Haramaya University Lecture Notes on Microeconomics II (Econ2022)

CHAPTER ONE

MONOPOLISTICALLY COMPETITIVE MARKET

Monopolistically competitive market is a kind of market which is practically available and

operating in real world. The model of monopolistic competition assumes a large number of
firms. It also assumes easy entry and exit. As the name implies, monopolistic competition is
a blend of competition and monopoly. The competitive element arises because there are
many sellers, each of which is too small to affect the other sellers. Firms can also enter and
leave a monopolistically competitive industry. The monopolistic element arises from
product differentiation. That is, since the product of each seller is similar but not identical,
each seller has a monopoly power over the specific product it sells. This monopoly power,
however, is severely limited by the existence of close substitutes. The common features of
monopolistic competition are

a. There are many sellers and many buyers in a given market: however, the number of
sellers and buyers are not too much large as perfectly competitive market. The
implication of this characteristic is that no firm can influence the market based on size
alone.

b. Similar products: This model differs from the model of perfect competition in one key
respect: it assumes that the goods and services produced by firms are differentiated. This
differentiation may occur by virtue of advertising, convenience of location, product
quality, reputation of the seller, or other factors. Product differentiation gives firms
producing a particular product some degree of price-setting or monopoly power.
However, because of the availability of close substitutes, the price-setting power of
monopolistically competitive firms is quite limited. Because of this heterogeneity or
product differentiation firms under monopolistic competition cannot be called an
industry. Rather, they form a product group. This is because their products are
somewhat dissimilar and not homogenous as is the case under competitive industry.

c. There is free entry and exit in the product group: When one monopolistically
competitive firm is quite profitable, we may expect that other firms will enter and set-up
business producing similar products. Moreover, the established firms may change the
characteristic the products they produce, to make those products more similar to the

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successful one. If firms lose money and make negative economic profits, then some
firms will drop out of the product group one by one.

d. The goal of the firm is profit maximization: The goal of all market is to maximize
profit or minimize loss. This will be attained where the gap between TR and TC is
maximum or where MR is equal to MC.

Restaurants are a monopolistically competitive sector; in most areas there are many firms,
each is different, and entry and exit are very easy. Each restaurant has many close substitutes
these may include other restaurants’, fast-foods, burger, pizza, or ketefo. Other industries that
engage in monopolistic competition include retail stores, barber and beauty shops, auto-repair
shops, taxis, buses (1st level, 2nd level and 3rd level), shops, and etc.

1.1. Product Differentiation, Demand Curve and Costs of the Firm

Product differentiation may be attributed to:

 Subjective judgment of the consumer,
 Quality and durability of the product,
 Characteristics (taste, color, and design) of the product,
 Sales promotion, packaging, trademarks, etc.

Product differentiation is generally intended to distinguish the product of one producer from
that of the others in the product group. It can be real or fancied.

Real differentiation: it is when the inherent characteristics of the product are different or
exists when there are differences in the specification of the products or differences in the
factor inputs, or the location of the firm that determines the convenience with which the
product is accessible to the consumer, or the services offered by the producer.

Fancied (spurious/imaginary) differentiation: exists when the products are basically the
same but the consumer is persuaded, via advertising or other selling activities, that the
products are different. It is established by advertising, difference in packaging, difference in
design, or simply by brand name.
Whatever the case, the aim of product differentiation is to make the product unique in the
mind of the consumer. The effect of product differentiation is that the producer has some
power in the determination of price. The firm is not a price-taker but faces the keen

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competition of close substitutes offered by other firms. Hence, product differentiation gives
rise to a negatively sloping demand curve. This demand curve is less than perfectly
competitive.

Figure 1. Monopolistic competitive demand curve

If the firm increases its price, it will lose some, but not all of its customers. Thus the
demand is very flat. The demand curve will shift if;
a. The style, service associated with the product like service delivery, or the selling
strategy of the firm changes.
b. Competitors change their price, output, services or selling policies
c. Taste, income, price or selling policies of products from other industries change.

Costs in a monopolistically competitive market are assumed to behave just like the case in a
perfectly competitive market. The AVC, MC and ATC curves are all U-shaped implying
that there is only a single level of output which can be optimally produced. The only
difference in monopolistically completion as long as costs are concerned is the inclusion of
selling costs. The recognition of product differentiation provides the rationale for the selling
expenses incurred by the firm. He also argued that the selling-costs curve is U-shaped, i.e.,
there are economies and diseconomies of scale of advertising as output changes. The U-
shaped selling cost, added to the U-shaped production costs, yields a U-shaped ATC curve.

The Concept of Industry and Product Group

Product differentiation creates difficulties in the analytical treatment of the industry.

Heterogeneous products cannot be added to form the market demand and supply schedules

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as in the case of homogeneous products. Further, we do not have a single equilibrium price
for the differentiated products, but a cluster of prices.

Under perfect competition, industry was defined as a collection of firms producing identical
(homogeneous) products. But when products are differentiated one cannot define an
industry in this narrow sense. Nonetheless, we can usefully lump together firms producing
very closely related commodities and refer to them as a ‘product group’.

1.2. Profit Maximization

Suppose a restaurant raises its prices slightly above those of similar restaurants with which it
competes. Will it have any customers? Probably. Because the restaurant is different from
other restaurants, some people will continue to patronize it. Within limits, then, the restaurant
can set its own prices; it does not take the market prices as given. In this section, we examine
how a monopolistically competitive firm determines its best level of output and price in the
short run and long run on the assumption that the firm has already decided on the
characteristics of the product to produce and on the selling expenses to incur.

A. Short run equilibrium of the firm

Because a monopolistically competitive firm faces a downward-sloping demand curve, its

marginal revenue curve is a downward sloping line that lies below the demand curve, as in
the monopoly model. However, the demand curve is more elastic than monopoly model. In
the short run, the monopolistically competitive firm faces limited competition. There are
other firms that sell products that are good substitutes for the firm’s own product. In order
to maximize its profit, the firm should operate at the level of output in which its marginal
cost of production is equal to its marginal revenue.

The following Figure 1 “Short-Run Equilibrium in Monopolistic Competition” shows the

demand, marginal revenue, marginal cost, and average total cost curves facing a
monopolistically competitive firm, Nani’s Pizza. Nani competes with several other similar
firms in a market in which entry and exit are relatively easy. Nani’s demand curve D1 is
downward sloping; even if Nani raises its prices above those of its competitors, it will still
have some customers. Given the downward sloping demand curve, Nani’s marginal revenue
curve is MR1 lies below demand. To sell more pizzas, Nani must lower its price, and that
means its marginal revenue from additional pizzas will be less than price.

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Figure 2. Short-Run Equilibrium in Monopolistic Competition

Looking at the intersection of the marginal revenue curve MR1 and the marginal cost curve
MC, we see that the profit-maximizing quantity is 2,150 units per week. Reading up to the
average total cost curve ATC, we see that the cost per unit equals 9.20 ETB. Price, given on
the demand curve D1, is 10.40 ETB, so the profit per unit is 1.20 ETB. Total profit per week
equals 1.20 ETB times 2,150, or 2,580 ETB; it is shown by the shaded rectangle.

The point of equality of MR with MC is always a point of profit maximization for ever
producer in every market. Moreover, it is the condition of ATC that determines whether
there is positive profit or loss. In short run, the monopolistic competitive firms in firms may
generate positive, negative or normal profit because of limited competition and fixed
number of producers.
Numerical Example

Assume a firm engaging in selling its product and promotional activities in monopolistic
competition face short run demand and cost functions as Qd = 20-0.5P and TC = 4Q2-
8Q+15, respectively. Having this information
a. Determine the optimal level of output and price in the short run.
b. Calculate the economic profit (loss) the firm will obtain (incur).
c. Show the economic profit (loss) of the firm.

Solution

A. Q = 20-0.5P B. ∏=TR-TC or Q (P-ATC)

Q-20 = -0.5P = (40Q-2Q2) – (4Q2-8Q+15) or 4(32-11.75)
*P = 40-2Q = (40(4)-2(4) 2) - (4(4) 2-8(4) +15) or 4(20.25)

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*TR = PQ = (160-64) – (64-32+15) or 81

= (40-2Q) Q =128 - 47 or 81
= 40Q-2Q2 =81=81

*MR= ∂TR = 40-4Q ` *TC = 4Q2-8Q+15

∂Q *MC = ∂TC = 8Q-8
∂Q
*MR = MC *P = 40-2Q
40-4Q = 8Q-8 *P = 40-2(4)
48 =12Q *P = 40-8 = 32
Q=4

B. Long run equilibrium of the firm

Long run is a production system in which all inputs variables and production and marketing
system is flexible. In short run it is expected that the numbers of producers are fixed and the
firms don’t compete up on price in order to catch more customers and profit. Moreover, in
long run there is entry of new firms and producers can also compete up on price. In
monopolistic competition, entry will eliminate any economic profits in the long run. If the
firms compete on price they reduce the price of goods and services and this will reduce their
profit. In general, long run equilibrium is achieved through price adjustments of the existing
firms and by new firms entering the product group.

Excess Capacity and Welfare Loss

The long-run equilibrium solution in monopolistic competition always produces zero

economic profit at a point to the left of the minimum of the average total cost curve. That is
because the zero profit solution occurs at the point where the downward-sloping demand
curve is tangent to the average total cost curve, and thus the average total cost curve is itself
downward-sloping. By expanding output, the firm could lower average total cost. The firm
thus produces less than the output at which it would minimize average total cost. A firm that
operates to the left of the lowest point on its average total cost curve has excess capacity.

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Figure 3. Excess Capacity

Because monopolistically competitive firms charge prices that exceed marginal cost,
monopolistic competition is inefficient. The marginal benefit consumers receive from an
additional unit of the good is given by its price. Since the benefit of an additional unit of
output is greater than the marginal cost, consumers would be better off if output were
expanded. Furthermore, an expansion of output would reduce average total cost. But
monopolistically competitive firms will not voluntarily increase output, since for them; the
marginal revenue would be less than the marginal cost.

In short, the long run equilibrium of the firm is defined by the point of tangency of the
demand curve to the LAC curve. At this point MR = MC and AC = P, but P > MC. As a
result price will be higher and output will be lower as compared with the perfectly
competitive model. There are too many firms in the product group, each producing an
output less than optimal (at the falling part of the LAC) in a monopolistically competitive
market. The difference between the level of output indicated by the lowest point on the
LAC curve and the monopolistic competitor’s output when in long run equilibrium
measures excess capacity. Excess capacity is the difference between the ideal output
corresponding to the minimum LAC and the output actually attained in the long run
equilibrium.

