Micro Economics

Economic Schools of Thoughts Economic Schools of Thoughts are divided into three classes: 1. Schools of Political Economy (Ancient times – 1871 A.D.), 2. Neoclassical Schools (1871 A.D. – today), and 3. Alternative Schools.

1. Schools of Political Economy: Schools of Political Economy can be traced back from Ancient times to 1871 A.D. The Schools of Political Economy can be further divided into two:

(a) Pre-Classical Thoughts: The Pre-Classical Thoughts consist of the contributions made by the following: (i)

The Ancients and Scholastics, including the great Greek philosophers Aristotle and Xenophon, and the Islamic philosopher Ibn Khaldun

(ii)

The Salamanca School initiated by Francisco de Vitoria around 1536

(iii)

The First Economists

(iv)

Sir William Petty and the Mercantilists

(v)

Richard Cantillon, Jacques Turgot and the Enlightenment Economics

(vi)

François Quesnay and the Physiocrats

(vii)

David Hume and Scottish Enlightenment

(viii)

Giliani and the Italian Tradition, and

(ix)

Social philosophers and commentators

(b) Classical Thoughts: The classical thoughts consist of the contributions made by the following: (i)

Adam Smith

(ii) David Ricardo, John Stuart Mill and the Classical Ricardian School (iii)

T. Robert Malthus and British Anti-Classical Economists

(iv)

Jeremy Bentham and the Utilitarians

(v)

Jean-Baptiste Say and the French Liberal School

(vi)

Jules Dupuit and the French Engineers

(vii)

Continental Proto-Marginalists

(viii)

Karl Marx and the Marxian School

(ix)

The Bullionist Controversies

(x)

The Manchester School

(xi)

Piero Sraffa and the Neo-Ricardians

(xii)

The Neo-Marxians

2. Neoclassical Schools: Neoclassical Schools of thought starts from 1871 A.D. till today. Neoclassical Schools is further divided into two:

(a) Anglo-American Neoclassicism: consists of the contributions of the following: (i) W. Stanley Jevons and the Anglo-American Marginalists (ii)

John Bates Clark and the American Apologists

(iii)

Alfred Marshall and the Cambridge Neoclassicals

(iv) Lord Robbins and the London School of Economics. (v)

Frank H. Knight and the Chicago School

(vi)

Milton Friedman and the Monetarists

(vii)

Robert Lucas and the New Classicals

(viii)

New Institutionalist Schools

(b) Continental Neoclassicism: consists of the contributions made by the following: (i)

Léon Walras and the Lausanne School

(ii)

Carl Menger and the Austrian School

(iii)

Knut Wicksell and the Swedish School

(iv) Revival.

Paul Samuelson, John Hicks and the Paretian

(v)

The Vienna Colloquium

(vi)

Tjalling Koopmans and the Cowles Commission

(vii) Kenneth Arrow, Gérard Debreu and the NeoWalrasian General Equilibrium School (viii)

Robert Aumann and the Edgeworthian Revival

3. Alternative Schools: can be divided into two schools of thoughts:

(a) Heterodox Traditions: consist of the contributions by the following: (i) (ii) (iii) School

Utopians and Socialists The Fabian Socialists Gustav Schmoller and the German Historical

(iv)

The English Historical School

(v)

The French Historical School

(vi) School.

Thorstein Veblen and the American Institutionalist

(vii)

Joseph Schumpeter and Evolutionary Economics.

(viii) (ix) (x) Research.

The Soviet Planning Economists The Neo-Marxians/Radical Political Economy Economics at the New School for Social

(b) Keynesians: School of Thought initiated by John Maynard Keynes. He revolutionized economics with his classic book, ‘The General Theory of Employment, Interest and Money’ in 1936. This is generally regarded as probably the most influential social science treatise of the 20th Century, in that it quickly and permanently changed the way the world looked at the economy and the role of government in society. No other single book, before or since, has had quite such an impact. Following are the contributors followed and improved his theory: (i)

Joan Robinson and the Cambridge Keynesians

(ii) Franco Modigliani, James Tobin and the Neo-Keynesian Synthesis. (iii)

Abba Lerner and the American Post Keynesians

(iv) Robert Clower, Axel Leijonhufvud and Disequilibrium Keynesianism (v)

Joseph E. Stiglitz and the New Keynesians

(vi)

The Mandarins

François Quesnay & the Physiocrats François Quesnay Tableau François Quesnay (1694 – 1774), a French surgeon, born in Méré to a family of laborers. Quesnay was orphaned at thirteen. He learned to read from a household medical companion and quickly acquired a voracious appetite for more books and more learning. After a brief apprenticeship, some schooling at Saint-Côme, and marrying a Parisian grocer's daughter, Quesnay a huge step up in social status and became a surgeon in Mantes. Through his rapid self-

education and skills, he gradually climbed up and finally entered into the service of local aristocrats. He became physician in King Louis XV’s court and the leader of a sect of ‘enlightenment’ thinkers also known as ‘physiocrats’ and ‘économistes’. Quesnay's interest in economics arose in 1756, he was asked to contribute several articles on farming to the Encylopèdie of Diderot and d'Alembert. Quesnay delved into the works of the Maréchal de Vauban, Pierre de Boisguilbert and Richard Cantillon and, mixing all these ingredients together, Quesnay gradually came up with his famous economic theory. In 1758, Quesnay wrote his Tableau Économique -- renowned for its famous "zig-zag" depiction of income flows between economic sectors. It became the founding document of the Physiocratic sect -- and the ancestor of the multisectoral input-output systems of Marx, Sraffa and Leontief and modern general equilibrium theory. Quesnay’s Tableau set out three classes of society, and showed how transactions flowed between them. The three classes were: (a) landowners, (b) the farmers and farm-labourers, and (c) others, called ‘sterile class’ According to him, only the agricultural sector produced any surplus value, the rest only reproducing what it consumed. He anticipated Malthus’s fear of under consumption arising from excessive savings. Net income would be reduced if the flows in the Tableau were interrupted by delays in spending. This was the first attempt to construct a macroeconomic input-output model of the economy. In fact, progress in this field had to await the application of matrix algebra and computerization. Quesnay suggested a single tax, ‘l’impôt unique’, on the net income from land, arguing that the nation would thereby save tax-collecting costs. Only agriculture yielded a surplus, and therefore ultimately it bears all taxes anyway.

