JOMO KENYATTA UNIVERSITY OF AGRICULTURE AND

TECHNOLOGY
HFIN 3103: MICROECONOMIC ANALYSIS GUIDE NOTES

Course Purpose
To impart the core elements of modern economic theory and applications to provide a foundation for
further study and research. Emphasis is given to applications of relevance and interest to
practitioners in the financial sector.

Course Objectives
At the end of the course it is expected that the student will be able to:
1. Evaluate the classical theories of microeconomics.
2. Apply the theories of microeconomics to solve economic problems.

Course Description

Classical microeconomics
• Classical Dichotomy Segments the Economy: Real & Financial Sides
• Quantity Theory of Money
• Theories of Market failure

Game theory
• Overview of the Game theory
• Utility Theory
• Game Trees
✓ Complete information
✓ Incomplete information
✓ Games of chance
✓ The Payoff function and equilibrium
• Normal and Strategic Form Games and Matrices
• Saddle Points, Mixed Strategies and the Minimax Theorem
• Nash’s Bargaining Problem and Cooperative Games

Industrial organization
Introduction
1 A historical appraisal
2 Oligopoly theory vs. the SCP paradigm
3 Variations of prices and welfare
✓ Price indices
✓ Welfare variations
✓ Consumer surplus
4 Producer surplus and deadweight welfare loss
5 Market and market power
✓ Definition of the market
✓ Concentration measures
✓ Degree of Monopoly
 ✓ Concentration indices and degree of monopoly
✓ Volatility measures

6 Homogeneous Product Oligopoly Models

✓ Cournot oligopoly. Quantity competition
✓ The geometry of the Cournot model
✓ Stability of the Cournot equilibrium
✓ Cournot vs. Bertrand

Asymmetric information and contract design

a) Incentives
• Formal Contracts
• Relational Contracts
• Career Concerns, Reputation, and the Ratchet Effect

b) Decision Rights
• Classics
• Ex Ante Incentives
• Ex Post Control

c) Dynamic Contracting
• Renegotiation and Incomplete Contracting
• Dynamic Risk-Sharing and Agency
• Dynamic Financial Contracting

d) Multi-Agent Contracting
• Mechanism Design
• Moral Hazard in Teams
• Common Agency
• Collusion and Cooperation
• Contract Externalities
• Non-Financial Motives in Agency
• Intrinsic Motivation

Bargaining Theory
a) Functions of Collective Bargaining
b) Bargaining Models
c) Negotiation strategies
• Industry-wide Bargaining
• Pattern Bargaining
• Coordinated Bargaining
d) The Bargaining Process
• Preparation for Negotiations: Formulation of Demands
• Trading Points and Counterpoints
• Costing Out the Contractual Changes
e) Behavioral Theories of the Negotiation Process
• Distributive and Integrative Bargaining Models
 • Attitudinal Structuring Tactics
f) Content of Agreements: Wage and Salary Issues

Theories of the firm and organizations

a) Forms of ownership
• Private
• Public
• Joint sector
b) Theories on objectives of Firm
• Profit maximization theory
• Baumol’s theory (Sales Rev. Max)
• Marris’ Hypothesis (Growth rate Max)
• William’s model (Managerial Utility Function)
• Behavioral Theories:
✓ Simons satisficing model
✓ Cyert & March model

Auction theory
a) Motivation and importance of Auctions.
b) Rules of some of the “standard/simple” Auctions.
c) Information Structure
d) Bidders’Valuation/(Preferences).a. Private Values.b. Interdependent Valuationc. Common
Values/General.
e) The Independent-Private-Values (IPV) Model:
f) The Independent-Interdependent-Values (IIV) Model
g) The Common-Values Model
h) The role of Risk-Aversion and The number of Bidders
i) Multiple-Units Auctions.

Course Text Books

Jehle, G. A. and Reny, P. J., 2011. Advanced Microeconomic Theory. Prentice Hall.
Varian, H. R., 1992. Microeconomic Analysis, W. W. Norton & Company.
Mas-Colell, A., Whinston, M. D. & Green, J. R., 2008. Microeconomic Theory. Oxford University
Press.
Andrew Schotter (2001), Microeconomics: A Modern Approach, 3rd edition, Addison Wesley
Hal R. Varian (2003), Intermediate Microeconomics: A Modern Approach, 6th edition, Norton.
Wyn Morgan, Micahael Katz & Harvey Rosen (2006), Microeconomics, European Edition,
McGraw-Hill
David Besanko and Ronald R. Braeutigam (2005), Microeconomics, 2nd edition, Wiley.
 MICROECONOMIC ANALYSIS
COURSE DETAILS
INTRODUCTION;

Classical Dichotomy Segments the Economy: Real & Financial Sides

Different schools of Macroeconomic school of thought

Macroeconomic schools of thought

• Classical economics is a school of thought that’s generally regarded as the first
school of economic thought and is widely associated with Adam Smith, the father of
modern economics. The central idea behind the ideology is that markets work best
when they are left alone and role of the government be as minimal as possible. The
‘invisible hand’ in the free markets automatically assigns resources to places where
they are best utilized.

Classical microeconomics

Classical economists developed a theory of value, or price, to investigate economic

dynamics.
However, in political economics, value usually refers to the value of exchange, which is
separate from the price.
Its main thinkers are held to be Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas
Robert Malthus, and John Stuart Mill. These economists produced a theory of market
economies as largely self-regulating systems, governed by natural laws of production and
exchange (famously captured by Adam Smith's metaphor of the invisible hand).

(Students are required to check out the economic principles of these thinkers!)
In terms of economic policy, the classical economists were pragmatic liberals, advocating
the freedom of the market, though they saw a role for the state in providing for the common
good.

▪ The fundamental principle of the classical theory is that the economy is self‐regulating.
Classical economists maintain that the economy is always capable of achieving the natural
level of real GDP or output, which is the level of real GDP that is obtained when the
economy's resources are fully employed. While circumstances arise from time to time that
cause the economy to fall below or to exceed the natural level of real GDP, self‐adjustment
mechanisms exist within the market system that work to bring the economy back to the
natural level of real GDP.

The classical doctrine—that the economy is always at or near the natural level of real
GDP—is based on two firmly held beliefs:
The Say's Law and the belief that prices, wages, and interest rates are flexible.

▪ According to Say's Law,

States that supply itself creates its own demand. “It is production which creates markets for
goods.
According to Say’s law, aggregate production necessarily creates an equal amount of
aggregate demand. It is an economic rule that production is the source of demand
Say had a classically liberal views and argued in favor of free trade and a laissez-faire
economy.

A laissez-faire economy is one in which business activities amongst economic agents other
entities are free from government interference, i.e. it is a free market economy.

According to Say, economic agents offer products and services for sale so that they can
spend the money that they expect to earn.
Money performs but a momentary function in this double exchange; and when the
transaction is finally closed, it will always be found, that one kind of commodity has been
exchanged for another.
When an economy produces a certain level of real GDP, it also generates the income
needed to purchase that level of real GDP. In other words, the economy is always capable
of demanding all of the output that its workers and firms choose to produce. Hence, the
economy is always capable of achieving the natural level of real GDP.

The achievement of the natural level of real GDP is not as simple as Say's Law would seem
to suggest. Consider, however, what happens when the funds from aggregate saving exceed
the needs of all borrowers in the economy. In this situation, real GDP will fall below its
natural level because investment expenditures will be less than the level of aggregate
saving.

Classics maintained that what is not consumed is saved and that all saving out of income is
automatically invested through the capital market. Thus, in a state of equilibrium saving
must equal investment.
If there is any divergence between the two, the equality is maintained through the
mechanism of the rate of interest. To the classicists, interest is a reward for saving.

Aggregate saving is an upward‐sloping function of the interest rate; as the interest rate rises,
the economy tends to save more. Aggregate investment is a downward‐sloping function of
the interest rate; as the interest rate rises, the cost of borrowing increases and investment
expenditures decline. Aggregate investment will be lower than aggregate saving, implying
that equilibrium real GDP will be below its natural level.
Flexible interest rates, wages, and prices. Classical economists believe that under these
circumstances, the interest rate will fall, causing investors to demand more of the available
savings. The interest rate will fall till the supply of funds from aggregate saving equal to the
demand for funds by all investors.
Hence, an increase in savings will lead to an increase in investment expenditures through a
reduction of the interest rate, and the economy will always return to the natural level of real
GDP.
The flexibility of the interest rate as well as other prices is the self‐adjusting mechanism of
the classical theory that ensures that real GDP is always at its natural level.

The flexibility of the interest rate keeps the money market, or the market for loanable
funds in equilibrium all the time and thus prevents real GDP from falling below its natural
level.

Similarly, flexibility of the wage rate keeps the labor market, or the market for workers,
in equilibrium all the time. If the supply of workers exceeds firms' demand for workers,
then wages paid to workers will fall so as to ensure that the work force is fully employed.
Classical economists believe that any unemployment that occurs in the labor market should
be considered voluntary unemployment because workers refuse to accept lower wages. If
they would only accept lower wages, firms would be eager to employ them.

Graphical illustration of the classical theory as it relates to a decrease in aggregate

demand. Figure considers a decrease in aggregate demand from AD 1 to AD 2.
The immediate, short‐run effect is that the economy moves down along the SAS curve
labeled SAS 1, causing the equilibrium price level to fall from P 1 to P 2, and equilibrium
real GDP to fall below its natural level of Y 1 to Y 2. If real GDP falls below its natural level,
the economy's workers and resources are not being fully employed. When there are
unemployed resources, the classical theory predicts that the wages paid to these resources
will fall. With the fall in wages, suppliers will be able to supply more goods at lower cost,
causing the SAS curve to shift to the right from SAS 1 to SAS 2. The end result is that the
equilibrium price level falls to P 3, but the economy returns to the natural level of real GDP.

Given wage-price flexibility, there are automatic competitive forces in the economic
system that tend to maintain full employment, and make the economy produce output at
that level in the long run.

If there were any unemployment in the classical model, it would be of a temporary nature.
But this could not persist for long. Unemployment implies excess supply of labour, which
would cause the money wage rate to fall. This, in its turn, would lead to a fall in the cost of
production and the price level.
As a result, the real wage, which is the ratio of money wage and the price level (W/P),
would also fall, the demand for labour would increase and the labour market would be
cleared. This was the belief of the classical economists. So the classical economists
considered only price adjustment, aggregate output remaining fixed at full employment
(whether the general price level was high or low).

The classical theory of income, output and employment is based on the following
assumptions:
1. There is a normal situation of full employment without inflation.
2. There is a laissez faire capitalist economy without foreign trade.
3. There is perfect competition in labour, money and product markets.
4. Labour is homogeneous.
5. Total output of the economy is divided between consumption and investment
expenditures.
6. The quantity of money is given. Money is only a medium of exchange.

• Neo-classical economics is hinged on the premise of rationality in behavior, and that

the consumers are looking for maximum “utility” and the firms are looking for
maximum profits. This fundamental conflict gives rise to the current demand and
supply theory.

• Monetarist economics is a school of thought largely attributed to the contributions of

Milton Friedman. The central belief is: The role of the government is to control
inflation through manipulating money supply. They believe that attempts to manage
demand in an artificial way (the Keynesian way) can be destabilizing to the overall
economy and can lead to inflation.

Keynesian price-wage rigidity

Keynesian economics derives its roots from the ideas of the British economist John
Maynard Keynes (widely regarded as the most important economist of the 20th century). It
is a theory which relies on government intervention to manipulate aggregate demand
through changes in fiscal policy. It also posits that free markets rarely move towards full-
employment equilibrium.

Keynes argued that prices and wages are not flexible as the classical theory asserts. Wages
tend to be rigid on the down side because workers will not accept wages which do not
permit them to live adequately; this is reinforced by the actions of unions.
If wages are too low, unemployment will exist. In the case of prices, firms prefer to cut
production and lay off workers than cut price. Their monopoly power often permits them
to act that way.

Classical Dichotomy
In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-
Keynesian economics, that real and nominal variables can be analyzed separately.

An economy exhibits the classical dichotomy if real variables such as output, employment
and real interest rates can be completely analyzed without considering what is happening to
their nominal counterparts, the money value of output and the interest rate.

In this view, the primary function of money is to act as a lubricant for the efficient
production and exchange of commodities.

In particular, this means that real GDP and other real variables can be determined without
knowing the level of the nominal money supply or the rate of inflation.

In classical theory, changes in the quantity of money affect only nominal variables (i.e.
money wages, nominal GNP, money balances), and have no influence whatsoever on the
real variables of the economy such as real GNP (i.e. output of goods and services
produced), level of employment (i.e. number of labour – hours or number of workers
employed), real wage rate (i.e. wage rate in terms of its purchasing power).

