____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 22,Perfect Competition

Module Tag BSE_P1_M22

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcome
2. Introduction
3.Market Structure and Firm Behaviour
3.1 Structure of a Competitive Market
3.2 Competitive Behaviour of Individual Firm
4. Perfectly Competitive Market
4.1 Assumptions of Perfect Competition
4.2 Demand and Revenue of a Firm in a Perfect Competition
4.3 Short-run Equilibrium of a Perfectly Competitive Firm
4.4 Long-run Equilibrium of a Competitive Firm

5. Summary

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

1. Learning Outcome of Perfect Competition

This module aims at discussing price and output determination under perfect competition. After
studying this module you will be able to know the meaning and features of perfect competition, to
distinguish between perfect competition and pure competition, and to understand price-output
determination and equilibrium of competitive firms in the short-run and in the long-run.

2. Introduction
In perfectly competitive industries, there are such a large number of firms, each producing such a
small proportion of the industry’s output, each firm cannot, by its own independent action, affect
the supply or the price. The degree to which firms can influence the price of their product through
their own strategy depends upon market structure. Perfectly competitive market structure is a
market situation where there are large number firms producing a homogeneous product and there
are large numbers of byers demanding the same products. In such a market every firm considers
that it can sell any amount of output at the prevailing market price. Similarly, there is no
restriction for the byers to purchase any amount from the market.

3. MARKET STRUCTURE AND FIRM BEHAVIOUR

The term market structure refers to the kind of market in which firms operates. Markets can
bedifferentiated by the number of firms in the market and the type of product that they produce
and sell.

3.1 Structure of Competitive Market

The market competitiveness depends on the power of individual firms to influence market prices
by changing cost and output level. If the power of individual firms to influence market prices is
zero then the market is perfectly competitive. In this case all the firms must accept the price set
by the market forces-the forces of market demand and market supply. Thus, perfect competition
is a market structure characterized by a complete absence of rivalry among the individual firms.
In such a market the firms can produce and sell any amount of output at the prevailing market
price and have zero market power to influence that price. Because of this zero market power to
influence the price, this kind of market structure is known as perfectly competitive market.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

3.2 Competitive Behaviour of Individual Firms

From the above discussion we can understand the term competitive behavior as the degree to
which individual firms actively compete with one another. In a perfectly competitive market
firms do not compete actively with each other due to their zero market power whereas firms that
do compete actively with each other in a market due to some power to influence the price and
output cannot be considered as firms functioning in a perfectlycompetitive market.

4. Perfectly Competitive Market

Perfectly competitive market is usually known as perfect competition and is considered as a

bench marking market with which other forms of market are compared. To what extent the other
forms of market exist in the real world depends upon to what extent their market power deviates
from zero market power of perfect competition. The main assumptions of Perfect Competition are
described below:

4.1Assumptions of Perfect Competition

The perfect competition is based on the following assumptions relating to firm and to the
industry.

4.1.1 Large Numbers of Sellers and Buyers

There are many buyers and sellers of the product and each is buying or selling only a very small
portion of the total product. Individual buyers and sellers have no bargaining power and are hence
price-takers

4.1.2 Homogenous Product

The product produced by all the firms in the concerned industry is exactly identical and hence
homogeneous. There is no scope for a buyer to differentiate among the products of different
firms. The homogenous products are perfect substitute of each other and their elasticity of
substitution is infinite.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

4.1.3Free Entry and Exit of Firms

There is freedom of entry or exit of firms from the industry. Entry or exit may take time but firms
have freedom of movement in and out of the industry. If barriers exist the number of firms in the
industry may be reduced so that each one of them may acquire power to affect the price and
output in the market.

4.1.4 Profit Maximization

The goal of all firms is to maximize profit.

4.1.5 No Government Interventionor open or secret understandings between producers

There is no government intervention or open or secret understanding between the producers in the
market. This is enough for the firm to be a price-taker and have an infinitely elastic demand
curve.

The above assumptions are required for a market structure to be known as pure competition. In
addition to the above assumptions if the following assumptions are fulfilled then the market is
known as a perfectly competitive market.

4.1.6 Perfect Mobility of Factors of Production

All factors of production are free to move from one place to another place or from one firm to
another throughout the market economy. This implies not only the absence of restrictions by the
Government, producers themselves or trade unions in this regard, but also absence of transport
costs.

4.1.7 Perfect Knowledge

All the sellers and buyers have complete knowledge regarding the market condition. Information
is freely available toeach buyer and seller.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

4.2 Demand and Revenue for a Firm in Perfect Competition

In perfect competition the demand curve faced by each individual firm is horizontal as changes in
output of the firm have no significant impact on prevailing market price. The horizontal nature of
demand curve indicates that price remains constant for any variation in output by an individual
firm. The price remains unchanged because the variation in output of any individual firm has
negligible impact onindustry’s total output.

Fig.4.1The Demand and Revenue Curve of a Competitive Firm

Fig.4.1 depicts the demand and revenue curve of a competitive firm of a given Industry. Revenue
is the sale receipt of the output of the firm. To study the revenues we will have to study the total,
average and marginal revenues. Total revenue (TR) is the total amount received by the firm from
the sale of its output. TR = P × Q, where Q is output sold at price P. Average revenue (AR) is the
amount of revenue per unit sold. AR= TR/Q. Marginal revenue (MR) is the change in a firm's
total revenue as a result a change in its sales by one unit.

As long as the amount of output of an individual firm does not affect the prevailing market price
significantly marginal revenue is equal to average revenue, which is always equal to price
because of the assumption that variations in output sold by an individual producer does not have

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

any impact on the market-determined price. Average revenue and marginal revenue are the same
horizontal line drawn at the level of market price shown in Fig.4.1. The horizontal line also
exhibits the firm's demand curve due to the fact that the firm can sell any quantity at this
prevailing market price. Because the market price is unchanged by any variations in the output of
any individual firm, the demand curve, average revenue curve, and marginal revenue curve of the
same firm coincide and become a horizontal line parallel to output axis. The total revenue of the
firm in competitive market rises in direct proportion to output so that it slopes upward from left to
right.

4.3 Short-run Equilibrium of a Perfectly Competitive Firm

Profit maximization is the basic aim of the firm. In the short-run some inputs are fixed and some
are variable. These fixed inputs are invariant to output in the short run and the costs incurred for
these are called fixed costs.With the market price decided by forces of demand and supply, a
competitive firm has to decide its level of output to maximize profits. This is the output for which
price equals marginal cost. In other words, the optimum level of output of the firm is the output at
which the firm maximizes profits or minimizes losses. At this level of output the marginal
revenue (MR) of the firm equals its short-run marginal cost (MC).

The firm continues expanding its output as long as MR exceeds MC because by doing so the firm
would add more to its total revenue than to its total costs. Similarly, the firm continues reducing
its output as long as MC exceeds MR because by doing so the firm will reduce its total cost more
than its total revenue. Thus, the optimum level of output of any firm is the one at which MR=MC.
Also the firm faces a horizontal demand curve, so that P=MR. Now the condition for the
optimum level of output can be restated as one at which P=MR=MC. This can be seen in Fig. 4.3
and can also be stated as follows:

Total profits (π) are equal to total revenue (TR) minus total costs (TC). That is,
π = TR – TC
Given price, P, TR=f1(Q) and TC=f2(Q).Differentiating total profit function partially with respect
to Q and setting it equal to zero gives
 TR TC
  0
Q Q Q

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

TR TC
or 
Q Q
TR TC
The term is the slope of the total revenue curve i.e. the marginal revenue. The term is
Q Q
the slope of the total cost curve i.e. the marginal cost. So the first order condition for profit
maximization is
MR=MC
Given that MC>0 implies that MR>0 at equilibrium. We know that MR=P. Hence the first order
condition may be written as MC=P.

The second order condition for profit maximization of the firm requires that second derivative of
the function be negative. Hence,

 2  2TR  2TC
 
Q 2 Q 2 Q 2
This must be negative for the profit function to be maximized, i.e.

 2TR  2TC
 0
Q 2 Q 2

 2TR  2TC
or 
Q 2 Q 2

 2TR  2TC
Here, is the slope of the MR curve and is the slope of the MC curve so that slope
Q 2 Q 2
of MR curve is less than slope of MC curve. This implies that MC must have a steeper slope than
the MR curve so that MC curve must cut the MR curve from below. The slope of the MR curve in
perfect competition is zero and the second order condition can be modified as

 2TC
0
Q 2
That is MC must be rising or MC curve must have a positive slope. Thus at point of equilibrium
the following condition must be satisfied.
(i) MC=MR
(ii) MC must be rising at the point of equilibrium

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

A firm in the short run does not necessarily make excess profit. The profit or loss of the firm
depends upon Average Total Cost (AC) at the point of equilibrium.

Fig.4.3aShort-run Equilibriumwith Fig.4.3bShort-run Equilibriumwith

Super Normal Profit of a Losses of a Competitive Firm
Competitive Firm

If the SATCfall below the price at equilibrium as shown in Fig. 4.3athe firm earns excess profits
equal to the area PABE. Similarly,if the SATCfall above the price as shown in Fig.4.3b the firm
makes a loss equal to the area FPEC. In this case the firm will continue to produce only if it
covers its average variable costs. Otherwise, the firm will decide to shut down, because by
discontinuing its operations the firm can minimize its losses. Hence the closing down point of the
firm is the point at which it covers its variable costs denoted by point z in Fig. 4.4. If price falls
below Pzthe firm does not cover its variable costs and is better off if it closes down.

Fig.4.4Shut Down Point of a Competitive Firm

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

(In short run the industry will be in equilibrium at that price at which quantity demanded will be
equal to quantity supplied and at that price market clears. In Fig. 4.5 the industry is in equilibrium
at price PE* at which quantity demanded and quantitysupplied are equal to QE*.) In short run the
firms may earn excess profit (Fig.4.5a) or may suffer from losses (Fig.4.5b). However, in long
run firms that make losses and cannot cover at least average variable cost will close down.

Fig. 4.5 Short-run Industry Fig.4.5a Short-run Fig.4.5b Short-run

Equilibrium equilibrium of a Firm with equilibrium of a Firm with
Supernormal profit Losses

4.4. Long-run Equilibrium of a Perfectly Competitive Firm

In the long-run all factor inputs and costs of production are variable. The firm will attain
equilibrium at which price equals the long-run marginal cost (LMC) of the firm. Being attracted
by the supernormal profit enjoyed by some firm in short run some new firms enter into the
industry. This increases the market supply of the output in long run and results in a lower market
price until all firms will get only normal profit. On the other hand, if some firms in the industry
suffer from losses, then they will leave the market in the long-run. Then the market supply of the
output will be reduced until all firms remaining in the market will get normal profit. Thus, in a
competitive market in long-run equilibrium all firms produce at the lowest point on their long-run
average cost (LAC) curve and get normal profit as shown by point E in Fig. 4.6a. The firm is
making supernormal profits at price P, working with the plant whose average cost is SAC1. This
firm will have an advantage to build new capacity and will move along its long run average cost
curve. Being attracted by supernormal profits enjoyed by this kind of firms some new firms will
BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

enter into the industry. Due to this quantity supplied in the market will rise and the supply curve
in the market will shift to the right. Then price will fall until it reaches the level P1 at which the
firms and industry are in long-run equilibrium. Then LAC curve shown in Fig. 4.6awill be the
final cost curve.

Fig. 4.6Industry in Long-run Fig. 4.6a Long-run Equilibrium of Firm

The condition for the long-run equilibrium of the firm is that the long run MC be equal to the
price and to the long run AC.
LMC=LAC=P

The SMC is equal to the LMC and the SAC is equal to the LAC at the point of equilibrium. The
short-run plants work at its optimal capacity at the minimum point of the LAC so that minimum
point of LAC and SAC coincide at equilibrium output level. At the same time the LMC and SMC
cuts the LAC and the SAC at their corresponding minimum points respectively so that
SMC=LMC=SAC=LAC=P=MR. However, when all firms are producing at the minimum point
of their LAC, they reached a price at which all the firms are in equilibrium and earn only normal

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

profits. This is the situation when the industry is in long run equilibrium. The long run
equilibrium of the industry is shown in Fig.4.7

Fig. 4.7 Equilibrium of the Industry in Long-run

5. Summary
In this module we have discussed the price and output determination under perfect competition.
Perfectly competitive market is characterized by large number of sellers and buyers with
homogenous product. In the short run a competitive firm may earn supernormal profit, normal
profit or may suffer from losses. But in the long run all firms earn only normal profit.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 22, PERFECT COMPETITION
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 23, Monopolistic Competition

Module Tag BSE_P1_M23

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3.Features of Monopolistic Competition
3.1 Product Differentiation
3.2 The Concept of the Industry and Product Group
3.3Free Entry and Exit
3.4 Number of Buyers and Sellers
3.5 Non-Price Competition
3.6 Independent Behaviour
4. Equilibrium of Monopolistic Competition
4.1 Assumption in Analyzing Firm Behaviour
4.2 Individual Equilibrium
4.3 Group Equilibrium
4.4 Equilibrium of Monopolistic Competition with Chamberlin’s Approach
4.5 Excess Capacity under Monopolistic Competition

5. Summary

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

1. Learning Outcomes
This module will help you to understand
 market structure of monopolistic competition;
 price and output determination under monopolistic competition;
 equilibrium of its market structure; and
 excess capacity creation under monopolistic competition.

2. Introduction
Perfect Competition and Monopoly are the two extreme cases of market structure. In practice, one
hardly observesany suchsituation,which fit into such kinds of market structure. The assumptions
in perfect competition and monopoly are not exactly happening in the real world. There are
always some deviations from the assumptions. For example, the assumption of homogenous
products in perfect competition does not resemblethe products available in real word. Economists
like Chamberlin and Joan Robinson contributed a lot to the economic literature by trying to
reconcile the two extremes so that they can fit into the real word. Their individual contributions to
the economic literaturebrought a new market structure which is known as “Monopolistic
Competition”. Therefore, monopolistic competition is a blending of both monopoly and perfect
competition, which we can observe from the industries with similar market structures viz. shoes,
restaurants, soft drinks, and clothing industries. In all these industries, products are homogenous
but they are slightly differentiated. They are close but not perfect substitute for the buyers. For
example, the soft drinks like Pepsi and Coke are homogenous but slightly differentiated products
with respect to brand name, packing design etc.

Thus, monopolistic competition is a form of market structure in which a large number of firms
are supplying homogenous but slightly differentiated product. The products of the competing
firms are close but not perfect substitutes because for buyers they are not identical as they are
slightly differentiated. This is a kind of market structure, where there iscompetition among a large
number of “monopolists” and therefore is known to economists as monopolistic competition.

3. Features of Monopolistic Competition

3.1 Product Differentiation

The products produced by different firms are not homogenous, they are heterogeneous. However,
the products of the same firm are close substitutes to each other. In order to make the product
unique, producers make their products different from others consciously. Firms adoptdifferent
ways todifferentiate the products. For example soft drinks like Pepsi, Coke, and ThumpsUp etc.
In these cases the firms simply change the chemical composition, appearance, brand
name,advertising, packing material etc. to make new and differentiated products in order to attract

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

the buyers. Thus in monopolistic completion firms produce homogenous but slightly
differentiated products. This differentiation among competing products can be attributed to real or
imaginary differences in quality. Sometimes advertisement has the impact of drawing the
attention of the buyers to imagine or believe that the advertisedproduct has better qualities.

3.2 The Concept of the Industry and Product Group

Industry is defined as a collection of firms producinga homogeneous product in case of perfect

competition.In case of differentiated product, we cannot define an industry by this definition. So
we will call the firmsproducing close substitutes as product groups. Also, there is a problem in
defining a product group. Because the degree ofsubstitutability is a relative concept so we cannot
preciselydefine a product group. According to Chamberlin, ‘product groups’ should
includeproducts, which are closely related and which are close technological and economic
substitutes. The demand for each single product is highly elastic.When the prices of other
products in the group change the demand for this product shifts.According to Chamberlin,
products forming the group should have high price and crosselasticities.

3.3Free Entry and Exit

There is freedom of entry and exit from the product group. Being attracted by the supernormal
profit earned by some firms,newfirms will enter into the product group. Similarly, if existing
firms are makinglosses, firms will quit group.

3.4 Number of Buyers and Sellers

There are a large number of buyers and sellers in a market of monopolistic competition.

3.5 Non-Price Competition

Non-price competition is observed in monopolistic competition. In order to increase the demand
for their products firms engage themselves in non-price competition through advertisement, by
giving free gifts etc.

3.6 Independent Behaviour

Firms in monopolistic competition behave independently. Because of large number of buyers and
sellers, the economic impact of one firm’s decision does not affect any other firm in the group.
This indicates that there is no rivalry among firms in the group.

4. Equilibrium of Monopolistic Competition

4.1 Assumption in Analyzing Firm Behaviour

In monopolistic competition the group demand curve of theproducts which are close substitutes to
each other is negatively sloped. It is assumed that all the firms in the group are identical, facing
similar demand andcost conditions. Thus, if all the firms charge the same price, then they will
have identical marketshares. We thenmake the following two heroic assumptions.

4.1.1 Demand Curves

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

We assume that the demand curves of all firms are symmetrical, which implies that market share
of every firm isthe same and equal to a constant proportion of total market demand.

4.1.2 Cost Curves

Also we assume that both average and marginal cost curves are symmetrical for each firm in
monopolistic competition.

4.2 Individual Equilibrium

The position and elasticity of demand curve for the product of firms under monopolistic
competition depend upon the availability of the competing substitutes and their prices. For the
sake of simplicity in analysis, conditions regarding the availability of substitute products
produced by the rival firms and prices charged for them are held constant while the equilibrium
adjustment of an individual firm is considered in isolation. Since close substitutes of the product
of the firm are available in the market, the demand for the product of an individual firm working
under monopolistic competition is fairly elastic.

Fig. 4.1 Individual Equilibrium Under Monopolistic Competition with Super Normal Profit

The individual equilibrium under monopolistic competition in short run is graphically shown in
Fig.4.1. DD is the demand curve for the product of an individual firm, the nature and prices of all
substitutes being given. This demand curve DD is also the average revenue curve of the firm. AC
represents the average cost curve of the firm, while MC is the marginal cost curve corresponding
to it. Given these demand and cost conditions, a firm will adjust its price and output at the level
which gives it maximum total profits. A firm in order to maximize profits will equate marginal

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

cost with marginal revenue. In Fig. 4.1 at the equilibrium point E, price is determined as
MQ=OPand quantity of output produced is OM. Thus, the area RSQP indicates the amount of
supernormal profits made by the firm.

In the short run, the firm, in equilibrium, may make losses too if the demand conditions for its
product are not so favourable relative to cost conditions. Fig.4.2 depicts the case of a firm the
firm making losses equal to the area GTKH.

Fig.4.2 Individual Equilibrium Under Monopolistic Competition with Losses

Thus a firm, in equilibrium, under monopolistic competition,may be making supernormal profits

or losses depending upon the position of the demand curve relative to the position of the average
cost curve in short run. Further, a firm may be making only normal profits even in the short run if
the demand curve happens to be tangent to the average cost curve.

4.3 Group Equilibrium

Each firm within a group has monopoly of its own particular product. However, its market is
interwoven with those of his competitors who produce closely related products. The price and
output decisions of a firm will affect his rival firms who may in turn react to the price and output
policies. This interdependence of the various producers upon one another is prominent feature of
monopolistic competition. The qualitative differences among the products lead to the large
variations in cost and demand curves of the various firms. The demand curves of the products of
various firms differ in respect of elasticity as well as position. Similarly, cost curves of the
BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

various firms differ in respect of shape and position. As a result of these heterogeneous conditions
surrounding each firm, there will be differences in prices, in outputs and profits of the various
firms in the group. Chamberlin in monopolistic competition make that under the heroic
assumption both demand and cost curves for all the ‘products’ are uniform throughout the group.

Further, to facilitate exposition of this theory, Chamberlin introduces a further assumption which
has been called ‘symmetry assumption’ by Prof. Stigler. It is that the number of firms being large
under monopolistic competition, an individual’s actions regarding prices and output adjustment
will have a negligible effect upon his numerous competitors so that they will not think of
retaliation for readjusting their prices and outputs.

The demand and cost curves of each of the firms in the group are DD and AC as depicted in
Fig.4.1. Each firm will set price OP at which marginal cost is equal to marginal revenue and
hence profits are maximum. Although all firms are making supernormal profits, there is no reason
for anyone to cut down price below OP.These supernormal profits will however attract new firms
in the field. New entrants are free to produce closely related products which are very similar to
the products of existing firms. Thus, under monopolistic competition there can be freedom of
entry only in the sense of freedom to produce close substitutes. When the new firms attracted by
the supernormal profits enjoyed by the existing firms enter into the field, the market would be
shared between more firms and as a result the demand curve for the product of each firm will
shift downward i.e., to the left. This process of entry of new firms and the resultant shift in the
demand curve to the left will continue until the average revenue curve becomes tangent to the
average cost curve and the abnormal profits are completely wiped out. This is shown in Fig.4.3
where average revenue curve is tangent to average cost curve at point T.

Fig.4.3 Group Equilibrium Under Monopolistic Competition in Long Run

Marginal cost and marginal revenue curves will intersect each other, exactly vertically below T.
Therefore, the firm is in long-run equilibrium but setting price LT or OK and producing OL

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

quantity of his product. Because average revenue is equal to average cost, the firm will be making
only normal profits. Since all firms are alike in respect of demand and cost curves, the average
revenue curves of all will be tangent to their average cost curves and all firms will therefore be
earning only normal profits.

4.4 Equilibrium of Monopolistic Competition with Chamberlin’s Approach

Chamberlin’s alternative approach makes use of two types of demand curves- perceived demand
curve and proportional demand curve. The demand curve facing an individual firm, as perceived
by it describes the demand for the product of one firm on the assumption that all other firms in
the industry or group keep the prices of their products constant. The number of firms being large
in a product group under monopolistic competition, it is assumed that each firm is so small
relative to the whole group that it thinks that the price change by it will have a negligible impact
upon its competitive firms, with the result that they would not think of reacting to the change in
price by it in retaliation.

On the other hand,the proportional demand curve facing an individual firm shows the demand of
the product when the prices of all firms of the product group change simultaneously in the same
direction and by the same amount so that they charge same or uniform price. So, the proportional
demand curve of a firm will be less elastic than its perceived demand curve, since equal change in
price by all firms of the industry simultaneously will prevent the movement of customers from
one seller to another. The proportional demand curve of each firm slopes downward and is a
fractional part of the total market demand curve. The greater the number of firms in a product
group, the smaller the share of an individual firm at a given price. Therefore, the proportional
demand curve facing an individual firm shifts to the left as more and more firms enter to the
product group or industry. The proportional demand curve DD́ and the perceived demand curve
dd́ are shown graphically in Fig.32.4.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

Fig.4.4 Perceived and Proportional Demand Curves

An individual firm perceives that its demand is elastic and it can increase it profits by cutting
down its price. Therefore, we construct the perceived demand curve dd́ passing through point A
as being more elastic than the proportional demand curve DD́. However, since each firm in the
product group will think independently that its price reduction will have a negligible effect upon
each of his rivals and therefore assumes that others would keep their prices constant, the actual
movement would not be along the perceived demand curve dd́ but along the proportional demand
curve DD́.Therefore, DD́ shows the actual sales by each firm when the prices of all change
equally and identically.

4.4.1 Short-Run Equilibriumof Monopolistic Competition in Chamberlin’s Approach

The firm is initially at point A on the proportional demand curve DD́ in Fig.4.5. Firm’s perceived
demand curve d0d́0 has been drawn through point A. Each firm’s share of demand for its product
is equal to OM0 and all of them are charging uniform price OP0. With Firm’s initial position at A
on the proportionate demand curve DD́, it perceives that it can increase its profits by cutting
down price below OP0 thinking that other firms would not react. It is observed from the Fig. 4.5
that if the firm cuts down price to OP1, it can maximize its profits by producing OM1 output
which is demanded at price OP1 provided others do not react to it. The perceived marginal
revenue curve MR0 corresponding to the perceived demand curve d0d́0intersects the marginal cost
curve, MC at the OM1 level of output. Thus, given the perceived demand curve d0d́0 passing
through point A on the proportional demand curve, the profit maximizing-output is equal to OM1,
which implies that the firm will have advantage to lower its price from OP0 to OP1 so as to raise
quantity demanded of its product to OM1 Level. Each firm in monopolistically competitive

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

industry will perceive independently that if they lower their price below the prevailing one, they
can attract customers from others thinking that others would not react.

Fig.4.5 Price Cutting with Perceived Demand Curve

But as a matter of fact since all firms would try to cut down their prices thinking others would not
react, each firm will not be in equilibrium at point Á. Instead, the firm will find themselves at
point B on the proportional demand curve, getting a proportionate share of the increase in market
demand at the lower price OP1. Thus each firm will be working at point B on the proportional
demand curve and producing OM2output. Thus, as a result of price cutting the perceived demand
curve of each firm will slide down the proportional demand curve to point B.With point B on the
new perceived demand curve d1d́1, the firm thinks that it can increase its profit if it lowers its
price below OP1 provided that others will not react. Because the new perceived marginal revenue
curve MR1 corresponding to the new perceived demand curve d1d́1lies above the marginal cost
curve MC in the relevant region. Though its earlier attempt to increase profits by lowering price
was retaliated by others, each firm again believes that if it lowers the price and thereby bringing
about increase in quantity demanded of its product, it can increase its profits.
Though each firm perceives in the same way and cuts down its prices independently, itwould not
succeed in snatching away customers from its rival firms. As a result, each firm instead of
moving along to a point on the perceived demand curve for maximizing its profits will land itself
on the proportional demand curve getting the same proportionate share from the increase in
quantity demanded of the product at the lower price. In this way the process of price cutting
competition and sliding down of perceived demand curve on the proportional demand curve
would continue until a firm has reached a point where it cannot perceive to increase its profits by
reducing its price.The firm in this situation will be maximizing its profits and will have therefore
no advantage to lower the price of the product further.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

Fig.4.6 Short-run Equilibrium of the Firm

As a result of price competition the perceived demand curve has slided down to the point H on
the proportional demand curve DD́ and accordingly price has fallen to OP2 and each firm is
producing and selling OM3 output as seen in Fig. 4.6.Each firm will be in equilibrium at this price
output combination and will have no incentive to change its price. Thus, according to
Chamberlin’s approach short-run equilibrium under monopolistic competition is reached and firm
will be maximizing its profits when the following two conditions are satisfied:

i) The price-output combination is such that perceived marginal revenue curve intersects
the marginal cost curve so that MR=MC.
ii) The price-output combination at which MR=MC is the point at which perceived demand
curve dd́ intersects the proportional demand curve DD́.

