Chapter 1: MONOPOLY

Definition: Monopoly is a market structure in which there is one seller in the market. Mono means
one and poly means seller. Monopoly→ one seller

Assumptions:
 Only one seller in the market. The monopoly is the industry.
 There are no close substitutes for the commodity it produces. It produces differentiated/unique
products.
 There are barriers to entry & hence there is no competition.
 Imperfect dissemination of information: cost, price, and product quality information is withheld
from uninformed buyers.
Origins of Monopoly Power:
Factors that lead to the establishment of monopoly are generally termed as barriers to entry. Four basic
types of factors that lead to barriers (or monopoly power) include:
1. Control over strategic raw materials. If a firm has exclusive control over strategic raw materials, or
exclusive knowledge of production techniques, then it can easily be a monopolistic producer.
2. Special knowledge of low-cost productive techniques. Firms may develop unique product or
techniques and takes measures & prevent others from copying technology through the use of patent
rights.
3. Substantial economies of scale. In this case the size of the market may not allow the existence of
more than a single large plant. Example, Rail-way transport electricity and other public utilities.
These are known as natural monopoly.
4. Government licensing and pricing policy-implies the imposition of foreign trade barriers to exclude
foreign competitors & a price policy aiming at the prevention of new entry.
Demand & Revenue under Monopoly
The demand curve for a monopolist is the industry demand curve. Because industry demand curves slope
down ward, monopolists also face a downward sloping demand curve. Thus, MR is always less than price
for output quantities greater than one because of the negatively sloped demand curve.

P We will use a linear demand curve for simplicity. i.e. the inverse
a demand function is: P = a – bQ, where (–b) = slope & a price axis
intercept. Note that the total revenue of the monopolist is: R = PQ. Its
price or average revenue equation is the same as demand equation:
P = a – bQ. Substituting price equation into the revenue equation, we
obtain total revenue (R):
R = aQ – bQ2. And marginal revenue (MR) is: MR = a -
0 a/2b 2bQ.This shows that the MR is a straight line with the same intercept as
a/b Q
the demand curve but twice as steep; that is the slope of MR is two times
MR the slope of AR or demand curve.

In general, the general relation between P & MR is mathematically found as follows:

R = PQ, and

The above relation shows that at any levels of output MR is smaller than P (or demand). Recall that price
elasticity of demand is given as:

1
Therefore, MR, price and elasticity of demand are related as follows:
 When demand is inelastic (e > 1), MR is positive indicating that R is rising with price; that is,
increase in output can be obtained only through large declines in market price, leading to decrease
in TR.
 If demand is elastic (e < 1), MR < 0 implying that R is falling (when price rises); that is, each
additional sale will increase revenue.
 When demand is unitary elastic (e =1), MR = 0 and hence R remain unchanged, i.e. revenue is at
its maximum.
Costs and Supply under Monopoly
Costs: The short-run cost conditions facing a monopolist are identical with those faced by a perfectly
competitive firm. That is, the AVC, ATC & MC curves are all U-shaped representing the law of variable
proportions, while AFC is rectangular hyperbola.
Supply Curve:
There is no unique supply curve for a monopolist. The MC is not the supply curve of the monopolist, as is
the case in pure competition. In monopoly there is no unique relationship between price and quantity
supplied, because given his MC curve,
 the same quantity can be offered at different prices depending on the price elasticity of demand,
or
 different quantity can be supplied at any one price based on demand and MR curve.

Short-run Equilibrium of the Monopolist

The goal of the firm (producer) is the same in both monopoly and perfect competition i.e. profit
maximization. However, MR is less than price in monopoly, while MR = P in competition. To sell an
additional unit the monopolist must lower its price, if he/she is to generate extra demand necessary to
absorb the increased supply.

P/C In order to maximize profit or minimize cost, a

MC monopoly firm would choose to produce that output
D
AC
level for which MR is equal to MC, provided that MC
cuts the MR from below (see figure below). The
Pe C equilibrium of the monopolist is defined by point e, at
which MC intersects MR curve from below. Thus,
A B
both necessary condition (MR = MC) & sufficient
e condition (slope of MC > slope of MR) are fulfilled for
equilibrium.
Thus, equilibrium price and quantity are Pe & Qe
0 Qe D Q respectively. And the monopolist realizes excess
MR profits equal to the area of rectangle ABCPe.

NB: When a monopoly equates MR and MC, it simultaneously determines the output level and the market
price for its product.
Algebraically, the monopolist’s equilibrium is derived as follows.
 The demand function is given as: Q = f(P) or P = f(Q)
 The cost function is given as:C = f(Q). Thus,
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  The total revenue (R) of the firm is : R = PQ
 The profit (π ) of the firm is :  = R –C
The objective of the monopolist is the maximization his/here profit (). But the necessary condition for
profit maximization is that the first-order derivative of profit with respect to output must be equal to zero.
That is,

The sufficient (2nd order ) condition for maximum profit is:

or

(Slope of MR) < (Slope of MC)

Example: Given the demand curve of the monopolist: Q = 30 – 0.3P, and given the cost function: C =
2Q2+ 20Q + 10,
a) find the profit maximizing level of output and price.
b) determine the maximum possible profit.
c) check for the 2nd order condition.
[Answer: a) Q = 7.5& P = 25; b) Profit = 290; and c) d2π/dQ2 <0; d(80 – 32Q/3)/dQ= -32/3]
Q. Say “true” or “false”. There is no unique supply curve for the monopolist that can be derived from his
MC. Explain.
Answer: True. Because, given the monopolist’s MC either the same quantity may be offered at different
prices depending on the price elasticity of demand, or various quantities may be supplied at any one price,
depending on the market demand curve. These two cases are graphically illustrated as below.
In figure (a) the given quantity Qe will be sold at price P1 if demand is D1, and the same quantity Qe will be
sold at price P2 if demand is D2. In figure (b), however, the monopolist can supply Q 1 if demand is D1 at
price Pe (for a given MC curve). At the same price P e, he would supply Q2 units of output if market
demand is D2.
In general, given a downward-sloping demand curve, the monopolist will either set his price or sell the
amount that the market will take at it, or he will produce the output defined by the intersection of MC and
MR, which will be sold at the corresponding price on the demand curve. Thus, the monopolist can
determine its output or price simultaneously but not both.
P/C
P/C
D2 MC Figure (a) D2
Figure (b)
D1
D1
P
1 MC
P
2
Pe
e
e1 e2
D1

D2 D2
0 Qe Q
MR2 0 Q1 Q2 D1
MR1
MR1 MR2

3
Long-run Equilibrium Condition of the Monopolist:
In the long-run the monopolist has time to expand his plant or to use the existing plant at any level which
will maximize profit. If the monopolist incurs a short-run loss and if there is no plant size that will result
in pure or excess profit, the monopolist go out of business; the monopolist will not stay in business if s/he
makes losses in the long-run. With entry blocked, however, it is not possible for the monopolist to reach
an optimal scale (that is, to reach the minimum point of the LAC curve).
Just like any other firm the monopolistic firm will maximize its profit when;
 LMC is equal to MR curve, and
 LMC curve is rising
In general, the size of his plant and the degree of utilization of any given plant size depends on the market
demand. Consider the following three cases:
1. Suboptimal plant and excess capacity:
P/C This figure indicates the case in which the
SAC SMC LMC market size doesn’t permit the monopolist to
LAC expand to the minimum point of the LAC
P
curve, point m. In this case full-economies of
scale are not exhausted (see point e, which is to
E e’ the left of point m) and the existing plant is
m
also underutilized (see point e’ on the falling
e D part of SAC curve). Thus, this is the case in
which there is excess capacity (of XeXm).

X
0 Xe Xm
MR

2. Plant is Larger than Optimal and Is Over-utilization:

P/C In this case the size of the market is so
LMC
large that the monopolist, in order to
SMC
LAC maximize his output, must build a plant
P
A SAC larger than the optimal (e’, which is to
the right of minimum point of LAC
e D curve) and over-utilized the existing plant
E (rising part of SAC curve). Thus, the
e’
plant that maximizes the monopolist’s
MR profits leads to higher costs because it is
X larger than the optimal size and over-
0 Xe utilized
This is the case in which the market size is just large enough to
permit the monopolist to build the optimal plant us it at full
3. Optimal Plant and Full Capacity capacity. That is, in the long-run the monopolist firm produces
its optimal output at the minimum point on both the short-run
AC and long-run AC curve point ‘E’). In general, which of the
above three situations will emerge in any particular case
depends on the size of the market, given the technology of the
market. Recall that the long-run equilibrium of the monopolist
illustrated in the 1st two conditions is not optimal from the
view point of the competitive firm. Under perfect competition
price is determined in the long-run by the minimum LAC
curve where LMC = LAC = SMC = SAC = P. In the case of
the monopolist the producer selects an output such 4 that
MC=MR and prices on the corresponding level on the demand
curve; and hence equilibrium price exceeds MC by a
substantial amount.
 C/P

LMC LAC
SAC
SMC
P

D
E

0 X
Xm=Xe
MR

Price Discrimination:
Definition:
Price discrimination is the selling of a product (at a given time) to different buyers at different prices
when the price differences are not justified by differences in the cost of producing the product for the
different buyers. In short, price discrimination exists when the same product is sold at different prices to
different buyers. The products are basically the same, but it may have slight differences: for instance:
 commercial and household uses of electricity,
 different bindings of the same book,
 different locations of seats in a theater, etc
Price discrimination is more easily implemented by the monopolist because s/he controls the whole supply
of the commodity.
Types of Price Discrimination:
There are three types of rice discrimination:
1. First degree price discrimination: This is also known as perfect price discrimination (or “take-it-
or-leave-it”). It occurs when the monopolist able to charge each buyer the maximum amount that
the consumer willingness to pay. Each buyer is charged exactly that price which leaves him
indifferent between buying and not-buying. Example, service charge by dentist. In this case all
consumers’ surplus is taken away by the monopolist.
2. Second-degree price discrimination: occurs when the monopolist can negotiate and sell at more
than two prices (higher than existing market price, P). In figure below the monopolist, by selling
OX1 at P1, X1X2 at P2, X2X3 at P3 and so on, will receive a still larger portion of the consumers’
surplus.
3. Third-degree price discrimination: occurs when a monopolist charges different prices in different
markets for the same product. So a higher price will be charged in the market with less elastic
demand.

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 Price P P
1st Degree 2nd Degree 3rd Degree
P1
P2 P1
P
P3 P
P

0
0 X Quantity 0 X1 X2 X3 X Q 0 X1 X Quantity

Here we concentrate on the third degree price discrimination. The reason for a monopolist (or any other
firm) to apply price discrimination is to obtain an increase in his total revenue and his profits.
Conditions for price discrimination to implement:
There are two necessary conditions for the implementation of price discrimination:
1. The market must be divided into sub-markets with different price elasticities.
2. There must be effective separation of sub-markets, so that no reselling can take place from a low
price market to a high price market.
Decisions how much to sell in each market to maximize Profit:
Assume that the monopolist will sell his product in two segregated markets, each of them having a
demand curve with different elasticities. The total demand curve is found by the horizontal summation of
the two demand curves. And the total marginal revenue curve is also the horizontal summation of the each
marginal revenue. Therefore:
 the total output that he must produce is defined by equating total MR and total (common) MC
[that is, MR (=MR1+MR2)=MC], and
 the price and quantity that maximize profit in each market is obtained by equating the common
MC to the corresponding marginal revenue in each market; that is, MR1=MC in the 1st market
------(1) and
MR2=MC in the 2nd market------(2)
Clearly from equation (1) and (2) we can deduce that the total profit of the monopolist is maximized when
he equates the common marginal cost (MC) to the individual marginal revenues. That is:
MR1 = MC = MR2 --------(3)
NB: The outputs sold in the different markets are assumed to be the same which is produced by a given
plant (using a given cost). So we have a single cost function.
Mathematical Derivation of Equilibrium Position of the Price Discriminating Monopolist:
 Given that the total demand of the monopolist is: P = f(Q), where Q = Q1+Q2.
 Assume that the demand for two segmented markets are: P1 = f1(Q1) & P2=f2(Q2).
 The cost structure of the monopolistic firm is: C = f(Q) = f(Q1+Q2).
 The firm aims at maximization of its profits. π = R1+R2 – C.
The first order condition for maximum profit requires that the 1 st order derivative of profit with respect to
each output must be zero. That is,

MR1 = MC1; but MC1=MC. Thus, MR1=MC ------ (i)

6
 MR2 = MC2; but MC1 = MC. Thus, MR2 = MC -----(ii)

From expression (i) and (ii) the equilibrium condition for a price discriminating monopolist is given as:
MC = MR1 = MR2 -------(iii).
The second order (or sufficient) condition for maximum profit is:

In short, (the slope of each MR) < (the slope of MC).

Multi-plant Monopolist:
It is possible for the monopolist to operate by more than one plant. Usually there could be one small and
one large plant or one old & one new plant. The cost curves of each plant that produces a homogeneous
product may differ.
Now the problem faced by the monopolist is the allocation of production between plant-1 (say small) &
plant-2 (say large plant).
Assumptions:
 The monopolist is assumed to know his market demand (& the corresponding MR curve).
 The monopolist also knows the cost structure of the different plants. Thus, the total MC of the
monopolist is given as the horizontal summation of the MC curves of the individual plants. i.e.
MC = ∑mci, where i =1, 2, ---,n and n is the umber of plants.
 Assume the monopolist has two plants (small & large) with which he produces the same output.
Thus, price is the same for both plants, small & large plant.

MC1 MC2
AC1 AC2 MC=MC1+MC2

Pe Pe Pe
Π2
Π1
MC1 e1 MC2 e2 MC=MR e D

0 Q1 0 Q2 0 Qe=Q1+Q2 Q
MR
Now total revenue (R) is given as: R = PQ, where Q = Q 1 + Q2 and Q1 its output of plant-1 & Q2 is output
produced by plant-2. Thus, R = P (Q 1 + Q2 ), and MR1 = MR2 = MR = since P is the same for both
plants.
Given the MR & MC curves, the monopolist can define the total output and the price at which it must be
sold in order to maximize his profit from the intersection of these two curves-MR & MC curves. (See
figure above).
The allocation of production between the plants is decided by the marginalistic rule given as: MC1 = MC2
= MR
NB: Total profit–maximizing output (Qe) & its price (Pe) is defined by the intersection of MR & total MC
curves (point e of the 3rd figure).

7
  Output produced by each plant is determined by equating the common MR to the MC of each plant
(points e1 and e2). Thus, at these points the equilibrium condition - MR =MC1 = MC2 - is
satisfied.
 The profit from plant-1 is given by the shaded region – π 1, & that from plant -2 is also given by the
shaded area, π2. Thus, total profit is the sum of profits from products of the two plants; (π = π 1 +
π2).
Mathematical Derivation of Equilibrium for Multi-plant Firm:
 Market demand is given as: P = f(Q) = f (Q1 + Q2), and
 The cost structures of the plants are given as: Plant -1: C1 = f1 (Q1), & plant -2: C2 = f2(Q2).
 The goal of the monopolist is the allocation of his production between plant-1 & plant-2 so as to
maximize his profit, π = R – (C1 + C2). That is, maximize:
π = R – C1 – C2.
First order condition for maximum π requires: . That is,

Given that each unit of the homogeneous output will be sold at the same price P & will yield the same
MR, irrespective of in which plant the unit has been produced, then MR 1 = MR2 = MR. Thus, from
expression (1) & (2): MR = MC1 = MC2 for profit maximizing multi-plant monopolist.
The 2nd order condition for maximum profit requires:

That is, the MC in each plant must be increasing

more rapidly than the (common) MR of the output as a whole.

