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GENERAL EQUILIBRILIUM
Unit Structure:
1.0 Objective s
1.1 Introduction
1.2 Concept of General Equilibrium
1.3 Walrasian General Equilibrium Model
1.4 Summary
1.5 Questions
1.0 OBJECTIVES
To study the concept of general equilibrium.
To study the Walrasian general equilibrium model .
1.1 INTRODUCTION
The concept of equilibrium plays very important role in the methodology
of economics. As a matter of fact economic theories are formulated on the
basis of the concept of equilibrium.
The concept of equilibrium in economics is borrowed fr om physics. In
physics equilibrium means a position of rest. In economics it cannot's a
little different meaning. In economics equilibrium means a state of balance
between two opposite force viz. demand and supply. In the midst of
balance there is a curren t of change. However once again the original
position of balance gets restored. Among different types of equilibrium
two concepts are very important viz. partial equilibrium and general
equilibrium.
In partial equilibrium approach we explain the price dete rminates of a
commodity, assuming the prices of other commodities to be constant. We
also assume that other commodities are not interdependent. In the words
of Dr. Alfred Marshall", the forces to be dealt with are, however, so
numerous that it is best to a nalyse a few at a time and to work out a
number of partial solutions as auxiliaries to our main study. Thus we begin
by islolating the primary relations of supply, demand and price in regard
to a particular commodity. We reduce the inaction of all other fo rces by
the phrase other things being equal i.e.cateris paribus. Thus in Marshallian
pricing under perfect competition, demand function (demand curve) for a
commodity is drawn with the common assumption that prices of other
commodities remain constant. Sim ilarly, supply curve of a commodity is
drawn by assuming that prices of other commodities prices of factors of
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2 determined in the market through the intersection of demand and supply
curves. So , the price of commodity X is determined independently of the
prices of all other goods. The partial equilibrium analysis of price
determination also studies how the equilibrium price changes an d a result
of changes in the supply and demand. The par tial equilibrium analysis
doesn't deal with the simultaneous determination of price of inter related
goods.
In General equilibrium analysis the price of a commodity is not
determined independently of the prices of other goods. There is a
interdependency an d interrelationship between different goods and their
prices. The price of commodity X affects the price and the quantities
demanded of other goods. On the otherhand the changes in prices and
qualities of other goods will affect the prices and the quantity demanded of
commodity X. Thus the general equilibrium analysis explains the mutual
and simultaneous determination of prices of all goods and factors of
production. The general equilibrium is also called as "multi - market
equilibrium" If for example commod ities X and Y are either
complementary or competitive goods then the change in the price of
commodities X will have its effect on demand for commodity Y. Which
explains the cross elasticity of demand.
General equilibrium analysis deals with interrelationsh ip and
interdependency between equilibrium adjustment with each other. General
equilibrium exists when at a price the quantities of goods and factors
demanded equal the quantities of good and factors supplied. A change in
the demand and supply of any commo dity or factor will cause a change in
the prices and quantities of goods and factors demanded and supplied.
This change will lead to establishing a new general equilibrium.
1.2 CONCEPT OF GENERAL EQUILIBRIUM
The concept of general equilibrium was given by Leon Walras (1834 -
1910) in his book," Elements of pure Economics" (1877) the English
translation of which was made in 1954. Leon Walras was a mathematical
economist. But he has not merely used a few mathematical notations or
simbols to save verbal discussi on. He has made use of mathematics
because of a close link or integration between economics and
mathematics. He has very cleanly brought out a judicious and harmonious
relationship between economics and mathematics which is no where
found. Mathematics help s and strengthens economics in proving the
theories of economics. Because of this rare quality Schumpeter considers
Walras to he the greatest of all economics. He further describes his work
of general equilibrium as "a revolutionary creativity". His work o f general
equilibrium has made him immortal. He was the first economist to work
out the complete theory of interdependent economic activity. He is unown
for his Walrasian system of "General equilibrium" and " Walrasian Law"
The Walrasian Law tells us that if equilibrium in all but one market exists
then the last market will be automatically in equilibrium. He constructed
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3 The Term, "General equilibrium" refers to the equilibrium of all economic
activities simultaneously in the whole economy. In a capitalist economy
number of individual units like consumers, produces, factors of production
would like to switch one to the maximising principle i.e. maximization of
satisfaction, maximization of profit etc. It i s due to the self
interestenvolved in their endeavour because of which they work
independently. In a situation of this type we get a puzzle as to whether the
whole economy will be is equilibrium. Leon Walran answers this question
by saying that yes there c an be a general equilibrium of the whole
economy. It can be attained through "exchange mechanism" or "price
mechanism".
A concept of general equilibrium can be defined as a state in which all
markets and all decision making units are simultaneously in equi librium.
Prof stigler definition ......" The theory of general equilibrium is the theory
of interrelationship among all parts of an economy".
It is clear from the definition of general equilibrium that general
equilibrium is consumed with the entire econom y rather than the
constituting sectors or individual units of an economy. General
equilibrium recognises that the different units of an economy like prices,
demand and supply of commodities, demand and supply of factors of
production (Leon Walras calls fac tors of production as services) etc. are
interdependent and interrelated. For example , a price of a commodity not
only defends upon the prices of other related goods and supply and
demand for goods but also depends upon prices of factor services. (Which
is term depend us an the demand and supply of the factors of production or
factor services.)
General equilibrium is a type of equilibrium in which a number of
economic variables are studied to see the interrelations and
interdependence among the variables for the proper understanding of the
economy as a whole. Whereas in the partial equilibrium analysis, only two
variables are taken into account, in general equilibrium analysis, all the
relevant variables are brought to play their part. General equilibrium can
be defined as a state of the economy in which all economic units and all
the markets are in equilibrium. General equilibrium analysis is Leon
Walras’ claim to immortality, says Baumol in his book “Economic Theory
and Operational Analysis”. With regard to pricing under perfect
completion there are two kinds of approaches, i.e. Marshallian ‘partial
equilibrium’ discussed above and Walrasian general equilibrium.
According to Marshalian Partial equilibrium analysis demand for a
commodity is determin ed/defined by its price alone, under ceteris paribus
assumption.
Symbolically state Dx is a function of price alone, other things remaining
constant.
Dx = f(P)
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4 Marshallian approach was critiq ued as ‘ too partial an approach’.
Walrasian General Equilibrium analysis as pointed out by Stonier and
Hague is a ‘study of’ multi -market equilibrium’. In multi -market
equilibrium analysis of price is not determined independently as in
Marshallian partial equilibr ium analysis. Thus, interdependency is taken
into account in this model.
1.3 WALRASIAN GENERAL EQUILIBRIUM MODEL
The most ambitious general equilibrium model was developed by the
French economist Leoan Walras. Walras argues that all prices and
quan tities i n all markets are determined simultaneously through their
interaction with each other. Walras used a system of simultaneous
equations to describe the interaction of individual sellers and buyers in all
markets. He maintained that all the relevant m agnitude i.e. prices and
quantities of all commodities and all factor services can be determined
simultaneously by the solution of this system.
In the Walsasian model the behaviour of each individual decision maker is
presented. by a set of equations. For example each consumer has a double
role to play both as a consumer and as a seller of services to enterprise.
Thus , for each consumer we will have a set of equations consisting of two
subsets viz. demand for different commodities and supply of input. On the
other hand , we will have behaviour of enterprise in terms of set of
equations with two subsets viz. the demand for factor service and the
production of goods i.e. output. The important characteristic feature of
these equations of the model are known as unk nowns i.e. the price and
quantities of all commodities and factors of production.
The general equilibrium analysis of Leon Walras depends upon the
following assumptions:
i) Full employment
ii) Perfect competition
iii) Homogeneity
iv) Income, Tastes prefere nces a re constant.
v) Constant returns to scale.
vi) Perfect mobility.
vii) Technology is given.
In a general equilibrium system of Walrasian type there are as many
markets as there are commodities and factors of production. For each
market there are three types of functions viz.
i) Demand function
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5 iii) Clearing function stating the equality between demand function and
supply functions.
In a commodity market the demand function is equal to number of
consumers and the supply function is e qual t o number of firms producing
the output. In the factor market the demand function equals the number of
firms multiplied by commodities produce by these firms. The supply
function equals the number of households owning the factors of
production.
A nece ssary condition for the existence of general equilibrium is that there
must be in a system as many independent equations as the number of
unknowns. Thus , the very first task in establishing the general equilibrium
is to describe the system of an economy by means of a system of equations
defining how many equations are required to solve the problem.
For example , let us assume that an economy consists of two consumers
viz. A and B owning two factors viz. K and L. these factors are used by
two firms to produce t wo c ommodities viz. X and Y. Thus , a simple 2 x 2
x 2 general equilibrium model gets farmed. It is assumed that each firm
produces one commodity and each Consumer buys some quantity of both.
It is also assumed that both consumers own some quantity of both t he
factors (the distribution of the factors is exogenously determined)
In such a simple 2x2x2 general equilibrium model we have the following
unknowns.
i) Quantities demanded of X and Y by the consumers
ii) Quantities supplied of K and L by consumers
iii) Quantities demand of K and L by firms
iv) Quantities of Y and X Supplied by firms
v) Price of commodities Y and X vi) Price of factors K and L Total Number of unknown 2x2=4
2x2=4
2x2=4
2
2
2
18
To find these unknowns we have the following number of e quation:
i) Demand function of Consumers.
ii)Supply function of factors
iii) Demand function for factors
iv) Supply function of commodities
v) Clearing the market of commodities
vi) Clearing the market of factors
Total number of equations = 2x2=4
2x2=4
2x2=4
2
2
2
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6 Since number of equations equals number of unknowns there exists a
general equilibrium solution. But unfortunately, though it is a necessary
condition for general equilibrium it is not a sufficient condition. In the
Walrasian system when one of the equations is not independent then there
happens tohe a redundant equation which deprives the system of solution
as the number of unknowns is larger than the number of independent
equations (The number of unknowns being 18 while the number of
independ ent equations being 17 only) In such a situation absolute level of
prices cannot be determined. Then the prices are expressed in terms of
ratios. The price of one commodity in arbitrarily chosen as a numeraire
means unit of account and the prices of rest of the commodities are
expressed in terms of numeraire. Thus , prices are expressed only as ratios.
Thus , we happen to attain equality of number of simultaneous equation
and number of unknown variables (each unknown in a set of related
variables requiring an equation for its determination).
PRODUCT and FACTOR MARKETS EQUILIBIUM:
We have already defined general equilibrium as a state in which all
markets and all decision -making units are simultaneously in equilibrium.
A general equilibrium exists if each market is cleared at an equilibrium
price at which each consumer is maximising his satisfaction and each
producer firm is maximising its profit. The scope of general equilibrium
analysis is the examination of how this state can be reached. It means now
prices ar e determined simultaneously in both the markets so that there is
equality between demand and supply of goods and an equality between
demand and supply of factors of production. Simultaneously the individual
decision -making units also attain their goals.
It is the rnodel of a competitive general equilibrium. It is assumed that
there prevails a free-market economy and a perfectly competitive market
situation in which both the individual buyer and an individual seller is a
price taker. It is a market consistin g of innumerable buyers, and sellers
such that neither an individual seller not the individual buyer can influence
the price prevailing is the perfectly competitive market situation. Both are
guided by their self interest. The consumers maximise their sati sfaction
while the firms maximise their profits.
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7
Figure No. 1.1
This diargram represents a two-market general equilibrium model. The
two markets are as follows:
i) The product market or Consumer market
ii) The factor market or Production market
Along X axis units of food are marked. Food gets produced with the help
of labour so it is but natural that factor labour gets marked along X axis.
Along Y axis units of car get marked. Car is produced with the help of
capital. Hence it is but natural that capi tal as a factor of product gets
marked along Y axis.
CF represent P. P. F. i.e. production possibility frontier. If we take a
tangent to the PPF we get PB line which is a budget like IC and IQ curve
is also tangential to the PPF. Point E is the equilibrium point at which
MRSfc is equal to MRTslc so point E is the general equilibrium point for
both the markets i.e. the product market and factor market and for both the
individuals viz consumer and the producer. At this equilibrium point there
is a maximizatio n of satisfaction to the consumer and a maximization of
profit accruing to the firm. At this equalization point OF, quantities of
food and OC' quantities of car are 1 exchanged as regards product market.
As regards factor market OF, quantities of labour an d OC' quantities of
capital are exchanged.
SUFFICIENT CONDITIONS:
We have already seen that the necessary condition for the existence of
general equilibrium is the equality between the number of unknowns
(variables) and the number of simultaneous equations . However the
question gets posed i.e. whether it in economically meaningful? Hence we
have to know as to what are the sufficient conditions to general
equilibrium. munotes.in
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8 General equilibrium can be economically meaningful only when three
conditions are satisfied which can be called as sufficient conditions which
are as follows:
i) A general equilibrium can be meaningful only when demand and supply
curves, intersect each other at a point stabilizing an equilibrium point.
ii) An equilibrium can be stable only when supply curve is normal and
upward slopping given that there is only one single point of intersections
between demand and supply curves.
iii) Even when the equilibrium is disturbed it gets restored through the
cob-meb activity. Which goes inside (When S>d t he activity goes
downward inside such that ultimately the original equilibrium gets
restored.
Figure No. 1.2
This diagram shows a stable equilibrium. Even when the original
equilibrium E gets, disturbed when there is hike in price from OP to OP'
supply exceeds demand by at amount due to which the price starts falling
and the activity goes inside heading towards the original equilibrium such
that ultimately the original equilibrium gets restored at the point 'E'. The
demand curve in relatively elastic whi le the supply curve in relatively
inelastic both the curves meet at a point of intersection which can be
termed as an equilibrium point. When it is disturbed finally the activity
reverts back to the original equilibrium i.e. 'E'
Evaluation:
Walras Contribu tion to general equilibrium in highly praise worthy such
that Joseph Schumpeter describes it as "revolutionary creativeness". Leon
Walras was an economist of no mean repute. He was the first economist
who did the pioneering work to bring to the forefront t he model of general
equilibrium. munotes.in
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9 1.4 SUMMARY
1) The concept of general equilibrium was given by Leon Walras.
2) The term general equilibrium refers to the equilibrium of all economic
activities simultaneously in the economy as a whole.
3) It is defined as a state in which all markets and all decision -making
units are simultaneously in equilibrium.
4) Assumption:
(a) Full employment
(b) Perfect competition
(c) Homogenates
(d) Income, taste habits and preference of consumers remain dustant.
(e) Constant retu rns to scale.
(f) Perfect mobility.
(g) Technology constant.
5) Necessary condition for general equilibrium: The number of unknowns
(variables) must be equal to the number of equations.
6) Sufficient conditions:
i) Demand and supply curves must interest ea ch other.
ii) Supply curve is normal and upward slopping. There should be only one
point of intersection between demand and supply curves.
iii) Even when the equilibrium gets disturbed it gets restored through
cobweb activity.
1.5 QUESTIONS
Q1. D efine and explain the concept of generale quilibrium.
Q2. E xplainthe Walrasiane quilibrium in production and exchang e.
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10 2
WELFARE ECONOMICS
Unit Structure:
2.0 Objectives
2.1 Pareto Optimality
2.2 The Pareto Optimality Conditions of Social Welfare
2.3 Marginal Conditions for Pareto Optimal Resource Allocation
2.4 Perfect Competition and Pareto Optimality
2.5 Arrow’s Impos sibility Theorem
2.6 Summary
2.7 Questions
2.0 OBJECTIVES
To understand the concept of pareto optimality.
To study the marginal conditions for pareto optimal resource
allocation.
To study the relation between perfect competition and pareto
optimality.
To study the Arrow’s impossibility theorem.