Thus in the short run,firm’s equilibrium occurs at the point on proportional demand curve and
perceived demand curve at which marginal revenue is equal to marginal cost.

4.4.1 Long –Run Equilibrium of the Firm and Group in Chamberlin’s Approach

Attracted by supernormal profits enjoyed by firms in short run,new firms will enter into the
industry. As a result of the entry of new firms, the market demand curve for the good would be
shared by more firms which would cause the proportionate demand curve to shift to left. Along
with the shift of the proportionate market demand curve, the perceived demand curve will also
shift to the left. The process of entry will continue until the perceived demand curve dd́ become
tangent to the long- run average cost curve LAC as seen in Fig.4.6. Further, it is observed that due
to the availability of more substitutes as a result of entry of more firms the perceived demand
curve has become more elastic. The tangency of the perceived demand curve dd́ with the long-run
BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

average cost curve LAC shows that the firms are making only normal profits. Hence there will be
no tendency for new firms to enter into the group. Consequently, when perceived demand curve
dd́ becomes tangent to the average cost curve LAC, the product group as a whole will be in
equilibrium.

Fig.4.6 Long-run Equilibrium of the Firm and Group

When sufficient numbers of new firms have entered the group and price cutting has been made,
the demand curve dd́ has fallen to the position of tangency with the long-run average cost curve
LAC in Fig.4.6. The proportional demand curve DD́ will intersect the dd́ and LAC at the point of
tangency. If too many firms have entered the group the perceived demand curve dd́ will fall to the
position below that of the tangency and the firms will be making losses. As a result some firms
will leave the group and DD́ along with dd́ curve will shift to the right.

The following two conditions are necessary forgroup equilibrium.

i) The perceived demand curve must be tangent to the LAC; and

ii) The proportional demand curve facing individual firm must intersect both the perceived
demand curve and LAC at the point of tangency.

In the Chamberlin’s approach, the two competitive forces- the entry of firms and the price
cuttingbehaviourare observed to be operating simultaneously and these force the dd́ curve to shift
and become tangent to the LAC curve. Then the DD́ curve cuts both of them at the point of
tangency which brings group equilibrium in Chamberlin’s approach.

4.5 Excess Capacity under Monopolistic Competition

In the long-run equilibrium of monopolistic competition, the perceived demand curve is tangent
to theLAC curve. Both the perceived demand curve and the LRAC aredownward sloping at point
of tangency. The firm’sequilibrium unlike in perfect competitionwould never be at the minimum
point of the LAC curve. Therefore,it is argued that the firm’s output under monopolistic
competition is not theoptimumoutput from welfare point of view and there exists excess capacity,

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

which is an under-utilization of resources of the society. The optimum output is associated with
the minimum point of the LAC curve. The excess capacity is the difference between the
optimaloutput and the actual output attained by the firm in the long-run as shown in Fig.4.6.In
Fig. 4.6, ON is the optimal output as it corresponds to minimum point of LACcurve and OQ is
the long-run equilibrium output in a monopolistic competition. Thus the excess capacity equal
toON minus OQ, which is equal to QN.Therefore, according to Chamberlin, excess capacity is
equal to QN which has arisen due to the free entry of the firms but absence of price competition.

5. Summary
Both monopoly and perfect competition are extreme forms of market structure and are rarely seen
in real world. Chamberlin blends these two market structuresand develops the concept of
monopolistic competition.The conditions of short-run and long-run equilibrium under
monopolistic competition differconsiderably from those of monopoly and perfect competition. In
short-runthere is excess profit and in the long-run these disappear as new firms enterthe market.
Under monopolistic competition firms do notoperate at optimal plant size. They work with excess
capacity.

BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 24, Non-Collusive Oligopoly I

Module Tag BSE_P1_M24

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Cournot’s Duopoly Model
3.1 Simple Duopoly model with zero costs
3.2 Reaction-Curves Approach
4. Bertrand’s Duopoly Model
5. Stackelberg’s Duopoly Model
6. Numerical Illustration of Cournot and Stackelberg models
7. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to

 Gain an insight about the oligopoly market structure

 Understand the determination of stable equilibrium in the classical duopoly models of
Cournot and Bertrand
 Comprehend the Stackelberg’s duopoly model of sophisticated behavior, which is an
extension of the Cournot model

2. Introduction
Oligopoly is a market structure in which only a few firms compete with one another, and entry by
new firms is impeded. The product that the firms produce may be homogenous (as in the case of
steel) or differentiated (as with automobiles). Oligopoly is a prevalent form of market structure.
Examples of oligopolistic industries include automobiles, steel, aluminium, petrochemicals,
electrical equipment, and computers. If there are two sellers in the market, it is called a situation
of duopoly.
Such a market structure is characterized by the following unique features—
 Since there are few rival firms, the behavior of the firms is mutually
interdependent and strategic. This implies that the action of one influences the
actions of others. The price and output policy of a firm will affect the price and
quantity sold by other firms.
 Advertising is a powerful instrument in the hands of an oligopolist. A firm can
take up aggressive advertising with the intention of capturing a large part of
rivals market.
 Oligopoly has few firms dominating the market. These firms produce products
that may be homogenous or differentiated, and also undertake measures to
restrict entry of new firms.
Because of the high degree of interdependency among oligopolistic firms, diverse behavioural
pattern may emerge. The firms may collude with each other and jointly agree to set prices and
quantities that maximize the sum of their profits. This sort of behavior is called collusive
behavior. Another form of interaction is when the firms compete with each other in one form or
the other. Such a behavior is described as non-collusive behavior. Based on different behavioural
assumptions, there are a variety of collusive and non-collusive models of oligopoly. Some of the
non-collusive models include Bertrand’s model, Cournot’s model, Stackelberg’s model,
Chamberlin’s model, and Paul Sweezy’s model. Price leadership, Cartels are some of the
collusive models.
The present and the subsequent modules will focus on the non-collusive models of
oligopoly. In this module, we will restrict ourselves to the case of two firms, i.e., duopoly. The
duopoly case allows us to capture many of the important features of firms engaged in strategic
interaction without the notational complications involved in models with a larger number of
firms.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

3. Cournot’s Duopoly Model

Cournot model is an oligopoly model in which firms produce a homogenous good, each firm
treats the output of its competitors as fixed, and all firms decide simultaneously how much to
produce.

3.1 Simple Duopoly model with zero costs

Consider a simple model of duopoly first developed by Augustin Cournot. Suppose there are two
firms, each owning a spring of mineral water. It is assumed that it is produced at zero costs.
Further, the firms sell their output in a market with a straight-line demand curve. Each firm acts
on the assumption that its competitor will not change its output, and decides its own output so as
to maximize profit.
Let us assume that firm A is the first to start producing and selling mineral water. As
illustrated in Figure 3.1, this firm will produce quantity A, at price P where profits are at a
maximum because at this point MC =- MR = 0. The elasticity of market demand at this level of
output is equal to unity and the total revenue of the firm is at a maximum. With zero costs,
maximum revenue implies maximum profits. Now firm B assumes that A will keep its output
fixed (at OA), and hence considers that its own demand curve is CD̒. It is evident that firm B will
produce half the quantity AD̒, because at this level of output (AB) and at price P̒, its revenue and
profit is at a maximum. Therefore, B’s output is ¼ (= ½×½) of the total market.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

FIGURE 3.1: COURNOT DUOPOLY MODEL WITH ZERO COSTS

Firm A, faced with this situation, assumes that B will retain his quantity constant in the
next period. So he will produce one-half of the market which is not supplied by B. Therefore, A
will, in the next period, produce ½(1-¼) = ⅜ of the total market. Firm B reacts on the Cournot
assumption, and will produce one-half of the unsupplied section of the market, i.e. ½(1-⅜).
This action-reaction pattern continues and eventually equilibrium is reached in which
each firm produces one-third of the total market. Each firm maximizes its profit in each period,
but the industry profits are not maximized. That is, the firms would have higher joint profits if
they recognized their interdependence. This would lead them to act as a monopolist, producing
one-half of the total market output, selling it at the profit-maximizing price P, and sharing the
market equally, that is, each producing one-quarter of the total market (instead of one-third).
The Cournot solution is stable. Each firm supplies one-third of the market, at a common
price which is lower than the monopoly price, but above the pure competitive price (which is zero
in this case of costless production). It can be shown that if there are three firms in the industry,
each will produce one-quarter of the market and all of them together will supply ¾ of the entire
market OD̒. And, in general, if there are n firms in the industry each will provide 1/(n+1) of the
market, and the industry output will be n/(n+1). The larger the number of firms, the closer is
output and price to the competitive level.

3.2 Reaction-Curves Approach

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

The assumption of costless production in Cournot’s model is however unrealistic. The reaction-
curves approach allows the relaxation of the assumption of identical costs and identical demands
without impairing the validity of the model.
This can be explained by considering a case of two firms producing a homogenous good.
Each firm must decide how much to produce, and the two firms make their decisions
simultaneously. Based on the Cournot assumption, each firm treats the output level of its
competitor as fixed when deciding how much to produce. Suppose firm A thinks that firm B will
produce nothing. In that case, firm A’s demand curve is the market demand curve (given by D 1 in
Figure 3.2). The corresponding marginal revenue curve is MR1.
Assume that firm A’s marginal cost MC1 is constant. As shown in the figure, firm A’s
profit maximizing output is 50 units, the point where MR1 intersects MC1. So, if firm B produces
zero, firm A should produce 50.
Now suppose firm A thinks firm B will produce 50 units. Then firm A’s demand curve is
D2, and the corresponding marginal revenue curve is MR2. Firm A’s profit maximizing output is
now 25 units (MR2 = MC1). Suppose firm A thinks that firm B will produce 75 units. Then firm
A’s demand curve is D3, and the corresponding marginal revenue curve is MR3. Firm A’s profit
maximizing output is now 12.5 units (MR3 = MC1). Finally, suppose firm A thinks that firm B
will produce 100 units. Then firm A’s demand and marginal revenue curves would intersect its
marginal cost on the vertical axis. This is to say that firm A will not produce anything.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

FIGURE 3.2: FIRM A’s OUTPUT DECISION

Thus, firm A’s profit maximizing output is a decreasing schedule of how much it thinks
firm B will produce. This schedule is firm A’s reaction curve denoted by QA*QB in Figure 3.3.
The same can be shown for firm B; that is, we can determine firm B’s profit maximizing
output given various assumptions about how much firm A will produce. This gives the reaction
curve for firm B, denoted by QB*QA.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

FIGURE 3.3: REACTION CURVES AND COURNOT EQUILIBRIUM

Each firm’s reaction curve tells it how much to produce, given the output of its
competitor. In equilibrium, each firm sets output according to its own reaction curve; the
equilibrium output levels are therefore found at the intersection of the two reaction curves. This
resulting set of output levels is called the Cournot equilibrium. In this equilibrium, each firm
correctly assumes how much its competitor will produce, and it maximizes its profit accordingly.

4. Bertrand’s Duopoly Model

In the Cournot model, it is assumed that the oligopolistic firms compete by setting quantities. In
many oligopolistic industries, however, competition occurs along price dimensions. For example,
automobile companies view price as a key strategic variable, and each one chooses its price with
its competitors in mind. Price competition in an oligopoly industry can be studied with the help of
Bertrand model.
The Bertrand model was developed by Joseph Bertrand. Like the Cournot model, it applies
to firms that produce the same homogenous good and make their decisions simultaneously. In this
case, however, the firms choose prices instead of quantities.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

Thus each firm is faced by the same market demand, and aims at the maximization of its
own profit on the assumption that the price of the competitor will remain constant. The model can
be presented using reaction functions of the duopolists. In Bertrand’s model, the reaction curves
are derived from isoprofit maps which are convex to the axes measuring the prices of the
duopolists. Each isoprofit curve for firm A shows the same level of profit which would accrue to
A from various levels of prices charged by this firm and its rival. The isoprofit curve for A is
convex to its price axis (PA). This shape implies that firm A must lower its price up to a certain
level (point e in Figure 4.1) to meet the cutting of price of its competitor, in order to maintain the
level of its profits at πA2. However, after that price level has been reached and if B continues to
cut its price, firm A will be unable to retain its profits, even if it keeps its own price unchanged (at
PAe). If firm B cuts its price at PB, firm A will find itself at a lower isoprofit curve (πA1) which
shows lower profits. Clearly, the lower the isoprofit curve, the lower the level of profits.

FIGURE 4.1: FIRM A’s REACTION CURVE

Thus for any price charged by firm B there will be a unique price of firm A which
maximizes the latter’s profit. This unique profit-maximizing price is determined at the lowest
point on the highest attainable isoprofit curve of A. The minimum points of the isoprofit curves
lie to the right of each other, reflecting the fact that as firm A moves to a higher level of profit, it
gains some of the customers of B when the latter increases its price, even if A also raises its price.
On joining the lowest points of the successive isoprofit curves, we obtain the reaction curve of
firm A. This reaction curve shows the locus of points of maximum profits that A can attain by
charging a certain price, given the price of its rival.
The reaction curve of firm B can be derived in a similar way, by joining the lowest points of
its isoprofits curves (Figure 4.2).

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

FIGURE 4.2: FIRM B’s REACTION CURVE

Bertrand’s model leads to a stable equilibrium, defined by the point of intersection of the
two reaction curves (Figure 4.3).

FIGURE 4.3: BERTRAND EQUILIBRIUM

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

Point e denotes a stable equilibrium, since any departure from it sets in motion forces which
will lead back to point e at which the price charged by A and B are PAe and PBe respectively.

5. Stackelberg’s Duopoly Model

This model was developed by Heinrich von Stackelberg and is an extension of Cournot’s model.
It is assumed that one duopolist is sufficiently sophisticated to recognize that his competitor acts
on the Cournot assumption. This allows the duopolist to determine the reaction curve of his rival
and incorporate it in his own profit function, which he then proceeds to maximize like a
monopolist.
Consider Figure 5.1 which shows the isoprofit curves and reaction functions of the
duopolists (similar to the Cournot model). The reaction curve of firm A is the locus of points of
highest profits that it can attain, given the level of output of rival B. It shows how firm A will
determine its output as a reaction to B’s decision to produce a certain level of output. Similarly,
each point on B’s reaction curve shows how much output B must produce in order to maximize
its own profit, given the level of output of its rival firm A.
If firm A is the sophisticated duopolist, it will assume that its rival will act on the basis of
its own reaction curve. This permits firm A to choose to set its own output at the level which
maximizes its own profit. This is the point a (in Figure 5.1) which lies on the lowest possible
isoprofit curve of A, denoting the maximum profit A can achieve given B’s reaction curve. Firm
A, acting as a monopolist (by incorporating B’s reaction curve in his profit-maximizing
calculations) will produce XA, and firm B will react by producing XB according to its reaction
curve. The sophisticated duopolist becomes the leader, while the rival firm which acts on the
Cournot assumption becomes the follower. Being a leader is rewarding for A because he reaches
an isoprofit curve closer to his axis than if he behaved like his rival. The follower is worse off as
compared with the Cournot equilibrium, since with this level of output he reaches an isoprofit
curve further away from his axis.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

FIGURE 5.1: STACKELBERG EQUILIBRIUM

If B is the sophisticated duopolist, it will choose to produce X̒B, corresponding to point b

on A’s reaction curve because this is the largest profit that B can achieve given his isoprofit map
and A’s reaction curve. Firm B will now be the leader while firm A becomes the follower. B has
a higher profit and firm A has a lower profit as compared with the Cournot equilibrium.
Thus, if only one firm is sophisticated, it will emerge as the leader, and a stable
equilibrium will emerge, since the rival firm will act as a follower.
However, if both firms are sophisticated, then both will want to act as leaders, because
this action yields a greater profit to them. In this case, the market situation becomes unstable. The
situation is known as Stackelberg’s disequilibrium and the effect will either be a price war until
one of the firms surrenders and agrees to act as follower, or a collusion is reached, with both
firms attaining higher profits.
The Stackelberg model has interesting implications.
 It shows that the rivals should recognize their interdependence. By recognizing
the other’s reactions each duopolist can reach a higher level of profit for himself.
 If both firms start recognizing their mutual interdependence, each starts worrying
about the rival’s profits and the rival’s reactions. If each ignores the other, a price
war will be inevitable, as a result of which both will be worse off.
 This model of sophisticated behavior is not applicable in a market in which the
firms behave on Bertrand’s assumption. In a Bertrand-type market the
sophisticated duopolist can do nothing which would increase his own profit and
persuade the other to stop price-cutting. The most he can do is to keep his own
price constant, that is, behave exactly as his opponent expects him to behave.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

6. Numerical Illustration of Cournot and Stackelberg models

Assume that the market demand and the costs of duopolists are
P = 100 – 0.5(X1+X2)
C1 = 5X1
C2 = 0.5X22

The profits of the duopolists are

(a) Π1 = PX1 – C1 = [100 – 0.5(X1+X2)] X1 - 5X1
Or
Π1 = 100X1 – 0.5X12 – 0.5X1X2 - 5X1

(b) Π2 = PX2 – C2 = [100 – 0.5(X1+X2)] X2 – 0.5X22

Or
Π2 = 100X2 – 0.5X22 - 0.5X1X2 – 0.5X22

Collecting terms we have

Π1 = 95X1 – 0.5X12 – 0.5X1X2 ……(1)

And
Π2 = 100X2 – X22 - 0.5X1X2 …….(2)

For profit-maximization under the Cournot assumption we have

∂Π1/∂X1 = 0 = 95 – X1 – 0.5X2

∂Π2/∂X2 = 0 = 100 – 2X2 – 0.5X1

The reaction functions are:

X1 = 95 – 0.5X2 ……(3)
X2 = 50 – 0.25X1 ……(4)

Cournot equilibrium is the point of intersection between the two reaction curves.
This implies substituting (4) in (3), we get

X1 = 95 – 0.5(50 – 0.25X1)
Or
X1 = 80
And
X2 = 50 – 0.25X1 = 50 – (0.25)(80) = 30

Thus the total output in the market is

X = X1 + X2= 110

And the market price

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

P = 100 – 0.5X = 45

The profits of the duopolists are

Π1 = PX1 – C1 = (45)(80) – 5(80) = 3200
And
Π2 = PX2 – C2 = (45)(30) – 0.5(30)2 = 900

Cournot solution is:

X1 = 80
X2 = 30
X = 110
P = 45
Π1 = 3200
Π2 = 900

Stackelberg’s solution has three situations as follows:

(a) Stackelberg’s solution with A being the sophisticated leader

In this case firm A will substitute B’s reaction function [computed as (4)] in its own profit
function [given by (1)], and maximize it—

Π1 = PX1 – C1 = 95X1 – 0.5X12 – 0.5X1X2

Substitute X2 = 50 – 0.25X1

Maximize Π1 = 70X1 – 0.375X12

First-order condition: ∂Π1/∂X1 = 0 = 70 – 0.75X1

This yields output: X1 = 93⅓

And profit: Π1 = 70X1 – 0.375X12 = 3267

The second-order condition for profit maximization is fulfilled.

Firm B would be the follower. It would assume that A would produce 93⅓ units; thus B
substitutes this amount in its reaction function

X2 = 50 – 0.25X1 = 26⅔

And its profit would be

Π2 = 100X2 – X22 - 0.5X1X2 = 711.1

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

(b) Stackelberg’s solution with firm B being the sophisticated leader

In this case, Firm B will substitute A’s reaction function [computed as (3)] in its own
profit function [given as (2)], and maximizes this profit as a monopolist—

Π2 = PX2 – C2 = 100X2 – X22 - 0.5X1X2

By substituting, X1 = 95 – 0.5X2, we get

Π2 = 52.5X2 – 0.75X22

The first-order profit-maximizing condition is:

∂Π2/∂X2 = 0 = 52.5 – 1.5X2

Which yields output: X2 = 35

And profit: Π2 = 52.5X2 – 0.75X22 = 918.75

The second-order condition for profit maximization is fulfilled.

The follower is now firm A which assumes that the rival will keep his quantity at X 2 = 35 units,
and calculates its own output by substituting this quantity in its reaction function.

X1 = 95 – 0.5X2 = 77.5

And its profit is Π1 = 95X1 – 0.5X12 – 0.5X1X2 = 3003.13

(c) Stackelberg’s disequilibrium

If both firms adopt Stackelberg’s sophisticated pattern of behavior, each will examine his profits
if he acts as a leader and if he acts as a follower, and will adopt the action that will yield him the
greatest profit.
Firm A calculates its profits both as a leader and as a follower:
If A is the leader his profits are 3267
If A is the follower his profits are 3003.13
Clearly firm A will prefer to act as the leader.
Similarly, Firm B calculates its profits both as a leader and as a follower:
If B is the leader his profits are 918.75
If B is the follower his profits are 711.1
Thus firm B will also choose to act as the leader.
With both firms acting in the sophisticated way implied by Stackelberg’s behavioural hypothesis
both will want to act as leaders. As they attempt to do so they find that their expectations about

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

the rival are not fulfilled and warfare will start, unless they decide to come to a collusive
agreement.

7. Summary

 Oligopoly is a market structure where only a few firms account for most or all of
production.
 Barriers to entry allow some firms to earn substantial profits.
 Economic decisions involve strategic considerations --- each firm must consider how its
actions will affect its rivals, and how they are likely to react.
 In the Cournot model, firms make their output decisions at the same time, each taking the
other’s output as fixed.
 In equilibrium, each firm is maximizing its profit, given the output of its competitor, so
no firm has an incentive to change its output.
 In the Stackelberg’s model, one firm sets its output first. That firm has a strategic
advantage and earns a higher profit.
 The Bertrand model applies to markets in which firms compete by setting price. In
equilibrium, each firm maximizes its profit, given the prices of its competitors, and so
has no incentive to change price.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 24: NON-COLLUSIVE OLIGOPOLY I
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 25, Non-Collusive Oligopoly II

Module Tag BSE_P1_M25

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Chamberlin’s Oligopoly Model
3.1 The Model
3.2 Critical Evaluation of Chamberlin’s Oligopoly Model
4. Sweezy’s Kinked Demand Model
4.1 The Model
4.2 Critical Analysis of Kinked Demand Curve Model
4.2 Example of Kinked Demand Model
5. Summary

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to

 Understand the non-collusive Chamberlin model, where the firms are conscious of their
interdependence
 Evaluate the Chamberlin model critically on various grounds
 Analyze the concept of kinked demand curve as a tool for the determination of the
equilibrium in oligopolistic markets
 Identify the various criticisms of the kinked demand curve model

2. Introduction
Oligopoly is an industry structure characterized by a few large firms producing most, or all, of
the output of some product. Examples include automobiles, steel, electrical equipment industries,
etc. The characteristic of oligopoly that distinguishes it from other forms of market structures is
the mutual interdependence of firms in the industry. Because there are only a few firms, each
realizes its actions will affect its rivals. Therefore, any price or output decision a firm makes must
be made with the thought of its rivals in mind and with some sort of guess about how rivals will
respond. Since firms can never be sure how rivals will react, they will make decisions in the
presence of uncertainty.

The nature of an oligopolistic industry makes it impossible for economists to develop a single
model that is applicable to all industries exhibiting oligopolistic characteristics. Instead,
economists have developed several theories of oligopoly, each with different behavioral
assumptions about how an oligopolist believes its rivals will react and how they actually do react.
The implications of these models vary since the assumptions made about rival behavior differ,
and when the assumptions vary, more outcomes become possible.

Oligopoly models have been broadly distinguished as Non-collusive models of Cournot,

Bertrand, Stackelberg, Chamberlin, Sweezy; and Collusive models like Cartels, Price Leadership.
Non-collusive oligopoly is a market where firms work independently and strategically by
recognizing the mutual interdependence; whereas collusive oligopoly is one where firms
maximize their joint profits by entering into a collusive agreement to restrict competition and to
avoid uncertainties arising from oligopolistic interdependence.

In continuation with the previous module, this module looks at the non-collusive oligopoly
models, namely, Chamberlin oligopoly model and Sweezy’s Kinked-Demand model.

3. Chamberlin’s Oligopoly Model

3.1 The Model

According to the Chamberlin theory of oligopoly, a stable equilibrium can be reached with the
monopoly price being charged by all firms, if firms recognize their interdependence and act so as
to maximize the industry profit (monopoly profit).
BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS
MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

Chamberlin accepts that if firm do not recognize their interdependence, the industry will reach
either the Cournot equilibrium, if each firm acts independently on the assumption that the rivals
will keep their output constant; or the industry will reach the Bertrand equilibrium if each firm
acts independently, trying to maximize its own profit on the assumption that the other rivals will
keep their price unchanged.

However, Chamberlin’s theory differs with the assumption of independent action by competitors.
According to him, in contrast to the Bertrand and Cournot assumption, the firms do in fact
recognize their interdependence. When changing their price and output, the firms do recognize
the direct and indirect effects of their decisions. The direct effects are those which would occur if
competitors were assumed to remain passive. The indirect effects are those which result from the
fact that rivals do not in fact remain passive but react to the decisions of the firm which changes
its prices or output. The recognition of the full effects (direct and indirect) of a change in the
firm’s output (or price), results in a stable industry equilibrium with the monopoly price and
monopoly output.

