MD.

ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
{3RD BATCH }
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883

ECN 5o1: Advance Microeconomics Theory - I

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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
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 1. (a) Cobb-Douglas Example
Consider a utility function given by

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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
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 3|P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 1. (b) Relationships between the utility maximization cost minimization
problems

1. (c) PROPERTIES OF INDIRECT UTILITY FUNCTION

The indirect utility function has the following properties

 ψ(m,p) is nonincreasing in p, that is if p’ ≥ p, ψ(m,p’) ≤ ψ(m,p).

 ψ(m,p) is nondecreasing in m, that is if m’ ≥ m, ψ(m’,p) ≥ ψ(m,p).
 ψ(m,p) is homogeneous of degree 0 in (p, m) so that ψ(tm,tp) = ψ(m,p) for t > 0.
 ψ(m,p) is quasiconvex in p; that is {p: ψ(m,p) < α } is a convex set for all α.
 ψ(m,p) is continuous for all p > 0, m > 0.
4|P a g e
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
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 2. (a) Moral Hazard and Adverse Selection

Moral Hazard:
Moral hazard refers to situations where one side of the market can’t observe the actions
of the other. For this reason it is sometimes called a hidden action problem.
This arises after a transaction is completed. It's the risk that one party can take actions,
after entering into an agreement, that are hidden from and may be detrimental to another
party. For example, after obtaining insurance, a person might take greater risks because
they know they are covered if something goes wrong.

Adverse Selection:
Adverse selection refers to situations where one side of the market can’t observe the
“type” or quality of the goods on other side of the market. For this reason it is sometimes
called a hidden information problem.
This occurs before a transaction is made. It's the risk that the party with more
information about its intentions or attributes will exploit that knowledge to the
detriment of the less informed party. For instance, in the context of health insurance,
sicker individuals may be more likely to seek insurance, making the pool of insured
riskier than the average population.
In short, while moral hazard concerns behavior after making an agreement, adverse
selection concerns hidden information before making the agreement.

Equilibrium in a market involving hidden action typically involves some form of

rationing—firms would like to provide more than they do, but they are unwilling to do

5|P a g e
MD. ABDUL ALIM
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
so since it will change the incentives of their customers. Equilibrium in a market
involving hidden information will typically involve too little trade taking place because
of the externality between the “good” and “bad” types.
Equilibrium outcomes in this market appear to be inefficient, but one has to be careful
in making such a claim. The question to ask is “inefficient relative to what?” The
equilibrium will always be inefficient relative to the equilibrium with full information.
But this is of little help in making policy decisions: if the firms in the industry find it
too costly to collect more information the government would probably find it too costly
as well. The real question to ask is whether some sort of governmental intervention in
the market could improve efficiency even if the government had the same information
problems as the firms.
In the case of hidden action considered above, the answer is usually “no.” If the
government can’t observe the care taken by the consumers, then it can do no better than
the insurance companies. Of course the government might have other tools at its
disposal that are not available to the insurance company—it could compel a particular
level of care, and it could set criminal punishments for those who did not take due care.
But if the government can only set prices and quantities, then it can do no better than
the private market can do.
Similar issues arise in the case of hidden information. We have already seen that if the
government can compel people of all risk classes to purchase insurance, it is possible
for everyone to be made better off. This is, on the face of it, a good case for intervention.
On the other hand, there are costs to government intervention as well; economic
decisions made by governmental decree may not be as cost-effective as those made by
private firms. Just because there are governmental actions that can improve social
welfare doesn’t mean that these actions will be taken!
Furthermore, there may be purely private solutions to the adverse selection problems.
For example, we have already seen how providing health insurance as a fringe benefit
can help to eliminate the adverse selection problem.

6|P a g e
MD. ABDUL ALIM
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 2. (b) Signaling
Signaling refers to actions taken by individuals or entities to convey certain information
to another party, typically to overcome information asymmetries.
In many contexts, especially in economics and business, the signaler hopes to
differentiate themselves or their product from others. A common example is a job
applicant obtaining a degree to signal competence to potential employers.