2.1 PARETO OPTIMALITY
Promotion of economic welfare is generally accepted as an important goal
of economic policy. Welfare economic is an important branch of
economics which is concerned with the evaluation of alternative economic
limitations from the point of view of the well being of the society.
The measurement of social welfare requires the use of Pareto optimality
criteria. Pareto optimality criteria refer to economic efficiency which can
be objectively mea sured. It is named after the famous Italian economist
Vilfredo Pareto. According to this criterion, any change that makes at least
one individual better off and no one worse off is an improvement in social
welfare, conversely a change that makes no one bet ter off and at least one
worse off is a decrease in social welfare.
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11 2.2 THE PARETO OPTIMALITY CONDITIONS OF
SOCIAL WELFARE
Pareto criterion can be alternatively stated as “an allocation is Pareto
efficient under a given set of consumer taste, technology and resources, if
it not possible to move to another allocation which could make some
people better off and nobody worse off”.
Three marginal conditions are to be satisfied for the attainment of Pareto
efficient situation.
a) efficiency of distribution of commodities among consumers.
b) efficiency of allocation of factors.
c) Efficiency in the allocation of factors among commodities.
According to the first condition the marginal rate of substitution between
two goods must be same for all the consumers i.e.
MRS
A XY MRSB XY
Where X and Y are commodities, A and B are individuals.
According to the second conditions i.e. efficiency in production, the
marginal rate of technical substitution (MRTS) between labour and capital
must be equal for all commodities i.e.
MRTS X MRTSY
LK LK
Where X and Y are commodities and L and K are labour and capital.
According to the third condition the marginal rate of product
transformation is equal to marginal rate of substitution for the same goods
in consumption i.e.
MRTXY MRSXY
It should be noted that a situation may be Pareto optimal without
maximisation of social welfare. However, welfare maximisation is
attained only at a situation i.e. Pareto optimal.
The main limitation of Pareto criteria is that it cannot evaluate a change
that makes some people better off and other s worse off.
2.3 MARGINAL CONDITIONS FOR PARETO OPTIMAL
RESOURCE ALLOCATION
Pareto optimality criteria refer to economic efficiency which can b
eobjectively measured. It is called Pareto criterion, after th e famous Italian
economist Vilfredo Pareto.
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12 Paret o has disagreed with the neo-classical approach to welfare. The neo -
classical economist believed that the term socialwelfare refers to the sum total
of individual utilities which are cardinally measurable. Pareto ’s disagreement
with the neo-classical appro ach is because;
1) Non-accepta nce of the cardinal measurement of utility.
2) Rejection of interpersonal composition of utility.
According to Pareto criterion, any change that make s atleast one individual
better off and none worse off is an improvement of social welfare. Conversely
a change that makes no one better and atleast one worse off is a decrease in
social welfare.
This criterion can be alternatively stated as follows:
An allocation is Pareto efficient under a given set ofconsumer taste,
technology and res ources. If it is no possible tomove to another allocation
which could make s ome people better off and nobody worse off.
Prof. Baumol has stated the same idea in the following words, Any change
which harms no one and makes one people better off in their own estimation
must be considered to be an improvement.
For the attainment of Pareto optimal situation in an economy, three marginal
conditions are to be satisfied.
1) efficiency of distribution of commodities among the consumers
(efficiency in exchange).
2) Efficiency of the allocation of the factors among firms (efficiency of
production).
3) efficiencyintheallocationoffactorsamongcommodities(efficien cyinprod
uctmixorcompositionofproduct).
Efficiency of distribution of commodities among the consumers:
This can be expla ined with the help of Edgeworth Box diagram.
Assumptions:
a) Only two individuals namely Suresh (S) and Ramesh (R) constitute the
entire society.
b) The total output consist of only two commodities food (F) and car (C)
c) There is absence of interpersonal comparison of utilitites.
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Figure No. 2.1 : Efficiency of Distribution of Commodities among
Consumers
In the diagram OS and OR are th e origin for Suresh and Ramesh
respectively. IS1 to IS5 are the indifference curves for Suresh. IR1 to IR5
are the indi fference curves for Ramesh. Initially the two goods are
distributed between Suresh and Ramesh at point K then Suresh gets KH of
food and KL of cars. Point K falls on the IR2 and IS4 (K is the
intersection point between (IR2 and IS4). It can be seen that a movement
from K to P increases the welfare of Suresh but does not decrease the
welfare of Ramesh. (Suresh moves from IS4 to IS5 but Rames h is on the
same indifference curve). Therefore, when compared to K, P is Pareto
efficient. Similarly , a movement from K to O increases the welfare of
Ramesh without reducing the welfare of Suresh. Hence O is also Pareto
efficient. Such as O and P which are points of tangency between
indifference curves of two individuals, can be considered as Pareto
optimal points. All s uch points (M, N, O, P) are connected by the line CC1
and this is known as the contract curve.
It can be seen that a movemen t from a point on the contract curve to a
point of it, results in a decrease of social welfare. Thus , the contract curve
shows the l ocus of point of Pareto optimal distribution of goods between
the two consumers.
The contract curve CC1 is connecting the poi nts of tangency of the IC3 of
the two individuals at the point of tangency the slopes of the IC5 are
equal. In other words, at each point on the contract curve, the following
conditions are satisfied.
Conclusion: Where MRS is marginal rate of substitution. X and Y are two
commodities and A and B are two individuals. This means that in the
society as a whole the MRS between the two goo ds must be equal to all
consumer in the given distribution is to be Pareto optimum.
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14 Efficiency of allocation of factors:
The Edgeworth box diagram can also be used to find out the Pareto
optimal allocation of factors. Instead of the indifference curves, w e have
to use iso -quants which are iso -product curves. An iso -quant shows the
same level of output which can be produced by d ifferent combinations of
the two factors namely labour and capital. In the Edgeworth box diagram
two sets of iso -quants for the two commodities can be drawn and their
tangency points can be connected by the contract curve, as was done in the
case if effici ency in distribution of commodity. The point on the contract
curve is a Pareto optimal point and at this point the slopes of the is o-
quants of the two commodities are equal.
The slope of the iso -quant is given by the marginal rate of technical
substitution between labour and capital (MRTSLK). Therefore , the
marginal condition for efficiency in factor allocation can be stated as,
MRTS X MRTSY
LK LK
Whe re, X and Y are commodities and L and K are Labour and Capital.
Efficiency in the composition of output
The third possib le way of increasing social welfare is a change in the
product mix. The marginal rate of product transformation between two
goods X a nd Y (MRPTXY) must be equal to the marginal rate of
substitution of commodity X and Y.
The marginal condition for a Pareto optimal composition ofoutput requires
that the MRPT between any two commodities must be equal to MRS
between the two goods.
MRPT XY
MRS A XY MRS B XY Where A and B are two individuals, X and Y are commodities. MRPTXY
shows the amount of Y that must be sacrificed in order to obtain an
additional unit of X. In other words, MRPT is the rate at which one
commodity is transformed into another. It is the slope of t he production
possibility curve. In summary a Pareto optimal state can be obtained if the
following three marginal conditions are f ulfilled.
1)The MRS between any two goods is equal for all consumers.
2)MRTS between any two factors is equal.
3)The MRPT of two goods be equal to the MRS of the same goods.
A.P. Lerner and Hicks have called the marginal condition as the first order
condit ion, which are as follows:
1) Optimum distribution among consumer.
2) Optimum resource allocation. munotes.in
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15 3) Optimum allocation of f actor time.
4) Optimum factor product relationship.
5) Optimum direction of the products.
Second degree conditions: Marginal condit ions are stated above, though
necessary are not sufficient for the achievement of Pareto efficiency. The
sufficient condition s are
1) all indifference curves are convex (diminishing MRS).
2) all transformation curves are concave to origin (This implies inc reasing
MRPT).
Evaluation :
Pareto has made a vital contribution to the development of welfare
economics. His concept of Paret o optimality is widely appreciated. His
rejection of cardinal measurement of utility and interpersonal comparison
of utility is a m ajor break through in the analysis of welfare economics.
However critics have pointed out certain deficiencies in Pareto anal ysis.
1) Element of value judgement:
Pareto optimality is not free from value judgement. One should know the
relative importance of co mmodities to different individuals before judging
whether a given allocation is optimal or not.
2) Limited applicability:
Pareto criterion cannot evaluate a change that makes some people better
off and other worse off. Since most government policies lead to c hanges
that benefit some people and harm others. It is clear that the strict Pareto
criterion is a limited applicability in t he real world situation.
3) Indeterminate:
In Pareto analysis every point on the contract curve ensures optimality. It
is not possible to make a choice among the various alternatives on the
contract curve. In the words of Henderson and Qund, ―The analysis of
welfare in terms of Pareto optimality leaves a considerable amount of
indeterminacy in the solution as these are infinite number of points which
are Pareto optimal.
Check Your Progress:
1. State the conditions to be satisfied for the attainment of Pareto e fficient
situation.
2. What is Pareto optimality criteria?
3. What are the deficiencies in Pareto analysis. munotes.in
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16 2.4 PERFECT COMPETITION AND PARETO
OPTIMALITY
In the previous section we studied the marginal conditions for the Pareto
optimality. All the marginal conditions are fully satisfied under perfect
competition. It is under perfect competition that product prices are
everywhere equal to marginal costs, and factors prices are everywhere
equal to their marginal value productivity. These requirements are
essential but not enough to satisfy the marginal conditions. In addition, all
buyers and sellers of goods and services must have perfec t knowledge
about market conditions, returns to scale must be constant and all factors
must be perfectly mobile so that all p roducers earn only normal profits.
Thus these requirements of perfect competition are necessary for the
satisfaction of the margina l conditions. This has led economists to
characterise every competitive equilibrium as a Pareto -optimum and every
Pareto -optimum as a competitive equilibrium. To examine this problem,
we lay down the conditions necessary for the attainment of Pareto
optima lity under perfect competition.
Conditions of Pareto Optimality:
An allocation is Pareto optimal if it is not possible to rea llocate resources
without making at least one person worse off. The conditions of Pareto
optimality related to efficiency in exchan ge (or consumption), efficiency
in production, and overall Pareto efficiency (or efficiency in both
consumption and productio n).
1. Efficiency in Exchange:
The first condition for Pareto optimality relates to efficiency in exchange.
The required condition is that ―the marginal rate of substitution between
any two products must be the same for every individual who consumes
both. It means that the marginal substitution (MRS) between two
consumer‘s goods must be equal to the ratio of their prices. Since under
perfect competition every consumer aims at maximising his utility, he will
equate his MRS for two goods, X and Y to their price ratio (PX / PY).
Suppose there are two consumers A and B who buys two goods X and Y,
and each faces the price ratio PX / PY. Thus A will choose X and Y such
that MRSXY = PX / PY. Similarly B will choose X and Y such that
MRSXY = PX / PY. Therefore, the co ndition for efficiency in exchange is
–MRSA
XY = MRSB
XY = P X/PY
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17
Figure No. 2. 2 : Efficiency in Exchange
The Edge worth box diagra m explains the optimum condition of
exchange. There are two individuals A and B who possess two
commodities X and Y in fixed quantities respectively. OA is the origin for
consumer A and OB the origin for B. The indifference curve of A
represented by the cu rves from A1, A2 and A3 and B‘s by B1, B2 and B3
indifference curve. At point E, where two indifference curve A1 and B1
intersect. At this position, A possesses OAYa units of Y and OAXa of
commodity X. B receives OBYb of Y and OBXb of X. At point E the
marginal rate of substitution between the two commodities is not equal to
the ratio of their prices because the two curves do no t have the same slope.
So E is not the point of optimum exchange of the two commodities X and
Y between the two individuals A and B .
Suppose A would like to have more of X and B more of Y. Each will be
better off without making the other worse off if he mo ves to a higher
indifference curve. At point R, A gets more of X by sacrificing some Y,
while B gets more of Y by sacrificing some amount of X. There is no
improvement in B‘s position because he is on the same indifference curve
B1, but A is much better of f at R having moved to a higher indifference
curve from A1 to A3. If however, A and B move from E to P, A is well off
as before for he remains on the same indifference curve A1. B becomes
much better off having moved from B1 to B3. It is only when they mov e
from E to Q that both are on higher indifference curves.
P, Q and R are thus the three conceivable points of exchange. The contra ct
curve CC1 is the locus of these points of tangency which shows the
various position of exchange that equalise the marginal rates of munotes.in
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Advance d Microeconomics - III
18 substitution of X and Y. any point on the CC1 curve, therefore, satisfies
this optimum condition of exchange.
2. Efficiency in Production:
The second condition for Pareto optimality related to efficiency in
production. There are three allocation rul es for demonstrating efficiency in
production under perfect competition.
Rule One relates to the optimum allocation of factors. It requires that the
marginal rate of technical substitution (MRTS) between any two factors
must be the same for any two firms u sing these factors to produce the
same product. Suppose there are two firms A and B that use two factors:
labour (L) and capital (K ) and produce one product. Given the prices of
the two factors, a firm is in equilibrium under perfect competition when
the s lope of an iso -quant equals the slope of the iso -cost line. The slope of
an iso -quant is the MRTS of labour and capital, and the sl ope of the iso -
cost line is the ratio of the prices of labour and capital. Thus the condition
of equilibrium for firm A is MR TSA
LK = P L/PK andthatoffirmBis
MRTSB
LK = P L/PK.
Therefore, rule one for efficiency in production is –
MRTSA
LK = is MRTSB
LK = P L/PK
Rule Two states that ―the marginal rate of transformation between any
factor and any product must be the same for any pair o f firms using the
factor and producing the product. It means that the marginal productivity
of any factor in producing a particular product must be the same for all
firms. A firm under perfect competition will employ a factor of production
up to the point at which its marginal value product (VMP) equals its price.
If MP is the marginal physical product of factor L (labour) in the
production of commodity X in firm A, then its IMP is the marginal
physical productivity multiplied by the price of X, i.e. MP = MPA
XL *
PX.
Thus the price of labour (P L) in firm A is
PL = MPA
XL * PX. or PL/PX = MPA
XL
Similarly in firm B the price of labour is
PL = MPB
XL * PX. or PL/PX = MPB
XL
Since the price of the product (P X) and the price of labour (PL) are the
same in both the firms, each firm will equate its marginal physical
productivity to PL /PX.
Thus , from equations (1) and (2), we have
MPA
XL = MPB
X = PL/PX
Rule Three for efficiency in production requires that ―the marg inal rate
of transformation (MRT) between any two products must be the same for
any two firms that produce both. This condition requires that if there are
two firms A and B, and both produce two products X and Y, then
MRTA
XY= MRTB
XY . A profit maximizing firm under perfect competition munotes.in
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Welfare Economics
19 will be in equilibrium when the iso- revenue line is tangent to its
transformation curve. It means that for equilibrium the marginal rate of
transformation between two products X and Y must equal their price
ratio, i.e.
MRT XY = P X / PY
Thus the optimum condition in the case of firm A will be
MRTA
XY = P X / PY and in the case of the firm B it will be MRTB
XY = P X /
PY. Thus, MRTA
XY = MRTB
XY = P X / PY.
Efficiency in Exchange and Production:
Pareto optimali ty under perfect competition also requires that the marginal
rate of substitution between two products must equal the marginal rate of
transformation between them. It means simultaneously efficiency in
consumption and production. Since the price ratios of the two products to
consumers and firms are the same under perfect competition, the MRS of
all individuals will be identical with MRT of all firms. As a result, the two
products will be produced and exchanged efficiently. Symbolically,
MRS XY = P X / PY, and MRT XY = PX / PY. Therefore, MRS XY = MRT XY.