Chamberlin assumes that the monopoly solution (with industry or joint profits being maximized)
can be achieved without collusion: the entrepreneurs are assumed to be intelligent enough to
quickly recognize their interdependence, learn from their past mistakes and adopt the best (for all)
position, which is charging the monopoly price.

The Chamberlin’s model can be best explained in a duopoly market situation. Consider a straight
line market demand with a negative slope. Assume that the production is costless (for simplicity).
If firm A is first to start production it will produce the profit maximizing output OXM and sell it at
the monopoly price PM (Figure 3.1). Firm B, under the Cournot assumption that the rival A will
retain his quantity unchanged, considers that its demand curve is CD and will attempt to
maximize its profit by producing one-half of this demand, that is, quantity XMB (at which B’s
MR = MC = 0). As a consequence the total industry output is OB and the price falls to P. Now
firm A realizes that its rival does in fact react to its actions, and taking that into account decides to
reduce its output to OA which is one-half of OXM and equal to B’s output. The industry output is
thus OXM and price rises to the monopoly level OPM. Firm B realizes that this is the best for both
of them and so will keep its output the same at XMB = AXM. Thus, by recognizing their
interdependence the firms reach the monopoly solution. Under the assumption of equal zero costs
the market will be shared equally between A and B (OA = AXM).

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

FIGURE 3.1: CHAMBERLIN’S OLIGOPOLY MODEL

3.2 Critical Evaluation of Chamberlin’s Oligopoly Model

Chamberlin’s model is an advance over the previous models (Bertrand and Cournot) in that it
assumes that the firms are sophisticated enough to realize their interdependence. Their behaviur
leads them to the monopoly solution of output and pricing which ensures maximization of joint
profits though they do not formally collude.

However, joint profit maximization via non-collusive action is not that simple. Various
difficulties may arise in such action because it implies that firms have a good knowledge of the
market demand curve and that they learn from their mistakes and realize that the ultimate
consequence of alternative chain of adjustments to rival’s moves will be less profitable than
sharing the monopoly profits equally with him. That is, they somehow acquire knowledge of the
total supply curve (that is of the individual costs of the rivals) and hence they define the
(monopoly) price which is best for the group as a whole.

Further, it is assumed in Chamberlin’s model that the oligopolist know fully the costs of produc-
tion of their rivals which enable them to arrive at a monopoly output and price which is in the
best interest of all of them.

Thus, unless all oligopolists have identical costs and demands, it seems impossible that the
oligopolist will be able to reach monopoly solution, that is, maximization of joint profits without
collusion. It may be noted that even in a formal collusion there is always incentive on the part of
rival firms to cheat by under-cutting price to increase their individual profits. In Chamberlin’s
BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS
MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

model of oligopoly without collusion, incentive for the firms to undercut price to increase their
share of profit will be relatively more.

Chamberlin’s model also suffers from the defect of ignoring entry. It is a closed model. Due to
the attraction of monopoly profits jointly earned by the existing firms, the new firms are likely to
enter the industry. If entry does occur it is not certain that the stable monopoly solution will ever
be reached, unless special assumptions are made concerning the behavior of the old firms and the
new entrant.

4. Sweezy’s Kinked Demand Model

In the 1930s Paul Sweezy developed the kinked demand curve model in an attempt to explain
why prices in oligopolistic industries apparently remained rigid despite moderate changes in cost
and demand conditions. Unlike Cournot’s duopolists, the oligopolist in this model is keenly
aware of its rivals and the interdependence of their pricing and output decisions.

The setting is an oligopolistic industry where price has already been determined, either by
independent action or by collusion.

4.1 The Model

As illustrated in Figure 4.1, the demand curve has a kink at point E, reflecting the following
behavioral pattern. If the entrepreneur reduces his price, he expects that his competitors will
follow suit, matching the price cut, so that, although the demand in the market increases, the
shares of competitors remain unchanged. Thus for price increases above P, the relevant demand
curve is the section FE of the FF̒ curve. The upper section of the kinked demand curve (that is at
prices above P) has higher price elasticity than the lower part. The reason is that the firm believes
that if it raises its price above P, other firms will not follow suit, and it will therefore lose sales
and much of its market share. On the other hand, the firm believes that if it lowers its price below
P, other firms will follow suit because they will not want to lose their shares of the market. Due to
the kink in the demand curve of the oligopolist, his MR curve is discontinuous at the level of
output corresponding to the kink. The MR has two segments: segment FA corresponds to the
upper part of the demand curve, while the segment from point B corresponds to the lower part of
the kinked-demand curve.

The equilibrium of the firm is defined by the point of the kink because at any point to the left of
the kink MC is below the MR, while to the right of the kink the MC is larger than the MR. Thus
total profit is maximized at the point of the kink. However, this equilibrium is not necessarily
defined by the intersection of the MC and the MR curve. The discontinuity (between A and B) of
the MR curve implies that there is a range within which costs may change without affecting the
equilibrium P and X of the firm. In Figure 4.1, so long as MC passes through the segment AB, the
firm maximizes its profits by producing P and X. This level of price and output is compatible
with a wide range of costs. Thus the kink can explain why price and output will not change
despite changes in costs (within the range AB defined by the discontinuity of the MR curve). The
greater the difference of elasticities of the upper and lower parts of the kinked demand curve the
BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS
MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

wider the discontinuity in the MR curves, and hence the wider the range of costs conditions
compatible with the equilibrium price P and output X.

FIGURE 4.1: KINKED DEMAND MODEL (A)

There is only one case in which a rise in cost will most certainly induce the firm to increase its
price when costs rise, despite the fact that the higher costs pass through the discontinuity of the
MR curve. This occurs when the rise in costs is general (for example, imposition of a sales tax)
and affects all firms equally. Under these circumstances the firm will increase its price with the
certainty that the others in the industry will follow, since their costs are similarly affected. The
point of the kink shifts upwards to the left, and equilibrium is established at a higher price and a
lower output (Figure 4.2). The firm, via independent action, move closer to the point of joint
profit maximization.

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

FIGURE 4.2: KINKED DEMAND MODEL (B)

Furthermore there is a range through which demand may shift without a change in price although
quantity will change. If the demand curve is kinked, a shift in the market demand upwards or
downwards will affect the volume of output, but not the level of price, so long as the cost passes
within the range of the discontinuity of the new MR. In this case the shift occurs along the same
price line (Figure 4.3). As the market expands, the firm will not raise its price, because its (given)
cost continues to pass through the discontinuity of the new MR curve and hence there is no
incentive to change P, although output will increase.

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

FIGURE 4.3: KINKED DEMAND MODEL (C)

4.2 Critical Analysis of Kinked Demand curve model

Initially, many economists regarded the kinked demand curve model as a general theory of
oligopoly, but empirical evidence raised doubts. Stigler, for example, examined seven
oligopolistic industries and found little evidence that rival firms were reluctant to match price
increases of other firms. Moreover, economists have criticized the model on more fundamental
grounds: although the kinked demand curve model explains price rigidity when cost and demand
conditions change, it does not explain how the original price is determined. Critics claim that
Sweezy’s kinked demand model can be useful mainly as a description of price rigidity rather than
as an explanation of it.

To put it differently, the behavioral pattern implied by the kink seems quite realistic in the highly
competitive business world which is dominated by strongly competing oligopolist. However, this
model does not explain the price and output decisions of the firms. It does not define the level at
which price will be set in order to maximize profits. The kinked-demand curve can explain the
‘stickiness’ of prices in a situation of changing costs and of high rivalry. The kink is the
consequence of the uncertainty of the oligopolist and of their expectations that competitors will
match price cuts, but not price increases. However, it does not explain the level of the price at
which the kink will occur. In other words, it says nothing about how firms arrive at the price at
the kink, and why they didn’t arrive at some different price. Figure 4.4 depicts two kinked
demand curves, with the kink occurring at a different price level. Sweezy’s theory cannot define
which of the two kinks (that is, which one of the two prices) will materialize. The kinked demand
hypothesis does not explain the height of the kink. Hence, it is argued that this is not a theory of

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

pricing, but rather a tool for explaining why the price, once determined in one way or another,
will tend to remain fixed.

FIGURE 4.4: KINKED DEMAND MODEL (D)

4.3 Example of Kinked Demand model

Let us consider an example to understand the effect of a change in marginal cost on the
equilibrium output and price in the oligopoly industry with kinked demand.

The kinked demand curve is shown in Figure 4.5. The demand curve is indicated as D, and the
corresponding discontinuous marginal revenue is given as MR. Suppose that the marginal cost is
MCO. As explained in the previous section, the equilibrium price and output is determined at the
kink of the demand curve. From Figure 4.5, it is clear that the equilibrium price is Rs.20 and the
output is 30 units. It should be noted that at this equilibrium price and output, the firm’s economic
profit cannot be determined. This is because the marginal revenue is discontinuous in that section
suggesting that there is a range within which costs may change without affecting the equilibrium
price and output of the firm.

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

FIGURE 4.5: EXAMPLE—KINKED DEMAND MODEL

Now consider a shift in the marginal cost to MC1. What will happen to the equilibrium price and
output? Clearly, the equilibrium price and output remains the same at Rs.20 and 30 units,
respectively. This is so because the kink in the demand curve and thus the equilibrium does not
change with the shift in the marginal cost as indicated in the figure.

This example illustrates that small changes in the marginal cost do not have any effect on the
equilibrium price and output of the oligopoly firm.

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

5. Summary

 Oligopoly is an industry structure characterized by a few large firms producing most, or

all, of the output of some product.
 Economic decisions involve mutual interdependence and strategic behavior – each firm
considers how its actions will affect its rivals, and how they are likely to react.
 Chamberlin’s oligopoly model suggests that a stable equilibrium can be reached in an
oligopolistic market if the firms recognize their interdependence.
 Sweezy’s kinked-demand curve model assumes that firms in an oligopoly try to maintain
their market share and that rival firms are unlikely to match another’s price increase but
may match a price fall. This is to say that rival firms within an oligopoly react
asymmetrically to a change in the price of another firm. Due to this price rigidity, the
firms have a kinked-demand curve.
 The profit maximizing price and output is attained at the kink of the demand curve.
 Changes in variable costs may not lead to a rise or fall in the profit maximizing price and
output.
 The theory has been criticized for not able to explain why firms start out at the
equilibrium price and quantity.
 Many economists have argued that Sweezy’s kinked-demand model is useful mainly as a
description of price rigidity rather than as an explanation of it.

BUSINESS ECONOMICS PAPER NO.: 1, MICROECONOMIC ANALYSIS

MODULE NO.: 25, NON-COLLUSIVE OLIGOPOLY II
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 26, Collusive Oligopoly (Cartels)

Module Tag BSE_P1_M26

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcome
2. Introduction
3. Cartel
3.1 Cartel Aiming at Joint Profit Maximization
3.2 Market Sharing Cartel
3.2.1 Non-Price Competition
3.2.2 Output Quotas
4. Drawbacks of Cartels
5. Summary

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

1. Learning Outcome

This module will help you to understand:

 Introduction to oligopoly with formal or tacit agreement

 Cartel aiming at joint profit maximization and market sharing cartel
 Non-price competition and output quotas for market sharing cartel
 Some drawbacks in cartels

2. Introduction

Interdependence, price wars and cut throat competition are regular phenomenon of oligopolistic
firms. Thus firms enter into agreement of uniform price-output policy with the intention of
evading uncertainty arising out of such interdependence, price war and cut throat competition.
Firms generally enter into either formal or tacit agreement. While formal agreements are taken on
openly, tacit agreements are taken on secretly. In most of countries formal or open agreements are
illegal and as a result tacit or secret agreement play an important role among oligopolistic firms.
The formal or tacit agreements are known as collusive agreements to the economists and for them
collusive oligopoly prevails in the market when the oligopolistic firms enter into such
agreements. In the case of such collusive oligopoly the competing firms collude in order to reduce
the uncertainties arising out of the inherent rivalries among them. Bound by agreements the
colluding firms try to maximize the joint profit of the group. The best example of such type of
collusion is the Organization of Petroleum Exporting Countries (OPEC).

Considering behaviour of firms regarding price and output such kind of collusions are divide into
two main types:

i. Cartels and
ii. Price leadership.

In this module we shall discuss the price and output behaviour of Cartels.

3. CARTELS

The term ‘cartel’ was earlier used by business firm for agreement where a common sales agency
was formed by them to undertake the business operation of all the participating firms.

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

Now-a-days ‘cartel’ represents formal or tacit agreements among the oligopolistic firms of an
industry. Cartel formation is treated as illegal in some countries as per their laws. For example,
under Anti-Trust Laws the formation of a cartel is illegal in U.S.A.

There are various forms of formal or tacit collusion or agreement adopted by oligopolists under
the coordination of a ‘Central Administrative Agency’ called Cartel. Generally, cartels are formed
among the firms due to the uncertainty arising out of mutual interdependence. Broadly, Cartels
are divided into two types:

i. Cartels aiming at joint profit maximization

ii. Market sharing Cartel

3.1 Cartels Aiming at Joint Profit Maximization

The collusion will be in extreme form when the participating firms consent to surrender their
price and output determination rights to a ‘Central Administrative Agency’ in order to receive
maximum joint profits. This kind of formal collusion is known as perfect cartel, where price and
output of the industry and participating firms is determined by the central administrative agency
in order to get maximum joint profits for the members.

In a Cartel the total profit is not distributed among the members as per the proportion of their
output quota that they supply and the cost they incur. They get their share of total profit as per the
pre-accepted agreement made between them. In order to minimize the total cost of total output
produced the central administrative agency decides the output quota to be produced by each firm.
Perfect cartel’s working and operation style is very similar to the working and operation style of
multiple plant monopolists. Under a perfect cartel output to be produced and price to be charged
by each firm is decided by the central authority. Thus the task of the central authority is to decide
how much output each firms in a cartel will produce so that the total cost will be minimum. Total
cost will be minimized at the level of output where the marginal cost of each firm will be equal. If
the marginal costs of the firms are unequal, then at a smaller cost the marginal product can be
produced by some firms. Thus each firm will be allocated the output to produce at the point
where their respective marginal costs will be equal to each other.

Fig. 1 shows how the cartel works in determining price and output in order to maximize joint
profits of the oligopolistic firms.

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

Let us assume that two firms-firm ‘a’ and ‘b’ have formed a cartel by entering into an agreement.
Here the objective of cartel is to maximize the joint profits of the member firms. Now the job of
the cartel is to estimate the demand curve of the industry’s product and to decide which firm will
produce how much of the total output. The demand curve that a cartel faces is the aggregate
demand curve of the consumers of the product, which slopes downward from left to right as is
shown by the curve DD in Fig. 1(c). Marginal revenue (MR) curve of the Cartel is the addition to
its revenue as a result of additions to its output and sales. The MR curve just like monopoly will
position half way between the demand curve DD curve and Y-axis.

Fig.1 Cartel aiming joint profit maximization

In Fig. 1, the Cartel’s marginal cost curve (MCc) is the horizontal addition of the marginal cost
curves of firm-a and firm-b. Thus in Fig. 1(c) MCc curve so obtained is the horizontal addition of
marginal cost curves (MCa) and (MCb) of firms-a and firm-b respectively. The marginal cost
curve MCc of cartel, which is obtained by adding horizontally the marginal cost curves of the two
firms- firm-a and firm-b indicates the output at which the total cost is minimum; thus the cartel
can distribute the output to be produced, among the firm-a and firm-b in such a way that their
marginal costs are equal.

The point at which, MR and MC curves of the cartel intersect each other is the output at which
the cartel maximizes its profits. In Fig. 1(c), MR and MC curves of the cartel intersect each other
at point R, where output OQ is produced. The demand curve DD of the cartel at output OQ
determines price, P(P= QL =OP).

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

Now the cartel will allocate total output OQ among both firms to be produced in such a way that
their MC will be same. A horizontal straight line from point R towards the Y-axis will possibly
intersect each MC of both firm-a and firm-b to determine their respective output quota.

Fig.1 shows that both MC will be equal to each other i.e. MCa= MCb when firm-a and firm-b
produce OQ1 and OQ2 output respectively. Thus for firm-a and firm-b, the output quota is fixed at
OQ1 and OQ2 respectively. It is observed from Fig.1 that the total output OQ is equal to the sum
of OQ1 and OQ2 i.e. OQ= OQ1 + OQ2.

The joint profit of the two firms with the formation of a cartel is thus maximized where total
output OQ produced is allocated among both firms to produce output of OQ1 and
OQ2 respectively. Fig. 1 (a) shows that firm-a earns a profit equal to KPFT with output OQ1 and
cartel price OP and firm-b earn profit equal to HPEG with output OQ2 and cartel price OP.

Under the given demand and cost conditions the joint profits earned by the cartel through both
firms is maximized by equating MCc with the MRc. In Fig.1 the cartel follows cost minimization
principle not profit distribution principle in order to allocate output quota to both firm-a and firm-
b.

3.2 Market Sharing Cartels

In the real world the type of perfect cartel just explained above has been observed rarely. Not
only the output but also the price to be charged is decided by a central authority and profits are
distributed among all the participating members according to the tacit or formal agreement made
previously in a perfect cartel. However, the work and operation style is different when cartels are
loose not perfect. In case of a loose cartel the allocation of output quota and fixation of price of
member firms are not similar just like they are determined in perfect cartel. The market-sharing
by the firms is a regular phenomenon in a loose cartel. Thus the in case of a loose cartel the
market sharing is mostly categorized into two:

(i) non-price competition and

(ii) output quotas.

3.2.1 Non-Price Competition

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

The participating members of the cartel under market sharing by non-price competition are free to
produce and sell any amount of output at uniform price that maximizes their individual profits.
They are free to change the shape and size of their product and are also free to advertise and
promote sales of their products. Given the uniform price the member firms compete on non-price
basis. In case of occurrence of identical costs of the participating member firms the previously
agreed uniform price will be the price just like the price of a monopoly firm ensuring joint profit
maximization. Similarly, in case of occurrence of differences in costs of the participating member
firms the price will be fixed by bargaining between them. The level of price will be decided in
such a way that at least the high-cost firms will get some profit. However, a loose cartel under
such price fixation as per cost differences is not stable because of cut throat competition among
participating firms. Because the low cost firms in this case have the advantage of price cutting in
order to increase profit by attracting more consumers and therefore will break away from the
cartel. These low cost firms don’t charge low price openly. Giving secret price concessions to the
consumers these firms cheat other member firms. The rivals gradually get to know about this and
follow the same procedure when they lose their customers and as a result open price wars start
forcing the cartel to break down.

3.2.2 Output Quotas

In some situation oligopolistic firms make tacit or formal agreement to produce output based
upon their previously decided quota and sell them at agreed price. This is another kind of market
sharing cartel where the entire market is divided between participating members based upon their
quota of output to be produced and sold at some agreed price. In this case market sharing depends
upon two possible situations:

(i) Identical cost condition with homogeneous product and

(ii) Cost differences.

Many times the member firms produce homogeneous product and their cost of production is more
or less same or identical.

Thus firms producing homogeneous product with identical cost condition will have advantage of
monopolizing the market with equal share and in such case they will have the incentive to
maximize their joint profit. Thus in this case each member firm will have equal quota of the
market i.e. the entire market is divided equally for all the participating firms.

Moreover, in case of prevalence of cost differences the entire market will be divided unequally
based upon their cost conditions and their quota of producing output will be different. Thus

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

different quotas for each member firm will be fixed because of their cost differences in producing
the output, which will mean different/ unequal market shares.

In cost difference cases each member firm will bargain to get their quota and market share. Thus
the quotas and market shares of each member firm will be decided based upon their achievement
in the market. The achievement in the market of the firms depends upon their two criteria such as:

(i) the past level of sales

(ii) the productive capacity

These in turn depend upon the firms’ bargaining power.

Sometimes the output quota of the member firms depends upon their geographical location. In
order to decide the quota the entire market is divided region wise. However, the geographical
division of market between the member firms led to differential price charged and heterogeneous
product produced by the firms.

Empirical evidence suggests that cost differences lead to insecurity of cartel and collapse of
collusive agreement. Hence, all types of collusion and cartels are unstable if cost differences
prevail between the member firms. Cost differences lead to price war and cut throat completion as
the low cost firms have the incentive to reduce price of the product in order to maximize their
profits and as a result collusive agreement collapses.

Among many factors free entry of the firm play major role in the instability of the cartel. Thus if
there exists free entry of firms in the oligopolistic industry then collusion would not be limited to
few firms and the instability of the cartel is increased multiple times.

The new entrants instead of joining the cartel will start a price war by fixing lower prices in order
to sell large quantities of their product. The price war between the cartel firms and the new
entrants leads to instability of the cartel. Thus maintaining a cartel is a more difficult task than
forming one.

4. Drawbacks of Cartels

Cartel is not free from problems even if sometimes they are legally formed. The basic inherent
problem with any cartel is that any member of a cartel can openly or secretly ‘cheat’ and break
the existing rules of tacit or formal agreement. This problem is explained in Fig.2.

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

In Fig. 2 let us suppose that the cartel decided the price pr to prevail in the market. The price
which is fixed at pr is observed to be higher than the price that should prevail under oligopolistic
competition. A Cartel makes this price sustainable if all participating firms follow the output
quota rule that allows them to produce a limited quantity, which is less than what they would
have produced if they were producing in oligopolistic competition.

In Fig.2 let us assume this quantity as yr. Thus at quantity yr under cartelization,

Total revenue of this member firm = area OyrCpr

Total cost of this member firm is the
Area under MC curve i.e. = area OyrBA
Now total profit of this member firm = area OyrCpr– area OyrBA
= area ABCpr

Fig.2 Cartel Problems

Thus the original situation in this cartel is that the member firms are charging the price pr and yr is
the limited quantity of output that each member firm is producing. It has been observed from
Fig.2 that given the price pr there is possibility for our particular firm increases output up to yc to
make higher profit because throughout the output range O to yc , the price which is equal to
marginal revenue (MR) exceeds marginal cost and MR=MC at output yc giving maximum profit
to the member firm. Fig.2 shows that at output level yc,

total revenue of this member firm = area OycDpr

total cost of this member firm is the
area under MC curve i.e. = area OycDA
Now total profit of this member firm = area OycDpr– area OycDA
BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

= area ADpr

Thus at the output level yc, our particular firm’s profit will be equal to ADpr, which exceeds
original profit ABCpr by the area BDC.

Thus this member firm takes the advantage of breaking the cartel rule in order to over-produce
and make greater profits. Then market price will start declining due to more supply by the cheater
firm. The other honest member firms will come to know about it as it will be difficult for them to
sell their quota of output at given market price.

The cheater firm may not always be identified but the honest member firms infer that someone in
the group has broken the rule. Then the consequence of this cheating is that the cartel collapses
and the industry will come back to oligopolistic competition.

The implication of this cheating case is that the cheater firm only gains in the short run and
suffers losses in the long run. Now it is up to the honest firms that how they behave after knowing
that someone has cheated. In this case the firms should value the future and trust each other very
much in order to prevent themselves of cheating by any other firms. Otherwise cheating is an
inherent problem, leading to instability and collapse of any cartel.

This is the reason that existence of a cartel for a long stretch of time is rarely seen in in the real
world. The best example is OPEC which also faces problems from time to time.

In some situation the joint profit maximization of cartel may not be possible. Some of the
possible reasons are:
 Delay in tacit or formal agreement among the member firms.
 Wrong prediction of the market demand.
 Rigidity of the tacitly or formally agreed price.
 Wrong prediction of the marginal cost curve.
 Interference of the government
 Allowing high-cost firm into the group

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

5. Summary

 Firms form cartels and enter into agreement of uniform price-output policy with the
intention of evading uncertainty arising out of interdependence, price war and cut throat
competition.

 In an oligopolistic market while formal agreements are taken on openly, tacit agreements
are taken on secretly.

 In the case of collusive oligopoly the competing firms collude in order to reduce the
uncertainties cropping out of the inherent rivalries among them. Bound by agreements the
colluding firms try to maximize the joint profit of the group.

 Considering behaviour of firms regarding price and output collusions are divide into two
main types- cartels and price leadership.

 A Cartel represents formal or tacit agreements among the oligopolistic firms of an

industry.

 Broadly, Cartels are divided into two types: cartels aiming at joint profit maximization
and market sharing cartel.

 The collusion will be in extreme form when the participating firms consent to surrender
their price and output determination rights to a ‘Central Administrative Agency’ in order
to receive maximum joint profits. This kind of formal collusion is known as a perfect
cartel.

 Member firms in a cartel get their share of total profit as per the pre-accepted agreement
made between them. In order to minimize the total cost of total output produced the
central administrative agency decides the output quota to be produced by each firm.
Under a perfect cartel, output to be produced and price to be charged by each firm is
decided by the central authority.

 The work and operation style is different when cartels are loose not perfect. In case of a
loose cartel the allocation of output quota and fixation of price of member firms are not
similar just like they are determined in a perfect cartel. In case of a loose cartel the
market sharing is mostly categorized into non-price competition and output quotas.

 The participating members of the cartel under market sharing by non-price competition
are free to produce and sell any amount of output at a uniform price that maximizes their
individual profits.

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

 Given the uniform price the member firms compete on non-price basis. In case of
occurrence of identical costs of the participating member firms the previously agreed
uniform price will be the price just like the price of a monopoly firm ensuring joint profit
maximization.

 Similarly, in case of occurrence of differences in costs of the participating member firms

the price will be fixed by bargaining between them. The level of price will be decided in
such a way that at least the high-cost firms will get some profit.

 Another kind of market sharing cartel is by output quota where the entire market is
divided between participating members based upon their quota of output to be produced
and sold at some agreed price. In this case market sharing depends upon two possible
situations:
 Identical cost condition with homogeneous product and
 Cost differences.

 Firms producing homogeneous product with identical cost condition will have advantage
of monopolizing the market with equal share and in such case they will have the
incentive to maximize their joint profit. In this case each member firm have equal quota
of the market i.e. the entire market is divided equally for all the participating firms.

 However, in case of prevalence of cost differences the entire market will be divided
unequally based upon their cost condition and their quota of producing output will be
different. In this case each member firm will bargain to get their quota and market share.