Recall our model of the used-car market:

The owners of the used cars knew the quality, but the purchasers had to guess at the
quality. We saw that this asymmetric information could cause problems in the market;
in some cases, the adverse selection problem would result in too few transactions being
made.
However, the story doesn’t end there. The owners of the good used cars have an
incentive to try to convey the fact that they have a good car to the potential purchasers.
They would like to choose actions that signal the quality of their car to those who might
buy it.
One sensible signal in this context would be for the owner of a good used car to offer a
warranty. This would be a promise to pay the purchaser some agreed upon amount if
the car turned out to be a lemon. Owners of the good used cars can afford to offer such
a warranty while the owners of the lemons can’t afford this. This is a way for the owners
of the good used cars to signal that they have good cars.
In this case signaling helps to make the market perform better. By offering the
warranty—the signal—the sellers of the good cars can distinguish themselves from the
sellers of the bad used cars. But there are other cases where signaling can make a market
perform less well.

7|P a g e
MD. ABDUL ALIM
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
Let’s consider a very simplified model of the education market first examined by
Michael Spence.
Suppose that we have two types of workers, able and unable. The able workers have a
marginal product of a2, and the unable workers have a marginal product of a1, where
a2 > a1.
Suppose that a fraction b of the workers are able and 1 − b of them are unable.

8|P a g e
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 9|P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 10 | P a g e
MD. ABDUL ALIM
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 Game Theory
Question 3 :
a) Finding Nash Equilibrium
b) Prisoners Dilemma
Question 4 :
a) Extensive / Sequential / Normal Form of Game
b) Mixed Strategy Game

 Game Theory
Game theory is a branch of mathematics that studies strategic interactions between
individuals or entities, involving choices and payoffs. It provides a framework to
analyze decisions made by players in various situations, like economics, politics, and
biology, to predict outcomes and strategies.

3. a) Finding Nash Equilibrium

 Nash Equilibrium
Nash Equilibrium is a state in a game where each player's strategy is optimal given the
strategy chosen by the other players, and no player has an incentive to deviate
unilaterally.

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Nash Equilibrium Dominant strategy equilibria are nice when they happen, but they
don’t happen all that often. For example, the game depicted in Table doesn’t have a
dominant strategy equilibrium. Here when B chooses left the payoffs to A are 2 or 0.
When B chooses right, the payoffs to A are 0 or 1. This means that when B chooses
left, A would want to choose top; and when B chooses right, A would want to choose
bottom. Thus A’s optimal choice depends on what he thinks B will do.

To find the Nash Equilibrium, we analyze the matrix by comparing payoffs:

Given Player B's choice:

 If Player B chooses "Left":
- Player A would choose "Top" since 2 > 0.
 2. If Player B chooses "Right":
- Player A would choose "Bottom" since 1 > 0.

12 | P a g e
MD. ABDUL ALIM
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
Given Player A's choice:
 If Player A chooses "Top":
- Player B would choose "Left" since 1 > 0.
 2. If Player A chooses "Bottom":
- Player B would choose "Right" since 2 > 0.

From the above:

- "Top" and "Left" is a Nash Equilibrium because if Player B is playing "Left", Player
A's best response is "Top", and if Player A is playing "Top", Player B's best response
is "Left".
- Similarly, "Bottom" and "Right" is also a Nash Equilibrium.
So, this game has two Nash Equilibria: (Top, Left) and (Bottom, Right).

However, perhaps the dominant strategy equilibrium is too demanding. Rather than
require that A’s choice be optimal for all choices of B, we can just require that it be
optimal for the optimal choices of B. For if B is a well-informed intelligent player, he
will only want to choose optimal strategies.
We will say that a pair of strategies is a Nash equilibrium if A’s choice is optimal, given
B’s choice, and B’s choice is optimal given A’s choice.Remember that neither person
knows what the other person will do when he has to make his own choice of strategy.
But each person may have John Nash is an American mathematician who formulated
this fundamental concept of game theory in 1951. In 1994 he received the Nobel Prize
in economics, along with two other game theory pioneers, John Harsanyi and Reinhard
Selten. The 2002 film A Beautiful Mind is loosely based on John Nash’s life; it won
13 | P a g e
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
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the Academy Award for best movie. some expectation about what the other person’s
choice will be. A Nash equilibrium can be interpreted as a pair of expectations about
each person’s choice such that, when the other person’s choice is revealed, neither
individual wants to change his behavior.