The Physiocrats The Physiocrats were a group of French Enlightenment thinkers of the 1760s led by the French court physician, François Quesnay. The founding document of Physiocratic doctrine was Quesnay's Tableau Économique (1759). The members of Physiocrats were Marquis de Mirabeau, Mercier de la Rivière, Dupont de Nemours, La Trosne, the Abbé Baudeau and others. To contemporaries, they were known simply as the économistes. The cornerstone of the Physiocratic doctrine was Quesnay's axiom that only agriculture yielded a surplus – known as ‘net product’. Manufacturing, the Physiocrats argued, took up as much value as inputs into production as it created in output, and consequently created no net product. Contrary to the

Mercantilists, the Physiocrats believed that the wealth of a nation lies not in its stocks of gold and silver, but rather in the size of its net product. French agriculture at the time was trapped in Medieval regulations which shackled enterprising farmers. The monopoly power of the merchant guilds in towns did not permit farmers to sell their output to the highest bidder and buy their inputs from cheapest source. An even bigger obstacle was the internal tariffs on the movement of grains between regions, which seriously hampered agricultural commerce. Public works essential for the agricultural sector, such as roads and drainage, remained in an awful state. Restrictions on the migration of agricultural laborers meant that a nation-wide labor market could not take shape. Farmers in productive areas of the country faced labor shortages and inflated wage costs, thus forcing them to scale down their activities. In unproductive areas, in contrast, masses of unemployed workers wallowing in penury kept wages too low and thus local farmers were not encouraged to implement any more productive agricultural techniques. It is at this point that the Physiocrats jumped into their laissez-faire attitude. They called for the removal of restrictions on internal trade and labor migration, the abolition of the corvée, the removal of state-sponsored monopolies and trading privileges, the dismantling of the guild system, etc. On fiscal matters, the Physiocrats famously pushed for their "single tax" on landed property -- l'impôt unique. According to Physiocrats, any tax levied throughout the economy will just passed from sector to sector until they fall upon the net product. As land is the only source of wealth, then the burden of all taxes ultimately bears down on the landowner. So instead of levying a complicated collection of scattered taxes (which are difficult to administer and can cause temporary distortions), it is most efficient to just go to the root and tax land rents directly. A general laissez-faire policy and the "single tax" were the speediest, least distortionary and least costly ways of arriving at the natural state. The Physiocrats believed that net product of the natural state was the maximum net product sustainable over the long run. The policy measures advocated by the Physiocrats went very much against the interests of the nobility and the landed gentry. But because Quesnay was the private physician to Madame de Pomapadour, the mistress of King Louis XV, the Physiocratic clique enjoyed a good degree of protection in the French court. The Physiocrats became so influential that even after the death of Pomapadour, they remain a furious publisher of different journals and articles that promote their ideas.

Equilibrium The term equilibrium has often to be used in economic analysis. In fact, Modern Economics is sometimes called equilibrium analysis. Equilibrium means a state

of balance. When forces acting in opposite directions are exactly equal, the object on which they are acting is said to be in a state of equilibrium.

Types of Equilibrium Basically, there are three types of any equilibrium: (a) Stable Equilibrium: There is stable equilibrium, when the object concerned, after having been disturbed, tends to resume its original position. Thus, in the case of a stable equilibrium, there is a tendency for the object to revert to the old position. (b) Unstable Equilibrium: On the other hand, the equilibrium is unstable when a slight disturbance evokes further disturbance, so that the original position is never restored. In this case, there is a tendency for the object to assume newer and newer positions once there is departure from the original position. (c) Neutral Equilibrium: It is neutral equilibrium when the disturbing forces neither bring it back to the original position nor do they drive it further away from it. It rests where it has been moved. Thus, in the case of a neutral equilibrium, the object assumes once for all a new position after the original position is disturbed.

When the word equilibrium is used to qualify the term value, then according to Professor Schumpeter, a stable equilibrium value is an equilibrium value that if changed by a small amount, calls into action forces that will tend to reproduce the old value; a neutral equilibrium value is an equilibrium value that does not know any such forces; and an unstable equilibrium value is an equilibrium value, change in which calls forth forces which tend to move the system farther and farther away from the equilibrium value. In the following figure 2, the stable equilibrium is shown. When in equilibrium at point P, the producer produces an output OM and maximises his profits. In case the producer increases his output to OM2 or decreases it to OM1, the size of profits is reduced. This automatically brings in forces that tend to establish equilibrium again at P.

Figure 3 represents the case of unstable equilibrium. Initially the producer is in equilibrium at point P, where MR = MC and he is maximising his profits. If now he increases his output to OM1, he would be in equilibrium output at point P1, where he will obtain higher profits, because, at this output, marginal revenue is greater than marginal cost. Thus there is no tendency to return to the original position at P. Figure 4 represents the situation of neutral equilibrium. In this case, MR = MC at all levels of output so that the producer has no tendency to return to the old position and every time a new equilibrium point is obtained, which is as good as the initial one.

Other Forms of Equilibrium (a) Short-term and Long-term Equilibrium: Equilibrium may be short-term equilibrium or long-term equilibrium as in case of short-term and long-term value.

In the short-term equilibrium, supply is adjusted to change in demand with the existing equipment or means of production, there being no time available to increase or decrease the factors of production. However, in case of long-term equilibrium, there is ample time to change even the equipment or the factors of production themselves, and a new factory can be erected or new machinery can be installed. (b) Partial Equilibrium: Partial equilibrium analysis is the analysis of an equilibrium position for a sector of the economy or for one or several partial groups of the economic unit corresponding to a particular set of data. This analysis excludes certain variables and relationship from the totality and studies only a few selected variables at a time. In other words, this method considers the changes in one or two variables keeping all others constant, i.e., ceteris paribus (others remaining the same). The ceteris paribus is the crux of partial equilibrium analysis. The equilibrium of a single consumer, a single producer, a single firm and a single industry are examples of partial equilibrium analysis. Marshall’s theory of value is a case of partial equilibrium analysis. If the Marshallian method (i.e., partial equilibrium analysis) is to be effective, even in its own terms, when applied to a hypothetical and idealised market, it necessary that the market should be small enough so that its inter-dependence with the rest of the hypothetical economy could be neglected without much loss of accuracy. (i) Consumer’s Equilibrium: With the application of partial equilibrium analysis, consumer’s equilibrium is indicated when he is getting maximum aggregate satisfaction from a given expenditure and in a given set of conditions relating to price and supply of the commodity. (ii) Producer’s Equilibrium: A producer is in equilibrium when he is able to maximise his aggregate net profit in the economic conditions in which he is working. (iii) Firm’s Equilibrium: A firm is said to be in long-run equilibrium when it has attained the optimum size when is ideal from the viewpoint of profit and utilisation of resources at its disposal. (iv) Industry’s Equilibrium: Equilibrium of an industry shows that there is no incentive for new firms to enter it or for the existing firms to leave it. This will happen when the marginal firm in the industry is making only normal profit, neither more nor less. In all these cases; those who have incentive to change it have no opportunity and those who have the opportunity have no incentive. (c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical economist, in his book ‘Elements of Pure Economics’, created his theoretical and

mathematical model of General Equilibrium as a means of integrating both the effects of demand and supply side forces in the whole economy. Walras’ Elements of Pure Economics provides a succession of models, each taking into account more aspects of a real economy. General equilibrium theory is a branch of theoretical microeconomics. The partial equilibrium analysis studies the relationship between only selected few variables, keeping others unchanged. Whereas the general equilibrium analysis enables us to study the behaviour of economic variables taking full account of the interaction between those variables and the rest of the economy. In partial equilibrium analysis, the determination of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant. General equilibrium is different from the aggregate or macro-economic equilibrium. General equilibrium tries to give an understanding of the whole economy using a bottom-top approach, starting with individual markets and agents. Whereas, the macro-economic equilibrium analysis utilises top-bottom approach, where the analysis starts with larger aggregates. In macro-economic equilibrium models, like Keynesian type, the entire system is described by relatively few, appropriately defined aggregates and functional relationships connecting aggregate variables such as total consumption expenditure, total investment, total employment, aggregate output and the like. In macro-economic analysis, many important variables and relationships tend to be disappeared in the process of aggregation. There are two major theorems presented by Kenneth Arrow and Gerard Debreu in the framework of general equilibrium: (i)

The first fundamental theorem is that every market equilibrium is Pareto optimal under certain conditions, and

(ii)

The second fundamental theorem is that every Pareto optimum is supported by a price system, again under certain conditions.