Figure No. 2. 3
Efficiency in Exchange and Produc tion
The above figure illustrates overall Pareto optimality in consumption and
production. PP1 is the transformation curve or the production possibility
frontier for two commodities X and Y. Any point on the PP1 curve shows
the marginal rate of transformation ( MRT) between X and Y which
reflects the relative opportunity costs of producing X and Y, that is MCX
/MCY. IC1 and IC2 are the indifference curve which repre sents consumer
tastes for these two commodities. The slopes of indifference curve at any munotes.in
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Advance d Microeconomics - III
20 point show s the marginal rate of substitution (MRS) between X and Y.
Pareto optimality is achieved at point E where the slope of the
transformation curve PP1 and the i ndifference curve IC2 are equal.
This equality is slope is shown by the price line cc which indicat es that at
point E the MRSXY = MRTXY = PX / PY or MUX / MUY = PX / PY.
Given the production possibility frontier PP1, there is no other
indifference curve wh ich satisfies Pareto efficiency. Point A is of
inefficient production because it is below the PP1 curve. Point B is on the
PPF but it is on a lower indifference curve IC1, where the consumer
satisfaction is not maximised. Therefore, Pareto optimality exist s only at
point E, where there is efficiency in both consumption and production
when the society c onsumers and produces OX1 of commodity X and OY1
of commodity Y.
2.5 ARROW’S IMPOSSIBILITY THEOREM
This theorem is a part of Arrow’s social choice theory ‘ba sed on the
representation of a society’s preference concerning individuals’
preferences. The consequences of Arrow’s Impossibility Theorem are
quite important for many democratic processes like electi ons. But
unfortunately, it also demonstrates that none o f the voting systems in the
world is flawless. As a result, it is impossible to obtain a realistic result
ever.
Arrow’s Impossibility Theorem :
Arrow’s impossibility theorem states that the social welf are function
assigns a social preference of order to eve ry valid profile of individual
choice of arrangements of a given set of options. The construction of
social welfare, which reflects the preference of all individuals constituting
a society, is an impo ssible task. So, it states that it is very difficult to set
up reasonable democratic procedures for aggregating individual
preferences into a social preference for making social change.
Arrow’s impossibility theorem is also called Arrow’s theory of social
choice or general impossibility theorem. The theorem is named after
the economics Nobel prize winner – Economist Kenneth Arrow. He
proposed it in 1951 in a paper, which then turned into a book called Social
Choice and Individual Values. The book explains t he effect of individual
choices on society during elections or voting.
This theorem begins by setting up a reasonable criterion for voting
conditions to accumulate the preferences of all the individua ls to represent
society’s preferences. However, the said conditions can either lead to
irrational team decisions or, straightforwardly, an undemocratic judgment.
Therefore, sometimes in the arrow impossibility theorem welfare
economics and Arrow’s impossib ility theorem economics discussion, it is
also called th e dictator theorem. munotes.in
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21 In this theorem, transitive means a sensible arrangement, and intransitive
means insensible order. For example, if one likes apples the most, then
like oranges and bananas the lea st. As a result, this order is transitive.
However, when purring the preference of the three fruits in best to least
arrangements, one gets the following: one prefers apples to oranges,
oranges to bananas, and bananas to apples, which is called intransitiv e.
Arrow’s Impossibility Theorem’s Five Criteria :
Arrow tried to create a system of preference for voting that would be just,
consistent, and more transitive in nature of group preference. Arrow
devised five criteria to make the voting fair for the same t o happen. They
are the following:
1. Non-dictatorship
2. Independence of irrelevant alternatives
3. Pareto efficiency
4. Unrestricted domain &
5. Social ordering
As per the theorem, it is impossible to vio late the five criteria mentioned
here and lead to intran sitive voting or cyclic preferences. The country’s
elected leader can even be a 50% vote winner. As an Arrow’s
Impossibility Theorem proof, one can study the US presidential elections
of 1992 , in which Bill Clinton won the elections with just 43% of the
popular votes. Despite his rivals – George W bush got 38% votes, and
Ross Perot got 19% votes.
Conditions In Arrow’s Impossibility Theorem :
There are certain criteri a for the applicability of Arrows impossibility
theorem. Only then can a country hold fair and reasonable elections. Each
one of these conditions is vital for electoral procedures. They include the
following:
1. Non-Dictatorship :
It states that a voter’s choice of a candidate can not be the choice of every
member of the society, and his preference cannot represent the society.
Hence, one must consider every member of society’s preferences to
comply wi th the social welfare function.
2. Independence Of Irrel evant Alternative :
The social ranking of a particular subset must be independent of the
change in the ranking of petty alternatives of that subset by an individual
of the society.
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22 3. Pareto Efficienc y:
Society should appreciate the concordant preferences made by every
single person. It means that if the majority of the individuals in the society
select an option, it must comply with the order of social preference.
Moreover, the voting outcome should b e devoid of any empathetic attitude
towards the preferen ce profile.
4) Unrestricted Domain :
Under this condition, one should count the choices of all the voters so that
it represents a full ranking of social preference.
5) Social Ordering :
This condition r equires that voters be able to exercise their choices of the
vote in a manner that is inter -related and in order from best to worse .
Example :
One needs to study the Arrow’s Impossibility Theorem example, as
discussed here, to understand the theorem.
Let u s assume there are three different varieties – A, B & C of coffee - at
Starbucks. A group of 3 people is selected to convey their order of
preference for the varieties of coffee at Starbuck, namely – David, Diana
& Brian. These people must disclose their ch oice along with the coffee
varieties’ ranking. So, they can rank their choices according to their taste,
from best to worse.
After a while, David, Diana & Brian present their order of preference as
below:
David – ABC
Diana – BCA
Brian - CAB
One can explain the result as below:
David prefers A over B and B over C. Diana prefers B over C and C over
A. Brian prefers C over A and A over B. So, one can conclude that 1/3
prefers A>B>C, 1/3 prefers B>C>A, and 1/3 prefers C>A>B.
In other words,
2/3 prefer A over B
2/3 prefer B over C; and
2/3 prefer C over A
Therefor e, a paradox occurs where 2/3 of each of the majority prefers A
over B, B over C, and C over A. Thus Kenneth Arrow’s impossibility
theorem gets validated as one of the conditions in the theorem is vio lated
while ranking the order of preference amongst the three alternatives A,
B & C.
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23 2.6 SUMMARY
1. Pareto optimality criteria refer to economic efficiency which can be
objectively measured. According to this criterion, any change that makes
at least one i ndividual better off and no one worse off is an improvem ent
in social welfare, conversely a change that makes no one better off and at
least one worse off is a decrease in social welfare.
2. For the attainment of Pareto optimal situation in an economy, three
marginal conditions are to be satisfied i.e. (a) effi ciency of distribution of
commodities among the consumers (efficiency in exchange), (b)
efficiency of the allocation of the factors among firms (efficiency of
production), (c) efficiency in the allocation of factors among commodities
(efficiency in product mix or composition of product)
3. All buyers and sellers of goods and services must have perfect
knowledge about market conditions, returns to scale must be constant and
all factors must be perfectly mobile so that all producers earn only normal
profits. Thus these requirements of perfect competition are necessary for
the satisfaction of the marginal conditions.
4. Under perfect compe tition every consumer aims at maximising his
utility, he will equate his MRS for two goods, X and Y to their price ratio
(PX / PY).
5. Given the prices of the two factors, a firm is in equilibrium under
perfect competition when the slope of an iso -quant eq uals the slope of the
iso-cost line.
6. A firm under perfect competition will employ a factor of production up
to the point at which its marginal value product (VMP) equals its price.
7. A profit maximising firm under perfect competition will be in
equilib rium when the iso -revenue line is tangent to its transformation
curve.
8. Pareto optimality under perfect competition also requires that the
marginal rate of substitution between two products must equal the
marginal rate of transformation between them.
2.7 QUESTIONS
1. Explain the pareto optimality conditions of social welfare.
2. What are the marginal conditions for pareto optimal resource allocation.
3. Explain the arrow’s impossibility theorem.
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24 3
MONOPOLY
Unit Structure:
3.0 Objectives
3.1 Concept of Monopoly
3.2 Measurement of Monopoly Power
3.3 Types and Classification of Price Discrimination
3.4 Equilibrium under discriminating monopoly
3.5 Summary
3.6 Questions
3.0 OBJECTIVES
To study the concept of monopoly and measurement of monopoly
power.
To know the types and classification of price discrimination.
To study the equilibrium under discriminating monopoly.
3.1 CONCEPT OF MONOPOLY
3.1.1 Meaning:
The word 'monopoly' has been derived from the two Greek words
'Monos' which means 'single' and 'Polus' which means 'seller', so the
word 'monopoly' means 'a single seller'. It is an imperfect market and an
extreme form of market situation. Thus, 'Monopoly Market' is a market
situation where there is only one producer of a commodity with no close
substitutes for its product in the market. It is complete negation of
competition. Absolute monopolies are rare, but important characteristics
of monopoly may manifest when a single seller provides less tha n the
whole supply and his share of the market is large enough to give him
nearly complete control over the market.
3.1.2 Features of Monopoly:
1. Single seller: There exists only one seller or producer or firm of a
commodity in the market, but there are many buyers.
2. Identical with industry: The monopolist is both the firm as well as the
industry and each firm constitutes the industry because it produces a
separate commodity. Since the firm itself is the industry and has full
control over supply of the commodi ty the distinction between industry and
firm disappears. The monopolist, therefore, may be an individual, a firm munotes.in
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Monopoly
25 or a group of firms or a government corporation or even the government
itself
3. Unique Commodity: The commodity sold by the monopolist is a
uniqu e product, which has no close substitutes in the market. In other
words, cross elasticity between the monopolist's product and the product
of other firms is zero. The consumer will have to buy the commodity
from the monopolist or go without the commodity.
4. Price -maker: Since the monopolist is the only seller in the market
he fixes the price and can also charge different prices for different
consumers. He is the price maker as he has complete control over the
market supply.
5. Profit Maximization: The main aim o f the monopolist is to maximize
his profits. So, the monopolist may charge uniform price to all
consumers or may charge different prices to different consumers.
That is, price discrimination is possible in a monopoly market. The
monopoly firm aims at earni ng supernormal profits.
6. Restricted entry: No other seller can enter the market, as the market
would no longer be a monopoly market. That is, there are strong barriers
to the entry of new firms and only one firm exercises sole control over
the production of a commodity.
7. No rivals: The monopolist does not face any rivalry from
competitors.
8. Downward sloping demand curve: The demand curve faced by a
monopolist is downward sloping (Fig. 3.1). It indicates that the volume
of sales can be increased only if prices are lowered.
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26 9. Fixes either the price or output to be sold: The monopolist likes
to fix a high price and sell maximum output in order to maximize
his profits. However, he can either fix the price or the output to be sold,
but not both. If he fixes the pric e, the output to be sold is to be decided
by the consumers or buyers and if he decides to sell more output, then he
has to lower the price.
10. No selling cost: The monopolist does not incur selling cost of any
kind i.e., the expenditure on advertising, transp ort etc. This is because he
sells a unique product, which has no close substitutes. If the
monopolist does incur selling cost, it is to make the public aware of the
product and not to increase sales.
3.1.3 Types of Monopoly:
1. Natural Monopoly:
Such monop oly arises due to endowment of resources by nature and
natural advantages such as climatic conditions, good location, and
availability of certain minerals or raw material at only certain places.
Man cannot increase the supply of these resources. When a sin gle
firm owns the source of such resources or whichever firm is the first to
claim the use of that resource it is said to have natural monopoly. The
producers of such a product enjoy natural monopoly as they have
complete control of its supply. The extent of exploitation by the seller
depends upon the importance of the product to the consumer e.g., at
international level Gulf countries have monopoly in oil, South
Africa in diamonds, Malaysia in tin and natural rubber and within
the country TISCO at Jamshedp ur, wheat in Punjab, rice in Tamil
Nadu and jute in Bangladesh and India.
2. Legal Monopoly:
It is also known as statutory monopoly. Such monopolies emerge on
account of deliberate legislation by the State. Legal provisions like patents,
copyrights, trademark s etc., are used by a producer to legally protect him
for a stipulated period, whenever he invents or discovers a new
product. The law forbids the potential competitors to imitate the design
and form of product registered under the given brand names, paten ts or
trademarks. Thus, the competitors are restrained by law e.g.
medicines, essential services such as water supply, electricity,
transport, postal services etc. Legal monopoly in the form of statutory
rationing is resorted to during times of scarcity su ch as war, foreign
aggression, famine etc.
3. Pure Monopoly:
It is also known as absolute monopoly. When a single firm controls the
supply of a commodity, which has no substitutes, not even a remote one,
it is called as pure monopoly. Such firms possess absol ute monopoly
power and are very rare. It is complete negation of competition. munotes.in
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Monopoly
27 4. Imperfect Monopoly:
It is also know as relative or limited monopoly. In such a monopoly
there is a limited degree of monopoly. It refers to a single firm, which
produces a commod ity having close substitutes. In practice, we can find
such monopolies. However, it does not have absolute monopoly power
in deciding its price and output policy.
5. Public or Social monopoly:
It is also known as essential monopoly. When production of a
commo dity is solely owned, controlled and managed by the State, it is
called as public or social monopoly. Goods and services of such
organisations are for the benefit of all the members of the society. The
government generally provides it. Hence, the prices ch arged are low as
they aim to maximize social welfare. There is no exploitation of any kind
e.g. Indian railways, which provides transport facilities is under a separate
department under the railway ministry. The ministry is answerable and
accountable to th e Parliament.
6. Private Monopoly:
When individuals or private body controls a monopoly firm it is called
as a private monopoly. The aim of private monopolists is to maximize
their profits and therefore the prices charged by them are very high.
Although s uch monopolies do not sell a unique product, they are
considered as monopolies as they are able to control the market by
restricting supply. This helps to raise prices and achieve the objective of
maximum profits e.g., Tata, Birla, Reliance, Mafatlal, Baja j etc.
7. Simple Monopoly:
In simple monopoly the monopolist charges the same price for his
commodity from all buyers in the market. It operates in a single market
and there is no discrimination of any kind e.g. cosmetic shampoos such
as clinic plus and su n silk and herbal shampoos like clinic plus ayurvedic -
they are distant substitutes.
Check Your Progress:
1. Define monopoly market.
2. Monopolist is a price maker -explain.
3. State the various types of monopoly.
3.2 MEASUREMENT OF MONOPOLY POWER
The degree of mo nopoly power is measured by taking perfect competition
as a base, professor A. P. Learner has regarded perfect competition as the
market providing socially optimum (maximum) welfare. Any deviation
from perfect competition implies an existence of monopoly p ower,
according to him. Under perfect competition, price is equal to marginal munotes.in
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Advanced Microeconomics - III
28 cost at the equilibrium level. The level of output associated with
equilibrium price implies optimum allocation of resources. When the
degree of competition is less than perfect, i.e. under the imperfect market,
the demand curve is downward sloping and price is not equal to marginal
cost. The divergence between price and marginal cost is an indicator of the
existence of monopoly power, according to Prof. Lerner. Greater. The
diver gence between the price and marginal cost, higher is the monopoly
power enjoyed by the seller,
Symbolically,
Where,
P – is equilibrium price.
MC - Marginal cost at the equilibrium level of output.
Under perfect competition, difference between marginal co st and price is
zero so,
There is an absence of monopoly power under perfectcompetition. Greater
the value of the index
, the greateris the degree of monopoly power
possessed by the seller.
Lerner’s Measure of monopoly power is criticized on thefollowing
grounds.
1. This measure is not useful in the market where there is non -
pricecompetition or product differentiation. Such as under themonopolistic
competition. In other words, when the productscompete with each other,
not in termsof price, b ut in terms ofproduct variation, advertising, or any
other sales promotionpractices, the above -mentioned formula cannot be
used tomeasure the degree of monopoly power.
