Micro II

UNIT ONE

Price and output determination under Imperfect Market structures

1. Introduction

Amarket is a group of buyers and sellers of a particular good or service. Markets are all around us
and they come in many forms. Some are on-line, others are physical. Some involves goods such
as food and vehicles; others involve health provision or financial advice. Markets differ also by the
degree of competition associated with each. For example the wholesale egg market is very
homogeneous in that the product has minimal variation. The restaurant market offers food, but
product variation is high – restaurants specialize in foods with specific ethnic or geographic
origins for example. So an Italian restaurant differs from a Thai restaurant even though they both
serve food.

In contrast to the egg and restaurant market, which tend to have very many suppliers and furnish
products that are strongly related, many other markets are characterized by just a few suppliers or
in some cases just one. For example, passenger train services may have just a single supplier, and
this supplier is therefore a monopolist. Pharmaceuticals tend to be supplied by a limited number
of large international corporations plus a group of generic drug manufacturers. Passenger aircraft
used by international airlines are all produced by just a handful of builders.

Market is generally categorized in to three types based on the nature of things exchanged. These
are: Product market, Factor market and Money market. Market structure refers to the relative
number and size of firms in an industry. Main characteristics are: number and size of sellers,
number of buyers, product differentiation, and entry and exit.

In this part we examine the reasons why markets take on different forms and display a variety of
patterns of behavior. We delve into the working of each market structure to understand why these
markets retain their structure.
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1.1. Revision on the perfect competition paradigm

The essence of a competitive market is that it permits competition on the part of a large number
of suppliers. Each supplier produces an output that forms a small part of the total market, and the
sum of all of these individual outputs represents the production of that sector of the economy.
Right off we might think of florists, barber shops or corner stores as enterprises that live in a
competitive environment.

At the other extreme, a market that has just a single supplier is a monopolist. For example, Via
Rail is the only supplier of passenger rail services between Windsor, Ontario and the city of
Quebec. We have used the word ‘paradigm’ in the title to this section, and for good reason: we will
develop once again a model of supply behavior for a market in which there are many small
suppliers, producing essentially the same product, competing with one-another to meet the
demands of consumers. The structures that we call perfect competition and monopoly are
extremes in the market place. Most sectors of the economy lie somewhere between these limiting
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cases. For example, the market for internet services usually contains several providers in any area
– some provide using a fibre cable, others by satellite. The market for smart-phones is dominated
by two major players – Apple and Samsung. Hence, while these markets that have a limited
number of suppliers are competitive in that they freely and fiercely compete for the buyer’s
expenditure, these are not perfectly competitive markets, because they do not have a very large
number of suppliers.

A perfectly competitive industry is one in which many suppliers, producing an identical product,
face many buyers, and no one participant can influence the market.

In all of the models we develop in this chapter we will assume that the objective of firms is to
maximize profit – the difference between revenues and costs.

Profit maximization is the goal of competitive suppliers – they seek to maximize the difference
between revenues and costs.

The presence of so many sellers in perfect competition means that each firm recognizes its own
small size in relation to the total market, and that its actions have no perceptible impact on the
market price for the good or service being traded. Each firm is therefore a price taker—in contrast
to a monopolist, who is a price setter. The same “smallness” characteristic was assumed when
we examined the demands of individuals earlier. Each buyer takes the price as given. He or she is
not big enough to be able to influence the price. So while customers do not engage in bargaining
when they go to the corner store to

buy bread or milk, Emirate Airlines engages in price negotiations when purchasing aircraft from
Airbus. So when we describe a market as being perfectly competitive we do not mean that other
forms of market are not competitive. All market structure are competitive in the sense that the
suppliers wish to make profit and they produce as efficiently as possible in order to meet that goal.

Market characteristics

The key attributes of a perfectly competitive market are the following:

1. There must be many firms, each one small and powerless relative to the entire industry.

2. The product must be standardized. Barber shops offer a standard product, but a Lexus
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differs from a Ford. Barbers tend to be price takers, but Lexus does not charge the same
price as Ford, and is a price setter.

3. Buyers are assumed to have full information about the product and its pricing. For example,
buyers know that the products of different suppliers really are the same in quality.

4. There are many buyers.

5. There is free entry and exit of firms.

In terms of the demand curve that suppliers face, the foregoing characteristics imply that the
demand curve facing the firm is horizontal, or infinitely elastic, as we defined earlier. In contrast,
the demand curve facing the whole industry is downward sloping.

The economic goal of the firm is to maximize profits.

Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost. Total Cost
includes all of the opportunity costs of production

Approaches to determine profit maximization point

1. Total condition (approach) of profit maximization: a profit maximizing firm chooses that level
of output where the difference between TR and TC is the highest.
2. Marginal condition (approach/rule): MR = MC rising): When both marginal revenue and
marginal cost are equal, the firm is in equilibrium. The firm at this equilibrium point is either
ensuring maximum profit or minimizing losses.

1.2. PURE MONOPOLY

While a competitive firm is a price taker, a monopoly firm is a price maker. A firm is considered a
monopoly if . . . it is the sole seller of its product. its product does not have close substitutes. The
fundamental cause of monopoly is barriers to entry.

Barriers to entry have three sources:

 Ownership of a key resource.

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 This tends to be rare. De Beers is an example

 The government gives a single firm the exclusive right to produce some good.

 Patents, Copyrights and Government Licensing.

 Costs of production make a single producer more efficient than a large number of
producers.
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 Competitive Firm
 Monopoly
 Is the sole producer  Is one of many producers
 Has a downward-  Has a horizontal demand curve
sloping demand
curve  Is a price taker
 Is a price maker  Sells as much or as little at
 Reduces price to same price
increase sales

A Monopoly’s Revenue

 Total Revenue;P x Q = TR

 Average Revenue;TR/Q = AR = P

 Marginal Revenue;DTR/DQ = MR

 A monopolist’s marginal revenue is always less than the price of its good.
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 The demand curve is downward sloping.

When a monopoly drops the price to sell one more unit, the revenue received from previously sold
units also decreases.

When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q).

The output effect—more output is sold, so Q is higher.

The price effect—price falls, so P is lower.

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For a competitive firm, price equals marginal cost. P = MR = MC

For a monopoly firm, price exceeds marginal cost.P > MR = MC

Profit equals total revenue minus total costs.

Profit = TR - TC

Profit = (TR/Q - TC/Q) x Q

Profit = (P - ATC) x Q
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The monopolist will receive economic profits as long as price is greater than average total cost.

Government responds to the problem of monopoly in one of four ways.

 Making monopolized industries more competitive.

 Regulating the behavior of monopolies.

 Turning some private monopolies into public enterprises.

 Doing nothing at all.

Sherman Antitrust Act (1890)

Reduced the market power of the large and powerful “trusts” of that time period.

Clayton Act (1914)

Strengthened the government’s powers and authorized private lawsuits.

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Price discrimination is the practice of selling the same good at different prices to different
customers, even though the costs for producing for the two customers are the same. In order to
do this, the firm must have market power.

1.3. MONOPOLISTIC COMPETITION

Markets that have some features of competition and some features of monopoly

Attributes of Monopolistic Competition

 Many sellers

 Product differentiation

 Free entry and exit

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There are two noteworthy differences between monopolistic and perfect competition—excess
capacity and markup.

