
In this way the concept of screening and Signalling help us to overcome
the problems created by lack of information. It helps us to know the
specific steps require to be taken in the say labour or insurance market. It
is essential for both the parties.

6.5 QUESTIONS
Q1. Write a note on the concept of Screening
Q2. Explain the process of screening in labour market.
Q3. How screening and signalling help in an insurance market.
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6.6 REFERENCES
 Arrow, K. J. (1971). Essays in the theory of risk bearing. New York:
North Holland.
 Gravelle H. and Rees R.(2004) : Microeconomics., 3rd Edition,
Pearson Edition Ltd, New Delhi.
 Gibbons R. A Primer in Game Theory, Harvester -Wheatsheaf, 1992
 A. Koutsoyiannis : Modern Microeconomics
 Salvatore D. (2003), Microeconomics: Theory and Applications,
Oxford University Press, New Delhi.
 Varian H (2000): Intermediate Microeconomics: A Modern
Approach, 8th Edition, W.W.Norton and Company
 Varian: Microeconomic Analysis, Third Edition
 Salvatore D. (2003), Microeconomics: Theory and Applications,
Oxford University Press, New Delhi.
 Williamson, O. E. (1988). Corporate finance and corporate
governance. Journal of Finance, 43, 567 –591.


*****
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MODULE IV

7

ALTERNATIVE THEORIES OF THE
FIRM -I

Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Marris Model of Managerial
7.3 Williamson’s Model of Managerial Discretion
7.4 Behavioural Theories of Firm
7.5 Full Cost Pricing Principle
7.6 Summary
7.7 Questions
7.8 References

7.0 OBJECTIVES
After studying this module, you shall be able to
 Know the concept of managerial theory of firm
 Why Williamson model is different from other managerial theories?
 Williamson’s Utility Function
 Understand why utility maximization is the goal of the managers
rather than profit maximization?
 Behavioural theories of firm
 Full cost pricing principle
 Existence, purpose and boundaries of firm
 Resource, Knowledge and Transaction cost -based theories of firm

7.1 INTRODUCTION
Alternative Theories of The Firm :
The traditional theories of firm had analysed the decision -making on the
basis of the objective of profit maximisation. As an alternative, Baumol
had put forward the notion that the firms maximi se sales revenue.
Williamson analyses the case for a firm which it maximises the managerial munotes.in

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utility function subject to a profit constraint. Marris in his model shows the
equilibrium as a fallout of maximisation of both the owners and the
managers

Alternative Theories of the Firm provides a range of fundamental readings
embracing the economics of firm behaviour from a non -neoclassical
perspective. The collection covers several basic topics including: the
importance of transaction costs and agency th eory for the analysis of firm
behaviour; capabilities and resource -based theories of the firm; the
economics of firm strategy; behavioural theories; Austrian theories;
evolutionary theories; and the historical development of firms. The
readings include sel ections from traditional masters as well as writings by
more recent authors. This collection will be of great value both to scholars
who want a summary of developments in the field and to students of
industrial economics and corporate strategy.

Managerial theories conceive the firm as a ‘coalition’ (of managers,
workers, stock -holders, suppliers, customers tax collectors) whose
members have conflicting goals that must be reconciled if the firm is to
survive. The conflicts are resolved by top mana gement by various methods
explained in behavioural theories.

It will be studies in two parts. First part will cover the Marris, Williamson
models and Behavioural theories of firm. It will also cover the concept of
full-cost pricing. In second part we wil l study Existence, purpose and
boundaries of firm and Resource, Knowledge and Transaction cost -based
theories of firm

7.2 MORRIS/MARRIS MODEL OF MANAGERIAL ENTERPRISE
I. Goals of the Firm:
The goal of the firm in Marris’s model is the maximisation of the balanced
rate of growth of the firm, that is, the maximisation of the rate of growth
of demand for the products of the firm, and of the growth of its capital
supply:
Maximise g = 𝑔஽= 𝑔஼
where g = balanced growth rate
𝑔஽= growth of demand for the products of the firm
𝑔஼= growth of the supply of capital

In pursuing this maximum balanced growth rate, the firm has two
constraints. Firstly, a constraint set by the available managerial team and
its skills. Secondly, a financial constraint, set by th e desire of managers to
achieve maximum job security. These constraints are analysed in a
subsequent section. The rationalisation of this goal is that by jointly
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achieve maximisation of their own utility as well as of the utility of the
owners -shareholders.

It is usually argued by managerial theorists that the division of ownership
and manage-ment allows the managers to set goals which do not
necessarily coincide with those of owners. The uti lity function of
managers includes variables such as salaries, status, power and job
security, while the utility function of owners includes variables such as
profits, size of output, size of capital, share of the market and public
image. Thus, managers wa nt to maximise their own utility
𝑈ெ= (salaries, power, status, job security)

while the owners seek the maximisation of their utility
𝑈ை= f* (profits, capital, output, market share, public esteem).

Marris argues that the difference between the goals of managers and the
goals of the owners is not so wide as other managerial theories claim,
because most of the variables appearing in both functions are strongly
correlated with a single variable the size of the firm (see below). There are
various measures (indicators) of size capital, output, revenue, market
share, and there is no consensus about which of these measures is the best.

However, Marris limits his model to situations of steady rate of growth
over time during which most of the relevant economic magnitudes change
simultaneously, so that ‘maximising the long -run growth rate of any
indicator can reasonably be assumed equivalent to maximising the long -
run rate of most others.’ (Marris, ‘A Model of the Managerial Enterprise’.)
Furthermore, Marris arg ues that the managers do not maximise the
absolute size of the firm (however measured), but the rate of growth (=
change of the size) of the firm. The size and the rate of growth are not
necessarily equivalent from the point of view of managerial utility. If they
were equivalent, we would observe a high mobility of managers between
firms: the managers would be indifferent in choosing between being
employed and promoted within the same growing firm (enjoying higher
salaries, power and prestige), and moving f rom a smaller firm to a larger
firm where they would eventually have the same earnings and status.

In the real world the mobility of managers is low. Various studies provide
evidence that managers prefer to be promoted within the same growing
organisation rather than move to a larger one, where the environment
might be hostile to the ‘newcomer’ and where he would have to give
considerable time and effort to ‘learn’ the mechanism of the new
organisation. Hence managers aim at the maximisation of the rate of
growth rather than the absolute size of the firm.

Marris argues that since growth happens to be compatible with the
interests of the shareholders in general, the goal of maximisation of the
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to distinguish between the rate of growth of demand (which maximises the
u of managers) and the rate of growth of capital supply (which maximises
the U of owners) since in equilibrium these growth rates are equal.

From Marris’s discussion it fol lows that the utility function of owners can
be written as follows
𝑈௢௪௡௘௥௦ = f*( 𝑔௖)
where 𝑔௖= rate of growth of capital.

It is not clear why owners should prefer growth to profits, unless gc and
profits are positively related. At the end of his article Marris argues in fact
that gc and IT are not always positively related. Under certain
circumstances gc and II become competing goals. Furthermore, from
Marris’s discussion of the nature of the variables of the managerial utility
function it seems that he implicitly assumes that salaries, status and power
of managers are strongly correlated with the growth of demand for the
products of the firm: managers will enjoy higher salaries and will have
more prestige the faster the rate of growth of demand. Therefore, the
managerial utility function may be written as follows
𝑈ெ = f (𝑔஽,s)
where 𝑔஽ = rate of growth of demand for the products of the firm
s = a measure of job security.

Marris, following Penrose, argues that there is a constraint to 𝑔஽set by the
decision -making capacity of the managerial team. Furthermore, Marris
suggests that ‘s’ can be measured by a weighted average of three crucial
ratios, the liquidity ratio, the leverage - debt ratio and the profit -retention
ratio, which reflect the f inancial policy of the firm.

As a first approximation Marris treats ‘s’ as an exogenously determined
constraint by assuming that there is a saturation level for job security
above the saturation level the marginal utility from an increase in ‘s’ (job
security) is zero, while below the saturation level the marginal utility from
an increase in ‘s’ is infinite. With this assumption the managerial utility
function becomes
𝑈ெ = f (𝑔஽,) s̅

where s̅ is the security constraint. Thus, in the initial model there are two
constraints – the managerial team constraint the job security constraint –
reflected in a financial constraint. Let us examine these constraints in
some detail.

II. Constraints:
The Managerial Constraint:
Marris adopts Penrose’s thesis of the existence of a definite limit on the
rate of efficient managerial expansion. At any one time period the capacity
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set by the capacity of its ma nagerial team. The managerial capacity can be
increased by hiring new managers, but there is a definite limit to the rate at
which management can expand and remain competent (efficient).

Penrose’s theory is that decision -making and the planning of the
operations of the firm are the result of teamwork requiring the co -
operation of all managers. Co -ordination and co -operation require
experience. A new manager requires time before he is fully ready to join
the teamwork necessary for the efficient functioning of the organisation.
Thus, although the ‘managerial ceiling’ is receding gradually, the process
cannot be speeded up.

Similarly, the ‘research and development’ (R & D) department sets a limit
to the rate of growth of the firm. This department is the sourc e of new
ideas and new products, which affect the growth of demand for the
products of the firm. The work in the R & D department is ‘teamwork’ and
as such it cannot be expanded quickly, simply by hiring more personnel
for this section: new scientists and designers require time before they can
efficiently contribute to the teamwork of the R & D department.

The managerial constraint and the R & D capacity of the firm set limits
both to the rate of growth of demand ( 𝑔஽) and the rate of growth of capital
supply ( 𝑔௖).

The Job Security Constraint:
We said that the managers want job security; they attach (not surprisingly)
a definite disutility to the risk of being dismissed. The desire of managers
for security is reflected in their preference for service co ntracts, generous
pension schemes, and their dislike for policies which endanger their
position by increasing the risk of their dismissal by the owners (that is, the
shareholders or the directors they appoint). Marris suggests that job
security is attained by adopting a prudent financial policy.

The risk of dismissal of managers arises if their policies lead the firm
towards financial failure (bankruptcy) or render the firm attractive to take -
over raiders. In the first case the shareholders may decide to r eplace the
old management in the hope that by appointing new management the firm
will be run more successfully. In the second case, if the take -over raid is
success-ful, the new owners may well decide to replace the old
management.

The risk of dismissal i s largely avoided by:
(a) Non-involvement with risky invest-ments. The managers choose
projects which guarantee a steady performance, rather than risky
ventures which may be highly profitable, if successful, but will
endanger the managers’ position if the y fail. Thus, the managers
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(b) Choosing a ‘prudent financial policy’. The latter consists of
determining optimal levels for three crucial financial ratios, the
leverage (or debt ratio), the liquidity ratio, and the retention ratio.

The leverage or debt ratio is defined as the ratio of debt to the gross
value of total assets of the firm:


The managers do not want excessive borrowing because the firm may
become insolvent and be proclaimed bankrupt, due to demands for interest
payments and repayment of loans, notwithstanding the good prospects that
the firm may have.

The liquidity ratio is defined as the ratio of liquid assets to the total gross
assets of the firm:



Liquidity policy is very important. Too low a liquidity rat io increases the
risk of in-solvency and bankruptcy. On the other hand, too high a liquidity
ratio makes the firm attractive to take -over raids, because the raiders think
that they can utilise the excessive liquid assets to promote the operations
of their enterprises. Thus the managers have to choose an optimal liquidity
ratio neither too high nor dangerously low. In his model, however, Marris
assumes without much justification, that the firm operates in the region
where there is a positive relation between liquidity and security: an
increase in liquidity increases security.

The retention ratio is defined as the ratio of retained profits (net of
interest on debt) to total profits:


Retained profits are, according to Marris, the most important source of
finance for the growth of capital. However, the firm is not free to retain as
much profits as it might wish, because distributed profits must be adequate
to satisfy the share-holders and avoid a fall in the price of shares which
would render the firm attract ive to take -over raiders. If distributed profits
are low the existing shareholders may decide to replace the top
management. If the low profits lead to a fall in the price of shares, a
take-over raid may be successful and the position of managers is thus
endangered.

The three financial ratios are combined (subjectively by the managers)
into a single parameter a̅ which is called the ‘financial security constraint’.
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This is exogenously deter-mined, by the risk attitude of the top
management. Marris does not explain the process by which a̅ is
determined. It is stated that it is not a simple average of the three ratios,
but rather a weighted average, the weights depending on the subjective
decisions of managers.

Two points should be stressed regarding the over all financial constraint a̅.
First: Let

Marris postulates that the overall a is negatively related to a1, and
positively to a2 and a3. That is, a̅ increases if either the liquidity is
reduced, or the debt ratio is raised by increasing external finance (l oans),
or the proportion of retained profits is increased. Similarly, a̅ declines if
the managers increase the liquidity of the firm, or reduce the pro-portion
of external finance (D/A), or reduce the proportion of retained profits (that
is, increase the d istributed profits), or a combination of all three.

Secondly: Marris implicitly assumes that there is a negative relation
between ‘job security’ (s) and the financial constraint a̅: if a̅ increases (by
either reducing 𝑎ଵ or in-creasing 𝑎ଶ or increasing 𝑎ଷ) clearly the position
of the firm becomes more vulnerable to bankruptcy and/or to take -over
raids, and consequently the job security of managers is reduced. Thus, a
high value of a̅ implies that the managers are risk-takers, while a low value
of a̅ shows that managers are risk -avoiders.

The financial security constraint sets a limit to the rate of growth of the
capital supply, 𝑔௖, in Marris model.

III. The Model: Equilibrium of the Firm:
The managers aim at the maximisation of their own utility, which is a
function of the growth of demand for the products of the firm (given the
security constraint)
𝑈௠௔௡௔௚௘௥௦ = f (𝑔஽)1

The owners -shareholders aim at the maximisation of their own utility
which Marris assumes to be a function of the rate of growth of the capital
supply (and not of profits, as the traditional theory postulated)
𝑈௢௪௡௘௥௦ = 𝑓∗ (𝑔௖)

The firm is in equilibrium when the maximum balanced -growth rate is
attained, that is, the condition for equilibrium is
𝑔஽ = 𝑔௖ = g* maximum
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The first stage in the solution of the model is to derive the ‘demand’ and
‘supply’ functions, that is, to determine the factors that determine 𝑔஽
and𝑔௖ .

Marris establishes that the factors that determine 𝑔஽ and𝑔௖ can be
expressed in te rms of two variables, the diversification rate, d, and the
average profit margin, m.

The Instrumental Variables:
The firm will first determine (subjectively) its financial policy, that is, the
value of the financial constraint a̅, and subsequently it will choose the rate
of diversification d, and the profit margin m, which maximise the
balanced -growth rate g*.

The following are policy variables in the Marris model:
Firstly , a implies freedom of choice of the financial policy of the firm.
The firm can affect its rate of growth by changing its three security ratios
(leverage, liquidity, dividend policies).

Secondly, the firm can choose its diversification rate, d, either by a change
in the style of its existing range of products, or by expanding the ran ge of
its products.

Thirdly, in Marris’s model price is given by the oligopolistic structure of
the industry.

Hence price is not actually a policy variable of the firm. The determination
of the price in the market is very briefly mentioned in Marris’s article. He
argues that eventually a price structure will develop in which the market
shares are stabilized. This equilibrium will be arrived at either by tacit
collusion, or after a period of war during which price competition,
advertising, product variat ion or all three weapons are used.

The length of time involved and the level of price and the number of firms
which will remain in business is uncertain, due to ‘imperfect knowledge of
the competitors’ strength, determination, and skill”, and from the
unpredictability of games containing chance moves.

From this line of argument, it seems that Marris is not concerned with
price determination in oligo-polistic markets, but rather takes it for granted
that a price structure will eventually develop. Thus, Mar ris seems to treat
price as a parameter (given) rather than as a policy variable at the
discretion of the firm. Similarly, Marris assumes that production costs are
given.

Fourthly, the firm can choose the level of its advertising. A, and of its
research a nd development activities, R&D. Since the price, P, and the
production costs, C, are given, then it is obvious that a higher A and/or
R&D expenditures will imply a lower average profit margin and, vice munotes.in

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versa, a low level of A and/or R&D implies a higher av erage profit rate.
Implicit in Marris’s model is the average -cost pricing rule

P̅ = C̅ + A + (R & D) + m

where P̅ = price, given from the market
C̅ = production costs, assumed given
A = advertising and other selling expenses
R & D = research and developm ent expenses
m= average profit margin
Clearly m is the residual
m = P̅ – C̅ – (A) – (R & D)

Given P̅ and C̅, m is negatively correlated with the level of advertising and
R & D ex-penditures. Thus,m is used as a proxy for the policy variables A
and R&D.

In summary, all the policy variables are combined into three instruments:
a̅, the financial security coefficient
d, the rate of diversification
m, the average profit margin

The next step is to define the variables that determine the rate of growth of
dema nd, 𝑔஽, and the rate of growth of supply, 𝑔஼ , and express these rates
in terms of the policy variables, a̅, d and m.

The rate of growth of the demand: 𝒈𝑫
It is assumed that the firm grows by diversification. Growth by merger or
take-over is excluded from this model. The rate of growth of demand for
the products of the firm depends on the diversific-ation rate, d, and the
percentage of successful new products, k, that is,
𝑔஽= 𝑓ଵ(d, k)

where d = the diversification rate, defined as the numb er of new products
introduced per time period, and k = the proportion of successful new
products.