Actually, according to classical theory, the nominal variables move in proportion to

changes in the quantity of money, while real variables such as GNP, employment, real wage
rate, real rate of interest remain unaffected.

Classical economists argue that real variables such as GNP, employment, real wage rate are
determined by real factors such as stock of capital, the state of technology, marginal
physical product of labour, households’ preferences regarding work and leisure.

The classical dichotomy is a derivation of the Quantity Theory of Money:

Quantity Theory of Money
Is a hypothesis relationship between Money stock, M and the general price level P.
The theory suggests an exact proportional relation between M and P. So, the Quantity
Theory of Money contains the seeds of inflation.

A Simple Model of Money

Quantity Theory of Money
That relation between money and prices is historically associated with the quantity theory of
money. There is strong empirical evidence of a direct relation between money-supply
growth and long-term price inflation, at least for rapid increases in the amount of money in
the economy.

The Quantity Theory of Money is captured by the formula MV = PT,

where M stands for the money stock, V is the velocity of money circulation, P is the price
level, and Y is the level of income.

The classical quantity theory of money states that the general price level changes directly
and proportionately to the supply of money.

The monetary value of output (PT) is thus equal to overall aggregate monetary expenditure.
Exogenous changes in the money supply (M) ultimately condition the price level for a given
level of economic activity.

If an economic system is at full employment, the only effect of increases in the money
supply is a proportionate increase in the domestic price level, which gives rise to a
depreciation of its currency’s exchange rate. The direction of causality runs therefore from
an exogenous money supply to the price level.

Exogenous changes in the supply of money are what shift market rates of interest.
In conclusion, the classical dichotomy implies that real variables and monetary variables are
independent of each other.
 Money growth rate
In terms of percentage changes, the percentage change in a product, say XY, is equal to the
sum of the percentage changes (%ΔX + %ΔY). So, denoting all percentage changes as per
unit of time:

%ΔM + %ΔV = %ΔP + %ΔQ.

This equation rearranged gives the basic inflation identity:

%ΔP = %ΔM + %ΔV – %ΔQ.

Inflation (%ΔP) is equal to the rate of money growth (%ΔM), plus the change in velocity
(%ΔV), minus the rate of output growth (%ΔQ).

So if in the long run the growth rate of velocity and the growth rate of real GDP are
exogenous constants (the former being dictated by changes in payment institutions and the
latter dictated by the growth in the economy’s productive capacity), then the monetary
growth rate and the inflation rate differ from each other by a fixed constant.

As before, this equation is only useful if %ΔV follows regular behavior. It also loses
usefulness if the central bank lacks control over %ΔM.

A simple Model for money - Rothbard’s Equation

The supply of money equals the total demand for money;

MS = MDE+ MDR= MD

Assumptions:
i. A three-commodity market: commodities are directly produced by the households in the
economy so that there are no factor markets or payments.
ii. Leisure is not a consumer’s good,
iii. Each good is produced by labor and a completely specific land factor owned by the
house hold and
iv. None of the producing households consumes any of the good produced
v. Money commodity is permanently fixed in supply
vi. household consumption and liquidity preferences, resource endowments, and technical
knowledge are liable to change from time to time resulting in uncertainty

When the Money Supply is increased the corresponding curve shifts from MS1 to MS2.
The price level rises from 2 to 4 and the value of money drops from ½ to ¼.

When money increases, people would have two choices: use the money to buy goods
and services, or put the money in the bank.
If the money is used to buy goods and services, the demand for those goods and services
increases, causing prices to rise.

If the money is put in the bank, then the banks have more money to lend. This causes the
banks to reduce interest rates to attract new borrowers. The new borrowers use the
money to buy durable items such as cars and houses. This increases demand for those
products, causing prices to rise. Thus, whether money is spent on goods and services or
put in the bank, the price level will tend to rise when the money supply is increased.

Value of
Money (1/P)

MS1 MS2

Money
Demand

M1 M2 Quantity Of Mone
Classical economists make a strong distinction between variables measured in monetary
terms (called nominal variables) and variables measured in physical terms (called real
variables).

This separation between nominal and real variables is called the classical dichotomy.

This distinction is useful because different things affect nominal and real variables.

In particular, the theory of money neutrality maintained that increasing the money supply
would only change nominal variables, but would not affect real variables.

The Fisher Effect

According to the Fisher Effect, increasing the growth rate of the money supply does not
affect the real interest rate, but because inflation will eventually occur, people begin to expect
inflation, causing the nominal interest rate to rise.

The nominal interest rate measures the percentage increase in money loaned over the course
of a year. The real interest rate measures the percentage increased in the buying power of the
money loaned over the course of the year. As a consequence:

The Real Interest Rate = the Nominal Interest Rate – the Inflation Rate

Increasing the rate of growth in the money supply raises the inflation rate and leaves the real
interest rate the same. The nominal interest rate will rise by the same amount as the increase
in inflation.

Evaluation how stable is demand for money?

The demand for money can vary due to many factors other than income and interest rates.
These include

• Technological changes – e.g. debit cards, make holding cash less important. Easy
access to current accounts can enable people to hold less cash.
• Availability of credit. If credit is more available, precautionary demand for money
will fall as individuals feel they can borrow – if they meet short-term difficulties.
• Irrational behaviour of asset prices. Markets can enter boom and busts driven by
psychological factors such as over-exuberance. In these bubble periods, demand for
assets will rise and demand for holding money will fall.
• It depends on how you define money. Narrow definitions such as M0 and M1 are quite
different from broader definitions. Also, there is near-money which includes short-
term gilts with the maturity of fewer than six months.
• The demand for money can refer to narrow definitions of the money supply (M0, M1)
or broad measures of the money supply like M3 or M4.

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QTM Assumptions
QTM adds assumptions to the logic of the equation of exchange.
a) In its most basic form, the theory assumes that V (velocity of circulation) and T (volume
of transactions) are constant in the short term. These assumptions, however, have been
criticized, particularly the assumption that V is constant. The arguments point out that the
velocity of circulation depends on consumer and business spending impulses, which
cannot be constant.

b) The quantity of money, which is determined by outside forces, is the main influence of
economic activity in a society. A change in money supply results in changes in price
levels and/or a change in supply of goods and services.

c) The velocity of circulation depends not on the amount of money available or on the
current price level but on changes in price levels.

d) The number of transactions (T) is determined by labor, capital, natural resources (i.e. the
factors of production), knowledge and organization.

e) The theory assumes an economy in equilibrium and at full employment.

f) The value of money is determined by the amount of money available in an economy. An

increase in money supply results in a decrease in the value of money because an increase
in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the
value of money, decreases. It therefore will cost more to buy the same quantity of goods
or services.

Assuming V (the velocity of money) and T (the total output) to be constant, a change in the
supply of money (AY) causes a proportional change in the price level (P). This is based on
the assumption that money acts only as a medium of exchange.
Classicals believed that workers respond to the changes in real wage rate in deciding to offer
more less labour and it is possible to determine the money wage consistent with a given real
wage

15
In the classical model based on flexibility of prices and wages, changes in money supply only
affect the price level and nominal magnitudes (i.e. money wages, nominal interest rate, while
the real variables such as levels of labour employment and output, saving and investment,
real wages, real rate of interest remain unaffected. This independence of real variables from
changes in money supply and nominal variables is called classical dichotomy.

(The in classical school of thought, the AS Curve is perfectly inelastic)

Refer to a graph
Hence any expansionary policy leaves price invariant

An economy exhibits the classical dichotomy if money is neutral, affecting only the price
level, not real variables.

In new classical macroeconomics there is a short-run Phillips curve which can shift vertically
according to the rational expectations being reviewed continuously.

• A Phillips curve shows the trade off between unemployment and inflation in an economy.
• Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal
policy that shifts the aggregate demand curve to the right.
• The other side of Keynesian policy occurs when the economy is operating above potential
GDP. In this situation, unemployment is low, but inflationary rises in the price level are a
concern. The Keynesian response would be contractionary fiscal policy that shifts
aggregate demand to the left.
• Contractionary fiscal policy consists of tax increases or cuts in government spending
designed to decrease aggregate demand and reduce inflationary pressures.
• Expansionary fiscal policy consists of tax cuts or increases in government spending
designed to stimulate aggregate demand and move the economy out of recession.

Inflation and Unemployment: The Phillips Curve

A. A Phillips curve is a curve that shows the relationship between the inflation rate and
the unemployment rate. There are two time frames for Phillips curves.
B. The Short-Run Phillips Curve

16
1. The short-run Phillips curve shows the tradeoff between the inflation rate and
unemployment rate holding constant the expected inflation rate and natural rate of
unemployment.
An illustration of short-run Phillips curve (SRPC)—a downward-sloping curve.

The figure shows that the negative relationship between the inflation rate and unemployment
rate is explained by the AS-AD model. An unexpectedly large increase in aggregate demand
raises the inflation rate and increases real GDP, which lowers the unemployment rate. So a
higher inflation is associated with a lower unemployment, as shown by a movement along a
short-run Phillips curve.

The Long-Run Phillips Curve

The long-run Phillips curve shows the relationship between inflation and unemployment
when the actual inflation rate equals the expected inflation rate.
An illustrates the long-run Phillips curve (LRPC) which is vertical at the natural rate of
unemployment.

17
Along the long-run Phillips curve, because a change in the inflation rate is anticipated, has no
effect on the unemployment rate.

The figure also shows how the short-run Phillips curve shifts when the expected inflation rate
changes. A higher expected inflation rate shifts the short-run Phillips curve upward by an
amount equal to the increase in the expected inflation rate.

The real-world AS curve is very flat at levels of output far below potential—the Keynesian
zone—very steep at levels of output above potential — the neoclassical zone—and curved in
between—the intermediate zone.
Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on
the x-axis and the inflation rate is on the y-axis.

18
The Long-Run Phillips Curve

The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation
and unemployment are unrelated in the long run.

The reason the short-run Phillips curve shifts is due to the changes in inflation expectations.
Workers, who are assumed to be completely rational and informed, will recognize their
nominal wages have not kept pace with inflation increases (the movement from A to B), so
their real wages have been decreased

As such, in the future, they will renegotiate their nominal wages to reflect the higher expected
inflation rate, in order to keep their real wages, the same. As nominal wages increase,
production costs for the supplier increase, which diminishes profits. As profits decline,
suppliers will decrease output and employ fewer workers (the movement from B to C).
Consequently, an attempt to decrease unemployment at the cost of higher inflation in the
short run led to higher inflation and no change in unemployment in the long run.

Assume the economy starts at point A and has an initial rate of unemployment and inflation
rate. If the government decides to pursue expansionary economic policies, inflation will
increase as aggregate demand shifts to the right. This is shown as a movement along the
short-run Phillips curve, to point B, which is an unstable equilibrium. As aggregate demand

19
increases, more workers will be hired by firms in order to produce more output to meet rising
demand, and unemployment will decrease. However, due to the higher inflation, workers’
expectations of future inflation changes, which shifts the short-run Phillips curve to the right,
from unstable equilibrium point B to the stable equilibrium point C. At point C, the rate of
unemployment has increased back to its natural rate, but inflation remains higher than its
initial level.

In the strict sense, money is not neutral in the short-run, that is, classical dichotomy does not
hold, since agents tend to respond to changes in prices and in the quantity of money through
changing their supply decisions.
However, money should be neutral in the long run, and the classical dichotomy should be
restored in the long-run, since there was no relationship between prices and real
macroeconomic performance at the data level. This view has serious economic policy
consequences. In the long-run, owing to the dichotomy, money is not assumed to be an
effective instrument in controlling macroeconomic performance, while in the short-run there
is a trade-off between prices and output (or unemployment), but, owing to rational
expectations, government cannot exploit it in order to build a systematic countercyclical
economic policy.

Discuss reasons why Keynesians and monetarists reject the classical dichotomy: because they
argue that prices are sticky. That is, they think prices fail to adjust in the short run, so that an
increase in the money supply raises aggregate demand and thus alters real macroeconomic
variables.
However, the post-Keynesians reject the classic dichotomy as well, emphasizing the role of
banks in creating money, as in monetary circuit theory.

Classical theories of growth and development

Analyzing the growth in the wealth of nations and advocating policies to promote such
growth was a major focus of most classical economists. However, John Stuart Mill believed
that a future stationary state of a constant population size and a constant stock of capital was
both inevitable, necessary and desirable for mankind to achieve. This is now known as a
steady-state economy.

