STUDENTS
Prepared By:
Demilie Basha
Department of Economics
Adigrat University
August, 2015
Adigrat
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Course description
Course objectives
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Contents of the Module in Brief
Collusive Oligopoly
Cartels
Price Leadership
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Chapter 4: pricing of factors of production and income distribution
Factor Pricing
Chapter 5: welfare economics, externalities and public goods
Introduction
Welfare Economics
Adam Smith's welfare criterion
Bentham's criterion
Pareto's optimality criterion
Hicks- Kaldor compensation criterion
Externalities
Positive Vs Negative Externalities
Externalities and inefficiency
public goods
Asymmetric Information
Moral Hazard.
Case Study: Information and Insurance Markets
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Micro Economics-II
Introduction
Definition
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Source and Types of Monopoly
The rise and existence of monopoly is related to the factors, which prevents the
entry of new firms. The different barriers to entry that are the causes of
monopoly are described below.
i. Legal Restrictions: A monopoly, which are created for the interest of the
public. For example the public utility sectors such as water supply, postal,
telegraph and telephone services, radio and TV services, generation and
distribution of electricity such monopolies are known as public monopolies
ii. Control over key raw materials: some firms may get monopoly power if
they posses certain scarce & key raw materials that are essential for the
production of certain goods or if the supply of a commodity is localized in a
single place. This type monopoly is known as raw material monopoly. For
example India possesses manganese mines, the extraction of diamonds is
controlled by South Africa
iii. Efficiency: A primary and technical reason for growth of monopolies is
economies of scale. The most efficient plant (probably large size firm), which
can produce at minimum cost, could eliminate the competitors by cutting
down its price for a short period and can acquire monopoly power.
Monopolies created through efficiency are known as natural monopolies.
iv. Patent rights: - The government has granted firms a patent right, for
producing a commodity of specified quantity and character so that firms will
have exclusive rights to produce the specified commodity. Such monopolies
are called patent monopolies.
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There is a single seller who sells the product to many buyers.
3-Price maker
Dear learner, in perfectly competitive market, we have said that, both sellers
and buyers are price takers. However, the monopolist is a price maker. Facing
a down ward sloped demand curve for its product, the monopolist can change
its product price by changing the quantity of the Product supplied. For
example, the monopolist can increase the price of its product by decreasing
the quantity of supply.
4-Barrier to entry
In monopoly, new competitors cannot freely enter in to the market due to some
barriers which can be economical, technical, legal or other type of barriers.
In the analysis of consumer behavior you have seen that the demand curve is
generally down ward sloping showing inverse relationship between price and
quantity demanded.
In perfectly competitive market the industry faces down ward sloping demand
curve; firms face a horizontal demand curve because of the existence of large
number of producers and homogeneity of the product, the firm cannot exert
power on the total industry supply.
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The monopoly industry on the other hand is a single firm industry. A monopoly
firm therefore faces a down ward sloping demand curve. It implies given the
demand curve, a monopoly firm has the option to choose between prices to be
charged or output to be sold. But he cannot simultaneously control both the
price and the level of output. He can either decide the level of out put, and
leave the price of the out put to be determined by consumer demand or he can
fix the price and leave the level of out put to be decided by the demand for the
product at that price. One of the fundamental differences between a monopolist
and a competitor is there fore the demand (AR) and marginal revenue curves
they face. In the case of perfectly competitive market MR = AR=P=D. But in the
case of down ward sloping demand curve of monopoly marginal revenue curve
falls twice as much as the fall of average revenue curves i.e. the slope of MR is
twice as steep as the average revenue curve. The following figure illustrates this
relationship
D=AR=P
MR
Quantity
0
T M
AR and RM curves for Monopoly
DM is the demand curve and DT is the marginal revenue curve, which bisects
the quantity demanded OM. Thus the distance OT = TM
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1. The demand function
P = a - bx where a = constant, x=quantity demanded
= ax -bx2
Thus the demand curve is also the AR curve of the monopolist with slope
= -b
=a-2bx
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Under monopoly, the firm is a price maker and has a power to alter the level of
output. Thus, profit maximization under monopoly involves determination of
the price and output combination that yields the firm the maximum possible
profit. Price and output combination that maximizes the monopolist profit can
be determined in the similar fashion as that of the perfectly competitive firm.
The profit maximizing level of output is that level of output at which marginal
cost curve cuts the marginal revenue curve from below. The equilibrium (profit
maximum) price is the price corresponding to the equilibrium price from the
demand curve.
P1
P2 SMC
d
P3
b
E
c
DD or AR
Q1 Q2 Q3
MR
10
The profit maximizing condition of MR = MC and MC is increasing can be
shown as follows.
∏ = TR – TC
d
0
∏ is maximized dQ when
D dTR dTC
0
dQ dQ dQ
That is,
MR – MC = 0
d 2
0
dQ 2
d 2 d 2TR d 2TC
0
dQ 2 dQ 2 dQ 2 dTR
That d is,
2
d TR dQ dMR
dQ 2 dQ dQ
dMR dMC
0
dQ dQ
(Because
and the same for MC)
Numerical example
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Suppose the monopolist faces a market demand function given by P=40-Q. The
firm has a fixed cost of $ 50 and its variable cost is given as TVC=Q2
determine:
Given: p=40-Q
TFC=50
TVC= Q2
TC=TFC+TVC =50 + Q2
Now,
dTR d (400 Q 2 )
MR 40 2Q
dQ dQ
dTC d (50 Q 2 )
MC 2Q
dQ dQ
MR=MC 40-2Q=2Q
40=4Q
Q=10
dTR
MR 2
Second order condition: slope dQ of
dMC
MC 2
dQ
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Slope of
dMC dMR
Thus, the profit maximizing level dQ dQ of output is10 and the
profit maximizing price is obtained by substituting the profit maximizing
quantity (10) in the demand function.
Thus, P = 40 – Q
P = 40 – 10 = 30
b) The maximum profit is the level of profit obtained from selling 10 units at $
30 each.
∏ = TR – TC
But TR = P.Q
= $ 30 * 10 = $ 300
TC = 50 + Q2 = 50 + 102 = $ 150
The monopolist’s long run condition is different from the perfectly competitive
firms’ long run situation in respect of the entry of new firms into an industry.