In the case of Table, the strategy (top, left) is a Nash equilibrium. To prove this note
that if A chooses top, then the best thing for B to do is to choose left, since the payoff
to B from choosing left is 1 and from choosing right is 0. And if B chooses left, then
the best thing for A to do is to choose top since then A will get a payoff of 2 rather than
of 0. Thus if A chooses top, the optimal choice for B is to choose left; and if B chooses
left, then the optimal choice for A is top. So we have a Nash equilibrium: each person
is making the optimal choice, given the other person’s choice.

The Nash equilibrium notion has a certain logic. Unfortunately, it also has some
problems.
First, a game may have more than one Nash equilibrium. In fact, in Table the choices
(bottom, right) also comprise a Nash equilibrium. You can either verify this by the kind
of argument used above, or just note that the structure of the game is symmetric: B’s
payoffs are the same in one outcome as A’s payoffs are in the other, so that our proof
that (top, left) is an equilibrium is also a proof that (bottom, right) is an equilibrium.
The second problem with the concept of a Nash equilibrium is that there are games that
have no Nash equilibrium of the sort we have been describing at all. Consider, for
example, the case depicted in Table . Here a Nash equilibrium of the sort we have been
examining does not exist. If player A plays top, then player B wants to play left. But if
player B plays left, then player A wants bottom. Similarly, if player A plays bottom,
then player B will play right. But if player B plays right, then player A will play top.

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 3. b) Prisoners Dilemma

Prisoners Dilemma
The Prisoner's Dilemma is a game theory scenario where two individuals, when acting
in their own self-interest, end up with a worse outcome than if they had cooperated,
highlighting a conflict between individual and collective rationality.

Put yourself in the position of player A. If player B decides to deny committing the
crime, then you are certainly better off confessing, since then you’ll get off free.
Similarly, if player B confesses, then you’ll be better off confessing, since then you get
a sentence of 3 months rather than a sentence of 6 months. Thus whatever player B
does, player A is better off confessing.

To determine if this is a Prisoner's Dilemma, we must analyze if both players have a

dominant strategy that leads to a suboptimal joint outcome.
15 | P a g e
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Given Player B's choice:
 If Player B chooses "Confess":
- Player A's payoff is higher with "Confess" (-3 > -6).
 If Player B chooses "Deny":
- Player A's payoff is still higher with "Confess" (0 > -1).

Given Player A's choice:

 If Player A chooses "Confess":
- Player B's payoff is higher with "Confess" (-3 > -6).
 If Player A chooses "Deny":
- Player B's payoff is still higher with "Confess" (0 > -1).

Both players have a dominant strategy to "Confess". However, when both confess, they
receive a payoff of (-3, -3). This is worse for both of them compared to if they both
chose "Deny", which would give them (-1, -1).

Thus, this is a Prisoner's Dilemma. The dominant strategy for both is to "Confess", but
this leads to a suboptimal outcome compared to mutual denial.

16 | P a g e
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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
The same thing goes for player B—he is better off confessing as well. Thus the unique
Nash equilibrium for this game is for both players to confess. In fact, both players
confessing is not only a Nash equilibrium, it is a dominant strategy equilibrium, since
each player has the same optimal choice independent of the other player.
But if they could both just hang tight, they would each be better off! If they both could
be sure the other would hold out, and both could agree to hold out themselves, they
would each get a payoff of −1, which would make each of them better off. The strategy
(deny, deny) is Pareto efficient—there is no other strategy choice that makes both
players better off—while the strategy (confess, confess) is Pareto inefficient.

The problem is that there is no way for the two prisoners to coordinate their actions. If
each could trust the other, then they could both be made better off.
The prisoner’s dilemma applies to a wide range of economic and political phenomena.
Consider, for example, the problem of arms control. Interpret the strategy of “confess”
as “deploy a new missile” and the strategy of “deny” as “don’t deploy.” Note that the
payoffs are reasonable. If my opponent deploys his missile, I certainly want to deploy,
even though the best strategy for both of us is to agree not to deploy. But if there is no
way to make a binding agreement, we each end up deploying the missile and are both
made worse off.
The prisoner’s dilemma has provoked a lot of controversy as to what is the “correct”
way to play the game—or, more precisely, what is a reasonable way to play the game.
The answer seems to depend on whether you are playing a one–shot game or whether
the game is to be repeated an indefinite number of times.
If the game is going to be played just one time, the strategy of defecting— in this
example, confessing—seems to be a reasonable one. After all, whatever the other fellow
does, you are better off, and you have no way of influencing the other person’s behavior.