Uses of General Equilibrium 1. To get an overall picture of the economy and study the problems involving the economy as a whole or even large segments / sectors of it. 2. It shows that the quantities of demanded goods / factors are equal to the quantities supplied. Such a condition implies that there is a full employment of resources. 3. It also provides with an ideal datum of economic efficiency. It brings out the fact that long-run competitive equilibrium is a standard of efficiency for the entire economy. Only when the competitive economy obtains general

equilibrium shall its economic efficiency be at its peak and there shall be no further gains made by any reallocation of resources. 4. General equilibrium also represents the state of optimum production of all commodities, because there can be no over-production or underproduction under such conditions. 5. It also provides an insight into the way the multitudes of individual decisions are integrated by the working of the price mechanism. It, therefore, solves the fundamental problems of a free market economy, viz., what to produce, how to produce, how much to produce, etc. This analysis shows that such decisions with regard to innumerable consumers and producers are co-ordinated by the price mechanism. 6. The general equilibrium analysis also gives us the clue for predicting the consequences of an economic event. 7. It also helps in the field of public policy. The formulation of a logically consistent public policy requires a complete understanding of the various sector markets and aspects of individual decision-making units, and the impact of policy on the whole economy.

Limitations of General Equilibrium Analysis 1. The Walrasian general equilibrium system is essentially static. It treats the coefficient of production as fixed. It considers the supply of resources to be given and consistent. It also takes tastes and preferences of the society as fixed. 2. It ignores leads and lags, for it considers everything to happen instantaneously. It is supposed to work just in the same way as an electric circuit does. In the real world, all economic events have links with the past and the future. 3. Walrasian general equilibrium analysis is of little practical utility. It involves astronomical volumes of calculations for estimating the various quantities and practices. This makes its application practically impossible. Even the use of computers cannot be of much help because such a system cannot aid in collecting and recording the innumerable sets of prices and quantities that are required to formulate these equations. The critics further argue that even if such a solution exists, the price mechanism may not necessarily cover it. 4. Last but not least, the general equilibrium analysis falls to the ground as its star assumption of perfect competition is contrary to the actual conditions prevailing in the real world.

General Disequilibrium (Keynesian Theory) Neoclassical economics thinks in terms of a market system in which supply equals demand in every market, so that no unemployment could ever occur. But this is an assumption. Keynes suggests a market system in which Disequilibrium can occur in some markets, including labour market, and in which the disequilibrium can spread contagiously from one market to another. Keynes’ idea was that, when this spreading disequilibrium settles down, there would be a kind of equilibrium – not supply and demand equilibrium, but often termed as ‘general disequilibrium’. Take an example of a commodity, say cellular telephone sets, its equilibrium of demand and supply is shown in the following figure:

In the above figure, MC curve is the marginal cost curve for the commodity. Originally, the market is in equilibrium at price P1 with demand curve D1. Then, for any reason, demand for that commodity decreases to D2, Neoclassical economists tells us that the new equilibrium will be at price P3. But, in fact, the prices do not drop quite that far, instead, prices drop to P2. Perhaps this is because the businessmen do not know just how far they need to cut their prices, and are cautious to avoid cutting too much. At a price P2, the seller can sell only Qd amount of output. By producing Qd amount of output at price P2, the producers are not maximising their short-run profit. We have ‘disequilibrium’ in the sense that production is not on the marginal cost curve. At P2, the sellers can sell Qd amount of output, but they cannot produce the same amount of output. Here is a qualification. Producer might temporarily produce more that Qd, in order to build up their inventories. But there is a limit to how much inventories they want, so they will cut their production back to Qd eventually. With a reduction of demand for cellular phones, any economist would expect a reduction in the quantity of that commodity produced. Neoclassical economics

leads us to expect that the price would drop to P3 and output cut back to Qe. At the same time, a certain number of workers would be laid off and would switch their efforts into their second best alternatives, working in other industries, perhaps at somewhat lower wages. But the ‘disequilibrium model’ states that the production and layoffs would go even further, with output dropping to Qd. A reduction in income does not only reduce the demand for cellular phones, but it also reduces the demand for all other normal goods as well. This disequilibrium will spread contagiously through many different goods markets, through the effect of disequilibrium on income. So every other industry will face a reduction in demand because of the reductions in productions in many other industries.

Utility Theory In economics, utility is a measure of the happiness or satisfaction gained from a good or service. The concept is applied by economists in such topics as the indifference curve, which measures the combination of a basket of commodities that an individual or a community requests at a given level(s) of satisfaction. The concept is also used in utility functions, social welfare functions, Pareto maximization, Edgeworth boxes and contract curves. It is a central concept of welfare economics. The doctrine of utilitarianism saw the maximisation of utility as a moral criterion for the organisation of society. According to utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximise the total utility of individuals, aiming for 'the greatest happiness for the greatest number'. Utility theory assumes that humankind is rational. That is, people maximize their utility wherever possible. For instance, one would request more of a good if it is available and if one has the ability to acquire that amount, if this is the rational thing to do in the circumstances.

Cardinal and Ordinal Utility There are mainly two kinds of measurement of utility implemented by economists: cardinal utility and ordinal utility. Utility was originally viewed as a measurable quantity, so that it would be possible to measure the utility of each individual in the society with respect to each good available in the society, and to add these together to yield the total utility of all people with respect to all goods in the society. Society could then aim to maximise the total utility of all people in society, or equivalently the average utility per person. This conception of utility as a measurable quantity that could be aggregated across individuals is called cardinal utility. Cardinal utility quantitatively measures the preference of an individual towards a certain commodity. Numbers assigned to different goods or services can be compared. A utility of 100 units towards a cup of coffee is twice as desirable as a cup of tea with a utility level of 50 units.

The concept of cardinal utility suffers from the absence of an objective measure of utility when comparing the utility gained from consumption of a particular good by one individual as opposed to another individual.

