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Monopolistic Competition Overview

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tukunamolu
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9 views249 pages

Monopolistic Competition Overview

Uploaded by

tukunamolu
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

CHAPTERONE

MONOPOLI
STI
CCOMPETI
TION

1.
1INTRDUCTI
ON

Lear
ningObj
ect
ive

1.
2MONOPOLI
STI
CALLYCOMPETI
TIVEMARKETSTRUCTURE

1.
3Pr
oductdi
ff
erent
iat
ionandt
hedemandcur
ve

1.
4COSTOFMONOPOLOSTI
CCOMPETI
OTI
ON

1.
5THECONCEPTOFPRODUCTGROUPANDI
NDUSTRY

1.
6EQULI
BRI
UM OFMONOPOLOSTI
CALLYCOMPETI
TIVEFI
RM I
N SHORT

RUN

1.
7Longr
unequi
li
bri
um

1.
7.1Model
1Equi
li
bri
um wi
thnewf
ir
msent
eri
ngt
hepr
oductgr
oup

1.
7.2Model2 Equi
li
bri
um wi
thpr
icecompet
it
ion

1.
7.3Model3Equi
li
bri
um t
houghpr
icecompet
it
ionandf
reeent
ry

1.
8Excesscapaci
tyandwel
far
elossi
nmonopol
istcompet
it
ion

1.
9Cr
it
iquesofChamber
li
nlar
gegr
oupmonopol
ist
iccompet
it
ionmar
ket

model

Summar
y

Keyconcept
sandt
erm

Suggest
edr
eadi
ngs

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 1
ECON102MI
CROECONOMI
CSI
I

1.
1INTRDUCTI
ON

Dearst
udent
s,i
nper
viouscour
seonmi
croeconomi
cswehav
eseent
hebasi
cfeat
uresof
monopol
yand pr
efectcompet
it
ivemar
ket
.Asy
ou know pr
efectcompet
it
ivemar
ket
assumesf
reeent
ryandl
argenumberofsmal
lfi
rmspr
oduci
nghomogenouspr
oduct
.In
suchmar
ketenv
ironment
,fi
rmsar
ewor
ryonl
yaboutt
heamountofout
putpr
oducedand
t
akemar
ketpr
iceasgi
ven.I
ncaseofmonopol
y,howev
eronl
ysi
ngl
efi
rm pr
oduci
nga
pr
oductf
orwhi
cht
her
eisnocl
osesubst
it
utedomi
nat
est
hei
ndust
[Link]
esul
t,t
he
monopol
i
sti
cfi
rm haspowert
osetpr
iceandout
putl
evel
,whi
chmaxi
mizesi
tspr
ofi
t.

Unt
il1920s,t
heset
woext
remef
ormsofmar
ketmodelar
etheonl
ymodelt
hatusedt
o
expl
aint
hebehav
ioroff
ir
[Link]
er,
by1930ssomeeconomi
stsbegant
oquest
iont
he
capaci
tyoft
hesemodel
stoexpl
aint
hemoder
nmar
keteconomi
[Link]
ain
sev
eralempi
ri
calf
act
[Link]
ionofhomogenouspr
oductofpr
efectcompet
it
ive
mar
ketdi
dnotf
itt
other
eal
wor
[Link]
ert
isi
ngandot
hersel
l
ingact
ivi
ti
es,
whi
char
ewi
del
y
pr
act
icedbybusi
nessper
sons,coul
dnotexpl
ainedbybot
hmar
ketmodel
[Link]
eov
er,
undert
heexi
stenceofl
egalmonopol
yoni
tst
rademar
ksandbr
andnamesf
oraf
ir
m,i
tis
possi
blef
orot
herf
ir
mst
opr
oducesi
mil
arpr
oduct
,whi
chi
snotexact
lyt
[Link]
pr
oductv
iewedasasubst
it
utebyaconsumert
osomedegr
eeunl
i
kenon-
exi
stenceof
cl
osesubst
it
uteassumpt
ionofmonopol
ymar
ketmodel
.Fr
om t
hev
iewpoi
ntofasi
ngl
e
f
ir
mther
efor
e,pr
oduct
iondeci
sionofi
tscompet
it
orwi
l
lbeav
eryi
mpor
tantconsi
der
ati
on
i
ndeci
dinghow muchi
tcanpr
oduceandwhatpr
icei
tcanchar
[Link]
simpl
i
esper
fect
compet
it
ionandmonopol
ymar
ketmodel
sar
eusef
ult
ool
sforsheddi
ngl
i
ghtonhow
mar
ketwor
ksbutt
heyr
arel
yrepr
esentt
her
eal
mar
ketsi
tuat
ion.

Edwar
d Chamber
li
n(1933)f
rom Har
var
d Uni
ver
sit
yin hi
stheor
y ofmonopol
i
sti
c
compet
it
ionandJoanRobi
nsonf
rom Cambr
idgeUni
ver
sit
yinhereconomi
csofi
mper
fect
compet
it
ionwor
kingi
ndependent
ly,comesupwi
thanewmodel
,whi
chf
all
sbet
weent
he
t
woext
rememodel
[Link]
smodel
,whi
chi
sthesubj
ectoft
hischapt
er,i
ster
medas
monopol
i
sti
ccompet
it
ionmar
ketst
ruct
[Link]
ati
vel
yiti
samar
ketmodelt
hatcanbet
ter
expl
aint
heexi
sti
ngmar
ketsi
tuat
[Link]
e,t
hewayr
etai
ltr
ade,f
astf
oodand
cosmet
icsmar
ketwor
ksbet
terexpl
ainedbymonopol
i
sti
cal
l
ycompet
it
ivemar
ketmodel
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 2
t
hanmonopol
i
sti
corper
fectcompet
it
ivemar
ketmodel
.
I
fwet
aker
etai
ltr
ader
s,t
heysel
lgoodsi
nmanydi
ff
erentst
oresbycompet
ingwi
thone
ot
hert
hroughdi
ff
erent
iat
ingt
hei
rpr
oductbasedonl
ocat
ion,av
ail
abi
l
ityandexper
ti
seof
sal
espeopl
esandt
hepr
ovi
sionofcr
edi
tter
ms.I
naddi
ti
on,ent
ryi
srel
ati
vel
yeasy
.
Ther
efor
e,i
fthebusi
nessi
spr
ofi
tabl
enew st
orewi
l
lbeest
abl
i
shedt
osuppl
ysl
i
ght
ly
di
ff
erent
iat
edpr
oduct
[Link]
eat
ureofr
etai
ltr
adebet
terf
it
stomonopol
i
sti
ccompet
it
ion
t
hant
oper
fect
lycompet
it
iveandmonopol
ymar
ket
.Thus,monopol
i
sti
ccompet
it
ionsai
d
t
oexi
stswhent
her
ear
emanyf
ir
ms,asi
nper
fectcompet
it
ionandeachf
ir
m pr
oducea
pr
oductt
hati
ssl
i
ght
lydi
ff
erentf
rom t
hatoft
heot
her
.

Lear
ningObj
ect
ive
Att
heendoft
hischapt
er,
thest
udent
swi
l
lbeabl
eto:
I
dent
if
ythef
eat
uresofmonopol
i
sti
ccompet
it
ivemar
ketst
ruct
ure.
Def
ineconcept
sli
kepr
oductdi
ff
erent
iat
ion,
productgr
oupandi
ndust
ry.
Descr
ibet
hedemandandcostst
ruct
ureofmonopol
i
sti
ccompet
it
ivef
ir
m.
Expl
ainhowshor
tandl
ongr
unequi
l
ibr
ium oft
hef
ir
m at
tai
ned.
Def
inet
heexcesscapaci
tyofmonopol
i
sti
ccompet
it
ivef
ir
m.
Descr
ibet
hewel
far
eef
fectofmonopol
i
sti
cal
l
ycompet
it
ivef
ir
mresour
ceal
l
ocat
ion.

1.
2MONOPOLI
STI
CALLYCOMPETI
TIVEMARKETSTRUCTURE
Dearst
udent
s,cany
ouguesswhatdowemeanbymonopol
i
sti
cal
l
ycompet
it
ivemar
ket
means?I
sther
eanychar
act
ershar
edbymonopol
yandmonopol
i
sti
ccompet
it
iveaswel
l
asper
fectcompet
it
ionandmonopol
i
sti
ccompet
it
ivemar
ketst
ruct
ure?Whati
sther
ein
monopol
i
sti
ccompet
it
ionbutnoti
sper
fectcompet
it
ionandmonopol
y?Whatar
ethe
f
eat
uresofdemand;costandpr
oduct
soff
ir
msoper
atei
nmonopol
i
sti
cal
l
ycompet
it
ive
mar
ket
?Ist
her
eanymar
ketf
orapr
oductt
hatappr
oxi
mat
esmonopol
i
sti
cal
l
ycompet
it
ive
mar
keti
nyoursur
roundi
ng?Wel
lst
udent
s,wear
egoi
ngt
oanswert
hesequest
ions
gr
adual
l
ywhi
l
ewedeal
wit
hmonopol
i
sti
cal
l
ycompet
it
ivemar
keti
nthi
schapt
er.

Webeganourdi
scussi
onbyst
ati
ngt
hebasi
cassumpt
ionofChamber
li
n’
slar
gegr
oup
model
ofmonopol
i
sti
ccompet
it
ionmar
ket
.Thesear
e:
Ther
ear
elar
genumber
sofsel
l
ersi
nthepr
oductgr
[Link]
sassumpt
ioni
mpl
i
eseach
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 3
ECON102MI
CROECONOMI
CSI
I

f
ir
mint
hepr
oductgr
oupcont
ri
but
essmal
lpr
opor
ti
onoft
het
otal
suppl
[Link]
esul
t,t
her
e
i
snosi
ngl
efi
rm domi
nancei
nset
ti
ngmar
ketpr
iceandcol
l
usi
onbet
weenf
ir
mst
ogai
n
mar
ketpoweri
simpossi
ble.
Sel
l
ersf
oundi
nthesamepr
oductgr
ouppr
oducedi
ff
erent
iat
edpr
oductandy
ett
heyar
e
cl
osesubst
it
utesofoneanot
her
.Thi
sist
omeant
hateachf
ir
m makesi
tspr
oduct
di
ff
erentf
rom ot
herf
ir
m bychangi
ngt
hei
rinher
entchar
act
eri
sti
csoft
hei
rpr
oductor
t
hroughdi
ff
erentsal
espr
omot
ionact
ivi
ti
[Link]
esul
t,f
ir
msgetcer
tai
nmonopol
ypower
t
osetpr
[Link]
er,t
hei
rmonopol
ypowerusual
l
ysmal
lrel
ati
vet
omonopol
i
sti
cfi
rm
becauseoft
heexi
stenceofst
if
fcompet
it
ionf
rom ot
herf
ir
mspr
oduci
ngsi
mil
arpr
oduct
.
I
tisr
elat
ivel
yeasyf
ornewf
ir
mst
oent
ert
hemar
ketwi
tht
hei
rownbr
andsandf
orexi
sti
ng
f
ir
mst
oleav
ethepr
oductgr
oupi
ftheyar
eunpr
ofi
tabl
[Link]
ncet
her
eisnobar
ri
ert
oent
ry,
a
f
ir
m cannotmakeposi
ti
vepr
ofi
tint
hel
ongr
un.
Theobj
ect
iveoft
hef
ir
msi
spr
ofi
tmaxi
mizat
ioni
nbot
htheshor
trunandl
ongr
un.
Fi
rmsassumedt
obehav
easi
fitknewi
tsdemandandcostcur
veswi
thcer
tai
nty
.
Bot
hdemandandcostcur
vesf
oral
lpr
oduct
sar
euni
for
mthr
oughoutt
hegr
[Link]
s
assumpt
ionmadei
nor
dert
opr
esentt
heequi
l
ibr
ium oft
hef
ir
m andpr
oductgr
oupont
he
samedi
agr
am.

Asi
ndi
cat
edi
ntheassumpt
ion,
amonopol
i
sti
cal
l
ycompet
it
ivemar
ketst
ruct
urehassome
el
ementofbot
hmonopol
yandpr
efectcompet
it
[Link]
actt
hatt
her
ear
emanyf
ir
msi
na
monopol
i
sti
cal
l
ycompet
it
ivesi
tuat
ioni
saper
fectcompet
it
iveel
ementt
hatr
est
ri
ctst
he
abi
l
ityoff
ir
mst
ocont
rolpr
icet
hroughpr
oductdi
ff
erent
iat
[Link]
gni
fi
cantdi
ff
erencei
n
pr
icebet
weenf
ir
msqui
ckl
yleadscust
omer
stoabandont
hel
oyal
ti
esbui
l
tbypr
oduct
di
ff
erent
iat
[Link]
swi
l
lcauseshi
fti
npr
efer
enceofconsumerf
rom hi
ghpr
icepr
oductt
o
l
owerpr
icecl
osesubst
it
[Link]
herper
fectcompet
it
iveel
ementi
seasyent
ryoff
ir
msi
n
amonopol
i
sti
cal
l
ycompet
it
ivemar
ketev
ent
houghpr
oductdi
ff
erent
iat
ion,whi
cht
akes
t
hef
orm ofbr
andnameorf
ir
m’sl
oyal
ty,canactasbar
ri
ert
oent
[Link]
efor
e,wecannot
sayt
hatt
her
eiscompl
etef
reedom ofent
ryasi
npur
ecompet
it
[Link]
hert
her
eis
r
easonabl
efr
eedom ofent
ry.

Ont
heot
herhand,t
hepr
oductofeachf
ir
minmonopol
i
sti
ccompet
it
ioni
sdi
ff
erent
iat
ed.
Thati
seach f
ir
m sel
l
sa br
and ora v
ersi
on oft
he pr
oductt
hatdi
ff
ersi
n qual
i
ty,
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 4
appear
anceorr
eput
ati
on and i
tisasol
epr
oducerofi
tsown br
[Link] pr
oduct
di
ff
erent
iat
iongi
vesmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m somemar
ketpowert
osetdi
ff
erent
pr
icef
rom t
hei
rcompet
it
orsr
athert
hanpassi
vel
yaccept
ingt
hemar
ketpr
[Link]
l
ythe
gr
eat
ert
hedi
ff
erent
iat
ion,
thegr
eat
ert
hedi
scr
eti
onar
ymar
ketpowerofagi
venf
ir
mtoset
i
tspr
oductpr
[Link]
oducti
shi
ghl
ydi
ff
erent
iat
ed,t
hepr
oductofeachsel
l
eri
s
si
mil
arbutnoti
dent
ical
.Thi
smaygi
vet
hem amonopol
ypowerov
ert
hespeci
fi
cpr
oducti
t
sel
l
s.

__
_______
____
____
____
___
____
____
_ _
____
___
___
_____
_____
____
___
_ _
____
_____
____
Acti
vi
ty1.1
Descri
bethefeat
ureofmonopol
isti
ccompet
it
ionthatr
esemblesperf
ectcompet
it
iveand
t
henmonopol
i
sti
cmar
ketst
ruct
ure.
Det
ermi
newhet
hert
hef
oll
owi
ngf
ir
msoper
atei
namonopol
i
sti
c,per
fectcompet
it
iveor
monopol
i
sti
cal
l
ycompet
it
ivemar
ketst
ruct
ure.
bar
bershop d)l
aundr
ysoappr
oducer
s
r
est
aur
ant
s e)t
oot
hpast
e pr
oducer
s
I
cecr
eam pr
oducer
s.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Fr
om t
heabov
edi
scussi
on,i
tispossi
blet
oconcl
udet
hatmonopol
i
sti
ccompet
it
ionasa
mar
ketst
ruct
urei
nwhi
ch:
Al
argenumberofi
ndependentf
ir
mscompet
e.
Eachf
ir
m pr
oducesadi
ff
erent
iat
edpr
oduct
.
Fi
rmscompet
eonpr
oductqual
i
ty,
pri
ceandmar
ket
ingact
ivi
ti
es.
Easyent
erandexi
toff
ir
mst
othemar
ket
.

1.
3Pr
oductdi
ff
erent
iat
ionandt
hedemandcur
ve
Chamber
li
ndev
elopshi
stheor
yofmonopol
i
sti
ccompet
it
ionbasedonsomeempi
ri
cal
f
act
[Link]
ear
ever
yfewmonopol
i
stsbecauset
her
ear
ever
yfewcommodi
ti
esf
orwhi
ch
cl
osesubst
it
utesdonotexi
[Link]
mil
arl
y,v
eryf
ewcommodi
ti
esar
eent
ir
elyhomogeneous
t
omakeper
fectcompet
it
ionassumpt
ionr
eal
i
sti
[Link]
nst
ancest
her
ear
enohomogenous
aut
omobi
l
es,
soaps,
sui
ts,
tel
evi
sionset
s,gr
ocer
yst
ores,
magazi
nesandot
her
[Link]
e
diff
erenti
[Link],eachpr oducert
ri
est
odi
ff
erent
iat
ehi
spr
oductt
omakei
t
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 5
ECON102MI
CROECONOMI
CSI
I

uni
queandr
educest
henumberofi
tscl
osesubst
it
[Link]
ocessofmaki
ngapr
oduct
uni
quef
rom ot
herpr
oducti
scal
l
edpr
oductdi
ff
erent
iat
[Link]
li
nusest
heconcept
ofpr
oductdi
ff
erent
iat
iont
odev
elopt
het
heor
yofmonopol
i
sti
ccompet
it
ion.

Ther
e ar
etwo t
ypes ofpr
oductdi
ff
erent
iat
ion:r
ealand f
anci
ed (
spur
ious)pr
oduct
di
ff
erent
iat
[Link]
oductdi
ff
erent
iat
ioni
ssai
dtober
eal
,i
fthepr
oduct
sfoundi
nthesame
pr
oductgr
oupdi
ff
eri
nter
msoft
hei
rinher
it
ancechar
act
eri
sti
[Link]
ff
erenti
n
t
het
ypeofi
nputusedt
opr
oducet
hepr
oduct
;speci
fi
cat
ionandl
ocat
ionoft
hef
ir
min
t
erms ofconv
ince t
o be accessed byt
he consumer
.Forexampl
e,shampoos wi
th
condi
ti
onerandwi
thoutcondi
ti
onerar
edi
ff
erent
iat
edi
nthei
rcont
ent
.Gr
ocer
yst
ores
f
ound neart
othe house ofcust
omerand f
arf
rom t
he house ofa cust
omerar
e
di
ff
erent
iat
edi
nter
msoft
hei
rlocat
ion.
Fanci
ed(
spur
ious)pr
oductdi
ff
erent
iat
ioni
sacasewher
ethepr
oduct
sar
ethesamebut
t
hepr
oducer
sthati
tspr
oductdi
ff
ersf
rom ot
hercl
osesubst
it
utesconv
inceconsumer
s.
Suchdi
ff
erent
iat
ionoccur
sthr
oughadv
ert
isement
,di
ff
erencei
npacki
ng,desi
gn,br
and
nameandot
hersal
espr
omot
ionact
ivi
ti
[Link]
evert
het
ype,pr
oductdi
ff
erent
iat
ion
det
ermi
nest
henat
ureofdemandcur
vef
aci
ngagi
vef
ir
m.

Thedemandcur
vef
aci
ngaf
ir
m wi
l
ldependonout
putdeci
sionsandpr
iceschar
gedby
ot
herf
ir
mst
hatpr
oducesi
mil
arpr
oduct
.Thati
sthesl
opeofdemandcur
vef
aci
ngt
hef
ir
m
wi
l
ldependonhow si
mil
art
hef
ir
m’spr
oduct
sar
e.I
flar
genumberoff
ir
mspr
oduces
i
dent
icalorhomogenouspr
oduct
s,t
hent
hedemandcur
vef
aci
ngt
hef
ir
msi
sfl
[Link]
f
ir
m mustsel
lit
spr
oductatmar
ketpr
[Link]
ir
mthatt
ri
est
orai
sei
tspr
iceabov
e
mar
ketpr
icewoul
dlossal
lofi
tscust
omer
[Link]
heot
herhand,i
faf
ir
m hasexcl
usi
ve
r
ightt
osel
lapar
ti
cul
arpr
oduct
,itmayr
aisei
tspr
icewi
thoutl
osi
ngal
lofi
tscust
omer
s.

Fi
rm cangai
ncer
tai
nmonopol
ypowert
hroughpr
oductdi
ff
erent
iat
ionbymaki
ngagi
ven
pr
oductuni
quet
othemi
ndoft
heconsumer
.Thi
swi
l
lcr
eat
ebr
andl
oyal
tyofconsumerf
or
apr
oductandgi
vensomedi
scr
eti
onpowerf
ort
hef
ir
mst
osett
hepr
iceoft
hei
rpr
oduct
di
ff
erentf
rom t
hei
rcompet
it
orpr
[Link] r
esul
tthe demand f
aci
ng i
ndi
vi
dualf
ir
m
becomesdownwar
dsl
opi
[Link]
ir
m di
dnotl
ossi
tsent
ir
ecust
omert
hroughpr
icer
ise
ev
en t
hough some oft
hem swi
tch t
oit
s compet
it
ors pr
oduct
.Howev
ergi
ven t
he
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 6
compet
it
iveel
ementofmonopol
i
sti
cal
l
ycompet
it
ivepr
oductgr
oup(
lar
genumberoff
ir
m
andeasyent
ry)
,smal
lri
sei
npr
icer
esul
tsi
nlar
gef
alli
nquant
iydemanded.
t Fori
nst
ance
i
fpr
icei
ncr
easesf
rom P1 t
oP2 i
nfi
gur
e1.
1,quant
it
ydemandeddecr
easesf
rom Q1 t
oQ2.
Becausei
ncr
easei
npr
icel
eadst
hef
ir
mtol
osesomeofi
tscust
omer
s.

Pr
ice

P2

P1

Demand

Q2 Q1 Quant
it
yDemand

Fi
gur
e1.
1:Demandcur
veofmonopol
ist
ical
lycompet
it
ivef
ir
m

I
nsummar
ypr
oductdi
ff
erent
iat
ion,whi
chi
sthebasi
sofnon-
pri
cecompet
it
ion,gi
ve
monopol
i
sti
cal
l
ycompet
it
ivef
ir
m cer
tai
nmonopol
ypowerandt
hendownwar
dsl
opi
ng
demandcur
ve.I
not
herwor
dinmonopol
i
sti
cal
l
ycompet
it
ivemar
ketst
ruct
ure,f
ir
mshav
e
acer
tai
ncapaci
tyt
ochanget
hedemandf
ort
hei
rpr
oductt
hroughpr
oductdi
ff
erent
iat
ion.
Ev
en t
hough f
ir
ms i
n monopol
i
sti
cal
l
y compet
it
ive mar
ketf
aces downwar
d sl
opi
ng
demandcur
ve,t
hei
rdemandcur
vei
shi
ghl
yel
ast
icbecauseoft
heexi
stenceofl
arge
numberoff
ir
mspr
oduci
ngcl
osel
ysubst
it
utepr
oduct
s.
_
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___
___
Act
ivi
ty1.
2
Howdoesaf
ir
m undert
akepr
oductdi
ff
erent
iat
ion?
Doespr
oductdi
ff
erent
iat
ionhav
eanyi
mpl
i
cat
ionont
hedemandf
ort
hepr
oductofaf
ir
m
andi
tsmar
ketpower
?
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 7
ECON102MI
CROECONOMI
CSI
I

Fr
om demandcur
veofmonopol
i
sti
ccompet
it
ionandmonopol
i
sti
cfi
rm,whi
chonei
s
mor
epr
iceel
ast
icandWhy
?
_
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___
___
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___
___
___
___
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___
___
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___
___
___
___
1.
4COSTOFMONOPOLOSTI
CCOMPETI
OTI
ON
Dearst
udent
s,wehav
eseent
hatmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m under
takedi
ff
erent
act
ivi
ti
esandchangescomposi
ti
onsofgoodst
odi
ff
erent
iat
ethei
rpr
oductf
rom t
hei
r
compet
it
[Link]
e,f
ir
msusei
ntensi
veadv
ert
isement
stoi
ncr
easesdemandand
ev
ent
oinf
orm pot
ent
ialbuy
ersaboutt
heav
ail
abi
l
ityoft
hepr
oduct
.Thi
scausesst
rong
at
tachmentofconsumert
othepr
oductsot
hatpr
iceel
ast
ici
tyofdemandf
ort
hepr
oduct
becomes v
eryl
ow.I
n ot
herwor
ds,f
ir
ms of
ten dev
ote consi
der
abl
eresour
ces t
o
di
ff
erent
iat
ethei
rpr
oductf
rom t
hei
rcompet
it
orst
hroughsuchdev
icesasqual
i
tyandst
yle
v
ari
ati
ons, war
rant
ies and guar
ant
ees, speci
al ser
vices f
eat
ures, and pr
oduct
adv
ert
isement
.Al
loft
heseact
ivi
ti
esr
equi
ref
ir
mst
oempl
oyanaddi
ti
onalr
esour
cet
hat
i
ncur
saddi
ti
oncostt
[Link]
scosti
sknownassel
l
ingcostorcostofpr
oduct
di
ff
erent
iat
[Link]
efor
e,f
ir
mshav
eto consi
dert
hiscostdur
ing pr
ici
ng and out
put
deci
si
oni
naddi
ti
ont
otr
adi
ti
onal
product
ioncost
s.

Li
ke per
fect compet
it
ion and monopol
i
sti
c f
ir
m, t
radi
ti
onal pr
oduct
ion cost of
monopol
i
sti
cal
l
ycompet
it
ivef
ir
m’sav
eragecost
sandmar
ginalcost
sar
eal
lU-
shaped.
Suchshapei
ndi
cat
est
heoper
ati
onofl
awofdi
mini
shi
ngmar
ginalr
etur
nint
heshor
trun
and l
aw ofr
etur
nto scal
eint
he l
ong r
un dur
ing pr
oduct
ion pr
ocess. Mor
eov
er,
Chamber
li
ntr
iest
oshowt
heav
erageandmar
ginalsel
l
ingcost
scur
veofmonopol
i
sti
cal
l
y
compet
it
ivef
ir
m hav
eU-
shape.I
fwet
akeadv
ert
isement
,costt
hatcompr
isest
hemaj
or
pr
opor
ti
onofsel
l
ingcostshowseconomi
esanddi
seconomi
esofscal
e.

Asi
ndi
cat
edi
nfi
gur
e1.
2,i
nit
ial
l
ytheamountofsel
l
sexpansi
ont
hroughadv
ert
isementwi
l
l
notr
esul
tinequal
l
yincr
easei
nsel
l
ingcost
.Iti
schar
act
eri
zedbyf
all
i
ngoft
heav
erage
sel
l
ingcostbecauseofi
ncr
easer
etur
ntoscal
eofadv
ert
isement(
economi
esofscal
e).
Howev
er,whenl
argequant
it
yofout
putsol
d,af
teracer
tai
nlev
el,f
ir
mshav
etospend
mor
eperuni
tinor
dert
oincr
easet
heamountofout
putsol
[Link]
sdi
seconomi
esof
adv
ert
isementst
artt
ooper
ateandav
eragesel
l
ingcosti
ncr
easeaf
teri
tsmi
nimum poi
nt.
Suchf
eat
ureofav
eragesel
l
ingcostgi
ver
iset
oU-
shapedav
eragesel
l
ingcost
.Ther
efor
e,
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 8
si
ncebot
hpr
oduct
ionandsel
l
ingcost
shav
eU-
shaped,t
het
otalav
erageandmar
ginal
cost
sofmonopol
i
sti
cal
l
ycompet
it
ionf
ir
misU-
shapedsi
mil
art
ocostcur
vesofmonopol
y
andper
fectcompet
it
ivef
ir
[Link]
er,t
heav
erageandmar
ginalcostofmonopol
i
sti
cal
l
y
compet
it
ivef
ir
misgr
eat
ert
hanav
erageandmar
ginalcostofper
fectcompet
it
iveand
monopol
i
sti
c f
ir
m because of t
he addi
ti
onal cost
s i
ncur
red t
o dur
ing pr
oduct
di
ff
erent
iat
ion.

Economicsof
AC adver
ti
sement

Diseconomies
of
adverti
sement

Out
putsol
d
M

Fi
gur
e1.
2:

1.
5THECONCEPTOFPRODUCTGROUPANDI
NDUSTRY
I
tisdef
inedi
nper
fectcompet
it
iont
hatani
ndust
ryi
sagr
oupoff
ir
mspr
oduci
nga
homogenouspr
oduct
.Howev
er,whenpr
oduct
sar
edi
ff
erent
iat
ed l
i
kei
nthecaseof
monopol
i
sti
ccompet
it
ion,
onecannotdef
ineani
ndust
ryi
nthi
snar
[Link]
eisno
aut
omobi
l
e,soaporf
urni
tur
eindust
[Link]
ir
mint
heaut
omobi
l
e,soaporf
urni
tur
e
i
ndust
rypr
oducesi
tsowndi
sti
nctpr
oduct
.Thi
simpl
i
espr
oductdi
ff
erent
iat
ioncr
eat
e
di
ff
icul
ti
esi
ndef
ini
ngt
heboundar
iesofani
ndust
[Link]
erogeneousgr
oupcannotadd
t
oget
hert
ofr
om ani
ndust
ryandt
othei
rmar
ketdemandandsuppl
yschedul
e.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 9
ECON102MI
CROECONOMI
CSI
I

Toov
ercomet
hispr
obl
em,Chamber
li
nint
roducest
heconceptofpr
oductgr
oup.I
tis
f
ormedbyl
umpi
ngt
oget
herf
ir
m’spr
oduci
ngsi
mil
arpr
oduct
s,whi
char
ecl
osesubst
it
utes.
Theyar
egr
oup ofpr
oductwi
th hi
gherpr
iceand cr
ossel
ast
ici
ti
[Link]
consumerpr
efer
encef
oreachpr
oductshi
ft
stoot
herpr
oducti
nthegr
oupwheni
tspr
ice
i
ncr
[Link]
nst
ance,wecanf
orm apr
oductgr
oupbyput
ti
ngt
oget
herdi
ff
erentmodel
ofaut
omobi
l
[Link]
omobi
l
esar
edi
ff
erent
iat
edpr
oduct
.Theyar
ecl
osesubst
it
ute(
used
f
ort
hesamepur
pose)andt
hei
rpr
iceandcr
ossel
ast
ici
tyofeachaut
omobi
l
emodelar
e
hi
gh.I
fthepr
iceofonemodel
incr
easeconsumer
sshi
ftt
hei
rpr
efer
encet
oot
hermodel
.

Dearst
udent
s,howdoeschamber
lai
n’
stheor
ywor
kwi
tht
hei
deaofpr
oductgr
oup?Dur
ing
t
hedet
ermi
nat
ionofequi
l
ibr
ium mar
ketpr
iceandout
put
,indust
rydemandandsuppl
y
shoul
dbeconsi
der
[Link]
scanbepossi
blebysummat
ionofi
ndi
vi
dualdemandand
suppl
ywhi
chneedcommonpr
[Link]
thpr
oductdi
ff
erent
iat
ionhowev
er,wecannotder
ive
i
ndust
rydemandandsuppl
ycur
veaswedi
dforper
fectcompet
it
ivemar
ket
.Wedonot
hav
easi
ngl
eequi
l
ibr
ium pr
icef
ordi
ff
erent
iat
edpr
oduct
,butacl
ust
erofpr
ices.

Fort
hisr
eason,i
nor
dert
oanal
yzehi
smodelofmonopol
i
sti
ccompet
it
ion,Chamber
li
n
madeassumpt
ionaboutdemandandcostoff
ir
msi
nthepr
oductgr
[Link]
sev
eryf
ir
m
i
nthepr
oductgr
oupf
acest
hesamedemandcur
vewi
thi
dent
ical
costev
ent
houghi
tisnot
t
hecasei
nrealsi
tuat
[Link]
ionenabl
esust
ogetuni
queequi
l
ibr
ium pr
iceand
t
otr
eatf
ir
msandmar
ketdemandont
hesamegr
[Link]
er,i
ffi
rmssuppl
ydi
ff
erent
pr
oductt
omar
kett
henwhyshoul
dthei
rdemandandcost
sar
eident
ical
?Thi
sisonepoi
nt
uponwhi
chChamber
li
nmodel
ofmonopol
i
sti
ccompet
it
ionwascr
it
ici
zed.
_
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___
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___
Act
ivi
ty1.
3
Doescostst
ruct
ureofmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m hav
eanydi
ff
erencef
rom f
ir
ms
f
oundi
not
hermar
ketst
ruct
ure?I
fyeshow?
Whati
sthedi
ff
erencebet
weenpr
oductgr
oupandi
ndust
ry?
St
atet
heassumpt
ionmadebyChamber
li
ninor
dert
ogetuni
queequi
l
ibr
ium pr
iceand
mar
ketdemandandsuppl
yfordi
ff
erent
iat
edpr
oduct
.
_
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___
___
___
___
1.
6EQULI
BRI
UM OFMONOPOLOSTI
CALLYCOMPETI
TIVEFI
RM I
N SHORT
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 10
RUN
Bynow wehav
egetf
ami
l
iarwi
tht
hedi
ff
erentcomponentofpr
ofi
tofmonopol
i
sti
cal
l
y
compet
it
ivef
ir
m,i
.e.t
hei
rcostand demand st
ruct
[Link] f
ir
m’s pr
oducti
nthe
Chamber
li
nwor
ldi
ssomewhatdi
ff
erentf
rom t
hepr
oductofi
tsr
ival
[Link]
ssi
tuat
iongi
ves
r
iset
odownwar
dsl
opi
ngdemandcur
vef
ort
hef
ir
[Link]
simpl
i
esadecr
easei
nthepr
ice
ofi
ndi
vi
dualpr
oductr
esul
tsi
nincr
ease i
n sal
es v
olume oft
he f
ir
m byat
tr
act
ing
cust
omer
sofot
herr
ival
ryf
ir
[Link]
heot
herhand,
incr
easei
npr
icewi
l
lresul
tindecr
ease
i
nthesal
esv
olumeoft
hef
ir
[Link]
sisbecausesomecust
omer
sshi
ftt
hei
rpr
efer
encet
o
ot
herpr
oductbecauseofi
ncr
easei
npr
ice. Suchr
elat
ionshi
pbet
weenpr
iceandsel
l
s
v
olumeoff
ir
mscanbei
ndi
cat
edbyi
ndi
vi
dualdemandcur
veasar
esul
tindi
vi
dualdemand
cur
veal
soknownaspl
annedsal
ecur
ve.

Asi
nthecaseofmonopol
y,si
ncet
hedemandcur
veofmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m
i
s negat
ivel
ysl
oped,t
he cor
respondi
ng mar
ginalr
evenue sl
oped downwar
[Link]
sis
i
ndi
cat
edby f
igur
e1.
3.Q1andP1r
epr
esentshor
trunequi
l
ibr
ium l
evelofout
putandpr
ice
r
espect
ivel
y..Bot
har
echar
act
eri
zedbyt
hei
nter
sect
ionofmar
ginal
rev
enue(
der
ivedf
rom
ef
fect
ivedemandcur
ve)andt
hef
ir
msmar
ginalcostcur
[Link]
ingachi
evedt
hispoi
nt,
the
f
ir
m woul
dhav
enoi
ncent
ivet
ochangei
tspr
icef
rom [Link]
i
tyofmar
ginalr
evenue
andmar
ginalcostatout
putQ1 meanst
hatf
ir
m bel
i
evest
hati
twoul
dmaxi
miz
eit
spr
ofi
t
bymai
ntai
ningi
tspr
[Link]
hei
ndi
cat
edpoi
ntmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m ear
n
aposi
ti
vepr
ofi
tequal
stot
hear
eaofshadedr
egi
on.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 11
ECON102MI
CROECONOMI
CSI
I

Pr
ice

SMC

P1 SAC

Economi
c
prof
it Demand

MR
Pr
ice

Q1
Quant
it
yofo
Sutput
MC
Fi
gur
e1.
3(a)Shor
trunequi
li
bri
um undermonopol
ist
iccompet
it
ion.

P1 SAC
Howev
er,
thef
actthatf
ir
msar
eatequi
l
ibr
ium wi
l
lnotgr
antposi
ti
veabnor
malprof
itt
othe
f
ir
[Link]
sist
otal
l
ydependi
ngonapoi
ntatwhi
chmar
ginalr
evenueequal
stomar
ginal
cos
Et
.o
cAn
sindc
omiicatedinfi
gur
e1.3(b)bel
ow,i
fthepoi
ntofint
ersect
ionMR=MC(margi
nalcost
prof
itr Demand
equal
sma ginalrev
enue)takesplaceswher
eaveragecostequalst
othedemandcurve,
t
hef
ir
m ear
nszer
o(nor
mal
)pr
ofi
tsi
ngl
ethei
rcostequal
tot
hei
rrev MR
enueatt
hispoi
nt

Q1
Pr
ice Quant
it
yofoutput
Fi
gur
e1.
3(a)Shor
trunequi
li
bri
um undermonopol
ist
iccompet
it
ion.
SMC

P1 SAC

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 12

Demand
I
fthepoi
ntofi
nter
sect
iont
akespl
ace,wher
edemandcur
vei
sbel
ow t
heav
eragecost
cur
ve,t
hef
ir
mincur
sal
ossequalt
otheshadedr
egi
oni
ndi
cat
edbyf
igur
e1.
3(c)
.Thi
sis
becauset
hei
rtot
alcostgr
eat
ert
hant
otal
rev
enue.

Pr
ice
SMC

P1

Demand

MR

Q1
Quant
it
yofout
put

Ther
efor
e,f
ormonopol
i
sti
cal
l
ycompet
it
ivef
ir
m t
o ear
n posi
ti
ve abnor
malpr
ofi
tat
equi
l
ibr
ium i
ntheshor
trun,t
heequal
i
tybet
weenMRandMCshoul
dtakepl
aceswhen
demandcur
vei
sgr
eat
ert
hanshor
trunav
eragecostcur
ve.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 13
ECON102MI
CROECONOMI
CSI
I

1.
7Longr
unequi
li
bri
um

I
nthel
ong r
unj
ustl
i
keper
fectcompet
it
ion,monopol
i
sti
cal
l
ycompet
it
ivef
ir
m make
changet
othescal
eoft
hei
rpl
antt
omi
nimi
zecostofpr
oduct
[Link]
sodeci
dest
o
l
eav
eindust
ryi
ftheyseet
hepr
ospectt
oear
ningnegat
ivepr
ofi
tandent
eri
ntot
he
i
ndust
ryi
fther
eisapr
ospectofear
ningposi
ti
vepr
ofi
[Link]
ust
mentpr
ocessl
eadst
o
l
ongr
unequi
l
ibr
ium l
evelofout
putandpr
ice,whi
chi
schar
act
eri
zedbyt
het
angencyof
l
ongr
unav
eragecostcur
veanddemandcur
ve.I
tisal
sochar
act
eri
zedbyt
heequal
i
tyof
l
ongr
unmar
ginalcostandmar
ginalr
[Link]
hispoi
ntt
otalr
evenueequal
stot
otal
costr
esul
ti
ngi
nzer
oeconomi
cpr
ofi
[Link]
swi
l
lcr
eat
edi
sincent
ivet
oent
ert
hemar
ket
.
Theadj
ust
ment
stosuchpoi
ntt
akespl
acet
hroughchangei
ntheposi
ti
onofdemand
cur
ver
esul
tedf
rom ent
erandexi
toff
ir
msorpr
iceadj
ust
mentbyt
heexi
sti
ngf
ir
m ora
combi
nat
ionoft
het
wo.

I
nor
dert
oanal
yzehow l
ongr
unequi
l
ibr
ium l
evelofout
putandpr
icef
oraf
ir
m andan
i
ndust
ryont
hesamedi
agr
am,Chamber
li
nmadet
woher
oicassumpt
[Link]
rmshav
e
i
dent
icalcostandconsumerpr
efer
encesar
eev
enl
ydi
str
ibut
edamongdi
ff
erentpr
oduct
.
Thati
sev
ent
hought
hepr
oduct
sar
edi
ff
erent
iat
ed;al
lfi
rmsassumedt
ohav
eident
ical
costanddemandcur
[Link]
heseassumpt
ions,i
tispossi
blet
ogetauni
quemar
ket
equi
l
ibr
ium pr
[Link]
vent
heabov
eassumpt
ion,
Chamber
li
ndev
elopedt
hreedi
sti
nctmodel
ofl
ongr
unequi
l
ibr
ium.
Equi
l
ibr
ium wi
thnewf
ir
m ent
eri
ngt
hei
ndust
ry
Equi
l
ibr
ium wi
thpr
icecompet
it
ion
Equi
l
ibr
ium wi
thpr
icecompet
it
ionandf
reeent
ryofnewf
ir
ms

1.
7.1Model1Equi
li
bri
um wi
thnewf
ir
msent
eri
ngt
hepr
oductgr
oup

I
nthi
smodel
,theexi
sti
ngf
ir
msar
eassumedt
obei
nshor
trunequi
l
ibr
ium r
eal
i
zing
abnor
mal
prof
it
,i.
e.,
exi
sti
ngf
ir
m donothav
eanyi
ncent
ivet
oadj
ustt
hei
rpr
[Link]
efor
e,
how i
slongr
unequi
l
ibr
ium r
unachi
eved?Accor
dingt
otheequi
l
ibr
ium wi
thnew ent
er
model
,equi
l
ibr
ium posi
ti
oncanbeat
tai
nedt
hroughent
ryofnewf
ir
mswhoar
eat
tr
act
ed
byt
heshor
trunposi
ti
veeconomi
cpr
ofi
[Link]
ryofnewf
ir
msandexi
tofol
dfi
rmscan
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 14
causesshi
fti
ndemandcur
vef
aci
nganysi
ngl
efi
[Link]
sincr
easei
nthenumberof
f
ir
mst
hroughent
ryi
nthepr
oductgr
oupshi
ft
sthei
ndi
vi
dualdemandcur
veoft
hef
ir
m
i
nwar
dtot
hel
eft
.Thi
sisbecausemar
ketdemand(
whi
chi
srel
ati
vel
yfi
xed)di
vi
dedamong
mor
efi
[Link]
ketshar
eofi
ndi
vi
dualf
ir
msdecr
easescausi
ng i
nwar
d shi
ftof
i
ndi
vi
dualdemandcur
veofaf
ir
[Link]
efor
e,ent
ryandexi
tpushdemandcur
vef
aci
ngany
si
ngl
efi
rmt
owar
dequi
l
ibr
ium posi
ti
onwher
eiti
stangentt
olongr
unav
eragecostcur
ve.

Asi
ndi
cat
edi
nfi
gur
e1.
4bel
owf
ir
m wi
thl
ongr
unav
eragecostofLAC,
longr
unmar
ginal
costofLMCandf
aci
ngademandcur
vedd1 ,wi
l
lsetpr
iceatapoi
ntwher
emar
ginal
r
evenueequal
stomar
ginalcosti
ntheshor
[Link]
hispoi
ntf
ir
msi
nthepr
oductgr
oup
ear
nabnor
mal
pr
ofi
tofar
[Link]
efor
e,t
her
eisnoi
ncent
ivef
ort
hesef
ir
mst
ochanget
hei
rpr
ice
P1 andout
[Link]
er,t
heabnor
malpr
ofi
tsobt
ainedbyexi
sti
ngf
ir
msat
tr
actot
her
newf
ir
mst
oent
eri
ntot
hemar
keti
nthel
ongr
un.

Pr
ice

LMC

P1
LAC

P2

MR1 d2 d1
MR2
Q2 Q1
Quant
it
yofout
put
Fi
gur
e1.
4:l
ongr
unequi
li
bri
um wi
thnewent
ryoff
ir
ms
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 15
ECON102MI
CROECONOMI
CSI
I

Asshowni
nfi
gur
e1-
4,f
ir
msf
oundi
nthepr
oductgr
oupr
eachshor
trunequi
l
ibr
ium at
pr
icel
evelp1 andt
heydonothav
eanyi
ncent
ivet
ochangei
tspr
icef
rom [Link]
er,
the
abnor
malpr
ofi
tear
nedbyexi
sti
ngf
ir
msat
tract
sot
hernewf
ir
msi
ntot
hemar
ket
.When
newf
ir
msent
eri
ntot
hemar
ket
,themar
ketshar
eofi
ndi
vi
dualf
ir
m decr
[Link]
swi
l
l
causesi
nwar
dshi
fti
nindi
vi
dual
demandcur
[Link]
ngt
hatcostcur
veswi
l
lnotshi
ftas
ent
ryoccur
s,eachshi
fti
ndemandcur
ver
esul
tinest
abl
i
shmentofnew equi
l
ibr
ium ata
poi
ntwher
enew mar
ginalr
evenuei
nter
sectmar
ginalcostcur
[Link]
s,asmor
eand
mor
enew f
ir
msent
ryi
ntot
hepr
oductgr
oup,t
her
eiscont
inuousshi
fti
ntheor
igi
nal
demandcur
ve,dd1 .Suchadj
ust
mentpr
ocesscont
inuesunt
ilt
heshi
ft
eddemandcur
ve
dd2,t
angentt
olongr
unav
eragecostcur
ve(
LAC)atpoi
[Link]
ntE,af
ir
m char
gesp2
andpr
oducesQ2 l
evelofout
putandear
nszer
oeconomi
cpr
ofi
[Link]
ir
msr
eachsuch
t
angencypoi
nt,t
her
eisnof
urt
herent
rysi
ncef
urt
herent
rymakesf
ir
mst
oear
nnegat
ive
pr
ofi
t(l
oss)
. Thus,t
hel
ongr
unequi
l
ibr
ium becomesst
abl
ewhent
heshi
ft
eddemand
cur
vei
stangentt
othel
ongr
unav
eragecostcur
ve.

1.
7.2Model2 Equi
li
bri
um wi
thpr
icecompet
it
ion
Equi
l
ibr
ium wi
thpr
icecompet
it
ionmodelassumest
henumberoff
ir
msi
nthei
ndust
ryi
s
compat
ibl
ewi
thl
ongr
unequi
l
ibr
[Link]
efor
e,noent
ryorexi
tthatwi
l
ltakepl
acei
nthe
l
ongr
[Link]
er,si
nceshor
trunequi
l
ibr
ium pr
icei
shi
ghert
hanl
ongr
unequi
l
ibr
ium
pr
ice,
longr
unequi
l
ibr
ium l
evelofpr
iceat
tai
nedt
hroughpr
icecompet
it
ionamongf
ir
msi
n
t
hepr
oductgr
oup.

Toconductt
heanal
ysi
sofhow l
ongr
unequi
l
ibr
ium achi
evedundert
heassumpt
ionof
pr
icecompet
it
ionmodel
,theseconddemandcur
ver
epr
esent
edDD’i
sint
roducedas
showni
nfi
gur
e1.
5.I
tisacur
vet
hatshowst
heact
ualsal
eofaf
ir
m ateachpr
icel
evel
af
teradj
ust
mentofpr
icet
o capt
uremor
eshar
eoft
hemar
ket
.Thi
sdemand cur
ve
somet
imescal
l
edact
ualsal
esorshar
eoft
hemar
ketcur
vesi
ncei
tindi
cat
etheshar
eof
eachf
ir
mint
hepr
oductgr
[Link]
it
orschanget
hei
rpr
ice,t
hemar
ketshar
eof
eachf
ir
mschangesandi
ndi
vi
dualdemandcur
veshi
ft
saccor
dingl
[Link]
ingpoi
nts
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 16
t
hatshow mar
ketshar
eofa f
ir
m when pr
iceadj
ust
mentmadebycompet
it
orf
ir
m
i
ndependent
lygi
vesact
ualsal
escur
ve(
mar
ketdemand)
.Amov
emental
ongDD’shows
change i
nthe act
ualsal
es oft
he exi
sti
ng f
ir
ms as al
loft
hem adj
ust
sthei
rpr
ice
si
mul
taneousl
yandhav
esi
mil
armar
ketshar
easbef
oret
hepr
iceadj
ust
mentmade.

d1

D3 D2 D1
Pr
ic
e d2

LMC
d3

LAC

P*

d’
1
D’
3
D’
2 d’
2
d’
3
D’
3

Q* MR3
Quant
it
yofout
put
Fi
gur
e1.
4:l
ongr
unequi
li
bri
um wi
thpr
icecompet
it
ion

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 17
ECON102MI
CROECONOMI
CSI
I

Dearst
udent
s,gi
vent
heassumpt
ionoft
hemodel
,how l
ongr
unequi
l
ibr
ium i
sachi
eved
t
hroughpr
icecompet
it
ion?Letusbeganf
rom shor
trunequi
l
ibr
ium posi
ti
onl
i
keP3and
seehow l
ongr
unequi
l
ibr
ium achi
evedt
hroughpr
iceadj
ust
mentofexi
sti
ngf
ir
[Link]
at
temptt
omaxi
mizei
tspr
ofi
tagi
venf
ir
mreducei
tspr
icet
oincr
easesi
tsmar
ketshar
e.
Howev
er,
theat
tempti
snotr
eal
i
zed,
becauseal
lot
herf
ir
mshav
ingt
hesamedemandand
costcondi
ti
onhav
ethei
ncent
ivet
oacti
nthesamewaysi
mul
taneousl
[Link]
ir
m
at
temptt
o maxi
mize t
hei
rpr
ofi
t,i
gnor
ing t
he r
eact
ion ofot
hercompet
it
oron t
he
assumpt
iont
hatt
heef
fectofot
herf
ir
msondemandofi
tspr
oducti
snotsi
gni
fi
cant
.
Suchact
ionoff
ir
msshi
ft
sthei
ndi
vi
dualdemandcur
vei
nwar
dresul
ti
ngi
nsmal
lamount
ofsal
ethanexpect
edamountont
heshi
ft
eddemandcur
vedd2 al
ongt
heshar
ecur
ve.I
n
t
hef
utur
eiff
ir
msl
ear
nfr
om t
hei
rpostexper
ience,t
heywi
l
lnotdot
hesamesi
ncei
t
r
educet
hei
rpr
ofi
[Link]
eraccor
dingt
othemodelf
ir
mssuf
ferf
rom my
opi
aandcannot
l
ear
nfor
mthei
rexper
iences.I
tcont
inuest
obehav
eont
heassumpt
iont
hati
tsnew
demanddd2 wi
l
lnotshi
ftf
urt
heruponl
ower
ingt
hei
rpr
[Link]
hef
ir
mloweri
tpr
ice
agai
ninanat
temptt
ogetmaxi
mum pr
ofi
t,st
il
lot
herf
ir
msal
sodot
hesamet
[Link]
s
wi
l
lcausesi
nwar
dshi
fti
ndemandcur
vet
[Link]
ocesswi
l
lcont
inueunt
ilt
heLAC
t
angentt
othei
nter
sect
ionpoi
ntoft
heshi
ft
edi
ndi
vi
dualdemandcur
veandact
ualsal
es
cur
veatpoi
[Link]
spoi
ntr
epr
esent
slongr
unequi
l
ibr
ium ofmonopol
i
sti
cal
l
ycompet
it
ive
f
ir
m compet
ingt
hroughpr
iceadj
ust
ment
.

1.
7.3Model3Equi
li
bri
um t
houghpr
icecompet
it
ionandf
reeent
ry
Dearst
udent
s,i
stheassumpt
ionofequi
l
ibr
ium wi
thpr
icecompet
it
ionmodelandnew
ent
ryoff
ir
mst
oreachonl
ongr
unequi
l
ibr
ium hol
dsi
nrealwor
ld?Thatmeans,i
sthe
numberoff
ir
msi
nthepr
oductgr
oupi
ntheshor
truni
sopt
imalasi
nthesecondmodel
andi
sequi
l
ibr
ium achi
evedt
hroughf
reeent
ryorexi
tonl
yasi
nthef
ir
stmodel
.As
Chamber
li
nsuggest
sinact
uall
i
fel
ongr
unequi
l
ibr
ium i
sachi
evedbot
hthr
oughpr
ice
adj
ust
mentofexi
sti
ngf
ir
msandbynew ent
[Link]
sist
hemai
nassumpt
ionoft
het
hir
d
model
thatweconsi
dernext
.
Asi
tisi
ndi
cat
edFi
gur
e1.
6,pr
iceadj
ust
menti
smadeal
ongt
heddcur
vewhi
l
eent
ry(
exi
t)
causeshi
ft
sinDDcur
[Link]
l
ibr
ium oft
hef
ir
misst
abl
eifDDcur
vet
angentt
oLACatt
he
i
nter
sect
ionpoi
ntbet
weenddandDDcur
ve(
act
ualsal
esequal
stopl
annedsal
es)
.Letus
seehowt
hel
ongr
unequi
l
ibr
ium oft
angencysol
uti
onachi
evedt
hroughpr
iceadj
ust
ment
,
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 18
ent
ryandexi
toff
ir
[Link]
trunequi
l
ibr
ium poi
nt,f
ir
msi
nthei
ndust
rygetabnor
mal
economi
cpr
ofi
[Link]
ir
msbei
ngat
tract
edt
osuchabnor
malpr
ofi
t,ent
eri
ntot
hemar
ket
.
Thi
swi
l
lcauseshi
fti
nDD1cur
vei
nwar
dst
epwi
seasmor
enewf
ir
msent
ryt
akepl
aceunt
il
t
heyst
artt
oear
nnor
mal
prof
it
.Att
hesamet
ime,
exi
sti
ngf
ir
msi
ndependent
lyr
educet
hei
r
pr
iceonmy
opi
cassumpt
iont
omaxi
mizet
hei
rpr
ofi
tthr
oughi
ncr
easi
ngmar
ketshar
e
emanat
edf
rom pr
icer
educt
[Link]
ioni
npr
icecausepl
annedsal
escur
ve,ddshi
ft
i
nwar
dal
ongDDcur
veandassumedt
ost
opatapoi
ntwher
eddcur
vet
angentt
oLAC
cur
[Link]
er,
ift
heycont
inuepr
icer
educt
ionbel
owt
angencypoi
nt,
eachf
ir
mreal
i
zesa
l
ossi
nst
eadofposi
ti
veornor
mal
prof
it
.

d1

D3 D2 D1
Pr
ice
d2
LMC
d3

LAC

P*

d’
1
D’
3
D’
2 d’
2
d’
3
D’
3

Q* MR3
Quant
it
yofout
put
ADAMAUNI Fi
gur
VERSIe1.
6:Equi
li
bri
um wi
thpr
icecompet
TYDEPARTMENTOFECONOMI
CS it
ionandf
reeent
ryandexi
ts 19
ECON102MI
CROECONOMI
CSI
I

Forexampl
eiff
ir
msr
educet
hei
rpr
icebel
owP*t
heyst
artt
oincural
ossandf
inanci
all
y
weakf
ir
mswi
l
lev
ent
ual
l
yleav
ethei
ndust
ryf
ir
st,sot
hatsur
viv
ingf
ir
mswi
l
lhav
eal
arge
shar
[Link]
twi
l
lcont
inueunt
ilddcur
ve(
plannedsal
escur
ve)t
angentt
otheav
eragecost
cur
veatt
hecut
ti
ngpoi
ntofDDcur
veatpoi
ntEasi
ndi
cat
edi
nfi
gur
e1.
[Link]
spoi
nti
sthe
l
ong r
un equi
l
ibr
ium of monopol
i
sti
cal
l
y compet
it
ivef
ir
m obt
ained t
hrough pr
ice
compet
it
ionandent
ryofnewf
ir
msandexi
tofol
dfi
rms.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty1.
4
St
ateshor
trunpr
ofi
tmaxi
mizat
ioncondi
ti
onofamonopol
i
sti
cal
l
ycompet
it
ivef
ir
m.
Descr
ibe how l
ong r
un equi
l
ibr
ium ofmonopol
i
sti
cal
l
y compet
it
ivef
ir
m achi
eved
accor
dingt
o:
Equi
l
ibr
ium wi
thpr
icecompet
it
ionmodel
b)Equi
l
ibr
ium wi
thent
ryandexi
toff
ir
msmodel
[Link]
ti
onshoul
dsat
isf
yformonopol
i
sti
cal
l
ycompet
it
ivef
ir
mtomaxi
mizel
ong
r
unpr
ofi
t?Howmuchpr
ofi
twoul
dthef
ir
m ear
natt
hisl
ongr
unequi
l
ibr
ium poi
nt?
1.
8Excesscapaci
tyandwel
far
elossi
nmonopol
istcompet
it
ion

Asy
our
ememberf
rom mi
croeconomi
csI
,fi
rmi
nper
fectcompet
it
ivemar
ketst
ruct
ure
oper
ateatami
nimum poi
ntofl
ongr
unav
eragecostcur
vei
nthel
ongr
[Link],
it
usedpl
ant
satt
hei
rful
lcapaci
tyandpr
oducedout
putatami
nimum f
easi
blecost
.Thi
s
i
mpl
i
esr
esour
cesal
l
ocat
edef
fi
cient
lybyf
ir
m oper
ati
ngi
nper
fectcompet
it
ionmar
ket
st
ruct
ure
compar
edt
ofi
rmsi
not
hermar
ketmodel
s.I
naddi
ti
on,out
putpr
oduct
iondeci
siont
ake
pl
aceatapoi
ntwher
eP=LMC=mi
nLACi
nthel
ongr
[Link],pr
icesandout
putsetat
equi
l
ibr
ium maxi
mizet
het
otalconsumer
sandpr
oducersur
pluscompar
edt
oot
herf
ir
ms
oper
ati
ngi
nimper
fectmar
ketst
ruct
[Link]
hisgr
ound,wecanuseper
fectcompet
it
ion
f
ir
m deci
si
onasabenchmar
ktoanal
yzet
heef
fi
ciencyandwel
far
eimpl
i
cat
ionoff
ir
ms
oper
atei
not
hermar
ketenv
ironment
.
Dearst
udent
s,dof
ir
msi
nmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m wi
l
ltendt
ooper
atewi
th
excess capaci
ty?I
n ot
her wor
ds,i
s monopol
i
sti
cal
l
y compet
it
ivef
ir
m expandi
ng
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 20
pr
oduct
ioni
nthel
ongr
unt
oapoi
ntatwhi
chi
tscostmi
nimi
zed?Toanswert
hisquest
ion
l
etusr
evi
sitChamber
li
n’
slongr
unequi
l
ibr
ium ofmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m.
Longr
unequi
l
ibr
ium oft
hef
ir
m undermonopol
i
sti
ccompet
it
ionat
tai
nedatapoi
ntwher
e
t
heper
cei
veddemandcur
vei
stangentt
oLACcur
[Link]
ncet
hedemandcur
vei
sdownwar
d
sl
opi
ng,t
heLACi
sal
sodownwar
dsl
opi
ngatt
hepoi
ntoft
angency
.Thus,unl
i
kepr
efect
compet
it
ion,
thef
ir
m’sequi
l
ibr
ium wi
l
lnotachi
evedatt
hemi
nimum poi
ntofav
eragecost
cur
ve.I
nst
ead,t
het
angencybet
weent
heLACcur
veanddemandcur
vet
akepl
acesat
downwar
dsl
opi
ngpor
ti
onoft
heLACcur
[Link]
s,f
ir
msi
nmonopol
i
sti
ccompet
it
ion
const
ructapl
antsmal
l
ert
hant
hemi
nimum costsi
zeandoper
atei
tatl
esst
hant
he
mi
nimum costout
put
.Ther
efor
emonopol
i
sti
cal
l
ycompet
it
ivef
ir
mint
hel
ongr
unpr
oduce
out
putbel
ow t
hei
rful
lcapaci
ty(
bel
ow t
heopt
imalpoi
nt)
.Thei
rcostofpr
oduct
ioni
s
hi
ghert
hant
hatofpur
ecompet
it
[Link]
sisbecausemonopol
i
sti
ccompet
it
ionf
ir
mincur
s
addi
ti
onal
cost
,whi
chi
sknownassel
l
ingcost
.