 In some situation the joint profit maximization of cartel may not be possible because
there may be delay in tacit or formal agreement among the member firms, and wrong
prediction of the market demand.

BUSINESS PAPER NO. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.26 : COLLUSIVE OLIGOPOLY (CARTELS)
____________________________________________________________________________________________________

Subject BUSINESS ECONOMICS

Paper No and Title 1, Microeconomic Analysis

Module No and Title 27, Price Leadership

Module Tag BSE_P1_M27

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcome
2. Introduction
3. Price Leadership
3.1 Low-Cost Price Leadership
3.2 Price Leadership by the Dominant Firm
3.3 Barometric Price Leadership
3.3.1 Emergence of Barometric Price Leader
3.4 Aggressive Price Leadership
4. Limitations of Price Leadership
5. Summary

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

1. Learning Outcome

This module will help you to understand:

 Introduction to oligopoly with formal or tacit agreement

 Price Leadership

 Low-Cost Price Leadership

 Price Leadership by the Dominant Firm

 Barometric Price Leadership and its Emergence

 Aggressive Price Leadership

 Limitations of Price Leadership

2. Introduction

An oligopoly market is dominated by a few producers. Few firms in oligopoly market means that
entry of new firms and exit of old firms rarely happens. Each oligopolistic firm in the industry is
big enough to influence the profit of other firms by simply changing price, output or
advertisement cost. In other words the market power of each oligopolistic firm is very high to
substantially affect profit of other oligopolistic firms by following rivalry policy of changing
price, output and advertising cost to some extent. Thus each firm is so important for any other
firm that their interdependence forces them to operate strategically.

Interdependence, price wars and cut throat competition are regular phenomenon of oligopolistic
firms. Thus firms enter into agreement of uniform price-output policy with the intention of
evading uncertainty arising out of such interdependence, price war and cut throat competition.
Firms generally enter into either formal or tacit agreements. While formal agreements are made
openly, tacit agreements are made secretly. In most of the countries formal or open agreements
are illegal and as a result tacit or secret agreements play an important role among oligopolistic
firms. The formal or tacit agreements are known as collusive agreements to the economists and
for them collusive oligopoly prevails in the market when the oligopolistic firms enter into such
agreements. In the case of such collusive oligopoly the competing firms collude in order to reduce
the uncertainties cropping out of the inherent rivalries among them. Bound by agreements the
colluding firms try to maximize the joint profit of the group. The best example of such type of
collusion is Organization of Petroleum Exporting Countries (OPEC).

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

Considering behaviour of firms regarding price and output such kind of collusions are divided
into two main types:

i. Cartels and
ii. Price leadership.

In this module we shall discuss the price and output behaviour of price leadership firms.

3.Price Leadership

One of the important forms of collusive oligopoly is price leadership. Price leadership is a form
of collusive oligopoly where one influential firm is the leader and sets the price and other firms
follow it. Collusion under ‘price leadership’ is either tacit or formal. However, mostly collusion
under ‘price leadership’ is tacit because open collusion to form price leadership is illegal in
almost every country. Thus the oligopolistic firms select a leader from among them and collude to
follow the decision of the leader on price in a secret meeting.

There are different types of ‘price leadership’ models under collusive oligopoly:
 price leadership by a low-cost firm
 price leadership by the dominant firm
 barometric price leadership
 aggressive price leadership

3.1 Low-Cost Price Leadership

In ‘low cost price leadership’ one firm with low level of cost of production sets the price and
other high cost firms follow it. The price set by low-cost price leader is always lower than the
profit maximizing price of high-cost firms and by doing so the low cost firm maximizes its own
profit ensuring that the high-cost firm gets at least some profit.

Price-output determination underprice leadership by a low-cost firm depends upon various

assumptions. In order to explain the model we make the following assumptions:

Assumptions
 There are two firms producing in the oligopolistic market- firm A and firm B.
 Cost of production of firm A is lower than firm B.
 Both firms produce homogenous product and thus consumers have no preference
between the products.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

 Both firms have equal market share i.e. demand curve of each firm will have half of the
total market demand curve.
 Both firm face identical demand curve.

Given the above assumptions, the equilibrium price and output underprice leadership is
determined which is explained in Fig.1. Let us assume in Fig.1 that Dd is the demand curve
faced by both firms which is half of the total market demand curve DD. The marginal revenue
curve faced by each firm is MR. Average cost curves faced by firm A and firm B are ACa and
ACb respectively. Similarly, marginal cost curves faced by firm A and firm B are MCa and MCb
respectively. As per our assumptions of low cost firm MC and AC of firm A lie below the MC
and AC of firm B respectively.

Fig.1 Price-Output determination under low cost price leadership

Fig.1 shows that at OM output and OP price, firm A maximizes profit by equating MC a with MR.
But firm B will maximize profit by equating MCb with MR at price OH and output ON.Itis
observed from fig.1 that firm A has lower profit- maximizing price than firm B because OP is less
than OH.

However, due to homogenous product produced by both firms they cannot charge two different
prices. At the level of profit maximization of each firm, price OP of firm A is lower than price

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

OH of firm B. Thus if a price war takes place, then firm A being the low cost firm will win by
charging lower price. Therefore, firm A emerges as price leader and firm B a follower. Under
such circumstances tacit collusion occurs between them where firm A is chosen as price leader
and firm B as follower.

Now firm B accepts firm A as the leader and charges price OP and produces and sells output OM.
Firm B can produce and sell OM output at price OP because demand curve facing both firm is the
same. Hence, both the firms will produce and sell OM output and charge the same price OP.

Now at price OP:

Output of firm A = OM
Output of firm B = OM
Total output of both firms = OM + OM = OQ

Thus fig. 1 shows that this OQ output is the market demand for product at price OP. However,
firm B cannot maximize profit at OP price. Only firm A being the price leader can maximize
profit by selling output OM and charging price OP. With this price-output combination firm B
cannot maximize profits because ON price and OH output are its price-output combination for
profit maximization. Thus by following price OP given by firm A, firm B earn less profit than
firm A because its cost is greater than the cost of firm A.

3.2 Price Leadership by the Dominant Firm

Price leadership by dominant firm is a situation where one firm dominant the entire industry by
producing a substantially large proportion of product of the entire market. The influence of the
dominant firm over the market for the product is very high. Other firms in the industry are very
small and are incapable of influencing the price and output decision of the dominant firm. These
small firms cannot make any impact on the market. The dominant firm uses this to his advantage
and estimates its own demand curve and fixes price which enable it to maximize profit. Other
small firms incapable of influencing the market individually simply follow by accepting price set
by the dominant firm and accordingly they adjust their output also.

Now to explain the price and output determination under dominant firm price leadership, let us
assume that one firm is the dominant firm who produces substantially large proportion of output
of the entire market and a number of small firms, who follow the dominant firm have small share
of the market. We also assume that the total market demand curve for the product is known to the
dominant firm.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

The marginal cost curves of smaller firms are also known to the dominant firm. The horizontal
summation of marginal cost curves of smaller firms yields the total supply at various prices of the
product by the smaller firms. The dominant firm from his past experience can predict the supply
of the product by the smaller firms. The dominant firm uses this information to estimate his
demand curve.

Panel (a) of Fig.2 shows that DD is the market demand curve for the product, and Sm is the
aggregate supply curve of the product of all the small firms. The smaller firms cannot fulfill the
entire market demand. Thus the part of the market demand which is not fulfilled by the smaller
firms can be supplied by the leader.

It is observed from Fig.2 that the small firms supply the whole output at price P1 which indicates
that the demand for the dominant firm’s product is zero. However, if the small firms supply P2C
quantity of market demand at P2 price then the remaining quantity CT of market demand will be
supplied by the leader. The curve dL in panel (b) of fig.2 shows the demand for product of the
leader. In panel (a) and (b) of fig.2, P2Z = C T.

Again, the small firm’s product at price P3 is zero. Thus dominant firm here is the market leader
in terms of price to supply whole market demand P3U.Similarly we can also find out other prices
to show how much of market demand the price leader can supply and how much of market
demand can be left for the small firms.

The marginal revenue curve MRL corresponding to demand curve dL of the price leader is shown
in panel (b) of fig. 2. The marginal and average cost curves of the price leader are shown as MC
and AC respectively in panel (b) of fig. 2.

The price leader will maximize his profit at the point where MC cuts MR from below. In panel
(b) of fig.2 the MC cuts MR at point E where output OQ and price OP is determined. Thus the
dominant price leader maximizes his own profits by producing output OQ at price OP.

The small firms being the followers will take this price for granted and at this price OP produce
and supply market demand of PB shown in panel (a) of fig.2. Thus in panel (a) of fig.2 at OP
price the price leader will supply the market demand of BS amount which is equal to PH or OQ
amount in panel (b) and small firms will supply the market demand of PB amount.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

Fig. 2 Price leadership by the dominant firm

Many times this profit maximizing price of price leader is not enough for the small firms to
maximize their profit. The price leader thus can be pushed to a non-profit maximizing position if
small firms will produce more or less than the PB amount. Thus collusion of market sharing
though may be tacit is important to keep price leader in his profit maximizing position.

3.3 Barometric Price Leadership

Barometric price leadership is one of the important forms of collusive oligopoly model. Under
barometric price leadership of the collusive oligopoly the price is set by a large, old and
experienced firm and thus considered as a leader of all followers. The role of the leader here is to
judge market conditions from time to time in terms of product’s demand, production cost, related
or substitute products etc. Taking into account the market condition and considering common
interest of all the firms in the industry the leader fixes or makes changes in price. Thus it is
obvious that willingly all the firms in the industry follow the leader.

Thus barometric price leader is a firm of the oligopolistic industry, which plays the role of a
barometer in order to predict demand and cost conditions in the industry from time to time. The
barometric price leader also estimates and forecasts the conditions in the economy in order to
predict price movement of the product which helps other firms in the industry to adjust the output
while following the price set by the leader. Under barometric price leadership formal or tacit
collusion is undertaken among the firms to follow the price and output decision given by the
barometric price leader in the industry.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

3.3.1 Emergence of Barometric Price Leadership

Some of the important reasons for which barometric price leadership emerges in oligopolistic
market are:

 Being dissatisfied with the rivalry behaviour of some firms with respect to cut-throat
competition and price war in oligopolistic industry, other firms choose one old,
experience and largest firm as price leader. If there is rivalry amongst large firms in the
industry then all the smaller firms or followers will choose that firm which will have
more experience and expertise in predicting price, output and cost condition.

 All the firms do not have expertise in predicting price, output and cost conditions. Thus
they choose one experienced leader to be the price leader to predict price, output and cost
conditions.

3.4 Aggressive Price Leadership

Under aggressive price leadership one well established and large firm plays the role of a leader by
following aggressive price policies and forces the other firms of the industry to follow his
decisions on price. The leader exploits the other firms in the industry and threatens them to follow
him in setting the price with formal or tacit collusion.

4. Limitation of Price Leadership

Price leadership has many limitations. Many times the leader predicts and sets price but he
doesn’t know how other firms will react to this. If his followers find him incorrectly predicting
the price then the entire collusion may collapses due to price war or cut-throat competition.

Sometimes followers cut price secretly in order to have a larger share of the market because the
price fixed by the leader appears higher than the expected price of the follower. This situation
leads to price war and as a result collusion collapses.

There are a number of schemes the follower firms adopt to cut price. The schemes through which
the follower firms cut price are:

 Offer of rebates: The firm gives rebate on purchase of certain products and still gets profit.
The net price after rebate will be less than the price fixed by the leader.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

 Favorable credit terms: The firm sells products on credit and recovers the total receipt of sale
in various installments.

 Money back guarantees: The firm gives money back guarantee on quality of the product. If
quality of the product deteriorates within a given period then total sale receipt of the product
will be returned to the consumer.

 After-delivery free services: The firm gives free service after delivery of the product.

Sometimes rival firms are involved in non-price competition to increase sales keeping the price
fixed by the leader constant. There are many ways to promote sales through non-price
competition. One such scheme is advertisement to promote sales. The follower or rival firms give
advertisements keeping price of the product constant that is fixed by the leader and increase the
market share. The price leader comes to know this when his market share decreases and retaliates
by incurring expenditure on advertisements or follows a price cut policy to achieve his target of
sales. Thus this kind of retaliation, price war and non-price competition between price leader and
follower result in the collapse of collusion between them. In this case the price leader cannot
maintain his leadership for a long time.

The most important limitation of price leadership is that the leader fixes a high price for his
product. As a result the follower or rival firm cut price secretly which will have some adverse
impact on sales and market share of the leader.

New firms of same product assume that there is high profit due to high price fixed by the leader.
Thus they make an entry to the industry but cannot accept the leader as price leader. Thus the
market is shared between new firm and price leader resulting in a collapse of collusion between
the leader and follower.

Cost differences between price leader and follower create a major problem in collusive oligopoly.
High price fixed by the price leader due to higher cost of production leads to cut-throat
completion and price war between leader and follower and it attracts new firms to the industry
leading to collapse of collusion.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

5 Summary

 Interdependence, price wars and cut throat competition are a regular phenomenon of
oligopolistic firms.
 Firms enter into agreements of uniform price-output policy with the intention of evading the
uncertainty arising out of such interdependence, price war and cut throat competition.
 Firms enter into either formal or tacit agreement. While formal agreements are made openly,
tacit agreements are made secretly.
 Price leadership is a form of collusive oligopoly where one influential firm is the leader and
sets the price while other firms follow it.
 Collusion under ‘price leadership’ is either tacit or formal. However, mostly collusion under
‘price leadership’ is tacit because open collusion to form price leadership is illegal in almost
every country.
 There are different types of ‘price leadership’ models under collusive oligopoly such as (i)
price leadership by a low-cost firm, (ii) price leadership by the dominant firm, (iii) barometric
price leadership and (iv) aggressive price leadership
 In ‘low cost price leadership’ one firm with low level of cost of production sets the price and
other high cost firms follow it.

 The price set by low-cost price leader is always lower than the profit maximizing price of
high-cost firms and by doing so the low cost firm maximizes its own profit ensuring that the
high-cost firm gets at least some profit.

 Price leadership by a dominant firm is a situation where one firm dominates the entire
industry by producing a substantially large proportion of product. Other firms in the industry
are very small and are incapable of influencing the price and output decision of the dominant
firm. These small firms cannot make any impact on the market. They are price takers.

 Other small firms are incapable of influencing the market individually and simply follow by
accepting the price set by the dominant firm and accordingly they adjust their output.

 Barometric price leadership is one of the important forms of collusive oligopoly model.
Under barometric price leadership the price is set by an, old and experienced firm and thus
considered as leader of all followers.

 The role of the barometric leader is to judge market conditions from time to time in terms of
product’s demand, production cost, related or substitute products etc.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

 Taking into account the market condition and considering common interest of all the firms in
the industry the barometric leader fixes or makes changes in price.

 Under aggressive price leadership one well established and very large firm plays the role of a
leader by following aggressive price policies and forces the other firms of the industry to
follow his decision on price.

 Many times the leader in the price leadership model predicts and sets price but he don’t know
how other firms will react to this. If his followers find him incorrectly predicting the price
then the entire collusion may collapse- due to price war or cut-throat competition.

 Sometimes followers cut price secretly in order to have a larger share of the market because
the price fixed by the leader appears higher than the expected price of the follower. This
situation leads to price war and as a result the collusion collapses.

 There are a number of schemes the follower firms adopt to cut price. The schemes through
which the follower firms cut price are (i) offer of rebates (ii) favorable credit terms (iii)
money back guarantees (iv) after-delivery free services etc.

 Sometimes rival firms are involved in non-price competition like advertising etc. to increase
sales keeping the price fixed by the leader constant.

 The most important limitation of price leadership is that the leader fixes high price of his
product. As a result follower or rival firms cut price secretly which will have some adverse
impact on sales and market share of the leader.

 New firms of same product many times also assume that there is high profit due to high price
fixed by the leader. Thus they make an entry into the industry but cannot accept the leader as
price leader. Thus the market is shared between the new firm and price leader resulting in
collapse of collusion between leader and follower.

BUSINESS PAPER NO. :1, MICROECONOMIC ANALYSIS

ECONOMICS MODULE NO.:27, PRICE LEADERSHIP
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 28, Monopoly (Bilateral Monopoly)

Module Tag BSE_P1_M28

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcome
2. Introduction
3.Monopoly Market
3.1 Structure of Monopoly Market
3.2 Demand and Revenue Function of Monopolist
3.3 Cost Function of Monopolist
4. Equilibrium of Monopolist
4.1 Short-run Equilibrium
4.2 Long-run Equilibrium
5. Price Discrimination
5.1 Equilibrium of Price Discrimination
5.2 Types of Price Discrimination
6. Bilateral Monopoly
7. Welfare, Efficiency and Monopoly Power
8. Summary

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

1. Learning Outcome
This module will help you to understand
 Monopoly Market-Structure, demand, revenue and cost function of monopolist
 Equilibrium of monopolist-short-run and long-run equilibrium
 Price Discrimination-equilibrium and types of price discrimination
 Bilateral Monopoly
 Welfare, Efficiency and Monopoly Power

2. Introduction
Monopoly occupies one extreme position in terms of market structure with perfect
competition occupying the other polar extreme. In monopoly a single firm acts as a price
setter and seller. Monopoly firms are called price setters because they select their own
price and supply the entire quantity demanded in the market. The monopolists have an
effective control over the market due to unavailability of close substitutes for the
monopoly product.

Some of the main causes that lead a firm to be monopoly are:

 Unique raw materials owned by the firm.

 Unique knowledge or techniques of production.
 Production of patented product.
 Use of patented methods of production.
 Government licensing to restrict competitors.
 Imposition of trade barrier to restrict foreign competitors.
 The size of the market to support not other than the monopoly firm.
 Prevalence of increasing returns to scale as a result cost of production of
monopoly firm declines which create barriers for other firm’s entry.

3.MONOPOLY MARKET
The term market structure refers to the kind of market in which firms operate. Markets
can be differentiated by the number of firms in the market and the type of product that
they produce and sell.

3.1 Structure of Monopoly Market

The market competitiveness depends on the power of individual firms to influence

market prices by changing cost and output level. If the individual firm can influence

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

market price entirely then the market is a monopoly market. Therefore, the type of
monopoly we have been discussing is called pure monopoly in contrast to other forms of
monopoly. In this case the seller has absolute control over the market. In this module,
we will be mainly focusing pure monopoly and bilateral monopoly.

3.2 Demand and Revenue Functions of a Monopolist

As per our above discussion we come to know that there is a single firm in the industry.
Hence, the firm’s demand curve is identical to the industry demand curve, which is
downward sloping.

Assuming X as quantity demanded at monopoly price P we can write:

The demand function as : X  1   2 P

1
The total revenue (TR) function as : TR = P.X 2
The average revenue (AR) function as : AR = TR/X = PX/X = P 3

The marginal revenue (MR) function can be derived as follows:

The above demand function can be converted into price equation as:

1 X
P   4
2 2
1 1
Let us assume that  b 1 and  b 2 . Then the price equation can be written as:
2  2

P  b1  b 2 X 5

Now from Eq.2 and Eq.5, the TR function can be written as:

TR  b 1 X  b 2 X
2
6
Differentiating Eq.6 w.r.t. X, we can write MR function as:

MR  b 1  2 b 2 X 7

The MR is a straight line having the same intercept as that of the demand curve but its
slope is twice the slope of the demand curve shown in Fig. 3.1.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Fig. 3.1: Relationship between MR and Demand Curve

The relationship between MR and price elasticity of demand (ep) can be derived as
follows:

Differentiating Eq. partially w.r.t. X we get:

R P
MR   P  X 8
X X
The price elasticity of demand is defined as:

X P
ep   9
P X

P P 1
    10
X X ep

P
Substituting the value of in Eq. 8, we get:
X

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

 P 1 
MR  P  X    
 X ep 
 

 1 
 MR  P  1  
 ep 
  11

Eq. 11 shows the relationship between MR and price elasticity of demand.

3.3 Cost function of monopolist

The shapes of the cost curves of the monopolist are the same as in the theory of perfect
competition. The average variable cost (AVC), marginal cost (MC) and average total
cost (ATC) curves are ‘U’ shaped. The average fixed cost (AFC) curve is a rectangular
hyperbola. However, in monopoly the particular shape of the cost curves do not make
any difference to the determination of the equilibrium, provided that the slope of the MC
curve is greater than that of the MR curve. Monopoly differs from perfect competition in
respect of the interpretation of the marginal cost curve. Unlike perfect competition, in
monopoly the MC curve is not the supply curve of the producer. In fact, in monopoly
there is no unique relationship between price charged and quantity supplied.

4. EQUILIBRIUM OF THE MONOPOLIST

A monopolist always tries to maximize profit and therefore to earn supernormal profit it
works with excess capacity.

4.1 Short-run Equilibrium

In the short run, the monopolist cannot adjust its plant size but it maximizes its short-run
profit at the point where the following order conditions are satisfied.

First order condition : MR =MC

Second order condition : MC cuts MR from below.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Fig. 4.1: Monopoly equilibrium with Profit

In Fig. 4.1 and 4.2, both the conditions MR= MC and MC cuts MR from below are met
and the monopolist makes profit equal to the area FCEG in Fig. 4.1 whereas it suffers
from losses equal to the area BCPF in Fig. 4.2.

In Fig. 4.1, AB is the demand curve of a firm and MR, the marginal revenue curve. The
short-run equilibrium is given by the point D where SMC (short run marginal cost curve)
cuts MR from below. The firm produces OH amount of output and sells it at price CH.
Short-run average total cost of producing OH unit of the commodity is HF. Therefore,
total profit of the firm is the area EGFC.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Fig. 4.2: Monopoly equilibrium with Loss

In Fig. 4.2, the short-run equilibrium is given by the point D where SMC cuts MR from
below. The firm produces OH amount of output and sells it at price CH. Short-run
average total cost of producing OH unit of the commodity is HB. Therefore, total loss of
the firm is the area BCPF.

4.2 Long-run Equilibrium

A monopolist continues to earn supernormal profits even in the long-run and she will not
stay in business if she makes losses in the long-run. However, the size of the plant and
degree of its resource utilization depend upon the market demand conditions. In the
following three figures, we depict three situations.

In the Fig. 4.3, the market size does not permit the monopolist to expand to the minimum
point of LAC. In this case not only her plant is of suboptimal size but also is
underutilized. The optimum use of the existing plant is at A and the minimum point of the
long-run average cost is given by B. Since the firm utilizes the capacity C, there is
excess capacity.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Fig. 4.3: Monopolist with suboptimal plant and excess capacity

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Fig. 4.4: Optimal Plant Size of a Monopoly Firm and Over Utilization of Capacity

However, in Fig.4.5 the market size is just large enough to permit the monopolist to build
the optimal plant and to use it at full capacity.

Fig. 4.5: Optimal Plant Size of a Monopolist

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Thus, there is no certainty that in the long-run the monopolist will reach optimal plant
size as in the case of perfect competition. Whether a monopolist stays in business in the
long-run will depend on the long run average cost curve. She will exit in the long run
unless all costs can be covered.

5. PRICE DISCRIMINATION
Price discrimination is a market situation where a monopolist charges different prices
from different buyers for the same product. Price discrimination is not possible under
perfect competition. There are two conditions that must be fulfilled for price
discrimination to be possible. These conditions are:

a. Price elasticity of products are different and there must be different sub markets
for the same products.
b. Reselling of products should not be possible from the low price market to the
high price market

Following are the reasons for price discrimination to be possible.

a. Consumer habits
b. Nature of the good
c. Distances of the market
d. Legal sanctions

Price discrimination is possible when a consumer is ignorant about the fact that other
consumers get the same commodity at lower prices, or he might have a false
assumption that higher prices imply higher quality or price differences is small enough
that he just snubs it.

5.1 Equilibrium of Price Discrimination

Let us assume that there are two different markets where a monopolist sells his output.
Let us assume that the output sold in the first market be X1 and in the second be X2 .

Thus, the total amount sold by the monopolist is (X1 + X2)

Let revenue from each market which is a function of amount sold be

TR1 = TR1 (X1)
TR2 = TR (X2)
Thus total revenue will be: TR = TR1 +TR2
= TR1 (X1)+ TR (X2) 12
The total cost is given by: C = C (X1 + X2) 13
Hence, profit of the discriminating monopolist will be

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

π = TR– C
= TR1 (X1) + TR2 (X2) – C(X1 + X2) 14

The condition for profit maximization requires that:


 TR  X2)  0
' '
1
(X 1 ) – C (X 1
15
X 1


 TR  X 2)  0
' '
2
(X 2
) – C (X 1
16
X 2

Comparing eq. 15 and eq.16 we get:

(X 1 )  TR )  C (X  X2)
' ' '
TR 1 2
(X 2 1

This implies that: MR1 = MR2 = MC 17

Eq. 17 states the condition of profit maximization for discriminating monopolist where
marginal revenue of each market will be equal and will also be equal to marginal cost. If
MR1 will be higher than MR2, it would be profitable for the monopolist to sell more of the
product in first market. The monopolist will continues selling in first market till marginal
revenue of both market will be equal. Then equilibrium will be restored when: MR1 = MR2
= MC. However, the equality of marginal revenues does not mean the equality of prices
in the two markets so long as the price elasticity of demand in both markets is different.

Fig. 5.1a: Market 1 Fig. 5.1b: Market 2 Fig. 5.1c: Equilibrium of Discriminating
Monopolist

In fig. 5.1a and fig. 5.1b, the MR and AR curves of first and second markets are drawn.
In the fig. 5.1c, the combined MR curves are drawn by horizontally summing over MR1
and MR2. In fig.5.1c the combined MR and MC curves intersect each other at point E.
Fig. 5.1a and fig. 5.1b indicate that at point E1 and E2 , MR1 = MC and MR2 = MC
BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

respectively, which satisfy the conditions of profit maximization for a discriminating

monopolist. Thus, the discriminating monopolist will sell X1* amount of output in market 1
and X2* amount of output in market 2 at price at price P1* and P2* respectively.