In perfectly competitive market there is free entry in the long run. Nevertheless,
entrance is barred by several factors in monopoly. More over, we have seen that
a perfectly competitive firm can earn only normal profit in the long run. The
monopolist firm can, however, get a positive profit even in the long run because
there are entry barriers that discourage new firms to enter the industry,
attracted by the positive profit. Let us now examine the long run equilibrium
situation for single plant monopolist. If the monopolist incur loss in the short
run (SAC>P) and if there is no plant size that will result in super normal profit
in the long run given the market size, the monopolist must stop operation (shut
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down). If the monopolist makes (P> SAC) in the short run in a given plant, the
monopolist not only continue its operation but also looks for different plant size
to expand, so that could maximize profit in the long run. But at what output
level the monopolist maximizes its profit? A monopolist maximizes its long run
profit when it produces and sells that output level where LMC = MR , slope of
LMC being greater than the slope of MR at the point of intersection, and the
optimal plant size is the one whose SAC curve is tangent to the LAC at the
point corresponding to long run equilibrium output.
SMC1
P1
C SAC1 LAC
SMC2 LMC
P SAC2 DD
MR
Q
Q1 QE
Fig 6.6 Suppose initially the monopolist builds the plant size having the costs
SAC1 and SMC1 the equivalence of SMC1 and MR leads into producing and
marketing output levels Q1 and P1, making a unit profit of P1 – C, since the
monopolist is making a positive profit, it decide to continue its operation and
looks for a more profitable plant size in the long run. This long run plant is
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attained when LMC = MR, and the corresponding output level and price are Qe
and Pe
respectively.
Finally, it should be noted that there is no certainty in the long run that the
monopolist will reach the optimal plant size (minimum LAC), as in perfectly
competitive case. The monopolist may reach optimal plant size or even may
exceed the optimal size if the market demand allows him (or if there is enough
demand which absorb that level of output).
Types of monopoly
Output and Price Marginal Marginal cost Marginal cost Multi plant
sales revenue
Plant -1 Plant-2 Marginal cost
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6 3.35 2.35 2.32 2.54 2.16
Given this information, how can the monopolist decide the total production and
how much of that output each plant should produce?
The logic used in choosing output levels is very similar to that of the single-
plant firm. We can find the answer intuitively in two steps.
Step 1 - Whatever the total output, it should be divided between the two plants
so that marginal cost is the same in each plant. Otherwise, the firm could
reduce its cost by reallocating production. For example, if marginal cost at
Plant-1 were higher than at Plant-2, the firm could produce the same output at
a lower total cost by producing less output at plant -1 and more output at
plant-2. Thus, for equilibrium to occur marginal cost at firm-1 (MC1) must
equal marginal cost at firm- 2 (MC2) i.e. MC1 = MC2
Step-2 We know that the total output must be such that marginal revenue
equals the multi plant marginal cost. Now it is essential to know first how the
multi -plant marginal cost is derived from each plant marginal costs. If the firm
wants to produce the first unit, it should produce it in plant 1 because, the MC
is lower in plant 1 than in plant 2 (i.e. 1.92 < 2.04). Hence, MC of producing
the first unit for the multi –plant monopolist is 1.92. If output is to be two
units or if the firm wants to add one more units, the second unit should also be
produced in plant 1 because the MC of the second unit in plant 1 is less than
MC of producing one unit in plant 2 (i.e. 2.00 < 2.04). Hence, multi-plant
marginal cost for the second unit is $2. If three units are to be produced, plant
2 will enter into production since the MC of producing one unit in plant 2
(2.04) is less than marginal cost of producing the third unit in plant 1, & 2.08.
Hence, multi-plant MC for the third unit is 2.04, the derivation of multi-plant
marginal cost continues in the same manner.
Once, multi-plant marginal cost is derived, the only thing left to obtain
equilibrium total output is equating the multi plant MC with the marginal
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revenue. So in the above table, equilibrium output is 8 units where MC of
multi-plant = Marginal revenue (i.e. 2.24 = 2.24).
Now the remaining issue will be how to allocate the total production between
plants 1 and 2. The multi plant monopolist allocates production in a way that
each plants MC equals common value of multi plant MC and marginal revenue.
The common value of multi plant MC and marginal revenue is 2.24. Thus it
follows that the allocation of production is in a way that MC of plant-1 = 2.24
and MC of plant-2 = 2.24
MR = MC1 =MC2
2. Price Discrimination
Price discrimination refers to the charging of different prices for the same good.
But not all price differences are price discrimination. If the costs of offering a
certain uniform commodity (service) to different group of customers are
different (say due to difference in transport costs), price of the commodity may
differ for each group owing to this cost difference. But this can not be
considered as price discrimination. A firm is said to be price discriminating if it
is charging different prices for the same commodity with out any justification of
cost differences.
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1-There should be effective separation of markets for different classes of
consumers, so that buyers of low price market can not resale the
commodity in high price market.
- Geographical variation with high transport cost so that the inter market price
margin is unable to cover the transport expense.
For example, a movie theatre knows that college students and old people differ
in their willingness to pay for a ticket and can exercise discrimination by
charging the college students a higher price. This condition can be justified by
using the markup formula. Suppose the firm has a marginal cost of MC and
the price elasticity’s of demand for its product into different markets are ed1
and ed2
MC MC
P1 , and .P 2
1 1
1 1
ed1 ed 2
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3- Lastly, the market should be imperfectly competitive. In other words,
the seller of the product should have some monopoly power (it should not be
price taker) to practice price discrimination.
The degree of price discrimination refers to the extent to which a seller can
divide the market and can take advantage of it in extracting the consumer
Surplus. In economics literature, there are three degrees of price
discrimination. These are discussed one by one here under.
First degree price discrimination is the limiting case of price discrimination, the
monopolist, in this case, individually negotiate with each buyer and sell each
unit of the out put at the corresponding price given on the demand curve of the
consumer, then receiving the entire of consumer’s surplus.
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For example, a doctor who knows his patients’ paying capacity charges high
price for the richest patients’ and low price for the poor patients for identical
services.
Many firms are unable to determine which customers have the highest
reservation prices. Such firms may know, how ever, that most customers are
willing to pay more for the first unit than for successive units. This is due to
the fact the typical customer’s demand curve is down ward sloping. Such a
firm can price discriminate by letting the price each customer pays vary with
the number of units the customer buys. The act of charging different prices for
different quantities of purchases is called second degree price discrimination or
some times called quantity discrimination. In second degree price
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discrimination the price various only with quantity: all customers pay the same
price for a given quantity.
-the number of consumers is large and price rationing can be effective e.g.
electricity and telephone services.
Typically, a firm does not know the reservation price for each of its customers.
But, the firm may know which groups of customers are likely to have higher
reservation prices than others. In such a situation the firm may divide potential
customers in to two or more groups and set a different price for each group.
Such an action of charging different prices in different markets is called third
degree price discrimination. All units of the good sold to customer with in a
group (in one market) are sold at a single price, but prices will differ among the
different groups or markets.