2. Another important point of criticism against Lerner’s measure of
monopoly power is th at, this measure is based on only one aspectof
monopoly and that is the control over prices. The degree ofcontrol over
prices depends on the availability of existingsubstitutes. But the monopoly
power may also be threatened bypotential substitute which is not
considered by this measure.
3.3 TYPES AND CLASSIFICATION OF PRICE
DISCRIMINATION
Price discrimination refers to the charging of different prices by the
monopolist for the same product. munotes.in
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Monopoly
29 3.3.1 Few Definitions:
“Price discrimination exists when the sam e product is sold at different
prices to different buyers.” – Koutsoyiannis
“Price discrimination refers to the sale of technically similar products at
prices which are not proportional to their marginal cost.” - Stigler
“Price discrimination is the act of selling the same article produced under
single control at a different price to the different buyers.” - Mrs. Joan
Robinson
“Price discrimination refers strictly to the practice by a seller of charging
different prices from different buyers for the same good.” - J.S. Bain
Price discrimination refers to the act of selling the same article, produced
under single control at different prices to different buyers. Price
discrimination generally takes place in case of monopoly.
3.3.2 Conditions for Price Discr imination:
1] Non -Transferability of goods –
A monopolist can charge different prices for the same good provided that
the consumers are not in a position to transfer the goods from one to other.
This could happened only if consumers either do not meet ea ch other or in
case they meet, will not be able to exchange the goods.
2] Geographical Distance –
If markets are situated at sufficiently long distances, then the transfer of
goods may not be economical. Example: I f we consider Mumbai and
Kolhapur market and price difference is of `50 per unit, the transfer of
goods from one buyer to other between the markets is not at all
economical.
3] Political Hurdles –
If political boundaries prevent the movement of people from one market to
other market, a monopol ist who operates in both markets can change
different prices for the same commodity.
4] Lack of awareness –
When the consumers are ignorant of the price difference, they will not
mind paying higher prices than what the others are paying.
5] Insignificant price difference –
When the price difference is very small, the consumers would not bother
about negligible price difference. Therefore, it is possible for the
monopolist to have price discrimination.
6] Link between Price and Quality –
When consumers , due to irrationality or any other reason consider higher
price as an indicator of better quality, then it is possible for the monopolist
to change higher price for such consumers. munotes.in
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Advanced Microeconomics - III
30 7] Location –
Goods sold in sophisticated or rich localities or sold in departmental stores
may be charged higher prices than the same goods sold in poor localities.
8] Tariff Barriers –
If home market is protected through tariffs, a monopolist may charge a
higher price in the protected home market and lower price in competi tive
world market.
9] Government Sanctions –
Government due to welfare social or political reasons may change
different prices for the same goods & services.
10] If monopolist can bring about some product differentiation like
changing packaging sale, pr omoting after sales services etc. then price
discrimination is possible.
11] Differences in Elasticity –
If elasticity of demand is different in different markets, it is possible for
the monopolist to have price discrimination.
3.3.2 Types of Price Disc rimination:
Following are the types of price discrimination.
1] Personal price discrimination -
In this type different prices are charged to different consumers for the
same product or service. Example: Doctors, Lawyers, Tuition Teachers
etc. Charges diff erent prices for different individuals. It is similar to first
degree price discrimination.
2] Group Price Discrimination –
Here entire population or area is divided into different groups and
different prices are charged for different groups of people. E xample:
Railways charges lower ticket to children and senior citizens and more for
others. Industrial areas are charged more electricity charges as compared
to residential areas. This is same as second degree price discrimination.
3] Market Price Discrimi nation –
This means charging different prices for the same product in different
markets.
Check your progress :
1) What do you mean by price discrimination?
2) What are the types of price discrimination?
3) Discuss any two conditions for price discrimin ation. munotes.in
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Monopoly
31 Degree of Price Discrimination
There are three degree as for as price discrimination is concerned.
1) First Degree P.D.
2) Second Degree P.D.
3) Third Degree P.D.
A.C. Pious has propounded degrees of price discrimination in the year
1952 in book economics of welfare.
1) First Degree Price discrimination :
When monopolist selling each quantity/ unit in different prices that is
called as first degree of price. (Take it or leave it)
Fig 3.2
2) Second Degree of Price Discrimination :
When the monopolist is charging different rates/ prices according to base
of purchase can be called as second degree discrimination.
Fig 3. 3
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32 Quantity Price
ox1 op1
ox2 op2
ox op
3) Third degree of Price Discrimination :
In this degree there are different categories and prices are charges on the
basis of that category can be called as third degree of price discrimination.
or
When different prices/ charge on the basis of/ different categories of
buyers it is known as third degree of price discrimination.
Fig 3. 4
Price Quantity
Op Ox
Op1 Ox1
OP 1CP1 + X 1XAB
OXAP + PBCP 1 - consumer's surplus out of it
Let us assume suppose monopolist selling quantity ox then he will get
OXAP revenue out of it. It he will sell OX 1 quantity then he will get
OX 1CP1 revenue. munotes.in
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Monopoly
33 PBCP, - (consumer's surplus) taken by the monopolists and this part want
get satisfaction for consumer.
This is what the third degree of price discrimination.
3.4 EQUILIBRIUM UNDER DISCRIMINATING
MONOPOLY
For explaining equilibrium of price discriminating monopolist we make
following assumptions: -
1] Monopolist operates in two different markets, i.e. market A & market B
2] Two markets differ in elasticit ies.
3] Production is undertaken at one place and it is at equal distance
between the two markets so that there is no scope for price differences
on the basis of transport cost.
Equilibrium of a price discriminating monopolist can be discussed with
the h elp of following diagram.
Figure 3. 5
Equilibrium of a price discriminating monopolist
Above diagram shows that in (Figure -A) & (Figure -B), there are two
markets - Market A & Market B. Market A is relatively inelastic and
Market B is relatively elastic. As Market A is relatively inelastic, AR &
MR, of Market A are steeper and as Market B is relatively elastic, AR2 &
MR2 of market B are flatter.
[AR & MR are the Average & Marginal revenue Curves of the two
markets.] (Figure -C) explains the production. CMR i s the Combined
Marginal Revenue Curve in (Figure -C) which is derived from horizontal
summation of MR1 and MR2. In figure -C Marginal Cost Curve (MC)
intersects the combined marginal revenue curve at point R. munotes.in
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34 Therefore , total output is OQ. This output is di stributed between market A
& B in such a way that MR1 = MR2 = MC. In order to show this equality
we have drawn horizontal line RL from point R in (Figure -C) to Y axis of
(Figure -A).
Accordingly, OQ1 output is sold in market A at price OP1 and OQ2
output i s sold in market B at price OP2. [Price in relatively inelastic
market is greater than price in relatively elastic market.]
Profit of the monopolist = TR – TC = OQRDA – OQRB = BRDA
3.5 SUMMARY
Therefore Price Discrimination monopolist will be in equilib rium when: -
1] Different markets differ in price elasticities enabling him to charge
different price.
2] Total output is distributed in all the markets in such a way that marginal
revenue in all the markets is equal.
3] Marginal Revenue in all markets w hich are equal must also be equal to
marginal cost at equilibrium output.
3.6 QUESTIONS
Q1. Explain the concept of monopoly and the measurement of monopoly
power.
Q2. What are the types and classification of price discrimination?
Q3. Explain the equilibri um under discriminating monopoly.
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35 4
MONOPOLISTIC COMPETITION
Unit Structure:
4.0 Objectives
4.1 Concept of Monopolistic Competition
4.2 Regulation of Monopoly Market Product Differentiation in
Monopolistic Competition
4.3 Equilibrium under Monopolistic Competition
4.4 Excess Capacity
4.5 Summary
4.6 Questions
4.0 OBJECTIVES
To know the concept of monopolistic competition.
To study the Chamberlin’s alternative approach.
To see the equilibrium under monopolistic competition.
To understand the concept of excess capacity.
4.1 CONCEPT OF MONO POLISTIC COMPETITION
Perfectly competitive market and monopoly market are extreme and
therefore not easy to find in real world. In the real world the market that
we find either have many sellers selling variety of products (such as
toothpaste, textile or c loth market) called monopolistic competition. Or
few sellers having dominant position in the market (such as airlines,
mineral water) called oligopoly market.
Monopolistically competitive market is the market which has some
characteristics of perfect compe tition and some of monopoly. Even though
there are many sellers under monopolistic competition, each seller has its
monopoly but still there is a competition due to product differentiation.
Prof. Edward Chamberlin introduced the concept of monopolistic
competition in his book Theory of Monopolistic Competition.
Features of monopolistic competition:
1. Fairly large number of sellers - In monopolistic competition there are
many sellers. Therefore an individual seller cannot influence the
market. Every seller to a certain extent follow an independent policy in
price and output.
2. Fairly large number of buyers - There are fairly large number of
buyers in a monopolistically competitive market.
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36 3. Close substitute products - Under monopolistic competition sellers
sold p roducts which are close substitutes of each other. For eg. Soaps,
pens etc.
4. Free entry and exit - There are no restrictions on entry and exit of the
firm under monopolistic competition. If existing firms are making
supernormal profit, new firms can enter in to the market but they have
to enter with a close substitute product. Similarly firms who are
making loss can leave the market. Therefore in the long run firm who
remains in the market will make only normal profit.
5. Selling cost - As close substitute pr oducts are available in monopolistic
competition, firms have to spend money for increasing sale of their
product in the market. This cost is called as selling cost. It includes all
expenditures of the firm which can increase their sale. It is in the form
of T.V, newspaper advertisement, hoardings, exhibitions, distribution
of free samples, discounts offered on products etc.
6. Product differentiation - As goods are close substitutes of each other,
it is necessary to have an independent identity of each produc t. Variety
of factors on which goods can be differentiated are brand name,
design, size, color, packing, taste, advertisement policy, after sales
services etc. Due to product differentiation, firm can have some degree
of monopoly.
7. Nature of demand curve - The demand curve of a monopolistically
competitive firm is more elastic. ie demand curve is flatter than it is
under monopoly. This is because of the availability of close substitute
products, where an increase in price of one commodity reduces its sale
by a greater amount.
Following diagram explains the shape of demand curve under
monopolistic competition.
Figure No. 4.1
Demand curve under monopolistic competition munotes.in
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Monopolistic
Competition
37 8. Concept of group - Prof. E. Chamberlin introduced the concept of
group under monopolisti c competition. Group includes those products
which are close substitutes in economic and technical sense. The group
will be in equilibrium in the long run when all firms in the group make
normal profit.
4.2 REGULATION OF MONOPOLY MARKET
PRODUCT DIFFERENTI ATION IN
MONOPOLISTIC COMPETITION
Product differentiation is one of the characteristics of monopolistic
competition. Products are close substitutes of each other due to small
differences in them. In case of products like soaps, garments, tooth paste
etc. variety of products are available but each product is different from
another due to following factors.
a) Brand name - Brand name develops loyalty of public towards the
product. Firms name itself is the name of its product. Raymond cloth, LG
TV, Colgat e toothpastes are some of the examples of branded products.
Brand name helps to differentiate between the products.
b) Design - On the basis of design products can be differentiated. Fridge,
cars, furniture are some of the products which are purchased on t he basis
of design.
c) Size - Firm produces their product in different sizes so that consumers
can consume their most preferred size. Various sizes of product include
economy size, family size, extra -large etc.
d) Color - Customers would like to purchase v arious products on the basis
of their color. Products like fridge, cupboard, tooth brush etc. are
consumed on the basis of their color.
e) Taste and perfume - Products like soaps, toothpaste, face powder,
shampoo etc. are purchased on the basis of their ta ste and perfume.
f) Salesmanship - People prefer products of a particular company because
of the positive attitude of the salesman, their good behavior, their
cooperation etc.
g) After sales services - Customers consider after sales services while
consuming a product. This is because products like TV, fridge, water
purifier have a warranty period during which company provide free
services to their customers.
Thus , the quality of after sales services is very important. Due to above
factors consumers have som e loyalty to their products. Loyalty towards
product gives some degree of monopoly to the firm. Product
differentiation allows firms to charge different prices for their products.
Under monopolistic competition it is necessary for the firm to maintain
mono poly power over loyal customers. munotes.in
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38 4.3 EQUILIBRIUM UNDER MONOPOLISTIC
COMPETITION
Short run equilibrium of a firm under monopolistic competition:
Monopolistically competitive firm can operate with supernormal profit,
normal profit or loss in the short run.
Following diagrams explains all the three cases.
• Excess profit
Given the demand curve and cost curves of a firm, firm would produce
profit maximizing level of output at that point where MR=MC. This is the
equilibrium level of output for the firm.
Figure No. 4. 2
On the X axis we measure output and on the Y axis we measure cost and
revenue. AR and MR are the average and marginal revenue curves which
are more elastic or flatter. SAC and SMC are the short run average and
marginal cost curves. Firms equil ibrium point is E and equilibrium level of
output is OQ. Thus the price determined is OP or QM. In the above
diagram with price OP and output OQ, TR= OQMP, TC=OQER. As
TR>TC, Excess profit = REMP (OQMP -OQER)
• Normal profit
Condition for normal profit is very rare. Due to change in demand and cost
conditions, sometimes it is possible for the firm to just cover its cost of
production ie the case of normal profit. munotes.in
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Monopolistic
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39
Figure No. 4. 3
With given revenue and cost curves firm is in equilibrium at point E1,
with th e intersection of MR and MC curves. Output= OQ1, Price= OP1,
TR= OQ1R1P1 TC= OQ1R1P1. As TR=TC, the firm will make normal
profit.
• Loss
Due to demand and cost conditions it is also possible that firm may
operate with loss. With the help of following diag ram we can explain the
case of loss.
Figure No. 4. 4 munotes.in
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40 With given revenue and cost curves, firm is in equilibrium at point at point
E2, where MR and MC curves intersects.
Equilibrium output= OQ2 and equilibrium price = OP2. TR= OQ2L2P2,
TC=OQ2N2M2. As TC>T R, firm will make loss. Loss= P2L2N2M2.
In the short run when the firm incurs loss, it has to decide whether to
continue with the business or not. As long as the firm is able to cover its
total variable cost, it will continue with the business and when TR .
Long run equilibrium of a firm under monopolistic competition:
In the long run it is possible for the firm to make all necessary changes in
its fixed factors of production. As all costs are variable, firm cannot
continue to operate with loss. As there is free entry and free exit, due to
supernormal profits earned by the existing firms, more firms will enter the
market and firms which cannot cover the cost of production will leave the
market. More firms who are entering the market reduces the share of
existing firms and therefore in the long run all firms will make only
normal profit. The case of normal profit can be discussed with the help of
following diagram.
Figure No. 4. 5
With given revenue and cost curves, equilibrium point is E where MR and
MC curves intersects. Equilibrium output= OQ, price= OP TR= OQRP
TC= OQRP. As TR=TC, there is a normal profit.
4.4 EXCESS CAPACITY
Excess capacity is created under monopolistic competition the equilibrium
of a firm under monopolistic competition is attained at a less than
optimum level of output. This means that the resources are not fully
utilized and therefore this underutilization of existing capacity leads to
excess capacity. Following diagram explains the case of excess capacity. munotes.in
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Monopolistic
Competition
41
Figure No. 4. 6
In the above diagram horizontal AR and MR curve indicates perfect
competition and downward sloping AR and MR curves indicates
monopolistic competition. It is clear from the diagram that equilibrium
under perfect competition is attained at point E with price OP a nd output
OQ. Whereas equilibrium under monopolistic competition is attained at
point E1, with price OP1 and output OQ1. This shoes that firm under
perfect competition produces optimum level of output (OQ) with
minimum cost and thus charges lower price (OP ). On the other hand under
monopolistic competition produces less than optimum level of output
(OQ1) and sells at a higher price (OP1). As firm produces less than
optimum level of output, Q1Q capacity of the form is unused. This is the
excess capacity of t he firm under monopolistic competition.