20
Value theory

Classical economists developed a theory of value, or price, to investigate economic

dynamics.

William Petty introduced a fundamental distinction between market price and natural price to
facilitate the portrayal of regularities in prices.

• Market prices are jostled by many transient influences that are difficult to theorize about
at any abstract level. Market prices always tend toward natural prices in a process that
Smith described as somewhat similar to gravitational attraction.
• Natural prices, according to Petty, Smith, and Ricardo, for example, capture systematic
and persistent forces operating at a point in time.

The theory of what determined natural prices varied within the Classical school. Petty tried to
develop a par between land and labour and had what might be called a land-and-labour theory
of value. Smith confined the labour theory of value to a mythical pre-capitalist past. Others
may interpret Smith to have believed in value as derived from labour. He stated that natural
prices were the sum of natural rates of wages, profits (including interest on capital and wages
of superintendence) and rent. Ricardo also had what might be described as a cost of
production theory of value. He criticized Smith for describing rent as price-determining,
instead of price-determined, and saw the labour theory of value as a good approximation.

Some historians of economic thought, in particular, Sraffian, see the classical theory of prices
as determined from three givens:

1. The level of outputs at the level of Smith's "effectual demand",

2. Technology, and
3. Wages.

From these givens, one can rigorously derive a theory of value.

The Classical economists took the theory of the determinants of the level and growth of
population as part of Political Economy. Since then, the theory of population has been seen as
part of Demography.

21
In contrast to the Classical theory, the determinants of the neoclassical theory value:

1. tastes
2. technology, and
3. endowments

are seen as exogenous to neoclassical economics.

Classical economics tended to stress the benefits of trade. Its theory of value was largely
displaced by marginalist schools of thought which sees "use value" as deriving from
the marginal utility that consumers finds in a good, and "exchange value" (i.e. natural price)
as determined by the marginal opportunity- or disutility-cost of the inputs that make up the
product. Ironically, considering the attachment of many classical economists to the free
market, the largest school of economic thought that still adheres to classical form is
the Marxian school.

Monetary theory

Monetarists such as Nicholas Kaldor, and monetarists, such as Milton Friedman and
members of the currency school argued that banks can and should control the supply of
money. According to their theories, inflation is caused by banks issuing an excessive supply
of money. According to proponents of the theory of endogenous money, the supply of money
automatically adjusts to the demand, and banks can only control the terms (e.g., the rate of
interest) on which loans are made.

The Classical Theory of Interest

Introduction to Interest:

The classical theory of interest rate determination says that people save and let their saving be
loaned out to be used as capital for the purpose of investment, i.e., these people supply
capital. On the other hand, there are some people who borrow money on behalf of their firms
to be used as capital in their business, i.e., these people demand capital.

According to the classical theory, there is perfect competition in the capital market with a
large number of people that supply savings or capital and a large number of people that

22
demand capital. The rate of interest is determined in such a market through the interaction of
demand for and supply of capital.

Supply of Savings (or Capital):

The classical theory says that the supply of savings comes from the households. By
spend-ing less than their incomes, the households save, and because of their savings, a
portion of the national product may be used for investment purposes.

The amount of savings to be supplied depends upon the degree of abstinence and waiting
involved in the act of savings. Some classi-cal economists emphasised the role of time
preference as a determinant of the supply of sav-ings.

According to the classical theory, interest is the reward for abstinence and waiting and for the
preference in favour of future consumption. That is why the more the rate of interest, the
more the people would abstain from present consumption and the more would be the supply
of savings.

We may write, therefore, S = s(r),s’ > 0 (1)

Here S = aggregate saving of the economy

and r = rate of interest

hence equation (1) implies that S is an increasing function of r, i.e., as r increases or

decreases, s also increases or decreases, respectively.

Demand for Savings (or Capital):

According to the classical theory, demand for savings or capital at any particular rate of
inter-est (r), depends on the marginal productivity of capital. To obtain maximum profit, the
firms demand or use, at any particular r, that amount of capital (savings) at which the value of
marginal product of capital per period becomes equal to the marginal interest expenses per
period.
[Introduce here MEC]

23
Under the law of diminishing returns, the marginal product of capital diminishes as the firm
uses more of this factor. That is why the firm may demand more of capital only when the rate
of interest diminishes (to balance the fall in MPK). We may write, therefore,

i = i(r), i’ < 0 (2)

Here i = investment demand for savings, and r = rate of interest.

From (2) we obtain that i is a decreasing function of r, i.e., as r increases or decreases, i

decreases or increases, respectively.

The classical theory of interest states that the equilibrium rate of interest is one at which
the supply of savings become equal to the investment demand for savings. Therefore, the
third equation of this theory is

s(r) = i(r) (3)

Determination of the Equilibrium Rate of interest:

If we solve eqn. (3) for r, we would obtain the equilibrium value of the rate of interest and if
we put this value of r in eqns. (1) and (2), we would obtain the equilibrium values of s and i,
which would be equal to each other (s = i) in equilibrium.

eqns. (1) and (2) are called the behavioural equations, respectively, of the savers and the
investors, and eqn. (3) is called the equilibrium condition of the classical capital market.

Rate of Interest Determination in the Classical Theory

We shall now see how we may obtain the solution of the equation system (1)—(3) with the
help of Fig. 1.

24
In this figure, the s(r) curve is the supply curve of savings. This curve is the graph of the
saving function (1).

Since s is an increasing function of r, the slope of the s(r) curve is positive. We may know
from the s(r) curve what would be saving(s) of the economy at any particular rate of interest
(r). Since the slope of the s(r) is positive, s would increase (diminish) as r increases
(diminishes).

The i(r) curve, on the other hand, is the investment demand curve for savings. This curve is
the graph of the investment function (2). Since i is a decreasing function of r, the slope of the
i(r) curve is negative, i.e., i would diminish (increase) as r increases (diminishes). We may
know from the i(r) curve what would be the investment demand for savings (i) at any
particular rate of interest.

In Fig. 1, at r = r0, the supply of savings and the investment demand for savings have become
equal to each other. Therefore, here the equilibrium rate of interest has been r = r0 and the
equilibrium amounts of savings and investment have been s0 = i0.

Stability of Equilibrium:
We see in Fig. 1 that at r > r0, we would have s > s0 and i < i0. As a result, here the supply of
savings would be greater than demand for savings. Since there is perfect competition in the
classical capital market, r in this case would be diminishing owing to competition among the

25
savers over lending out their savings, till r comes down to its equilibrium level, r0, and,
conse-quently, the saving-investment equilibrium is restored.

On the other hand, at r < r0, we would have s < s0 and i > i0. As a result, here the investment
demand for savings would be greater than the supply of savings. Now, owing to competition
among the investors over getting the supply of capital, r would be increasing in the market till
r goes up to its equilibrium level, r0, and, consequently, the saving-investment balance is
restored.

We have seen in the above analysis that if the classical capital market is not in equilibrium,
then the savers and/or investors behave in such a way that the equilibrium is (soon) restored
in the market. That is why the equilibrium in the classical capital market is considered to be a
stable equilibrium.

Conditions for Stability of Equilibrium:

Here we have two behavioural assumptions. First, if s > i, then owing to competition among
the savers, r would fall. Second, if i > s, then owing to competition among the investors, r
would rise. Now, stability of equilibrium in the capital market requires that subject to these
two behavioural assumptions, s should be greater than i if r is greater than r0, and i would be
greater than s if r is less than r0.
The significance of these conditions is not difficult to understand. If s > i at r > r0, then owing
to the first behavioural assumption, r would decline and so it would be possible for r to
become equal to r0 subsequently, and for the system to come back to equilib-rium.

Similarly, if i > s at r < r0, then owing to the second behavioural assumption, r would
increase and so it would be possible for r to become equal to r0 subsequently, and it would be
possible for the market to come back to equilibrium.

We have derived above the conditions for stability of equilibrium in the capital market. It is
evident that these conditions would be satisfied if the s(r) curve is positively sloped and the i
(r) curve is negatively sloped. That is why the equilibrium shown in Fig. 1 is a stable
equilibrium.

26
Full Employment Equilibrium:
We have to note here that the saving-investment equilibrium in the classical capital market
implies the demand-supply equilibrium in the goods market.

(Check Keynesian Full Employment. Compare with Classical thoughts)

For, the saving-investment equi-librium implies that the value the savers save is equal to
the value the investors invest, i.e., the goods and services (worth that value) that the savers
would not purchase, would be purchased and used by the investors for investment purposes,
which in its turn implies goods market equilibrium. In other words, eqn. (.3) is the classical
capital market equilibrium condition as well as the goods market equilibrium condition.

Now, the classical economists thought that there is perfect competition in the market for each
good and service. Because of this, there would occur no problem of oversupply in the market
for any good or service. For if, in any market, sellers are not able to sell what they are willing
to sell, then the price would come down to make the necessary demand-supply adjust-ment.

Therefore, under perfect competition, there would be full utilisation and employment of the
economy’s state of technology and resources, and, people’s willingness to work. As a result,
the national production would be in equilibrium at the maximum possible level.

In these circumstances, if there is saving = investment equilibrium in the capital market

implying de-mand = supply equilibrium in the goods market, then there would be no problem
of deficient demand or excess demand in the latter market, and there would be no harm to full
employment equilibrium in the economy.

Therefore, (subject to other assumptions), the existence of saving-investment equilibrium in

the capital market is also the condition for full employment equilibrium in classical macro-
economy.

Classical economists explained that real variables such as GNP, employment, real wage rate

are determined by real factors such as stock of capital, the state of technology, marginal
physical product of labour, households’ preferences regarding work and leisure.

27
In the classical model based on flexibility of prices and wages, changes in money supply only

affect the price level and nominal magnitudes (i.e. money wages, nominal interest rate, while

the real variables such as levels of labour employment and output, saving and investment,

real wages, real rate of interest remain unaffected. This independence of real variables from

changes in money supply and nominal variables is called classical dichotomy.

The neutrality of money can be graphically illustrated with the help Fig. 3.7 and 3.8. Suppose
to begin with, the stock of money in the economy is equal to M0. With this, as will be seen

from Panel (d) of Figure 3.7, aggregate demand curve for output is AD0 which with

interaction with aggregate supply curve AS determines price level P0. Given the price level

P0, labour-market equilibrium determines money wage rate W0 and real wage rate equal to

W0 / P0 and level of employment NF in Panel (a) of Fig. 3.7. The level of employment

NFgiven the production function, determines aggregate output YF. in Panel (b) of Fig. 3.7.

Now suppose there is expansion in money supply from M0 to M1 which causes an upward

shift in the aggregate demand curve from AD0 to AD1 [see Panel (d) of Fig. 3.7], As a result

of this upward shift in the aggregate demand curve from AD0 to AD1 price level rises from

28
P0 to P1 Now, as will be seen from Panel (a) of Fig. 3.7, with money wage rate W0 and price

level equal to P1, real wage rate falls to W0/ P1

at which demand for labour exceeds supply of labour. This will cause, according to classical

theory, money wage rate to rise to W1 in equal proportion to the rise in price level so that real

wage is restored to the original level (W1/P1 = W0/P0) and labour-market equilibrium

determines the original level of employment N1.

With the same level of labour employment aggregate output (i.e. GNP) will not be affected.

Thus, we see that with the expansion in money supply, nominal wage rate and price level

have risen, but real wage rate, level of employment and output remain constant. Hence it

shows that money is neutral in its effect on real variables.

Critical Evaluation of the Classical Theory:

Economists have pointed out some defects of the classical theory of interest:
(i) The classical economists thought that interest is a real phenomenon. For, according to
them, the rate of interest depends on some real factors only.

(ii) It has been assumed in the classical theory that there is full employment in the economy.
Therefore, if the producers increase capital goods production, then the output of consumer
goods would have to decrease, i.e., the households would have to abstain from present
con-sumption, i.e., the households would have to save some portion of their income—they
cannot spend all their income on consumption.

As a reward for this, the households should get interest. So far the classical theory’s
contention is correct. But if a situation of less than full employment prevails in the economy
as it does in many countries, then the classical theory cannot explain why there should be
interest.

For, if there are unemployed resources in the economy, then these may be utilised in the
production of capital goods without hampering the production of con-sumer goods. The

29
households in this case are not required to abstain from present consump-tion, and the
question of giving them any reward in the form of interest does not arise.

(iii) Keynes has told us about another major defect of the classical theory. The classical
theory assumes that saving (s) is a function of the rate of interest (r) [eqn (1)]. But, according
to Keynes, although saving depends on the rate of interest, saving is more dependent on
income.