For simplicity, let us assume that there are only two markets. To maximize
profits, the monopolist must produce the level of out put (defined by MC=MR)
and sell that out put in the two markets in such away that the marginal
revenue of the last unit sold in each market is the same. This will require the
monopolist to sell the commodity at higher p rice in the market with the less
elastic demand.
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100 units between the two markets to maximize its profit? Suppose, initially,
that the monopolist simply sold 50 units in each market and also assume that
the marginal revenue of the last unit sold in market 1 is 5 and the marginal
revenue of the last unit sold in market 2 is 3.
In this case, the monopolist can increase its total revenue by decreasing the
number of units sold in market 2 and increasing the number of units sold in
market 1. Hence, if one less unit is sold in market 2, total revenue falls by $3.
But by selling this unit in market 1 total revenue increases by $5.So, by
reallocating it sales from market 2 to market 1 the monopolist can increase its
total revenue by $2 ($5-3$). Obviously, reallocation of sales will increase the
firm’s total revenue until the marginal revenue of the last unit sold in each
market gets equal.
Thus we can conclude that to maximize the total revenue received from the sale
of a given quantity a commodity, the monopolist should allocate the total
quantity in each sub market in such away that the marginal revenue of the last
unit sold in each sub market is the same. Symbolically, the equilibrium
condition for a third degree price discriminating monopolist is: MC=MR1=MR2.
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competitive industry produces a good with the surplus that results when a
monopolist supplies the entire market. Referring to the following figure,
suppose DD represents the market demand curve, MR represents the
corresponding marginal revenue.
Dead
weight
loss
41 = pm D
MC
A B Ec
Em 25 = pc
C
DD= Price = MR (for perfect competitor)
G Em
0 Qm Qc Q
6 10
Fig.6.8
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On the other hand the producer surplus is the area below the dropped
line PcEc and above the MC curve.
- A monopolist equilibrium occurs when MC = MR i.e. at Em and the
equilibrium price and quantity become Pm and Qm respectively. Hence,
in monopoly lower quantity is sold at higher price. The new consumers’
welfare is the area above the dropped line PmD and below the demand
curve (i.e. area of PmFD) where as the producers surplus becomes the
area below the dropped line PmD and above MC curve to the left of Qm
(i.e. the area GPm DEm)
- Thus monopoly power reduces the consumers’ surplus by the amount
which equals area A+B. But increases the producers’ surplus by the area
A-C. The net welfare effect (loss) is obtained by deducting the welfare loss
of consumers from the welfare gain of producers i.e.,
Net welfare = Welfare gain by producers – Welfare loss by consumers
= A-C – (A+B)
= A-C – A-B
= -C –B or – (C +B)
Thus monopoly results in a welfare loss which is given by the area ( C+B)
This area is called dead weight loss. It is gained neither by producers nor by
consumers.
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Chapter 2, MONOPOLISTIC COMPETITION
The assumptions of the monopolistic competition are the same as those of perfect
differentiated products, which are close, but not perfect, substitutes for one
another.
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There is a large number of sellers and buyers in market
The products of the sellers are differentiated, yet they are close substitutes
of one another.
The goal of the firm is profit maximization both in the short run and long
run
The prices of factors of production (labor, capital, etc) and technology are
given
Product Differentiation
by the price policy of the firm, but also by the style of the product,
the services associated with it, and the selling activities of the firms.
policies
industries change
gives rise to a negatively sloping demand curve for the product of the
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individual firm. That means, since each firm produces a differentiated
product, it holds the monopoly power over its own products and the
firm has some power to influence the market price of its products.
Price
x
The demand (dd) curve of a firm for its products in monopolistic
competitive is negatively sloped and highly elastic (or greater than the
the market. In other words, products are close substitutes one to the
product price (p), customers will shift to the other producers and
hence the demand for a firm's product (x) decreases and vice versa.
The demand is determined not only by the price policy of the firm but
also by the style of the product and other services. Two important
policy variables in the theory of the firm are the product itself and
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selling activities. Thus the dd curve will shift if all other things (other
than the firm's price of its product) are changed. Variables other than
firm's price can be style, quality, design, advertising, etc. They are
product, the dd curve shifts to the right, implying at that level of price
price (other things being constant) leads a movement along the same
Costs
All cost curves short- run average variable cost (AVC), average cost
(AC),marginal cost (MC) and long- run total average cost (LAC) of a
markets.
improving the quality and style, etc. of the product. Selling costs help
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Accordingly, selling costs curve is U- shaped, i.e., there are economics
than the advertisement cost and after a certain point the sales rate
rise. This leads to a fall in the average selling cost initially and it rises
get the market demand and supply of the products. But here, in the
the market demand and supply. For this reason, it is very important to
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monopolistically competitive industry is a ' group' of firms
the various firms in the group. When the market demand shifts or cost
conditions change in a way affecting all firms, then the entire cluster
market arrives at its equilibrium in the short and long run. This
Models of Equilibrium
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In order to be able to analyze the equilibrium of the firm and the
dTC
of total cost with respect to quantity produced and sold ( ).
dQ
31
Chamberlin develops three models of equilibrium.
LMC
dE
Pm LAC
Pe E
d|E d|
Qe Qm Q
MR2 MR1
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market is shared by a larger number of sellers. The process will continue until
the dd curve is tangent to the average cost curve at its equilibrium. i.e. until
the abnormal profit is eliminated and excess profit is wiped out. In the final
equilibrium of the firm, the price will be Pe and the ultimate demand curve will
be dd|E. In the long run the equilibrium occurs at P=LAC, at this point there
will be neither entry nor exit, and the equilibrium is stable.
d D
LMC
P0
d|1
P1
d||1 LAC
P2
d|2 d
e d|1
Pe
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d||1
d|e
X0 X1X2Xe MR Xol
The analysis of this case is done by the introduction of a second demand curve,
labeled DD’, which shows the actual sales of the firm at each price after
accounting for the adjustments of the prices of other firms in the group. DD’ is
sometimes called actual sales curve or share of the market curve. It is a locus
of points of shifting dd curves as competitors change their price.
According to Chamberlin, the firm suffers from myopia and does not learn from
pas experience and may further reduce price expecting that the others will not
react. Thus the firm lowers its price again in an attempt to reach equilibrium,
but instead of the expected sales Xo the firm achieves actual sales of X2,
because all other firms act identically, though independently. The process
stops when the dd’ curve has shifted so far to the left as to be tangent to the
LAC curve. Equilibrium is determined by the tangency of dd’ and the LAC. At
the point of tangency the DD| curve cuts the dd| curve. Obviously it will pay
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no one firm to cut the price beyond that point, because its costs of producing
the larger output would exceed the price at which this output could be sold in
the market.