5.2 Types of Price Discrimination

There are three types of price discrimination viz. personal, local and type of use. In case
of personal price discrimination monopolists charges different prices to different persons.
For example, for different patients a doctor may charge different amounts of consultation
fees for same disease. If the monopolists charges different prices to same product for
people of different localities then price discrimination is said to be local. Price
discrimination as per use of goods and services depends upon different uses of same
commodity. Electricity board charges different prices for commercial and domestic
purposes.

Besides, A.C. Pigou has also introduced three types of price discrimination. He opined
three degrees of price discrimination viz. first degree, second degree and third degree
price discrimination. First degree price discrimination is said to happen when the
monopolist charges a different price for each unit of output. In first degree of price
discrimination monopolist not only charges different prices to different consumers but
also charges different prices for different units sold to the same consumer.

Fig. 5.2: First Degree Price Discrimination

According to A.C. Pigou, price of the commodity depends upon consumers’ willingness
to pay (WTP) for it in discriminating monopoly market. Thus the maximum price that the
consumer is willing to pay for a unit of output is called the ‘reservation price’. The
monopolist which are perfectly discriminating charges the reservation price remain same
for each unit of output. In this case the marginal revenue curve for the monopolist is the
demand curve. The output in this case which is obtained by intersection of demand

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

curve and MC curve is the same output obtained in perfect competition. In fig. 5.2, the
monopolist produces output OX* and its revenue is given by (OA)(OX*)= the area
OABX*.

There is no unique equilibrium price in this case because the monopolist charges a
different price i.e. ‘reservation price’ for each unit of output sold. In fig. 5.2 the dotted
area represents the monopolist’s profit. It has been observed in fig.5.2 that in first degree
price discrimination the monopolist includes the whole consumer surplus into his profit.
First degree price discrimination is not so easy to implement in practice. It is possible
only for products for which no resale is possible.

According to A.C. Pigou, sometimes the monopolist charges several different prices for
different groups of output. This is known as second degree price discrimination. Each of
first X1 units of output as has been observed in fig. 5.3, are sold at a price of P1.
Similarly, price P2 is set between X1 and X2 units of output and so on. Thus number of
each additional unit between 1 to X1 multiplied by P1 contribute to the revenues.
Similarly, each additional unit between X1 to X2 multiplied by P2 contribute to the
revenues and so on. This as a result make MR curve to be a step function as has been
observed by the thick line in fig.5.3. The point of intersection between MC and MR curve
is the equilibrium point of the monopolists where output X3 is produced. The monopolist’s
profit is demarcated by the dotted area in fig.5.3.

Fig. 5.3: Second Degree Price Discrimination

In third degree price discrimination the monopolist divide the entire market as per the
demand condition into two or more groups of consumers and then charges different
prices to the different groups keeping the price constant/same for different persons
within a group. Third degree of price discrimination is possible only when the various
consumer groups have different elasticities of demand.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

6. BILATERAL MONOPOLY
A bilateral monopoly is a market condition when one producer has monopoly output and
there is only one buyer for the product. Since there is only one consumer and one seller,
the price and quantity is determined by negotiation. However, we can always find the
upper and lower limits of price and quantities. The situation is described by Fig. 6.1.

Fig. 6.1: Equilibrium of a Bilateral Monopolist

The demand curve facing the monopoly firm is DD and the marginal revenue curve is
MR. MCS is the marginal cost curve of the monopolist. If the monopolist has a superior
bargaining power, she will make the buyer behave as if there were many buyers. She
will equate MCS to MR and will produce XS and will charge price Ps. However, if the
single buyer is super normal bargaining power, she can make the monopolist behave
like a perfect competitor. Thus, the MCS would be the supply curve of the monopolist.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Corresponding to this supply curve, we can construct the MCB curve, which shows the
marginal cost of buying an additional unit. MCB exceeds the price because in order to
purchase an additional unit, the buyer must pay a price and that higher price must
pertain to all the units purchased. The buyer equates her marginal cost of buying an
additional unit with the marginal value of an additional unit as given by the demand curve
and purchases XB amount. Since the seller is behaving like a competitor with supply
curve MCs, she will sell the XB units at per unit price PB. The actual solution for the
bilateral monopoly problem is indeterminate, depending on the bargaining power of the
seller and the buyer.

Empirical evidence suggests that bilateral monopoly is a common phenomenon in labour

markets. In such a market workers have labour union and they can challenge a single
employer. However, the buyer can take over the monopolist if such a bilateral monopoly
occurs in a commodity market and can enjoy vertical integration.

7. WELFARE, EFFICIENCY AND MONOPOLY POWER

It is a common belief that the objective of monopolist is to earn supernormal profit at the
cost of efficiency and welfare of consumer in particular and society in general.

The monopoly price always remains over and above MC and AC leading to a loss of
allocative efficiency and market failure. The monopolist charges a very high price and
resource allocation is inefficient as monopolist works always with excess capacity.
Monopolists cannot use resources optimally and by doing so try to equate MC with MR
at less than optimum point of resource allocation where price remain very high over and
above the MC and AC.

In a competitive industry market demand equates market supply, price equates MC and
dead weight loss is zero as the industry meets the conditions for allocative efficiency.
But in case of monopolist the industry/firm charges a higher price by restricting total
output and social welfare is reduced due to declining consumer surplus.

In fig 7.1, competitive industry is in equilibrium at the point where market demand and
market supply equate to each other in order to decide equilibrium price and quantity. At
this equilibrium point competitive firms produce quantity Q1 at Pcomp prices in order to
maximize social welfare because at this point both consumer’s and produce’s surplus is
maximized.

But if same industry will be monopoly then social welfare will be declined by the area
ABC as monopoly restricts output at Q2 and charges high price Pmon. Monopoly tries to
restrict output by inefficiently allocating resources.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Fig. 7.1: Equilibrium of a Bilateral Monopolist

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

8. Summary
In this module we have discussed the price and output determination under monopoly
and bilateral monopoly.

The monopolist faces a downward sloping demand function and she is a price setter. In
a monopoly market, the producer will have a smaller output and will charge a higher
price than the equivalent competitive industry. In case of bilateral monopoly there is a
single producer and a single buyer for the monopoly product. With bilateral monopoly the
market price and output is indeterminate.

There are two conditions that must be fulfilled for price discrimination to be possible.
These conditions are (i) price elasticity of products are different and there must be
different sub markets for the same products and (ii) reselling of products should not be
possible from the low price market to the high price market.

In case of personal price discrimination monopolists charges different prices to different

persons. If the monopolists charges different prices to same product for people of
different localities then price discrimination is said to be local. Price discrimination as per
use of goods and services depends upon different uses of same commodity.

A.C. Pigou has also introduced three types of price discrimination viz. first degree,
second degree and third degree price discrimination. First degree price discrimination is
said to happen when the monopolist charges a different price for each unit of output.
According to A.C. Pigou, sometimes the monopolist charges several different prices for
different groups of output. This is known as second degree price discrimination. In third
degree price discrimination the monopolist divide the entire market as per the demand
condition into two or more groups of consumers and then charges different prices to the
different groups keeping the price constant/same for different persons within a group.

Bilateral monopoly is a common phenomenon in labour markets. In labour market

workers have labour union and they can challenge a single employer. However, the
buyer can take over the monopolist if such a bilateral monopoly occurs in a commodity
market and can enjoy vertical integration.

The monopoly price always remains over and above MC and AC leading to a loss of
allocative efficiency and market failure. In monopoly market the resource allocation is
inefficient as monopolist works always with excess capacity. Monopolists cannot use
resources optimally and by doing so try to equate MC with MR at less than optimum
point of resource allocation where price remain very high over and above the MC and
AC. However, in a competitive industry market demand equates market supply, price
equates MC and dead weight loss is zero as the industry meets the conditions for
allocative efficiency. But in case of monopolist the industry charges a higher price by
restricting total output and social welfare is reduced due to declining consumer surplus.

BUSINESS PAPER No.1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 28 : MONOPOLY (BILATERAL MONOPOLY)
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 29, Degree of Monopoly and Concentration

Module Tag BSE_P1_M29

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning outcome
2. Introduction
3. Measurement of the Degree of Monopoly Power
3.1 Elasticity of Demand Approach
3.2 Lerner’s Approach
3.3 Cross Elasticity of Demand Approach
3.4 Rothschild’s Approach
4. Market Concentration
4.1 The Herfindahl Index (HHI)
4.2 The Concentration Ratio (CR)
5. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

1. Learning Outcome of Monopoly

This module helps you to understand
 monopoly power;
 various measures of monopoly power;
 market concentration and
 Various measures of market concentration.

2. Introduction
Monopoly power depends upon the capacity of the firms to influence market price and
output. Besides by the pure monopolist, monopoly power is also enjoyed by the sellers
in all markets in which a monopoly element is present either in a large or small scale. In
fact sellers in monopolistic competition, price discriminating monopoly and oligopoly
enjoy monopoly power to a certain degree depending upon their power to control price
and output.

3.Measurement of Degree of Monopoly Power

As discussed above monopoly power shows the degree of control, a producer or seller
exercises over price and output. Therefore, taking into account price and output, various
measures of monopoly power have been formulated by economists. Some important
measures of monopoly power are discussed below.

3.1 Elasticity of Demand Approach

The elasticity of demand has been regarded by economists as one of the important
indicators of the degree of monopoly power. The monopoly power depends upon the
extent to which a seller exercises its control over the price and output, which also
depends upon the elasticity of demand. Under perfect competition demand is perfectly
elastic so that firms enjoy no monopoly power. When the demand curve is less than
perfectly elastic, some element of monopoly will be present indicating that the seller will
enjoy some degree of monopoly power. This is seen in case of the markets like
monopoly, monopolistic competition, oligopoly etc. The seller in this case can increase
the price of the product as the demand curve for his product slopes downward. Also the
seller can lower the price and increase the quantity supply to grab some buyers from his
rivals.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

Therefore, when the demand curve slopes downward, the seller uses his power to
change the price. The less the elasticity of demand for his product, the greater the
degree of monopoly power and vice versa. When demand is perfectly inelastic the seller
can charge any price for his product. With fixed demand the seller will enjoy absolute
monopoly power. Thus greater the elasticity of demand, the less the degree of monopoly
power enjoyed by the firm. Hence, a measure of monopoly power is given by the inverse
of the elasticity of demand as given below:

1
M= 1
ep

Where, in eq.-1, M is the degree of monopoly power and e p is the price elasticity of
demand. For example, when price elasticity of demand is 1/5 the degree of monopoly
power will be equal to 1/(1/5)=5. Similarly if the elasticity of demand is 5, the degree of
monopoly power will be equal to =1/5. Hence, the more the elasticity of demand the less
the monopoly power enjoyed by a seller and vice versa.

3.2 Lerner’s Approach

A measure of monopoly power which has gained great popularity is developed by

Lerner. Lerner considers perfect competition as the state of maximum welfare and any
divergence from it would be considered as the presence of some monopoly power,
which as a result leads to inefficient allocation of resources by the monopolist. Lerner
argues that when the market is imperfect, marginal cost will equal marginal revenue but
price will be higher than marginal cost or marginal revenue at equilibrium. This
divergence between price and marginal cost is the indicator of the measure of monopoly
power. The greater this divergence between price and marginal cost, the greater is the
degree of monopoly power possessed by the monopolist. Lerner’s index of monopoly
power is given below.

P  MC
M= 2
P

Where, in eq.-2, M denotes index of Lerner’s monopoly power, P denotes price and MC
denotes marginal cost at the equilibrium level of output of the monopolist.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

In one extreme when the market is perfectly competitive, price is equal to marginal cost.
In this case Lerner’s index of monopoly power is equal to zero indicating no monopoly
power at all. Thus, when,

P=MC 3

P  MC 0
This implies, M   0 4
P P

In the another extreme, when the monopolized product involves no cost of production
the marginal cost will be equal to zero and Lerner’s index of monopoly power would be
equal to one. That is, when:

MC=0 5

P  MC P  0 P
This implies, M     1. 6
P P P

Thus Lerner’s index of monopoly power varies between zero and unity. As a result, the
closer M is to unity, the greater the degree of monopoly power possessed by the
monopolist. For example, let the price of a product be equal to Rs.50 per unit and let its
marginal cost be equal to Rs. 30, then,

50  30 20
M=   0 .4 .
50 50

However, the Lerner index has many limitations and is obviously not a good measure of
monopoly power. The Lerner index can be proved to be the inverse of the elasticity of
demand in the case of a profit maximizing firm in equilibrium and as a result may be
taken as a characterization of the demand for the product of the firm. However, it is no
guide to the nature of demand in the case of a non-maximizing firm. While it indicates
the divergence between price and marginal cost, it says hardly anything about the
degree of market pressure or the extent to which administrative action keep the costs at
a lower level. Lerner’s measure is based upon only one aspect i.e. ”control over price”. It
ignores the restraints on monopoly power put by potential substitutes. These would
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

come to exist with the entry of new firms into the industry and powerful factors limiting
the monopoly power of the existing sellers.

3.3 Cross Elasticity of Demand Approach

The concept of using cross elasticity of demand to measure the degree of monopoly
power was first advocated by Kaldor. However, it has been reformulated by Robert
Triffin in his famous work ‘Value Theory and General Equilibrium Analysis. Cross
elasticity of demand means the proportionate change in quantity demanded of a product
as a result of a proportionate change in the price of another product. In the cross
elasticity of demand approach, the measure of monopoly power points to the degree of
dependence of a firm’s product upon the prices of other firms’ products. If demand for a
firm’s product does not depend upon the prices of other firm’s products, then that firm
will be completely independent of price and output policies of others and cross elasticity
of demand for its product will be zero. The smaller the degree of cross elasticity of
demand for the product, the greater the degree of monopoly power enjoyed by it and
vice versa. The cross elasticity of demand between the products of two firms, X and Y,
can be written as:

q x p y q x py q x. . p y
M     7
qx py q x p y p y .q x

Where, in eq. 7,
M : measure of monopoly power
qx : quantity of good x produced by firm X
qy : quantity of good y produced by firm Y

The value of M will vary in between 0 to ∞, which shows the degree of monopoly power
of the firm. When the demand for the output of firm X is not affected at all by the price of
any other firm Y, the cross elasticity of demand for its product will be zero, that is, M=0.
In this case the firm X will enjoy absolute monopoly power in pursuing his own price and
output policy in the one extreme. In the another extreme, according to Triffin and others,
the cross elasticity of demand between the products of various firms under perfect
competition is infinite and therefore firms under perfect competition enjoy no monopoly
power at all. Hence, pure monopoly having zero cross elasticity of demand enjoys
absolute monopoly power and perfectly competitive firm having infinite cross elasticity of
demand possesses zero monopoly power. These are two limiting cases. Given these
two limits, the less the coefficient of the cross elasticity of demand, the greater the
monopoly power and vice versa.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

3.4 Rothschild’s Approach

One measure of the degree of monopoly power has been formulated by K. W.

Rothschild to show how far a particular firm controls the market for a commodity.
According to Rothschild the degree of monopoly power can be measured by taking the
ratio of slope of two demand curves of the firm: one being dd'; the demand curve for the
individual firm on the assumption that "competing firms do not change their price or
output" and another being DD'; the demand curve on the assumption that "other firms
change their price or output in the same or some other predetermined way". Rothschild’s
index (M) is given in eq.-8.

tan A
M (8)
tan B

Fig.1: Rothschild’s Index (M)

Rothschild’s index (M) postulates some assumptions concerning the reactions of other
firms and varies between 0 and 1. If the demand curve for the product of the individual
firm is independent of the reactions of other firms, dd' and DD' coincide. In this case:

tan A
M 1 (9)
tan B

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

On the other hand if the firm is producing under purely competitive conditions so that its
price is market-determined and completely independent of its own discretion, the index
is equal to zero. That is,

tan A
M  0 10
tan B

Therefore, degree of monopoly power in this case depends upon the extent to which M
approaches 1.The more M is nearer to 1 the greater the degree of monopoly power.

4. Market Concentration
The market concentration is functionally related to the number of firms and their
respective shares of the total production in a market. Market concentration is associated
with industrial concentration. Industrial concentration is concerned with the distribution of
production within an industry. Thus market concentration is a measure of competition
which positively varies with the rate of profit in industrial organization.

There are two widely acceptable market concentration measures. They are:

i) The Herfindahl-Hirschman Index (HHI) and

ii) The Concentration Ratio (CR).

These two concentration measures are discussed below.

4.1 The Herfindahl Index (HHI)

The Herfindahl index, which is also known as Herfindahl–Hirschman Index, or HHI is a

measure of the size of firms in relation to the industry. HHI is an indicator of the amount
of competition among the firms. It is a measure of concentration widely applied in
competition law, antitrust policy and in technology management.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

We can define HHI as the sum of the squares of the market shares of a maximum of 50
largest firms within the industry, where the market shares are expressed in terms of
fractions. Thus,

N
HHI   S i2 11
i 1

Where, in eq.-11, Si is the market share of firm i in the market, and N is the number of
firms. For a competitive industry with no dominant players the index will be very small.
The reciprocal of the index shows the number of firms in the industry only if all firms
have an equal share. For firms with unequal shares, the reciprocal of the index indicates
the "equivalent" number of firms in the industry.

The normalization form of HHI, which ranges from 0 to 1, is written as:

HHI  1 / N
HHI *  12
1  1/ N

Where, N is the number of firms in the market, and HHI is the Herfindahl Index in eq.-12.

If all the market is shared by N firms, then the index can be reformulated as:

1
HHI   NV 13
N

Where, in eq.-13, N is the number of firms and V is the statistical variance of the firm
shares, defined as:

 (S i  1/ N ) 2
V i N
14
N

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

When all firms have equal shares, that is, the market structure is completely symmetric
so that Si=1/N for all i then:

V = 0 and HHI = 1/N 15

For a given number of firms in the market a higher variance due to a higher level of
asymmetry between firms' shares will result in a higher index value.

4.2 The Concentration Ratio (CR)

Given number of firms, the concentration ratio is a measure of the total output produced
in an industry. Concentration ratios measure the extent of market control of the largest
firms in the industry and to illustrate the degree to which an industry is monopolistic.
Thus the concentration ratio is the percentage of market share held by the largest firms
in an industry.

m
CR m   S i 16
i 1

Where, in eq.-16Si is the market share and m indicates the ith firm.

The CR4 and the CR8 are the most common concentration ratios, which indicate the
market share of the four and the eight largest firms. Generally, these two common ratios
are comparable from industry to industry, while concentration ratios for other numbers of
firms can also be calculated. Concentration ratios vary from 0 to 100 percent as shown
in table-1.

Table 1:Degree of Concentration

CRm Degree of Concentration Market Type
0% No concentration perfect competition

0% to 50% Low concentration perfect competition to

oligopoly
50% to 80% Medium concentration Oligopoly

80% to 100% High concentration oligopoly to monopoly

100% Total concentration Monopoly

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

The concentration ratio measures the extent of market control and does not use market
shares of all the firms in the industry. It does not provide the distribution of firm size and
also does not provide detail about competitiveness of the industry. So in this sense, the
Herfindahl index provides a more complete and realistic picture of industry concentration
than does the concentration ratio.

6. Summary
Monopoly power shows the degree of control a producer or seller exercises over the
price and output. Some important measures of monopoly power are (i) elasticity of
demand approach, (ii) Lerner’s Approach, and (iii) cross elasticity of demand approach.
In elasticity of demand approach, monopoly power depends upon the extent to which a
seller exercises its control over the price and output, which often depends upon the
elasticity of demand. In Lerner’s approach, the divergence between price and marginal
cost is the indicator of the measure of monopoly power. In the cross elasticity of demand
approach the measure of monopoly power indicates the degree of dependence of a
firm’s product upon the prices of other firms’ products. According to Rothschild the
degree of monopoly power can be measured by taking the ratio of the slopes of two
demand curves of the firm: one being the demand curve for the individual firm on the
assumption that "competing firms do not change their price or output" and another being
the demand curve on the assumption that "other firms change their price or output in the
same or some other predetermined way".

The market concentration is functionally related to the number of firms and their
respective shares of the total output in a market. There are two widely acceptable
market concentration measures. They are (i) the Herfindahl Index (HHI) and (ii) the
Concentration Ratio (CR). While, HHI is an indicator of the amount of competition among
the firms, CR measures the extent of market control of the largest firms in the industry
and to illustrate the degree to which an industry is monopolistic. However, the
concentration ratio does not use the market shares of all the firms in the industry. In this
sense, the Herfindahl index provides a more complete and realistic picture of industry
concentration than does the concentration ratio.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 29: DEGREE OF MONOPOLY AND
CONCENTRATION
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 30, Welfare Economics-Basic Ideas

Module Tag BSE_P1_M30

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Pareto Efficiency
4. Fundamental Theorems of Welfare Economics
4.1 The First Welfare Theorem
4.2 The Second Welfare Theorem
5. Social Welfare Function
5.1 Arrow’s Impossibility Theorem
5.2 Different Types of Welfare Functions
6. Welfare Maximization
7. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you will be able to

 Understand the concept of Pareto Efficiency

 Know the two fundamental theorems of Welfare Economics
 Identify social welfare function
 Evaluate welfare maximization

2. Introduction

Welfare

Welfare economics is the branch of economics which deals with normative issues. It
deals with the way various economic arrangements affect the welfare or well-being, of each and
every members of society.
A major concept in welfare economics is the notion of Pareto efficiency in evaluating
economic allocations. But it must also be remembered that Pareto efficiency has nothing to say
about the distribution of welfare across people. Consumer utility, production mixes, and factor
input combinations consistent with efficiency come up with lots of combinations. In other words,
there will usually be many Pareto efficient allocations. So how can society choose the most
desirable among them? This decision is made when we specify the social welfare function,
which embodies value judgments about interpersonal utility.
Since the concept of efficiency plays a major role in welfare economics, we begin by
discussing it in brief. After that, we will study the two fundamental theorems of welfare
economics. Next we will study the idea of social welfare function and its implications.

3. Pareto Efficiency
A Pareto efficient allocation is one where we cannot make an individual better off without
making the other one worse off.
To reach the ideal state, three criteria’s are required to meet:
 The marginal rates of substitution in consumption are homogeneous i.e. identical for all
consumers. This happens when no consumer can be made better off without making
others worse off. Or we can say when:
MRSA12 = MRSB12
Where, MRS12 is the marginal rate of substitution between good 1 and 2 for
consumers A and B.
 The marginal rate of transformation in production is also homogeneous for all products. It
happens when it is not possible to increase the production of any good without reducing
the production of other goods. Or we can say when,
MRT1LK = MRT2LK
Where, MRTLK is the marginal rate of transformation between labour and capital.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

 The marginal rates of substitution in consumption are

equal to the marginal rate of transformation in
production, which means that production processes and consumer wants must match
with each other. That is,
MRSi12 = MRT12
Where, MRSi12 is the marginal rate of substitution between good 1 and 2 for
consumer i.

4. Fundamental Theorems of Welfare Economics

There are two fundamental theorems of welfare economics.

4.1 The First Welfare Theorem

This theorem states that the equilibrium in a set of competitive markets is Pareto efficient. This is
illustrated in Figure 4.1.

Figure 4.1: Pareto efficient Equilibrium

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

It turns out that the market equilibrium allocation is Pareto efficient. This can be proved
as follows: an allocation in the Edgeworth box is Pareto efficient if the set of bundles that A
prefers doesn’t intersect the set of bundles that B prefers. That is to say that the indifference
curves of the two agents (A and B) must be tangential to each other at any Pareto efficient
allocation in the interior of box. If the two indifference curves are not tangent at an allocation,
then they must cross. In such a situation, there must be some mutually advantageous trade --- so
that point cannot be Pareto efficient. But at the market equilibrium, the total amount that A and B
want to buy of each good must equal to the total amount available. Said another way, the set of
bundles preferred by A must lie above his budget set, and the same thing holds for B. This
implies that in equilibrium, each person is choosing the most-preferred bundle in his budget set,
and the choices exhaust the available supply. Thus the two sets of preferred allocations can’t
intersect. This means that there are no allocations that both agents prefer to the equilibrium
allocation, so the equilibrium is Pareto efficient.
This can also be shown algebraically. Suppose that there is a market equilibrium that is
not Pareto efficient. Then it can be shown that this assumption leads to a logical contradiction.
To say that the market equilibrium is not Pareto efficient means that there is some other feasible
allocation (y1A, y2A, y1B, y2B) such that
y1A+ y1B= ω1A+ ω1B …………(4.1)
y2A+ y2B= ω2A+ ω2B ……………(4.2)
where ω1i, ω2i are the initial endowments of good 1 and 2 for agent i.
and
(y1A, y2A) >A (x1A, x2A) …………. (4.3)
(y1B, y2B) >B (x1B, x2B) …………… (4.4)

The first two equations say that the y–allocation is feasible, and the next two equations say that it
is preferred by each agent to the x–allocation. (The symbols >A and >B refer to the preferences of
agents A and B.)
But by hypothesis, there is a market equilibrium where each agent is purchasing the best bundle
he can afford. If (y1A, y2A) is better than the bundle that A is choosing, then it must cost more than
A can afford, and similarly for B:
p1y1A+ p2y2A> p1ω1A+ p2ω2A
p1y1B+ p2y2B> p1ω1B+ p2ω2B

Now add these two equations together to get

p1(y1A+ y1B) + p2(y2A+ y2B) > p1(ω1A+ ω1B) + p2(ω2A+ ω2B).
Substitute from equations (4.1) and (4.2) to get
p1(ω1A+ ω1B) + p2(ω2A+ ω2B) > p1(ω1A+ ω1B) + p2(ω2A+ ω2B),
This is clearly a contradiction, since the left-hand side and the right-hand side are the same.
We derived this contradiction by assuming that the market equilibrium was not Pareto
efficient. Therefore, this assumption must be wrong. It follows that all market equilibria are
Pareto efficient, i.e., the First Theorem of Welfare Economics.
The First Welfare Theorem guarantees that a competitive market will exhaust all of the
gains from trade: an equilibrium allocation achieved by a set of competitive markets will
necessarily be Pareto efficient.