Example: The monopolist’s demand schedule is: Q = 200 – P, and the cost structure of the two plants are:
C1=50Q1 and C2=0.5Q22.
(a) Determine the profit maximizing output and price in each plant.
(b) The monopolist’s profit in each plant and the total multi-plant profit.
(c) Check for the second-order condition.
[Answer: (a) Q1=25, Q2=50 and hence Q=75; P=125 (b) ∏1=1875; ∏2=5000 & ∏=6875]

(c) 2nd order condition:

Social Cost of Monopoly Power

The comparison between the equilibrium for a monopolist and perfect competition reflects differences in
consumer welfare. This difference is illustrated as below:

8
 P/C In perfect competition the rising portion of
Fig. Monopoly & Welfare Loss industry MC curve shows society’s supply curve.
A
Thus, given the market demand curve (D)
MC=Society’s Supply
competitive market equilibrium is attained at point
E, where equilibrium output and price is given as
Pm B Qs & Ps from the society’s point of view. The
C E monopolist’s equilibrium is, however, determined
Ps
by the intersection between MR & MC at point e.
e Thus, equilibrium output is Qm and price is Pm (on
D
the corresponding demand curve.
F

0 Qm Qs MR Q

Therefore, under perfect competition the area AEF (= AEPs+EPsF; i.e. consumer surplus plus Producer
surplus) shows the overall welfare of the society. But under monopoly, the overall surplus to the society
equals area of ABeF (=ABPm+FeBPm=Consumer surplus plus Producer surplus). Thus, area BeE
represents loses to the society as a result of a monopoly power in the market; where area BCE shows a
loss from consumer surplus & area CeE a loss from producer surplus. Thus, area of a triangle BeE shows
welfare or deadweight loss due to monopoly, and hence referred to as social cost of monopoly.

Chapter 2:
MONOPOLICTIC COMPETITION

In the first part of this course we examined two "pure" market structures: Perfect Competition and Pure
Monopoly. We defined perfect Competition as the form of market organization in which there are many
sellers of a homogeneous product. Moreover, we defined Pure Monopoly as a single seller of a
commodity for which there are no close substitutes. Between these two extreme forms of market
organization lies monopolistic competition and oligopoly. In this chapter we consider monopolistic
competition. It refers to the case in which there are many sellers of a heterogeneous or differentiated
product & entry into or exit from the industry is rather is easy in the long run. In summary, an industry is
characterized as a monopolistically competitive if:
 there are many buyers and sellers.
 each firm in the industry (or Product group) produces differentiated product that are close
substitute.
 there are free entry into and exit from the industry.
Thus, monopolistic competition is a market structure in which a relatively large number of small
producers are offering similar, but not identical products. Note: as the name implies, monopolistic
competition is a blend of (perfect) competition & monopoly. The Competitive element arises because:
there are many sellers in the market, each of which is too small to affect the other sells, and
Firms can enter & leave a monopolistically competitive industry easily in the long-run.
The monopolistic element arises from product differentiation. That is, since the product of each seller is
similar but not identical, each seller has a monopoly power over the specific product it sells.

Chamberlin made other heroic assumptions of monopolistic competition. That is,

 all firms face the same demand conditions which implies that consumers' preferences are evenly
distributed among different sellers; and

9
  all firms also face the same cost conditions, i.e. the differences in products does not give rise to
differences in costs.

These assumptions help to show the equilibrium of the firm and market on the same diagram.

Product Differentiation & the Demand Curve

Differentiated Products are products that are similar but not identical. The similarity of differentiated
products arises from the fact that they satisfy the same basic consumption needs. Examples include
numerous brands of breakfast cereals, toothpaste, cigarettes and cold medicines on the market today. The
product differentiation may be real (when the inherent characteristics of the products are different) or
imaginary (when the products are basically the same but consumers are persuaded that the products are
different)

 The real differentiation exists when there are differences in the:

 Specification of products, or
 Factor inputs used, or
The case of the various breakfast cereals with various nutritional and sugar contents is best example of
real differentiation.

 Imaginary (Fancied) differentiation is established by:

 Advertising, or
 Differences in packaging, or
 Differences in product design, or
 Brand name; example: The case of different brands of aspirin, all of which contain
the same ingredients.

Demand Schedule: since the product of each seller is similar but not identical, each seller has a
monopoly power over the specific product it sells. This monopoly power, however, is severely limited by
the existence of close substitutes. Thus, these product differentiations create brand loyalty of consumers
and give rise to downward sloping elastic demand curve. That is, consumers are willing to pay a higher
price to enjoy the advantage of product differentiation. Since this differentiation is slight the firm faces
highly elastic demand curve.

Price Highly elastic

demand curve

0 quantity

Industry and Product Group

Because each firm produces a somewhat different product under monopolistic competition, we cannot
define the industry, which refers to the producers of identical product. To overcome this difficulty,
Chamberlin redefined industry as a "product-group"- a group of firms/producers producing similar (or
closely related) products. Here, for simplicity we will continue to use the term "industry" (to refer to all
the sellers of the slightly differentiated products in a product group).
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Price & Output Determination in the Short-run and Long run
Before we examine equilibrium of monopolistically competitive firm let us briefly explain some basic
concepts.

*Costs: Chamberlin adopts the shape of costs of the traditional theory of the firm. That is, ATC,
AVC and MC curves are all U-shaped; and AFC has a geometric hyperbola shape.
*Actual-Sales (or share- of the market) Demand Curve: It is also called proportional (or prorata)
demand curve. It shows the actual sales of a firm at each price after accounting for the adjustments of the
prices of other firms in the group. Alternatively, it is the amount of demand going to a typical firm when
all firms are charging the same price. Here all firms adjust price simultaneously but independently.
*Perceived (or Planned) demand curves: the amount of demand going to a typical firm when there is no
a simultaneous price adjustment by other firms.

Derivation of Prorata Demand Curve:

Actual-sales curve (DD) is derived from perceived demand curve (dd). If price is P 0, the firm's sale could
be Q0. When this typical firm reduces price to P 1 perceiving that his sales will rise to Q’ 0, all other firms
will adjust their price to P 1 simultaneously but independently and hence the typical firm will actually sale
only Q1 amount on a
downward shifted perceived demand curve (d 1d1). If
Price any one firm further reduces price to P 2 the perceived
demand curve slide-down to d2d2 because of
simultaneous price adjustment by all other firms.
d D
Thus, at P2 a firm plans to sell Q ’1 but actually sell
d’ only Q2 on d2d2 (planned demand curve). Thus, the
P0 proportional demand curve (DD) is the locus of
d’’ shifting perceived demand curves (dd) as
competitors, acting simultaneously, change their
P1 price. A movement along the DD curve shows
changes in the actual sales of existing firms as all of
P2 them adjust their price simultaneously, with their
d share remaining constant. However, the shift in DD
d’ curve is caused by entry of new firms into and exit of
D d’’ existing firms from the industry, and shows a decline
(entry) or increase (exit) in the share of the firm.
0 Q0 Q1 Q2 Q’0 Q’1 Quantity

Short-Run and Long-run Equilibrium

Short-Run Equilibrium: Just like any other firm, the monopolistically competitive firm will produce as
long as the marginal (extra) revenue from selling output exceeds the extra (marginal) cost of producing
that output. In the short-run, maximum profit (or equilibrium) occurs when these extra revenue (MR) and
extra costs (MC) are equal. See point E of figure (a) below. In general, short-run equilibrium conditions
are:
 MR = MC and MC is rising, &
 Proportional demand curve intersects perceive demand curve.
Graphical illustration of equilibrium:

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 P/C
P/C
MC
D D
MC AC
AC

Pe C A
Pe

A
B
d
E e
d
D D

Q 0 Q
0 Qe Qe
MR MR

Figure (a)—short run equilibrium Panel (b)—Long run equilibrium

Long-Run Equilibrium: In monopolistic competition entry & exist are free in the long run. Firms can
enter an industry when there are excess (or abnormal) profits to be made, and firms suffering losses can
fold-up and go out of business. Consider the case where short-run excess profits are there, i.e. panel (a) of
figure above shows excess profit of area ABCP e. The abnormal profits (area ABCP) will attract new
competitors into the market.
The result of new entry is a downward shift of the
Long-run equilibrium of perceived demand curve (dd) and the proportional
P/C monopolistic competition demand curve (DD), since a large number of sellers share
the market. Assuming that the new cost curves will not
D
D’
d
shift as entry occurs; each shift to the left of the planned
d’ demand curve will be followed by a price adjustment as
the firm reaches a new equilibrium position, equating the
B LMC new marginal revenue on the shifted marginal revenue
Pm
LAC curve to its marginal cost. This process will continue
until the perceived demand is tangent to the average cost
P’m A curve, & hence the excess profits are wiped out
(represented by point A). In short, long-run equilibrium
e is defined by three conditions:
1) MR = MC & MC must be rising.
e’ d 2) The perceived demand curve (dd) must be tangent to
D’ the LAC curve, representing zero economic profits.
d’
3) The proportional demand curve (DD) must intersect
both the planned demand curve (dd) & LAC curve at
0 Q’m Qm Quantity
a point of their tangency.
MR’ MR
Exercise:
1. Each proportional demand curve shows a constant share of the market, and, as such, it has the
same elasticity as the market demand at any one price. Proof!
2. Given the long-run equilibrium proportional demand curve P = 51-2q and LATC curve ATC(q) =
q2 – 16q + 100 for a firm in a monopolistic competition:
a) What is the long-run equilibrium price and quantity?
b) What is the elasticity of perceived demand curve at the equilibrium quantity?
(Ans. for Q2: a) Qe=7 and Pe=37; b) From question (1), ep for proportional demand=ep of market
demand; so ep =2.64)

12
 CHAPTER 3:
OLIGOPOLY
Definition: Oligopoly is the form of market organization in which there are few sellers of
homogeneous or differentiated product. If there are only two sellers in the market, we have a duopoly.
That is, duopoly is a special case of oligopoly in which there are only two sellers in the market. If the
product is homogeneous, we have a pure oligopoly. If the product is differentiated, we have a
differentiated oligopoly.

Because there are only few firms selling a homogeneous or differentiated product in oligopolistic markets,
the action of each firm affects the other firms in the industry, and vice versa. Thus, it is clear that the
distinguishing characteristic of oligopoly is the interdependence or rivalry among firms in the industry.
This interdependence is the natural result of fewness.

The sources of oligopoly are generally the same as for monopoly, that is:
1. Economies of scale, which enable few firms supplying the entire market.
2. Huge capital investment & specialized inputs are required to enter oligopolistic industry (eg.
Automobiles, aluminum, steel, ...)
3. Patent right (exclusive right to produce a commodity or to use a particular production process).
4. Established firms may have loyal following customers
5. Control over entire supply of raw materials.
6. The government may award a franchise to only few firms to operate.

Types of Oligopoly: In general, oligopoly market is divided into two broad categories:

I. Non-collusive Oligopoly: in which firms may be better rivals of each other through advertising,
product differentiation, and so on.
II. Collusive Oligopoly: in which firms form coalition and cooperate.

I. NON-COLLUSIVE OLIGOPOLY

Since an oligopolist knows that its own actions will have a significant impact on the other Oligopolists in
the industry, each oligopolist must consider the possible reaction of competitors in deciding its pricing
policies, the degree of product differentiation to introduce, the level of advertising to undertake, & so on.

Because competitors can react in many different ways, we do not have a single oligopoly model. Here we
present some of the most important Oligopoly models:

A) Cournot's Model (lies between competition & monopoly)

B) The Stackelberg model (extension of Cournot model).
C) The "Kinked-Demand" model
D) Bertrand's Model (similar with perfect competition)
E) Chamberlin's model (monopoly solution)

A. COURNOT'S DUOPOLY MODEL

The French Economist Augustin Cournot introduced the first formal oligopoly model (in 1838). He made
the following assumptions to illustrate his model.
1) For simplicity, Cournot assumed that there are only two firms (duopoly)- A & B- selling identical
spring water, and operating with zero costs.

13
 2) They sell their output in a market with a straight-line downward sloping demand curve.
3) Each firm, while trying to maximize profits, assumes that the other duopolist holds its output
constant at existing level. In other words, firms are assumed never to learn from past experience,
which makes their behavior at least naive.

The third assumption is the basic behavioral assumption made in Cournot model. The result is a cycle of
moves and countermoves by the duopolists until each sells one-third of the total industry output and
n/(n+1) of market output (where n = number of firms). This is shown in figure below.

P P
12 Panel (a) 12 Panel (b)

9 Market
Demand (D)
8
6 A dE
D 6
A’
dB 4.5
4 E
B d’A
3 3 B
dB

0 3 6 0 3 4 4.5 6 8 9 12 Q
mrB mrA

In panel (a), D is the market demand curve for spring water. The marginal cost of production is assumed
to be zero. When only firm A is in the market, D=d A and the firm maximizes profits by selling Q=6 at P =
$6 (at point A, given by MR A = MC =0). When firm B enters the market it well faces d B (the unsupplied
portion of the market). Firm B maximizes profits by selling Q = 3 at P = $3 (at point B, the midpoint of d B
at which MRB = MC = 0).

Firm A now faces d'A given by market demand (D) minus amount sold by B (Q B=3) and maximizes profits
by selling Q = 4.5 at P =$4.5 (see panel (b) of point A'). While firm A’s equilibrium output goes on
decreasing that of B rises. This process continues until each produces one-third of the market (1/3 x 12 = 4
units) and two-third together (8 units = 2/3 x 12) - (see point E on dE).

In general, for n-firms each will produces 1/(n+1) and the industry output will be n/(n+1). So, the larger
the number of firms, the closer is its output and price to the competitive level. For instance, from our
illustration:
Under perfect competition, Q = 12 units at P =0 (P = MC = 0)
Under Monopoly Market, Q = ½(12) = 6 units at P = $6 (MR =MC =0)
Under Oligopoly (duopoly) Market, Q = 2/3 (12) = 4 units at P = $4 (lies between
competition & Monopoly)

NOTE:Each firm produces 1/(n+1) of the total output that would be supplied to the market at P=MC=0;
industry supply will be n[1/(n+1)] of output that would be supplied to the market at P = MC = 0.

NB: The assumption of cost less production is unrealistic. But it can be relaxed without impairing the
validity of the model. This is illustrated with the help of the reaction-curves approach.