If incomes of households and the income of the country in aggregate increase or decrease,
then the savings of the households or the saving of the country in aggre-gate, also increase or
decrease. Therefore, in place of (1), we should write

where s = aggregate saving of the economy, y = level of the economy’s income

and r = rate of interest.

Now, as Keynes has said, saving depends on the rate of interest as also on income, then, in
order to know the position of the s(r) curve or function in Fig. 1, we have to know the level of
income (y) of the country.

Again, in order to know y, we have to know the level of investment and in order to know i,
we have to know the rate of interest (r), for i = i (r) [eqn (2)].

Therefore, Keynes has said that while going to determine r in classical theory, we have to
know r beforehand. In other words, according to Keynes, the classical interest theory is
indeterminate—this theory cannot determine a unique interest rate.

Quantity Theory of Money

The theory points out that there is a direct relationship between the money supply and the
general price level in an economy. However, the basic identity underlying the quantity theory
was first developed by the great American economist Irving Fisher in 1911.

30
The Fisher equation — known as the quantity equation of exchange — is expressed as:

MV = PT
However, the identity can be converted into testable equation by assuming that the velocity of
circulation (V) and the volume of transactions (T) remain unchanged in the short run. This
assumption makes enormous good sense. V depends on people’s spending behaviour.

Cambridge economists like Alfred Marshall and A.C. Pigou reformulated the traditional
quantity theory of money to emphasise the relationship between the stock of money in an
economy (M) and national income (Y).

The income velocity of circulation in the Cambridge equation is expressed as follows:

V = Y/M …

Here V is the average number of times the stock of money of an economy changes hands in
financing the purchase of goods and services. A simple example-will make the point clear.
We denote GNP by Y. Thus, if a country has a GNP of Ksh. 5,000 and an average stock of
money (M) over a year is Ksh. 1,000 then V is 5.

Inflation is caused by an increase in money supply, with all other things remaining
unchanged. Thus, the quantity theory explains inflation from the demand side. If M rises the
aggregate demand for goods and services will also increase. So, too much money will be
changing too few goods and the general price level will rise.

With V and T fixed, the price level is determined by the stock of money (M). Any increase in
the supply of money immediately leads to an increase in the demand for goods and services
(aggregate demand). It therefore follows that if the supply of M and hence aggregate demand
increase over time faster than the supply (preservation) capacity of the economy (T), the
result will be a rise in the general price level, P (inflation).

Work:
Use quantitative Theory of Money and show how it causes Inflation

Criticisms of the Quantity Theory of Money:

31
The Quantity Theory of Money has been subjected to many criticisms.

The important criticisms are stated below:

1. Truism:
Fisher’s Equation is a truism. All that it states is that the means of payment (MV) must equal
the total payments actually made (PT).

2. Inactive Balance:
There are always inactive balances in an economy. Under Fisher’s formula, the price level
depends upon the total quantity of money. But it is only a part of the total quantity of money
which influences prices. There always exist inactive balances (hoards) which exert no pres-
sure at all on the prices of goods and services. This is clearly seen during depression.

3. Unrealistic Assumption:
The theory is based on unrealistic assumptions. The quantity equation cannot be used for
analysing the effects of changes in M, or T, on the price level except on the assumption that,
“other things remain constant”.

But in the case of monetary variables such an assumption cannot be made. When M changes,
T and V both change. When T changes, M and V change. The net effect on the price level of
a change in any of the variables of the quantity equation depends on how the other variables
are simultaneously changed.

4. Lack of Dynamism:
The quantity equation does not show the process through which changes in the amount of
money affect the price level. Keynes put great emphasis on the objection against the quantity
equation. He observed that, “The fundamental problem of monetary theory is not merely
to establish identities or statistical relations, but to treat the problem dynamically,
analysing the different elements involved in such a manner as to exhibit the causal
processes by which the price level is determined and the method of transition from one
position of equilibrium to another.”

5. Full Employment:
The theory is based on the assumption of full employment. Increase in the quantity of money
does not always increase prices. If there are unemployed resources an increase of money
supply creates employment and does not raise prices.

32
As Keynes points out the quantity theory is based on the assumption of full employment. He
has pointed out that the quantity theory is inapplicable to a country which has unemployed
resources.

In such a country creation of more money will lead to more employment and greater
production (greater supply of goods) and no change in the price level. Prices will change in
proportion to money supply only when there is no scope for increasing production, i.e., when
there are no unemployed resources in the economy.

6. Interrelationship among Variables:

Critics argued that all the factors in the equation of exchange are variables and statistical
studies have shown that they are interrelated. Moreover, the line of causation is not always
from M (money supply) to P (the price level).

It may be from V to P. A change in the rate of spending, all the other factors remaining the
same, will result in a change in prices just as surely as would a change in the quantity of
money in circulation. Or a change in T, other things remaining the same, will cause a change
in prices.

So, it is difficult to accept the unqualified theory that changes in the quantity of money are
always the causes of changes in the price level. Studies have shown that the price level
cannot be easily and quickly controlled by changing the amount of money and credit
available for the purchase of goods and services.

The value of money determines the quantity of money. According to quantity theory, an
increase in the supply of goods or T will cause a fall in the price level P. But under the
present monetary and banking practices, an increase in the supply of goods almost always
leads to an increase in the supply of money (through creation of credit and otherwise).

Therefore M depends on T; they are not independent variables. If this view is correct, the
value of money is not determined by its quantity; on the contrary it is the value of money
which determines its quantity.

As Crowther comments, “The modern tendency in economic thinking, in fact, is to

discard the old notion of the quantity of money as a causative factor in the state of
business and a determinant of the value of money and to regard it as a consequence”.

33
The Concept of Market Failure
The general term market failure is used to refer to situations in which the market, absent
government intervention, leads to inefficiencies (specifically, losses in wealth, or
KaldorHicks inefficiencies).
There is an ambiguity in the term market failure. We usually evaluate efficiency relative to
the perfectly competitive benchmark, because we know PC exhausts all opportunities for gain
without any dead weight. The problem, of course, is that PC may be unattainable. If that's so,
then by condemning a situation for failing to meet that benchmark, we're committing the
Nirvana Fallacy. The Nirvana Fallacy is the error of condemning a situation because it fails to
meet an impossible ideal. So it's important to remember, when using the term market failure,
that complete success may not be an option. A "failure" may still be the best of all possible
worlds. To reach reasonable policy conclusions, it's necessary to engage in comparative
institutional analysis, which looks at all the different options (market, various forms of
government intervention) and compares them warts and all.

Imperfect Competition
As we've discussed extensively in previous sections, imperfect competition creates
inefficiency (dead weight loss) relative to perfect competition. In general, the DWL results
from price being set greater than marginal cost. The usual remedy proposed for imperfect
competition is antitrust regulation, under which the government prohibits and punishes
cartelization and price setting, and sometimes even breaks up monopolies. Of course, in
making the decision about whether to inhibit greater concentration in an industry, the
government considers (or should consider) the countervailing factors we talked about earlier -
- specifically, that greater concentration may allow greater economies of scale. In addition,
our discussion of game theory and strategic behavior indicates that collusion, when it occurs,
is likely to be a transitory phenomenon.

Externalities
An externality is a cost or benefit for a party not directly involved in a transaction.
Externalities can be negative, if a cost is imposed on a third party, or positive, if a benefit is
accrued by a third party. The prototypical negative externality is pollution, such as smoke
emitted into the air or sewage poured into the water. To an economist, using air and water in
this way is not necessarily a bad thing. So the question to an economist is whether these

34
resources are being used optimally. To assure optimal usage of a resource, it must be the case
that a price is paid for it that covers its opportunity cost.

When there is a factor of production that the firm does not have to pay for, that means the
market supply curve does not represent the full marginal cost of production. (Remember that
the firm's short-run supply curve is actually the same as its MC, so long as the price is high
enough for the firm not to shut down.) We must therefore distinguish between private cost (as
reflected in the market supply curve) and social cost.

In general, social cost = private cost + external cost. As with any other type of input cost, we
are most concerned with its marginal effect. So we can also say, marginal social cost =
marginal private cost + marginal external cost MSC = MPC + MEC In general, the MPC is
represented by the market supply curve. The MSC curve lies above the supply curve,
representing the addition of external costs. MSC

S = MPC

Pmkt

P Pmkt

35
 GAME THEORY
Game Theory is the formal study of strategic interaction. In a strategic setting the actions of
several agents are interdependent. Each agent’s outcome depends not only on his actions, but
also on the actions of other agents. How to predict opponents’ play and respond optimally?

Game theory is concerned with predicting the outcome of games of strategy in which the
participants (for example two or more businesses competing in a market) have incomplete
information about the others' intentions
Game Theory is the study of optimal decision making under competition when one
individual’s decisions affect the outcome of a situation for all other individuals involved

Most modern economic research includes game theoretical elements. Eleven game theorists
have won the economics Nobel Prize so far.
▪ Cournot (1838): quantity setting duopoly
▪ Zermelo (1913): backward induction
▪ Von Neumann (1928), Borel (1938), and Morgenstern (1944): zero-sum games
▪ Flood and Dresher (1950): experiments
▪ Nash (1950): equilibrium
▪ Selten (1965): dynamic games
▪ Harsanyi (1967): incomplete information
▪ Akerlof (1970), Spence (1973): first applications
▪ 1980s boom, continuing nowadays: repeated games, bargaining, reputation, equilibrium
refinements, industrial organization, contract theory, mechanism/market design
▪ 1990s: parallel development of behavioral economics
▪ More recently: applications to computer science, political science, psychology,
evolutionary biology

Key Elements of a Game

A game: an interaction between two or more players (decision makers). The model includes
the constraints on actions that players can take and the players’ interests, but does not specify
the actions that the players do take.
Players: Who is interacting?

36
The models we study assume that decision-makers are "rational" in the sense that they are
aware of their alternatives, form expectations about any unknowns, have clear preferences,
and choose their action deliberately after some process of optimization. In our case, the
preference of all "rational" players is to maximize their own payoff.
Action: The set of available actions essentially defines the rules of the game, what the players
are allowed to do (all the rest is not allowed and thus not explicitly stated).
Strategies: What are the options of each player? In what order do players act?
Payoffs (utilities): How do strategies translate into outcomes? What are players’ preferences
over possible outcomes?
This reflects an Ordinal (qualitative) point of view where we look at the payoff as a measure
to what outcome we prefer more or less. In a Cardinal (quantitative) point of view there is
also a measure of how much more or less do we prefer a certain outcome
Information/Beliefs: What do players know/believe about the situation and about one
another? What actions do they observe before making decisions?
Rationality: How do players think?

Introduction

Competition situation exists when two or more individuals are making decisions in a situation that

involves conflicting interests and in which the outcome is controlled by the decisions of all the parties

concerned. In a competitive business world, the relevant problems of the executive are to study or at

least guess the activities or actions of his competitor. The experience with the behaviour makes it

possible to predict competitor’s strategies.

While Theodore and Stengel (2001) define game theory as the formal study of decision-

making where several players must make choices that potentially affect the interests of the

other players, McNulty (2008) defines game theory as the process of modeling the strategic

interaction between two or more players in a situation containing set rules and outcomes. The

author intones that the economic application of game theory is a valuable tool to aide in the

fundamental analysis of industries, sectors and any strategic interaction between two or more

37
firms. Any time we have a situation with two or more players that involves known payouts or

quantifiable consequences, we can use game theory to help determine the most likely

outcomes. To fully understand a competitive situation, McNulty, therefore defines the

following terms as used in a competitive situation:

• Game: Any set of circumstances that has a result dependent on the actions of two of

more decision makers ("players")

• Players: A strategic decision maker within the context of the game

• Strategy: A complete plan of action a player will take given the set of circumstances

that might arise within the game

• Payoff: The payout a player receives from arriving at a particular outcome. The

payout can be in any quantifiable form, from dollars to utility.

• Information Set: The information available at a given point in the game. The term

information set is most usually applied when the game has a sequential component.

• Equilibrium: The point in a game where both players have made their decisions and

an outcome is reached.

Assumptions

In order for the theory of games to hold, McNulty highlight the following assumptions and

characteristics must hold for all competitive situations:

✓ Rationality. All players will select a strategy that will maximize his pay-off

✓ For each competitor, there are finite number of possible courses of action (alternative

strategies)

✓ The interest of each other is conflicting in nature

38
✓ The outcome of all the combinations of course of action is associated with: positive,

negative, or zero benefit. Thus after each play of the game, loosing player pays to the

winning player an amount determined by the course of action chosen.