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Haramaya University Lecture Notes on Microeconomics II (Econ2022)

CHAPTER TWO

OLIGOPOLY MARKET

Oligopoly is a market organization in which there are few, but large firms that produce
identical or closely substituted products (identical or differentiated). Oligopoly is said to
exist when there are more than one producer in the market, but their number is not so large
so as to make the contribution of each firm negligible. Firms thus, are situated mutually
interdependence. That is they behave as if any one firm’s action directly affect other rivals
and is affected by the action of others.

There are different oligopoly models, each of which is applicable to some specific
situations. The sources of oligopoly are generally the same as for monopoly but weaker in
the case of oligopoly. In addition, incumbent (existing) firms may take strategic actions to
deter (protect) entry.
The properties of oligopoly are;

a. There are few large producers in oligopoly: There are few firms dominate the market
each having relatively equal market shares. Moreover, the actions of one firm can
influence the actions of the other firms.
b. Barriers to entry: the same barriers to entry that creates pure monopoly are relevant in
explaining the existence of oligopoly. The most important barriers are economies of scale,
patents, access to expensive and complex technology, and strategic actions by incumbent
firms designed to discourage or destroy nascent firms. Economies of scale are important
entry barriers in a number of oligopolistic industries such as aircraft, and cement
factories.
c. Products in oligopoly may be either homogenous or differentiated: Many industrial
products (steel, zinc, copper, cement, industrial alcohol) are virtually standardized
products that are produced in oligopoly. Alternatively, some oligopoly industries make
differentiated products such as automobiles, tires, computers, soft drinks, electric
equipment, and cigarettes) are differentiated oligopolies.
d. Profit maximization conditions: An oligopoly maximizes profits by producing where
marginal revenue equals marginal costs.
e. Long run profits: Oligopolies can retain long run abnormal profits. High barriers of
entry prevent sideline firms from entering market to capture excess profits.

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f. Firms in oligopoly control over price, but recognize their interdependency:

although oligopolies are price makers, they must consider how its rivals react to any
change in its price, output, product characteristics, or advertising. The distinctive feature
of an oligopoly is interdependence. This is a situation in which each firm’s profit
depends not only on its own price and sales strategies but on those of its rivals. Mutual
interdependence means, the action of one firm will affect the price and sales of the rival
firm in the industry and vice versa. That is why price in oligopoly tends to be sticky or
rigid.

Each firm is so large that its actions affect market conditions. Therefore the competing
firms will be aware of a firm's market actions and will respond appropriately. This means
that in contemplating a market action, a firm must take into consideration the possible
reactions of all competing firms and the firm's countermoves. It is very much like a game of
chess or pool in which a player must anticipate a whole sequence of moves and
countermoves in determining how to achieve his objectives. For example, an oligopoly
considering a price reduction may wish to estimate the likelihood that competing firms
would also lower their prices and possibly trigger a ruinous price war. On the other hand, if
the firm is considering a price increase, it may want to know whether other firms will also
increase prices or hold existing prices constant. This high degree of interdependence and
need to be aware of what the other guy is doing or might do is to be contrasted with lack of
interdependence in other market structures.

In a perfectly competitive market there is zero interdependence because no firm is large

enough to affect market price. All firms in a perfectly competitive market are price takers,
information which they robotically follow in maximizing profits. In a monopoly there are
no competitors to be concerned about. In a monopolistically competitive market each firm's
effects on market conditions is so negligible as to be safely ignored by competitors. The
special case of oligopoly is duopoly; the market in which two firms competes with each
other.

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2.1. Types of oligopoly models

Firms in oligopolistic market structure may behave independently although they are
interdependent in the market (non-collusive oligopoly) or may enter into agreements
regarding their decisions (collusive oligopoly).

2.1.1. Non-Collusive Oligopoly

In non-collusive type of oligopoly market, there is no collusion or no cooperation among

them. Under non-collusive oligopoly each firm develops an expectation about what the
other firms are likely to do. Since firms are mutually interdependent, a firm expects some
reaction from its rivals when it decides to take a given course of action. For example, when
a firm increases its own output or price, it expects some reaction from the rivals to its
action; increment of output or price. There is no single model describing the operation of an
oligopolistic market. The variety and complexity of the models is because you can have two
to 102 firms competing on the basis of price, quantity, technological innovations,
marketing, advertising and reputation. Fortunately, there are a series of simplified models
that attempt to describe market behavior under certain circumstances. Some of the better-
known models are;

A. Cournot’s model (1838)

B. The Kinked demand (Sweezy’s) model (1839)
C. The Bertrand’s model (1883)
D. The Stackelberg’s model (1920)
For analytical convenience, we usually assume that the products within the oligopoly
market are identical and there are two firms duopoly in most of the forthcoming
discussions.

A. Cournot’s Duopoly Model

Cournot’s model is the earliest duopoly model (developed in 1838). The model assumes that
there are two “equally positioned firms”; the firms compete on the basis of quantity rather
than price and each firm makes an “output decision assuming that the other firm’s behavior is
fixed”. The market demand curve is assumed to be linear and marginal costs are constant. To
find the Cournot-Nash equilibrium one determines how each firm reacts to a change in the
output of the other firm. The path to equilibrium is a series of actions and reactions. The

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pattern continues until a point is reached where neither firm desires “to change what it is
doing, given how it believes the other firm will react to any change.” The equilibrium is the
intersection of the two firm’s reaction functions. The reaction function shows how one firm
reacts to the quantity choice of the other firm.

The original version of the model makes “heroic” assumptions that the duopolies have
identical products and identical costs. He also assumed that the marginal (additional) cost is
zero for both firms and these firms fully know their linear demand curve, and each firm acts
on the assumption that the competitor will not change its output, and decides its own output
to maximize profit.

Assume that firm A is the first to start producing and selling mineral water. It will produce
quantity A and sells at price P1.

Figure. Cournot’s demand case

Now, firm B assumes that A will keep its output fixed at OA and hence considers that its
own demand curve is CD’. It produces AB (=1/2AD’) and charges price P2 in order to
maximize profit. Firm A, faced with this situation, assumes that, B will retain its quantity
constant in the next period. Therefore, A will produce ½ of the market that is not supplied
by B [=1/2(1-1/4) OD’]. B (again) reacts and will produce ½ of the unsupplied market
[(=1/2(1-3/8) OD’]. This action-reaction pattern continues until equilibrium is reached. At
equilibrium, each firm produces one-third (1/3) of the total market.

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Firm A Firm B
½ ½ (1-1/2) = ¼
½(1- ¼) = ½ - 1/8 = 3/8 1//2(1-3/8) =1/4+1/16 = 5/16
½(1-5/16) = ½ - 1/8 – 1/32 = 11/32 ½(1-11/32) = 1/4+1/16+1/64 = 21/64
. .
. .
Product of firm ‘A’ in equilibrium = ½ -1/8-1/32-1/128 - … = ½ - (1/8+1/32+1/128) [This

is a geometric progression with ratio r = ¼] and, thus = ½ - [ 1 / 8 ] = 1/3.

1  1/ 4

Product of firm B in equilibrium = ¼+1/16+1/64+1/256+… = [ 1 / 4 ] = 1/3.

1  1/ 4

Let us now relax the assumption of zero marginal cost and see the equilibrium of a duopoly
market (Cournot’s equilibrium) based on the reaction-curves approach. To determine the
Cournot’s equilibrium you can solve the equations simultaneously. The equilibrium
quantities can also be determined graphically. The equilibrium solution would be at the
intersection of the two reaction functions. Reaction curve is a curve that shows the
relationship between a firm’s profit maximizing output and the amount it thinks its
competitor will produce. For instance, if we have two firms (A&B), firm A’s reaction
function (curve) shows how much output A must produce in order to maximize its own profit
for every specific level of output of its rival (B). The reaction functions are not necessarily
symmetric. The firms may face differing cost functions; in which case the reaction functions
would not be identical nor would the equilibrium quantities.

Consider the following example. Find the Cournot’s equilibrium if the market demand and
the costs of the duopolists producing mineral water are:

P =100 – 0.5X where X = X1(Origin) + X2(Yes)

C1 = 5 X1(Origin)
C2 = 0.5 X22(Yes)

Firm 1(Origin)’s profit is given by П1 = P X1 – TC1

= [100 – 0.5 (X1+X2)] X1 - 5X1
= 100 X1 - 0.5 X12 – 0.5 X1X2 - 5 X1
П1 (Origin) = 95 X1 - 0.5 X12– 0.5 X1X2

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Firm 2(Yes)’s profit is given by П2 = P X2 – TC2

= [100 – 0.5 (X1+X2)] X2 - 0.5 X22
= 100 X2 - 0.5 X1X2 - 0.5 X22 - 0.5 X22
П2 (Yes) = 100 X2 - 0.5 X1X2 - X22
Each firm maximizes its own profit (which depends on the output of the other firm as well).
 1  2
Profit maximization → = 0 and =0
X 1 X 2

 1
= 95 - X1 – 0.5X2 = 0 95– 0.5X2 = X1……….firm 1(origin)’s reaction function
XX11
[eq.1].
 2
= 100 - 2 X2 – 0.5X1 = 0  X2 = 50 - 0.25X1… firm 2(Yes)’s reaction function
X 2
[eq.2].
Solve equations 1&2 simultaneously to find equilibrium quantities of the two firms.
X1 = 95– 0.5X2
X2 = 50 – 0.25X1

 X1 = 95– 0.5(50 – 0.25X1)

X1 = 95– 25 + 0.125X1
X1– 0.125X1 = 70
0.875 X1 = 70
X1 = 80 and, X2 = 50 – 0.25X1 = 50 – 0.25(80) = 50 –20 = 30

The total output in the market is X = X1+X2 = 80+30 = 110.  The market (equilibrium)
price is P =100 – 0.5X = 100 – 0.5(110) = 45.
Exercise 1. Assume that the firm 1’s demand function is P = (60 - Q). Where Q= (Q1 +Q2)
moreover, Q1 is the output produced by firm 1, where Q2 is the quantity produced by firm 2.
In addition to this, TC1 = 12Q1 and TC2 = 12Q2. Find the quantity produced by firm 1 and
firm 2 (Cournot’s equilibrium).