For this reason, neoclassical economics abandoned utility as a foundation for the analysis of economic behaviour, in favour of an analysis based upon preferences. This led to the development of tools such as indifference curves to explain economic behaviour. In this analysis, an individual is observed to prefer one choice to another. Preferences can be ordered from most satisfying to least satisfying. Only the ordering is important: the magnitude of the numerical values are not important except in as much as they establish the order. A utility of 100 towards an ice cream is not twice as desirable as a utility of 50 towards candy. All that can be said is that ice cream is preferred to candy. There is no attempt to explain why one choice is preferred to another; hence no need for a quantitative concept of utility. It is nonetheless possible, given a set of preferences which satisfy certain criteria of reasonableness, to find a utility function that will explain these preferences. Such a utility function takes on higher values for choices that the individual prefers. Utility functions are a useful and widely used tool in modern economics. A utility function to describe an individual's set of preferences clearly is not unique. If the value of the utility function were to be, for e.g., doubled, squared, or subjected to any other strictly monotonically increasing function, it would still describe the same preferences. With this approach to utility, known as ordinal utility it is not possible to compare utility between individuals, or find the total utility for society as the Utilitarians hoped to do.

Price Determination under Monopoly Monopoly is that market form in which a single producer controls the whole supply of a single commodity which has no close substitute. From this definition there are two points that must be noted: (i)

(ii)

(i) Single Producer: There must be only one producer who may be an individual, a partnership firm or a joint stock company. Thus single firm constitutes the industry. The distinction between firm and industry disappears under conditions of monopoly. (ii) No Close Substitute: The commodity produced by the producer must have no closely competing substitutes, if he is to be called a monopolist. This ensures that there is no rival of the monopolist. Therefore, the cross elasticity of demand between the product of the monopolist and the product of any other producer must be very low.

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY:

A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further, in monopoly, since average revenue falls as more units of output are sold, the marginal revenue is less than the average revenue. In other words, under monopoly the MR curve lies below the AR curve. The Equilibrium level in monopoly is that level of output in which marginal revenue equals marginal cost. The producer will continue producer as long as marginal revenue exceeds the marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond this point the producer will stop producing. Y

MC

Revenue / Cost

AC

P’ L

P T

AR

E MR

O

M

X Output

It can be seen from the diagram that up till OM output, marginal revenue is greater than marginal cost, but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium at output OM where marginal revenue is equal to marginal cost and the profits are the greatest. The corresponding price in the diagram is MP’ or OP. It can be seen from the diagram at output OM, while MP’ is the average revenue, ML is the average cost, therefore, P’L is the profit per unit. Now the total profit is equal to P’L (profit per unit) multiply by OM (total output). In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop producing. In the long run, the monopolist can change the size of plant in response to a change in demand. In the long run, he will make adjustment in the amount of the factors, fixed and variable, so that MR equals not only to short run MC but also long run MC. COMPARISON OF PRICE DETERMINATION UNDER PERFECT COMPETITION AND MONOPOLY: The key points of comparison of price determination under Perfect Competition and Monopoly is as below: Perfect Competition

Monopoly

(i) The demand curve or average revenue curve is perfectly elastic and is a horizontal straight line.

(i) The demand curve or average revenue curve is relatively elastic and a downward sloping from left to right.

(ii) The firm is in equilibrium at the level of output where MC is equal to MR. Since in perfect competition MR is equal to AR or price, therefore, when MC is equal to MR, it is also equal to AR or price at the equlibrium position, i.e., MC=MR=AR (Price)

(ii) The firm is in equilibrium at the level of output where MC is equal to MR.

(iii) In equilibrium position, the price charged by the firm equals to MC.

(iii) In equilibrium position, the price charged by the firm is above MC.

(iv) The firm is in long-run equilibrium at the minimum point of the long-run AC curve.

(iv) The firm is in long-run equilibrium at the point where AC curve is still declining and has not reached the minimum point.

(v) The firm is in equilibrium at the level of (v) The firm is in equilibrium at the level of output at which MR curve is sloping output at which MC curve is rising, and is downwards, and MC curve is cutting it cutting MR curve from below. from below or above. (See figure 1)

(vi) In the long run, the firm is earning normal profit. There may be super normal profit in the short run but they will be swept away in the long run, as new firms entered into the industry.

(vi) The firm can earn abnormal or supernormal profit even in the long run, as there is no competitor in the industry.

(vii) Price can be set lower at greater output (vii) Price is set higher and output smaller in case of constant-cost and decreasing-cost by the monopolist. (See Figure 2) industries.

Y

Y MC P

P’

P AC

T

L

O

L

T MR

AC=MC

P’

AR

AR

MR

M

X

Equilibrium with rising MC

O

M

X

Equilibrium with constant MC

Y P L

P’ T

AC AR O

M

MC

MR

X

Equilibrium with falling MC Figure 1: Equilibrium with rising, constant & falling MC under Monopoly

MPS

Y D P’ P” P P”’

SRS

D’

E

S

D Q

LRS D

O

Y Price

M

M’

M”

S

D’ X

S MR

O

M

Output Equilibrium Position in a Decreasing Cost Industry under Perfect Equilibrium Competition

X

Output

Position under Monopoly

Figure 2: Comparison of Equilibrium Position between Perfect Competition & Monopoly

L

D

PRICE DISCRIMINATION IN MONOPOLY: Price discrimination may be (a) personal, (b) local, or (c) according to trade or use: (a) (a) Personal: It is personal when different prices are charged for different persons. (b) (b) Local: It is local when the price varies according to locality. (c) (c) According to Trade or Use: It is according to trade or use when different prices are charged for different uses to which the commodity is put, for example, electricity is supplied at cheaper rates for domestic than for commercial purposes. Some monopolists used product differentiation for price discrimination by means of special labels, wrappers, packing, etc. For example, the perfume manufacturers discriminate prices of the same fragrance by packing it with different labels or brands. Conditions of Price-Discrimination: There are three main types of situation: (a) (a) When consumers have certain preferences or prejudices. Certain consumers usually have the irrational feeling that they are paying higher prices for a good because it is of a better quality, although actually it may be of the same quality. Sometimes, the price differences may be so small that consumers do not consider it worthwhile to bother about such differences. (b) (b) When the nature of the good is such as makes it possible for the monopolist to charge different prices. This happens particularly when the good in question is a direct service. (c) (c) When consumers are separated by distance or tariff barriers. A good may be sold in one town for Re. 1 and in another town for Rs. 2. Similarly, the monopolist can charge higher prices in a city with greater distance or a country levying heavy import duty. Conditions making Price Discrimination Possible and Profitable: The following conditions are essential to make price discrimination possible and profitable: (a) (a) The elasticities of demand in different markets must be different. The market is divided into sub-markets. The sub-market will be arranged in ascending order of their elasticities, the higher price being charged in the least elastic market and vice versa. (b) (b) The costs incurred in dividing the market into sub-markets and keeping them separate should not be so large as to neutralise the difference in demand elasticities.