Pr
ic
e SMC
LMC

LAC

SMC
P2 E SAC
E’

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 21
MR Demand
ECON102MI
CROECONOMI
CSI
I

I
tiscl
earf
rom f
igur
e1.
7,t
heshor
truncostcur
vesofmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m
whobehav
einChamber
li
nwaybui
l
dingsmal
l
erpl
antsi
zet
hanami
nimum costpl
antand
oper
ateatpoi
ntE.I
naddi
ti
on,l
ongr
unav
eragecostcur
vei
stangentt
odemandcur
veat
poi
ntEbef
orei
treachmi
nimum poi
[Link]
efor
e,f
ir
minmonopol
i
sti
ccompet
it
ionwoul
d
notev
enbepr
oduci
ngatt
hemi
nimum ofi
tshor
trunav
eragecost
,poi
ntE.
Thi
simpl
i
esmonopol
i
sti
cal
l
ycompet
it
ivef
ir
m wor
king atsubopt
imalscal
eswi
thout
exhaust
ivel
yusi
ngt
headv
ant
ageofeconomi
esofscal
[Link]
eoper
ati
ngwi
thexcess
capaci
tydef
inedast
hedi
ff
erencebet
weent
hel
ongr
unequi
l
ibr
ium l
evelofout
putandt
he
out
putl
evelatami
nimum poi
ntofLAC(
equi
l
ibr
ium poi
ntofper
fectcompet
it
ivef
ir
ms)
.It
i
sthedi
ff
erencebet
weenM andQ2

Fr
om soci
albenef
itpoi
ntofVi
ew,Monopol
i
sti
ccompet
it
iondeci
siondi
dnotmaxi
mize
soci
alwel
far
esi
nceequi
l
ibr
ium pr
icei
shi
ghert
hanMCandout
puti
sbel
owsoci
aldesi
red
l
evel
.Ifat
tempti
smadet
oequal
i
zepr
iceandmar
ginalcost
,thef
ir
mincur
sal
ossi
nthe
l
ongr
[Link]
sisbecausel
ongr
unmar
ginalcostcur
vei
nter
sectDD2 (
shi
ft
edact
ualsal
es
cur
ve)bel
ow l
ongr
unav
eragecostcur
[Link]
simpl
i
est
hesoci
aldesi
redpoi
nt,P=MC
cannotachi
evewi
tht
heassumpt
ionofmonopol
i
sti
cal
l
ycompet
it
ivemar
ketst
ruct
ure.

Howev
er,Chamber
li
nar
gued t
hatt
hecr
isi
sofexcesscapaci
tyand mi
sal
l
ocat
ionof
r
esour
cei
sval
i
donl
yifoneassumest
hatdemandcur
veofi
ndi
vi
dualf
ir
mishor
izont
al.I
f
demandcur
vei
sdownwar
dsl
opi
ngandf
ir
msent
eri
ntopr
icecompet
it
ionwhi
l
eent
ryi
s
f
ree,
thenpoi
ntM
cannotbeconsi
der
edassoci
alopt
imall
evelofout
put
.Consumerwant
stohav
evar
iet
ies
ofpr
oduct
[Link]
oductdi
ff
erent
iat
ionand downwar
d sl
opi
ng demand cur
ver
efl
ectt
he
desi
resofconsumert
opayhi
gherpr
icei
nor
dert
ohav
echoi
ceamongdi
ff
erent
iat
ed
pr
oduct
s.I
fsuchpr
oduct
spr
oducedathi
ghercostt
hanmi
nimum amount
,iti
ssoci
all
y
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 22
accept
abl
erat
hert
hanconsi
der
edassoci
alcost
.Ther
efor
e,t
hedi
ff
erencebet
weenM and
Q2 woul
dnotbeameasur
eofexcesscapaci
tyf
orChamber
li
[Link]
heri
trepr
esent
ssoci
al
costofpr
oduci
ngandof
fer
ingconsumer
sal
argedi
ver
sit
yofpr
oduct
[Link]
li
n,
excesscapaci
tyi
sther
esul
tofnon-
pri
cecompet
it
ioncoupl
edwi
thf
reeent
ry.I
nthi
scase
f
ir
mignor
esi
tddcur
ve(
sinceonpr
iceadj
ust
mentar
emade)andconcer
nitsel
fwi
thi
ts
mar
ketshar
e.I
not
herwor
ds,
act
ualsal
escur
ve(
DD)becomest
her
elev
antdemandcur
ve
off
ir
[Link]
orChamber
li
nexcesscapaci
tyi
sthedi
ff
erencebet
weenQ2 and Q1
i
ndi
cat
edi
nfi
gur
e1.

Recent
ly,di
ff
erentt
ypesofr
esear
chsuggestt
hatt
hear
gumentofexcesscapaci
tyi
s
somewhatmy
opi
[Link]
inash di
xi
t,Mi
chaelSpence,Joseph st
igl
i
tz and ot
herhav
e
suggest
edt
hatpr
oductdi
ver
sit
yof
fer
edt
oconsumer
sbymonopol
i
sti
cal
l
ycompet
it
ive
f
ir
m suppor
tthei
deaofsoci
albenef
it
.consumer
shav
egotmor
echancet
osel
ectf
orm
wi
dev
ari
etyofpr
oduct
swhenpr
oduct
sar
edi
ff
erent
iat
ed(di
ver
sif
ied)andsot
hesoci
ety
benef
itconsumer
shav
egotmor
echanget
osel
ectf
rom wi
thv
ari
etyofpr
oduct
swhen
pr
oduct
sar
edi
ff
erent
iat
ed(di
ver
sif
ied).Thesoci
etybenef
itmor
ethani
tscost and
soci
alwel
far
eismaxi
mized

Pr
ice

LAC
PO1
ADAMAUNI
VERSI
TYDEPARTMENTOFEC NOMI
CS 23
ECON102MI
CROECONOMI
CSI
I

I
ngener
al,compar
edt
ofi
rmi
naper
fectcompet
it
ivemar
ket
,fi
rm undermonopol
i
sti
c
compet
it
ionpr
obabl
ypr
oducesl
essandsetahi
gherpr
[Link]
veconf
ront
ing
t
hemonopol
i
sti
ccompet
it
orwoul
dnotbeper
fect
lyel
ast
icasi
nper
fectcompet
it
ivef
ir
m.
I
tsmar
ginalr
evenuet
her
efor
e,i
slowert
hanpr
icecompar
edt
otheequal
i
tyofmar
ginal
r
evenuewi
thpr
icei
nper
fectcompet
it
ivemar
ket
.Ont
heot
herhand,monopol
i
sti
cal
l
y
compet
it
ivef
ir
msar
eli
kel
ytohav
elowerpr
ofi
tgr
eat
eroutput
,andl
owerpr
icecompar
ed
t
omonopol
i
sti
cfi
rm.

1.
9Cr
it
iquesofChamber
li
nlar
gegr
oupmonopol
ist
iccompet
it
ionmar
ketmodel
Thi
smodel
coul
dbeat
tackedont
hef
oll
owi
ngpoi
nts;
-
The assumpt
ion ofpr
oductdi
ff
erent
iat
ion i
sincompat
ibl
e wi
tht
he assumpt
ion of
i
ndependentact
ion and f
ree ent
ry off
ir
ms.I
tassumes t
hatt
he f
ir
m act
ions ar
e
i
ndependentbutf
ir
msar
edependentoneachot
her
.Ther
ear
ea\
l
soent
rybar
ri
erf
ornewf
ir
ms.
I
tisdi
ff
icul
ttoacceptt
hemy
opi
cbehav
iorofbusi
nessf
ir
mimpl
i
edi
nthemodel
.Nor
mal
l
y,
busi
nessf
ir
msl
ear
nfr
om t
hei
rexper
ience.
The concept of i
ndust
ryi
s dest
roy
ed by r
ecogni
ti
on of pr
oduct di
ff
erent
iat
ion.
Het
erogeneouspr
oduct
scannotbeaddedt
oget
hert
ofor
mindust
ri
esdemandcur
vei
n
or
dert
ocomeupwi
thauni
queEqui
l
ibr
ium pr
ice.
Themodelassumesal
argenumberoff
ir
mswi
thhi
gherpr
iceel
ast
ici
tyofpr
oductsol
din
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 24
monopol
i
sti
ccompet
it
ivemar
ket
.But
,thedonotobj
ect
ivel
ydef
inedt
henumberoff
ir
ms
andt
hel
evel
ofel
ast
ici
tyr
equi
redt
ohav
eamonopol
i
sti
ccompet
it
ivemar
ketst
ruct
ure.

Cont
ri
but
ionoft
hemodel
I
ntr
oducet
heconceptofpr
oductdi
ff
erent
iat
ionandsel
l
ingst
rat
egyast
woaddi
ti
onal
pol
i
cyv
ari
abl
esi
nopt
imaldeci
sion-
maki
ngpr
ocessoft
hef
ir
[Link]
act
orsar
ethe
basi
sofnon-
pri
cecompet
it
ion,
whi
chi
sat
ypi
cal
for
m ofcompet
it
ioni
nreal
wor
ld.
I
tint
roducest
heconceptofshar
eoft
hemar
ketdemandcur
veasat
ool
ofanal
ysi
s.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
__
Act
ivi
ty1.
5
Def
inemonopol
i
sti
ccompet
it
ionexcesscapaci
ty.
St
atet
hecondi
ti
onatwhi
chout
putandpr
icesett
omaxi
mizessoci
alwel
far
eandachi
eve
pr
oduct
ionef
fi
ci
ency
.
Dot
hel
ongr
unequi
l
ibr
ium l
evel
out
putandpr
icemaxi
mizesoci
alwel
far
e?Why
?
Descr
ibe t
he cont
ri
but
ions of monopol
i
sti
cal
l
y compet
it
ive mar
ket model t
o
mi
croeconomi
cst
heor
y.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

Summar
y
Monopol
i
sti
ccompet
it
ioni
samar
ketst
ruct
urei
nwhi
chl
argenumberoff
ir
mscompet
es
by sel
l
ingdi
ff
erent
iat
edpr
oduct
[Link]
ent
hought
hepr
oduct
sar
edi
ff
erent
iat
ed,
theyar
e
st
il
lcl
osesubst
it
ute.
Pr
oductdi
ff
erent
iat
ioncanbef
anci
edorr
eal
.Fanci
edpr
oductdi
ff
erent
iat
ioni
sacase
whent
hepr
oduct
sar
ethesamebutt
heconsumeri
sper
suadedt
hroughdi
ff
erentsel
l
s
pr
omot
ionact
ivi
tysuchasadv
ert
isement t
hati
tspr
oducti
suni
quef
rom i
tscl
ose
subst
it
ute
Realdi
ff
erent
iat
ioni
scasewhent
hei
nher
tantchar
act
eroft
hepr
oducti
sdi
ff
erent
.Each
cl
osesubst
it
utedi
ff
ersi
nter
msoft
hei
nputused,
qual
i
tyandl
ocat
ion.
Pr
oduct
sdi
ff
erent
iat
iongi
vesmonopol
i
sti
ccompet
it
ionf
ir
m acer
tai
nmonopol
i
sti
cpower
t
oinf
luencet
hepr
iceofi
tspr
oduct
.Compar
edt
omonopol
i
sti
cfi
rmt
hemonopol
ypower
i
srest
ri
ctedbyt
heexi
stenceofcl
osesubst
it
ute.
ADAMAUNI
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TYDEPARTMENTOFECONOMI
CS 25
ECON102MI
CROECONOMI
CSI
I

Pr
oductdi
ff
erent
iat
iongi
ver
iset
odownwar
dsl
opi
ngdemandcur
[Link]
rmscani
ncr
ease
pr
icewi
thoutl
osi
ngal
li
tscust
omer
sorhast
oreducepr
icet
oat
tr
actmor
ecust
omer
s.
Monopol
i
sti
cal
l
ycompet
it
ivemar
kethasU-
shapedcostcur
vesl
i
ket
hecasei
naper
fect
ly
compet
it
ivemar
ket
.Howev
er,costofmonopol
i
sti
ccompet
it
ionf
ir
mincl
udessel
l
ingcost
i
naddi
ti
ont
otr
adi
ti
onal
product
ioncost
.
I
nmonopol
i
sti
ccompet
it
ion,t
her
eisaneedf
oradv
ert
isi
ngt
oconv
inceconsumer
sthat
t
hepr
oducti
sindeeduni
queandbet
ter
.
I
nthe shor
trun,monopol
i
sti
c compet
it
ion f
ir
ms act
s as a monopol
i
stand opt
imal
deci
si
onbyequat
ingmar
ginalr
evenuewi
thmar
ginalcost
.Atapoi
ntwher
emar
ginal
r
evenueequal
stomar
ginalcost
,thef
ir
m ear
nposi
ti
veorabnor
malpr
ofi
tpr
ovi
dedt
hati
t
t
akespl
acewher
edemandcur
vegr
eat
ert
hant
hemi
nimum poi
ntofshor
trunACcur
ve.
Long r
un equi
l
ibr
ium i
sofmonopol
i
sti
ccompet
it
ivef
ir
m achi
eved ata poi
ntwher
e
demand cur
vei
stangentt
othef
all
i
ng por
ti
onofl
ong r
unav
eragecostcur
[Link]
t
angencypoi
ntar
ri
vet
hroughadj
ust
mentcausedbyshi
fti
ndemandcur
vesdue:
Pr
icecompet
it
ion
ent
ryofnewf
ir
msat
tract
edbyshor
trunabnor
mal
prof
it
Bot
hthr
oughent
ryofnewf
ir
msandpr
icecompet
it
ionatt
hesamet
ime
Monopol
i
sti
ccompet
it
ionf
ir
mint
hel
ongr
unmakeout
putdeci
sionathi
ghercost
.Iti
s
pr
oducedatapoi
ntbef
oret
hemi
nimum l
ongr
unav
eragecost
.Asar
esul
tfi
rmsi
n
monopol
i
sti
ccompet
it
ioni
ndust
rysai
dto bei
nef
fi
cient
.Theycoul
d notuset
hef
ull
capaci
ty.
Fr
om soci
alpoi
ntofv
iew monopol
i
sti
ccompet
it
ionf
ir
m woul
dnotmaxi
mizessoci
al
wel
far
eint
hel
ongr
[Link]
sbecauset
heysetpr
icesabov
ethemar
ginal
cost
.

Keyconcept
sandt
erms
Pr
oductdi
ff
erent
iat
ion I
ndust
ry
Pr
oductgr
oup Chamber
li
nexcesscapaci
ty
Sel
l
ingcost r
eal
andf
anci
eddi
ff
erent
iat
ion
Her
oicchamber
li
nassumpt
ion equi
l
ibr
ium wi
thnewent
ryoff
ir
ms
equi
l
ibr
ium wi
thpr
icecompet
it
ion

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 26
Suggest
edr
eadi
ngs
Ni
chol
son,
w:Mi
croeconomi
ctheor
y;basi
cpr
inci
pleandext on.5thedi
ensi ti
on
Sal
vat
ore,
D(2003)
:Mi
croeconomi
cs;
theor
yandappl
icat
i 4thedi
ons. ti
on
Mansf
iel
d,E.
andYohe,
G(2000)
:Mi
croeconomi
cs,
theor
yandappl
icat
i 10thedi
ons. ti
on
Var
ian,
[Link]
l(1999)
:Int
ermedi
atemi
cr cs3rdedi
oeconomi ti
on
Pi
ndy
ck,
[Link]
nfel
d,D.
L.(
2003)
:Mi
cr cs.6thedi
oeconomi ti
on

CHAPTERTWO
OLI
GOPOLYMARKETSTRUCTURE

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 27
ECON102MI
CROECONOMI
CSI
I

2.
1Int
roduct
ion
Lear
ningobj
ect
ive
2.
2Noncol
lusi
veol
igopol
y
2.
2.1Theki
nkeddemandcur
vemodel
2.
2.2Cour
notmodel
2.
2.2.
1React
ioncur
veappr
oach
2.
2.2.
2Mat
hemat
icalv
ersi
onofcour
notduopol
ymodel
2.
2.3TheBer
trandduopol
ymodel
2.
2.4St
ackel
ber
gModel
2.
3Col
lusi
veol
igopol
y
2.
3.1Car
tel
2.
3.1.
1Car
telai
mingatj
ointpr
ofi
tmaxi
mizat
ion
2.
3.1.
2Mar
ketShar
ingCar
tel
2.
3.2Pr
icel
eader
shi
p
2.
3.2.
1Lowcostpr
icel
eader
shi
p
2.
3.2.
2Domi
nantf
ir
m pr
icel
eader
shi
p
2.
3.2.
3Bar
omet
ri
cpr
icel
eadershi
p
Summar
y
Keyconcept
sandt
erms
Exer
cise
Suggest
edr
eadi
ngs

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 28
2.
1Int
roduct
ion
Dearst
udent
s,i
ntheor
yofMi
croeconomi
csI
,wehav
est
udi
edper
fectcompet
it
ionand
monopol
ymar
ketst
ruct
[Link]
hoft
hem i
ncommonassumet
hatt
hedeci
siont
akenby
anypar
ti
cul
arf
ir
m hasnodi
ff
usedef
fectont
heenv
ironmenti
nwhi
chot
herf
ir
msoper
ate.
I
ndi
vi
dualf
ir
mther
efor
esaf
elynegl
ectt
her
eact
ionorbehav
iorofi
tscompet
it
ori
nmaki
ng
i
tsdeci
si
[Link]
all
y,t
hei
ssueofst
rat
egi
cint
eract
ionbet
weenf
ir
msi
sir
rel
evanti
n
per
fect compet
it
ion because t
he pr
evai
l
ing mar
ket pr
ice conv
ey al
lthe ext
ernal
i
nfor
mat
iont
hatwasr
elev
antt
othef
ir
m.I
stheabov
efeat
ureoff
ir
mscanbeappl
i
edt
o
f
ir
msi
nol
i
gopol
ymar
ketst
ruct
ure?No,becausewhensmal
lnumberofl
argef
ir
ms
domi
nat
ingapar
ti
cul
ari
ndust
rypr
oduci
nghomogenousordi
ff
erent
iat
edpr
oduct
,any
changei
naf
ir
m’spr
iceorout
puti
nfl
uencet
hesal
esandpr
ofi
tofi
tscompet
it
[Link]
r
esul
t,eachf
ir
mfor
mul
atesi
tspol
i
ciesandst
rat
egi
eswi
thaney
eoni
tscompet
it
or
deci
si
on.A mar
ketmodel
,whi
chconsi
der
ssuchi
nter
dependenceoff
ew f
ir
mswhen
maki
ngopt
imaldeci
si
on,i
scal
l
edol
i
gopol
ymar
ketmodel
/st
ruct
ure,whi
chi
sthesubj
ect
oft
hischapt
er.

Thechapt
erbegi
nswi
thdi
scussi
onaboutt
hechar
act
eri
sti
csandsour
ceofol
i
gopol
y
mar
ketmodel
;then,exami
nev
ari
ouscol
l
usi
veandnon-
col
l
usi
veduopol
ymodelopt
imal
pr
iceandout
putdet
ermi
nat
ionunderdi
ff
erentbehav
ior
alassumpt
ionaboutt
hef
ir
ms
oper
ati
ngi
ndi
ff
erentol
i
gopol
yindust
ry.
Lear
ningobj
ect
ive
Att
heendoft
hechapt
er,
youar
eexpect
edt
o:
Di
ff
erent
iat
eol
i
gopol
yfr
om ot
herf
ormsofmar
ket
I
dent
if
yhowi
nter
dependencebet
weenf
ir
msaf
fectt
hei
ropt
imal
deci
sion
Expl
aint
hedi
ff
erencebet
weendi
ff
erentduopol
ymodel
s
Expl
ain how equi
l
ibr
ium pr
ice and out
putdet
ermi
ned i
n col
l
usi
ve and non-
col
l
usi
ve
ol
i
gopol
ymar
ketst
ruct
ure.

Ol
igopol
y
Asi
tisment
ionedabov
e,ol
i
gopol
yisamar
ketst
ruct
uredomi
nat
edbyf
ew sel
l
ersof
homogenousordi ffer
entiatedpr oduct
.Asar
esul
t,t
heact
ionofeachf
ir
m af
fect
sthe
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 29
ECON102MI
CROECONOMI
CSI
I

ot
herf
ir
m’sdeci
si
oni
nthei
ndust
[Link]
ndust
ryi
nEt
hiopi
aisagoodexampl
eofsuch
t
ypeofi
ndust
[Link]
hemaj
orbeerpr
oducer
stakesi
ntoaccountt
her
eact
ionof
ot
her
swhent
heyf
ormul
atet
hei
rpr
iceandout
putpol
i
[Link]
nthi
scase
know t
hati
tsownact
ionwi
l
lhav
esi
gni
fi
canti
mpactont
her
estoft
hebeerpr
oducer
s.
Ther
efor
e,Bedeloranyot
herpr
oducerconsi
der
sthepossi
bler
eact
ionofi
tscompet
it
ori
n
deci
ding pr
ices,degr
ee of pr
oduct di
ff
erent
iat
ion t
o be i
ntr
oduced,t
he l
evelof
adv
ert
isementt
obeunder
takenandt
heamountofser
vicet
obepr
ovi
dedandsoon.

Aut
omobi
l
eindust
ry,whi
chpr
oducesdi
ff
erentcar
sandaer
ospacei
ndust
rypr
oduci
ng
di
ff
erentai
rpl
anes ar
e al
so an exampl
e ofol
i
gopol
yindust
[Link]
e al
so t
hat
,al
l
ol
i
gopol
i
stsar
enotnecessar
ylar
gef
ir
msasgi
veni
ntheabov
eexampl
[Link]
ocer
y
st
orest
hatexi
sti
nisol
atedcommuni
tycanbeol
i
gopol
i
stsgi
vent
hatt
hei
rdeci
sionsar
e
i
nter
dependentandt
heyar
ethesol
esuppl
i
erofaspeci
fi
cpr
oduct
.Thi
simpl
i
est
hatt
he
di
sti
ngui
shi
ngf
eat
ureofol
i
gopol
yist
hei
nter
dependenceofdeci
sionmaki
ngbyr
ival
ry
f
ir
msi
nani
ndust
[Link]
nter
dependencebet
weenf
ir
msi
sthenat
uralr
esul
toft
he
exi
stenceoff
ewnumber
soff
ir
msi
nani
ndust
ry.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty2.
1
Li
stt
hekeyf
eat
ureofol
i
gopol
ymar
ketst
ruct
ure
I
dent
if
yindust
ryy
ouknowt
hatappr
oxi
mat
eol
i
gopol
ymar
ketot
hert
hant
heonegi
veni
n
t
heexampl
e
Whatar
ethesi
mil
ari
tyanddi
ff
erencebet
weenol
i
gopol
yandmonopol
i
sti
cal
l
ycompet
it
ive
mar
ketst
ruct
ure?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
I
nsummar
y,ol
i
gopol
ymar
ketst
ruct
urei
samar
ketst
ruct
urewhi
chcont
ainf
ir
ms
char
act
eri
zedbyt
hef
oll
owi
ngf
eat
ures
Fewnumberoff
ir
msi
nagi
veni
ndust
ry
I
nter
dependenceoff
ir
msi
ndeci
sionmaki
ng
Fi
rmspr
oducehomogenousordi
ff
erent
iat
edpr
oduct
Fi
rmshav
esomepowert
osetpr
ice

Wel
lst
udent
sbynowwehav
egetf
ami
l
iart
othekeyf
eat
uresoft
hef
ourdi
ff
erent
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 30
t
ypesmar
ketst
ruct
ure(
per
fectcompet
it
ion,
monopol
i
sti
ccompet
it
ion,
oli
gopol
yand
monopol
y)
Tor
ecapt
hemai
npoi
nts,
thei
rcompar
isoni
nter
msofmar
ketpower
,ent
rycondi
ti
on
ofnewf
ir
msandst
rat
egi
cbehav
ior
soft
hef
ir
msar
esummar
izedi
ntabl
e2.
1.
Tabl
e2.
1pr
oper
ti
esofmonopol
y,ol
igopol
y,monopol
ist
iccompet
it
ionandper
fect
compet
it
ion
Char
act
eri
sti
c Monopol
y Ol
i
gopol
y Monopol
ist
i Per
fect
s c compet
iti
on
compet
it
ion
1 Numberof One Few Fewor Many
fi
rmsinan Many
i
ndustry
2 Typeof Si
ngl
e(uni
que) Homogenou Di
ff
erent
iat
e Homogenou
product sor d s
dif
fer
enti
ate
d
3 Abil
i
tyt
oset Pr
iceset
ter Pri
cesett
er Pri
ceset
ter Pr
icet
aker
pr
ice buthave wit
hli
mit
ed
veryli
mit
ed power
power
4 Profi
t MR=MC MR=MC MR=MC MR=MC=P
maximizati
on
condit
ion
5 Entry Noent
ry Li
mit
edent
ry easyent
ry Fr
eeent
ry
condit
ion
6 Strat
egic Hasnor
ival Yes Yes No
dependence
fi
rmsoni ts
ri
vals
7 Example Localnat
ural
gas Aut
omobi
le Ret
ail
trades Apple
uti
l
ity manuf
act
ure far
mers
r

CausesofOl
igopol
y

Ther
ear
emanycauseofol
i
gopol
ymar
ket
.Someoft
hem ar
e
Economi
esofscal
e:l
owcost
scannotachi
evedi
nsomei
ndust
ri
esunl
essaf
ewf
ir
msar
e
pr
oduci
ngout
putt
hataccountf
orsubst
ant
ialper
cent
agesoft
het
otalmar
ketdemand
.
Thatmeanst
heav
eragecostofpr
oduct
ion r
eachmi
nimum onl
ywhent
heout
put
pr
oducedi
nlar
geamountbyaf
ewf
ir
[Link]
esul
t,t
henumberoff
ir
msi
nsucht
ypeof
i
ndust
ryshoul
dber
educedi
nor
dert
omakeuseoft
headv
ant
ageofeconomi
esofscal
e

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 31
ECON102MI
CROECONOMI
CSI
I

i
npr
oduct
[Link]
esofscal
einsal
espr
omot
ionandadv
ert
isi
ngmayal
sopr
omot
e
ol
i
gopol
y.
Bar
ri
erst
oent
ry:
-ther
ear
evar
iet
iesofbar
ri
ert
hatdi
dnotal
l
owt
heent
ryofsomef
ir
msi
n
t
othei
ndust
[Link]
sbar
ri
ermaybet
echnol
ogi
cal
,ski
l
l,cost
,andsi
zeoft
hemar
keti
n
r
elat
iont
oeconomi
esofscal
e,pat
entr
ightanddi
ff
erentact
ivi
ti
esofgov
ernmentsuchas
l
i
censi
ngandmar
ket
ingquot
a
Col
lusi
on(
mer
gerofsmal
lfi
rms)
:Smal
lfi
rmscol
l
idet
ogetmar
ketpowerandov
ercome
t
hei
rcompet
it
or’
spr
essur
e.I
ftheygai
nmar
ketpower
,fi
rmssethi
gherpr
iceandr
est
ri
cts
out
putsuppl
ythatmax
imi
zest
hei
rpr
ofi
[Link]
ir
msdev
elopt
ool
i
gopol
ywhi
l
eot
her
r
emov
edf
rom t
hemar
ket
.

Dearst
udent
s,f
rom ourper
vioussect
iondi
scussi
ony
ouhav
esomei
deaaboutt
he
gener
alf
eat
uresofol
i
gopol
ymar
ketst
ruct
ureandi
[Link]
etusi
dent
if
ydi
ff
erent
t
ypes ofol
i
gopol
y modeland see how equi
l
ibr
ium l
evelofout
putand pr
ices ar
e
det
ermi
nedi
neachmodelgi
vent
hei
runder
lyi
ng assumpt
[Link]
mpl
i
cit
y,weconsi
der
onl
ythecaseoft
wof
ir
mst
hati
ster
medasduopol
y.I
naddi
ti
on,wel
i
mitoursel
ftot
he
st
udyoff
ir
mspr
oduci
nghomogenouspr
oduct
.Thi
swi
l
lal
l
ow ust
oav
oidt
hepr
obl
em
r
elat
edt
oanal
ysi
spr
oductdi
ff
erent
iat
ionandf
ocusont
hest
udyofst
rat
egi
cint
eract
ion
bet
weenf
ir
ms.

Basedont
her
eact
ionpat
ter
noff
ir
msi
nthei
ndust
ry,
iti
spossi
blet
ocl
assi
fyol
i
gopol
yin
t
otwogr
[Link]
ecol
l
usi
veol
i
gopol
yandnon-
col
l
usi
veol
i
gopol
[Link]-
col
l
usi
ve
ol
i
gopol
yisacondi
ti
oni
nwhi
chf
ir
msoper
atei
ndependent
lyt
odet
ermi
net
heopt
imal
l
evelofpr
iceandout
put
.Thati
sfi
rmsi
nthei
ndust
rywi
l
lnotgo i
nto cont
ract
ual
agr
eementt
ocooper
atei
nmaki
ngopt
imaldeci
[Link],negot
iat
ionand
enf
orcementofbi
ndi
ngagr
eementi
snotpossi
bleev
ent
hougheachf
ir
msmakesome
expect
ati
on(
assumpt
ion)aboutt
her
eact
ionofi
tsr
ival
ryi
nresponset
oit
sact
ionor
obser
vet
hedeci
si
onofi
tsr
ival
rywhi
l
eset
ti
ngpr
ofi
tmaxi
mizi
ngl
evelofout
putandpr
ice.
Forexampl
e,i
faf
ir
minnon-
col
l
usi
veol
i
gopol
ywant
stoi
ncr
easeout
putorpr
icet
o
maxi
mizei
tspr
ofi
t,i
thast
oassumesomet
hingaboutt
hepossi
bler
eact
ionofi
tsr
ival
ry
andt
heef
fectoft
her
eact
iononpr
ofi
tmaxi
mizat
ionpr
ocess.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 32
Dearst
udent
sdoy
out
hinkt
hatt
heassumpt
ionf
ir
msmakeaboutt
hei
rri
valf
ir
mist
he
samei
nal
ldi
ff
erentt
ypeofnon-
col
l
usi
veol
i
gopol
ymodel
.Theanswert
othi
squest
ionwi
l
l
obt
ainaf
terdi
scussi
ngt
hedi
ff
erentnon-
col
l
usi
veol
i
gopol
yinsubsequentsubsect
ions.
Her
ear
esomeofnon-
col
l
usi
veol
i
gopol
ymodelt
hatwewi
l
lconsi
derr
ightnow af
tera
moment
Ki
nkeddemandmodel
Cour
notduopol
ymodel
Ber
trandduopol
ymodel
St
ackel
ber
gduopol
ymodel

I
ncol
l
usi
veol
i
gopol
yhowev
er,f
ir
msgett
oget
hert
omakeopenandf
ormalagr
eementi
n
set
ti
ngpr
icesandout
putsoast
omaxi
mizest
het
otalpr
ofi
toft
hei
ndust
ryasi
nthecase
ofcar
tel
.Itcanbeal
soi
mpl
i
citcooper
ati
onoff
ir
msi
nthei
ndust
rywi
thoutact
ual
l
y
maki
ngexpl
i
cit
lyagr
eementwi
thoneanot
herasi
nthecaseofpr
icel
eader

2.
2Noncol
lusi
veol
igopol
y
2.
2.1Theki
nkeddemandcur
vemodel
Dearst
udent
sasy
ouknow f
rom y
ourper
viousmi
croeconomi
ccour
se,Pr
icei
nper
fect
compet
it
ion,
monopol
yandmonopol
i
sti
ccompet
it
ionmar
ket
sadj
ust
srapi
dlyt
ochangi
ng
costordemandcondi
ti
ons.I
stheadj
ust
mentofpr
icepossi
blet
ochangei
ncostand
demandcondi
ti
onsi
nthecaseofol
i
gopol
ymar
ketl
i
kei
not
hermar
ket
?Fori
nst
ance,i
s
t
hepr
iceofbeerorsof
tdr
inkchangesf
requent
lyast
hei
rdemandandcostcondi
ti
on
changes?Youmi
ghtanswert
hesequest
ionsbasedupont
heassumpt
ionhowol
i
gopol
i
st
r
eactt
oeachot
her
’sdeci
sionsaccor
dingt
oki
nkeddemandcur
vemodel
.

Theki
nkeddemandcur
vemodel
,dev
elopedbyPaulSweezyi
n1939,expl
ainswhypr
ices
ar
eri
gidi
nsomeol
i
gopol
ymar
ket
.Themodelassumet
hatol
i
gopol
i
stof
tenhav
est
rong
desi
ret
okeepst
abl
epr
[Link]
enundert
hecondi
ti
onwhencostanddemandchanges,
f
ir
msar
erel
uct
antt
ochanget
hei
rpr
ices.I
fcost
sfal
lormar
ketdemanddecl
i
nes,t
hey
f
eart
hatt
hel
owerpr
icessendt
hewr
ongmessaget
othei
rcompet
it
orsandi
nit
iat
epr
ice
waramongt
hem.I
fcost
sanddemandr
ises,t
heydonoti
ncr
easepr
icebecauset
heyar
e
af
rai
dthatt
hei
rcompet
it
orsmaynotr
aiset
hei
rpr
ice.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 33
ECON102MI
CROECONOMI
CSI
I

Accor
dingt
othi
smodelt
her
efor
e,demandcur
vef
aci
ngeachf
ir
minol
i
gopol
ymar
keti
s
ki
nked atpr
evai
l
ing mar
ketpr
ice(
Chamber
li
n’
sint
ersect
ionofi
ndi
vi
dualand mar
ket
demand)r
efl
ect
ingt
hef
oll
owi
ngbehav
ior
alpat
ter
nofol
i
gopol
i
[Link]
val
ryf
ir
msexpect
ed
t
ofol
l
ow decr
easei
npr
icebuti
gnor
epr
icei
ncr
[Link]
faf
ir
mincr
easesi
ts
pr
ice,
duet
oincr
easecostofpr
oduct
ionori
ncr
easedemandf
ori
tspr
oduct
,itwoul
dloss
mostofi
tscust
omerandcauset
otalr
evenuet
odecr
[Link]
sisbecauseot
herf
ir
msi
n
t
hei
ndust
rywoul
dnotf
oll
ow t
hei
ncr
easei
npr
[Link]
esul
t,gi
vent
hatt
hepr
oduct
pr
oducedi
nthei
ndust
ryi
shomogenous,
consumerpr
efer
enceshi
ft
sfr
om t
heot
herhand
anol
i
gopol
i
stcoul
dnoti
ncr
easei
tsmar
ketshar
ebyl
ower
int
endt
omai
ntai
npr
ices
const
antev
enundert
hecondi
ti
onwher
ethei
rdemandandcostchangesasshowni
n
f
igur
e2.
[Link]
vei
smuchmor
eel
ast
icabov
epoi
ntE(
kinkedpoi
nt)t
han
bel
owt
heki
nkont
heassumpt
iont
hatt
hecompet
it
orswi
l
lnotf
oll
owpr
icei
ncr
easebut
qui
ckl
yfol
l
owpr
icedecr
ease.

D
MC1
MC2
d
Pr
ice MC3

E
Po

B
D

MR
Q0
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS
Quant
it
y 34

Fi
gur
e2.
1:Theki
nkeddemandcur
ve
Asshowni
ntheabov
efi
gur
e2.
1,anol
i
gopol
i
stf
ir
m f
acest
wo demandcur
vesf
or
di
ff
erentr
angesofpr
[Link]
eP0t
her
elev
antdemandcur
vef
ort
hef
ir
[Link]
i
fthef
ir
mincr
easesi
tspr
ice,i
twoul
dlosesomeofi
tscust
omert
ofi
rmt
hatmai
ntai
ned
t
hei
rpr
evi
ouspr
[Link]
ir
m wi
l
lthenf
aceademandcur
vegi
venbydE,whi
chi
sver
y
el
ast
[Link]
heot
herhand,i
fthef
ir
m decr
easesi
tspr
icebel
ow Po f
ormt
hei
ntent
ionof
i
ncr
easi
ngt
hei
rmar
ketshar
e,t
heywi
l
lnotabl
etoi
ncr
easet
hei
rmar
ketshar
e,si
nceot
her
f
ir
msal
sodecr
easet
hei
rpr
icei
nor
dert
okeepupt
hei
rcust
omer
[Link]
efor
e,bel
owPot
he
r
elev
antdemandcur
veoft
hef
ir
[Link]
simpl
i
est
hedemandcur
vef
aci
ngol
i
gopol
i
es
i
snotst
rai
ghtl
i
ne,
rat
herki
nkedatacer
tai
npr
ice.

Wel
lst
udent
s,wehav
eseent
hatol
i
gopol
i
sti
cisr
eluct
antt
opr
icechangei
nresponset
o
changei
nthei
rcostanddemandcondi
ti
[Link],t
hei
rdemandcur
vei
ski
nkedatt
he
i
nter
sect
ionpoi
ntofmar
ketandi
ndi
vi
dualdemandcur
vet
oref
lectt
her
igi
dit
yofpr
ices.
Nowl
etusseehowt
hei
rmar
ginalr
evenuecur
veder
ivedandhowt
heyunder
takeopt
imal
deci
si
[Link]
mal
l
y,mar
ginalr
evenuecur
veder
ivedf
rom demandcur
[Link]
hemar
ginal
r
evenuecur
veassoci
atedt
oki
nkeddemandcur
vei
sdi
scont
inuesatt
hel
evelofout
put
cor
respondst
otheki
nkedpoi
nt.I
thast
wosegment
sasi
ndi
cat
edi
nfi
gur
e2.
1,dAand
[Link]
respondst
otheupperpar
tofdemandcur
ve,whi
l
ethesegment
BMRcor
respondst
othel
owerpar
tofdemandcur
veandt
heki
nkpoi
ntondemandcur
ve
cor
respondst
othedi
scont
inuouspor
ti
onofmar
ginal
rev
enuecur
ve.

Thepoi
ntofki
nkdef
inesequi
l
ibr
ium oft
hef
ir
m si
nceatanypoi
ntt
othel
eftoft
heki
nk,
MCi
sbel
owMR,
whi
l
etot
her
ightoft
heki
nk;
MCi
slar
gert
[Link]
ofi
toft
hef
ir
m
maxi
mizedatt
hepoi
ntoft
heki
[Link]
er,t
hisequi
l
ibr
ium i
snotnecessar
ydef
inedby
t
hei
nter
sect
ionofMCandMRcur
[Link]
ongasMCpassest
hroughsegmentAB,
thef
ir
m
maxi
mizesi
tspr
ofi
tbypr
oduci
ngQo andchar
gingpo l
evelofpr
[Link]
slev
elofpr
iceand
out
puti
scompat
ibl
ewi
thwi
der
angeofcost
.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 35
ECON102MI
CROECONOMI
CSI
I

Tosum up,t
heki
nkeddemandcur
vemodelgi
veussomei
nsi
ghtaboutwhypr
iceand
out
putwi
l
lnotchangedespi
techangesi
ncostanddemandi
nol
i
gopol
ymar
ketst
ruct
ure.
Theonl
ycasewher
ear
isei
ncostr
esul
tsi
nincr
easei
npr
icei
swhent
her
isei
ncost
equal
l
yaf
fect
sal
lfi
rmsi
nthei
ndust
ry.I
tisi
mpor
tantt
onot
eher
ethataki
nkeddemand
cur
vemodeldoesnotexpl
ainhow equi
l
ibr
ium pr
iceandout
putdet
ermi
nedl
i
keot
her
model
srat
her
,expl
ainwhypr
iceoncesetr
emai
nfi
[Link]
lysomeeconomi
stshav
e
beenv
erycr
it
icaloft
hemodel
’
sassumpt
ion.
Itwoul
dcer
tai
nlybeami
staket
oconcl
ude
t
hatol
i
gopol
i
esi
ngener
alar
eunr
esponsi
vet
ochangei
ncostaswel
lasunr
esponsi
vet
o
changei
ndemandi
nthewor
ldoft
echnol
ogi
caladv
ancementandchangei
ntast
eof
consumerpr
efer
[Link]
hapsweobser
vet
heopposi
tei
nmanyol
i
gopol
yindust
ri
es.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty2.
2
Whypr
icei
nol
i
gopol
yindust
rybecomesunr
esponsi
vet
ochangei
ndemandandcost
condi
ti
ons
Descr
ibet
henat
ureofdemandcur
vef
aci
nganol
i
gopol
i
staccor
dingt
oki
nkeddemand
cur
vemodel
.
ki
nkeddemandcur
vemodel
;
Expl
ainhowanequi
l
ibr
ium pr
icei
sest
abl
i
shed.
Expl
ainhowf
ir
mschanget
hei
rpr
icewhencostofpr
oduct
ionanddemandchanges
Expl
ainhowequi
l
ibr
ium pr
icedet
ermi
ned
I
texpl
ainspr
icesar
eri
gidi
nol
i
gopol
ymar
ket
.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

2.
2.2Cour
notmodel
A Fr
ench mat
hemat
ici
an,August
ine cour
not i
n 1938 usi
ng t
wo f
ir
m pr
oduci
ng
homogenouspr
oduct
s,i
l
lust
rat
edcour
notmodel
fort
hef
ir
stt
[Link]
l
lust
rat
est
hemodel
assumi
ng t
wo f
ir
mshav
ing i
dent
icalcostf
aci
ng l
i
nearmar
[Link]
vent
hese
assumpt
ions,eachf
ir
msknownt
hatt
hemar
ketpr
icewi
l
ldependont
het
otalout
putof
bot
hfi
[Link]
omaxi
mizet
hei
rpr
ofi
teachoft
hecour
notduopol
i
stsi
mul
taneousl
y
deci
des,how mucht
o pr
oducebyt
aki
ngi
tsr
ival
s’out
putconst
antatexi
sti
ngl
evel
r
egar
dlessofwhatout
puti
tdeci
dest
opr
[Link],eachf
ir
mtakest
heot
herf
ir
ms
ADAMAUNI
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DEPARTMENTOFECONOMI
CS 36
out
putl
evelasgi
venandchoosesi
tsownout
putl
evelt
omaxi
mizepr
ofi
[Link]
evelof
out
putt
hati
tchooseswi
l
l,ofcour
sedependonhowmuchi
tthi
nksi
tsr
ival
wil
lpr
oduce.I
n
ot
herwor
ds,eachf
ir
mrecogni
zest
hati
tsowndeci
sionaboutout
put wi
l
laf
fecti
ts

r
evenuet
hroughaf
fect
ingmar
ketpr
icebutanyonef
ir
m hasout
putdeci
sionsdonot

af
fectt
hoseofanyot
herf
ir
[Link]
s,eachf
ir
mrecogni
zest
hat butassume

t
hat ,
for .

Dearst
udent
snow l
etusseecour
notsi
mpl
i
fiedi
l
lust
rat
ionoft
hemodel
.Hest
art
edhi
s
i
l
lust
rat
ionbyassumi
ngt
hatt
her
ear
etwof
ir
ms(
fi
rm-
A andf
ir
m-B)
,eachpr
oduci
ng
mi
ner
alwat
eratzer
ocostandf
acel
i
neardemandcur
veDDasshowni
nfi
gur
e2.
2..Each
f
ir
m al
soact
sont
henaï
veassumpt
iont
hati
tscompet
it
orwi
l
lnotchangei
tsout
putwhen
deci
dingi
tspr
ofi
tmaxi
mizi
ngl
evel
ofout .
put

Assumet
hatf
ir
m Ai
sthef
ir
stt
ost
artpr
oduci
ngandsel
l
ingmi
ner
alwat
erassumi
ngt
hat
f
ir
m Bpr
oducenot
[Link]
rm-
Ather
efor
ethi
nkst
hati
tsef
fect
ivedemandcur
vei
sthe
mar
ketdemandbecauset
hef
ir
mthi
nkst
hati
twi
l
lbet
hesol
epr
oducerofmi
ner
alwat
er.
Sot
ofi
ndt
hepr
ofi
tmaxi
mizi
ngl
evelofout
putandpr
ice,weuset
hemar
ginalpr
inci
ple
(
MR=MC)
.Si
ncei
tisassumedt
hatcostofpr
oduct
ionequal
stozer
oMCi
sal
sozer
o.
Ther
efor
e pr
ofi
tmaxi
mizat
ion condi
ti
on oft
he f
ir
m r
educed t
o MR= [Link]
s poi
nt
cor
respondst
oQ1l
evel
ofout
putt
hati
shal
foft
het
otal
mar
ketdemand.

Pr
ice
D

C
P

E
P1

P2
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 37
D’
Q1 Q2 Q3 MRA out
put
ECON102MI
CROECONOMI
CSI
I

Now f
ir
m-Bassumet
hatf
ir
m-A wi
l
lkeepi
tsout
putf
ixedatQ1 anddef
ineCD’asi
ts
r
elev
antdemandcur
vet
odet
ermi
nei
tspr
ofi
tmaxi
mizi
ngl
evelofout
put
.Appl
yi
ngt
he
samemar
ginalr
ulet
otheper
cei
veddemandsect
ion,f
ir
m-Bpr
oducehal
foft
hemar
ket

whi
chi
snotsuppl
i
edbyf
ir
[Link]
sB’
spr
ofi
tmaxi
mizi
ngl
evelofout
puti
s

oft
het
otal
mar
[Link]
spoi
ntr
epr
esent
edbyQ2.

I
nthenextr
ound,
fir
m-AassumesBwi
l
lpr
oducef
ixedl
evelofout
putasbef
ore oft
he

t
otalmar
ket)
,itwi
l
lpr
oducehal
fofwhati
snotsuppl
i
edbyB, = oft
het
otal

mar
ketdemandf
ir
[Link]
sor
eact
sint
hesamef
ashi
onandpr
oduces oft
he

t
otalmar
ket
.Thi
sact
ionandr
eact
ionpat
ter
ncont
inues,si
ncet
hef
ir
msar
eact
ingont
he
nai
vebehav
ior
alassumpt
ion(
fi
rmscannotl
ear
nfr
om t
hei
rexper
ience)
.Ev
ent
ual
l
y,t
he
equi
l
ibr
ium l
evel
ofout
putobt
ained,
wheneachf
ir
m pr
oducesone-
thi
rdoft
het
otal
mar
ket
.
Thi
sequi
l
ibr
ium l
evel
canobt
ainedasf
oll
ows

Fi
rm A’
sequi
l
ibr
ium l
evel
ofout
putatdi
ff
erentsuccessi
veper
iod;

Per
iod-
1:

Per
iod-
2:

Per
iod-
3:

Per
iod-
4:

Wecangetequi
l
ibr
ium l
evel
ofout
putf
orf
ir
m-byaddi
ngupt
hedi
ff
erentl
evel
ofout
put
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 38
f
ir
m-Apr
oducesbyassumi
ngagi
venl
evel
ofout
putsuppl
ybyf
ir
m-b’
s:

Theex
pressi
oni
npar
ent
hesi
sisi
nfi
nit
egeomet
ri
cpr
ogr
essi
onwi
thcommonr
ati
or= .

Appl
yi
ngt
hesummat
ionf
ormul
aforani
nfi
nit
egeomet
ri
cser
ies,
Gn= (
Gn-t
hesum of

Ngeomet
ri
esi
nfi
nit
eser
ies,
G1-t
hef
ir
stt
erm ofgeomet
ri
cinf
ini
teser
iesand
r
-Commonr
ati
o

= -
Oft
otal
mar
ketdemand

Forf
ir
m –B:

Per
iod-
1:

Per
iod-
2:

Per
iod-
3:

Per
iod4:

Wecanwr
it
eB’
sequi
l
ibr
ium l
evel
ofout
putas

Oft
het
otal
mar
ketdemand.

Exampl
e:I
fthemar
ketdemandf
orcour
not
’smi
ner
alwat
eri
ntheexampl
eabov
eis,
equal
sto120,
whatl
evel
ofout
putmaxi
mizet
hepr
ofi
tofeachf
ir
m.
Sol
uti
on:wesai
dundert
heabov
eassumpt
ion(
zer
ocostandcour
notbehav
ior
al

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 39
ECON102MI
CROECONOMI
CSI
I

assumpt
ion)t
het
wof
ir
msmaxi
mizei
tspr
ofi
tbypr
oduci
ng oft
het
otalmar
ket

demandeach,
thati
s,

Ther
efor
e,undercour
notcost
less pr
oduct
ion assumpt
ion,t
he out
putl
evelt
hat
maxi
mizest
hepr
ofi
tofaduopol
i
sti
sequalt
o1/
3oft
het
otalmar
ket
. Bysi
mil
ar
anal
ogy
,iti
sal
sopossi
blet
ogener
ali
zef
orN-
fi
rm [Link]
sforani
ndust
rywi
thn-

f
ir
mst
heout
put
,whi
chmaxi
mizest
hepr
ofi
tofaf
ir
m,i
s oft
het
otalmar
ket

[Link]
eift
her
ear
efourf
ir
msi
nani
ndust
ryactundercour
notnaï
ve

assumpt
ion,
theout
putl
evelt
hatmaxi
mizest
hepr
ofi
tofeachf
ir
mis oft
he

t
otal
mar
ketdemand.

Dearst
udent
s,i
sthecost
lesspr
oduct
ion(
ident
icalcostanddemand)assumpt
ionof
cour
noti
ntheabov
eanal
ysi
sisr
eal
i
sti
c?No,becauset
her
ear
edi
ff
erentt
ypeofcost
i
nvol
vedi
npr
oduct
ioni
nrealwor
ldanddef
ini
tel
y,t
hecostofpr
oduct
ioni
nmostcases
di
ff
erentf
rom onef
ir
mtot
heot
her
.Hence,l
etusr
econsi
dert
hemodelaf
terr
elaxi
ng
i
dent
icalcostanddemandassumpt
ions.I
not
herwor
dshow muchshoul
deachf
ir
m
pr
oducet
omaxi
miz
est
hei
rpr
ofi
tift
heyundert
akepr
oduct
ionoft
hei
rout
putat
di
ff
erentcostanddemandcondi
ti
[Link]
scanbedet
ermi
nedusi
nganot
herappr
oach
cal
l
edar
eact
ioncur
veappr
oacht
hatweconsi
dernext
.

2.
2.2.
1React
ioncur
veappr
oach

Undert
hisappr
oach,wet
ryt
oseehow cour
notduopol
i
stchoi
ceout
putl
evelt
hat
maxi
mizest
hei
rpr
ofi
taf
terr
elaxi
ngt
hei
dent
icalcostanddemandassumpt
[Link]
e
weuset
her
eact
ioncur
vesoft
het
wof
ir
mst
odet
ermi
net
heopt
imall
evelofout
putof
t
heduopol
i
stundert
hebasi
ccour
notbehav
ior
alassumpt
[Link]
oreusi
ngt
he
r
eact
ioncur
vesasat
oolf
ordet
ermi
nat
ionoft
heopt
imalchooseoft
hef
ir
ms,i
tis
hel
pfulf
ir
sti
fweunder
standwhatar
eact
ioncur
vei
sandhow onecander
ivea
r
eact
ioncur
ve.

ADAMAUNI
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DEPARTMENTOFECONOMI
CS 40
QA

React
ioncur
veofA

I
sopr
ofi
tcur
veoft
hef
ir
m-A

QA
Fi
gur
e2.
3.:(
a):I
sopr
ofi
toff
ir
m-A

Ar
eact
ioncur
vei
sagr
aphi
crepr
esent
ati
onofr
eact
ionf
unct
[Link]
eact
ionf
unct
ioni
s
af
unct
iont
hatshowst
hef
unct
ionalr
elat
ionshi
pbet
weent
heopt
imalout
putl
evelof
onef
ir
m andi
tsbel
i
efsaboutot
herf
ir
m opt
imalchoi
[Link]
nst
ance,
react
ionf
unct
ion
off
ir
m-Ashows,
howf
ir
m-Awi
l
lreacti
nmaki
ngi
tsout
putdeci
siont
oit
sper
cept
ionof
howmuchi
tthi
nksf
ir
m-Bwi
l
lpr
oduceandsel
l
.Thati
sforf
ir
m-At
odeci
det
opr
oduce
l
etsayY1 l
evelofout
put
,ithast
ofor
ecastf
ir
stt
heamountofout
putf
ir
m-Bpr
oduce
[Link]
unct
ionwhi
chshowst
heamountofY1 asaf
unct
ionofY2 gi
vest
he
r
eact
ionoff
ir
[Link]
mil
arl
y,r
eact
ionf
unct
ionoff
ir
m-Bdef
inedi
nthesamef
ashi
on.
Gr
aphi
cal
l
yther
eact
ioncur
veofcour
notduopol
i
stsder
ivedf
rom t
hei
rrespect
ive
i
sopr
ofi
tcur
[Link]
vecont
ainsal
ocusofpoi
ntt
haty
iel
dst
hesamel
evelofpr
ofi
tfor
t
hef
ir
m.I
sopr
ofi
toff
ir
m-Ai
sthel
ocusofpoi
ntsdef
inedbydi
ff
erentl
evelofout
putof
f
ir
m-Aandi
tsr
ivalBwhi
chy
iel
dst
hesamel
evelofpr
ofi
ttof
ir
[Link]
mil
arl
y,i
sopr
ofi
t
cur
veoff
ir
m-Bi
sthel
ocusofpoi
ntdef
inedbydi
ff
erentl
evelofout
putoff
ir
m-Bandi
ts
r
ivalf
ir
m-Awhi
chy
iel
dst
hesamel
evelofpr
ofi
ttof
ir
m [Link]
sopr
ofi
tcur
vesoft
he
t
wof
ir
msgi
veni
nfi
gur
e2.
3(a)&(
b).Fr
om t
hedef
ini
ti
on,i
tshoul
dbecl
eart
hatt
he
i
sopr
ofi
tcur
vesar
eat
ypeofi
ndi
ff
erencecur
ve

ADAMAUNI
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TYDEPARTMENTOFECONOMI
CS 41
ECON102MI
CROECONOMI
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I

QB

I
sopr
ofi
tcur
veoft
hef
ir
m-A

React
ioncur
veofB

QA
Fi
gur
e2.
3.:(
b):i
sopr
ofi
toff
ir
m-B

Pr
oper
ti
esofi
sopr
ofi
tcur
ve

I
sopr
ofi
tcur
vesf
orsubst
it
utecommodi
ti
esar
econcav
etot
heaxi
sal
ongwhi
chwe
measur
etheout
putoft
her
ivalasi
ndi
cat
edi
nfi
gur
e2.
[Link]
efor
e,i
sopr
ofi
tof
f
ir
m-Ai
sconcav
etoaxi
sthatmeasur
est
heout
putofAandi
sopr
ofi
tcur
veoff
ir
m-Bi
s
concav
etot
hequant
it
yaxi
soff
ir
[Link]
sopr
ofi
tcur
veoff
ir
m-AshowshowA
r
eactt
oB’
sout
putdeci
sionsoast
oret
ainagi
venl
evel
ofpr
ofi
[Link]
e,consi
dert
he
i
sopr
ofi
tcur
veoff
ir
m-A, andf
ir
m-B, asi
nthef
igur
e-2.
[Link]
ow.I
tisconcav
etoA’
s

quant
it
yaxi
s
Letussupposet
hatBdeci
det
opr
oducesB1 amountofout
put
,fi
rm-
Awi
l
lreal
i
zest
he
samel
evelofpr
ofi
tbypr
oduci
ngAh orAg amountofout
put
.Assumef
ir
m-Adeci
det
o
pr
oduceAg amountofout
put
.Iff
ir
m-Bi
ncr
easesi
tsout
putt
oB2,f
ir
m-Amustdecr
eases
i
tsout
putt
oAft
omai
ntai
nthesamel
evelofpr
ofi
t.I
ffi
rm-
A cont
inuepr
oduci
ng Ag
amountwhi
l
efi
rm-
Bincr
easei
tsout
putl
evelt
oB2 t
het
otalamountofout
putsuppl
i
edt
o
t
hemar
keti
ncr
easeandr
esul
tindecr
easei
npr
icesandhencepr
ofi
toft
hef
ir
ms.I
fB
f
urt
heri
ncr
easesi
tsout
putt
opoi
ntB3,
fir
m-Ashoul
ddecr
easei
tsout
putt
oAe,
otherwi
se

ADAMAUNI
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DEPARTMENTOFECONOMI
CS 42
i
tresul
tinr
educt
ionofpr
iceandt
henpr
ofi
[Link]
ondpoi
ntE,i
ncr
easei
nout
putbyf
ir
m-B
r
esul
tinf
alli
nmar
ketpr
iceandi
ncr
easecostofpr
oduct
ionwhi
chr
esul
tindecr
easei
n
pr
ofi
t of t
he f
ir
[Link]
sisi
ndi
cat
ed by out war
d shi
fti
nisopr
ofi
tfunct
ion t
o
,
repr
esent
ingl
owerl
evel
ofpr
ofi
[Link]
simpl
i
est
hei
sopr
ofi
tli
newhi
chi
sfoundf
arf
rom

quant
it
yaxi
srepr
esentl
owerl
evelofpr
ofi
twhi
l
ethei
sopr
ofi
tcur
vef
oundnear
ert
o
quant
it
yaxi
srepr
esenthi
gherl
evel
ofpr
ofi
t

QB

B3
k f B4
B2

h g B3 ¶
A2
B1

A1

A1

Ah Ak Ae Af Ag QA
Forf
ir
m-At
hehi
ghestpoi
ntsofsuccessi
vei
sopr
ofi
tcur
vesl
i
est
othel
eftofeachaswe
F
gi
guu
ofr
er
t2
h.
4
e.
r:
i
aso
wap
yr
o
ff
ri
t
omcu
Ar
v
’
sesu
q ant
it
yaxi
sandl
i
est
other
ightofeachot
heraswegot
owar
ds
t
oquant
it
yaxi
[Link]
heot
herhandt
hehi
ghestpoi
ntoft
hei
sopr
ofi
tcur
vesoff
ir
m-Bl
i
est
o
t
her
ightofeachot
heraswemov
efur
therawayf
rom t
hequant
it
yaxi
s)QA andl
i
est
othe
l
eftaswemov
etowar
dthequant
it
yaxi
[Link]
ningt
heser
espect
ivehi
ghestpoi
ntsof
i
sopr
ofi
tcur
veoft
het
wof
ir
msgi
vest
hei
rreact
ioncur
[Link],
ther
eact
ioncur
veoff
ir
m
-
Aisal
ocusofhi
ghestpoi
ntofI
sopr
ofi
tthatf
ir
m-Acanat
tai
n,gi
vent
hel
evelofout
putof
r
[Link]
eact
ioncur
veoff
ir
m-Bal
sor
epr
esentt
hel
ocusofhi
ghesti
sopr
ofi
tpoi
ntt
hat
f
ir
m-Bcanat
tai
nas i
ndi
cat
edi
nfi
gur
e2.
3.(
a)and(
b).

Dearst
udent
swehav
eseenwhatar
eact
ioncur
vei
sandhow t
oder
ivei
tfor
misopr
ofi
t
cur
[Link] l
etusseenhow r
eact
ioncur
vesusedt
odet
ermi
net
heequi
l
ibr
ium l
evelof
out
putf
orcour
notduopol
i
[Link]
ir
msr
eact
ioncur
vet
ellushowmucht
opr
oducegi
ven
t
heout
putofi
tscompet
it
[Link]
efor
e,atequi
l
ibr
ium t
hebel
i
eft
hateachf
ir
m makeabout

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 43
ECON102MI
CROECONOMI
CSI
I

ot
her
’sf
ir
m out
putl
eveldur
ingset
ti
ngt
hei
rout
puti
sequalt
otheact
ualamountofout
put
pr
oducedbyi
tsr
ival
.Thi
spoi
ntcor
respondst
othei
nter
sect
ionoft
wor
eact
ioncur
ves,
poi
nteasshowni
nfi
gur
e2.
4.

QB
QB ¶B3 ¶B41
¶B2

¶B1

¶A4
e
¶A3
¶A2
¶A1

QA

Not
ethatatpoi
nte,eachf
ir
m maxi
mizesi
tsownpr
ofi
tbutt
hei
ndust
ry’
s(j
ointpr
ofi
t)
pr
ofi
ti F
snoi
gu
t r
ex
ma 2
i.
4.
mi:e
zcour
d.n
To
ht
i’
sd
sc u
aop
neo
al
y
si
lmo
ysd
ee
eleq
nb ui
yrl
i
eb
fr
i
eu
r
rm
i
ngt
othecont
ractcur
ve.I
tist
he
cur
vef
ormedbyj
oini
ngt
het
angencypoi
ntbet
weent
het
wof
ir
ms’
isopr
ofi
tcur
[Link]
nts
ont
hiscur
ver
epr
esent
sopt
imalpoi
nt(
maxi
mizei
ndust
ry’
spr
ofi
t)
.Poi
ntsof
fcont
ract
cur
vehowev
err
epr
esentl
owerl
evelpr
ofi
ttoonef
ir
m orbot
hpr
ofi
[Link]
efor
e,si
nce
poi
ntef
oundof
fthecont
ractcur
vei
tcannotmaxi
mizesi
ndust
ry’
spr
ofi
tandr
epr
esent
s
subopt
imall
evelofout
put
.Suchsubopt
imalr
esour
ceal
l
ocat
ioni
sther
esul
tofnaï
ve
cour
notbehav
ior
alassumpt
ionoff
ir
mscannotl
ear
nfor
mst
hei
rexper
[Link]
hey
l
ear
nfr
om exper
ience,t
heywoul
dshow adi
ff
erentst
rat
egi
cbehav
ior
.Fori
nst
ance,t
hey
woul
dhav
ecomet
oget
herandagr
eet
oshar
ethemar
keti
nsuchawayt
hatwoul
drai
se
t
hepr
ofi
toft
het
wof
ir
msort
hei
ndust
ryast
hewhol
e.
_
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___
___
___
___
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___
___
___

Act
ivi
ty2.
3

ADAMAUNI
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DEPARTMENTOFECONOMI
CS 44
Def
inet
hef
oll
owi
ngt
erms.
I
sopr
ofi
tcur
ve c)cont
ractcur
ve
React
ioncur
ve d)cour
not
’sequi
l
ibr
ium
St
atet
hebasi
csassumpt
ionmadeaboutf
ir
msi
ncour
notduopol
ymodel
whi
l
e
t
heyar
eset
ti
ngout
putl
evel
thatmaxi
mizest
hei
rpr
ofi
t.
I
scour
notequi
l
ibr
ium l
evel
ofout
putmaxi
mizesi
ndust
ry’
spr
ofi
t?I
fnot
,why
?
Fi
ndt
hel
evelofout
putpr
oducedt
hatmaxi
mizest
hepr
ofi
tofaf
ir
mthatact
sunder
cost
lesspr
oduct
ionassumpt
ionofcour
not
,ift
het
otalmar
ketdemandf
aci
ngt
hef
ir
mis
3000.