There is no excess capacity in perfect competition in the long run.

Free entry results in competitive firms producing at the point where average total cost is
minimized, which is the efficient scale of the firm.
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Markup over Marginal Cost

For a competitive firm, price equals marginal cost.

For a monopolistically competitive firm, price exceeds marginal cost.

Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for
the monopolistically competitive firm.
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Some behaviors of monopolistic market

Advertising

When firms sell differentiated products and charge prices above marginal cost, each firm has an
incentive to advertise in order to attract more buyers to its particular product.

Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of
revenue on advertising.

Overall, about 2 percent of total revenue, or over $100 billion a year, is spent on advertising.

Critics of advertising argue that firms advertise in order to manipulate people’s tastes.

They also argue that it impedes competition by implying that products are more different than
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they truly are.

Defenders argue that advertising provides information to consumers

They also argue that advertising increases competition by offering a greater variety of products
and prices.

The willingness of a firm to spend advertising dollars can be a signal to consumers about the
quality of the product being offered.

Brand names

Critics argue that brand names cause consumers to perceive differences that do not really exist.

Economists have argued that brand names may be a useful way for consumers to ensure that the
goods they are buying are of high quality.

Providing information about quality.

Giving firms incentive to maintain high quality.

1.4. OLIGOPOLY MARKET STRUCTURE

Oligopoly is a market structure in which a few firms dominate the industry. Crucially, these few
firms recognize their rivalry and interdependence, fully aware that any action on their part is likely
to induce counter-actions by their rivals. This leads us to consider strategies and counter-
strategies between market participants. Imperfect competition includes industries in which firms
have competitors but do not face so much competition that they are price takers.

Characteristics of an Oligopoly Market

 Few sellers offering similar or identical products

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 Interdependent firms

 Best off cooperating and acting like a monopolist by producing a small quantity of output
and charging a price above marginal cost

There is a tension between cooperation and self-interest.

A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

The price of water in a perfectly competitive market would be driven to where the marginal cost is
zero: P = MC = $0, Q = 120 gallons

The price and quantity in a monopoly market would be where total profit is maximized: P = $60, Q
= 60 gallons

The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60
gallons of water.
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So what outcome then could be expected from duopolists?

The two types of oligopoly models

There are different models to explain the behavior of oligopolistic firms. There are two types of
oligopoly firms: Non-collusive and Collusive Oligopoly firms. The classification of oligopoly firms
as collusive or non-collusive is based up on whether there exist some agreements between firms
or not. When firms enter into some form of agreement as to the price level they charge or the
quantity of output they produce, such firms are said to be collusive oligopoly. On the other hand, if
there is no any form of agreement between firms, firms are said to be non-collusive oligopoly.

Non-collusive oligopoly

In non-collusive type of oligopoly market, there is no collusion. In other words there is no

cooperation among rivals. Hence, the common feature of non-collusive oligopoly models is there
is no cooperation among rival firms. Thus, under non-collusive oligopoly each firm develops an
expectation about what the other firms are likely to do. Since firms are mutually interdependent, a
firm expects some reaction from its rivals when it decides to take a given course of action. For
example, when a firm increases its own output or price, it expects some reaction from the rivals to
its action; increment of output or price. However, the question is ‘what kind of reaction’ does a
firm expect to its action? What then is the implication of this expectation on the behavioral pattern
of oligopolists?

The different models that you are going to discuss in the subsequent sub-sections try to predict
the behavior of oligopolists by assuming a certain pattern of action and reaction . Hence, the basic
distinctions between the different types of non-collusive oligopoly models lie on: the assumption
as to the kind of action an oligopoly firm will take; the kind of reaction a firm will expect from its
rival as a response to its action; and

The resultant effects of these behavioral patterns (action and reaction) of oligopolists on
equilibrium output and/or price.

Non-collusive oligopoly models

 The Kinked Demand Model

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 Cournot's Duopoly Model

 Bertrand’s Duopoly Model

 Stackelberg’s Duopoly Model

Collusive Oligopoly

One way of avoiding the uncertainty arising from oligopolistic interdependence is to enter into
collusive agreements. There are two main types of collision, cartels and price leadership. Both
forms generally imply tacit (secrete) agreement since open collusive action is commonly illegal in
most countries at present.

Collusion-agreement between firms in an industry is to set certain prices or to share markets in

certain ways.

Cartels

Cartels is a combination of firms whose object if to limit the scope of competitive forces within
the market. It may take open the form of collusion, the member firms entering into an enforceable
contract pertaining to price and possibly other variables. On other words, a cartel may be formed
by secrete collusion among sellers.

Typically, there are two forms of cartel. These are:

 Cartel aiming at joint profit maximization

 Cartels aiming at the sharing of the market

The above result implies two important points. First , firms can maximize their joint profits (the
profit of the industry) through collusion. They can raise the industry’s profit from 4100 to 5525.
That is, they can attain higher level of joint profit if both recognize their interdependence and
abandon their naïve behavior. Second , collusion under such cartel requires some arrangements
about the distribution of profits between the two firms. If each firm is going to earn only the profit
generated by its self, there is a danger that one firm will bebetter off leaving the otherworse off.

Summary of Equilibrium for an Oligopoly

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 Possible outcome if oligopoly firms pursue their own self-interests:

 Joint output is greater than the monopoly quantity but less than the competitive industry
quantity.

 Market prices are lower than monopoly price but greater than competitive price.

 Total profits are less than the monopoly profit.

How the Size of an Oligopoly Affects the Market Outcome

How increasing the number of sellers affects the price and quantity:

The output effect: Because price is above marginal cost, selling more at the going price raises
profits.

The price effect: Raising production lowers the price and the profit per unit on all units sold.

As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and
more like a competitive market.

The price approaches marginal cost, and the quantity produced approaches the socially efficient
level.

UNIT TWO
2. PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION UNDER DIFFERENT
MARKETS

The fundamental principles governing factor pricing are the same, whether we apply them to
perfectly competitive markets, monopoly or monopolistically competitive markets. However,
some important adjustments in the case of demand as well as supply of factors of production
have to be made.

For better understanding of the concept of factor pricing, it is important to know the following
concepts.

Marginal Factor Cost (MFC): is the change in cost as a result of employing of a single factor of
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production. It is given as

Δtotalfactorcost
Δininputlevel

Marginal Revenue of product (MRP): is the change in revenue obtained from the sale of additional
produced by that factor unit. It is given as

Δtotalrevenue ΔTRx
=
Δininputlevel Δininputa

If input a is used produce output x

Value Marginal Product (VMP): amount obtained from the sale of additional unit of a product. It is
given as

Δtotalvalueproduct ΔTVPx
MPa * px = =
Δininputalevel Δininputa

Average Factor Cost (AFC): is the per unit cost incurred for acquiring a factor of production. It is
given as

totalFactorCost
AFC = =
totalinputlevel

Average Revenue Production (ARP): is the per unit revenue from the sale of additional output
produced by a given input. It is given as

totalrevenuex ΔTVPx
ARP = =
totalinputalevel Δininputa

If input a is used produce output x

2.1. FACTOR PRICING IN PERFECTLY COMPETITIVE MARKET

Afactor of production is any resource that is used by firms to producegoods andservices, items
that are consumed by households. Factors of production are bought and sold infactor markets,
and the prices in factor markets are known asfactor prices .
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What are these factors of production, and why do factor prices matter?