(c) (c) There should be complete agreement among the sellers otherwise the competitors will gain by selling in the dear market. (d) (d) When goods are sold on special orders because then the purchaser cannot know what is being charged from others. Price Determination under Price Discrimination: (i) (i) First of all, the monopolist divides his total market into sub-markets. In the following diagrams, the monopolist has divided his total market into two sub-markets, i.e., A and B: Market A

Y

Y

Price

Market B

Y

Price

MC

P1

P2

P”

P’ E’

E” MR’

O

Total Market

Price

M1 Output

AR’ X

O

AR” MR”

M2 Output

X

CMR O

M

X

Output

Price Discrimination in Monopoly (ii)

(ii) The monopolist has now to decide at what level of output he should produce. To achieve maximum profit, hence, he will be in equilibrium at output at which MR=MC, and MC curve cuts the MR curve from below. In the above diagram (c) it is shown that the equilibrium of the discriminating monopolist is established at output OM at which MC cuts CMR. The output OM is distributed between two markets in such a way that marginal revenue in each is equal to ME. Therefore, he will sell output OM 1 in Market A, because only at this output marginal revenue MR’ in Market A is equal to ME (M1E’ = ME). The same condition is applied in Market B where MR” is equal to ME (M2E” = ME). In the above diagram, it is also shown that in Market B in which elasticity of demand is greater, the price charged is lower than that in Market B where the elasticity of demand is less.

Price Determination under Oligopoly Oligopoly is that market situation in which the number of firms is small but each firm in the industry takes into consideration the reaction of the rival firms in the formulation of price policy. The number of firms in the industry may be two or more than two but not more than 20. Oligopoly differs from monopoly and monopolistic competition in this that in monopoly, there is a single seller; in monopolistic competition, there is quite a larger number of them; and in oligopoly, there are only a small number of sellers. CLASSIFICATION OF OLIGOPOLY:

The oligopolistic industries are classified in a number of ways: (a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further classified as below: (i) (i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical products it is called perfect or pure duopoly. (ii) (ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing differentiated products it is called imperfect or impure duopoly. (b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration the reactions of the rival firms in formulating its own price policy it is called oligopoly. Oligopoly is further classified as below: (i) (ii)

(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical products it is called perfect or pure oligopoly. (ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing differentiated products it is called imperfect or impure oligopoly.

Types of Market Structures Structure

Perfect competition

No. of Producers & Degree of Product Differentiation

Part of economy where prevalent

Many producers, Identical products

Financial markets, & Some agricultural products

Many producers, Many real or perceived differences in product

Retail trade (Gasoline, PCs, etc.)

Few producers, No differences in product.

Steel, chemicals, etc.

Few producers, Some differentiation of products

Autos, aircraft, etc.

Single producer, Product without close substitutes

Local telephone, electricity, and gas

Firm’s degree of control over price

Methods of Marketing

None

Market exchange or auction

Some

Advertising and Quality rivalry, Administered prices

Considerable but usually regulated

Advertising and Service promotion

Imperfect competition: Monopolistic competition

Oligopoly

Monopoly

CAUSES OF OLIGOPOLY: 1. Economies of Scale: The firms in the industry, with heavy investment, using improved technology and reaping economies of scale in production, sales, promotion, etc, will compete and stay in the market. 2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the big firms have ownership of patents or control of essential raw material used in the production of an output. The heavy expenditure on advertising by the oligopolistic industries may also be a financial barrier for the new firms to enter the industry. 3. Merger: If the few firms in the industry smell the danger of entry of new firms, they then immediately merge and formulate a joint policy in the pricing and production of the products. The joint action of the few big firms discourages the entry of new firms into the industry. 4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry, therefore, they keep a strict watch of the price charged by rival firms in the industry. The firm generally avoid price ware and try to create conditions of mutual interdependence. CHARACTERISTICS OF OLIGOPOLY: 1. 1. Every seller can exercise an important influence on the price-output policies of his rivals. Every seller is so influential that his rivals cannot ignore the likely adverse effect on them of a given change in the price-output policy of any single manufacturer. The rival consciousness or the recognition on the part of the seller is because of the fact of interdependence. 2. 2. The demand curve under oligopoly is indeterminate because any step taken by his rivals may change the demand curve. It is more elastic than under simple monopoly and not perfectly elastic as under perfect competition. 3. 3. It is often noticed that there is stability in price under oligopoly. This is because the oligopolist avoids experimenting with price changes. He knows that if raises the price, he will lose his customers and if he lowers it he will invite his rivals to price war. EFFECTS OF OLIGOPOLY: 1. 1. Small output and high prices: As compared with perfect competition, oligopolist sets the prices at higher level and output at low level. 2. 2. Restriction on the entry: Like monopoly, there is a restriction on the entry of new firms in an oligopolistic industry. 3. 3. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at the level higher than the AC. The consumers have to pay more than it is necessary to retain the resources in the industry. In other words, the economy’s productive capacity is not utilised in conformity with the consumers’ preferences. 4. 4. Lower efficiency: Some economists argued that there is a low level of production efficiency in oligopoly. There is no tendency for the oligopolists to build optimum scales of plant and operate them at the optimum rates of output. However, the Schumpeterian hypothesis states that there is high tendency of innovation and technological advancement in oligopolistic industries. As a result, the product cost decreases with production capacity enhancement. It will offset the loss of consumer surplus from too high prices. 5. 5. Selling Costs: In order to snatch markets from their rivals, the oligopolistic firms may engage in aggressive and extensive sales promotion effort by means of advertisement and by changing the design and improving the quality of their products. 6. 6. Wider range of products: As compared with pure monopoly or pure competition, differentiated oligopoly places at the consumers’ disposal a wider variety of commodities. 7. 7. Welfare Effect: Under oligopoly, vide sums of money are poured into sales promotion to create quality and design differentiations. Hence, from the point of view of economic welfare, oligopoly fares fairly badly. The oligopolists push non-price competition beyond socially desirable limits. PRICE DETERMINATION UNDER OLIGOPOLY: The price and output behaviour of the firms operating in oligopolistic or duopolistic market condition can be studied under two main heads: 1. Price and Output Determination under Duopoly:

(a) (a) If an industry is composed of two giant firms each selling identical or homogenous products and having half of the total market, the price and output policy of each is likely to affect the other appreciably, therefore there is every likelihood of collusion between the two firms. The firms may agree on a price, or divide the total market, or assign quota, or merge themselves into one unit and form a monopoly or try to differentiate their products or accept the price fixed by the leader firm, etc. (b) (b) In case of perfect substitutes the two firms may be engaged in price competition. The firm having lower costs, better goodwill and clientele will drive the rival firm out of the market and then establish a monopoly. (c) (c) If the products of the duopolists are differentiated, each firm will have a close watch on the actions of its rival firms. The firm good quality product with lesser cost will earn abnormal profits. Each firm will fix the price of the commodity and expand output in accordance with the demand of the commodity in the market. 2. Price and Output Determination under Oligopoly: (a) (a) If an industry is composed of few firms each selling identical or homogenous products and having powerful influence on the total market, the price and output policy of each is likely to affect the other appreciably, therefore they will try to promote collusion. (b) (b) In case there is product differentiation, an oligopolist can raise or lower his price without any fear of losing customers or of immediate reactions from his rivals. However, keen rivalry among them may create condition of monopolistic competition. There is no single theory which satisfactorily explains the oligopoly behaviour regarding price and output in the market. There are set of theories like Cournot Duopoly Model, Bertrand Duopoly Model, the Chamberlin Model, the Kinked Demand Curve Model, the Centralised Cartel Model, Price Leadership Model, etc., which have been developed on particular set of assumptions about the reaction of other firms to the action of the firm under study. COLLUSIVE OLIGOPOLY: The degree of imperfect competition in a market is influenced not just by the number and size of firms but by how they behave. When only a few firms operate in a market, they see what their rivals are doing and react. ‘Strategic interaction’ is a term that describes how each firm’s business strategy depends upon its rivals’ business behaviour. When there are only a small number of firms in a market, they have a choice between ‘cooperative’ and ‘noncooperative’ behaviour: • •

Firms act non-cooperatively when they act on their own without any explicit or implicit agreement with other firms. That’s what produces ‘price wars’. Firms operate in a cooperative mode when they try to minimise competition between them. When firms in an oligopoly actively cooperate with each other, they engage in ‘collusion’. Collusion is an oligopolistic situation in which two or more firms jointly set their prices or outputs, divide the market among them, or make other business decisions jointly.