✓ The rules governing the choice of action are known to all competitors. The choice of

actions are assumed to be made simultaneously, so that none known knows the opponents

choice till he has selected his own course of action.

✓ The assumption of maximization i.e. It is assumed that players within the game are

rational and will strive to maximize their payoffs in the game.

✓ The number of players (competitors) in a game can theoretically be infinite, but most

games will be put into the context (finite). One of the simplest games is a sequential game

involving two players.

Types of games

Cooperative / Non-cooperative

A game is cooperative if the players are able to form binding commitments. For instance, the

legal system requires them to adhere to their promises. In non-cooperative games, this is not

possible. Often it is assumed that communication among players is allowed in cooperative

games, but not in non-cooperative ones. However, this classification on two binary criteria

has been questioned, and sometimes rejected (Harsanyi 1974).

Of the two types of games, non-cooperative games are able to model situations to the finest

details, producing accurate results. Cooperative games focus on the game at large.

Considerable efforts have been made to link the two approaches. The so-called Nash-

programme (Nash program is the research agenda for investigating on the one hand axiomatic

bargaining solutions and on the other hand the equilibrium outcomes of strategic bargaining

39
procedures) has already established many of the cooperative solutions as non-cooperative

equilibria.

Hybrid games contain cooperative and non-cooperative elements. For instance, coalitions of

players are formed in a cooperative game, but these play in a non-cooperative fashion.

Symmetric / Asymmetric

A symmetric game is a game where the payoffs for playing E F

a particular strategy depend only on the other strategies E 1, 2 0, 0
employed, not on who is playing them. If the identities of F 0, 0 1, 2

the players can be changed without changing the payoff to An asymmetric game

the strategies, then a game is symmetric. Many of the commonly studied 2×2 games are

symmetric.

The standard representations of chicken, the prisoner's dilemma, and the stag hunt are all

symmetric games. Some scholars would consider certain asymmetric games as examples of

these games as well. However, the most common payoffs for each of these games are

symmetric.

Most commonly studied asymmetric games are games where there are not identical strategy

sets for both players. For instance, the ultimatum game and similarly the dictator game have

different strategies for each player. It is possible, however, for a game to have identical

strategies for both players, yet be asymmetric. For example, the game pictured to the right is

asymmetric despite having identical strategy sets for both players.

40
Zero-sum / Non-zero-sum

Zero-sum games are a special case of constant-sum games, in which A B

choices by players can neither increase nor decrease the available
A –1, 1 3, –3
resources. In zero-sum games the total benefit to all players in the

game, for every combination of strategies, always adds to zero (more B 0, 0 –2, 2

informally, a player benefits only at the equal expense of others).

A zero-sum game
Poker exemplifies a zero-sum game (ignoring the possibility of the

house's cut), because one wins exactly the amount one's opponents lose. Other zero-sum

games include matching pennies and most classical board games including Go and chess.

Many games studied by game theorists (including the infamous prisoner's dilemma) are non-

zero-sum games, because the outcome has net results greater or less than zero. Informally, in

non-zero-sum games, a gain by one player does not necessarily correspond with a loss by

another.

Constant-sum games correspond to activities like theft and gambling, but not to the

fundamental economic situation in which there are potential gains from trade. It is possible to

transform any game into a (possibly asymmetric) zero-sum game by adding a dummy player

(often called "the board") whose losses compensate the players' net winnings.

Simultaneous / Sequential

According to McNulty (2008), simultaneous games are games where both players move

simultaneously, or if they do not move simultaneously, the later players are unaware of the

earlier players' actions (making them effectively simultaneous). Sequential games (or dynamic

games) however, are games where later players have some knowledge about earlier actions.

This need not be perfect information about every action of earlier players; it might be very

41
little knowledge. For instance, a player may know that an earlier player did not perform one

particular action, while he does not know which of the other available actions the first player

actually performed.

For example, in a game of two companies that could include product release scenarios. If

Company 1 wanted to release a product, what might Company 2 do in response? Will

Company 2 release a similar competing product? Below is an altar-example of how such a

game cam be modeled.

Figure 1: Solving Sequential Games (Adopted from McNulty, 2008)

In the above figure, the labels with company one and two within them are their information

respectively. The numbers in the parentheses at the bottom of the tree are the payoffs at each

respective point, in the format (Player 1, Player 2). The game is also sequential, so company

1 makes the first decision (left or right) and company 2 makes its decision after company 1.

An important subset of sequential games consists of games of perfect information. A game is

one of perfect information if all players know the moves previously made by all other

players. (Leyton-Brown & Shoham 2008). Thus, only sequential games can be games of

perfect information because players in simultaneous games do not know the actions of the

other players. Most games studied in game theory are imperfect-information games.

42
Recreational games of perfect information games include chess. However, many card games

are games of imperfect information, such as poker or contract bridge.

Perfect information is often confused with complete information, which is a similar concept.

Complete information requires that every player know the strategies and payoffs available to

the other players but not necessarily the actions taken. Games of incomplete information can

be reduced, however, to games of imperfect information by introducing "moves by nature" as

Leyton-Brown & Shoham (2008) intones.

Combinatorial games

Games in which the difficulty of finding an optimal strategy stems from the multiplicity of

possible moves are called combinatorial games. Example is a game of chess. Games that

involve imperfect or incomplete information may also have a strong combinatorial character.

According to Picardo (2013), there is no unified theory addressing combinatorial elements in

games. Games of perfect information have been studied in combinatorial game theory, which

has developed novel representations, e.g. surreal numbers, as well as combinatorial and

algebraic (and sometimes non-constructive) proof methods to solve games of certain types,

including "loopy" games that may result in infinitely long sequences of moves.

According to Picardo, research in artificial intelligence has addressed both perfect and

imperfect (or incomplete) information games that have very complex combinatorial structures

for which no provable optimal strategies have been found. The practical solutions involve

computational heuristics, like alpha-beta pruning or use of artificial neural networks trained

by reinforcement learning, which make games more tractable in computing practice

43
Infinitely long games

Games, as studied by economists and real-world game players, are generally finished in

finitely many moves. Pure mathematicians are not so constrained, and set theorists in

particular study games that last for infinitely many moves, with the winner (or other payoff)

not known until after all those moves are completed.

The focus of attention is usually not so much on what is the best way to play such a game, but

simply on whether one or the other player has a winning strategy. (It can be proven, using the

axiom of choice, that there are games – even with perfect information and where the only

outcomes are "win" or "lose" – for which neither player has a winning strategy.) The

existence of such strategies, for cleverly designed games, has important consequences in

descriptive set theory.

Discrete and continuous games

Much of game theory is concerned with finite, discrete games, which have a finite number of

players, moves, events, outcomes, etc. Many concepts can be extended, however. Continuous

games allow players to choose a strategy from a continuous strategy set. For instance,

Cournot competition is typically modeled with players' strategies being any non-negative

quantities, including fractional quantities.

Differential games

Differential games such as the continuous pursuit and evasion game are continuous games

where the evolution of the players' state variables is governed by differential equations. The

problem of finding an optimal strategy in a differential game is closely related to the optimal

control theory. In particular, there are two types of strategies: the open-loop strategies are

44
found using the Pontryagin maximum principle while the closed-loop strategies are found

using Bellman's Dynamic Programming method.

A particular case of differential games are the games with a random time horizon. In such

games, the terminal time is a random variable with a given probability distribution function.

Therefore, the players maximize the mathematical expectation of the cost function. It was

shown that the modified optimization problem can be reformulated as a discounted

differential game over an infinite time interval.

According to Kothari (2009), a strategy, as used in game theory referring to total patterns of

choices employed by any player, can either be: Pure or Mixed strategy. Pure strategy is when

the player plays one row or (column) all the time. That is there exists a unique strategy that

maximizes pay off for both players. In a mixed strategy, player X will play each of his rows a

certain portion of the time, and player Y plays each of his columns a certain proportion of the

time. In addition, Kothari asserts that the value of the game is determined by examining

SADDLE point of the given game strategies.

A saddle point in a pay – off matrix occurs where the smallest value in its row and the largest

value in its column intersect. This is an equilibrium point for the game (strategy).

Player Y This means that the value of the game

0 10 -30 is 5 in favour of player X. hence the optimal

Player 15 0 -10 strategies for both players X and Y are

X 35 12 5 strategies (iii)

45
In his article, Ratliff (1997) pens off by saying that if every player plays a pure strategy, then

the payoffs to all players are deterministic—there is no uncertainty concerning the payoffs

resulting from a specified pure-strategy profile.

Mixed strategies

A game in strategic form does not always have a Nash equilibrium in which each player

deterministically chooses one of his strategies. However, players may instead randomly select

from among these pure strategies with certain probabilities (Theodore and Stengel, 2001).

Randomizing one’s own choice in this way is called a mixed strategy. According to Theodore

and Stengel, Nash showed in 1951 that any finite strategic-form game has an equilibrium if

mixed strategies are allowed. As before, an equilibrium is defined by a (possibly mixed)

strategy for each player where no player can gain on average by unilateral deviation. Average

(that is, expected) payoffs must be considered because the outcome of the game may be

random.

However, as Theodore and Stengel (2001) acknowledge, it is not easy, neither is it always

that there will be a saddle point for a particular game. Such are a mixed strategy game. In

order to find a solution to a mixed strategy game, Von Neumann introduced the concept of

Mini – Max Theorem which states thus:

“If the set of possible strategies of the players is extended beyond pure strategy to
include all the possible mixed strategies, there is always some mixed strategy for
player A whose minimum pay – off is bigger than any other, and there is always some
mixed strategy for player B whose minimum pay – off is smaller than any others, and
those pay – offs are equal in value”

According to Kothari, such mixed strategy dilemma can be solved by three different methods:

algebraically (probability), graphically, and or by Linear programming simplex method.

46
As Ratliff (1997) intones, in a mixed strategy, randomize over the set of available actions

according to some probability distribution. The author further asserts that in a mixed strategy,

option for player X is a probability distribution over player Ys pure-strategy choices.

Illustration:

Find the optimum strategies and the value of the game from the following pay – off matrix

concerning a two-person game:

Player Y

1 4

Player X 5 3

Steps:

i. Subtract the smaller pay – off in each row row/ column from the larger one
ii. Interchange each of these pairs subtracted numbers found in step I above
iii. Put each of the interchanged numbers over the sum of the pairs of numbers
iv. Now determine the value of the game thus:

Player Y
1 4 2/5
Player
X 5 3 3/5
1/5 4/5
Thus looking at the game from player X point, the value (V) of the game is:

1 2 3 4 2 3 17
V = 5 {(1)(5) +5(5) + 5 4(5) + 3(5) = 5

17
→ This implies that player X expects to win an average pay – off of points for each play
5

47
The least intuitive aspect of mixed equilibrium is that the probabilities depend on the

opponent’s payoffs and not on the player’s own payoffs (as long as the qualitative preference

structure, represented by the arrows, remains intact).

Rule of Dominance

Dominating row or column may be deleted which reduces the size of the game. Kothari

advices that always look for dominance whenever solving the value of the game.

Illustration:

Player Y

6 3 -1 0 -3

Player X 3 2 -4 2 -1

From player Y point, he chooses NOT to play columns 1, 2, and 4, since columns 3 and 5

offers a better alternative irrespective of the actions by X. hence columns 1,2 and 4 are

dominated by columns 3 and 5; hence would never be played by player Y.

Then the game can be reduced to:

Player Y Then the optimum strategies and the value

of the game can easily be determined as
Player X -1 -3
per the method illustrated above
-4 -1 −11
V= 5

Game theory has been used in business and industry to develop bidding tactics, pricing

policies, advertising strategies, and timing of the introduction of new models into the market.

48
The theory provides the basis of rational decision making and thus improves the quality of

decision-making process. In spite of all these, Kothari however, intones that game theory

suffers certain limitations and this question its practicality in real life situation:

a) Businessmen do not have all the knowledge required by the theory of games. They do not

even know all the strategies opened to them

b) There is a great deal of uncertainties involved in the outcome

c) The technique of solving, especially when larger pay – offs are involved is more complex

lessening the significance of this analysis

d) The market in which managerial decisions are taken is never a two – person situation

e) To convert precisely monetary pay – offs for the matrix game in real life decision

situation is extremely difficult

Conclusion

A strategic-form game is determined by a set of players, a pure-strategy space for each

player, and a von Neumann-Morgenstern utility function for each player, the arguments of

which are the pure strategies chosen by all the players. Such games can be conveniently

represented by a matrix which includes a side for each player and whose cells contain payoff

vectors.