Diversification May Take Two Forms:
Firstly, the firm may introduce a completely new product, which has no
close substitutes, which creates new demand and th us competes with other
products for the income of the consumer. (Marris seems to narrow his
analysis to firms producing consumers’ goods.) This Marris calls
differentiated diversification, and is considered the most important form in
which the firm seeks t o grow, since there is no danger of encroaching on
the market of competitors and hence provoking retaliation.
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Secondly, the firm may introduce a product which is a substitute for
similar commodities already produced by existing competitors. This is
called imitative diversification, and is almost certain to induce
competitors’ reactions. Given the uncertainty regarding the reactions of
competitors the firm prefers to diversify with new products. The greater d,
the higher the rate of growth of demand.

The proportion of successful new products, k, depends on the rate of
diversification d, on their price, the advertising expenses, and the R & D
expenditure, as well as on the intrinsic value of the products
k = 𝑓ଷ (d, P, A, R&D, intrinsic value)

Regarding th e intrinsic value of the new product Marris seems to adopt
Galbraith’sand Penrose’s thesis (rather far -fetched) that a firm can sell
almost anything to the consumers by an appropriately organised selling
campaign, even against consumers’ resistance. He imp licitly combines
intrinsic value with price, that is, price is associated with a given intrinsic
value. Price is assumed to have reached equilibrium in some way or
another. Thus, price is taken as given, despite the fact that the product is
new.

k depends on the advertising, A, the R & D expenditures and on d. The
higher A and/or R&D, the higher the proportion of successful new
products and vice versa. Marris uses m, the average profit margin as a
proxy for these two policy variables. Given that m is negat ively related to
A and R&D, the proportion of successful new products is also negatively
correlated with the average profit margin.

Finally, k depends on d, the rate of new products introduced in each period
if too many new products are introduced too fast, the proportion of fails
increases. Thus, although the rate of growth of demand, 𝑔஽ , is positively
correlated with the diversific-ation rate (d) 𝑔஽, increases at a decreasing
rate as d increases, due to the rate of intro-duction of new products
outrunning the capacity of the personnel involved in the devel-opment and
the marketing of the products.

There is an optimal rate of flow of ‘new ideas’ from the R & D department
of the firm. If the research team is pressed to speed up the development
process of new products there is no time to ‘research’ the product and/or
its marketability adequately. Furthermore, top management becomes
overworked when the rate of introduction of new products is high, and the
proportion of unsuccessful products is bound t o increase.

In summary

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Mathematical Expression for Optimal Rate of Flow of 'New Ideas'
The 𝑔஽function is shown in following diagram
Fig.No. 7.1 Fig.No. 7.2

gd= f(d) given m gd= f(d, m) given m

Optimal Rate of Flow of 'New Ideas' :
The average rate of profit is constant along any gD curve. But the curve
shifts down-wards as m increases ( 𝑚¯̅̅ଵ< 𝑚¯̅ଶ<𝑚̅ଷ). This is due to the
negative relationship between 𝑔஽ and m. With a given rate of
diversification (for example, at 𝑑ଵin above figur e) and given the price of
the products, the lower m, the larger the A and/or the R & D expenses, and
hence the larger the proportion of successful products and the higher the
growth of demand ( 𝑔ଷ > 𝑔ଶ > 𝑔ଵ). Of course, the monotonic positive
relationshi p between d and A (and R & D), which is implied by
Galbraith’s and Penrose’s hypothesis and is adopted by Marris, is highly
questionable on a priori and empirical grounds.

The Rate of Growth of Capital Supply:
It is assumed that the shareholder -owners aim at the maximisation of the
rate of growth of the corporate capital, which is taken as a measure of the
size of the firm. Corporate capital is defined as the sum of fixed assets,
inventories, short -term assets and cash reserves. It is not stated why the
shareholders prefer growth to profits in periods during which growth is not
steady.

The rate of growth is financed from internal and external sources. The
source of in-ternal finance for growth is profits. External finance may be
obtained by the issue of ne w bonds or from bank loans. The optimal
relation between external and internal finance is still strongly disputed in
economic literature.

Marris takes the position that the main source of finance for growth is
profits, on the following grounds. Firstly, t he issue of new shares as a
means of obtaining funds is, for prestige and other reasons, not often used
by an established firm. Secondly, external finance is limited by the
security attitude of managers, that is, from their desire to avoid mass
dismissal. Financial security is achieved by setting an upper limit to the
debt/assets ratio (leverage) and a lower limit to the liquidity ratio in the
long run.

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Although profits are the main source of finance for growth, the top
management can-not retain as much profits as it would like. There is an
upper limit to the ‘retention ratio’, set by the desire of managers to
distribute a satisfactory dividend, which will keep shareholders happy and
avoid a fall in the prices of shares. Otherwise the selling of shares, o r a
successful take -over raid, would endanger the position of managers.

The three security ratios are subjectively determined by the managers
through the security parameter a, which is a determinant of the retained
profits, and hence a deter-minant of the rate of growth of capital.

Under Marris’s assumptions the rate of growth of capital supply is
proportional to the level of profits
𝑔௖ = a̅(Π)

where a̅ = the financial security coefficient
Π = level of total profits

The security coefficient a is assumed constant and exogenously
determined in this model. This assumption is relaxed at a later stage. It
should be stressed, however, that so long as a is constant, growth, gc, and
profits, Π, are not competing goals, but are positively related higher pr ofits
imply higher rate of growth.

The next step is to express gc in terms of the policy variables d and m. The
level of total profits depends on the average rate of profit, m, and on the
efficiency of the performance of the firm as reflected by its overa ll capital
output ratio, K/X:
Π = 𝑓ସ (m, K/X)

It is intuitively obvious that n and m are positively correlated (an increase
in the aver-age profit margin results in an increase in the total profits)

∂Π/ ∂m > 0

The relationship between Π and the capital /output ratio is more
complicated. The capital/output ratio is claimed to be a measure of
efficiency of the activity of the firm, given its human and capital
resources. The overall K/X ratio is not a simple arithmetic average of the
capital/output ratios o f the individual products of the firm, but is a
func-tion of the diversification rate d

(K/X) = 𝑓ହ(d)

Given K, the relation between X and d is up to a certain level of d positive,
reaches a maximum, and subsequently output declines with further
increase s in the number of new products the overall output increases
initially with d due to a better utilization of the team in the R & D
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Output reaches a maximum when the d is at its optimum le vel allowing the
optimal use of the managerial team and the R & D personnel. Beyond that
point, the total output X decreases with further increases in d, and the
efficiency of the firm falls the R&D per-sonnel are overworked and the
decision -making process becomes inefficient, as there is not enough time
allowed for the development of new products or for the study of their
marketability. Hence the success rate for new products falls and efficiency
declines.

Substituting for K/X in the profit function we obtain Π = 𝑓ସ(m, d)

The relationship between n and d is initially positive, reaches a maximum,
and then declines as d is further accelerated.

We next substitute Π in the gc function 𝑔௖ = a.[𝑓ସ(m, d)]

The rate of growth of capital is determined by three factors the financial
policies of the managers, the average rate of profit and the diversification
rate.

Marris assumes in his initial model that a is a constant parameter
exogenously deter-mined by the risk -attitude of managers, while there is a
positive relation between gc and m
∂𝑔஼ / ∂m > 0

The relationship between gc and d is not monotonic. The rate of growth of
capital, gc, is positively correlated with d up to the point of optimal use of
the R & D personnel and the team of managers; but gc is negatively
correlated with d beyond that point a higher d implies hastening up of the
diversification process → inefficient decisions → fall in the overall profit
level → low availability of internal finance and consequently a lower rate
of growth gc.

The relation between gc and d, keeping a and m constant, is shown in
figure 7.3. If we allow both d and m to change, while keeping a constant,
we obtain a family of gc = f2 (d, m) curves (figure 7.4). The average profit
rate is depicted as a shift factor of the g c = f(0) curve. The higher the
average profit rate, the further from the origin the gc curves will be (m1 <
m2 < m3). These curves are drawn under the assumption that a is constant.
(The effects of a change in a are discussed in section IV below.)

Figure No. 7.3 Figure No. 7.4

gd= f(d) given m gc= f(d, m) given m
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Summarising the above arguments, we may present Marris’s model in its
complete form as follows:
gD = f1(m, d) – (demand -growth equation)
Π = f4(m, d) – (profit equation)
gC = a.[f4(m, d)] – (supply -of-capital equation)
a < a* (security constraint)
gD = gc (balanced -growth equilibrium condition)

a is exogenously determined by the risk -attitude of managers. The level of
profit Π is endogenously determined. The variables m and d are the policy
instruments. Given the balanced -growth equilibrium condition, we have in
fact one equation in two unknowns (m and d, given a)
f1(m, d) = a.[f4(m, d)]

Equilibrium of the firm:
Clearly the model cannot be solved (is under identified), unless one of the
variables m or d is subjectively determined by the managers. Once the
managers define a and one of the other two policy variables, the
equilibrium rate of growth can be determined.

The equilibrium of the firm is presented graphically in figure 16.5, formed
by super-imposing figures 16.2 and 16.4. Given their shapes, the gD and
gc curves associated with a given profit rate intersect at some point. For
example, the gD and gc curves corres-ponding to m, intersect at point A;
the gD and gc curves as sociated with m2 intersect at point B, and so on. If
we join all points of intersection of gD and gc curves corresponding to the
same level of m we form what Marris calls the balanced -growth curve
(BGC), given the financial coefficient a.

Figure No. 7. 5



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Equilibrium of Firm in Marris Model :
The firm is in equilibrium when it reaches the highest point on the
balanced -growth curve. The firm decides its financial policy, denoted by a.
It next chooses subjectively a value for either m or d. With these decis ions
taken, the firm can find its maximum bal-anced -growth rate, consistent
with a and with the chosen value of one of the other two policy variables.
In figure 7.5 the BGC corresponding to a is ABCD.

The balanced - growth rate g* is defined by the highest point B of this
BGC. This g* rate is compatible with a unique pair of values of the policy
variables, m* and d*. If the firm chooses d*, then m* is simultaneously
determined; alternatively, if the firm chooses m*, then d* is
simul-taneously determined fro m the function
g* = ƒ1 (m*, d*) = a. [ƒ4 (m*, d*)]

Substituting m* and d* in the profit function
Π = a[ƒ4 (m, d)]

we find the level of profit, Π*, required to finance the balanced -growth
rate, g*. Thus profit is endogenously determined in Marris’s model.
Furthermore, growth and profit are not competing goals (so long as a is
constant). From the gc function
gc = a . (Π)

it is obvious that higher profit implies higher growth rate. However, if the
financial coefficient a is allowed to vary, then profits and growth become
competing goals.

The question is does the BGC have a maximum? Marris argues that so
long as either (or both) of the gc or gD curves flattens out or bends, there
will always be a maximum point on the BGC curve. Furthermore,
depending on the shape of the gc and the gD curves, the BGC may be
platykurtic, that is, have a flat stretch which indicates that there are several
optimal solutions the g* may be achieved by a large number of
com-binations of the values of the policy variables m and d (gi ven a is
already chosen).

It is only if the gc curve is parallel to the 4 -axis (gc = ƒ(m) but gc ≠ ƒ(d))
and the gD curves are straight upwards -sloping curves (implying that gD =
ƒ(d, m), but k ≠ ƒ(d) and hence the gD curve does not flatten out) that the
BGC increases continuously, never reaching a maximum. This situation is,
however, improbable given the capacity for efficient de-cision making of
the managerial team and the capacity for well -explored new products of
the R & D department of the firm.

Thes e cases are graphically shown in figures 7.6-7.9. Figure 7.6 depicts
the case where gc ≠ (d), while gD = f(d, m). The gc curve becomes
parallel to the d -axis, show-ing that gc does not vary as d increases. The gc
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increases, given that gc and m are positively related. The balanced -growth
curve has a maximum defined by the curvature of the gD = f (m, d)
function (the maximum g occurs at point e3 in figure 16.6).
Figure No. 7. 6


Balanced -Growth Curve of Marris Model :
Figure 7.7 depicts the case where gn = ƒx(m, d), and gc = ƒ2(d, m). But
the curve gD becomes a straight line through the origin, showing that gD
has a constant slope irrespective of changes in the diversification rate . The
gD curve (line) shifts downwards towards the x -axis as m increases. The
balanced -growth curve has still a maximum (e2) due to the curvature of
the gc function.

Figure No. 7. 7

Figure 7.8 shows a platykurtic balanced -growth curve the gD and gc
functions have several points of intersection (due to their shapes) that lie
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on a straight line. The flat part of the balanced -growth curve implies that
the same optimal (maximum) g* may be achieved by a very large number
of combinations of m and d.
Figure No. 7. 8


Platykurticf Balanced -Growth Curve in Marris Model :
Finally figure 16.9 shows the improbable case a balanced -growth curve
which never reaches a maximum (explosive growth).

Figure No. 7. 9


Improbable Case of Balanced -Growth Curve in Marris Model
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IV. Maximum Rate of Growth and Profits:
Marris argues that in the real world the financial coefficient a is not a
constant, but varies. Changes in a clearly affect gc, given
gc = a(Π) = a [ƒ4(m, d)]

A change in a will shift the gc curves if a increases the gc curves will shift
upwards, while if a is reduced the gc curves will shift downwards. The
new set of gc intersects the given set of gD curves at new points, which
form a new balanced -growth c urve. Given that the relationship between gc
and a is positive (∂gD/∂a > 0), an increase in a leads to an increase in the
rate of growth.

An increase in a will occur if one or more of the three security ratios
changes as follows a is higher if the liquidi ty ratio (a1) is lowered; or if the
debt ratio (a2) is increased; or if the retention ratio (a3) is increased. This
is due to the fact that a is positively related to a2 and a3, but negatively
related to ay.

Clearly an increase in a, however realised, imp lies a less ‘prudent’, more
risky policy of the managers, since a decrease in the liquidity ratio, or an
increase in the indebtedness or an increase in the retained profits (which
implies a reduction in the paid dividends) reduces the job security of the
managers.

Graphically an increase in a is shown by an upwards shift of the BGC (to
the position A’B’C’D’ in figure 16.10). Given the gD curves, the highest
point of the new BGC will be above the highest point of the original BGC.
This implies that the balanced rate of growth g cannot be maximised
unless a assumes its highest optimal value a*. Con-sequently in
equilibrium a – a*, that is, the financial constraint takes the form of
equality at equilibrium.
Figure No. 7. 10

Maximum Rate of Growth and Profit in Marris Model
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Marris next argues that if a is allowed to vary, growth and profits may
become com-peting goals. If a is lowered below its optimum value a* the
growth rate is reduced but the profit level, Π, may be raised. A lower value
of a (given the d rate) denotes a shift to a lower balanced -growth curve,
which implies the intersection of gD and gc curves cor-responding to a
higher m, and hence a higher n, since n is a positive function of m (figure
7.11).
Figure No. 7. 11


Profit Maximisation in Marris Model :
Thus, although when a is held constant, maximising the growth rate
implies maximising profit (g and Π are not competing goals), when a is
allowed to vary, growth and profits become competing goals if a is treated
as a variable, the firm ca nnot maxi-mise both the rate of growth and profit.

This explains that under some circumstances managers’ objectives (for
higher g) and stockholders’ objectives (for higher Π) may con-flict. It
should, however, be clear that a cannot be increased beyond a certain
value, determined by the minimum profit requirements of the
shareholders; otherwise the job security of managers decreases
dangerously.

If the solution of the model does not yield in adequate to satisfy the
stockholders, a will be reduced (via, fo r example, a lowering of the
retention ratio), until the maximum obtainable balanced -growth rate is
consistent with a level of profit that is satisfactory. This implies that
managers seek to maximise the growth rate subject to a minimum profit
constraint.

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7.3 WILLIAMSON'S MODEL OF MANAGERIAL DISCRETION
Oliver E. Williamson hypothesised (1964) that profit maximization would
not be the objective of the managers of a joint stock organisation. This
theory, like other managerial theories of the firm, assumes t hat utility
maximisation is a manager’s sole objective. However it is only in a
corporate form of business organisation that a self -interest seeking
manager maximise his/her own utility, since there exists a separation of
ownership and control. The manager s can use their ‘discretion’ to frame
and execute policies which would maximise their own utilities rather than
maximising the shareholders’ utilities. This is essentially the principal –
agent problem. This could however threaten their job security, if a
minimum level of profit is not attained by the firm to distribute among the
shareholders.

The managerial theory of firm developed by Oliver E. Williamson states
that managers apply discretion in making and implementing policies to
maximize their own utility rather than trying for the maximization of profit
which ultimately maximize own utility subject to minimum profit. Profit
works as a limit to the top managers’ behaviour in the sense that the
financial market and the shareholders require a minimum profit to be paid
out in the form of dividends, otherwise the job security of managers is put
in danger. Hence, managers look at their self -interest while making
decision on price and selling quantity of output. Manager’s decision on
price and output differs from the decisions of profit maximizing firm.

Utility maximization of managers guided by their own self -interest is
possible, like in Baumol’s sales maximization model, only in a corporate
type of business organization with the separation of ownership and
manageme nt functions. Such organizational structure permits the
managers of a firm to pursue their own self -interest, subject only to their
ability to keep effective control over the firm. In particular managers are
fairly certain of keeping hold of their power (i ) if profits at any time are at
an acceptable level, (ii) if the firm shows a reasonable rate of growth over
time, and (iii) if sufficient dividends are paid to keep the stockholders
happy.

Williamson’s model suggests that manager’s self -interest focuses on the
achievement of goals in four particular areas, namely:
1. High salaries
2. Staff under their control
3. Discretionary investment expenditures
4. Fringe benefits (i.e., additional employee benefit: an additional benefit
provided to an employee, for example, a co mpany car or health
insurance)
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The basic assumptions of the model are:
1. Imperfect competition in the markets.
2. Weakly competitive environment.
3. Divorce of ownership and management. A divorce of ownership from
control of firm (manager is free to perform any action)
4. A minimum profit constraint exists for the firms to be able to pay
dividends to their share holders.A capital market imposes minimum
profit constraint (manager’s work for minimum profit imposed by a
capital market).