B. The ‘Kinked - Demand’ Model

Paul Sweezy introduced this model in 1939. This model attempts to explain the price
rigidity that is often observed in some oligopolistic markets. The conjectural assumptions of

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the model are; if the firm raises its price above the current existing price, it would lose most
of its customers because the other firms in the industry would not follow the price increase.
On the other hand, an oligopolist could not increase its share of the market by lowering its
price below the existing price, since its competitors would immediately follow the price
reduction to retain their market share and the firm's output will increase only marginally. As
a result, oligopolies face a demand curve that is highly elastic for price increases and less
elastic for price reductions. That is the demand curve faced by oligopolies has a kink at the
established price; and, because of this, oligopolies tend to keep prices constant even in the
face of changed costs and demand conditions (hence, interdependence is recognized).

Figure 4. Kinked demand curve

The demand curve facing the oligopolist is HBD and has a kink at the prevailing price P*
and quantity Q*. The major weakness of this model is that it cannot explain at what price
the kink occurs and how prices are determined.
C. Bertrand’s Duopoly Model

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

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Because the good is homogeneous, consumers purchase only from the lowest-price seller.
Thus, if the two firms charge different prices, the lower-price firm will supply the entire
market and the higher-price firm will sell nothing. If both firms charge the same price,
consumers will be indifferent as to which firm they buy from. And, it is assumed that each
firm will supply half the market.
 Numerical Example: Given P = 100 – 0.5Q, where Q = q1+q2, TC1= 5q1, TC2 = 0.5q22 find
the Bertrand’s equilibrium.
 Solution:

Firm 1 Firm 2
P = MC1 P = MC2
P=5 P = q2
5 = 100 – 0.5Q
-95 = -0.5Q
Q = 95/0.5 = 190
 Check that P = MC1 = MC2
100 – 0.5 (q1 + q2) = 5 100 – 0.5 (q1 + q2) = q2
95 – 0.5q1 – 0.5q2 100 – 0.5q1 –1.5q2
95 = 0.5q1 + 0.5q2 100 = 0.5q1 + 1.5q2
 Solving the two equations simultaneously
 95 = 0.5q1 + 0.5q2
(100 = 0.5q1 +1.5q2) –1
95 = 0.5q1 + 0.5q2
-100 = -0.5q1 – 1.5q2
-5 = -q2, q2 = 5
95 = 0.5q1 + 0.5 (5)
95 = 0.5q1 + 2.5
0.5q1 = 95 – 2.5
0.5q1 = 92.5, q1 = 92.5/0.5 = 185 and Q = 5+185 = 190
 P = 100 – 0.5Q
= 100 – 0.5 (5 + 185)
= 100 – 0.5 (190)
= 100 – 95 = 5, is the price which cannot be undercut because it is equal to MC1
and MC2.

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D. Stackelberg’s Duopoly Model

This model was developed by Heinrich von Stackleberg and is an extension of Cournot’s
model. Unlike the Cournot’s model, where firms are naïve (do not recognize their rivalry)
and where the two firms make their output decisions at the same time, under Stackleberg’s
model one of the two firms is sufficiently sophisticated to recognize that its competitor is
naïve and thus sets its output before the other.

Consider the example below (which is the same as the example under Cournot’s model).
Assume that in a duopoly market the demand function is P =100 – 0.5(X1+X2) and the
duopolists’ costs are C1 = 5 X1 and C2 = 0.5 X22.

1. Stackleberg’s solution with firm 1 being the sophisticated leader:

Firm 1(origin) knows the reaction function of firm 2 (Yes), substitutes this reaction function
into its own profit function, and maximizes its profit as if it were a monopolist.
Reaction function of firm 2 (Yes) is:
П2 = P X2 – C2
= [100 – 0.5 X1 –0.5X2] X2 - 0.5 X22
= 100 X2 - 0.5 X1X2 - 0.5 X22 - 0.5 X22
= 100 X2 - 0.5 X1X2 - X22
 2
= 100 – 2 X2 - 0.5 X1 = 0.  X2 = 50 - 0.25X1 firm 2’s reaction function
X 2

Substitute this into firm 1’s profit function and maximize.

П1 = P X1 – C1
= [100 – 0.5 (X1+X2)] X1 - 5 X1
= 100 X1 - 0.5 X12 – 0.5 X1X2 - 5 X1
= 95 X1 - 0.5 X12– 0.5 X1X2
П1 = 95 X1 - 0.5 X12– 0.5 X1 (50 - 0.25X1).
= 95 X1 - 0.5 X12 – 25 X1 + 0.125 X12
= 70X1 – 0.375 X12
 1
 = 70 – 0.75 X1 = 0X1 = 280/3.
X 1

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Firm 2 would assume that firm 1 produces 280/3 units; thus substitutes this amount into its
reaction function:
X2 = 50 - 0.25X1 = 50 – 0.25(280/3) = 80/3.

П1 = 70X1 – 0.375 X12 = 70() – 0.375(280/3) 2 ≈ 3267.

П2 = 100 X2 - 0.5 X1X2 - X22 = 100 (80/3) - 0.5 (280/3)*(80/3) – (80/3) 2 ≈ 711.

What is the price charged per unit of output?

2. If firm 2 is assumed to be the Stackleberg’s sophisticated leader:

X2 =35, X1 = 77.5, П2 = 918.75, П1 ≈ 3003.

What is the price charged per unit of output?

In general, each firm (duopolist) estimates the maximum profit it would earn (a) if it acted
as leader, (b) if it acted as follower, and chooses the behavior which yields the largest
maximum profit.

Determinate equilibrium results if one of the two firms wants to be leader and the other to
be a follower. If both firms desire to be followers, their expectations do not materialize. One
of the rivals must alter its behavior and act as a leader, or the Cournot’s equilibrium will be
reached if each duopolist recognizes that its rival also wants to be follower. If both firms
want to be leaders disequilibrium arises, the outcome, according to Stackleberg, is
economic warfare. Equilibrium will be reached either by collusion, or after the ‘weaker’
firm is eliminated or succumbs to the leadership of the other.

2.1.2. Collusive Oligopoly

Firms in any industry could achieve the maximum profit attainable if they all agreed to
select the price and output and to share the profits. One approach to the analysis of
oligopoly is to assume that firms in the industry collude, selecting the monopoly solution.
There are main types of collusion: cartels. These forms may represent tacit (secret)
agreements since open collusion action is commonly illegal in most countries at present.

A. Cartels

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Cartel is a combination of firms whose objective is to limit the scope of competitive forces
within the market and to gain monopoly power. Cartel is an organization of suppliers of a
commodity aimed at restricting competition and increasing profits.

A successful cartel can earn large profits, but there are several problems with forming and
maintaining one. First, in many countries, including the United States, cartels are generally
illegal. They are banned, because their purpose is to raise prices and restrict output. Second,
the cartel may not succeed in inducing all firms in the industry to join. Firms that remain
outside the cartel can compete by lowering price, and thus they prevent the cartel from
achieving high profit. Third, there is always an incentive for individual members to cheat on
cartel agreements. Suppose the members of a cartel have agreed to impose the monopoly
price in their market and to limit their output accordingly. Any one firm might calculate that
it could charge slightly less than the cartel price and thus capture a larger share of the market
for itself. Cheating firms expand output and drive prices down below the level originally
chosen.

The Organization of Petroleum Exporting Countries (OPEC), perhaps the best-known cartel,
is made up of 13 oil-producing countries. In the 1970s, OPEC successfully acted like a
monopoly by restricting output and raising prices. By the mid-1980s, however, the monopoly
power of the cartel had been weakened by expansion of output by nonmember producers such
as Mexico and Norway and by cheating among the cartel members.

There are two typical forms cartels:

 Cartels aiming at joint-profit maximization, and
 Cartels aiming at the sharing of the market.

I. Cartels Aiming at Joint-Profit Maximization (Centralized Cartels)

Cartels aiming at joint profit maximization cartels imply direct (although secret or open)
agreements among the competing oligopolies with the aim of reducing the uncertainty
arising from their mutual interdependences. The key objective of the cartel is the
maximization of joint profits on behalf of its members. Consider a pure oligopoly; an
oligopoly where all firms produce a homogeneous product. The firms in the cartel appoint a
centralized agency to which they delegate the authority to decide on:

- The total quantity to be produced by the industry,

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- The price at which the output is sold,

- The allocation of production, and
- The distribution of the maximum joint-profit among the members.

To do this the central agency has to assess the cost structure of the industry (and firms) and
the market demand. For the simple case of two firms (duopoly), the equilibrium is
determined as follows:

Figure 5. collusive oligopoly

Given P = f (X)…demand function [where X = X1 + X2]

C1 = f (X1) and C2 = f (X2)…cost functions of the two firms.
F.O.C: MR = MC1 = MC2
Note that: 1) MC is the summation of MC1 and MC2 (but not the simple horizontal
summation).
2) 1 and 2 do not necessarily go to the two firms; the total profit  (= 1 + 2)
could be shared between the two firms on a criterion other than the cost of the firms.

Numerical example

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Assume that Market demand is P =100 – 0.5X where X = X1+X2

And the two colluding firms have costs given by C1 = 5 X1
C2 = 0.5 X22
The central agency of the cartel aims at the maximization of the total profit
П = П1+ П2
Where π1 = TR1 – TC1 and π2 = TR2 – TC2
Thus, π = TR1+TR2 – TC1- TC2 = P (X1+X2) - C1 - C1
TR = TR1 + TR2 P*X1 +P*X2 = P(X1 +X2) = P*X Substituting the demand function for P
= [100 – 0.5 (X1+X2)] (X1+X2) - 5 X1 - 0.5 X22

= 95 X1+100 X2 - 0.5 X12–X1X2-X22

 1  2
Profit maximization  = 0 and =0
X 1 X 2

 1
= 95 - X1 – X2 = 0  95= X1+ X2 …………(1)
X 1

 2
= 100 -X1- 2 X2 = 0 X1+ 2X2 = 100. …………(2)
X 2
Solving equations 1&2 simultaneously gives: X1 = 90 and X2 = 5

The total output in the market is X = X1+X2 = 90+5 = 95.  The market (equilibrium) price
is: P =100 – 0.5X = 100 – 0.5(95) = 52.5.
Find the profit of the cartel.
П1 = TR1 - TC1 = P*X1 - 5X1 = 52.5*90 - 5*90 = 4275
And
П2 = TR2 – TC2 = P*X2 – 0.5X22 = 52.5*5 – 0.5*52 = 250
(Note that this profit is greater than П1+ П2 if the firms do not collude)
In practice, however, this monopoly equilibrium (maximization of industry profit) may not
be achieved. In other words, there are factors that militate against achievement of the joint
profit maximization of the cartel. These reasons are:

 Mistakes in the estimation of market demand and costs.