14
Reaction Curves Approach: is based on the concept of isoprofit curves of the competitors. An isoprofit
curve for firm A is the locus of points defined by different levels of output of A and his rival, firm B,
which yield to A the same level of profit.
QB
QB
A’s Reaction
function

ΠBi = B’s
Isoprofits
ΠAi = A’s
ΠB1
Isoprofits
ΠB2 B’s Reaction
ΠA3 function
ΠA2

ΠA1 ΠB3

0 0 QA
QA

Similarly, an isoprofit curve for firm B is the locus of points of different levels of output of the two
competitors (A & B) which yield to B the same level of profits.

Properties of Isoprofit curves:

1) Isoprofit curves are concave to the axis along which we measure the output of the rival firms. For
example, isoprofit of firm A is concave to QB axis & that of B is to QA axis.
2) The further the isoprofit curves of a firm lie from its axis, the lower is the profit it represents and
vice versa. i.e. ∏A1>∏A2>∏A3, and ∏B1>∏B2>∏B3.
3) The highest points of successive isoprofit curves lie to the left of each other for firm A and to the
right of each other for firm B.

NOTE:
1) The profit maximizing output of A (for any given quantity of B) is established at the highest point
on the lowest attainable isoprofit curve of A.
2) If we join the highest points of the isoprofit curves of A and B, we will obtain firm A's & firm B's
reaction curve, respectively.

Definition: Reaction curve of firm A is the locus of points of highest profits that firm A can attain, given
the level of output of rival firm, say B. Similarly, reaction curve of firm B shows how much output firm B
must produce in order to maximize its own profit, given the level of output of its rival, firm A.

EQUILIBRIUM OF THE DUOPOLIST

15
 QB Cournot's equilibrium is determined by the intersection
of the two reaction curves. It is a stable equilibrium,
provided that A's reaction curve is steeper than B's
A’s Reaction reaction curve.
curve NB: At point e each firm maximizes its own profit.
The action & reaction of the duopolists leads toward
point e.
Be e
B2
B1 B’s Reaction
curve
0 A A2 A1 QA

Mathematical Derivation of Reaction Curves:

Suppose the market demand facing the Duopolist is: Q = a + bP, where Q = market output, P = price & b
= slope, which is less than zero. Assume also that the two duopolists have different costs:
C1 = f1(Q1), and C2 = f2(Q2).
Thus, 1 = R1 - C1 ------ the first duopolist profit function &
2 = R2 - C2 ----- the 2nd duopolist profit function
Note: R1 = PQ1 and R2 = PQ2 , and Q1 + Q2 = Q

i) The first duopolist maximizes his profit by assuming second firm's output (Q 2) constant, irrespective
of his own decisions; while the second duopolist maximizes his profit by assuming that Q 1 will be
remain constant.

The first -order (necessary) condition for profit maximization of each duopolist is:

1 =  (R1-C1)= R1 - C1 =0, and

Q1 Q1 Q1 Q1

2 =  (R2-C2)= R2 - C2 =0, and

Q2 Q2 Q2 Q2

NB: R1 = MR1, R2 =MR2, C1 = MC1 & C2 = MC2
Q1 Q2 Q1 Q2

Thus, 1 = MR1 - MC1 = 0  MR1 = MC1 .......... (1)

Q1

And 2 = MR2 - MC2 = 0  MR2 = MC2 .............. (2)

Q2
Solving from expression (1) for Q1, we obtain Q1 as a function of Q2 & hence we obtain 1st firm's
reaction function.
Solving from the 2nd equation for Q2 we obtain Q2 as a function of Q1, which represents 2nd firm's
reaction function.
Finally, solving the reaction functions of the two duopolists simultaneously we obtain the Cournot
stable equilibrium; that is, the values of Q1 & Q2 which satisfies both equations.
16
ii) The second-order (sufficient) conditions for equilibrium are:

; and

That is, MC must cut MR curve from below, or (Slope of MR) < (Slope of MC) for both duopolists.

Example 1: Assume that the market demand equation is given as: Q = 12-P, where Q = total quantity of
spring water sold in the market & P is the market price. Suppose that spring water is supplied with zero
costs. Thus, MC is zero for the two firms, A & B.
a) Find the reaction function of both firms.
b) Compute QA & QB that leads to Cournot stable equilibrium.

Solution: Q = 12-P or P = 12- Q, where QA + QB = Q

Q = 12 - QA - QB
a) Revenue of A: RA = PQA = (12 - QA - QB)QA
RA = 12QA -Q2A - QAQB; and hence A = RA - CA = 12QA - Q2A - QAQB
Revenue of B: RB = PQB = (12 - QA - QB)QB
RB = 12QB - QAQB – Q2B ; and hence B = RB - CB = 12QB - QAQB - Q2B

i) Necessary condition for maximum profits is:

A = 0, and B = 0
QA QB

A = (12QA - Q2A - QAQB) = 0  12 -2QA - QB = 0 ….......(1)

QA QA

B =  (12QB - QAQB - Q2B) = 0 12 -QA -2QB = 0 .......... (2)

QB QB

Solving for QA from expression (1) , we get A's reaction function, i.e.
QA = 12 - QB ------------- (3) A's reaction function
2
Solving for QB from equation (2), we obtain B's reaction function
i.e. QB = 12 - QA ------- (4) B's reaction function
2
b) The Cournot equilibrium can be obtained by substituting duopolist B's reaction function into
duopolist A's reaction function (equation 3 ). Doing this, we get:

QA = 12 - (12 - QA)/2 = 12 - (6 - 0.5QA) = 12 - 6 + 0.5QA

2 2 2
QA = 6 + 0.5QA = 3 + 0.25QA  3 + QA = QA

Multiplying both sides by 4 we get:

4QA = 12 + QA  4QA -QA = 12  3QA = 12; thus, QA = 12/3 = 4

With QA = 4, QB = (12- QA)/2 = (12 – 4)/2 = 8/2 = 4

So that, QA = QB = 4 (Cournot equilibrium).

17
 But P = 12 - Q, where Q = QA + QB = 8 (Industry out put)
Thus, P = 12 - 8 = $4 Each duopolist will sell spring water at P = $4

Example 2 : Assume that the market demand & the costs of the duopolists are as given below:
Market Demand: P = 100 - 0.5Q = 100 - 0.5(Q1 + Q2); and Costs: C1 = 5Q1 , and C2 = 0.5Q22 .

a) Find the reaction function of each firm.

b) Find Q1 and Q2, the satisfy Cournot's equilibrium.

Answer: a) For A: Q1 = 95 - 0.5 Q2, & b) Q1 = 80 , Q2 = 30 and P = 45

For B: Q2 = 50 - 0.25Q1

Example 3: The marginal revenues of the duopolists need not be the same. Actually, if the duopolists
are unequal size the one with the larger output will have the smaller marginal revenue.
Proof!

(That is, proof that ).

NB: For the last two examples, you must show all the necessary steps.

B. THE STACKELBERG MODEL:

Heinrich Stackelberg (German economist) made an important extension to the Cournot model.
Stackelberg assumed that one of the duopolists, say duopolist A, knows that duopolist B behaves in the
naive Cournot fashion (i.e., firm A knows B's reaction function) and uses that knowledge in choosing its
own output. Duopolist A is then called the Stackelberg leader, duopolist B is referred to as the
Stackelberg follower. All the other assumptions of the Cournot model hold.

This model shows that duopolist A will have higher profits than under Cournot solution at the expense of
duopolist B (the Stackelberg follower).

The Stackelberg leader substitutes the follower's reaction function in market demand equation and solve
for his output (QA). The resulting expression is the demand function facing duopolist A (the leader).
Then, as usual cases the leader maximizes profit by equating his MR to his MC.

Example: Assume market demand is given by:

Q = QA + QB = 12 - P, & both firms have equal average (and marginal) costs which is zero. Thus,
A's reaction function is: QA = (12 - QB)/2 ................. (1)
B's reaction function is: QB = (12 – QA)/2 ............. (2)

Because duopolist A knows duopolist B's reaction function, we can substitute expression (2) into market
demand, i.e
QA + QB = 12-P  QA + (12 - QA)/2 = 12- P  QA = 12 - 2P ......(3)

18
Equation (3) is the demand function facing duopolist A when he knows duopolist B's reaction function &
behavior.

From expression (3), we get MRA, i.e.

RA = PQA, where P = 6- 0.5QA
= (6-0.5QA)QA = 6QA - 0.5Q2A
MRA = RA = 6 - QA
QA
At equilibrium MRA = MCA  6 - QA = 0  QA = 6. But P = 6 - 0.5QA  P = 6 - 0.5(6)  P = 3

Thus, since MC = 0, duopolist A maximizes its total revenue and total profits by selling six units at
P = $3. Duopolist B would then sell three units; because.
QA + QB = 12 - P
6 + QB = 12 - 3  6 + QB = 9  QB = 3
With Q = QA + QB = 9, P = $3, duopolist A earns $18 (PQ A = 3 x 6 = 18) and duopolist B earns $3 (PQ B =
3 x 3 = $9). Note that under the Stackelberg Solution, whether duopolist A or B is the Stackelberg leader,
the combined total revenue and profits of both firms would be the same ($27 = $18 + $9, in our example).

Alternative Method: The Stackelberg leader substitute the Stackelberg follower's reaction function into
his own profit function to determine his own output & market price.

C. THE KINKED-DEMAND MODEL:

Here interdependence is recognized unlike the Cournot model. This model, introduced by Paul Sweezy in
1939, attempts to explain the price rigidity that is often observed in some oligopolistic markets. The two
basic assumptions of this model that leads to a kinked-demand curve are:

1) If an oligopolistic firm raised price, it would lose most of its customers because the other firms
in the industry would not match the price increase. Thus, the oligopolists face a demand curve
that is highly elastic (i.e. dA).
2) Oligopolists could not increase its share of the market by lowering its price, since its
competitors would immediately match the price reduction as a result the firm faces a demand
curve that is less elastic for price reductions (like segment AD).
P/C Because of the above two assumptions, the demand
curve faced by oligopolists has a kink at the established
price (PA or Point A). As a result the marginal revenue
is discontinuous at the level of output corresponding to
d the kink (at QA the discontinuity segment is EF).
MC’ MC2 Oligopolist's marginal revenue curve is MR or dEFG.
PA A
Segment dE of MR curve corresponds to segment AD
MC’’
of the demand curve (see figure).
E
The discontinuity (between E & F) of the MR curve
MC1
implies that there is a range with in which costs may
F change without affecting the equilibrium price (P A) &
G quantity (QA).
Q
0 QA D
MR NOTE: Oligopolists' demand curve is given by
segment dAD and MR is dEFG.

In general, the behavioral pattern implied by the "kink" seems quite realistic in the highly competitive
business world which is dominated by strongly competing oligopolists. It can explain the stickiness of
19
prices in a situation of changing costs & high rivalry. However, there are some major limitations in this
model:
 The model implies that price rigidity coincides with quantity rigidity (but not the case in reality)
 It doesn't explain the level of price at which the kink will occur.
 The assumption that firms don't match price increase is also questioned.

D. BERTRAND DUOPOLY MODEL:

Bertrand’s duopoly model (which was developed in 1883) differs from Cournot’s in that it assumes that
each firm expects that the rival will keep its price, irrespective of its own decision about pricing. Each
firm is faced by the same market demand, and aims at the maximization of its own profit on the
assumption that price of the competitor will remain constant. In this case the firm chooses price in stead of
quantities (unlike case of Cournot). Like the Cournot model, the Bertrand model duopoly model applies to
firms that produce homogenous product.

Because products are homogenous, consumers purchase only from the lowest price seller. Thus, if the two
firms charge different prices, the higher priced firm will sell nothing. If both firms charge the same price,
consumers will be indifferent as to which firm they buy from. And it is assumed that each will supply half
the market. In general, this model leads to price competition over time. Each firm tries to cut price to
capture all the market share. Thus, all will seek to undercut their rivals and a price cutting war will result.
Firms will stop cutting their prices only when competitive price level is reached. In other words,
Bertrand’s equilibrium is at a perfectly competitive price such that no further price cutting occurs.

Consider the following example where the market demand for a good is: P = 80 – Q, where Q = Q 1+Q2;
and both firms have a constant MC of 10. Thus, if price is below this MC, there will be an incentive to
reduce price with the intension of capturing more market share. This price cut will continue until it equals
MC, which is, of course, a competitive price. Thus, for Bertrand equilibrium occurs when P = MC = 10,
and over all equilibrium output equals 70 (Q=80-P), where each firm supplies half of the market; i.e.
Q1=Q2= Q/2=70/2 = 35 units.

Criticism:
Just like Cournot model, Bertrand’s duopoly model is criticized on the following points:
1. Assumption of naïve behavior; i.e. rivals don’t learn from past experience.
2. It is closed model in the sense that entry is blocked.
3. Other variables of competition are not included in the model; it considers only price competition.
Note that price competition is more natural (than quantity choice) when products have some degree of
differentiation. To illustrate this, consider duopolists with costs and demand schedule for each given as
follows:
Costs: C1=10+3Q1 and C2=10+3Q2; Demand: Q1=12-2P1+P2 and Q2=12-2P2+P1. What will be the
equilibrium of the two firms setting their prices at the same time?
Solution:
First firm’s profit: π1 = R1-C1=18P1-2P21+P1P2-3P2-46; so at maximum profit.
Solving P1 as a function of P2, we obtain firm-1’s reaction function as: P1 = 4.5+0.25P2.
Firm-2’s profit: π2 = R2-C2=18P2-2P22+P1P2-3P1-46; so at maximum profit.
Solving P2 as a function of P1, we obtain firm-2’s reaction function as: P2 = 4.5+0.25P1.
Finally, solving the two reaction functions simultaneously, we arrive at Bertrand’s stable
equilibrium solution: P1=P2=$6, Q1=Q2=6 units and π1= π2=$8 (in thousands).

20
THE EDGEWORTH MODEL: Special Case of Bertrand where there is no stable Solution!
In this model, as in the Cournot model, we assume that there are two firms: A & B, selling a homogenous
commodity at zero cost. In Edgeworth model, the following further assumptions are made:
1. Each firm faces an identical straight-line demand curve for its product,
2. Each firm can’t supply the entire market by itself (or each has maximum level of output), and
3. Each firm, in attempting to maximize profits or revenue, assumes that the other firm holds its price
constant.
Given the above assumptions there will be a continuous oscillation of the product price between the
monopoly price and the maximum output price of each firm.Consider 2-firms, A & B, ach with the same demand &
P zero cost. And the maximum output of each firm is
assumed to be 300 units. Thus, if A enters first, A will
6
sell 200 units at price of $3 and maximizes its profit or
TR at $600, which is a monopoly solution. Let B enters
next, & assumes that A will continue to charge P=$3.
Thus, by selling at a price slightly below $3 (as
Monopoly price indicated by broken line below P=3), B can sell its
3 maximum output of 300 units & thus captures most of
dA A’s customers. Thus, B’s profit or TR is about $800.
=d
B Firm A now reacts by reducing its price slightly below
1.5 Max. output price price of B and it can sell its maximum output of 300
(capturing most of B’s market). This process will
QA=QB continue until each firm will sell its maximum output of
0 200 300 400 300 units at price of $1.5 & thus make a profit of $300.
But this result is not stable. Because, next either firm
MRA=MRB
realizes that by raising price back to monopoly
level,
can increase its profits. Say firm A notes that if firm B maintains the price of $1.5, A could increase its
profit again to $600 by selling 200 units at a price of $3. By raising its price to $3, A will lose only those
customers who are not willing to pay the high price; it doesn’t lose any customers to firm B since B is
already selling its maximum output of 300 units. B now realizes that by raising its price to slightly below
$3 (A’s price), can still sell its maximum output of 300; then A reacts and so the price oscillates
continuously between monopoly price, $3, and maximum output price, $1.5.