Managerial Utility Function :
The managerial utility function includes variables such as salary, job
security, power, status, dominance, prestige and professional excellence of
managers. Of these, salary is the only quantitative variable and thus
measurable. The other variables are non -pecuniary, which are non -
quantifiable. The variables expenditure on staff salary, management slack,
discretionary investments can be assigned nominal values. Thus, these will
be used as proxy variables to measure the real or unquantifiable concepts
like j ob security, power, status, dominance, prestige and professional
excellence of managers, appearing in the managerial utility function.

Utility function or "expense preference" of a manager can be given by:

where U denotes the Utility function, S denotes the “monetary expenditure
on the staff”, M stands for "Management Slack" and ID stands for amount
of "Discretionary Investment".

"Monetary expenditure on staff" include not only the manager's salary
and other forms of monetary compensation received by hi m from the
business firm but also the number of staff under the control of the manager
as there is a close positive relationship between the number of staff and the
manager's salary.

"Management slack" consists of those non -essential management
perquisite s such as entertainment expenses, lavishly furnished offices,
luxurious cars, large expense accounts, etc. which are above minimum to
retain the managers in the firm. These perks, even if not provided would
not make the manager quit his job, but these are incentives which enhance
their prestige and status in the organisation in turn contributing to
efficiency of the firm's operations. The Management Slack is also a part of
the cost of production of the firm.

"Discretionary investment" refers to the amount of resources left at a
manager's disposal, to be able to spend at his own discretion. For example,
spending on latest equipment, furniture, decoration material, etc. It
satisfies their ego and gives them a sense of pride. These give a boost to
the manager' s esteem and status in the organisation. Such investments are
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over and above the amount required for the survival of the firm (such as
periodic replacement of the capital equipment).

Concepts of profit in the model :
The various concepts of profit used in the model needs to be understood
clearly before moving to the main model. Williamson has put forth four
main concepts of profits in his model:
Actual profit (Π) :


where R is the total revenue, C is the cost of production and S is the staff
expenditure.

Reported profit (Πr)

where Π is the actual profit and M is the management slack.

Minimum Profit ( 𝜫𝟎):
It is the amount of profit after tax deducted which should be paid to the
shareholders of the firm, in the form of dividends, to keep them satisfied.
If the minimum level of profit cannot be given out to the shareholders,
they might resort of bulk sale of their shares which will transfer the
ownership to other hands leaving the company in the risk of a complete
take over. Since the shareholders have th e voting rights, they might also
vote for the change of the top level of management. Thus the job security
of the manager is also threatened. Ideally the reported profits must be
either equal to or greater than the minimum profits plus the taxes, as it is
only after paying out the minimum profit that the additional profit can be
used to increase the managerial utility further.



where Πr is the reported profit, Π0 is the minimum profit and T is the tax.

Discretionary profit (ΠD) :
It is basically the enti re amount of profit left after minimum profits and tax
which is used to increase the manager’s utility, that is, to pay out
managerial emoluments as well as allow them to make discretionary
investments.


where ΠD is the discretionary profit, Π is the act ual profit, Π0 is the
minimum profit and T is the tax amount.

However, what appears in the managerial utility function is discretionary
investments (ID) and not discretionary profits. Thus it is very important to
distinguish between the two as further in the model we would have to
maximize the managerial utility function given the profit constraint.
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where Πr is the reported profit, Π0 is the minimum profit and T is the tax
amount.

Thus it can be seen that the difference in the Discretionary Profit and the
Discretionary investment arises because of the amount of managerial
slack. This can be represented by the given equation



where ΠD is the discretionary profit, ID is the Discretionary investment
and M is the management slack.

Model Framework :
For simple representation of the model the managerial slack is considered
to be zero. Thus there is no difference between the actual profit and
reported profit, which implies that the discretionary profit is equal to the
discretionary investment. I.e.



wher e Πr is the reported profit, Π is the actual profit, ΠD is the
discretionary profit and ID is the discretionary investment. Such that the
utility function of the manager becomes



where S is the staff expenditure and ID is the discretionary investment.

There is a trade off between these two variables. Increase in either will
give the manager a higher level of satisfaction. At any point of time the
amount of both these variables combined is the same, therefore an increase
in one would automatically requir e a decrease in the other. The manager
therefore has to make a choice of the correct combination of these two
variables to attain a certain level of desired utility.

Substituting
in the new managerial utility function, it can be
rewritten as

The relationship between the two variables in the manager’s utility
function is determined by the profit function. Profit of a firm is dependent
on the demand and cost conditions. Given the cost conditions the demand
is dependent of the price, staff expenditur es and the market condition.


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Price and market condition is assumed to be given exogenously at
equilibrium. Thus the profit of the firm becomes dependent on the staff
expenditure which can be written as


Discretionary profit can be rewritten as

In th e model, the managers would try to maximise their utility given the
profit constraint



Graphical representation of the model:

Fig No. 7.12
Utility indifference curves of managers


Fig 7.12. shows the various levels of utility (U1, U2, U3) derived by the
manager by combining different amounts of discretionary profits and staff
expenditure. Higher the indifference curve, higher is the level of utility
derived by the manager. Hence the manager would try to be on the highest
level of indifference curve possible given the constraints. Staff
expenditure is plotted on the x -axis and discretionary profits on the y -axis.
The discretionary profit in this simplified model is equal to the
discretionary investment. The indifference curves are downward sloping
and convex to the origin. This shows diminishing marginal rate of
substitution of staff expenditure for discretionary profits. The curves are
asymptotic in nature which implies that at any point of time and under any
given circumstance the manager will choos e positive amounts of both
discretionary profits and staff expenditure.

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Fig No. 7.13
Discretionary Profit Curve

Assuming that the firm is producing an optimum level of output and the
market environment is given, the discretionary profits curve is generated,
shown in Fig 7.13. It gives the relationship between staff expenditure and
discretionary profits.

It can be s een from the figure that profit will be positive in the region
between the points B and C. Initially with increase in profits, the staff
expenditure the discretionary profits also increase, but this is only till the
point Πmax, that is, till S level of sta ff expenditure. Beyond this if staff
expenditure is increased due to increase in output, then a fall in the
discretionary profits is noticed. Staff expenditure of less than B and more
than C is not feasible as it wouldn't satisfy the minimum profit constra int
and would in turn threaten the job security of managers.

Fig No. 7.14
Equilibrium of a firm in Williamson's Model

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To find the equilibrium in the model, Fig 7.12. is superimposed on Fig
7.13. The equilibrium point is the point where the discretionary profit
curve is tangent to the highest possible indifference curve of the manager,
which is point E in Fig 3. Staying at the highest profit point would require
the manager to be at a lower indiff erence curve U2. In this case the highest
attainable level of utility is U3. At equilibrium, the level of profits would
be lower but staff expenditure S* is higher than the staff expenditure made
at the maximum profit point. As indifference curve is downwa rd sloping,
the equilibrium point would always be on the right of the maximum profit
point. Thus, the model shows the higher preference of managers for staff
expenditure as compared to the discretionary investments.

Criticism
1. The model fails to describe h ow businesses take their price and output
decisions in a highly competitive set up.
2. The relationship between better performance of managers and the
increasing amounts spent on manager’s utility by the firm is not
always true.
3. The model does not apply in a dynamic set up like changing demand
and cost conditions during booms and recessions.
4. This model fails to deal with the core problem of oligopolistic
interdependence and of strong oligopolistic rivalry.
5. This model is applicable in markets where rivalry is n ot strong (for
example ,in an oligopolistic market where there is some form of
collusion), or for firms who have some advantage over their rivals (for
example, Patent , superior know -how). However, in the long run such
advantages which shelter a firm from c ompetition are usually
weakened, and competition is enhanced.

Williamson like other managerial theory of the firm assumes that utility
maximization is the sole objective of the managers of a joint stock
organization. It is also known as “Managerial discretion Theory”.
Williamson emphasize that managers are motivated by their own self -
interest and they tries to maximize their own utility function. Alike
Baumol sales maximization model, the utility maximization objective of
the managers are subject to the constraint that after tax profits are large
enough to pay dividends to the shareholders. However, it is pointed out
that utility maximization by the self-interest seeking managers is possible
only in corporate form of the business organization as there exists
separation of ownership and control.

7.4 BEHAVIOURAL THEORIES OF THE FIRM
Introduction: The behavioral theory of the firm first appeared in the
1963 book A Behavioral Theory of the Firm by Richard M.
Cyert and James G. March . The work on the behavioral theory started in
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where Cyert was an economist. Before this model was formed, the existing
theory of the firm had two main assumptions: profit maximization and
perfect knowledge. Cyert and March questioned these two critical
assumptions.

A behavioral model of rational choice by Herbert A. Simon paved the way
for the behavioral model. Neo-classical economists assumed that firms
enjoyed perfect information. In addition, the firm maximized profits and
did not suffer f rom internal resource allocation problems.

Advocates of the behavioral approach also challenged the omission of the
element of uncertainty from the conventional theory. The behavioral
model, like the managerial models of Oliver E. Williamson and Robin
Marris , considers a large corporate business firm in which the ownership
is separate from the management.

In classical economics, the theory of firms is based on the assumption that
they will seek profit maximisation . However, in the real-world managers
and owners may behave quite differently. Behavioural Theories of the
Firm include:
 Size of a firm/prestige . Some managers may simply aim for working
in a big and seemingl y successful firm which gives more prestige and
honour. Managers may be motivated to prove their projects are
successful. This can cause firms to pursue goals which have a high
profile. It may explain why firms persist with projects which may not
be desira ble. There is a cost to letting go of past decisions.
 Profit satisficing . Based on the problem of asymmetric information.
Owners wish to maximise profits, but, workers d on’t. Because owners
don’t have perfect information, workers and managers are able to get
away with decisions that don’t maximise profits.
 Co-operative/ethical concerns . Some firms may be set up with very
different objectives to the traditional model of pr ofit maximisation. In
co-operative firms, the goal is to maximise the welfare of all
stakeholders. In this model, ideas of altruism, concern for the
environment and workers welfare may explain many decisions. The
firm may also be set up with specific chari table aims.
 Human emotion/bias . The economic model of a rational economic
man assumes that individuals seek to maximise their economic welfare
with rat ional choice. However, in the real world, we are influenced by
human emotion. This could be discrimination based on bias and
prejudice. Or it could be irrational exuberance and the perceived
wisdom of following the crowd. For example, in asset bubbles,
mortgage companies can get caught up in relaxing their lending criteria
and lending mortgages to those at risk of default.


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The Cyert and March Theory of Firm:

Firm depends on the demand of the members of the coalition :
The behavioural theory of firm was developed by Cyert and March,
focuses on the decision making process of the large multi -product firm
under uncertainty in an imperfect market. They deal w ith the large
corporate managerial business in which ownership is separated. Their
theory was originated from the concern about the organizational problem
with the internal structure of such firms that creates the need to investigate
the effect on the decision-making process in these large organizations. The
internal organizational actors may well explain the difference in the
reactions of firms to the same external stimuli, that to the same changes in
their economic environment.

The assumptions underlying the behavioural theories about the complex
nature of the firm introduces an element of realism into the theory of the
firm. The firm is not treated as a single -goal, single decision unit, as in the
traditional theory, but as a multi goal, multi
decision organization coalition. The firm is as a coalition of different
groups which are connected with its activity; in various ways, managers,
workers, shareholders, customers, suppliers, bankers, tax inspectors and so
on. Each group has its own set of goals or d emands.

The behavioural theory recognizes explicitly that there exists a basic
dichotomy in the firm, there are individual members of the coalition firm
and there is the organization coalition known as ‘the firm’. The
consequence of the dichotomy is a conflict of goals; individu als may have
different goals to those of the organization firm.

Cyert and March argue that the goals of the firm depends on the demand
of the members of the coalition, while the demand of these members are
determined by various factors such as aspiration of the members, their
success in the past in occupying their demands, the expectations, the
achievements of other groups in the same or other firms, the information
available to them. The demands of the various groups of the coalition firm
change continuou sly over time. Given the resources of the firm in any one
period, not all demands, which confront the top management can be
satisfied. Hence, there is a regular bargaining process between the various
members of the coalition firm and inevitable conflict.

The top management has several tasks; to get the goals of the firm which
are often in conflict with the demands of the various groups, to resolve the
conflict between the various groups, to reconcile as far as possible the
conflict in goals of the firm and of its individual groups.

There is a strong relation between demands and past achievement.
Demands take the form of aspiration levels. Demands change
continuously, depending on past achieve ment and on changes in the firm
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presented by any particular group to the top management depend on past
achievement of demands previously pursued by the particular group, on
the achievement of other groups in the same firm, on the achievement of
similar groups in other firms, on past aspiration levels, on expectations,
and on available information.

Cyert and March argue that the relationship between demands -aspirations
and past achievement depends on actual and expected changes in the
performance of the firm and changes in its environment: Firstly, in a
‘steady situation’, with no growth or dynamic changes in the environment,
aspirations (demands) and past achievement tend to become equal.
Secondly, in a dynamic situation with growth, aspiration le vels (demands)
lag behind achievement.

This time -lag is crucial to the behavioural theory. During this time lag the
firm is able to accumulate ‘surpluses’ or ‘excess -profits’, which may be
used as a means of resolution of the conflict in the firm and whic h act as a
stabiliser of the firm’s activity in a changing environment. Thirdly, in a
period of decline of the activity of the firm, demands are larger than past
achievements, because the aspiration levels of the members of the
coalition adjust downwards s lowly.

This process of demand and aspiration -level formation renders the
behavioural theory dynamic: the aspiration levels -demands at any time t
depend on the previous history of the firm, that is, on previous levels of
achievement and previous aspiration levels.

The goals of the firm are set by the top management, which the main five
goals of the firm are:
1. Production Goal: The production goal originates from the production
department. The main goal of the production manager is the smooth
running of the p roduction process. Production should be distributed
evenly over time, irrespective of possible seasonal fluctuations of
demand, so as to avoid excess capacity and lay off of workers at some
periods and over working the plant and resorting to rush recruitme nt
of workers at other times with the consequence of higher, costs due to
excess capacity and dismissal payments or too frequent breakdowns
of machinery and waste of raw materials in period of ‘rush’
production.
2. Inventory Goal: The inventory goal originate s mainly from the
inventory department if such a department exists, or from the sales
and production department. The sales department wants an adequate
stock of output for the customers, while the production department
needs adequate stocks of raw material s and other items necessary for a
smooth flow of the output process.
3. Sales Goal: The sales goal and the share of the market goal originate
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set the ‘sales strategy’ that is decided on the adv ertising campaigns,
the market research programs, and so on.
4. Profit Goal: The profit goals is set by the management so as to satisfy
the demand of share holders and the expectations of bankers and other
finance institutions; and also to create funds with w hich they
can accomplish their own goals and projects, or satisfy the other goals
of the firm.
5. Share of the market goal: While making decisions, the firms are
guided by these goals. All goals must be satisfied but there is an
implicit order of priority among them. The conflict among different
goals may crop up.

The number of goals of the firm may be increased, but the decision
making process becomes increasing complex. The efficiency of decision
making decreases as the number of goals increases. The law of
diminishing returns holds for managerial work as for all other types of
labor.

The goals of the firm are ultimately decided by the top management
through continuous bargaining between the groups of the coalition. In the
process of goal formation, t he top management attempts to satisfy as many
as possible of the demands with which the various members of the
coalitions confront it. The goals of the firm such as the goals of the
individual members or particular groups of the coalition take the form of
aspiration levels rather than strict maximizing constraints.

The firm in the behavioural theories seeks to satisfy, i.e., to attain a
‘satisfactory’ overall performance as defined by the set aspiration goals,
rather than maximize profits, sales or other m agnitudes. The firm is as
satisfying organization rather than a maximizing entrepreneur. The top
management, responsible for the coordination of the activities of the
various members of the firm, wishes to attain a ‘satisfactory’ level of
production, to at tain a share of the market, to earn a ‘satisfactory’ level of
profit, to divert a ‘satisfactory’ percentage of their total receipts to
research and development or to advertising, to acquire a ‘satisfactory’
public image and so on. But it is not clear in th e behavioral theories what
is a satisfactory and what an unsatisfactory attainment is.

They argue that satisfying behaviour is rational given the limitations,
internal and external with in which the operation of the firm is confined.
They take by the form of aspiration levels, and whether attained, the
performance of the firm is considered as satisfactory. The goals do not
normally take the form of maximization of the relevant magnitudes. The
firm is not a maximizing but rather a satisfying organization.

Some of the above goals may be desirable to (and consequently acceptable
by) all members of the coalition. For example , the sales goal is directly
desirable to the sales manager and his department, to the top management
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desirable to all the other members of the coalition, since all groups know
that unless the firm sells whatever it produces no one will be able to attain
his own individual goals.

Other goals are desirable to only some of the groups. For example, profits
are the concern of the shareholders and the top manage ment, but not of the
employees in lower administrative levels or of the workers ‘on the floor.’
The conflicts arising in the process of goal -setting at the level of top
management are resolved by various means which are examined below.

Conflicting Goals :
The aspiration levels of the individuals within the firm which determine
these goals change over time as a result of organizational learning. Thus,
these goals are regarded as the product of a bargaining learning process in
the organization coalition. But it is not essential that the different goals
may be resolved amicably. There may be conflicts among these goals.