Chamberlin suggests that in the real world adjustment towards long run
equilibrium takes place through both entry/exit and price competition. Price
adjustments are shown along the dd| curve while entry/exit cause shifts in the
DD’ curve. Equilibrium is stable if the dd| curve is tangent to the AC curve
and expected sales are equal to actual sales, i..e, DD| curve cuts dd| curve at
the point of tangency of dd’ & LAC.
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D|
D* D LMC
e2
C d| A
LAC
P1 B
d* e1
X X1 X 2 X* MR*
Let’s start from e1 where there is an abnormal profit. This excess profit attracts
other firms to enter into the market. When they enter in to the market, the
market will be shared by larger number of firms then DD (market share curve)
keeps on shifting left ward until it becomes tangent to LAC, DD|.
Although, firms earn normal profit, e2 does not constitute stable equilibrium,
because the firm believes that dd is its demand curve. By taking dd as its sales
planning function the firm will feel that it can expand sales and earn excess
profit by reducing price to P1. But all the firms will be doing the same thing
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simultaneously. As price is reduced by all firms dd shifts down to dd| and
each firm realizes a loss of area CABP1 instead of positive profit.
The firm is still in myopia assumption, now also he believes that he can
obtain positive profit by cutting its price. However, all the firms do the same.
One might think that the process would stop when dd becomes tangent to the
LAC, dd*. This would be so if the firm could produce X*. However, there are so
many firms and the share of the firm is only X2. The firm still on the myopia
assumption believes that it can reach X* if he reduces to P*. However, all firms
do the same and dd* falls below the LAC with ever increasing losses. At this
time, the financially weakest firms will leave the market. So that the surviving
firms will have a higher market share then DD| will move to the right with dd | .
Exit will continue until the dd becomes tangent to the LAC curve and the
market share curve, DD, cuts the dd curve at the point of tangency, point E.
Equilibrium is then stable at point E with normal profits earned by all firms
and no entry or exit taking place. The equilibrium price is P*, which is unique
and each firm have a share equal to OX* at E, expected share is equal to actual
sale.
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define the number of firms and the magnitude of elasticity required to
have monopolistic market structure.
Despite his critics chamberlin’s contribution to the theory of pricing are:
1. The tangency of the long run average cost and demand occurs at the
falling point of the average cost curve.
2. Firms incur selling cost which is not presented in perfectly competitive
market structure. Therefore, firms in monopolistically competitive
market structure have an excess capacity measured by the difference
between the ideal output (YF) corresponding to the minimum cost level on
the LAC curve and the output actually obtained in the long run (YE).
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P
LMC
d Excess
Capacity
39
Chamberlin’s argument is based on the assumption of active price competition
and free entry. He argues that the equilibrium output will be very close to the
minimum cost output, because firms will be competing along their individual
dd curves which are very elastic.
Chamberlin divides the competition into two, price and non-price competition.
If firms avoid price competition and instead enter into a non price competition
there will be an excess capacity in each firm and inefficient product capacity in
the industry and that is an inexhaustible economy of scale for the firms in the
industry. Chamberlin argues “excess capacity in monopolistically
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Chapter 3, OLIGOPOLY THEORY
Oligopoly is the fourth type of market structure. Oligopoly is a form of
other factors).
then there exists oligopoly in the market. That means if one seller
following:
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A. Keen (or intense) competition between firms: The number of firms is
small enough that each seller takes into account the actions of
other firms in its pricing and output decisions. In other words, each
firm keeps a close watch on the activities of the rival firms and
strategies.
number implies there is barrier for new firms to enter into the
analyze oligopoly market. Firms may come ‘in collusion with each
Collusive Oligopoly
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cooperate, their decision-making process is analyzed using the
oligopoly. Augustin Cournot, a French economist, was the first to develop a formal
duopoly model in 1838. To precede our analysis of the model, the assumptions of the
a) There are only two firms, A and B each owing a mineral water wells;
c) Both face a down ward sloping straight line demand curve; and
d) Each seller
P acts on the assumption that its competitor will not react to its decision
to change its output and price
MRA MRB
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Graphical Presentation of Price and output determination under
Cournot’s Duopoly
Now let us assume that firm A is the first to start producing and
total quantity demanded. The market demand curve for the product is
revenue curve ( MRA). Firm A will sell half of the total quantity
demanded OD.
MRA is twice steeper than the DD curve (please try to show how this
Now firm B enters into the market (next to A). The market open to B is
therefore, the remaining half (XmB) out of the total OD. Hence the
MRB which cuts XmD at the middle at point B. At point B profit of firm
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the Price P. Here we can observe that firm B will supply ¼ X. That
attempts to adjust its price and output to the changed condition. Thus
A assumes that B will not change its output XmB and price P as B is
profit A will supply ½ (¾) = 3/8 of the market. Now it is B's turn to
react (to move). This action and reaction will continue until both reach
I ½ (1) = ½ 1 1 1
=
2 2 4
II 1 1 3 1 3 5
1 = 1
2 4 8 2 8 16
III 1 5 11 1 11 21
1 1
2 16 32 2 32 64
IV 1 21 43 1 43 85
1 1
2 64 128 2 128 153
. . .
. . .
N 1 1 1 1 1 1
1 1
. .2 3 3 .2 3 3
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We observe that the output share of Firm A declines gradually. We
1 1 1 1 1 1 1 1
= [ * * ( ) 2 * ( ) 3 .....] .
2 8 8 4 8 4 8 4
a
geometric series S (where S=sum, a= first term of series, r= ratio)
1 r
1
1 8 =1/3.
we obtain [Product share of firm A in equilibrium] =
2 1
1
4
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The supply by each firm remains 1/3 in the rest of the periods.
level in the Cournot models is lower than the monopoly priced but
above the pure competitive price. In general if there are n firms in the
1
industry each will provide of the market, and the industry output
( n 1)
n
will be clearly as more firms exist in the industry, the higher the
( n 1)
total quantity supplied and hence the lower the price. The larger the
number of firms the closer is output and price to the competitive level.