A ‘cartel’ is an organisation of independent firms, producing similar products, which work together to raise prices and restrict output. It is strictly illegal in Pakistan and most countries of the world for companies to collude by jointly setting prices or dividing markets. Nonetheless, firms are often tempted to engage in ‘tacit Y collusion’, which occurs when they refrain from competition without explicit agreements. When firms tacitly Da Price MC collude, they often quote identical (high) prices, pushing up profits and decreasing the risk of doing business. The rewards of collusion, when it is successful, can be great. It is more illustrated in the following diagram: AC

G P

E

T MR O

Q

Da X

Quantity

Equilibrium under Collusive Oligopoly

The above diagram illustrates the situation of oligopolist A and his demand curve DaDa assuming that the other firms all follow firm A’s lead in raising and lowering prices. Thus the firm’s demand curve has the same elasticity as the industry’s DD curve. The optimum price for the collusive oligopolist is shown at point G on DaDa just above point E. This price is identical to the monopoly price, it is well above marginal cost and earns the colluding oligopolists a handsome monopoly profit. PRICE DETERMINATION MODELS OF OLIGOPOLY: 1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive oligopolistic industries there are not frequent changes in the market prices of the products. The demand curve is drawn on the assumption that the kink in the curve is always at the ruling price. The reason is that a firm in the market supplies a significant share of the product and has a powerful influence in the prevailing price of the commodity. Under oligopoly, a firm has two choices: (a) (a) The first choice is that the firm increases the price of the product. Each firm in the industry is fully aware of the fact that if it increases the price of the product, it will lose most of its customers to its rival. In such a case, the upper part of demand curve is more elastic than the part of the curve lying below the kink. (b) (b) The second option for the firm is to decrease the price. In case the firm lowers the price, its total sales will increase, but it cannot push up its sales very much because the rival firms also follow suit with a price cut. If the rival firms make larger price cut than the one which initiated it, the firm which first started the price cut will suffer a lot and may finish up with decreased sales. The oligopolists, therefore avoid cutting price, and try to sell their products at the prevailing market price. These firms, however, compete with one another on the basis of quality, product design, after-sales services, advertising, discounts, gifts, warrantees, special offers, etc. Y D

Price

MR P MC

P’ T MC O

D S N

X

Output

The Kinky Demand Curve MR

In the above diagram, we shall notice that there is a discontinuity in the marginal revenue curve just below the point corresponding to the kink. During this discontinuity the marginal cost curve is drawn. This is because of the fact that the firm is in equilibrium at output ON where the MC curve is intersecting the MR curve from below. The kinky demand curve is further explained in the following diagram:

Present Price

Y Price 12 – 10 –

D B

8– 6– 4–

D’

2– 0 20 40 60 80 100 120 140 160 180

X

Output

In the above diagram, the demand curve is made up of two segments DB and BD’. The demand curve is kinked at point B. When the price is Rs. 10 per unit, a firm sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it loses a large part of the market and its sales come down to 40 units with a loss of 80 units. In case, the producer lowers the price to Rs. 4 per unit, its competitors in the industry will match the price cut. Its sales with a big price cut of Rs. 6 increases the sale by only 40 units. The firm does not gain as its total revenue decreases with the price cut. 2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader and fixes the price of the product for the entire industry. The other firms in the industry simply follow the price leader and accept the price fixed by him and adjust their output to this price. The price leader is generally a very large or dominant firm or a firm with the lowest cost of production. It often happens that price leadership is established as a result of price war in which one firm emerges as the winner. In oligopolistic market situation, it is very rare that prices are set independently and there is usually some understanding among the oligopolists operating in the industry. This agreement may be either tacit or explicit. Types of Price Leadership: There are several types of price leadership. The following are the principal types: (a) (a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product of the industry. It sets the price and rest of the firms simply accepts this price. (b) (b) Barometric price leadership, i.e., the price leadership of an old, experienced and the largest firm assumes the role of a leader, but undertakes also to protect the interest of all firms instead of promoting its own interests as in the case of price leadership of a dominant firm. (c) (c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the market by following aggressive price leadership. It compels other firms to follow it and accept the price fixed by it. In case the other firms show any independence, this firm threatens them and coerces them to follow its leadership. Price Determination under Price Leadership: There are various models concerning price-output determination under price leadership on the basis of certain assumptions regarding the behaviour of the price leader and his followers. In the following case, there are few assumptions for determining price-output level under price leadership: (a) (a) There are only two firms A and B and firm A has a lower cost of production than the firm B. (b) (b) The product is homogenous or identical so that the customers are indifferent as between the firms. (c) (c) Both A and B have equal share in the market, i.e., they are facing the same demand curve which will be the half of the total demand curve. Price &