The conflicting interest can be reconciled by the distribution of
side payments’ to members of the coalition. Side payments may be in cash
or kind, the latter being mostly in the form of policy side payments. But
the actual total side payments is not fixed for the coalition but depends
upon the demand of members and on the form of the coalition. Demands
of coalition members equal actual side payments only in the long -run. But
the behavioral theory focuses on the short -run relation between
side payments and demands and on the imperfections in factor markets .

In the short -run, new demands are being constantly made and the goals of
the organization are continually adapted, to a greater or lesser extent, to
take account of these demands. The demands of the members of the
organizational coalition need not be mu tually consistent. But all demands
are not made simultaneously and the organization can remain viable by
attending the demands in sequence. A problem will arise when
the organization is not able to accommodate the demands of its members
even sequentially, because it lacks the resources to do so.

Besides, side payments, the conflicting goals of the organization are
resolved by subjecting them to a constant review. This is because,
aspiration levels’ of coalition members change with experience. In fact,
the aspiration levels change with the process of satisfying. Each person in
the organization has a satisfying level for each of his goals

Uncertainty and the Environment of the Firm:
Cyert and Match -distinguish two types of uncertainty: market uncertainty
and uncertainty of competitors’ reactions. Market uncertainty refers to
possible changes in customers’ preferences or changes in the techniques of
production. This form of uncertainty is inherent in any market structure. It
can partly be avoided by search act ivity and information -gathering, but it
cannot be avoided completely. Given the market uncertainty the
managerial firm avoids long -term planning and works within a short time -
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short -run and chooses to ignore the long -run consequences of short -run
decisions.

The uncertainty arising from competitors’ actions and reactions, that is,
from oligopolistic interdependence, is brushed aside by this theory by
assuming that existing firms have arrived at some form of tacit collusion.
The various forms of trade associations, clubs and the issue of various
‘informative’ bulletins or other publications provide a means by which
firms give out information concerning their prices or future outlays of
various kinds, expecting every other competitor to do the same.

This sort of modus vivendi is called a ‘negotiated environment’ by Cyert
and March. The firm is assumed to ‘negotiate’ in some way or another
with its competitors so as to avoid uncertainty. Thus, the core problem of
oligopolistic markets that of competitors’ interdependence, is ‘solved’ by
assuming collusive action of the firms.

In general, the theory pays too little attention to the environment and its
effect on the goal -formation process and the pricing and output decisions
at the level of top manage ment. It examines internal resource allocation,
assuming collusion with competitors. It says nothing about the threat of
potential entry which is crucial in the present world of mergers and
continuous diversification.

The environment is taken as given and as such is practically ignored in the
analysis of the behaviour of the firm. This ignoring of the environment is
apparent in the model that follows, which is used by Cyert and March as
an ill ustration of the workings of their theory. The rules by which demand
and costs are estimated, the rules for investment decisions and other
crucial steps in the analysis are too mechanical.

A Simple Model of Behaviourism:
Here we briefly present the simple model used by Cyert and March as an
illustration of the decision -making process within the modern large
corporation. The model refers to the case of a duopoly. The decision
process involves the deter mination of the output which is homogeneous,
so that a single price will ultimately prevail in the market. Of course, each
firm, in deciding its output automatically induces price changes in the
market. However, when both firms finally decide their outputs, price will
be determined by the market. No changes in inventories are allowed in this
model.

The steps may be outlined as follows (K. J. Cohen and R. M. Cyert,
Theory of the Firm):

1. Forecast of Competitors’ Reactions:
The forecast is basically a straightforward extrapolation of the past
observed reaction s of competitors.
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2. Forecast of Firm’s Demand:
This is based on an estimate of the demand function from past
observations. Future demand is thus an extrapolation of the past sales of
the firm.

3. Estimation of Costs:
The cost in the current period is assumed to be the same as in the past
period. However, if the profit goal has been achieved over the past two
periods, average unit costs are increased by a certain percentage to allow
for slack payments.

4. Specification of Goals of the Firm:
These are a spiration levels. In this model profit is the only goal of the
firm. The aspiration level of profits is some average of the profits of past
periods.

5. Evaluation of Results by Comparing Them to the Goals:
From the information obtained in steps 1 -3 we obt ain a solution, i.e. an
estimate of the level of output, price, cost and profits. These are compared
to the target level of profits. If the goals are satisfied by this solution the
firm adopts it. If the profit and other goals are not achieved the firm
proceeds to step 6.

6. If Goals are Not Attained the Firm Re -Examines the Estimate of its
Costs:
Re-examination starts with costs because this variable is under the direct
control of the firm. It usually involves a cut in slack and other expenses.

7. Evaluation of the New Solution by comparing it to Goals:
If the new solution with the downward -adjusted costs leads to the target
profits it is adopted. If not, the firm proceeds to step 8.

8. If Goals are Not Attained the Firm Re -Examines the Estimate of its
Demand:
The re -examination consists in considering possible changes in the sales
strategy (more market research, more advertising, more salesmen, etc).
The result is an upward adjustment of the initial estimate of demand.

9. Evaluation of the New So lution by comparing it to Goals:
If the new solution with the revised costs and demand estimates attains the
target profits, it is adopted. If not, the firm proceeds to step 10.

10. If Goals are not met the Firm Readjusts Downwards its Aspiration
Levels:
If with the revision of costs (in step 6) and of demand (in step 9) the goals
are not attainable, the firm readjusts downwards its aspiration levels. The
firm has multiple goals (although only one explicitly appears in the above
model), which take the form of aspiration levels the firm is a satisfice
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attainments, aspirations, demands of groups, and expectations. The
criterion of choice for goal -setting is that the alternative selected mee ts the
demands (goals) of the coalition.

The organisation seeks to avoid uncertainty. The market -originated
uncertainty is avoided by undertaking information searches, by avoiding
long-term planning, by following ‘regular procedures and a policy of
reacti ng to feedback information rather than of forecasting the
environment. The competitor -originated uncertainty is avoided by creating
a ‘negotiated’ environment, that is, by some sort of collusive behaviour.

Comparison :
The behavioural theory has contributed to the development of the theory
of the firm in several respects. Its main contributions are: firstly, the
insight into the process of goal -formation and the internal resource
allocation, and secondly, the systematic analysis of the stabilizing role of
‘slack’ on the activity of the firm.

The behavioural theory deals with the allocation of resources within the
firm, and the decision -making processes, an aspect neglected in the
traditional theory. In the latter the firm was assumed to react to t he all -
powerful environment. The behaviourist school assumes that the firm has
some discretion, and does not necessarily take the constraints of the
environment as definite and impossible to change.

The traditional theory stressed the role of the market ( price) mechanism
for the allocation of resources between the various sectors of the economy,
while the behavioural theory examines the mechanism of the resource
allocation within the firm. Clearly the two theories are complementary
rather than substitutes. Actually various theorists have attempted to
incorporate the behavioural aspects of Cyert and March’s theory into their
own models.

Cyert and March’s definition of ‘slack’ shows that this concept is
equivalent to the ‘economic rent’ of factors of product ion of the traditional
theory of the firm. The con tribution of the behavioural school lies in the
analysis of the stabilising role of ‘slack’ on the activity of the firm.
Changes in slack payments in periods of booming and depressed business
enable the fi rm to maintain its aspiration levels despite the changing
environment.

It should be pointed out that Cyert and March deal only with one form of
slack, the managerial slack. Slack payments accruing to other members of
the firm -coalition and their short -run and long -run implications for the
performance of the firm are not examined

Criticisms of the Cyert and March Theory :
The behavioural theory has, however, serious shortcomings. The Cyert
and March theory of firm has been severely criticized on the following
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1. The behavioral theory relates to a duopoly firm and fails as the theory of
market structures. It does not explain the interdependence and interaction
of firms, nor the way in which the interrelationship of firms leads to
equilibrium o f output and price at the industry level. Thus, the conditions
for the attainment of a stable equilibrium in the industry are not
determined.
2. The theory does not consider either the conditions of entry, effects on
the behavior of existing firms of and t he threat of potential entry by firms.
3. The behavioral theory explains the short -run behavior of firms and
ignores their long -run behavior. It cannot explain the dynamic aspects of
inventions and innovations which are related to the long -run.
4. The beha vior theory is based on the simulations approach which is a
predictive technique. It is simply the products of behavior of the firm but
does not explain it.
5. The behavioural theories basically provide a simulation approach to the
complexity of the mechan ism of the modern multigoal, multiproduct
corporation. Simulation, how ever, is a predictive technique. It does not
explain the behaviour of the firm; it predicts the behaviour without
providing an explanation of any particular action of the firm.
6. The b ehavioural theories do not deal with industry equilibrium. They do
not explain the interdependence and interaction of firms, nor the way in
which the interrelationship of firms leads to an equilibrium of output and
price at the industry level. Thus, the co nditions for the attainment of a
stable equilibrium in the industry are not determined. No account is given
of conditions of entry or of the effects on the behaviour of es tablished
firms of a threat by potential entrants.
7. The behavioural theory, altho ugh dealing realistically with the search
activity of the firm (in the sense that search is considered as problem -
oriented), cannot explain the dynamic aspects of invention and innovation,
which are by their nature long -run activities with long -run implica tions.
8. The ‘plasticity’ (readjustment) of the aspiration levels downwards
whenever the set targets are not attained deprives the theory of objective
criteria for the evaluation of ‘satisfactory’ performance. To judge whether
the performance of a firm is satisfactory one should have a ‘constant
measuring -rod’, that is, a well -defined set of (long -run) goals. If goals are
readjusted downward whenever their attainment has not been achieved,
how are we to judge the performance of the firm? The ‘measuring -rod’
behaves like an elastic ruler that stretches and shrinks, depending on the
attainment or not of the aspiration (goals) initially set.
9. No exact predictions can be derived from the postulates of the
behavioural theory. The acceptance of satisficing beha viour renders
practically the theory into a tautological structure: whatever the firms are
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10. The behavioural theory implies a short -sighted behaviour of firms.
Surely the uncer tainty of the market cannot be avoided by short -term
planning. Most decisions require a long -term view of the environment.
11. The behavioural theory resolves the chore problem of oligopolistic
interdependence by accepting tacit collusion of the firms in the industry.
This solution is unstable, especially when entry takes place, a situation
brushed aside by the behavioural theorists. Cyert and March based their
theory on four actual case studies and two experimental studies conducted
with hypothetical firms.

Conclusion: Despite these criticisms, the behavioural theory of Cyert and
March is an important contribution to the theory of the firm which brings
into focus “multiple, changing and acceptable goals’ in managerial
decision -making.

7.5 FULL COST PRICING PRINCIPLE
Introduction:
For many years, Chamberlin ‘s and Joan Robinson’s price theory
of monopolistic competition had come to be generally accepted.
According to This theory, the firms were able to act atomistically on the
principle of profit maximisation without fear of rivals’ reactions. They
fixed prices so as to maximise their profits and this they did by equating
marginal cost to marginal revenue (M C= MR). Empirical studies made
by Oxford economists under the leadership of Professors Hall and Hitch
(Price Theory and Business Behaviour) showed that the firms did not use
the marginalist rule (MC = MR) and that oligopoly was the main
market structure in the business world. According to Hall and Hitch, the
firms did not act atomistically or irrespective of what their rival firms did.
Rather they are continuously watching’ the reactions of the rival
firms . The traditional theory could not adequately explain the oligopolistic
interdependence.

In such a situation, the firms do not attempt to maximise short -run profits
by acting on the marginalized rule (MC = MR) but aim at maximising
long-run profits by acting on the average -cost principle, i.e., the firms do
not set their price and output at the intersection of MC and MR curves but
they set them at a level which covers the average variable cost, (A VC)
and average fixed cost (AFC) and normal profit margin in the business in
question. A VC + AFC + Normal Profit. Firms do not se ek abnormal
profits for fear of to accept the prevailing price and has no option,
there fore, the question of profit maximization does not arise. In the case
(If monopolistic competition and absolute monopoly, the entrepreneurs are
in a position to fix their price and maximize their profits. But in the case
(If oligopoly, profit maximization cannot be considered a
valid assumption. The oligopolist has both the desire and the power to
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for security rather than the desire for maxi mum profit rules the
entrepreneur’s mind.

Full Cost Pricing Principle :
In 1939, Hall and Hitch published some results of research undertaken at
Oxford University and aiming at the investigation of the decision
processes of businessmen in relation to government measures. Their study
covered 38 firms out of which 33 were manufacturing firms ,3 were retail
trading firms and 2 were building firms. Out of 33 manufactur ing firms,
15 produced consumer goods, 4 intermediate products, 7 capital goods,
and 7 textiles. The sample was not random, but included firms which may
well be expected to belong to ‘efficiently managed enterprises.’

Hall and Hitch sought information fro m them about the elasticity and the
position of their demand, and their attempts to equate their estimated
marginal cost and marginal revenue. The answers revealed that the
majority of them apparently made no efforts, even implicitly, to estimate
elasticit ies of demand or marginal cost. They did not consider them to be
of any relevance to the pricing process.

On the basis of the empirical study, Hall and Hitch concluded that the
majority of entrepreneurs under oligopoly base their selling prices upon,
what they call, ‘full cost’ and including an allowance of profit, and not in
terms of the equality of marginal cost and marginal revenue at all.

Thus, a price based on full average cost is the ‘right price’, the one which
‘ought to be charged’, based on the i dea of ‘fairness to competition’ under
oligopoly. But what is full cost? Full cost is full average cost which
includes average direct costs (AVC) plus average overhead costs (AFC)
plus a normal margin for profit: Thus price, P = AVC + AFC + profit
margin ( usually 10%).

According to Hall and Hitch, there are certain reasons which induce
firms to follow the full -cost pricing policy:
(i) Tacit or open collusion among producers;
(ii) Failure to know consumers’ preferences;
(iii) Reaction of competitors to a change in price;
(iv) Moral conviction of fairness; and
(v) Uncertainty of effects of price increases or decreases. All these
reasons prevent oligopolistic producers from setting a price other than
the full -cost price.

Thus, firms set their price on th e basis of the full -cost principle and sell at
that price whatever the market takes. They observed that prices were
sticky in the oligopoly market despite changes in demand and costs. They
explained the stickiness of prices in terms of the kinked demand cu rve.
The kink occurs at the point where the price QP (= OB) fixed on the full -
cost principle actually stands in Figure 7.15
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Figure No. 7. 15

Any increase in the price above it, will reduce the firm’s sales, for its
competitors will not follow it in raising their prices. This is because the
PD portion of the kinked demand curve is elastic. On the other hand, if the
firm reduces the price below QP, its competitors will also reduce their
prices.

The firm will increase its sales but its profits will be less than before. This
is because the PD 1 portion of the curve is less elastic. Thus, in both the
price -raising and price -reducing situations, the firm will be a loser. It
would, therefore, stick to the price QP so long as the prices of the direct
factors of production (i.e., raw materials, etc.) remain unchanged.

As the AC curve falls over a large range of output, price varies inversely
with output. The smaller the level of output, the higher will be the average
cost and the higher the price of the produc t. But Hall and Hitch rule out
the possibility of oligopoly firms producing small outputs and charging
higher prices.

They give three reasons for this;
(a) Oligopoly firms prefer price rigidity,
(b) They cannot raise the price because of the kink, and
(c) They want to “keep the plant running as full as possible, giving rise to
a general feeling in favour of price concessions”.

Hall and Hitch mention two exceptions to this phenomenon of a rigid
price:
(i) If the demand decreases much and remains so for some time, the price
is likely to be reduced in the hope of maintaining output. This is likely to
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happen when the lower portion of the demand curve becomes more elastic.
The reason for this price - cut is when one firm becomes panicky and
reduces its price ; it forces others to cut their prices,

(ii) Any circumstances which lower or raise the AC curves of all firms by
similar amounts due to changes in factor prices or technology are likely to
lead to a revaluation of the full -cost price QP (= OB). But there is no
tendency for prices to fall or rise more than the wage and raw material
costs.

The Andrews Version:
The Hall -Hitch explanation is based on the presumption that the price to
be charged in the oligopoly market is pre -set by the firm. Further, the
kinky demand curve complicates the analysis. In order to simplify the
exposition, we give a modified version of the full -cost pricing by Prof.
Andrews.

Prof. Andrews in his study Manufacturing Business, 1949, explains how a
manufacturing firm actually fixes the selling price of its product on the
basis of the full cost or average cost. The firm finds out the average direct
costs (AVC) by dividing the current total costs by current total output.
These are the average variable costs which are assumed to be cons tant
over a wide range of output.

In other words, the AVC curve is a straight line parallel to the output axis
over a part of its length if the prices of direct cost factors are given. The
price which a firm will normally quote for a particular product wi ll equal
the estimated average direct costs of production plus a costing -margin or
mark -up.

The costing -margin will normally tend to cover the costs of the indirect
factors of production (inputs) and provide a normal level of net profit,
looking at the in dustry as a whole.

The usual formula for costing -margin (or mark -up) is,
M = P -AVC/AVC … …. (1)

Where M is mark -up, P is price and AVC is the average variable cost and
the numerator P -AVC is the profit margin. If the cost of a book is Rs. 100
and its pr ice is Rs. 125,
M = 125 -100/100 = 0.25 or 25%

If we solve equation (1) for price, the result is
P = AVC (1 + M) ……. (2):

The firm should set the price
P = Rs. 100 (1 + 0.25) = Rs. 125.
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Once this price is chosen by the firm, the costing -margin will remain
constant given its organisation, whatever the level of its output. But it will
tend to change with any general permanent changes in the prices of the
indirect factors of production.