NB: The Cournot, the Bertrand and the Edgeworth models are all based on the extremely naïve
assumption that the duopolists act independently; i.e. they never recognize their interdependence. In
addition, the Edgeworth model assumes that the duopolists have maximum output levels, although output
can be increased in the long-run.

E. CHAMBERLIN MODEL
Chamberlin model is one of the more realistic models unlike the Cournot and Edgeworth (or Bertrand
models). Chamberlin starts with the same basic assumptions as Cournot. But Chamberlin further assumes
that the duopolists do recognize their interdependence. The result is that without any form of agreement or
collusion the duopolists set identical prices, sell identical quantities and maximize their joint profits.

21
 P Let firm is the 1st one to enter the market. Thus, given
the market demand (D=dA), A choose to be at point A on
12 Demand (D): Q=1200-100P
D selling 600 units at price $6. Then firm B taking firm-
A’s output as given, faces demand curve d B decides to
sell 300 units at point B (since the Chamberlin model is
identical to the Cournot model). However, the duopolists
recognize each other and hence the best thing they do is
B’ A to share equally the monopoly profits of $3600, because
6 this is the best they can do. Thus, each duopolist sells
D= 300 units or half of the monopoly output at the
dA
monopoly price of $6 and makes a profit of $1800. This
3 B equilibrium is stable, which is reached without collusion
dB and generates more profits for than under Cournot
solution.
0 300 600 1200 Q

II. CULLUSIVE OLIGOPOLY

One way of avoiding uncertainty (eg. price war) arising from oligopolistic interdependence is to enter into
collusive agreements. There are two types of collusion: Cartels and Price Leadership Models. Collusion
can be explicit or tacit (implicit).

2.1 Cartel: is a combination of firms whose objective is to limit the scope of competitive forces
within a market. There are two forms of Cartels:
A) Centralized Cartel (cartels aiming at joint profit maximization), and
B) Market-sharing cartel.

A) Centralized Cartel: operates as a monopolist. It is a formal organization of producers of a

commodity whose purpose is to coordinate the policies of the member firms so as to increase joint or
industry profits. The centralized cartel appoints a central agency to which they delegate the authority to
decide:
 the monopoly price for the commodity & monopoly output.
 the allocation of monopoly output among the member firms
 the share (distribution) of monopoly profits among member firms.

Note that the agency:

 will have access to the cost figures of individual firms,
 knows the market demand curve from which he estimates marginal revenue.

Thus, total marginal cost is obtained by the horizontal summation of each firm's in the cartel. We consider
a homogeneous commodity or pure oligopoly. Industry (monopoly) price & output is determined by
equating market MR and industry MC (= SMC). Consider two firms form a cartel.

Given the market demand (DD) & each firm's MC in figure above the monopoly solution, which
maximizes joint profits, is determined by the intersection of total MC & MR (point e). The total output is
Qm and it will be sold at . The central agency allocates the production (Q m) among firm A & firm B by
equating the common MR to the individual marginal costs (i.e. MR = MC 1 = MC2; see point e1 & e2).
Thus, firm A will produce Q1 and firm B will produce Q 2. Similarly, the distribution of profits is decided
by a central agency of the cartel

22
 P/C P/C MC=MC1+MC2
p/c
Firm-A Firm-B D Market
AC1 MC2 AC2
MC1

P
c
P
d
f
g P
a b
MC1=MR MC2=MR e2 MC=MR e
e1

0 Q1 QA 0 Q2 QB 0 Qm=Q1+Q2 D Q
MR

mainly based on their cost structure. The shaded areas (or area abc for firm A & area of dgf for firm
B) of figures shown above represents profits of each firm. A total industry profit is the sum of the profits
of the two firms.

Mathematical Presentation of this Cartel:

Suppose the market demand is given as:

P = f(Q) = f(Q1 + Q2). Thus, Q1 = PQ1 & R2 = PQ2
 And the cost curves of the two firms are:
C1 = f1(Q1) and C2 = f2(Q2).
 The profit function of each firm will be:
1 = R1 - C1, and 2 = R2 – C2
 The joint or industry profit is:  = 1 + 2, i.e.
 = (R1 + R2) - (C1 + C2) = R - C1 - C2
 The first- order condition for maximum profit is:
. That is,

Note that MR = MR1 = MR2 , since all units are sold at the same price.

 From expression (1) & (2), the necessary condition for equilibrium is:

(MR1 = MR2 = MR) = MC1 = MC2 or MR = MC1 = MC2

 Second-order condition is:

2R  2C2 or (slope of MR)  (Slope of MC)
Q22 Q22

Example: assume that the four identical firms in a purely oligopolistic industry form a centralized cartel.
Suppose that the total market demand function facing the cartel is: Q = 20 -2P, and P is given in birr.
Each firm's short-run marginal cost function is given by birr 0.25q , & input prices are constant.
a) Find the best level of output and price for this centralized cartel.

23
 b) How much should each firm produce if the cartel wants to minimize production costs?
c) How much profit will the cartel make if the average total cost of each firm at the best level
of output is birr 4?

{Answer: (a) Q = 160/17, & P = 90/17 (b) Q1 = Q2 = Q3 = Q4 = 40/17 and (c) Unit  = P - AC = 90/17
-4 = 38/17, & 1 = ....= 4 = 38/17 x 40/17; since total π = (unit profit)*Output  1 = 2 = ..... = 4
= 1520/289. NB: (Q1 = Q2 = Q3 = Q4) = q & Q1 + Q2 + Q3 + Q4 = Q = 4q}

B) Market - Sharing Cartel

In a market - sharing cartel the member firms agree only on how to share the market, but keep a
considerable degree of freedom concerning the style of output, their selling activities & other decisions.

There are two methods of sharing the market:

1) Non-Price competition, and
2) Determination of Quotas

1) Non-Price Competition: In this case the member firms agree on common price, at which each
firm can sell any quantity demanded. The price is set by bargaining, with the low - cost firms pressing for
a lower price & the high -cost firms for a high price. But the firms agree not to sell at a price below the
cartel price.

This form of Cartel is "loose" in the sense that it is more unstable than the complete cartel aiming at joint
profit maximization. This is because with cost differences, the low - cost firms will have a strong
incentive to break away from the Cartel openly & charge a lower price, or to cheat the other firms
(members) by secret price concessions to the buyers. Such cheating will soon be discovered by the other
members, who will gradually lose their customers. Therefore, others may split from the cartel and price
war and instability may develop.
P/C
MCB MC=MCA+MCB
MCA PBe
Pm
Pm Pm
PAe PA
eB D
e
dA dB
eA
MR
MRB

0 qAe MRA qA 0 qBe qB 0 Qm=qAe+qBe Q

A: Low-cost Firm B: High-cost Firm Industry Equilibrium

NB: Pm is agreed price; P Ae & PBe are equilibrium price of firm A & B if they separately want to
maximize. Low-cost Firm wants to cheat by lowers of price.

2. Market-Sharing by Agreement on Quotas: This method represents the agreement on the quantity
that each member may sell at the agreed price (prices). If all firms have identical costs, the

24
 monopoly solution will emerge, with the market being shared equally among member firms;
otherwise shares of the market will differ. (See figure below for a monopoly solution).

SMC
Pm
B NB: Another popular method of
=d sharing the market is the
dA definition of geographical
D region in which each firm is
allowed to sell

0 qA=qB Qm
mrA=mrB MR

2.2 Price-Leadership:
In this form of coordinated behaviour of oligopolists one firm-usually the dominant or the largest firm in
the industry -initiates price changes, and allows all the other (small) firms to sell all they want at that
price.

There are two most common types of price-leadership:

a) Low -cost price -leadership &
b) Price -leadership by large (dominant) firm.

a) The low-cost price -leadership

In this model the firms may come to an agreement to share the markets equally or may agree to have
unequal shares. The important condition here is that the firms have unequal costs.

25
 s
are
Sh
-
ket
ar
M
ual
eq
Un
2.
Fg
P/C P/C
Fig. 1: Equal Market -Shares MCB
MCA
MCB ACB
MCA PB
PA
PB ACA
PA
eB
eB dA
dA D eA
=d
B =M
eA R dB

Q
0 qeB qeA=qB Q 0 qeB qB qeA
MRA=MRB
MRA
MRB

* In figure 1, firm A has the lowest cost and charges a lower price P A & produces qA to maximize
profit. Firm B with the highest cost would like to charge P B & produce qeB (point eB); but it prefers
to follow the leader (PA) in order to avoid a price war. If B charges P B his sales become zero
because customers switch to a low price firm, firm A. Thus, Firm B must change its price to P A
and sale qB which equals qA since there is equal market sharing.

* In fig. 2, the leader (A) maximizes his profit by setting his price at P A & selling qA amount of
output. The follower (B) must supply q B which is sufficient to maintain the price set by the leader,
although firm B maximizes his profit at point eB, selling qeB at price PB.

b) The Dominant Firm Price Leader

In the price leadership model by the dominant firm, the dominant firm sets the price for the commodity
that maximizes its profits, allows all the other smaller firms in the industry to sell all they want at that
price, and then comes in to fill the market. Thus, the small firms in the industry behave as perfect
competitors or Price-takers, and the dominant firm acts as the residual supplier of the commodity. (See
figure below).

26
 P/C
MCd NB:
A d is the demand curve of the dominant
∑MCS=SS of small firms firm (i.e. d = HKFG).
 MRd is the marginal revenue curve of the
H B dominant firm
K L D (ABCFG) is the market demand curve.
P e
C

D Since the small firms can sell all they want at

the price set by the dominant firm, they
d F behave as perfect competitors and produce
P3
where P = MCS. The horizontal distance
between market demand (D) and the total
0 G Q supply of smaller firms (MCS) at each price
Qd QS Qm Q3
gives the product (residual) of the leader. For
MRd
instance, at price the demand for the
product of the leader will be given by segme-
nt LC, which is equal to Q d. Because at this price market demand is Q m of which QS is supplied by smaller
firms. So the difference between Qm and Qs equals leader’s output, LC=Qd.

As price falls down the supply of the smaller firms decrease while the leader’s output increases. For
example, at price P3 total market demand is Q 3 which is, of course supplied by the leader because at that
high price the small firms don’t supply any quantity. Then below this price (P 3), market demand will
coincide with the leader’s demand curve.

Now having derived the leader’s demand curve (HKFG=d), and given the MC curve (MC d), the dominant
firm will be at equilibrium when his MR equals his MC. This is given by point e, where OQ d output is
produced and price of is set. Thus, at this price, small firms supply 0Qs (point L on their supply curve)
and total market demand will be OQm, which is equal to OQd+OQS.
NB:
 The dominant firm is maximizing his profit by equating his MR to MC, and the smaller firms are
just price-takers and maximize profit by equating their MC to market price.
 In order to maximize profit the leader must make sure that the small firms:
1. will follow his price, as well as
2. will produce the right output (OQs).

Mathematical Presentation of the dominant firm model: The case of pure duopolists!
Suppose the market demand is given as: P = f(Q), or Q = f(P), where Q=Qd+QS.
And the cost structure of the two groups are: Dominant firm: C d=f1(Qd), and many small firms:
Cs=f2(Qs), from which their supply is derived; QS=fs(P)
Then the demand function of the dominant firm is: Qd=Q-Qs; Qd=f(P) – fs(P). Thus, Rd=PQd.
Calculate MR of dominant firm from its demand schedule (MR d=dRd/dQd), and MC from its cost
structure: MCd= dCd/dQd.
Finally, leader equates MCd to MCd to determine the equilibrium market price & its optimal
output. The followers adopt the price set by the leader and then determine its optimal output from
their supply schedule.
NB: The low-cost price leader set price by equating his MC with his MR just like any other rational
firm. The follower (the high-cost) firm takes the price set by the leader & substitute it in to his market-
share to determine quantity produced.

27
Example 1: Price-leadership by low -cost firm. Assume the duopolists share the market equally for a
homogeneous product. If short -run MC (SMC) for firm 1 and firm-2 is given respectively as = SMC 1 =
2Q1 and SMC2 = 6 + 2Q2, what price & quantity of the commodity will each duopolist produce? (Q = 12-P
is given to be market demand). (Answer: Q1 = Q2 = 2 units, & P = 8).

Example 2: Price -leadership by Dominant firm: Assume that in a purely oligopolistic industry, there is
one dominant firm and ten small identical firms. The market demand for the commodity is: Q = 210-20P.
Suppose MCd = 1.5 + Qd/2, while MCs = 1 + Qs/4 (each small firms' MC curve).

a) Find the price the dominant firm will set.

b) How much will the small firms supply together?
c) How much will the dominant firm supply?

(Ans. a) P = 49/12, Qm = 385/3 b) Qs = 370/3 & C) Qd = 5

Chapter 4:
GAME THEORY & OLIGOPOLISTIC BEHAVIOR
A. Basic Concepts of Game Theory
*Game theory is concerned with the choice of the optimum strategy in conflict situations. It can help an oligopolist
choose the course of action of best price, best level of advertising, and optimal degree of product differentiation that
maximizes its benefits or profit after considering all possible reactions of its competitors.

Game Theory
 Game theory is concerned with the general analysis of strategic interaction. Though it has a wide variety of
application, here we will provide a brief introduction of game theory with a primary focus on its use in
explaining pricing & entry behavior in oligopolistic markets.
28
  Any situation in which individuals must make strategic choices & in which the outcome will depend on
what each person chooses to do can be viewed as a game. All games have three basic elements: Players,
Strategies, and Payoffs. Game may be cooperative, in which players make binding agreements or non
cooperative, where such agreements are not possible. Here we will concentrate on the latter.
 A Player implies each decision-maker in a game. Each player is assumed to select the course of action that
yields the most favorable outcome.
 Strategy represents each course of action open to a player in a game. Each strategy is assumed to be a well-
defined, specific course of action. Each player is uncertain about what the other will do. Strategy can be
pure or "mixed".
 Payoffs incorporate all aspects associated with outcomes of a game; that is both explicit monetary payoffs
& implicit outcomes. The outcome of each combination of strategies adopted by the two players or firms is
called the payoff. The payoff of all strategies is called Payoff Matrix

B. Nash Equilibrium
Are there strategic choices that, once made, provide no incentives for the players to alter their behavior further?
According to John Nash, a pair of strategies, say (a, b) for two respective firms (A & B), is defined to be an
equilibrium if "a" represents player A's best strategy when B plays "b" & "b" represents B's best strategy when A
Plays "a". Even if one of the players reveals the optimal strategy she/he will use, the other players cannot benefit
from knowing this. Thus, strategies "a" & "b" are called dominant strategies.

C. Two-Person zero-sum game:

Certainty model: A game where the gains of one firm equal the losses of the other (so that the total gains plus the
total losses sums to zero) is called zero-sum game. E.g. A duopoly model in which each duopolist attempts to
maximize his/her market share. Given this goal, whatever a firm gains the other firm losses.