2.
2.2.
2Mat
hemat
icalv
ersi
onofcour
notduopol
ymodel

So f
ar,we hav
e seen gr
aphi
calpr
esent
ati
on ofcour
notmodel
.Now l
etus see
mat
hemat
icalt
reat
mentoft
hemodel
.Det
ermi
ningequi
l
ibr
ium out
putl
eveloft
hecour
not
duopol
i
stsmat
hemat
ical
l
ygi
vent
hei
rcostanddemandf
unct
[Link]
ewebegi
nfr
om t
he
assumpt
ion oft
he model
,each f
ir
m deci
de how much t
o pr
oduce by t
reat
ing i
ts
compet
it
orl
evelofout
putf
ixedatexi
sti
ngl
evel
.Forexampl
e,i
ftheuni
tsofout
putt
hat
f
ir
m-2pr
oducecur
rent
lyi
sY2,f
ir
m 1assumef
ir
m 2cont
inuepr
oduci
ngY2 amountof
out
putwhi
l
edeci
dingt
opr
oduceY1 uni
tofout
put
.Sot
het
otalout
putsuppl
i
edt
othe
mar
ketequal
sY=Y2 +Y1 andt
hemar
ketpr
iceoft
hepr
oduct
,P(
y)=P(
Y1+Y2)
.Gi
vent
he
costf
unct
ionoff
ir
m 1,C1 (
Y1)andf
ir
m 2,C2(
Y2)
,wecandef
inet
hepr
ofi
tmaxi
mizat
ion
pr
obl
em oft
hef
ir
msasf
oll
ows.
Forf
ir
m 1:
MaxP(
Y1+Y2)Y1-
C1(
Y1)
Forf
ir
m 2:
MaxP(
Y1+Y2)Y1-C2(
Y2)

Fol
l
owi
ngt
heusual
l
yopt
imi
zat
ionpr
ocedur
e,t
aket
hef
ir
stor
dercondi
ti
onoft
hepr
ofi
t
f
unct
ionofeachf
ir
m wi
thr
espectt
ochoi
cev
ari
abl
e(t
hei
rout
putl
evel
).Ther
esul
toff
ir
st
or
dercondi
ti
ongi
vest
her
eact
ionf
unct
ionofeachf
ir
[Link]
vet
het
wo-
react
ion
cur
vest
ogat
hersi
mul
taneousl
ytogett
heequi
l
ibr
ium out
putl
evel
oft
het
wof
ir
ms.
Exampl
e:Supposet
hatt
wof
ir
mspr
oduci
ngi
dent
icalpr
oductandsuppl
ytoamar
ketwi
th
al
i
neardemandf
unct
ion, .Wher
e and r
epr
esentuni
tofout
put
ADAMAUNI
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ECON102MI
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pr
oducebyf
ir
ms-
1and r
epr
esentuni
tofout
putpr
oducebyf
ir
[Link]

pr
oduct
ionoff
ir
m 1andf
ir
m-2i
sgi
venby = and r
espect
ivel
[Link]
nd

t
heout
putl
evelt
hatt
het
wof
ir
msshoul
dpr
oducet
omaxi
mizest
hei
rpr
ofi
tundercour
not
behav
ior
alassumpt
ion.
Sol
uti
on:st
art
ssol
vi
ngt
hepr
obl
em bydef
ini
ngt
hepr
ofi
tmaxi
mizat
ionpr
obl
em oft
het
wo
f
ir
ms.
Fi
rm-
1

F.
O.C:

Equat
ion(
1)r
epr
esent
sther
eact
ioncur
veoff
ir
m –1
Fi
rm2

F.
O.C:

Equat
ion(
2)r
epr
esent
sther
eact
ionf
unct
ionoff
ir
m [Link]
vesi
mul
taneousl
ythet
wo
r
eact
ioncur
vest
oget
hert
ogett
hecour
notequi
l
ibr
ium l
evel
ofout
put
.

React
ioncur
veoff
ir
ms-
1

-
React
ioncur
veoff
ir
ms–2

ADAMAUNI
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DEPARTMENTOFECONOMI
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Subst
it
uti
ngequat
ion(
1)i
nequat
ion(
2)

(
Equi
l
ibr
ium l
evel
ofout
putoff
ir
m –2)

Thet
otal
out
putoft
hei
ndust
ryatequi
l
ibr
ium i
sthesum ofY1and
Y2

Theabov
eresul
tcanr
epr
esent
edgr
aphi
cal
l
yasshowni
nfi
gur
e2.
5bel
ow

Y2

30 React
ioncur
vef
orf
ir
m1

14 Cour
not
’sequi
l
ibr
ium

10.
8 React
ioncur
vef
orf
ir
m2

Y1
6.
4 1 28
0

Fi
gur
e2.
5Cour
notequi
l
ibr
ium

ADAMAUNI
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ECON102MI
CROECONOMI
CSI
I

Themar
ketpr
iceoft
hepr
oduct

=60-
2(17.
2)
=60-
34.
4
P(
Y*)=25.
6
Thepr
ofi
tofeachduopol
i
sti
cis

…….
.Pr
ofi
toff
ir
m-1

=(
25.
6)(
10.
8)–4(
10.
8)
=276.
48-
43.
2
….
.Pr
ofi
toff
ir
m–2

Tot
ali
ndust
ry’
spr
ofi
t,
=163.
84+233.
28

_
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Act
ivi
ty2.
4
[Link]
vent
hef
oll
owi
ngdemandandcostf
unct
ionofcour
notduopol
i
st
Y=40-
0.2pwher
eY=Y1+Y2
C1=50+2y
1 C2=100+10y
2

Fi
ndt
hepr
ofi
tfunct
ionofeachf
ir
m andt
hei
rreact
ionf
unct
ion
Fi
ndcour
notequi
l
ibr
ium l
evel
ofout
putandpr
ice
Cal
cul
atet
hepr
ofi
tofeachf
ir
m
Showgr
aphi
cal
l
ytheequi
l
ibr
ium l
evel
ofout
putoft
het
wof
ir
ms.
[Link]
hatwehav
etwof
ir
mst
hatf
aceal
i
neardemandcur
ve and

hav
econst
antmar
ginalcost
s,c,f
oreachf
ir
[Link]
ndt
heequi
l
ibr
ium l
evelofout
putf
ort
he
t
wof
ir
msi
nter
msofaandbassumi
ngt
hatar
eactaccor
dingt
ocour
notmodel
.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 48
2.
2.3TheBer
trandduopol
ymodel
I
ncour
notmodel
,wehav
eseent
hatf
ir
msar
echoosi
ngquant
it
iesofout
putpr
oducedand
l
ett
ingt
hemar
kett
odet
ermi
nepr
[Link]
er,i
ncaseofBer
trandmodel
,fi
rmssett
hei
r
pr
iceandl
ett
ingt
hemar
kett
odet
ermi
net
heamountofout
putsol
[Link]
simpl
i
est
he
st
rat
egi
cvar
iabl
euponwhi
chf
ir
msar
ecompet
ingt
omaxi
mizet
hei
rpr
ofi
tispr
icer
ather
t
hanout
putf
orBer
trandduopol
i
[Link]
mil
art
ocour
notmodelhowev
er,eachf
ir
m makes
deci
si
onaboutt
hel
evelofpr
icet
hatmaxi
mizest
hei
rpr
ofi
tsi
mul
taneousl
ybyassumi
ng
t
hei
rcompet
it
or’
spr
icef
ixedatexi
sti
ngl
evel
.

Themodelal
so assumest
hatf
ir
msoper
ati
ng i
nthei
ndust
rypr
oducehomogenous
pr
oductwi
thi
dent
icalcost
.Thi
simpl
i
est
hateachf
ir
mfacest
hesamedemandcur
veand
consumerwi
l
lpr
efert
opur
chasef
rom l
owerpr
icesel
l
erorf
ir
[Link]
fthet
wof
ir
m
char
gedi
ff
erentpr
ice,l
owerpr
icef
ir
m wi
l
lsuppl
ytheent
ir
emar
ketwhi
l
ethef
ir
m whi
ch
char
geshi
gherpr
icesel
lnot
hing.I
fbot
hfi
rmschar
get
hesamepr
ice,t
heconsumer
sar
e
i
ndi
ff
erentbet
weent
het
wof
ir
ms’
product
.Thi
sleadst
oar
etur
ntof
ir
m-1oft
hef
orm:

Equat
ion(
1)t
o(3)r
epr
esentt
hepr
ofi
tear
nedbyf
ir
m-1,wheni
tsetpr
icel
esst
han,equal
t
oandgr
eat
ert
hanf
ir
m-2r
espect
ivel
y.
Ther
efor
e,Ber
trandmodeli
sanol
i
gopol
ymodeli
nwhi
chf
ir
mspr
oduci
nghomogenous
pr
oductsetpr
icesi
mul
taneousl
ythatmaxi
mizet
hei
rpr
ofi
tbyassumi
ngt
hei
rcompet
it
ors
pr
icef
ixedatacer
tai
nlev
el.
_
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Act
ivi
ty2.
5
Gi
vent
heabov
eunder
li
nef
eat
uresoft
heBer
trandmodel
,whatl
evelofpr
icesshoul
deach
f
ir
m char
get
omaxi
mizet
hei
rpr
ofi
t?
_
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___
___
I
tisknownt
hatpr
icecannotbesetl
esst
hanmar
ginalcostsi
nceeachf
ir
m hast
he

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 49
ECON102MI
CROECONOMI
CSI
I

i
ncent
ivet
odecr
easet
hei
rpr
icet
oincr
easesi
tspr
ofi
tbyr
educi
ngpr
oduct
ionl
evel
.Sol
et
usseehow Ber
trandduopol
i
stsetpr
iceundert
hecasewher
epr
icei
sgr
eat
ert
han
mar
ginal
costf
ort
het
wocompet
ingf
ir
ms.
Supposet
hatbot
hfi
rmssel
lthei
rpr
oductatsomepr
icegr
eat
ert
hanmar
ginalcost
.Iff
ir
m
-
1loweri
tspr
icebysmal
lamountwhi
l
etheot
herf
ir
m keepsi
tspr
icef
ixed,t
heent
ir
e
consumerwi
l
lpr
efert
opur
chasef
rom f
ir
m-1andt
heot
herf
ir
m sel
lnot
hingasst
ated
abov
[Link]
er,
theot
herf
ir
m al
soact
sint
hesameway(
hav
ethei
ncent
ivet
oreducei
ts
pr
oduct
)ifi
tspr
icei
sgr
eat
ert
hanmar
ginalcost
.Ther
efor
e,pr
icegr
eat
ert
hanmar
ginal
costcannotbest
abl
eequi
l
ibr
ium becauseeachf
ir
m hasani
ncent
ivet
ocutpr
iceasl
ong
aspr
oduct
ionr
emai
npr
ofi
tabl
[Link]
yequi
l
ibr
ium poi
ntwher
efi
rmshav
enoi
ncent
ive
t
ochanget
hei
rdeci
sioni
swher
epr
iceequalt
omar
ginalcost
.Thi
sist
hesameas
compet
it
ivemar
ketequi
l
ibr
ium condi
ti
[Link]
hfi
rmssetpr
iceequal
stomar
ginalcosti
n
t
heshor
trunandbot
hwi
l
lsetpr
iceequalt
oav
eragecosti
nthel
ongr
unbecauseof
const
antcostassumpt
ion,
whi
chl
eadst
oear
ningofzer
opr
ofi
t.

Theequi
l
ibr
ium pr
icel
evelofBer
trandmodelcanbeal
sodet
ermi
nedt
hroughr
eact
ion
cur
veappr
[Link]
eseenundercour
notmodel
,react
ioncur
vesar
eder
ivedf
rom
I
sopr
ofi
[Link]
er,Ber
trandI
sopr
ofi
tcur
ver
epr
esentdi
ff
erentt
hingf
rom cour
not
’s
i
sopr
ofi
tcur
[Link]
trandmodeli
sopr
ofi
tcur
vescont
ainl
ocusofpoi
ntt
hatr
epr
esent
sa
combi
nat
ionofpr
icesofaf
ir
m andi
tscompet
it
ort
haty
iel
dst
hesamel
evelofpr
ofi
tto
t
hef
ir
[Link]
i
kecour
noti
sopr
ofi
tcur
ve,t
heshapeofBer
trandduopol
i
sti
sopr
ofi
tcur
vei
s
conv
ext
othepr
iceaxi
soft
hef
ir
ms.

Dearst
udent
s,whatdoest
heshapeofBer
trandduopol
i
sti
sopr
ofi
timpl
y?Theshapeof
I
sopr
ofi
tofBer
trandduopol
i
stshowhowaf
ir
mreact
stopr
icecutbyi
tscompet
it
[Link]
exampl
eift
hecompet
it
orofaf
ir
m cutpr
ice,t
hef
ir
m al
soadj
usti
tspr
icet
omai
ntai
nit
s
pr
ofi
tatt
hesamel
evel
.Suchpr
ocesscont
inuesupt
othemi
nimum poi
ntoft
hei
sopr
ofi
t
cur
ve,whi
chr
epr
esent
slowerl
evelofpr
ofi
t.I
fthecompet
it
orcutpr
icebey
ondt
he
mi
nimum poi
nt,
thef
ir
m cannotadj
usti
tspr
icet
okeept
hesamel
evelofpr
ofi
[Link]
ofi
t
oft
hef
ir
m decr
easesduet
ofal
li
npr
iceandi
ncr
easei
nout
putl
evel
.Thi
scanbei
ndi
cat
ed
bymov
ingt
othel
owerl
evel
ofI
sopr
ofi
tcur
ve.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 50
P2A
PA

4B
PA
4A
3B

2B
3A

2A 1B

1A

P2B PB

PB
Fi
gur
e:2.
[Link]
ionandI
sopr
ofi
tcur
vesofBer
trandduopol
ist

Forexampl
e,f
ir
m-Ai
nfi
gur
e2.
6mov
esf
rom I
sopr
ofi
tcur
ve t
oIsopr
ofi
tcur
ve when

f
ir
m-Bcuti
tspr
icebel
[Link]
simpl
i
esI
sopr
ofi
tcur
vef
oundnear
ert
othepr
iceaxi
sof
t
heduopol
i
str
epr
esentl
owerl
evelofpr
ofi
t.I
fwej
oint
hemi
nimum poi
ntofsuccessi
ve
i
sopr
ofi
tcur
vesoff
ir
m-A,
itr
esul
tinr
eact
ioncur
[Link]
elocusofpoi
ntf
ir
m-Acan
at
tai
nbychar
gingacer
tai
npr
ice,gi
vent
hepr
iceofi
tsr
ival
.Ther
eact
ioncur
vef
orf
ir
m-B
al
soder
ivedi
nthesi
mil
arwaybyj
oini
ngt
hel
owestpoi
ntofi
sopr
ofi
tcur
vesgi
vent
he
pr
icel
eveloff
ir
[Link]
vent
het
wor
eact
ioncur
ves,Ber
trandequi
l
ibr
ium def
inedbyt
he
i
nter
sect
ionoft
her
eact
ioncur
vesoft
hef
ir
msasi
ndi
cat
edbyf
igur
e2.
7.

PA

B
ADAMAUNI
VE’
s
R r
SI
Teac
YDEt
i
Po
ARn
TMENTOFECONOMI
CS 51

PA* e A’
sreact
ioncur
ve
ECON102MI
CROECONOMI
CSI
I

Pr
icel
evel
(PA*
,PB*
)ist
heequi
l
ibr
ium l
evel
ofBer
trandduopol
ymodel
.Al
sol
i
kecour
not
model
,Ber
trandequi
l
ibr
ium doesnotl
eadt
omax
imi
zat
ionofi
ndust
ry(
joi
nt)pr
ofi
t,duet
o
t
hef
actt
hatf
ir
msbehav
enai
vel
y(f
ir
mssett
hei
rpr
icebyassumi
ngi
tsr
ival
keepi
tspr
ice
f
ixedandt
heynev
erl
ear
nfr
om pastexper
ience)t
odeci
det
hepr
icet
hatmaxi
mizest
hei
r
pr
ofi
[Link]
ndust
rypr
ofi
tcoul
dbei
ncr
easedi
ffi
rmsr
ecogni
zedt
hei
rpastmi
stakesand
abandonedt
heBer
trandpat
ter
nofbehav
ior
.

Al
thought
heBer
trandmodel
usedt
ounder
standt
hest
rat
egi
cint
eract
ionofol
i
gopol
i
ston
pr
iceset
ti
ng,
ithaspl
ent
yofshor
tcomi
ngsf
orv
ari
ousr
[Link]
hing,
fir
ms,
whi
ch
pr
oduceexact
lyt
hesamepr
oduct
,seem t
ocompet
emor
ebyf
ocusi
ngonnon-
pri
ce
compet
it
iont
hanonpr
icecompet
it
[Link]
eov
er,
ift
heyf
ocusonpr
icecompet
it
ion,
they
sett
hesamepr
icei
naccor
dancewi
tht
hemodel
;ther
eisnor
eal
assur
ancet
hatt
heyspl
i
t
t
hemar
ketequal
l
[Link]
sol
i
kecour
notmodel
,Ber
trandmodel
iscr
it
ici
zedf
ori
tsnaï
ve
assumpt
ionoff
ir
ms.
_
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Act
ivi
ty2.
6
Whatar
ethedi
ff
erenceandsi
mil
ari
tybet
weenBer
trandandcour
notmodel
.
Onwhi
chv
ari
abl
edof
ir
msi
nBer
trandmodel
makest
rat
egi
cint
eract
ion(
out
put
,pr
ice)
Whatdot
heconcav
eshapeoft
hei
sopr
ofi
tcur
veofBer
trandduopol
yimpl
i
es?
I
nwhataspectt
hatt
heBer
trandmodel
simi
l
arwi
thper
fectcompet
it
ionmar
ketmodel
_
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___

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 52
St
ackel
ber
gModel

Dearst
udent
s,i
nthe per
vious duopol
ymodelwe hav
e seen t
hatduopol
i
sts make
si
mul
taneousopt
imal
deci
sionaboutl
evel
ofout
putpr
oducedandpr
icechar
[Link]
er,
accor
dingt
oSt
ackel
ber
gmodelf
ir
msmakedeci
sionaboutout
putt
hatmaxi
mizest
hei
r
pr
ofi
tsequent
ial
l
[Link]
s,t
her
eisaf
ir
m knownasadomi
nant(
stackel
ber
gleader
)whi
ch
knowst
heot
herf
ir
m behav
esnai
vel
yincour
notf
ashi
on(
i.
[Link]
her
eact
ionf
unct
ion
ofnaï
vef
ir
m).Thef
ir
m,whi
chbehav
esi
ncour
not
,fashi
on(
takecompet
it
or’
sout
putas
gi
ven)andmakedeci
sionaf
terobser
vingl
eader
’sdeci
sioni
scal
l
edt
hef
oll
ower
.The
l
eaderhasext
rai
nfor
mat
ionandpot
ent
ialt
hant
hef
oll
owerf
ir
mtomakedeci
sionbef
ore
t
hef
oll
owerf
ir
m.I
nchoosi
ngi
tsownout
put
,ther
efor
e,t
hel
eadercoul
daccountt
heef
fect
ofi
tsout
putonf
oll
owerbehav
iorwhi
l
ethef
oll
owernai
vel
ytookl
eader
’sout
putasgi
ven.
Fori
nst
ance,I
BM i
sof
tenconsi
der
edasadomi
nantf
ir
mint
hecomput
eri
ndust
[Link]
l
f
ir
msi
nthei
ndust
rywai
tfort
hedeci
sionmadebyI
BM i
nor
dert
omakedeci
sionhow
mucht
opr
oduceandt
het
ypeofpr
oductt
heysuppl
ytot
hemar
ket
.Ingener
al,t
hel
eader
f
ir
m(t
hef
ir
stmov
er)deci
dest
opr
oducescer
tai
namountofout
put
,whi
chmaxi
mizesi
ts
pr
ofi
t;i
twi
l
ltakei
ntoconsi
der
ati
ont
hei
mpactoff
oll
owerf
ir
[Link]
oll
owerf
ir
m,af
ter
i
dent
if
yingt
hel
evelofout
putpr
oducedbyt
hel
eaderf
ir
m,r
espondsbypr
oduci
ngcer
tai
n
amountofout
putt
omaxi
mizei
tspr
ofi
[Link]
ir
m acti
nthest
atedwaywhi
l
emaki
ngi
ts
out
putdeci
sion becauseeachoft
hem know t
hatt
het
otalout
putpr
oduceddet
ermi
ned
t
hemar
ketpr
iceandt
henpr
ofi
ttheyear
n.

Gi
vent
hest
ruct
ureoft
hemodel
,whatout
putshoul
dthel
eaderchooset
omaxi
mizei
ts
pr
ofi
ts?Leaderf
ir
mrecogni
zesi
tsi
nfl
uenceont
heact
ionoff
oll
ower
sfi
rm andt
otall
evel
ofout
putwhenmaki
ngdeci
sionont
hel
evelofout
putt
omaxi
mizepr
ofi
[Link]
srel
ati
on
shi
pbet
weenf
oll
owerandl
eaderopt
imalchoi
cecanbesummar
izedwi
tht
hehel
pof
r
eact
ionf
unct
ionoff
oll
owerf
ir
[Link]
hel
eader
sfi
rstdet
ermi
net
her
eact
ionf
unct
ionof
i
tsf
oll
owerandt
heni
ncor
por
atei
ttoi
tsownpr
ofi
tfunct
[Link]
tmaxi
mizest
henewl
y
f
ormedpr
ofi
tfunct
ionl
i
kemonopol
yfi
rm byset
ti
ngmar
ginalr
evenueequal
stomar
ginal
cost
.Ont
heot
herhandf
oll
owerf
ir
mreactt
otheopt
imalchoi
ceoft
hel
eaderaccor
ding
t
oit
sreact
ionf
unct
iont
ocomeupwi
thi
tspr
ofi
tmaxi
mizi
ngl
evel
ofout
put
.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 53
ECON102MI
CROECONOMI
CSI
I

Thest
ackl
eber
gsol
uti
oncanal
sobei
l
lust
rat
edgr
aphi
cal
l
yusi
ngi
sopr
ofi
tcur
vesand
r
eact
ioncur
[Link]
hfi
rmshav
ethesameshapedi
sopr
ofi
tcur
veasi
nthecaseofcour
not
.
Thehi
ghestpr
ofi
tlev
eli
srepr
esent
edbyt
hei
sopr
ofi
tcur
vef
oundneart
othequant
it
yaxi
s
ofeachf
ir
m andt
hel
owestl
evelofpr
ofi
tisr
epr
esent
edbyi
sopr
ofi
tcur
ve,whi
chf
ound
awayf
rom t
hequant
it
yaxi
[Link]
vensuchpr
oper
ti
esofi
sopr
ofi
tcur
vesoft
hef
ir
ms,
theyar
e
act
ingi
nthef
oll
owi
ngway
stodet
ermi
net
hei
ropt
imal
out
putl
evel
.

Y2 Reacti
oncur
ve
offi
rm-1

Cour
not
equi
l
ibr
ium

Reacti
o
ncurve
offi
rm-2 Stackel
berg
equil
ibr
ium

I
sopr
ofi
tcur
veof
e f
ir
m-1
Y*
2

Y2* Y1

Fi
gur
e:2.
[Link]
ackel
ber
gequi
li
bri
um
Fi
rm 2asaf
oll
owerwi
l
lchooseanout
putal
ongi
tsr
eact
ioncur
ve,
whi
l
efi
rm-
1(t
hel
eader
)
chooset
heout
putl
evelon t
her
eact
ion cur
veoff
ir
m-2t
hatgi
veshi
m t
hehi
ghest
maxi
mum pr
ofi
[Link]
esul
t,t
heequi
l
ibr
ium poi
ntoft
hest
ackel
ber
gduopol
i
stsi
snot
def
inedbyt
hei
nter
sect
ionoft
hei
rreact
ioncur
[Link]
sisbecauset
hel
eaderf
ir
msno
mor
etaket
hef
oll
ower
’sout
putasgi
ven.I
tknowst
hef
oll
owerout
putwoul
ddependoni
ts
ownout
putl
eveli
naccor
dancewi
thi
tsr
eact
ionf
unct
[Link]
simpl
i
est
heequi
l
ibr
ium
poi
ntoft
heSt
ackel
ber
gmodeldef
inedbyt
het
angencyoft
hei
sopr
ofi
toft
hel
eaderwi
th
t
her
eact
ioncur
veoft
hef
oll
owerasi
ndi
cat
edbyf
igur
e2.
8bel
ow.

Si
ncet
hel
eader
,fi
rm-
1makeschooseont
her
eact
ioncur
veoff
oll
ower
,fi
rm 2,poi
nte
r
epr
esent
sst
abl
est
ackl
eber
g’sequi
l
ibr
[Link]
nt-
e,t
hel
eadergethi
gherpr
ofi
tandt
he

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 54
f
oll
owerf
ir
m getl
owerpr
ofi
tcompar
edt
ocour
notequi
l
ibr
ium.

I
nshor
tifonef
ir
missophi
sti
cat
ed,i
twi
l
lemer
geasal
eaderandst
abl
eequi
l
ibr
ium wi
l
l
est
abl
i
shedsi
ncet
henaï
vef
ir
m actasaf
oll
ower
.Howev
eri
fbot
hfi
rmsar
esophi
sti
cat
ed,
bot
hwant
stobeal
eadert
ogethi
gherpr
ofi
t.I
nthi
scase,mar
ketsi
tuat
ionbecomes
unst
abl
[Link] si
tuat
ion i
sknown asSt
ackl
eber
g di
sequi
l
ibr
[Link]
fectofsuch
si
tuat
ionwi
l
lbeei
therapr
icewarunt
iloneoft
hem sur
renderandagr
eet
oactasf
oll
ower
orcol
l
usi
onofbot
hfi
rmsabandoni
ngt
hei
rreact
ionf
unct
ionandmov
etoapoi
ntcl
oset
o
edgewor
thcont
ractcur
vewher
ebot
hoft
hem gethi
gherpr
ofi
t

Numer
icali
ll
ust
rat
ionofSt
ackl
eber
gmodel
Consi
dert
hedemandandcostf
unct
ionusedf
orcour
notmodel
P=60-
2(y
1+y
2)

2
C1=y
1 ,C2=4y2

Fi
nd
a)St
ackl
eber
gequi
l
ibr
ium assumi
ngf
ir
m –1i
sal
eader
b)St
ackl
eber
gequi
l
ibr
ium assumi
ngf
ir
m –2i
sal
eader
.
Sol
uti
on
I
ffi
rm-
1isal
eader
,iti
stheonewhi
chchoosesout
putl
evelt
hatmaxi
mizesi
tspr
ofi
tfi
rst
byi
ncor
por
ati
ngr
eact
ionf
unct
ionofi
tsf
oll
oweri
ntoi
tsowni
sopr
ofi
tfunct
ionasf
oll
ows:
Fol
l
ower
’spr
ofi
tfunct
ion,
╥2=[
60-
2(y
1+y2)
]y2-
4y2

2
╥2=60y
2-2y
1y2-2y
2- 4y
2

2
╥2=560y
2-2y
1y2-2y
2

Takefir
storderpar
ti
alder
ivat
iveoft
hepr
ofi
tfunct
ionwi
thr
espectt
oy2t
odet
ermi
net
he
react
ionfunct
ionoffol
l
owerfir
m;

Thereact
ionf
unct
ionoff
oll
ower
fi
rm

Leader
’spr
ofi
tfunct
ioncandef
ineas:
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 55
ECON102MI
CROECONOMI
CSI
I

Todet
ermi
nei
tsopti
mal l
evel
ofout
putt
hel
eaderi
ncor
por
atef
oll
ower
’sr
eact
ionf
unct
ion
i
ntoi
tsownpr
ofi
tfunct
ion:

Thent
akef
ir
stor
dercondi
ti
ont
odet
ermi
net
hel
evel
ofout
putt
hatmaxi
mizest
hepr
ofi
t
oft
hel
eader
.

Thel
eaderpr
oduces8uni
tofout
putt
omaxi
mizei
tspr
ofi
t.
Todet
ermi
nef
oll
ower
’sopt
imal
choi
cesubst
it
utel
eader
’sout
putl
evel
int
her
eact
ion
f
unct
ionoft
hef
oll
owerf
ir
m.

Pr
ofi
toft
hel
eader
Pr
ofi
toff
oll
ower

b) Assumef
ir
m-2i
sal
eaderandf
ir
m-1i
saf
oll
ower

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 56
Sol
vebackwar
dst
art
ingf
ormt
hef
oll
owerpr
ofi
tmaxi
mizat
ion

Equat
iononeabov
erepr
esentt
her
eact
ion
f
unct
ionoff
ir
m-1,
thef
oll
owerandt
henFi
rm-
2(
thel
eader
)subst
it
utest
her
eact
ionf
unct
ion
oft
hef
oll
ower
,fi
rm-
1int
oit
spr
ofi
tfunct
iont
o
det
ermi
nepr
ofi
tmaxi
mizi
ngl
evel
ofout
putas
f
oll
ows:

Todet
ermi
net
heopt
imal
lev
elofout
putf
ort
hef
oll
ower
,
subst
it
utet
heopt
imal
out
putl
evel
oft
hel
eader(
fi
rm-
2)i
n
t
her
eact
ionf
unct
ionof

t
hef
oll
ower
:

Leaderpr
ofi
t’
s f
oll
ower
’spr
ofi
t

_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_
Sel
f-
testexer
cise
Supposet
hatt
hest
ackel
ber
gduopol
i
stf
acet
hef
oll
owi
ngmar
ketdemandcur
ve:
Wher
eyi
sthet
otalout
putsuppl
i
edt
othemar
ket( .
Alsosupposet
hatt
he

t
wo f
ir
mshav
ezer
omar
ginal
cost
, .Assumi
ngf
ir
m-1i
sst
ackel
ber
gleader

f
ind:
a)
.Thepr
ofi
tmaxi
mizi
ngl
evel
out
putoft
hel
eaderf
ir
m andt
heamountofout
put
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 57
ECON102MI
CROECONOMI
CSI
I

Pr
oducedbyt
hef
oll
oweratt
hepr
ofi
tmaxi
mizi
ngl
evel
oft
hel
eader
b)
.Themaxi
mum l
evel
ofpr
ofi
tear
nedbyt
het
wof
ir
ms.
2)I
nSt
ackl
eber
gmodel
,whi
chf
ir
m setopt
imalout
putl
evelf
ir
st?(
Thel
eaderort
he
f
oll
ower
).
3)Whatdowemeanbyst
ackel
ber
gdi
sequi
l
ibr
ium?Doesi
thasanyef
fect
?
_
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___
___
___
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___
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___
___
___
___
___
___
___

2.
3Col
lusi
veol
igopol
y
Al
lol
i
gopol
ymodel
sdescr
ibedupunt
ilnowar
eanexampl
eofnon-
col
l
usi
veol
i
gopol
y.I
n
sucht
ypeofi
ndust
ryeachf
ir
m makei
ndependentdeci
siont
omaxi
mizei
tspr
ofi
tev
en
t
hougheachoft
hem t
akeot
her
’sl
i
kel
ybehav
iori
ntoaccountdur
ingt
hepr
ocessof
deci
si
onmaki
[Link] weconsi
derot
herpossi
bil
i
tyi
nwhi
chf
ir
msf
oundi
nagi
ven
i
ndust
rymakecol
l
usi
veagr
eementi
mpl
i
cit
lyorexpl
i
cit
lyt
osomedegr
eei
nset
ti
ngpr
ice
andout
put
.Fi
rm ent
eri
ntosuchcol
l
usi
veagr
eementi
nor
dert
ocul
ti
vat
etheadv
ant
ageof
i
ncr
easi
ngpr
ofi
t,decr
easi
nguncer
tai
nti
esandt
ocr
eat
ebet
teroppor
tuni
tyt
opr
event
ot
her
’sent
ryt
othei
ndust
[Link] f
ir
msoper
ati
ngi
nsuchar
rangementmake
deci
si
onwewi
l
lconsi
dercar
tel
andpr
icel
eadershi
pint
hissubsect
ion.

2.
3.1Car
tel
Acar
teli
saf
ormalor
gani
zat
ionoff
ir
mspr
oduci
ngt
hesamepr
oduct
.Iti
sfor
medt
o
coor
dinat
ethepol
i
ciesofmemberf
ir
m soast
oincr
easet
hei
rjoi
ntpr
ofi
tbyl
i
mit
ingt
he
scopeofcompet
it
ionamongt
hem.I
tal
sor
educesuncer
tai
ntyar
isi
ngf
rom t
hei
rmut
ual
i
nter
[Link]
ewewi
l
lst
udyt
wot
ypi
cal
for
msofcar
tel
s.
a)Car
tel
sai
mingatj
ointpr
ofi
tmaxi
mizat
ion
b)Mar
ketshar
ingcar
tel

2.
3.1.
1Car
tel
aimi
ngatj
ointpr
ofi
tmaxi
mizat
ion.
Car
telai
ming atj
ointpr
ofi
tmaxi
mizat
ion i
sfor
med asi
tsnamei
ndi
cat
eswi
tht
he
obj
ect
iveofmaxi
mizi
ng t
het
otali
ndust
ry’
spr
ofi
t.I
n or
dert
o achi
evet
hisobj
ect
ive
memberf
ir
m appoi
ntacent
ralagencyt
owhi
cht
heydel
egat
etheaut
hor
it
ytodeci
denot

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 58
onl
ythe t
otalquant
it
yand pr
ice atwhi
ch t
he i
ndust
ry’
s pr
ofi
tmaxi
mized butal
so
al
l
ocat
ionofout
putandpr
ofi
tamongt
hememberofcar
tel
.

Tomakesuchdeci
si
ons,i
tisassumedt
hatcent
ralagencyhav
eaccesst
oinf
ormat
ion
aboutt
hecostofi
ndi
vi
dualf
ir
msandknowmar
[Link]
vent
hei
nfor
mat
ionabout
costanddemand,cent
ralagencydet
ermi
nepr
iceandout
putt
hatmaxi
mizesi
ndust
ry’
s
pr
ofi
tdef
inedbyt
hei
nter
sect
ionofmar
ginalr
evenueandmar
ginalcostcur
[Link]
ginal
r
evenuecur
vecanbeder
ived f
rom mar
ketdemand and t
hemar
ginalcostused f
or
deci
si
oncanbeobt
ainedbysummi
ngupi
ndi
vi
dualmar
ginalcost
.Int
hiscase,t
hecar
tel
actasmul
ti
plantmonopol
yandchooses t
omaxi
mizet
het
otali
ndust
ry

pr
ofi
ts:

Takef
ir
stor
dercondi
ti
onofi
ndust
rypr
ofi
tfunct
iont
odet
ermi
nepr
ofi
tmaxi
miz
ati
onl
evel
ofout
putandpr
ice:

Si
ncet
otalr
evenuedependsont
hesum ofal
lcar
telmember
s’out
putl
evel
s,mar
ginal
r
evenuei
sthesamenomat
terwhoseout
putl
eveli
ssol
[Link]
hepr
ofi
tmaxi
mizat
ionpoi
nt
t
her
efor
e,t
hiscommon mar
ginalr
evenuewi
l
lbeequat
ed wi
th each f
ir
m’smar
ginal
pr
oduct
ioncost
.
Forsi
mpl
i
cit
yletusassumest
her
ear
eonl
ytwof
ir
msi
nthecar
telwi
thmar
ginalcost
MC1andMC2asi
ndi
cat
edi
nfi
gur
e2.
[Link]
hei
ndust
ry’
smar
ginalcost(
MC)obt
ainedby
summi
ngupmar
ginalcost
soft
het
wof
ir
[Link]
om t
hemar
ketdemandDD,
wecander
ive
i
ndust
ry’
smar
ginalr
[Link]
nter
sect
ionpoi
ntofMCandMRgi
vespr
ofi
t-
maxi
mizi
ng
l
evel
ofout
putandpr
ice.

. MC2 AC2
MC1
AC1 MC=MC1+MC2
D

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS P* 59
ECON102MI
CROECONOMI
CSI
I

D
Q*
1 Q*
2 Q*
=Q*
1+Q*2

Fi
gur
e:2.
9Joi
ntpr
ofi
tmaxi
mizi
ngcar
tel

Att
hesamet
imecent
ralagency
,al
l
ocat
epr
oduct
ionbet
weent
het
wof
ir
mssi
mil
art
o
Mul
ti
plantmonopol
ybyequat
ingt
heMRt
oindi
vi
dualmar
ginalcost
.Mat
hemat
ical
l
ythe
pr
ofi
tmaxi
mizat
ionofcar
tel
canbeder
ivedas

Max =R1+R2-
C1-
C2
Y1,
Y2

=p(
y1+y2)(
y1+y2)–C1(
y1)–C2(
y2)

Taki
ngF.
[Link]
orj
ointpr
ofi
tmaxi
mizat
ion

1. =0

2.

Rear
rangi
ngequat
ion(
1)and(
2)wecanget

MR=MC1=MC2 Si
nce

Car
tel
sai
mingatj
ointpr
ofi
tmaxi
mizat
iondet
ermi
net
heamountofout
putpr
oducedby
eachmemberf
ir
m usi
ngt
heabov
econdi
ti
on(
MR=MC1=MC2 )

Numer
icali
ll
ust
rat
ion
Assumet
hatt
heMar
ketdemandf
aci
ngt
hemember
sofacar
teli
sP=60-
2(y
1+y2)and
t
hei
rcostofpr
oduct
ioni
sgi
venbyC1=Y12,
C2=4y
[Link]
ndt
hel
evelofout
putandpr
icet
hat
maxi
mizest
hei
ndust
ry’
spr
ofi
t.
Sol
uti
on
Weder
ivepr
ofi
tmaxi
mizat
ioncondi
ti
onf
orcar
telai
mingatj
ointpr
ofi
tmaxi
mizat
ionas
MR=MC1=MC1
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 60
MR=MC1
MR=MC2
60-
4y=2y
1Wher
ey=y
1+y2

60–4(
y1+y2)=2y
1

60–4y
1-4y
2=2y1

60–6y
1-4y
2=0

Fr
om Equat
ion(
3)
60–4y=4
60–4y
1-4y
2=4

56–4y
1-4y
2=0…(
4)
Sol
vesi
mul
taneousl
yequat
ion3and4
56-4y
1-4y
2=0

60-6y
1-4y
2=0

4-
2y1=0

Y1=2
Subst
it
utei
nequat
ion(
1)
60-
6y1-4y
2=0

60-12-4y
2=0

48-
4y2=0

Y2=2
Tot
alout
putt
hatmaxi
mizesi
ndust
ry’
spr
ofi
tist
hesum ofi
ndi
vi
dual
fir
m’sout
put
Y=y
1+y
2=12+2=14
Y=14
P=60-
2(y
)
=60-
2(14)=22
P=22
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 61
ECON102MI
CROECONOMI
CSI
I

Joi
ntpr
ofi
toft
hei
ndust
ry (
y1+y
2)=[
p(y
1+y
2)][
y1+y
2]-
2 2
(
y1+y
2) =60y
1+56y
2–3y1 –2y2 -4y
1y2

2 2
(
y1+y
2) =60y
1+56y
2–3y1 –2y2 -4y
1y2

2 2
=60(
2)+56(
12)–3(
2) –2(
12)-4(
2)(
12)
=120+672–12–288-
96
=792–396=396

I
nPr
act
icehowev
er,
car
tel
srar
elyachi
evemaxi
mum j
ointpr
ofi
[Link]
ear
esev
eral
r
easonswhycar
tel
’
sindust
rypr
ofi
tcannotbemaxi
[Link]
hem ar
e
Mi
stakesi
ntheest
imat
ionofmar
[Link]
stakei
nest
imat
ionofmar
ketdemand
l
eadst
omi
stakei
ntheder
ivat
ionoft
heMRandhencepr
iceandout
putwhi
chmaxi
mizes
pr
ofi
t.
Mi
stakesi
nest
imat
ionofMCduet
oincompl
eteknowl
edgeoft
hei
ndi
vi
dual
fir
m’scost
sat
di
ff
erentl
evel
ofout
put
.Sucher
rorl
eadst
oequi
l
ibr
ium l
evel
ofout
putandpr
ice,
dif
fer
ent
f
rom t
heexpect
edcar
tel
sol
uti
on.
Sl
owpr
ocessofcar
tel
negot
iat
[Link]
ncememberf
ir
mshav
edi
ff
erentcostandmar
ket
shar
e,t
obr
ingt
hem t
ocommonl
evel
ofpr
icei
ttakest
[Link]
het
imet
akenf
ormaki
ng
deci
si
oni
slonger
,thepr
iceofgoodsandser
veschangesf
orwhati
tisexpect
edt
[Link]
t
hei
nfor
mat
ionusedbycent
ral
agencyf
ordeci
sionmaki
ngbecomesoutdat
edandcor
rect
l
evel
ofpr
icet
hatmaxi
miz
est
hei
ndust
rypr
ofi
tcannotbeset
.
St
icki
nessoft
henegot
iat
edpr
[Link]
enwhenmar
ketcondi
ti
onchanges,
oncepr
iceset
,it
needl
ongt
imef
ornegot
iat
ionandsetpr
ofi
tmaxi
mizi
ngpr
ice.
Cheat
ingbymemberf
ir
m dur
ingbar
gai
ningpr
ocesst
hroughgi
vi
ngbi
asedi
nfor
mat
ioni
n
or
dert
oachi
evel
argemar
ketshar
e.
Ex
ist
enceofhi
ghcostf
ir
ms.I
faf
ir
m oper
ateswi
thhi
ghert
hanequi
l
ibr
ium MC,
itr
educes
t
het
otal
joi
ntpr
ofi
[Link]
esul
t,i
thast
ocl
osedownt
omaxi
mizej
ointi
ndust
ry’
spr
ofi
t.
Nev
ert
hel
ess,
ther
eisnosucht
hingwi
thf
ir
m ai
mingofj
oini
ngi
ndust
rymaxi
mizat
ion.
Fearofgov
ernmenti
nter
fer
encet
ochanget
hel
evel
ofpr
icewhi
chmaxi
mizescar
tel
s’
i
ndust
rypr
ofi
t
Thewi
sht
ohav
egoodpubl
i
cimagecar
tel
agencywi
l
lnoti
ncr
easepr
icet
opr
ofi
t
maxi
mizat
ionl
evel
oft
hei
ndust
ry.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 62
_
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___
___
___
___
___
___
___
___
___
___

Sel
f-
testexer
cise
Supposet
hatt
hemar
ketdemandf
aci
ngt
wof
ir
mspr
oduci
ngt
hesamepr
oduct
i
sgi
venby wher
e ,t
otalout
put
.Ift
hepr
oduct
ioncostof

t
het
wof
ir
msi
sequalandgi
venby andt
hent
heagr
eet
o
f
orm car
tel
aimi
ngatj
ointpr
ofi
tmaxi
mizat
ion,
find:
a)Theamountofout
putt
hatmaxi
mizest
hei
rpr
ofi
t.
b)Thei
ndust
ry’
spr
ice.
c)Theout
putandt
hepr
ofi
tofeachf
ir
m.
_
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___

2.
3.1.
2Mar
ketShar
ingCar
tel
I
nmar
ketshar
ingcar
tel
thememberf
ir
msagr
eeonhowt
oshar
ethemar
ketbutt
heykeep
a consi
der
abl
e degr
ee off
reedom concer
ning t
he st
yle oft
hei
rout
put
,thei
rsel
l
ing
act
ivi
ti
esandot
herdeci
[Link]
ir
mther
efor
eoper
atesi
nonear
eaorr
egi
onagr
eed
uponwi
thoutencr
oachi
ngonot
her
s’t
err
it
ori
[Link]
sfor
m ofcar
teli
smor
ecommoni
n
r
ealwor
ldandmor
epopul
art
hancar
telai
mingatmaxi
mizat
ionofj
ointi
ndust
rypr
ofi
t.
Ther
ear
etwobasi
cmet
hodsf
orshar
ingmar
ketbyt
hememberf
ir
m ofcar
tel
:non-
pri
ce
compet
it
ionandquot
a.

[Link]-pr
icecompet
it
ion
I
nsuchf
orm ofcar
telt
hememberf
ir
m agr
eeonacommonpr
iceatwhi
cht
heysel
lthei
r
out
put
.Thepr
iceuponwhi
cht
heyagr
eedsetbyt
hepr
ocessofbar
gai
ning.I
nthe
bar
gai
ningpr
ocess,l
ow costf
ir
m pr
essi
ngf
orl
owerpr
iceandhi
ghcostf
ir
m pr
essf
or
hi
gherpr
[Link]
heendcommonpr
icewhi
chal
l
owal
lmember
scer
tai
namountofpr
ofi
t,i
s
set
.Atsuchpr
icef
ir
mscompet
etomaxi
mizi
ngt
hei
rpr
ofi
tbyi
ncr
easi
ngt
hei
rsel
lvol
ume
t
hroughdi
ff
erentwayofnon-
pri
cecompet
it
ionl
i
kequal
i
ty,st
yle,sel
l
ingact
ivi
ti
esand
adv
ert
isi
[Link]
orm ofcar
teli
sunst
abl
emostoft
het
imecompar
edt
ocar
telai
mingat
j
ointpr
ofi
tmaxi
mizat
[Link],
whenev
ert
her
eiscostandl
i
qui
dit
ydi
ff
erence,
lowcost
f
ir
mshav
ethei
ncent
ivet
ocheatbyl
ower
ingt
hei
rpr
iceandi
nit
iat
espr
icewaramong

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 63
ECON102MI
CROECONOMI
CSI
I

memberf
ir
ms,
whi
chr
esul
tini
nst
abi
l
ity
.

[Link]
ingoft
hemar
ketbyagr
eementonquot
as
I
nthi
scase,memberf
ir
msagr
eet
osuppl
yacer
tai
nquant
it
yofout
putatagr
eedpr
ice.
Thequot
aal
l
ocat
ionmadebasedont
hecostst
ruct
ureoft
hef
ir
ms.I
ftheyhav
eident
ical
cost
s,t
hemonopol
ysol
uti
onwi
l
lemer
gebyshar
ingt
hemar
ketequal
l
[Link]
eri
fcost
s
ar
edi
ff
erent
,thequot
aofmar
ketshar
edi
ff
ersbet
weent
hef
ir
[Link]
a
shar
ingdependont
hebar
gai
ningpoweroft
hef
ir
[Link]
ingbar
gai
ningpr
ocesspast
l
evel
ssal
esandort
hebasi
sforpr
oduct
ivecapaci
tyoft
hef
ir
msar
econsi
der
edf
or
deci
si
on.

Theot
herf
orm ofshar
ingmar
keti
smadet
hroughdef
ini
nggeogr
aphi
calboundar
iest
o
whi
ch each memberf
ir
m suppl
ythei
rpr
oduct
.Li
ke non-
pri
cing compet
it
ion,mar
ket
shar
ingcar
tel
sorr
egi
onalshar
ingcar
tel
sagr
eementar
eal
sounst
abl
[Link]
eement
s
ar
evi
olat
edi
ntent
ional
l
yorbymi
stakebyl
owcostf
ir
m whohav
ethei
ncent
ivet
oexpand
t
hei
rout
putbycut
ti
ngpr
ice.

Mostoft
heabov
efor
msofcar
tel
sar
eunst
abl
[Link]
ir
mswi
l
lnotactaccor
dingt
oout
put
andpr
icel
eveluponwhi
cht
heyagr
eedduet
oanumberofr
[Link]
her
easons
i
ncl
udes:t
hememberf
ir
mshav
edi
ff
erentcost
s,di
ff
erentassessment
soft
hemar
ket
demandandev
enhav
edi
ff
erentobj
ect
[Link]
het
imet
heywant
stosetpr
iceat
di
ff
erentl
evel
.Fur
ther
mor
e,eachmemberoft
hecar
telt
empt
edt
ocheatbyl
ower
ingpr
ice
sl
i
ght
lyt
ocapt
urel
argershar
eofmar
kett
hanal
l
ocat
edf
ort
hef
ir
[Link]
simpl
i
est
her
e
shoul
dbesomesor
tofenf
orcementmechani
sm f
oracar
telt
obesuccessf
[Link]
eati
n
t
hel
ongr
unf
ort
hememberwhobr
eakst
heagr
eementshoul
dbet
her
[Link]
sogai
ning
cer
tai
nmonopol
ypowert
osetpr
icebycar
tel
isot
herf
act
orf
ort
hesuccessofcar
tel
i.
e.,
if
t
hepot
ent
ialgai
nfor
m cooper
ati
onar
elar
ge,
car
telmemberhav
emor
eincent
ivet
osol
ve
t
hei
ror
gani
zat
ionalpr
obl
em andhencepr
ofi
tforcar
tel
i
zat
ioni
slar
geenought
ogi
ve
i
ncent
ivef
ort
hemember
stoactaccor
dingt
othecont
ract
ual
agr
eement
.

2.
3.2Pr
icel
eader
shi
p
Dearst
udent
s,unl
i
kef
ir
msi
ncar
tel
,whi
chagr
eeexpl
i
cit
lyt
ocooper
atei
nset
ti
ngpr
ice
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 64
andout
put
,fi
rmsi
npr
icel
eader
shi
pcol
l
usi
veol
i
gopol
y,agr
eet
ocooper
atei
mpl
i
cit
lyi
n
maki
ngdeci
si
onsaboutpr
iceandout
putwi
thoutanyf
ormaldi
scussi
[Link]
eri
nto
suchagr
eementv
olunt
ari
l
ytoav
oidanyuncer
tai
ntyaboutt
hecompet
it
orr
eact
ion.I
nsuch
t
ypeofmodel
,onef
ir
m i
mpl
i
cit
lyr
ecogni
zedast
hel
eaderandsetpr
[Link]
her
r
emai
ningf
ir
m,t
hef
oll
owert
akepr
iceasgi
venandadoptt
hepr
icesetbyt
hel
eaderf
ir
m
ev
ent
houghi
tspr
ofi
tdi
dnotmaxi
mized.

Thi
sfol
l
ow f
rom t
heassumpt
iont
hatt
het
wo f
ir
m sel
l
ingi
dent
icalpr
oduct
s.I
fone
char
gedadi
ff
erentpr
icef
ormt
heot
her
,al
loft
heconsumer
swoul
dpr
efert
hepr
oducer
s
wi
tht
hel
owerpr
ice.I
naddi
ti
on,i
ftwof
ir
msdonotagr
eei
mpl
i
cit
lyoncommonpr
ice,
t
her
eispossi
bil
i
tyt
oent
eri
ntoapr
icewar
.Pr
icewart
hroughr
educt
ionofpr
icescause
l
ow pr
ofi
tlev
elandev
encausesdest
ruct
ionoft
hef
ir
[Link]
ti
onsmayf
orce
ol
i
gopol
yfi
rmst
ocooper
atewi
thoutact
ual
l
ymaki
ngexpl
i
cit
lyagr
eement
swi
thoneot
her
.
Ther
ear
evar
iousf
orm ofpr
icel
eader
shi
p,t
hemostcommononesar
e:
[Link]
icel
eader
shi
pbyl
owcostf
ir
m
[Link]
icel
eader
shi
pbyl
arge(
domi
nant
)fi
rm
[Link]
omet
ri
cpr
icel
eader
shi
p

2.
3.2.
1Lowcostpr
icel
eader
shi
p
Thi
smodelassumest
hatt
her
ear
etwof
ir
msi
nthei
ndust
rypr
oduci
nghomogenous
pr
oductatdi
ff
erentcost
.Onef
ir
m pr
oduceatl
ow costcompar
edt
oit
scompet
it
or.
Mor
eov
er,f
ir
msmayhav
eequalorunequalmar
ketshar
[Link]
venf
ir
mswi
tht
hest
ated
f
eat
ures,l
ow costf
ir
m becomest
hel
eaderandsetpr
ice,whi
chmaxi
mizesi
tspr
ofi
t.
Fol
l
owerf
ir
m byscar
if
yingsomeofi
tspr
ofi
ttaket
hepr
icesetbyt
hel
eader
.Thi
sist
o
av
oidapr
icewar
,whi
chwoul
del
i
minat
ethef
ir
mfr
om t
hei
ndust
ryi
fpr
icesetl
owert
hen
i
tsLAC.

Howev
er,t
hepr
icesetbyt
hel
eaderf
ir
m usi
ngmar
ginalpr
inci
ple(
MC=MR)woul
d
r
emai
natt
hest
atedposi
ti
ont
hroughmai
ntai
ningout
putconst
ant
. Dev
iat
ionofout
put
f
rom t
hepoi
ntwher
eMR=MCduet
oov
erorundersuppl
yofout
putbyf
oll
owerf
ir
m wi
l
l
changet
hepr
iceandt
hent
hepr
ofi
toft
hel
eaderwi
l
lnotmaxi
[Link]
simpl
i
est
hat
t
hef
oll
owermustsuppl
yaquant
it
ysuf
fi
cientt
omai
ntai
nthepr
icesetbyt
hel
eader
.So
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 65
ECON102MI
CROECONOMI
CSI
I

att
heopt
imalpr
icel
evel
,thef
ir
msmustal
soent
eragr
eementont
heshar
eoft
he
mar
ketf
ormal
l
yori
nfor
mal
l
[Link]
herwi
seev
ent
hought
hef
oll
oweradoptl
eader
spr
ice,
pr
oduci
nghi
gherorl
owerl
evel
ofout
putr
equi
redt
omai
ntai
nthepr
ice(
setbyt
hel
eader
)
i
nthemar
ketpusht
hel
eadert
onon-
prof
itmaxi
mizi
ngposi
ti
on.I
nthi
srespect
,the
f
oll
oweri
snotcompl
etel
ypassi
ve;i
tcanaf
fectt
hemar
ketpr
iceandt
hent
hepr
ofi
tof
t
hel
eaderunl
esst
heyent
eri
ntof
ormalori
nfor
malagr
eementt
o suppl
ycer
tai
n
pr
opor
ti
onoft
het
otal
out
put
.

Numer
ical
il
lust
rat
ion
Recal
lthatt
heexampl
esweusef
orot
her
sduopol
ymodel
wit
h:
Mar
ketdemand:
P=60-
2(y
1+y2)

2
CostC(
y1)=y
1 C(
y2)=4Y2
Whenweseet
hei
rcostst
ruct
ure,
fir
mtwoi
sal
owcostf
ir
m sot
hati
tcanbet
akenas
t
hel
eader
.So,
iti
stheonewhosetpr
iceusi
ngt
hemar
ginal
pri
nci
plebutt
het
wof
ir
ms
goi
ntoagr
eementaboutt
heshar
eoft
hemar
ketatl
eader
’spr
ofi
tmaxi
mizi
ngl
evel
of
pr
[Link]
heyagr
eet
oshar
eequal
l
[Link]
tht
hisassumpt
ion,
thedemandcur
ve
r
elev
antt
oleader
’sdeci
sionwoul
dbemodi
fi
edas:
P=60-
2(Y1+Y2) ,
Y1=Y2
P=60-
2(Y2+Y2)=P=60-
4Y2

Take F.
C.O t
o det
ermi
ne equi
l
ibr
ium l
evelofout
putt
hatmaxi
mizes

l
eader
’spr
ofi
t.

56-
8Y2=0 Y2=Y1=7
P=60-
4Y2
=60-
4(7)=60-
28=32
P*
=32
Howev
er, andout
putl
evelY1=7woul
dnotmaxi
mizest
hepr
ofi
toft
hef
oll
ower
f
ir
[Link]
icet
hatmaxi
mizest
hepr
ofi
toft
hef
oll
owerf
ir
m canbedet
ermi
ned
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 66
t
hroughmaxi
mizi
ngt
hei
tspr
ofi
tfunct
ionasf
oll
ows;

TakeF.
O.C

P=60-
4
P=60-
4(6)=60-
24=36
P*
=36
Theout
putl
evelwhi
chmaxi
mizest
hepr
ofi
toff
ir
m one(
fol
l
ower
)woul
dbeY1 =6uni
ts
andchar
geapr
iceP*
=36i
fitdi
dnotr
ecogni
zest
hel
eadernessoff
ir
mtwo.

_
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___
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___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_

Act
ivi
ty2.
7
I
nlow costpr
icel
eader
shi
pmodelwhati
sthev
ari
abl
euponwhi
chf
ir
msst
rat
egi
cal
l
y
i
nter
actdur
ingdeci
sion-
maki
ng.
St
atet
heuni
quef
eat
ureoft
hef
ir
m,whi
char
ecl
assi
fi
edasl
eaderf
ir
minl
owcostpr
ice
l
eader
shi
p.
Whyf
ir
msi
nlowcostpr
icel
eadershi
pent
erexpl
i
citori
mpl
i
citagr
eementont
hel
evelof
out
putt
obesuppl
i
edwhent
hel
eadersetpr
ice?
supposet
hatt
hemar
ketdemandf
aci
ngt
wof
ir
mspr
oduci
ngt
hesamepr
oducti
sgi
venby
wher
e andt
hei
rcost
sofpr
oduct
ioni
s:

.I
fthet
wof
ir
msent
eri
ntoi
mpl
i
cit
lyagr
eementt
opr
oducet
he
samel
evel
ofout
putaccor
dingt
olowpr
icel
eadershi
pol
i
gopol
ymodel
,
a)Whi
chf
ir
misl
owcostpr
icel
eader
shi
p?
b)Fi
ndt
hepr
icet
hatmaxi
mizest
hepr
ofi
toft
hel
eader
.
c)I
fthef
oll
owerf
ir
m want
stomaxi
mizesi
tspr
ofi
twhatpr
iceandout
put
Lev
elshoul
ditset
?

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 67
ECON102MI
CROECONOMI
CSI
I

_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
__

2.
3.2.
2Domi
nantf
ir
m pr
icel
eader
shi
p
I
nsuchol
i
gopol
yindust
ryt
her
eisonel
argef
ir
m hav
ingl
argeshar
eoft
het
otalmar
ket
wi
thagr
oupofsmal
l
erf
ir
mssuppl
yther
est
.Thel
argerf
ir
m,whi
chi
sal
soknownas,t
he
domi
nantf
ir
m becomet
hel
eaderandsetpr
icet
hatmaxi
mizei
tspr
ofi
[Link]
hersmal
l
er
f
ir
ms,whi
chcoul
dhav
eli
tt
lei
nfl
uenceov
erpr
ice,woul
dbeapr
icet
akerl
i
kef
ir
msi
n
per
fectcompet
it
ivef
ir
[Link]
seachoft
hesmal
lfi
rmspr
oducesanamountdet
ermi
ned
byset
ti
ngmar
ginalcostequal
stopr
iceannouncedbyt
hel
eaderandt
hel
eadersuppl
ythe
r
esi
dual
.

Gi
vent
hest
ruct
ureoft
hemodel
,whatpr
icewoul
dthedomi
nantf
ir
m sett
omaxi
mizei
ts
pr
ofi
t?I
sthel
eaderf
ir
m consi
der
ingt
hei
mpactofot
hersmal
lfi
rmswhi
l
eset
ti
ngpr
ice?
Byassumpt
ion,t
hedomi
nantf
ir
m knowst
hemar
ketdemandandt
hemar
ginalcostof
smal
lfi
[Link]
sassumpt
ionenabl
est
hedomi
nant(
thel
eader
)fi
rmt
oder
ivei
tsown
demandf
unct
ionf
ormt
hemar
ketdemandandmar
ginalcost
sofsmal
l
erf
ir
[Link]
s
si
ncesmal
lfi
rmsi
nthei
ndust
rybehav
eli
kepr
efectcompet
it
ivef
ir
m,t
hedomi
nantf
ir
m
equat
e pr
ice wi
tht
he sum oft
hei
rmar
ginalcost
sto gett
hei
rsuppl
yfunct
ion
( )
.Thent
hel
eaderf
ir
m’sdemandf
unct
ion,whi
chi
sal
soknownas,t
he

r
esi
dualdemandcur
ve,canbeobt
ainedbysubt
ract
ingt
hesuppl
yfunct
ionoft
hesmal
l
er
f
ir
msf
rom t
hemar
ketdemand.