Depending upon the firm’s capacity and given the prices of the dir ect
factors of production (i.e., wages and raw materials), price will tend to
remain unchanged, whatever the level of output. At that price, the firm
will have a more or less clearly defined market and will sell the amount
which its customers demand from i t.

But how is the level of output determined?
It is determined in any of the three ways:
(a) As a percentage of capacity output; or
(b) As the output sold in the preceding production period; or
(c) As the minimum or average output that the firm expects to sell in the
future.

If the firm is a new one, or if it is an existing firm introducing a new
product, then only the first and third of these interpretations will be
relevant. In these circumstances, indeed, it is likely that the first will
coincide ro ughly with the third, for the capacity of the plant will depend
on expected future sales.
Figure No. 7. 16



The Andrews version of full -cost pricing is illustrated in Figure 4 where
AC is the average variable or direct costs curve which is shown as a
horizontal straight line over a wide range of output. MC is its
corresponding marginal cost curve.

Suppose the firm chooses OQ level of output. At this level of output, QС
is the full -cost of the firm made up of average direct costs QV plus the
costing -margin VC. Its selling price OP will, therefore, equal QC.
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The firm will continue to charge the same price OP but it might sell fig. 4
more depending upon the demand for its product, as represented by the
curve DD. In this situation, it will sell OQ 1 output. This price will not be
altered in response to changes in demand, but only in response to changes
in the prices of the direct and indirect factors.

The following are advantages to using the full cost-plus pricing method:
1. Simple : It is quite easy to derive a product price using this method,
since it is based on a simple formula. Given the use of a standard
formula, it can be derived at almost any level of an organization. The
concepts involved are familiar to businessmen and accountants.
2. Price -Setting: Average cost rule facilitates price -setting in
multiproduct firms. In these firms acquisition of information on price
elasticities for all productes is both difficult and costly.
3. Likely profit : As long as the budget assumptions used to derive the
price turn out to be correct, a company is very likely going to earn a
profit on sales if it uses this method to calculate prices.
4. Justifiable : In cases where the supplier must persuade its customers
of the need for a price increase, the supplier can show that its p rices
are based on costs, and that those costs have increased.
5. Classical Method: It is the classical method of charging a price for a
commodity. It is also a logical way of maximising long -run profit.
6. Firms Ideal: It is an ideal which the firms aim at. Cov ering the cost
of production and earning a certain predetermined percentage of profit
should be the objective even if it could not be fully achieved.
7. Fair Price: Price based on cost of production are considered fair for
producers as well as consumers.
8. Stop Frequent Changes: Full cost piecing method can avoid frequent
changes in price, Consumers do not appreciate changes in prices
which occur frequently.
9. Most preferred: In reality market is uncertain and knowledge is
incomplete making the market imperfect. Under these circumstances
business people prefer a stable price based on full cost.

Criticism:

The full -cost pricing theory has been severely criticised on the
following grounds:

(1) Not free from profit maximisation:
Critics like Robinson and Kahn have pointed out that the full -cost pricing
theory is not free from the elements of profits maximisation which entered
into the pricing decisions of many of the firms inv estigated by Hall and
Hitch.

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(2) Whose full cost?
One of the weaknesses of the theory is that it fails to point out the firm
whose full cost will determine the price in the oligopoly market that will
be followed by the other firms.

(3) Firms follow independent price policy:
The full -cost pricing theory is criticised for its adherence to a rigid price.
Firms often lower the price to clear their stocks during a recession. They
also raise the price when costs rise during a boom. Therefore, firms often
follow an independent price policy rather than a rigid price policy.

(4) Circular relationship:
If fixed costs of a firm form a large proportion of its total cost, a circular
relationship may arise in which the price would rise in a falling market and
fall in an expanding market. This happens because average fixed cost per
unit of output is low when output is large, and when it is small, average
fixed cost per unit of output is low.

(5) Profit margin a vague concept:
Moreover, the term ‘profit margin’ or ‘costing margin’ is vague. The
theory does not clarify how this costing margin is determined and charged
in the full cost by a firm. The firm may charge more or less as the just
profit margin depending on its cost and demand conditions.

As pointed out by Hawkins, “The bulk of the evidence suggests that the
size of the ‘plus’ margin varies: it grows in boom times and it varies
with elasticity of demand and barriers to entry.”

(6) Naive method:
This pricing method is naive because it does not explicitly take into
account the elasticity of demand. In fact, where the price elasticity of
demand for a product is low, the cost plus price may be too low, and vice
versa.

(7) Not for perishable goods:
This method cannot be used for price determination of perisha ble goods
because it relates to the long period.

(8) Full -cost pricing principle not strictly followed:
Empirical studies in England and the U.S. on the pricing process of
industries reveal that the exact methods followed by firms do not adhere
strictly t o the full - cost principle. The calculation of both of average cost
and the margin is a much less mechanical process than is usually thought.
As a matter of fact, businessmen are reluctant to tell economists how they
calculated prices and to discuss their relations with rival firms so as not to
endanger their long -run profits or to avoid government intervention and
maintain good public image.

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(9) Firms follow marginal principles;
Prof. Earley’s study of the 110 ‘excellently managed companies in the
U.S. d oes not support the principle of full -cost pricing. Earley found a
widespread distrust of full -cost principle among these firms. He reported
that the firms followed marginal accounting and costing principles, and the
majority of them followed pricing, mark eting and new product policies.

Conclusion: Average -cost rules of pricing are useful for avoiding
uncertainty and to ‘co -ordinate’ the market.

7.6 SUMMARY
In this way the module explains us the difference between the traditional
theories and the new theories explaining the role of managers in the
business activity. It explains us that how the managers try to expand the
welfare of the labourers.

7.7 QUESTIONS
Q1. Write an explanatory note on marris model of managerial enterprise.
Q2. Explain Williamson’s model of managerial discretion.
Q3. Write an explanatory note on Williamson’s managerial Utility
function.
Q4. Write a note on Behavioural Theory of firm.
Q5. Explain the behavioural theory of Cyert and March.
Q6. Explain in details the principle of full -cost pricing.

7.8 REFERENCES
 Gravelle H. and Rees R.(2004) : Microeconomics., 3rd Edition,
Pearson Edition Ltd, New Delhi.
 Gibbons R. A Primer in Game Theory, Harvester -Wheatsheaf, 1992
 A. Koutsoyiannis : Modern Microeconomics
 Salvatore D. (2003), Microeconomics: Theory and Applications,
Oxford University Press, New Delhi.
 Varian H (2000): Intermediate Microeconomics: A Modern
Approach, 8th Edition, W.W .Norton and Company
 Varian: Microeconomic Analysis, Third Edition
 Salvatore D. (2003), Microeconomics: Theory and Applications,
Oxford University Press, New Delhi.


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8

ALTERNATIVE THEORIES OF THE
FIRM -II

Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Existence, Purpose and Boundaries of Firm
8.3 Resource Based Theor y
8.4 Knowledge Based Theory
8.5 Transaction Cost based Theory
8.6 Summary
8.7 Questions
8.8 References

8.0 OBJECTIVE
 To provide clear understanding of the concepts of Existence, Purpose
and Boundaries of the firm and their importance .
 You will also learn the concepts of economies of scale
 To analyse the concept of resource -based theory
 Studying the importance of the knowledge in todays dynamic and
competitive world.
 To study the concepts related to the Knowledge based Theory
 To understand the meaning of transaction cost

8.1 INTRODUCTION
Maximisation of profit is the main objective of the firm. But along with
that the firm also tries to maximise several other objectives. Resources
play a very important role in the growth of any firm. The Knowledge -
based view of the firm is a recent extension of the Resource - based view
of the firm very adequate to the present economic context. Knowledge is
considered to be a very special strategic resour ce that does not depreciate
in the way traditional economic productive factors do, and can generate
increasing returns. The nature of most knowledge -based resources is
mainly intangible and dynamic, allowing for idiosyncratic development
through path depen dency and causal ambiguity, which are the basis of the
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the firm. Firms exist to simplify and reduce the transactional costs of
coordinating economic activities

8.2 EXISTENCE, PURPOSE AND BOUNDARIES OF FIRMS
What is a Firm? :
A firm is a business organisation (which can take form as a corporation,
partnership, Limited Liability Company (LLC) among others) which
transforms inputs into outputs for profit. This can be in the form of goods
(such as laptops or French fries), service s (such as gardening or cleaning),
or both (restaurants where we pay for the food we order, but also for the
experience). Firms typically embody some kind of institutional structure
with the management of the firm having both a set of objectives and a
strategy with the goal of maximising profits.

Most firms, in the way we talk about in economics, are assumed that what
a firm does maximises its profits. In general, that's true - it is in most
legislation, and it is also required by law that a public traded company,
which has shareholders, has an obligation to their shareholders who expect
this firm would act in the best interest of the shareholders. There are also
some other types of firms also such as

Social enterprises : Social enterprises are firms that exist for the purpose
of maximising well -being and social impact, rather than profit. These
firms may still be involved in buying and selling, as well as transforming
inputs to outputs. In the business process, social ent erprises try to achieve
different purposes. For example, social enterprises may try to employ
people from disadvantaged backgrounds who have difficulties in finding
jobs otherwise, so they are paying back society through employment, or
social enterprises m ay use their profits to help the society. In a sense,
social enterprises are a bit like charities which don't get donations but
instead use a firm as a vehicle to generate profits which are then donated
to people in need. Given that a social enterprise is set up to maximise it's
social impact, which it typically uses it's profits to drive, social enterprises
are often still profit maximising firms.

Government -owned companies : In general, they serve the public and
also have certain obligations like the Univ ersal Service Obligation. Even if
it is not profitable to serve certain persons because, for instance, they live
very far and the outback, it might be required for those government -owned
companies to serve those people, which they wouldn't necessarily do s o if
they were private companies due to the lack of profitability.

But in general, we deal with firms that maximise, or at least try to
maximise their profits. As profits should be maximising at a long -term
vision which can't be seen from now, expectation s are needed to estimate
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to reflect those long -term visions, and people can deduce that if the share
price of a company goes up, the firm is doing well in terms of its long -
term pr ofitability.

The theory of the firm consists of a number of economic theories that
explain and predict the nature of the firm, company, or corporation,
including its existence, behaviour, structure, and relationship to the
market.

In simplified terms, th e theory of the firm aims to answer few questions
such as,
1. Existence. Why do firms emerge? Why are not all transactions in the
economy mediated over the market?
2. Boundaries. Why is the boundary between firms and the market
located exactly there with r elation to size and output variety? Which
transactions are performed internally and which are negotiated on the
market?
3. Organization. Why are firms structured in such a specific way, for
example as to hierarchy or decentralization? What is the interplay of
formal and informal relationships?
4. Heterogeneity of firm actions/performances.What drives different
actions and performances of firms?
5. Evidence. What tests are there for respective theories of the firm?

Firms exist as an alternative system to th e market -price mechanism when
it is more efficient to produce in a non -market environment. For example,
in a labor market, it might be very difficult or costly for firms or
organizations to engage in production when they have to hire and fire their
workers depending on demand/supply conditions. It might also be costly
for employees to shift companies every day looking for better alternatives.
Similarly, it may be costly for companies to find new suppliers daily.
Thus, firms engage in a long -term contract wi th their employees or a long -
term contract with suppliers to minimize the cost or maximize the value of
property rights.

Why do firms exist?
Firms exist to simplify and reduce the transactional costs of coordinating
economic activities (Ronald Coase "The Nature of the Firm" 1937). By
utilising the principles of economies of scale and scope, firms are able to
reduce the transactional costs of operating within the market. Larger firms
reduce costs by more efficiently satisfying 3 major factors required in
economic activities:

1. Search & Information : Firms can minimise search costs regarding
things like marketing and advertising (e.g. it's easier for a university than
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etc, as the u niversity is doing these things for all lectures and all degrees
throughout the university).

2. Bargaining & Decision making : Firms can use enterprise bargaining to
set a price for everyone compared to freelancers negotiating at different
prices with different people.

3. Policing & enforcement : Firms have strong policies in place to
maintain quality.

An example of this is a model working freelance who has to do all of their
own advertising, marketing and management of finances. If the model
worked under a booking agent, their jobs would be set up, transport
organised and payment collected by the firm. Therefore, it would take the
pressure and stress of the model to perform their job better. To further
explain, firms are needed to set a price and create a market. By creating a
market a firm is able to consolidate demands of a certain good and
produce it altogether to achieve ec onomies of scale. Firms might even be
able to use their resources to aid in the production of other in -demand
products, which then becomes a form of economies of scope.

Industries formed by different firms competing in the same market may
face disruption due to the rise of a new technology which helps eliminate
transaction costs and consequently reduces the need for firms. Examples:
• Person -to-person car sharing: Where people's idle cars are
temporarily made available to people who need transport. This re sults
in a significantly lower demand for car rental agencies as any person
can make their vehicles available through the application and can avoid
the logistics required by a large firm (people might get rid of the firms
that are normally organising these activities, and they might have
individual trades with each other without the firms' getting percentage
cuts).
• Airbnb: Airbnb is disrupting the hotel industry through the use of new
technology such as applications to connect homeowners with travellers.
• Video streaming: online video streaming like YouTube and Netflix are
disrupting Television company, which changes the way of people
watching programs.
• Coursera: Coursera is disrupting universities as it provides massive
free online learning courses whi ch allow learners to be more flexible in
their learning.

However, these new technologies can help further lower transaction cost
which is a benefit for consumers. Over time, some conventional firms in
the industry might be eliminated, while some might lea rn from these new
technologies and further improve their industry standards.

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Horizontal Boundaries of Firms :
Horizontal boundaries refer to the quantity (Economies of Scale) and
variety (Economies of Scope) of products that a firm produces. Economies
of Scale and Scope exist whenever large -scale operations provide a cost
advantage over smaller ones, such that the average variable cost per unit
reduces as the quantity of output of a single product, or a variety of
products produced in a single plant increa ses. Production processes that
are Capital Intensive generally are more likely to display Economies of
Scale or Scope than Labour or Resource Intensive processes. Capital
Intensive processes tend to have a higher fixed to variable cost ratio which
benefits more from improving production techniques.

Economies of Scale :
Economies of scale are the cost advantages that firms obtain based on their
scale of operation, with the cost per unit of output decreasing as the scale
of production increases. However, some of the companies will not take
advantage of economies of scale, preferring differentiation over cost
leadership. When a market is producing at a level of economies of scale,
allocative efficiency within the market is achieved. This means the market
is pro ducing at perfect competition, reducing costs and profit.

Sources of Economies of Scale:
Economies of Scale exists if there are:

1. Indivisibilities in Production and the Spreading of Fixed Cost:
One of the common sources of Economies of Scale is the spreading of
fixed costs over an even larger volume of output produced. Indivisibilities
refer to the minimum level at which any element of production requires to
operate. Indivisibilities exist when the minimum level of production is
significantly larger for new entrants to be economically viable. This occurs
when there are high setup costs, long -run fixed costs, and volumetric
returns to scale or a combination of all three. Larger firms can take
advantage of indivisibilities by spreading costs over a grea ter volume of
production as well as having better access to capital markets (assuming
imperfect access to firms). Indivisibilities exist when it is possible to do
things on a large scale that cannot be done on a small scale. Some inputs
cannot be scaled do wn below a certain minimum size, even when the level
of output is minimal. In general term, there is minimum expenditure a firm
must incur in order to commence production (e.g. with a small backyard
farm, a tractor is still needed to reduce labour intensit y because it is not
possible to purchase 0.01 of a tractor). Therefore, the first unit produced
requires a significantly higher level of investment than the subsequent
units, with the increase in subsequent units produced, it allows for costs to
be spread out, allowing for Economies of Scale. If the indivisible input is
not overly specialised, the firm can diversify its line of products at a lower
cost as opposed to the total cost of individual specialised enterprises.
Indivisibilities also promote economie s of scope. For example, when
airlines add new routes, they utilise conveyancing.
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2. Specialisation:
Specialisation occurs when workers assigned to specific production tasks,
increase in productivity and efficiency over time, allowing them to benefit
from the lower average costs per increased in output. In order to conduct
specialization, firms must be ready to make substantial investments,
however, reluctance for firms will occur unless the present or forecasted
demand justifies the volume to utilize spe cialization. From Adam Smith’
theorem, it has stated that the division of labour is restricted to the span of
the market (1) As the markets increase in size, economies of scale will
enable the utilization of specialisation in productions, (2) The larger
markets with volume advantages will support an arrangement of
specialised activities

3. Inventories:
By carrying inventories, firms who conduct high volumes of business are
able to maintain a lower ratio of inventory to sales. By buying in bulk,
moving and storing big volumes of inventory reduces the overall cost per
unit, hence Economies of Scale. Additionally, consolidation of inventories
reduces costs associated with stock -outs and lost sales. There are various
incentives for firms to possess inventories (1) Avoid stock -outs and lost
sales (Safety stock is essential due to the uncertainty in the forecasts of
sales. The added accuracy to the forecast, the fewer safety stock is
required) (2)Avoid adversely influencing customer commitment,
(3)Assuring no setb acks occur in the production process. However, by
taking onto excess inventories, there will be consequences attached to such
action as (1) Opportunity cost of cashflow restricted in inventory, (2) Rent,
depreciation, insurance needed for inventory storage (3) Cost of
deterioration and obsolescence of the inventories

4. Large volumes of input purchases:
Firms that purchase relatively greater quantities of inputs may obtain
discounts from suppliers. Reasons for this include lower negotiating costs
with a s ingle supplier as opposed to multiple suppliers, suppliers
benefiting from an association with reputable firms purchasing the inputs,
and the security of confidentiality dealing with a single supplier can all
induce discounting. Additionally, suppliers tha t rely on large purchases
from a few firms are more inclined to discount, as they are risk -averse to
losing the firms they supply.