Basic Assumptions
1. Firms have well defined goal
2. Each firm knows the strategies open to it and its rival
3. Each firm knows with a certainty the payoffs of all combinations of the strategies being considered.
4. The actions chosen by the duopolists do not affect the total size of the market.
5. Firms are 'rational', i.e. each firm chooses its strategy expecting the worst from its rival.

Now in order to find the equilibrium solution we need information on the payoff matrix of the two firms. Assume
that firm A has two strategies open to it & firm B has three strategies.

Combined payoff matrix

Firm B's Strategies

Strategies
Firm A's

B1 B2 B3
A1 0.15 0.25 0.50
A2 0.55 0.35 0.40

NB: The sum of payoffs of firm A & B is equal to 1. Thus, if player B responds with B 1 to strategy A1 (by firm
A), A will gain 0.15 (first entry in the first row), and firm B will gain 0.85 (1-.15) of the market. However, if B
responds with strategy B2 to strategy A1, A will gain 0.25 of the market and B will gain the remaining (0.75). The
same interpretations are made for others.

Before we deal with equilibrium solution, we have to understand the basic concepts of maximin and minimax
strategies.
Maxmin: In game theory, firm A knows that firm B will always respond to A's gains because that is the strategy
that minimizes B's loss. For example if firm A adopts strategy A 1, the worst (minimum) outcome that it may expect
is the share of 0.15 (which corresponds to best strategy of firm B, B 1). If firm A adopts A2, the worst outcome will

29
be a share of 0.35 (if firm B adopts the best action for him, B 2). Thus, among all these minima (or the worst
outcomes) firm A chooses the maximum, i.e. the 'best of the worst'. This is called maximin strategy-a strategy that
maximizes its minimum gain. In our examples, the maximin of firm A is A 2, which yields a share of 0.35.

Minimax:
Firm B considers the columns of its payoff table, since it shows the payoffs of each of the strategies open to firm B.
For each strategy (or column) firm B looks for the worst outcome (on the assumption that the rival will choose the
best) and should choose the best among these worst outcomes.

Firm B behaves exactly the same way as firm A. If firm B adopts strategy B 1, the worst outcome will be A's best
outcome, i.e. 0.55. If firm B adopts B2, the worst outcome will be 0.35, for strategy B 3 the worst outcome is 0.50.
Among these maxima of each column (or strategy) firm B will choose the strategy with minimum value. Therefore,
the strategy of firm B is minimax strategy-B chooses a strategy that minimizes its loss or minimizes A's gains. In
our example, the minimax strategy of firm B is B 2, which yields a share of 65 % (=1-0.35). Now it is direct forward
to talk about equilibrium solution. The equilibrium solution is strategy A 2 for firm A and B2 for firm B. This
solution yields shares of 0.35 for firm A and 0.65 for firm B. The preferred strategies A 2 and B2 are called
dominant strategy - a strategy that provides a greater outcome to any one firm no matter what the rival does. These
strategies obey the Nash Criterion for Equilibrium.

In Summary:
Firm B's Strategies Row Minima
B1 B2 B3
Firm A's
Strategy

A1 0.15 0.25 0.50 0.15

A2 0.55 0.35 0.40 0.35
Column 0.35
maxima 0.55 0.35 0.50 0.35

Definition:
* Maximin Strategy is the strategy of maximizing the minimum payoff in game theory.
* Minimax Strategy is the strategy of minimizing the maximum payoff of the rival player in game theory.

NB: In a game where the maximum of the row minima (maximin) coincides with the minimum of the column
maxima (or minimax), each firm is said to choose a pure strategy. The game is then said to be a strictly determined
game and the solution is called the saddle point. If the game is not strictly determined, a firm should choose a
mixed strategy.

*Pure strategy is the single best strategy in game theory. Mixed Strategy is the best strategy for each firm in a
game, which is, not strictly determined (a game in which maximin equals minimax). The solution or outcome of a
strictly determined game is called Saddle Point.

D. Non-Zero - Sum Game: is game in which the sum of the payoffs for each combination of strategies not equal to
zero. This model can be illustrated with a duopolistic market in which the firms aim at the maximization of their
profit.

For simplicity, suppose that there are two strategies open to each competitor-low price & high price strategies. The
payoff table of the two firms is shown as follows:

Combined Payoff Matrix

Firm B's Strategies
low Low Price High Price
A's
Fir
m

price (1000, 1000) (3000, -1000)

30
 Strate
high (-1000, 3000) (2000, 2000)

gies
price

Note that in the above pay-off matrix, the first entry of each combination of strategies refers to firm A’s pay-off and
the 2nd refers to firm B. Here each firm expects the worst from the rival. Thus, both firm A's and B's choice is a
maximin strategy. If firm A charges a low price the minimum gain is birr 1000; if it sets a high price its minimum
return is a loss of birr 1000. Thus, firm A chooses the maximum among these two minima-i.e. profit of 1000 with
preferred strategy of low price.

Similarly, if firm B charges a low price the worst it can expect is a profit of 1000 birr; if it charges a high price the
minimum possible return is a loss of 1000 birr. Thus, firm B should go for strategy of low price since it yields the
"best of the worst". This is a strictly determined non-zero-sum game with a saddle point occurring when each firm
charges a low-price (which is a dominant strategy) and earns a profit of birr 1000. NB. Collusion, though illegal,
enable both firms to charge a high price & increase their profits to birr 2000.

E. Prisoner's Dilemma (Negative payoffs)

Suppose two suspects are arrested after committing a big bank robbery. Each suspect has two strategies open to
him: to confess or not to confess. Suspects are interrogated separately & no communication is allowed between
them. Each suspect is faced with a dilemma to confess & go free if the other doesn't confess, or get a ten year
prison sentence; or not to confess & go free it the other does not confess or get a heavy twenty-year sentence if the
other suspect confess. The payoff of the two prisoners is given as follows:
Suspect B
Prisoner A's

Confess Not confess

Strategies

Confess 10, 10 0, 20
not confess 20, 0 0,0
Clearly, suspect A gets 10 years or goes free by confessing, as opposed to 20 years or zero year by not confessing.
Thus, suspect A confesses. Similarly, suspect B either gets a 10-year sentence or goes free by confessing as
opposed to 20 years or zero years by not confessing. Thus, the dominant strategy is to confess, so that both get a 10
year sentence.

CHAPTER-5:

PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION

Income disparities exist among individuals in any economy. The main reason for this income disparity is:
-differences in the quantity and quality of resources owned,
-and differences in the price received for the services each type of resources.

In a free-enterprise economy, therefore, the distribution of income among individuals in the economy is determined
to a considerable extent by the configuration of input prices. Thus, in this chapter we concentrate on the

31
determinants of the price and employment of inputs. This, of course, requires the interaction of demand for and
supply of inputs. Thus, we first examine the demand for a competitive firm then pass to imperfect market
situations. We follow the same step for input supply.

Input Demand Curve of a Competitive Firm

a) The Firm's Demand curve-One variable input case:

Simplifying assumptions:
i. Consider only one variable input, labor, non labor inputs are fixed.
ii. There is perfect competition in both commodities and factor/input markets. That means, price of a
commodity, say X, as well as the price of labor services (wage rate) is given. In other words, the demand for a
commodity X and the supply of labor (workers) is perfectly elastic. That is, firms can sell any amount of
commodity demanded at a given market price, ; and firms can hire any amount of labor at the going market wage
rate, .
P
Perfectly elastic W Perfectly Elastic
output Demand Labor Supply

W
P d SL

0 Q W L

iii) Firms have perfect information concerning the productivity of all inputs including workers.
iv) The goal of the firm is profit-maximization.
v) Technology is given, i.e. production changes only if labor input changes.

Profit Maximization and Derivation of Labor Demand

It is clear that a firm's hiring of inputs is directly related to its desire to maximize profits. Hence any profit-
maximizing firm should hire (employ) additional units of each factor of production up to the point at which extra
revenue yielded by hiring one more unit is equal to the extra cost of hiring that unit.

Some basic concepts:

 The marginal revenue product (MRP) from hiring extra unit of any input is the extra revenue yielded by
selling what that extra input produces. It can be obtained by multiplying the input's marginal productivity
with the marginal revenue obtainable from the firm's output in the market for goods. i.e.
MRPL = dR/dL = MPL*MR. Proof!

Thus, MRPL = MPL (MR), which is the general formula for MRPL.

However, we know that MR is equal to price in a perfectly competitive market. Thus, the marginal revenue product
of labor in this competitive market becomes: MRPL = MPL(P), which also indicates the value of marginal product of
labor (VMPL). That is, for a competitive firm: MRPL = VMPL = MPL*P.

Definition: The value of marginal product of labor (VMP L) measures the extra revenue a competitive firm receives
by selling the additional output generated when employment of an input increased by one unit.

 Marginal Cost of input, say labor (MC L): is the extra cost or expense of a firm incurred from hiring
additional unit of that input. It is a change in cost of input per unit change of the input used. Symbolically:
MCL = dCL/dL.

32
In a competitive factor markets, marginal expense (extra cost) is simply equal to the inputs price. That is,
MCL = dCL/dL = . Proof!

, can be factored out since it is fixed ( a

constant doesn’t affect the derivative). Thus, in a competitive factor markets, marginal expense (or extra cost) is
simply equal to the input’s price; MCL = .

The first order condition for profit maximization therefore, becomes: MRP L = MVPL = W, since P = MR in perfect
competition.

Profit Maximization:
Any profit maximizing firm should hire additional units of each factor of production up to the point at which extra
revenue yielded by hiring one more unit of an input is equal to the extra cost of employing that unit. That is,
equilibrium occurs only when:
 MRPL = MCL, in general, and
 VMPL = for competitive firm in particular.
Why other points are not equilibrium? Because:
1. When MRPL > MCL, one additional employment of worker adds more to revenue than costs, and hence
firms are motivated to hire more labor & produce more.
2. If MRPL > MCL, an extra unit of hiring labor adds more to costs than revenue and hence the firm should
cut employment.
3. It follows from the above two conditions that a stable (or equilibrium) condition occurs only when
MRPL equals MCL in general.
Since MR = P in a perfectly competitive market, the equilibrium condition in this market will be:
(MRPL = MPL*MR= MCL) = (MPL*P = VMPL= ).
The proof: Any firm's profit () can be expressed as the difference between revenue (R) and costs (C), each of
which can be regarded as functions of inputs used, labor. That is,
C = f(L) = L + FC, and R = PQ, where Q = f(L); thus R = f(L). We know that π = R – C.
The first order condition for maximum  are:

, d(FC)=0.

Graphical illustration: Note that the relevant portion of production function for a rational firm is the portion of
following but positive marginal productivity of inputs - the law of variable proportion. Multiplying this MP of an
input by a given commodity price we obtain VMP, which measures the extra revenue a competitive firm receives by
selling the additional output generated when employment of an input increased by one unit. By equating this VMP L
to inputs price (W), we determine profit maximizing level of employment.

MPL/ W/VMPL
VMPL Equilibrium

VMPL
e
MPL W SL

VMPL
0 L* L
0 L

33
At any point to the left of L*, VMP L  W. Thus, profit is maximized by hiring more labor. But to the right of L*,
VMPL < W, implying that profit can be raised only by cutting the level of employment. Therefore, it follows that,
maximum profit is maintained only at point e (L* units of labor) where VMP L = .

Derivation of Individual Labor Demand Curve

The firm's demand for any input depends on:
 how productive a particular input is in making goods, & thereby yielding revenue to the firm, and
 how hiring of inputs affects costs.

We expect the demand for labor to be downward sloping (slope = dW/dL)  0; i.e. a decrease in wage (W) will
cause more labor to be hired to bring about the equality of W & VMP L (=MPL* ); this is because a fall in W must
be met by a fall in MPL, which is possible only by increasing L (NB: product price is fixed).

Equilibrium at different wages Wage Derived Labor Demand Curve

W/VMPL

W1 e1 SL1 W1 e1’

e2 e2’
W2 SL2 W2

W3 e3
SL3 W3 e3’

dL = VMPL
VMPL

L1 L3 L
0 L1 L2 L3 L L2
If the market wage rate is W 1 the firm is in equilibrium by hiring L 1 (point e1 where MVPL = W1). If market wage
rate falls to W2, the firm will maximize its profit by increasing its employment to L 2 at point e2 (where MVPL = W2).
Thus, if the firm demands the optimal amount of input, labor, at each wage rate, its demand curve for the input
(labor) must be the VMPL curve. Therefore, the marginal-value product curve is the firm's demand curve for a
given input (labor) when all other inputs are fixed.

Example: Suppose that the number of quintals of coffee harvested in a particular region during one season is given
by: Q = 100√L where L is the number of workers hired to plant and harvest coffee. Assuming coffee sell for $ 60
per quintal, and workers' seasonal wages are $500, what will be the level of employment determined by the owner
to maximize profit?

Solution: TR = PQ = 60 (100√L)=6000√L, and MRPL = .

Optimal labor is determined by equating MRPL to wage rate, W: MRPL = W; 3000L-1/2 = 500.
L-1/2=1/6, or L1/2 = 6; or L* = 36. With 36 workers, the MRPL is $500, which is precisely what the owners must pay
in wages. The 36 workers produce a total of 600 quintal of coffee during the season.

b) Firm's Demand Curve: The case of Several Variable Inputs

Suppose now that the firm uses a number of inputs that can be varied in quantity and labor is only one of them.
Under these circumstances, the firm's demand curve for labor is no longer the VMP curve, since the change in price
of labor will result in a change in the quantities of the other variable inputs used. For simplicity consider only two
variable inputs, labor (L) and capital (K). Now if W falls, there will not only be a change in labor but also a change
in capital as a new cost minimizing combination of inputs is chosen. When capital changes the entire MP L function
changes, because labor now has a different amount of capital to work with.
34
Note that when wage rate falls, we can decompose the total effect on quantity of labor hired into two components:
The substitution effect and output effect. These effects can be analyzed by the concept of isoquants.
Capital
b) Product
Effect of fall in Wage on
A1 equilibrium! P/C market

MC
A MC’

C
K3 e3
K1 e1
e2 e1 e3 d
K2
e1’
Q3
P

Q1 Q2 e’1

B D B’ B1
0 K1 L’1 L2 L3 Labor 0 Q1 Q3 Q

Initially the firm produces the profit-maximizing output, Q 1, with combination of K1 & L1 at point e1. When the
price of labor falls, the isocost line becomes flatter (since slope W/r falls) i.e. the new isocost line is AB'. Thus, the
firm using the same expenditure can now produce a higher output, Q 2, using K2 & L2 at e2.Movement from e1 to
point e2 shows total effect of fall in wage, which can be split is to two:
 One of these, the substitution effect, would cause more of labor to be purchased if output were held constant
at Q1. This is shown as a movement from point e 1 to e'1 on the same isoquant curve. To produce an
unchanged output, the firm uses more labor and less capital when the relative cost of labor falls (i.e. it
substitutes L for K).
 The other, the output effect, is shown by the movement from e’1 to e2. The hiring of labor will also increase
(to L2) due to output effect of reduction in wage rate (while the total expenditure remains unchanged).