 Slow process of cartel negotiations- by the time agreement is reached market conditions
may have changed.

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 Fear of government interference- particularly if the monopoly price yields too high
profits.
 Fear of entry – the fear of attracting new firms to the industry by too high profits.
 Stickiness of the negotiated price, etc.

II. Cartel aiming at increasing Market Sharing

In this type of cartel, firms agree to share the market, but keep a considerable degree of
freedom concerning the style of their product, their selling activities and other decisions.
This type of collusion is more common. There are two basic methods for sharing the
market:

a. Non-price competition and

b. Determination of quotas.

a. Non-Price Competition Agreements

Under this cartel members agree on a common price informally not by bargaining. This
implies that firms agree not to sell below the cartel price; but they can vary the style of their
products and their selling activities. For example Doctors charge the same price
 Barbers charge the same price

 Gasoline stations charge the same price

 Cinema halls charge the same price etc. These prices are not the result of perfect
competition in the market. Rather, they result from tacit agreement upon price. Hence,
sellers will compete one another through advertising; but not by price changes. Due to
cost difference among manufacturing firms, this type of cartel is loose or unstable than
the complete cartel aiming at joint profit maximization. In other words, the cartel is
inherently unstable for there is a temptation to cheat by low cost firm. Hence, there is a
strong incentive to break away from the cartel and charge lower price (give price
concession to buyers). However, other members from the cartel will soon discover such
a cheating when they lose consumers.

Another method (way) to acquire information as to whether other firms keep track of the
price is to use your customers to spy on the other firms. When firms are not sure that the

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other firm is not cheating on their agreement and selling at the implicitly agreed price, price
war (instability) may develop and the cartel splits.

b. Sharing of the Market by Agreement on Quotas

Firms may make agreement on quotas, i.e. the quantity that each firm may sell at the agreed
on price. If all firms have identical costs, the monopoly solution will emerge with the
market being shared equally among the members. If costs are different, the final quota of
each firm depends on the level of its costs as well as on its bargaining skill. During the
bargaining process two main statistical criteria are most often adopted: past levels of sales
and productive capacity.
Another popular method of sharing the market is the definition of the region in which each
firm is allowed to sell. In this case of geographical sharing of the market, the price as well as
the style of the product may differ

Price Leadership
The collusion among the oligopolies also entails that one firm will set the market price and others
followed (adopt) it. Followers usually prefer to avoid the uncertainty that might occur because of
their competitor’s reaction for their action even if this implies departure from profit maximizing
point.
 Price leadership is more widespread than cartel. The two most common types of price
leadership are
 Price leadership by low cost firm
 Price leadership by the dominant (large) firm
1. Low Cost Price Leadership:- Consider a situation where there are only two firms (duopoly)
that produce identical (homogenous) products at different costs but sell their products at the
same market price. However, firms may have equal (the high cost firm also to produce the
same level of output to that of the low cost firm and sell at the same price) or unequal share.

 Assuming firm 2 is the low cost firm and firm 1 is the high cost firm, the graphic solution is
given as follows.
P
MC1

P1 MC2

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P2

D
E

d
q1 q2 MR Q = q2+q2

Q = 2(q2)
 Firm 2 has lower cost and hence it charges lower price, p2, and produce q2 to maximize
profits. Firm 1, with the highest cost, on the other hand would like to charge p1 and
produce q1. However, firm 1 prefers to follow the leader because if it charges p 1 its sells
will be zero implying no one will pay a higher price for identical products. Therefore, the
high cost firm 1 must be willing (satisfied) to accept the price decision of the low cost firm.
Thus, it changes P2 and produces the same quantity as firm 2, q2.
 The two together then produce output level, which is equal to q2 + q2 = 2Q2. It is only in
this case the anti trust monopoly legislation, which forbid monopoly production will work.
In short the high cost firm must tolerate to the price and output level equal to the low cost
firm to avoid the uncertainty that may arise when firm 2, reduces price lower than p2.
 Numerical example: Given P = 24 – 0.1Q, where Q = q1+q2 and q1 = q2, TC1 = 0.1q12, TC2
= 0.05q22,
a) Determine the output and price of low cost firm
b) Calculate the profit of the low cost firm
c) What is the profit maximizing price level the high firm would like to charge but that
doesn’t realise in the market
d) Compare the profits of the price taker at its own profit maximizing output and low
cost firm’s output
e) Show the results a to d graphically
 Solution
a) Since q1 = q2, 0.075q12 > 0.05q22. This implies that firm 2 is a low cost price leader.
Hence,
П2 = Pq2 – TC2 P = 24 – 0.1Q, where q1 = q2
= (24 – 0.1(q1+q2)) q2 – 0.05q22 P = 24 – 0.1 (2q2)
= (24 – 0.1 (q2+q2)) q2 – 0.05q22 = 24 – 0.2q2
2
= (24 – 0.1 (2q2)) q2 – 0.05q2 = 24 – 0.2 (48)

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= (24 – 0.2q2) q2 – 0.05q22 = 24 – 9.6 = 14.4

= 24q2 – 0.2q22 – 0.05q22 b) П2 = Pq2 –TC2
= 24q2 – 0.25q22
dП2 = 0 = 24 – 0.5q2 = 0 = 14.4 (48) – 0.05 (48) 2
dq2
= q2 = 24/0.5 = 48 = 691.2 –115.2 = 576
c) П1 = Pq1 – TC1 d) П1= Pq1 – TC1
= (24 – 0.1(q1+q2)) q1 – 0.075q12 = 14.4 (43.63) – 0.075 (43.63) 2
= (24 – 0.1 (q1+q1)) q1 – 0.075q12 = 628.36 –142.77= 485.59 and
2
= (24 – 0.1 (2q1) q1 – 0.075q1 П1= Pq1 – TC1
= (24 – 0.2q1) q1 – 0.075q12 = 14.4 (48) – 0.1 (48) 2
= 24q1 –0.2q12 – 0.075q12 = 691.2 – 230.4 = 460.8
= 24q1 – 0.275q12 though, 485.59>460.8 firm 1 will
50.8
produce 48 than 43.63
dП1 = 0 = 24 –0.55q1 = 0
dq1
q1= 24/0.55 = 43.63

 Exercise: Given P = 300 – 5X, where X = x1+x2, TC1= 0.5x12, TC2 = 3x22 answer the
questions above.
 Answer: x1 = 14.29, P1 = 157.96, x2 =11.54, and P2 = 184.62

2) The Dominant – Firm Price Leadership (Partial Monopoly)

 This type of duopoly assumes that there is a dominant firm, which has considerable share of
the market and smaller firms, each of them having a smaller market share.
 The dominant firm is assumed
 To know the market demand curve
 The MC of smaller firms. Hence, firm the horizontal summation of the MCs of
smaller firms the dominant firms found the total SS by the smaller firms at each
price.
 Knowing the market DD and the SS of the smaller firms the dominant firm calculates its
DD curve as follows. At each price the dominant firm will be able to SS that section of the

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total market DD not supplied by the smaller forms. That is, the DD for the product of the
firm will be the difference between the total dd (D) and the total SS of the smaller firms.
P S small

MCL

PS D1
SSsm
B C
PL1

SSsm SSL1
P2 A D2
SSsm SSL2
D3
P3 dL
SSL3 DD MRL

Q qL q2 q3
Smaller firms Dominant firm
 At ps, market DD is equal to the market SS of smaller firms. This is equal to PSD1 amount.
The dd for the product of the leader will be zero.
 As price falls below PS, the dd for the leader increases, for instance, at P2, total market dd is
P2D2 amount of which P2A is supplied by the smaller firms. The share of the dominant is
AD2.
 At P3, total market dd is P3D3 of which the share of smaller firms is zero, while P3D3 (all) is
the share of the dominant firm. Below Ps the market dd coincides with the leader dd curve.
 Having derived the dd curve of the leader (dL) and given its MC, the dominant firm will set
the price p at which MRL = MCL and out put is qL. At price PL1 the total market dd is PL1C of
which PLA is the share of smaller firms while AC is the share of the dominant firm. The
dominant firm maximizes its profit be equating its MR to MC, but the smaller firms or price
taker may or may not attain the point where MRS = MCS.
 Numerical example: Given Q = 120 – 0.2P, SSsm = 4.8P, and TCL = 4qL determine the
supply, price, and profit of the dominant (large) firm. Finally, the supply of smaller
(followers) firms.
 Solution:
qL (dL ) = Q – SSsm)
qL= 120 – 0.2P – 4.8P

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qL = 120 – 5P
qL – 120 = -5P
 P = 24 - 0.2qL
 TRL = (24 – 0.2 q2) q2
 ПL = TRL – TCL
= (24 – 0.2qL) qL – 4qL
= 24qL – 0.2qL2 – 4qL
= 20qL - 0.2qL2
d ПL= 20 – 0.4qL = 0
dqL
= 20 = 0.4qL
qL = 20/0.4 = 50
 P = 24 – 0.2 qL
 P = 24 – 0.2 (50)
= 24 – 10 = 14, this is the equilibrium price both the dominant and smaller firms
will adopt.
ПL = PqL – TCL
= 14 (50) – 4 (50)
= 700 – 200 = 500
 The supply of smaller firms will then be Q – dL. That is
SSsm = (120 – 0.2P) – 50 or SSsm = 4.8P
= (120 – 0.2 (14)) – 50 = 4.8(14)
= (120 – 2.8) – 50
= 67.2
= 117.82– 50 = 67.2

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UNIT THREE

GAME THEORY

The oligopoly theories we discussed so far are the classical theory of strategic interaction among
firms. Oligopoly economic agents can have been studied by using the apparatus of game theory.
Game theory can help an oligopoly firm to choose the best level of advertising, the best price to
charge, the optimum level of product differentiation, etc. that maximizes its benefit or profit after
considering all possible reactions of its competitors. Thus, in this chapter we will briefly explore
this fascinating subject to give you a flavor or how it works and how it can be used to study
economic behavior in oligopolistic markets.