Oncet
hel
eaderi
dent
if
yit
sdemandf
unct
ion,
itactl
i
keamonopol
ytosetpr
iceandout
put
l
evelwhi
chmaxi
mizesi
tspr
ofi
tbyequat
ingmar
ginalr
evenuewi
thi
tsmar
[Link]
e
t
hemar
ginalr
evenueusedf
ordeci
sioni
sder
ivedf
rom r
esi
dualdemandt
hatact
ual
l
y
measur
eshowmuchout
puti
twi
l
lbeabl
etosel
lateachgi
venpr
ice.

Smal
lfi
rmssuppl
y Out
put

Leader
's MC
D suppl
y
ADAMAUNI
VERSI DE1
TY, PARTMENTOFECONOMI
CS 68
P1 AC
A D2 P
P
Asi
ndi
cat
edi
nfi
gur
e2.
10.f
orexampl
eatP1t
hedemandf
ort
hepr
oductoft
hel
eaderwi
l
l
bezer
o,becauset
het
otal
quant
it
yD1i
ssuppl
i
edbysmal
l
erf
ir
[Link]
icef
all
bel
owp1 t
he
demandf
ort
hel
eader
’spr
oducti
ncr
[Link]
het
otaldemandi
sD2outofwhi
chPAi
s
suppl
i
edbysmal
lfi
rmsandt
her
emai
ningAD2i
ssuppl
i
edbyt
hel
eader
.

Hav
ingder
ivedt
hedemandcur
veoft
hel
eaderasi
nfi
gur
e2.
10(
b)andgi
veni
tsMC,t
he
domi
nantf
ir
m wi
l
lsetpr
iceatwhi
chhi
sMR=[Link]
ersmal
l
erf
ir
msmayormaynot
maxi
mizesi
tpr
ofi
tdependi
nguponi
tscostst
ruct
ureatt
hesetl
evel
ofpr
ice.

Numer
icali
ll
ust
rat
ion
Supposet
hatt
hemar
ketdemandf
aci
ngt
hei
ndust
ry’
spr
oducti
sD(
P)=50-
0.3Pandt
he
suppl
yfunct
ionofsmal
l
erf
ir
msasaf
unct
ionofpr
icei
sS=0.
2P
Sot
hedomi
nantf
ir
m’sdemandf
unct
ioncanbeder
ivedasY=D-
S
=50-
0.3p=50-
0.5P
P=100-
2Y
I
fdomi
nantf
ir
m’scostf
unct
ioni
sC=2Yt
heni
tspr
ofi
tfunct
ion,

98-
4Y=0

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 69
ECON102MI
CROECONOMI
CSI
I

Y*

Leaderwi
l
lsetpr
iceP=100-
2X=100-
2(24.
5)
P=51
Att
hispr
icet
het
otal
quant
it
ydemanded
D=50-
0.3(
51)=34.
7
D=34.
7
Theamountsuppl
i
edbysmal
l
erf
ir
msi
s=0.
2P
S=0.
2(51)=10.
2 S=10.
2
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
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___
___
___
Act
ivi
ty2.
8.
1)Descr
ibet
hest
ruct
uredomi
nantf
ir
m pr
icel
eader
shi
p.
2)Whati
sthedi
ff
erencebet
weenl
owcostpr
icel
eader
shi
pandt
hedomi
nantf
ir
m pr
ice
l
eadershi
p?
3)Supposet
hatt
hemar
ketdemandf
orapr
oductbyonel
argerf
ir
m andmanysmal
lfi
rms
i
sgi
venas .Thet
otalamountofout
putsuppl
i
edbyt
hesmal
l
erf
ir
msi
sgi
ven
by .
ift
hemar
ginalcostoft
hel
argerf
ir
misequal
stoC(
y)=2.
96y
,whatpr
ice
shoul
dthef
ir
m char
get
omaxi
mizei
tspr
ofi
t?Howmucht
hei
ndust
rypr
oducesaswhol
e
att
hispr
ice?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

2.
3.2.
3Bar
omet
ri
cpr
icel
eadershi
p
I
nthi
sty
peofpr
icel
eader
shi
pol
i
gopol
y,t
her
eisaf
ir
m whi
chhav
egoodknowl
edgeoft
he
pr
evai
l
ingcondi
ti
oni
nthemar
ketandcanf
orecastbet
tert
hanot
heraboutt
hef
utur
e
dev
elopmenti
nthemar
ket
.Sucht
ypeoff
ir
m usedast
hebar
omet
erf
orot
herf
ir
mst
o
r
efl
ectt
hechangesi
neconomi
cenv
ironment
.Sucht
ypeoff
ir
m act
sasal
eaderandwhen
i
tspr
icechanges,
otherf
ir
mfol
l
owchangei
npr
[Link]
l
yabar
omet
ri
cfi
rm mayormay
notbeaf
ir
m wi
thl
ow costorl
argerf
ir
[Link]
er,i
tisaf
ir
m whi
chest
abl
i
shesgood
r
eput
ati
oni
nthepasti
nfor
ecast
ingeconomi
[Link]
enaf
ir
m bel
ongi
ngt
oot
her
i
ndust
ryhav
inggoodr
eput
ati
onmayal
sousedasabar
omet
ri
cleadert
oaf
fectt
he
deci
si
onofot
herf
ir
[Link]
e,af
ir
minst
eeli
ndust
rymi
ghtbet
akenasbar
omet
ri
c
pr
icel
eaderf
ormot
orcari
ndust
ry.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 70
Summar
y

Ol
i
gopol
yis a mar
ketst
ruct
ure wi
th onl
yfew f
ir
ms domi
nat
ethe whol
eindust
ry.
Economi
cdeci
sioni
nsucht
ypeofmar
keti
nvol
vesst
rat
egi
cconsi
der
ati
ons;eachf
ir
m
mustconsi
derhowi
tsact
ionaf
fect
sit
sri
val
sandhowt
heyl
i
kel
yreact
.

Ther
ear
etwodi
ff
erentf
ormsofol
i
gopol
[Link]
enon-
col
l
usi
vemodel
sandcol
l
usi
ve
model
[Link] cl
assi
fi
cat
ion i
s based up on whet
hert
her
e exi
stsome f
orms of
cooper
ati
onbet
weenf
ir
msornot
.Iti
sal
sopossi
blet
ocl
assi
fynoncol
l
usi
veol
i
gopol
yin
t
ofourt
ypesdependi
ngupont
hewayt
heymakedeci
sionandt
hest
rat
egi
cvar
iabl
e
upon whi
ch t
heyi
nter
act
:ki
nked demand,cour
notduopol
y,Ber
trand duopol
y,and
St
ackel
ber
gduopol
ymodel
s.
Theki
nkeddemandcur
vemodel expl
ainswhypr
icesof
tenr
emai
nst
abl
einol
i
gopol
y
mar
ket
s,ev
enwhencost
sri
[Link]
hert
hreemodel
str
ytopr
edi
ctt
hebehav
iour
sof
ol
i
gopol
yfi
rmsbasedondi
ff
erentki
ndsofassumpt
ionaboutt
her
ival
fir
m.

I
nCour
notduopol
ymodelofol
i
gopol
y,f
ir
msmaket
hei
rout
putdeci
sionsatt
hesame
t
imebyassumi
ngot
her
sfi
rm keepi
tsout
putf
ixedatexi
sti
ngl
evel
.Atequi
l
ibr
ium
t
her
efor
eeachf
ir
m maxi
mizest
hei
rpr
ofi
tgi
vent
heout
putofi
tscompet
it
or.
I
nBer
trandf
ir
m makest
rat
egi
cdeci
siononpr
iceast
hesamet
imebyassumi
ngt
he
pr
iceoft
hei
rcompet
it
orr
emai
nfi
xed.I
nthi
smodelt
heequi
l
ibr
ium out
comei
sthesame
asper
fect
ivel
ycompet
it
ivemar
ketev
ent
hought
henumberoff
ir
mint
hei
ndust
ryi
stwo.
I
nSt
ackel
ber
g’sduopol
ymodeli
tisassumedt
hatoneduopol
i
stwi
thbet
teri
nfor
mat
ion
becomessophi
sti
cat
edt
orecogni
zehi
scompet
it
oractont
hecour
notassumpt
[Link]
t
hesophi
sti
cat
edf
ir
m wi
l
ldet
ermi
net
her
eact
ioncur
veofhi
sri
valandi
ncor
por
atesi
tin
hi
sownpr
ofi
tfunct
ion,
todet
ermi
nepr
icet
hatmaxi
mizesi
tspr
ofi
tandt
akenasgi
venby
t
hef
oll
owerf
ir
m.
Theot
herf
orm ofol
i
gopol
yiscol
l
usi
veol
i
gopol
yinwhi
chf
ir
msmakecooper
ati
ve
agr
eementi
mpl
i
cit
lyorexpl
i
cit
lyt
osetopt
imall
evelofout
putpr
oducedandpr
ice
char
ged.
Car
teli
sacol
l
usi
vef
orm ofol
i
gopol
yinwhi
chf
ir
m pr
oduci
ngt
hesamepr
oductent
eri
n
t
oexpl
i
citcont
ract
ualagr
eement
stosetpr
iceandt
hel
evelofout
putpr
[Link]
swi
l
l
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 71
ECON102MI
CROECONOMI
CSI
I

av
oidt
heuncer
tai
ntycr
eat
edbet
weenf
ordeci
sionmaki
[Link]
ear
etwodi
ff
erent
f
ormsofcar
tel
.Thesear
eCar
telai
mingatj
ointpr
ofi
tmaxi
mizi
ngoft
hei
ndust
ryand
mar
ketshar
ingcar
tel
Joi
ntpr
ofi
tmaxi
mizi
ngcar
telhast
heobj
ect
ivet
omaxi
mizi
ngt
hepr
ofi
toft
hei
ndust
ry.
Deci
sionf
orsucht
ypeofcar
teli
smadebyt
hecent
ralagencyassi
gnedbyt
hemember
f
ir
[Link]
ralagencysetpr
icewhi
chmaxi
mizest
hei
ndust
ry’
spr
ofi
tandal
l
ocat
ethe
pr
ofi
tamongt
hememberf
ir
ms.I
npr
act
icet
hei
ndust
rypr
ofi
tcannotmaxi
mizedduet
o
v
ari
ousr
easonl
i
kecheat
ingbyl
owcostf
ir
m,mi
stakei
nest
imat
ionofcost
sandmar
ket
demandbycent
ral
agencywhi
l
eset
ti
ngpr
iceandout
putl
evel
s.
I
nMar
ketshar
ingcar
tel
,thef
ir
m agr
eet
oshar
ethemar
ket
,butkeepaconsi
der
abl
e
degr
eeoff
reedom concer
ningt
hest
yleoft
hei
rout
put
,thei
rsel
l
ingact
ivi
ti
esandot
her
deci
si
[Link]
scanoccurwhenf
ir
msagr
eednott
ocompet
eonpr
ice.

Becauseoft
hedi
ff
icul
toff
ormi
ngef
fect
ivecar
tel
,ol
i
gopol
i
stsmayat
temptt
ocooper
ate
i
mpl
i
cit
lywi
thoutmaki
ngexpl
i
citagr
eement
swi
thoneot
her
.Sucht
ypeofol
i
gopol
yis
cal
l
edpr
icel
eaderol
i
gopol
[Link]
ear
ethr
eef
ormsofpr
icel
eader
shi
p;pr
icel
eader
shi
p
byal
ow costf
ir
m,pr
icel
eader
shi
pbyal
arge(
domi
nant
)fi
rm andBar
omet
ri
cpr
ice
l
eader
shi
p.I
nal
lthet
hreef
ormst
hel
eaderf
ir
m setpr
iceandt
hef
oll
owerf
ir
mtakepr
ice
setbyt
hel
eaderasgi
ven
Keyconcept
sandt
erms
Ki
nkeddemand cour
notequi
l
ibr
ium
React
ionf
unct
ion Ber
trandequi
l
ibr
ium
I
sopr
ofi
tcur
ve st
ackel
ber
gequi
l
ibr
ium
Naï
vebehav
iour
alassumpt
ion car
tel
Col
l
usi
veol
i
gopol
y Bar
omet
ri
cfi
rm
Non-
col
l
usi
veol
i
gopol
y st
ickypr
ice
Leaderf
ir
m st
ackel
ber
gdi
sequi
l
ibr
ium
Fol
l
owerf
ir
m r
esi
dual
demand
Cont
ractcur
ve pr
icel
eaderol
i
gopol
y

Exer
cise
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 72
I
.Answert
hef
oll
owi
ngquest
ionbr
ief
ly

1)
.Di
scusest
hebehav
ior
alassumpt
ionsmadeaboutf
ir
msoper
ati
ng i
nthef
oll
owi
ng
duopol
ymodel

a)Cour
notduopol
ymodel b)ki
nkeddemandcur
vemodel

c)St
ackel
ber
gduopol
y d)domi
nantf
ir
m pr
icel
eader
shi
p.

2)
.Accordi
ngtoki
nkeddemandcur
vemodelwhydoespr
icer
igi
dit
yoccuri
nol
i
gopol
i
sti
c
market
?Whataret
heli
mit
ati
onsoft
hismodel
?

3)expl
ainhowdi
ff
erentt
ypesofpr
icel
eaderol
i
gopol
ydet
ermi
nepr
ofi
tmaxi
mizat
ionl
evel
ofpr
ice;
a)l
owcostpr
icel
eader
shi
p b)domi
nantf
ir
m pr
icel
eader
shi
p
4)I
nmostcases,t
hepr
ofi
tmaxi
mizat
ionl
evelofpr
icecannotmaxi
mizet
hepr
ofi
toft
he
i
ndust
[Link]
?

I
[Link]
hebestanswerf
ort
hef
oll
owi
ngquest
ions.

1)
.Al
loft
hef
oll
owi
ngol
i
gopol
ymodel
hav
esomet
hingi
ncommonexcept

a)
.cour
not
’sduopol
ymodel c)
.Ki
nkeddemandcur
vemodel

b)
.Ber
trandduopol
ymodel d)
.St
ackel
ber
gduopol
ymodel

2)
.Inwhi
choft
hef
oll
owi
ngmodel
opt
imal
deci
sionmadebyf
ir
mssi
mul
taneousl
y

a)
.lowcostpr
icel
eader
shi
p c)
.St
ackel
ber
gduopol
ymodel

b)
.Ber
trandduopol
ymodel d)
.Domi
nantf
ir
m pr
icel
eader
shi
p

3)
.Inwhi
choneoft
hef
oll
owi
ngduopol
ymodelt
hest
rat
egi
cint
eract
ionbet
weenf
ir
ms
madeonquant
it
yofout
putpr
oduced.

a)
.lowcostpr
icel
eader
shi
p c)
.St
ackel
ber
gduopol
ymodel

b)
.Ber
trandduopol
ymodel d)
.Domi
nantf
ir
m pr
icel
eader
shi
p

4)Oneoft
hef
oll
owi
ngi
str
ueaboutduopol
ymodel
s;

a)I
nBer
trandduopol
ymodelf
ir
msar
emaki
ngdeci
sionatt
hesamet
imeaboutout
put

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 73
ECON102MI
CROECONOMI
CSI
I

t
hatmaxi
mizest
hei
rpr
ofi
t.

b)Thei
sopr
ofi
tcur
vef
oundneart
othepr
iceaxi
sincaseofBer
trandmodelr
epr
esent
hi
gherl
evel
ofpr
ofi
tli
ket
heofcour
notmodel
.

c)Fi
rmsi
ncour
notmodelgethi
gherpr
ofi
tift
hedeci
dedt
ooper
ateoncont
ractcur
ve
r
atherdeci
dingt
opr
oduceatt
hei
nter
sect
ionbet
weent
her
eact
ioncur
ves.

d)
.Inl
owcostpr
icel
eader
shi
pfol
l
owerf
ir
m actpassi
vel
y.

I
IIwor
koutquest
ions;

1)
.Supposet
hemar
ketf
orTVsethav
eonedomi
nantf
ir
m andf
ivesmal
l
erf
ir
[Link]
mar
ketdemandf
aci
ngf
ir
msi
sY=400-
[Link]
nantf
ir
m hasconst
antmar
ginalcost
[Link]
lfi
rmseachhav
eamar
ginal
costofMC=20+5Y.

a)
.ver
if
ythatt
het
otal
suppl
ycur
vef
ort
hef
ivesmal
lfi
rmsi
sYs=P-
20

b)
.Fi
ndt
hedomi
nantf
ir
msdemandcur
ve

c)
.Fi
ndt
hepr
ofi
tmaxi
mizi
ngquant
it
ypr
oducedandpr
icechar
gedbyt
hedomi
nant
f
ir
m,andt
hequant
it
ypr
oducedandpr
icechar
gedbyeachoft
hesmal
lfi
rms.

d)
.supposet
her
ear
etensmal
lfi
rmsi
nst
eadoff
ivehowdoest
hischangey
ourr
esul
t?

e)
.supposet
hemar
ginalcostofeachoft
hef
ivef
ir
mschangedt
oMC=20+[Link]
doest
hischangei
nresul
t.

2)
.Assumet
hatf
ourf
ir
mspr
oduci
ngi
dent
icalpr
oducti
nanol
i
gopol
i
sti
cindust
ryf
orma
car
telai
mingatmaxi
mizat
ionofj
ointpr
ofi
[Link]
otalmar
ketdemandf
aci
ngt
hecar
teli
sY

=20-
2Pandeachf
ir
msmar
ginal
costf
unct
ioni
sgi
venby ;

a)
.fi
ndt
hel
evel
ofout
putandpr
icet
hatmaxi
mizet
hepr
ofi
tofcar
tel
indust
ry.

b)
.howmuchshoul
deachf
ir
mspr
oduceatcar
tel
’
spr
ofi
tmaxi
mizi
ngl
evel
ofpr
ice.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 74
c)
.howmuchpr
ofi
tcant
hecar
tel
wil
lear
n.

3)
.gi
vent
hedemandf
unct
ionoft
woduopol
i
stas
p=40-0.
4y wher
e y=y
1+y
2,out
putpr
oducedbyt
wof
ir
ms
y
1-out
putpr
oducedbyf
ir
m –1
y
2–outputpr
oducedbyf
ir
m -2
I
fthecostf
unct
ionoft
het
wof
ir
msgi
venas
2
Tc1=0.
6y1 Tc2=10.
4y2

Fi
nd t
he equi
l
ibr
ium pr
ice and out
putl
evelofeach f
ir
ms assumi
ng bot
hfi
rms ar
e
oper
ati
ngundercour
not
’sassumpt
ion
Fi
ndt
heequi
l
ibr
ium pr
iceandout
putl
evelofeachf
ir
msassumi
ngt
het
wof
ir
msar
e
St
ackl
eber
gduopol
i
standf
ir
m 2i
sthel
eaderf
ir
m.
Assumi
ng t
hese t
wo f
ir
ms ar
e mer
ged t
ofor
m one monopol
yfi
rm,cal
cul
atet
he
equi
l
ibr
ium andout
putoft
hef
ir
m.
I
fthet
wof
ir
msagr
eedt
oshar
ethemar
keti
nsuchawayt
hatl
owcostf
ir
m pr
oducet
hree
f
our
thoft
het
otalout
putdet
ermi
net
hepr
iceandquant
it
ythatwi
l
lmaxi
mizet
hepr
ofi
tof
l
owcostf
ir
m
4)
.supposet
hatt
hemar
ketofagi
vepr
oducthasonedomi
nantf
ir
m andf
ewsmal
lfi
rms.
Themar
ketdemandoft
hef
ir
msi
sQ=80-
3P.
Thecostofdomi
nantf
ir
misC1 =20Qd and
t
het
otalcostoft
hesmal
lfi
rmsi 5Q2s+20Qst
sC2=0. hesuppl
yfunct
ionofsmal
lfi
rmsi
s
equal
toQs=20-
[Link]
ngt
hemar
ketst
ruct
urei
sdomi
nantf
ir
m pr
icel
eader
shi
pty
pe:
Fi
nd:
a)domi
nant
’sf
ir
m demandf
unct
ion.
b)Pr
ofi
tmaxi
mizat
ionl
evel
ofout
putandpr
icef
orbot
hdomi
nantandsmal
l
erf
ir
ms.
c)I
fthedomi
nantf
ir
misal
owcostf
ir
m andsetpr
icef
ort
hemar
keti
nsuchway
t
hatt
hequant
it
yofout
putpr
oducebyt
hedomi
nantandsmal
lfi
rmsi
sequal
,fi
nd
t
hepr
ofi
tmaxi
mizi
ngl
evel
ofpr
iceandout
putoft
hedomi
nantandsmal
lfi
rms.
d)I
fthef
oll
ower(
smal
l
er)f
ir
m want
stomaxi
mizet
hei
rpr
ofi
tbyset
ti
ngpr
ice,
what
l
evel ofpr
iceandout
putmaxi
mizest
hei
rpr
ofi
t?

Suggest
edr
eadi
ngs
Ni
chol
son,
w:Mi
croeconomi
ctheor
y;basi
cpr
inci
pleandext on.5thedi
ensi ti
on
Sal
vat
ore,
D(2003)
:Mi
croeconomi
cs;
theor
yandappl
icat
i 4thedi
ons. ti
on

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 75
ECON102MI
CROECONOMI
CSI
I

Mansf
iel
d,E.
andYohe,
G(2000)
:Mi
croeconomi
cs,
theor
yandappl
icat
i 10thedi
ons. ti
on
Var
ian,
[Link]
l(1999)
:Int
ermedi
atemi
cr cs3rdedi
oeconomi ti
on
Pi
ndy
ck,
[Link]
nfel
d,D.
L.(
2003)
:Mi
cr cs.6thedi
oeconomi ti
on

CHAPTERTHREE
GAMETHEORY

3.
1Int
roduct
ion

Lear
ningobj
ect
ives

3.
2Gamet
heor
yandSt
rat
egi
cBehav
ior

Basi
cConcept
s

3.
3Domi
nantSt
rat
egyandNashEqui
li
bri
um

3.
3.1El
imi
nat
ionofdomi
nat
edst
rat
egi
es
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 76
3.
4ThePr
isoner
s’Di
lemma

3.
5 Mi
xedSt
rat
egi
esNashequi
li
bri
um

3.
6Repeat
edGame

3.
7Sequent
ialGame

Summar
y

Keyconcept
sandt
erms

Exer
cise

Suggest
edr
eadi
ngs

3.
1Int
roduct
ion

Dearst
udent
sinpr
evi
ouschapt
erwehav
eseen t
hathoweachf
ir
minol
i
gopol
ymar
ket
t
akei
ntoaccounti
tsr
ival
’
sreact
iont
omakedeci
siononl
evelofpr
iceandout
putt
hat
maxi
mizest
hei
rpr
ofi
tusi
ngcl
assi
cal
economi
ctheor
[Link]
rat
egi
cint
eract
ionbet
ween
f
ir
mscanbeal
sost
udi
edbyat
oolknownasgamet
heor
y.I
twasdev
elopedi
n1920and
gr
ewr
api
dlydur
ingWor
ldWarI
Iinr
esponset
otheneedt
odev
elopf
ormalwayoft
hinki
ng
aboutmi
l
itar
yst
rat
egy
.Int
hischapt
er,wewi
l
lseet
hist
heor
ytogi
vey
ousomef
lav
orof
howi
twor
ksandhowi
tcanbeusedt
ost
udyeconomi
cbehav
iori
nol
i
gopol
i
sti
cmar
ket
.

Thechapt
erbegi
nswi
thexpl
anat
ionoft
hebasi
cconcept
sofgamet
heor
y.I
tthendef
ines
a domi
nantst
rat
egy and Nash equi
l
ibr
ium and t
hei
rusef
ulness i
nthe anal
ysi
s of
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 77
ECON102MI
CROECONOMI
CSI
I

ol
i
gopol
i
sti
cbehav
ior
.Next
,itdescr
ibest
hepr
isoner
’sdi
l
emmaandi
tsappl
i
cabi
l
ityt
othe
anal
ysi
sofpr
iceandnon-
pri
cecompet
it
[Link]
nal
l
y,weconcl
udet
hechapt
erbyanal
yzi
ng
r
epeat
edandsequent
ial
game
Lear
ningobj
ect
ives
Att
heendoft
hischapt
er,
student
sabl
eto
- Def
ineagame,
pay
off
,st
rat
egy
I
dent
if
yopt
imal
str
ategyofpl
ayer
s
Di
ff
erent
iat
ebet
weenpur
eandmi
xedst
rat
egy
Descr
ibepr
isonerdi
l
emma
Det
ermi
neequi
l
ibr
ium ofsi
mul
taneousandsequent
ial
game
Di
ff
erent
iat
ebet
weenNashanddomi
nat
est
rat
egyequi
l
ibr
ium
Descr
ibet
hebehav
ioroff
ir
msusi
nggamet
heor
y

3.
2Gamet
heor
yandSt
rat
egi
cBehav
ior
Basi
cConcept
s
I
tisknownt
hatol
i
gopol
i
sti
cfi
rmsi
nter
actst
rat
egi
cal
l
ytomakedeci
sioni
nav
ari
etyof
way
[Link]
nter
act
ionofeconomi
cagent
sandt
heexpect
edr
ewar
doft
hei
rdeci
sioncan
best
udi
edusi
nggamet
heor
y.I
thel
psust
oshow how anol
i
gopol
i
sti
cfi
rm canmake
st
rat
egi
cdeci
si
ont
ogai
nacompet
it
iveadv
ant
ageov
eri
tsr
ival
sorhow i
tcanmi
nimi
ze
t
hepot
ent
ialhar
mfr
om ast
rat
egi
cmov
ebyar
ival
.Howev
er,whatdowemeanbyt
he
t
erm game?A gamei
sanysi
tuat
ioni
nwhi
chpl
ayer
s(par
ti
cipant
s)makedeci
sionby
t
aki
ngi
ntoaccounteachot
her
’sact
ionandr
esponseandt
heout
comeoft
hegame
dependsont
hedeci
si
onofeachpl
ayer
.Forexampl
e,Cour
notduopol
i
stsetpr
icebyt
aki
ng
i
ntoaccountt
her
eact
ionofi
tscompet
it
orandhencet
hel
evelofpr
ofi
tobt
aineddepends
ondeci
sionmadebyt
het
wof
ir
[Link]
sion-
maki
ngr
epr
esent
sagame.

Al
lgameshav
ethr
eebasi
cel
ement
s:pl
ayer
s,st
rat
egi
esandpay
off
[Link]
sionmaker
i
nagamei
scal
l
edapl
ayer
.Thesepl
ayer
smaybei
ndi
vi
dual
s,f
ir
ms(
asi
nol
i
gopol
y
mar
ket
s),ent
ir
enat
ion(
asi
nmi
l
itar
yconf
li
ct)oror
gani
zat
ion. Pl
ayer
sar
eassumed
r
ati
onali
nthesenset
hateachpl
ayerchoosest
hecour
seofact
iont
haty
iel
dst
hemost
f
avor
abl
eout
[Link]
eov
er,pl
ayer
sst
artt
opl
ayt
hegamebyassumi
ngt
hatt
hei
r
compet
it
orsar
ejustr
ati
onal
andassmar
tast
heyar
e.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 78
Ast
rat
egyi
sacour
seofact
ionapl
ayerwi
l
ltakeundereachcont
ingencyi
npl
ayi
ngoft
he
game.I
nthe pr
ice set
ti
ng,a st
rat
egymi
ghtbe i
ncr
ease pr
ice ordecr
easi
ng pr
ice
dependi
ngupont
heact
ionofi
tsr
ival

Usual
l
ythenumberofst
rat
egi
esav
ail
abl
eofeachpl
ayerwi
l
lbef
ini
teandmanyaspectof
gamet
heor
ycanbei
l
lust
rat
edf
orsi
tuat
ioni
nwhi
cheachpl
ayerhasonl
ytwoort
hree
st
rat
egi
[Link]
rat
egyi
ssai
dtobeopt
imalst
rat
egyi
fitmaxi
mizesexpect
edr
etur
noft
he
st
rat
egi
cchoi
ce.I
ntheabov
eexampl
eifi
ncr
easi
ngpr
icemaxi
mizest
hepr
ofi
toft
hef
ir
m
i
tissai
dtobet
heopt
imal
str
ategyoft
hef
ir
m whot
aket
heact
ion.

Thef
inalr
etur
ntot
hepl
ayer
sofagamet
ochosencombi
nat
ionofst
rat
egyi
ster
medas
pay
off
s.I
not
herwor
ds,
apay
offi
stheout
comeort
heconsequenceofeachcombi
nat
ion
ofst
rat
egypl
ayedbyt
het
wopl
ayer
[Link]
off
sar
eusual
l
ymeasur
edi
nthel
evelofut
il
it
y
obt
ainedbyt
hepl
ayeral
thoughf
requent
lymonet
arypay
off
s(say
,pr
ofi
tsf
orf
ir
ms)ar
e
usedi
nst
ead.I
ngener
ali
tisassumedt
hatpl
ayer
scanr
ankt
hepay
off
sofagamef
rom
mostpr
efer
redt
oleastpr
efer
redandchooset
hehi
ghestr
ankedpay
offat
tai
nabl
e.I
nthe
abov
epr
iceset
ti
nggameexampl
e,t
her
etur
ntost
rat
egy(
Pay
off
)oft
hegamet
oincr
ease
ordecr
easepr
icei
sdi
ff
erentl
evelofpr
ofi
tforeachf
ir
msf
ort
hei
rrespect
iveact
ion.
Ther
efor
e,byr
anki
ngt
hepr
ofi
tgai
nedunderdi
ff
erentst
rat
egy
,eachf
ir
m pl
aysst
rat
egy
t
hatgi
vesi
tthehi
ghestpossi
blel
evel
ofpr
ofi
t.
At
abl
e,whi
chsummar
izest
hepay
off
sforal
lthest
rat
egi
esopent
othef
ir
m andr
ival
s
r
esponse,
iscal
l
edt
hepay
offmat
ri
x.
Dearst
udent
s,wecani
l
lust
rat
ethebasi
cel
ement
sofagameusi
ngasi
mpl
eadv
ert
isi
ng
gamepl
ayedbyt
wof
ir
msassummar
izedi
nTabl
e3.
1.

Fi
rm-A’
sSt
rat
egi
es
A D
Fi
rm B’
s A (
7,5) (
5,4) St
rat
egi
es
D (
6,4) (
6,3)

Tabl
e3.
1Payof
fmat
ri
xforadver
ti
singgame.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 79
ECON102MI
CROECONOMI
CSI
I

Thegamecont
aint
wopl
ayer
s,f
ir
m-Aandf
ir
m-Bandeachf
ir
m hast
wost
rat
egi
es;t
o
adv
ert
ise(
A)anddonotadv
ert
ise(
D).
Theact
uall
evelofpr
ofi
tfi
rmsear
ndependsont
he
deci
si
ont
heymadet
oadv
ert
iseornott
oadv
ert
iseaswel
lasi
tscompet
it
ordeci
sion.
Thus,
eachst
rat
egybyf
ir
m-A(
adv
ert
iseordonotadv
ert
ise)canbeassoci
atedwi
theach
off
ir
m B’
sst
rat
egi
es(
adv
ert
iseanddonotadv
ert
ise)
.Thef
ourpossi
bleout
comesf
rom
t
hissi
mpl
egamear
eil
l
ust
rat
edbyt
hepay
offmat
ri
xinTabl
e-3.
1.

I
nthepay
offmat
ri
x,t
hef
ir
stnumberi
neachoft
hef
ourcel
l
srepr
esent
spay
offt
othe
pl
ayert
hatf
oundt
othel
eftoft
het
abl
eassoci
atedwi
tht
hest
rat
egyi
[Link]
eas
t
hesecondnumberr
epr
esent
sthepay
offofpl
ayerf
oundacr
osst
het
opoft
het
abl
e
associ
atedwi
thi
tsst
rat
egy
.Int
heabov
eexampl
ethef
ir
stnumberofeachcel
lrepr
esent
s
t
hepay
offf
ir
m-Bobt
ainbychoosi
ngspeci
fi
cst
rat
egyandt
hesecondnumberbel
ongst
o
f
ir
msA’
spay
offdeci
dest
oadv
ert
ise,f
ir
m-Bear
nsapr
ofi
tequal
sto7andf
ir
m-Aear
nsa
pr
ofi
tequal
[Link]
heot
herhand,i
ffi
rm-
B adv
ert
isewhi
l
efi
rm-
A deci
desnott
o
adv
ert
ise,f
ir
m-Bgetapr
ofi
tof5andf
ir
m-Aget
sapr
ofi
[Link]
her
spay
offf
oundi
n
t
her
estoft
hecel
l
sforot
her
scombi
nat
ionofst
rat
egi
esi
nter
pret
edi
nthesameway
.

3.
3Domi
nantSt
rat
egyandNashEqui
li
bri
um
Wel
lst
udent
s,i
nthepr
ecedi
ngsect
ionwehav
eseent
hathowagamei
srepr
esent
edbya
pay
offmat
ri
xandi
dent
if
ythepay
offassoci
atedwi
thdi
ff
erentcombi
nat
ionsofst
rat
egi
es.
Now l
etusseehow f
ir
mschooseopt
imalst
rat
egyamongdi
ff
erentst
rat
egi
eswhen
pl
ayi
[Link]
l
lal
sost
udyhowequi
l
ibr
ium ofagamei
sdet
ermi
ned.

Consi
dert
wof
ir
ms,f
ir
m-A andf
ir
m-Bpr
oduci
nghomogenouspr
oduct
.Bot
hhav
etwo
st
rat
egi
copt
ionst
omaxi
mizet
hei
rpr
ofi
t;decr
easepr
iceordonotdecr
easepr
[Link]
st
rat
egyshoul
deachf
ir
m choosei
ftheexpect
edpay
offt
othegamei
ssummar
izedi
n
Tabl
e-3.
2

Fi
rm-
A
decr
ease Doesn’
t
decr
ease
Fi
rm-
B
decr
ease (
10,
5) (
15,
0)
ADAMAUNI
VERSI
TY,
DEPA
DRT
oME
e N
snTOFECONOMI
’
t (
6,CS
8) (
10,
2) 80
decr
ease
Tabl
e3.
2Payof
fmat
ri
xforpr
ici
nggame.
Letusconsi
derf
ir
m-Af
ir
st.I
ffi
rm-
Bdecr
easesi
tspr
ice,f
ir
m-Awi
l
lear
napr
ofi
tof5by
decr
easi
ngpr
iceand0i
fitdoesnot
.Thust
heopt
imal
str
ategyf
orf
ir
m-Ai
stodecr
easei
ts
pr
icewhi
l
efi
rm Bdecr
easesi
tspr
[Link]
heot
herhand,i
ffi
rm-
Bdoesnotdecr
easei
ts
pr
ice,f
ir
m-Awi
l
lear
napr
ofi
tof8bydecr
easi
ngi
tspr
iceand2i
fitdoesnotdecr
eases.
Thus,f
ir
m-Ai
sbet
terof
fbydecr
easi
ngi
tspr
iceal
sowhi
l
efi
rm-Bdoesnotdecr
easei
ts
pr
[Link]
smeansf
ir
m-Awi
l
lal
way
sgetl
argepr
ofi
tifi
tdecr
easesi
tspr
icer
egar
dlessof
whatf
ir
[Link]
easi
ngpr
icei
sthedomi
nantst
rat
egyf
orf
ir
m-A.
Domi
nantst
rat
egyi
sanopt
imalst
rat
egyofapl
ayernomat
tert
hest
rat
egychosenby
ot
herf
ir
m.I
ntheexampl
eabov
edecr
easepr
icest
rat
egy
,pr
ovi
degr
eat
erpr
ofi
tst
ofi
rm-A,
nomat
terwhatBdoes.

Thesamei
str
uef
orf
ir
m [Link]
everf
ir
m-Adoes(
decr
easepr
iceordoesnotdecr
ease
pr
ice)f
ir
m-Bi
sbet
terof
f(ear
nlar
gepr
ofi
t)bydecr
easi
ngi
tspr
[Link]
siff
ir
m-A
decr
easepr
ice,f
ir
m-B’
spr
ofi
tisequalt
o10bydecr
easi
ngpr
iceand5i
fitdoesnot
.
Si
mil
arl
y,i
ffi
rm-
Adoesnotdecr
easei
tspr
icef
ir
m B’
spr
ofi
twoul
dbe15bydecr
easi
ngi
ts
pr
iceand10i
fitdoesnot
.Thus,
thedomi
nantst
rat
egyf
orf
ir
m-Bi
stodecr
easepr
ice.

Ther
efor
e,t
heopt
imalst
rat
egyf
orbot
hfi
rmsi
sdecr
easi
ngofpr
[Link]
erpl
ayerhas
domi
nantst
rat
egy
,wecal
ltheout
comeoft
hegamei
sanequi
l
ibr
ium i
ndomi
nantst
rat
egy
.
I
ntheabov
epr
ici
nggamest
rat
egy
;(decr
ease,
decr
ease)wi
tht
heout
comer
epr
esent
edby
l
eftt
opcel
lpay
offr
epr
esent
sequi
l
ibr
ium i
nthedomi
nantst
rat
egyoft
hegame.I
nthe
caseofadv
ert
isi
nggamesummar
izedbyt
abl
e3.
1,adv
ert
isi
ngi
sadomi
nantst
rat
egyf
or
f
ir
[Link]
terwhatf
ir
m-Bdoes,adv
ert
isementi
sthest
rat
egyt
hatgi
vemaxi
mum
pr
ofi
ttof
ir
m-At
handoesnotadv
ert
isest
rat
egy
.Si
mil
arl
y,adv
ert
isi
ngst
rat
egygi
ves
maxi
mum pr
ofi
tthandoesnotadv
ert
isest
rat
egy
.Soadv
ert
isi
ngi
sadomi
nantst
rat
egyf
or
f
ir
m B.t
hisi
mpl
i
est
hest
rat
egy(
adv
ert
ise,adv
ert
ise)r
epr
esentequi
l
ibr
ium i
ndomi
nant
st
rat
egy
.

Oneaddi
ti
onalpoi
ntt
hatweshoul
dnot
iceher
eist
hatt
headv
ert
isi
nggameandpr
ice
set
ti
nggamei
ndi
cat
edabov
erepr
esentagamei
nwhi
chpl
ayermov
esi
mul
taneousl
y.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 81
ECON102MI
CROECONOMI
CSI
I

Eachpl
ayersel
ect
sast
rat
egybef
oreobser
vinganyact
ionorst
rat
egychosenbyt
heot
her
pl
ayer
.Notal
lgamesar
eoft
hist
[Link]
l
lseel
ateron,
somet
imesonepl
ayermost
goesf
ir
st.I
nsucht
ypeofgame,
theor
derpl
aycanmakebi
gdi
ff
erencei
ntheout
come.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty3.
1
Descr
ibet
hef
oll
owi
ngconcept
s
a)Game,
str
ategy
,pl
ayer
,pay
offandpay
offmat
ri
x
b)Domi
nantst
rat
egyandopt
imal
str
ategy
.
[Link]
oll
owi
ngpay
offmat
ri
xrepr
esent
stheut
il
it
ythathusbandandwi
fegetf
rom
buy
ingmi
croeconomi
csandmacr
oeconomi
cst
ext
book.

Husband
mi
croeconomi Macr
oeconomi

Wi
fe cs cs
mi
croeconomi
c (
4,4) (
2,3)
s
Det
ermi
ne: a)
.the domi
nant
macr
oeconomi (
3,1) (
1,5)
st
rat
egy of t
he cs husbandi
fany
b)
. t
he domi
nant
st
rat
egyoft
hewi
fei
fany
.
c)
.theopt
imal
str
ategyofeachf
ir
ms.
d)
.equi
l
ibr
ium i
nthedomi
nantst
rat
egyoft
hegamei
fany
.

_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

Nashequi
li
bri
um
Domi
nantst
rat
egyequi
l
ibr
ium doesnotexi
stal
way
[Link]
e,t
hegameshowni
n
t
abl
e3.
2doesnothav
edomi
nantst
rat
egyequi
l
ibr
[Link]
ewhenBchoosesl
eftt
he
pay
off
stoAi
[Link]
ight
,thepay
off
stoAi
[Link]
smeanst
hat
whenBchoosesl
eft
,Awoul
dwantt
ochooset
opandwhenBchooser
ight
,Awoul
dwant
t
ochoosebot
[Link]’
sopt
imal
choi
cedependsonwhathet
hinksBwi
l
ldo.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 82
Pl
ayerB’
sopt
imalchoi
ceal
sodependsonwhathet
hinkspl
ayer
-Awi
l
[Link]
sthe
opt
imalst
rat
egyoff
ir
m-Bi
stopl
ayr
ightwhenApl
aybot
tom andl
eftwhenApl
ayt
[Link]
t
hest
rat
egi
es(
Top,l
eft
)and(
bot
tom,r
ight
)ar
etheequi
l
ibr
ium oft
[Link]
ypeof
equi
l
ibr
ium i
ssai
dtobeNashequi
l
ibr
ium namedaf
terJohnNash,
thePr
incet
onuni
ver
sit
y
mat
hemat
ici
anand1994Nobel
Pri
zewi
nnerwhof
ir
stf
ormal
i
zedt
henot
ioni
n1951.
Pl
ayer
-B
Lef
t Ri
ght
Pl
ayer
-B Top (
2,1) (
0,0)
bot
tom (
0,0) (
1,2)

Tabl
e3.
2Nashequi
li
bri
um

TheNashequi
l
ibr
ium i
sasi
tuat
ioni
nwhi
cheachpl
ayerchoosesanopt
imalst
rat
egy
,
gi
vent
hest
rat
egychosenbyt
heot
herpl
ayer
.Inwor
dsaNashequi
l
ibr
ium i
sasetof
st
rat
egi
essucht
hateachpl
ayerbel
i
efs(
accur
atel
y)t
hati
tisdoi
ngt
hebesti
tcangi
ven
t
hatt
heot
herpl
ayerpl
ayi
tsequi
l
ibr
ium st
rat
egy
.Not
ethatnei
theroft
hepl
ayer
sknows
whatot
herper
sonwi
l
ldowhenhehast
omakechoi
ceofst
rat
egy
.Buteachper
sonhas
someexpect
ati
onwhatt
heper
sonchoosewi
l
[Link]
eNashequi
l
ibr
ium i
sapai
rof
expect
ati
on,sucht
hat
,whenot
herchoi
cei
srev
eal
ed,nei
therpl
ayerwant
stochangei
ts
behav
ior
.Inourexampl
e,(
Top,
lef
t),
(bot
tom,
right
)ar
eaNashequi
l
ibr
ium.

Thi
sisbecausei
fAchooset
op,t
hent
hebestst
rat
egyf
orBi
stochoosel
eftsi
ncet
he
pay
offt
oBf
orm choosi
ngl
efti
s1andf
rom choosi
ngr
ighti
s0.I
naddi
ti
on,i
fBchooses
l
eft
,thent
hebestt
hingf
orAi
stochooset
opsi
nceAwi
l
lgetapay
off2r
athert
han0.
Thus,
ifAchoosest
op,
theopt
imalchoi
cef
orBi
stochoosel
eftandi
fBchoosel
eft
,then
opt
imalchoi
cef
orAi
[Link]
sindi
cat
eseachpl
ayeropt
imalchoi
cewi
l
lbemadeaf
ter
maki
ngcer
tai
nexpect
ati
onaboutot
herpl
ayer
’sst
rat
egi
cchoi
ce.

Nashequi
l
ibr
ium i
sagener
ali
zat
ionofcour
notequi
l
ibr
ium t
hatwehav
eseeni
nchapt
er
t
wo.I
ncour
notduopol
ymodeleachf
ir
m choosei
tsout
putl
evelt
hatmaxi
mizesi
tspr
ofi
t
byassumi
ngt
heot
herf
ir
m cont
inui
ngt
opr
oducet
heout
putl
eveli
thadchosen,i
.[Link]
t
aki
ngt
hest
rat
egyofi
tsr
ivalf
ir
m asi
fitkeepconst
antl
evelofout
put
.Undert
his
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 83
ECON102MI
CROECONOMI
CSI
I

assumpt
ioncour
not
,equi
l
ibr
ium occur
swheneachf
ir
mismaxi
mizi
ngpr
ofi
tsgi
vent
he
ot
herf
ir
m’sbehav
ior
,whi
chi
ssi
mil
art
oNashequi
l
ibr
ium.

Dearst
udent
s,hav
eyounot
iceanydi
ff
erencebet
weenNashequi
l
ibr
ium sol
uti
onanda
sol
uti
onofagamei
nwhi
cheachpl
ayerhasadomi
nantst
rat
egy
?Yes,
ifeachpl
ayerhasa
domi
nantst
rat
egyt
hent
hatst
rat
egyi
sit
sbestchoi
cer
egar
dlessofwhatot
herpl
ayer
sdo.
I
nNashequi
l
ibr
ium,
ont
heot
herhandeachpl
ayeradopt
sast
rat
egyt
hati
sit
sbestchoi
ce
gi
venwhatt
heot
herpl
ayer
sdoatequi
l
ibr
[Link]
er,domi
nantst
rat
egyequi
l
ibr
ium i
s
Nashequi
l
ibr
ium,
butal
lNashequi
l
ibr
iaar
enotadomi
nantst
rat
egy
.

Nash equi
l
ibr
ium hassomepr
obl
[Link]
ir
stpr
obl
em wi
tht
heconceptofNash
equi
l
ibr
ium i
sthatt
her
ear
egamest
hathav
enoNashequi
l
ibr
ium asi
nthecaseof
mat
chi
ngpenni
esgame.I
nmat
chi
ngpenni
esgame,t
her
ear
etwopl
ayer
s,Row and
Col
[Link]
ayerhasacoi
n,whi
chhecanar
rangesot
hatei
thert
heheadsi
deort
he
t
ailsi
def
acesup.
thuseachpl
ayerhast
wost
rat
egi
es;headandt
ail
.Oncet
hest
rat
egi
es
ar
echosen,
ther
ear
epay
off
stoeachpl
ayerwhi
chdependont
hechoi
cet
hatbot
hpl
ayer
s
[Link]
cesar
emadei
ndependent
lyandnei
therpl
ayerknowsot
her
schoi
ce.I
f
bot
hpl
ayershowsheadsort
ail
s,t
henr
owwi
nsadol
l
arandacol
umnl
osesadol
l
ar.
Ifon
t
her
ehand,
onepl
ayerexhi
bitheadsandt
heot
hershowst
ail
,thencol
umnwi
nsadol
l
ar
andr
owl
osesadol
l
[Link]
offmat
ri
xfort
hegamei
sshowni
ntabl
e3.
3

ThegamehasnoNashequi
l
ibr
ium becauset
her
eisnocombi
nat
ionofheadsort
ail
s
l
eav
esbot
hpl
ayer
ssat
isf
[Link]’
spay
offi
sthenegat
iveofCol
umn’
spay
off
.Sucht
ype
ofgamei
sazer
osum game,t
hei
nter
estoft
hepl
ayer
sar
eopposi
[Link]
esul
t,one
pl
ayerort
heot
herwi
l
lal
way
swantt
ochanget
hei
rst
rat
egy
.

Col
umn
Head Tai
l
Row Head (
1,-
1) (
-1,
1)
Tai
l (
-1,
1) (
1,-
1)
Tabl
e3.
3 mat
chi
ng penni
es
game
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 84
Secondpr
obl
em wi
thNashequi
l
ibr
ium ofagamei
sthati
tdoesnotnecessar
il
yleadt
o
par
etoef
fi
cientout
[Link]
swi
l
lbei
l
lust
rat
edusi
ngpr
isoner
’sdi
l
emmagamei
nthe
nextsect
[Link]
her
,pr
obl
em wi
thNashequi
l
ibr
ium i
sthatt
hegamemayhav
emor
e
t
hanoneNashequi
l
ibr
ium asi
nthecaseoft
heexampl
eabov
[Link],i
tis
possi
blet
oident
if
yauni
queequi
l
ibr
ium byapr
ocessknownasel
i
minat
ionofdomi
nat
ed
st
rat
egy
.

3.
3.1El
imi
nat
ionofdomi
nat
edst
rat
egi
es
Whent
her
eisnodomi
nantst
rat
egyequi
l
ibr
ium,wehav
etor
est
oret
othei
deaofNash
equi
l
ibr
[Link]
obl
em t
heni
stot
ryt
oel
i
minat
esomeoft
heNashequi
l
ibr
ium asbei
ng
unr
easonabl
[Link]
blebel
i
eft
ohav
eaboutpl
ayer
s’behav
iori
sthati
twoul
dbe
unr
easonabl
efort
hem t
opl
ayst
rat
egi
est
hatar
edomi
nat
edbyot
herst
rat
egi
[Link]
s
suggest
sthatwhen gi
ven a game,we shoul
dfi
rstel
i
minat
e al
lst
rat
egi
es t
hatar
e
domi
nat
edandt
hencal
cul
atet
heNashequi
l
ibr
ium oft
her
emai
[Link]
spr
ocedur
e
i
scal
l
edel
i
minat
ionofdomi
nat
edst
rat
egi
es;i
tcansomet
imesr
esul
tinasi
gni
fi
cant
r
educt
ioni
nthenumberofNashequi
l
ibr
[Link]
e,consi
dert
hef
oll
owi
nggame.
Col
umn
Lef
t Ri
ght
Row Top (
2,2) (
0,2)
Bot
tom (
2,0) (
1,1)
Tabl
e 3.
4 a game wi
th
domi
nat
edst
rat
egy

Not
ethatt
her
ear
etwopur
est
rat
egyNashequi
l
ibr
ia,(
top,l
eft
)and(
bot
tom,r
ight
).
Ther
efor
e,t
ogetauni
queNashequi
l
ibr
ium appl
i
est
hei
ter
ati
veel
i
minat
ionofdomi
nat
ed
st
rat
egyi
nfav
orofi
tsdomi
nantst
rat
egy
.Her
eifwest
artf
rom Row pl
ayer
,thest
rat
egy
bot
tom domi
nat
est
hest
rat
egyt
[Link]
simpl
i
esel
i
minat
ethest
rat
egyt
opt
ofi
ndt
he
equi
l
ibr
ium oft
hegameandl
eftRowpl
ayerwi
thbot
tom st
rat
egy
.Thepay
offmat
ri
xaf
ter
el
i
minat
ionofRow’
sdomi
nat
edst
rat
egyr
epr
esent
edbyt
abl
e3.
5.
Col
umn
Lef
t Ri
ght
ADAMAUNI TYDEPARTMENTOFECONOB
VERSI o
MI
Ct
St
om (
2,0) (
1,1) 85
ECON102MI
CROECONOMI
CSI
I

Row

Tabl
e3.
5el
imi
nat
ionofdomi
nat
edst
rat
egy.

I
nthi
ssi
mpl
i
fiedaf
terel
i
minat
ionoft
hedomi
nat
edst
rat
egy
,bot
tom cont
inuedet
ermi
ning
t
hedomi
nat
edst
rat
egyf
orcol
umnpl
ayer
.Thati
slef
tisadomi
nat
edst
rat
egybyr
ight.
So
el
i
minat
east
rat
egyl
eftandendupwi
thuni
queNashequi
l
ibr
ium (
Bot
tom,
right
)

Dearst
udent
,it
erat
iveel
i
minat
ionofdomi
nat
edst
rat
egi
esenabl
esust
osol
vegamesi
n
whi
cheachpl
ayerhasmor
ethant
wost
rat
egi
[Link]
akeagamei
nvol
vi
ngt
wopl
ayer
s,
eachofwhom hast
hreest
rat
egi
est
ochoosef
[Link]
lthatwehav
etodoi
stoel
i
minat
e
domi
nat
ed st
rat
egi
es f
rom a pl
ayer
,then go t
othe ot
herpl
ayerand el
i
minat
e hi
s
domi
nat
edst
rat
egi
esf
rom t
her
emai
ningst
rat
egi
esandpay
off
saf
tert
hef
ir
stel
i
minat
ion
andr
epeatt
hepr
ocessunt
ilweendupatt
heequi
l
ibr
[Link]
sthr
eebyt
hreemodeli
s
showni
ntabl
e3.
6.

Col
umn
Lef
t Cent
er r
ight
Row Top (
-5,
-
1) (
2,2) (
3,3)
Tabl
e mi
ddl
e (
1,-
3) (
1,2) (
1,1) 3.
6at
hree by
t
hreegame Bot
tom (
0,10) (
0,0) (
0,-
10)

Thepr
ocessofi
ter
atedel
i
minat
ionofdomi
nat
edst
rat
egi
esi
sil
l
ust
rat
edbyact
ual
l
y
el
i
minat
ingt
heRowandCol
umn’
sdomi
nat
edst
rat
egi
est
urnbyt
urnasf
oll
ows.
Fort
heRow pl
ayer
,topandmi
ddl
est
rat
egi
esdomi
nat
ebot
tom st
rat
egy
.Ther
efor
e,we
canel
i
minat
ethebot
tom asadomi
nat
edst
rat
egy
.Thi
sisbecausei
ftheRow pl
ayer
expect
sthecol
umnpl
ayert
opl
ayl
eft
,shewoul
dchoosemi
ddl
e,i
fsheassumest
he
col
umnpl
ayerwoul
dpl
aycent
er,shewoul
dgof
ort
op;andi
fsheassumest
hecol
umn
pl
ayerwi
l
lchooser
ight
,shewi
l
lchooset
opagai
[Link]
s,nomat
terwhatt
hecol
umn
pl
ayerdoes,t
heRow pl
ayerwi
l
lnotchoosebot
tom asherst
rat
egy
.Thi
simpl
i
est
he
Bot
tom st
rat
egyi
sdomi
nat
edbyTopandmi
ddl
eandcanbeel
i
minat
ed.
Col
umn
Lef
t Cent
er r
ight
ADAMAUNI
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DEPARTMENTOFECONOMI
Top CS
(
-5,
-
1) (
2,2) (
3,3) 86
mi
ddl
e (
1,-
3) (
1,2) (
1,1)
Row

Tabl
e3.
7el
imi
nat
ingdomi
nat
edst
rat
egyf
orRowpl
ayer

Af
terbot
tom st
rat
egyi
sel
i
minat
ed,l
etusi
dent
if
ydomi
nat
edst
rat
egyf
orCol
umnpl
ayer
.
Whenweseei
ntot
hepay
offofCol
umnpl
ayerst
rat
egyl
efti
sdomi
nat
edbycent
erand
Ri
ght.
Thi
sisbecausei
fcol
umnt
hinkt
hatRow pl
ayt
op,col
umnpl
ayr
ight
.Ifcol
umn
t
hinkst
hatRowpl
aymi
ddl
e,col
umnpl
aycent
[Link]
eftst
rat
egyi
sst
ri
ctl
ydomi
nat
edby
l
eftandr
ightandshoul
dbeel
i
minat
ed.
Col
umn
Cent
er r
ight
Row Top (
2,2) (
3,3)
mi
ddl
e (
1,2) (
1,1)

Tabl
e3.
7bel
imi
nat
ingdomi
nat
edst
rat
egyf
orCol
umnpl
ayer

Att
hisr
ound,t
heRowpl
ayer
’sdomi
nat
edst
rat
egyi
sthemi
ddl
e,sowecanel
i
minat
ethe
mi
ddl
est
rat
egy
.

Col
umn
Cent
er r
ight
Row Top (
2,2) (
3,3)

Tabl
e3.
7cel
imi
nat
ingdomi
nat
edst
rat
egyf
orr
owpl
ayer

Fi
nal
l
y,col
umnchoosesRi
ghtov
erl
eft
,yi
eldi
ngauni
queout
comeaf
tert
hei
ter
ated
el
i
minat
ionofdomi
nat
edst
rat
egi
es,
whi
chi
s(Top,
Right
).
Thei
ter
atedel
i
minat
ionofdomi
nat
edst
rat
egi
esi
sausef
ulconcept
,andwheni
tappl
i
es,
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 87
ECON102MI
CROECONOMI
CSI
I

t
hepr
edi
ctedout
comei
susual
l
yqui
ter
easonabl
[Link]
tai
nly
,ithast
hepr
oper
tyt
hatno
pl
ayerhasani
ncent
ivet
ochanget
hei
rbehav
iorgi
vent
hebehav
iorofot
her
[Link]
er,
t
her
ear
egameswher
eitdoesn’
tappl
y.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

Act
ivi
ty3.
2
1)Di
ff
erent
iat
ebet
weendomi
nantst
rat
egyequi
l
ibr
ium andNashequi
l
ibr
ium
2)WhyNashequi
l
ibr
ium i
snotpar
etoef
fi
cient
?
3)Descr
ibeel
i
minat
ionofdomi
nat
edst
rat
egymet
hodoff
indi
nguni
queNashequi
l
ibr
ium.
4)Twof
ir
mspr
oduci
ngt
hesamepr
oducthav
eachoi
cet
opr
oduceshi
ghqual
i
ty(
H)and
l
owqual
i
ty(
L).Ther
esul
ti
ngpr
ofi
tisgi
venbyt
hef
oll
owi
ngpay
offmat
ri
x.

Fi
rm-
2
Low Hi
gh
Fi
rm- Low (
-10,
-30) (
100,
160) 1
Hi
gh (
90,
80) (
50,
50)
Det
ermi
ne t
he Nash equi
l
ibr
ium oft
he
game
Supposet
hatt
hef
ir
mscoor
dinat
etheact
ion,whatwoul
dbet
heequi
l
ibr
ium out
comeof
t
hegame.
5)Twocompet
ingf
ir
msar
eeachpl
anni
ngt
oint
roduceanewpr
oduct
.Eachwi
l
ldeci
de
whet
hert
opr
oducepr
oductA,pr
oductB,orpr
[Link]
l
lmaket
hei
rchoi
ceat
t
hesamet
[Link]
esul
ti
ngpay
off
sar
easshownbel
ow.

Fi
rm-
2
Pr
oduct
-A Pr
oduct
-B Pr
oduct
-C

Pr
oduct
-A (
-10,
-
10) (
0,10) (
10,
20)
Pr
oduct
-B (
10,
20) (
-20,
-
20) (
-5,
15)
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 88
Pr
oduct
-C (
20,
10) (
15,
-
5) (
-30,
-
30)
Fi
rm-
1

Fi
ndt
heNashEqui
l
ibr
iaoft
hegamei
fany
Det
ermi
neauni
queNashequi
l
ibr
ium oft
hegamebyusi
ngel
i
minat
ionofdomi
nat
ed
st
rat
egymet
hod.
_
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___
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___
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___
___
___
___
___
___
___
___
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___
___
___
___

3.
4ThePr
isoner
s’Di
lemma
Dearst
udent
s,hav
ingdescr
ibedt
hebasi
cfeat
uresofgamet
heor
y,wenow t
urnour
at
tent
iont
oani
mpor
tantt
ypeofgameknownast
hepr
isoner
’sdi
l
emma.I
thasbeent
he
sour
ceofsomei
nsi
ghtwi
thwhi
chweappr
oachmoder
nol
i
gopol
ytheor
yaswel
lasmany
ot
herar
easofeconomi
cs,
behav
ior
alandpol
i
tical
sci
ence.

Thegameconsi
derasi
tuat
ionwher
etwopr
isoner
swhoar
epar
tner
sinacr
imewher
e
quest
ionedi
ntwosepar
ater
oomsandcommuni
cat
ioni
snotal
l
[Link]
isonerhada
choi
ceofconf
essi
ngf
ort
hecr
imeandt
her
ebyi
mpl
i
cat
ingt
heot
herordeny
ingt
hathe
hadpar
ti
cipat
edi
nthecr
ime.

I
fonl
yonesuspectconf
essed,t
henhewoul
dgof
reewhi
l
etheot
hersuspect(
whodoes
notconf
ess)wi
l
lrecei
ve6y
earsent
ence.I
fbot
hsuspect
sdeni
edbei
ngi
nvol
vedi
nthe
cr
ime,
thenbot
hwoul
dbehel
dfor1y
ear
.Ifbot
hconf
essed,
theywoul
dbehel
dfor3y
ear
s
i
npr
[Link]
offmat
ri
xfort
hegamei
sgi
veni
ntabl
e3.
8.