NB: Q2 or e2 is the equilibrium of the firm only if the firm were to spend the same amount of money as initially.
But firms produce as much as the available demand allows, by increasing its expenditure further.

A change in wage, because it changes relative factor costs, will shift all the firm's cost curves. In figure (b) the
marginal cost curve for the firm has shifted downward to MC' due to fall in wage rate. Consequently, the firm's
profit maximizing output rises from Q2 to Q3. As the firm produces more output, it moves to a higher isocost line
A1B1. That is, the firm's expenditure rises by an area e 1Q1Q2e3 (see fig. b) which is equal to AA 1 (of fig. a). This
new equilibrium (movement from e2 to e3) is sometimes called the profit- maximizing effect.

In summary:
The substitution effect of a fall in W tends to raise the demand for labor but reduces that of capital. Thus, MP L
will decrease (since more L is used with smaller K) i.e. MP L shifts inward. On the other hand, the output effect
(and profit maximizing effect) of a fall in W results in use of more L and K & hence MP L will rise. This shifts
MPL to the right which outweighs the inward shift due to substitution effect. Thus, the net effect is an outward
shift in MPL and hence the VMPL (= P*MPL).

Derivation of Labor Demand: Several Variable Input Case!

The firm employs more workers at a lower wage rate because it uses more L per unit of output (the substitution
effect) and because it is profitable to increase output when production costs falls (the output effect).

35
 W/VMPL In this figure, let the initial price of L be W 1. The firm is in
equilibrium, using OL1 quantity of L at point A. If the price of L
VMP2 falls to W2, it changes the quantity of the other factors (K), which
shift the VMPL to the right. It becomes VMP 2 instead of VMP1.
W1 A The firm then equates W2 and VMP2, to arrive at the amount OL2 of
B factor L. If W falls farther to W 3 VMP curve shift again to VMP3
W2
and the firm reaches equilibrium at point C, where W 3 = VMP3,
W3 C hiring more labor, L3, at lower wage rate, W 3. Joining these points
dL
of equilibrium on the shifting VMPL (like points A, B, C), we
VMP1 VMP3 obtain demand curve for labor, d L, when the quantities of others are
0 also variable.
L1 L2 L3 L

Factors that affect Firm's Demand for a variable input:

1. Price of the input. For instance, there is inverse relation between W and L.
2. Marginal product of the input, which is derived from the production function. Positive relation!
3. Price of a commodity produced by the input also affects it directly.
4. The amount of other factors which are combined with labor affects dL.
5. The prices of other factors. Positively if other inputs are substitute, & inversely if it is complement.
6. Technological change/progress. For example, labor intensive technology rises labor demand.

c) Market Demand Curve

The price of the product remained unchanged when we derive the competitive firm's input demand curve (in the
previous section). That is, when W fell, the firm expanded output and sold the larger output at unchanged price.
P
S This is appropriate when we are dealing with only one firm. Hence, when all
S’ firms simultaneously increase output they can sell more (total industry
P* e output) only at a lower price. For instance, at the initial wage rate firms
P’ e’ supply Q* amount of output B sell it at P*. If wage rate falls, then all firms
tend to hire more labor which, in turn, leads to more industry output. This
D more output is represented by a rightward shift in supply curve (to S'),
leading to a new lower equilibrium price, P'. This decline in price again
0 Q* Q’ Q
reduces VMPL ( = P'*MPL), implying a downward shift in individual demand
curve for labor (VMPL shifts to left from dL to d’L), see figure below.

W W DL
Demand of Firm
Market Demand
a A
W1 W1

b b’
W2 W2 B
dL ∑dL
d’L ∑d’L

0 l1 l2 l’2 L 0 L1 L2 L

In the 1st panel, the decline in the individual input demand attributable to the decline in the commodity price (P* to
P’) is represented by the shift leftward from d L to d’. Thus, at input price W2, b is the equilibrium point, with 0l 2
units employed. So aggregating for all employers, 0L 2 units of the productive service are used (as indicated by point
B of the 2nd panel). Here it is the quantity demanded of labor on this new demand curve (d' L) that must be added in
order to get a new market demand (DL) when wage falls.

d) Supply of a Variable Productive Service: Labor

36
All variable productive services may be broadly classified into three groups: natural resources (or land),
intermediate goods, and labor.
 Intermediate goods are those produced by one entrepreneur and sold to another who, in turn, utilizes them
in the productive process. The supply curves of intermediate goods are positively sloped just like any other
commodities, because they are also the commodity outputs of manufacturers, even if they are variable
inputs to others.
 Natural resources may be regarded as the commodity outputs of (usually) mining operations. As such they
also have a positively sloped supply curve. If you consider land, however, its supply is usually constant in
the short run and hence we face a perfectly inelastic (vertical) supply curve. It doesn’t change with change
in rent in the short-run. But the supply curve of land is also upward sloping in the long-run.
 Here our attention is restricted to the most important category, labor. Note that the change in the size of the
population, age structure (labor force participation), and the occupational & geographic distribution of labor
force will shift the labor supply & hence they are constants (independent of its slope). Thus, we have to
analyze, what induces a person to forego leisure for work?

Indifference Curve Analysis of Labor Supply:

The supply of labor offered by one individual can be determined by indifference curve analysis. (see figure below).
Hours of leisure are measured along the horizontal axis, OZ representing the maximum, or the total number of
potential work hours in a day. The total money income from work is measured along the vertical axis.
Definition: Indifference curve (IC) shows the various combinations of leisure & income that yields the worker the
same level of satisfaction. And the income (wage) line shows the locus of points of leisure and income that the
worker can have with a given wage income. The slope of IC is marginal rate of substitution between leisure &
income; and the slope of a wage line represents a wage per hour. For instance, if 0M 1 is the money income that
could be received for 0Z hours of work (maximum hours of work), the hourly wage rate is OM 1/OZ, (say W1),
which is the slope of wage-line ZM1.

When the wage rate is W1 (the slope of ZM1), the tangency condition for maximization establishes equilibrium at
point e1 on IC I. The individual works Z 1Z (or L1) hours for income of Z1e1. Leisure, therefore, is OZ1. Let the wage
rate increases to W2), as given by the slope of wage line (ZM 2). The new equilibrium is e 2 on indifference curve II.
Now hours pf work expands from Z 1Z to Z2Z (or from L1 to L2) as a result of increase in the wage rate; workers
would further expand to Z3Z (or L3) if wage rises to W3 (on ZM3 income-line). But if wage rate further increases to
W4 and above, workers start preferring leisure time to work, and start reducing work time. With wage-line ZM 4,
equilibrium is e4 on IV curve. Here hours of work reduces from Z 3Z to Z4Z; but leisure time rises from OZ3 to OZ4.
The equilibrium points e1, e2, e3, e4, --- can be connected by the dashed curve S, showing the supply of labor offered
by a single individual.

37
 Income from Fig. Derivation of Indv. Labor
work(M) Supply
NB: 24-Z3 24-Z2 24-Z1 & Z=24
M4
M3 W Sl
E4
W4
e4 S
M2
e3
W3 E3
M1
e2
IV W2
E2
III
e1 W1
II E2
I
0 Z3 Z2=Z4 Z1 Z Leisure 0 L1 L2 L3 Labor
Z 24-Z3 24-Z2 24-Z1 0 Work
Note that the individual supply curve of unskilled labor is always upward sloping both in the short-run and in the
long-run. Most economists argue that the slope of supply curve of skilled workers may be positive, negative, or both
in the short-run. In the long-run, however, it would be positively sloped (on average). Market supply curve of labor
has positive slope in the long run (for detail, see below).

Market Supply of Labor: In general, the supply curve of specialized workers is upward sloping mainly due
Wage to two factors:
SL 1. The newly educated people would like to join an industry where hourly wage rate
is relatively high. Young people plan their education in line with current &
expected returns.
2. Old (& retired) people also retrain themselves and join high wage sector.
Thus, though some workers prefer leisure to work at a very high wage rate, still
there are a large part of people would like to offer more services at high wage
0
Labor rate, leading to upward sloping labor supply curve in the long-run.
Even if labor is not specialized to one industry, the labor supply curve to any one industry must be positively
sloped, because to expand employment, workers must be obtained from the other industries, thereby increasing the
demand price of labor. In general, the supply curves of non-specialized types of labor are positively sloped. And in
the short-run the supply of specialized labor may take any shape or slope; but in the long-run it, too, tends to be
positively sloped.
e) Market Equilibrium: The demand for and supply of a variable productive factor jointly
Market equilibrium determine its market equilibrium price. As indicated in figure below, D L
Wage and SL are the market demand and supply curves, respectively. Their
SL intersection at point e determines the stable market equilibrium price
OW* and quantity demanded & supplied OL*. Thus, the commodity
market equilibrium and factor market equilibrium is the same – equality
W* e between market demand & supply. The only features unique to factor
market are the methods of determining the demand for and the supply of
productive factor (labor) services. Input demand is based on the value-
DL of-the-marginal product of that input; and labor supply is determined by
workers attitude between leisure & work. But commodity supply is cost-
Labor determined.
0 L*

Factor Pricing In Imperfectly Competitive Market

38
Just like the case of competitive markets, the demand and supply determine the price of the factor and the level of
employment when there are imperfections. But the determinants of demand and supply differ in this case which will
consider three models with three kinds of imperfections:

Model A: Input demand and employment assuming imperfect competition (monopoly) in the product market.
Model B: Monopsonistic power in the factor market & monopolistic power in the output market
Model C: Bilateral Monopoly

Model A: Monopolistic Power in the Output Market while

Factor Market is Competitive

1. The firm's Demand Curve: The case of one variable input

A firm can be a sole seller of a product and still compete with large number of firms in hiring inputs. In that case,
the firm is a monopoly in the product market and a competitor in its input markets.

Just like a competitive firm, the price that must be paid for an input measures the added (marginal) cost of
employing it in the case of monopoly also. The difference in the two market settings rests on how the added (one
more) input affects the firm's revenue. For a competitive firm, employing one more input unit adds to revenue an
amount equal to VMP (=P*MP). For monopoly, one more input unit adds to revenue by expanding output which
amounts marginal revenue product - MRP (= MR*MP).

w Graphically: Competitive firm's equilibrium is:

(VMPL = MRPL) = W, since P = MR, VMP=MRP; and
Monopoly's equilibrium is: MRPL = W; note that
VMPL > MRPL in monopoly because P is always
w SL greater than MR (since demand is down-sloping)
VMPL
MRPL

0 L1 L2 L
Thus, under down-ward sloping product demand curve, we will show that the demand for labor of an individual
firm is not the VMPL but the MRPL defined by multiplying the MPL with the MR of selling the commodity
produced. That is, MRPL = MPL*MR

Proof: Let the demand function for the product be P = f(Q), and total revenue (R) of the firm is: R = PQ. Hence,
marginal revenue (MR) becomes: MR = R/Q = (PQ)/ Q = P*Q/Q + Q*P/Q. Thus,
MR = P + QP/Q ----- (1)

Suppose production function with one variable input, labor, is Q = f(L) and hence marginal product of labor
becomes: MPL = Q/L ----- (2)
Now by definition the marginal revenue product of labor (MRPL) is the change in revenue (R) attributable to a unit
change in labor, i.e.
MRPL = R/L = (PQ)/ L = P*Q/L + Q*P/Q*Q/L---- with the help of chain rule
= Q/L(P + Q*P/Q)

But from equation (1) and (2): P + Q*P/Q = MR and Q/L = MPL.
 MRPL = MPL (MR)

Note that all firms demand and hire inputs to maximize profits. The monopoly firm that use a single variable input
in his production maximizes profit when the input's price is equal to its MRP. That is, equilibrium is reached when:
MRPL = W

39
Proof: Obviously, firms want to maximize profits (), which is the difference between revenue (R) & cost (C).
 = R - C, where R = PQ & C = WL + FC, where WL is variable cost & FC is fixed cost.
  = PQ - (WL + FC)
 = PQ - WL - FC
At equilibrium (or maximum profit) the first order derivative of profit with respect to labor must be zero; that is,
/L = 0
MRPL = /L = (PQ)/L - (WL)/L = 0

, but P+Q*P/Q=MR and Q/L=MPL

----- Necessary condition for profit maximization

Therefore, given the perfectly elastic supply of labor for an individual (monopoly) firm and the MRP L, equilibrium
is attained when W = MRPL.

Graphically: If wage is W2 a monopoly firm demands l2 on MRPL at e2 and if wage rate fall to W1 the monopoly
hires l1 units of labor at point e 1 on MRPL. Thus, it follows that if the firm is a monopoly and uses only one
variable factor, the marginal revenue product (MRPL) is the demand curve of the input.

2) The Firm's Demand Curve: The Case of Several Variable Inputs

As in the case of perfect competition, firm's demand curve for input, labor (L), is no longer its marginal revenue
product curve rather it is formed from points on shifting MRP curve due to three effects of change in wage rate:
 Substitution effect,
 Output effect, and
 Profit-maximizing effect. Assume that the market price of labor is w and 1
its MRP is given by MRP1. Thus, the
MRP2 monopolistic firm is in equilibrium at point e1
W
hiring l1 units of labor on MRP1. If wage rate
MRP1
falls to W2 the MRP curve shifts to the right (to
e1 MRP2) due to the net effect of the above three
W1 effects. Thus, the new equilibrium occurs at
W2 e2 point e2 on MRP2 & the firm hires l2.

The locus of points such as e1 & e2 is called the

demand curve for labor by the monopolist when
dL several factors are used. In general, the demand
curve for inputs is negatively sloped regardless of
0 l1 l2 L the degree of competition in the product market.

3) Market Demand for Labor: is the summation of the demand curves of the individual monopolistic firms
after taking into account their shift (as the price of the factor changes). For example, a fall in wage initiates
all monopolistic firms to expand their output, which of course, leads to a fall in market price. (This is
because the demand and MR curve for the commodity shifts to the left with fall in wage). Thus, the MRP L
(and hence dL) shifts inward. Derivation of market demand for input is just similar to the competitive case;
see figure below.

40
 w
w DL
w1 a w1 A
MRPL1

w2 b B B’
b’ w2

MRPL1 MRPL2
MRPL2

0 l1 l2 l’2 L 0 L1 L2 L

4) The Market Supply of Labor: is not affected by the fact that firms have monopolistic power in the product
market. Thus, individual and market supply of labor is just as derived earlier in competitive case. That is,
they are usually upward sloping, indicating a direct relationship between labor supply and wage rate.

5) Market Equilibrium: Given the market demand for and the supply of labor, the market price of labor is
determined by the interaction of the two curves.

(a) Firm Equilibrium (b) Market Equilibrium

w w
SL
Monopolistic
b Exploitation

wc

A
w a SL wm ∑VMPL
VMPL
MRPL ∑MRPL

0 l1 L 0 Lm Lc L

When the firm has monopolistic power in the output market the factor is paid its MRP which is smaller than the
VMP of an input. According to some economists (like Joan Robinson), this difference between VMP and MRP is
called monopolistic exploitation. The difference ‘ab’ in figure (a) and w cwm in figure (b) shows that the profit
maximizing behaviour of imperfectly competitive firms causes the factor price to be less than their VMP. Further
more, employment is higher under perfect competition than imperfect market (i.e. L c > Lm).