Game theory can be regarded as a multi-agent decision problem. It is an analysis of a

decision making process when there are more than one decision-makers where each agent’s
payoff possibly depends on the actions taken by the other agents.
 Games are a convenient way in which to model the strategic interactions among
economic agents. Many economic issues involve strategic interaction.
 Behavior in imperfectly competitive markets,
e.g. Coca-Cola versus Pepsi.
 Behavior in auctions, e.g. Investment banks bidding on Treasury bills.
 Behavior in economic negotiations, e.g. trade.
 Game theory is not limited to Economics.

The payoff matrix of a game

The following are the basic elements of any game
 Players: are parties involved in the game
 A set of rules (Allowable actions and sequencing of actions by each player)
 Strategies: all the actions that each player can take. They are set of actions
(alternatives) available to each player. Strategies may include charging high or low
price, introducing new products or selling the existing one, advertising, etc.
 Payoffs: are outcomes for each player resulting from all combination of strategies by
players. The amount each player gets for every possible combination of the actions.
 Informational structure (what players know at each point in the game)
Strategic interaction can involve many players and many strategies, but we will limit ourselves to
two-person game with a finite number of strategies. This will allow us to depict the game easily
in a payoff (outcome) matrix. Suppose that -two people (A and B) are playing a simple game and
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- Each has two strategies to play

Let the two strategies of A are top and bottom and that of B left and right. Their strategies could
represent economic choices like “raise price” or “lower price” and “don’t advertise” or
“advertise” or they could represent political choices like “declare war” or “don’t declare war”.
 The payoff matrix of a game simply depicts the payoffs to each player for each combination
of strategies that are chosen. What will be the outcome of this sort of game?
 Consider the following example 1. In this matrix the payoffs to A are in the first entry and
the payoff to B are in the second entry in the cells of the box.
A pay off matrix of a game

Player B

Left(don’t adv) Right(advertise)

Top(p) 1,2 0,1

Player A
Bottom(p ) 2,1 1,0

From the viewpoint of person A, it is always better for him to play bottom. Since his/her
payoff from this choice (2 or 1) are always greater than their corresponding entries in top (1
or 0). Similarly, it is always better for B to play left. Since (2 and 1) dominate (1 and 0).
Thus, we would expect that the equilibrium strategy for A is to play bottom and B to play left

3.2. The dominant strategy equilibrium

A dominant strategy is the optimal (best) choice of strategy for each player no matter what the
other player does. Whatever choice B makes, player A will get a higher payoff if he/she plays
bottom, so it make sense for A to play bottom and bottom(decreasing price ) is thus the dominant
strategy for A. And whatever choice A makes, B will get a higher payoff if he plays left, thus
left (do not advertise) is the dominant strategy for B.

If there is a dominant strategy for each player, in the same game, then we would predict that it
would be the equilibrium outcome of the game. We call it the dominant strategy equilibrium. In
this example, we would expect an equilibrium outcome in which A plays bottom, receiving an
equilibrium pay off of 2, and B plays left, receiving an equilibrium pay off of 1.

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3.3.Nash Equilibrium

Dominant strategy equilibriums do not happen all the time. This is because we may not have
dominant strategy equilibrium when the optimal (best) choice of one depends on what he/she
thinks the other will do. If this is the case, we call the equilibrium Nash equilibrium. Nash
equilibrium can be interpreted as a pair of expectations about each person’s choice such that,
when the other person’s choice is revealed neither individual wants to change his/her behaviour.
A game may have no Nash equilibrium, may have one Nash equilibrium, or it can have multiple
Nash equilibria.

A. Game with no Nash equilibrium

Let us assume that there are two firms, firm A and firm B, in the market producing and selling
the same product. The strategy adopted by either firm will have an impact on the demand, hence
on the profit of the other firm. Firm A has two strategic choices: Fight and accommodate, and
firm B have two strategies: advertise and do not advertise. The following table represents the
payoff matrix of the two firms.

Player B
Advertise Don’t advertise
Player A Fight (5,4) (4,1)
Accommodate (7,3) (3,4)

If firm A plays ‘fight’, firm B is better off by playing ‘advertise’, but if firm B plays ‘advertise’,
firm A is better off by playing ‘accommodate’. Hence, (advertise, accommodate) is not Nash
equilibrium. If firm B plays ‘do not advertise’, the best strategy for firm A is to play ‘fight’ but
‘do not advertise’ is not the best strategy for firm B, if firm A plays ‘fight’. Hence, (fight, do not
advertise) is not Nash equilibrium. A similar calculation of all the other payoffs of a pair of
strategies reveals no Nash equilibrium.

Generally in this game there is no Nash equilibrium in the sense that there is no set of strategies
by each firm which imply one firm is better off given what the other is doing and vice versa.

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B. Game with one Nash equilibrium

If we assume two firms: A and B, A with the strategies ‘advertise’ and ‘do not advertise’ and B
with the strategies ‘expand production’ and ‘cut production’. The payoff for each player is given
in the following table.
Player B
Expand production Cut production
Player A Advertise (2,1) (0,0)
Do not advertise (0,0) (-1,2)

In the above table, the strategy (advertise, expand production) is a Nash equilibrium. If A
chooses to advertise, the best strategy for B is to expand production. And if B chooses to expand
production then optimal choice for A is to choose to advertise (since 2>0).

C. Game with multiple Nash equilibra

Consider the following payoff matrix:
Player B
Left right
Player A Top 1,2 0,0
Bottom 0,0 1,2

Here when B chooses right, the payoffs to A are 0 or 1. This means that when B chooses right, A
would want to choose bottom, and when B chooses left, A would want to choose top. Thus, A’s
optimal choice depends on what he thinks B will do and vice versa. Therefore, we will say that a
pair of strategies is a Nash equilibrium If A’s choice is optimal given B’s choice, and B’s choice
is optimal given A’s choice. Remember that neither person knows what the other player will do
when he has to make his own choice of strategy. But each person may have some expectation
about what the other person’s choice will be.
 Therefore,
- If A choose top, then the best thing for B is to choose left, since the payoffs to B from
choosing left is 2 and from choosing right is 0.
- And if B chooses left, then A will be better off by choosing top than bottom because
(1>0). Thus (Top, left) is Nash equilibrium. Similarly, if A choose bottom, B will choose
right and
- If B chooses right, A will choose bottom. Thus (bottom, right) is also Nash equilibrium.

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From the above we can conclude that the Nash equilibrium is a generalization of the Cournot
equilibrium for each firm chooses its output level taking the other firm’s choice as being fixed.

3.4.Mixed Strategy Equilibrium

In all the games that we have examined so far, considered pure strategies – strategies in
which a player makes a specific choice or take a specific action (choosing a strategy once and
for all). Sometimes players may randomize their strategies to assign a probability to each
choice and play according to these strategies. This kind of strategy is called mixed strategy. It
is defined as a strategy in which a player makes a random choice among two or more
possible actions, based on a set of chosen probabilities.

Nash equilibrium in mixed strategies refers to an equilibrium situation in which

each agent chooses the optimal frequency with which to play his strategies given the
frequency choices of the other agent.

firm B

Advertise (25%) Price incentive (75%)

firm A Sales promotion (50%) (0,0) (0,-1)
Deliver cargo via port (50%) (1,0) (-1,3)

If firm A assigns 50% of the time to make sales promotion and B chooses to advertise 25% of
the time ,their expected payoffs will be zero [(0.25)(0.5)(0)+(0.5)(0.75)(0)] from making
sales promotion and -0.25=[(0.5)(0.25)(1)+(0.75)(0.5)(-1)] from delivering cargo transport
for firm A: and that of B from advertising equals zero[(0.25)(0.5)(0)+(0.5)(0.25)(0)]and
0.75=[(0.75)(0.5)(-1)+(0.75)(0.5)(3)] from offering price incentive to customers. This implies
that the Nash equilibrium for firm A is to make sales promotion and for b is to provide price
incentive to customers.

3.5.The Prisoner’s Dilemma

Another problem of Nash equilibrium is that it doesn’t necessarily lead to Pareto efficient
outcome. Consider for example, the game depicted in the table 4. It refers to a situation where
two prisoners who were partners in a crime were being questioned in separate rooms. Each

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prisoner has a choice of confessing (guilty) in the crime and there by implicating the other or
denying (not guilty) that he/she had participated in the crime.

 If only one prisoner confessed, then he would go free and the authority (judges) will
throw the book (sentenced) at the other prisoner, requiring him to spend 6 months in
prison.
 If both prisoner denied being involved, then both would be held for 1 month on a
technicality (labour work) and
 If both prisoners confessed they would be both held for 3 months. The payoff matrix
for this game is given as
The prisoner’s dilemma

Player B
confess deny
Player A confess -3,-3 0,-6
Deny -6,0 -1,-1

 Put yourself in the position of player A.

- If B decides to deny committing the crime, then you are certainly better off confessing,
since you will get off free.
- Similarly, if B confesses, then you will better off confessing since you will get a sentence
of 3 months rather than a sentence of 6 months. Thus, whatever player B does, player A
is better off confessing. The same is true for plays B–he/she is better off confessing.
Thus, the unique Nash equilibrium for this game is for both to confess.
 In fact, both players’ confessing is not only a Nash equilibrium; it is dominant strategy
equilibrium since each player has the same optimal (best) choice independent of the other.
 However, if they could both just hang tight, they would each be better off. In other words, if
they both could be sure that the other would hold out and both could agree to hold out
themselves, they would get a payoff of -1, which would make each of them better off.
 The strategy (deny, deny) is not only Pareto efficient but also Pareto Optimal because there is
no other strategy choice that makes both players better off or either of them without making
the other worse off. Thus, the strategy (confess, confess) is Pareto inefficient for both.
The problem is that there is no way for the two prisoners to coordinate their action. If each could
trust the other, they could both be made better off. This applies to a wide range of economic and
political phenomena. Consider, for example, the problem of arms control. Interpret “confess” as

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“deploy a new missiles” and the strategy of “deny” as “don’t deploy”. Note that the payoffs are
reasonable. If my opponent deploys his missile, I certainly want to deploy. But if there is no way
to make a binding agreement not to deploy a missile, we each end up deploying the missile and
are both made worse off, which is Pareto inefficient for both of us. However, if there had been a
strong binding agreement that forces us not to deploy a missile or absolute trust among us,
both would have been better off by reducing the likely hood of human and physical capital loss
and using the money in activities that will enhance economic growth and is not only Pareto
efficient but also Pareto optimal for both of us.
 Another good example is the problem of cheating in a cartel. Now interpret confess a
“produce more than your quota” and interpret deny as “stick to the original quota”. If one
firm (A) thinks the other firm (B) is going to stick to its quota, it will pay to it to produce
more than its quota. And if A thinks that B will overproduce, then A might as well, too.
 The prisoner’s dilemma provoked controversy as to what is a reasonable way to play the
game. The answer seems to depend on whether you are playing a one-shot game or the game
is to be repeated an indefinite number of time.