5. The Cube Square Rule:
The mathematical concept which can be addressed to explain economies
of scale. The Cube -Square Rul e expresses the relationship between
volume and the surface area. It implies that an increase in volume will
incur an increase in surface area proportionally. This is another source of
economies of scale. For many manufacturing processes, the capability of
the machine to produce is related to the volume of the production vessel,
and the total cost of production is closely associated with the surface area
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the capacity of production o f the plant and decrease the ratio between the
surface area and the volume of the production vessel.

6. Many processes are dealt with in volume but their costs are associated
with an area (i.e. Storage). As the volume of a vessel increases by a given
proportion, the surface area then increases by less than this proportion. In
various production processes, production capacity is to be found
proportional to the volume of the production vessel while the total cost of
producing at capacity is proportional to t he available surface area of the
vessel. This concludes that as capacity increases, the average cost of
producing at capacity will decrease because the ratio of surface area to
volume decreases. For example, shipping of chairs in a shipping container.
By s tacking the chairs on top of each other, the capacity of chairs
increases, hence decreasing the cost of shipping per surface area,
achieving Economies of Scale.

7. Marketing costs:
Advertising has a certain fixed cost to all firms; therefore, larger firm s are
able to spread this cost over a relatively larger number of potential
customers and can better adapt production to changes in demand from
advertising campaigns in comparison to smaller firms. These fixed costs
are similar for national firms as they a re for regional firms. Firms with a
greater scope of product offerings benefit from umbrella branding, which
influences customer perception for all of the brand’s products despite a
campaign focusing on a single offering.

8. Other sources :
Other sources of Economies of Scale include labour specialisation, more
efficient inventory management due to predictable customer demand and
industries that encounter the cube square rule – where processes are
volume related but costs are area related. A reduction in per-unit costs
occurs in the short run when fixed costs are spread over increased
production through better utilisation of a production plant’s given
capacity. In the long run this is represented by improvements in
technology or increases in a plant’s tota l production capacity, altering the
dynamic of a firm’s fixed to variable cost ratio.

9. The network effect :
The network effect is a unique source of Economies of Scale, which arises
when customers experience greater benefit from using a product as a resu lt
of more people using it. For instance, Facebook provide the same value as
a diary without the social function of interacting with other users. The
utility and value of Facebook is higher than a diary is due to having
increasingly high volume of users. The resulting ‘demand -side’ of
Economies of Scale has a network effect if it benefits other adopters of the
product (total effect) and incentivises others to adopt the product
(marginal effect).

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Types of Economies of scale :

1. Internal : Internal economies are factors and capabilities that are unique
to and can be controlled by an organization that at minimal costs, can
produce in large quantities. The big operational and financial size of an
organization usually means they can take advan tage of internal economies.

2. External : External economies result from advantageous conditions
coming from outside the organization or, within an entire industry or
economy. External economies mean that as an industry or sector grows,
the average cost of doing business falls.

Short -Run Economies of Scale :
The reductions in unit costs are related to spreading fixed costs for a firm
of a given size. Short -run economies of scale occur because of firms
utilising a plant of a given capacity. For short -run eco nomies of scale, it is
assumed that there are fixed costs and the short -term average cost curve
has a U -Shape [4]. The average cost in the short run is calculated by taking
the total cost and dividing by output at each different level of output.
Average co st shows that firms can earn profits given the market price.

Long -Run Economies of Scale :
The reductions in unit costs are caused by a firm switching from a low
fixed/high variable cost plant to a high fixed/low variable cost plant. This
happens when new technology is adopted by firms or when plant sizes are
increased. For the long -run economies of scale, the average cost curve us
more downward -sloping and it assumes that all factors/variables of
production could change .

Economies of Scope :
Economies of scope happen when manufacturing one good causes the
reduction of the production cost of another related product. As a result,
which the marginal cost or the long -run average of a company decreases
due to the production of complementary goods and services.
Consequently, economies of scope are described by variety.

Economies of scope can be achieved when the cost of producing two
different products together is less costly when a single firm produces them
instead of tow separate firms. (ie. C(q1,q2) < C(q1, 0) + C(0,q2) where q1
the production level of good one and q2 is the production level of good
two). This may occur when two products are complementary in their use
to each other, when they have complementary production processes or
when they share the same inputs to production.

Learning economies :
There is a learning economy where costs fall with experience. The
learning economy can not directly expand the size of the company, but it
can contribute to the success of the company. This stems from the fact t hat
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managers become better at allocating resources and scheduling production
processes.

Economies of Scale and Scope :
Economies of both Scale and Scope present whenever large -scale
production, distribution, or retail processes provide a cost advantage over
smaller processes. In general, capital -intensive production processes are
more inclined to demonstrate economies of scale and scope as compared
to other labour or materials intensive processes. By allowing cost
advantages, economies of scale and scope will not only influence the
magnitude of firms and the structure of markets, but they will, too,
configure critical business strategy arrangements, with an example of the
possibility of the merging of independent firms and the likelihood of a
firm achieving a long -term cost advantage. Economies of scale and scope
are used to help cut a firm’s operational costs. They occur when a firm
experiences a cost advantage from implementing large -scale production
over smaller processes. Economies of scope deal with average total cost of
production of multiple goods while economies of scale are concerned with
cost advantage that occurs due to the increased production of a single
good. Economies of sco pe occur if it is possible for a firm to produce more
than one good with the same resources, to increase the range of products
they produce, while saving money on production costs, as opposed to
producing the same amount of output with different resources. Economies
of scale only occur with the indivisibilities, or the ability to manufacture
products on a large scale that can’t be manufactured on a smaller scale.
Indivisibilities include returns to scale, long -run fixed costs and setup
costs, costs that wou ld be too expensive to maintain production if only a
small volume of output was being produced.

Differences between Economies of Scope and Economies of Scale :
The economy of scope and economy of scale are two different concepts
used to help cut a company' s costs. Economies of scope focus on the
average total cost of production of a variety of goods, whereas economies
of scale focus on the cost advantage that arises when there is a higher level
of production of one good. Economies of scale are reductions in average
costs because production volume increases; whereas, economies of scope
are reductions in average costs because the number of good produced
increases .

Differences :

1) Economies of scale : firms reach a point of production where the cost of
it no longer increases (bulk production). It is an old concept used in
business and economics. This reduces the cost of one product. It consists
in producing one type of product in bulk. The strategy beh ind is the
standardization of the product. It uses a large number of resources because
of bulk production.
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2) Economies of scope : firms produce a variety of products and their cost
of production gets reduced. It is a new term in business economics. This
reduces the cost of multiple products. It consists of producing multiple
products under the same operation. The strategy behind eco nomies of
scope is the diversification of products. It uses fewer resources because
firms produce multiple products under one operation.

Horizontal Mergers :
Horizontal mergers have very high potential to have anticompetitive
effects. This is because the t otal number of firms is reduced by one. Any
potential increase in market power (ability of firm to raise prices above
marginal cost) of a single firm must be balanced against any socially
beneficial cost savings. Real world mergers can be very complex and
require a number of steps to assess their viability.

1. Market Definition : this can be defined by the product, geography,
product function, customers etc. Another way is the SSNIP test which
refers to a 'small but significant non -transitory increase in price', this
method helps define the market a firm operates in by assessing i ts market
power.

2. Safe Harbours : mergers are significantly less likely to have negative
effects on competition if post -merger market concentration is low. Market
concentration can be determined by the Herfindahl index (HHI)

3. Effect of Merger on Exist ing Competition : evaluation of the
competitive nature of the market, taking into account: the type of
competition (price, quantity, fixed capacities), conduct of firms
(coordinated?) and product differentiation

4. Effect of Merger on Potential Competition : possibility of entry
deterrence/predation with or without merger, supplier relations and
alternative technologies/networks

5. Other Competition Fac tors: changes in market powers of buyers and
suppliers, scope for efficiency defence

Vertical Boundaries of the Firm :
Vertical boundaries of the firm refers to how much control the firm has
over its industry operations, such as the production and distribution of
their good or service.

Vertical integration can be divided into two streams – forward integration
and backward integration.

In forward integration, companies will control their downstream
counterparts, in order to increase control over the supply chain. For
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Backward integration refers to wh en companies seek to control their
upstream counterparts, in order to increase control over the final product.
For example, a chocolate manufacturer may seek to own cocoa farms.
Why not use the market for supplying inputs?

Benefits of using the market :
• Firms can achieve economies of scale that in -house departments
producing for their own needs cannot - specialised firms will typically
produce more than an in house department will
• Discipline of the market forces efficiencies on firms. That is,
competiti on tends to promote effectiveness and quality. Relying on an
in house department that meets the bare minimum requirements, will
not have the same level of innovation & quality as an external firm.

Costs of using the market :
1. Hold -up problem: Is an issue of imperfect contracts - that is where
negotiations/changes in circumstances can result in time delays or
increased costs. This raises the costs of transacting market exchanges.
 It is argued that the possibility of hold -up can lead to underinv estment
in relationship -specific investments and hence to inefficiency. For
example, one supplier has an exclusive contract to supply body parts
for the cars of General Motors. The supplier can hold up General
Motors by increasing the price for the additio nal parts produced if
exceeding demands occur.
 It can lead to difficult contract negotiations and more frequent
renegotiations
 It can lead to distrust between corporations
2. Difficulties in coordination: External firms are harder to control than
internal departments. This in turn can raise costs with bottlenecks in the
production flow. The failure of one firm to deliver supplies on time can
lead to another factory being shut down.
3. Security of private information: Private information may be leaked
when u sing the market. Leakages can result in firms' competitive
advantage being compromised. An example of this is a patent or special
know -how.
4. Transaction costs in contracting: Cost incurred during the process of
purchasing and selling goods or services.

Vertical Separation :
Some firms may decide to develop looser relationships then complete full
vertical integration. That is, instead of fully moving all production in -
house, they will utilise a balance between internal departments and the
market.


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Advantage of a looser relationship over full vertical integration
1. Preservation of firm’s independence
2. Avoidance of costs that may be associated with full vertical integration

Examples of looser relationships:
• Franchising : involves a specific contr actual relationship/arrangement
between franchiser & franchisee E.g., McDonald's, Hungry Jacks, 7 -
Eleven
• Networks of independent firms that are linked vertically & establish
nonexclusive contracts or relationships with one another E.g. Grocery
retailers and Metcash (grocery wholesaler)

Other alternatives to vertical integration:
Tapered integration: A mix of vertical integration and market exchange,
making some inputs and buying the remaining portion from independent
firms. Example: BMW uses some external market research along with in
house market research. The advantage of Tapered Integration: Produ cing
part of the production requested materials and input the rest of the
materials from other companies in exists in the market. This will reduce
the initial cost of capital and reduce the cost of misunderstanding the
market price. Manufacturing some of t he demand whist purchasing the rest
from the market will not only increase the bargaining power of the
company itself, and also threat the external suppliers to discipline the
supply process and quality of the supplies. Disadvantage of Tapered
Integration: The company may not achieve the economies of scale,
because of the sufficiency of production will need both internal production
and external suppliers to coordinate. Other than the loss of economies of
scale, the tapered integration may incur higher coord ination costs and
freight in and out costs due to purchasing supplies from external suppliers.
The efficiency of production process will also be a problem if coordination
of supplies and internal production process does not collaborate.

Joint Venture: Whe re two or more parties decide to work together by
pooling their resources with the goal of achieving a specific task or
completing a certain business activity. However, the venture is separate
from the other business interests and the two companies operate as one in
the venture. Example: the creation of google earth was as a result of a joint
venture between Google and NASA.

Strategic Alliance: A strategic alliance is where two or more firms work
together to increase each other's performance. They operate in the same
way as a joint venture however what makes them different is they operate
as separate companies and don’t require a legal contract. Example:
ApplePay and Mastercard; Mastercard was the first to offer ApplePay this
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Long term collaborative relationships: At least two parties who agree to
share resources, such as finance, knowledge an d people to accomplish a
mutual goal. Example: business relationships.

Implicit contracts between firms: Are a non -binding agreement
voluntarily entered into in regard to future exchanges of goods and
services. Example: an employer continues to offer empl oyment given the
employee remains sincere in not looking for another job and continues
their duties

Recently in Western countries: This strategy forester the vertical
disintegration and concentrate on create core competencies for companies,
aiming to outp erform other companies in within the market.

8.3 THE RESOURCE -BASED THEORY OR VIEW (RBT/RBV)
The resource -based view / theory (RBV) is a managerial framework used
to determine the strategic resources a firm can exploit to achieve
sustainable competitive advantage.

Barney's 1994 article "Firm Resources and Sustained Competitive
Advantage" is widely cited as a pivotal work in the emergence of the
resource -based view. However, some scholars argue that there was
evidence for a fragmentary resource -based theo ry from the 1930s. RBV
proposes that firms are heterogeneous because they possess heterogeneous
resources, meaning firms can have different strategies because they have
different resource mixes.

The RBV focuses managerial attention on the firm's internal resources in
an effort to identify those assets, capabilities and competencies with the
potential to deliver superior competitive advantages.

Origins and background :
During the 1990s, the resource -based view (also known as the resource -
advantage theory) of the firm became the dominant paradigm in strategic
planning. RBV can be seen as a reaction against the positioning school and
its somewhat prescriptive approach whic h focused managerial attention on
external considerations, notably industry structure. The so -called
positioning school had dominated the discipline throughout the 1980s. In
contrast, the resource -based view argued that sustainable competitive
advantage de rives from developing superior capabilities and resources. Jay
Barney's 1991 article, "Firm Resources and Sustained Competitive
Advantage," is seen as pivotal in the emergence of the resource -based
view. A number of scholars point out that a fragmentary re source -based
perspective was evident from the 1930s. Scholars suggest that the
resource -based view represents a new paradigm, albeit with roots in
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earn sustainable supranormal returns if, and only if, they have superior
resources and those resources are protected by some form of isolating
mechanism precluding their diffusion throughout the industry."

The RBV is an interdisciplinary approach that represents a substantial shift
in thinki ng. The resource -based view is interdisciplinary in that it was
developed within the disciplines of economics, ethics, law, management,
marketing, supply chain management and general business.

RBV focuses attention on an organization’s internal resources as a means
of organising processes and obtaining a competitive advantage. Barney
stated that for resources to hold potential as sources of sustainable
competitive advantage, they should be valuable, rare, imperfectly imitable
and not substitutable (now ge nerally known as VRIN criteria). The
resource -based view suggests that organisations must develop unique,
firm-specific core competencies that will allow them to outperform
competitors by doing things differently.

The resource -based view (RBV) of the org anisation is a strategy for
achieving competitive advantage that emerged during the 1980s and
1990s, following the works of academics and businessmen. Key theorists
who have contributed to the development of a coherent body of literature
include Birger Wer nerfelt, Spender, Grant.Jay B. Barney, George S. Day,
Gary Hamel, Shelby D. Hunt, G. Hooley and C.K. Prahalad.

The core idea of the theory is that instead of looking at the competitive
business environment to get a niche in the market or an edge over
competition and threats, the organisation should instead look within at the
resources and potential it already has available.

According to RBV, it is significantly easier to exploit new opportunities
using resources and competencies that are already avail able, rather than
having to acquire new skills, traits or functions for each different
opportunity. These resources are the main focus of the RBV model, with
its supporters arguing that these should be prioritised within organisational
strategy development .

Although the literature presents many different ideas around the concept
of the resource -advantage perspective, at its heart, the common theme is
that the firm's resources are financial, legal, human, organisational,
informational and relational; resour ces are heterogeneous and imperfectly
mobile and that management's key task is to understand and organise
resources for sustainable competitive advantage.

Concept :
Achieving a sustainable competitive advantage lies at the heart of much of
the literature in strategic management and strategic marketing. The
resource -based view offers strategists a means of evaluating potential
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arising from the resource -based view is that not all resour ces are of equal
importance, nor do they possess the potential to become a source of
sustainable competitive advantage. The sustainability of any competitive
advantage depends on the extent to which resources can be imitated or
substituted. Barney and othe rs point out that understanding the causal
relationship between the sources of advantage and successful strategies
can be very difficult in practice. Thus, a great deal of managerial effort
must be invested in identifying, understanding and classifying cor e
competencies. In addition, management must invest in organisational
learning to develop, nurture and maintain key resources and competencies.
Resource - based theory contends that the possession of strategic resources
provides an organisation with a golde n opportunity to develop competitive
advantage over its rivals.

In the resource -based view, strategists select the strategy or competitive
position that best exploits the internal resources and capabilities relative to
external opportunities. Given that s trategic resources represent a complex
network of inter -related assets and capabilities, organisations can adopt
many possible competitive positions. Although scholars debate the precise
categories of competitive positions that are used, there is general
agreement, within the literature, that the resource -based view is much
more flexible than Porter's prescriptive approach to strategy formulation.
Identification, evaluation, development, protection, expansion etc. of
resources becomes very much essential in strategic management process.

The key managerial tasks are:
1. Identify the firm's potential key resources.
2. Evaluate whether these resources fulfill the following criteria (also
known as VRIN criteria:
 Valuable - they enable a firm to implement str ategies that improve its
efficiency and effectiveness.
 Rare - not available to other competitors.
 Imperfectly imitable - not easily implemented by others.
 Non-substitutable - not able to be replaced by some other non -
rare resource.
3. Develop, nurture and protect resources that pass these evaluations.

Given the centrality of resources in terms of conferring competitive
advantage, the management and marketing literature carefully defines and
classifies resources and capabilities. It is defined and explained as follows.