• As there is underutilization of a capacity, it leads to the problem of
unemployment.
• If the firm is not successful in increasing demand for their product in the
market, all firms expenditure in the form of sellin g cost will be a
wastage.
• Heavy expenditure on advertisement will increase the prices of goods
and services and therefore there is an exploitation of the consumers.
4.5 SUMMARY
This unit studies the monopolistically competitive market. It includes the
features of monopolistic competition. The concept of monopolistic
competition was introduced by professor chambertin. Monopolistic
competition is a more realistic market structure in which we live. This unit
discusses the equilibrium of a firm in the short r un and in the long run. It
concentrates on product differentiation and also explains the factors that
leads to product differentiation.
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42 4.6 QUESTIONS
Write a note on –
1. Concept and Features of Monopolistic Competition .
2. Product Differentiation in Mono polistic Competitio n.
3. Chamberlin’s Alternative Approach
4. Equilibrium under Monopolistic Competition
5. Excess Capacity
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43 5
OLIGOPOLY – 1
Unit Structure:
5.0 Objectives
5.1 Meaning of Oligopoly Market
5.2 Characteristics of Oligopoly Market
5.3 The Cournot Model
5.4 The Sweezy Model of Kinked Demand Curve
5.5 Summary
5.6 Questions
5.0 OBJECTIVES
To know the meaning of oligo poly market.
To study the characteristics of oligopoly market.
To understand the concept of rigid prices.
To study the Cournot model and sweezy model.
5.1 MEANING OF OLIGOPOLY MARKET
Oligopoly is another important form of imperfect competition. When ther e
are a few firms selling homogeneous or differentiated products, the market
is known as oligopolistic. There may be more than two but not may sellers
of a product in the market. It is also market known as competition among
the few firms. Duopoly is a spec ial case of oligopoly. In duopoly, there are
only two sellers or firms. The number of firms are two to ten under
oligopoly market.
Since there are a few firms in the market, all firms are interdependent.
When products produced by few firms are homogeneous, it is called pure
or perfect oligopoly. When products of few firms are differentiated, it is
known as imperfect or differentiated oligopoly. Oligopoly may be
collusive or non -collusive. Under collusive oligopoly there exists formal
or tacit agreement, whi le there are no such agreements under non -
collusive oligopoly.
Oligopolistic markets are characterised by a small number of firms and
their interdependence. Oligopolistic markets emerges due to economics of
Large -scale production absolute cost advantages, large financial capital
requirements, merger and restricted competition, product differentiation,
etc. munotes.in
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44 5.2 CHARACTERISTICS OF OLIGOPOLY MARKET
The characteristics of oligopoly market are as follows -
1. Few sellers - In case of oligopoly market there are f ew sellers. The
number of sellers is not more than 10. In case if there are more than ten
sellers, few sellers are dominant and others are insignificant.
2. Homogeneous or differentiated products - goods which are sold under
oligopoly are either homogeneou s or differentiated. Differentiation is in
the form of brand name, design, color etc.
3. Entry is possible but difficult - In case of oligopoly a new firm can
enter the market but in reality, it is difficult because of the technological,
financial and othe r barriers
4. Interdependence - as there are few firms under oligopoly, a single firm
is not in a position to take any decision about price and output
independently. Any decision taken by one firm has the reactions from the
rival firms or competitive firms . Different firms will have different
decisions. Thus the firms are interdependent. Therefore it is necessary for
the firm to take in to consideration the possible reactions of the rival firms.
5. Uncertainty - as the firms are interdependent for deciding the price and
output, it creates the atmosphere of uncertainty. If one 36 seller increases
his output to capture large share of the market, others will react in the
same way. If one seller increases the price of his product, others will not
follow him due to the fear of losing the market. On the other hand if one
seller reduces the price, others will also reduce their prices. But how much
price reduction they will do is uncertain. This means that an oligopolist is
uncertain about the reactions of the compet itive firms.
6. Indeterminateness of the demand curve - in case of perfect
competition price is determined in the market with demand and supply
factors and the firm is a price taker therefore demand curve of the firm is
perfectly elastic (parallel to x axi s). In case of monopoly a single seller
decides the price for his commodity and accordingly sells his output. Thus
the demand curve of the monopolist slopes downward. And the demand
curve is steeper as the substitute products are not available. Under
monop olistic competition as close substitute products are available,
demand curve is downward sloping and more elastic or flatter. This means
that under perfect competition, monopoly and monopolistic competition
there is a definite shape of the demand curve.
In case of oligopoly due to interdependence of firms and the uncertainty
aspect, Demand curve do not have a definite shape. It loses its
determinateness.
The demand curve under oligopoly is kinky as shown in the following
diagram.
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Oligopoly – 1
45
Figure No. 5.1
5.3 THE COURNOT MODEL
The Cournot‘s model, the oldest and the most famous of the oligopoly
theories, was introduced by the French and mathematician
Augustin A Cournot in 1838. Strictly a duopoly theory, it provides
valuable insight into the nature of oligopolist ic interdependence. Although
crude, it is certainly a path -breaking theory.
Cournot begins his analysis with the basic assumption that duopolist A
believes that duopolist B will not change his output whatever A may do.
Similarly, B believes that A will not change his output whatever he may
do. Cournot supposes that A and B are two producers who own
identical mineral water wells, located side by-side. Mineral water from
these wells can be bottled and sold without cost. Thus, the second
assumption is that the re is no cost of production and, therefore, we have
only to analyze the demand side.
Cournot's solution is illustrated in Fig 1 .1 DB is the market demand for
mineral water. Further suppose that OA = AB is the maximum daily
output of each well. Thus, if th e total output of the two wells is put in
the market, the price will be exactly zero. Suppose producer A enters
the market first. He will produce OA output and sell it for the monopoly
profit -maximising price OC per bottle. His total profit is OACP, the
maximum possible because at output OA, MR = MC = O. The elasticity of
market demand at this level of output is equal to unity and the total
revenue of the firm A is maximum. When cost is zero, maximum
revenue implies maximum profits also. Now let us suppose that B also
enters the market. Since A is selling OA output and assuming that he will
not change his output, the best B can do is to regard PB as his
demand curve and produce AH (1/2 AB). At this output, MC = MR = O.
Total supply now becomes OA + AH = OH a nd price per unit now munotes.in
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Advanced Microeconom ics - III
46 falls to ON. Total profit falls to OHQN of which A's share is OAKN
and B's is AHQK.
Now that B has entered the market, A must reconsider his position. Under
the assumption that B will continue to produce AH units, the best that A
can do is to produce 1/2 of (OB —AH) i.e.OF units (Panel B). He reduces
his output from OA to OF units. Total supply then OF + AH = OG and
the price per unit is OM. Total profit now increases to OGRM of which
A's share is OFTM and B's share is FGRT. Now that A has surprised B
by reducing his output, B must reconsider his position. Assuming that
A will hold his output constant, the best B can do to produce 1/2 of
(OB—OF) i.e.1/2 FB. Thus, to A's surprise, B increases its output.
Then A must reconsider producing 1/2 of (OB —B's output). This process
goes on till a total OE units is produced selling for OL price per unit.
Firm A produces OS units and B produces SE units. Equilibrium
is reached when output is 2/3 of OB. Had A and B joined together, each
would have p roduced 1/2 of OA and earned maximum total profits to
OAPC. They could have shared them equally, each getting OVCW in
profit. Actually, each earns OSZL only. Therefore, the result of
competition is to lower price and profits but output is greater than what
would be in a monopoly. In other world consumers are better off because of
competition. But consumers are worse off than what would have been
their condition under perfect competition. Had there been perfect
competition, producers would have produced OB o utput and price would
have been zero. Since cost is zero, therefore, MC is also zero. MC =
MR at OB output. In short, Cournot's solution results in output which is
2/3 of that under perfect competition and price which is 2/3 of the
monopoly price (OL is 2/ 3 of OC).
Reaction curve: But if B sells the output indicated by point 1, A will
move to point 2 on his reaction curve. The move to point 2 by A calls
for a move by B to point 3 on RBRB and so on. As the adjustments continue munotes.in
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Oligopoly – 1
47 to be made, the firms approach the point of intersection at E. This point E
lies on both the reaction curves. Thus, E is that point at which A will
produce 1/3Xc (competitive output) if B produces 1/3Xc. Similarly, B will
produce 1/3Xc units of X commodity if A also produces 1/3 Xc unit s.
Since there is a coincidence of plans and fulfillments, the duopoly has
reached equilibrium of output at E. Until some other factor such as a
change in consumer demand or a change in price alters the conditions
under which the equilibrium is maintained, there would be no further
adjustments in the industry. Thus, E represents stable equilibrium.
Significance:
1. Cournot's model, although crude in nature, does depict the nature of
moves and countermoves made in an oligopolistic industry.
Viewed from this ang le, it may be regarded as a precursor of what
has come to be known as the Game Theory.
2. Out of the Cournot's model have come two important concepts used
in oligopoly. First is the analytical tool known as Reaction curves
and, second, the concept of conjectu ral variation.
3. Cournot's model is good introduction to the difficulties of
constructing even a limited theory of oligopoly.
However, this model may be criticised on the following grounds.
Criticism:
1. The firm's behaviour is naive in so far as they do no t learn from past
experience. Without fail, each supposes that the rival will not react in
response to any action he may take despite the fact that there is always
a reaction to the move of one's rival. This is irrational behaviour for no
one learns from e xperience.
2. It is a closed model in the sense that entry is not allowed. The number
of firms that are assumed in the first period remains the same throughout
the adjustment period.
3. The model does not say how long the adjustment period will be.
4. The assumption of costless production is unrealistic However, this can
be relaxed without any harm to validity of the model. This can be done
by explaining the model with the help of reaction curves.
However, in Cournot's defence one thing may be said, Economic theory
has often been criticised for making the assumption of rationality. If
the critics believe that economic theory should include some models based
on irrational behaviour, here is one.
Oligopoly is a market structure, in which a few sellers dominate the
sales of a product and the entry of new sellers is difficult or impossible.
The products can be differentiated or standardized. Automobiles,
cigarettes, and chewing gums are some examples of differentiated munotes.in
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48 products whose market structures are oligopoli stic. Oligopolistic markets
are characterized by high market concentration.
In oligopolistic markets, at least some firms can influence price by
virtue of their large shares of total output produced. Sellers in
oligopolistic markets know that when they or their competitors change
their prices of output, the profit of all firms in the market will be
affected. The sellers are aware of their interdependence. They know that a
change in one firm's price or output will cause a reaction by competing
firms. The res ponse an individual seller expects from his rival is a
crucial determinant of his choices. Examples of Oligopoly are
Automobiles, Steel, Camera films, Oil, Airline companies etc.
Check Your Progress:
1. What do you understand by an oligopoly market?
2. Explain t he characteristics of oligopoly.
3. Give examples of oligopoly.
4. Explain the significance of Cournot ’s model .
5.4 THE SWEEZY MODEL OF KINKED DEMAND
CURVE
The concept of kinked demand curve was originally used to explain why,
in an oligopoly market, the price w hich has been determined on the basis
of average cost principle, would tend to remain rigid. The basic postulate
of the average cost pricing is that the firm sets the price equal to the
average total cost which includes not only average variable cost but
also a gross profit margin. The yield is a normal profit. However, the
kinked demand curve, used by Paul Sweezy, explained the observed
rigidity of price in an oligopoly market.
The kinked demand model is based on the following
assumptions:
There are many f irms in the oligopolistic industry.
Each producer manufactures a product which is a close
substitute for that of the other firm.
Product qualities are constant, advertising expenditures are zero.
Each oligopolist believes that, if he reduces the price of h is product,
his competitors will also lower the prices of their products and that
if he rises they will maintain the prices at the existing levels.
Based on the above assumptions, the demand curve faced by any
individual seller has a kink at the initial pr ice-quantity combination. The
kinked shape of the demand curve is based on the assumption that the
competitors react differently to a rise in price or to a fall in price. It is
also assumed that when an individual seller increases the price of his
product other sellers will not increase their prices so that the sales of
the seller increasing the price will be reduced considerably. This means munotes.in
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Oligopoly – 1
49 that the demand curve is relatively elastic for a rise in price. On the other
hand, it is assumed that when a single seller reduces the price, other
sellers will also reduce the price so that the seller who reduces the price
first cannot gain much for a fall in the price. Hence, when the price is
reduced the demand curve will be relatively inelastic. The kinked
demand cu rve is therefore based on the assumption that a rise in price by
one seller will not be followed by the corresponding fall in the price by
others and a reduction in price by a firm is followed by reduction in
price by all other firms. This can be explained with the help of figure
5.3.
Figure No. 5.3
In figure 5.3 dd and DD represent the demand curves. The demand curve
dd is based on the assumption that when one seller changes his price, the
other sellers do not change their prices and keep their prices un affected.
The demand curve DD is drawn on the assumption that when one seller
changes his price, the other sellers also change their prices in the same
direction. The demand curves dd and DD intersect at point P. Hence,
the demand curve is dPD which has a kink at the point P. Suppose, if the
price is reduced from OP1 to OP2, then the other sellers also reduce the
price, the quantity sold by this seller will increase by QR. But if the other
sellers do not reduce prices the quantity sold will increase by QS.
Similarly, when the price is increased from OP1 to OP3 the quantity
demanded is reduced by PQ' (if other sellers do not increase their
prices) and the quantity demanded will be reduced to PR' (if other
sellers also increase their prices). Since it is assum ed that price decrease
by a firm will be matched by a price reduction by the competitors but an
increase in the price is not matched by the competitors, the relevant
demand curve is dPD, which has a kink at P. The upper section of the
kinked demand curve h as higher price elasticity than the lower part. munotes.in
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50 The position of the curve is determined by the location of OP1, the
price at which the oligopolist sells his product. Thus, the price OP1 is
given data and it is not determined in the model.
If the demand cur ve is kinked, the implication of kink in the demand
curve faced by the seller in the market can be explained with the help of
the following figure 5.4.
It is clear from figure 5.4, that if there is a kink in the demand
curve, then the corresponding MR cu rve will be discontinuous.
dA portion of the MR curve corresponds to the dE portion of the demand
curve, while BMR portion of the MR curve corresponds to the ED portion
of the demand curve. The length of the discontinuity is equal to AB. The
point E, on the demand curve indicates two elasticities of demand namely,
point E is a point on the demand curve dd and the same point E gives
another elasticity of demand on DD curve.
The greater the difference between the two elasticities of demand, the
greater will be the length of the discontinuity because MR = Price (1 - 1/e).
Thus, at the point P, both the demand curves DD and dd have the same
output level. The MR will therefore be different because of differences in
the elasticities of demand. Only when the elastic ities are equal at point P,
the discontinuous range also disappears.
Suppose the MC curve of the firm passes through the discontinuous range
of the MR curve, and then MR will not be equal to the MC at the
equilibrium implying that equality between MR and M C is not possible
and MR cannot be less than MC. In this situation, the price and
quantity remain same, at the kink point. Even if the MC curve
shifts but passes through the discontinuous range AB, the price -
quantity combination will remain constant. The p rice-quantity
combination given by the point of the kink remains more or less munotes.in
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Oligopoly – 1
51 stable in the oligopoly market. The price rise or the price fall is not
profitable for a single seller because of the asymmetrical behavior of
sellers for a price rise or a price decrease.
The equilibrium of the firm is defined by the point of the kink because for
any output level less than OM, MC is below MR while for any output
level greater than OM, MC is greater than MR. Thus, total profit is
maximized at the kink though the p rofit maximizing condition (MR =
MC) is not fulfilled at the kink point.