3.6.Repeated Games

In the above section the players met only once and played the prisoner’s dilemma game a
single time. However the situation is different if the game is to be played repeatedly by the
same player. In this case there are new strategic possibilities open to each player. If the other
player chooses to defeat in one round, then you can choose to defeat on the next round. Thus
your opponent can be punished for the bad behavior. In a repeated game each player has the
opportunity to establish reputation for cooperation and thereby encourage the other player to
do the same. Whether this kind will be possible depends on whether the game is to be played
for a fixed number of times or an infinite number of times.

If the game has fixed number of rounds ( say 10) then each player will defeat on every round
because if there is no way to enforce cooperation on the last round (10th round) there will be
no way to enforce cooperation on the next last round (9th) round and so on. Players cooperate
because they hope that cooperation will include further cooperation in the future.

On the other hand, if the game is going to be repeated for an infinite number of times, a
player has an option of influencing other player’s behavior. If the opponent refuses to
cooperate this time you can refuse to cooperate next time. As long as both players care

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enough about future payoffs, the treat of non-cooperation may be sufficient to convince
players to choose the optimal strategy. Therefore the wining strategy – the one with the
highest payoff is the tit for tat that is to do whatever the last player did in the last round.

Tit for tat is a highly effective strategy in game theory for the iterated prisoner’s dilemma.
Based on the English saying meaning ‘equivalent retaliation’ (tit for tat) an agent using this
strategy will initially cooperate, and then respond in kind to an opponent’s previous action. If
the opponent previously was cooperative, the agent is cooperative. If not, the agent is not.
This strategy is dependent on four conditions that have allowed it to become the most
prevalent strategy for the prisoner’s dilemma:

 Unless provoked, the agent will always cooperate

 If provoked, the agent will retaliate
 The agent is quick to forgive
 The agent must have a good chance of competing against the opponent more than
once

When a game is to be played repeatedly there may be a chance to retaliate defectors by

adopting a simple strategy that may prove to be remarkably effective at keeping potential
defectors in check. The strategy is called tit for tat and works as follows:

The first time intact with someone, you cooperate. In each subsequent interaction you simply
do what the other person did in the previous interaction. Thus if your partner defected on you
in the first interaction then you would then defect on the next interaction with him. If he then
cooperates your move next time will be cooperate as well.

By tit for tat strategy it is meant that do whatever your rival does on the last round. It holds
in a game where players move simultaneously (or play strategies at the same time). Each
player has to choose his strategy knowing only the incentives facing his opponent, not the
actual choice of strategy.

3.7.Sequential Game and Entry Deterrence

Sequential Game

Games where players choose actions in a particular sequence are sequential move games,
here one player get to move first and the other player responds. Example of such type games

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include the stackelberg model of oligopoly, one firm sets output before the other does; an
advertizing decision by one firm and the response by its competitor; entry deterring
investment by an incumbent firm the decision whether to enter the market by the potential
competitor; or a new government regulator policy and the investment and output response of
the regulated firms. Here players must look ahead in order to know what action to choose
now. Many sequential move games have deadlines/ time limits on moves.

Example of sequential game

Player B
Left Right
Player A Top 1,9 1,9
Bottom 0,0 2,1

Note that when the game is set in this form, it has two Nash equilibria; (top, left) and
(bottom, right). However one equilibria is not really reasonable.
When sequential game represent the possible moves in a decision tree we call it extensive
form of a game. Here the analysis of the game will go to end and work backward.
(1,9)
Left

Top PB Right (1, 9)

PA Left (0, 0)

Bottom PB
Right
(2, 1)
Suppose player A has already made her choice and we are starting in one branch of the game
tree. As a rational player she prefers to play bottom than top because 2 is greater than 1. The
Player B chooses to play left than right. The strategies (top, right) are not a reasonable
equilibrium in this sequential game.
How about from player B point of view?

Entry Deterrence

To deter entry the incumbent/existing firm must convince any potential competitor that entry
will be unprofitable. Here the strategy of the entrant firm is entry or to stay out while the
existing firm strategies are to charge high price (accommodation) or low price (warfare).

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Potential entrant
Entry Stay out
High price 100,20 200,0
Incumbent Low price 70,-10 130,0

The entry of the new firm depends on the threat of the existing firm charges lower price. If
new firm takes the threat seriously, it will not enter the market because it can expect to loss
Br 10 million. However the threat is not credible, once entry has occurred, the best interest of
the incumbent firm will be to accommodate and maintain a high price.

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CHAPTER FOUR
PRICING OF FACTORS OF PRODUCTION AND
INCOME DISTRIBUTION

The demand for labour in perfectly competitive markets

We will examine the demand for labor in two cases: (i) when labor is the only variable factor
of production, (ii) when there are several variable factors.
(i) Demand of a firm for a single variable factor
The following assumptions underlie our analysis:
(a) A single commodity X is produced in a perfectly competitive market. Hence P x is
given for all firms in the market.
(b) The goal of the firm is profit maximisation.
(c) There is a single variable factor, labour, whose market is perfectly competitive.
(d) Technology is given.

The relevant section of the production function is shown in figure Hence the price of labour
services, w, is given for all firms. This implies that the supply of labour to the individual firm
is perfectly elastic. It can be denoted by a straight line through w parallel to the horizontal axis
(figure 4.1). At the going market wage rate the firm can employ (hire) any amount of labour it

wants.
Figure: 4.1
The slope of the production function is the marginal physical product of labor;

The MPPL declines at higher levels of employment, given the law of variable proportions. If
we multiply the MPPL at each level of employment by the given price of the output, Px, we
obtain the value-of-marginal-product curve VMPL (figure 4.3). This curve shows the value
of the output produced by an additional unit of labour employed

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Figure 4.2 Figure 4.3

The firm, being a profit maximiser, will hire a factor as long as it adds more to total revenue
than to total cost. Thus a firm will hire a resource up to the point at which the last unit
contributes as much to total cost as to total revenue, because total profit cannot be further
increased. In other words the condition of equilibrium of a profit maximiser in the labour
market is

Where MCL = marginal cost of labor, or

The formal derivation of w= VMPL is as follows.

W=VMPL

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In figure 4.4 the equilibrium of the firm is denoted by e. At the market wage rate w the firm
will maximise its profit hiring l* units of labour. This is so because to the left of I* each unit
of labour costs less than the value of its product (VMPL > ), hence the profit of the firm
will be increased by hiring more workers.

Figure 4.4 Figure 4.5

Conversely to the right of I* the VMPL < , and hence profits are reduced. It follows that
profits are at a maximum when VMPL = . If the market wage is raised to w1 the firm will
reduce its demand for labour to l1 (figure 4.5) in order to maximise its profit (at e1 in figure
4.5 w1 = VMPL). Similarly, if the wage falls to w2, the firm will maximise its profit by
increasing its employment to L2. It follows from the above analysis that the demand curve of
a firm for a single variable factor is its value-of-marginal-product curve.
4.1.1.1. Demand of a firm for several variable factors

When there are more than one variable factors of production the VMP curve of an input is
not its demand curve. This is so because the various resources are used simultaneously in the
production of goods so that a change in the price of one factor leads to changes in the
employment (use) of the others. The latter, in tum, shifts the MPP curve of the input whose
price initially changed. Assume that the wage rate falls. We will derive the new demand for
labour, using isoquant analysis. The change in the wage rate has in general three effects: a
substitution effect, an output effect, and a profit-maximising effect. Let us examine these
effects, using figure 4.6.

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Figure 4.6

Suppose that initially the firm produces the profit-maximising output X1 with the
combination of factors K1, L1, given the (initial) factor prices w1 and r1, whose ratio defines
the slope of the isocost line AB. Now let us assume that the wage rate falls (w2) so that the
new isocost line is AB' (the price of capital remains constant).

The firm, using the same expenditure, can now produce the higher output denoted by the
isoquant X2, using K2 and L2 amounts of capital and labour respectively. This result is derived
from the tangency of the new isocost line AB' with the highest isoquant, which, in our
example, is X2.

 The movement from e1 to e2 can be split into two separate effects: a

substitution effect and an output effect.

 The movement from e1 to e2 can be split into two separate effects: a substitution
effect and an output effect. To understand these two effects we draw an isocost line
parallel to the new one (AB') so that it reflects the new price ratio, but tangent to the
old isoquant X1.

 The tangency occurs at point a in figure 4.6. The movement from e1 to a constitutes
the substitution effect: the firm will substitute the cheaper labour for the relatively
more expensive capita~ even if it were to produce the original level of output
X1.Thus, the employment of labour increases from L1 to L‟1. However, the firm will

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not stay at a. Because, when the wage falls, the firm, with the same total expenditure,
can buy more of labour, more of capital, or more of both. Consequently the firm can
produce the higher output X2, employing K2 of capital and L2 of labour. The increase
of employment from L'1 to L2 , corresponding to the movement from a to e2 , is the
output effect. Point e2 is not the final equilibrium of the firm. It would be if the firm
were to spend the same amount of money as initially. However, keeping the total cost
expenditure constant does not maximise the profit of the firm. The firm will increase
its expenditure and its output in order to maximise its profit.

Figure 4.7

To understand this let us assume that the initial equilibrium of the firm is defined by point H
in figure 4.7, where the firm's MC is equal to the price of X. The fall in the wage rate shifts
the MC curve downwards to the right, and the profit-maximising output of the perfectly
competitive firm increases to X3. This requires an increase in expenditures equal to the
shaded area X1HGX3.

Thus in figure 4.6 the isocost line AB' must shift outwards, parallel to itself, at a distance
corresponding to the increase in the firm's outlays. Actually the new isocost can be
determined by dividing the increase (addition) in total cost by the price of capital, r, and
adding the result to the distance OA. The new point, A', on the vertical axis is the vertical
intercept of the required isocost. The location of the firm's new isocost curve is now
determined, since this isocost is parallel to AB'.