Some economists argue that Robinson’s exploitation cannot be accepted on its face value, because lower wage rate
in imperfect markets reflects the downward sloping demand curve which is due to brand loyalty of consumers (or
consumers’ desire for variety due to product differentiation).

Example: Assume that production function and demand function of a monopoly firm is given respectively by: Q =
100L1/2, and P = 100 – Q. If the price of labor is fixed at w, what is the demand function for labor? (State L as a
function of w). Answer: L = 50002/(w+10,000)2, where dL/dw < 0.

Model B: Monopsony in Input Markets and Monopoly in Product Markets

41
Up to this point we have assumed that there is perfect competition in input market. Now we begin by considering
the case of monopsony. Monopsony is a situation in which there is a single buyer (of a product and/or inputs). Thus,
pure monopsony in input markets occurs when a firm is the sole purchaser of an input. In this case the demand for
labor by the individual firm is the same as in model – A. That is, the demand for labor by a monopolistic firm is the
marginal revenue product of labor (MRP L). The supply curve of labor to the individual firm, however, differs,
which is our concern in the next section.

1) Input Supply Curves & Marginal Expenditure Curves:

The supply curve of the input facing the monopsonist is the market supply curve. The reason is that the
monopsonist is the entire market for the input> It is the sole buyer of the input. As a sole buyer, a monopsony
faces the market supply curve of the input, a curve that is often upward sloping.
W
Thus, in an input market the monopsony firm has some discretion over the
SL price paid for an input. If the monopsonist wants more of the factor, it must
pay a higher price not only for the additional units but for all the units of the
factor that it purchases. Hence, the marginal cost of the input exceeds the
price of that factor under monopsony; for example, MCL > W. That is, when
the firm faces an upward sloping input supply curve, marginal input cost is
always greater than average expenditure (or input price, which is also input
0 L supply)----MCL>W, where, W=AEL = fL(L) is input supply function.
Marginal expense of an input, say labor (ME L) is the change in total expenditure on the factor (say labor) arising
from one additional unit of the factor. That is, MEL=d(TEL)/dL, where TEL shows total expenditure on L, W*L.

Derivation of MEL: By definition MEL is change in TE when labor changes by one unit; i.e.
------- (1)
Given the supply function fL(L), its slope is dW/dL >0. So the MEL is greater than W (or AEL) from expression (1).
Moreover, the MEL has a steeper slope as compared with the AEL or labor supply curve as shown in figure.
W
MEL
 The slope of the supply function (W=fL(L)) is dW/dL>0.
W=SL=AEL  And the slope of MEL curve is: d(MEL)/dL, or

0
L Clearly the slope of MEL is greater than that of AEL (dW/dL). For
instance, if labor supply curve is linear, then d 2W/dL2 = 0 and slope of ME L = 2(slope of SL); if SL is a curvature,
MEL is even more steeper.

2) Equilibrium Price & Employment: Single Variable Input, Labor:

Note that firms demand & hire factors of production to maximize profit. The equilibrium of the monopsonistic firm
is given by the point where the marginal expenditure on the factor is equal its marginal revenue product.. That is, at
equilibrium: MEL = MRPL.

Proof: The firm maximizes its profit: π = R – C, where R = PQ and C = WL + FC. But at equilibrium the 1 st order
condition must be equal to zero; dπ/dL = 0.

Graphical illustration of equilibrium:

42
 MEL
W The monopsonist sets a price of OWe and employs OLe
SL=W is determined by equating MRPL with MEL at point e.
e But the monopsonist sets the input’s price (W) at the
level at which the quantity it demands (Le) will be
supplied; that is, wage rate (We) is determined by
substituting equilibrium level of employment into the
We
labor supply curve.
MRPL=DL
=

0 L
Le

3) Equilibrium Price & Employment: Several Variable Input, Labor:

The monopsonistic firm will stop increasing its use of each input when the input’s MRP equals the ME of the input.
Therefore, since an input’s MRP equals its marginal product times the firm’s marginal revenue, it follows that the
monopsonist will hire inputs so that:
 MRPL (=MPL*MR) = MEL, and hence MR = MEL/MPL ------- (1),
 MRPK (=MPK*MR) = MEK, and hence MR = MEK/MPK ------ (2) and so on.
 From equation (1) and (2): MEL/MPL = MR = MEK/MPK; or after rearranging this expression we get the
equilibrium situation of a monopsonist who uses several variable input:

-------- (3)

Recall that in a perfectly competitive market ME of an input is equal to the price of the input; ME L=W, MEK=r.
Thus, for a competitive firm who uses several variable input equilibrium condition is given as:

Monopsonistic (and monopolistic) Exploitation:

When the firm has a monopsonistic power in the input market it pays to the factor a price which is less not only than
its value-of-marginal product, but also less than its marginal revenue product. This gives rise to “ monopsonistic
exploitation”, which is something in addition to “monopolistic exploitation.” Workers are said to be exploited if
they receive a wage rate less than their VMP. These concepts are illustrated with the aid of a diagram as follows.
Wage
MEL  If we assume competition in both output & factor markets
equilibrium will occur at point A where SL(=W) and VMPL (or
dL) intersects leading to WC levels of wage & LC units of
SL=AEL employment.
Wc e S ec  If we assume monopoly in the output market while factor market
is competitive, the input market is in equilibrium at point e m
Wm em where MRPL=W. Now equilibrium wage & employment falls
respectively to Wm & Lm due to monopoly power. Thus, the
WS C difference between WC and Wm is the monopolistic exploitation.
VMPL
 If the firm has a monopsony power in the factor market,
MRPL equilibrium is reached at point eS where MRPL=MEL. To
maximize its profit the firm pays even a lower wage rate (W S) &
further reduces its employment to L s. Thus, the difference
0 LS Lm Lc Labor between WC & WS (=WCWm+WmWS) represents monopsonistic
monopsonistic elements. It would exist even if the firmexploitation,
were not a where the part
sole buyer in W CW
the M is not
labor uniquely
market. Theattributable
part W mW tos is
due to the monopsonistic power of the firm in the labor market.

43
Model C: Bilateral Monopoly
In this model we assume that all firms are organized in a single body (example, federation of manufacturers or
management of a firm) which acts like a monopsonist, while labor is organized in a labor (or trade) union which
acts like a monopolist (or as a single seller of labor). Thus, we have a model in which the participants are two
monopolies: (1) Trade union as a single seller of labor (monopoly)-supply side; (2) Sole buyer of labor
(monopsony) –demand side.

Next we will show that the solution to bilateral monopoly situation is “indeterminate”. The model gives only the
upper and the lower limits within which the wage rate will be determined by bargaining.

1. Supply side (Monopoly): From the point of view of the monopolist D b represents his
average revenue curve (ARS). Thus, given ARS marginal revenue curve of the seller (MRS) can be derived
by the usual graphic technique. If AR S is linear, then MRS is twice as steep as the AR curve; i.e. MR S <
ARS. Similarly, from the monopolist’s view point, S L represents the MC curve of the seller (labor union),
since the union considers the buyer as if they act as a perfect competitor. Thus, given the cost and revenue
curves, the monopolist (labor union) maximizes his gains at point U, where his MC intersects his MR. So,
the monopolist will want to supply LS units of labor and receive a wage equal to WS.
Wage 2. Monopsony (Single buyer of labor): In this
MEb figure the monopsonist’s demand curve is Db. It
is also the MRP of labor being demanded.
A SL=AEb=MCS Similarly, SL represents the supply of labor
WS (average expense of labor) facing the
F
monopsonist). Corresponding to this average
cost curve (AEb) is the marginal expenditure
(MEb) curve of the buyer. Thus, the
Wb b
U monopsonist (federation of manufacturers)
maximizes profit at point F, where his
MEb=MRPL. So the monopsonist will desire to
MRPL=Db=ARS hire Lb units of labor and pay the wage rate
equal to Wb.

0 LS Lb Labor
In summary, price desired by the monopsonist is
the lower limit (Wb), which can be realized only if
he could force the monopolist seller to act as a
MRS
perf-
ct competitor. Likewise, the price desired by the labor union (monopolist) is the upper limit (W S), which could be
realized if he could force the monopsonist (single buyer) to act as a perfect competitor.

Therefore, since the goal of the two parts can’t be realized, the price and quantity in the bilateral monopoly market
are indeterminate. The level at which the price will be settled depends on the bargaining skills and power of the
participants. The power of each participant is, in turn, determined by his ability to inflict losses to the opposite part
and his ability to withstand losses inflicted by the opponent. Usually, labor union use strike to get higher wages, and
buyers use dismissal of workers to pay lower wages.

44
 Chapter 6:
GENERAL EQUILIBRIUM ANALYSIS AND WELFARE ECONOMICS
GENERAL EQUILIBRIUM ANALYSIS:

So far we dealt with partial equilibrium analysis, which focuses on an equilibrium price and quantity in a given
product or input market (where the market is viewed as largely self contained and independent of other markets).
Partial equilibrium analysis largely depends on "other things equal" assumption.

On the other hand, the theory which explains the relationships between different markets and different prices
simultaneously is called general equilibrium. It deals with the problem of whether the independent action by each
decision-makers leads to a position in which equilibrium is reached by all. More generally, it is defined as a state in
which all markets and all decision - making units are in simultaneous equilibrium.

Here we will consider the static properties of general equilibrium, not the dynamic process. There are three static
properties which are observed in general equilibrium solution, reached with a free competitive market mechanism:
1. Equilibrium of consumption (or efficient distribution of commodities between two consumers),
2. Equilibrium of production (Efficient allocation of resources among firms), &
3. Simultaneous equilibrium of production and consumption (Efficient combination of products)

These properties are called marginal conditions of Pareto optimality or Pareto efficiency. Note that a situation is
defined as Pareto Optimal (or efficient) if it is impossible to make anyone better-off without someone worse-off.

General Equilibrium of Simple Economy: A case where there are two factors of production, two commodities &
two consumers ( 2 x 2 x 2 model) :

Assumptions:
 There are only two factors of production, labor & capital, which are homogeneous & perfectly divisible.
 There are only two commodities, X & Y. Their production function exhibits constant returns to scale.
 There are only two consumers, A & B, whose preferences are represented by ordinal indifference curves.
 There are perfect competitions both in the factor and output market.
 Factors are fully employed and all incomes are spent (by A and B).
 The goal of consumers is utility maximization & that of firms are profit maximization.

1. General Equilibrium in Pure Exchange Economy (Equilibrium of Consumption)

From the theory of consumers we know that the consumer maximizes his utility by equating the slope of
indifference curve (MRSxy) to the price ratio of the two commodities (P x/Py). Thus, the condition for consumer
equilibrium is: MRSxy =Px/Py . Since both consumers (A & B) in perfectly competitive markets are faced with the
same prices (Px & Py), the condition for joint or general equilibrium of both consumers is:

MRSAx,y = MRSBx,y =Px/Py

Graphic Illustration: We construct the edge worth box for consumption with the precise dimensions X e and Ye
shown as in this figure. NB: Xe & Ye represents total quantities of output in the economy. O AXeOBYe is an
Edgeworth box. Any point in the Edge worth box of consumption shows six variables: the total quantities Y e & Xe,
and a particular distribution of these quantities between the two consumers (e.g. O AXA, XAXe, OAYA & YAYe
amounts at point Z). However, not all distributions are efficient in the Pareto sense. A Pareto-efficient distribution
of commodities is one such that it is impossible to increase the utility of one consumer without reducing the utility
of the other. Thus, point Z is, for instance, not efficient. From figure below, only points of tangency of the
indifference curves of the two consumers represent Pareto efficient distribution. The locus of these points (like
point a, b, c & d) is called the Edgeworth Contract Curve of Consumption.

45
 At each point of this curve the following
0B equilibrium condition is satisfied:
Ye MRSAx,y=MRSBx,y=Px/Py (since the
indifference curves are tangent to each
other). Thus, for a given product-mix (X e &
Z Ye) there are an infinite number of possible
YA
d Pareto Optimal equilibrium of distribution
(i.e. all points on the contract curve satisfies
A4
Pareto-efficiency). But with Perfect
c
competition, only one of these points is
B1 consistent with the general equilibrium of the
N b A3 system. This is the point of the contract
a curve where the "equalized" MRSx,y of the
A2
B3 two consumers is equal to the price ratio of
B2
B4 A1 the commodities, defined by point b. i.e.
0A Xe MRSAx,y = MRSBx,y =Px/Py
XA M

2. General Equilibrium in Production

Consider a simple economy in which only two goods (X & Y) are being produced. Suppose that there are only two
inputs, labor & capital to be allocated between the two industries (X & Y). Suppose the initial allocation of labor &
n
capital is represented by point Z in the Edgeworth box-i.e X-industry has OB units of labor BOA units of capital, &
tio
the Y-industry has BL units of labor and AK units of capital. uc
od
Pr
of What will be the optimal allocation of inputs between
ve the two industries? At point Z, MRTSLK in producing
ur X is higher than in producing Y. (Because slope of
C X1 is greater than slope of Y 2 at point Z). Thus, the
t fact that the MRTS are unequal means that the inputs
ac are not being allocated efficiently. From point z it is
tr possible to more to point b where only output of x
on
increases. Or it is possible to more to a point between
K OY C
a & b (say ) where both outputs rise.

Z c
A
X3
b
Y1
U’ X2
S a
X1 Y2
Y3
OX R
B
L
In general, production should occur at a point at which the MRTS between inputs is the same for producers, i.e
x y
where MRTSLK = MRTSLK. That is, the allocation of inputs is said to be efficient if the increase in the output of one
commodity can be achieved only by reducing the output of the other commodity. Thus, the optimal allocation of
inputs will occur where X isoquant
y is tangent to Y-isoquant (i.e. where MRTS LK = MRTSLK.). This locus of points
x
of tangency (like ,, . . .) is called contract curve of production, along which MRTS of inputs are equal for all
producers. Thus, it is an optimal set of inputs.

46
In our simple general equilibrium model firms will be in equilibrium if they produce somewhere on the production
contract curve. Thus, assuming competitive markets, profit maximization requires that each firm equates its
MRTSLK with the ratio of factor prices, W/r. So general equilibrium in production occurs when:
x
MRTSLK = MRTSLK = W/r

NB: Given factor prices, we can determine the amounts of X and Y which maximizes the profit of firms (from
the Edgeworth Box), which must be equal to those which consumers want to buy in order to maximize their utility
in general equilibrium. Therefore, in order to bring together the production side of the system with the demand
side, we must define the equilibrium of firms in the product space using a tool of production possibility curve of the
ve
ur
economy, which is derived from Edgeworth contract curve of production. C
on
ati
m
or
sf
an
Tr
t
uc
OY
K Y od
Pr
Y*
a’
Y4
d
Y3 b’
X4
A Z
c Y1 c’
Y2

b X3

U’ X2 d’
S Y2 Y1
a Y3
X1
Y4
OX X
B R
L 0 X1 X2 X3 X4 X*
For instance, point b in figure above shows that, given the level of X is X 2, the maximum quantity of Y that can be
produced (with the given factor L & K ) is Y 3. Thus, X2 & Y3 combination is presented by point b' in the 2 nd figure -
similar procedure holds for other points (a', c', d').