Y

D

MCb

Cost

K P L

MCa

F E

D MR

O

N M Quantity

X

In the above diagram, MCa is the marginal cost curve of firm A and MCb is the marginal cost curve of firm B. Since we have assumed that the firm A has a lower cost of production than the firm B, therefore, the MCa is drawn below MCb. Now let us take the firm A first, firm A will be maximising its profit by selling OM level of output at price MP, because at output OM the firm A will be in equilibrium as its marginal cost is equal to marginal revenue at point E. Whereas the firm B will be in equilibrium at point F, selling ON level of output at price NK, which is higher than the price MP. Two firms have to charge the same price in order to survive in the industry. Therefore, the firm B has to accept and follow the price set by firm A. This shows that firm A is the price leader and firm B is the follower. Since the demand curve faced by both firms is the same, therefore, the firm B will produce OM level of output instead of ON. Since the marginal cost of firm B is greater than the marginal cost of firm A, therefore, the profit earned by firm B will be lesser than the profit earned by firm A. Difficulties of Price Leadership: The following are the challenges faced by a price leader: (a) (a) It is difficult for a price leader to correctly assess the reactions of his followers. (b) (b) The rival firms may secretly charge lower prices when they find that the leader charged unduly high prices. Such price cutting devices are rebates, favourable credit terms, money back guarantees, after delivery free services, easy instalment sales, etc. (c) (c) The rivals may indulge in non-price competition. Such non-price competition devices are heavy advertisement and sales promotion. (d) (d) The high price set by the price leader may also attract new entrants into the industry and these new entrants may not accept his leadership. ECONOMIC COSTS OF IMPERFECT COMPETITION AND OLIGOPOLY: (a) (a) The cost of inflated prices and insufficient output: The monopolist, by keeping the output a little scarce, raises its price above marginal cost. Hence, the society does not get as much of the monopolist’s output as it wants in terms of product’s marginal cost and marginal value. The same is true for oligopoly and monopolistic competition. (b) (b) Measuring the waste from imperfect competition: Monopolists cause economic waste by restricting output. If the industry could be competitive, then the equilibrium would be reached at the point where MC = P at point E. Under perfect competition, this industry’s quantity would be 6 with a price of 100. The monopolist would set its MC equal to MR (not to P), displacing the equilibrium to Q = 3 and P = 150. The GBAF is the monopolist’s profit, which compares with a zero-profit competitive equilibrium. Economists measure the economic harm from insufficiency in terms of the deadweight loss; this term signifies the loss in real income that arises because of monopoly, tariffs and quotas, taxes, or other distortions. The efficiency loss is the vertical distance between the demand curve and the MC curve. The total deadweight loss from the monopolist’s output restriction is the sum of all such losses represented by theYgrey D triangle ABE: Prices, MC, AC

Deadweight Loss

200 150 G (P’) F 100

B MC = AC E A

50

D

MR 0

2 (Q’) 4

6

8

X

Output

The Economic Waste cause by the Monopolist

In the above diagram, DD curve represents the consumers’ marginal utility at each level of output, while the MC curve represents the opportunity cost of the devoting production to this good rather than to other industries. For example, at Q = 3, the vertical difference between B and A represents the utility that would be gained from a small increase to the output of Q. Adding up all the lost social utility from Q = 3 to Q = 6 gives the shaded region ABE. EMPIRICAL STUDIES OF COSTS OF MONOPOLY: 1. 1. Economists have studied impact of the overall costs of imperfect competition to an economy. These studies estimate the deadweight loss of consumer surplus in ABE for all industries. Early studies set the total deadweight loss from monopoly at less than 0.1% of US GDP. Now, in modern days, it would total only about $7 billion. 2. 2. The next important reservation about this approach is that it ignores the impact of market structure upon technological advance or ‘dynamic efficiency’. But according to Schumpeterian hypothesis, imperfect competition actually promotes the invention and technological advances which offset the efficiency loss from too high prices. 3. 3. Some skeptical economists retort that monopolists mainly promote the quiet life, poor quality and uncivil service. Indeed, a common complaint about companies with a dominant market position is that they pay little attention to quality of product. 4. 4. Most people object to imperfect competition on the grounds that monopolists may be earning supernormal profits and enriching themselves at the expense of hapless consumers. INTERVENTION STRATEGIES: According to a Nobel Prize winner Milton Friedman, basically there are three choices – private unregulated monopoly, private monopoly regulated by the government, or the government operation. In most market economies of the world, the monopolists are regulated by the State. There are several methods and tools for controlling the power misuse by monopolistic and oligopolistic firms: 1. Anti-trust Policy: Anti-trust policies are laws that prohibit certain kinds of behaviour (such as firm’s joining together to fix prices) or curb certain market structures (such as pure monopolies and highly concentrated oligopolies). 2. Encouraging Competition: Most generally, anticompetitive abuses can be avoided by encouraging competition whenever possible. There are many government policies that can promote vigorous rivalry even among large firms. In particular, it is crucial to keep the barriers to entry low. 3. Economic Regulations: Economic regulation allows specialised regulatory agencies to oversee the prices, outputs, entry, and exit of firms in regulated industries such as public utilities and transportation. Unlike antitrust policies, which tell businesses what not to do, regulation tells businesses what to do and how to do. 4. Government Ownership of Monopolies: Government ownership of monopolies has been an approach widely used. In recent years, many governments have privatised industries that were in former times public enterprises, and encouraged other firms to enter for competition. 5. Price Control: Price control on most goods and services has been used in wartime, partly as a way of containing inflation, partly as a way of keeping down prices in concentrated industries. 6. Taxes: Taxes have sometimes been used to alleviate the income-distribution effects. By taxing monopolies, a government can reduce monopoly profits, thereby softening some of the socially unacceptable effects of monopoly. Game Theory

GAME THEORY AND OLIGOPOLY BEHAVIOUR: Game theory analyses the way that two or more players or parties choose actions or strategies that jointly affect each participant. In other words, game theory determines rational behaviour of players whose interests are mutually dependent on one another’s decision. Its objective is to find mathematically complete principles which define rational behaviour for the participants in a social economy, or to derive from them the general characteristics of that behaviour. The theory was developed by John von Neumann (1903-1957), who was a Hungarian born mathematician. By game we mean any situation in which the interests of the participants conflict. While taking decision each party must consider what probably will be the decision of the other so that he may make a choice most profitable to himself. This what usually happens in a game of chess or cards. This is applicable to situations arising in an oligopoly. There are two common games, i.e., constant-sum game and zero-sum game: • •

Constant-Sum Game: is the game in which the participants take share of the total gain. Zero-Sum Game: is the game in which the winnings of one are matched exactly by the losses of the other.

In the following example, the dynamics of price-cutting will be analysed, so lets the game begin! Suppose there are two rival firms in an industry, viz., Berney & Max: At present the Berney’s Motto: “We will not be undersold” Currently, the Max’s Motto: “We sell for 10% less” Y

Max’s Berney’s matching

Price

Max’ s

O

Berney’s Price

X

In the above diagram, the vertical arrows show Max’s price cuts; the horizontal arrows show Berney’s responding strategy of matching each price cut. By tracing through the pattern of reaction and counter-reaction, you can see that this kind of rivalry will end in mutual ruin at a zero price. Because the only price compatible with both strategies is a price of zero; 90 percent of zero is zero. If one party cut the price, the other party will match the price cuts, and it will continue until the price of zero is attained. Now the Berney will start ‘what-if’ analysis. What Max will do if Berney charge price A, price B, and so forth. The novel element in the duopoly game is that the firm’s profits will depend on the rival’s strategy as well as on its own. The useful tool for representing the interaction between two players is a two-way ‘payoff table’. A payoff table is a means of showing the strategies and the payoffs of a game between two players. In the payoff table, a firm can choose between the strategies listed in its rows or columns. For example, Max can choose between its two columns and Berney can choose between its two rows. In this example, each firm decides whether to charge its Max’s Price normal price or to start a price war by choosing a low price: A Normal Price *