4.2 The Second Welfare Theorem

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

This theorem states that when preferences are convex, a Pareto

efficient allocation is equilibrium for some set of prices. This is
illustrated in Figure 4.2.
Consider that at a Pareto efficient allocation, the set of allocations A prefers is disjoint
from the set that B prefers. This implies that the two indifference curves are tangent at the Pareto
efficient allocation (pt. X). Let us draw a straight line that is their common tangent. Suppose that
the straight line represents the agents’ budget sets. Then if each agent chooses the best bundle on
his budget set, the resulting equilibrium will be the original Pareto efficient allocation. Thus the
fact that the original allocation is efficient automatically determines the equilibrium prices. The
endowments can be any bundles that give rise to the appropriate budget set—that is, bundles that
lie somewhere on the constructed budget line.

Figure 4.2: The Second Welfare Theorem

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

Now consider Figure 4.3. Here the illustrated point X is Pareto efficient, but there are no prices at
which A and B will want to consume at point X. The optimal demands of agents A and B don’t
coincide for the given budget. Agent A wants to demand the bundle Y, but agent B wants the
bundle X—demand does not equal supply at these prices. The difference between Figure 4.2 and
Figure 4.3 is that the preferences in Figure 4.2 are convex while the ones in Figure 4.3 are not. If
the preferences of both agents are convex, then the common tangent will not intersect either
indifference curve more than once, and everything will work out fine. This observation gives us
the Second Theorem of Welfare Economics: if all agents have convex preferences, then there will
always be a set of prices such that each Pareto efficient allocation is a market equilibrium for an
appropriate assignment of endowments.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

At a Pareto efficient allocation, the bundles preferred by agent A and by agent B must be disjoint.
Thus if both agents have convex preferences we can draw a straight line between the two sets of
preferred bundles that separates one from the other. The slope of this line gives us the relative
prices, and any endowment that puts the two agents on this line will lead to the final market
equilibrium being the original Pareto efficient allocation.

5. Social Welfare Function

Up until now, we focused on considerations of Pareto efficiency in evaluating economic
allocations. There are other important considerations. Pareto efficiency is in itself a desirable
goal. But there will usually be many Pareto efficient allocations; how can society choose among
them? This decision can be made by specifying the social welfare function.
A social welfare function provides a way to rank different distributions of utility among
consumers. Now the question arises as to how one might go about “adding together” the
individual consumers’ preferences to construct some kind of “social preferences.” Before we
examine this question, it will be worth examining whether such an attempt is logically warranted.

5.1 Arrow’s Impossibility Theorem

Arrow’s Impossibility Theorem shows that there is no perfect way to “aggregate” individual
preferences to make one social preference.
It is pointed out by Arrow that a social decision mechanism (way of aggregating preferences),
should have the following features:
 Given any set of complete, reflexive, and transitive individual preferences, the social
decision mechanism should result in social preferences that satisfy the same properties.
 If everybody prefers alternative x to alternative y, then the social preferences should rank
x ahead of y.
 The preferences between x and y should depend only on how people rank x versus y, and
not on how they rank other alternatives.

Arrow’s theorem says that the three very plausible and desirable features of a social decision
mechanism are inconsistent with democracy: there is no “perfect” way to make social decisions.
In order to find a way to aggregate individual preferences to form social preferences, we will
have to give up one of the properties of a social decision mechanism described in Arrow’s
theorem.
The most probable feature of social welfare function, described above, that can be dropped
is the property 3. Actually, if the property that social preference between two alternatives only
depends on the ranking of those two alternatives, then certain kinds of rank-order voting become
possible.

5.2 Different Types of Welfare Functions

Given the preferences of each individual i over the allocations, we can construct utility functions,
ui(x), that summarize the individuals’ value judgments: person i prefers x to y if and only if ui(x)
> ui(y).
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

Let us pick some utility representation. Then one way of

getting social preferences from individuals’ preferences is to
add up the individual utilities and use the resulting number as a kind of social utility.
That is, we will say that allocation x is socially preferred to allocation y if
> ,
where n is the number of individuals in the society.
This works—but of course it is totally arbitrary, since our choice of utility representation
is totally arbitrary. The choice of using the sum is also arbitrary. Why not use a weighted sum of
utilities? Why not use the product of utilities, or the sum of the squares of utilities?
One reasonable restriction that we might place on the “aggregating function” is that it be
increasing in each individual’s utility. That way we are assured that if everybody prefers x to y,
then the social preferences will prefer x to y.
This kind of aggregating function is called a social welfare function. A social welfare
function is just some function of the individual utility functions: W(u1(x), . . . , un(x)). It gives a
way to rank different allocations that depends only on the individual preferences, and it is an
increasing function of each individual’s utility.
Let’s look at some examples. One special case mentioned above is the sum of the
individual utility functions
W(u1, . . . , un) =
This is sometimes referred to as a classical utilitarian or Benthamite welfare function.
A slight generalization of this form is the weighted sum-of-utilities welfare function:
W(u1, . . . , un) =
Here the weights, a1, . . . , an, are supposed to be numbers indicating how important each agent’s
utility is to the overall social welfare. It is natural to take each ai as being positive.
Another interesting welfare function is the minimax or Rawlsian social welfare function:
W(u1, . . . , un) = min{u1, . . . , un}.
This welfare function says that the social welfare of an allocation depends only on the welfare of
the worst off agent—the person with the minimal utility.
Another special form of welfare function is the individualistic welfare function or a
Bergson-Samuelson welfare function. If xi denotes an individual i’s consumption bundle, and
ui(xi) is the individual i’s utility level using some fixed representation of utility, then such a social
welfare function will have the form
W = W(u1(x1), . . . , un(xn)).
The welfare function is directly a function of the individuals’ utility levels, but it is indirectly a
function of the individual agents’ consumption bundles.

6. Welfare Maximization
Once we have a welfare function, the problem of social welfare maximization can be examined.
Let xj i denote how much individual i has of good j, and suppose that there are n consumers and k
goods. Then the allocation x consists of the list of how much each of the agents has of each of the
goods.
If we have a total amount X1, . . . , Xk of goods 1, . . . , k to distribute among the
consumers, then the social welfare maximization problem can be stated as:
Max W(u1(x), . . . , un(x))
such that = X1
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

. .
.
= Xk

The feasible allocation that maximizes social welfare should have the following property,
i.e., a maximal welfare allocation must be a Pareto efficient allocation. The proof is easy: suppose
that it were not. Then there would be some other feasible allocation that gave everyone at least as
large a utility, and someone strictly greater utility. But the social welfare function is an increasing
function of each agent’s utility. Thus this new allocation would have to have higher welfare,
which contradicts the assumption that we originally had a social welfare maximum.
This situation is illustrated Figure 6.1, where the set U indicates the set of possible
utilities in the case of two individuals. This set is known as the utility possibilities set. The
boundary of this set—the utility possibilities frontier—is the set of utility levels associated with
Pareto efficient allocations. If an allocation is on the boundary of the utility possibilities set, then
there are no other feasible allocations that yield higher utilities for both agents.

Figure 6.1: Social Welfare Maximization

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

The “indifference curves” in this diagram are called isowelfare curves since they depict
those distributions of utility that have constant welfare. As usual, the optimal point is
characterized by a tangency condition. The notable thing about this maximal social welfare point
is that it is Pareto efficient—it must occur on the boundary of the utility possibilities set. The next
observation we can make from this diagram is that any Pareto efficient allocation must be a social
welfare maximum for some social welfare function. An example is given in Figure 6.2.

Fi
gure 6.2: Social Welfare Maximization
In Figure 6.2, we have taken a Pareto efficient allocation and found a set of isowelfare
curves for which it yields maximal welfare. Moreover, as illustrated in Figure 6.2, if the set of
possible utility distributions is a convex set, then every point on its frontier is a social welfare
maximum for a weighted-sum-of-utilities welfare function. The welfare function thus provides a
way to single out Pareto efficient allocations: every social welfare maximum is a Pareto efficient
allocation, and every Pareto efficient allocation is a social welfare maximum.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

7. Summary
 A Pareto efficient allocation is one in which there is no feasible reallocation of the goods
that would make all consumers at least as well-off and at least one consumer strictly
better off.
 The First theorem of Welfare Economics states that a competitive equilibrium is Pareto
efficient.
 The Second theorem of Welfare Economics states that as long as preferences are convex,
then every Pareto efficient allocation can be supported as a competitive equilibrium.
 Arrow’s Impossibility theorem shows that there is no ideal way to aggregate individual
preferences into social preferences.
 Nevertheless, economists often use social welfare functions of one sort or another to
represent distributional judgments about allocations.
 As long as the social welfare function is increasing in each individual’s utility, a welfare
maximum will be Pareto efficient. Furthermore, every Pareto efficient allocation can be
thought of as maximizing some social welfare function.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 30: WELFARE ECONOMICS-BASIC IDEAS
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 31, Market Failure and Externalities

Module Tag BSE_P1_M31

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Externalities
4. Consumption Externalities
4.1 Example: Smokers and Non-smokers
4.2 Quasilinear Preferences and Coase theorem
5. Production Externalities
5.1 Example: Pollution
5.2 Solutions to efficiency loss due to production externalities
6. Summary

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you will be able to

 Understand the concept of market failure and its main causes

 Learn about externalities, one of the important reasons of market failure
 Identify different types of externalities, i.e. consumption and production
 Comprehend the different ways in which the government and the legal system can help in
curing the efficiency loss due to the presence of these externalities

2. Introduction

Market Failure

Till now, we have studied that under competitive market conditions, every equilibrium allocation
will be Pareto efficient. That means there is no other allocation under equilibrium where you can
make one person better off without making the others worse off. However, in some situations,
even competitive markets are not capable of producing efficient outcomes. There might exist
another conceivable outcome where a person in the market may be made better-off without
making someone else worse-off. Such a situation is described as market failure.
Market failure occurs when markets which functions freely, fails in delivering the
efficient allocation of resources. The reason for this is that the benefits which an individual gets
from the free market carrying out a particular activity diverge from the benefits to society as a
whole.
The results of Market failure leads to:
 Productive inefficiency: Producers are not maximizing output from given factor inputs. In
other words, when firm is not producing at the lowest unit cost it leads to productive
inefficiency. This is a problem because the output which is being lost in inefficient
production could have been used to satisfy more wants.
 Allocative inefficiency: Resources are misallocated and are producing goods and services
which consumers don’t want. This is problematic because better use of resources can be
done by producing the products which consumer wants.
There are many instances when the free market fails to deliver an efficient allocation of resources.
Some important causes of market failure are as follows:
 Presence of externalities
 Public goods
 Imperfect information
In such situations, it is argued that government can get involved with an appropriate policy that
will “mimic” the market mechanism to some degree and thereby achieve Pareto efficiency.

In this module, we will focus on how the presence of externalities leads to market failure,
and how the legal system and government intervention helps in achieving a Pareto efficient
outcome in such a situation.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

3. Externalities
An externality is a consequence of an economic activity that is experienced by unrelated third
parties. It is defined as a profit or cost that is imposed on a third party, such as society, other than
the producer or consumer of a good or service. It can be either positive or negative. Positive
externalities refer to the benefit and negative externalities refer to the costs associated with the
production or consumption of a good or service. For example, emission of pollution by a factory
spoiling the neighbouring environment and affecting the health of nearby residents is an example
of negative externality. An example of a positive externality is the benefit of productivity which a
firm gets from its well-educated workers.
Externalities are present in both consumption and production. An economic situation
involves consumption externality when the level of consumption of some good or service by one
consumer has a direct effect on the welfare of another consumer. Instances of this kind are
playing loud music at 3 in the morning; drifting smoke from cheap cigars; and a neighbor who
keeps a beautiful flower garden.
Externalities exist in production when there is positive relation between the production
activities of two firm. For example, firm A discharges effluent into a river, which will increase
costs of firm B downstream; firm A sets up a coaching institute for computer programmers,
which increases the availability of programmers to the other firm.
If externalities are not taken into account, an efficient allocation of resources from the
social point of view may not emerge.

4. Consumption Externalities

4.1 Example: Smokers and Non-Smokers

Let us start with an example to illustrate some of the main considerations. Imagine two
roommates, A and B, who have preferences over “money” and “smoke.” Suppose that both
consumers like money, but that A likes to smoke and B likes clean air. The consumption
possibilities for the two consumers can be depicted in an Edgeworth box. The length of the
horizontal axis represents the total amount of money the two agents have, and the height of the
vertical axis represents the total amount of smoke that can be generated. The preferences of agent
A are increasing in both money and smoke, while agent B’s preferences are increasing in money
and clean air—the absence of smoke. Smoke is measured on a scale from 0 to 1, where 0 is no
smoke at all, and 1 is the proverbial smoke-filled room.
This setup is depicted in Figure 4.1. The amount of smoke is a good for A and a bad for
B, so that B is moved to a more preferred position as A consumes less smoke. In the ordinary
Edgeworth box diagram B is made better off when A reduces his consumption of good 2—but
that is because B then gets to consume more of good 2. In the Edgeworth box in Figure 4.1, B is
also better off when A reduces his consumption of good 2 (smoke), but for a very different
reason. In this example, B is better off when A reduces his consumption of smoke since both
agents must consume the same amount of smoke and smoke is a bad for agent B.
Now, suppose they both have the same amount of money, say Rs.100 apiece, so that their
endowments will lie somewhere on the vertical line in Figure 4.1. In order to determine exactly

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

where on this line the endowments lie, the initial “endowment”

of smoke/clean air needs to be determined.

Figure4.1: Case of Consumption externality: smoker and non-smoker

This depends on the legal rights prevalent in the concerned society regarding the property of
smoke/clean air. It may be that A has a right to smoke as much as he wants, and B just has to put
up with it. Or, it could be that B has a right to clean air. Or the legal right to smoke and clean air
could be somewhere between these two extremes. The initial endowment of smoke depends on
the legal system.
Consider a legal situation where person B has a legal right to clean air. Then the initial
endowment in Figure 4.1 is labelled E; it is where A has (100, 0) and B has (100, 0). This means
that both A and B have Rs.100, and that the initial endowment—what there would be in the
absence of trade—is clean air. One of the aspects of having a property right to clean air is having
the right to trade some of it away for other desirable goods—in this case, for money. It can easily
happen that B would prefer to trade some of his right to clean air for some more money. The
point labelled X in Figure 4.1 is an example of such a case. As we know a Pareto efficient
allocation is one where neither consumer can be made better off without the other being made
worse off. Such an allocation will be characterized by the usual tangency condition that the
marginal rates of substitution between smoke and money should be the same between the two
agents, as illustrated in Figure 4.1 (point X). It is easy to imagine A and B trading to such a
Pareto efficient point. In effect, B has the right to clean air, but he can allow himself to be
“bribed” to consume some of A’s smoke.
BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

We could imagine a legal system where A had a right

to smoke as much as he wanted, and B would have to bribe A
to reduce his consumption of smoke. This would correspond to the endowment labelled E̒ in
Figure 4.1. Just as before, this would typically not be Pareto efficient, so the agents can trade to a
mutually preferred point such as the one labelled X̒. Both X and X̒ are Pareto efficient allocations;
they just come from different initial endowments. Certainly the smoker, A, is better off at X̒ than
at X, and the non-smoker, B, is better off at X than at X̒. The two points have different
distributional consequences, but on grounds of efficiency they are equally satisfactory.
In fact, there will be a whole contract curve of Pareto efficient allocations of smoke and
money. If agents are free to trade both of these goods, they will end up somewhere on this
contract curve. The exact position will depend on their property rights involving smoke and
money and on the precise mechanism that they use to trade. As long as there are well-defined
property rights in the good involving the externality—no matter who holds the property rights—
the agents can trade from their initial endowment to a Pareto efficient allocation. The only
problem arises if the property rights are not well defined. If A believes that he has the right to
smoke and B believes that he has the right to clean air, we have difficulties. The practical
problems with externalities generally arise because of poorly defined property rights.
Cases where property rights are poorly defined can lead to an inefficient production of
externalities—which means that there would be ways to make both parties involved better off by
changing the production of externalities. If property rights are well defined, and mechanisms are
in place to allow for negotiation between people, then people can trade their rights to produce
externalities; and there will not be a need for direct government intervention in the market
mechanism to make people internalize these externalities.

4.2 Quasilinear Preferences and the Coase Theorem

But there is a special case where the outcome of the externality is independent of the assignment
of property rights. If the agents’ preferences are Quasilinear, then every efficient solution must
have the same amount of the externality.
This case is illustrated in Figure 4.2 for the Edgeworth box case of the smoker versus the
non-smoker. Since the indifference curves are all horizontal translates of each other, the locus of
mutual tangencies—the set of Pareto efficient allocations—will be a horizontal line. This means
that the amount of smoke is the same in every Pareto efficient allocation; only the rupee amounts
held by the agents differ across the efficient allocations.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

Fig.4.2: Quasilinear Preferences

The result that under certain conditions the efficient amount of the good involved in the
externality is independent of the distribution of property rights is known as the Coase Theorem.
However, it should be emphasized that the Coase theorem is valid if there are no “income
effects.” This is because the Quasilinear preference assumption implies that the demand for the
good causing the externality does not depend on the distribution of income. Therefore a
reallocation of endowments doesn’t affect the efficient amount of the externalities. In this case,
the Pareto efficient allocations will involve a unique amount of the externality being generated.
The different Pareto efficient allocations will involve different amounts of money being held by
the consumers; but the amount of the externality—the amount of smoke—will be independent of
the distribution of wealth.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

5. Production Externalities

5.1 Example: Pollution

Consider a situation involving production externalities. Firm S produces some amount of steel, s,
and also produces a certain amount of pollution, x, which it dumps into a river. Firm F, a fishery,
is located downstream and is adversely affected by S’s pollution. Suppose that firm S’s cost
function is given by cs(s, x), where s is the amount of steel produced and x is the amount of
pollution produced. Firm F’s cost function is given by cf (f, x), where f indicates the production of
fish and x is the amount of pollution. Note that F’s costs of producing a given amount of fish
depend on the amount of pollution produced by the steel firm. Suppose that pollution increases
the cost of providing fish Δcf /Δx > 0, and that pollution decreases the cost of steel production,
Δcs/Δx ≤ 0. This last assumption says that increasing the amount of pollution will decrease the
cost of producing steel—that reducing pollution will increase the cost of steel production, at least
over some range.
The steel firm’s profit-maximization problem is
Max s,x pss − cs(s, x)
and the fishery’s profit-maximization problem is
Max f pf f − cf (f, x).
Note that the steel mill gets to choose the amount of pollution that it generates, but the fishery
must take the level of pollution as outside of its control.
The conditions characterizing profit maximization will be
ps =

0=

for the steel firm and

pf =

for the fishery.

These conditions say that at the profit-maximizing point, the price of each good—steel
and pollution—should equal its marginal cost. In the case of the steel firm, one of its products is
pollution, which, by assumption, has a zero price. So the condition determining the profit
maximizing supply of pollution says to produce pollution until the cost of an extra unit is zero.
The presence of the externality is evident here: the fishery cares about the production of pollution
but has no control over it. The steel firm looks only at the cost of producing steel when
maximizing its profits; it doesn’t consider the cost it imposes on the fishery. The increase in the
cost of fishing associated with an increase in pollution is part of the social cost of steel
production, and it is being ignored by the steel firm.
Now suppose that the fishery and the steel firm merge and form one firm that produces both fish
and steel (and possibly pollution). Then there is no externality. For a production externality only
arises when one firm’s actions affect another firm’s production possibilities. If there is only one
firm, then it will take the interactions between its different divisions into account when it chooses
the profit-maximizing production plan. By this reassignment of property rights, the externality is
BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

said to be internalized. Before the merger, each firm had the

right to produce whatever amount of steel or fish or pollution
that it wanted, regardless of what the other firm did. After the merger, the combined firm has the
right to control the production of both the steel mill and the fishery.
The merged firm’s profit-maximization problem is
Maxs,f,x
pss + pf f − cs(s, x) − cf (f, x),
which yields optimality conditions of
ps = Δcs(ŝ, x̂) / Δs

pf =Δcf (f̂ ,x̂) / Δf

0 = Δcs(ŝ, x̂) /Δx + Δcf (f̂ ,x̂) / Δx

.
The last term shows that the merged firm will take into account the effect of pollution on the
marginal costs of both the steel firm and the fishery. When the steel division decides how much
pollution to produce, it considers the effect of this action on the profits of the fish division; that is,
it takes the social cost of its production plan into account.
It should be noted that when the steel firm acted independently, the amount of pollution was
determined by the condition
Δcs(s∗, x∗) / Δx = 0.

That is, the steel firm produced pollution until the marginal cost was zero:

MCS(s∗, x∗) = 0.

In the merged firm, the amount of pollution is determined by the condition

Δcs(ŝ, x̂) / Δx + Δcf (f̂ ,x̂) / Δx = 0.

That is, the merged firm produces pollution until the sum of the marginal cost to the steel firm
and the marginal cost to the fishery is zero. This condition can also be written as

−Δcs(ŝ,x̂) / Δx = Δcf (f̂, x̂) / Δx

or

−MCS(ŝ,x̂) = MCF (f̂, x̂).

In this latter expression MCF (f̂, x̂) is positive, since more pollution increases the cost of
producing a given amount of fish. Hence the merged firm will want to produce where −MCS(ŝ, x̂)
is positive; that is, it will want to produce less pollution than the independent steel firm. When the
true social cost of the externality involved in the steel production is taken into account, the
optimal production of pollution will be reduced.
When the steel firm considers minimizing its private costs of producing steel, it produces where
the marginal cost of extra pollution equals zero; but the Pareto efficient level of pollution requires
minimizing the social costs of the pollution. At the Pareto efficient level of pollution, the sum of
the two firm’s marginal costs of pollution must be equal to zero.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

The steel firm produces pollution up to the point where the marginal cost of extra pollution equals
zero. But the Pareto efficient production of pollution is at the point where price equals marginal
social cost, which includes the cost of pollution borne by the fishery.
This is illustrated in Figure 4.3. In this diagram –MCS measures the marginal cost to the
steel firm from producing more pollution. The curve labelled MCF measures the marginal cost to
the fishery of more pollution. MCF is positive, since more pollution increases the cost of
producing a given amount of fish. The profit-maximizing steel firm produces pollution up to the
point where its marginal cost from generating more pollution equals zero.

Fig.4.3: Production externality: Social cost and Private cost

At the efficient level of pollution production, the amount that the steel firm is willing to
pay for an extra unit of pollution should equal the social costs generated by that extra pollution—
which include the costs it imposes on the fishery. When the true social cost of the externality
involved in the steel production is taken into account, the optimal production of pollution will be
reduced. This is consistent with the efficiency arguments where there are no externalities, so that
private costs and social costs coincide. In this case the free market will determine a Pareto
efficient amount of output of each good. But if the private costs and the social costs diverge, the
market alone may not be sufficient to achieve Pareto efficiency.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

5.2 Solutions to efficiency loss due to production

externalities

There are several useful interpretations which suggest ways to correct the efficiency loss created
by the production externality.
The first interpretation is that the steel firm faces the wrong price for pollution. As far as
the steel firm is concerned, production of pollution costs nothing. But that neglects the costs that
the pollution imposes on the fishery. According to this view, the situation can be rectified by
making sure that the polluter faces the correct social cost of its actions. One way to do this is to
place a tax on the pollution generated by the steel firm. This kind of a tax is known as a
Pigouvian tax. However, in order to impose the tax, we should know the optimal level of
pollution.
Another interpretation of the problem is that there is a missing market— the market for
the pollutant. The externality problem arises because the polluter faces a zero price for an output
good that it produces, even though people would be willing to pay money to have that output
level reduced. From a social point of view, the output of pollution should have a negative price. If
we consider a situation where the fishery had the right to clean water, it could sell the right to
allow pollution. In such a case, each firm will be facing the social marginal cost of each of its
actions when it chooses how much pollution to buy or sell. If the price of pollution is adjusted
until the demand for pollution equals the supply of pollution, we will have an efficient
equilibrium, just as with any other good.
The third interpretation of externalities relates to market signals. In the case of the steel
mill and the fishery there is no problem if both firms merge. In fact, there is a definite incentive
for the two firms to merge: if the actions of one affect the other, then they can make higher profits
together by coordinating their behavior than by each going alone. The objective of profit
maximization itself should encourage the internalization of production externalities. In other
words, if the joint profits of the firms with coordination exceed the sum of the profits without
coordination, then the current owners could each be bought out for an amount equal to the present
value of the stream of profits for their firm, the two firms could be coordinated, and the buyer
could retain the excess profits. The new buyer could be either of the old firms, or anybody else
for that matter. The market itself provides a signal to internalize production externalities.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

6. Summary

 Market failure occurs when the allocation of goods and services by a free market is not
efficient, i.e. the outcome is not Pareto optimal.
 Market failure is associated with externalities, public goods, and asymmetric information.
 Externalities are the harmful or beneficial effects of activities that are borne by people
who are not directly involved in the market exchanges.
 If externalities are present, the outcome of a competitive market is unlikely to be Pareto
efficient.
 However, government intervention and the legal system can ensure that property rights
are well defined, so that efficiency enhancing trades can be made.
 If preferences are quasilinear, the efficient amount of a consumption externality will be
independent of the assignment of property rights.
 Cures for production externalities include the use of Pigouvian taxes, setting up a market
for the externality, or allowing firms to merge.