17 | P a g e
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 4.(a) Extensive / Sequential / Normal Form of Game

 Extensive / Sequential / Normal Form of Game

The extensive form of a game represents it as a tree structure, detailing the sequence of
moves, decision points, and possible outcomes, typically used for games with a clear
order of play.

In the first round, player A gets to choose top or bottom. Player B gets to observe the
first player’s choice and then chooses left or right. The payoffs are illustrated in a game
matrix in Table.

Note that when the game is presented in this form it has two Nash equilibria: (top, left)
and (bottom, right). However, we’ll show below that one of these equilibria isn’t really
reasonable. The payoff matrix hides the fact that one player gets to know what the other
player has chosen before he makes his choice. In this case it is more useful to consider
a diagram that illustrates the asymmetric nature of the game.

Figure is a picture of the game in extensive form—a way to represent the game that
shows the time pattern of the choices. First, player A has to choose top or bottom, and
then player B has to choose left or right. But when B makes his choice, he will know
what A has done.
18 | P a g e
MD. ABDUL ALIM
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The way to analyze this game is to go to the end and work backward. Suppose that
player A has already made his choice and we are sitting in one branch of the game tree.
If player A has chosen top, then it doesn’t matter what player B does, and the payoff is
(1,9). If player A has chosen bottom, then the sensible thing for player B to do is to
choose right, and the payoff is (2,1).
19 | P a g e
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CELL: 01791-972883
Now think about player A’s initial choice. If he chooses top, the outcome will be (1,9)
and thus he will get a payoff of 1. But if he chooses bottom, he gets a payoff of 2. So
the sensible thing for him to do is to choose bottom. Thus the equilibrium choices in
the game will be (bottom, right), so that the payoff to player A will be 2 and to player
B will be 1.
The strategies (top, left) are not a reasonable equilibrium in this sequential game. That
is, they are not an equilibrium given the order in which the players actually get to make
their choices. It is true that if player A chooses top, player B could choose left—but it
would be silly for player A to ever choose top!
From player B’s point of view this is rather unfortunate, since he ends up with a payoff
of 1 rather than 9! What might he do about it? Well, he can threaten to play left if player
A plays bottom. If player A thought that player B would actually carry out this threat,
he would be well advised to play top. For top gives him 1, while bottom—if player B
carries out his threat—will only give him 0.
But is this threat credible? After all, once player A makes his choice, that’s it. Player B
can get either 0 or 1, and he might as well get 1. Unless player B can somehow convince
player A that he will really carry out his threat—even when it hurts him to do so—he
will just have to settle for the lower payoff.
Player B’s problem is that once player A has made his choice, player A expects player
B to do the rational thing. Player B would be better off if he could commit himself to
play left if player A plays bottom.
One way for B to make such a commitment is to allow someone else to make his
choices. For example, B might hire a lawyer and instruct him to play left if A plays
bottom. If A is aware of these instructions, the situation is radically different from his
point of view. If he knows about B’s instructions to his lawyer, then he knows that if
he plays bottom he will end up with a payoff of 0. So the sensible thing for him to do
is to play top. In this case B has done better for himself by limiting his choices.

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 4.(b) Mixed Strategy Game

 Mixed strategies
Mixed strategies involve players randomizing their actions based on certain
probabilities, rather than committing to a single, deterministic strategy. It's used in
games where no pure strategy Nash Equilibrium exists.