If the demand curve is kinked, a shift in the market demand upwards or
downwards will affect the volume of output but not the level of price,
so long as the cost passes through the discontinuous range of the
new MR curve. In this instance, as the market expands, the firm will not
raise its price, although output will increase. This is due to the fact that
cost continues to pass through the discontinuity of the new MR curve
and hence th ere is no incentive to change price .
5.5 SUMMARY
1. An oligopoly is market form in which a market is dominated by a small
number of sellers (oligopolists). Because there are few participants in this
type of market, each oligopolist is aware of the actions of the others.
2. An Oligopolist faces a downward sloping demand curve; however;
the price elasticity depends on the rivals reaction to change its price,
investment and output.
3. OPEC is an example of Oligopoly since few countries control the
production of oil. OP EC acts as a cartel. If OPEC and other oil exporters
did not compete, they could ensure much higher prices for prices for
everyone.
4. The kinked demand curve, used by Paul Sweezy, explained the
observed rigidity of price in an oligopoly market.
5. The demand cu rve faced by any individual seller has a kink at the
initial price -quantity combination. The kinked shape of the demand
curve is based on the assumption that the competitors react differently to
a rise in price or to a fall in price.
5.6 QUESTIONS
Q1. Give the definition of oligopoly market and explain the characteristics
of oligopoly market.
Q2. Write note on ‘rigid prices.’
Q3. Explain Cournot model.
Q4. Explain the Sweezy model.
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OLIGOPOLY – 2
Unit Structure:
6.0 Objectives
6.1 Collusive Oligopoly
6.2 Carte l
6.3 Imperfect Collusion
6.4 Price Leadership Models
6.5 Game Theory
6.6 Prisoner’s Dilemma
6.7 Nash Equilibrium and Dominant Strategy
6.8 Questions
6.0 OBJECTIVES
After stu dying this unit, you will be know n about the collusive and non -
collusive oligopoly, cartel, imperfect collusion, price leadership models,
game theory, prisoner’s dilemma, nash equilibrium and dominant strategy
equilibrium.
6.1 COLLUSIVE OLIGOPOLY
The olig opoly market faces the problem of price determination because of
the continuous reactions of the rival firms. Due to differentiate products,
competition in the oligopoly market is also high. An oligopoly can be
collusive or non -collusive.
Non collusive o ligopoly: In case of non - collusive oligopoly, firms
behave independently, even though they are interdependent.
interdependence of the firm leads to stiff competition among the rivals. In
this case the behavior of the Seller depends on how he thinks his
competitors will react to his decision making. In case of non - collusive
oligopoly firm while deciding price for its product assumes that rival firms
will keep their price and output constant and will not react to any change
in price and output introduced by the firm. A very good example of non -
collusive oligopoly is sweezy’s kinked demand curve model.
Collusive oligopoly: collusive oligopoly prevails when the firms working
under oligopoly market enter into an agreement regarding uniform price
and output po licy to avoid uncertainty arising due to interdependence of
the firm and to avoid high level of competition. munotes.in
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53 The agreement may be either formal (open) or tacit (secret). As the open
agreement to form monopolies are illegal in most of the countries
agreeme nts between the oligopolists are tacit.
6.2 CARTEL
In the real world we generally have loose type of cartel. Here we have two
types of market sharing. They are
a. Market sharing by non - price competition and
b. Market sharing by output quota
a. Market sharing by non - price competition - In case of oligopoly, due
to interdependence of firms and uncertainty, price is rigid i.e. firms follow
a particular price and there is no tendency either to increase or to reduce
the price. At a uniform price firms are f ree to produce and sell that level of
output which will maximize their profits. Here even though the firms are
following same price they are free to change the style of their product,
style of advertising the product, additional facilities or discounts may be
given. If all member firms have identical cost, they will be agreeing to
uniform monopoly price and this price will maximize their joint profits.
But if their costs are different, cartel price will be decided by the
bargaining between the firms. If low cost firms are interested in charging
lower price cartel may break away.
b. Market sharing buy output quota - In this case an oligopoly firm
enters in to an agreement regarding quota of output to be produced and
sold by each of the firm at a particular ag reed price.
If the cost of production is same for all the firms and firms are producing
homogeneous product, a monopoly element will exist and all firms will
share the market equally and charge the maximum possible price. On the
other hand, if the cost of production is different for different firms, market
share of the firms will differ. These differences are dependent on the
bargaining power of the firms. The Quota of output shared by the firm
depends on the past records and negotiation skills.
Another m ethod for market sharing quota is to divide the markets region
wise. In this case firms are free to decide the price and to bring changes in
their product. When there are cost differences between the firms all types
of cartels are unstable.
6.3 IMPERFECT C OLLUSION
Definition: Imperfect competition is a competitive market situation where
there are many sellers, but they are selling heterogeneous (dissimilar)
goods as opposed to the perfect competitive market scenario. As the name
suggests, competitive market s that are imperfect in nature.
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54 Description: Imperfect competition is the real world competition. Today
some of the industries and sellers follow it to earn surplus profits. In this
market scenario, the seller enjoys the luxury of influencing the price in
order to earn more profits.
If a seller is selling a non identical good in the market, then he can raise
the prices and earn profits. High profits attract other sellers to enter the
market and sellers, who are incurring losses, can very easily exit the
market.
6.4 PRICE LEADERSHIP MODELS
Price -leadership is another form of collusion. In this, one firm sets the
price and others follow it either because it is beneficial to them or
because they like to avoid uncertainty regarding their competitors'
reactions even if they have to depart from profit -maximising output
position. Price leadership is more commonly found than cartels because it
allows complete freedom to the members as regards their output and
selling activities. That is why it is more acceptable to the followers than a
complete cartel which demands surrendering of all freedom of action to
the central agency.
There are various forms of price leadership. The most common types are:
1. Price -leadership by a low cost firm
2. Price -leadership by a dominant fir m
3. Barometric price leadership.
1. Price -leadership by a low cost (efficient) firm:
In this model, it is assumed that there are two firms in the industry : their
products are homogeneous ; one firm is more efficient and hence its
costs are lower than those of the other; each firm is allocated half the
marks share according to the tacit market - sharing agreement. In Fig.
6.1, DD is the market demand curve and dd is the demand curve facing
each firm. SAC1 and SMC2 are the average and marginal cost curves of
the efficient or low cost firm while SAC2 and SMC2 are the average
and marginal cost curves of the less efficient or high cost firm. MR is the
marginal revenue curve facing each firm. The high cost firm would like
to produce OX2 output and charge OP price b ecause it is at this output
that the firm's MR curve intersects SMC2 curve. The low cost firm, on
the other hand, would like to produce OX1 output and charge OP price
because it is at OX1 output that the MR curve intersects SMC1. This
is the profit -maximis ing output and price for the efficient firm. It is
evident that the low cost firm will dictate the price and the high cost
firm will be compelled to follow it. The follower can obtain a higher
profit by producing a smaller output OX2 and selling it at a hi gher price
OP2 (it is at this out put that its MR SMC2) However, he prefers to
follow the leader sacrificing some of its profits in order to avoid a
price war. Such a price war can eliminate the high cost firm if price fell
sufficient low as not to cover i ts LAC. It should be noted that for the munotes.in
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Oligopoly – 2
55 leader to maximise his profit, price must be maintained at the level OP
and he should sell OX1 quantity. This implies that is assumed that each
firm is allocated half the market share, therefore OX1 + X2 = OX,
the market demand.
Although this model of price leadership stresses the fact that the
leader sets the price and the follower accepts it, it is obvious that the
firms must also reach agreement on the sharing of the market. If such
an agreement is not reached, the follower can accept the price of the
leader but produce a quantity smaller than that required to maintain the
leader's price, and thus force the leader to a non -profit maximising
output. In this respect, the follower is not completely passive.
Figure No . 6.1
2. Leadership by the dominant firm:
In oligopoly market, large and small firms exist side by side. When
the oligopoly is composed of a large firm and many small firms, the
large firm becomes the dominant firm and acts as the price -leader. The
dominant firm sets the price for the industry and allows the small firms
to sell all that they want to sell at that price. The rest of the market
demand for the product is met by the dominant firm. For the small firms,
the price is given and fixed and they can beha ve as if it were perfect
competition for them. It is clear that each small firm is faced with a
perfectly elastic demand curve (horizontal straight line). This demand
curve is situated at the level of the price fixed by the dominant firm. It
means that each firm behaves as if it were functioning in atmosphere
of perfect competition. The only difference is that in a competitive
market, the industry sets the price, but in this case, the price is fixed by
the dominant firm. Since for every small firm, the dema nd curve is
horizontal straight line, its marginal revenue curve coincides with
it. In other words, for a small firm, AR = MR. The small firm's AR
curve (demand curve) is also its MR curve. Thus, in order to earn munotes.in
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56 maximum profits, the small firm should prod uce that output at which
its marginal cost is equal to its marginal revenue i.e. the price fixed by
the dominant firm. By horizontal summation of the marginal cost
curves of the small firms, we obtain the supply curve for all the small
firms. In Fig. 6.2, CMC is such a supply curve for the small firms. This
supply curve shows the amounts of the product which all the small firms
taken together will place in the market at different prices. DD indicates the
market demand curve. It shows what amounts of the pro duct the
consumers will purchase at each possible price. We can now derive
the demand curve faced by the dominant firm. The horizontal
difference between the market demand curve DD and the supply curve
of the small firms CMC at different prices indicates how much the
dominant firm would be able to supply at different prices. The demand
curve for the dominant firm is obtained by horizontally substracting the
CMC curve from the DD curve. Let us see how it is done. Suppose the
dominant firm fixes OP as the pr ice. At this price, the small firms will
be able to meet the entire market demand because opposite OP price, DD
= CmC i.e. the market demand is equal to the supply of all the small firms
taken together. Therefore, the dominant firm will have no sales to make.
Let us now consider a lower price OP1. At this price, the small firms
will supply P1A1 output although the market demand at this price is
P1B1.
Figure No. 6.2
The dominant firm will sell A1B1 at this price. In order to locat e the
demand curve for the dominant firm, we relate price (OP1) and
demand for the dominant firm's product at this price. For this
purpose, we take a distance equal to P1C1 which is the same thing as
A1B1. In other words, we transfer distance A1B1 to the l eft so that it
gets coordinated with the price OP1. It is thus clear that at the price
OP1, the dominant firm will sell P1C1. C1 is a point which would lie on
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57 the dominant firm's demand curve. In the same manner, we can consider
other prices and link the d emand for the dominant firm's product with
these prices. In this manner, we obtain the dominant firm's demand
curve. It is shown as P1d in the diagram. Having located the demand
curve, we can locate the MR curve of the dominant firm which lies
below the AR curve. In the diagram, MRd shows the MR of the dominant
firm. MCd is the marginal cost of the dominant firm.
The dominant firm is to set the price. It will follow the general
principle of profit maximisation i.e. MC = MR. The dominant firm
maximises its p rofits at output level OQ because it is at this output that
MCd is equal MRd. Thus, dominant firm sets the price OP2. At OP2
price, the total market demand is OQ of which the dominant firm
supplies OQd and the rest OdQ is supplied by the small firms. It ma y be
noted that the dominant firm maximises its profit by equating its marginal
cost to its marginal revenue. The smaller firms being price -takers, may or
may not maximise their profit. It all depends on their cost structure. But
one thing is definite. It the dominant firm wishes to maximise its profits,
it must make sure that the small firms will not only follow its price, but
will also produce the right amount of output. Unless there is a tight
market sharing agreement the small firms may produce less tha n OQs
and thus force the dominant firm to a position where profits are not the
maximum.
There can be many variations of the dominant firm model. For
instances if there are two or more dominant firms in an industry, the
small firms may look to one or all of the large firms for price
leadership. Product differentiation may further complicate the situation.
3. Barometric Price -Leadership:
In this model, that firm is chosen as leader which is supposed a have
a better knowledge of market conditions as well as a bet ter ability to
forecast future market developments. All other firms agree, formally or
informally, to follow its price changes. In other words, the firm chosen as
leader is regarded as a barometer reflecting the changes in economic
conditions. The barometr ic firm may neither be a low cost nor a very
large firm. Generally, it is a firm which, on the basis of its past
performance, has established the reputation of a good forecaster of
economic changes. A firm belonging to pother industry may be chosen as
the barometric leader. For example, a firm in the steel industry may be
accepted as barometric leader for price changes in the motor car industry.
There are various reasons for establishing barometric price leadership.
Firstly, rivalry among several large firm s in an industry may make it
impossible to accept any one of them as leader.
Secondly, followers do not have to continuously recalculate costs as
economic condition change. They simply follow the barometric leader. munotes.in
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58 Thirdly, the barometric firm has the repu tation of a good forecaster of
changes in cost and demand conditions in a particular industry and
the economy as a whole. By following other firms can be reasonably sure
that they have chosen the correct price policy
Leadership in oligopoly markets is comm on in modern countries. When
formal collusion agreements are declared illegal, oligopolists enter into tacit,
informal, and secret agreement under which all firms follow the price -lead
of one firm and yet escape the anti-trust, anti -cartel laws. Besides,
there are gentlemen's agreements regarding price, output are
market - sharing, etc. reached on social occasions.
Check Your Progress:
1. Write notes on:
i) Price leadership by a low cost firm
ii) Leadership by a dominant firm
iii) Barometric price leadership
6.5 GAM E THEORY
The inter -dependence of firm in oligopoly and uncertainty about the
reaction of rivals of any action taken by a firm cannot be fully analysed
by the traditional tools of economic theory. It is true that economists
have developed different models : collusive models, limit -pricing
models, managerial models and behavioural models. However, none of
these provides a general theory of oligopoly in the sense that they do not
fully explain the process of decision -making in a firm.
The Theory of Games offer s a different approach to the study of
oligopoly. In the late 1920s, the French mathematician Emil Barel wrote
a series of articles to show how games, war, and economic behaviour were
similar activities in that they all involve the necessity of making
strategic decisions. Barel's work gained the attention of a number of
economists and mathematicians who believed that if a full -fledged theory
of games could be developed, it might provide a much better
understanding of oligopolistic behaviour than that offere d by the
traditional theory. In later developments, games theory was advanced by
work of a number of scholars; the most significant achievement was
the publication in 1944 of John von Neumann and Oskar
Morgenstern's monumental "The theory of Games and Econ omics
Behaviour."
Some Preliminary Definitions:
A strategy is one firm's plan of action adopted in the light of its belief
about the reaction of its rivals. The players in the game may be thought of
as the firms or their managers comprising the oligopoly industry. The
players make their moves when they actually decide on the strategy
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59 move. The play of a firm consists of a detailed description of the firm's
activities in carrying out its mov e. Thus, if two firms, A and B, decide to
form collusive oligopoly, their play would be description of how they made
their decision to collude, how they propose to carry it out, and so forth.
The pay -off of game or strategy is the result of the player's moves. It may
be defined as the not gain a strategy will bring to the firm for any given
counter strategy of the rivals.
The pay -off matrix of a firm is a table showing the pay -offs coming to it
as a result of each possible combination of strategies adopted by it and by
its competitors.
In the theory of games, the firms in oligopolistic markets are treated as
players in a chess game; to each move by one player, the other may
choose among several counter moves. The counter -moves of rivals
are probable but not certain. Yet, it is possible to choose a strategy
which will maximise the firm's expected gain, after making due
allowance for the effects of rival's probable reactions.
Two -Person Zero -Sum Game:
The simplest model is a duopoly market in which each firm tries to
maximise its market share. Given this aim, it is clear that whatever one
firm gains, the other losses. In other words, any gains of one firm is
cancelled by the loss of the other firm so that the net gain is zero. Hence
the name Zero -sum game. Sinc e only two persons or firms are involved, it
is called a two person game.