The final equilibrium of the firm will be denoted by the point of tangency of the new isocost
A' B" with the isoquant denoting the profit-maximising output x* (point e3 in figure 4.8).

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Figure 4.8

In summary, the substitution effect of a decrease in the wage rate causes a decrease in the
MPPL because there is a smaller quantity of capital with which labour is combined.
However, the output effect and the profit-maximising effect result in an increased
employment of both inputs. Thus both these effects cause the MPPL of labour to shift
upwards to the right.

In general the output and profit-maximising effects more than offset the substitution effect, so
that the final result of a fall in the wage rate is a shift of the MPPL curve of labour to the right.
Given the price of the final commodity, Px , the VMPL shifts to the right when several
variable factors are used in the production process.

The shift is shown in figure 4.9. The new equilibrium demand for labour is denoted by point
Bon VMPL2. By repeating the above analysis with different wage rates we can generate a
series of points such as A and B. The locus of these points is the demand for labour by the
firm when several factors are variable. This is sometimes referred to as the long-run demand
for labour by the firm.

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Figure 4.9

In summary, the demand of the firm for a single variable factor is its VM P curve. The
demand for a factor when several resources are variable is the locus of points belonging to
shifting VMP curves. This long-run demand for a factor is negatively sloped, because, on
balance, the three effects of an input-price change must cause quantity demanded of the
factor to vary inversely with price.

4.1.1.2. The market demand for a factor

The market demand for an input is not the simple horizontal summation of the demand
curves of individual firms. This is due to the fact that as the price of the input falls all firms
will seek to employ more of this factor and expand their output.

Thus the supply of the commodity shifts downwards to the right, leading to a fall in the price
of the commodity, P x. Since this price is one of the components of the demand curves of the
individual firms for thefactor, these curves shift downward to the left.

Figure 4.10 shows the demand curve d1 of an individual firm for labour. Initially, suppose the
wage rate is w1. The firm is at point a on its demand curve and employs / 1 units of labour.
Summing over all employing firms, we obtain the total demand for the input at the wage rate
w1. Point A in figure 4.11 is one point on the market demand curve for labour.

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Figure 4.10 Demand of a single firm Figure 4.11 Market demand for labour

Assume next that the wage rate declines to w2. Other things being equal, the firm would
move along its demand curve dt. to point b', increasing the employed labour to L2. However,
other things do not remain equal.

When the wage rate falls, all firms tend to demand more labour, and the increased
employment leads to an increase in total output. The market supply curve for the commodity
produced shifts downward to the right, and the price of the commodity (given its demand)
falls. The decline in the price of the good reduces the value of the marginal product of labour
at all levels of employment.

In other words, the VMPL curves (the individual demand curves for labour) shift downward.
In figure 4.10 the new demand curve is d2.When the wage rate falls to w2 the firm is in
equilibrium not at point b' (on theoriginal d1 curve) but at point b on the new demand curve
d2. Summing horizontally over allfirms we obtain point B of the market demand curve.

If the fall of the commodity-price wasnot taken into account, we would be led to an over
estimation of the demand for labour following a decline in the wage rate. In figure 4.11
point B' represents the demand for labour in the market with the price of the commodity
unchanged. Note, however, that this point does not belong to the market demand curve for
labour.

The supply of labour (a variable factor) in perfectly competitive markets

The most important variable factors are raw materials, intermediate goods and labour. The
first two types are commodities, and hence their market supply is derived on the same

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principles as the supply of any commodity. The supply of labour, however, requires a
different approach.

To begin with we assume that labour is a homogeneous factor: all labour units are identical.

The main determinants of the market supply of labour are:

(a) The price of labour (wage rate).

(b) The tastes of consumers, which define their trade-off between leisure and work.

(c) The size of the population.

(d) The labour-force participation rate.

(e) The occupational, educational and geographic distribution of the labour force.

The relationship between the supply of labour and the wage rate defines the supply curve. The
other determinants can be considered as shift factors of the supply curve. Since we are
interested in the supply curve, we assume that all the other determinants are given (i.e. we
make use of the ceteris paribus clause) in order to concentrate on the slope of the supply
curve.

The market supply is the summation of the supply of labour by individuals. Thus we begin by
the derivation of the supply of labour by a single individual.

The supply of labour by an individual

The supply of labour by an individual can be derived by indifference curves analysis. On the
horizontal axis of figure 4.12 we measure the hours available for leisure (and work) over a
given period of time.

For example there are OZ maximum hours in a day, which an individual can use for leisure or
for work. On the vertical axis we measure money income. The slope of a line from Z to any
point on the vertical axis represents the wage per hour. For example, if the individual were to
work all the OZ hours and earn a total income of 0 Y0 , the wage rate would be;

From the figure we can observe that, the steeper the line, the higher the hourly wage rate.

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Figure 4.12

The indifference curves represent the preferences of the individual between leisure and
income. For example on indifference curve II of figure 4.12 the individual is indifferent
between OB hours of leisure and BZ hours of work (which bring to him an income of BN),
and OC hours of leisure and CZ hours of work (from which he earns an income of CM).

When the wage rate is w1 the individual is in equilibrium by working AZ hours, earning AA'
( = OA") income and spending OA hours on leisure. If the wage rate increases to w2 the
individual will work more hours (BZ > AZ), will earn a higher income (BB') and will have
less hours (OB) for leisure. The supply of labour can be obtained from the locus of the
equilibrium points A', B', C', etc. This supply curve is shown in figure 4.13.

Figure 4.13

However, at some higher wage rate the hours offered for work may decline. For example in
figure 4.14 if the wage rate is increased to w4 the individual will work BZ hours, the same
amount as when the wage rate was w2. If the wage rate increases still further (to w5 ), the
hours supplied for work decline even more: they drop back to AZ.

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This pattern of response to higher wage rates produces a backward-bending supply curve for
labour (figure 4.15)

Figure 4.14

Figure 4.15

Up to w3 , increases in wage rates create an incentive for increased supply of labour.

However, higher wage rates create a disincentive for longer hours of work. The reason for this
behaviour is the fact that longer working hours imply less leisure hours. As the wage rate
increases, the individual's income rises, and this enables the worker to have more leisure
activities. However, the time for such activities is less. Hence, beyond a certain level of the
wage rate, the supply of labour decreases as the worker prefers to use his income on more
leisure activities.

The market supply of labour

Although there is general agreement that the supply curve of labour by single individuals
exhibits the backward-bending pattern, economists disagree as to the shape of the aggregate
supply of labour (see koutsoynous 2nd edition PP 450). For the time being we will consider
the horizontal summation of individual supply curves to reach at positive aggregate supply of
labor.

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The determination of the factor price in perfect markets given the market demand and the
market supply of an input, its price is determined by the intersection of these two curves.

Figure 4.16

In figure 4.16 the equilibrium wage is we and the employment level is Ie. We see that the
market model is valid for the determination of the equilibrium price of a commodity or a
productive resource. The difference between commodity pricing and factor pricing lies in the
determinants of the demand for variable factors and the method used to derive the supply of
labour.

Factor Pricing In Imperfectly Competitive Markets

The price of an input, when there are imperfections in the commodity and the factor markets,
is determined by the same mechanism as in the case of perfectly competitive markets: demand
and supply determine the price of the factor and the level of its employment. However, the
determinants of the demand and the supply are different in the case of market imperfections.

We will consider four models with various kinds of imperfections.

Model A. Monopolistic power in the product market

(a) Demand of a monopolistic firm for a single variable factor

In this model we assume that the firm uses a single variable factor, labour, whose market is
perfect: the wage rate is given and the supply of labour to the individual firm is perfectly
elastic. However, the firm has monopolistic power in the market of the commodity it
produces.

This implies that the demand for the product of the firm is downward-sloping and the
marginal revenue is smaller than the price at all levels of output (figure 4.17).

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Under these conditions we will show that the demand for labour of an individual firm is not
the VMPL curve but the marginal-revenue-product curve, defined by multiplying the M P P L
times the marginal revenue of selling the commodity produced:

Figure 4.17: Imperfect product market Figure 4.18: Perfect factor market

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Recall that in this model we assume that the labour market is perfectly competitive. Hence
the supply of labour to the individual firm is perfectly elastic. This is shown by the horizontal
line S L in figure 4.19, which passes through the market wage w.

Figure 4.19
The firm, being a profit maximiser, will be in equilibrium at point e, employing lt. units of
labour. At this point

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(b) Demand of a variable factor by a monopolistic firm when several factors are used

When more than one variable factor is used in the production process the demand for a
variable factor is not its marginal-revenue-product curve, but is formed from points on
shifting MRP curves.
The analysis is similar to that of the previous section. Suppose that the market price of labour
is w1 and that its marginal revenue product is given by MRP 1 (figure 4.20). The
monopolistic firm is in equilibrium at point A, employing 11 units of labour. If the wage rate
falls to w2 the firm would move along its MRP1 curve, topoint A', if other things remained
equal.

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However, other things do not remain equal. The fall in the wage rate has a substitution effect,
an output effect and a profit maximizing effect, as in the case of a perfectly competitive firm.
The net result of these effects is a shift of the marginal-revenue-product curve to the right (in
general), which leads to the equilibrium point B. Generating points such as A and Bat various
levels of w we obtain the demand curve of labour.

Figure 4.20
The market demand for and supply of labour
The market demand for a factor is the summation of the demand curves of the individual
monopolistic firms. In aggregating these curves, however, we must take into account their
shift as the price of the factor falls: as all monopolistic firms expand their output, the market
price falls. The market price of the factor is determined by the intersection of the market
demand and the market supply. Thus the analysis does not change. However, there is an
important difference: the market demand is based on the MRPL and not on the VMPL. This
means that when the firms have monopolistic power the factor is paid its MRP which is
smaller than the VMP. This effect has been called monopolistic exploitation by Joan
Robinson(1933). According to Joan Robinson a productive factor is exploited if it is paid a
price less than the value of its marginal product (VMP).

Figure 4.21

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Thus when the commodity market is perfectly competitive the profit maximising behaviour
of firms leads to the payment of factor prices which are equal to the value of the marginal
product (VMP) of the factors.
However, the condition of equilibrium of a monopolistic firm is

and so that factors are paid less than the value of their marginal product.
Model B: Monopoly Power in The Product Market And Monopsony Power In The Factor
Market
I. Equilibrium of a monopolistic firm who use a single variable factor
In the case of a monopolistic firm the demand for labour is the as in model A. That is the
demand for labour is MRPL curve. The SS of labour to the individual firm, however, is not
perfectly elastic because the firm is large (monopsonist or the only buyer) in the labour
market. In this case the SS of labour to the firm has a positive slope. As the monopsonist
expands the use of labour, he must pay a higher wage. The SS of labour shows the average
expenditure or price that the monopsonist pays at different level of employment.