Price War

Rs. 10 B

Normal Price * Rs. 10

Price War

– Rs. 100

– Rs. 100

A Payoff Table for a Price War

* Normal price strategy is the dominant price strategy. The above payoff table shows the price war game between Berney and Max. The amounts in rupees inside the cells show the payoffs of the two firms; that is, these are the profits earned by each firm for each of the four outcomes. The lower left amount shows the payoff to the player on the left, i.e., Berney; the upper right shows the payoff to the player at the top, i.e., Max. Just like Max, Berney has two choices, i.e., either to opt for normal price or go for a price war. In cell C, the Berney plays normal price and Max plays price war. The result is that Berney has a profit of – Rs. 100 while Max has a profit of – Rs. 10. Thinking through the best strategies for each player leads to the dominant equilibrium in cell A, where both the players avoid price war. Dominant Strategy: The simplest strategy in game theory is ‘dominant strategy’. This situation arises when one player has a best strategy no matter what strategy the other player follows. The firm’s best price strategy is to follow normal price. In the above case, charging the normal price is a dominant strategy for both firms in the ‘price-war game’. When both or all players have a dominant strategy, the outcome is said to be ‘dominant equilibrium’ because each player is having its own dominant strategy. Nash Equilibrium: This theory presented by a mathematician John Nash. Nash equilibrium applies to the situation when all the participants in a game are each pursuing their best possible strategy in the knowledge of the strategies of all other participants. For example, imagine a two-person country where both the people have to decide the side of the road on which to drive. The payoffs are as follows: (i) No crash: happens when both drive on the left or right. It is Nash equilibrium. There are two possible Nash equilibria, i.e., either both driving on the left, or both driving on the right. (ii) Crash: happens when one drives on the left and the other drives on the right. If one drives on the left and the other drives on right, it is not Nash equilibrium because, given the choice of the other, each would change their own policy. Now take our previous example of Bernie and Max. Suppose each firm considers whether to have its normal price or to raise its price toward the monopoly price and try to earn monopoly profits. It is a rivalry game, which is shown in the following diagram: Max’s Price

A

High Price Normal Price *

Rs. 100 B

High Price

Rs. 200

Normal Price *

Rs. 150

– Rs. 20

A Payoff Table showing Rivalry Game

In the above game, it is shown that the firms can stay at their normal price equilibrium that we found in the price-war game, or they can try to raise their price to earn some monopoly profits. Cell A: Each firm follows high price strategy and both firms have the highest joint profit of Rs. 300. It is the situation where both the firms behave like a monopolist for having high prices.

Cell D: Each firm follows normal price strategy and both firms have the lowest joint profit of Rs. 20. It is the situation of normal price equilibrium that we found in the price-war game. Cell C: Max follows a high price strategy but Burney undercuts. So Burney takes most of the market and has the highest profit of any situation, while Max actually loses money. Cell B: Berney gambles on high price, but Max’s normal price means a loss for Berney. Conclusion: In the above example of the rivalry game, Berney has a dominant strategy; it will profit more by choosing a normal price no matter what Max does. On the other hand, Max does not have a dominant strategy because Max would want to play normal if Berney plays normal and would want to play high if Berney plays high. In the above game, the best policy for Max is to play normal price. This situation illustrates the basic rule of basing your strategy on the assumptions that your opponent will act in his or her best interest. This is Nash equilibrium. Nash equilibrium is one in which no player can improve his or her payoff given the other player’s strategy. The Nash equilibrium is also sometimes called ‘non-cooperative equilibrium’, because each party chooses its strategy without collusion or cooperation, choosing that strategy which is best for itself, without regard for the welfare of society or any other party. EXAMPLES OF GAME THEORY: To Collude or Not to Collude: (a) (a) The duopolists may decide to collude, which means that they will behave in a cooperative manner. A cooperative equilibrium comes when the parties act in unison to find strategies that will benefit their joint payoffs. They may decide to form a cartel, setting a high price and dividing all profit equally between the firms. Clearly this will benefit the duopolists at the expense of consumers. (b) (b) If the cooperative equilibrium is not possible, the firms would quickly gravitate to the noncooperative or Nash equilibrium. This is also known as a ‘perfectly competitive equilibrium’ because each firm and consumer makes decisions by taking the prices of everyone else as given. In this equilibrium, each firm maximises profits and each consumer maximises utility leading to zero-profit outcome in which price equals marginal cost. According to Adam Smith, there is an invisible hand that makes perfectly competitive equilibrium socially efficient, even though each person is behaving in a non-cooperative manner. By contrast, if some parties were to cooperate and decide to move to the monopoly price, the efficiency of the economy would suffer. That is why governments intervene to enforce antitrust laws that contain harsh penalties for those who collude to fix prices or divide up the markets. The Pollution Game: In many circumstances, non-cooperative behaviour leads to economic inefficiency or social misery. One notable example is the arms race, where non-cooperative behaviour between the United States and the (former) Soviet Union, and Pakistan and India led to massive military spending and development of weapons of mass destruction, makes the continents unsafe. Another example of pollution game is shown in payoff table as follows: US Steel Low Pollution

A

Low Pollution High Pollution *

* Nash equilibrium

Rs. 100

Rs. 100 B

High Pollution *

Rs. 120

– Rs. 30

A Payoff Table showing Non-cooperative behaviour leads to more Pollution

In the above diagram, an example of two steel manufacturing concerns, namely, US Steel and Oxy Steel, operating in the United States is taken. In this world of unregulated firms, each individual profit-maximising firm would prefer to pollute the earth’s environment rather than install expensive pollution-control equipment.

In such a world, if a firm behaves altruistically and cleans up its wastes, that firm will have higher production costs, higher prices, and fewer customers. If the costs are high enough, the firm may even go bankrupt. This is a situation in which the Nash equilibrium is inefficient. When markets or decentralised equilibria become dangerously inefficient, governments may step in. By setting efficient regulations or emissions charges, government can induce firms to move to outcome A, the Low pollute/Low pollute world. In that equilibrium, the firms make the same profit as in the high-pollution world, and the earth is a healthier place to live in. Monetary-Fiscal Game: The game theory is also important to understanding a nation’s economic policies. Economists and politicians have argued that monetary policy and fiscal policy are skewed in an undesirable direction; fiscal deficits are too high and reduce national saving, while monetary policy produces interest rates that retard investments. It is customary in a modern economy to separate monetary and fiscal functions. A country’s central bank determines the monetary policy – interest rates, and the fiscal policy – taxes and spending – is determined by the executive and legislative branches. But the monetary and fiscal authorities have different objectives. The central bank takes a stance that emphasises austerity and low inflation. The fiscal authorities worry about full employment, popularity, keeping taxes low, preserving spending programs, and getting re-elected. Thus they pick high deficits. The central bank wants minimise the inflation and chooses high interest rates. Thus the outcome is the non-cooperative equilibrium between fiscal authorities and monetary policy makers at cell C: Fiscal Policy

High Deficits * Low Deficits †

A • • • B • • •

High Deficits *

Low Deficits †

Very low unemployment Very high inflation Moderate investment Moderate unemployment Moderate inflation High investment

C

* Nash equilibrium † Cooperative equilibrium

A Payoff Table showing the Monetary-Fiscal Game

Perhaps the best strategy of monetary fiscal game is to lower the deficits, lower interest rates and raise investment, which was adopted by President Bill Clinton for the survival of US economy