We are interested in looking for mixed strategy equilibria as well as pure strategy
equilibria, so we let r be the probability that row plays top, and (1 − r) the probability
that he plays bottom. Similarly, let c be the probability that column plays left, and (1−c)
the probability that she plays right. The pure strategies occur when r and c equal 0 or 1.
Let us calculate row’s expected payoff if he chooses probability r of playing top and
column chooses probability c of playing left. Look at the following array

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HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
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 Combination Probability Payoff to Row
Top, Left rc 2
Bottom, Left (1 − r)c 0
Top, Right r(1 − c) 0
Bottom, Right (1 − r)(1 − c) 1

To calculate the expected payoff to row, we weight row’s payoffs in the third column
by the probability that they occur, given in the second column, and add these up. The
answer is

Row’s payoff = 2rc + (1 − r)(1 − c),

which we can multiply out to be
Row’s payoff = 2rc + 1 – c – r + rc
=2rc + 1 − r − c + rc

Now suppose that row contemplates increasing r by Δr. How will his payoff change?
Δpayoff to row = 2c Δr − Δr + c Δr
= Δr ( 2c – 1 + c )
= Δr (3c − 1)

This expression will be positive when 3c > 1 and negative when 3c < 1. Hence, row
will want to increase r whenever c > 1/3, decrease r when c < 1/3, and be happy with
any value of 0 ≤ r ≤ 1 when c = 1/3.

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Similarly, the payoff to column is given by
Column’s payoff = cr + 2(1 − c)(1 − r).

Column’s payoff will change when c changes by Δc according to

Δ payoff to column = r Δc + 2r Δc − 2Δc
= (3r − 2)Δc.

Hence column will want to increase c whenever r > 2/3, decrease c when r < 2/3, and
be happy with any value of 0 ≤ c ≤ 1 when r = 2/3.

We can use this information to plot the best response curves. Start with row. If column
choses c = 0, row will want to make r as small as possible, so r = 0 is the best response
to c = 0. This choice will continue to be the best response up until c = 1/3, at which
point any value of r between 0 and 1 is a best response. For all c > 1/3, the best response
row can make is r = 1.

These curves are depicted in Figure. It is easy to see that they cross in three places: (0,
0), (2/3, 1/3), and (1, 1), which correspond to the three Nash equilibria of this game.
Two of these strategies are pure strategies, and one is a mixed strategy.

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 24 | P a g e
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 Question - 5 Theory of Firm

 The Elasticity of Substitution

The elasticity of substitution measures how easy it is to substitute one input for another
in a production process.
Specifically, it gauges the percentage change in the ratio of two inputs used in response
to a percentage change in their relative marginal products. If the elasticity of
substitution is high, it's relatively easy to swap one input for another; if it's low,
substitution is more difficult. This concept is often applied to labor and capital in
economic models to see how changes in relative wages or prices affect the mix of inputs
used.

For a production function f(x), the elasticity of substitution of input j for input i at the
point x0 ∈ Rn ++ is defined as

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The elasticity of substitution σij(x0) is a measure of the curvature of the i-j isoquant
through x0 at x0. When the production function is quasiconcave, the elasticity of
substitution can never be negative, so σij ≥ 0.
In general, the closer it is to zero, the more ‘difficult’ is substitution between the inputs;
the larger it is, the ‘easier’ is substitution between them. When there are only two inputs
we will write σ rather than σ12. Let us consider a few two-input examples.
In Fig.(a), the isoquant is linear and there is perfect substitutability between the inputs.
There, σ is infinite. In Fig. (c), the two inputs are productive only in fixed proportions
with one another – substitution between them is effectively impossible, and σ is zero.
In Fig.(b), we have illustrated an intermediate case where σ is neither zero nor infinite,
and the isoquants are neither straight lines nor right angles.
In general, the closer σ is to zero, the more L-shaped the isoquants are and the more
‘difficult’ substitution between inputs; the larger σ is, the flatter the isoquants and the
‘easier’ substitution between them.

(a) σ is infinite and there is perfect substitutability between inputs. (b) σ is finite but
larger than zero, indicating less than perfect substitutability. (c) σ is zero and there is
no substitutability between inputs.
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  EXAMPLE-
We are familiar with the CES utility function from demand theory. Perhaps it is time
we see where this name comes from by considering the CES production function,

27 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
  RETURNS TO SCALE AND VARYING PROPORTIONS

Returns to scale refer to how output changes when all inputs are scaled up or down
proportionately.