Assumptions:
This model is based on the following assumptions.
1. The firms have only one goal, namely, to maximise their
market share.
2. Each firm knows the strategies available to it a nd to its rival.
3. Each firm knows with certainty the pay -offs— total revenue, total
costs, and total profits from each combination of strategies.
4. The actions taken by duopolists do not affect the total size of the
market.
5. Each firm chooses its strategy expe cting the worst from its rival.
It means that each firm acts in the most conservative way,
expecting that the rival will choose the best possible counter -
strategy open to him. This behaviour is called rational.
6. In the zero sum game, there is no possibi lity of collusion. Each firm
wants to maximise its market share. It means that the aims of the
firm are opposed to each other. munotes.in
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60 6.6 PRISONER’S DILEMMA
The prisoner's dilemma is a paradox in decision analysis in which two
individuals acting in their own self -interests do not produce the optimal
outcome.
A prime example of game theory, the prisoner's dilemma was developed
in 1950 by RAND Corporation mathematicians Merrill Flood and Melvin
Dresher during the Cold War (but later given its name by the game
theorist Alvin Tucker). Some have speculated that the prisoner's dilemma
was crafted to simulate strategic thinking between the U.S.A. and
U.S.S.R. during the Cold War. 1
Today, the prisoner 's dilemma is a paradigmatic example of how strategic
thinking between individuals can lead to suboptimal outcomes for both
players.
The typical prisoner's dilemma is set up in such a way that both parties
choose to protect themselves at the expense of the other participant. As a
result, both participants find themselves in a worse state than if they had
cooperated with each other in the decision -making process. The prisoner's
dilemma is one of the most well -known concepts in modern game theory .
The prisoner’s dilemma presents a situation where two parties, separated
and unable to communicate, must each choose between cooperating with
the other or not. The highest reward for each party occurs when both
parties choose to co -operate.
The classic prisoner’s dilemma goes like this:
Two bank robbers, Elizabeth and Henry, have been arrested and are
being interrogated in separate rooms.
The authorities have no other witnesses, and can only prove the c ase
against them if they can convince at least one of the robbers to betray
their accomplice and testify to the crime.
Each bank robber is faced with the choice to cooperate with their
accomplice and remain silent or to defect from the gang and testify for
the prosecution.
If they both co -operate and remain silent, then the authorities will only
be able to convict them on a lesser charge resulting in one year in jail
for each (1 year for Elizabeth + 1 year for Henry = 2 years total jail
time).
If one testif ies and the other does not, then the one who testifies will
go free and the other will get five years (0 years for the one who
defects + 5 for the one convicted = 5 years total).
However, if both testify against the other, each will get three years in
jail for being partly responsible for the robbery (3 years for Elizabeth +
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61 The respective penalties can be expressed visually as follows:
Possible Outcomes of Prisoner's Dilemma
Outcome Henry Cooperates Henry D efects Elizabeth Cooperates (1,1) (5,0)
Elizabeth Defects (0,5) (3,3)
Penalties for (Elizabeth, Henry)
In this case, each robber always has an incentive to defect, regardless of
the choice the other makes. From Elizabeth's point of view, if Henry
remains silent, then Elizabeth can either co -operate with Henry and do a
year in jail, or defect and go free. Obviously, she would be better off
betraying Henry in this case. On the other hand, if Henry defects and
testifies against Elizabeth, then her cho ice becomes either to remain silent
and do five years or to talk and do three years in jail. Again, obviously,
she would prefer to do the three years over five.
In both cases, whether Henry cooperates with Elizabeth or defects to the
prosecution, Elizabeth will be better off if she defects and testifies. Now,
since Henry faces the exact same set of choices he also will always be
better off defecting as well.
The paradox of the prisoner’s dilemma is this: both robbers can minimize
the total jail time that th e two of them will do only if they both co -operate
and stay silent (two years total), but the incentives that they each face
separately will always drive them each to defect and end up doing the
maximum total jail time between the two of them of six years total.
Examples of the Prisoner's Dilemma
The economy is replete with examples of prisoner’s dilemmas which can
have outcomes that are either beneficial or harmful to the economy and
society as a whole. The common thread is this: a situation where the
incentives faced by each individual decision -maker would induce them
each to behave in a way that makes them all collectively worse off, while
individually avoiding choices that would make them all collectively better
off if all could somehow cooperatively cho ose.
One such example is the tragedy of the commons . It may be to everyone’s
collective advantage to conserve and reinvest in the propagation of a
common pool of natural resourc es in order to be able to continue
consuming it, but each individual always has an incentive to instead
consume as much as possible as quickly as possible, which then depletes
the resource. Finding some way to co -operate would clearly make
everyone better off here.
On the other hand, the behavior of cartels can also be considered a
prisoner’s dilemma. All members of a cart el can collectively enrich
themselves by restricting output to keep the pri ce that each receives high munotes.in
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62 enough to capture economic rents from consumers, but each cartel
member individually has an incentive to cheat on the cartel and increase
output to also capture rents away from the other cartel members. In terms
of the welfare of the overall society that the cartel operates in, this is an
example of how individual incentives can sometimes actually make
society better off as a whole.
6.7 NASH EQUILIBRIUM AND DOMINANT STRATEGY
Nash equilibrium is a concept within game theory where the optimal
outcome of a game is where there is no incentive to deviate from the
initial strategy. More specifically, the Nash equilibrium is a concept
of game theory where the optimal outco me of a game is one where no
player has an incentive to deviate from their chosen strategy after
considering an opponent's choice. 1
Overall, an individual can receive no incremental benefit from changing
actions, assuming other players remain constant in t heir strategies. A
game may have multiple Nash equilibria or none at all.
Important Point:
The Nash equilibrium is a decision -making theorem within game
theory that states a player can achieve the desired outcome by not
deviating from their initial strateg y.
In the Nash equilibrium, each player's strategy is optimal when
considering the decisions of other players. Every player wins because
everyone gets the outcome they desire.
The prisoners' dilemma is a common game theory example and one
that adequately s howcases the effect of the Nash equilibrium.
The Nash equilibrium is often discussed in conjunction with
dominant strategy, which states that the chosen strategy of an actor
will lead to better results out of all the possible strategies that can be
used, r egardless of the strategy that the opponent uses.
The Nash equilibrium does not always mean that the most optimal
strategy is chosen
Nash equilibrium is named after its inventor, John Nas h, an American
mathematician. It is considered one of the most important concepts of
game theory, which attempts to determine mathematically and logically
the actions that participants of a game should take to secure the best
outcomes for themselves.
The reason why Nash equilibrium is considered such an important
concept of game theory relates to its applicability. The Nash equilibrium
can be incorporated into a wide range of disciplines, from economics to
the social sciences. munotes.in
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63 To quickly find the Nash equilibrium or see if it even exists, reveal each
player's strategy to the other players. If no one changes their strategy,
then the Nash equilibrium is proven
Nash Equilibrium vs. Dominant Strategy
Nash equilibrium is often compared alongside dominant strategy, both
being strategies of game theory . The Nas h equilibrium states that the
optimal strategy for an actor is to stay the course of their initial strategy
while knowing the opponent's strategy and that all players maintain the
same strategy, as long as all other players do not change their strategy.
Dominant strategy asserts that the chosen strategy of an actor will lead to
better results out of all the possible strategies that can be used, regardless
of the strategy that the opponent uses.
Both the terms are similar but slightly different. Nash equilib rium states
that nothing is gained if any of the players change their strategy if all
other players maintain their strategy. Dominant strategy asserts that a
player will choose a strategy that will lead to the best outcome regardless
of the strategies that other plays have chosen. Dominant strategy can be
included in Nash equilibrium whereas a Nash equilibrium may not be the
best strategy in a game.
6.8 QUESTIONS
Q1. Write a note on following -
i) Collusive and Non -collusive Oligopoly
ii) Cartel
iii) Imperfect Collu sion
iv) Game Theory
v) Prisoner’s Dilemma
vi) Nash Equilibrium and Dominant Strategy
Q2. Explain the price leadership models.
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64 7
INFORMATION ECONOMICS
Unit Structure:
7.0 Objectives
7.1 Introduction
7.2 Economics of Search and Search Cost
7.3 The Theory of Asymmetric Information
7.4 The Market for Lemons and Adverse Selection
7.5 The Problem of Moral Hazard
7.6 Market Signaling
7.7 Principal -Agent Problem
7.8 Summary
7.9 Questions
7.0 OBJECTIVES
To understand the concept of economics of search and search cost.
To study about the theory of asymmetric information.
To know about the market for lemons and adverse selection.
To understand the Problem of Moral Hazard
To study the concept of Market Signaling
To study the concept of principal -agent problem
7.1 INTRODUCTION
In this unit we study the economics of information. This area of study is
becoming increasingly important in economics - and deservingly so. The
unit begins by examining the economics of search: search costs, the
process of searching for the lowest price of the product, and the
information content of advertising. The unit goes on to discussing
asymmetric infor mation and the market for lemons (i.e. defective products),
the insurance market and adverse selection, market signalling, moral
hazard, the principal -agent problem, and the efficiency wage theory.
7.2 ECONOMICS OF SEARCH AND SEARCH COST
The unit begins by discussing search costs, sketching the process of
searching for the lowest commodity price, and examining the
informational content of advertising. munotes.in
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Economics
65 Search Costs:
A cost of purchasing a product is the time and money is spend on
searching information about the product likeWhat are the properties of the
product? What are the substitutes? How good is the product? How safe?
How much does the product cost in one store as compared to
another?
Thus Search costs include the time spent in reading advertising,
telepho ning, travelling, inspecting the product, and comparing shopping
for the lowest price. Although the most important component of
search costs is the time spent learning about characteristics of the
product, consumers also spend money on purchasing informati on to
assist them in their search. For instance, consumers might purchase
Consumer Reports magazine to check on the quality of the product, pay an
impartial mechanic to evaluate a used car before deciding on purchasing it,
or seek professional help from a financial advisor before making a major
investment in the financial product.
In most cases, however, the major cost of search is the time required to
learn about the product.
One of the most important and time -consuming aspects of purchasing a
product is c omparison shopping for the lowest price. Even when a
product is standardized and conditions of sale are identical (i.e. locational
convenience, politeness of service, availability of credit, returns policy,
etc), there will be price dispersion in the absen ce of perfect
information on the part of buyers.
The general rule is that a consumer should continue the search for
lower prices as long as the marginal benefit from continuing the search
exceeds the marginal cost, and until the marginal benefit equals the
marginal cost. The marginal benefit (MB) is equal to the degree by
which a lower price is found as a result of each additional search times the
number of units of the product purchased at the lower price. The marginal
cost (MC) of continuing the search de pends on the value that consumers
place on their time and money spend. Since the value that consumers
place on their time differs for different consumers, when each consumer
behaves according to the MB = MC rule the product will be purchased at
different p rices by different consumers.
Specifically, those consumers giving up more money on searching for
lower prices will stop the search before consumers who face lower
opportunity costs for their time, and thus will purchase the product at a
higher price. On t he other hand, with the MC curve of search declines due
to internet facilities, consumers search more now than a decade ago.
Searching for the Lowest Price:
There will be price dispersion in the market at any time even for a
homogeneous product. Unless the consumer knows that the price quoted
by the first seller is the lower price in the market, he or she should continue munotes.in
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66 the search for lower prices as long as the MB from continuing the search
exceeds the MC of additional search. In general, the MB from sear ching
declines as the time spent searching for lower prices continues. Even if
the MC of additional search is constant, a point is reached where MB =
MC. At that point, the consumer should end the search.
For example, suppose that a consumer wants to purch ase an LCD of a
given brand and knows the prices of different sellers range from $800 to
$1200. All sellers are identical in location, service, and so on, so that
price is the only consideration. Suppose also that sellers are equally divided
into five clas sifications: Sellers of type I charge a price of $800 for the
LCD, type II sellers charge $900, type III charge $1000, type IV charge
$1100 and type V charge $1200. For a single search, the probability of
each price is 1/5, and the expected price is the we ighted average of all prices,
or $1000. The consumer can now purchase the LCD at the price of $1000,
or she can continue the search for lower prices. With each additional search
the consumer will find a lower price, until the lowest price of $800 is
found. The reduction in price with each search gives the marginal benefit
of the search. The consumer will end the search when the MB from the
search equals the MC.
We can use a simple formula to obtain the approximate lowest price
expected with each additional search. This is –
Search and Advertising
Even though most advertising contains an important manipulative
component, it also provides a great deal of useful information to
consumers on the availability of products, their use and properties, the
firms sel ling particular products, retail outlets that carry the product, and
product prices. Thus, advertising greatly reduces consumers‘ search costs.
In most cases, it also reduces both price dispersion and average prices.
Clearly, advertising often results in i ncreased competition among sellers
and lower product prices, and it provides very useful information to
consumers.
In examining the role of advertising, Philip Nelson
distinguishes between search goods and experience goods.2Search
goods are those goods who se quality can be evaluated by inspection at the
time of purchase. Examples of search goods are fresh fruits and
vegetables, clothes, and greeting cards. Experience goods, on the
other hand, are those which cannot be judged by inspection at the time of
purchase but only after using them. Examples of experience goods are
automobiles, LCD, Laptops, canned foods and laundry detergents. Some
goods, of course are borderline. For example, the content of a book or
magazine can be partially gathered by quick inspec tion at the bookstore
before purchasing it. But its quality can be fully evaluated after reading it
more carefully after the purchase. munotes.in
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67 Nelson points out that the advertisements of search goods must by
necessity contain large information content. Any attemp t on the part of
the seller to misrepresent the product in any way would be easily
detected by potential buyers before the purchase and would thus be self -
detecting. The situation is different for experience goods, where the buyer
cannot determine the true properties of the product before use.
Nevertheless, the very fact that a large and established seller is willing
to spend a great deal on advertising the product provides indirect support
for the seller‘s claims. After all, a large seller that has been in business for
a long time must have enjoyed repeated purchases from other satisfied
customers.
7.4 ASYMMETRIC INFORMATION: THE MARKET
FOR LEMONS AND ADVERSE SELECTION
We now discuss asymmetric information and the market for lemons as
well as the problem o f adverse selection in the insurance market.
Asymmetric Information and the Market for Lemons:
Often one party to a transaction (i.e. the seller of the buyer of a product or
service) has more information than the other party regarding the quality of
the pr oduct or service. This is a case of asymmetric information. An
example of the problems created by asymmetric information is the market
for ―lemons (i.e. defective products, such as used cars, that will require a
great deal of costly repairs and are not wor th their price), discussed by
Ackerlof.
For example, sellers of used cars know exactly the quality of the cars that
they are selling while prospective buyers do not. As a result, the market
price for used cars will depend on the quality of the average used cars
available for sale. As such, the owners of ―lemons would then tend to
receive a higher price than their cars are worth, while the owners of
high-quality used cars would tend to get a lower price than their cars are
worth. The owners of high -quality used cars would therefore withdraw
their cars fro m the market, thus lowering the average quality and
price of the remaining cars available for sale. Sellers of the now above -
average quality cars withdraw their cars from the market, further
reducing the quality and price of the remaining used cars offered for
sale. The process continues until only the lowest -quality cars are sold in
the market at the appropriate very low price. Thus, the end result is that low -
quality cars drive high -quality cars out of the market. This is known as
adverse selection.