Suspect(
play
er)
-B

Conf
ess Deny
Suspect(
play
er) Conf
ess (
-3,
-
3) (
0,-
6) -
A
Deny (
-6,
0) (
-1,
-
1)
Tabl
e 3.
8 Pr
isoner
s’ di
lemma
game

Whi
chst
rat
egyi
stheopt
imalst
rat
egyf
ort
het
wosuspect
s?Whati
stheequi
l
ibr
ium out
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 89
ECON102MI
CROECONOMI
CSI
I

comeoft
hegame?Wel
lst
udent
s,t
oanswert
hesequest
ionsl
etuscompar
ethepay
off
t
hatt
hepl
ayerr
ecei
vesbychoosi
ngaspeci
fi
ccombi
nat
ionofst
rat
egi
[Link]
artf
orm
pl
ayer
.A.
I
fpl
ayer
-Bdeci
dest
odeny
,pl
ayer
-Ai
sbet
terof
fconf
essi
ngsi
ncei
twi
l
llef
tfr
ee.I
fpl
ayerB
deci
dest
oconf
ess,st
il
lpl
ayer
-A i
sbet
terof
fbyconf
essi
ngsi
ncei
trecei
ves3-
year
sent
encer
athert
han6y
earsent
[Link]
everpl
ayerBdoes,pl
ayerAi
sbet
terof
f
byconf
essi
[Link]
sthedomi
nantst
rat
egyf
orpl
ayerAi
sconf
essi
[Link]
sot
hedomi
nant
st
rat
egyf
orf
ir
m Bi
sconf
essi
[Link]
easoni
sthati
fpl
ayerAconf
esses,pl
ayer
sBgeta
t
hreey
earj
ailsent
enceandsi
xyearj
ailsent
encei
fthedoesnot
.Thi
simpl
i
est
heuni
que
Nashequi
l
ibr
ium oft
hegamei
sbot
hpl
ayer
stoconf
[Link]
sequi
l
ibr
ium i
sal
sodomi
nant
st
rat
egyequi
l
ibr
ium,si
nceeachpl
ayerhast
hesameopt
imalchoi
cei
ndependentoft
he
ot
herpl
ayer
.

Butt
heequi
l
ibr
ium out
come(
conf
ess,
Conf
ess)i
snotapar
etoef
fi
cientout
[Link]
i
ftheycoor
dinat
ether
eact
ionandchoi
ceast
rat
egy(
deny
,deny
)bot
hsuspect
sar
ebet
ter
of
[Link]
sthet
wosuspect
srecei
veonl
yone-
yeari
mpr
isonmentbydeny
[Link]
obl
em
i
showev
ert
her
eisnowayf
ort
het
wosuspect
stocommuni
cat
ewi
thoneanot
hert
omake
sur
ethatt
het
wosuspect
scooper
ate.I
feachcoul
dtr
ustt
heeachot
her
,thent
heycoul
d
bebet
terof
fbychoosi
ngast
rat
egy(
deny
,deny
).

Pr
isoner
s’di
l
emmagamei
susef
uli
nanal
yzi
ngt
hebehav
iorofol
i
gopol
y.I
tcanbeusedt
o
i
ndi
cat
ethesi
tuat
ionunderwhi
chf
ir
mswoul
dbet
empt
edt
ocheatonacar
telagr
eement
bycut
ti
ngpr
icef
rom agr
eedl
evel
ori
ncr
easi
ngt
heout
putpr
oducedmor
ethani
tsquot
a.

Supposet
hatt
her
ear
etwof
ir
ms’
product
ionoi
l
,fi
rm-Aandf
ir
m-Bf
orm car
tel
.Eachf
ir
m
hast
wopossi
blest
rat
egi
es:t
ost
ickwi
tht
hecar
telagr
eementort
ocheat
.Ther
ear
efour
possi
bleout
comes,
dependi
nguponwhi
chst
rat
egyeachf
ir
m pur
[Link]
offmat
ri
x
i
sgi
veni
ntabl
e3.
9.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 90
Fi
rm-
B
St
ickt eement c
oagr heat

Fi
rm-
A St
ick t
o (
4,4) (
1,5)
agr
eement
cheat (
5,1) (
3,3)
Tabl
e 3.
9 car
tel
cheat
inggame.

Asi
ndi
cat
eint
hepay
offmat
ri
x,cheat
ingi
sadomi
nantst
rat
egyf
orbot
hfi
[Link]
s
f
ir
m-Agetapr
ofi
tof5mi
l
li
onbycheat
ingand4mi
l
li
onbyst
ickt
otheagr
eementwhi
l
e
f
ir
m-Bst
ickt
otheagr
eement
.Whenf
ir
m-Bdeci
det
ocheatf
ir
m-Agetapr
ofi
tof1mi
l
li
on
byst
icki
ngt
otheagr
eementand3mi
l
li
onbycheat
[Link]
sindi
cat
esf
ir
m-Agethi
gher
r
etur
nbycheat
ingwhat
everst
rat
egychosenbyf
ir
m [Link]
mil
arl
yfi
rm-
Bget
shi
gherr
etur
n
bycheat
ingwhat
everst
rat
egychosenbyf
ir
[Link]
hfi
rmswoul
dcheatev
ent
hough
t
heywoul
dbebet
terof
fift
heywoul
dbot
hst
ickt
otheagr
eementandsust
aincooper
ati
ve
sol
uti
[Link]
sexampl
eist
hesameaspr
isoner
s’di
l
emmagame.

_
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___
___
___
___
___
___
___
___
___

Act
ivi
ty3.
3
Thi
nkofU.
[Link]
radepol
i
ciesaspr
ison’
sdi
l
[Link]
wocount
ri
esar
e
consi
der
ingpol
i
ciest
oopenorcl
oset
hei
rimpor
tmar
ket
[Link]
offmat
ri
xtot
hei
r
deci
si
oni
sshownbel
ow.
Japan
Open Cl
ose
U.
S. Open (
10,
10) (
5,5)
Cl
ose (
-100,
5) (
1,1)
Assume t
hat t
he t
wo count
ri
es know
t
hepay
offmat
ri
xandbel
i
evet
hatt
heot
hercount
ryacti
nit
sowni
nter
est
.Doesei
ther
count
ryhav
eadomi
nantst
rat
egy
?Whatwi
l
lbet
heequi
l
ibr
ium pol
i
ciesi
feachcount
ry
act
srat
ional
l
ytomaxi
mizei
tswel
far
e?
_
___
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___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 91
ECON102MI
CROECONOMI
CSI
I

3.
5Mi
xedSt
rat
egi
esNashequi
li
bri
um
I
nal
loft
hegamest
hatwehav
eseensof
ar,
weconsi
derast
rat
egyi
nwhi
chpl
ayer
sonce
makeaspeci
fi
cchoi
ce,
itwi
l
lst
ickt
oit
.Sucht
ypeofst
rat
egyi
ssai
dtobeapur
est
rat
egy
.
I
tisacondi
ti
oni
nwhi
chpl
ayer
schooseast
rat
egywi
thapr
obabi
l
ityequal
[Link]
e
i
sanot
herf
orm ofst
rat
egyt
hatweconsi
deri
nthi
ssect
ion.I
tisasi
tuat
ioni
nwhi
chagent
s
(
play
ers)assi
gnapr
obabi
l
ityt
oeachchoi
ce(
str
ategy
)andpl
ayt
hei
rchoi
cesaccor
dingt
o
t
hosepr
obabi
l
iti
[Link]
efi
rm-
Ami
ghtchooset
opl
ayt
op50per
centoft
het
ime
andbot
tom 50per
centoft
het
ime,
whi
l
eBmi
ghtchooset
opl
ayl
eft50per
centoft
het
ime
andr
ight50per
centoft
het
[Link]
ski
ndofst
rat
egi
esar
esai
dtobeami
xedst
rat
egi
es.
St
rat
egi
esi
nwhi
chapl
ayermakesar
andom choi
ceamongt
woormor
epossi
bleact
ions,
basedonasetofchosenpr
obabi
l
iti
es.

I
ffi
rm-
A andf
ir
m-Bf
oll
ow t
hemi
xedst
rat
egi
esgi
venabov
e,t
hent
heywi
l
lhav
ethe
pr
obabi
l
ityof¼ ofendi
ngupi
neachoft
hef
ourcel
l
soft
hepay
offmat
ri
[Link]
he

av
eragepay
offt
oAwi
l
lbezer
o,[
=(¼x0)+(
¼x0)+(
¼x(
-1)+ x(
1)]andt
heav
erage

pay
offf
orBwi
l
lbe½,
[=(
¼x0)+(
¼x(
-1)+0x¼)+(
3x¼)
].

Fi
rm-
B
Lef
t Ri
ght
Fi
rm-
a Lef
t (
0,0) (
0,-
1)
Ri
ght (
1,0) (
-1,
-
3)
Tabl
e 3.
10 Game wi
th no Nash
equi
li
bri
um i
npur
est
rat
egi
es.

St
udent
s,oneadv
ant
ageofmi
xedst
rat
egi
esov
erpur
est
rat
egi
esi
sthat
,ital
l
owsust
o
det
ermi
neNashequi
l
ibr
ium t
osomegamewhi
chdonothav
eNashequi
l
ibr
ium i
npur
e
st
rat
egi
esl
i
ket
hegamer
epr
esent
edbyt
abl
e3.
[Link]
l
ibr
ium i
nmi
xed
st
rat
egi
esdet
ermi
ned?I
sitdi
ff
ersf
rom Nashequi
l
ibr
ium i
npur
est
rat
egy
?

Nashequi
l
ibr
ium i
nmi
xedst
rat
egi
esr
efer
stoanequi
l
ibr
ium i
nwhi
cheachagentchooses

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 92
t
heopt
imalf
requencywi
thwhi
cht
opl
ayhi
sst
rat
egi
esgi
vent
hef
requencychoi
cesoft
he
ot
heragent
.Inot
herwor
dsNashequi
l
ibr
ium i
nmi
xedst
rat
egi
esi
sapai
rofmi
xed
st
rat
egy(
Pr,Pc)sucht
hateachagent
’schoi
ceapr
obabi
l
ityt
hatmaxi
mizeshi
sexpect
pay
off
,gi
vent
hest
rat
egyoft
heot
heragent
.Wher
ePr r
epr
esent
sthepr
obabi
l
ityt
hatRow
pl
ayshi
sst
rat
egi
esandPcr
epr
esent
sthepr
obabi
l
ityt
hatcol
umnpl
ayi
tsst
rat
egi
es.

Letusconsi
dert
hemat
chi
ngpenni
esgameonceagai
ntoi
l
lust
rat
ehow t
odet
ermi
ne
equi
l
ibr
ium i
nami
xedst
rat
egi
es.

Col
umn
Head Tai
l
Head (
1,-
1) (
-1,
1)
Row Tai
l (
-1,
1) (
1,-
1)

Tabl
e3.
11mat
chi
ngt
hepenni
esgame.

Supposet
hatRowbel
i
evescol
umnpl
aysheadwi
thpr
obabi
l
[Link]
fRowpl
ayshead,
Rowget
sqwi
thpr
obabi
l
ityPand-
1wi
thpr
obabi
l
ity(
1-P)
.Sot
heexpect
edpay
offofpl
ayer
Rowwhi
l
epl
ayercol
umnpl
ayheadi
sequalt
o1P+(
-1)(
1-P)=2P-
[Link]
mil
arl
yifRowpl
ays
Tai
l
s,Row get
s-1wi
thRow’
sexpect
edpay
offbypl
ayi
ngt
ailwhi
l
ecol
umnpl
ayheadi
s
equal
to-
1P+1(
1-P)=1-
2P.

Theexpect
edpay
off
sforbot
hRowandcol
umnpl
ayerar
esummar
izedTabl
e3.
12bel
ow

Col
umn
Head Tai
l Row’
s expect
ed
pay
off
Head (
1,-
1) (
-1,
1) 1p+(
-1)
(1-
p)
Row
=2p-
1
Tai
l (
-1,
1) (
1,-
1) -
1p+1(
1-p)
=1-
2p
Col
umn’
s -
1q+1(
1-q) 1q+(
-1)
(1-
q)
expect
edpay
off =1-
2q =2q-
1

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 93
ECON102MI
CROECONOMI
CSI
I

Tabl
e3.
12Expect
edpayof
fbot
hpl
ayer
s

Now l
etqbet
hepr
obabi
l
ityt
hatcol
umnwoul
dpl
ayHeadt
hen,i
fcol
umnpl
ayshead,
col
umnget
s-1wi
thpr
obabi
l
ityqand1wi
thpr
obabi
l
ity(
1-q)
.Sot
heexpect
edpay
offof
col
umnbypl
ayi
nghead,
whi
l
eRowpl
ayheadi
sequal
sto-
1q+1(
1-q)=1-
[Link]
ind
t
heexpect
edpay
offf
orRowpl
ayerusi
ngt
hesamef
ashi
ont
obe2p-
1asi
ndi
cat
edi
nthe
abov
e-expect
edpay
offTabl
e.

Dearst
udent
s,gi
vent
heexpect
edpay
offf
ort
het
wopl
ayerhow canwedet
ermi
net
he
opt
imalst
rat
egyoft
hem?Todet
ermi
net
hei
ropt
imalst
rat
egywehav
etocompar
ethei
r
expect
edpay
off
.If2P-
1>1-
2P,t
henRowi
sbet
terof
fonav
eragepl
ayi
ngHeadt
hanTai
l
.
Si
mil
arl
yif2P-
1<1-
2P,
Rowi
sbet
terof
fpl
ayi
ngTai
[Link]
heot
herhand,
if2p-
1=
1-
2P,t
henRow gett
hesameexpect
edpay
offnomat
terwhati
tdoes.I
nthi
scase,Row
canpl
ayHead,Tai
lorcoul
dfl
i
pacoi
nandr
andomi
zei
tspl
[Link]
umn,al
sowecan
det
ermi
net
heopt
imal
str
ategyf
oll
owi
ngt
hesamef
ashi
on.

Aswedef
ineear
li
er,
ami
xedst
rat
egyNashequi
l
ibr
ium i
nvol
vesatl
eastonepl
ayerpl
ayi
ng
ar
andomi
zedst
rat
egy
,andnopl
ayerabl
etoi
ncr
easet
hei
rexpect
edpay
offbypl
ayi
nga
pur
est
rat
egy
.Randomi
zedst
rat
egyhowev
er,r
equi
resequal
i
tyofexpect
edpay
off
s.I
fa
pl
ayeri
ssupposedt
orandomi
zeov
erst
rat
egi
es,t
henbot
hoft
hesest
rat
egi
esmust
pr
oducest
hesameexpect
edpay
off
.Ot
her
wise,t
hepl
ayerwoul
dpr
eferoneoft
hem and
woul
dnotpl
ayt
heot
her
.Sot
ofi
ndt
hepr
obabi
l
itywi
thwhi
chpl
ayerchoosesagi
ven
st
rat
egycanbeobt
ainedbyequat
ingt
heexpect
edpay
offoft
het
wost
rat
egi
esofagi
ven
pl
ayer
.

Thati
s:
ForRow, 2P–1=1-2P
4P= P=½
ForCol
umn, 1-2q=2q-
1
4q=2 q=½
Sot
heNashequi
l
ibr
ium i
nmi
xedst
rat
egi
esf
ort
hemat
chi
ngpenni
esgamei
sdef
inedby
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 94
t
hepr
obabi
l
itywhi
chmaxi
mizest
heexpect
edpay
offf
orRow andcol
[Link]
sat
equi
l
ibr
ium Row pl
ay50per
centoft
het
imeheadand50per
centoft
het
imet
ail
.Al
so
col
umnpl
ay50per
centoft
het
imeheadand50per
centoft
het
imet
ail
.Sot
heuni
que
Nashequi
l
ibr
ium i
nmi
xedst
rat
egi
esoft
hegamebecomes(
½,½)

Act
ivi
ty3.
4
1)
.di
ff
erent
iat
ebet
weenpur
est
rat
egyandmi
xedst
rat
egy
.
2)
.descr
ibeaNashequi
l
ibr
ium i
nmi
xedst
rat
egy
.
3)
.gi
vent
hef
oll
owi
ngpay
offmat
ri
x,
Col
umn
Lef
t Ri
ght
Row Lef
t (
-3,
-
3) (
2,0)
Ri
ght (
0,2) (
1,1)
Fi
nd: a)
. pur
e st
rat
egyequi
l
ibr
ium oft
hegame
b)
.mi
xedst
rat
egyequi
l
ibr
ium oft
hegame
c)
.theexpect
edpay
offofCol
umnandRowpl
ayer
d)
.thepr
obabi
l
ityt
hatt
hest
rat
egi
cchoi
ceoft
hepl
ayerf
all
ina(
bot
tom,
right
)
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_

3.
6Repeat
edGame
DearSt
udent
s,upt
onow wehav
ebeenassumi
ngt
hatpl
ayer
s,pl
ayt
hegameonl
yone
(
oneshotgame)andt
her
eisnocommuni
cat
ionbet
weenpl
ayer
[Link]
etusconsi
dert
he
casewher
ether
eisapossi
bil
i
tyt
orepeatt
[Link]
out
hinkt
hatt
heequi
l
ibr
ium
out
comeoft
hegamechangedi
fthegamei
stobepl
ayedr
epeat
edl
y?

I
nrepeat
edgamei
fonepl
ayerchoosest
odef
ectononer
ound,t
hent
heot
herpl
ayercan
chooset
odef
ectont
henextr
[Link]
hepl
ayerwhodef
ect
sint
hef
ir
str
ound
canbepuni
shedbyt
heot
herpl
ayerf
orhi
sbadbehav
ior
sint
henextr
[Link]
ayer
hast
heoppor
tuni
tyt
oest
abl
i
shar
eput
ati
onf
orcooper
ati
onandt
her
ebyencour
aget
he
ot
herpl
ayert
odot
hesamei
nar
epeat
[Link]
er,sucht
ypeofr
esul
texpect
ed
dependi
nguponwhet
hert
hegamepl
ayedf
orf
ixednumberoft
imesorani
ndef
ini
te
numberoft
ime.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 95
ECON102MI
CROECONOMI
CSI
I

I
nthecaseoff
ixednumberofr
epet
it
ion,
theequi
l
ibr
ium out
comeoft
hegamei
ssi
mil
art
o
oneshotgamei
fther
eisnowayt
oenf
orcecooper
ati
oni
nthel
astr
[Link]
cal
l
ypl
ayer
s
cooper
atebecauset
heyhopet
hatcooper
ati
oni
npr
esentwi
l
linducef
urt
hercooper
ati
oni
n
t
hef
utur
[Link]
hisr
equi
rest
hatt
her
ewi
l
lal
way
sbepossi
bil
i
tyoff
utur
epl
[Link]
ncet
her
e
i
snopossi
bil
i
tyoff
utur
epl
ayi
nthecaseoff
ixed(
fi
nit
e)number
sofr
epeat
edgame,
pl
ayer
sdonotcooper
atei
nthel
astr
[Link],t
heout
come(
resul
t)ofpl
ayi
ngf
orf
ixed
numberofgamei
sthesameaspl
ayi
ngoneshotgame.

Howev
er,i
fthegamei
sgoi
ngt
ober
epeat
edani
nfi
nit
ivenumberoft
imes,andt
hen
pl
ayer
shav
einf
luenceont
hei
ropponent
’sbehav
iort
hrought
het
it
-f
or-
tatst
rat
egy
.Thi
s
meansdot
oyouropponentwhatheorshehasj
ustdonet
[Link]
sbegi
nni
ngby
cooper
ati
ngandcont
inuest
ocooper
ateasl
ongasy
ouropponentcooper
ates.I
fone
pl
ayerr
efusest
ocooper
atet
hist
ime,t
heot
herpl
ayerr
efusest
ocooper
atenextt
[Link]
l
ongasbot
hpar
ti
escar
eenoughaboutf
utur
epay
off
s,bot
hpar
it
iescooper
atef
earof
r
etal
i
ati
oni
nthenextr
[Link]
swi
l
lresul
tinPar
etoef
fi
cientequi
l
ibr
ium out
[Link]
gamemi
ghtexpl
ainpr
iceset
ti
ngst
rat
egyi
ncar
tel
sandot
herol
i
gopol
i
stf
ir
m oper
ati
ngi
n
t
hesamei
ndust
ry.

Forexampl
e,consi
derapr
iceset
ti
nggamepl
ayedbyduopol
i
stpr
oduci
nghomogenous
pr
oduct
.Ifeachf
ir
m char
geshi
ghpr
icet
henbot
hgetl
argerpr
ofi
[Link]
sist
hesi
tuat
ion
wher
ebot
hfi
rm cooper
atet
o mai
ntai
n Par
eto ef
fi
cientout
[Link]
fonef
ir
m i
s
char
gingahi
ghpr
ice,andt
heot
herl
oweri
tspr
ice,t
heonewhocuti
tspr
icecapt
uret
he
ot
her
’s mar
ketandt
hei
rbygetev
enhi
gherpr
ofi
[Link]
er,i
fbot
hfi
rm cutpr
ices,bot
h
f
ir
msendi
ngupmaki
ngl
owerpr
ofi
[Link]
everpr
icet
heot
herf
ell
ow i
schangi
ng,t
he
domi
nantst
rat
egyofeachf
ir
mist
ocutpr
iceandt
heequi
l
ibr
ium outcomebecomesNash
equi
l
ibr
[Link]
esul
toft
hegamei
ssummar
izedi
ntabl
ebel
ow3.
13
Fi
rm-
2
Lowerpr
ice Hi
ghpr
ice
Fi
rm-
1 Lowerpr
ice (
5,5) (
0,20)

Tabl
e Hi
ghpr
ice (
20,
0) (
10,
10) 3.
13pr
iceset
ti
ng
game

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 96
Howev
er,
ift
hegamei
srepeat
edani
nfi
nit
enumberoft
imes,
ther
emaybeot
herpossi
ble
out
comessi
ncef
ir
msuset
it
-f
or-
tatst
rat
egy
.Ifonef
ir
m cutpr
icei
nthi
sweekandget
hi
gherpr
ofi
tatt
heexpensi
veoft
heot
her
,theot
herf
ir
mret
ali
atei
nthenextr
oundby
cut
ti
ngi
tspr
iceandgethi
gherpr
ofi
t.

I
feachpl
ayerknowst
hatt
heot
herpl
ayer
spl
ayi
ngt
itf
ort
at,t
heneachpl
ayerf
earof
cut
ti
ngpr
icewhi
chi
nit
iat
epr
icewar
,theywoul
dcooper
[Link]
oav
oidsuchpr
icewar
bot
hfi
rmspr
efert
omai
ntai
nhi
gherpr
iceandgetPar
etoef
fi
cientl
evelofpr
ofi
[Link]
s
out
comei
srepr
esent
edbybot
tom r
ightcel
lint
hepr
iceset
ti
nggamepay
offmat
ri
x
exampl
e.

Fort
it
-f
or-
tatst
rat
egyt
obecomeanopt
imalst
rat
egy
,howev
ert
her
ear
ecer
tai
ncondi
ti
ons
t
hatmustbehol
[Link]
rst
,ar
easonabl
est
abl
esetofpl
ayer
sisr
equi
red.I
fthenumber
sof
pl
ayer
schangef
requent
ly,t
her
eisl
i
ttl
echancef
orcooper
ati
vebehav
iort
o dev
elop.
Second,t
her
emustbesmal
lnumberofpl
ayer
s(ot
her
wise,i
tbecomesdi
ff
icul
ttokeep
t
rackofwhateachi
sdoi
ng)
.Thi
rd,i
tisassumedt
hateachf
ir
m canqui
ckl
ydet
ectand
wi
l
li
ngt
oret
ali
atei
fot
herf
ir
m cheat
.Cheat
ing(
def
ect
)thatgoesundet
ect
edf
oral
ong
t
imeencour
agecheat
ing.

Last
ly,i
tmustbeper
cei
ved byt
hepl
ayert
hatt
hegamei
srepeat
ed i
nfi
nit
ivel
yfor
uncer
tai
nnumberoft
imes.I
nmostmar
kethowev
er,t
hegamei
srepeat
edf
orl
ongand
uncer
tai
nper
iodoft
[Link]
esul
t,i
nsomei
ndust
ri
es,par
ti
cul
arl
ythosei
nwhi
chonl
ya
f
ewf
ir
mscompet
eforl
ongper
iodunderst
abl
edemandandcostcondi
ti
on,cooper
ati
on
pr
evai
l
sev
ent
hought
her
ear
enocont
ract
ual
agr
eement
sar
emade.
3.
7Sequent
ialGame
Aswehav
eseeni
nmostoft
hegamest
hatwehav
edi
scussedsof
ar,bot
hpl
ayer
smov
e
att
hesamet
imeandi
tisknownassi
mul
taneousgame.I
nthi
ssect
ion,wear
egoi
ngt
o
consi
deracasewher
eonpl
ayermov
efi
rstandt
heot
herpl
ayerpl
ayi
tsst
rat
egyaf
ter
obser
vingt
hest
rat
egypl
ayedbyi
tsopponent
.Sucht
ypeofgamei
scal
l
edsequent
ial
[Link]
eofsucht
ypeofgamei
ncl
udest
heSt
ackl
eber
gmodelofol
i
gopol
y-One
f
ir
m(t
hel
eader
)fi
rstseti
tsout
putbef
oret
heot
herdoes;anadv
ert
isi
ngdeci
sionbyone
f
ir
m andt
her
esponseofi
tscompet
it
or;ent
ry-det
err
ingi
nvest
mentbyani
ncumbentf
ir
m
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 97
ECON102MI
CROECONOMI
CSI
I

and t
he deci
si
on whet
hert
o ent
ert
he mar
ketbya pot
ent
ialcompet
it
or;ora new
gov
ernmentr
egul
ator
ypol
i
cyandt
hei
nvest
mentandout
putr
esponseoft
her
egul
ated
f
ir
m.I
sther
e any di
ff
erence i
nthe equi
l
ibr
ium out
come ofa game when pl
ayed
si
mul
taneousl
yandsequent
ial
l
y?Howcanwegoabouti
ttodet
ermi
net
heequi
l
ibr
ium of
sequent
ial
game?Wewi
l
ltr
ytogi
veanswert
osucht
ypeofquest
ioni
nthi
ssect
ion
Consi
deragamegi
veni
ntabl
e3-
14.I
nthef
ir
str
ound,
play
erAhasast
rat
egyt
omov
etop
orbot
[Link]
ayerBaf
terobser
vingt
heopt
imalst
rat
egypl
aysast
rat
egyl
eftorr
ight
.The
r
etur
ntoeachcombi
nat
ionofst
rat
egi
eschosenassummar
izedi
ntabl
e3.
14.
Pl
ayerB
l
eft Ri
ght
Pl
ayerA Top (
1,9) (
1,9)
bot
tom (
0,0) (
2,1)

Tabl
e3.
14t
hepayof
fmat
ri
xofasequent
ialgame

Whent
hegamei
spr
esentusi
ngapay
offmat
ri
x,i
thast
woNashequi
l
ibr
ia(
top,l
eft
)and
(
bot
tom,
right
).Howev
er,
wewi
l
lshowbel
owt
hatoneoft
hisequi
l
ibr
ium i
snotr
easonabl
e
equi
l
ibr
[Link]
offmat
ri
xhi
dest
hef
actt
hatonepl
ayerget
stoknowwhatt
heot
her
pl
ayerhaschosenbef
oreshemakesherchoi
[Link]
esul
tsequent
ialgamesar
eeasi
er
t
ovi
sual
i
ze i
fwe pr
esentt
he possi
ble mov
eint
he f
orm ofdeci
sion t
[Link]
r
epr
esent
ati
onofagamei
scal
l
ed ext
ensi
vef
orm ofagame.I
tshowshow pl
ayer
sequent
ialpl
ayt
hegameoneaf
tert
heot
her
.Theabov
egame,t
her
efor
eshoul
dbe
pr
esenti
stheext
ensi
vef
orm asi
nfi
gur
e3.
1toeasi
l
yident
if
ytheequi
l
ibr
ium oft
hegame

Lef
t–(
1,9)
Top Pl
ayerB

Ri
ght–(
1,9)

Pl
ayer-A

Lef
t-(
0,0)

Bot
tom Pl
ayerB

Ri
ght
-(2,
1)
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 98
Fi
gur
e3.
1agamei
next
ensi
vef
orm.

I
nthi
sgame,f
ir
stpl
ayer
-Ahast
ochoosef
rom st
rat
egyt
oporbot
tom,andpl
ayer
-Baf
ter
det
ect
ingt
hest
rat
egychosenbypl
ayer
-A,chooseast
rat
egyl
eftorr
ight
.Wi
tht
hisbasi
c
r
uleoft
hegame,t
heequi
l
ibr
ium oft
hegamecanbedet
ermi
nedbypl
ayi
ngt
hegame
backwar
d st
art
ing f
rom t
hepl
ayer
,whi
chmov
[Link]
hatpl
ayer
-A has
al
readymadeherchoi
ceandwear
eident
if
ythebr
ancht
hatcor
respondst
oA’
schoi
ce.
Forex
ampl
eifpl
ayer
-Achosent
op,
theni
tdoesnotmat
terwhatpl
ayerBdoes,
thepay
off
f
acedbyt
hepl
ayeri
s(1,9)
.Ifpl
ayer
-Achoi
cet
opl
aybot
tom ,
thent
her
easonabl
echoi
ce
f
orpl
ayer
-Bi
stochooser
ightandt
hepay
offcor
respondst
othei
ndi
cat
edcombi
nat
ionof
st
rat
egyi
s(2,
1).

Nowt
hinkaboutpl
ayerA’
sini
ti
alchoi
ce.I
fshechooset
op,
theout
comewi
l
lbe(
1,9)and
t
husshewi
l
lgetapay
[Link]
fshechoosesbot
tom,sheget
sapay
[Link]
he
r
easonabl
ethi
ngf
orheri
stochoosebot
[Link]
heequi
l
ibr
ium out
comeoft
hegame
wi
l
lbe(
bot
tom,
right
),sot
hatt
hepay
offt
opl
ayerAwi
l
lbe2andt
opl
ayerBwi
l
lbe1.

Thest
rat
egi
es(
top,l
eft
)ar
enotar
easonabl
eequi
l
ibr
ium i
nthi
ssequent
[Link]
s
t
heyar
enotanequi
l
ibr
ium gi
vent
heor
deri
nwhi
cht
hepl
ayer
sact
ual
l
ygett
omaket
hei
r
choi
ces.I
tist
ruet
hati
fpl
ayer
-Achooset
op,pl
ayer
-Bcoul
dchoosel
eftbuti
twoul
dbe
si
l
lyf
orpl
ayer
-At
oev
erchooset
op.

Forpl
ayerB’
spoi
ntofv
iewt
hisi
srat
herunf
ort
unat
e,si
ncesheendsupwi
thapay
offof1
r
athert
[Link]
ghtshedoabouti
t?Shecant
hreat
ent
o,f
orexampl
e,t
opl
ayl
efti
f
pl
ayerApl
aysbot
tom.I
fpl
ayerBwoul
dact
ual
l
ycar
ryoutt
hist
hreat
,shewoul
dbewel
l
adv
isedt
opl
ayt
[Link]
opgi
vesher1,
whi
l
ebot
tom-i
fpl
ayerBcar
ri
esouthert
hreatwi
l
l
onl
ygi
veher0.
_
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___
___
___
___
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___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty3.
5
Whatar
ethedi
ff
erencebet
weensequent
ial
gameandsi
mul
taneousgame?
2) TwoDoupol
i
stf
ir
msAandBar
epl
anni
ngt
omaxi
mizet
hei
rpr
ofi
tthr
oughi
nvest
ingi
n
new t
echnol
ogyt
hati
mpr
ovest
hei
rpr
oductqual
i
[Link]
ketr
esear
chi
ndi
cat
est
hatt
he

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 99
ECON102MI
CROECONOMI
CSI
I

f
oll
owi
ngt
abl
egi
vest
her
esul
ti
ngpr
ofi
tst
oeachf
ir
mfort
heal
ter
nat
ivest
rat
egi
es.

Fi
rm-
B

I
nvest Noti
nvest
Fi
rm-
A I
nvest (
25,
20) (
40,
30)
Noti
nvest (
30,
25) (
5,0)

I
fthet
wof
ir
mspl
aysi
mul
taneousgamet
odeci
desi
nmaki
ngt
hei
nvest
ment
,det
ermi
nat
e
t
heequi
l
ibr
ium oft
hegame.I
stheequi
l
ibr
ium i
sdomi
nantorNashequi
l
ibr
ium?
Supposet
hatf
ir
m-A mov
efi
rstandf
ir
m-Bpl
ay(
deci
des)af
terobser
vingt
hest
rat
egy
chosenbyf
ir
m [Link]
stheequi
l
ibr
ium oft
hegameassumi
ngt
hatt
het
hreatf
rom f
ir
m
Bi
snotcr
edi
ble?Useex
tensi
vef
orm ofgamer
epr
esent
ati
on.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

Summar
y
Game t
heor
yisat
oolt
hati
s used f
orexami
ning st
rat
egi
c behav
iori
n economi
c
ci
rcumst
ances
A gamei
sanysi
tuat
ioni
nwhi
chpl
ayer
s(par
ti
cipant
s)makest
rat
egi
cdeci
sionsi
.e.
deci
si
onst
hatt
akei
ntoaccounteachot
her
’sact
ionsandr
esponses.
A gamei
scooper
ati
ve,i
fthepl
ayercancommuni
cat
eandar
rangebi
ndi
ngcont
ract
s
ot
her
wise,
iti
snon-
cooper
ati
ves.
St
rat
egi
cdeci
si
onsr
esul
tinpay
off
stot
hepl
ayer
sandt
heopt
imalst
rat
egyf
orapl
ayeri
s
t
heonet
hatmaxi
mizesherexpect
edpay
off
.
ANashequi
l
ibr
ium i
sasetofst
rat
egi
essucht
hatal
lpl
ayer
sar
edoi
ngt
hei
rbestgi
vent
he
st
rat
egi
esoft
heot
herpl
ayer
[Link]
l
lsayt
hatapai
rofst
rat
egi
esi
saNashequi
l
ibr
ium i
f
A’
schoi
cei
sopt
imalgi
ven B’
schoi
ce,and B’
schoi
cei
sopt
imalgi
ven A’
schoi
ce.
Equi
l
ibr
ium i
ndomi
nantst
rat
egyi
saspeci
alcaseofNashequi
l
ibr
ium.
Adomi
nantst
rat
egyi
sast
rat
egyt
hatwi
l
lmaxi
mizet
heexpect
edpay
offofapl
ayerno
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 100
mat
terwhatt
heot
herpl
ayerdoes.
Thepr
isoner
’sdi
l
emmai
sat
ypeofgamet
hati
sver
ymuchhel
pful
l
yinunder
standi
ng
ol
i
gopol
ybehav
ior
.Inpar
ti
cul
ar,i
thel
psexpl
ainwhyf
ir
mshav
eat
endencyt
ocheaton
car
telagr
eement
.Howev
er,
ift
hegamei
srepeat
edi
ndef
ini
tel
y,t
henf
ir
msmaynotcheat
.
Whent
hegamei
srepeat
edaf
ixedknownnumberoft
imes,ont
heot
herhandcheat
ing
sol
uti
oni
sret
urn.
Thedomi
nantst
rat
egyequi
l
ibr
ium canbef
oundbyel
i
minat
ingdomi
nat
edst
rat
egi
esof
eachpl
ayeral
ter
nat
ivel
ymost
lyi
nthecaseofmor
ethant
hreest
rat
egi
escase.
Apur
est
rat
egyi
sst
rat
egyi
nwhi
chapl
ayermakesaspeci
fi
cchoi
ceort
akesaspeci
fi
c
act
ionwi
thpr
obabi
l
ityequal
[Link]
eas,
mixedst
rat
egi
esar
ethosei
nwhi
chapl
ayer
makesar
andom choi
ceamongt
woormor
epossi
bleact
ions,basedonasetofchosen
pr
obabi
l
iti
es.
Nashequi
l
ibr
ium i
nmi
xedst
rat
egi
esr
efer
stoanequi
l
ibr
ium i
nwhi
cheachagentchooses
t
heopt
imalf
requencywi
thwhi
cht
opl
ayhi
sst
rat
egi
esgi
vent
hef
requencychoi
cesoft
he
ot
heragent
.
Agamesai
dtobesequent
ialgamei
fpl
ayermov
eint
[Link]
l
esi
mul
taneousgamea
casewher
eapl
ayermov
eatt
hesamet
imebyassumi
ngagi
venst
rat
egi
cchoosef
ort
he
ot
herpl
ayer
.
Keyconcept
sandt
erms
Game domi
nantst
rat
egy pur
est
rat
egy
Pl
ayer opt
imal
str
ategy par
eopt
imal
i
ty
Pay
off Nashequi
l
ibr
ium pr
isonerdi
l
emma
St
rat
egy mi
xedst
rat
egy sequent
ial
game
Si
mul
taneousgame r
epeat
edgame pay
offmat
ri
x
Expect
edpay
off
El
i
minat
ionofdomi
nat
edst
rat
egy ext
ensi
vef
orm

Rev
iewquest
ions.
Answert
hef
oll
owi
ngquest
ionbr
ief
ly
We know t
hata si
ngl
e-shotpr
isoner
’s di
l
emma game r
esul
tsi
n a domi
nantNash
equi
l
ibr
ium st
rat
egyt
hati
sPar
etoi
nef
fi
cient
.Supposeweal
l
owt
hepr
isoner
stor
etal
i
ate
af
tert
hei
rrespect
ivepr
isont
erms.
for
mal
l
ywhataspectoft
hegamewoul
daf
fect
?Coul
d
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 101
ECON102MI
CROECONOMI
CSI
I

aPar
etoef
fi
cientout
comer
esul
t?
Whati
sthedomi
nantNashequi
l
ibr
ium st
rat
egyf
ort
her
epeat
edpr
isoner
’sdi
l
emmagame
whenbot
hpl
ayer
sknowt
hatt
hegamewi
l
lendaf
teronet
housand-
ti
mer
epet
it
ion?
Let
uandLat
aar
epl
ayi
nganumbermat
chi
nggame.Eachchooses1,2or3.I
fthe
number
smat
ch,
Let
upay
sLat
a3bi
rr
.ift
heydi
ff
erLat
apay
sLet
u1bi
rr.
Descr
ibet
hepay
offmat
ri
xfort
hisgame,andshow i
tdoesnothav
eaNashequi
l
ibr
ium
st
rat
egi
espai
r.
Show t
hatwi
thmi
xedst
rat
egi
est
hisgamedoeshav
eNashequi
l
ibr
ium i
feachpl
ayer

pl
ayseachnumberwi
thapr
obabi
l
ity .Fi
ndt
heexpect
edpay
offoft
het
wopl
ayer
s.

Pr
obl
ems.
Twof
ir
ms,
AandBexi
sti
napar
ti
cul
armar
ket
.Eachhast
wost
rat
egi
[Link]
offmat
ri
x
f
oreachcombi
nat
ioni
sshownbel
ow.
Fi
rm-
A
Lef
t r
ight
Fi
rm-
B Top (
-5,
-
6) (
5,10)
Bot
tom (
10,
5) (
-6,
-5)
I
ffi
rm A mov
efi
rst
,what st
rat
egy woul
d i
t
choose?Whatst
rat
egywoul
dfi
rm-
Bthenmov
e?
I
ffi
rm Bmov
esf
ir
stwhatst
rat
egy
,woul
dhechoose?Whatst
rat
egyf
ir
m-At
henchooset
o
mov
e.
Repr
esentt
hegameunderquest
ion(
a)and(
b)wi
thext
ensi
vef
orm orgamet
ree.
consi
dert
hegameshownbel
ow:
Col
umn

Lef
t Mi
ddl
e Ri
ght
Top (
1,0) (
1,2) (
2,-
1)
Row
Mi
ddl
e (
1,1) (
1,0) (
0,-
1)
Bot
tom (
-3,
-
3) (
-3,
-
3) (
-3,
-
3)
a) Det
ermi
ne t
he domi
nant
st
rat
egyofRowwhatev
erCol
umndoes
b)Whi
chst
rat
egyofRowi
sdomi
nat
edst
rat
egy
?

ADAMAUNI
VERSI
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DEPARTMENTOFECONOMI
CS 102
c) Whi
chst
rat
egyofcol
umni
sdomi
nat
edst
rat
egy
?
d)Det
ermi
net
heequi
l
ibr
ium oft
hegameusi
ngel
i
minat
ionofdomi
nat
edst
rat
egy
met
hod.
3)Fr
om t
hef
oll
owi
ngpay
offmat
ri
x,wher
ethepay
off
sar
ethepr
ofi
tsorl
ossesoft
wo
f
ir
ms,
Fi
rm-
B
Lowpr
ice Hi
gh
Fi
rm-
A pr
ice
Lowpr
ice (
1,1) (
3,-
1)
Det
ermi
ne Hi
ghpr
ice (
-1,
3) (
4,2)
Whet
her f
ir
m-A has a domi
nantst
rat
egy
Whet
herf
ir
m-Bhasadomi
nantst
rat
egy
Theopt
imal
str
ategyf
oreachf
ir
m.
TheNashequi
l
ibr
ium i
fther
eis

Suggest
edr
eadi
ngs
Ni
chol
son,
w:Mi
croeconomi
ctheor
y;basi
cpr
inci
pleandext on.5thedi
ensi ti
on
Sal
vat
ore,
D(2003)
:Mi
croeconomi
cs;
theor
yandappl
icat
i 4thedi
ons. ti
on
Mansf
iel
d,[Link],
G(2000)
:Mi
croeconomi
cs,
theor
yandappl
icat
i 10thedi
ons. ti
on
Var
ian,
[Link]
l(1999)
:Int
ermedi
atemi
cr cs3rdedi
oeconomi ti
on
Pi
ndy
ck,
[Link]
nfel
d,D.
L.(
2003)
:Mi
cr cs.6thedi
oeconomi ti
on
Kout
soy
ianni
sA.(
1985)
:Moder
nmi
cr cs2ndedi
oeconomi ti
on.

CHAPTERFOUR

PRI
CINGOFFACTORSOFPRODUCTI
ONANDI
NCOMEDI
STRI
BUTI
ON

ADAMAUNI
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ECON102MI
CROECONOMI
CSI
I

4.
1.I
NTRODUCTI
ON
LEARNI
NGOBJECTI
VES

BASI
CCONCEPTSOFFACTORMARKET
FACTORPRI
CINGI
NPERFECTLYCOMPETI
TIVEMARKET
4.
[Link]
RM FORASI
NGLEVARI
ABLEFACTOR
I
NSHORTRUN:LABOR

ADAMAUNI
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TY,
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CS 104
CHAPTERFOUR

PRI
CINGOFFACTORSOFPRODUCTI
ONANDI
NCOMEDI
STRI
BUTI
ON
4.
1INRODUCTI
ON
Whydomaj
orexecut
ivesseem t
oear
nmor
ethanwor
kerf
orexampl
ewagesi
nthe
nei
ghbor
hoodof$2.
5mi
l
li
onpery
ear
?
Whydosecr
etar
iesear
nabout$15t
o$20prhour
?
Whydof
oot
bal
lpl
ayer
sear
nmanymi
l
li
ondol
l
arspery
ear
?
Toanswert
heseandot
her
squest
ionswehav
etounder
standt
hedet
ermi
nat
ionofi
nput
s
pr
ices.

I
nthepr
ecedi
ngchapt
ers,hav
ecompl
etedourexami
nat
ionoft
hepr
oductmar
ket
,wher
e
t
he pr
icesofgoodsand ser
vicesar
e det
ermi
[Link] pr
oduct
sar
e pr
oduced by
pr
ocessi
ngoneormor
efact
orsofpr
oduct
ion:l
and,l
abor
,capi
tal
,andent
repr
eneur
shi
p.
Ast
heyi
nvol
vecostofpr
oduct
ionofcer
tai
npr
oductt
hei
rpr
ices(
rentf
orl
and,wagef
or
l
abor
,int
erestf
orcapi
tal
,pr
ofi
tforent
repr
eneur
shi
p)det
ermi
neswhatt
opr
oducesand
how t
o pr
[Link] t
heor
yofi
nputpr
ici
ng i
s,t
her
efor
e,a t
heor
yoft
he i
ncome
di
str
ibut
ionamongl
andowner
s,wageear
ner
sandcapi
tal
i
st.I
tisequal
l
yimpor
tantt
osee
f
act
ors mar
kett
hatt
akes us i
nto a bat
tl
egr
ound ofeconomi
cs wher
efact
ors of
pr
oduct
ionsar
edet
ermi
ned.

Themechani
sm ofdet
ermi
nat
ionoff
act
orspr
icesdoesnotdi
ff
erf
undament
all
yfr
om t
he
pr
ici
ngofcommodi
ti
[Link]
ff
erencel
i
esi
nthedet
ermi
nat
ionoft
hedemandandsuppl
y
ofpr
oduct
iver
esour
cesandi
nther
ever
saloft
her
olepl
ayedbyf
ir
msandconsumer
s.
Fact
orspr
icear
edet
ermi
nedi
nmar
ketundert
hef
orcesofdemandandsuppl
[Link]
rms
suppl
yofcommodi
ti
est
othe mar
ket
,butt
heydemand i
nput
s;consumer
sdemand
commodi
ti
esf
rom t
hemar
ketpl
aces,butt
heysuppl
ysomev
eryi
mpor
tanti
nput
[Link]
sis
whatci
rcul
arf
lowofeconomi
cact
ivi
ti
esf
orsi
mpl
i
fiedeconomyi
nwhi
cht
her
ear
efi
rms
andhousehol
dswi
tht
hei
rrespect
iveobj
ect
ivesal
labout
.

I
tist
her
efor
eimpor
tantf
orust
ounder
standt
hegener
alpr
inci
plest
hatgov
ernt
he
det
ermi
nat
ionoff
act
orspr
[Link]
thought
her
ear
emanycommonf
act
orsofpr
oduct
ion
ADAMAUNI
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CROECONOMI
CSI
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under
lyi
ngt
hedet
ermi
nat
ionoft
hepr
icesofi
nput
s,agener
alf
ramewor
kwi
l
lbedev
eloped
t
o anal
yzi
ngt
hepr
ici
ngmechani
sm ofanypr
oduct
iver
esour
cesi
nthi
smodul
[Link],
in
t
hecomi
ngt
opi
cs wesel
ectl
aborasr
epr
esent
ati
vef
act
orofpr
oduct
ionandseehow
pr
iceofl
aborandcapi
tali
sdet
ermi
nedi
nthei
rrespect
ivemar
kett
hrought
hei
nter
act
ion
ofdemandandsuppl
y.

LEARNI
NGOBJECTI
VES
Thegener
alobj
ect
iveoft
hischapt
eri
stoshowhowt
hepr
icesofpr
oduct
ivef
act
orsar
e
det
ermi
nedandhowt
hisi
ntur
ndet
ermi
nest
hel
evel
ofi
ncomeenj
oyedbyt
hei
rowner
s.
Ther
efor
e,af
tercompl
eti
ngt
hischapt
er,
youwi
l
lbeabl
eto:
Under
standt
hedi
ff
erencebet
weenpr
icemaker
sandpr
icet
aker
sint
hef
act
ormar
ket
s
Cal
cul
atet
hemar
ginal
cont
ri
but
ionofaf
act
ort
oaf
ir
m’sr
evenue
Expl
aint
hepr
ofi
t-
maxi
mizi
ngr
ulei
nthef
act
ormar
ketunderdi
ff
erentmar
ketst
ruct
ure.
Descr
ibehowt
hef
unct
ional
dist
ri
but
ionofi
ncomei
sdet
ermi
ned.
Measur
ethesubst
it
utabi
l
ityoff
act
ors.
Expl
aint
hei
mpl
i
cat
ionoft
echnol
ogi
cal
progr
essoni
ncomedi
str
ibut
ion.

4.
[Link]
CCONCEPTSOFFACTORMARKET

Pr
oduct
ionf
unct
ioni
sther
elat
ionshi
pbet
weeni
nput
sandout
put
[Link]
ir
m’sdemandf
or
af
act
ori
nputdependsupont
hei
nput
’sphy
sicalpr
oduct
ivi
tyandt
hedemandf
ort
hegood
t
hef
act
ori
sbei
ngusedt
opr
[Link]
nessf
ir
m par
ti
cipat
esi
nbot
hthepr
oduct
mar
ket
,wher
eitsel
l
sthegoodsandser
vicesi
tpr
oduces,andi
nthef
act
ormar
ket
,wher
e
i
tbuy
sfact
orssuchast
hel
and,l
aborandcapi
tali
tneedst
opr
oducest
heout
put
.Fact
or
mar
ket
sdi
ff
erf
rom pr
oductmar
keti
nthr
eei
mpor
tantaspect
s.

Fi
rst
,fact
ormar
kett
endst
obemor
ecompet
it
ivet
hanpr
oductmar
ket
.Inpr
oductmar
ket
,
f
ir
mscompet
eagai
nstot
hersel
l
ers/
fir
msonsameorsi
mil
arpr
oduct
s.I
nmanycases
pr
oducer
scansuf
fi
ci
ent
lydi
ff
erent
iat
edt
hei
rpr
oductandcanexer
cisesamecont
rolov
er
pr
ices.I
nfact
ormar
ket
,al
lbusi
nessf
ir
mst
endt
ocompet
efort
hesamef
act
orr
esour
ces.
Fori
nst
ances,Gener
alMot
ors,Mi
crosof
ttel
evi
sionst
ati
ons.
..et
ccompet
esf
ort
he
gener
alpoolofl
abor
,capi
taland l
and t
houghtpr
oduci
ng qui
tedi
ff
erentgoodsand

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 106
ser
[Link] al
lneed wor
d pr
ocessi
ng speci
ali
sts,comput
ers,t
rucks dr
iver
s and
manger
s.I
tis,
ther
efor
e,r
aret
hatonef
ir
m canexer
cisesuf
fi
cientcont
rolov
erapar
ti
cul
ar
f
act
orsmar
kett
obeabl
etoi
nfl
uencet
hepr
icesoft
hosef
act
[Link]
ir
msar
epr
ice
t
aker
sinf
act
ormar
keti
nasenset
hatbusi
nessf
ir
mssi
mpl
ymustpayt
hegoi
ngr
atef
or
t
hef
act
orsofpr
oduct
ions.

Second,t
hedemandf
orf
act
orsofpr
oduct
ioni
sader
iveddemandi
nasenset
hati
ts
demandcomesf
rom t
hedemandf
ort
hegoodsandser
vicespr
oducedbyt
hef
act
orsof
pr
oduct
[Link]
ir
m buy
sfact
orsofpr
oduct
ionbecauset
heypr
oducegoodsandser
vices
t
hatgener
ater
evenuef
ort
hef
ir
[Link]
menti
ndust
ry,f
ori
nst
ances,buy
ssewi
ng
machi
nesbecausei
thel
pst
opr
oducesui
ts,
shi
rt
s,anddr
essest
hatconsumer
swi
l
lbuyor
[Link]
inci
pleofder
iveddemandi
sessent
ialt
ounder
standi
ngt
hewor
kingsoff
act
or
mar
ket
s.I
fconsumer
sreducet
hei
rdemandf
orl
ett
uce,
thedemandf
orwor
ker
sempl
oyed
i
nlet
tucedecl
i
ne,t
hedemandf
orf
arml
andusedf
orl
ett
uceandev
ent
hedemandf
or
wat
erusedi
nfar
mir
ri
gat
ionwi
l
lal
sof
all
.

Thi
rd,
thepr
oduct
ionofagoodr
equi
rest
hecooper
ati
onofdi
ff
erentf
act
orsofpr
oduct
ion.
Far
m wor
ker
scanpr
oducenocor
nwi
thoutf
arml
andandf
arml
andwi
thoutf
arml
abori
s
usel
[Link]
hfar
mlandandf
arm wor
ker
srequi
ref
armi
mpl
ement
s(r
angi
ngf
rom hand
t
ool
stosophi
sti
cat
edf
arm machi
ner
y)t
opr
oducecor
[Link],i
tisj
ointdet
ermi
nat
ionof
f
act
orsdemand.

Thedet
ermi
nat
ionofpr
icesoff
act
orsofpr
oduct
ioni
ssomet
hingr
elat
edt
hesuppl
yand
demandofpr
oduct
sasi
tisader
[Link]
heor
yofpr
icesi
srel
atedt
othe
behav
iorofpr
oduct
ionf
unct
[Link]
lpr
oduct
ionf
unct
ionsexhi
bit
sthel
aw ofdi
mini
shi
ng
r
etur
nsasl
argerquant
it
iesofv
ari
abl
efact
orsar
ecombi
nedwi
thf
ixedamount
soft
he
f
ir
m’sot
herf
act
ors,
themar
ginalphy
sicalpr
oduct(
theamountofext
raout
putofanext
ra
wor
ks)oft
hev
ari
abl
efact
orwi
l
lev
ent
ual
l
ydecl
i
[Link]
nter
dependenceoft
hemar
ginal
phy
sicalpr
oductofl
and,
labor
,andcapi
taldoesnotmaket
hepr
obl
em off
act
orspr
ici
ngi
n
amar
ketset
ti
ngdi
ff
icul
t.

Thedet
ermi
nat
ionoff
act
orpr
icesdi
ff
ersdependi
ngont
het
ypeofmar
ketst
ruct
ures
ADAMAUNI
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(
per
fectmar
ketanddi
ff
erentr
angesofi
mper
fectmar
ket
).I
nthi
sregar
d,wewi
l
lfi
rst
exami
ne t
he pr
ici
ng sy
stem of t
hese i
nput
s underper
fect
ly compet
it
ive mar
ket
.
Subsequent
lywer
elaxourassumpt
ionandseehow t
het
heor
ywoksunderi
mper
fect
compet
it
ion.I
nthesesect
ions,wewi
l
lexami
net
heeconomi
cfor
cest
hatgov
ernwages
andot
hercondi
ti
onsofempl
oyment
.

¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬¬_
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___
___
___
___
___
___
___
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_
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___
_
4.
[Link]
ivi
ty
[Link]
act
ormar
ket
sdi
ff
erf
rom t
hepr
oductmar
ket
?
2.I
thasbeenar
guedt
hatt
hedemandf
orf
act
ori
sder
[Link]
aint
hisconcept
wi
tht
hehel
poft
hedemandf
orl
aborbyWanj
iSugarFact
oryassumi
ngt
hef
act
oryi
s
pr
ivat
elyowned?

FACTORPRI
CINGI
NPERFECTLYCOMPETI
TIVEMARKET
Wehav
eseenhow f
ir
m’smakef
act
orempl
oymentdeci
sionsbasedont
heobj
ect
ive
f
unct
ionunderpr
oduct
ionchapt
erspeci
fi
cal
l
yinmodul
e–[Link]
edev
elopedt
he
opt
imi
zat
ioncondi
ti
onsofpr
oduct
ionandi
nputempl
oyment
;howmuchofeachi
nputt
he
f
ir
mswoul
ddemandunderv
ari
ousset
sofci
rcumst
ancesbasedoni
tsdeci
sionoft
he
l
evelofout
put
.Thi
sisani
mpor
tantbegi
nni
ngf
orconst
ruct
ingamodelofi
nputpr
ici
ng
andut
il
izat
ionunderper
fectcompet
it
ions.

Forourbet
terunder
standi
ngl
ets,wer
evi
ew someoft
hemai
npoi
[Link]
her
e
t
hataf
ir
m mi
nimi
zesi
tscostbypi
cki
ngt
hecombi
nat
ionofi
nput
sforwhi
cht
her
ati
osof
t
hei
rmar
ginalpr
oduct
stot
hei
rpr
icesar
eal
lequal
.Thati
s,acost
-mi
nimi
zi
ngf
ir
m shoul
d
set

Wher
e i
sthemar
ginalpr
oduct
ionofi
nputx, i
sthepr
icesofi
nputx, i
s
mar
ginalpr
oductofi
nputy
, i
sthepr
icesofi
nputy
,andsoon.I
fitdi
dnothol
d,f
ir
m
al
way
smakecer
tai
nadj
ust
ment
sinsuchawayt
hati
treducecost
sandhenceopt
imi
ze
hi
sobj
ect
ivef
unct
[Link]
ngast
epf
urt
her
,itcanal
sobeshownt
hatt
heabov
ecost
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 108
mi
nimi
zi
ngf
ir
m’sr
ati
osequal
stot
her
eci
procal
oft
hef
ir
m mar
ginal
cost
.Thati
s

Wher
eMCi
sit
smar
ginal
cost
Mor
eov
er,wehav
eseent
hatt
hepr
ofi
tmaxi
mizi
ngf
ir
m mustoper
ateatt
hepoi
ntf
or
whi
chmar
ginal
costequal
smar
ginal
rev
enue.I
tfol
l
ows,
ther
efor
e,t
hat

Wher
eMRi
sthef
ir
m’smar
ginal
rev
enue

Rear
rangi
ngt
het
ermsi
nequat
ionabov
eweget

Weconcl
udedt
hatt
hepr
ofi
tmaxi
mizi
ngf
ir
m shoul
dempl
oyeachi
nputupt
othepoi
nt
wher
eit
smar
ginalpr
oductmul
ti
pli
edbyt
hef
ir
m’smar
ginalr
evenueequal
sint
hei
nput
s
peruni
tpr
ice.I
nthi
scompet
it
ivepr
oductandi
nputmar
ket
s,f
act
orsar
epai
dthev
alueof
t
hei
rmar
ginalphy
sicalpr
oduct
,whi
chi
sdet
ermi
nedbyt
hef
orceoft
otaldemandand
suppl
y.

Af
ir
m hasademandf
orf
act
ors(
laborandcapi
tal
)isr
elat
edt
hecont
ri
but
ionoft
hef
act
or
t
otheobj
ect
ivef
unct
ionoft
hef
ir
[Link]
ri
but
ionofl
abor
,forani
nst
ance,
tot
hef
ir
m’s
pr
ofi
tfunct
ioni
sdet
ermi
nedbyt
wot
hings:t
hequant
it
yofaddi
ti
onalout
putauni
tlabor
i
nputcanpr
oducesandt
hepr
icet
hatt
hef
ir
m cansel
lit
spr
oduct
.Theanal
ysi
soft
he
demandf
ort
hel
abordi
ff
erswhenl
abori
stheonl
yvar
iabl
efact
orofpr
oduct
ionandwhen
t
her
ear
esev
eralv
ari
abl
efact
[Link]
dingl
y,wewi
l
ldev
elopf
ir
stt
hedemandf
orl
abor
byasi
ngl
evar
iabl
efact
orf
ort
hef
ir
m andmar
[Link]
akeal
ookatt
he
der
ivat
iondemandcur
vef
ori
nputwhent
her
ear
esev
eralv
ari
abl
efact
[Link]
hesame
anal
ogywewi
l
ldev
elopt
hesuppl
yofl
aborbyi
ndi
vi
dual
consumerandt
henmar
ketsuppl
y.

4.
3.1.
DEMANDOFAFI
RM FORASI
NGLEVARI
ABLEFACTOR
I
NSHORTRUN:LABOR

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 109
ECON102MI
CROECONOMI
CSI
I

Ourf
ir
stst
epi
nanal
yzi
ngt
hedemandf
orani
nputi
stoconsi
dert
hedemandcur
veofan
i
ndi
vi
dualf
ir
mforsomei
nput(
cal
llabor
)undert
heassumpt
iont
hatl
abori
sonl
yvar
iabl
e
f
act
ori
nthef
ir
m’spr
oduct
ionpr
[Link]
ysi
sofdemandl
aborunder
li
nest
he
f
oll
owi
ngassumpt
ions:
Asi
ngl
ecommodi
tyxi
spr
oducedi
nper
fect
lycompet
it
ivemar
ket
.Forexampl
eaf
ir
mis
pr
oduci
ngwheatandi
tspr
icesPi
sgi
venf
oral
lfi
rmsi
nthemar
ket
Thegoal
oft
hef
ir
mispr
ofi
tmaxi
mizat
ion
Ther
eisasi
ngl
evar
iabl
einputi
nthef
ir
m’spr
oduct
ionpr
ocess:Laborandal
lot
heri
nput
s
ar
efi
[Link]
ker
swhoar
eassumedt
obehomogeneousi
nourexampl
eofwheat
,for
i
nst
ances,v
ari
es i
nthei
rabi
l
ityt
opr
oduce,butt
hef
arm,machi
ner
y,f
ert
il
izer
,seedsand
soonar
eal
lfi
xed.
Per
fect
lycompet
it
ivemar
ket
.
Thepr
iceofl
aborser
vices,
w,i
sgi
venf
oral
lfi
rmsast
hef
ir
mispr
icet
aker
.
Thi
simpl
i
est
hatt
hesuppl
yofl
abort
othei
ndi
vi
dualf
ir
misper
fect
lyel
ast
ic.
Thi
scanbedenot
edbyast
rai
ghtl
i
nepar
all
elt
othehor
izont
alaxi
s(Fi
gur
e
4.
1).Att
hegoi
ngmar
ketwager
atet
hef
ir
m canempl
oy(
hir
e)anyamountof
l
abori
twant
s.

w SL

O Labor

Fi
gur
e4.
1:Laborsuppl
yforani
ndi
vi
dual
fir
m

Technol
ogyi
sgi
[Link]
ail
abl
etechnol
ogyenabl
est
hef
ir
mtopr
oducecer
tai
nlev
elof
out
put
.Thi
sisshownbyt
hepr
oduct
ionf
unct
ionoft
hef
oll
owi
ngf
igur
e4.
1.