BUSINESS PAPER No. 1 : MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 31: MARKET FAILURE AND EXTERNALITIES
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 32, Market Failure and Public Goods

Module Tag BSE_P1_M32

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Provision of Public Goods
3.1 When to provide public good
3.2 Efficient level of public good
4. The Free Rider Problem
5. Methods to determine supply of Public goods
6. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to

 Know what a public good is

 Learn about the conditions for providing efficient level of public good
 Understand the problem of free rider
 Gain knowledge of the various decision methods to determine the supply of a public good

2. Introduction

Public Goods

A public good is one which is non-excludable and non-rivalrous in nature and where use by one
individual does not reduce availability to others. Common examples of public goods include: air
pollution, street lights, roads. National Defense is another good example; there is one level of
national defense provided for all the inhabitants of a country. Each citizen may value it
differently—some may want more, some may want less—but they are all provided with the same
amount.
Public goods are an example of a particular kind of consumption externality: everyone
must consume the same amount of the good. Assigning property rights can solve externality
problems when there are small numbers of parties involved, but not in the case of large group
externalities or public goods. When public goods exist, competitive markets cannot be counted on
to generate efficient outcomes.

3. Provision of Public Goods

3.1 When to provide public good

Let’s explain it with a simple example. Suppose that there are two roommates, 1 and 2 who are
deciding whether to purchase a TV or not. Given the size of their apartment, the TV will
necessarily go in the living room, and both roommates will be able to watch it. Thus it will be a
public good, rather than a private good.
Let w1 and w2 denote each person’s initial wealth, g1 and g2 denote each person’s
contribution to the TV, and x1 and x2 denote each person’s money left over to spend on private
consumption. The budget constraints are given by
x1 + g1 = w1
x2 + g2 = w2.
Suppose that the TV costs c rupees, so that in order to purchase it, the sum of the two
contributions must be at least c:
g1 + g2 ≥ c.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

This equation summarizes the technology available to provide

the public good: the roommates can acquire one TV if together
they pay the cost c. The utility function of person 1 will depend on his private consumption, x1,
and the availability of the TV—the public good.
Person 1’s utility function is given as u1(x1, G), where G will either be 0, indicating no
TV, or 1, indicating that a TV is present. Person 2’s utility function is u2(x2,G). The roommates
may value the services of the TV quite differently. The value of T.V placed by each person can be
measured by asking how much the each person would be ready to pay to have the TV available.
This can be done using reservation price. The reservation price of person 1 is the maximum
amount that person 1would be willing to pay to have the TV present. That is, it is that price, r1,
such that person 1 is just indifferent between paying r1 and having the TV available, and not
having the TV at all. If person 1 pays the reservation price and gets the TV, he will have w1−r1
available for private consumption. If he doesn’t get the TV, he will have w1 available for private
consumption. If he is to be just indifferent between these two alternatives, we must have
u1(w1 − r1, 1) = u1(w1, 0).
This equation defines the reservation price for person 1—the maximum amount that he
would be willing to pay to have the TV present. A similar equation defines the reservation price
for person 2. It should be noted that the reservation price of each person will depend on that
person’s wealth: the maximum amount that an individual will be willing to pay will depend to
some degree on how much that individual is able to pay.
As we know, an allocation is Pareto inefficient if there is some way to make both people
better off the following by bringing about a Pareto improvement. In the TV problem there are
only two sorts of allocations that are of interest. One is an allocation where the TV is not
provided. This allocation takes the simple form (w1, w2, 0); that is, each person spends his wealth
only on his private consumption. The other kind of allocation is the one where the public good is
provided. This will be an allocation of the form (x1, x2, 1), where
x1 = w1 − g1
x2 = w2 − g2.
These two equations imply that each individual’s private consumption is determined by
the wealth that he has left over after making his contribution to the public good.
Under what conditions the TV should be provided? That is, when is there a payment
scheme (g1, g2) such that both people will be better off having the TV and paying their share than
not having the TV? In other words, when will it be a Pareto improvement to provide the TV?
It will be a Pareto improvement to provide the allocation (x1, x2, 1) if both people would
be better off having the TV provided than not having it provided. This means
u1(w1, 0) < u1(x1, 1)
u2(w2, 0) < u2(x2, 1).
Using the definition of the reservation prices r1 and r2 and the budget constraint to write
u1(w1 − r1, 1) = u1(w1, 0) < u1(x1, 1) = u1(w1 − g1, 1)
u2(w2 − r2, 1) = u2(w2, 0) < u2(x2, 1) = u2(w2 − g2, 1).
Looking at the left- and the right-hand sides of these inequalities, and knowing that more
private consumption must increase utility, we can conclude that
w1 − r1 < w1 − g1
w2 − r2 < w2 − g2,
which in turn implies
r1 > g1
r2 > g2.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

This is a condition that must be satisfied if an

allocation (w1, w2, 0) is Pareto inefficient: it must be that the
contribution that each person is making to the TV is less than his willingness to pay for the TV. If
a consumer can acquire the good for less than the maximum that he would be willing to pay, then
the acquisition would be to his benefit. Thus the condition that the reservation price exceeds the
cost share simply says that a Pareto improvement will result when each roommate can acquire the
services of the TV for less than the maximum that he would be willing to pay for it. This is a
necessary condition for purchase of the TV to be a Pareto improvement.
If each roommate’s willingness to pay exceeds his cost share, then the sum of the
willingness to pay must be greater than the cost of the TV:
r1 + r2 > g1 + g2 = c.

This condition is a sufficient condition for it to be a Pareto improvement to provide the TV. If the
condition is satisfied, then there will be some payment plan such that both people will be made
better off by providing the public good. If r1 +r2 ≥ c, then the total amount that the roommates
will be willing to pay is at least as large as the cost of purchase, so they can easily find a payment
plan (g1, g2) such that r1 ≥ g1, r2 ≥ g2, and g1 + g2 = c.
It is important to note that the condition describing when provision of the public good
will be a Pareto improvement only depends on each agent’s willingness to pay and on the total
cost. If the sum of the reservation prices exceeds the cost of the TV, then there will always exist a
payment scheme such that both people will be better off having the public good than not having
it.
Also, whether or not it is Pareto efficient to provide the public good will, in general,
depend on the initial distribution of wealth (w1, w2). This is true because, in general, the
reservation prices r1 and r2 will depend on the distribution of wealth. It is possible that for some
distributions of wealth r1 + r2 > c, and for other distributions of wealth r1 + r2 < c. But in specific
cases the provision of the public good may be independent of the distribution of wealth. An
instance of this kind arises if the preferences of the two roommates are Quasilinear.

3.2 Efficient level of Public good

In order to determine the efficient output of a public good, we must compare the marginal
benefits (marginal rate of substitution) and the marginal costs associated with different levels of
output. The marginal cost of a public good is the opportunity cost of using resources to produce
that good rather than other goods. Because of the non-rival nature of the benefits of a public
good, though, its marginal benefit differs from that of a private good. It is not the marginal value
to any one person alone since many people benefit simultaneously from the same unit. Instead,
we must add the marginal benefits (marginal rates of substitution) of every person who values the
additional unit of a public good, and the resulting sum indicates the combined willingness of the
public to pay for more defense- that is, its marginal benefit.
This is illustrated in Figure 3.1. For simplicity, assume that only two individuals 1 and 2
benefit from the consumption of the public good. Each person has a MRS curve, shown as MRS1
and MRS2. The marginal rate of substitution can be interpreted as measuring the marginal
willingness to pay for an extra unit of the public good. The combined MRS curve is derived by
vertically adding the individual MRS curve.
It is evident from Figure 3.1 that at any level of output where the combined MRS curve
lies above the marginal cost curve MC, the sum of the marginal willingness to pay for the public
good exceeds the marginal cost, and it is appropriate to provide more of the public good. When

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

MC lies above combined MRS curve, however, too much of

the public good is being produced—the combined marginal
willingness to pay is less than the marginal cost over this range of output.
Thus, the efficient allocation of public good occurs at the point where the sum of the
MRSs curve equals the marginal cost, as illustrated in Figure 3.1. In other words, at the optimal
amount of the public good (as given by G*), the sum of the marginal willingness to pay should
equal the marginal cost.
It is worthwhile comparing the efficiency condition for a public good to the efficiency
condition for a private good. For a private good, each person’s marginal rate of substitution must
equal the marginal cost; for a public good, the sum of the marginal rates of substitution must
equal the marginal cost. In the case of a private good, each person can consume a different
amount of the private good, but they all must value it the same at the margin—otherwise they
would want to trade. In the case of a public good, each person must consume the same amount of
the public good, but they can all value it differently at the margin.

Figure 3.1: Efficient output of a public good

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

4. The Free Rider problem

Even when a public good is worth more to people than it costs to produce, private markets may
fail to provide it.
Consider the construction of a dam that will lessen the probability of flooding for
members of a specific community; the dam is a public good for residents of the community. Even
though it is in each resident’s interest to have the dam constructed, there is a good chance that it
won’t be built if private markets are relied upon to organize the construction. To finance the dam,
several residents must jointly agree to contribute, and individuals will realize that they will
receive the benefits of the dam once it is built regardless of whether they make any contribution
toward the dam’s construction. Each resident, therefore, has incentive to understate what the dam
is worth in an effort to secure the benefit at a lower, or zero, cost. If enough people behave this
way- as free riders- voluntary contributions will be insufficient to finance the dam and it won’t
be built. As the group size increases, it is more likely that everyone will behave like a free rider,
and the public good will not be provided.
A case like this is depicted in Figure 4.1. Here each person’s private consumption is
illustrated on the horizontal axis and his public consumption on the vertical axis. The endowment
of each person consists of his wealth, wi, along with the amount of the public good contribution of
the other person—since this is how much of the public good will be available if the person in
question decides not to contribute. Figure 4.1A shows a case where person 1 is the only
contributor to the public good, so that g1, the amount of public good purchased by person 1,
equals G, the total amount of public good. If person 1 contributes G units to the public good, then
person 2’s endowment will consist of his private wealth, w2, and the amount of the public good
G—since person 2 gets to consume the public good whether or not she contributes to it. Since
person 2 cannot reduce the amount of the public good, but can only increase it, his budget
constraint is the bold line in Figure 4.1B. This is an example where person 2 is free riding on
person 1’s contribution to the public good. Given the shape of 2’s indifference curve, it is optimal
from his point of view to free ride on 1’s contribution and consumes his endowment, as depicted.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

Figure 4.1: The Free Rider problem

Since a public good is a good that everyone must consume in the same amount, the provision of a
public good by any one person will tend to reduce the other peoples’ provision. Thus in general
there will be too little of the public good supplied in a voluntary equilibrium, relative to an
efficient provision of the public good.

5. Methods to determine supply of public good

Private provision of a public good doesn’t work very well, but there are several other mechanisms
to determine the provision of public goods. Sometimes people use a command mechanism,
where one person or small group of people determines the amount of various public goods that
will be provided by the populace. Other times people use a voting system where individuals vote
on the provision of public goods. Besides this, Vickrey-Clarke-Groves (VCG) mechanism of
auction is also used, which is a sealed-bid auction wherein bidders report their valuations for the
items.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

6. Summary
 Public goods are goods which are non-rival and non-excludable in nature. They are goods
for which everyone must consume the same amount, such as national defense, air
pollution, and so on.
 If a public good is to be provided in some fixed amount or not provided at all, then a
necessary and sufficient condition for provision to be Pareto efficient is that the sum of
the willingness to pay (the reservation prices) exceeds the cost of the public good.
 If a public good can be provided in a variable amount, then the necessary condition for a
given amount to be Pareto efficient is that the sum of the marginal willingness to pay (the
marginal rates of substitution) should equal the marginal cost.
 The free rider problem refers to the temptation of individuals to let others provide the
public goods. In general, purely individualistic mechanisms will not generate the optimal
amount of a public good because of the free rider problem.
 Various collective decision methods have been proposed to determine the supply of a
public good. Such methods include the command mechanism, voting, and VCG auction
mechanism.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 32 : MARKET FAILURE AND PUBLIC GOODS
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 33, Behaviour under Certainty and Uncertainty

Module Tag BSE_P1_M33

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Capital-Budgeting Process
3.1 Generation of Capital Investment Projects
3.2 Estimation of the Cash flows
3.3 Evaluation of Investment Projects
3.3.1 Payback Period
3.3.2 Accounting Rate of Return
3.3.3 Net Present Value
3.3.4 Internal Rate of Return
3.4 Ex-post evaluation of Projects
4. Decision making under Risk and Uncertainty
4.1 Risk Adjustments in Decision making
4.2 Decision making under Uncertainty
4.3 Managing Risk and Uncertainty
5. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to

 Get an overview of the investment decision process, which is called the capital budgeting
process
 Grasp the manner in which risk and uncertainty can be incorporated into the decision-
making process

2. Introduction
Generally, decisions regarding the optimal levels of production, consumption, or factor input
employment, are taken by comparing the current expenditures and the current revenues or
marginal products. This is acceptable with inputs like labour where one has to decide on the level
of employment of labour in view of the current wages and the current marginal revenue products.
However, with the factor input capital, the decision-making process, while being the same, has to
be based on a different set of data. Capital expenditure is typically expenditure on plant and
machinery, wherein the current level of expenditure has to be compared with the revenues that
will be generated in the future. Therefore, we require a method to bring the future revenue down
to the present revenue to enable us to compare it with the current expenditure.
While considering future revenues, the various kinds of risks and uncertainties should
also be allowed for. Therefore, we also focus on how the aspects of risk and uncertainty can be
incorporated into evaluation techniques, and thereby the decision-making process.

3. Capital-Budgeting Process
Capital budgeting is the process of planning the capital expenditure after a careful evaluation of
the available capital expenditure alternatives. Optimality requires that firms should undertake
additional capital expenditure projects as long as the marginal returns from the projects exceed
their marginal cost. This is shown in Figure 3.1. In the figure, the vertical bars are the different
capital expenditure projects arranged in descending order of returns. The curve sloping upwards
is the marginal cost curve. That it is rising shows the rising cost of raising additional amounts of
capital by the firm. The firm should undertake those projects, the returns from which exceed the
marginal cost of capital. In the figure, it corresponds to the first three projects.

The above model can be divided into four stages:

1. Generation of capital investment projects

2. Estimation of the cash flows
3. Evaluation of investment projects
4. Ex-post evaluation of projects

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

3.1 Generation of Capital Investment Projects

Idea generation is the first step towards the generation of capital investment projects. Ideas/
proposals can be generated at all levels of the organization. Replacement projects involve
replacements of old and worn-out pieces of machinery. Projects can also reduce costs, such as
labour-saving equipment and machinery for technologically new processes to reduce costs by
replacing obsolete machinery.
The demand for increased capital outlays may come from market expansion. A market
expansion plan has to be backed by an adequate production expansion plan, which essentially
means capital outlays for capacity expansion. Diversification into new products also calls for
capital investment projects.

Estimation of the cash flows

Estimating the cash flow involves estimating cash outflows and inflows over the life of a project.
Since it involves projecting cash flows into the future, it is ridden with uncertainties. Let us
assume that the decision maker can project these cash flows with certainty.
There are certain guidelines that must be borne in mind while estimating the cash flow.
The first principle is that the cash flow has to be measured on an incremental basis. This means
that the relevant cash flow is the difference between the cash flow that existed before the project
and the cash flow with the start of the project.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

The second principle is that the cash flow should be post-tax flow. The third principle is
that it should consider both the direct and the indirect effects of the project in its costs and
benefits stream. If capital investment by one division of a firm is going to help reduce costs of
other divisions also, these reductions have to be considered in the cash flow of the project.
According to the fourth principle, all sunk costs are to be ignored. Sunk costs are those
costs that are incurred in the past, or have been committed to and cannot be withdrawn under any
circumstance.
The fifth principle is that the resources employed in the project should be valued at their
opportunity cost, that is, at what has been foregone. For a capital expenditure project, there will
be an initial investment at t = 0, which will generate a cash flow stream in the future. This initial
investment is a cash outflow and the revenue streams from time period onwards are cash inflows.
There would also be cash outflows during the life of the project and not just at t = 0. The post-tax
incremental net cash flow (NCF) is equal to the difference between cash inflows and cash
outflows. Depreciation being a non-cash charge is added back to get the correct estimate of the
cash flow.

3.3 Evaluation of Investment Projects

After identifying a capital investment project and its cash outflows, we have the data required to
evaluate the project, that is, to see whether the project is economically viable and whether it
satisfies the marginal rule.
There are several methods of evaluating a project. These are as follows:
 Payback period
 Average return on investment or the accounting rate of return
 Net present value
 Yield on investment or the internal rate of return

3.3.1 Payback Period

This measure gives the time period required to recover the initial capital outlay from the cash
inflows. The period over which the sum of the cash inflows equals the initial capital outlay is
called the payback period. The smaller the payback period, the more desirable is the project.

3.3.2 Accounting Rate of return

This method relates income to investment. It is defined as the ratio of net average annual income
from the project to its initial investment.
Net average annual income = [Net income/ Life of the project (in years)]
Net income is the difference between net cash inflows generated by the project over its life and
the net cash outflow of the initial capital.

3.3.3 Net Present Value

The net present value (NPV) method compares the cash inflow generated with the initial
investment. If the sum of discounted cash inflows received over the life of the project exceeds the

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

initial capital outlay, the project is considered to be economically viable. That is, if the NPV is
positive, the project is considered worthwhile.
Thus,
NPV = -C + P1/ (1+r) + P2/ (1+r) 2 + ………. + Pn/ (1+r) n

= ∑ [Pt. / (1+r) t] - C

where, C is the initial capital outflow (and hence, is negative); P1, P2,……Pn are the cash inflows
occurring in time periods 1 to n; and ‘r’ is the discount rate.
The NPV is a function of the discount rate ‘r’. For the same project, with higher discount
rates, the NPV reduces and becomes negative, while at lower discount rates, the NPV may be
positive. Thus, a project, which is rejected with one discount rate, may be accepted with another
discount rate, thereby making the choice of the discount rate an extremely critical input.

3.3.4 Internal Rate of Return

In this method, a discount rate is found so that the NPV at that discount rate is zero. This discount
rate, which equates the initial capital investment to the present value of net cash inflows over the
life of the project, making the NPV zero, is called the internal rate of return (IRR).
It is the value of ‘r’ in the following equation:
C = ∑ [Pt/ (1+r)t]
Here C is the initial capital investment, Pt is the net cash inflow in time period t (t =1 to
n) and ‘n’ is the life of the project.

3.4 Ex-post Evaluation of projects

At this stage, the quality of the estimates is tested by comparing it with the actual cash flows. The
smaller the deviation between estimates and actual, the better is the quality of the estimates. This
feedback on the estimation procedures is an extremely important piece of input for future capital
investment decisions. 4. Summary

4. Decision-making under Risk and Uncertainty

4.1 Risk Adjustments in Decision making

A decision-making situation, in which the possible outcomes can vary and the probability of the
occurrence of each outcome is known, is said to be a risky situation.

Risks are of two kinds—diversifiable and non-diversifiable. Diversifiable risks can be

removed by investing in many projects. However, non-diversifiable risks cannot be removed
through diversification. The possibility of a recession in the economy is a non-diversifiable risk
for a firm.
There are various methods of incorporating risks into the decision-making process:

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

 Subjective approach: The decision maker assesses the risk subjectively. When
faced with a situation where the net returns of two exclusive projects are the same, the decision
maker makes a subjective assessment of the risk involved and chooses the one with the lower
risk. However, where both returns and risk are unequal, decision-making is more difficult, but
risk is still assessed subjectively.

 Utility function approach: Under this approach, the individual maximizes the
expected utility. This assumes that the individual is able to attach a level of utility to each of the
possible outcomes of a decision. That is,
E (u) = ∑ui × Pi,
Where ui is the utility of the ith outcome and Pi is the probability of occurrence of that outcome.
This E (u) is compared with the E (u) of another decision and the decision maker will choose the
one with higher E (u). An E (u) = 0 indicates indifference.

 Risk adjusted discount rate approach: In this method, a risk premium is added to
the risk-free discount rate. Where the risk is diversifiable, the discount rate will be the risk-free
interest rate. However, where the risk is non-diversifiable, a premium is added to the discount
rate. With a risk adjusted discount rate, the NPV is equal to:
∑[Pt/ (1+ k)t] – C
Where Pt. is the net cash flow at time‘t’, ‘k’ is the risk adjusted discount rate, and C is the initial
capital outflow.

4.2 Decision making under Uncertainty

Uncertainty is a situation where the decision maker does not know the probability of an outcome.
In such situations, there are some decision rules that the decision maker can use, provided he can
identify the possible outcomes and the pay offs associated with each other.

 Maximin Criterion: In this, the decision maker, faced with the pay offs of the
various outcomes of the strategy, chooses the best amongst the worst possible
outcomes.

 Minimax Regret Criterion: This criterion enables the decision maker to select the
investment project that minimizes the maximum ‘regret. Regret is measured as
the difference between the payoff of the best strategy under each ‘state of nature’.

4.3 Managing Risk and Uncertainty

Besides the above explained criteria, many other ways of reducing risks and uncertainties are
employed.

 Seek more Information: In many situations, the uncertainty can be reduced by

seeking out more information. For example, if the investment was towards the
development and launch of a new product, the uncertainty regarding the success
or failure of the product launch can be, to a great extent, removed by launching a
trial version of the product in a representative market.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

 Diversification: Where the risk is diversifiable, investors invest in several diverse

assets with differing levels of risk so that, on an average, the risk is evened out.
Diversification can be undertaken at the level of both the stockholders and the
firm. At the level of stockholders, it happens when individuals, in order to
diversify their risk, invest in a portfolio of assets. At the level of the firm, a firm
acquires a wide range of firms in unrelated industries—the rationale being that
these acquisitions would reduce the inherent cyclical risk of the industry to which
the acquiring firm belongs. Whereas, at the firm level, such kinds of
diversifications are costly, they are much more easily managed at the
stockholders level, with no premium attached.

 Hedging: This is a strategy to reduce risk wherein the investor takes off setting
positions in the ownership of an asset through instruments called derivatives. An
investor often uses buying or selling of a future contract to offset risk in the cash
market. These contracts are legal obligations to buy or sell goods specified in the
contract at the price agreed upon at some time in the future. This shields the
investor against price fluctuations in the future.

 Purchasing Insurance: It involves paying a premium to protect against different

kinds of risks—accident, fire, death, etc. Insurance is commonly available for
losses due to fires, accidents, theft, and fraud. Whether insurance is required or
not depends on the degree of risk averseness of the buyer, his assessment of the
severity of the consequences of the event occurring, and the premium itself.

 Restricted Use of Firm-Specific Assets: Setting up a production center that

necessities the use of firm-specific assets ties down the producer. Firm-specific
assets do not have general purpose uses and so, in the event of a closure, resale of
these assets is not easy. Since firm-specific investments offer few, if any, options
for diverse use, investors should opt for these investments only after a thorough
evaluation.

5. Summary
 The evaluation of a capital investment project requires the comparison of current
expenditures with revenues that are expected to accrue in the future.
 The capital budgeting is the process of planning for capital expenditure based on a careful
evaluation of the alternatives.
 The four stages in the capital budgeting process include generation of alternative
investment projects; estimation of cash flows; evaluation of projects; and ex-post
evaluation of projects.
 Risk is when there are several possible outcomes and the probability of their occurrence
is known. As against this, an uncertain situation is one where the possible outcomes are
many with unknown probabilities.
BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

 The risk is adjusted for subjectively, through a utility function, or a risk adjusted discount
rate approach.
 In an uncertain situation, two criteria are primarily used—the maximin criterion and the
minimax regret criterion.
 Risk and uncertainty in situations are mitigated to a great extent by seeking more
information, through diversification at the stock holder level and at the firm level and
through hedging and insurance.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 33: BEHAVIOUR UNDER CERTAINTY AND
UNCERTAINTY
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 34, Economics of Information I

Module Tag BSE_P1_M34

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Hidden Characteristic: Adverse Selection
3.1 Market for Lemons
3.2 Quality Choice
4. Market Responses to Adverse Selection
4.1 Market Signaling
4.2 Screening
5. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you will be able to

 Know the notion of asymmetry in information

 Learn about the different outcomes of asymmetric information
 Analyze the problem of adverse selection in various markets
 Identify the various market responses in the form of signaling and screening, to cope with
the problem of adverse selection

2. Introduction

Asymmetric Information

Till now, it has been assumed that consumers and producers have complete information about the
economic variables that are relevant for the choices they face. In this module, we will examine a
situation where the characteristic of ‘perfect information’ does not exist. In such a case, one some
parties have more information about the transaction than the others. This is a situation of
asymmetric information.
The asymmetry in information can arise from two types of information—first, about the
characteristic, wherein one side knows some characteristic which the other side would like to
know; and second, about an action that one side can take and the other side cannot directly
observe. The former is referred to as a situation of hidden characteristic and the latter is referred
to as a situation of hidden action. In such situations, the markets perform differently, leading to
inefficiencies and undesirable outcomes.
The present module focuses on hidden characteristics and the subsequent module
discusses hidden action.