Factor prices play a key role in the allocation of resources among producers due to two features
that make these markets special:

 Demand for the factor is derived from the firm’s output choice.

 Factor markets are where most of us get the largest shares of our income

 The factor distribution of income is the division of total income among labor, land, and
capital.

 Factor prices, which are set in factor markets, determine thefactor distribution of income.

 Labor receives the bulk

Under condition of perfect competition, it is the force of demand and supply of factors which
determine theprice of factors . It is therefore, essential to understand first the nature of demand
for factors of production.

The demand for a factor is derived from the demand for the product that it helps to produce. That
is, the greater the demand for goods that a particular types of factor helps to produce, the greater
the demand for that type of factor. In other words, as demand for a good depends on its utility, the
demand for factor depends on the MRP of the factor.

All economic decisions are about comparing costs and benefits. For a producer, it could be
deciding whether to hire an additional worker…But what is the marginal benefit of that worker? We
will use the production function, which relates inputs to output to answer that question. We will
assume that all producers are prie-takers—they operate in a perfectly competitive industry.

Input a Output x MP of input MRx=Px MRPa=VMPa Pa

a
3 6 - 10 - 20
4 11 5 10 50 20
5 15 4 10 40 20
6 18 3 10 30 20
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7 20 2 10 20 20
8 21 1 10 10 20

 The general rule is that a profit-maximizing, price-taking producer employs each factor of
production up to the point at whichthe value of the marginal product of the last unit of the
factor employed is equal to that factor’s price.

As can be seen in the table, MPa declines because we are in stage II production, a rational stage
of production. MRx equals Px b/c we are in perfect competition in the product market. Pa is
constant b/c we are in perfect competition in input market.

When we plot the MRPa column with input column, we get the MRPa curve and this curve is the
demand curve for input A. in order to maximize profits, the firm will hire more units of input A as
long as the MRPa>Pa and until MRPa=Pa.

Note: MRPa is a derived demand curve from MPa and Px. That is, the demand for an input will
continue to decline as long as its MP is declining even though its price is constant. So, MRP curve
explains (shows) the demand for an input and hence this concept goes much more beyond than
input demand curve which is drawn by plotting input price and quantity demanded of that input
on the x-y plane.

General equilibrium of firms in factor employment in a perfectly competitive product and input
market

Where there is perfect competition in product market, a firm’s AR=MR=Price of a product. Thus
MRP=MRx*MPP

MRP=Px*MPP and this is equal to VMP (MPP*P)

MRP=VMP

When there is perfect competition in factor market, a firm can’t affect the price of factor by
varying its level of factor employment. Therefore, the firm can employ as many numbers of factor
units as it wishes at the prevailing factor market price. So the supply curve of the factor for an
individual firm under perfect competition in the factor market will be perfectly elastic. Here the
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MFC=price of factor= AFC (average factor cost) and they are horizontal to x-axes.

At point E, MRPa=VMPa=MFC=AFC=Pa

As can be seen, OPa is the prevailed market price which the firm should accept. VMP=MRP is the
factor demand curve and AFC=MFC is the factor supply for the firm. So the firm is in equilibrium
for input market at point E. because at that point, DD for input is equal to SSof an input and it is
the point where VMP=MFC. So in a perfectly competitive input market, a firm will be maximizing
its profit by employing quantity of inputs where MRP=MFC and at this point DD for factor will be
equal to its SS.

Short run equilibrium of firms in a perfectly competitive product and input market

In a short run period of perfect competition, a firm may get profit or loss depending upon the
situation of average revenue productivity of a factor input.
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At equilibrium E, it employs ON units of the factor at OP factor price. At ON units of factor

employed, ARP is OR. Thus PR is the per unit profit (ARP>AFC/MFC). Total profit=area (PRAE).
Loss situation: Here at ON level factor employment, the AFC (Pf) is OP while the ARP is OM.
Since ARP<AFC, the firm get a loss. Per unit loss is MP while Total loss is represented by the area

PEAM

No profit situation or normal profit situation: Here at ON level of factor employment Average
factor cost (Pf) is OP which is equal to ARP. Hence firm earn normal profit
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Long-run equilibrium of the firm in a perfectly competitive product and input market

In the long-run, a firm will get a normal profit only, because there is free entry and exit of firms into
and from the industry and perfect mobility of resources

a firm gets no profit no loss in the LR-period. It is b/c of free entry and free exit of firms into and
from the industry and perfect mobility of factors of production. When there is super normal profit
in the industry, new firms will enter into it. As a result the DD for the factor will rise. The increased
DD for the factor will increase its price and thus the AFC curve will shift upward. The product will
also rise which will lead to a fall in the price of the product, so that the ARP & MRP curves will shift
upward. Thus AFC (MFC) curves will shift upward while ARP & MRP curves downward in the LR,
they become tangent to each other. In the graph below, the LR equilibrium point is E were the firm
employs ON units of the factor at OP price.

Similarly, if there is loss in the SR period, then it will also disappear in the LR b/c of exit of old firm
from the industry. In the LR, equilibrium point of the firm is established at the highest point of the
ARP curve.

Labor market

What is optimal number of workers? That is, how many workers should employ to maximize profit?

 As we know from earlier chapters, a price-taking firm’s profit is maximized by producing the
quantity of output at which the marginal cost of the last unit produced is equal to the
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market price.

Once we determine the optimal quantity of output, we can go back to the production function and
find the optimal number of workers.

 There is also an alternative approach based on the value of the marginal product…

 The value of the marginal product of a factor is the value of the additional output
generated by employing one more unit of that factor.

 Value of the marginal product of labor =

 VMPL =P ×MPL
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To maximize profit the firm will employ workers up to the point at which, for the last worker
employed,VMPL =W.

Shifts of the Factor Demand Curve

What causes factor demand curves to shift?

There are three main causes:

 Changes in prices of goods

 Changes in supply of other factors

 Changes in technology

We have learned that when the markets for goods and services and the factor markets are
perfectly competitive, factors of production will be employed up to the point at which their value of
the marginal product is equal to their price.

What does this say about the factor distribution of income?

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Although Farmer Jones grows wheat and Farmer Smith grows corn, they both compete in the
same market for labor and must therefore pay the same wage rate, $200. Each producer hires
labor up to the point at whichVMPL = $200: 5 workers for Jones, 7 workers for Smith.

Equilibrium in the Labor Market

Each firm will hire labor up to the point at which the value of the marginal product of labor is equal
to the equilibrium wage rate.

This means that, in equilibrium, the marginal product of labor will be the same for all employers.

So the equilibrium (or market) wage rate is equal to the equilibrium value of the marginal product
of labor—the additional value produced by the last unit of labor employed in the labor market as a
whole.

It doesn’t matter where that additional unit is employed, sinceVMPL is the same for all producers.

The theory that each factor is paid the value of the output generated by the last unit employed in
the factor market as a whole is known as the marginal productivity theory of income distribution.

The Supply of Labor

Work Versus Leisure

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Decisions about labor supply result from decisions about time allocation: how many hours to
spend on different activities.

Leisure is time available for purposes other than earning money to buy marketed goods.

A rise in the wage rate causes both an income and a substitution effect on an individual’s labor
supply.