Figure 4.22

Multiplying the price of the input (w) by the level of employment gives the total expenditure
(TE) of the monopsonist for the input. That is TEL = W*L, then the average expenditure
(AEL) = TEL/L = wL/L = w. note that w is not constant in this case, but depends on the level
of employment (L); w = f(L)
Thus, w = AEL = f(L) indicating the supply of labor the monopsonist faces. The slope of the
labor supply function, dw/dL, is positive (i.e., dw/dL>0). However, the relevant magnitude
for the equilibrium of the monopsonist is the marginal expenditure of purchasing an
additional unit of the variable factor. The marginal expense is the change in the total
expenditure (on the factor) arising from hiring an additional unit of the factor i.e.,

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Since, , it follows that , for any value of L.

Therefore, The ME curve has a positive slope and lies above and to the left of the supply of
the input curve. This implies that the slope of the ME curve is greater than the slope of the
supply curve, assuming linear relations.
The slope of is

The firm is in equilibrium when it equates the marginal expenditure (MEL) on the factor to its
MRP. This is shown by pointe in figure 4.23. At e the marginal expense (which is the
marginal cost) of labour is equal to the marginal revenue product of labour.

The wage rate that the firm will pay for the le units of labour is wF, defined by the point on the
supply curve corresponding to the equilibrium point e. To state this differently, wF is the
equilibrium wage corresponding to the equilibrium level of employment. When the firm has
monopsonist power in the input market it pays to the factor a price which is less (not only
than its VM P, but also less) than its M RP. This gives rise to monopsonistic exploitation,
which is something in addition to monopolistic exploitation. To illustrate this it is convenient
to begin from the equilibrium wage rate in previous market ( perfect competion and
monopolistic market structure for both market ) by refering the following figures.

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Figure 4.24

In summary. (a) In perfectly competitive markets the factor is paid its VMP. (b) If the firm
has monopolistic power in the product market but no power in the input market, the factor is
paid its MRP < VMP. (c) If the firm has both monopolistic power in the product market and
monopsonistic power in the input market the factor is paid a price which is even lower than
its M RP. This is the basic characteristic of monopsonistic exploitation. The input price is
determined from the SL curve so that the factor does not get its MRP, which is its
contribution to the total receipts of the firm.

II. Equilibrium of a monopsonist who uses several variable factors

We have shown in previous topics that if the input markets are perfectly competitive the firm
minimizes its cost by using the factor combination at which

If the factor markets are monopsonistic, changes in the amount of factors employed causes
changes in the prices of factors. Thus w and r are not given. The monopsonist must look at
the marginal expense of the factors. It can be shown that a monopsonist who uses several
variable factors will use the input combination at which the ratio of the MPP to the ME is
equal for all variable inputs.

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Thus, the least-cost combination is obtained when the marginal rate of technical substitution
(MRTSL.K) equals the marginal expense of input ratio. For the two-input case the equilibrium
condition of the monopsonist may be stated as follows. (Read the proof from Koutsoyiannis
PP, 463)

Model C. Bilateral monopoly

In this model we assume that all firms are organised in a single body which acts like a
monopsonist, while the labour is organised in a labour union which acts like a monopolist.
Thus we have a model in which the participants are two monopolies, one on the supply side
and one on the demand side.
In general bilateral monopoly arises when a single seller (monopolist) faces a single buyer
(monopsonist). An example of a bilateral monopoly is the case of a single uranium mining
company and the uranium miners' union in a small town. We will show that the solution to a
bilateral monopoly situation is 'indeterminate'.
The model gives only upper and lower limits within which the wage rate will be determined
by bargaining. The outcome of the bargaining cannot be known with certainty. It will depend
on bargaining skills, political and economic power of the labour union and the firms, and on
many other factors.

Figure 4.25
In figure 4.25 the monopsonists' (single buyer's) demand curve is Db. It is the MRPL of the
input being demanded. From the point of view of the monopolist (labour union) this curve

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(Db) represents his average revenue curve. Thus we denote this curve as Db= AR. (average
revenue curve of seller). The seller's (union's) MRs curve can be derived by the usual
graphical technique; the MRs will lie below the AR. (and will cut any horizontal line at its
mid-point)
The supply of labour facing the monopsonist is the upward sloping curve SL. This shows the
average expense (average cost) of labour to the monopsonist. Corresponding to this average
cost curve is the ME curve. From the point of view of the monopolist (labour union) the
curve SL is its marginal cost.
Given the above cost and revenue curves we can find the equilibrium position of each
participant in the market. The monopsonist maximises its profit at point F, where the
marginal expense on labour (MEb) is equal to the marginal revenue product of labour. Thus
the monopsonist will desire to hire LF units of labour and pay a wage rate equal to wF.
The monopolist (labour union), on the other hand, maximises its profit (gains) at point U,
where his marginal cost is equal to his marginal revenue. Thus the monopolist (union) will
want to supply L, units of labour and receive a wage equal to wu. The price desired by the
monopsonist is the lower limit of price.
The price desired by the monopsonist is the lower limit and the price desired by the
monopolist is the upper limit. Therefore, the actual wage is between wf and wu which is
determined by based on the bargaining skill (power) of the two parties.

Elasticity of Factor Substitution, Technological Progress and Income Distribution

A. The Elasticity of Input Substitution and the Shares of Factors of Production

In this part we will examine how changes in factor prices affect the shares of factors and
income distribution. As factor prices change, the firm will substitute a cheaper input for a
more expensive one. This profit-maximising behaviour will result in a change of the K/ L
ratio, and, hence, to a change in the relative shares of the factors. The size of this effect
depends on the responsiveness of the change of the K/ L ratio to the factor price changes. A
measure of this responsiveness is the elasticity of substitution.
Recall that the elasticity of substitution is defined;

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In perfect input markets the firm is in equilibrium when it chooses the input combination at
which the MRTS is equal to the ratio of factor prices

Thus, in equilibrium with perfect factor markets the elasticity of substitution may be written
as

The sign of the elasticity of substitution is always positive (unless = 0) because the
numerator and denominator change in the same direction. When w/r increases, labour is
relatively more expensive than capital and this will induce the firm to substitute capital for
labour, so that the K/ L ratio increases. Conversely a decrease in w/r will result in a decrease
in the K/ L ratio. The value of u ranges from zero to infinity. Thus,
 If u = 0 it is impossible to substitute one factor for another; K and L are used
in fixed proportions (as in the input-output analysis) and the isoquants have
the shape of right angles.
 If u = the two factors are perfect substitutes: the isoquants become straight
lines with a negative slope.
 If 0 < u < factors can substitute each other to a certain extent: the isoquants
are convex to the origin. The Cobb-Douglas production function has u = 1.

In general the larger the value of u, the greater the substitutability between K and L. We may
classify u in three categories:
 < 1 : inelastic substitutability
 = 1: unitary substitutability
 > 1: elastic substitutability

There is an important relationship between the above values of u and the distributive shares
of factors. The share of the factors are expressed as

Share of labor =

Share of capital =

The factor shares depends on the state of technology which defines the production function,
and on the relative prices
Relative factor share = wL share of K = rK

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Assume that σ < 1. This implies that a given percentage change in the wjr ratio results in a
smaller percentage change in the K/ L ratio, so that the relative-share expression increases.
Thus, if σ < 1, an increase in the w/r ratio increases the distributive share of labour.
For example assume that = 0.5. Then a 10 per cent increase in w/r results in a 5 per cent
increase in the K/ L ratio. The new relative shares are

)* =

Clearly, if σ > 1 a change in w/r leads to a smaller percentage change in K/L, so that the
relative share of labour decreases. For example assume that = 2. A 20 per cent increase in
w/r leads to a 40 per cent increase in K/L The new share ratio is

 If > 1 the relative share oflabour decreases following an increase in the w/r ratio.
With a similar reasoning it can be shown that
 If = 1 the relative shares of K and L remain unchanged.

In summary, an increase in the w/r ratio will cause labour's share, relative to capital's share, to
(a) increase, if a< 1
(b) decrease, if a > 1
(c) remain the same, if a= 1

A decrease in the w/r share will have the opposite effects of the share of labour relative to
capital's share.

B. Technological Progress And Income Distribution

We have assumed up to now for a given production function the technological progress is
constant. However, technological change takes place continuously, and this shifts the
production function, leading to changes in the K/L ratio and the elasticity of substitution.
Thus, it ·is important to consider the effects of technical progress on factor shares. The
technological progress can be classified into three types, neutral, capital deepening and

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labour-deepening. The relevant diagrams (figures 21.37, 21.38, 21.39) are reproduced for
convenience.

Technological progress shifts the isoquants downwards, given that the same level of output
can be produced with smaller quantities of factor inputs as technological progress occurs.
In all three figures the isoquants X, X' and X" represent the same level of output. OR is the
ray whose slope shows a constant K/ L ratio. Points a, b and c show the points of production
at the given constant K/L ratio as technological progress takes place.
(a) Technological progress is neutral, if at a constant K/L ratio, the MRTSL,K remains
unchanged. Since in equilibrium MRTSL,K = w/r it follows that when
technological progress is neutral both the K/L ratio and the w/r ratio are
unchanged. Consequently the relative shares of factors remain unchanged.
(b) Technological progress is capital-deepening if at a constant K/L ratio, the
MRTSL,K declines. This implies that at equilibrium the w/r ratio declines, that is, r
increases relative tow, while K/L remains constant. Consequently the ratio of
factor shares declines:

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(c) Technological progress is labour-deepening if at a constant K/L ratio the M R TS

L. K increases. Then at equilibrium the w/r ratio increases as technological
progress takes place. This implies that the share of labour will increase and the
share of capital will decrease.

In summary, the relative share of labout

(a) increases if technological progress is labour-deepening,
(b) remains unchanged if technological progress is neutral,
(c) decreases if technological change is capital-deepening.

The opposite is true for the relative share of capital: this share decreases if technological
change is labourdeepening, remains constant if technological change is neutral, increases if
echnological progress is capital-deepening.

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