The p roblem of adverse selection that arises from asymmetric
information can be overcome or reduced by the acquisition of more
information by the party lacking it. For example, in the used -car market, a
prospective buyer can have the car evaluated at an indepen dent
automotive service center, or the used-car dealer can provide guarantees
for the cars they sell. With more information on the quality of used
cars, buyers would be willing to pay a higher price for higher -quality munotes.in
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68 cars, and the problem of adverse selec tion can be reduced. More
generally, brand names (such as LG Electronics), chain retailers (such as Big
Bazaar and McDonald‘s) and professional licensing (of doctors,
lawyers, beauticians, etc) are important methods of ensuring the quality
of products and services, and thus reduce the degree of asymmetric
information and the resulting problem of adverse selection. Travellers
are often willing to pay higher prices for nationally advertised products
and services than for competitive local products, because th ey do not
know the quality of local products and services. Thus is why tourists often
pay more for products and services than residents. Sometimes, higher
prices are themselves taken as an indication of higher quality.7
The Insurance Market and Adverse Sel ection:
The problem of adverse selection arises not only in the market for used
cars, but in any market characterised by asymmetric information. This
is certainly the case for the insurance market. Here, the individual knows
much more about the state of her health than an insurance company can
ever find out, even with a medical examination. As a result, when an
insurance company sets the insurance premium for the average
individual (i.e. an individual of average health), unhealthy people are
more likely to purchase insurance than healthy people. Because of this
adverse selection problem, the insurance company is forced to raise the
insurance premium, thus making it even less advantageous for healthy
individuals to purchase insurance. This increases even more the
proportion of unhealthy people in the pool of insured people, thus
requiring still higher insurance premiums. In the end, insurance premiums
would have to be so high that even unhealthy people would stop buying
insurance. Why buy insurance if the prem ium is as high as the cost of
personally paying for an illness?
The problem of adverse selection arises in the market for any other type of
insurance (i.e. for accidents, fire, floods, and so on). In each case, only
above -average risk people buy insurance, and this forces insurance
companies to raise their premiums. The worsening adverse selection
problem can lead to insurance premium being so high that in the end no
one would buy insurance. The same occurs in the market for credit.
Since credit card compan ies and banks must charge the same interest rate
to all borrowers, they attract more low -than high -quality borrowers
(i.e.more borrowers who either do not repay their debts of repay their
debts late). This force up the interest rate, which increases even m ore
the proportion of low -quality borrowers, until interest rates have to be
so high that it would not pay even for low -quality borrowers to borrow.
Insurance companies try to overcome or reduce the problem of adverse
selection by requiring medical checkup s, charging different premium for
different age groups and occupations, and offering different rates of
coinsurance, amounts of deductibility, length of contracts, and so on.
These limit the variation in risk within each group and reduce the problem
of adv erse selection. Because there will always be some variability in risk
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69 entirely eliminated in this way. The only way to avoid the problem
entirely is to provide compulsory insurance to a ll the people in the group.
Individuals facing somewhat lower risks than the group average will then
get a slightly worse deal, while individuals facing somewhat higher
risks will then get a slightly worse deal, while individual facing
somewhat higher risk s will get a slightly better deal (in relation to the
equal premium that each group member must pay). Indeed, this is an
argument in favour of universal, government -provided, compulsory health
insurance and no -fault auto insurance. On the other hand, credi t
companies significantly reduce the adverse selection problem that
they face by sharing ―credit histories with other credit companies.
Although such sharing of credit histories is justifiably attacked as an
invasion of privacy, it does allow the credit market to operate and keep
interest charges to acceptably low levels.
both price dispersio n and average prices. Clearly, advertising often results
in increased competition among sellers and lower product prices, and it
provides very useful information to consumers.
In examining the role of advertising, Philip Nelson
distinguishes between search goods and experience goods.2Search
goods are those goods whose quality can be evaluated by inspection at the
time of purchase. Examples of search goods are fresh fruits and
vegetables, clothes, and greeting cards. Experience goods, on the
other hand, are those which cannot be judged by inspection at the time of
purchase but only after using them. Examples of experience goods are
automobiles, LCD, Laptops, canned foods and laundry detergents. Some
goods, of course are borderline. For example, the content of a book or
magazine can be partially gathered by quick inspection at the bookstore
before purchasing it. But its quality can be fully evaluated after reading it
more carefully after the purchase.
Nelson points out that the advertisements of search goods mu st by
necessity contain large information content. Any attempt on the part of
the seller to misrepresent the product in any way would be easily
detected by potential buyers before the purchase and would thus be self -
detecting. The situation is different fo r experience goods, where the buyer
cannot determine the true properties of the product before use.
Nevertheless, the very fact that a large and established seller is willing
to spend a great deal on advertising the product provides indirect support
for th e seller‘s claims. After all, a large seller that has been in business for
a long time must have enjoyed repeated purchases from other satisfied
customers.
7.5 THE PROBLEM OF MORAL HAZARD
Another problem that arises in the insurance market is that of mora l
hazard. This refers to the increase in the probability of an illness, fire, or
accident when an individual is insured than when he or she is not. With
insurance, the loss from an illness, fire of other accident is shifted from the
individual to the insur ance company. Therefore, the individual will take munotes.in
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70 fewer precautions to avoid the illness, fire, or other accident, and when
a loss does occur he or she may tend to inflate the amount of the loss. For
example, with medical insurance, an individual may spend less on
preventive health care (thus increasing the probability of getting ill);
and if he or she does become ill, will tend to spend more on treatment than
if he or she had no insurance. With auto insurance, an individual may drive
more carelessly (thus increasing the probability of a car accident) and then
may be likely to exaggerate the injury and inflate the property damage
suffered if the driver does get into an accident. Similarly, with fire
insurance, a firm may take fewer reasonable precautions (su ch as the
installation of a fire -detector system, thereby increasing the probability of
a fire) than in the absence of fire insurance; and then the firm is likely to
inflate the property damage suffered if a fire does occur. Indeed, the
probability of a fi re is high if the property is insured for an amount greater
than the real value of the property.
If the problem of moral hazard is not reduced or somehow contained, it
could lead to unacceptably high insurance rates and costs and thus defeat
the very purpo se of insurance. The socially valid purpose of insurance
is to share given risks of a large loss among many economic units. But if
the ability to buy insurance increases total risks and claimed losses, then
insurance is no longer efficient and may not even be possible. One
method by which insurance companies try to overcome the problem of
moral hazard is by specifying the precautions that an individual or firm
must take as a condition for buying insurance. For example, the insurance
company might require ye arly physical check -ups as a condition for
continuing to provide health insurance to an individual, increase insurance
premiums for drivers involved in accidents, and require the installation
of a fire detector before providing fire insurance to a firm. By doing
this, the insurance company tries to limit the possibility of illness,
accident, or fire, and thereby reduce the number and amount of possible
claims it will face.
Another method used by insurance companies to overcome or reduce
the problem of moral hazard is coinsurance. This refers to insuring only
part of the possible loss or value of the property being insured. The idea is
that if the individual or firm shares a significant portion of a potential
loss with the insurance company, the individual or firm will be more
careful and will take more precautions to avoid losses from illness or
accidents. Although we have examined moral hazard in connection with
the insurance market, the problem of moral hazard arises whenever an
externality is present (i.e. any time an economic agent can shift some of
its costs to other).
7.6 MARKET SIGNALING
The problem of adverse selection resulting from asymmetric information
can be resolved or greatly reduced by market signalling. If sellers
of higher -quality products, lower -risk individuals, better -quality
borrowers, or more productive workers can somehow inform or send
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71 potential buyers of the product, insurance companies, credit companies,
and em ployers, then the problem of adverse selection can, for the most part,
be overcome. Individuals would then be able to identify high -quality
products; insurance and credit companies would be able to distinguish
between low and high -risk individuals and firm s; and firms would be able
to identify higher -productivity workers. As a result, sellers of higher -
quality products would be able to sell their products at proportionately
higher prices; lower -risk individuals could be charged lower insurance
premiums; bet ter-quality borrowers would have more access to credit; and
higher -productivity workers could be paid higher wages. Such market
signalling can thus overcome the problem of adverse selection.
A firm can signal the higher quality of its products to potential customers by
adopting brand names, by offering guarantees and warranties, and by a
policy of exchanging defective items. A similar function is performed by
franchising (such as McDonald‘s) and the existence of national retail outlets
(such as Big Bazaar) that do not produce the goods they sell themselves, but
select products from other firms and on which they put their brand
name as an assurance of quality. The seller, in effect, is saying ―I am
so confident of the quality of my products that I am willing to put my
name on them and guarantee them. The high rate of product returns and
need to service low -quality merchandise would make it too costly for
sellers of low -quality products to offe r such guarantees and
warranties. The acceptance of coinsurance and deductibles by an
individual or firm similarly sends a powerful message to insurance
companies indicating that they are good risks. The credit history of a
potential borrower (indicating t hat he or she has repaid past debts in full
and on time) also sends a strong signal to credit companies that he or she
is a goods credit risk.
Education serves as a powerful signalling device regarding the
productivity of potential employees. That is, high er levels of educational
accomplishments (such as years of schooling, degrees awarded, grade -point
average achieved, etc) not only represent an investment in human capital
but also serve as a powerful signal to an employer of the greater
productivity of a potential employee.
After all, the individual had the intelligence and perseverance to complete
college. A less intelligent and/or a less motivated person is usually not
able to do so, or it might cost her so much more (for e.g., it may take five
or six ye ars rather than four years to get a college degree) as not to pay
for her to get a college education even if she could. Thus, a college
degree provides a powerful signal that its holder is in general a more
productive individual than a person without a deg ree. Even if
education did not in fact increase productivity, it would still serve as an
important signal to employers of the greater inherent ability and higher
productivity of a potential employee.
A firm could fire an employee if it subsequently found t hat the
employee‘s productivity was too low. But this is usually difficult (the firm
would have to show due cause) and expensive (the firm might have to give munotes.in
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72 laying -off pay). In any event, it usually takes a great deal of on -the-job
training before the fir m can correctly evaluate the productivity of a new
employee. Thus, firms are eager to determine as accurately as possible
the productivity of a potential employee before he or she is hired. There
is empirical evidence to suggest that education does in fact provide such
an important signalling device. Liu and Wong found that while firms pay
higher initial salaries to holders of educational certificates (such as college
degrees) than to non -certificate holders, employees ’ salaries
subsequently depend on their actual on -the-job productivity. Thus, the
firm relies on the market signal provided by education when it first hires an
employee, for lack of a better signalling device, but then relies on actual
performance after it has had adequate opportunity to determ ine the
employee ’s true productivity on the job.
7.7 PRINCIPAL AGENT PROBLEM
A firm ’s manager‘s act as the agents for the owners or stockholders
(legally referred to as the principals) of the firm. Because of this
separation of ownership from control in t he modern corporation, a
principal -agent problem arises. This problem refers to the fact that while
the owners of the firm want to maximize the total profits or the present
value of the firm, the managers or agents want to maximize their own
personal inter ests, such as their salaries, tenure, influence, and
reputation. The principal -agent problem often becomes evident in the
case of takeover bids for a firm by another firm. Although the owners or
stockholders of the firm may benefit from the takeover if it raises the
value of the firm‘s stock, the managers may oppose it for fear of losing
their jobs in the reorganization of the firm that may follow the takeover.
One may of overcoming the principal -agent problem and ensuring that the
firm‘s managers act in th e stockholders‘ interests is by providing
managers with golden parachutes. These are large financial settlement paid
out by a firm to its managers if they are forced out or choose to leave as
a result of the firm being taken over. With golden parachuted, t he firm is
in essence buying the firm mangers‘ approval for the takeover. Even
though golden parachutes may cost a firm millions of dollars, they may
be more than justified by the sharp increase in the value of the firm that
might result from a takeover. N ote that a principal -agent problem may
also arise in the acquiring firm. Specifically, the agents or managers of a
firm may initiate and carry out a takeover bid more for personal gain
(in the form of higher salaries, more secure tenure, and the enhanced
reputation and prestige in directing the resulting larger corporation) than
to further the stockholders‘ interest. In fact, the mangers of the
acquiring firm may be carried away by their egos and bid too much for
the firm being acquired.
More generally (and independently of takeovers) a firm can overcome the
principal -agent problem by offering big bonuses to its top managers based
on the firm‘s long -term performance and profitability or a generous
deferred -compensation package, which provides relatively low
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73 Such incentives would induce managers to stay with the firm and strive
for its long -term success. In the case of public enterprises such as
public -transportation agency, or in a non -profit enterprise such as a
hospital, an incompetent manger can be voted out or removed.
Check your progress:
1) What is moral hazard?
2) Define co -insurance.
3) Define principal – agent problem.
4) How one can overcome the principal -agent problem?
7.8 SUMMARY
1. Search c osts refer to the time and money we spend seeking
information about a product. The general rule is to continue the search
for lower prices, higher quality, and so on until the marginal benefit from
the search equals the marginal cost. In most instances, co sts, advertising
provides a great deal of information and greatly reduces consumers‘
search costs, especially for search goods. These are goods whose quality
can be evaluated by inspection at the time of purchase (as opposed to
experience goods, which can only be judged after using them).
2. When one party to a transaction has more information than the other
on the quality of the product (i.e., in the case of asymmetric
information), the low -quality product, or ―lemon£, will drive the high -
quality product out of the market. One way to overcome or reduce such a
problem of adverse selection is for the buyer to get, or the seller to
provide, more information on the quality of the product or service. Such is
the func tion of brand names, chain retailers, professional licensing, and
guarantees. Insurance companies try to overcome the problem of
adverse selection by requiring medical checkups, charging different
premiums for different age groups and occupations, and offe ring different
rates of coinsurance, amounts of deductibility, and length of contracts.
The only way to avoid the problem entirely is with universal
compulsory health insurance. Credit companies reduce the adverse
selection process that they face by sharin g ―credit histories with other
insurance companies.
3. The problem of adverse selection resulting from asymmetric
information can also be resolved or greatly reduced by market signalling.
Brand names, guarantees, and warranties are used as signals for higher -
quality products, for which consumers are willing to pay higher prices.
The willingness to accept coinsurance and deductibles signals low -risk
individuals to whom insurance companies can charge lower
premiums. Credit companies use good credit histories to make more
credit available to good -quality borrowers, and firms use educational
certificates to identify more -productive potential employees who may then
receive higher salaries. munotes.in
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74 4. The insurance market also faces the problem of moral hazard, or the
increase in the probability of an illness, fire, or other accident when an
individual is insured than when he or she is not. If not contained, moral
hazard leads to unacceptably high insurance costs. Insurance companies try
to overcome the problem of moral hazard b y specifying the precautions that
an individual or firm must take as a condition of insurance, and by
coinsuran ce (i.e., insuring only part of the possible loss). The problem of
moral hazard arises whenever an externality is present (i.e. any time an
economic agent can shift some of its costs to others).
5. Because ownership is divorced from control in the modern
corporation, a principal -agent problem arises. This refers to the fact that
managers seek to maximise their own benefits rather than the owners‘ or
principals‘ interests, which are to maximise the total profits or value of
the firm. The firm may use golden par achutes (large financial payments
to managers if they are forced out or choose to leave if the firm is taken
over by another firm) to overcome the managers ’ objections to a takeover
bid that sharply increases the value of the firm. The firm may also set up
generous deferred -compensation schemes for its managers to settle
their long -term interests with those of the firm.
6. According to the efficiency wage theory, firms willingly pay higher
than equilibrium wages to induce workers to avoid shirking or slacking
off on the job. The no -shirk constraint curve is positively sloped and
shows that the efficiency or minimum wage that the firm must pay to
avoid shirking is higher the smaller the level of unemployment. The
equilibrium efficiency wage is given by the inter section of the firm ’s
demand curve for labour and the no -shirking curve.
7.9 QUESTIONS
Write the detail note on –
1. conomics of search and search cost.
2. Asymmetric information. And the market for lemons and adverse
selection.
3. Problem of Moral Hazard
4. Market S ignaling
5. Principal -agent problem
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