3. Hidden Characteristic: Adverse Selection

One of the outcomes of asymmetric information is adverse selection. Adverse selection is a
hidden characteristic problem. It refers to the situations where one side of the market is unable in
observing the ‘type’ or quality of the goods that other type of market is using. In other words, the
seller knows more about the attributes of the good being sold than the buyer does. In such a
situation, the buyer runs the risk of being sold a good of low quality. That is, the ‘selection’ of
goods sold may be ‘adverse’ from the standpoint of the uninformed buyer.
The classic example of adverse selection is the market for used cars. Sellers of used cars
know their vehicles’ defects while buyers often do not. The owners of the worst cars are more
likely to offer them at a price higher than their actual marginal cost because of the advantageous
information asymmetry.
Another example of adverse selection occurs in the labour market. The workers, who
vary in their abilities, may know their own abilities better than do the firms that hire them. When
a firm cuts the wage it pays, the more talented workers are more likely to quit, knowing they are
better able to find other employment.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

3.1 Market for Lemons

Let us look at the standard example of a market for second hand used cars to illustrate the
implications of the problem of adverse selection.
Consider a market with 100 people who want to sell their used cars and 100 people who
want to buy a used car. Everyone knows that 50 of the cars are good cars and 50 are ‘lemons’
(bad cars). The quality of each car is known to the current owner, but the prospective purchasers
have no idea whether any given car is a good car or a lemon. The owner of a lemon is willing to
give it for Rs.60, 000 and the owner of a good car is willing to give it up for Rs.1, 50,000. The
buyers of the car are willing to pay Rs.2, 00,000 for a good car and Rs.90, 000 for a lemon. If it is
easy to verify the quality of the cars there will be no problems in this market. The lemons will sell
at some price between Rs.60, 000 and Rs.90, 000 and the good cars will sell at some price
between Rs.1, 50,000 and Rs.2, 00,000. But if the buyers are unable to observe the quality of the
car, then in that case the worth of the car will be guessed by the buyer.
Let us assume that if a car is equally likely to be a good car as a lemon, then a typical
buyer would be willing to pay the expected value of the car. Using the numbers described above
this means that the buyer would be willing to pay [½ (90,000) + ½(2, 00,000)] = Rs.1, 45,000.
At this price, the owners of the lemons would certainly be willing to sell their car, but the
owners of the good cars wouldn’t be willing to sell their cars—by assumption they need at least
Rs.1, 50,000 to part with their cars. The price that the buyers are willing to pay for an “average”
car is less than the price that the sellers of the good cars want in order to part with their cars. At a
price of Rs.1, 45,000 only lemons would be offered for sale. But if the buyer was certain that he
would get a lemon, then he wouldn’t be willing to pay Rs.1, 45,000 for it! In fact, the equilibrium
price in this market would have to be somewhere between Rs.60, 000 and Rs.90, 000. For a price
in this range only owners of lemons would offer their cars for sale, and buyers would therefore
(correctly) expect to get a lemon. In this market, none of the good cars ever get sold! Even though
the price at which buyers are willing to buy good cars exceeds the price at which sellers are
willing to sell them, no such transactions will take place.
It is worth contemplating the source of this market failure. The problem is that there is an
externality between the sellers of good cars and bad cars; when an individual decides to try to sell
a bad car, he affects the purchasers’ perceptions of the quality of the average car on the market.
This lowers the price that they are willing to pay for the average car, and thus hurts the people
who are trying to sell good cars. It is this externality that creates the market failure. The cars that
are most likely to be offered for sale are the ones that people want most to get rid of. The very act
of offering to sell something sends a signal to the prospective buyer about its quality. If too many
low-quality items are offered for sale it makes it difficult for the owners of high-quality items to
sell their products.

3.2 Quality Choice

In the lemons model there were a fixed number of cars of each quality. Now let us consider a
variation on that model where quality may be determined by the producers. We will show how
the equilibrium quality is determined in this simple market.
Suppose that each consumer wants to buy a single umbrella and that there are two
different qualities available. Consumers value high-quality umbrellas at Rs.240 and low-quality

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

umbrellas at Rs.100. It is impossible to tell the quality of the umbrellas in the store; this can only
be determined after a few rainstorms.
Suppose that some manufacturers produce high-quality umbrellas and some produce low-
quality umbrellas. Suppose further that both high quality and low-quality umbrellas cost Rs.180
to manufacture and that the industry is perfectly competitive. In such a situation what would be
the equilibrium quality of umbrellas produced.
Now suppose that consumers judge the quality of the umbrellas available in the market
by the average quality sold, just as in the case of the lemons market. If the fraction of high-quality
umbrellas is q, then the consumer would be willing to pay p = 240q + 100(1 − q) for an umbrella.
There are three cases to consider.
Only low-quality manufacturers’ produce- In this case then the consumers would be willing to
pay only Rs.100 for an average umbrella. But it costs Rs.180 to produce an umbrella, so none
would be sold.
Only high-quality manufacturers produce- In this case the producers would compete the price of
an umbrella down to marginal cost, Rs.180. The consumers are willing to pay Rs.240 for an
umbrella, so they would get some consumers’ surplus.
Both qualities are produced- In this case competition ensures that the price will be Rs.180. The
average quality available must therefore have a value to the consumer of at least Rs.180. This
means that we must have 240q + 100(1 − q) ≥ 180.
The lowest value of q that satisfies this inequality is q = 4/7. This means that if 4/7 of the
suppliers are high-quality the consumers are just willing to pay Rs.180 for an umbrella.
The determination of the equilibrium ratio of high-quality producers is depicted in Figure
3.1. The horizontal axis measures q, the fraction of high-quality producers. The vertical axis
measures the consumers’ willingness to pay for an umbrella if the fraction of high-quality
umbrellas offered is q. Producers are willing to supply either quality of umbrella at a price of
$180, so the supply conditions are summarized by the bold coloured horizontal line at Rs.180.

Figure 3.1: Equilibrium Quality

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

The slanted line represents the demand conditions: consumers are willing to pay more if the
average quality is higher. Consumers are willing to purchase umbrellas only if 240q + 100(1 − q)
≥ 180; the boundary of this region is illustrated by the dashed line. The equilibrium value of q is
between 4/7 and 1.
In this market the equilibrium price is Rs.180, but the value of the average umbrella to a
consumer can be anywhere between Rs.180 and Rs.240, depending on the fraction of high-quality
producers. Any value of q between 1 and 4/7 is equilibrium. However, all of these equilibria are
not equivalent from the social point of view. The producers get zero producer surpluses in all the
equilibria, due to the assumption of pure competition and constant marginal cost. Here it is easy
to see that the higher the average quality, the better off the consumers is. The best equilibrium
from the viewpoint of the consumers is the one in which only the high-quality goods are
produced.
Now let us change the model a bit. Suppose that each producer can choose the quality of
umbrella that he produces and that it costs Rs.180 to produce a high-quality umbrella and Rs.170
to produce a low-quality umbrella.
Suppose that the fraction of producers who choose high-quality umbrellas is q, where 0 <
q < 1. Consider one of these producers. If it behaves competitively and believes that it has only a
negligible effect on the market price and quality, then it would always want to produce only low-
quality umbrellas. Since this producer is by assumption only a small part of the market, it neglects
its influence on the market price and therefore chooses to produce the more profitable product.
But every producer will reason the same way and only low-quality umbrellas will be
produced. But consumers are only willing to pay Rs.100 for a low-quality umbrella, so there is no
equilibrium. Or the only equilibrium involves zero production of either quality of umbrella! The
possibility of low-quality production has destroyed the market for both qualities of the good!

4. Market Responses to Adverse Selection

From the above discussion, it is evident that asymmetric information can sometimes lead to a
lemons problem: Because sellers know more about the quality of a good than buyers do, buyers
may assume that quality is low, causing price to fall and only low-quality goods to be sold.
Markets respond to the problems of asymmetric information in many ways. One of them is
signaling, which refers to activities taken by an informed party for the sole purpose of credibly
revealing his private information. The other is screening, wherein an uninformed party takes
actions to induce the informed party to reveal private information.

4.1 Market Signaling

In the case of market for lemons, the owners of the good cars have an incentive to try to convey
the fact that they have a good car to the potential purchasers. They would like to choose actions
that signal the quality of their car to those who might buy it. One sensible signal in this context
would be for the owner of a good used car to offer a warranty. This would be a promise to pay the
purchaser some agreed upon amount if the car turned out to be a lemon. Owners of the good used
cars can afford to offer such a warranty while the owners of the lemons can’t afford this. This is a
way for the owners of the good used cars to signal that they have good cars. In this case,

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

signalling helps to make the market perform better. By offering the warranty—the signal—the
sellers of the good cars can distinguish themselves from the sellers of the bad used cars.

Let us consider a simple model of the education market to examine how signalling works.
Suppose that we have two types of workers, able and unable, in a competitive market. The able
workers have a marginal product of a2, and the unable workers have a marginal product of a1,
where a2 > a1. Suppose that a fraction b of the workers are able and 1 − b of them are unable. For
simplicity we assume a linear production function so that the total output produced by L2 able
workers and L1 unable workers is a1L1+a2L2.
If worker quality is easily observable, then firms would just offer a wage of w2 = a2 to the
able workers and of w1 = a1 to the unable workers. That is, each worker would be paid his
marginal product and there would be an efficient equilibrium.
But if a firm can’t observe the marginal products and distinguish the types of workers,
then the best that it can do is to offer the average wage, which is w = (1−b)a1+ba2. As long as the
good and the bad workers both agree to work at this wage there is no problem with adverse
selection. And, given the assumption about the production function, the firm produces just as
much output and makes just as much profit as it would if it could perfectly observe the type of the
worker.
However, suppose now that there is some signal that the workers can acquire that will
distinguish the two types. For example, suppose that the workers can acquire education. Let e1 be
the amount of education attained by the type 1 workers and e2 the amount attained by the type 2
workers. Suppose that the workers have different costs of acquiring education, so that the total
cost of education for the able workers is c2e2 and the total cost of education for the unable
workers is c1e1. These costs are meant to include not only the rupee costs of attending school, but
also the opportunity costs, the costs of the effort required, and so on.
Now there are two decisions to consider. The workers have to decide how much
education to acquire and the firms have to decide how much to pay workers with different
amounts of education. Let us make the extreme assumption that the education doesn’t affect
worker productivity at all. It turns out that the nature of the equilibrium in this model depends
crucially on the cost of acquiring education.
Suppose that c2 < c1. This says that the marginal cost of acquiring education is less for
the able workers than the unable workers. Let e∗ be an education level that satisfies the following
inequalities:
[(a2 − a1) / c1] < e∗ < [(a2 − a1) / c2]
.
Given the assumption that a2 > a1 and that c2 < c1 there must be such an e∗.
Now consider the following set of choices: the able workers all acquire education level e∗
and the unable workers all acquire education level 0, and the firm pays workers with education
level e∗ a wage of a2 and workers with less education than this a wage of a1. Note that the choice
of the education level of a worker perfectly signals his type.
Now the question is whether the workers are behaving rationally given the wage schedule they
face. Would it be in the interest of an unable worker to purchase education level e∗? The benefit
to the worker would be the increase in wages a2 −a1. The cost to the unable worker would be c1e∗.
The benefits are less than the costs if
a2 − a1 < c1e∗.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

But this condition holds by the choice of e∗. Hence the unable workers find it optimal to
choose a zero educational level.
Is it actually in the interest of the able workers to acquire the level of education e∗? The
condition for the benefits to exceed the costs is
a2 − a1 > c2e∗,
and this condition also holds due to the choice of e∗.
Hence this pattern of wages is indeed equilibrium: if each able worker chooses education
level e∗ and each unable worker chooses a zero educational level, then no worker has any reason
to change his behaviour. Due to the assumption about the cost differences, the education level of
a worker can, in equilibrium, serve as a signal of the different productivities.
However, this equilibrium is inefficient from a social point of view. Each able worker
finds it in his interest to pay for acquiring the signal, even though it doesn’t change his
productivity at all. The able workers want to acquire the signal not because it makes them any
more productive, but just because it distinguishes them from the unable workers. Exactly the
same amount of output is produced in the signalling equilibrium as would be if there was no
signalling at all. In this model the acquisition of the signal is a total waste from the social point of
view.
This inefficiency arises because of an externality. If both able and unable workers were
paid their average product, the wage of the able workers would be depressed because of the
presence of the unable workers. Thus they would have an incentive to invest in signals that will
distinguish them from the less able. This investment offers a private benefit but no social benefit.
Signalling doesn’t always lead to inefficiencies. Some types of signals, such as the used-car
warranties described above, help to facilitate trade. In that case the equilibrium with signals is
preferred to the equilibrium without signals. So signalling can make things better or worse; each
case has to be examined on its own merits.

4.2 Screening

When an uninformed party takes an action to induce the informed party to reveal private
information, the phenomenon is called screening.
A person buying a used car may ask that it be checked by an auto mechanic before the
sale. A seller who refuses this request reveals his private information that the car is a lemon. The
buyer may decide to offer a lower price or to look for another car.
In the insurance market, insurance companies have come up with a good number of
screening devices. One of the most commonly used screening mechanisms is the medical
examination, which screens an individual and categorizes him as healthy or sick. While such an
examination prevents adverse selection, which is desirable from the company’s point of view,
socially, the test does not add value. If anything, it imposes a cost on the individuals and deprives
a section of the society of the benefits of insurance (because insurance policies are priced very
steeply for sick individuals).

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

5. Summary
 In many economic transactions, information is asymmetric, i.e., a situation where some
people are better informed than others.
 Asymmetric information causes significant problems with the efficient functioning of a
market.
 The asymmetry in information can arise from hidden characteristics, wherein one side
knows some characteristics which the other side would like to know, but does not know.
 Hidden characteristics lead to situations where the type of the agents is not observable so
that one side of the market has to guess the type or quality of a product based on the
behavior of the other side of the market. This leads to the problem of adverse selection.
 In markets involving adverse selection too little trade may take place. A buyer of a car
gets to trade with sellers of bad cars only; a health insurance company gets to trade with
only unwell people.
 In situations of adverse selection, the informed party looks for indicators of hidden
characteristics called signals, and often use a screening device to sort out customers
according to their willingness to pay.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 34: ECONOMICS OF INFORMATION I
____________________________________________________________________________________________________

Subject Business Economics

Paper No and Title 1, Microeconomic Analysis

Module No and Title 35, Economics of Information II

Module Tag BSE_P1_M35

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Hidden Actions: Moral Hazard
3.1 Moral Hazards in the Insurance market
3.2 Efficiency Outcome under Moral Hazards
3.3 Measures of Mitigating Moral Hazard
3.4 The Principal – Agent Problem
3.5 Moral Hazards in Product Markets
3.5.1 Brand Name Reputations
3.5.2 Guarantees and Warrantees
4. Summary

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you will be able to

 Learn about moral hazard, one of the outcomes of asymmetric information.

 Analyze the problem of moral hazard in an insurance market.
 Comprehend the efficiency effects of moral hazard.
 Explore the various measures that can be undertaken to cope with the problem of moral
hazard.
 Understand the principal-agent problem.

2. Introduction

Asymmetric Information

As discussed in the earlier module, asymmetric information may cause significant problems with
the efficient functioning of a market, leading to market failure.
One of the outcomes of this information problem, adverse selection, has already been
elaborated in the earlier module. In this module, we will focus on another module of asymmetric
information, i.e., moral hazard. Moral hazard refers to situations where one side of the market
can’t observe the actions of the other. It is also sometimes called a hidden action.

3. Hidden Actions: Moral Hazard

In contrast to hidden characteristics, a hidden action is something that is fully under the control of
the individual and the other party has no information as to whether the individual is actually
going to perform the hidden action or not. For example a worker is hired and expected to work
hard, but the employer has no idea and does not have the time to observe whether the worker is
actually working hard. It is entirely under the control of the worker and he can choose to work
hard or not work hard. An individual who has taken fire insurance can choose to smoke in the
kitchen, but the information company will have no information as to whether he has chosen to
smoke or not. Similarly, if an individual’s home is fully insured against theft, he may be less
diligent about locking doors when he leaves, and may choose not to install an alarm system.
When one party is fully insured and cannot be accurately monitored by an insurance company
with limited information, the insured party may take an action that increases the likelihood that an
accident or injury will occur.
In such situations of asymmetric information arising out of hidden actions, the problem
that arises is that the informed side may take the wrong actions, an action which ought not to have
taken. The term moral hazard refers to the risk, or “hazard” of such inappropriate behavior by the
informed side.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

3.1 Moral Hazards in the Insurance Market

This problem of moral hazard was first identified in the insurance market, wherein once insured,
the individuals made no attempt to prevent accidents. Sometimes individuals actually made
accidents happen. There are incidents of owners setting warehouses on fire to claim insurance. No
attempt is made to prevent accidents because there is no incentive to do so.

Consider a situation of driving. A driver with no insurance will take all possible measures
to prevent any accident because the cost incurred due to an accident is so high that it is worth
preventing. Figure 3.1 shows the total cost of damages associated with each level of preventive
measures taken. It is downward sloping as higher levels of preventive measures are associated
with lower levels of cost of damages.

Figure 3.1: Total Cost of Damages

Figure 3.2 shows the marginal benefits of increasing levels of preventive measures. As the levels
of preventive measures taken increases, the contribution by further units of preventive measures
decreases.
Let us assume that the marginal cost of taking up preventive measures is constant at Rs.X.
In the absence of insurance, the optimal level of preventive measures will be that at which
marginal benefit is equal to marginal cost. As shown in Figure 3.3, this occurs at point ‘e’.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

Now suppose that the driver takes up comprehensive auto insurance. In such a situation,
the marginal cost of preventive measures does not change. However, the marginal benefit of
preventive measures does change dramatically. The driver will now not see the prevention of an
accident as a great benefit because the cost incurred in case of an accident is now borne by the
insurance company.
This reduction in marginal benefit is captured in Figure 3.4, wherein the marginal benefit
curve shifts inwards. With this shift, the optimal level of preventive measures reduces from the
level ‘e’ in the absence of insurance to level ‘e̒’ in the presence of insurance. Thus, with
insurance, the cost of the accident to be borne by the individual reduces and therefore, the
incentive to prevent accidents reduces, leading to much lower levels of preventive measures.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

Moral hazard not only alters behavior; it also created economic inefficiency. The inefficiency
arises because the insured individual perceives either the cost or the benefit of the activity
differently from the true social cost or benefit. In the example illustrated above, the optimum
outcome is given by the intersection of marginal benefit (MB) and marginal cost (MC) curves, at
point e. With moral hazard, however, the individual’s perceived marginal benefit (MB̒) is less
than actual, and the level of preventive measures is much lower than the efficient level.

3.2 Efficiency Outcome under Moral Hazard

In the example illustrated above, one may conclude that society is benefitted by a reduction in the
cost to be borne by individuals in case of accidents. However, it actually leads to a shift in the
incidence of the burden. The cost of the accident to society as a whole does not reduce with
insurance. Besides this, when policy holders choose low levels of preventive measures, the
insurance company is forced to hike the premiums to cover the increase in expected claims. But
the premiums would not go down if policy holders chose higher levels of care. This is because the
insurance company has no information on the hidden actions of the policy holders and so does not
trust them. Given this, the policyholders will stick to low levels of preventive measures. In such a

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

situation of moral hazard, inefficiency in pricing emerges as unduly high premia have to be borne
by all policyholders.

3.3 Methods of Mitigating Moral Hazard

It is clear from the above discussion that in the presence of hidden actions of those who insure,
full insurance means too little care will be undertaken because the individuals don’t face the full
costs of their actions. In general, insurance companies will not want to offer the consumers
‘complete’ insurance. They will always want the consumer to face some part of the risk. This is
practiced by insurance companies through what is called co-insurance. Under this scheme, the
insurance company does not pay full value of the claim (or the cost of the accident). If the co-
insurance rate is 20% it means that the insurance company will pay 80% of the claim and the
individual will pay 20%. The higher the co-insurance rate, the larger the proportion of the cost or
claim to be borne by the policy holder, and thus, the greater the incentive to prevent it. The policy
holder is, thus, forced to take a higher level of preventive measures to ensure that his burden is
reduced.
Another instrument which used by insurance companies is called a ‘deductable’. This is a
scheme wherein the policy holder, in case of a claim, pays the in initial damages up to a certain
predetermined limit, above which the insurance company pays. For example, if the estimate of
damages is to the tune of Rs.2,50,000 and the deductable is Rs.60,000, the policy holder pays the
initial Rs.60,000 and the insurance company bears the rest of the cost of damages. If the damage
is to the extent of Rs.60,000, the policy holder pays the entire amount. This scheme also ensures
that the policy holder takes reasonable level of preventive measures so that the cash outflow does
not actually have to be borne by him/her.
While these measures do not prevent the problems associated with moral hazard, they
certainly reduce the intensity.

3.4 The Principal – Agent Problem

A principal-agent relationship exists whenever the principal (such as the owner) employs an agent
(such as a manager) to carry out what the principal wishes. Two sets of problems may arise in
such a relationship. First, the principal and the agent may have different and even conflicting
objectives. For instance, profit maximization may be the objective of the firm, but the manager
would be interested in enhancing and enriching his own compensation, which would work against
profit maximization by resulting in higher costs and reduction in profits. Second, the principal
cannot monitor the agent in a cost-effective manner. These two characteristics lead to a situation
of moral hazard.
Agency relationships are widespread; doctors serving as agents in hospital, managers
serving as agents in firms, managers serving as agents in real estate firms, etc., are some
examples.
The principal-agent problem is widely prevalent in private and public enterprises, since
most of these are controlled by the management. The managers’ objective is to increase cash,
thereby enabling them to enrich their compensation. However, there are certain markets forces
that keep the managers under control. One such force is the voice of the shareholders, which can
publicize the fact that profits are not being maximized. Another force is that of corporate control,

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

which sends the signal that poorly-managed companies will face takeover bids, which is a very
credible threat, and will make the managers perform. While public enterprises may not have
many of these market forces helping them, the government machinery does a part of the difficult
monitoring job – offices of account and budgets monitor the public sector enterprises. However,
despite this, the principal – agent problem still persists.
The principal’s concern is that they cannot observe the managers when they are not
performing, that is, when they shirk work. A manager shirks work because he prefers leisure to
work. The principal is concerned about this because there is an inverse relationship between
profits and shirking.
A flat salary to the manager is one of the prevailing forms of compensation. A flat salary
gives no incentive for not shirking. A manager can shirk work for the entire period that he was
supposed to work and yet get his salary. This form of compensation will ward off the principal-
agent problem only when shirking is observable. The principal can then fire the manager.
However, where shirking is unobservable, this form of compensation fails to address the
principal-agent problem.
This leads us to performance-based compensation schemes, wherein the owner may tie
up the managers’ salary to the profitability of the firm. One such scheme is one where the
manager is a residual claimant. This happens when his salary is arrived at by a formula, such as
salary = profits minus a fixed amount. The managers’ salary varies directly with the firm’s profits
and so he has an incentive to work towards profit maximization, which is in the interest of the
owners.
However, flat salary still remains popular because most salary earners do not see shirking
as equivalent to leisure. The residual-claimant model, despite being successful in addressing the
moral hazard issue, is not implemented universally because in this model the business risk is to be
borne entirely by the agent, while the owner has greater capability to bear the risk, and should at
least share the risk. Hence, this compensation model is not widely applied.

3.5 Moral Hazards in Product Markets

The problem of moral hazards has so far been discussed in the context of insurance markets. It is
a problem in product markets too with a category of goods called experience goods. In the case of
a movie, for instance, about which the movie maker has full information, a consumer gets to
know about it only after ‘experiencing’ the movie. In many markets, there is asymmetric
information on product quality, and firms actually cheat the consumers, and the consequence is
the same as that in the ‘lemons market’, wherein the bad quality goods drive out the good quality
goods. The producers of good quality goods and the consumers are interested in mitigating this
problem, and have responded in many different ways.

3.5.1 Brand Name Reputations

One of the most important market responses to the problems of moral hazards is the development
of brand name reputations. It is in the interest of the producer of good quality producers to let the
market know the goods’ quality. IBM, Toyota, McDonald’s, GE, and many others have sunk in

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

substantial investments over extended periods of time to establish a reputation and make
customers indulge in repeated purchases, with good quality being reinforced each time the good
is experienced. Once this is done, the firm cannot change the quality of the product, and buyers
are convinced that the manager will not do anything that will destroy the brand name reputation.
Brand name, therefore, gives an assurance to the buyer that the seller will maintain the quality of
the goods. Brand name, once successful, can be extended to the whole range of products sold by
the firm. Britannia, originally in confectionery business, has used the brand to sell its range of
dairy products; LG has extended its brand name from consumer durables to computers; Nestle has
extended its original hot chocolate brand to candy bars and cookies. In such extensions, the firm’s
reputation is the assurance it offers the consumers in order to ensure that it is providing a good
quality product.
The above mechanism will successfully substitute a full-information situation only when
the seller has the incentive to do so. A seller is forced not to deviate from quality because of the
threatened loss of reputation in the future. This would be an effective threat only if he is assured
of earning super-normal profits in the future due the reputation.
If the seller gets the price just equal to or marginally above the good-quality cost, he has
no incentive to maintain good quality. He would rather cheat by delivering low-quality products
to increase his present profits. The seller certainly requires a price much above the cost in the
future which, even when discounted to the present, results in a positive stream of profits.
However, the prevalence of a price much above the costs means inefficiency from society’s point
of view. Thus, while the problem of asymmetric information is overcome, it has been done at the
cost of efficiency in resource allocation.

3.5.2 Guarantees and Warrantees

Another popular response of sellers of good-quality products is to offer guarantees and

warrantees. The firm producing a good-quality product can sell its product for a higher price only
if it is able to convince the consumer that its brand of the product is more dependable. A firm by
offering guarantee/warrantee is signaling its willingness to take on the risk/burden of poor
quality. Taking on such a burden is a very costly proposition for a commodity of poor quality,
whereas for the producer of a good quality product, this burden or risk is low. Thus, a firm that
offers extended guarantee/warrantee schemes is conveying to the market that its product quality is
good.
While market responses are forthcoming to overcome the problem of asymmetric
information, they do not result in solutions that would have been arrived at if full information
prevailed, and do not make the markets more efficient in terms of price.

4. Summary
 Markets fail to perform when there is asymmetric information.
 Asymmetric information is a situation where one side in a transaction has more
information than the other side.
 The asymmetry in information can arise from a hidden action, an action that one side can
take, but which cannot be observed by the other side.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II
____________________________________________________________________________________________________

 In situations of hidden actions, it is likely that the more informed side will indulge in
wrong actions, leading to the problem of moral hazard.
 In the presence of moral hazards, the more informed side or the insured person tends to
undertake low levels of preventive care, leading to inefficiency in pricing.
 To cope up with the problem of moral hazard, insurance companies carry out different
practices in the form of co-insurance and deductable. This helps in reducing the intensity
of moral hazard.
 In situations of moral hazard, the parties get into contracts that provide incentives to the
informed party to not resort to hidden actions. This is the way the market overcomes
principal – agent problem.
 In product markets, the problem of asymmetric information is mitigated through a system
of guarantees and warrantees, and by using brand reputation as hostage.

BUSINESS PAPER No. 1: MICROECONOMIC ANALYSIS

ECONOMICS MODULE No. 35: ECONOMICS OF INFORMATION II