Resources: Barney defines firm resources as: "all assets, capabilities,
organizational processes, firm attributes, information, knowledge, etc.
controlled by a firm that enable the firm to conceive of and implement
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Capabilities : Capabilities are "a special type of resource, specifically an
organizationally embedded non -transferable firm -specific resource whose
purpose is to improve the productivity of the other resources possessed by
the firm."

Competitive advantage: Barney defined a competitive advantage as
"when [a firm] is able to implement a value creating strategy not
simultaneously being implemented by any current or potential
competitors."

Classification of Resources and Capabilities :
Within an RBV model, there are two main types of resource (assets),
which will likely be familiar to accountants and financial specialists. Firm -
based resources may be divided into two main categories viz tangible or
intangible.
1. Tangible resources : These are physical assets such as financial
resources and human resources including real estate, property, raw
materials, machinery, plant, inventory, brands, land, products and capital,
patents and trademarks and cash. These are resources which can generally
be bought easily on the market and thus offer little competitive advantage,
as other organisations can also acquire identical assets quickly if they
should like.
2. Intangible resources: This refers to items and concepts that have no
physica l value but can still claim to be owned by the organisation. These
may be embedded in organisational routines or practices such as an
organization's reputation, culture, knowledge or know -how, accumulated
experience, relationships with customers, supplier s or other key
stakeholders, trademarks or intellectual property which the organisation
may possess. Some of these - e.g. reputation - are built up over a
significant period of time, and is something which other competitors or
comparable organisations cann ot buy on the market. These will likely stay
within the organisation and are their main source of competitive
advantage. They are particularly valuable in resource -based view because
they give companies advantages in using resources. For example, patents
make it impossible for other firms to use their resources in the same way
and brand might be the only thing differentiating the product from the
competitor’s.

The resources are divided into two critical assumptions:
1. Heterogeneous: This first major assu mption is that resources, skills and
capabilities must vary significantly from one organisation to another. It is
the assumption that each company has different skills, capabilities,
structure, resources and that makes each company different. Due to the
different forms of employment and number of resources, organizations can
design different strategies that promote competitiveness in the market. If
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with one another, as other organisations would be able to follow them
step-by-step (known as "perfect competition").

Perfect competition does not exist in the real world - companies may be
exposed to the exact same compe titive and external forces, but they are
still able to formulate different strategies to compete with one another.
Thus, RBV assumes that this is due to the varying values of their resources
and skills.

2. Immobile: The second assumption of RBV is that re sources are
immobile, and thus unable to move freely from organisation to
organisation (e.g., employee movement), at least over the short -term. Due
to this, organisations are unable to quickly replicate the resources of rival
organisations and therefore im plement the same strategies. Intangible
assets - knowledge, processes, intellectual property, etc. - are more likely
to be 100% immobile than are tangible assets.

It is the assumption that is based on the resources that an organization
owns are not mobile, in other words, at least in short terms, cannot be
transferred from one company to another. Companies can hardly obtain
the immobile resources of their competitors since those resources have an
important value for companies.
 A resource is valuable up to which it helps a firm create unique
strategies that capitalize on opportunities and diminishes threats. A
resource is non -substitutable when alternative ways to gain the
benefits the resource provides is impossible to get. A rare resource
provides st rategic advantages to the company which owns it.
 Competitors find it hard to duplicate resources that are difficult to
imitate. Some of these are protected by various legal means, including
trademarks, patents, and copyrights.
 Resource -based theory also fo cuses on the merit of an old saying “the
whole is greater than the sum of its parts”. Strategic resources can be
created by various strategies and resources, bundling them together in
a way that cannot be copied. Distinguishing strategic resources from
other resources is important. Cash is an important resource. Tangible
goods, including car and home are also vital resources.

From Resources to Capabilities :

Resources and capabilities may also be intraorganizational or
interorganizational:
While RBV scholars have traditionally focused on intraorganizational
resources and capabilities, recent research points to the importance of
interorganizational routines. Routines between organizations and the
ability to manage interorganizational relation ships can improve
performance. Such collaboration capabilities are, in particular, supported
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of information, e nhance organizational learning, and help develop
relational capital.
 The tangibility of a firm’s resource is an important consideration
within resource -based theory. Tangible resources are resources that
can have a physical presence. A firm’s property, pl ant, and
equipment, as well as cash, are tangible resources.
 In contrast, intangible resources are not physically present. The
knowledge and skills of employees, a firm’s reputation, and a firm’s
culture are intangible resources.

Capabilities: Capabilitie s are another key concept. Resources refer to
what an organization owns, capabilities refer to what the organization can
do. Capabilities often arise over time while the firm takes actions that
build on its strategic resources. Some firms develop a dynamic capability,
where a company has a unique ability of creating new capabilities to keep
pace with changes in its environment.

Dynamic Capabilities of GE and Coca Cola: General Electric, for
example, buys and sells firms to maintain its market leadership over time,
while Coca -Cola is known for building new brands and products as the
soft-drink market changes. Both of these firms are among the top fifteen
among the “World’s Most Admired Companies”.

The Importance of Marketing Mix :
 Leveraging resources and capabilities to create desirable products and
services is important. The marketing mix —also known as the four Ps
of marketing —provides important insights into how to make
customers convinced to purchase the goods and services.
 The real purpose of the marke ting mix is not to cheat but actually to
provide a strong combination among the four Ps (product, price,
place, and promotion) to offer the customers a useful and persuasive
message.

VRIO Framework :
Although possession of heterogeneous and immobile resour ces is crucial
to organisational success, it is not alone if they wish to sustain this
competitive advantage.

Barney (1991) identified a framework for examining the key properties of
resources and organisations (VRIO). These criteria were altered later b y
other leadership thinkers, and the new acronym VRIO was developed.
This stands for:
 Valuable : Resources are valuable if they can help to increase the
value of the service or product supplied to customers or others reliant
on the organisation. This can be improved by increasing
differentiation, decreasing the cost of production, or other general
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resources that do not meet this condition may lead to a competitive
disadvantage.
 Rare. Any resources : both tangible or intangible - which can only
be acquired by one or very few organisati ons, may be considered rare.
If organisations have the same resources or capabilities, this can result
in competitive parity.
 Low Imitability : If an organisation holds resources which are
valuable or rare, they can at least achieve a competitive advantage in
the short -term. However, to sustain this advantage the resources need
to be costly to imitate or substitute, or else rivals may begin to close
the gap by obtaining the same or similar resources.
 Organised to capture value : Resources do not necessarily convey a
competitive advantage - if the organisation, its systems and its
processes are not designed to exploit the resource to its fullest, then it
cannot hope to gain a competitive advantage. This could refer to not
utilisin g talented or knowledgeable individuals in the correct
department or role, or not fully building campaigns that utilise the
organisation's positive reputation, amongst many other examples.

Only when all of these factors are fulfilled can one gain a susta ined
competitive advantage, and can innovate and get ahead in the market. The
process for maximising an advantage using the RBV should follow as
such:
1. Identify the organisation's potential key resources
2. Evaluate whether the resources fulfil the VRIO criteria (using the
flowchart below)
3. Develop and nurture the resources that pass these criteria

If organisational leaders do as such, the organisation should hypothetically
be expected to pull ahead of rivals and to advance through new ground in
the market.

RBV and strategy formulation :
Firms in possession of a resource, or mix of resources that are rare among
competitors, are said to have a comparative advantage. This comparative
advantage enables firms to produce marketing offerings that are eithe r (a)
perceived as having superior value or (b) can be produced at lower costs.
Therefore, a comparative advantage in resources can lead to a competitive
advantage in market position.

In the resource -based view, strategists select the strategy or competi tive
position that best exploits the internal resources and capabilities relative to
external opportunities. Given that strategic resources represent a complex
network of inter -related assets and capabilities, organisations can adopt
many possible competit ive positions. Although scholars debate the precise
categories of competitive positions that are used, there is general
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more flexible than Porter's prescriptive approach to strategy for mulation.
Though the original formulators of the RBV play down the importance of
external activity within the market, Hooley et al. (1998) have suggested
that the marketing paradigm and the RBV are not unreconcilable, and that
external strategic planning i s still important for success.

In an RBV -centric organisation, leaders should select strategies that best
exploit internal resources relative to external opportunities and
competition. This can involve many different strategic positions, due to
the variet y of forms which resources can take.

Hooley et al. suggest that there are six different competitive positions one
can take when utilising a resource -based view of the organisation:
• Price positioning
• Quality positioning
• Innovation positioning
• Service positioning
• Benefit positioning
• Tailored positioning (one -to-one marketing)

These various strategies have been posited as being significantly less rigid
than Porter's well -known competitive strategies, and depend entirely upon
the resources av ailable to the firm.

Criticisms :
A number of criticisms of RBV have been widely cited and are as follows:
o The RBV is tautological
o Different resource configurations can generate the same value for
firms and thus would not be competitive advantage
o The role of product markets is underdeveloped in the argument
o The theory has limited prescriptive implications.
Other criticisms include:
o The failure to consider factors surrounding resources; that is, an
assumption that they simply exist, rather than a critical investigation
of how key capabilities are acquired or developed.
o It is perhaps difficult (if not impossible) to find a resource wh ich
satisfies all of Barney's VRIN criteria.
o An assumption that a firm can be profitable in a highly competitive
market as long as it can exploit advantageous resources does not
always hold true. It ignores external factors concerning the industry as
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o Supporters of RBV posit that competitive advantage is best achieved
by utilising present internal resources. However, this has drawn many
critics within leadership and management, and othe r theories and
frameworks such as the industrial organisation view (I/O), place more
emphasis on strategic planning, regulatory policy and the activity of
market competition.
o In reality, the likelihood is that significant amounts of an
organisation's perfo rmance can be explained by both factors, though
some studies have indicated that internal resources are indeed more
important with regards to competitive advantage and performance
overall.
o There are other critiques, however. The authors of RBV frameworks
tell managers that they should find and develop high potential
resources, using the VRIO framework; however, they do not suggest
how this should be done, and in reality, there is often nothing that
managers appear able to do to improve the resources availab le. What
it does neglect to mention, is that leaders and managers have the
capability to improve the processes and systems that create higher -
value resources - which could over the longer -term have a more
significant impact on the performance of the organi sation.
o In addition - when in unpredictable markets such as the technology
industry, innovations and new inventions can almost -instantly have a
drastic effect on the value of resources. This can render previous
activities to try and generate a sustainable advantage totally null -
thus, RBV can be considered to only be a practical view when situated
in a stable competitive environment. Some (e.g. Eisenhardt and
Martin, 2000) have indicated that levels of organisational learning and
adaptiveness are more cruc ial to success over the long term, though
RBV can be an important model in the short term.
o Further critiques include the extreme rarity of resources that match the
VRIO criteria, the limit of the VRIO criteria itself in determining
value, the unclear and indeterminate nature of VRIO itself, and the
ambiguous nature of the term "resources". The general concluding
thought is that RBV can be useful for developing competitive
advantage, particularly in the short -term, but should be considered in
partnership wi th other frameworks and theories when performing
long-term strategic planning.

8.4 KNOWLEDGE BASED THEORY OF FIRM
Introduction :
The knowledge -based theory of the firm considers knowledge as the most
strategically significant resource of a firm. Its propo nents argue that
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firms are the major determinants of sustained competitive advantage and
superior corporate perfor mance.

This knowledge is embedded and carried through multiple entities
including organizational culture and identity, policies, routines,
documents, systems, and employees. Originating from the strategic
management literature, this perspective builds upo n and extends the
resource -based view of the firm (RBV) initially promoted by Penrose
(1959) and later expanded by others (Wernerfelt 1984, Barney 1991,
Conner 1991).

Although the resource -based view of the firm recognizes the important
role of knowledge in firms that achieve a competitive advantage,
proponents of the knowledge -based view argue that the resource -based
perspective does not go far enough. Specifically, the RBV treats
knowledge as a generic resource, rather than having special characteristics .
It therefore does not distinguish between different types of knowledge -
based capabilities. Information technologies can play an important role in
the knowledge -based view of the firm in that information systems can be
used to synthesize, enhance, and exp edite large -scale intra - and inter -firm
knowledge management.

The knowledge -based theory :
In the last two decades of the 20th century a resource -based theory of the
firm has received attention as an alternative to the traditional product -
based or competit ive advantage. The resource -based perspective promises
to improve understanding of strategy formulation also in firms, which are
dependent on intangible resources, such as, the rapidly growing
knowledge -based services and knowledge -intensive industries.
Organizational knowledge presents a tremendous wealth creating
potential.

Contrary to traditional and finite production factors, knowledge can
generate increasing returns, through its systematic use. Knowledge
presents very special characteristics that differentiate it from physical
resources and contribute to the creation and sustainability of competitive
advantage. Knowledge can be used simultaneously i n several applications
and still it does not devaluate. Organizational knowledge is such a
marvellous substance, contrary to other resources, its utilization, under
different forms, increases it, instead of decreasing it. Knowledge -based
capabilities are considered to be the most strategically important.

ones to create and sustain competitive advantage A distinction was made
between three epistemologies that guided the practice and research under
an epistemological perspective: the cognitivist, the connec tionist and the
autopoietic. The cognitivist perspective assumes organisations to be open
systems, which develop knowledge by formulating increasingly accurate
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organisations can gather the close r the representation will be. Hence most
cognitivist perspectives equate knowledge with information and data.

According to the connectionist epistemology the organisation still
“represents” its outside world, but the process of representation of reality
is different. As in cognitivist epistemology information processing is the
basic activity of the system.

Autopoietic epistemology provides a fundamentally different
understanding of the input to a system. Input is regarded as data only.
Knowledge is privat e concept related to “personal” knowledge.
Autopoietic systems are both closed and open. Open to data, but closed to
information and knowledge, both of which have to be interpreted inside
the system. Autopoietic systems are self -referring, it is constructe d within
the system and it is therefore not possible to “represent” reality.

Knowledge defined as a “capacity -to act” is dynamic, personal and
distinctly different from data (discrete, unstructured symbols) and
information (a medium for explicit communic ation).

A Knowledge -Based Theory for Strategy Formulation :
The word “Strategy” is usually associated with activities and decisions
concerning the long -term interaction of an organisation with its
environment. While competitive -based and product -based str ategy
formulation generally makes markets and customers the starting point for
the study the resource -based approach tends to place more emphasis on the
organisation’s capabilities or core competences.

A knowledge -based strategy formulation starts with th e primary intangible
resource: the competence of people. People are seen as the only true
agents in business; all tangible physical products and assets as well as the
intangible relations are results of human action, and depend ultimately on
people for the ir continued existence. People are seen to be constantly
extending themselves into their world by both tangible means, such as
craft, houses, gardens and cars and intangible corporate associations,
ideas, and relationships. These intangible extensions are called ‘media’.

People can use their competence to create value in two directions: by
transferring and converting knowledge externally or internally to the
organisation they belong to. When the managers of a manufacturer direct
the efforts of their employ ees internally, they create tangible goods and
intangible structures such as better processes and new designs for
products. When they direct their attention outwards, they will in addition
to delivery of goods and money also create intangible structures, s uch as
customer relationships, brand awareness, reputation and new experiences
for the customers.

Three ‘Families’ of Intangible Resources :
The External structure can be seen as a family3 of intangible relationships
with customers and suppliers, which form the basis for the reputation
(image) of the firm. Some of these relationships can be converted into
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intangible resources is primarily influenced by how well the company
solves its customers´ problems, which involves an element of uncertainty.

Internal Structure can be seen or created when people direct their actions
interna lly. The family of Internal Structure can be seen to hold patents,
concepts, models, templates, computer systems and other administrative
more or less explicit processes. These are created by the employees and
are generally “owned” by the organisation. “cu lture” or the “spirit” can
also be regarded as belonging to the internal structure.

The Individual Competence family consists of the competence of the
professional/technical staff, the experts, the R& D people, the factory
workers, sales and marketing – in short all those that have a direct contact
with customers and whose work are directly influencing the customers
view of the organisation.

knowledge transfers are different from tangible goods transf ers. In contrast
to tangible goods, which tend to depreciate in value when they are used,
knowledge grows when used and depreciates when not used. Building up
competence in a language or a sport requires huge investments in training
and managerial competen ce takes a long time on -the-job to learn. If one
stops speaking the language it gradually dissipates.

The manufacturing and transportation of physical goods from suppliers,
via a factory to a buyer gave us the concept of the Value Chain. If we see
the or ganisation as creating value from transfers and conversions of
knowledge together with its customers the Value Chain collapses and the
relationship should better be seen as a Value Network; an interaction
between people in different roles and relationships who create both
intangible value (knowledge, ideas, feedback, etc) and tangible value.

Individual Competence External Structure Internal Structure $ Knowledge
transfers, knowledge conversions
Figure No. 8.1

The Firm from a Knowledge -based Perspective4



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In contrast to the Value Chain the intangible value in a Value Network
grows each time a transfer takes place because knowledge does not
physically leave the creator as a consequence of a transfer. The knowledge
I learn from you adds to my knowledge, but it does not leave you. Thus,
from an organisational viewpoint the knowledge has effectively doubled.
Knowledge shared is knowledge doubled. From an individual’s point -of-
view the perspective however, is different. Here knowledge shared may be
an opport unity lost if the effect of the sharing becomes lost career
opportunities, extra work and no recognition. Knowledge shared can be
competitiveness lost. Fear of dismissal or competition are commonly cited
reasons why individuals do not share what they know or what they create.

While the above primarily is concerned with transfer of existing (often
hidden and/or underutilised knowledge), another issue is the creation of
entirely new knowledge. Some have argued that new knowledge is created
in the conversion of explicit/tacit knowledge from one type to another.