Note that: The Cournot game is also called an out put game as the
strategies of firms are their outputs. Firms are using their outputs as
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2- The further the iso-profit curves lie from the axis, there lower is
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This model attempts to explain the phenomenon of price rigidity in
rival firms will follow & neutralize the expected gain from price
reduction. But if it raises its price, the firms would either maintain
would lose, at least its market share. The oligopoly firm would find
The analysis:
There are three possible ways in which rival firms may react:
I. Rival firms follow the changes in price, both price hike and price
cut
II. Rival firms do not follow the changes in price, both price hike
III. Rival firms follow the price cut changes but not follow price hike
change
If rival firms react in manner (I) and (II) an oligopolistic firm taking
dd’ = Which is based on reaction (I) (Follow both hike & cut)
DD’ = Which is based on reaction (II) ( Do not follow both price hike
and cut)
49
dd’ is less elastic than DD’ because of the changes in dd in
Figure 2.2
the following behavioral pattern. Now let us look how this kink is
the expected sale is equal to the actual sale and the price is P and the
output level is X. If a firm reduces its price, all other firms also follow
this action and will reduce their price. So that, although, the demand
As a result the demand curve of the firm below price level p is ED'.
In other round, if the firm increases price above P, other firms will not
follow this action and consequently the demand curve of the firm will
be dE, implies its sales decreases due to the shift of some of its
50
customers to the other firms. Thus for price increases above P, the
Finally, the demand curve of the firm will be dED' which is a ‘'kinked
demand’' curve.
Due to the kink in the demand curve of the oligopolist firm, its
to the upper part of the demand curve, dE while the segments from
ED'.
dE and ED'. The greater the difference of elasticities of the upper (dE)
and lower (ED') parts of the kinked- demand curve, the wider
discontinuity in the MR curve, and hence the wider the range of AB.
Now let us look the behavior of the equilibrium of the firm. The
51
implying the firm is maximizing profit by producing x and charging the
price P.
Here you should note that whether the MC increases or decreases (in
the range AB) price remains the same p, i.e. price is rigid or sticky in
the firm faces from its competitors. In other words firms do not
firms.
There is only one case in which a rise in cost will most certainly
induce the firm to increase its price. This occurs when the rise in costs
Under these circumstances the firm will increase its price with the
certainty that the other in the industry will follow. Hence the point of
This model assumes that firms choose price rather than output. The first piece of
decisions. When firms offer identical goods and have a constant marginal cost,
there is a unique Nash Equilibrium when firms choose price and it entails both
firms pricing at marginal cost. The Bertrand model yields the surprising result that
each firm’s price lies between the competitive price and the monopoly price. One of
the most significant ways in which firms compete is trying to make their product
unique relative to the other products in the market. The reason is that the more
differentiated is one’s product; the more one is able to act like a monopolist. That is,
you can set a higher price without inducing large numbers of consumers to switch
let us follow the suggestion of Bertrand and assume that firms make simultaneous
price decisions with constant marginal cost –though, of course, we will assume that
firms’ outputs are differentiated. This means that consumers perceive these
products as being imperfect substitutes. That is, there are consumers who are
willing to buy one firm’s output even though it is priced higher than its
competitors’. It also typically means that a small change in a firm’s price causes a
of his rival and incorporate it in his own profit function which he then
the bases of its ok2wn reaction curve. This will permit A to chose to
set its own out put at the level which maximizes its own profit. This is
53
denoting the maximum profit A can attain given B’s reaction curve. So
Collusive Oligopoly
Sometimes firms form collusion each other in many actions to avoid uncertainty
or competition among themselves. This collusion helps the oligopolist firms to act
like a monopoly. The two main types of collusion, cartels and price leadership.
1-Cartels
Cartels imply direct agreements among the competing oligopolist with the aim of
benefits.
54
There is one typical example of cartels i.e., OPEC (Oil and Petroleum Exporting
Countries). These countries (or oil producing firms) form the organization called
OPEC and this OPEC acts as decision maker and all firms are governed under it.
B) Market- sharing between its members firms. Now let us look these two
oligopoly, i.e., all firms produce a homogenous products. The equilibrium analysis
is similar to that of the multi-plant monopolist. The cartel ( the central agency )
acting as a multi- plant monopolist, will set the profit maximizing price defined by
a- Firm 1
b- Firm 1 c- Industry
MR
For simplicity we assume that there are only two firms in the cartel, firm 1 and
firm 2. Given the market demand D in figure c the monopoly solution, which
e. The total output is X=X1 +X2 and sold at price P. Now once the central agency
55
decides these variables (P and X) it allocates the production among firms 1 and
individual MCs’.
Since all firms have the same price P, their MRs, are also the same. Therefore at
equilibrium points, i.e., at point e, MC=MR and at point e2 MC2=MR. Thus firm 1
produces X1 and B produces X2. The firm with the lower cost produces a larger
amount of output but the distribution of profits is decided by the central agency of
the cartel.
As noted above the second service of the cartel is to share the market between its
members. There are two basic methods for sharing the market: non - price
each of them can sell any quantity demanded. The agreed price must be such as
to allow some profits to all members. In this type of agreement firms cannot sell at
lower price but they can use different kinds of selling activities (e.g. changing
style, package, etc). In other words by using these selling activities firms can have
This form of cartel is indeed ' loose', in the sense that it is more unstable than the
cartel aiming at joint profit maximization. Because, since there are cost differences
among firms, the low cost firms will have a strong incentive to break the
agreement and sell at lower price or to cheat the other members by secret price
concessions to the buyers. Then the price war and instability of the agreement
occur.
Sharing the market by agreement on quotas: if all firms have identical costs, the
monopoly solution will emerge with the market being shared equally among the
56
firms. But if costs are different, the quotas and shares are determined by
2- Price Leadership
Price leadership is another form of collusion. In this form of coordination one firm
sets the price and the other follows it. There are various forms of price leadership
.The most common types of leadership are price leaderships by a low- cost firm
Due to economies of scale, efficiency, etc. a firm in the oligopoly market can be a
low- cost firm. Thus this firm takes the lead to charge price of the commodity and
other firms will follow the action. To look the model, let us assume there are two
firms, which produce a homogenous product at different costs. The firms may
have equal markets (figure 1) or they may have unequal markets (figure 2)
Figure1 Figure2
As you
observe
in the
figures
above,
firm A
is the
low-
cost firm and it takes a lead to charge price and the high cost firm (i.e., firm 2) will
follow this price. In figure 1 firm A, a leader, determines its price PA that
57
maximizes its profit at the output level (x1) where MCA= MR and firm B, the
follower takes this price PA through it does not maximize its profit by producing X2
Here you should note that since both firms sell the same amount at the same
price, both firms have the same demand curve d and one marginal revenue curve
MR1= MR2 in figure1 above. The market demand curve is D. In figure1 both firms
will sell the same quantity X1 =X2 at the same price PA. However, firm B's profit
maximizing price and out put would be PB and XBe respectively. At price PA the
In figure 2 since both firms have not equal market share their demand and
marginal revenue curves are different. Here also firm A, the leader, decides price
PA according to the marginal rule MRA = MCA, maximizes it’s Profit by selling XA,
but firm B taking this price PA will sell XB, not maximizing profit. As in figure1
firm B could maximize profit if it charged price PB. To avoid price war firm B
In this model it is assumed that there is a large dominant firm which supplies a
large proportion of the total market, and some smaller firms, each of them having
a small market share. Thus if this dominant firm increases or decreases price the
other firms will follow it. The dominant firm sets its price so as to maximize its
profit (the point where its MR=MC) but the followers may or may not maximize
Now let us look a mathematical model how a dominant firm sets its profit
58
Here we represent the market demand by D and the total output that is supplied
by the smaller firms by S then the output sold by the dominant firm will be
X= D - S
X=D-S
X = b - cP - aP
X = b – (c + a)P,
(c + a)P = b - X
P=b–X
(c + a)
(c + a)
= b–X X _ dx
(c + a)
Then to determine its profit maximizing level of out put the dominant firm will set
the first derivative of its profit function with respect to X must be equal to zero.