The PPC is also called the product transformation curve because it shows how one commodity is "transformed" to
into another through reallocation of the given inputs (L & K). The negative of the slope of PPC /Product
transformation is called the marginal rate of product transformation (MRPTx,y) and it shows the amount of y that
must be sacrificed in order to obtain an additional unit of X. By definition:
MRPTx,y = -dY/dX, but dY/dx  0 & hence -dY/dX (= MRPTx,y)  0  +ve.

Show that MRPTx,y = -dY/dX = MCx/MCy

Step1: By definition:
MCx = d(Cx), & MCy = d(Cy)
dX dY
Step2: Divide the above two expressions, i.e. MCx = dCx . dY

47
 MCy dCy dX
Step3: Cx = WLx + FKx, & Cy = WLy + FKy. Thus,
d(Cx) = W(dLx) + r(dKx), & d(Cy) = W(dLy) + r(dKy)

 d(Cx) = W(dLx) + r(dKx) , but dLx = -dLy, &

d(Cy) W(dLy) + F(dKy) dKx = -dKy, so

= W(-dLy) + F(-dKy) = -1 (W(dLy) + r(dKy)

W(dLy) + F(dKy) W(dLy) +F(dKy)

Thus, MCx = d(Cx) . dY = (-1) dY = -dY = MRPTx,y

MCy d(Cy) dX dX dX

However, a profit-maximizing competitive producer equates the price of the commodity produced to the MC of
production, i.e. MCx = Px & MCy = Py. Thus, the slope of PPC becomes:

MRPTx,y = -dY = MCx = Px

dX MCy Py

Therefore, given the commodity prices, general equilibrium of production is reached at the point on the production
transformation curve that has a slope equal to the ratio of these prices. That is, general equilibrium of production
occurs when: MRPT x,y = Px (Point T)
Py

The general product - mix from the point of view of firms is given
by point T. The two firms are in equilibrium producing the levels
of output Xe & Ye, which are optimally distributed to the two
consumers (Point T'). That is:

OXe = OXA (for A) + XAXe (for B)

OYe = OYA (for A) + YAYe (for B)

C) Simultaneous Equilibrium of Production & Consumption

From the illustration of the previous sections (Exchange & Production) if follows that the general equilibrium of the
system as a whole requires the fulfillment that the slope of PPC (MRPTx,y) be equal to the MRS of the two
commodities between the two consumers. That is
MRPTx,y = MRSx,y = MRSx,y . In perfect competition this condition is satisfied because:

MRSx,y = MRSx,y = Px/Py ...... Consumption Equilibrium

MRPTx,y = Px/Py ......Production Equilibrium, and it follows that:

MRPTxy = MRSxy = MRSxy (since all equal to Px/Py).

In summary, with perfect competition (and constant returns to scale), the simple 2 x 2 x 2 system has a general
equilibrium solution in which 3 Pareto-efficiency conditions are satisfied:
i) The MRS between the two goods must be equal for both consumers. i.e. optimal distribution of the
goods among consumers.
ii) The MRTS between the two factors is equal for all firms, i.e. efficiency in allocation/distribution of
factor inputs among the two firms

48
 iii) The MRS and MRPT are equal for the two goods. This efficiency in product-mix implies optimal
composition of output in the economy and hence optimal allocation of resources.

WELFARE ECONOMICS:
Definition of Welfare Economics

Welfare can be defined as the branch of economic science which evolutes alternative economic situation
( i.e. alternative pattern of resource allocations) from the view point of economic well being of the society
as a whole.

To illustrate this definition assume that the total welfare in an economy or a country is W, but given the
factor endowments ( resources) and the state of technology suppose that this welfare could be large, for
example W* that tasks of welfare economics are

a. To show the present state W <W* and

b. To suggest ways of raising W to W*

Criteria of Social Welfare

Various criteria of social welfare have been suggested by economists of different times. We will discuss
briefly some of these criteria. The whole discussion is broadly divided into:
I. Classical welfare criteria
II. Neo classical welfare criteria
III. Paretian welfare economics
IV. Post Paretian contributions to welfare economics

I. Classical Welfare Economics

( Adam smith’s Welfare Criteria)
Adam smith implicitly accepted the growth of the wealth of the society, i.e. the growth of the GNP as
welfare criteria. The final aim of all production is consumption and increase in consumption results in
increase in the level of satisfaction. Therefore an increase in GNP ( or wealth) leads to an increase in the
level of satisfaction ( or welfare) ( It shows that there is direct r/n b/n the two).
Distribution of national wealth was only a subsidiary theme to Adam smith. With respect to resource
allocation, he assumed that free competition in the market leads to optimum allocation of resources.
Adam smith’s welfare criteria assumes existing income distribution as just. Since growth in GNP
might result in inequalities of income distribution and reduction of social welfare

II. Neo – classical welfare economics

The neo- classical welfare economics refers to the welfare propositions which emerged from the mixture
b/n classical economic ideas and those of the marginal utility school.
* Major contributors of the Neo- classical welfare
1. Sidegewick:- He accepts the classical view that increases in production of the total
national output increases total social welfare. In addition he favored the view that a more
equal distribution of income tends to increase welfare.
2. Bentham:- He argued that welfare is improved when the greatest good is secured for the
greatest number Implicate in this opinion is that total welfare is the sum of the utilities of
the individuals of the society
W = UA + UB + UC+------+ UN

49
 3. Pigou:- Pigou argued that the economic welfare of an individual implies the total utility he
derives from the goods and services. Following Bentham, he defined the welfare of a
society as the arithmetic sum of utilities of individuals of the society.
Pigou adopted dual criteria for judging the improvement in social welfare. His dual criteria may be stated
as increases in the value of national income without corresponding to increase in the supply of factors and
transfer income from rich to poor indicate increase in welfare He provided additional qualifications to his
dual criteria as follows.

In regard to the first criterion he felt that national dividend could be increased given constant factors
supply, either by increasing some goods without diminishing the production of others or transferring
factors to activities in which their social value is higher. Any such increase in national dividend without
decreases in the share of the share of the poor is to be regarded as improvement in social welfare.

Regarding the 2nd criterion he suggested that redistribution of national income must not lead to decrease
the national dividend. Thus, he proposed that any reorganization of the economy or redistribution of
income which increases the shares of the poor without causing reduction in the national dividend as an
improvement in the social welfare

Weakness of the Neo- classical economics

- Utility can not be measured cardinally.
- Composition of national output is was not taken to account.

III. The Paretian welfare Economics / pareto optimality criteria/

According to Pareto criterion any change that makes at least one person better off without making some
one else worse off definitely causes an improvement in social welfare. Conversely any change that makes
at least one person worse off and no one better off causes decreases in social welfare.

The criterion can be stated in some what d/nt way A situation in which it is impossible to make any one
better off without some making some one worse off is said to be pareto optimal or pareto – efficient for
the attainment of a pareto efficient situation .In an economy three marginal conditions must be satisfied

i. Efficiency of distribution of commodities among consumers ( efficiency in exchange)

ii. Efficiency of the allocation of factors among firms ( efficiency of production)
iii. Efficiency of in allocation of factors among commodities ( efficiency in the product – mix or
composition of output)

Assumptions for 2x2x2 model

1. Tow commodities (X & Y) two consumers (A&B) two factors (K & L) and two firms
2. consumers maximize their respective utility functions which are independent of each other
3. Factors K&L are homogeneous perfectly divisible and available in fixed quantities which
are exogenously determined. Both factors are used in production of each goods.
4. Production function of both goods are given
5. There is perfect competition in both product & factor markets .

A. Efficiency of Distribution of Commodities among Consumers

Pareto optimality in exchange is achieved when allocation of the given commodities X & Y b/n the two
consumers is impossible by redistribution of these goods to increase the utility of one individual without
reducing the utility of the other.

50
Points on the contract curve of exchange satisfy the Pareto optimality conditions;but any movement by
person A towards B’s origin will make A better off and B worse off and vice versa

Any other distribution of the contract curve is inefficient and any movement towards the contract curve
improves social welfare. At each point on the contract curve of exchange the following condition is
satisfied

MRSAx,y = MRSBx,y

 The marginal condition for a pareto – optimal or efficient distribution of commodities among
consumers requires that the MRS b/n the two goods be equal for all consumers

B. Efficiency of Allocaiton of factors Among producers

Pareto optimality in allocation of factors (L&K) requires that factors are so allocated to the various goods
(x&y) that it is not possible to increase the output of any commodity, by reallocating factors, without
causing decrease in the production of another. This will be on the contract curve of production. At each
points on this curve

MRTSxL,K = MRTSyL,K

 The marginal condition for pareto optimal or efficient allocation of factor input requires that the
MRTS b/n labor and capital be equal for all commodities produced by all firms.

C. Efficiency in the Composition of out put ( product Mix)

Recall that the slope of PPC is called MRPT x,y and it shows the amount of Y that must be sacrificed in
order to obtain an additional unit of X. In other words, the MRPT x,y is the rate at w/c a good can be
transformed in to another.

The marginal condition for pareto – optimal or efficient composition of output requires that MRPT b/n
any two commodities be equal to the MRS b/n the same two goods.

MRPT xy = MRSA x,y = MRSx,By

In summary a pareto – optimal state in the economy can be attained in if the following marginal
conditions are fulfilled.

1. The MRS x,yb/n any two goods equal for all consumers
2. The MRTSL,K b/n any two inputs be equal in production of all commodities
3. The MRPT x,y be equal to the MRSx,y for any two goods.

A situation may be pareto – optimal with out maximizing social welfare, i.e. pareto optimality is a
necessary but not sufficient condition for welfare maximization.

The main Weaknesses of the pareto criteria are:-

1. A pareto optimal situation doesn’t guarantee the maximization of social welfare. Any points on
the PPC represent a pareto – efficient situation but to decide w/c of these points yields maximum
social welfare we need an interpersonal comparison of individual’s utility. Thus, Pareto –
optimality offers only a necessary but not sufficient condition of welfare maximization.

51
 2. The pareto – optimality cannot evaluate a change that makes some individuals better off and others
worse off since most government policies involve changes that benefit some and harm others it is
obvious that the strict pareto criterion is of limited applicability in real world situations.

IV Post Paretian Welfare Economics

A The Kaldor – Hicks “compensation Criterion

Assume that a change in the economy is being considered, w/c will benefit some (‘gainers’) how much
money they would be prepared to pay in order to have the change and the ‘losers’ how much money they
would be prepared to pay in order to prevent the change. If the amount of money of the ‘gainers’
constitutes an improvement in social welfare b/c the ‘gainers’ could compensate the ‘losers’ and still have
some ‘net gain’. Thus, the Kaldor –Hicks ‘compensation criterion’ states that a change constitutes an
improvement in social welfare if those who benefit from it could compensate those who are hurt, and still
be left with some ‘net gain’.

Whether compensation is actually paid or not is in kaldor’s opinion is that, it is a matter of political or
ethical decision. In the welfare criteria, compensation is simply a measure of loser’s lose. In formulating
his criterion for judging the social desirability of economic change, Kaldor merely suggests that gainers
must be potentially able to compensate the losers ( out of their gain) and yet retain some gain to
themselves. kaldor- Hicks criterion are thus considered as potentially superior and improvement in welfare
criterion.

B. The Bergson Criterion (The Social Welfare Function)

The various welfare criteria so far discussed show that when a change in the economy benefits some
individuals and hurts the others it is impossible to evaluate without making some value judgment about
the deservingness of the d/nt individuals or groups. Bergson suggested the use of an explicate set of value
judgments in the form of social welfare function. A social welfare function analysis to the individual’s
consumer’s utility function. It provides a ranking of alternative states (situations, configurations) in w/c
d/nt individuals enjoy d/nt utility levels. If the economy consists of two individuals the social welfare
function could be presented by a set of social indifference contours ( in utility space) like the ones shown
below.
Each curve is the locus of combinations of utilities of A & B w/c yield the same level of social welfare the
further to the right a social indifference contours is the higher the level of social welfare will be with such
as set of social indifference contours alternative states in the economy can be unambiguously evaluated.

UB W = f(UA,UB)

c
W4
b W3
a W2
W1

O UA
Bergson’s welfare contours

52
For example a change would move the society from point b to c (or d) increases the social welfare. A
change moving the society from a to b leaves the level of social welfare unaltered.

Criticisms

1. Bergson criteria requires explicitly value judgments of d/nt categories of judges may differ.
Bergson doesn’t offer a solution to resolve such differences in value judgment.
2. There is no easy method of constructing social welfare function. Bergson’s criterion doesn’t come
out with necessary instructions for drafting welfare judgments w/c are required in the formula of
welfare function

The Utility possibilities frontier

Utility possibility frontier is a curve that shows all efficient allocations of resources measured in terms of
resource utility levels of two individuals.

Recall our two consumers, two firm and two input model along with its assumptions. Efficiency in
product mix requires that MRSAx,y = MRSBx,y MRPTx,y the point that satisfies this condition is point K ( fig
on page 8) the output mix at this point is O AX1 + OAY1= The distribution of OAX1 and OAY1 b/n A & B
will be some where on the exchange contract curve O AK, and some points of tangency b/n A’s B’s
indifference curves

53
 J

Grand utility possibility frontier is the locaus of utility combination of two cansumers which satisfy the
three marginal conditions MRPT= MRS for each commodity

Let the distribution of two goods between the two individuals takes place at point C. point C satisfy the
optimality condition i.e, MRSA x,y = MRSTx,y b/c line e’f’ & ef are parallel to each other. The distribution
of OAX1 and OAY1 at point C yields some utility to A & some utility to B suppose by plotting their utility
on the utility surface, we get point K w/c represents the point of grand utility available to the society of
two persons A &B

This procedure can be repeated for each point on PPC ( i.e. transformation curve). For example if point J
gives the product mix ( i.e OAX2 + OAY2) and point d gives the distribution of OAX2 and OAY2 b/n A & B,
the grand utility is represented by point J. If we repeat this procedure continuously for other points on the
PPC, we get a curve GU through points K & J. At shows the maximum utility available to the society,
given the PPC.

Determination of the point of bliss:-

( The point of maximum welfare) Social welfare is maximized
when
the envelop of utility possibility
UB Bliss point frontier is tangent is tangent to the
N the highest possible social
Indifference contour

UB* W*
W4
W3
W2

W1
UA*

Maximization of social welfare

This point is called the point of bliss. It is denoted by W* (fig on page8). The maximum social welfare
attainable in our example is the level implied by the indifference contour W 3 .The two consumers will
enjoy the levels of utility UA* UB*.

Any other point on the GU curve, say, N, is inferior b/c it lies on a lower social indifference curve. The
figure reveals that pareto optimality conditions are only necessary but not sufficient conditions. Each
point of the GUC satisfies the first three marginal conditions. But only point W* is Pareto optimal

54
 Chapter 7:
INTRODUCTION TO ASYMMETRIC INFORMATION

55