Gi
vent
heabov
eassumpt
ion,t
hedemandcur
vef
orl
aborbyt
hef
ir
mist
hequant
it
yof
i
nputt
hatt
hef
ir
m woul
ddemandateachpossi
blepr
ice(
wage)
.Thef
ir
m wi
l
ldemand
cer
tai
n amountofi
nputf
orwhi
ch t
he v
alue oft
he ext
ra out
putpr
oduced byt
he

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 110
empl
oymentoft
hel
astuni
tofi
nputi
sequalt
othepr
icesoft
hepr
oduct
.Tomaket
hese
meani
ngmor
econcer
t,weuset
hepr
oduct
ionf
unct
ionbasedonourassumpt
ionand
deducet
heconceptf
rom mar
ginalpr
oductofi
nputateachl
evelofempl
oyment
.Lookat
t
hef
oll
owi
ngpr
oduct
ionf
unct
[Link]
putmeasur
edi
nuni
tsdependsont
henumberof
wor
ker
shi
red.

X=f
(L)
k

St
age-
St
age-

St
age-

L
Fi
gure 4.
2. The pr oducti
on
f
uncti
on.
Themor
ewor
ker
s,t
hemor eout
put
.Howev
er,
ast heworkf
orcei
ncr
eases,
thei
ncr
ease
i
nout
puti
sunl
i
kel
ytochangeatt
hesamepr
opor
ti
onast
hei
ncr
easei
nthenumberof
wor
ker
sempl
oyed add l
esserand l
esserev
ennot
hing t
othepr
oduct
ionpr
ocess
becauseofdi
mini
shi
ngmar
ginalpr
oductofl
abor
.Asmor
eandmor
ewor
keri
sadded
(
empl
oyed)t
hemar
ginalphy
sicalpr
oductofaddi
ti
onall
abordecl
i
net
hought
het
otal
pr
oducti
ncr
[Link] sl
ope oft
he pr
oduct
ion f
unct
ion measur
es t
he mar
ginal
phy
sical
productofl
abor(
MPPL)
. Thati
s

Fr
om pr
oduct
ion,t
heor
yweknowt
hatagi
venpr
oduct
ionf
unct
ionhast
hreest
agesof

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 111
ECON102MI
CROECONOMI
CSI
I

pr
oduct
[Link]
ir
stst
age(
Stage-
Ipr
oduct
ion)i
sther
angeov
erwhi
cht
hemar
ginal
phy
sicalpr
oductofl
abori
ncr
easeati
ncr
easi
ngr
ate(
theext
raout
putgai
nedf
rom
ext
rai
nputi
shi
gherascompar
edt
othepr
evi
ousi
nput
).Thef
ir
m hi
resmor
efact
ors
ov
ert
hisr
[Link]
agei
swher
etheMPPL decl
i
neathi
gherl
evel
sof
empl
oyment
,gi
vent
hel
awofv
ari
abl
epr
opor
ti
[Link]
ert
hir
dst
ageofpr
oduct
ion,t
he
ext
rai
nput(
labor
)hasnegat
iveef
fectorcont
ri
but
ionsont
otal
out
put
.

Wear
econv
ergi
ngt
othesecondst
age,wher
eMPPL i
sfal
l
ingbutposi
ti
vebecause
t
hesepr
ofi
tsmaxi
mizi
ngf
ir
msoper
atei
nthi
srange.I
fwemul
ti
plyt
heMPPL ateach
l
evelofempl
oymentbyt
hegi
venpr
icesoft
heout
putPx,weobt
aint
heVal
ueof
Mar
ginal
ProductorMar
ginal
Rev
enuePr
oducti
nmonet
aryt
erm-
VMP(
MRP)
.Inshor
t:

Apr
ofi
tmaxi
mizi
ngf
ir
m wi
l
lhi
reaf
act
orasl
ongasi
taddsmor
etot
otalr
evenuet
han
t
othecost
.Thi
sisso,asf
ir
misgui
dedbypr
ofi
tmaxi
mizat
ionobj
ect
ivei
nthef
act
or
mar
ketwhi
chi
sbasi
cal
l
ythesameaspr
ofi
tmaxi
mizi
ngdeci
sionsi
nthepr
oduct
mar
ketasdeci
dingont
hequant
it
yofi
nput
sdet
ermi
nest
hel
evelofout
put
.Hence,
the
hi
ghert
hepr
icesofani
nput
,thel
essert
hef
ir
m want
stobuy
.Iti
sadown-
wor
dsl
opi
ng
cur
vebecauset
hegr
eat
ert
heamountoff
act
orused,
thel
oweri
sthemar
ginalr
evenue
pr
oductast
hel
awofdi
mini
shi
ngr
etur
nshol
ds.I
naddi
ti
on,
ast
hef
ir
misapr
icet
aker
i
nthepr
oductmar
kett
osomeext
ent
,hi
gherl
evel
sofout
putwi
l
lresul
tsi
nlower
mar
ginalr
[Link]
om t
heseonecanseewi
tht
hequant
it
yoff
act
ori
ncr
eases,bot
h
mar
ginal
phy
sical
productandhencet
hemar
ginal
rev
enuet
endt
odecl
i
ne,
sot
hatMRP
(
whi
chMPPxMR)decl
i
nes.

MPPL
VMPL

VMPL=MPPLXPX
MPPL
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 112
VMPL cur
vei
sthef
ir
m’sdemandcur
vef
oraf
act
orasi
tdet
ermi
nest
hel
evelofext
ra
out
putpr
oduced byaddi
ti
onall
aborand hence demands f
orl
abor
.Hence,how do
equi
l
ibr
ium l
evel
ofempl
oymenti
sdet
ermi
nedgi
vent
hel
abordemandandsuppl
y?

Foracompet
it
iveempl
oyerofl
abor
,themar
ginalcostofhi
ri
ngonemor
ewor
kerperhour
i
sthewage,[Link]
ri
nganext
rawor
kerr
aisest
hef
ir
m’spr
ofi
tift
hemar
ginalbenef
it
,
mar
ginalr
evenuepr
oductofl
abori
sgr
eat
ert
hant
hemar
ginalcost(
thewage)
from one
mor
ewor
ker
:MRPL>W.I
fthemar
ginalr
evenuepr
oductofl
abori
slesst
hant
hewage,
MRPL<w,
thef
ir
m canr
aisei
tspr
ofi
tbyr
educi
ngt
henumberofwor
ker
sit
sempl
oys.

VMPL
w
e1
e1
w SL1

e e2
e
w W S

ee
w 2 3 SL2
VMPL 2
VMPL

O L O L
L*
L1 L* L2

Fi
gure4.4-
A Demandcur
veoft
hef
ir
m Fi
gur
e4.
4-B Demandcur
vewhenwage
changes

Thus,t
hef
ir
msmaxi
miz
esi
tspr
ofi
tbyr
educi
ngt
henumberofwor
ker
sunt
ilt
hemar
ginal
r
evenuepr
oductoft
hel
astl
abori
sexact
lyequal
stot
hemar
ginalcostofempl
oyi
ngt
hat
wor
k,whi
chi
sthewage;
MRPL =[Link]
sisi
ndi
cat
edbypoi
nt‘
e’onf
igur
e4.
4-B.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 113
ECON102MI
CROECONOMI
CSI
I

Ast
hewager
atechanges,
thef
ir
m wi
l
lmov
eal
ongi
tsVMPLcur
vet
odet
ermi
net
hepr
ofi
t
maxi
mizat
ionl
evelofempl
oyment
.Ift
hemar
ketwagei
srai
sedt
ow1 f
rom or
igi
nalpoi
nt,
t
hef
ir
m wi
l
lreducei
tdemandf
orl
abort
oL1i
nfi
gur
e4.
4-Bi
nor
dert
omaxi
mizei
tspr
ofi
t
(
ate,wher
eW1 =VMPL)
.Si
mil
arl
y,i
fthewagef
all
stoW2,t
hef
ir
m wi
l
lmaxi
mizei
tspr
ofi
t
byi
ncr
easi
ngi
tsempl
oyment
stoL2..
Itf
oll
owsf
rom t
heabov
eanal
ysi
sthatt
hedemand
cur
veofaf
ir
mforasi
ngl
evar
iabl
efact
or,
labor
,isv
alueofmar
ginalpr
oductcur
veandi
s
downwar
dsl
opi
ng.
For
mal
der
ivat
ionoft
heequi
l
ibr
ium oft
hef
ir
misasf
oll
ows:
Thepr
oduct
ionf
unct
ioni
sspeci
fi
edas X=f
(L)
k

Thet
otal
costconsi
stsoft
hev
ari
abl
ecostW.
Landt
hef
ixedcostFcanbest
atedas
C=W.L+F
Ther
evenueoft
hef
ir
misR=Px.X whi
chi
s R=Px.[
f(
L)]
.
Thef
ir
m want
stomaxi
mizei
tspr
ofi
t
=R–C
=Px.
[f
(L)
]–(
W.L+F)
Thef
ir
stor
derder
ivat
iveoft
hepr
ofi
tfunct
ionswi
thr
espectt
olaborequalt
ozer
owe
obt
ain

Rear
rangi
ng

Px.(
MPPL)=W gi
ven , VMPL=W

Theabov
edi
scussi
oncanbei
l
lust
rat
edwi
thnumer
icalexampl
ebyassumeapr
oduct
ion
pr
ocess,
whi
chi
nvol
vesaf
ixedamountofmachi
ner
ygi
vi
ngr
iset
oat
otalf
ixedcostofBi
rr
50,andt
hel
aborwhi
chi
stheonl
yvar
iabl
efact
[Link]
atei
s40andt
hepr
icesof
t
hecommodi
typr
oducedar
[Link]
oduct
ionf
unct
ioni
sspeci
fi
edbyt
hei
nfor
mat
ionof
t
hef
ir
stf
ourcol
umnsoft
abl
e4.
[Link]
umn6showst
otalr
evenue(
=[Link] )
,col
umn10
i
ndi
cat
est
otalv
ari
abl
ecost(
=L.
W).Fi
nal
l
ycol
umn12showst
hepr
ofi
toft
hef
ir
m(=R–
TVC–FC)

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 114
Tabl
e4.
1:Dat
afort
heder
ivat
ionoft
hedemandcur
vef
ort
hef
ir
m
Thepr
oduct
ionf
unct
ion Cost
s,r
evenues,
prof
it
Val
ue
of
Mar
gina Tot
al mar
gin Tot
al
Uni
t Uni
t Tot
al Pr
ice
l r
evenu al Tot
a v
ari
abl
of of out
p of Wag Tot
al Pr
ofi
phy
sical e phy
sica l e
f
ixed l
abo ut pr
odu e Cost t
pr
oduct R=X. l f
ixe Cost
capi
t r (
uni
t) ctPx r
ate TC=TVC TI=
ofl
abor Px pr
oduct d TVC
al
K L X £ w +F R–
MPPL £ ofl
abor cost =W.L
£ C TC
VMPl £ £
£
(
£)
10 0 0 _ 10 0 0 50 40 0 50 -
50
10 1 20 20 10 200 200 50 40 40 90 110
10 2 38 18 10 380 180 50 40 80 130 250
10 3 54 16 10 540 160 50 40 120 170 370
10 4 68 14 10 680 140 50 40 160 210 420
10 5 80 12 10 800 120 50 40 200 250 550
10 6 90 10 10 900 100 50 40 240 290 610
10 7 98 8 10 980 80 50 40 280 330 650
10 8 104 6 10 1040 60 50 40 320 370 670
10 9 108 4 10 1080 40 50 40 360 410 670
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 115
ECON102MI
CROECONOMI
CSI
I

10 10 110 2 10 1100 20 50 40 400 450 650


Sour
ce:
Kot
isy
anos,
1984

Ther
ear
etwoway
sofl
ooki
ngatpr
ofi
tmaxi
mizat
ionoft
hef
ir
m basedont
heTabl
e4.
1.
[Link]
alr
evenueort
otal
costappr
oach
Pr
ofi
tisatamaxi
mum wher
ethedi
ff
erencesbet
weent
otalcostandr
evenuear
egr
eat
est
.
Themaxi
mum dev
iat
ioni
satpoi
ntwer
ethedi
stancesbet
weent
wocur
vei
sthel
argest
.
Thi
sisatpoi
ntwher
eMR=MC,whi
chi
sMRP=W =MCL atl
aborut
il
izat
ioni
sequalt
o
ei
ght(
seet
abl
eabov
e).

TheVMPLappr
oach
Thesuppl
yofl
abort
othei
ndi
vi
dualf
ir
mist
hest
rai
ghtl
i
nesequalt
ogi
venwager
atef
or
compet
it
ivef
ir
[Link]
l
ibr
ium i
swher
etheVMPLi
nter
sectt
hesuppl
ySL=[Link]
ding
t
oourdat
a,t
hisoccur
satwager
ate,$40andl
aborempl
oymentequal
sto8.(
SeeTabl
e
xx)
.Underbot
happr
oachpr
ofi
tismaxi
mi he8th l
zedatt evelofempl
oymentwher
eW =
VMPL.

Exampl
e
Supposecer
tai
nhy
pot
het
ical
fir
m hasaCobb–Dougl
aspr
oduct
ionf
unct
ionf
orCanadi
an
t
hreadmi
l
lisspeci
fedQ=[Link]
i urt
hert
hatmi
l
l’
scapi
tal
,K,
isf
ixedat32uni
ts,
l
abori
sonl
yvar
iabl
einput
.Det
ermi
ne,
MPPL,
VMPL,
andpr
ofi
tmaxi
mizi
ngl
evel
ofout
put
?

Sol
uti
on:
F=L0.6k0.2 = L0.6( 0.
2
32) =2L0.6,
thenext
ral
evelofout
putorMPPLcanbedet
ermi
nedby
l
ooki
ngt
heext
raout
putf
rom t
hel
astwor
kerwhenf
ir
m’sgoesf
rom 31t
o32wor
ker
sis
2x320.6)–(
2x310.6)
0.
3
F=( .TheVMPLatt
hispoi
nti
s VMPL=MPPLxW=0.
3x5=1.
5.
Thef
ir
m cansel
li
tsout
putat$50peruni
t,t
hef
ir
m’sMRP1=PxMPL=$50x0.
3=$15
Thus,whent
hepr
icei
s$50andwagei
s15,att
hisl
evelt
hef
ir
m hi
res32wor
ker
[Link]
e
gener
all
y,t
hemar
ginalpr
oductofl
aborf
unct
ion,whenwehol
dcapi
talf
ixedatk=32,i
s
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 116
2L–[Link]
MPL=1. sisobt
ainedbyhol
dingcapi
talf
ixedatk=32anddi
ff
erent
iat
ingt
he
shor
trunpr
oduct
ionf
unct
i f=2L0.6wi
on, thr
espectt
olabor
:

MPL= 6x2x20.6-L=1-
=0. 2L-0.4

Theabov
ecal
cul
atormet
hodf
ordi
scr
etechangef
rom 31t
o32wor
ker
scanbestbe
est
imat
edbyi
nfi
nit
esi
mal
l
ysmal
lchangei
nlabor
.Wecanf
indMPLatL=32i
sexact
ly0.
3
-0.
4
=1.
2(32)
_
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___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
4.
[Link]
ivi
ty
[Link]
vent
heabov
eexampl
eofCanadi
anmi
l
l,whatwi
l
lbet
heVMPLandMPP1whencapi
tal
i
sfi
xedatK=35?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

4.
[Link]
RM FORSEVERALVARI
ABLEFACTORS

Supposet
henowt
hatt
hef
ir
m usesmor
ethanonev
ari
abl
[Link]
sthedemandcur
vef
or
f
act
orofpr
oduct
ion?Doy
out
hinkVMPL i
sdemandcur
vef
orl
abor
?Unl
i
ket
hecaseofone
Var
iabl
e,t
heVMPLi
snotl
ongerdemandcur
vef
ort
hesev
eralv
ari
abl
efact
orsofpr
oduct
ion.
Becausewhent
hemanyv
ari
edf
act
orsar
eusedt
oget
heri
npr
oduct
ionchangei
npr
iceof
onef
act
orl
eadt
ochangei
nempl
oymentoft
heot
herf
act
orofpr
oduct
ion. Changei
n
empl
oyment
sofot
herf
act
ori
ntur
nshi
ft
stheMPPcur
veofi
nput
swhosepr
icei
nit
ial
l
y
changedast
hepr
oduct
ivi
tyofagi
venl
abori
snott
hesamewheni
tisassoci
atedwi
th
di
ff
erentl
evel
soff
act
orssuchascapi
tal
.

Consi
dert
hecaseoft
wov
ari
abl
einput
s:l
aborandcapi
tal
.Thef
ir
m wi
l
lempl
oyl
aborand
capi
talt
othepoi
ntwher
ethev
alueoft
hemar
ginalpr
oductofeachf
act
ori
sequalt
othe
pr
icesoft
hef
act
ors.I
fthei
nput
sar
eindependent
,achangei
nthequant
it
yofonei
nputhas
noef
fectont
hemar
ginalpr
oductoft
heot
her
;thedemandcur
vesf
oreachf
act
orcanbe
der
ivedsepar
atel
yasi
tisdonef
orl
abor
.
Thus: Val
ueofmar
ginal
productofl
abor (
VMP)L=(
MP)L.
Po=PL
Val
ueofmar
ginal
productofl
abor (
VMP)K=(
MP)K.
Po=PK
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 117
ECON102MI
CROECONOMI
CSI
I

Howev
er,t
hedemandf
oronef
act
ordependsont
henat
ureoft
her
elat
ionshi
pbet
weent
he
i
nput
[Link]
het
imesi
nput
sar
ecompl
ement
arysot
hatt
hemar
ginalpr
oduct
ofonei
nputi
ncr
easeswi
thhi
gherempl
oymentoft
heot
heri
nput
[Link]
ginalpr
oductof
l
aborf
oreachuni
tofl
abor
,fori
nst
ances,i
ncr
easeswi
thal
argerquant
it
yempl
oyedoft
he
compl
ement
aryi
nput
ssuchmor
etool
sandmachi
ner
y.

Toseet
hispoi
ntcl
ear
ly,consi
dert
hei
mpactofadecl
i
nei
nthewager
atet
hatmakest
he
f
ir
m hi
remor
elabor
.Thel
owerwagecausest
hemar
ginalcostt
ofal
l
ssot
hatt
hef
ir
m
expandsout
put
.Ast
hef
ir
mtr
iest
oexpandout
putbyi
ncr
easi
ngempl
oymentofl
abor
,itwi
l
l
pr
obabl
ynecessar
ytohi
remor
ecapi
tal
.Wi
thcapi
talusagei
ncr
eases,t
heVMPcur
veof
capi
talandt
hedemandf
orl
aborcur
veshi
ftt
other
ight
,incl
udi
ngaf
urt
heri
ncr
easei
nthe
quant
it
yofl
aborempl
[Link]
esul
ti
ngdemandcur
vef
orl
aborl
ooksl
i
ket
heoneshown
byf
igur
exxwi
thdot
tedl
i
ne. Poi
ntAal
sol
i
esoncur
veVMPL -i
nit
ialmar
ginalr
evenue
pr
oductcur
vef
ori
nputcombi
nat
ionassoci
atedwi
thi
tspr
ice.I
tsv
eryconst
ruct
ionassumes
t
hatt
heempl
oymentofot
heri
nput
sisf
ixed,andi
twoul
dbedemandcur
vesf
orl
abori
f
noneofot
herf
act
orswer
evar
iabl
[Link]
ert
hel
ess,whatwoul
dhappenwhent
hepr
iceof
l
abordecl
i
net
o$6andot
heri
nput
swer
evar
iabl
e? Themar
ginalr
evenuepr
oductofl
abor
now exceedsi
tsnew pr
icesandt
hef
ir
m expandsl
aborempl
oyment
.Howev
er,i
ncr
easi
ng
empl
oymentofl
aborwoul
dshi
ftt
hemar
ginalr
evenuepr
oductofot
herf
act
orf
rom K=10t
o
K=15.

Thesechangef
urt
heri
ncr
easet
hel
aborandt
hesy
stem [Link]
teral
loft
hesechanges
hav
ewor
kedt
hei
rwayt
hrought
hef
ir
m'scostmi
nimi
zat
iondeci
sionsy
stem,
thef
ir
m woul
d
beonadi
ff
erentmar
ginalr
evenuepr
oductofl
abor
-(VMPL)
*.Nowt
heempl
oymentofl
abor
woul
dbedet
ermi
nedbyt
hepoi
ntwher
eit
snewmar
ginalr
evenuepr
oductcur
vei
nter
sect
s.
Thef
ir
m nowdemandsabout200l
aborwi
thwager
ate$[Link]
sindi
cat
edbyPoi
ntCl
i
eson
cur
ve(
VMPL)
*-t
hemar
ginalr
evenuepr
oductcur
vef
orandi
nputcombi
nat
ionassoci
ated
wi
thhi
gherpr
[Link]
esul
t,wecanbesur
ethatpoi
ntsAandcwoul
dbot
hli
eont
he
f
ir
m'sdemandcur
vef
ori
nput(
labor
).Ot
herpoi
ntsf
orot
herpr
icescoul
dbedet
ermi
nedi
na
si
mil
arf
ashi
[Link]
esul
toft
hedet
ermi
nat
ioni
sthedemandcur
vef
orl
abor
.Thi
sdemand
cur
vei
srepr
esent
edi
nfi
gur
e4.
5bycur
veDL,
aswoul
dbeexpect
edi
tcanbeshownt
hatal
l
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 118
demandcur
vesoft
hist
ypessl
opedownandt
other
ight
.

Wage VMPL
rat
e VMPL*

A
1
C
6
DL=demand

K=15
K=10

O Numberof
100 200
wor
ker
(
peruni
tof
Finger4.5:
demandf
orl
aboral
l
owi
ngf
orchangesi
nthe
capital

Al
ter
nat
ivel
y,Whent
her
ear
evar
iesf
act
orsar
eusedt
oget
heri
npr
oduct
ion;t
hedemand
cur
vef
orl
abori
sder
ivedusi
ngI
so-
quantanal
ysi
[Link]
shasbeendi
scussedi
noneoft
he
pr
evi
ouschapt
[Link]
nthewager
atehasi
ngener
alt
hreeef
fect
s:
Subst
it
uti
onef
fect
s
Out
putef
fect
s(i
ncomeef
fectorsal
esef
fect
s)
Pr
ofi
tmaxi
mizi
ngef
fect
Thi
scanbepr
esent
edusi
ngsi
mpl
i
fieddi
agr
am 4.
[Link]
hati
nit
ial
l
ythef
ir
m pr
oduces
t
hepr
ofi
tmaxi
mizi
ngout
putx,
wit
hthecombi
nat
ionoff
act
orK,
L,gi
vent
he(
ini
ti
al)f
act
ors
pr
icesw1andr
1,whoser
ati
odef
ines,
thesl
opeoft
heI
so-
costl
i
neAB.

Supposewager
atef
all
stow2,
sot
hatt
heI
so-
costl
i
neAB(
thepr
icesofcapi
talr
emai
nst
he
same)shi
ft
edt
oAB*ast
her
ati
[Link]
ir
m usi
ngt
hesameexpendi
tur
ecannow
pr
oducet
enhi
gherout
putdenot
edbyt
heI
so-
quantX2,usi
ngK2,L2 amountofcapi
taland
l
aborr
espect
ivel
[Link]
l
ibr
ium mov
esf
rom poi
nte1t
[Link]
ementcanbespl
i
ted
i
ntot
wosepar
ateef
fect
s:
subst
it
uti
onef
fect
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 119
ECON102MI
CROECONOMI
CSI
I

Out
putef
fect

K2 e2
K
K1 e1
a X2
X1

L1 L2 B B
L*
1

Fi
gure4.
6:Der
ivat
ionofdemandcur
veforvari
abl
e
Tose
i
np
pa
ur
at
t et
hetwoef fectdr
awanIso-
costparal
l
eltot
henewoneAB*sot
hati
tref
lect
s
t
henewpr
icesr
ati
o,butt
angentt
otheol
dIso-
[Link]
angencyoccur
satpoi
nt‘
a’
.The
mov
ementf
rom poi
nt'
e’
,to'
a'al
ongol
dIso-
quanti
spur
esubst
it
uti
onef
fectt
hatshowt
he
cheaperl
aborsubst
it
utedf
orcapi
tal
.Thus,t
heempl
oymentofl
abori
ncr
easesf
rom L1 t
o
L1*
.But
,ast
hef
ir
m canbuymor
elaborandcapi
talwi
tht
hesameexpendi
tur
e,i
tcan
pr
oducet
hehi
gherout
putX2,empl
oyi
ngK2 ofcapi
talandL2 ofl
abor
. Thei
ncr
easeof
empl
oymentf
rom L1*t
oL2,
cor
respondi
ngt
hemov
ementf
rom '
a't
o'e2',
ist
heout
putef
fect
.

Poi
nt'
e2'i
snott
hef
inalequi
l
ibr
ium oft
hef
ir
m.I
twoul
dbei
tthef
ir
m wer
etospendt
he
sameamountofmanyasi
nit
ial
l
[Link]
er,keepi
ngt
het
otalcostexpendi
tur
econst
ant
doesnotmaxi
mizet
hepr
ofi
toft
hef
ir
m. Thef
ir
m wi
l
lincr
easei
tsexpendi
tur
eandi
ts
out
puti
nor
dert
omaxi
mizei
tspr
ofi
[Link]
standt
hisl
etusassumet
hatt
hei
nit
ial
equi
l
ibr
ium oft
hef
ir
misdenot
edbypoi
ntHi
nfi
gur
exxwher
ethef
ir
m’sMCi
sequalt
othe
pr
[Link]
alli
nthewager
ateshi
ft
stheMCcur
vedownwar
dst
other
ight
,andt
he
pr
ofi
tmaxi
mizi
ngout
putoft
heper
fect
lycompet
it
ivef
ir
mincr
easest
[Link]
srequi
resan
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 120
i
ncr
easei
nexpendi
tur
eequal
tot
heshadedar
eaX1HGX3.

PX
MC
1 MC
1

H G
PX

X
O
X1 X3

Fi
gur
e4.
7:Ef
fectofi
ncr
easei
nexpendi
tur
e

Thi
s,I
so-
costl
i
neAB*mustshi
ftoutwar
ds,
par
all
elt
oit
sel
fatadi
stancecor
respondi
ngt
o
t
hei
ncr
easei
nthef
ir
msout
lay
s(seef
igur
e4.
8bel
ow)
. Act
ual
l
ythenew I
so-
costcanbe
det
ermi
nedbydi
vi
dingt
hei
ncr
ease(
addi
ti
on)i
ntot
alcostbypr
iceofcapi
tal
,r,andaddi
ng
t
her
esul
ttot
hedi
[Link]
nt'
A’,ont
hev
ert
icalaxi
sist
hev
ert
icali
nter
cept
oft
her
equi
redI
so-
costandpar
all
elt
oAB’
anewI
socostl
i
neA*
B*.Thef
inalequi
l
ibr
ium of
t
hef
ir
m wi
l
lbedenot
edbyt
hepoi
ntoft
angencyoft
henewI
so-
costA*
B*wi
tht
heI
so-
quant
denot
ingt
hepr
ofi
t-
maxi
mizi putXXate3off
ngout igur
e4.
8.

A
*

e3
K2
e2 X
K1 e1 *
a X2
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 121
X1
ECON102MI
CROECONOMI
CSI
I

I
nsum,
thesubst
it
uti
onef
fectofadecr
easei
nthewager
atecausesadecr
easei
ntheMPP,
ev
en t
hought
,the out
putef
fectand pr
ofi
tmaxi
mizi
ng ef
fectr
esul
tin an i
ncr
eased
empl
oymentofbot
hinput
[Link]
woef
fect
sex
ceedst
hef
ormeronehencet
heMPPLcur
ve
shi
ftout
war
d.

Gi
vent
hepr
icesoft
hef
inalcommodi
ty,
Px,
theVMPLshi
ftt
other
ightwhensev
eralv
ari
abl
e
f
act
orsar
eusedi
nthepr
oduct
ionpr
[Link]
l
ibr
ium demandf
orl
abori
sthen
denot
edbypoi
[Link]
epeat
ingt
heabov
eanal
ysi
swi
thdi
ff
erentwager
ateswe
cangener
ateaser
iesofpoi
ntsuchasA,
[Link]
ocusoft
hesepoi
ntsi
sthedemand
f
orl
aborbyt
hef
ir
m whensev
eral
fact
orsar
evar
iabl
e.(
Seef
igur
e4.
9bel
ow)

Thi
slongr
undemandf
oraf
act
ori
snegat
ivel
ysl
opedast
het
hreeef
fectofani
nput-
pri
ces
changemustcausequant
it
ydemandedoft
hef
act
ort
ovar
yinv
ersel
ywi
thpr
ices.

w A

w B
VMPL

w NIVERSITY,DEPARTMENTOFECONOMICS C
ADAMAU
VMPL 122

VMPL d1
Thi
sissomewhatt
hedemandf
orf
act
orsi
nthel
ongr
unwhenal
lfact
orscanv
arybecause
ofadj
ust
ment
soft
hest
ruct
ureofpr
oduct
ion.
_
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___
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___
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___
___
___
___
___
___
___
___
___
___
___
___
___
___
_
4.
[Link]
ivi
ty:
AssumeCoca-
Col
aCompanyusesl
abor
,capi
tal
andl
andasf
act
orsofpr
oduct
ion:
laborand
capi
talar
erel
ati
vel
yvar
iabl
efact
orswher
easl
andi
sfi
xedf
act
orofpr
oduct
[Link]
ther
mor
e,t
hedemandf
orf
act
orsar
ebasedont
hemar
ginalpr
oductoft
hef
act
or(
MPPLand
MPPK)and t
hepr
iceoft
hepr
oduct(
P)and i
nput
s(w and r
). Based on t
heabov
e
i
nfor
mat
ionder
ivet
hedemandcur
vef
orl
aborusi
ngt
heI
s-costl
i
net
heor
ydi
scussedabov
e?
_
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_

4.
[Link]

Hav
ingder
ivedt
hei
ndi
vi
dualf
ir
msdemandf
ori
nput
s,t
henextst
epi
stoder
ivemar
ket
demand cur
vef
oran i
nput
.Recal
lhow we der
ived a mar
ketdemand cur
vef
ora
commodi
tyi
npr
evi
oussect
[Link]
izont
all
yov
ert
hedemandcur
vesof
i
ndi
vi
dualconsumer
soft
hecommodi
[Link]
out
hinkwecanappl
ythesamet
echni
quet
o
dr
ivemar
keti
nputdemand?

Al
thought
hesepr
ovi
deaf
ir
stappr
oxi
mat
ion,i
twoul
dnoty
iel
dthecor
rectr
esul
tbecause
i
twoul
dnegl
ectt
heef
fectofchangesi
nthei
nputpr
icesont
hepr
oductpr
[Link]
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 123
ECON102MI
CROECONOMI
CSI
I

i
nst
ances,ast
hepr
icesoft
hei
nputf
all
sal
lfi
rmswi
l
lseekt
oempl
oymor
eoft
hisf
act
or
andexpandt
hei
rout
put
.Thus,
thesuppl
yoft
hecommodi
tyshi
ft
sdownwar
dst
other
ight
s,
l
eadi
ngt
oaf
alli
nthepr
iceofcommodi
ty,
[Link]
ncet
hesepr
icesi
soneoft
hecomponent
s
oft
hedemandcur
vesoft
hei
ndi
vi
dualf
ir
msf
ort
hef
act
or,t
hesecur
vesshi
ftdownwar
d
t
othel
eft
.

Asi
nput
ssuchasl
aborar
eusedi
nmanyout
putmar
ket
s,t
hus,t
oder
ivet
hemar
ket
demandcur
vef
orl
abor
,wef
ir
stdet
ermi
net
hel
abordemandcur
vef
oreachout
putmar
ket
andt
hensum acr
ossout
putmar
ket
stoobt
aint
hef
act
ormar
ketdemandcur
ve.

Mar
ketdemandf
or
w
d1 Marketdemandf
or
d2
a fact
ors
w1=2 A
hadPbeenconst
ant

b b1 B
w2=10 B1

MR
L1 L2 L’
2
L1 L2 L’
21

Fi
gure4.
10A:
Demandcur
veofasi
ngl
e Figure4.
10B:Mar
ketdemandcur
ve
fi
rm forlabor

Ear
li
erweder
ivedt
hef
act
ordemandofacompet
it
ivef
ir
mthatt
heout
putmar
ketpr
ice
dependsont
hef
act
or’
spr
[Link]
hef
act
or’
spr
icef
all
s,eachf
ir
m,t
aki
ngt
heor
igi
nal
mar
ketpr
icesasgi
ven,usesmor
eoft
hef
act
orst
opr
oducemor
eout
put
.Thi
sext
ra
pr
oduct
ionbyal
lthef
ir
msi
nthemar
ketcausest
hemar
ketpr
icest
ofal
l
.Ast
hemar
ket
pr
icef
all
s,eachf
ir
mreducesi
tsout
putandhencei
tsdemandf
ort
hei
nput
.Thusaf
alli
n
i
nputpr
icecausesl
essofani
ncr
easei
nfact
ordemandt
hanwoul
doccuri
fthemar
ket
pr
icer
emai
nedconst
ant
.Thi
scanbei
l
lust
rat
edwi
thf
igur
e4.
10.I
nit
ial
l
ysupposet
he
wager
atei
sw1 (
e.g.w1 =25)andout
putmar
ketpr
icesPx(
e.g.Px1 =9Bi
rr
).Thef
ir
misat
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 124
poi
nt'
a'oni
tsdemandcur
veandempl
oysL1uni
tsofl
abor
.

Summi
ngov
eral
lempl
oyi
ngf
ir
ms,weobt
aint
het
otaldemandf
ort
hei
nputatwager
ate
[Link]
hatt
hewager
atedecl
i
nest
ow2 (
w2 =10)
.Ot
hert
hingbei
ngequal
,the
f
ir
m woul
dmov
eal
ongi
tsdemandcur
ved1,t ntb1,i
opoi ncr
easi
ngt
heempl
oyedl
abort
o
L’
2becausecostdecl
i
net
hatmot
ivat
efi
rmt
opr
oducemor
[Link]
esul
tofmor
eout
put
,
t
hepr
iceofpr
oductdecl
i
ne,t
hati
ntur
nleadst
odecl
i
nei
nempl
oymentandl
essdemand
f
ori
nput
[Link]
ginalr
evenuepr
oductofl
abordecl
i
neandhav
einwar
dshi
ftofdemand
cur
vef
orl
abor
.

Theequi
l
ibr
ium undernew wager
atei ntb1,butatpoi
snotatpoi ntbonnew demand
cur
[Link]
nghor
izont
all
yov
eral
lfi
rmsweobt
ainpoi
ntBofmar
ketdemandcur
ve.I
f
t
hef
alloft
hecommodi
ty–pr
icewasnott
akeni
ntoaccount
,wewoul
dbel
edt
oan
ov
erest
imat
ionoft
hedemandf
orl
aborf
oll
owi
ngadecl
i
nei
nwager
[Link]
sindi
cat
edby
poi
ntB'oft
hef
igur
e4.
10-(
b).Thust
hemar
ketdemandcur
vef
orl
abori
sshownbyt
he
l
i
neABr
athert
hanAB'
.

Thi
slong r
un demand f
ora f
act
ori
s negat
ivel
y sl
oped as t
he t
hree ef
fect
s ofan
i
nput
–pr
iceschangemustcausequant
it
ydemandedoft
hef
act
ort
ovar
yinv
ersel
ywi
th
pr
ices.
_
___
___
___
___
___
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___
_
4.
[Link]
ivi
ty

Di
scusswhatdot
hedemandf
orl
abori
nthel
ongr
unl
ookl
i
kewhenwager
ater
ises?

I
nsummar
y,t
hedet
ermi
nant
soft
hedemandf
orav
ari
abl
efact
orbyi
ndi
vi
dualf
ir
m depend
on:
Thepr
icesofi
nput
Themar
ginal
phy
sical
productoft
hef
act
or
Thepr
icesoft
hecommodi
typr
oducedbyt
he f
act
orasVMPL=Px’MPL
Theamountofot
herf
act
orswhi
char
ecombi
newi
thl
abor(
[Link]
tal
)
Technol
ogi
cal
progr
essasi
tchangest
heMPPofal
li
nput
sandhencet
hei
rdemand,
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 125
ECON102MI
CROECONOMI
CSI
I

Wehav
eder
ivedt
hedemandcur
vef
ort
hei
ndi
vi
dual
sandt
hemar
ket
.Thenextt
hingt
obe
done i
s der
ivi
ng t
he cor
respondi
ng i
ndi
vi
dualas wel
las mar
ketsuppl
y ofunder
compet
it
ivemar
ketst
ruct
urei
nsuchawayt
hatweseet
hemar
ketequi
l
ibr
ium.

4.
[Link]
NPERFECTLYCOMPETI
TIVEMARKET

Thesuppl
yofl
abort
othemar
ketdependsondi
ff
erentf
act
[Link]
hesear
e:-
Thepr
icesofl
abor(
wager
ate)
Thet
ast
esofconsumer
s(t
hatdef
inest
rade-of
fbet
weenl
eisur
eandwor
k)
Thesi
zeoft
hepopul
ati
on
Thel
abor-f
orcepar
ti
ci
pat
ionr
ate
Theoccupat
ional
,educat
ional
andgeogr
aphi
cdi
str
ibut
ionoft
hel
aborf
orces

Ther
elat
ionbet
weent
hesuppl
yofl
aborandt
hewager
atedef
inest
hesuppl
ycur
[Link]
ot
herf
act
orscanbeconsi
der
edasshi
ftf
act
orsoft
hesuppl
ycur
[Link]
eint
erest
ed
i
nthesuppl
ycur
ve,weassumeal
lot
herf
act
orsasgi
[Link]
i
kef
ort
hesuppl
yof
commodi
tyi
npr
oductmar
ket
,themar
ketsuppl
yforf
act
orsi
sthesuppl
yofl
aborby
i
ndi
vi
dual
[Link],webegi
nbyt
heder
ivat
ionofsuppl
yofl
aborbyasi
ngl
eindi
vi
dualand
t
hent
hatofmar
ket
.

4.
4.1.
THESUPPLYOFLABORBYANI
NDI
VIDUAL

Foror
dinar
yrat
ionaleconomi
cagent
,hi
ghert
hepr
iceofi
nputi
srequi
redt
oincr
easet
he
quant
it
yofi
nputwi
l
li
ngl
ysuppl
i
[Link]
ndi
vi
duall
aborf
acewi
thcer
tai
nconst
rai
nt
especi
all
yrel
atedt
othet
imeav
ail
abl
efort
heagent
. Thi
stakeust
othet
heor
yof
consumerpr
efer
encecov
eredi
nmodul
eoneoft
hecour
[Link]
ndi
vi
dualeconomi
cagent
hasonl
y24hourwi
thadayandt
endt
oal
l
ocat
ehi
s/hert
imef
orwor
kandf
orl
eisur
ewhi
ch
i
ntur
naf
fectt
hesuppl
yofl
aborf
orwor
[Link]
ivet
hesuppl
ycur
veusi
ngt
hist
heor
y.

Hence,t
hesuppl
yofl
aborbyani
ndi
vi
dualcanbeder
ivedbyi
ndi
ff
erencecur
vesanal
ysi
s.
A si
mpl
econsumerchoi
cepr
obl
em i
sbet
weent
wo goods“
incomef
rom wor
k”and
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 126
“
lei
sur
e”i
nthest
andar
dconsumerchoi
cespr
obl
[Link]
ndi
vi
duali
sassumedt
ohav
e
pr
efer
encesov
ert
het
wogoodst
hatcanbesummar
izedi
nthef
orm ofani
ndi
ff
erence
[Link]
yofl
abordi
rect
lyr
elat
edt
otheamountoft
imeani
ndi
vi
duali
swi
l
li
ngt
o
wor
k.

Theder
ivat
ioncanbei
l
lust
rat
edwi
thFi
gur
e4.
11onwhi
cht
hehor
izont
alaxi
smeasur
es
t
hehour
sav
ail
abl
eforl
eisur
e(andwor
k)ov
eragi
venper
iodoft
[Link]
e,t
her
e
ar
eOZmaxi
mum hour
sinaday
,whi
chani
ndi
vi
dualcanusef
orl
eisur
eorf
orwor
[Link]
he
v
ert
icalaxi
swemeasur
emoneyi
[Link]
opeofal
i
nef
rom Zt
oanypoi
ntt
othe
v
ert
icalaxi
srepr
esent
sthewageperhour
.Ift
hei
ndi
vi
dualwer
etowor
kal
ltheOZhour
s

andear
nat
otali
ncomeofOYo,
thewager
atewoul
dbe w= [
slopeofZYol
i
ne]
.

Thest
eepert
hel
i
neori
ndi
ff
erencecur
vest
hehi
ghert
hehour
lywager
ate.

Yo D’
w
C’ I
V
II
I w
B’
I
I
A” A’ w
I w

O
C DB A A”B”C”
D”
Fi
gur
e4.
11-
1;Theopt
imal
choi
ce Fi
gur
e4.
11-
2laborsuppl
ycur
ve
of oftheworkers

Forexampl
eoni
ndi
ff
erencecur
veI
,thei
ndi
vi
dual
isi
nequi
l
ibr
ium bywor
kingAZhour
s

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 127
ECON102MI
CROECONOMI
CSI
I

OA11)andgetwager
( ateW1.I
fthewager
atei
ncr
easest
oW2t
hei
ndi
vi
dualwi
l
lwor
kmor
e
hour
s(BZ>AZ)andwi
l
lear
nahi
gheri BB1)andwi
ncome( l
lhav
elesshour
s(OB)f
orl
eisur
e.
Theequi
l
ibr
ium att
hist
imei [Link]
satpoi mil
arl
ywhenwager
ater
iset
oW3,t
he
equi
l
ibr
ium becomeC1.

Asweknow f
rom consumerbehav
ior
,indi
vi
dualt
endt
o wor
kmor
ehour
saswage
i
ncr
easeupt
ocer
tai
npoi
[Link]
gherwager
atet
hehour
sof
fer
edf
orwor
kmay
decl
i
nebecauseofsomeot
herr
[Link]
gherwagecr
eat
esdi
sincent
ivesf
orl
onger
hour
sofwor
kaf
teracer
tai
npoi
[Link]
atesofpayr
eacheshi
ghl
evel
s,t
hei
ncomesof
suchi
ndi
vi
dual
smaybecomesohi
ght
hatt
heymaychooset
oreducet
heamountofwor
k
andt
heydor
athert
hani
ncr
easel
eisur
eti
[Link]
heset
hesuppl
yofl
abori
s
backwar
dbendi
ngcur
ve.

Ascanbeseenf
rom abov
edi
agr
am,i
fwager
atei
sincr
easedt
oW4,t
hei
ndi
vi
dualwi
l
l
wor
kBZhour
s,t
hesameaswager
ateW2.I
fthewager
atei
ncr
easesst
il
lfur
ther(
toW5 )
1

t
hehour
ssuppl
i
edf
orwor
kdecl
i
neev
enmor
e:Theydr
opbackt
[Link]
sissof
ort
he
f
actt
hatl
ongerwor
kinghour
simpl
i
esl
essl
eisur
ehour
[Link]
spat
ter
nofr
esponset
o
hi
gherwager
atespr
oducesabackwar
d–bendi
ngsuppl
ycur
vef
orl
[Link],t
he
suppl
yofl
aborcanbeobt
ainedf
rom t
hel
ocusoft
heequi
l
ibr
ium poi
ntA’
,B’
,C’
,D’
,et
c.
Thi
sisshownbyf
igur
e4.
11-
[Link]
atei
ncr
eases,t
hei
ndi
vi
dual
’
sincomer
ise,and
t
hisenabl
ethewor
kert
ohav
eshor
terl
eisur
eact
ivi
ti
es. Howev
er,t
het
imef
orsuch
act
ivi
ti
esi
[Link]
ondacer
tai
nlev
elofwager
ate,t
hesuppl
yofl
abordecr
easesas
wor
kerpr
efer
stousehi
sincomeonmor
einsur
esact
ivi
ti
es.

Thi
snat
ureofsuppl
ycur
veofl
abori
sther
esul
tofi
ncomeandsubst
it
uti
onef
fect
sthat
accompanyi
ncr
easesi
nthepr
icespai
dtol
abor
,thewager
[Link]
it
uti
onef
fect
suggest
sthataswagei
ncr
easepeopl
etendt
osubst
it
utet
hei
rlei
sur
eti
mebywor
king
mor
ehour
sandi
ncr
easest
heamountoft
imet
heywor
[Link]
heot
herhand,t
hei
ncome
ef
fectshowst
hatast
hepeopl
ear
eget
ti
nghi
gheri
ncomebecauseoft
hei
ncr
easesi
n
wager
ate,t
heper
sonf
eelweal
thi
erandst
art
stoenj
oymor
elei
sur
eti
mebycut
ti
nghi
s
l
aborsuppl
[Link]
it
uti
onandi
ncomeef
fectwor
kst
oget
her
.Atl
owerl
evel
ofempl
oymentt
hesubst
it
uti
onef
fectt
endst
obegr
eat
ert
hant
henegat
ivei
ncomeef
fect
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 128
sol
aborsuppl
ytendt
oincr
easeswi
thani
ncr
easesi
nwager
[Link]
adual
l
y,howev
er,t
he
negat
ivei
ncomeef
fectt
endst
odomi
nat
etheposi
ti
vesubst
it
uti
onef
fectandhence,
i
ndi
vi
dualr
educest
hei
rlaborsuppl
yifwager
atekeepsoni
ncr
easi
ngatt
hishi
ghwage
r
ate.
_
___
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___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
4.
[Link]
ivi
ty
How dot
hesubst
it
uti
onandi
ncomeef
fectoft
imeaf
fectt
hesuppl
yofl
abori
ndi
vi
dual
underper
fect
lycompet
it
ivemar
ket
?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
4.
[Link]
Al
thought
her
eisdi
sagr
eementoni
ndi
vi
dualbackwar
d bendi
ng l
aborsuppl
ypat
ter
n
amongeconomi
st,i
nshor
trunmar
ketsuppl
yofl
abormayhav
esegment
swi
thposi
ti
ve
andsegment
swi
thnegat
ivesl
[Link]
,inl
ongr
unt
hemar
ketsuppl
ymusthav
ea
posi
ti
vel
ysl
[Link],
mor
ewagei
sani
ncent
ivesf
ory
oungwor
ker
s,andchanget
he
j
[Link]
her
smai
ntai
nbackwor
d-bendi
ngsuppl
ycur
veaspeopl
etendt
osuppl
ymor
e
l
aborunt
ilt
hei
ncomer
eacht
hel
evelr
equi
redf
oracomf
ort
abl
est
andar
dofl
i
ving.I
t
seemst
hataposi
ti
veaggr
egat
esuppl
yofl
aborwor
kingener
alcase.

Justast
hemar
ketsuppl
ycur
vei
npr
oductmar
ket
scoul
dbedet
ermi
nedbysummi
ngt
he
quant
it
iesi
ndi
vi
dualf
ir
mswoul
dsuppl
yatv
ari
ouspr
ices/
wager
ate. Thi
sismai
nly
becauseanynegat
iveef
fectofani
ncr
easei
nwagecanbeof
fsat
ed,ast
heal
lindi
vi
dual
donotbehav
eint
hesomeway
.Thati
swhensomeone i
stendt
odecr
easet
hesuppl
yof
l
abort
heot
her
smayi
ncr
easet
hewi
l
li
ngnesst
osuppl
ythatmakest
hesuppl
ycur
ve
upwar
dsl
opi
ng.

4.
[Link]
LIBRI
UM PRI
CEANDEMPLOYMENTOFANI
NPUT

Themar
ketdemandandsuppl
ycur
vesofani
nputdet
ermi
net
hei
nput
sequi
l
ibr
ium pr
ice.
Thepr
iceofi
nputwi
l
ltendi
nequi
l
ibr
ium t
oset
tl
etot
hel
evelatwhi
cht
hequant
it
yoft
he
i
nputdemandedequal
sthequant
it
yoft
hei
nputsuppl
i
ed. Thi
sisi
ndi
cat
edbyusi
ng
f
igur
e4.
[Link]
spoi
ntB i
stheequi
l
ibr
ium posi
ti
onf
ori
nputmar
ketwi
thpr
iceoft
hei
nput
i
sPoandquant
it
yofi
nputQo.I
fthepr
iceswer
ehi
ghert
hanPo,
thent
hequant
it
ysuppl
i
ed
ADAMAUNI
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CS 129
ECON102MI
CROECONOMI
CSI
I

woul
dexceedt
hequant
it
ydemandedandt
her
ewoul
dbedownwor
dpr
essur
eont
he
pr
icesandv
icev
[Link],t
hemar
ketmodeli
sval
i
dfort
hedet
ermi
nat
ionoft
he
equi
l
ibr
ium pr
icesofacommodi
tyorpr
oduct
iver
esour
ces.

Pr
ices Demand
Suppl
y
BO
PO

Q Quant
it
yof
O

4.
[Link]
FCT
i
guO
rRP
e R
4.I
12C
:I
N
DeGI
t NI
er
miMPE
nat
iR
oFE
noC
fT
eL
qYC
ui
lbO
irMP
i
umE
pT
r
iI
T
cI
eVEMA
s R
andquKEt
anT
it
yof
inputs

Wehav
eseenhowpr
icesofi
nputar
edet
ermi
nedunderper
fect
lycompet
it
ivemar
ket
.The
nextst
epi
sthedet
ermi
nat
ionofi
nputpr
ici
ngunderi
mper
fectcompet
it
[Link]
woul
dthet
heor
ysayaboutacasei
nwhi
cht
her
ewasper
fectcompet
it
ioni
nthemar
ket
f
ori
nputbuti
mper
fectcompet
it
ion(
monopol
y,ol
i
gopol
y,monopol
i
sti
c,compet
it
ion)i
nthe
r
elev
antpr
oductmar
ket
?Thei
nputpr
iceunderi
mper
fect
ionsi
nthecommodi
tyandt
he
f
act
ormar
ket
sisdet
ermi
nedi
nthesamemannerast
hecaseofper
fect
lycompet
it
ive
mar
ket
[Link]
ydet
ermi
nest
hepr
icesoff
act
orandt
hel
evelofi
ts
empl
oymentt
hought
hedet
ermi
nant
sdi
ff
erf
rom per
fectmar
ket
.Fur
thermor
e,t
her
ear
e
di
ff
erentst
ruct
uresofmar
ketbasedont
hepowerofeconomi
cagenti
ntwomar
ket
s
(
productandi
nputmar
ket
).Ther
ear
efourknownsi
mpl
i
fiedmodel
sar
eundert
hese.
Thesear
e:

Model Pr
oductmar
ket Fact
ormar
ket
A Monopol
y Per
fect
lycompet
it
ive
B Monopol
y Monopsony
C Monopol
y Monopsony+uni
oni
zedl
aborsuppl
y
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 130
D Nomonopol
y Nomonopsonybutuni
oni
zedl
abor

Theabov
emodel
sar
eext
ensi
onoft
hemar
ginalpr
oduct
ivi
tyt
heor
yoff
act
orpr
ici
ngand
i
ncomedi
str
ibut
[Link]
l
lseeeachoft
hem i
ndomedet
ail
.

4.
6.1.
MODEL–A:MONOPOLI
STI
CPOWERI
NTHEPRODUCTMARKET

I
nthi
smodel
,weassumet
hatt
hef
ir
m hasmonopol
i
sti
cpoweri
nthepr
oductmar
ket
,
whi
l
ethef
act
ormar
keti
sper
fect
lycompet
it
[Link]
dforf
act
orpr
ici
ng under
per
fect
lycompet
it
ivepr
oductandf
act
ormar
ket
swewi
l
lanal
yzef
ir
sthow demandand
suppl
yofl
abori
sdet
ermi
[Link]
l
lseedet
ermi
nat
ionequi
l
ibr
ium f
act
orpr
iceand
empl
oyment
.Theanal
ysi
soff
ir
m’sdemandf
orl
abordi
ff
erswheni
tisasi
ngl
evar
iabl
e
f
act
orandwhent
her
ear
emanyv
ari
abl
efact
[Link]
l
lseeeachonedet
ail
independent
ly.

4.
6.1.
1Demandf
orasi
ngl
evar
iabl
efact
orbyamonopol
ist
icf
ir
m

Toi
l
lust
rat
ehow t
hef
act
orpr
icesar
edet
ermi
nedundert
hiscondi
ti
on,wemakesome
assumpt
[Link]:
[Link]
ir
m wi
thmonopol
i
sti
cpoweri
napr
oductmar
ket
.Recal
lhowt
hemar
ketdemandcur
ve
f
orout
putofaf
ir
m wi
thmonopol
ypowerbehav
esi
npr
oductmar
ket
.Wehav
esai
dthat
t
hedemandf
ort
hepr
oductoft
hef
ir
misdown-
war
dsl
opi
ngandt
hemar
ginal
rev
enuei
s
smal
l
ert
hant
hepr
iceatal
ll
evel
sofout
put
.
[Link]
rmi
nthemar
kett
hatt
hef
ir
m usesasi
ngl
evar
iabl
efact
or,l
abori
nper
fectmar
ket
.
Thesuppl
yofl
abort
othei
ndi
vi
dualf
ir
misper
fect
lyel
ast
icandt
hewager
atei
sgi
ven
ordet
ermi
nedbyt
hemar
ket
.

Undert
hesecondi
ti
onst
hedemandf
orl
aborbyani
ndi
vi
dualf
ir
misnott
heVMPL cur
ebut
mar
ginalr
evenuepr
oductcur
[Link]
l
lust
rat
etheder
ivat
ionoft
heMar
ginalRev
enue
Pr
oductofl
aborcur
ve,gr
aphi
cal
l
yusi
ngt
heexampl
eoft
hepr
evi
oussect
ion,wi
tht
he
di
ff
erencest
hatt
hepr
icesoft
hecommodi
typr
oduceddecl
i
nesasout
puti
ncr
eases.

Becauseoft
het
heor
yunder
lyi
ngt
hemonopol
i
stt
hepr
iceandmar
ginalr
evenuedi
ff
ers.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 131
ECON102MI
CROECONOMI
CSI
I

Ther
eisdi
ff
erencebet
weenVMPL(
=[Link])andMRPL(
=MPPL,MRx)
.Thef
ewdi
ff
ers,
due
t
othef
actt
hatPx>MRxatal
ll
evel
sofout
putandempl
oyment
,henceVMPL>MRPL. Except
t
hatbot
htheVMPL andMRPL hav
enegat
ivel
ysl
opedbecauset
hei
rcomponent
s(MPPL,Px,
MRx)decl
i
neasout
putexpandsandt
hepr
icesoft
hepr
oductf
all
s.

MR
W

VMPL=MPPL.
PL

MRPL=MPPL.
M

O O
MR dx X
L

Fi
gure4.13A:
Imper
fectpr
oduct Fi
gure4.13B:
per
fectf
act
or
market market

Thi
scanbeder
ivedal
gebr
aical
l
yasf
oll
owsbyf
ir
stder
ivi
ngpar
tsMRxandMPPL,
andt
hen
MRPLaswel
lasMRxf
rom t
otal
rev
enuef
unct
ion.
[Link]
hedemandf
unct
ionf
ort
hepr
oducti
ngener
ali
zedf
orm be Px=f
1(Qx)
.
Tot
alr
evenueoft
hef
ir
m’si
sTR=Px.
Qx t
hen,
Themar
ginal
rev
enuei
sobt
ainedbyt
aki
ngt
hef
ir
stor
derder
ivat
ivewi
thr
espectt
oQx

Or

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 132
MRx= Px+Qx.

[Link]
oduct
ionf
unct
ionwi
thl
aborast
heonl
yvar
iabl
efact
ori
s Qx=f
2(L)

Byt
aki
ngf
ir
stor
derder
ivat
ivewegetMPPL

[Link]
ginal
rev
enuepr
oductofl
abori
sthechangei
ntot
alr
evenueat
tr
ibut
etoauni
t

changei
nlaborMRPL=

Gi
venTR=Px,
Qx,
theder
ivat
iveoft
otal
rev
enuewi
thr
espectt
oLi
s

Or MRPL=

Butf
rom (
3) =MPPLandf
rom (
2)MRx

Ther
efor
e:MRPL=MPPL.
MRx

Thus,t
hepr
ofi
tmaxi
mizi
ngf
ir
m’st
hedemandf
orl
abori
smar
ginalr
evenuepr
oductcur
ve
ast
hedeci
siont
ohi
re ext
ral
abori
sbasedont
headdi
ti
onalr
evenuei
tgener
ate..The
suppl
yofl
abort
othei
ndi
vi
dualf
ir
misper
fect
lyel
ast
icshownbyhor
izont
all
i
[Link],
t
heequi
l
ibr
ium i
sdet
ermi
nedbyt
hei
nter
act
ionoft
het
wo(
demandandsuppl
y)l
i
ket
hatof
compet
it
ivemar
ket
. Theequi
l
ibr
ium i
satpoi
nt‘
e’whenMRPL=MCL=W wi
th‘
L‘l
evelof
empl
oyment
.Tot
hel
eftof‘
e’auni
tofl
aboraddsmor
etot
her
evenueoft
hef
ir
mthant
he
amountofi
tscost
:hencei
tpay
sthef
ir
mtoi
ncr
easei
tsempl
oyment
.Conv
ersel
yatany
poi
ntt
other
ightof‘
e’anaddi
ti
onaluni
tofl
aboraddsmor
etot
otalcostt
hant
otot
al
r
[Link],
fir
m empl
oyl
aborupt
othepoi
ntofequal
i
ty.

e
w SL

MRPL
ADAMAUNI
O
VERSI
TYDEPARTMENTOFECONOMI
CS 133
ECON102MI
CROECONOMI
CSI
I

L1

Fi
gur
e4.
14:
Det
ermi
nat
ionofequi
l
ibr
ium

For
mal
der
ivat
ionoft
heequi
l
ibr
ium oft
hemonopol
i
sti
cfi
rmi
sasf
oll
ows;

Thef
ir
m want
stomaxi
mizei
tspr
ofi
t

Gi
venPx:f
1(Qx) andQx=f
2(L)

Thef
istor
dercondi
ti
onf
or maxi
sthatt
heder
ivat
iveof w.
r.
tisequal
tozer
o

-
W=0

Rear
rangi
ngweobt
ain =w

Wehav
eshownt
hat and =MRx

Ther
efor
e

(
MPPL)
,(Px) =W wher
eMRx,Px

Thi
sshowst
her
elat
ionsamongcommodi
typr
ice,
fact
orpr
ice,
elast
ici
tyofdemandandt
he
pr
oduct
ionf
unct
ions.

4.
6.1.
[Link]
ABLEFACTORBYAMONOPOLI
STI
CFI
RM UNDERSEVERAL
FACTORS

Unl
i
ket
hecaseofonev
ari
abl
e,mar
ginal
-r
evenuepr
oductcur
vei
snotdemandcur
ve,f
or
sev
eralv
ari
abl
ecase,r
athert
hedemandcur
vei
sfor
medf
rom poi
ntsonshi
ft
ingMRP
cur
[Link]
ysi
sissi
mil
art
othatoft
hepr
evi
oussect
ionst
hecaseofper
fect
ly
compet
it
ivemar
ket
.Supposet
hatt
hemar
ketpr
iceofl
abori
sw1 wi
thMRP1 (
seef
igur
e

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 134
4.
15)
.Themonopol
i
sti
cfi
rmi
sinequi
l
ibr
ium atpoi
ntA,empl
oyi
ngL1 uni
tsofl
abor
.Ift
he
wager
atef
allt
ow2 t
hef
ir
m woul
dmov
eal
ongi
tsMRP2,cur
vet
opoi
ntA’
,i
fot
hert
hings
r
emai
nedconst
ant
.Howev
er,t
hef
alli
nwager
atehast
hreeef
fect
s(subst
it
uti
on,out
put
andpr
ofi
t–maxi
mizi
ngef
fect
s)t
hatr
esul
tinshi
ftoft
hemar
ginalr
evenuepr
oducecur
vet
o
t
her
ightwhi
chal
sol
eadequi
l
ibr
ium poi
ntt
[Link]
mil
aranal
ogyonecander
iveot
her
poi
ntofequi
l
ibr
[Link]
ingpoi
ntssuchasAandBatv
ari
ousl
evelof'
w'weobt
aint
he
demandcur
veofl
abor
.Fr
om ouranal
ysi
sonecanconcl
udet
hatt
hedemandcur
vesof
i
nput
sar
enegat
ivel
ysl
opedi
rr
espect
iveoft
hecondi
ti
onofcompet
it
ioni
nthepr
oduct
mar
ket
.