The strategy formulation issues are concerned with how to utilise the
leverage and how to avoid the blockages that prevent sharing and creation
of new knowledge. The key to value creation lies with th e effectiveness of
such transfers and conversions. The choice of the words “transfer” and
“conversion” may suggest one -directional movements of knowledge. This
is not the intention. Knowledge transfer between two individuals is a
bidirectional process, whi ch tends to improve competence of both and
teamwork tends to be a cocreation of knowledge involving the whole
team. Moreover, transfer of competence depends on conversion from tacit
to explicit and back to tacit again in an endless spiral.

One feature of a knowledge -based theory of the firm is that it challenges
perceptions about the boundaries of an organisation. What is indeed “the
organisation” if customers and suppliers are included as families of the
firm as in Figure 1? When the importance is placed on how effective the
value creation is in the whole system, the issue of whether an individual is
a formal employee, a customer, a contractor, a supplier or a customer
becomes less of an issue as long as the relationship generates value. An
ex-employee can for instance be more valuable as a customer than as an
employee, a fact long exploited by the professional services firms.
The Ten Knowledge Strategy Issues

From the framework above we can distinguish nine basic knowledge
transfers/conversions, which have the potential to create value for an
organisation. Activities that form the backbone of a knowledge strategy,
are to be aimed at improving the capacity -to-act of people both inside and
outside the organisation.
1. Knowledge transfers/conversions betw een individuals
2. Knowledge transfers/conversions from individuals to external
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3. Knowledge transfers/conversions from external structure to
individuals
4. Knowledge transfers/conversions from individual competence into
internal structure
5. Knowledge transfers/conversions from internal structure to individual
competence
6. Knowledge transfers/conversions within the external structure
7. Knowledge transfers/conversions from external to internal structure
8. Knowledge transfers/conver sions from internal to external structure
9. Knowledge transfers/conversions within internal structure
10. Maximise Value Creation – See the Whole

Figure No. 8.2



The Ten Knowledge Strategy Issues are :
1. Knowledge Transfers/Conversions
Between Individual Professionals Knowledge transfers/conversions
between individuals are concerned with how to best enable the
communication between employees within in the organisation and
determine what types environments are most conducive to creativit y. The
strategic questions are: How can we improve the transfer of competence
between people in the organisation? How can we improve the
collaborative climate? The most important issues are probably concerning
trust in the organisation. How willing are pe ople to share their ideas and
what they know?

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Answers to such questions lead towards activities focused on trust
building, enabling team activities, induction programs, job rotation,
master/apprentice schemes, etc.

Examples: Oticon, the Danish hearing -aid manufacturer established in
1905, has re -designed whole work areas to create an atmosphere of
openness, flexibility, creativity and sharing. The company emphasizes
“live” interaction. Stand -up coffee bars encourage impromptu meetings,
and dialogue rooms” with a table and chairs help employees relax while
solving problems or sharing knowledge. Oticon even locked up elevators
so there would be more “accidental” meetings in the stairwell. The
company believes that paperwork hamp ers the exchange of information
because it is slower and more formal than oral communication. The
company therefore designated a “paper room,” the only room where paper
is ”safe.” Even electronic mail is discouraged in favor of face -to-face
communication. These tactics have contributed towards live dialog
becoming an integral part of Oticon’s business, so much so that other
forms of communication are almost non -existent.

Personnel rotation programs are common, and expose employees to
expertise held locall y and tacitly and are common. For instance, every
executive including the CEO at Southwest Airlines spends at least one day
every quarter as a baggage handler, ticket agent, or flight attendant. This
“shop-floor” experience keeps the knowledge of the opera tion fresh in the
minds of all employed. It also improves communication across all levels.

2. Knowledge Transfers/conversions from Individuals to External
Struct ure:
Knowledge transfers/conversions from individuals to the external structure
are concerne d with how the organisation’s employees transfer their
knowledge to the outer world. The strategic question is: How can the
organisation’s employees improve the competence of customers, suppliers
and other stakeholders? Answers to such questions lead towar ds activities
focused on empowering the employees to help the customers learn about
the products, getting rid of red tape, doing job rotation with customers,
holding product seminars, providing customer education, etc.

Examples: Consultants at McKinsey, the US based consulting firm, are
encouraged to spend time on publishing their research and methods in
order to build the reputation of the firm. Baxter International markets
healthcare products and has extended its offering to include service to
hospitals . Baxter employees now mix drugs in intravenous solutions and
act as brokers for other vendors.

3. Knowledge Transfers/conversions from External Structure to
Individuals :
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are concerned with how the organisation’s employees can learn from the
external structure. Organisations tend to have procedures in place that
capture such knowledge but they are scattered, not measured and hence do
not systematically influence strategy formulation. The strategic question
is: How can the organisation’s customers, suppliers and other stakeholders
improve the competence of the employees? Answers to such questions
lead towards activities focused on creating and maintaining good personal
relationships between the organisation’s own pe ople and the people
outside the organisation.

Examples: Employees at Betz Laboratories in Trevose, Pennsylvania,
frequently participates in its customers’ quality management teams in
order to gain a better understanding of, and even anticipate, customer
needs. This knowledge is used to develop products that will boost
customer sales. Betz measures value added from this knowledge by
tracking its customers’ return on investment, and its own employees
receive awards for outstanding efforts to increase these returns.

4. Knowledge Transfers/conversions from Competence to Internal
Structure :
Huge investments are currently being made in order to convert
competence (often tacitly held) individual into data repositories. The idea
is that information in such repo sitories will be shared with the whole
organisation. Indeed, the marketers of database software have been so
successful that many managers believe that buying a database is equal to
“Knowledge Management”. To focus one’s investments on databases and
docume nt handling etc. will realise only a fraction of the value of a more
strategic approach based on a knowledge -based theory of the firm.

The strategic question is: How can we improve the conversion of
individually held competence to systems, tools and temp lates? Answers to
this question lead towards activities focused tools, templates, process and
systems so they can be shared more easily and efficiently. Examples
systems for medical diagnostics, intranets, document handling systems,
databases, etc.

The k ey to create value from database or intranet system is not the
sophistication of the technology but on the climate in the firm and the
level of involvement from all agents in the system. The US chemicals
manufacturer Buckman Labs is well -known for nurturin g a collaborative
climate despite the fact that its 1,300 associates are spread all over the
world. The company has been using electronic means for capturing
experiences and information since 1987. It’s new products to sales ratio
went from ~25% to >35% wh en it began involving the customers in their
intranet in 1994.


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5. Knowledge Transfers/conversions from Internal Structure to
Individual Competence :
This is the counterpart of the 4th strategy. Competence “captured in a
system” is information and this information needs to be made available to
other individuals in such a way that they improve their capacity to act;
otherwise, the investment is a waste. IT systems can by definition only
produce information. The key to value creation is whether the informa tion
generates competence. The strategic question is: How can we improve
individuals’ competence by using systems, tools and templates? Answers
to such questions lead towards activities focused on improving the human -
computer interface of systems, action -based learning processes,
simulations and interactive e -learning environments.
Examples: IKEA, the Swedish furniture company, uses customised
simulations for speeding up the learning of its warehouse employees.

The Copeland Corporation, a manufacturer of compressors, changed its
entire manufacturing approach based on the results of a single
demonstration effort, in which a multifunctional team designed a
demonstration factory to manufacture a new product line.
Experimentation, whether an ongoing program or a demonstration project,
helps individuals move from superficial knowledge to a more basic
understanding of its processes —from knowing about something to
learning how and why.

6. Knowledge Transfers/conversion s within the External Structure :
What do the customers tell each other about the services/products of a
supplier? How are the products used? The conversations among the
constituencies can have an enormous impact on the strategy of a company.
Strategy formulation from a knowledge perspecti ve adds a richer range of
possible activities to traditional customer satisfaction surveys and one -way
PR-activities. The company can support the competence growth of
customers and influence how competence is transferred also between the
stakeholders in th e external structure. The strategic question is: How can
we enable conversations among the customers, suppliers and other
stakeholders to improve their competence to serve their customers?
Answers to such questions lead towards activities focused on partne ring
and alliances, improving the image of the organisation and the brand
equity of its products and services; improving the quality of the offering;
conducting product seminars and alumni programs. Examples: Danish
biomedical producer Novo actively engage s in building local communities
to improve the image of its products in its local community. Book
publisher Berrett -Koehler runs seminars for its book buyers featuring its
authors as speakers.

7. Knowledge Transfers/conversions from External to Internal
Structure
Knowledge Transfers/conversions from External to Internal Structure are
concerned with what knowledge the organisation can gain from the
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The strategic question is: How can c ompetence from the customers,
suppliers and other stakeholders improve the organisation’s systems, tools
& processes and products? Answers to such questions lead towards
activities focused on empowering call centres to interpret customer
complaints, creati ng alliances to generate ideas for new products, R&D
alliances, etc.

Example: Frito -Lay, the US potato chips maker provides an interesting
case of product differentiation of a commodity. The company uses its sales
force to collect data about their custome rs. The data are analysed and fed
back to their sales people empowering them with superior customer
knowledge and competitive intelligence. Frito -Lay representatives not
only use the information themselves, but they also give it away for “free”
provided th e shop buys their potato chips rather than their competitors’.

8. Knowledge Transfers/conversions from Internal to External
Structure :
This is the counterpart of strategy 7. The strategic question is: How can
the organisation’s systems, tools & processe s and products improve the
competence of the customers, suppliers and other stakeholders? Answers
to such questions lead towards activities focused on making the
organisation’s systems, tools & processes effective in servicing the
customer, extranets, prod uct tracking, help desks, business, etc.

Examples: Ernst & Young has created a tax and legal database, “Ernie”,
which allows its clients to tap into the data sources used also by its own
consultants. 12 Ritz Carlton, the hotel chain renowned for its serv ice, has
installed a customer information database with global access. All staff are
required to fill in cards with information from every personal encounter
with a guest. These data plus guest profiles are stored and made available
to staff in order to en sure personal treatment of all guests.

9. Knowledge Transfers/conversions within Internal Structure
The internal structure is the supporting backbone of the organisation. The
strategic question is: How can the organisation’s systems, tools &
processes a nd products be effectively integrated? Answers to such
questions lead towards activities focused on streamlining databases,
building integrated IT systems, improving the office layout, etc.

Example: Again, this is a field dominated by Enterprise Systems and
other company -wide IT solutions. Knowledge Curve, Pricewater house
Cooper’s intranet integrates several thousands of databases previously
held individually or locally.

10. Maximise Value Creation – See the Whole :
The nine knowledge transfers/conversions exist in most organisations.
However, they tend not to be coordinated in a coherent strategy, because
management lack the full perspective that a knowledge -based theory may
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block the leverage. Therefore, many of good initiatives go to waste or
neutralize each other.

Investment in a sophisticated IT system for information sharing is for
instance a waste of money if the organisation’s climate is highly
competitive – only junk will be shared. Reward systems that encourage
individual competition will effectively block efforts to enhance knowledge
sharing. Lack of standards and poor taxonomies reduce the value of
document handling systems. A program for knowledge sharing with
customers is neutralised by red tape protecting commercial secrets. Efforts
to use ex -employees for building marketing relationships are useless if
people leave the firm alienated or alumni programs are delegated to the
administr ative function. Data repositories do not improve individuals’
capacity to act unless the databases are made highly interactive.

The Affärsvärlden case (see below) illustrates how important it is to
integrate all activities in a strategic framework, so they leverage each other
and do not neutralise investments made in other areas.
Figure No . 8.3


Affärsvärlden’s Knowledge -based Strategy :
The competition between the two weekly Swedish business magazines
Affärsvärlden (AFV) and Veckans affärer (VA) offer’s a vivid illustration
of the value of a knowledge -based strategy in publishing, one of the olde st
industries on earth. There are substantial advantages of scale in the
printing process, since loading the press with plates and paper and
adjusting it represents a large fixed cost; after that, the marginal cost of
printing the second copy is no more th an maybe 10% of the average cost.
Thus the larger the imprint, the lower the cost per page. The leverage is
not as extreme as copying a CD, but not far from it.

The cost advantage enjoyed by a larger paper enables it to hire good
journalists and maintain a higher overall level of editorial quality. This can
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be a ticket to a virtuous circle of more readers who provide more
resources, which enable better quality, which attracts more readers, etc.

Even if the smaller magazine keeps lower prices than the lar ger, the larger
and (for the magazine) more profitable advertisers tend to prefer to place
their ads in a large magazine, 14 because it gives them access to a larger
audience. Publishers know that, once established, the largest newspaper or
magazine in a m arket is a licence to print money.

AFV, being less than one tenth the size of VA was close to bankruptcy in
1977. The printing costs alone were 30% higher for AFV, even though its
pages contained only half as much full -color print as VA´s. The journal’s
new owners in 1978 thus faced a formidable competitive barrier and had
no alternative but to try a different strategy than VA. AFV adopted a more
knowledge -based strategy.

Affärsvärlden´s Knowledge Strategy :
The knowledge strategy gave Affärsvärlden a dis tinct competitive
advantage on the market for financial information. The strategy and some
of the activities went against “common sense” in publishing, but its
ultimate success made Affärsvärlden a “cult publication” in the 1980s and
created a following am ong other journals and publishers in the country. A
summary of Affärsvärlden´s knowledge strategy is found in Figure 4.
below.

Sveiby (1994) identified two features that contributed most of the
difference in margin during the period 1980 - 1993:
1. High editorial productivity. In 1983 -84 the AFV journalists wrote
twice as many pages as their colleagues on the VA staff (133
compared to VA´s 62). This difference in editorial productivity was
sustained for 15 years. The knowledge -based strategy initiatives w ere:
• Recruit highly educated staff. AFV journalists had access to more
expertise in -house because they all had MBAs or higher, whereas
VA’s journalists rarely held such degrees. Higher education also
gives competence in information processing.
• Create Collaborative climate. No individual by -lines on the
articles reduced the traditional competitive climate among
journalists. Articles written by teams, “piggybacking” at
interviews and master/apprentice model supported tacit
knowledge transfer. Open office design (also in sales departments
and for managers) supported informal information knowledge
transfers/conversions.
• Build flat organisation. Visible managers, employee ownership
and profit sharing contributed to a shared vision and the
collaborati ve climate.
• Invest in new editorial technology. AFV was at least one year
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implementing the new technologies that revolutionised publishing
during the 1980s.
• Computerise analytical models. AFV’s analysts were early in
computerising their analytical models and basic number
crunching. Computerisation freed up time to do more qualified
analyses.
Figure No. 8.4



2. Low Staff turnover. The financial markets in the 1980s were exploding
(such as the IT markets in the 1990s) and AFV’s financial analysts
were prime targets of the investment bankers. The ownership model
and the collaborative culture were the strategic init iatives 15 that
worked as “golden handcuffs” and kept the staff turnover at 5 -7%
throughout the whole period, while VA suffered at least twice the
turnover.

AFV proved the value of its strategy by being more profitable than VA
almost the whole period, se e below, figure 8.5.














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Figure No. 8.5



When the depression of the nineties hit the Swedish financial markets,
both magazines came under heavy pressure. VA was hardest hit because
its editorial concept involved high fixed costs. AFV had lower fixed costs
and a much more flexible concept and was thus able to adjust rapidly by
reducing the number of pages and cutting down its fixed costs. AFV
continued to operate at a profit while VA went into the red.

Veckans Affärer´s problems caused its publishers to decide, with effect
from March 1994, to spl it it into two journals: a smaller, cheaper weekly
with a different concept and a more expensive monthly.

After 18 years (!) of single -minded head -on competition, AFV had forced
the leader to move out.

8.4 TRANSACTION COST THEORY
The transaction cost ap proach to the theory of firm was created by Ronald
Coase. Transaction Cost refers to the cost of providing for some good or
service through the market rather than having it provided from within the
firm.

Which components should a manufacturing firm make in-house, which
should it co -produce, and which should it outsource? Who should sit on
the firm’s board of directors? What is the right balance between debt and
equity financing?

These questions may appear different on the surface, but they are all
variat ions on the same theme: how should a complex contractual
relationship be governed to avoid waste and to create transaction value?
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Transaction Cost Economics (TCE) is one of the most established theories
to address this fundamental question.

Ronald Coase:
Figure No. 8.6



The model shows institutions and market as a possible form of
organization to coordinate economic transactions. When the external
transaction costs are higher than the internal transaction costs, the
company will grow. If the external tr ansaction costs are lower than the
internal transaction costs the company will be downsized by outsourcing.

According to Ronald Coase's essay The Nature of the Firm, people begin
to organise their production in firms when the transaction cost of
coordinating production through the market exchange, given imperfect
information, is greater than within the firm.

Ronald Coase set out his transaction cost theory of the firm in 1937,
making it one of the first (neo -classical) attempts to define the firm
theoretically in relation to the market. One aspect of its 'neoclassicism' lies
in presenting an explanation of the firm consistent with constant returns to
scale, rather than relying on increasing returns to scale. Another is in
defining a firm in a mann er which is both realistic and compatible with the
idea of substitution at the margin, so instruments of conventional
economic analysis apply.

He notes that a firm's interactions with the market may not be under its
control (for instance because of sales taxes), but its internal allocation of
resources are: “Within a firm, … market transactions are eliminated and in
place of the complicated market structure with exchange transactions is
substituted the entrepreneur … who directs production.”

Coase begin s from the standpoint that markets could in theory carry out all
production, and that what needs to be explained is the existence of the
firm, with its "distinguishing mark … [of] the supersession of the price
mechanism." Coase identifies some reasons why firms might arise, and
dismisses each as unimportant:
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