 Thesubstitution effect of a higher wage rate induces longer work hours, other things equal.

 This is countered by theincome effect : higher income leads to a higher demand for leisure,
a normal good.

If the income effect dominates, a rise in the wage rate can actually cause theindividual labor
supply curve to slope the “wrong” way: downward.

Shifts of the Labor Supply Curve

The market labor supply curve is the horizontal sum of the individual supply curves of all workers
in that market.

It shifts for four main reasons:

 changes in preferences and social norms,

 changes in population,

 changes in opportunities, and

 changes in wealth.

Rent, Interest, and Profit

• What is land?

– Land is a resource or a factor of production

– The owner of land is paid rent for allowing its use in the production process

– The amount of rent paid for a piece of land is based on the supply of and the demand for
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land

• Land is land

• How land is used depends on its location, its fertility, and whether it possesses any
valuable minerals

• Sometimes we confuse land with what is built on it

– Land with an apartment building on it will rent for more than a vacant lot

• However ineconomic terms we pay rent on the land itself

• A plot of land may have a few alternative uses

• If it is used at all, it will be used by the highest bidder – the one willing to pay the most for it

• The basic way one piece of land differs from another is location

– An acre of land in the middle of a desert is worth a lot less than an acre of land in a
metropolitan area

• In economics we say the supply of land is fixed

• We can make more efficient use of land

• We represent the supply of land as a vertical line

• The demand for land, like the demand for labor and capital, is derived from a firm’s MRP
(Marginal Revenue Product) curve

• The land will go to the highest bidder

• The demand curve for land slopes downward to the right because its marginal physical
product declines with output (due to diminishing returns)

– If the firm is an imperfect competitor, it must lower price to increase sales, thereby further
depressing MRP as output expands

Determination of rent
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• Marginal Revenue of product (MRP): is the change in revenue obtained from the sale of
additional produced by that factor unit.

• The demand for rent is the MRP schedule of the highest bidder for a specific piece of land.

• The supply of land is fixed, so its supply curve is perfectly inelastic.

• The rent, like the price of anything else, is set by supply and demand

200,000

160,000

120,000 D 2

80,000
D 1

40,000

Amount of land

• Economic rent is payment in excess of what people would be willing to accept

• Rent paid to landlords (exclusive of any payment for buildings and property improvement )
is, by definition, economic rent

• What is capital

– Capital consists of office buildings, factories, stores, machinery and equipment,

computer systems, and other synthetic goods used in the production process

– When we invest we are spending money on new capital

– The stock of capital increases by means of a flow of investment

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• Say you have a capital stock of four machines. You buy two more. That’s your
investment for the year. Now you have a capital stock of six machines

How Is the Interest Rate Determined?

The interest rate is determined by the demand for loanable funds and the supply of loanable funds.
The supply of loanable funds (or savings) slopes upward to the right because the amount of
money people save is somewhat responsive to interest rates

16 S

14

12

10

4 D

Q 1

Quantity of loanable funds

How Are Profits Determined?

• Economist treat profits as a residual left to the entrepreneur after rent, interest, and wages
have been paid

– One could argue that because these three resource payments are determined by
supply and demand, then what is left over, profits, are indirectly determined by
supply and demand

2.2. FACTOR PRICING UNDER IMPERFECT COMPETITION

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Factor pricing under perfectly competitive input market and monopolistic competitive product
market

When there is imperfect competition in the product market, MR of a product is less than price of
the product. This affects the demand for a factor and the price it will get under conditions of
imperfect competition in the product market.

Since perfect competition is assumed to prevail in the factor market, price of factor will be
determined by demand and supply of factors of production. Hence the supply or cost curve of
input suppliers is AFC= MFC curve horizontal to x-axis.

But since there is imperfect market (monopoly) in the product market, the MRP curve will lie below
VMP curve. That is, MRP<VMP since MR<P, under imperfect competition or monopoly both AR
and MR curve slope downward

The firm will be in equilibrium where MRP=MFC even under this condition
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As can be seen, point E is the equilibrium point where the firm employs ON quantity of factor at
OP price (factor cost). At this point, the MRP of employing ON quantity of the factor is EN and is
less than the value of marginal product given by RN.

Thus, from this, we can observe that the factor of production gets less than the value of its
marginal product byRE amount and this is the influence of imperfect product market even though
the input market is competitive.

Monopsony in the factor market and perfect competition in the product market

A monopsony in factor market means that there is only one firm which buys the factor of
production. Hence if the monopsonist decreases his factor employment (decreases its demand
for factor), then it can lower the price of the factor and if it increases its factor employment
(increases its demand for factor), it can raise the price of the inputs. Therefore, it can be deducted
that the supply curve of factor or AFC curve that the monopsonist will face is a raising/ positively
sloping supply curve. But the MRP and ARP curve will assume their usual shape since perfect
competition in the product market.

The firm will be in equilibrium by employing quantity factor where MRP=MFC.

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As can be seen, the firm employs ON quantity of factor at OP price (factor cost). Since there is
monopsony in the factor market, it gets super normal profit equivalent to the area RPST. In other
words, the factor is being paid NT(OP) price while its average revenue product is SN. The
difference (TS) between them is called monopsonic exploitation per unit of factor of production.
Total exploitation is given by RPST.

Monopsony in factor market and monopoly in product market

As can be understood from the previous discussion, when there is monopsony in the factor
market and monopoly in the product market, then MRP<VMP and MFC>AFC respectively.

Here the equilibrium point E where the MRP curve cuts MFC curve. At that point, the firm employs
ON units of factor at OP (TN) price which is less than NE (MRP of the factor). The gap ET is due to
the existence of monopsony in the factor market and is therefore called monopsonistic
exploitation of the factor. The gap SE between MRP and VMP is due to the existence of monopoly
in the product market and is therefore called the monopolistic exploitation of the factor. Thus the
total exploitation (ST=RP) is the exploitation of the factor employed from both side i.e. from
monopsonist in the factor market and monopolist in the product market.
 Micro II

UNIT THREE

3. MARKET FAILURE AND THE ROLE OF GOVERNMENT

Markets are fine institutions when all of the conditions for their efficient operation are in place.
The principal sources of market failure are: externalities, public goods, asymmetric information,
and the concentration of power. In addition markets may produce outcomes that are unfavorable
to certain groups – perhaps those on low incomes. The circumstances described here lead to
what is termed market failure.

Market failure defines outcomes in which the allocation of resources is not efficient.

Although markets are usually a good way to organize economic activity, this rule has some
important exceptions. There are two broad reasons for a government to intervene in the economy:
to promote efficiency and to promote equity. That is, most policies aim either to enlarge the
economic pie or to change how the pie is divided.

Imperfect market competitions

In examining monopoly and imperfect competition we repeatedly stressed how such market
structures can give rise to inefficient outcomes, in the sense that the value placed on the last unit
of output does not equal the cost at the margin. In monopoly structures this arises because the
supplier uses his market power in order to maximize profits.

What can governments do about such power concentrations? Every developed economy has a
body similar to Canada’s Competition Bureau. Such regulatory bodies are charged with seeing that
the interests of the consumer and the economy more broadly, are represented in the market place.