Increasing returns to scale: When a proportional increase in all inputs leads to a more
than proportional increase in output.
Constant returns to scale: When a proportional increase in all inputs results in the
same proportional increase in output.
Decreasing returns to scale: When a proportional increase in all inputs leads to a less
than proportional increase in output.
In short, returns to scale deals with the response of output when all inputs change
proportionately, while the law of varying proportions looks at the output response when
only one input is changed, keeping others constant.

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MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
We frequently want to know how output responds as the amounts of different inputs are
varied. For instance, in the short run, the period of time in which at least one input is
fixed, output can be varied only by changing the amounts of some inputs but not others.
As amounts of the variable inputs are changed, the proportions in which fixed and
variable inputs are used are also changed.
‘Returns to variable proportions’ refer to how output responds in this situation. In the
long run, the firm is free to vary all inputs, and classifying production functions by their
‘returns to scale’ is one way of describing how output responds in this situation.
Specifically, returns to scale refer to how output responds when all inputs are varied in
the same proportion, i.e., when the entire ‘scale’ of operation is increased or decreased
proportionally.
In the two-input case, the distinction between these two attributes of the production
function is best grasped by considering Fig. Returns to varying proportions concern
how output behaves as we move through the isoquant map along the horizontal at x¯2,
keeping x2 constant and varying the amount of x1. Returns to scale have to do with
how output behaves as we move through the isoquant map along a ray such as OA,
where the levels of x1 and x2 are changed simultaneously, always staying in the
proportion x2/x1 = α.

Elementary measures of returns to varying proportions include the marginal product,

MPi(x) ≡ fi(x), and the average product, APi(x) ≡ f(x)/xi, of each input. The output
elasticity of input i, measuring the percentage response of output to a 1 per cent change
in input i, is given by μi(x) ≡ fi(x)xi/f(x) = MPi(x)/APi(x).
Each of these is a local mea sure, defined at a point. The scale properties of the
technology may be defined either locally or globally. A production function is said to
have globally constant, increasing, or decreasing returns to scale according to the
following definitions.

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MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
  (Global) Returns to Scale

A production function f(x) has the property of (globally):

1. Constant returns to scale if f(tx) = tf(x) for all t > 0 and all x;
2. Increasing returns to scale if f(tx) > tf(x) for all t > 1 and all x;
3. Decreasing returns to scale if f(tx) < tf(x) for all t > 1 and all x.

Notice from these global definitions of returns to scale that a production function has
constant returns if it is a (positive) linear homogeneous function. Notice carefully,
however, that every homogeneous production function of degree greater (less) than one
must have increasing (decreasing) returns, though the converse need not hold.

Note that many production functions satisfying Assumption do not fall into any of the
preceding three categories. Many technologies exhibit increasing, constant, and
decreasing returns over only certain ranges of output. It is therefore useful to have a
local measure of returns to scale.
One such measure, defined at a point, tells us the instantaneous percentage change in
output that occurs with a 1 per cent increase in all inputs. It is variously known as the
elasticity of scale or the (overall) elasticity of output, and is defined as follows.

30 | P a g e
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B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 Question- 6 The Cournot Model

 The Cournot Model

The Cournot model of duopoly is one in which firms simultaneously choose quantities
for a homogeneous product.
i e Each firm assumes the other firm i.e., Each firm assumes the other firms output will
output will not change if it changes its own output level.

 Quantity Competition

 Assumptions on Cournot Duopoly

There are two firms and no others can enter the market.
The firms have identical costs.
The firms sell identical products.
The firms set their quantities simultaneously. e.g., Airline market

 The Cournot Equilibrium (or Cournot (or Cournot-Nash Equilibrium)

The Cournot NE is a set of quantities chosen by firms such that, holding quantities of
other firms constant no firm can obtain higher profit firms constant, no firm can obtain
higher profit by choosing a different quantity.

31 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 32 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 33 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 34 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 35 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883
 THE END
36 | P a g e
MD. ABDUL ALIM
B.S.S. (HONS.) IN ECONOMICS
HAJEE MOHAMMAD DANESH SCIENCE & TECHNOLOGY UNIVERSITY, DINAJPUR
CELL: 01791-972883