After determining this level of out put the dominant firm will set at what price will
59
it sell the product. And the small firms will follow this desided price by the
INCOME DISTRIBUTION
firms.
of each market in the national income. Ex- The share of labour income
in the national income equals the average wage rate multiplied by the
number of workers.
- This implies that theory of factor pricing also explains how national
no single seller or buyer can affect the price of the factor, each of
60
Factor prices are determined through the forces of demand and
earlier units, we will develop first the demand for labor by a single
firm. Here we will examine the demand for labor in two cases: A) where
labor is the only variable factor and B) when there are several variable
labour so long as the value of its product is greater than its cost.
A.1.1 The Demand for one (Single) variable productive factor(Lr)
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We derive the demand for labour by a single firm when labor is the only variable
factor in the production process. The following assumptions underlie our analysis:
iv) The market of labour is perfectly competitive, i.e., the price of labor services
is given for all firms. This implies that the supply of labour to the individual
firm is perfectly elastic as shown below. At with the firm can employ any
variable factor in
production of commodity x,
X MPPL
X= f(Lr) VMPL
62
Lr
maximum and TPL maximum. In other words, this stage II- the
MPL curve in figure b above. Now let us derive the equilibrium of the
Using the marginal value, profit is maximized when the marginal cost
63
incurred as a firm employ an extra labour is the marginal cost of labor
(MCL)
dc
MCL= . Thus profit maximizing firm will hire (employ) a resource
dL
(L) up to the point at which MCL= VMPL which implies =VMPL which
follows.
dX
P x MPL- = 0, since is MPL
dL
At the same time the VMPLr which is the Value of the additional labor
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To Prove this: VMPLr = MPL x Px
= TR
Lr
MRPLr = MR x MPL
= TR x Q
Q Lr
= TR
Lr
This equilibrium of the firm can be shown using graph. To show the
(SL) curve drawn under the assumption number (iv above) and the
(a) (b)
65
Point e in the first figure denotes the equilibrium of the firm. At point e the MCL =
=VMPL. That means at the market wage rate the firm will maximize its profit
by hiring L* units of labour
Now let us consider figure b. At point e the wage rate is and the quantity of
equilibrium shifts to e1. That means as wage increases to maximize profit the
quantity labor demanded by the firm decreases from L* to L1. To the contrary, if
variable factor (L) is its value of marginal product (VMPL) curve and is
A.1.2 The Demand for a factor (Lr) in case of Several Variable Inputs
Now we are going to derive the demand for a factor (L) when there are several
variable factors in the production process. When there are more than one variable
factors of production the VMP curve of an input is not the demand curve of a firm
that a change in the price of one factor leads to changes in the employment (use)
of the others. The latter, in turn, shifts the VMP curve of the input whose price
initially changed.
To see this, now let us assume that Lr and K are the two factors of production
existing and again assume that the wage rate falls down cause we are about to
derive the demand of the firm for Lr input. The change (the fall) in the wage rate
affects not only the demand for labour but also the demand for capital through
three effects: i) a substitution effect, ii) an output effect, and iii) a profit -
66
maximizing effect. We will look these three effects using the Isoquant-Isocost
analysis and we derive the demand for labour from these three effects.
r1
Figure 1
A’’
K1
K2 E1
OL1 Labour and OK1 capital at Isocost AB and indifference curve X1.
Now let the wage rate of Lr fall from w1 to w2 and hence the new Isocost
become AB’ and the new equilibrium become point e2 at Isocost X2. Here
labour demand has increased by L1L2 and this increase in labour use is as a
To decompose the two effect we draw an ideal Isocost curve A’’ which is
parallel to AB’ and tangent to the original Isoquant X1. And this A’’ will
remove the output effect of the fall in wage rate and specify the substitution
effect.
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And the remaining i.e. L1L2 – L1E1, a movement from point E1 to e2 is an out
put effect.
Since the firm will ultimately settle at point e2 it will use more Lr and capital.
The third effect is profit effect which arises from a down ward shift in the
MC curve due to a fall in wage rate. On figure 2 below at price OP the initial
profit maximizing out put was OX1 at equilibrium point H and suppose it is
Now when the wage rate falls the MC shifts to the position of MC 1' and the
new equilibrium point becomes G and the profit maximizing out put
increases from OX1 to OX3. Now the firm has expanded its output by X1X3
The increase in expenditure (cost) will shift Isocost AB’ to A’B’’ and the firm
total demand for labour is OL3 for which L2L3 is the profit effect additional
labour demand.
Figure 2
The output and profit effect both being positive will lead to additional
a result of output and profit maximization effect. This will ultimately lead to
68
an increase in the value of MPLr. Finally the decrease in wage rate will shift
Now we can easily derive demand for labour when other factor say capital is
variable.
w1 to w2
OL1 to OL2
increases from
O L1 L2 L3 OL1 to OL3
And by joining the initial anf final equilibrium points(E and E’) we arrive at the
The derivation of the market demand for a factor is different from that of the
of each individual's demand for a commodity. But the market demand for an input
is not the simple horizontal summation of the demand curves of individual firms.
This is due to the fact that as the price of the input falls all firms (In market)
will seek to employ more of this factor and expend their outputs. As output
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(supply) all firms in the market increases price of the output (Px) falls down.
Since this Px is one component of the VMP of a factor (i.e., VMPL= Px. MPL), as Px
falls the VMPL decreases or shifts down to the left from d1 to d2 as shown below.
=VMPL1
=VMPL2
labor
Initially the firm is at point a employing OL1, at wage rate w1 in the figure above.