Interventions, regulatory procedures and efforts to prevent the abuse of market power come in a
variety of forms. Even if governments successfully address the problems posed by the market
failures described above, there is nothing to guarantee that market-driven outcomes will be ‘fair’,
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or accord with the notions of justice or equity. The marketplace generates many low paying jobs,
unemployment and poverty. Governments address these outcomes through a variety of social
programmes and transfers monopolized business into privatization.

Imperfect market will result in:

 Buyers/and sellers have some influence on price

 Due to this, MR is not equal to price, hence, firms are not price takers

 Inefficiency can result deadweight loss

Imperfect information

Markets for information abound in the modern economy. Governments frequently supply
information on account of its public good characteristics. But the problem of asymmetric
information poses additional challenges. Asymmetric information is where at least one party in an
economic relationship has less than full information. This situation characterizes many
interactions: bosses do not always know how hard their subordinates work; life-insurance
companies do not have perfect information on the lifestyle and health of their clients.

Asymmetric information is where at least one party in an economic relationship has less than full
information and has a different amount of information from another party.

Smith is saying that participants in the economy are motivated by self-interest and that the
“invisible hand” of the marketplace guides this self-interest into promoting general economic well-
being. The invisible hand usually leads markets to allocate resources efficiently. Without perfect
information, for various reasons, the invisible hand sometimes does not work. The “invisible hand”
of the marketplace leads self-interested buyers and sellers in a market to maximize the total
benefit that society derives from that market. In particular, the invisible hand ofthe market leads to
an allocation of resources that makes total surplus as large asit can be.

Asymmetric information can lead to two kinds of problems. The first is adverse selection. For
example, can the life-insurance company be sure that it is not insuring only the lives of people who
are high risk and likely to die young? If primarily high-risk people buy such insurance then the
insurance company must set its premiums accordingly. In effect the company is getting an
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adverse selection rather than a random selection of clients. Frequently governments decide to run
compulsory-membership insurance plans (auto or health are examples in Canada) precisely
because they may not wish to charge higher rates to higher-risk individuals.

Adverse selection occurs when incomplete or asymmetric information describes an economic

relationship.

The second type of problem is moral hazard. If an individual does not face the full consequences
of his actions, his behavior may be influenced: If the boss cannot observe the worker’s effort level,
the worker may shirk. Or, if a homeowner has a fully insured home he may be less security
conscious than an owner who does not.

Moral hazard may characterize behavior where the costs of certain activities are not incurred by
those undertaking them.

Solutions to these problems do not always involve the government, but in critical situations do.
For example, the government requires most professional societies and orders to ensure that their
members are trained, accredited and capable. Whether for a medical doctor, a plumber or an
engineer, a license or certificate of competence is a signal that the work and advice of these
professionals is bona fide. Equally, the government sets standards so that individuals do not have
to incur the cost of ascertaining the quality of their purchases – bicycle helmets must satisfy
specific crash norms. These situations differ from those where solutions to the information
problem may be implemented in the market place: life insurance companies can establish the
past medical history of its clients, and employers may be able to provide incentives to its
employees to work hard.

Externality

One possible cause of market failure is an externality. An externality is the impact of one person’s
actions on the well-being of a bystander. The classic example of an external cost is pollution. If a
chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much.
Here, the government can raise economic well-being through environmental regulation. The
classic example of an external benefit is the creation of knowledge. When a scientist makes an
important discovery, he produces a valuable resource that other people can use. In this case, the
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government can raise economic well-being by subsidizing basic research, as in fact it does.

A negative externality is one resulting, perhaps, from the polluting activity of a producer, or the
emission of greenhouse gases into the atmosphere. A positive externality is one where the activity
of one individual confers a benefit on others. An example here is where individuals choose to get
immunized against a particular illness. As more people become immune, the lower is the
probability that the illness can propagate itself through hosts and therefore the greater the
benefits to those not immunized. Solutions to these market failures come in several forms:
government taxes and subsidies, or quota systems that place limits on the production of products
generating externalities. Taxes on gasoline discourage its use and therefore reduce the emission
of poisons into the atmosphere. Taxes on cigarettes and alcohol lower the consumption of goods
that may place an additional demand on our publicly-funded health system. The provision of free,
or low-cost, immunization against specific diseases to children benefits the whole population.

These measures attempt to compensate for the absence of a market in certain activities.
Producers may have no great desire to pay for the right to emit pollutants, and consequently if the
government steps in to counter such an externality, the government is effectively implementing a
solution to the missing market.

Mechanism to overcome the effect of externality

Internalizing the effect of externality through subsidy if the externality is positive and through tax
if the externality has negative impact on the wellbeing. This simply means that the costs that are
borne by the society must be taken into account in production decision by the producers.

Industrial policy: issuing patent to firms

The coase theorem- bargaining of private parties and firms due to extra cost incurred. This
agreement may fail. A solution to externality problems which shows that in the case of small
numbers of affected parties, a property right assignment is sufficient to internalize any externality
that is present.

Public policy:-

 command and control policy

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 forbid certain behaviors

 require certain behaviors

 market-based policies

 government uses taxes and subsidies to align private incentives with social efficiency

Public Goods

Another possible cause of market failure is public goods.Public goods are sometimes called
collective consumption goods, on account of their non-rivalries and non-excludability
characteristics. For example, if the government meteorological office provides daily forecasts
over the nation’s airwaves, it is no more expensive to supply that information to one million than
to one hundred individuals in the same region. Its provision to one is not rivalries with its provision
to others – in contrast to private goods that cannot be ‘consumed’ simultaneously by more than
one individual. In addition, it may be difficult to exclude certain individuals from receiving the
information.

Public goods are non-rivalries, in that they can be consumed simultaneously by more than one
individual; additionally they may have a non-excludability characteristic.

Examples of such goods and services abound: highways (up to their congestion point), street
lighting, information on trans-fats and tobacco, or public defense provision. Such goods pose a
problem for private markets: if it is difficult to exclude individuals from their consumption, then
potential private suppliers will likely be deterred from supplying them because the suppliers
cannot generate revenue from free-riders. Governments therefore normally supply such goods
and services. But how much should governments supply?Goods can be free goods or economic
goods. When goods are available free of charge then that good is free good.Free goods provide a
special challenge for economic analysis. Most goods in our economy are allocated in markets. If
the goods are not available free of charge it is economic goods. When goods are available free of
charge, the market forces that normally allocate resources in our economy are absent. When a
good does not have a price attached to it, private markets cannot ensure that the good is
produced and consumed in the proper amounts. In such cases, government policy can potentially
 Micro II

remedy the market failure that results, and raise economic well-being.

When thinking about the various goods in the economy, it is useful to group them according to
two characteristics:

 Is the good excludable?

 Is the good rival?

Goods can also be categorized as excludability or rival. Excludability-refers to the property of a

good whereby a person can be prevented from using it. Rivalry- refers to the property of a good
whereby one person’s use diminishes other people use. Depend on these two definitions we have
four types of goods.

 common goods- are rival but not excludible

 natural monopolies- are excludible but not rival

 private goods- are excludible and rival

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 public goods- neither excludible nor rival

Public goods are nonexclusive benefits to everyone in a group and that can be provided to one
more user at zero marginal cost. A free rider is a person who receives the benefits of a good but
avoids paying for it. This action prevents private markets from supplying public goods.
Government can decide to provide the public good if the total benefits exceed the costs. Since
people cannot be excluded from enjoying the benefits of a public good, individuals may withhold
paying for the good hoping that others will pay for it.The free-rider problem prevents private
markets from supplying public goods.