Rational players choose actions which maximize their expected utility given their beliefs

about the actions of their opponents. There exists the problem of what choice a rational player

would make given her beliefs about the choices of her opponents, determination of each

player’s pure-strategy best response(s) to the pure-strategy choices of her opponents. Then

expanded the set of choices available to the players by introducing mixed strategies, which

are probability distributions over pure strategies. We saw that mixed strategies are members

of a unit simplex and that pure strategies are degenerate mixed strategies.

49
The players’ expected payoffs were calculated to arbitrary mixed-strategy profiles by

weighting the payoffs to pure-strategy profiles by the probability that each pure-strategy

profile would be realized by the players’ independent randomizations.

50
 Industrial organization

A complete account of Industrial Organization can be found in Schumpeter (1958). Cournot (1838)
was the first in proposing a solution concept to determine market prices under oligopolistic
interaction.
Cournot proposes that the price arising in the market will be determined by the interplay of aggregate
supply and demand. Also, such a price will be an equilibrium price when every producer’s production
decision maximizes its profits conditional on the expectation over the production of the rival.

It is worth noting that this equilibrium involves a price above the marginal cost of production.
This concept of equilibrium is what Nash (1950) proposed as solution of a non-cooperative
game when we consider quantities as strategic variables.

Cournot tackles the case of complementary products. Interestingly enough he assumed in this
case that producers would choose prices and applied the same solution concept, (Nash
equilibrium) with prices as strategic variables. In this case, the equilibrium price is larger than
the monopoly price.

Porter’s 5 -forces of industry Analysis: A competitive strategy model

Distinctive, sustainable competitive advantage grows out of securing a better position with
respect to five structural variables that characterize an industry: threat of entry, intensity of
rivalry, power of suppliers, power of buyers, and availability of substitutes. Above-average
returns, then, can be achieved by sustaining an advantage in one or more of the structural
variables.

Threat of Entry
New entrants bring new capacity resources, and need for market share, placing pressure on
industry prices and profitability. If barriers to entry are high, newcomers are less likely to
enter. Economies of scale are an example of an entry barrier. They require a newcomer to
enter at large scale and risk strong reaction from existing firms or to enter on a smaller scale
at a cost disadvantage. Firms protect themselves by maintaining high entry barriers.

51
Intensity Of Rivalry
Rivalry is the jockeying for position that firms do using tactics such as price competition,
marketing skirmishes, increased warranties, or customer service. These tactics raise costs and
invite retaliation. Intense rivalry is common where there are numerous firms of equal size,
slow industry growth, or a lack of competitor differentiation. By encouraging low levels of
rivalry, firms stabilize the industry and protect their positions.

Power Of Buyers
Buyers may force down prices or bargain for more services by playing competitors against
one another at the expense of industry profitability. A buyer group is powerful if the
products/services it purchases are standard or undifferentiated, the buyers' group itself earns
low profits, or the buyer has full information about the sellers' costs. Firms should act to
avoid powerful buyers when possible.

Power Of Suppliers
Suppliers can exert pressure for higher prices or a reduction in quality. Both may squeeze
profits if firms cannot raise prices to cover these cost increases. Suppliers are powerful if the
suppliers' industry is more concentrated than that of the buyers, there are no substitutes, or the
suppliers' product/service is vital to the buyer. Access to weak suppliers usually is preferable.

Availability Of Substitutes
Substitutes limit the prices for products/services that firms can charge, thereby limiting
profitability. The more attractive the price/performance alternative, the firmer the ceiling.
New competitors may offer some customer services as loss leaders to encourage substitution.
Such actions both reduce industry margins and increase rivalry.
Assignment:
For an industry of your choice:
a) Offer a brief outline of the industry
b) Determine employment rate vs the actual employed in the industry
c) Number of establishments in the industry
d) Industry classification by sub – sectors
e) Domestic industry output
f) Analyse the industry using Porters 5 – Forces and offer economic policy turn around
interventions

52
 g)

Variations of prices and welfare

Variations in the economic environment (i.e price changes, taxes, etc) give rise to variations
in the consumers’ welfare. Thus, it is reasonable to try to obtain quantitative estimations of
those changes in prices and welfare with clear economic interpretations.

The classic and most used measure of welfare variation is the consumer surplus. The problem
with this measure is that it is precise only in the special case of quasilinear preferences. En
general, consumer surplus only gives an approximation of the impact on welfare of a
variation of some basic magnitude of the economy.

Consumer surplus refers to the value that consumers derive from purchasing a good.
For example, if you would be willing to spend Ksh.100 on a good, but you are able to
purchase it for just Ksh. 70, your consumer surplus from the transaction is Ksh.30. meaning
the consumer is getting Ksh.30 more value from the good than it cost.
Consumer surplus = maximum price (consumers are willing to pay) – actual price

EXAMPLE:

The following chart shows the perfectly competitive market for a good X. The market is
in equilibrium at the price PE and the quantity QE. As we know, the demand curve
indicates consumers’ willingness to pay. The amount that consumers actually are paying
is PE — the equilibrium market price for the good. Therefore, for each transaction that
occurs up to QE, consumer surplus is achieved in an amount equal to the distance
between the demand curve and PE. As a result, the shaded area in the chart indicates the
total consumer surplus achieved in the orange market.

53
 Consumer and Producer Surplus in Perfect Competition

To calculate the total consumer surplus achieved in the market, we would want to
calculate the area of the shaded. If you think back to geometry class, you will recall that
the formula for area of a triangle is ½ x base x height. In this case, the base of the
triangle is the equilibrium quantity (QE). And the height of the triangle is the amount by
which the y-intercept of the demand curve (i.e., the price at which quantity demanded is
zero) exceeds the equilibrium price (PE).

“Total surplus” refers to the sum of consumer surplus and producer surplus. Total
surplus is maximized in perfect competition because free-market equilibrium is reached.
That is, if a quantity less than the free-market equilibrium quantity were transacted,
total surplus would be less, because there would be beneficial transactions that are
failing to occur (i.e., transactions where consumers’ willingness to pay is greater than the
lowest price suppliers are willing to accept). And if a quantity greater than the free-
market equilibrium quantity were transacted, total surplus would be less, because
transactions that cost more to producers than consumers would be willing to pay would
occur.

Consumer surplus is usually at zero level when the demand for goods and services exhibits
perfect elasticity. This is because consumers are more willing to match the prices asked for
different goods and services
When demand is perfectly inelastic, consumer surplus becomes infinite. This is because the
demand for goods and services is not affected by the price change. This means that whatever
the pricing, the demanded quantity remains constant. A good example of these types

54
of products is life-saving products e.g. medicines that have no substitutes; Consumers’
willingness to pay for these products is extremely high since they do not have an alternative.

Definitions
A price index measures the impact on the welfare level following a price variation

R
This index measures the cost of the bundle x at prices p1 with respect to the cost of this
very bundle at prices p0 . The relevance of the index thus obtained depends on how
representative is the bundle xR in the economy.

𝑃1
Formally, the consumer surplus by the function: ∫𝑃0 𝑋(𝑡) 𝑑𝑡

max x1;x2 u (x1; x2)

s.t: p1x1 + p2x2 ≤ M
solve using Lagrangean function

Constrained Optimisation - Solutions

1. Using the substitution method, optimise x + 2 xy subject to 2 x + 4 y = 100

Objective function: x + 2 xy constraint: 2 x + 4 y = 100

The substitution method:
Step 1: from the constraint…..
2 x = 100 − 4 y
x = 50 − 2 y

Step 2: substitute in this value of x into the objective function

f = x + 2 xy
f = 50 − 2 y + 2(50 − 2 y )y
f = 50 − 2 y + 100 y − 4 y 2
f = 50 + 98 y − 4 y 2

55
Step 3: Now the objective function as a function of one variable, while constraining the
value of x to being equal to x = 50 – 2y . So optimise this function with respect to y
to find the value of y at the stationary point
df
First Order Condition: = 98 − 8 y = 0
dy
8 y = 98 , y = 12.25
d2 f
Second Order Condition: = −8  0 so maximum at y = 12.25
dy 2

Step 4: Substitute in this value of y into the constraint function to find the value of x

x = 50 − 2 y = 50 − 2(12.25) = 25.5
Solution: maximum where x = 25.5 , y = 12.25

2.Using the Lagrange multiplier method, solve the following:

(i) optimise objective function y + x 2 subject to constraint x + y = 1

Step 1: The Lagrangian: L = y + x 2 +  (1 − x − y )

L
Step 2: = 2x −  = 0 eq.1
x
L
= 1−  = 0 eq.2
y
L
= 1− x − y = 0 eq.3


Step 3: Solve the 3 simultaneous equations:

EQ2:   = 1
EQ1: 2 x − 1 = 0 so 2 x = 1 and x = ½
EQ3: 1 − 1 2 − y = 0 so y = ½

(ii) Optimise the objective function 3x 2 + y 2 − 2 xy subject to the constraint 6 = x + y

Step 1: The Lagrangian:

L = 3x 2 + y 2 − 2 xy +  (6 − x − y )

L
Step 2: = 6x − 2 y −  = 0 eq.1
x
L
= 2 y − 2x −  = 0 eq.2
y
L
= 6− x− y= 0 eq.3


56
Step 3: Solve the 3 simultaneous equations:
Solving EQ1: 2 y = 6 x −  and EQ2: 2 y = 2 x + 

So 6x −  = 2x + 
4 x = 2
 = 2x

EQ3: y = 6 − x

Substituting values of y and  into eq1:

EQ1: 6 x − 2 y −  = 0

6x − 2(6 − x) − 2x = 0
6 x − 12 + 2 x − 2 x = 0
6 x = 12
x=2
thus, y = 6 − x = 6 − 2 = 4

The solution is: x = 2, y = 4

(iii) Optimise the objective function 30 xy subject to the constraint 500 = x + 25 y

The Lagrange multiplier method:

Step 1: The Lagrangian:
L = 30 xy +  (500 − x − 25 y )

L
Step 2: = 30 y −  = 0 eq.1
x
L
= 30 x − 25 =0 eq.2
y
L
= 500 − x − 25 y = 0 eq.3


Step 3: Solve the 3 simultaneous equations:

EQ2: 30 x = 25
so 6 5x = 

EQ3: y = 20 − x 25

EQ1: 30 y −  = 0

30(20 − x 25) − 6 5 x = 0

57
 600 − 6 5 x − 6 5 x = 0

600 − 12 5 x = 0

(600 − 12 5 x) = 0
600 = 12 5 x
x = 250
y = 20 − x 25

y = 20 − 250 25 = 10
Optimum points at: x = 250 , y = 10

(iv) Optimise the objective function x 0.25 y 0.25 subject to the constraint 24 = x 10 + y

The Lagrange multiplier method:

Step 1: The Lagrangian:

L = x 0.25 y 0.25 +  (24 − x 10 − y )

L
Step 2: = 0.25 x −0.75 y 0.25 −  10 = 0 eq.1
x
L
= 0.25 x 0.25 y −0.75 −  = 0 eq.2
y
L
= 24 − x 10 − y = 0 eq.3


Step 3: Solve the 3 simultaneous equations:

EQ2: 0.25 x 0.25 y −0.75 −  = 0

0.25 x 0.25 y −0.75 = 

EQ1: ( )
0.25 x −0.75 y 0.25 − 0.25 x 0.25 y −0.75 10 = 0
2.5x −0.75 y 0.25 = 0.25 x 0.25 y −0.75
2.5 y 0.25 y −0.75 = 0.25 x 0.25 x −0.75
2.5 y = 0.25 x
10 y = x

EQ3: 24 − x 10 − y = 0
24 − 10 y 10 − y = 0
24 − 2 y = 0
y = 12
10 y = x

58
 10(12) = x
120 = x
Optimum point at: x = 120 , y = 12

(v) optimise y − x 2 subject to y = 6 x − 9

(Non-linear therefore use Lagrange Multiplier Method)
The Lagrange multiplier method:
Step 1: The Lagrangian:
L = y − x 2 +  (9 − 6 x + y )
L
Step 2: = −2 x − 6
x
L
= 1+ 
y
L
= 9 − 6x + y

Step 3: Solve the simultaneous equations:
EQ1: − 2 x − 6 = 0
EQ2: 1 +  = 0
EQ3: 9 − 6 x + y = 0

EQ2:  = −1
EQ1: − 2x − 6(− 1) = 0
x=3
Sub in to EQ3:
9 − 6(3) + y = 0
y=9

The solution is x = 3 , y = 9

(vi) optimise y − 2 x subject to y = x 2

(Non-linear therefore use Lagrange Multiplier Method)
The Lagrange multiplier method:
Step 1: The Lagrangian:
(
L = y − 2x +  y − x 2 )
L
Step 2: = −2 − 2 x
x
L
= 1+ 
y
L
= y − x2

Step 3: Solve the simultaneous equations:

59
 EQ1: − 2 − 2 x = 0
EQ2: 1 +  = 0
EQ3: y − x 2 = 0

EQ2:  = −1
EQ1: − 2 − 2x(− 1) = 0
x =1
Sub in to EQ3:

y − (1)2 = 0
y =1

The solution is x = 1 , y = 1

3. A consumer’s utility function is given by U = x1 x2 where x1 is the quantity of

good 1 that is bought and x 2 is the quantity of good 2 that is bought. The price
of good 1 is €10 while the price of good 2 is €2. If the consumer’s income is €100
what will the consumer’s optimal utility level be?