Then aggregating OL1 of all firms at w1 we get the market demand for labour OL1
at point A in figure b. Now assume wage falls from w1 to w2. Other things being
constant the firm would move along d1 to point b' employing OL '2 . However, other
things do not remain constant (as mentioned above as w1 falls to w2, VMPL or d1
shifts to d2 the new demand curve will be d2.) This is because as each firm uses
L2L '2 additional unit of labour their supply of commodity increase a price fall of
the commodity will occur lead to a fall in VMPL (VMPL = MPL x P) a
downward shift in the demand for Lr from d1 to d2. At w2 the firm is in equilibrium
not at point b' but at point b on d2 and employing L2 not L'2. And market demand
at this point will be multiplying OL2 by the number of labour employing firms and
it is the point B on figure b not B’. Finally the market demand is given by line AB
70
and is negatively sloped showing an inverse relation ship between w and L in
figure b.
is derived and combining this supply curve with the demand curve of a factor we
determine the market equilibrium price of that factor. As we did in the previous
factor: all labour units are identical .The supply of labor by an individual can be
preferences of the individual between leisure and income. These curves are called
curve shows substitution between leisure and income such that worker's total
Y2
Y1
71
There are of maximum hours in a day (24 hrs), which an individual can use for
leisure or for work or for both. The slope of a line from z to any point on the
vertical axis represents the wage per hour. For example, if an individual work all
hours and earn 0Y0 total income, the income per hour (or the wage rate) will be w0
oY0 oY2
= Slope of zy0 line. Similarly, w2= = slope of zy2.
oz oz
Thus as we move up from the origin the wage rate increases, i.e., w0 > w1 > w2
because the slope of the line increases as we move from zy0, to zy1 to zy2, the
steeper the line the higher the wage rate. Accordingly as we move up from the
origin the level of satisfaction or utility of the individual increases, i.e., III > II >I
When the wage rate is w0, the individual is in equilibrium at point A by working
AZ hours earning AA income and spending OA hours of leisure. If wage increases
to w1 the individual work more hours BZ and will earn a higher income BBand
will have less OB for leisure. That means, as wage increases the individual works
more hour by decreasing his leisure time. In other words, as wage (income)
increases the supply of labour by individual increases. The locus of points of A,
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Do you think that the supply of labor increases indefinitely as wage (income)
increases? Please imagine the amount of hours a typical rich person may work in
a day. Have you tried? As we observe from the above graph as wage increases the
supply of labour increases. However, at some higher wage rate the hours offered
for work may decline. This is so because higher wages (incomes) create incentive
wage rate increases, The individual's income increases and this enables the
workers to have more leisure activities. Hence beyond a certain level of the wage
rate, the supply of labour decreases as the person prefers to use his income on
Up to a certain wage level the labor supply increases as wage increases this is
the some wage level i.e., as income increases the person becomes richer then he
works less and spends more of his time for leisure this is Wealth effect. As a
result the supply curve bends backward after a certain level of wage. The supply
curve has both a positive (the rising parts) and a negative (the bending parts)
slopes, or the supply curve for labour in the short run is ‘backward bending’.
Different shapes have been suggested for short and long run market supply curve,
depending on the occupational mobility, and the type of labour used and level of
economic growth. In general, however, the backward bending labour supply curve
is a phenomenon of the short run but in the long run the supply curve must have
73
The market labor supply curve is the sum of individual labour supply curves.
Even if higher wages may induce some people to work less hours, in the long run
as more young people will be attracted to the market, the market supply of labor
is positively slopped,
determined at the intersection of the market demand and market supply curve of
The equilibrium wage is we and employment level is Le. The market model is valid
resource. The difference between commodity pricing and factor pricing lies
in the determinants of the demand for variable factors and the method used
to derive the supply of labour. The demand for factors is a derived demand
(i.e., based on the demand of the commodities produced by the factor). The supply
of labor is not cost determined like the supply of commodities, but involves
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CHAPTER 5, WELFARE ECONOMICS, EXTERNALITIES AND
PUBLIC GOODS
Introduction
market structures. But, each economic situation in each market structure has its
own implications on the well- being of the society. So, we will examine some
or social well- being. Besides, we will analyze how markets fail in the presence of
The price system works efficiently because market prices convey information to
directly in market prices. The impact of externalities and public goods will be
quality, the market system will not operate efficiently. Asymmetric information
Bentham's Criterion
75
Pareto's optimality Criterion
than others.
The term ' welfare' has been defined in diverse ways, because it is difficult to give
situations, we need some criteria of social well- being or welfare. And various
According to Adam Smith, the final aim of all production is to make goods and
determinant of welfare.
increase in welfare. So, his welfare criterion assumes existing income distributions
76
as just and fair. However, growth in national income with greater income
Jeremy Bentham argued that welfare is improved when the greatest good is
secured for the greatest number. Welfare is the sum total of utility (welfare) of
UA = utility of individual A
UB = utility of individual B
UC = utility of individual C
And, welfare is improved as long as change in: - W (W) which is UA+ UB+ UC
should be greater that 0 (i.e. W>0), where = Change. But, this criterion has
social welfare
is positive. Example, if UA and UB decrease and UA increase. But (UA+ UB <
UC), W will be greater than 0 while two out of three individuals are
relatively affected.
According to this criterion, any change which makes at least one individual
77
better off and no one worse off is an improvement in social welfare.
Suppose there are 3 individuals. Take you and two of your friends. To say welfare
is improved, at least the welfare of one of you should be improved and there
should be no one negatively affected. If two of you have gained and one lost, we
can't say that welfare is improved. This criterion is related to the concept of general
equilibrium of production and exchange. Let's see the following two cases.
person who becomes worse- off due to this policy, and yet remain
better off. The compensations should, however, not exceed his benefit. To
considered which will benefit some (gainers) and hurt others (losers). So,
78
If the amount of money of the ' gainers' is greater than the amount of the 'losers',
the change
could compensate
those who are hurt, and still be left with some ' net gain'
there will be some gainers and losers. To say that the construction of the road
improve welfare, those who gain (benefit) from the construction could
A.2 Externalities
Positive externalities - arise when the action of one party benefits another
party.
79
Example- Suppose- you are a florist (keeps a flower garden) and your neighbor is
a Beekeeper (has a beehive). You know that Bees use flowers as a feed. In this
case, you benefit the Beekeeper in your neighborhood. Yet, your decision about
flowering did not take the benefits for the beekeeper in to account. That is, you are
road will benefit yet they don't pay for the benefits they get. This is
another case.
Negative Externalities- arise when the action of one party imposes costs on
another party.