UNIT FOUR
Partial and General Equilibrium

Partial equilibrium analysis is the determination of equilibrium price and quantity of a single
market assuming certain other things remaining constant.

General equilibrium analysis is the determination of simultaneous equilibrium prices and

quantities of all markets in a system.

Therefore, general equilibrium analysis examines the inter relation among the various decision
making units and the various markets in the economy in attempt to give a complete, explicit and
simultaneous answer to the basic economic questions of what, how and for whom to produce.

In this analysis, we use a two factor – two-commodities, two-consumer (commonly called as a

2x2x2) – general equilibrium model. In the section we are not interested in analyzing as to how
the dynamic processes finally lead to equilibrium. Rather our interest, here, is on the conditions
required for each markets and economic agents to be in a state of equilibrium.
 Micro II

Assumptions

There are two factors, labor (L) and capital (K) with fixed quantity and these factors are fully
utilized

Given the technology, only two goods, X and Y, are produced in the economy. And the production
function are represented by isoquants having the usual properties (negatively sloped, convex to
the origin, never intersect each other, diminishing marginal rates of substitution, etc.).

There are consumers, A and B, whose utility represented by the usual indifference curve.

All economic agents maximize their interest given their constraints – firms maximize profits,
consumers maximize utility, etc.

All markets are perfectly competitive and are initially at equilibrium.

General equilibrium of exchange

This is an equilibrium condition which occurs when the two individuals reached equilibrium in the
exchange of the two commodities at the point where marginal rate of substitution in consumption
for the two commodities is the same for both individuals.

e.g. suppose that individual A and B possesses together a combined total of 14 units of Y and 16
units of X. suppose also that the tastes of individual A are represented by indifference curve I, II
and III while the tastes of individual B are given by indifference curve I’, II’, and III’, (with origin at 0)

Individual B A
IC I’ II’ III’ I II III
Commodities X Y X Y X Y X Y X Y X Y
15 4 15 7 15 10 1 10 3 10 5 12
12 5 12 8 13 11 2 5 5 5 7 7
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9 7 11 9 12 13 3 3 9 3 11 5
7 10 10 11

In the above figure, I, II, and III represent indifference curve of individual A and I’ II’ and III’
represent the indifference curve of individual B. each point on and inside the box represent a
particular distribution of 14 Y and 16 X between individuals A and B. for example, at point C, A has
 Micro II

10Y and 1X and B has 4Y and 15X. at point C, since the MRSxy for individual A exceeds MRSxy for
individual B, there is a base for exchange between individual A and B. starting from point C,
individual A would be willing to give up 5Y to get one additional unit X and hence move to point D
on indifference curve I.

Since A is willing to give up more of Y than necessary to induce B to give up one unit of X, there is
a base for exchange. In such exchange, A will give up some Y in return for X from B.

Starting from point C, if A gives up 3Y in exchange for 6X from B, A would move from point C on
IC1 to point S on IC3 (at C A had 1x and 10y and B had 15x and 4y but after the exchange A will
have 7x and 7y and B will have 9x and 7y, hence moves along indifference curve I’ from point C to
S. A would gain from these exchange since he/she move from IC1 to IC3 and B would neither gain
nor lose since he/she is on the same IC (IC1). At point S, indifference curve III and I’ are tangent
and so their slope are equal.) That is MRSxy for A equals the MRSxy for B so there is no base for
further exchange. That is the amount of Y that A would be willing to give up to obtain one unit of x
from B is not sufficient to induce B to give a unit of x.

If B gave up 2x in exchange for 7y from A, individual B would move from point C on indifference
curve I’ to point F on indifference curve III’. In this case, all the gains from exchange will accrue to
B and A will neither gain nor lose since it will still remain on indifference curve I. at point F, MRSxy
for A equals the MRSxy for B and so no further base for exchange.

Starting from point C on indifference curve I and I’, if individual A exchange 5y and 4x with
individual B, both will move to point E and both will gain from the exchange since E is on
indifference curve II and II’ and this point is the equilibrium point for exchange. Joining at these
equilibrium points (point of tangency) we get a contract curve. So if A and B are on the contract
curve, no base for exchange i.e. MRSxy for A equals the MRSxy for B but if both of them are
outside this curve, either A or B or both can gain from exchange.

General equilibrium of production

A producer of two commodities (X and Y) using two factor (L and K) reaches general equilibrium
of production whenever the marginal rate of technical substitution between labor and capital
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(MRTSlk) in the production of x is equal to the MRTSlk in the production of y.

X Y
X1 X2 X3 Y1 Y2 Y3
L K L K L K L K L K L K
5 1 11 3 13 7.5 1 6 4 10 10 11
4 2 8 5 11 8 3 4 6 7 10 10
3 8 6 8 8 11 7 2 9 5 13 7
2.5 10 11 2

If this economy was initially at point R, it would not be maximizing its output of x and y because at
point R, MRTSlk of x exceeds MRTSlk in the production of y.

By simply transferring 8 k from production of Y and 1L from the production of Y to the production
of X, this economy can move from point R (on X1 and Y1) to point J (on x1 and Y3) and increase
 Micro II

its output of Y without reducing its output of X.

On the other hand, this economy can move from point R to point N and as a result increase in
output of X without reducing its output of Y by transferring 2K from the production of X to the
production of Y and 8L from Y to X.

By transferring 5K from the production of X to the production of Y and 5L from Y to X, this

economy can move from point R (on X1 and Y1) to point M (on X2 and Y2) and increases its
output of both X and Y. at points J, M and N X’s isoquant is tangent to Y’s isoquant and so
MRTSlk of x equal to MRTSlk in the production of y.

If we join such tangency points, we get the production contract curve OXJMNOY. Thus by simply
transferring some of the given and fixed quantities of L and K available between the production of
X and Y, this economy can move from a point on the production contract curve to a point on it and
so increase its output. However once on its production contract curve there is no further net gain
in output to be obtained and the economy is in general equilibrium of production.

General equilibrium of production and exchange

An economy is said to be in equilibrium of production and exchange when MRTxy=(MRSxy)A =

(MRSxy)B.

Marginal rate of transformation of X for Y (MRTxy) measures by how much this economy must
reduce its output of Y in order to release enough L and K to produce exactly one more unit of X.

Suppose that the amount of output of X and Y to be produced in the economy are 12X and 12Y on
the transformation curve and A1, A2, and A3 are the three indifference curves for individual A and
B1, B2 and B3 are the indifference curves for individual B.
 Micro II

Graph: production possibility curve

From above figure,

At H, A has 4X and 8Y and B has 8X and 4Y, at C, MRSxy for A= MRSxy for B= 5. When moving to D,
A has 7X and 5Y and B has 5X and 7Y. Therefore, at D, MRSxy for A= MRSxy for B=1.