Budget constraint: p1x1 + p2x2 = M where M is income

Thus 10 x1 + 2 x2 = 100

So, Maximise U = x1 x2 subject to 10 x1 + 2 x2 = 100

The Lagrange multiplier method:

Step 1: The Lagrangian:
L = x1 x2 +  (100 − 10 x1 − 2x2 )

L
Step 2: = x 2 − 10 = 0 eq.1
x1
L
= x1 − 2 = 0 eq.2
x 2
L
= 100 − 10 x1 − 2 x2 = 0 eq.3


Step 3: Solve the 3 simultaneous equations:

EQ2: x1 = 2

x1 2 = 

60
 EQ1: x2 − 10(x1 2) = 0

x2 = 5x1

EQ3: 100 − 10 x1 − 2(5x1 ) = 0

20 x1 = 100

x1 = 5

x2 = 5x1 = 5(5) = 25

The optimal value of U is where x1 = 5 and x2 = 25

U = x1 x2 = 5(25) = 125

4. A firm’s production function is given by Q = L0.25 K 0.25 where L is the quantity of

labour employed and K is the quantity of capital employed. The price of labour is
€20 and the price of capital is €5. If the producer’s costs are constrained to €320
find the maximum level of production of the firm.
Maximise Q = L0.25 K 0.25 subject to 20 L + 5K = 320

The Lagrange multiplier method:

Step 1: The Lagrangian:
L = L0.25 K 0.25 +  (320 − 20 L − 5K )

L
Step 2: = 0.25 L−0.75 K 0.25 − 20
L
L
= 0.25L0.25 K −0.75 − 5
K
L
= 320 − 20 L − 5K


Step 3: Solve the simultaneous equations:

EQ1: 0.25L−0.75 K 0.25 − 20 = 0
EQ2: 0.25L0.25 K −0.75 − 5 = 0
EQ3: 320 − 20 L − 5K = 0

EQ1: 0.25L−0.75 K 0.25 20 = 

EQ2: 0.25L0.25 K −0.75 5 = 

Equate both expressions for  :

0.25L−0.75 K 0.25 20 = 0.25L0.25 K −0.75 5

61
 1.25L−0.75 K 0.25 = 5L0.25 K −0.75

K 0.25 K −0.75 = 4 L0.25 L−0.75

K = 4L
EQ3: 320 − 20L − 5(4L) = 0

320 − 40 L = 0
L=8
K = 4L = 4(8) = 32
The optimal value of Qis where L = 8 and K = 32
Q = L0.25 K 0.25 = (8)0.25 (32 )0.25 = 4

Production function: Q = 50 K a L b

62
 PROFIT MAXIMIZATION IN DIFERENT MARKET STRUCTURES

Introduce the concepts of

a) Revenues
i. Average Revenues
ii. Total Revenue
iii. Marginal Revenue

Given the price in dollar per unit p = −3x2 + 600x, find:

a) the marginal revenue at x = 300 units. Interpret the result.
b) Average cost

b) Costs
Given the average cost in dollar per unit C = 357x + 1800, find:
i. TC
ii. AC
iii. MC

c) Profits = TR - TC

NB
Profit maximizing condition: MR = MC
Examples:
1) Let the demand function and cost functions be given by the following:
P = 150 – 0.5x, C(x) = 100 + 3x + 7x2
Determine the profit maximizing price and output. Is the profit maximum? Check for the
second order condition

2) Given that C = 36 + (Q-8)2, where C is marginal cost of producing Q units of output, and R =
100 – 2Q, where R is Marginal Revenue from selling Q units. Required:
i. Profit maximizing output for the firm
ii. Value of total profit (assume

63
3) A company has established that the revenue function in dollars is R(x)=2x 3 + 40x2 + 8x and the
cost function in dollars is C(x)=3x3 + 19x2 + 80x − 800. Find the price per unit to maximize the
profit

4) Max ltd. employed a cost accountant who developed two functions to describe the operations
of the firm. He found the MR function to be MR = 25 – 5x -2x2, while MC = 15 – 2x – x2,
where x is the units of output. Determine the profit maximizing output and the total profit.
5) An accountant has estimated TC = 120Q – Q2 + 0.02Q. the sales manager has provided the
sales forecasting function as P = 114 – 0.25Q
a) Output to maximize profit
b) Price that shall maximize profits
c) Maximum revenue

6) The sales department of Kenya Beer co. ltd have forecasted: S = 10,000 – 100P, where P is
the price and S are the sales in units. The TC = 30,000 + 50S. given that a Ksh. 2 per unit tax
is imposed to the brewer in the external market:
i. What price should the company charge in the internal market to max profits
ii. What price should the company charge in the external market
Master of Finance class

Elasticity of Demand
1) The demand of a product is p = 25 − x2 where x is the demanded quantity. Find: (a) the price
elasticity of demand.

𝑷
Elasticity of demand = , where P’ is the derivative of p function
𝑿.𝑷′

10
2) Given that demand for a product P = 𝑥+2, find the price elasticity of demand

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Different market structures
a) Perfect competitive market
b) Monopolist
c) Oligopolist

❖ Discuss their characteristics

Defining Monopoly
A monopoly is an economic market structure where a specific person or enterprise is the only supplier
of a particular good.

Characteristics of a Monopoly
A monopoly can be recognized by certain characteristics that set it aside from the other market
structures:
• Profit maximizer: a monopoly maximizes profits. Due to the lack of competition a firm can
charge a set price above what would be charged in a competitive market, thereby maximizing
its revenue.
• Price maker: the monopoly decides the price of the good or product being sold. The price is
set by determining the quantity in order to demand the price desired by the firm (maximizes
revenue).
• High barriers to entry: other sellers are unable to enter the market of the monopoly.
• Single seller: in a monopoly one seller produces all of the output for a good or service. The
entire market is served by a single firm. For practical purposes the firm is the same as the
industry.
• Price discrimination: in a monopoly the firm can change the price and quantity of the good
or service. In an elastic market the firm will sell a high quantity of the good if the price is less.
If the price is high, the firm will sell a reduced quantity in an elastic market.
Sources of Monopoly Power
In a monopoly, specific sources generate the individual control of the market. Sources of power
include:
• Economies of scale • Control of natural resources
• Capital requirements • Network externalities
• Technological superiority • Legal barriers
• No substitute goods • Deliberate actions

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Monopolies are characterized by a lack of competition within the market producing a good or
service.

Monopoly: The graph shows a monopoly and the price (P) and change in price (P reg) as
well as the output (Q) and output change (Q reg).

What Is a Discriminating Monopoly?

A discriminating monopoly is a single entity that charges different prices—typically, those that are
not associated with the cost to provide the product or service—for its products or services for different
consumers.

With first-degree discrimination, the company charges the maximum possible price for each unit
consumed.

Second-degree discrimination involves discounts for products or services bought in bulk, while

Third-degree discrimination reflects different prices for different consumer groups.

Degree of Monopoly
Market power is the ability to charge a price above marginal cost.
A firm in a competitive market produces where P=MC.
Any time a firm is able to charge a price such that P>MC, it has a degree of market power.

The most popular measure of monopoly power of a firm was proposed by Lerner (1934) and
thus called Lerner’s index:
𝑀𝐶
𝐿𝑖=𝑃−𝑀𝐶 = 1 − 𝑃
𝑃

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It will be a value between 0 and 1. A competitive firm would have a value of closer to 0,
while a monopolist would have a value closer to 1, showing a more market power it has.

From the individual Lerner indices in an industry, we can obtain an aggregate index of
monopoly power. Let ℑn(L1, L2, · · · , Ln) be the aggregate index of monopoly power in an
industry with n firms. This index has to satisfy three properties:
1) The value of ℑn(L1, L2, · · · , Ln) must lay in the range defined by the extreme values of
the distribution of individual Lerner indices(L1, L2, · · · , Ln) i.e. max{L1, L2, · · · , Ln}
≥ ℑn(L1, L2, · · · , Ln) ≥ min{L1, L2, · · · , Ln}. This result has two interpretations.
Either the industry is perfectly competitive or it is a perfect cartel.

2) In an industry, some of its members may be “price takers” so that their monopoly power
are nil, i.e. Li = 0.

3) If two or more firms merge, the aggregate index of monopoly power must not decrease,
i.e. ℑn(L1, L2, · · · , Ln) ≤ ℑn−1(L1,2, L3, · · · , Ln).

Example one
Consider a firm has a monopoly in an industry which faces a market demand curve
. It has a constant marginal cost of production of 10. What price and quantity
combination will it choose?

Solution
The monopoly firm always produces where MR = MC.

First write the inverse demand function: and now express it in terms of total
revenue: .

so when MR=MC,

Our inverse demand function now gives us the price:

So at the profit maximising point where it produces, this firm has got a marginal cost of
production of 10 and is selling at a price of 25.

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Hence,

The Lerner Index is then

The firm has 60% market share.

For discrimination to take place, certain conditions must be met:

a) First the market must be a form of imperfect competition. There must be some level of
monopoly power to allow producers the ability to price set and not price take.
b) The monopolist must prevent re-sale. If consumers can simply buy a product at cheaper prices
and sell it on for a profit to a consumer who would have paid a higher price then there is no price
discrimination. This re-sale could take the form of second hand shops and re-sale ticket
companies such as stub-hub. These companies capitalise on this arbitrage and re-sell the good
creating a profit. Prevention of re-sale could be enforced in many different ways..

c) A key condition is the identification of different market segments. If this is possible different
groups have different price elasticities of demand. Therefore the firm can charge different prices
depending on the consumers sensitivity to price changes.

d) To gain knowledge of different groups of PED and different individual consume PED firms
may have to gain information or market intelligence on consumers through means such as deep
data digging in cookies and browser histories..

e) Price discrimination is possible when the two markets or markets are separated by large
distance or tariff barriers, so that it is not possible to transfer goods from a cheaper market to
dearer markets

f) The consumers are ignorant about price discrimination, they are not aware that in one part of
the market prices are lower than in the other part. Thus, he purchases in dearer market, than in
cheaper market since he is ignorant of the prices that are prevailing in different markets.
g) Price discrimination occurs when the government rules and regulations permit. For instance,
electricity rates are fixed at higher level for industrial purposes and lower for domestic uses.

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 Similarly, railways charge by law higher fares from first class passengers than from the second
class passengers. Hence, price discrimination is possible because of legal sanction.

h) Price discrimination may be possible on account of geographical situations. The monopolist may
discriminate between home and foreign buyers by selling at lower price in the foreign market
than in the domestic market. Geographical discrimination is possible because no unit of the
commodity sold in one market can be transferred to another.

i) A monopolist may create artificial differences by presenting the same commodity under different
names and labels, one for the rich and snobbish buyers and the other for the ordinary customers.
For instance, a biscuit manufacturer may wrap small quantity of the biscuits, give it separate name
and charge a higher price. Thus, he may charge different price for substantially the same product.
He may charge Ks. 20/- for 100-gram wrapped biscuits and Ks. 15 for unwrapped biscuits.

Evaluation of price discrimination

Advantages
From the firm’s perspective

From a firm’s perspective price discrimination can offer many advantages, making it one of
the commonest pricing strategies used by local, national and global companies. Benefits to
firms include:

Profit maximization

Firstly, matching prices to the specific characteristics of the market, and its various segments,
is a profit maximizing strategy (see above), where the firm can extract some (or even all) of
the consumer surplus available in the market, and turn it into producer surplus (i.e. profits).

Economies of scale

Given that charging different prices can increase sales volume, especially as a result of new
consumers entering the market, attracted in by the discounted prices, firms can benefit from
the economies of scale which arise from increased output and production.