Example- Suppose there is a steel plant (factory) in a given area. And there are
fishermen down stream that depend on the river for their daily catch. If the steel
plant dumps its waste into the rivers, the fisher men will be affected. It results a
The negative externality arises because the steel firm has no incentive to account
for the external cost that it imposes on fisher men when making its production
decision.
80
If there is a night club in your surrounding, the noise will disturb (put
Since externalities are not directly reflected in the market and not considered
when decisions are made, they affect efficiency. Let's see the effects of positive and
Please consider the above example of the florist and beekeeper. Given the demand
curve of the florist (private Benefit) and marginal cost, the marginal social benefit
Benefit
P
MC= Marginal cost of the florist
P1 Benefit
MEB
MSB
MC Q
D=MPB
O q1 q*
81
From the side of the florist, since it doesn't consider the external benefit when
decision is made, it equates its private benefit with its cost. That is, using
But, this florist generates external benefits to the neighbors, as the marginal
external benefit (MSB) curve show. From the side of the society, by including
all benefits (MPB + MEB), what is important is MSB. Then, by equating MSB =
Now, why the inefficiency arises? It is because the florist doesn't capture all
while it had to produce q*. So, the under production (q*-q1) is the cause of the
inefficiency.
Once again consider the above example of the steel plant and the
fishermen.
Given the following graph, MC is the marginal cost of the steel plant
which doesn't include the external cost. But, the cost of producing
steel to the society (including fishery) is greater than the cost of the
private firm i.e. the Marginal social cost of steel production is greater
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MC= Marginal private cost of
Price the plant
MEC
MR
P B A
O qs qf
Q (output)
Now, from the side of the firm, equilibrium is at A when MC=MR and
maximizes profit by producing qf. But, from the side of the society, MC
is not the only cost MSC includes both MC and the external cost on
fishermen.
83
While it should be produced qs amount of output by considering all costs, the
production cost.
The economic inefficiency is the excess production that causes too much out
put.(qf - qs ) is
the excess production due to negative externality i.e. by imposing cost and
ignoring it
Example: The use of a high way (road) during a period of low traffic. In this case,
adding more cars up to capacity will not reduce what is available for others.
Example: Once a nation has provided for its national defense, all
citizens enjoy its benefits i.e. you can't be excluded from getting
defense service.
While some of public goods are pure others are not.
84
A good is pure public good if it is both non- rival and non - excludable in
If a good can't be excluded, can you enforce payment? No. For instance, take
street lighting. Any one can't be excluded from using it so that you can't charge
payments. In this case, private investors get it unprofitable because they can't
charge prices so; public goods must either be provided by the government or
This is the reason why road, street lighting, defense, etc services are provided
by the government.
that consumers and producers have complete information about the economic
Asymmetric information arises when some parties know more than others.
information
85
In a number of markets, the sellers know much more about the quality of a good
than the buyers do. When the concerned parties have differential access to
Information asymmetry can cause serious problems to the efficiency with which
the market system operates. Under asymmetric information, decisions will involve
uncertainty that lead to market failure. At this level, to see how asymmetric
information can cause market failure, let us take two problems A) Adverse
A) Adverse Selection
In some markets, because of asymmetric information, the bad quality products
drive good quality out of the market. This scenario is called adverse selection.
Suppose
There is asymmetric information in insurance i.e. people who buy insurance
know much more about their general health than any insurance company can
happen?
Yes, because unhealthy people are more likely to want insurance, the
This forces the price of insurance to rise, so that more healthy people, realizing
86
This further increases the proportion of unhealthy people, which forces the
price of insurance up more, until nearly all people who want to buy insurance
are unhealthy.
Thus, selling insurance becomes unprofitable. So, adverse selection makes the
B) Moral Hazard.
This is the other effect of asymmetric information. Let's again take the case of
insurance market.
incident, the insurance market can be a victim of the problem of moral hazard.
Moral Hazard arises when the customer changes his/her behavior after
purchasing insurance.
Example-1-: Please take your self. Suppose you bought insurance for your
property (House). And, compare the amount of care you give for your property
before and after you buy the insurance. In most of the cases, you put less effort in
caring for the property after you buy because you feel insured i.e. your behavior
compensations than expected because your behavior has changed. But, what
would be the case if these were equal information (that is, if there is symmetric
information)? It might give compensations for those who care for the property. In
Moral Hazard.
87
Example-2-: Take the workers’- managers’ relationship. Usually, the manager
because they are not monitored, their behavior may change and creates a problem
in their relationship.
88
Assignment:
a. Compute the optimum level of output and price in the short run
b. Calculate the optimum profit
8. How collusive oligopoly differs from non-collusive oligopoly?
9. Graphically derive the equilibrium condition of Bertrand and Stackleberg’s Duopoly
model
10. Discuses types of collusive oligopoly market strictures
11. Explain the process by which economic profits are eliminated in a monopolistically
competitive market as compared to a perfectly competitive market.
12. What is the essential difference between the Cournot and Stackelberg models
13. Assume that a two-firm duopoly dominates the market for spreadsheet application
software, and that the firms face a linear market demand curve of P = 1,250 – Q
where P is price and Q is total output in the market (in thousands) . Thus Q = QA +
89
QB. For simplicity, also assume that both firms produce an identical product, have no
fixed costs and marginal cost MCA = MCB = 50. Then,
a. Derive the output reaction curves for Firms A and B.
b. Calculate the Courtnot market equilibrium (price-output solutions).
14. Derive mathematically the relationship between MPPL and VMPL(single-variable
case)
15. Suppose the monopolist faces a market demand function given by P=10-Q The firm
has a total cost of TC=4 Q2 + 10 and determine:
a. The profit maximizing unit of output and price
b. The maximum profit
16. If the total cost function of a firm is given by C = 200 + 10Q + 5Q2 – 2Q3 and the
market clearing price be 100 Br per unit of output the find
A, the level of output that maximizes firm’s profit
B, the shutdown level of output
C, what shall do the firm if the price falls to 50 Br per unit of output?
17. What is the difference between monopolistic completion and perfect completion
market structure?
18. Show mathematically that MR is below the demand curve in the case of pure
monopoly
19. Suppose the cost of production for a firm be given by: 𝐶 = 11 − 2𝑄 + 5𝑄 2
where, C & Q stands for cost and level of output respectively. Then,
a. what will be the level of output that maximizes the firm’s profit if market price for the
good be 28 units
b. compute the total profit at this optimum output level
20. If the cost function of perfectly competitive firm is given by: C= a + bQ –cQ2
then the firm will enjoy maximum profit if it sales ----- amount of Q at price p =
1
b.
2
90