When moving to E, A=9X and 7Y and B= 3X and 5Y, at E, MRSxy for A= MRSxy for B=1/5

At point C, A will have 5X and 3Y; and B will have 7X and 9Y; therefore, MRSxy in the
 Micro II

ΔY 9-3
economy= = =3
ΔX 7-5

At point D, A will have 7X and 5Y; and B will have 5X and 7Y; therefore, MRSxy in the
ΔY 7-5
economy= = =1
ΔX 5-7

At point E, A will have 9X and 7Y; and B will have 3X and 5Y; therefore, MRSxy in the
ΔY 5-7
economy= = = 1/3
ΔX 3-9

Therefore at D, MRSxy for A= MRSxy for B=1

So at that point, the economy will be in simultaneous equilibrium of production and exchange.

Welfare Economics

Welfare economics is concerned with the evaluation of alternative economic situations from the
point of view of the society’s well-being.

Welfare economics studies the condition under which the solution to a general equilibrium model
can be said to be optimal. This requires an optimal allocation of factors among commodities and
an optimal allocation of commodities (distribution of income) among consumers. An allocation of
factors of production is said to be pareto optimal if production can’t be re-organized to increase
the output of one or more commodities without decreasing the output of some other commodity.
Thus in a two commodity economy, the production contract curve is the locus of pareto optimal
allocation of factors in the production of the two commodities.

Similarly, an allocation of commodities can be said to be pareto optimal if distribution can’t be re-
organized to increase the utility of one individual without decreasing the utility of some other
individual. Thus, in a two individual economy, the consumption contract curve is the locus of
pareto optimal distribution of commodities between the two individuals.

¬¬¬¬¬¬Key points:

Any production on the Edge worth contract curve is efficient.

Allocation of factors in such a way to produce just on the Edge worth contract curve is Pareto
 Micro II

optimal.

If the allocation in a system is already Pareto optimal, reallocation of factors from one industry to
another industry will increase output on one industry only at a cost of reduction in output of the
other industry.

UNIT FIVE: GAME THEORY AND ECONOMICS OF INFORMATION

Game theory

Definition:A game is any situation in which players (participants) make strategic

decisions – i.e., decisions that take into account each other’s actions and responses.

Examples of games include firms competing with each other by setting prices, or a
group of consumers bidding against each other at an auction for a particular
commodity. A key objective of game theory is to determine the optimal strategy for
each player. A strategy is a rule or plan of action for playing the game. For our price
setting firms, a strategy might be: “I will keep my price high as long as my competitors
do the same, but once a competitor lowers her price, I will lower mine even more”. For
a bidder at an auction, a strategy might be: “I will make a first bid of Br 2000 to
convince the other bidders that I am serious about winning, but I will drop out if other
bidders push the price above Br 5,000.”

Strategic decisions result in payoffs to the players: outcomes that generate rewards
or benefits. For the price-setting firms, the payoffs are profits; for the bidders at the
action, the winner’s payoff is her consumer surplus – i.e, the value she places on the
commodity less the amount she must pay. In general, the payoff of a strategy is the
net gain it will bring to the player for any given counterstrategy of the competitor(s).
The optimal strategy for a player is the one that maximizes her expected payoff.

The payoff matrix of a player is a table showing the payoffs accruing to this player as
a result of each possible combination of strategies adopted by her and by her rival(s).
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To explain the payoff matrix of a game let us limit ourselves with two-person games
each having two strategies. Suppose that two people, A and B, are playing a simple
game. Person A will choose between “Top” and “Bottom”. Simultaneously, person B
will independently choose between “Left” and “Right”. Different combinations of their
choices will have different payoffs for the players as depicted in Table.

Player B

Left Right

Player A Top 1, 2 0, 1

2, 1 1, 0 Bottom

A payoff matrix of a game

Person A has two strategies: she can choose Top or she can choose Bottom. Person
B also has two strategies: she can choose Left or she can choose Right. If A chooses
Top and B chooses Left, then we examine the top left-hand corner of the matrix. In
this matrix the payoff to A is the first entry in the box, 1, and the payoff to B is the
second entry, 2. Similarly, if A says Bottom and B says Right, then A will get a payoff of
1 and B will get a payoff of 0. The payoff matrix of a game simply depicts the payoffs
to each player for each combination of strategies that are chosen. These choices can
represent economic choices like “raise price” or “lower price”; “sticking to an agreed
upon price/quantity” or “cheating on the agreement”; “advertise” or “do not advertise”
and so on that will make game theory very applicable in day to day business life. The
strategies could also represent political choices like “declare war” or “do not declare
war”.

A Dominant Strategy is a strategy that is optimal no matter what an opponent does.

 Micro II

The dominant strategy will maximize the expected payoff of the player no matter what
the other player does.

Assumptions of game theory

This game theory assumes that while selecting its strategy, a duopolist will assume
that his rivals will adopt a strategy which will be most unfavorable to its interest

This game theory also assumes that duopolist knows all the possible strategies open
to it as well as those strategies available to his rival.

Game theory can be classified as zero-sum game and non-zero-sum game

Zero-sum game: is the one in which the algebraic sum of the outcome (profit or loss)
for all participating firms equals to zero for every possible combination of strategies.
In this game the gain of one firm is considered as a loss to the other firm.

e.g.

Firm B
B1 B2 B3 Row minimum
Firm A A1 1 0 2 0
A2 -2 -1 0 -2
Column Maximum 1 0 2 0=0
Note: numbers in the box represent the possible profit or loss of each firm

In the above example, if firm A uses strategy A1 and if firm B responds by strategy B1
then A will get a profit 1 from the market share of B. But if strategy A1 of firm A is
confronted by strategy B2 of firm B, A will gain nothing from the market and as a
result B suffers no loss of market share.

If firm A uses strategy A2 and if B responds by strategy B1, A loses a profit of 2 and
this will be taken by firm B. and if B responds by strategy B2, firm A loses a market
share of 1 and this again will be taken by firm B.
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In the above example, firm A knows that B will use a strategy that will minimize A’s
gain. Hence, it adopts a maximin strategy (maximum of the minimum profits will be
selected by A) and selects strategy A1 since it results in maximization of its minimum
gain in view or anticipation of B’s response.

Firm B knows that firm A will always use strategy A1. Hence firm B will adopt strategy
B2 to minimize A’s gain (B’s loss). Thus B adopts minimax strategy. That is B adopts
minimum of maximum strategy and hence minimize the column maxima.

All these interaction will result in the coinciding of the maximum of the row minima
with the minimum of the column maxima (0=0). Such game is said to be a strictly
determined game and the solution is said to be the saddle point (0, 0).

Non-zero sum game: this is a type of game in which the algebraic sum of all the
possible outcomes for all the participating firms is less or greater than zero for every
possible combination of the strategies.

e.g. given the following strategy of charging a low or a high price by the two firms, the
best strategy of each firm can be determined as follows.

Firm B
Lower price Higher price
Firm A Lower price 1,1 3, -1
Higher price -1,3 2,2

In the above table, the first outcome of each combination of strategy refers to firm A
and the second number refers to firm B and numbers represent percent of market
share or profit by each firm.

If firm A use a low price strategy, it will get 1% of market share or profit if firm B
responds with low price strategy and get 3% of market share or profit if firm B
responds with high price strategy. However, if it adopts a higher price strategy, it will
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lose 1% of market share or profit if firm B responds with low price strategy and get 2%
of market share or profit if firm B responds with high price strategy.

If firm B use a low price strategy, it will get 1% of market share or profit if firm A
responds with low price strategy and get 3% of market share or profit if firm A
responds with high price strategy. However, if it adopts a higher price strategy, it will
lose 1% of market share or profit if firm A responds with low price strategy and get 2%
of market share or profit if firm A responds with high price strategy.