Efficient use of infrastructure

Price discrimination can benefit firms with high fixed costs associated with the building of
infrastructure, and its maintenance. This includes natural monopolies such as gas, electricity
supply, and transport services. For example, having more passengers on a train that is going
to run anyway provides additional revenue to the train operators. This revenue may be used to

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add to profits (given that the marginal cost of one extra passenger is virtually zero) or to
cover new fixed costs, such as track or safety improvements.

Better use of space

Similarly, price discrimination may also enable manufacturing and retail firms to clear their
existing stocks quickly when required - hence making better use of their shop or factory
space.

Managing the flow customers

Price discrimination according to the time of day means that the flow of customers into retail
stores can be managed more effectively, which might provide a better experience for
shoppers and spread out the work for staff. For example, having a ‘happy hour’ or ‘early bird’
prices may encourage shoppers to adjust their shopping times so that queues are shortened at
more peak times, as well as ensuring that staff are better employed throughout the day.

Understanding the market

Firms may wish to trial new products in different locations, and may match their prices to the
specific demand conditions found in those local markets. Also, firms can offer discounts in
order to get consumer feedback on these trialled products, and on existing ones.

Similarly, price discrimination may enable firms sell to export markets, basing their prices on
what consumers are prepared to pay in each territory – which can vary considerably from
country to country. From a macro-economic perspective, international trade is likely to be
created by price discrimination.

Enables survival

As a result of generating additional revenue, price discrimination can enable firms to survive.
For example, small cinemas might be better able to survive if they can offer low priced off-
peak cinema tickets to the over-65s for day-time screenings.

From the consumer’s perspective

Possibility of lower prices

From the consumer’s point of view, some, especially those in the highly elastic sub-market,
may gain consumer surplus as a result of lower prices. Lower prices could also result from
the application of scale economies (as above).

Benefits to groups of consumers

If we look specifically at goods and services consumed by children, but where adults are
needed to accompany them, it can be argued that charging children a much lower price
enables families as a whole to benefit, and gain increased group utility. For example, if
cinemas or theme parks set low prices for children (or even zero price for those under a
certain age), or offer with family discounts, more parents will be able to attend, and
accompany their children. This means that, in the longer term, cinema chains and theme

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parks will increase their revenue and profits. The same logic can be applied to travel and
holidays, with child and family discounts encouraging demand and helping generate revenue.

Enables flexibility

Having different prices may enable consumers to match their purchasing and shopping to
their own free time. For example, ‘early bird’ prices can benefit individuals who are retired,
or who work flexible hours.

Generating positive externalities

We can extend the analysis to consider the role of price discrimination in reducing market
failure, such as enabling wider consumption of merit goods. For example, if ‘private’ schools
charge relatively high tuition fees for those who can afford them, and where demand is
inelastic, the revenue generated allows them to cover their costs and run classes. With fixed
costs covered, they can then offer places at discounted fees (to cover the variable costs only)
to those who cannot afford them. Given that the demand for private education by less well-off
parents is likely to be price (fee) elastic, the lower price will encourage greater demand. The
benefit to ‘society’ is that more education is ‘consumed’ and more positive externalities
generated.

Survival

Consumers can also gain from the fact that firms can more easily survive, so that future
generations can derived continued benefit.

Disadvantages
Exploitation of captive markets

However, it could be argued that consumers in a captive sub-market are being unduly
exploited due to their inelasticity. This is especially relevant when we look at transport, and
the high ticket prices charged for peak travel, compared with off-peak. The same could be
said for energy prices, where existing and loyal customers often pay higher prices, which
subsidises the discounts available to ‘new’ customers.

Limitations

Ultimately, the ability to price discriminate may be limited because the conditions necessary
are not fully met. In other words, there are limits on the extent to which different prices can
be applied.

Examples
1) A monopolist has the cost function TC(y) = 200y + 15y2 and faces the demand function given
by p = 1200 10y. What output maximizes its profit? What is the profit-maximizing price?
What is its maximal profit?

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2) A price discriminating monopolist sells in two markets. Inverse demand in market 1 is given by:
P1(Q1)=80−(1/2)Q1, and inverse demand in market 2 is given by:
P2(Q2)=100−Q2
The monopolist's cost function is C(Q)=(Q1+Q2)2
i. Calculate the monopoly's profit maximizing quantity sold in markets 1 and 2 and the
corresponding prices.

ii. Now suppose the government forbids price discrimination, so the monopolist can only set a
single price for the two markets. Compute the monopoly price and quantity.

3) In market 1 we have Qd(p) = 10 - p/2 while in market 2 we have Qd(p) = 32 - 2p. The
monopolist's total cost function is TC(y) = y2. What outputs does the monopolist sell in each
market?

4) A monopolist faces two totally separated markets with inverse demand P=100–QA and
P=160−2QB respectively. The monopolist has no fixed costs and a marginal cost given by
MC=23Q. Find the profit maximizing total output and how much of it that is sold on market A
and market B respectively if the monopoly uses third degree price discrimination. What prices
will our monopolist charge in the two separate markets? (b) Calculate the price elasticity of
demand in each market and explain the intuition behind the relationship between the prices and
elasticities in these two separate markets.

Oligopoly Market Structure

What is an Oligopoly?
Oligopoly is a market structure with a small number of firms, none of which can keep the
others from having significant influence. The concentration ratio measures the market share
of the largest firms. A monopoly is one firm, duopoly is two firms and oligopoly is two or
more firms. There is no precise upper limit to the number of firms in an oligopoly, but the
number must be low enough that the actions of one firm significantly influence the others.

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Its main characteristics are discussed as follows:
1. Interdependence:
The foremost characteristic of oligopoly is interdependence of the various firms in the
decision making.
This fact is recognized by all the firms in an oligopolistic industry. If a small number of
sizeable firms constitute an industry and one of these firms starts advertising campaign on a
big scale or designs a new model of the product which immediately captures the market, it
will surely provoke countermoves on the part of rival firms in the industry.
Thus different firms are closely inter dependent on each other.
2. Advertising:
Under oligopoly a major policy change on the part of a firm is likely to have immediate
effects on other firms in the industry. Therefore, the rival firms remain all the time vigilant
about the moves of the firm which takes initiative and makes policy changes. Thus,
advertising is a powerful instrument in the hands of an oligopolist. A firm under oligopoly
can start an aggressive advertising campaign with the intention of capturing a large part of the
market. Other firms in the industry will obviously resist its defensive advertising.
Under perfect competition advertising is unnecessary while a monopolist may find some
advertising to be profitable when his product is new or when there exist a large number of
potential consumers who have never tried his product earlier. But according to Prof. Baumol,
“under oligopoly, advertising can become a life-and-death matter where a firm which fails to
keep up with the advertising budget of its competitors may find its customers drifting off to
rival products.”
3. Group Behaviour:
In oligopoly, the most relevant aspect is the behaviour of the group. There can be two firms
in the group, or three or five or even fifteen, but not a few hundred. Whatever the number, it
is quite small so that each firm knows that its actions will have some effect on other firms in
the group. In contrast, under perfect competition there are a large number of firms each
attempting to maximise its profits.
Similar is the situation under monopolistic competition. Under monopoly, there is just one
profit maximising firm. Whether one considers monopoly or a competitive market, the
behaviour of a firm is generally predictable.
In oligopoly, however, this is not possible due to various reasons:
(i) The firms constituting the group may not have a common goal

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(ii) The group may or may not have a formal or informal organization with accepted rules of
conduct
(iii) The group may be dominated by a leader but other firms in the group may not follow him
in a uniform manner.
4. Competition:
This leads to another feature of the oligopolistic market, the presence of competition. Since
under oligopoly, there are a few sellers, a move by one seller immediately affects the rivals.
So each seller is always on the alert and keeps a close watch over the moves of its rivals in
order to have a counter-move. This is true competition, “True competition consists of the life
of constant struggle, rival against rival, whom one can only find under oligopoly.”
5. Barriers to Entry of Firms:
As there is keen competition in an oligopolistic industry, there are no barriers to entry into or
exit from it. However, in the long-run, there are some types of barriers to entry which tend to
restrain new firms from entering the industry.
These may be:
(a) Economics of scale enjoyed by a few large firms;
(b) Control over essential and specialized inputs;
(c) High capital requirements due to plant costs, advertising costs, etc.
(d) Exclusive patents; and licenses; and
(e) The existence of unused capacity which makes the industry unattractive.
When entry is restricted or blocked by such natural and artificial barriers the oligopolistic
industry can earn long-run supernormal profits.
6. Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms. Firms differ
considerably in size. Some may be small, others very large. Such a situation is asymmetrical.
This is very common in the American economy. A symmetrical situation with firms of a
uniform size is rare.
7. Existence of Price Rigidity:
In oligopoly situation, each firm has to stick to its price. If any firm tries to reduce its price,
the rival firms will retaliate by a higher reduction in their prices. This will lead to a situation
of price war which benefits none. On the other hand, if any firm increases its price with a
view to increase its profits; the other rival firms will not follow the same. Hence, no firm
would like to reduce the price or to increase the price. The price rigidity will take place.
8. No Unique Pattern of Pricing Behaviour:

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The rivalry arising from interdependence among the oligopolists leads to two conflicting
motives. Each wants to remain independent and to get the maxmium possible profit. Towards
this end, they act and react on the price-output movements of one another which are a
continuous element of uncertainty.
On the other hand, again motivated by profit maximisation each seller wishes to cooperate
with his rivals to reduce or eliminate the element of uncertainty. All rivals enter into tacit or
formal agreement with regard to price-output changes.
It leads to a sort of monopoly within oligopoly. They may even recognize one seller as a
leader at whose initiative all the other sellers raise or lower the price. In this case, the
individual seller’s demand curve is a part of the industry demand curve, having the elasticity
of the latter. Given these conflicting attitudes, it is not possible to predict any unique pattern
of pricing behaviour in oligopoly markets.
9. Indeterminateness of Demand Curve:
In market structures other than oligopolistic, demand curve faced by a firm is determinate.
The interdependence of the oligopolists, however, makes it impossible to draw a demand
curve for such sellers except for the situations where the form of interdependence is well
defined. In real business operations, the demand curve remains indeterminate. Under
oligopoly a firm can expect at least three different reactions of the other sellers when it
lowers its prices.

This happened due to the reason:

(i) It is possible that other maintain the prices they had before. In this case, an oligopolist can
hope that its demand would increase substantially as the prices are lowered,
(ii) When an oligopolist reduces his price, the other sellers also lower their prices by an
equivalent amount. In this situation although demand of the oligopolist making the first move
will increase as he lowers his price, the increase itself would be much smaller than in the first
case.
(iii) When a firm reduces its price, the other sellers reduce their prices far more. Under the
circumstances the demand for the product of the oligopolistic firm which makes the first
move may decrease. Thus uncertainty under oligopoly is inevitable, and as a result, the
demand curve faced by each firm belonging to the group is necessarily indeterminate.

Draw the diagram

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In addition, the groups are to work on the following topics, and to be discussed in class.

a) Theories of the firm and organizations

b) Asymmetric information and contract design;

c) Bargaining;

d) Auction theory.

Students are advised to check these areas in details.

PRACTICAL EXAM QUESTIONS

Case one

Banana Republic sells casual dress items under its highly valued brand through its own
network of stores. One of its seasonal products is offered for sale from November through
February, at which point the product is removed from the stores to make room for the Spring
season product. The fashion driven, seasonal nature of demand and storage cost eliminate the
option of storing surplus units for future use, so at the end of the season, the product is of no
value to anyone. This product is manufactured overseas but must be ordered by April 1st to
give manufacturer enough time. The foreign manufacturers charge $20 per unit.

a) The marketing team in charge formulates two scenarios about the likely state of demand
during the holiday season. The Optimistic Scenario is based on historical average
marketing data from the past ten holiday seasons; under this scenario, (inverse) demand
should be P =140 – 5Q (P in $ and Q in '000 of units). One dissenting voice suggests that
this is based on the flawed assumption that the upcoming season will be an average
season; the Pessimistic Scenario reflects the possibility that the current recession will
result in less consumer spending and (inverse) demand of only P =140 – 8Q. Find the
optimal quantities and prices under each of the two scenarios.

b) Assume that if it wants to order the product, Banana Republic has to pay a fixed fee to the
manufacturer of $500,000 (on top of the $20 per unit mentioned earlier) to cover the
manufacturer’s overhead and other fixed manufacturing costs. The management is
provided with the two scenarios of how demand might turn out without any specific
recommendation. If the management believed that the Optimistic Scenario will prevail for
sure, would it order the quantity found in the first question, and if so what would it expect
profits to be? How about if the management believed that the Pessimistic Scenario will
prevail for sure?

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