MRPL
A
w1 SL1

A’ B
w SL2

MRP1 MRP2
O L

Figur
e4.15:Demandcur
vewhent
her
ear
esev
eral
vari
ablesi
nputs

4.
6.1.
3Themar
ketdemandf
orandsuppl
yofl
abor

Themar
ketdemandf
oraf
act
ori
sder
ivedi
nthesamewayasi
nthecaseofper
fect
ly
compet
it
ive mar
ket f
rom t
he summat
ion of t
he demand cur
ves of t
he i
ndi
vi
dual
monopol
i
sti
cfi
rms.I
naggr
egat
ingt
hesecur
ves,wemustt
akei
ntoaccountt
hei
rshi
ftas
t
hepr
iceoft
hef
act
orsf
all
s:asal
lmonopol
i
sti
cfi
rmsexpandt
hei
rout
put
,themar
ketpr
ice
f
all
s. Thei
ndi
vi
dualdemandcur
veandt
hemar
ginalr
evenueAsopposedt
ocompet
it
ivem
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 135
ECON102MI
CROECONOMI
CSI
I

cur
vef
ort
hecommodi
typr
oducedshi
ftt
othel
eft
.Gr
aphi
cal
l
y,t
heder
ivat
ionofdemand
cur
vei
sexact
lyt
hesameasper
fect
lycompet
it
ivemar
ket
.

Themar
ketpr
icef
ort
hef
act
ori
sdet
ermi
nedbyt
hemar
ketdemandandsuppl
y,j
ustl
i
ke
t
hatofper
fect
lycompet
it
ivemar
ket
.Thedi
ff
erencewast
hatt
hef
igur
eisbasedont
he
MRPL andnotonVMPL. Thi
smeanst
hatwhent
hef
ir
m hasamonopol
i
sti
cpower
,the
f
act
orsar
epai
dtheMRPLwhi
chi
ssmal
l
ert
hanVMPLast
heMRPLi
sthemar
ketdemandf
or
i
mper
fectmar
ketandMRPL <[Link]
sef
fecthasbeencal
l
edmonopol
i
sti
cexpl
oit
ati
on
byRobi
nson. Thi
sisi
ndi
cat
ed byf
igur
e 4.
16 (
a).Monopol
i
sti
c expl
oit
ati
on say
sa
pr
oduct
ivef
act
ori
sexpl
oit
edi
fiti
spai
dapr
icel
esst
hant
hev
alueofi
tsmar
ginalpr
oduct
(
VMP)
.

Mar
ketdemandf
or
w Marketdemandf
or
d1
d2 fact
ors
a
w1=2 A hadPbeenconst
ant

b b1 B
w2=10 B1

MR
L1 L2 L’
2
L1 L2 L’
21

Fi
gur
e4.
16A:
Demandcur
veofa Fi
gure4.
16B:Mar
ketdemand
si
ngl
efi
rm cur
veforl
abor

Butt
hemar
ketsuppl
yisnotaf
fect
edbyt
hef
actt
hatf
ir
mshav
emonopol
i
sti
cpower
.Thus,
t
hemar
ketsuppl
yofl
abori
sthesummat
ionoft
hesuppl
ycur
veofi
ndi
vi
dual
sasder
ived
ear
li
[Link]
l
ibr
ium i
sdet
ermi
nedbyt
hei
nter
act
ionofsuppl
[Link],t
he
anal
ysi
sist
hesame,butt
her
eisani
mpor
tantdi
ff
erencei
sthatt
hemar
ketdemandi
s
basedont
hemar
ginalr
evenuepr
oductoft
hef
act
orsnotonv
alueonmar
ginalpr
oductof
f
act
ors.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 136
Thi
scanbeder
ivedal
gebr
aical
l
y.
Foraper
fect
lycompet
it
ivef
ir
m
VMPL=MRPL
BecauseVMPL=[Link]=MPPL.
MR,
Px=MRx sot
hatVMPL=MRPL
Butf
ormonopol
i
stPx>MRx sot
hatVMPL<MRPL

Thus,when t
he commodi
ty mar
keti
s compet
it
ivet
he pr
ofi
tmaxi
mizi
ng l
evelshow
VMPL=[Link]
ort
hemonopol
i
sti
cfi
rmi
npr
oductmar
ket
,thepay
ment
soff
act
orsar
e
pai
dlesst
henv
alueoft
hemar
ginalpr
oduct
,hencei
nef
fi
cienci
es. TheamountWcWm
shown byt
hef
igur
eabov
e i
ndi
cat
ed t
hatpr
ofi
tmaxi
mizi
ng behav
iorofi
mper
fect
ly
compet
it
ivef
ir
mscausest
hef
act
orspr
icesl
esst
hani
ts VMPL.
Fur
thermor
e,t
hel
evelof
empl
oymenti
sloweri
nindust
ri
eswhi
char
enotper
fect
lycompet
it
iveLc>Lm.

W SL

WW b*
Monopol
i
sti
cexpl
oit
ati
on
Wc
w b S1
Wm
(
VMPL)
(
MPRL)
MRPL VMPL

O Lm Lc
0 L2 L1 L
Fi
gur
e4.
17:Monopol
i
sti
cexpl
oit
ati
on(
a) Figur
e4.
17:
demandcur
vef
orl
abor
(
b)

4.
[Link]-
B:THEFIRM WI
THMONOPOLI
STI
CPOWERI
NCOMMODITY
MARKETANDMONOPSONI
STICPOWERI
NTHEFACORMARKET

Assume:
-
Themonopol
yinpr
oduct
smar
ket
,asi
ngl
esel
l
erofpr
oduct
-Monopsonypoweri
nfact
ormar
ket
-asi
ngl
ebuy
eroff
act
orofpr
oduct
ion:
labor
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 137
ECON102MI
CROECONOMI
CSI
I

Bot
hpar
ti
eswantt
omaxi
mizepr
ofi
toft
hei
ract
ivi
[Link]
l
llookatt
heequi
l
ibr
ium l
evel
undert
hismodelwhenl
abori
sonl
yvar
iabl
efact
orandf
orsev
eralf
act
orsaswedi
dfor
model
[Link]
hisev
erhappen?

I
tisdi
ff
icul
ttot
ellt
hest
oryt
hatf
itt
othebi
l
[Link]
oupsmal
lfi
rmsmay
besetupt
opr
ovi
de
t
ool
s,suppl
i
es,ormat
eri
alf
orasi
ngl
elar
gemanuf
act
uri
ngf
ir
[Link]
sfi
rm maybet
heonl
y
ofi
tst
ypei
nthear
ea,
andi
tsr
equi
rement
smi
ghtbev
eryspeci
ali
zed.

4.
6.2.
[Link]
LIBRI
UM OFMONOPSONI
ST,
WHOUSESASI
NGLEVARI
ABLEFACTOR

Supposet
hataf
ir
mist
hesol
eempl
oyeri
nat
owni
nlocalmar
ket
-monopsony
.Thef
ir
m
usesonl
yonef
act
or,
Labor(
L),
topr
oducef
inal
[Link]
hedemandandsuppl
ycur
ve
l
ookl
i
ke?Howequi
l
ibr
ium i
sdet
ermi
ned?Thel
abordemandf
ort
hef
ir
misMRPLasf
ort
he
caseofmodel–A,
andper
fect
lycompet
it
ivemar
ket
[Link]
ir
mval
uest
hel
astext
rawor
ker
i
thi
resbymar
ginal
rev
enuepr
oductoft
hatwor
ker
.Hence,
thef
ir
m hasadownwar
dsl
opi
ng
demandcur
veasshowni
nfi
gur
e4.
18.

Thesuppl
ycur
vef
orl
abort
oindi
vi
dualf
ir
misnothor
izont
alandper
fect
lyel
ast
icbecause
t
hef
ir
misl
arge-amonopsoni
stf
ir
mint
hel
abormar
ket
.Thesuppl
yofl
abori
sposi
ti
vel
y
sl
opes(
upwar
d-sl
opi
ng)ast
hemonopsoni
stexpandst
heuseofl
aborbypayahi
gherwage.
Thehi
gheri
tsdai
l
ywage,w1,t
hemor
epeopl
ewantt
owor
kfort
hef
ir
[Link]
hef
ir
m
payal
lwor
ker
sthesamewage,t
hemonopsonymustpaymor
etoeachwor
keri
twas
al
readyempl
[Link]
ti
plyt
hei
nputpr
icesbyt
hel
evelofempl
oymentwef
ind
t
otalexpendi
tur
eofmonopsoni
[Link],
thesuppl
yofl
aborcur
vei
sshownbyt
heav
erage
expendi
tur
e,atdi
ff
erentl
evel
ofempl
oyment
.

Howev
er,whati
srel
evantf
ort
he det
ermi
nat
ion ofl
evelofempl
oymenti
s mar
ginal
expendi
tur
ethatcanbeder
ivedf
rom changei
ntot
alexpendi
tur
eatal
llev
elofempl
oyment
.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 138
Hi
ri
nganaddi
ti
onaluni
tofi
nputi
ncr
easest
het
otalexpendi
tur
eont
hef
act
orbymor
ethan
t
hepr
iceoft
hisuni
tbecauseal
lpr
evi
ousuni
tsempl
oyedar
epai
dthenewhi
gherpr
[Link]
mar
ginalexpendi
tur
e(ME)cur
vel
i
esabov
ethesuppl
ycur
ve(
aver
ageexpensecur
ve)
.
Becauset
hepr
icesperuni
tri
seasempl
oymenti
ncr
eases,t
hemar
ginalexpenseoft
he
i
nput
sisgr
eat
ert
hani
tspr
icesatal
llev
elsofempl
oyment
.Hence,t
heMEcur
vehasa
posi
ti
vel
ysl
opedandl
i
esabov
eandt
othel
eftoft
hesuppl
yofi
nput
scur
ves.
t
expendi e
ur

ME
nal

SL(
aver
ageexpendi
tur
e
gi

e C
Mar

wf

VMPL

MRPL

L
Le Lc
Fi
gur
e4.
18:
DemandandSupplycur
veofmonopol
i
st

Ascanbeseenf
rom t
het
abl
esi
ncet
hepr
iceperuni
tofi
nputr
isesasempl
oyment
i
ncr
eases,t
hemar
ginalexpenses(
ME)oft
hei
nputi
sgr
eat
ert
hani
tspr
icesatal
llev
elof
empl
oyment
.Undert
hesecondi
ti
ons,
thef
ir
misi
nequi
l
ibr
ium wheni
tsmar
ginalexpendi
tur
e
ont
hef
act
ori
sequalt
oMRPLori
tbuy
slaborser
vicesupt
othatpoi
ntofequal
i
[Link]
s,
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 139
ECON102MI
CROECONOMI
CSI
I

atpoi
nt‘
e’onf
igur
e4.
[Link]
eME=[Link]
sisshowni
nfi
gur
exxabov
e.I
fthel
astuni
t
i
swor
thmor
etot
hebuy
ert
hani
tsmar
ginalexpendi
tur
e,t
hebuy
erpur
chasesanot
heruni
t.
Thi
sref
erst
oar
eat
other
ightof‘
e’
.Ont
heot
herhand,i
fthel
astuni
tisl
essv
aluabl
ethan
i
tsmar
ginal
expendi
tur
e,t
hebuy
erpur
chasesonel
essuni
[Link]
sisshownbyar
eat
othel
eft
of‘
e’
.

Thusatequi
l
ibr
ium poi
nt,‘
e’
,thewager
atet
hatt
hef
ir
m wi
l
lpayf
ort
heLe uni
tsofl
abori
s
[Link]
er,i
fthemar
keti
scompet
it
ive,t
hei
nter
sect
ionofdemandandsuppl
ycur
ve
det
ermi
nest
heequi
l
ibr
ium atpoi
ntCwi
tht
hel
evelofempl
oymentLcandcor
respondi
ng
pay
[Link],t
hemonopsoni
sthi
resl
essl
aborandpayl
owerwageascompar
edt
o
t
heper
fect
lycompet
it
ivemar
ket
.

Themonosonypoweri
stheabi
l
ityofasi
ngl
ebuy
ert
opayl
esst
hant
hecompet
it
ivepr
ice
pr
ofi
tabl
[Link]
zeoft
heGapbet
weent
hev
aluet
hemonopsonypl
acesont
hel
astwor
ker
(
thehei
ghtofi
tsdemandcur
vesandwhati
tpay
sdependont
heel
ast
ici
tyofsuppl
yatt
he
monopsonyopt
imum.

Bycr
eat
ingawagedi
ff
erencesbet
weent
hev
alueont
hemonopsonyandt
hev
aluet
othe
suppl
i
es,t
he monopsony causes a wel
far
eloss i
n monopsoni
stexpl
oit
ati
on. The
expl
oit
ati
onar
isesf
rom monopsonost
icpoweroff
ir
ms,andi
ssomet
hingi
naddi
ti
ont
o
monopol
i
sti
cexpl
oit
ati
[Link] di
ff
erence bet
ween wage pai
d bycompet
it
ivef
ir
m and
monopsoni
sti
cfi
rmi
smonopsoni
sti
cexpl
oit
ati
on. Eachuni
tsofl
aborr
ecei
vesi
tsMRP
whi
chi
slesst
hant
heVMP.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty:
1.
Der
iveMEcur
veandt
heequi
l
ibr
ium l
evel
ofempl
oymentusi
ngt
hef
oll
owi
ngdat
a.
Tabl
e4.
2Tot
alandmar
ginal
expenseonl
abor

Unit
sof Pri
ceof Total Mar
ginalexpenseTRPL
labor labor expendit
ure onl
abor (PxL)
onl abor
1 4 4 - 4
2 5 10 6 10
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 140
3 6 18 8 18
4 8 28 10 32
5 9 40 12 45
6 10 54 14 60
7 11 70 16 77
8 12 88 18 96
9 13 108 20 117
10 14 130 22 140

4.
6.2.
[Link]
LIBRUM OFAMONOPSONI
STWHOUSESSEVERALVARI
ABLEFACTOS
Recal
lthatunderper
fect
lycompet
it
ivemar
ket
,thef
ir
m hi
rel
aborupt
othepoi
ntwher
e

Or

Howdomonopsoni
sti
cdet
ermi
neequi
l
ibr
ium l
evel
ofempl
oyememt
?
I
fthef
act
ormar
ket
sar
emonpsoni
sti
c,changesi
ntheamountoff
act
orsempl
oyedcauses
changesi
nthepr
icesoff
act
[Link]‘
w’and‘
r’ar
enotgi
[Link]
stmustl
ook
att
hemar
ginalexpenseoft
hef
act
[Link]
stwhousessev
eralv
ari
abl
efact
ors
wi
l
luset
hei
nputcombi
nat
ionsatwhi
cht
her
ati
ooft
heMPPL t
otheMEi
sequalf
oral
l
v
ari
abl
einput
[Link]
eastcombi
nat
ioni
sobt
ainedwhent
hemar
ginalr
ateoft
echni
cal
subst
it
uti
on(
MRTSL.
K)equal
sthemar
ginalexpensesofi
nputr
ati
[Link]
het
woi
nputcase
t
heequi
l
ibr
ium condi
ti
onoft
hemonopsoni
stmaybest
atedasf
oll
ows

I
tisappar
entt
hatt
hel
eastcostcondi
ti
onf
orper
fecti
nputmar
ket
[Link]
y

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 141
ECON102MI
CROECONOMI
CSI
I

i
saspeci
alcaseofexpr
essi
onsi
ncei
nper
fectf
act
ormar
ket
sMEL=wandMEK=r
.

4.
[Link]
–C:Bi
lat
eralmonopol
y

Bi
l
ater
almonopol
yar
isewhenasi
ngl
esel
l
er(
Monopol
i
st)f
aceasi
ngl
ebuy
er(
Monopsoni
st)
i
nthel
abormar
ket
.Assumet
hatal
lthef
ir
msar
eor
gani
zedi
nasi
ngl
ebodywhi
chact
sas
l
i
kemonopsoni
[Link],weal
soassumel
abor
sar
eor
gani
zedi
nal
aboruni
onwhi
chact
s
l
i
keamonopol
i
[Link],
wehav
etwomonopol
i
espar
ti
cipat
ingi
namar
ketoneonsuppl
y
si
deandt
heot
heront
hedemandsi
[Link]
het
wopar
tybar
gai
ns?I
sther
eauni
que
equi
l
ibr
ium f
ort
hemar
ketl
i
ket
hatoft
heabov
etwomodel
s?
Thesecanbebet
terpr
esent
edt
hroughgr
aphi
calappr
[Link]
igur
e4.
19bel
ow shows
how t
het
wopar
ti
esi
nter
acti
nthemar
ket
. Themonopsoni
sts(
singl
ebuy
er’
s)demand
cur
vei
sDb whi
chi
sMRPLofi
nputbei
[Link]
om t
hepoi
ntofv
iew ofmonopol
i
st
(
laboruni
on)Db r
epr
esentav
erager
evenuecur
ve,hence,AR=[Link]
l
er’
s(Uni
on)MRs
cur
vecanbeder
ivedbyusualgr
aphi
ctechni
quesandi
tisbel
ow t
heARsandwi
l
lcutany
hor
izont
all
i
neati
tsmi
d-poi
nt(
seef
igur
e4.
19)
.

W
MR
b

w
u SL=AEb=MCS
F

wf

U
MR DL=MRPL=A
s
RS

O
Lu Lf L

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 142
Fi
gur
e4.
19:
Thedet
ermi
nat
ionofequi
l
ibr
ium underbi
l
ater
almonopol
y
Thesuppl
yofl
aborf
aci
ngmonopsoni
sti
stheupwar
dsl
opi
ngcur
vesSL whi
chsi
mil
ar
t
echni
quewehav
eseenundermonopsony
.Fr
om poi
ntt
ovi
ew oft
hemonopol
i
st(
labor
uni
on)t
heSL i
sit
smar
ginalcost
.Assumet
hatmonopol
i
st’
sbehav
easi
fhi
s pr
iceswer
e
det
ermi
nedbyout
sidef
orcej
ustl
i
keper
fect
lycompet
it
ivemar
ketsel
l
ers,
andhenceMCsi
s
suppl
ycur
[Link]
vent
heabov
ecostandr
evenuecur
vewecanf
indt
heequi
l
ibr
ium posi
ti
onof
eachpar
ti
cipanti
nthemar
ket
.

Themonopsoni
stmaxi
mizeshi
spr
ofi
tatpoi
ntFwher
emar
ginalexpenseofl
abor(
MEb)
equal
stot
hemar
ginalr
evenuepr
oductofl
abor
.Themonopsoni
stdesi
reLFuni
tsofl
abour
and paya wage r
ate equalt
o [Link] monopol
i
st(
laboruni
on)
,on t
he ot
herhand,
maxi
mizesWupr
ofi
t(gai
ns)atpoi
ntU,wher
ehi
smar
ginalcosti
sequalt
oWumar
ginal
r
[Link]
s,hewant
stosuppl
yLuuni
tsofl
aborandr
ecei
vesawageequal
toWu.

Asy
oucanseef
rom t
hedi
agr
am t
hepoi
ntofequi
l
ibr
ium f
ort
het
wopar
ti
esdi
ff
[Link]
pr
icedesi
redbyt
hemonopsoni
st(
fi
rm’
smanagement
)ist
hel
owerl
i
mitofpr
ice,Wf,
whi
l
e
t
hepr
icedesi
redbyt
hemonopol
i
stsel
l
er,Wui
supperl
i
mitpr
ices,si
ncet
hepr
icegoal
sof
t
womonopol
i
stscannotber
eal
i
zed,
thepr
iceandquant
it
yint
hebi
l
ater
almonopol
ymar
ket
ar
eindet
ermi
nat
eineconomi
csense.

Theequi
l
ibr
ium si
tuat
ioni
nbi
l
ater
almonopol
ysi
tuat
ioni
sindet
ermi
nat
[Link]
ves
onl
ytheupperandl
owerl
i
mitwi
thi
nwhi
cht
hewagewi
l
lbedet
ermi
nedbybar
gai
[Link]
l
evelatwhi
cht
hepr
icewi
l
lbeset
tl
eddependont
hebar
gai
ningski
l
lsandpoweroft
he
par
ti
cipant
[Link]
ti
cipanti
sdet
ermi
nedbyhi
sabi
l
ityt
oinf
li
ctl
ossest
o
t
heopposi
tepar
tyandhi
sabi
l
ityt
owi
thst
andl
ossesi
nfl
i
ctedbyt
heopponent
.Hence,t
he
out
comeoft
hebar
gai
ningcannotbeknownwi
thcer
tai
nty
.Itdependsonbar
gai
ningski
l
ls,
pol
i
tical
andeconomi
cpoweroft
hel
aboruni
onandt
hef
ir
ms,
andonmanyot
herf
act
ors.

4.
[Link]-
D:COMPETI
TIVEBUYER-
FIRM VERSUSMONOPOLYUNI
ON

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 143
ECON102MI
CROECONOMI
CSI
I

I
nthi
scaseweassumet
hatf
ir
mshav
enomonopol
i
sti
cormonoposoni
sti
cpower
,butt
he
l
aborf
orcei
suni
oni
zedandbehav
eli
kemonopol
i
[Link]
tuat
ioni
spr
esent
edi
nfi
gur
exx.
I
nthi
scasel
aborsuppl
ycur
ve,SL,i
sshownbymar
ginalcostoft
heuni
onasi
nthecaseof
bi
l
ater
almonopol
[Link] mar
ketdemand f
orl
abori
s DL der
ives f
rom VMPL t
hrough
summat
ion ofi
ndi
vi
dualf
ir
m’s demand. I
tal
so r
epr
esent
s [Link] do wage i
s
det
ermi
nedundert
hesecondi
ti
on?

Thedet
ermi
nat
ionofwageandot
herf
act
or’
spay
menti
sdependi
ngont
hegoal
soft
he
uni
[Link]
ear
ethr
eecommongoal
sofl
aboruni
[Link]
e:

Themaxi
mizat
ionofempl
oyment
Theempl
oymenti
sdet
ermi
nedbyi
nter
sect
ionofdemandandsuppl
ycur
vet
hrought
he
mar
ketf
[Link]
hel
aboruni
onwi
l
ldemandawager
ateequalt
[Link]
ir
ms,
bei
ng
pr
icet
aker
s,wi
l
lmaxi
mizet
hei
rpr
ofi
tbyequat
ing W t
otheVMPL. TheOLi
stot
al
empl
oyment
.

w SL=MCs
MRs
w

e
w

e2

D2=VMPL=A
Rs
O
L2 L1 L L

Fi
gur
[Link]
oymentdet
ermi
nat
ionunderuni
on
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 144
Themaxi
mizat
ionoft
het
otal
wagebi
ll
.
I
fthegoal
ofuni
oni
stot
alwagebi
l
lmaxi
mizat
ion,
theysetwageatpoi
ntwher
eMRsi
szer
o.
Hence,t
heequi
l
ibr
ium oft
heuni
oni
satpoi
[Link]
respondi
ngwager
atei
sw1 and
l
evel
ofempl
oymenti
satLs1(
seef
igur
exx)

Themaxi
mizat
ionoft
het
otal
gai
nst
otheuni
onaswhol
e
Thegoali
sat
tai
ned byset
ti
ng wageatpoi
ntwher
eMC=MR oft
heuni
[Link],t
he
equi
l
ibr
ium undert
hiscondi
ti
oni
satpoi
[Link]
spoi
ntsi
dent
if
iedbyw2l
evelofwaget
hat
cor
respondwi
thL2l
evel
ofempl
oyment
s(seef
igur
exx)

I
nsum,i
fthef
ir
msdonothav
emonopsoni
sti
cpower
,thewager
ateandt
hel
evelof
empl
oymentar
edet
ermi
nedbyt
hegoodoft
heuni
on.

4.
[Link]
CITYOFI
NPUTSUBSTATI
ON,
TECHNOLOGI
CALPROGRESSANDI
NCOME
DI
STRI
BUTI
ON

I
nthepr
evi
oussect
ion,weexami
nedt
hedet
ermi
nant
soff
act
orpr
[Link]
act
orpr
ice
change,t
hef
ir
ms’st
ruct
ureofempl
oymentwi
l
lchangeasi
taf
fect
sthepr
ofi
tmaxi
mizi
ng
behav
iorandi
ncomedi
str
ibut
[Link]
croeconomi
ctheor
yofpr
oduct
ionwehav
eseen
t
heel
ast
ici
ty,t
echnol
ogi
calpr
ogr
essandot
herf
act
orsasmaj
orshi
ft
ingf
act
orst
hatar
e
necessar
yforpol
i
cypur
[Link]
l
lrel
atet
hatt
heor
eti
calconceptwi
tht
hei
nputmar
ket
andi
ncomedi
str
ibut
ionespeci
all
ysubst
it
utabi
l
ityoff
act
ors.I
nthesect
ionwewi
l
lexami
ne
how t
hesubst
it
utabi
l
ityofpr
oduct
ivef
act
orsandt
echnol
ogi
calpr
ogr
essaf
fecti
ncome
di
str
ibut
ion.

Obj
ect
ives:
Att
heendoft
hissect
ion,
youwi
l
lbeabl
eto:
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 145
ECON102MI
CROECONOMI
CSI
I

Expl
ainhowsubst
it
utabi
l
ityoff
act
orsofpr
oduct
ionaf
fect
sincomedi
str
ibut
ion.
Anal
yzehowt
echnol
ogi
cal
changesorpr
ogr
essaf
fecti
ncomedi
str
ibut
ion
I
dent
if
yhowchangesi
nfact
orspr
icesaf
fectt
hei
ncomeshar
esoff
act
ors.

4.
7.1.
THEELASTI
CITYOFI
NPUTSUBSTI
TUTI
ON ANDTHESHARESOFFACTORS
OFPRODUCTI
ON
Howdochangesi
nfact
orspr
icesaf
fectt
heshar
esoff
act
orsandi
ncomedi
str
ibut
ion?
Whati
sit
sconsequence?

Fr
om ourmi
croeconomi
ctheor
y,r
ati
onaleconomi
cagentt
endst
osubst
it
uteacheaper
i
nputf
orar
elat
ivel
ymor
eexpensi
[Link]
l
ityt
osubst
it
uteonei
nputf
oranot
heri
s
r
efl
ect
ed i
nthe el
ast
ici
tyofsubst
it
uti
on bet
ween t
he t
wo i
nput
s.A l
arge el
ast
ici
ty
i
ndi
cat
est
hatt
het
woi
nput
sar
ecl
osesubst
it
utesi
npr
oduct
[Link] i
fther
eisacl
ose
subst
it
uteav
ail
abl
e,t
henwhent
hepr
iceofani
nputr
ises,t
hef
ir
m cansi
mpl
ysubst
it
ute
t
heot
heri
nput
.Ther
efor
e,i
flaborandcapi
talar
ecl
osesubst
it
utes,t
henwhent
hewage
r
ater
isesf
ir
mswi
l
lsubst
it
utescapi
talf
orl
abor
,andt
hedecl
i
nei
nempl
oymentwi
l
lbe
gr
eat
[Link],
thedemandf
orani
nputwi
l
lbemor
eel
ast
icwheni
thascl
osesubst
it
utes
ar
eav
ail
abl
e.

Thi
swi
l
lresul
tinachangeoft
heK/
Lrat
io,andt
hesi
zeoft
hisef
fectdependsont
he
r
esponsi
venessoft
hechangeoft
heK/
Lrat
iot
othef
act
orpr
icechangewhi
chwecal
l
el
ast
ici
tyofsubst
it
uti
[Link] di
scussed t
hisi
nfi
rstmodul
e of mi
croeconomi
cs i
n
connect
ionwi
tht
hepr
oduct
ionf
unct
[Link]
lthatt
heel
ast
ici
tyofsubst
it
uti
oni
sdef
ined
ast
her
ati
ooft
heper
cent
agechangei
ntheK/
Lrat
iot
otheper
cent
agechangeoft
he
MRTSL,k.

I
nthe per
fecti
nputmar
ket
sthe f
ir
m i
sin equi
l
ibr
ium when i
tchoosest
he i
nput
combi
nat
ionatwhi
cht
heMRTSi
sequal
tot
her
ati
ooff
act
orpr
ices.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 146
MRTS =

Thus,
inequi
l
ibr
ium wi
thper
fectf
act
ormar
ket
stheel
ast
ici
tyofsubst
it
uti
onmaybe

Thesi
gnoft
heel
ast
ici
tyofsubst
it
uti
oni
sal
way
sposi
ti
ve(
unl
ess =0)becauset
he
numer
atoranddenomi
nat
orchangei
nthesamedi
rect
[Link]
oint
erestr
ati
o
i
ncr
easel
abori
srel
ati
vel
ymor
eexpensi
vet
hancapi
talandt
hiswi
l
linducet
hef
ir
mto
subst
it
utecapi
tal
forl
abor
,sot
hati
nK/
Lrat
iowoul
ddecl
i
ne.

Thev
alueofel
ast
ici
tyr
angesf
rom zer
otoi
nfi
nit
y.I
f =0i
tisi
mpossi
blet
osubst
it
ute
onef
act
orf
oranot
her
;KandLar
eusedi
nfi
xedpr
opor
ti
ons(
asi
nthei
nput–out
put
anal
ysi
s)andt
hei
soquant
shav
etheshapeofr
ightangl
es.I
f = t
het
wof
act
orsar
e
per
fectsubst
it
utes:t
hei
soqant
sbecomest
rai
ghtl
i
neswi
thanegat
ivesl
ope.I
f0< <
f
act
orscansubst
it
uteeachot
hert
oacer
tai
next
ent
:thei
soquantar
econv
ext
othe
or
igi
n.

TheCobb–Dougl
aspr
oduct
ionf
unct
ionhas =1.I
ngener
alt
hel
argert
hev
alueof ,
t
hegr
eat
ert
hesubst
it
utabi
l
itybet
weenKandL
Wemaycl
assi
fy i
nthr
eecat
egor
ies:
<1:
inel
ast
icsubst
it
utabi
l
ity
=1:
Uni
tar
ysubst
it
utabi
l
ity
>1:
elast
icsubst
it
utabi
l
ity
Ther
eisani
mpor
tantr
elat
ionshi
pbet
weent
heabov
eval
uesof andt
hedi
str
ibut
ive
shar
esoff
act
[Link]
ini
ti
on

= and =

Theconceptoft
heel
ast
ici
tyofsubst
it
uti
onoff
act
orshasbeeni
ntr
oducedbySi
rJohnR.

ADAMAUNI
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CS 147
ECON102MI
CROECONOMI
CSI
I

Wecaneasi
l
yfi
ndt
heef
fectofachangei
nthew/
rrat
ioont
her
elat
iveshar
esoft
het
wo
f
act
ors.
Assumet
hat <[Link]
simpl
i
est
hatagi
venper
cent
agechangei
nthew/
rrat
ion
r
esul
tsi
nasmal
l
erper
cent
agechangei
ntheK/
Lrat
io,
sot
hatr
elat
ive–shar
eexpr
essi
on
i
ncr
[Link],
if =1,
ani
ncr
easesi
nthew/
rrat
ioi
ncr
easest
hedi
str
ibut
iveshar
eof
l
abor
.Forexampl
eassumet
hat =0.
5.Thena10per
centi
ncr
easei
nw/
rresul
tsi
na5
per
centi
ncr
easei
ntheK/
Lrat
[Link]
elat
iveshar
esar
e

Cl
ear
ly,
newr
elat
iveshar
erat
io >i
nit
ial
rel
ati
veshar
erat
io

I
f >1changei
nw/
rleadst
oasmal
l
erper
cent
agechangei
nK/
Lsot
hatt
her
elat
iveshar
e
ofl
abordecr
eases:Forexampl
eassumet
hat =2.A20per
centi
ncr
easei
nw/
rleadst
oa
40per
centi
ncr
easei
nK/
[Link]
erat
ioi
s

Cl
ear
lyi
f >1t
her
elat
iveshar
eofl
abordecr
easesf
oll
owi
ngani
ncr
easei
nthew/
rrat
io.

Wi
thasi
mil
arr
easoni
ngi
tcanbeshownt
hati
f =1t
her
elat
iveshar
esofKandLr
emai
n
unchanged.

I
nsummar
y,ani
ncr
easei
nthew/
rrat
iowi
l
lcausel
abor
’sshar
e,r
elat
ivet
ocapi
tal
’
sshar
e.
I
tshoul
dbenot
edt
hatt
her
eisat
wo-
waycausat
ionbet
weenw/
randK/
[Link]
nthe
capi
tal-
laborr
ati
oresul
tinchangesi
nther
elat
ivef
act
orpr
ices,andhencei
nchangesi
n
t
heshar
esoft
hef
act
orst
otot
alout
[Link]
fectofchangesoft
heK/
Lrat
ioonf
act
or
shar
escanbeexpl
oredwi
tht
heuseoft
heel
ast
ici
tyofsubst
it
uti
on. Theanal
ysi
sis
anal
ogoust
otheoneweusedabov
eforchangesi
nthew/
rrat
io.

Fr
om t
heabov
edi
scussi
ons,i
tiscl
eart
hatt
heconceptoft
heel
ast
ici
tyofsubst
it
uti
oni
s
v
eryi
mpor
tanti
ntheneocl
assi
calt
heor
yofi
ncomedi
str
ibut
ion.I
tisext
remel
yusef
uli
n
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 148
exami
ningt
hewayi
nwhi
chchangi
ngi
nputpr
icesori
nputr
ati
osaf
fecti
ncomeshar
es.
Gi
vent
hatchangesi
nw/
rleadt
ochangesi
nK/
Landv
icev
ersa,
itf
oll
owst
hatpr
edi
cti
ona
boutf
act
orshar
esf
oll
owi
ngchangesi
noneoft
heser
ati
onsar
eboundt
obemi
sleadi
ngi
f
t
heydonott
akei
ntoaccountt
hepossi
bil
i
tyoft
heassoci
atedchangesi
ntheot
herr
ati
on.

4.
[Link]
CALPROGRESSAND I
NCOMEDI
STRI
BUTI
ON

Upunt
ilnowwehav
eassumedagi
venpr
oduct
ionf
unct
[Link]
er,
technol
ogi
calchange
t
akespl
acecont
inuousl
y,andt
hisshi
ft
sthepr
oduct
ionf
unct
ion,l
eadi
ngt
ochangesi
nthe
K/
Lrat
ioandt
heel
ast
ici
tyofsubst
it
uti
[Link],i
tisi
mpor
tantt
oconsi
dert
heef
fect
sof
t
echnol
ogi
calpr
ogr
essonf
act
orshar
[Link]
ogi
calpr
ogr
essshi
ft
sthei
soquant
’sdown
wor
ds,gi
vent
hatt
hesamel
evelofout
putt
hatcanbepr
oducedwi
thsmal
l
erquant
it
iesof
f
act
ori
nput
sast
echnol
ogi
calpr
ogr
essoccur
[Link]
ogr
esscanbecl
assi
fi
edi
ntot
hree
t
ypes,
neut
ral
,capi
tal
-deepeni
ngandl
abor
–deepeni
[Link]
e:
Technol
ogi
calpr
ogr
essi
sneut
rali
fataconst
antK/
Lrat
iot
heMRTSL.K r
emai
nsunchanged.
Si
ncei
nequi
l
ibr
ium MRTSL.K =w/
r,i
tfol
l
owt
hatwhent
echnol
ogi
calpr
ogr
essi
sneut
ralbot
h
t
heK/
Lrat
ioandt
hew/
rrat
io,ar
[Link]
ly,t
her
elat
iveshar
esoff
act
ors
r
emai
nunchanged.
Technol
ogi
calpr
ogr
essi
scapi
tal
-deepeni
ngi
fataconst
antK/
Lrat
iot
heMRTSL.K decl
i
nes.
Thi
simpl
i
est
hatatequi
l
ibr
ium t
hew/
rrat
iodecl
i
nes,asri
ncr
easer
elat
ivet
ow,whi
l
eK/
L
r
emai
nsconst
ant
.Consequent
ly,t
her
ati
ooff
act
orsshar
esdecl
i
nes,i
.e.
,nt
heshar
eof
l
abordecr
easeandt
heshar
eofcapi
tal
incr
eases.
Technol
ogi
cal
progr
essi
sLabor–deepeni
ngi
fataconst
antK/
Lrat
iot
[Link]
ncr
eases.
Then,atequi
l
ibr
ium,t
hew/
rrat
ioi
ncr
easeast
echnol
ogi
calpr
ogr
essTakespl
[Link]
s
i
mpl
i
est
hatt
heshar
esofl
aborwi
l
lincr
easeandt
heshar
eofcapi
tal
wil
ldecr
ease.
I
n shor
t,t
he r
elat
ive shar
e ofl
abori
ncr
eases i
ftechnol
ogi
calPr
ogr
ess i
slabor
–deepeni
ng,r
emai
nunchanged i
ftechnol
ogi
calpr
ogr
ess i
sneut
ral,anddecr
easesi
f
t
echnol
ogi
cal
changesi
scapi
tal
-deepeni
ng.

SUMMARY

Pr
oduct
ionf
unct
ioni
sther
elat
ionshi
pbet
weeni
nput
sandout
put
[Link]
ir
m’sdemandf
or
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 149
ECON102MI
CROECONOMI
CSI
I

af
act
ori
nputdependsupont
hei
nput
’sphy
sicalpr
oduct
ivi
tyandt
hedemandf
ort
hegood
t
hef
act
ori
sbei
ngusedt
opr
oduces.
Fact
ordemandi
sder
iveddemandi
sasenset
hati
t’
scomesf
ormt
hedemandf
ort
he
pr
oduct
.
Fact
ormar
ket
sdi
ff
erf
rom pr
oductmar
keti
nthr
eei
mpor
tantaspect
[Link]
rst
,fact
ormar
ket
t
endst
obemor
ecompet
it
ivet
hanpr
oductmar
ket
.Second,t
hedemandf
orf
act
orsof
pr
oduct
ioni
sader
iveddemandi
nasenset
hati
tsdemandcomesf
rom t
hedemandf
or
t
hegoodsandser
vicespr
oducedbyt
hef
act
orsofpr
oduct
[Link]
rd,t
hepr
oduct
ionofa
goodr
equi
rest
hecooper
ati
onofdi
ff
erentf
act
orsofpr
oduct
ion.
Af
ir
m hasademandf
orf
act
ors(
laborandcapi
tal
)isr
elat
edt
hecont
ri
but
ionoft
hef
act
or
t
otheobj
ect
ivef
unct
ionoft
hef
ir
[Link]
ri
but
ionofl
abort
othef
ir
m’spr
ofi
tfunct
ion
i
sdet
ermi
nedbyt
wot
hings:t
hequant
it
yofaddi
ti
onalout
putauni
tlabori
nputcan
pr
oducesandt
hepr
icet
hatt
hef
ir
m cansel
li
tspr
oduct
.
Underper
fect
lycompet
it
ivemar
kett
hef
ir
m demandf
oronl
yonev
ari
abl
einput–l
abori
s
v
alueofmar
ginalpr
oductofl
aborf
orwhi
cht
hev
alueoft
heext
raout
putpr
oducedbyt
he
empl
oymentoft
hel
astuni
tofi
nputi
sequalt
othepr
icesoft
hepr
oductmul
ti
pli
edby
pr
[Link]
er,t
hisnol
ongert
ruewhent
hef
ir
m usesmor
ethanonev
ari
abl
einput
s
whi
chi
sthemar
ginalr
evenuepr
oductofl
abor
.Inbot
hcasest
hedemandf
orl
abori
s
downwar
dsl
opi
ng.
Ev
ent
hought
hesuppl
yofl
abori
sdet
ermi
nedbydi
ff
erentf
act
orsandev
olv
esbehav
ior
al
aspectf
ormostcasesi
sbackwar
dbendi
ngcur
[Link]
i
ket
hatofper
fect
lycompet
it
ive
mar
ket
,theequi
l
ibr
ium i
sdet
ermi
nedbyt
hef
orcesofsuppl
yanddemandf
orl
abor
.
Det
ermi
nat
ionoff
act
orpr
icesandempl
oymentar
eunderi
mper
fectcompet
it
ionsl
i
ght
ly
di
ff
eri
ngf
rom t
hatofper
fectcompet
it
iondependi
ngupont
hemodelunderconsi
der
ati
on.
Themaj
ordi
ff
erencel
i
esi
nthemar
ginalr
evenuepr
oductofl
aborandv
alueofmar
ginal
pr
oductofl
abori
nwhi
chcaset
hef
ormeri
sthedemandcur
veoff
act
orofpr
oduct
ionas
opposedt
otheper
fectmodel
.Asar
esul
toft
heset
her
eisexpl
oit
ati
onofl
aborby
monopol
i
st.
Fact
orssubst
it
utabi
l
ityandt
echnol
ogi
calpr
ogr
essar
ethebasi
cissuef
ort
hef
ir
m’s
f
act
orsempl
oymentdeci
[Link]
ther
mor
e,i
tshowsi
ncomedi
str
ibut
ionandar
eaof
i
nter
vent
ionf
orgov
ernment
.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 150
KEYTERMS
Mar
ginal
phy
sical
product Val
ueofmar
ginal
phy
sical
product
Out
putef
fect Subst
it
uti
onef
fect
I
ncomeef
fect Pr
ofi
tmaxi
mizi
ngf
ir
m
Backwar
dbendi
ngsuppl
ycur
ve Monopsoni
st
Bi
l
ater
almonopol
y El
ast
ici
tyoff
act
orsubst
it
uti
on
Laboruni
on Mar
ginal
rev
enuepr
oductofl
abor
Labor
-deepeni
ngt
echnol
ogi
calpr
ogr
ess Capi
tal–deepeni
ngt
echnol
ogi
cal
pr
ogr
ess
Demandf
orl
abor

Rev
iewQuest
ions
Gi
vent
hef
oll
owi
ngi
nTabl
e4.
2bel
owder
ivet
hedemandcur
vef
orl
aborassumi
ngi
tist
he
onl
yvar
iabl
efact
orofpr
oduct
[Link]
urt
her
,fi
xedout
putpr
icesequalt
o3andwage
r
ateequal
tow=4
Tabl
e4.
2:Empl
oymentoff
act
orandi
tsmar
ginal
product
ivi
ty
Quant
it
yofl
aborused 3 4 5 6 7 8 9
Mar
ginal
productofl
abor 8 7 6 5 4 3 2

Suggest
edr
eadi
ngs
Ni
chol
son,
w:Mi
croeconomi
ctheor
y;basi
cpr
inci
pleandext on.5thedi
ensi ti
on
Sal
vat
ore,
D(2003)
:Mi
croeconomi
cs;
theor
yandappl
icat
i 4thedi
ons. ti
on
Mansf
iel
d,[Link],
G(2000)
:Mi
croeconomi
cs,
theor
yandappl
icat
i 10thedi
ons. ti
on
Var
ian,
[Link]
l(1999)
:Int
ermedi
atemi
cr cs3rdedi
oeconomi ti
on
Pi
ndy
ck,
[Link]
nfel
d,D.
L.(
2003)
:Mi
cr cs.6thedi
oeconomi ti
on
Kout
soy
ianni
sA.(
1985)
:Moder
nmi
cr cs2ndedi
oeconomi ti
on.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 151
ECON102MI
CROECONOMI
CSI
I

UNI
TCONTENTS
5.
1.I
ntr
oduct
ion
5.
[Link]
alequi
l
ibr
ium anal
ysi
s
5.
[Link]
alequi
l
ibr
ium i
npur
eexchange
5.
[Link]
alequi
l
ibr
ium i
npr
oduct
ion,
Two-
inputTwo-out
putcase

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 152
5.
[Link]
oduct
ionpossi
bil
i
tiescur
ve
5.
[Link]
oduct
ionandexchange
5.
[Link]
alequi
l
ibr
ium i
ntwo-
consumereconomy(
2X2X2model
)
5.
[Link]
econdi
ti
onsf
oreconomi
cef
fi
ciency
5.
[Link]
tSummar
y

CHAPTERFI
VE

GENERALEQUI
LIBRI
UM ANALYSI
S

5.
1.I
NTRODUCTI
ON

D earr
eader
s,unt
ilt
hispoi
ntwehav
eexami
nedt
hebehav
iorofi
ndi
vi
dualdeci
sion
maki
nguni
[Link]
ecal
l
,wehav
eseeni
ndi
vi
dual
sasconsumer
sofcommodi
ti
esand
suppl
i
ersofi
nput
s,andf
ir
msasempl
oyer
sofi
nput
sandpr
oducer
sofcommodi
ti
es.
Fur
thermor
e,wehav
edi
scussedt
hewor
kingofi
ndi
vi
dualmar
ketf
orcommodi
ti
esand
i
nput
sunderv
ari
ousmar
ketst
ruct
uresandt
hei
rrespect
iveequi
l
ibr
[Link]
ebeen
donebyi
sol
ati
ngot
herf
act
orst
hataf
fectt
her
elat
ionshi
ps-
eachuni
tormar
ketbei
ng
consi
der
edsepar
atel
[Link]
hinksuchsi
tuat
ionexi
sts? Rat
hert
heeconomi
cagent
sar
e
ADAMAUNI
VERSI
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CS 153
ECON102MI
CROECONOMI
CSI
I

hi
ghl
yint
err
elat
edi
nter
dependent
.Fori
nst
ance,t
heact
ivi
ti
esofconsumer
saf
fectt
he
pr
oducer
sandt
hev
icev
ersa.

I
nthi
schapt
er,
wet
akeupt
het
opi
cofi
nter
dependenceorr
elat
ionshi
pamongt
hev
ari
ous
deci
si
onmaki
nguni
tsandmar
ket
[Link]
sal
l
owsust
otr
acebot
htheef
fect
sofachangei
n
anypar
toft
heeconomi
csy
stem onev
eryot
herpar
toft
hesy
stem,
andt
her
eper
cussi
ons
f
rom t
hel
att
eront
hef
ormer
.Inot
herwor
dweexami
nehowt
hev
ari
ousi
ndi
vi
dualpi
eces
f
itt
oget
hert
ofor
m ani
ntegr
atedeconomi
csy
[Link]
nobj
ect
ivei
sjustl
i
ket
hatof
ot
her
s(i
ndi
vi
dualmar
ket
)toanal
yzet
heequi
l
ibr
ium oft
hesy
stem t
hatmaxi
mizest
he
soci
alwel
far
[Link]
nthechapt
erbydi
sti
ngui
shi
ngbet
weenpar
ti
alequi
l
ibr
ium and
gener
alequi
l
ibr
ium anal
ysi
sandexami
ningt
hecondi
ti
onsunderwhi
cheacht
ypeof
anal
ysi
sisappr
opr
iat
[Link],wewi
l
ldi
scusst
hecondi
ti
onsr
equi
redf
ort
heeconomyt
o
be i
n gener
alequi
l
ibr
ium ofexchange,pr
oduct
ion and pr
oduct
ion and exchange
si
mul
taneousl
[Link]
lyt
hewel
far
eimpl
i
cat
ion ofgener
alequi
l
ibr
ium anal
ysi
swi
l
lbe
anal
yzed.
OBJECTI
VE
Af
tercompl
eti
ngt
hischapt
er,
student
sshoul
dbeabl
eto:
Under
standt
hedi
ff
erencebet
weenpar
ti
alandgener
alequi
l
ibr
ium
Expl
aint
hegener
alequi
l
ibr
ium i
nexchange
Expl
aint
hegener
alequi
l
ibr
ium i
npr
oduct
ion
Showt
hei
mpl
i
cat
ionofgener
alequi
l
ibr
ium onwel
far
e

5.
2GENERALEQUI
LIBRI
UM ANALYSI
S

5.
2.1PARTI
ALVERSUSGENERALEQUI
LIBRI
UM ANALYSI
S

Dearr
eader
s,i
nthepr
evi
ouschapt
erwest
udi
ed t
hebehav
iorofi
ndi
vi
dualdeci
sion
maki
ng uni
ts and i
ndi
vi
dualmar
ket
sini
sol
ati
[Link] exami
ned how an i
ndi
vi
dual
maxi
mizessat
isf
act
ionsubj
ectt
ohi
sorheri
ncomeconst
rai
nt,howaf
ir
m mi
nimi
zesi
ts
cost
sofpr
oduct
ionandmaxi
mizespr
ofi
tunderv
ari
ousmar
ketst
ruct
ures,andhow t
he
pr
icesandempl
oymentofeacht
ypeofi
nputi
sdet
ermi
[Link]
eshownhowdemand
andsuppl
yineachmar
ketdet
ermi
net
heequi
l
ibr
ium pr
iceandquant
it
yint
hatmar
ket
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 154
i
ndependent
lyofot
hermar
ket
[Link]
hatwehav
eusedhast
aughtust
hatt
he
pr
icesandquant
it
yineachsuchmar
keti
sdet
ermi
nedbyt
hesuppl
yanddemand. Each
mar
kethasbeenr
egar
dedasi
ndependentandsel
f–cont
aineduni
ts,
forpr
act
icalpur
pose.
I
ndoi
ngso,wehav
eabst
ract
edf
rom al
lthei
nter
connect
ionst
hatexi
stbet
weent
he
mar
ketunderst
udyandt
her
estoft
heeconomy
.Theanal
ysest
hatassumet
hatchanges
i
npr
icescanoccurwi
thoutcausi
ngsi
gni
fi
cantchangesi
npr
icesi
not
hermar
ket
sar
e
cal
l
edPar
ti
alEqui
l
ibr
ium

Howev
er,t
heassumpt
ionmaybei
nreal
i
tybeser
iousl
yfl
[Link]
ketcanadj
ustt
o
changesi
nitcondi
ti
onwi
thoutcausi
ngchangesi
not
hermar
ket
,andt
hechangei
nthe
ot
hermar
ketcanbesubst
ant
ialandsi
gni
fi
cant
.Achangei
nanymar
kethasspi
l
lov
er
ef
fect
s on ot
hermar
ket
s and t
he change i
nthe ot
hermar
ket
s wi
l
l,i
ntur
n,has
r
eper
cussi
onsorf
eedbackef
fect
sont
heor
igi
nalmar
ket
.Forexampl
e,supposedemand
f
orhousi
ngi
ncr
eases,suppl
yremai
ningt
hesame,atsomepoi
ntoft
imei
naneconomy
.
Asar
esul
toft
his(
incr
easei
nhousi
ngdemand)homer
ent
swi
l
lgoupandpr
ofi
tabi
l
ityof
t
hehousi
ngi
ndust
ryi
ncr
easeswhi
chi
ntur
nincr
easest
henumberoff
ir
msi
nthei
ndust
ry
whopar
eat
tract
edbyt
hei
ncr
easei
npr
ofi
ts.

Fur
ther
mor
e,t
he demand f
or i
nter
medi
ate goods st
eelcement
s and br
icks and
const
ruct
ion l
abori
ncr
[Link] numberoff
ir
ms pr
oduci
ng i
nter
medi
ate goods
i
ncr
easesandt
hei
rdemandf
orf
act
ori
nput
ssuchasl
and,l
aborandcapi
tal
.Ift
hese
f
act
orsar
einshor
tsuppl
y,f
act
orpay
menti
ncr
[Link]
ly,
lar
gerf
act
ori
ncomes
f
low t
othehousehol
[Link]
dincomei
ncr
eases,demandf
orot
herconsumer
goodsandser
vicesi
ncr
easesandcr
eat
esanot
herchai
nofact
ionandr
eact
ionbet
ween
househol
dandf
ir
msi
npr
oductandf
act
ormar
ket
[Link]
exi
tyi
sfur
theri
ncr
easedas
changei
nrel
ati
vepr
icesofpr
oduct
sandf
act
orsl
eadt
osubst
it
uti
onef
fect
sandot
her
ef
fect
s.I
nthi
swayt
hewhol
eeconomi
csy
stem f
unct
ionsi
nacompl
exmanner
.These
ef
fect
sar
est
udi
edbygener
alequi
l
ibr
ium anal
ysi
s.

Gener
alequi
l
ibr
ium anal
ysi
sst
udi
est
hei
nter
dependenceori
nter
connect
ionst
hatexi
st
amongal
lmar
ket
sandpr
icesi
ntheeconomyandat
temptt
ogi
veacompl
ete,
expl
i
cit
,and
si
mul
taneousanswert
othequest
ionsofwhat
,howandf
orwhom t
opr
oduce.
ADAMAUNI
VERSI
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CS 155
ECON102MI
CROECONOMI
CSI
I

Agener
alequi
l
ibr
ium i
s,t
hus,def
inedasast
atei
nwhi
chal
leconomi
cuni
ts
opt
imi
zet
hei
rrespect
iveobj
ect
ivef
unct
ionandal
lpr
icesar
esi
mul
taneousl
y
i
nequi
l
ibr
ium,
andal
lmar
ket
sar
ecl
ear
ed.

Bot
har
ever
yusef
[Link]
ti
alequi
l
ibr
ium anal
ysesar
eper
fect
lyadequat
eint
hecasei
n
whi
cht
heef
fectonachangei
nthemar
ketcondi
ti
oni
nonemar
kethasl
i
ttl
eorno
ef
fectonpr
icesi
not
hermar
ket
.Thest
udy
ingt
heef
fectofsmal
lexci
set
axont
he
pr
oduct
ion ofan i
nsi
gni
fi
cantcommodi
ty may wor
k per
fect
ly wel
lundert
he
assumpt
iont
hatt
hepr
iceofal
lot
hergoodsar
efi
[Link]
icesmi
ghtnotchange,
andsoi
twoul
dnotbewor
tht
heef
for
ttomodelf
eedbacksandi
nter
act
ionst
hatar
e
notatl
arge;apar
ti
alequi
l
ibr
ium ofsor
tpr
esent
edabov
ewoul
dthenbeappr
opr
iat
e.
Ont
heot
herhand,st
udy
ingt
heef
fect
soft
hel
argeofexci
se t
axoncommodi
ty
whose pur
chases absor
b si
gni
fi
cant pr
opor
ti
on consumer
sincome coul
d be
i
nappr
opr
iat
eifi
treper
cussi
onsonot
herpr
iceswer
enotconsi
der
ed.I
nthi
scase,a
gener
alequi
l
ibr
ium anal
ysi
scoul
dber
equi
redt
omakecer
tai
nthatt
hef
eedbacksand
i
nter
act
iondi
dnotser
iousl
yunder
minet
hev
ali
dit
yoft
heconcl
usi
onsdr
awnf
rom a
par
ti
alequi
l
ibr
ium appr
oach.

5.
[Link]
STACESOFGENERALEQUI
LIBRI
UM

Thegener
alequi
l
ibr
ium anal
ysi
s,l
i
kepar
ti
alequi
l
ibr
ium anal
ysi
s,canbeusedt
osol
ve
pr
obl
emsofmanyki
nds.I
tisbasedont
henot
iont
hatgener
alequi
l
ibr
ium f
oral
lthe
economi
cagentandmar
ketcanber
[Link]
alequi
l
ibr
ium i
sast
ateofi
nwhi
ch
t
hef
oll
owi
ngcondi
ti
onshol
d:
Ev
eryconsumerchooseshi
sorherpr
efer
redmar
ketbasketsubj
ect
edt
ohi
sorherbudget
l
i
ne.
Ev
eryconsumersuppl
i
eswhat
everamountofi
nput
sheorshechooses,gi
vent
he
i
nputandpr
oductpr
icest
hatpr
evai
l
.
Ev
eryf
ir
m maxi
mizesi
tspr
ofi
tsubj
ect
edt
otheconst
rai
ntsi
mposedbyt
heav
ail
abl
e
t
echnol
ogy,
thedemandf
ori
tspr
oduct
,andt
hesuppl
yofi
nput
s
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 156
Long-
runeconomi
cspr
ofi
tsar
ezer
oforev
eryf
ir
m.
Thequant
it
ydemandedequal
sthequant
it
ysuppl
i
edatt
hepr
evai
l
ingpr
icesi
nal
l
pr
oductandi
nputmar
ket
.

I
tis ev
identf
rom t
he def
ini
ti
on t
hata gr
eatmany condi
ti
ons mustbe sat
isf
ied
si
mul
taneousl
yift
heequi
l
ibr
ium i
stobeachi
[Link]
ncl
udeequi
l
ibr
ium i
n
exchange
pr
oduct
ion
Consumpt
ion…et
c.
Gi
vent
heabov
econdi
ti
onsf
orequi
l
ibr
ium;canwebesur
ethati
tcanbeachi
eved?I
fso,
whatar
ethesecondi
ti
ons?

Thef
ir
standsi
mpl
estgener
alequi
l
ibr
ium modelwasi
ntr
oducedi
n1874byLeonWal
ras,
t
houghthewasnev
erabl
etopr
ovet
heexi
stenceofagener
alequi
l
ibr
ium. I
nthe
Wal
rasi
ansy
stem,al
lpr
icesandquant
it
iesi
nal
lmar
ket
sar
edet
ermi
nedsi
mul
taneousl
y
t
hrought
hei
rint
eract
ionwi
thoneanot
her(
byt
hesol
uti
onoft
hesy
stem ofequat
ions)
.
Thust
hef
ir
stt
aski
nest
abl
i
shi
ngt
heexi
stenceofagener
alequi
l
ibr
ium i
stodescr
ibet
he
economybymeansofasy
stem ofequat
ionsi
nwhi
cht
henumberofunknownsshoul
dbe
equalt
othenumberofequat
[Link]
ssy
stem oneoft
heequat
ionshasar
edundant(
not
ani
ndependent
)equat
ionanddepr
ivest
hesy
stem ofasol
uti
onsi
ncet
henumberof
i
ndependentequat
ionsi
slesst
hant
[Link],i
nthi
smodel
,the
absol
utel
evel
ofpr
icescannotbedet
ermi
ned.

To sol
vet
hese pr
obl
em gener
alequi
l
ibr
ium t
heor
ist
s hav
e adopt
ed t
he dev
ice of
choosi
ngar
bit
rar
il
ythepr
iceofonecommodi
tyasanumer
air
e(oruni
tofaccount
)and
expr
essal
lot
herpr
icesi
nter
imsoft
hepr
iceoft
henumer
air
[Link]
tht
hisdev
iceeachpr
ice
i
sgi
venr
elat
ivet
othepr
iceoft
henumer
air
[Link]
eni
fther
eisequal
i
tyofi
ndependent
equat
ionsandunknownst
her
eisnoguar
ant
eet
hatagener
alequi
l
ibr
ium sol
uti
onexi
sts.

I
n1954Ar
row andDebr
eupr
ovi
dedapr
oofoft
heexi
stenceofagener
alequi
l
ibr
ium i
n
per
fect
lycompet
it
ivemar
ket
s,i
nwhi
cht
her
ear
enoi
ndi
vi
sibi
l
iti
esandnoi
ncr
easi
ng
r
etur
nst
oscal
e.I
n1971Debr
euandHahnpr
ovedt
heexi
stenceofagener
alequi
l
ibr
ium
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 157
ECON102MI
CROECONOMI
CSI
I

f
oraneconomywi
thl
i
mit
edi
ncr
easi
ngr
etur
nsandmonopol
i
sti
ccompet
it
ion,wi
thout
i
ndi
vi
sibi
l
iti
[Link]
eisnopr
oofsof
art
hatshowst
heexi
stenceofagener
alequi
l
ibr
ium i
n
ol
i
gopol
yandmonopol
ymar
ket
s.

Apar
tfr
om t
heexi
stencepr
obl
em,t
woot
herpr
obl
emsar
eassoci
atedwi
thequi
l
ibr
ium:
t
hepr
obl
em ofi
tsst
abi
l
ityandt
hepr
obl
em ofi
tsuni
queness. Thati
srel
atedt
othepr
ice
andout
putt
hatmakeupt
hegener
alequi
l
ibr
[Link]
ethepr
iceandout
putt
hatmakeup
t
hegener
alequi
l
ibr
ium beuni
que?Ori
sther
eonesetofpr
icesandout
put
sthatf
orwhi
ch
t
hequant
it
ysuppl
i
edequal
squant
it
ydemandedi
nal
lmar
ket
?Cl
ear
lyt
heansweri
sno.
Thi
sisbey
ondt
hescopeoft
hecour
se.

Thoughti
thav
eal
lthesedr
awbacks,i
tisi
mpor
tantt
oknowt
hegener
alequi
l
ibr
ium can
be achi
eved underper
fect
ly compet
it
ive mar
ket
.Because t
he ci
rcumst
ances under
per
fect
lycompet
it
iveeconomyhasav
ari
etyofdesi
rabl
echar
act
eri
sti
csast
hemar
keti
sa
benchmar
kforcompar
isonwi
thot
hermar
ket
.Hence,
wel
ookatgener
alequi
l
ibr
ium f
orm
undercompet
it
ivemar
ketf
rom t
hosemaj
oract
ivi
ti
es:
exchange,pr
oduct
ion,consumpt
ion
andt
hei
rint
erdependences.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
5.
[Link]
ivi
ty:
[Link]
ethedi
ff
erencesandsi
mil
ari
ti
esofpar
ti
alandgener
alequi
l
ibr
ium?
[Link]
chonedoy
out
hinki
sappr
opr
iat
efordeci
si
onmaki
ngandpol
i
cymaki
ng?