This is astrictly determined non-zero positive sum game with saddle point accuracy
when each firm charge a low price and earns a profit of 1.

Non-zero negative sum game

The idea of this game can be well be understood by using the concept of prisoners’
dilemma. e.gIn the prisoners’ dilemma, two criminals named Prisoner A and Prisoner
B have been detained by the police and are being questioned separately . They are
jointly guilty of participating in a crime. Each player can choose either to confess or
not. The payoff matrix is depicted in the following table.

Prisoner B

Confess Don’t

Prisoner A Confess (-10, -10) (0, -20)

Don’t (-20, 0) (-1, -1)

From the above table, confessing is
the best strategy for prisoner A no matter what prisoner B does. The reason is that if
prisoner A confesses, we are in the top row of the matrix (corresponding to the row
labeled Confess). Similarly, if B confesses, the payoff will be in the relevant column. In
this case, if only one player confesses, that player goes free and the other serves
twenty years in jail. (The entries correspond to the number of years lost to prison. The
first entry is always A’s payoff, the second B’s payoff.) Thus, for example, if B
confesses and A does not, the relevant payoff is the first column and the second row.
 Micro II

If B confesses and A does not, A will be imprisoned for twenty years, and B loses no
years, that is, goes free. This is the payoff (-20, 0). If both confess, they are both
convicted and neither goes free, but they only serve ten years each. Finally, if neither
confesses, there is a chance they are convicted anyway (using evidence other than the
confession), in which case they will be imprisoned for a year each.

The prisoners’ dilemma is famous partly because it is readily solvable. First, A has a
strict advantage to confessing, no matter what B is going to do. If B confesses, A gets
-10 from confessing, -20 from not, and thus is better off from confessing. Similarly, if
B doesn’t confess, A gets 0 from confessing, -1 from not confessing, and is better off
confessing. Either way, no matter what B does, A should choose to confess. This is
what we called a dominant strategy , a strategy that is optimal no matter what the
other players do.

So the saddle point (equilibrium point) for this game will be -10, -10. In this case both
suspects are losers. Therefore this game is called non-zero negative sum game and
represents the case of two non-collusive duopolists.

Limitation of game theory

It assumes that duopolistic is always a risk averse but in reality, duopolistic take a risk

This theory assumes that duopolist will fight only for fixed amount of profit in the
market but this is not practically true.

It assumes that duopolistic have all knowledge of strategies open to them and as well
as to their rivals. But this is not practically true. So due to all these limitations, game
theory can’t be practically applied.

5.2. Economics of Information

So far we have not examined the problems raised by differences in information. There
are many markets in the real world in which it may be very costly or even impossible to
gain accurate information about the quality of the goods being sold. Example: labor
market- it may be very difficult for a firm to determine how productive its employees
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are.

Signaling: iscommunication that conveys information. It refers to an action taken by

an informed party to reveal private information to an uninformed party.

Market signaling: Actions taken by buyers and sellers to communicate quality in a

world of uncertainty. E.g. Warranty in selling new cars

Signaling helps to make the market perform better.

Two properties of signaling:

Signals must be costly to fake

If some individuals use signals that convey favorable information about themselves,
others will be forced to reveal information even when it is considerably less favorable.

5.2.1. Information asymmetry

A difference in access to relevant knowledge is called information asymmetry.

When some people know more than others do, the market may fail to put the
resources to their best uses.

One of the parties has information relevant to the transaction that the other party does
not have.

Asymmetric information can lead to drastic differences in the nature of market

equilibrium

The decision a consumer makes when outcomes are uncertain is based on limited
information.

If more information were available, the consumer could make better predictions and
reduce risk.

Because information is a valuable commodity, people will pay for it.

The value of information is the difference between the expected value of a choice
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when there is complete information and the expected value when information is
incomplete.

Value of info.=EV with info.-EV with uncertainty

5.2.2 Adverse selection

Adverse selection is a situation in which asymmetric information results in high-

quality goods or high-quality consumers being squeezed out of transactions because
they cannot demonstrate their quality.

It refers to the tendency for the mix of unobserved attributes to become undesirable
from the standpoint of a uniformed party.

It refers to situations where one side of the market has to guess the type or quality of
a product based on the behavior of the other side of the market.

It is a process by which the less desirable potential trading partners volunteer to

exchange.

Adverse selection problem is also called hidden information problem.

5.2.3. Moral hazard

Moral hazard refers to the tendency of a person who is imperfectly monitored to

engage in dishonest or otherwise undesirable behavior. It refers to a situation where
one side of the market can’t observe the actions of the other side.

e.g1. Employees on wages with little effective monitoring.

An office employee may spend time shirking (slacking), studying for an exam, or
chatting on the phone with friends when there is work waiting to be done.

All sorts of shirking are MH problems

e.g2. Senior executives may pursue their own goals of status, high salaries, and job
security rather than the stockholders’ interests
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They may push sales growth over profits.

They may oppose takeovers that would oust them and increase the value of the firm.
They may ignore the shareholder’s rightful claims.

◦Moral hazard problem is also called hidden action problem

5.3. Risk and uncertainty

So far, we have assumed prices, incomes, and other variables are known with
certainty

However, many of the choices that people make involve considerable uncertainty

What is uncertain in economic systems?

 tomorrow‘s prices

 future wealth

 future availability of commodities

 Present and future actions of other people…

Uncertainty is a fact of life

People face risks anytime they make decisions Example: People borrow with the
intention to pay in the future. But future incomes are uncertain; … How should we take
uncertainties into account when making major consumption or investment decisions?
The consumer is presumably concerned with the probability distribution of getting
different consumption bundles of goods. Suppose that you have $100 now and that
you are contemplating buying lottery ticket number 13.

If number 13 is drawn in the lottery, you will be paid $200. This ticket costs, say, $5.

The two outcomes that are of interest:

◦the event that the ticket is drawn and

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◦the event that it isn't.

The amount that you would have if you did not purchase the lottery ticket is $100.

if you buy the lottery ticket for $5, you will have:

 ◦$295 if the ticket is a winner,

 ◦$95 if it is not a winner.

In this example there are two states of nature: winning or losing. But in general there
could be many different states of nature. We can then think of a contingent plan as
being a specification of what will be the outcome in each different state of nature.
Contingent means depending on something not yet certain, so a contingent
consumption plan means a plan that depends on the outcome of some event. E.g. the
insurer pays only if there is an accident. A probability distribution consists of a list of
different outcomes and the probability associated with each outcome.

5.3.1. type of risk preference

Risk averse: utility function with diminishing marginal utility of wealth.

Risk seeking: preferences described by a utility function with increasing marginal

utility of wealth.

Risk neutral: preferences described by a utility function with constant marginal utility
of wealth.

Minimizing risk

Insurance offers a way to change probability distribution.

Diversification: involve in different enterprises. Eg.growing different crop types on the

farm

Risk Spreading each consumer spreads his risk over all of the other consumers and
thereby reduces the amount of risk he bears. Spreading over time or over space also
possible.
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Stock market allows the original owners of the firm to convert their stream of returns
over time to a lump sum. A way of spreading the risk over a large number of
shareholders. Invest in additional information