5.
[Link]
LIBRUI
MINPERFECTLYCOMPETI
TIYMARKET
5.
[Link]
MPLEMODELOFGENERALEQUI
LIBRI
UM
Toi
l
lust
rat
etheconceptofgener
alequi
l
ibr
ium i
nsi
mpl
emodelwemakeassumpt
ions
aboutt
heeconomi
cagentandt
hemar
kett
heeconomy
.Supposet
hatoursi
mpl
i
fied
economyhav
eonl
ytwoi
ndi
vi
dual
swi
thcer
tai
nlev
elofr
esour
ceendowment
sisol
ated
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 158
f
rom t
her
estoft
hewor
[Link]
especi
fi
cal
l
ywecr
eat
eawor
ldwher
e;
Ther
ear
etwocommodi
ti
es“
X:and“
Y”;andt
hesecommodi
ti
esar
eav
ail
abl
einaf
ixed
amount
.
Ther
ear
etwoi
ndi
vi
dual
ssay
,AandB,
eachpossessagi
venamountofbot
hresour
cesas
t
hei
rini
ti
alendowment
.
Thepr
efer
enceandt
ast
e ofagent
sfort
het
wopr
oduct
sdi
ff
[Link]
lassumpt
ionf
ort
he
r
ati
onali
ndi
vi
dualwedi
scussedunderconsumerpr
efer
encet
heor
[Link]
nst
ances,t
hei
r
goal
ismaxi
mizat
ionofut
il
it
y,nonsat
iat
ion,
usual
U-shapedi
ndi
ff
erencecur
ve.
..
etc

Supposethetot
alamountofgoodsXandYarer
epresentedby and r espect
ivel
[Link]
h
i
ndivi
dual
sownsomeofXandsomeofYast hei
rini
ti
alendowment
.Thus, = A + B and
= A+ B..

Thi
scanbepr
esent
edgr
aphi
cal
l
ybyl
abel
i
ngt
hev
ert
icalaxi
sthel
evelofout
putY
consumedbyeachi
ndi
vi
dual
,wher
east
hehor
izont
alaxi
sthel
evelout
putXconsumed
byeachi
ndi
vi
duali
nsuchawayt
hateachoft
hem ar
eont
hei
rrespect
ivei
ndi
ff
erence
cur
veI
A and I
B .Atanypoi
nti
nthedi
agr
am i
ndi
cat
eacer
tai
nal
l
ocat
ionoft
he
commodi
tyf
orconsumpt
ion.
A

I
B(B)
B,

B
0A A 0B

Fi
gur
e5.
[Link]
thBoxofi
ndi
vi
dualAandB

Supposef
urt
hert
hatt
het
woagent
sint
eracti
nsuchawayt
hateachmaxi
mizesi
ts
sat
isf
act
ion.I
not
herwor
dtheyv
olunt
arypar
ti
ci
pat
eint
radeassumi
ngbot
hindi
vi
dual
s
gai
nfr
om t
[Link]
eisaconv
eni
entgr
aphi
calt
oolknownast
heEdgewor
th
boxt
hatcanbeusedt
oanal
yzet
heexchangeoft
wocommodi
ti
esbet
weent
wopeopl
e.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 159
ECON102MI
CROECONOMI
CSI
I

Si
mpl
emodel
scanmakepr
oduct
iveuseofwhateconomi
stshav
edubbedt
he“
Edge
wor
thboxdi
agr
am”
.Theboxal
l
owsust
odepi
ctt
heendowmentandpr
efer
encesoft
wo
i
ndi
vi
dual
inaconv
eni
entdi
agr
am,
whi
chcanbeusedt
ost
udyt
hev
ari
oust
radi
ngpr
ocess.
AnEdgewor
thboxdi
agr
am showst
hei
nter
act
ionbet
weent
woeconomi
cact
ivi
ti
eswhen
t
het
otalquant
it
iesofcommodi
ti
esconsumedori
nput
sar
efi
xed. Thel
engt
handwi
dth
ofanEdgewor
dboxdi
agr
am r
epr
esentt
hequant
it
iesoft
wocommodi
ti
est
hatar
e
av
ail
abl
etobot
hconsumer
[Link]
nti
ntheboxr
epr
esent
sanal
l
ocat
ionbet
ween
t
woconsumer
soft
het
otalquant
it
iesoft
het
wogoodssuppl
i
[Link]
hei
rint
eract
ion
weputt
oget
hert
heset
wogr
aphsbymaki
ngcer
tai
nrear
rangementont
hepr
esent
ati
ons.
Thi
scanbedonei
fwer
otat aphby1800i
eBsgr tappear
stobeupsi
de-dawnandconnect
i
twi
tht
[Link]-
wor
thBoxdi
agr
am i
sfor
medbybr
ini
ngt
het
wogr
aphst
oget
her
asshownbel
ow.

Theal
l
ocat
ioncanber
eadf
rom t
[Link]
ntPf
orexampl
e,i
ndi
cat
est
hatA’
sconsumes
OAXAuni
tofXandOAYAuni
[Link]’
sconsumpt
ioni
smeasur
edf
rom i
tsv
ert
exat
t
het
opupperr
ightcor
neroft
heboxdi
agr
am -
[Link]
it
yofXconsumedbyBi
s
measur
edbyt
hehor
izont
aldi
stancet
othel
eftofasecondor
igi
[Link]
s,OBXBuni
tof
X. Ver
ti
caldi
stancesdownwar
dfr
om t
he same or
igi
n measur
est
he quant
it
yofY
consumedbyB–OBYBuni
tofY.
Ev
erypoi
nti
ntheboxt
her
efor
eindi
cat
esacer
tai
nal
l
ocat
ionoff
oodt
[Link]
di
mensi
onoft
hebox pr
ovi
deev
enmor
einf
ormat
ion-t
heydef
inet
het
otalquant
it
y
av
ail
abl
eforconsumpt
ionf
ort
het
woagent
[Link]
ntPi
ndi
cat
ethatAconsumesOAXA
ofX,
thust
her
estwi
l
[Link]
sX-
OAXA=[Link]
ogywi
l
l
hol
dforY.
Aswehav
eseeni
nmodul
eonet
heunderconsumerpr
efer
encet
heor
y,t
heeconomi
c
agent
spr
efer
encesf
orgooddi
ff
ersdependi
ngont
heendowmentandot
herf
act
ors.
Hence,
agentmayhav
eser
iesofi
ndi
ff
erencecur
[Link]
hati
ndi
vi
dual
A’s
pr
efer
encesf
orgoodXandgoodYar
eshownbyi
ndi
ff
erencecur
ves,
IA,
II
A,I
II
[Link]
he
ot
herhand,
indi
vi
dual
B’si
ndi
ff
erencecur
vesar
eshownbyI
B,I
IBandI
II
Bint
hef
oll
owi
ng
f
igur
e

B
ADAMAUNI
VERSI
TY,
DEPARTMENTO
BFECONOMI
CS
0B 160
Y
I
fwer
otat
eindi
vi
dualB’
sindi
ff
erencecur
veby1800 wegett
hef
oll
owi
ngFi
gur
e5.
[Link]
cannow uset
heEdgewor
thboxconst
ruct
iont
oanchoradi
scussi
onoft
hepr
ocessof
[Link]
hatend,consi
deroursi
mpl
eeconomyoft
woconsumer
s(AandB)
,and
onl
ytwocommodi
ti
es(
XandY)
.Ther
eisnopr
oduct
[Link]
yeconomi
cpr
obl
em i
s
t
heal
l
ocat
ionofagi
venamountofXandYbet
weent
het
woconsumer
[Link]
economy
,tobesur
e,butonewi
thenoughr
ichnesst
oassi
sti
nexpl
ori
ngt
hepr
ocessof
[Link]
ir
stt
oest
abl
i
shi
ndi
vi
dualendowment
[Link]
hat
poi
ntPr
epr
esent
sthei
nit
ialdi
str
ibut
ion(
Endowment
)ofcommodi
tyXandYbyi
ndi
vi
dual
A andB.I
ndi
vi
dualA has A uni
tsofX and A uni
[Link]
mil
arl
yindi
vi
dualBhas

B uni
tsofXandBuni
[Link]
tof
t
radi
ngmi
ghtt
akepl
ace(
ift
het
womenwer
efr
eet
otr
adewi
thoneanot
her
)?Whatcan
besai
daboutt
heef
fi
ci
ental
l
ocat
ionoft
hecommodi
ti
esbet
weent
het
women?

ADAMAUNI TYDEPARTMENTOFECI
VERSI I
OI
NOMI
A CS 161
D
A
I
IA
I
II
B
ECON102MI
CROECONOMI
CSI
I

(
a) (
b)

Tof
indout
,wemusti
nser
tindi
ff
erencecur
vest
oouranal
ysi
sandsel
ectt
hecombi
nat
ion
t
hatmaxi
mizet
hei
rsat
isf
act
[Link]
vent
hei
ndi
ff
erencecur
veofA,A’
swel
l
-bei
ng i
s
i
ncr
easedbymov
ingt
owar
dst
heor
igi
[Link]
eeofA’
sindi
ff
erencecur
vesar
edr
awn
t
her
e:I
A,I
IA,andI
II
[Link]
het
hree,t
hehi
ghesti
ndi
ff
erencecur
vei
sII
IA;t
hel
owesti
sI .
A.

Si
mil
arl
y,B’
swel
lbei
ngwi
l
lbei
ncr
easedbymov
ingt
owar
dst
heor
igi
[Link]
eeofB’
s
i
ndi
ff
erencecur
vesar
eal
sodr
awnt
her
e:I
B,I
IBandI
II
[Link]
ghesti
ndi
ff
erencecur
veof
t
het
hreei
sII
IB;t
hel
owesti
sIB.A’
ssat
isf
act
ionwoul
dgener
all
yimpr
ovei
fwemov
edhi
s
al
l
ocat
ionf
rom poi
ntscl
oset
ohi
sor
igi
n(poi
ntOA)t
opoi
ntscl
osert
otheupper
-r
ight
cor
neroft
[Link]
ersel
y,B’
ssat
isf
act
ionwoul
dgener
all
yimpr
ovei
fwemov
edhi
s
al
l
ocat
ionf
rom poi
ntscl
oset
otheupper
-r
ightcor
neroft
heboxt
opoi
ntscl
osert
othe
or
igi
nOA.

Gi
vent
hei
nit
ialal
l
ocat
ionoff
oodandmedi
cine,
wef
indt
heAi
soni
ndi
ff
erencescur
veI
IA

andBi
soni
ndi
ff
erencecur
veI
Batpoi
[Link]
hispoi
nt,A’
smar
ginalr
ateofsubst
it
uti
on
ofXf
orYi
smuchhi
ghert
hanB’
[Link]
hat
?Fi
gur
e5.
4showst
hatt
hesl
ope
ofI
IAatpoi
ntPi
slar
gert
hant
hesl
opofI
B.I
fbot
hmenwer
efr
eet
otr
ade,t
her
efor
e,A
woul
dbei
nter
est
edi
ntr
adi
ngsomeYt
oBi
nexchangef
[Link]
ntt
o
whi
cht
heymi
ghtmov
ecannotbepr
edi
cted.I
fAwer
ethemor
east
utebar
gai
ner
,thenhe
mi
ghtgetBt
oacceptt
heal
l
ocat
ionatpoi
ntE4wher
eBwoul
dbenobet
terof
fthanbef
ore
(
sincehewoul
dst
il
lbeoni
ndi
ff
erencescur
veI
IB)
.If
,ont
heot
herhand,Bwer
ebet
ter
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 162
negot
iat
or,t
henhemi
ghtgetAt
oacceptt
heal
l
ocat
ionatpoi
ntE2 wher
eAwoul
dbeno
bet
terof
fthanbef
ore(
sincehewoul
dst
il
lbeoni
ndi
ff
erencescur
veI
IA)
.Ifnei
therBnorA
wer
esoski
l
ledi
nnegot
iat
ingt
hathecoul
dext
ractal
loft
he“
sur
plusv
alue”f
rom t
het
rade,
t
hens(
aswoul
dbemostl
i
kel
y),t
heul
ti
mat
epoi
ntofequi
l
ibr
ium woul
dli
esomewher
e
bet
weenE2andE4.

B XB

I
B OB

YB
A I
I B
B
P
I
II
B E5
E4 VB

I
VB E3
I
VA
E2 I
II
A

I
VB E1 I
IA

I
A
YA

OA A

XA

Fi
gur
e.5.
[Link]
mul
taneousequi
li
bri
um ofbot
hindi
vi
dual
s

Andwhatwoul
dchar
act
eri
zet
hisequi
l
ibr
ium?Theabsenceofanyt
radest
hat(
1)woul
dbe
accept
abl
etobot
hBandAand(
2)woul
dimpr
ovet
hewel
far
eofoneorbot
hoft
hem.
Thati
stosay
,themar
ginalr
atesofsubst
it
uti
onoff
oodf
ormedi
cinewoul
dhav
etobet
he
samef
orbot
hi.
e.t
hei
rindi
ff
erencecur
veswoul
dhav
etobet
hesamef
orbot
hi.
e.,t
hei
r
i
ndi
ff
erencecur
veswoul
dhav
etobet
angentt
ooneanot
heratt
hepoi
ntofequi
l
ibr
ium.

5.
[Link]
CIENCY

Thenot
ionofequi
l
ibr
ium canbeext
ended.I
ftheobj
ectwer
etomaket
hemenaswel
l
-of
f
possi
ble(
giv
ent
hei
runf
ort
unat
eci
rcumst
ancet
obegi
nwi
th)
,thenanef
fi
ciental
l
ocat
ion
oft
hecommodi
ti
eswoul
dbeonei
nwhi
cht
hemar
ginal
rat
eofsubst
it
uti
onofXf
orYwer
e
t
hesamef
orbot
[Link]
ustar
guedf
rom t
heot
hersi
de,i
fthatwer
enott
hecase,
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 163
ECON102MI
CROECONOMI
CSI
I

onemancoul
dbemadebet
terof
fwi
thoutmaki
ngt
heot
herwor
seof
f. Tangencyof
i
ndi
ff
erencecur
vesi
sther
efor
ethekeyt
ochar
act
eri
zi
ngequi
l
ibr
ium,
buti
tdoesnoty
iel
da
uni
quesol
uti
ont
othet
radi
ngquest
ion.I
ndeed,
ther
eisal
ocusofpoi
ntsatwhi
cht
het
wo
men’
sindi
ff
erencecur
vesar
etangent
;thi
slocusi
scal
l
edt
hecont
ractcur
ve.I
tisshown
i
nFi
gur
e5.
4andi
tincl
udesal
loft
hepoi
nts,
li
keE1,E2,
E3,
E4andE5,
forwhi
cht
hemar
ginal
r
atesofsubst
it
uti
onar
eequalf
orbot
hconsumer
[Link]
ractcur
eisasetofef
fi
cient
poi
ntsi
nav
eryspeci
[Link]
sli
keBandAwhomi
ghtbeatapoi
ntt
hatl
i
esof
f
t
hecont
ractcur
vecanal
way
sfi
ndapoi
ntont
hecont
ractcur
vet
hati
spr
efer
abl
etobot
h.
Why
?Becausemov
ingt
osuchapoi
ntwoul
dnotcostei
theranywel
far
eev
ent
houghi
t
guar
ant
eest
hatt
hewel
far
eofatl
eastoneoft
hem woul
dimpr
ove.

Par
etoef
fi
ci
encyi
sdef
ined,
asapoi
nt(
condi
ti
on)wher
eiti
simpossi
blet
omakeanyone
bet
ter
-of
fwi
thoutmaki
ngsomeonewor
se-
off
.But
,ifi
tispossi
blet
omakeanyonebet
ter
-of
fwi
thoutmaki
ngt
heot
herwor
se-of
f,t
hent
hecondi
ti
on(
thatpoi
nt)i
snotPar
eto-
ef
fi
cient
.Apoi
nti
saPar
etoopt
imali
fandonl
yift
her
eisnochanget
hatcanmakesome
onebet
terof
f,wi
thoutmaki
nganyonewor
se-of
f.

Thus,t
heabov
econdi
ti
on(
poi
ntP)i
snotPar
etoef
fi
cientf
orbot
hindi
vi
dual
[Link],i
t
i
spossi
blet
omakebet
ter
-of
foneoft
het
woi
ndi
vi
dual
swi
thoutmaki
ngt
heot
her
-wor
se-
of
fbyhav
ingv
olunt
aryexchangebet
weent
heset
woi
ndi
vi
dual
[Link]
nit
ialendowment
pl
acesi
ndi
vi
dualAoni
ndi
ff
erencecur
veI
IAandi
ndi
vi
dualBonI
[Link]
swi
l
li
ngt
ogi
veup
mor
euni
tsofYi
nor
dert
ogetaddi
ti
onaluni
tofX(
Becausei
twi
l
lbeonhi
gherl
evelof
i
ndi
ff
erencecur
ve)
.Si
mil
arl
yBi
sfol
l
owi
ngt
ogi
veupmor
euni
tofXt
oobt
ainaddi
ti
onal
uni
[Link]
tuat
ionwi
l
lleadt
otheexchangebet
weeni
ndi
vi
dual
s
Fr
om t
hepoi
ntP,
Awi
l
ltr
adesomeYt
oB,
recei
vi
ngXi
nexchange
Theexactbar
gai
nreachedbyt
het
wopar
ti
es.
I
fAi
smor
eski
l
l-f
ullnegot
iat
or,Amayi
nduceBt
omov
eal
ongi
ndi
ff
erencecur
veI
IBf
orm
poi
ntPt
oe4whi
l
eAmov
esf
rom i
ndi
ff
erencecur
veI
IAt
oII
A.

Thus,
indi
vi
dualAr
ecei
vesal
lthegai
nfr
om t
heexchangewhi
l
eBgai
nsorl
oses
not
hing (
indi
ff
erent
) That i
s,t
he Par
eto opt
imal
i
ty occur
s,(
the Par
eto
i
mpr
ovement
). Atpoi
nte4 I
VA and I
IB i
stangentso t
hatt
hei
rsl
ope of
i
ndi
ff
erencecur
ve(
MRSXY)ar
eequal
andt
her
eisnof
utur
ebasef
orex
change.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 164
Ont
heot
herhand,i
fB i
smor
eski
l
l-f
ullnegot
iat
orandi
nducesA t
omov
eal
ongi
ts
i
ndi
ff
erencecur
veI
IAf
rom poi
ntPt
oe4 t
henBwoul
dgetal
lbenef
it
sofexchange,andA
woul
dnei
thergai
nnorl
ose.ATE2 t
heMRSXY ofAequal
sMRTSXY [Link]
her
eisnot
basef
orf
urt
herexchange.
Fi
nal
l
yifAmov
esf
rom poi
ntPt
oE3andBmov
esal
sof
rom Pt
oE3(
i.
[Link]
esf
rom I
IAt
o
I
II
AandBmov
esf
rom I
IBt
oII
IB)bot
hindi
vi
dual
sgai
nfr
om exchange.

Thus,st
art
ingf
rom poi
ntP,bot
hindi
vi
dual
sgai
nthr
oughexchangebymov
ingt
oapoi
nt
onal
i
neE2E4orbet
[Link]
vest
hatj
oint
hel
ocusofal
ltangencypoi
ntsof
t
hei
ndi
ff
erencecur
vesoft
het
woi
ndi
vi
dual
s(OA,OB)i
scal
l
edt
hecont
ractcur
veof
exchangeAl
ongt
hiscur
vet
heMRSXYi
sthesamef
ori
ndi
vi
dual
sAandB,
andt
heeconomy
i
singener
alequi
l
ibr
ium ofexchange.
Thus,
equi
l
ibr
ium i esMRSAXY=MRSBXY
mpl
i

St
art
ingf
rom anypoi
ntoutsi
det
hecont
ractcur
veAorBorbot
hcanbebenef
it
edf
rom
exchangewi
thoutmaki
ngt
heot
herwor
se-
off
.Onceont
hecont
ractcur
vet
het
wo
i
ndi
vi
dual
scannotbebet
terof
fwi
thoutmaki
ngt
heot
herwor
se-
off
.Thus,
ever
ypoi
nton
t
hecont
ractcur
vei
sPar
etoopt
imal
andt
hecont
ractcur
vei
sal
owofPar
etoopt
imal
i
ty.

Consi
dert
hef
oll
owi
ngEdgewor
th1 boxdi
agr
am f
[Link]
mensi
onsoft
hebox
ar
egi
venbyt
het
otalamountoft
het
wocommodi
ti
es(
10Xand8Y)ownedbyt
het
wo
i
ndi
vi
dual
stoget
her
.Int
hebox,cur
vesdenot
edbyA1,A2 …A4r
epr
esentt
hei
ndi
ff
erence
cur
vesofi
ndi
vi
dualA andt
hecur
vesdenot
edbyB1,B2…B4 r
epr
esentt
hei
ndi
ff
erence
cur
vesofi
ndi
vi
dual
B

Anypoi
nti
nsi
det
heboxi
ndi
cat
eshow t
het
otalamountoft
het
wocommodi
ti
esi
s
di
str
ibut
edbet
weent
woi
ndi
vi
dual
[Link]
e,poi
ntCi
ndi
cat
est
hati
ndi
vi
dualAhas
3Xand6Yf
ort
hecombi
nedt
otal
of10Xand8Y(
thedi
mensi
onsoft
hebox)
.
Supposet
hatpoi
ntcdoesi
nfactr
epr
esentt
heor
igi
naldi
str
ibut
ionofcommodi
ti
esXand
Ybet
weeni
ndi
vi
dual
[Link]
nceatpoi
ntC,i
ndi
ff
erencecur
vesA2 andB1i
nter
sect
,
1
TheEdgewor
thboxisaconvenientgraphical
toolt
hatcanbeusedtoanal
yzetheexchangeoft
wogoods
bet
weentwopeople.I
tisnamedinhonorofFr anci
sYsidroEdgewor
th(
1845-1926)
,anEngli
sheconomi
st
whowasoneofthef i
rstt
ousethisanalyt
icalt
ool.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 165
ECON102MI
CROECONOMI
CSI
I

t
hei
rsl
opeormar
ginalr
ateofsubst
it
uti
onofcommodi
tyX f
orcommodi
tyY(
MRSxy)
di
ff
[Link]
art
ingatpoi
ntC,i
ndi
vi
dualAi
swi
l
li
ngogi
veup4Yt
ogetoneaddi
ti
onaluni
tof
X(andmov
etopoi
ntEonA2)
,whi
l
eindi
vi
dualBi
swi
l
li
ngt
oaccept0.
2Yi
nexchangef
or
oneuni
tofXandmov
etopoi
ntHonB1)i
.e.
,MRSxy=4f
orAandMRSxy=0.
[Link]
Ai
swi
l
li
ngt
ogi
veupmuchmor
eYt
hannecessar
ytoi
nduceBt
ogi
veup1X,t
her
eisa
basi
sforexchanget
hatwi
l
lbenef
itei
therorbot
hindi
vi
dual
[Link]
sist
ruewhenev
er,asat
poi
ntC,
theMRSxyf
ort
het
woi
ndi
vi
dual
sdi
ff
ers.

10 9 8 7 6 5 4 3 2 1 OB
8
1
7
H
C 2
6
Y
A4
G 3
5 B1
A3 4
B2
yY

4 F
t

5
Commodi

3
B3
6
E
2 B4 7
A2
D

1 8
A1

OA 1 2 3 4 5 6 7 8 9 10

Commodi
tyX

Forexampl
e,st
art
ingf
rom poi
ntC,
ifi
ndi
vi
dualAexchanges4Yf
or1Xwi
thi
ndi
vi
dualB,
A
mov
esf
rom poi
ntCt
opoi
ntDal
ongt
hei
ndi
ff
erencecur
veA1whi
l
eBmov
esf
rom poi
ntC
onB1 t
opoi
ntD al
ongA1 whi
l
eBmov
esf
rom poi
ntC onB1 t
opoi
ntD [Link],
i
ndi
vi
dualBr
ecei
vesal
loft
hegai
nsf
rom exchangewhi
l
eindi
vi
dualA gai
nsorl
oses

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 166
not
hing(
sinceAr
emai
nsonA1)
.Atpoi
ntD,A1 andB3 ar
etangent
,sot
hatt
hei
rsl
opes
(
MRSxy)ar
eequal
,andt
her
eisnof
urt
herbasi
[Link]
ntD,t
heamountofy
t
hatAi
swi
l
li
ngt
ogi
veupf
or1Xi
sexact
lyequalt
owhatBr
equi
rest
ogi
[Link]
f
urt
herexchangewoul
dmakeei
theri
ndi
vi
dualwor
seof
fthanhe/
shei
satpoi
ntD.t
he
samecanbesai
daboutpoi
ntsEandF,
.Thel
ocusoft
angencypoi
ntsoft
hei
ndi
ff
erence
cur
vesoft
het
woi
ndi
vi
dual
s(OADEFOB)i
sthecont
ractcur
vef
[Link]
s,al
ong
t
hecont
ractcur
vef
orexchange,t
hemar
ginalr
ateofsubst
it
uti
onofcommodi
tyXf
or
commodi
tyYi
sthesamef
ori
ndi
vi
dualAandB,
andt
heeconomyi
singener
alequi
l
ibr
ium
[Link],
forequi
l
ibr
ium,

MRSxyA=MRSxyB
St
art
ingf
rom anypoi
ntont
hecont
ractcur
ve,
bot
hindi
vi
dual
scangai
nfr
om ex
changeby
get
ti
ngt
oapoi
ntont
hecont
ractcur
[Link]
s
and manycommodi
ti
es,t
hegener
alequi
l
ibr
ium ofexchangeoccur
swher
etheMRS
bet
ween ev
erypai
rofcommodi
ti
esi
sthesamef
oral
lconsumer
sconsumi
ng bot
h
commodi
ti
es.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
__
5.
[Link]
ivi
ty
Whendowesayt
hatagi
veneconomyi
sinagener
alequi
l
ibr
ium ofexchange?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_

5.
[Link]
alEqui
li
bri
um i
npr
oduct
ion;
Two-
Input
-Two–Out
putCase

Thepr
ecedi
ngsect
ionf
ocusedourat
tent
ionont
hecasei
nwhi
chconsumer
sexchange
quant
it
iesofcommodi
ti
esi
ntheabsenceofpr
oduct
ion.I
nthi
ssect
ionandt
henext
,we
t
akeupt
heequi
val
entsi
mpl
ecasei
nwhi
cht
her
eispr
oduct
ionbutnoconsumpt
[Link]
dogener
alequi
l
ibr
ium l
ookl
i
ke?

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 167
ECON102MI
CROECONOMI
CSI
I

To exami
ne gener
alequi
l
ibr
ium i
n pr
oduct
ion,we make assume aboutt
he pr
oduct
pr
oducedandf
act
[Link]
der
av
erysi
mpl
eeconomyt
hatpr
oducesonl
ytwogoods,
XandY,
wit
honl
ytwoi
nput
s(Land
K)
Thecount
ryhasf
ixedendowmentofandwhi
chwi
l
lbeusedt
opr
oducebot
hXandY
Suppose xuni
tofl
aborand xuni
tofcapi
tal
areusedi
npr
oduci
ngcommodi
tyX.
Ther
emai
ningyuni
tofl
abor
,andyuni
tofcapi
tal
areusedt
opr
oducecommodi
ty
[Link]
s =x+y and =x+y

Toexami
negener
alequi
l
ibr
ium ofpr
oduct
ion,weagai
nst
artf
rom andabst
ractanEdge
wor
thboxdi
agr
am f
orpr
oduct
ionusi
ngt
hei
soquant
sforcommodi
ti
esX andYi
na
mannercompl
etel
yanal
ogoust
otheEdgewor
thboxdi
agr
am f
orconsumpt
ionabov
eof
Fi
gur
e5.
[Link]
alequi
l
ibr
ium i
npr
oduct
ioni
spr
esent
edbyt
hef
igur
e5.
5.I
ntheedge
wor
thdi
agr
am f
orpr
oduct
ionshownabov
einf
igur
e5.
5,t
hesi
zeoft
heboxr
efer
stot
he
t
otalamountofLandK av
ail
abl
etot
heeconomy
.Whi
l
ethecur
vesi
nsi
det
hebox
i
ndi
cat
eshow t
het
otalamountoft
het
woi
nput
sisut
il
izedi
nthepr
oduct
ionoft
het
wo
commodi
ti
[Link]
dingl
y,l
ett
het
otalamountofl
abort
obeal
l
ocat
edbet
weent
het
wo
sect
orsbeOXLandt
het
otalamountofcapi
talt
obeal
l
ocat
edbet
weent
het
wosect
ors
[Link]
nal
l
y,supposet
hatt
hei
nit
ial
all
ocat
ionofl
aborandcapi
tal
bet
weent
het
wosect
ors
wer
erepr
esent
edbypoi
ntZi
ntheEdgewor
thboxdi
agr
am por
tray
edi
nFi
gur
e5.
[Link]
e
t
hat
;theXi
ndust
ryst
art
swi
thOxAuni
tsofl
aborandOxBuni
tsofcapi
tal
,whi
l
etheY
sect
orcomest
othet
abl
ewi
thOxL-
OxAuni
tsofl
aborandOxK-
OxBuni
tsofcapi
tal
.

Ont
hebasi
soft
hepr
oduct
ionf
unct
ionsf
orXandY,wecani
nser
tisoquant
sforbot
hX
pr
oduct
ionandYpr
oduct
ioni
nFi
gur
e5.
[Link]
eisoquant
sforXpr
oduct
ionar
edi
spl
ayed
t
her
e:I
x,I
Ix,andI
II
[Link]
het
hree,t
hei
soquantt
hatr
efl
ect
scombi
nat
ionsofcapi
taland
l
aborwi
tht
hehi
ghestout
putoff
oodi
sII
Ix,andt
hei
soquantf
ort
hel
owest–out
putof
f
oodsi
[Link]
eei
soquant
sformedi
cinepr
oduct
ionar
eal
sodi
spl
ayed:I
y,I
Iy,andI
II
y.
.
Agai
n,oft
het
hree,
thei
soquant
sthatr
efl
ect
scombi
nat
ionsofcapi
talandl
aborwi
tht
he
hi
ghestout
putofmedi
cinei
sII
Iy,
andt
hei
soquantf
ort
hel
owestout
putofmedi
cinei
sIy
.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 168
Ly 0y

Ly OY
KX Z I
y e4
A
I
Iy I
Vx KY
e3

I
II
x

e2
I
II
y I
V4
S I
Ix
I
Vy U’
e1

I
x
KX
OX B R Ky

0x Lx

Fi
gur
e5.
5:Gener
alEqui
li
bri
um i
npr
oduct
ion

Whatwoul
dbeanef
fi
ci
ental
l
ocat
ionofi
nput
sbet
weent
het
woout
put
s?Att
heor
igi
nal
al
l
ocat
ionatpoi
ntZ,t
hemar
ginalr
ateoft
echni
calsubst
it
uti
onofcapi
talf
orl
abori
n
pr
oduci
ngXi
shi
ghert
hani
tisi
npr
oduci
[Link]
sobser
vat
ioni
sbasedont
hef
actt
hat
t
hesl
opeofI
xatpoi
ntZi
sgr
eat
ert
hant
hesl
opofI
[Link]
actt
hatt
hemar
ginalr
atesof
t
echni
calsubst
it
uti
onar
eunequalatpoi
ntZmeanst
hatt
hei
nput
sar
enotbei
ngal
l
ocat
ed
ef
fi
cient
ly.

Toseewhy
,supposet
hatt
heXi
ndust
ryoper
ati
ngatpoi
ntZcoul
dsubst
it
ute2uni
tsof
l
aborf
or1uni
tofcapi
talwi
thoutchangi
ngi
tsout
putwhi
l
etheYi
ndust
rywoul
dhav
eto
subst
it
ute1uni
tofl
aborf
or2uni
tsofcapi
talt
omai
ntai
nit
sout
put
.Int
hiscase(
wher
e
t
heYi
ndust
ryusesmor
elaborandl
esscapi
talr
elat
ivet
othef
oodi
ndust
ry)
,itwoul
dbe
possi
blef
oronei
ndust
ryt
oexpandi
tsout
putwi
thoutanyr
educt
ioni
ntheot
heri
ndust
ry’
s
out
put
.Speci
fi
cal
l
y,i
twoul
dbepossi
blet
omov
etopoi
nt‘
e2’
,wher
etheout
putofXwoul
d
be t
he same as atpoi
ntZ ev
en t
hough t
he out
putofY woul
d cl
i
mb t
othe l
evel
cor
respondi
ngt
oII
Iy.I
twoul
dpossi
blet
omov
e t
opoi
nt ‘
e3’,wher
etheout
putof
medi
cinewoul
dbet
hesameasatpoi
ntZbutt
heout
putofXwoul
dcl
i
mbt
othel
evel

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 169
ECON102MI
CROECONOMI
CSI
I

cor
respondi
ngt
oII
[Link],ofcour
sei
twoul
dbepossi
blet
omov
etoapoi
ntbet
ween‘
e2’
and‘
e3’
forwhi
cht
heout
put
sofbot
hsect
orswoul
dexpandr
elat
ivet
othei
rlev
elsatpoi
nt
Z.

Regar
dlessofwhi
chpoi
ntwer
echosen,t
hesamei
deadescr
ibedabov
eshoul
dappl
y.
Pr
oduct
ionshoul
doccuratapoi
ntatwhi
cht
hemar
ginalr
atesoft
echni
calsubst
it
uti
on
bet
weeni
nput
sar
ethesamef
oral
lpr
oducer
[Link]
ythenwoul
dtheal
l
ocat
ionofi
nput
sbe
ef
fi
cienti
nthesenset
hatani
ncr
easei
ntheout
putofonecommodi
tycoul
dbeachi
eved
onl
ybyar
educt
ioni
ntheout
putoft
heot
hercommodi
[Link]
fi
ciental
l
ocat
ionofi
nput
s
must
,ther
efor
e,l
i
esomewher
eal
ongt
hel
ocusofpoi
ntswher
ethemar
ginalr
atesof
t
echni
calsubst
it
uti
onar
eequal
,and soi
tmustl
i
eatapoi
ntswer
eaYi
soquanti
s
t
angentt
oaXi
soquant
.Thel
ocusoft
hesepoi
nts,
li
ket
heanal
ogousseti
nthepr
ecedi
ng
sect
ion,i
sal
socal
l
edt
hecont
ractcur
ve;i
tisshowni
nFi
gur
[Link]
veOxe1e2e3Oyi
s
t
hecont
ractcur
vef
orpr
oduct
ion.I
tist
hel
ocusoft
angencypoi
ntsoft
hei
soquant
sforX
andYatwhi
cht
heMar
ginalRat
eofTechni
calSubst
it
uti
onofl
aborf
orcapi
tali
sthesame
i
nthepr
oduct
ionofXandY.t
hati
s,t
heeconomyi
singener
alequi
l
ibr
ium ofpr
oduct
ion
when
MRTSLKX=MRTSLKY
Pr
oducer
swhof
indt
hemsel
vesatapoi
ntt
hatl
i
esof
fthecont
ractcur
vecan,
ifsoci
etyi
s
i
nter
est
edi
npr
oduci
ngasmuchaspossi
bleofeachgood,mov
etoapoi
ntwher
ethe
out
putofonei
ndust
rycanbei
ncr
easedwi
thoutar
educt
iont
heot
heri
ndust
ry’
sout
put
.
Thusbysi
mpl
ytr
ansf
err
ingsomeoft
hegi
venandf
ixedamount
sofav
ail
abl
eLandk
bet
weent
hepr
oduct
ionofXandY,t
hiseconomycanmov
efr
om apoi
ntnotont
he
cont
ractcur
vef
orpr
oduct
iont
oapoi
ntont
hecur
veandi
ncr
easei
tsout
putofei
theror
bot
hcommodi
ti
[Link]
ti
esandmanyi
nput
s,t
hegener
al
equi
l
ibr
ium ofpr
oduct
ion occur
s wher
ethe mar
ginalr
ate oft
echni
calsubst
it
uti
on
bet
weenanypai
rofi
nput
sist
hesamef
oral
lcommodi
ti
esandpr
oducer
susi
ngbot
h
i
nput
s.
_
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___
5.
[Link]
ivi
ty

Whatdowemeanbyacontr
actcur
veforpr
oduct
ion?
__
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_ _
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___
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_
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 170
__
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____
___
_____
__ _
____
______
_____
____
____
____
___
Whatist
hecondi
tionfortheatt
ainmentofagener
alequi
li
bri
um ofpr
oduct
ion?
__
___
____
___
_____
__ _
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______
_____
____
____
____
____
_____
____
___
_____
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_ _
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___

5.
4.1.
THEPRODUCTI
ONPOSSI
BILI
TIESCURE

Thecont
ractcur
vei
nFi
gur
e5.
5showedt
hev
ari
ousal
l
ocat
ionsofi
nput
sthatar
eef
fi
cient
i
nthespeci
alsensedescr
ibei
nthepr
ecedi
ngsect
ion,Ther
eis,ofcour
se,al
evelof
out
putf
orX andY cor
respondi
ngt
oeachpoi
ntont
hecont
ractcur
e. Consi
der
,for
exampl
e,poi
nte2i
nFi
gur
exx.I
fthel
evelofout
putofXcor
respondi
ngt
oisoquantI
xwer
e
100andi
fthel
evelofout
putofYcor
respondi
ngt
oisoquantI
II
ywer
e200,
thenanout
put
of100uni
tsofXand200uni
tsofYwoul
dcor
respondt
othepoi
[Link]
mil
arl
y,i
fthel
evel
ofout
putofXcor
respondi
ngt
oisoquantI
Ixwer
e200andi
fthel
evelofout
putofY
cor
respondi
ngt
oisoquantI
Iywer
e100,t
henanout
putof200uni
tsofXand100uni
tsof
medi
cinewoul
dcor
respondt
othepoi
nte3.

Pr
oceedi
ngi
nthi
sway
,wecanf
indt
hepai
rofout
put
scor
respondi
ngt
oeachpoi
ntont
he
cont
ractcur
[Link]
henpl
oteachsuchpai
rofpoi
ntsi
nagr
aphl
i
ket
hati
nFi
gur
e
5.
6bel
ow,wher
etheamountofX pr
oducedi
sshownont
hehor
izont
alaxi
sandt
he
amountofYpr
oducedi
sshownont
hev
ert
icalaxi
[Link]
e,t
hepai
rofout
put
s
cor
respondi
ngt
opoi
nte2ont
hecont
ractcur
vesi
spl
ott
edaspoi
ntAi
nFi
gur
e5.
6,andt
he
pai
rofout
put
scor
respondi
ngt
opoi
nte3 ont
hecont
ractcur
eispl
ott
edaspoi
ntBi
n
Fi
gur
e5.
[Link]
heopposi
teor
igi
ninFi
gur
e5.
6,wher
eXpr
oduct
ioni
szer
obecauseY
empl
oysal
loft
hecapi
tal
andl
abor
,ispor
tray
edbypoi
ntPi
nfi
gur
e5.
[Link]
oini
ngpoi
ntsor
t
heout
putpai
rscor
respondi
ngt
oeachi
soquantt
angencypoi
ntswecander
ivet
hecer
tai
n
cur
[Link]
vePP’i
nFi
gur
e5.
6ist
her
esul
tofpl
ott
ingal
lthesepoi
ntsi
.e.t
heout
put
combi
nat
ionsassoci
atedwi
thal
loft
hepoi
ntsont
hecont
ractcur
e.I
tiscal
l
edt
he
pr
oduct
ionpossi
bil
it
ycur
[Link]
emembert
hisconceptf
rom y
ourf
ir
stl
ect
urei
n
i
ntr
oduct
oryeconomi
cs(
buti
twaspr
obabl
yder
ivedf
rom apr
oduct
ionf
unct
ionwi
thonl
y
onei
nput
).

ADAMAUNI
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ECON102MI
CROECONOMI
CSI
I

P Pr
oduct
ionpossi
bil
i
tiescur
ve
A’
200 .
D

.
E

100 B

100 200 P’ X

Fi
gur
e5.
6:Pr
oduct
ionpossi
bil
i
tiescur
ve

Thepr
oduct
ionpossi
bil
i
tiescur
veshowst
hev
ari
ouscombi
nat
ionofX out
putandY
out
putt
hatcanbeder
ivedf
rom t
heeconomy
’si
nputbase.I
noursi
mpl
emodelabov
eat
t
hebegi
nni
ngi
nfi
gur
e5.
5,t
hisbasei
sOFLuni
tsofl
aborandOFKuni
tsofcapi
tal
.Mor
e
speci
fi
cal
l
y,i
tshowst
hemaxi
mum out
putofonegoodt
hatcanbepr
oducedundert
he
ADAMAUNI
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CS 172
assumpt
iont
hatt
heout
putoft
heot
hergoodi
shel
dfi
[Link]
e;atpoi
nte2 gi
ven
quant
it
yofXi
sII
x,t
hemaxi
mum quant
it
yofYt
hatcanbepr
oducedi
sII
[Link]
y mil
arl
y,poi
nt
e3 oft
hecont
ractcur
veofpr
oduct
ionshowst
hatgi
venI
II
xthemaxi
mum amountofYt
he
economycanpr
oducei
sII
y.

Gi
vent
heeconomy
’si
nputbaseandexi
sti
ngt
echnol
ogy
,iti
simpossi
blet
oat
tai
napoi
nt
l
i
keDi
nFi
gur
e5.
6thati
sout
sidet
hepr
oduct
ionpossi
bil
i
tiescur
[Link]
heot
herhand,a
poi
nti
nsi
det
hePPFcor
respondst
oapoi
ntof
fthepr
oduct
ioncont
ractcur
vei
ndi
cat
es
t
hatt
heeconomyi
snoti
ngener
alequi
l
ibr
ium ofpr
oduct
ion,andi
snotut
il
izi
ngi
tsi
nput
s
ofl
aborandcapi
talmostef
fi
cient
ly.I
tispossi
blet
oat
tai
napoi
ntl
i
keEt
hati
sinsi
det
he
pr
oduct
ionpossi
bil
i
tiescur
ve,buti
twoul
dbei
nef
fi
cientt
odoso.I
ndeed,apoi
ntl
i
keE
woul
dcor
respondt
oapoi
ntl
i
keZi
nFi
gur
e5.
6(got
opr
oduct
ionpar
t)anal
l
ocat
ionof
i
nput
sthatdoesnotl
i
eal
ongt
hecont
ractcur
ve.

5.
4.2PRODUCTI
ONEFFI
CIENCYANDEQULI
BRI
UM

Asl
ongaspr
oduct
ioni
sef
fi
cient
,inputal
l
ocat
ionsl
i
eal
ongt
hecont
ractcur
vef
orwhi
ch
t
hemar
ginalr
atesoft
echni
calsubst
it
uti
onar
eequalf
oreachsect
or,
product
ionoccur
sat
somepoi
ntal
ongt
hepr
oduct
ionpossi
bil
i
tiescur
[Link]
hePPF,t
heout
putofei
ther
commodi
tycanbei
ncr
easedonl
ybyr
educi
ngt
heout
putoft
heot
her
.Theamountof
commodi
tyYt
hatt
heeconomymustgi
veup,atapar
ti
cul
arpoi
ntont
hePPFsoast
o
r
eleasej
ustenoughl
aborandcapi
talt
opr
oduceoneaddi
ti
onaluni
tofcommodi
tyX,i
s
cal
l
edt
heMar
ginal
Rat
eofTr
ansf
ormat
ionofXf
orY(
MRTxy)
.Thi
sisgi
venbyt
heabsol
ute
v
alueoft
hesl
opeoft
hePPFatt
hatpoi
nt.I
tisal
soequalt
other
ati
ooft
hemar
ginalcost
ofXt
othemar
ginal
costofY.

Thati
s,

TheMRPT measur
est
heamountofY t
hatmustbesacr
if
icedi
nor
dert
oobt
ainan
addi
ti
onal
uni
tofX.
ADAMAUNI
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ECON102MI
CROECONOMI
CSI
I

I
n per
fectmar
kett
he pr
ofi
tmaxi
mizi
ng pr
oducerorf
ir
m equat
ethe pr
ice oft
he
commodi
tyt
othemar
ginal
costpr
oduct
ion.i
.e.
,P=MCwhi
chi
mpl
i
es

Gi
vent
hecommodi
typr
ices,
gener
alequi
l
ibr
ium ofpr
oduct
ioncanbeat
tai
nedont
hePPC
atwhi
cht
hesl
opeofPPCequal
tot
her
ati
ooft
hepr
icesoft
hepr
oduct
[Link]
urt
hercl
ari
fy
wi
tht
hehel
pofgr
aphassumet
hatt
hemar
ketpr
iceofcommodi
tydef
inet
hesl
opeoft
he
l
i
[Link]
ati
oOA/
OBmeasur
est
her
ati
ooft
hemar
ginalcostoft
heset
wopr
oduct
s.
Thegener
alequi
l
ibr
ium ofpr
oductmi
xisshownbel
ow i
nFi
gur
e5.
[Link]
ryi
sin
equi
l
ibr
ium atpoi
ntTwher
ethel
evel
product
ioni
s X*andY*
.

A
MRPTXY=sl
ope

Y* T=MRPTXY=PX/
PY

Sl
ope=PX/
PY

X*
Fi
gur
e5.
7:Gener
alequi
li
bri
um i
npr
oductmi
x

5.
[Link]
ONANDEXCHANGE
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 174
Dearr
eader
s,upunt
ilnowwehav
ebeendev
elopi
ngt
ool
sformeasur
ingt
heat
tai
nmentof
gener
alequi
l
ibr
ium i
npr
oduct
ionandexchanger
espect
ivel
[Link]
ssect
ionbr
ingst
het
ool
s
t
oget
herso ast
o det
ermi
net
hesi
mul
taneousgener
alequi
l
ibr
ium ofpr
oduct
ionand
[Link]
s,wecanuset
hePPFandt
hecont
ractcur
vef
orexchanget
oexami
ne
howoursi
mpl
eeconomycanr
eachsi
mul
taneousl
ygener
alequi
l
ibr
ium ofpr
oduct
ionand
[Link]
l
lanal
yzehow t
heeconomycomest
oequi
l
ibr
ium?Fort
hispur
pose
i
l
lust
rat
ionswecombi
neourofexchangeandpr
oduct
ionassumpt
ionsabov
etoget
her
.

5.
5GeneralEquil
ibr
ium i
naTwo-
Fact
or,
Two-
Commodi
ty,
Two-
Consumer(2x2x2)Economy

Assumpt
ionsoft
he2x2x2model

Ther
ear
etwof
act
orsofpr
oduct
ion(
LandK)whosequant
it
iesar
egi
venexogenousl
y.
Thesef
act
orsar
eper
fect
lydi
vi
sibl
eandhomogeneous.
Onl
ytwocommodi
ti
es(
XandY)ar
epr
[Link]
ogyi
sgi
[Link]
soquant
maps hav
ethe usualpr
oper
ti
es (
smoot
h and conv
ex t
othe or
igi
nimpl
yi
ng
di
mini
shi
ngMRTSbet
weenf
act
orsal
onganyi
soquant
).
Eachpr
oduct
ionf
unct
ion
exhi
bit
sconst
antr
etur
nst
oscal
[Link]
wopr
oduct
ionf
unct
ionsar
eindependent
(
noext
ernal
i
tiesi
npr
oduct
ion)
.
Ther
e ar
etwo consumer
sint
he economy (
A and B)whose pr
efer
ences ar
e
r
epr
esent
edbyor
dinal
indi
ff
erencecur
ves,
whi
char
econv
ext
otheor
igi
n,exhi
bit
ing
di
mini
shi
ngMRSbet
weencommodi
ti
[Link]
s’choi
cesar
eindependent(
no
ext
ernal
i
tiesi
nconsumpt
ion)
.
Thegoalofeachf
ir
mispr
ofi
tmaxi
mizat
ionandt
hatofeachconsumeri
sut
il
it
y
maxi
mizat
ion.
Thef
act
orsofpr
oduct
ionar
eownedbyt
heconsumer
s.
Ther
eisf
ullempl
oymentoff
act
orsofpr
oduct
ion,andal
lincomesr
ecei
vedbyt
hei
r
owner
s(AandB)ar
espent
.
Ther
eisper
fectcompet
it
ioni
nbot
hcommodi
tyandf
act
ormar
ket
[Link]
sand
f
ir
msf
acet
hesamesetofpr
ices(
Px,
Py,
w,r
).

ADAMAUNI
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I

Theal
l
ocat
ionquest
ioncannowbecasti
nthi
scombi
nat
ionwor
[Link]
vent
hei
nputbase,
t
he i
ndi
ff
erence maps oft
he consumer
s,and t
he pr
oduct
ion f
unct
ions i
nthe t
wo
i
ndust
ri
es,howshoul
dthesei
nput
sbeal
l
ocat
edbet
weeni
ndust
ri
es?Andhowshoul
dthe
out
putofgoodsbeal
l
ocat
edbet
weent
heconsumer
s?

I
nthi
smodelagener
alequi
l
ibr
ium i
sreachedwhent
hef
ourmar
ket
s(t
wocommodi
tyand
t
wo f
act
ormar
ket
s)ar
ecl
ear
ed atasetofequi
l
ibr
ium pr
icesand each par
ti
cipant
economi
cagent(
twof
ir
msandt
woconsumer
s)i
ssi
mul
taneousl
yinequi
l
ibr
[Link]
nthe
pr
ecedi
ngt
wosect
ions,t
hiseconomycanuseat
otalofOFLuni
tsofl
aborandOFKuni
ts
ofcapi
tal
.

Y
Pr
oduct
ionpossi
bil
i
tiescur
ve
P A”

200

A’
N
C1’

B” A”
”
H3’

T1’
B
M1 H2’

B”
T2’
H1’
C1
T3’
O
F1 100 Q 200 P’ X

Fi
gur
e5.
8:Pr
oduct
ionandexchangeequi
l
ibr
ium
ADAMAUNI
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CS 176
[Link]
NGCONSUMPTI
ONBETWEENI
NDI
VIDUALS

I
fthei
soquantmapi
neachi
ndust
rydi
spl
ayedi
nfi
gur
ebbwer
eappl
i
cabl
ethenwewoul
d
knowf
rom t
hepr
ecedi
ngsect
iont
hatt
hev
ari
ouscombi
nat
ionsofXout
putandYout
put
t
hatcoul
dbeder
ivedf
rom t
hisi
nputbasewer
egi
venbyt
hepr
oduct
ionpossi
bil
i
tiescur
ve
PP’
inFi
gur
e5.
[Link]
scur
vePP’
repr
oducedi
nfi
gur
e5.
[Link],
fort
hemoment
,thatwe
al
soknewt
hecomposi
ti
onofout
put(
i.
e.,
theamountofXandY)t
hatshoul
dbepr
oduced
i
ntheeconomy
.Wecoul
dtheni
nser
tanEdgewor
thboxdi
agr
am si
mil
art
othati
nFi
gur
e
5.
5asi
nexchangecasei
ntoFi
gur
e5.
[Link]
-r
ightcor
neroft
heboxwoul
dsi
mpl
ybe
t
he poi
nton t
he pr
oduct
ion possi
bil
i
ties cur
ve cor
respondi
ng t
othi
s pr
edet
ermi
ned
composi
ti
onofout
put
.

Tobemor
especi
fi
c,supposet
hatweknewt
hatt
hecomposi
ti
onofout
puti
ntheeconomy
shoul
dber
epr
esent
edbypoi
ntA’
,wher
ethequant
it
yofXpr
oducedwoul
dequal
Qandt
he
quant
it
yofYpr
oducedwoul
dbeN. Wecoul
dthendr
aw anEdgewor
thdi
agr
am f
or
consumpt
ionwi
thQasi
tswi
dthandNasi
tshei
ght
.Si
nceQandNwoul
dbet
het
otal
amountofXandYt
obedi
str
ibut
edt
oAandB,r
espect
ivel
[Link]
sboxdi
agr
am coul
dbe
usedt
oseehowmuchoft
otal
out
putofeachgoodwoul
dgot
oeachconsumer
.Fi
gur
edd
showsi
ndi
ff
erencecur
vef
oreachconsumer(
T1’
,T2’
,andT3f
orA;H1’
,H2’
,andH3’f
orB)
wi
thi
ntheboxdef
inedbyQ,A’
,N,andt
heor
igi
n.I
tal
soshowst
hecont
ractcur
e,C1C1’
.
Recal
lthatt
hisi
sthel
ocusofpoi
ntswher
eA’
sindi
ff
erencecur
vesar
etangentt
oB’
s.

Weknowt
hatt
hedi
str
ibut
ionofout
putbet
weent
het
woconsumer
sshoul
dbesucht
hat
t
heyshoul
dli
eont
hecont
ractcur
veC1C1’
.But
,wher
e?Weshowi
nthef
oll
owi
ngsect
ion
t
hat
,ift
he economy
’s out
putwer
e al
l
ocat
ed so t
hatconsumersat
isf
act
ion wer
e
maxi
mized,t
hent
hemar
ginalr
ateofpr
oductt
ransf
ormat
ion(
themagni
tudeoft
hesl
ope
oft
hepr
oduct
ionpossi
bil
i
tiescur
ve)shoul
dequalt
hemar
ginalr
ateofsubst
it
uti
on.I
fthe
economy
’sout
putwer
eal
l
ocat
edt
omaxi
mizeconsumersat
isf
act
ion,
thent
heconsumer
s
shoul
dbeatt
hepoi
ntoft
hecont
ractcur
vewher
ethecommonsl
opeoft
hei
rindi
ff
erence
ADAMAUNI
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CSI
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cur
vesequal
sthesl
opeoft
hepr
oduct
ionpossi
bil
i
tiescur
veatA’
.

Wher
eont
hecont
ractcur
vewoul
dthecommonsl
opeoft
hei
rindi
ff
erencecur
vesequal
t
hesl
opeoft
hepr
oduct
ionpossi
bil
i
tiescur
veatA’
?Anexami
nat
ionofFi
gur
eddshows
t
hatt
hiscondi
ti
onwoul
dbef
ulf
il
ledatpoi
ntBont
hecont
ractcur
ve,wher
eA woul
d
r
ecei
veF1uni
tsofXandM1uni
tsofYwhi
l
eBwoul
drecei
veQ-
F1uni
tsofXandN-
M1uni
ts
[Link]
opesoft
hei
ndi
ff
erencecur
esatpoi
ntBequalt
hesl
opeoft
hepr
oduct
ion
possi
bil
i
tiescur
veatpoi
ntA’
.How doweknow?Thet
angentl
i
nesB”
B”andA”
A”ar
e
par
all
[Link],gi
vent
heamountt
obepr
oducedofeachcommodi
ty,wehav
edev
isedaway
t
odet
ermi
net
heamountofeachcommodi
ty,wehav
edev
isedawayt
odet
ermi
net
he
amountofeachcommodi
tyt
hatshoul
dbeal
l
ocat
edt
oAandB.

[Link]
NGI
NPUTSBETWEENCOMMODI
TIES

We can al
so f
ind t
he amountofl
aborand capi
talt
hatshoul
d be al
l
ocat
ed t
othe
pr
oduct
ionofeachcommodi
tybyconsul
ti
ngt
heEdgewor
thboxdi
agr
am i
nFi
gur
e5.
5.
Recal
lthatt
hecont
ractcur
vedr
awnt
her
eunder
li
est
hepr
oduct
ionpossi
bil
i
tiescur
e
dr
awni
nFi
gur
[Link]
l
,aswel
l,t
hateachpoi
ntont
hepr
oduct
ionpossi
bil
i
tiescur
ve
cor
respondst
oapoi
ntont
hecont
ractcur
vei
nFi
gur
e5.
5thateachpoi
ntont
hecont
ract
cur
vei
nFi
gur
e5.
5cor
respondst
oapar
ti
cul
aral
l
ocat
ionofl
aborandcapi
talbet
weent
he
pr
oduct
ionoft
het
wocommodi
ti
[Link]
e,assumet
hatpoi
ntA’ont
hecont
ract
cur
vei
nFi
gur
e5.
5cor
respondst
oapar
ti
cul
aral
l
ocat
ionofl
aborandcapi
talbet
weent
he
pr
oduct
ionsoft
het
wocommodi
ti
[Link]
e,assumet
hatpoi
ntA’
ont
hepr
oduct
ion
possi
bil
i
tiescur
vecor
respondst
opoi
ntU’ont
hecont
ractcur
vei
nFi
gur
e5.
[Link],i
fwe
knewt
hatt
hecomposi
ti
onofout
puti
ntheeconomyshoul
dbegi
venbypoi
ntA’
,thenwe
woul
dknowt
hatOxSuni
tsofl
aborshoul
dbedev
otedt
othepr
oduct
ionofXandOxL-
OxS
uni
tsofl
aborshoul
dbedenot
edt
othepr
oduct
[Link]
dknowt
hatOxRuni
tsof
capi
tal
shoul
dbedev
otedt
othepr
oduct
ionofX,
andt
hatOxL-
OxSuni
tsofl
aborshoul
dbe
dev
otedt
othepr
oduct
ionofY. Wewoul
dknow t
hatOxRuni
tsofcapi
talshoul
dbe
dev
otedt
othepr
oduct
ionofX,andt
hatOFK—OFRuni
tsofcapi
talshoul
dbedev
otedt
o
t
hepr
oduct
[Link]
nal
l
y,wewoul
dknowt
hatt
hisal
l
ocat
ionofi
nput
swoul
dguar
ant
ee
t
hatt
hemar
ginalr
atesoft
echni
calsubst
it
uti
onbet
weencapi
talandl
aborwoul
dbeequal
ADAMAUNI
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i
nthepr
oduct
ionofbot
hXandY.
[Link] MARGINAL RATE OF PRODUCT TRANSFORMATI
ON,MARGI
NAL RATE OF
SUBSTI
TUTION,ANDCONSUMERSATISFACTION

Weasser
tedi
nthepr
ecedi
ngsect
iont
hatconsumersat
isf
act
ionwoul
dnotbemaxi
mized
unl
esst
hemar
ginalr
ateofpr
oductt
ransf
ormat
ionbet
weent
wogoodsi
sequalt
othe
mar
ginal
rat
eofsubst
it
uti
onbet
weent
het
wogoods.

5.
[Link]
TIONSFORECONOMI
CEFFI
CENCY

Thepr
ecedi
ngsect
ionshav
etol
dal
ongst
oryf
rom whi
chwecandr
aw somegener
al
i
nsi
ghti
ntot
hecondi
ti
onst
hatchar
act
eri
zeanef
fi
ciental
l
ocat
ionofr
esour
ce-
i.
e,an
al
l
ocat
ionwher
eiti
simpossi
blet
oimpr
ovesomebody
’swel
far
ewi
thoutcausi
nghar
mto
any
bodyel
[Link]
oper
ti
esar
ecal
l
edmar
ginalcondi
ti
onsofPar
etoopt
imal
i
tyor
Par
etoef
fi
ciency
.Indeed,
itt
urnsoutt
hatt
her
ear
ethr
eesuchcondi
ti
onst
obef
ulf
il
led.I
f
r
esour
cesar
etobeal
l
ocat
edef
fi
cient
ly,si
mul
taneousgener
alequi
l
ibr
ium ofpr
oduct
ion
andexchangehast
ober
[Link]
equi
ret
hreecondi
ti
onst
obef
ulf
il
[Link]
e;
Themar
ginalr
atesofsubst
it
uti
onbet
weenanyt
wogoodsmustbet
hesamef
oral
l
i
ndi
vi
dual
s(ot
her
wise,atl
eastt
woi
ndi
vi
dual
scangett
oget
herf
oramut
ual
l
ybenef
ici
al
t
radeandt
her
ebyi
ncr
easet
heut
il
it
yofoneorbot
hpeopl
e).Thati
s,gener
alequi
l
ibr
ium of
exchange(
dist
ri
but
ion)f
ort
woi
ndi
vi
dual
isgi
venby
:
MRSAXY=MRSBXY
Themar
ginalr
atesoft
echni
calsubst
it
uti
onbet
weenanyt
woi
nput
smustbet
hesamei
n
t
hepr
oduct
ionofal
lgoods(
other
wise,
twopr
oducer
scangett
oget
hert
otr
adei
nput
sand
t
her
ebyi
ncr
easet
heout
putofoneorbot
hpr
oduct
s).Gener
alequi
l
ibr
ium i
npr
oduct
ioni
s
gi
venbyr
elat
ioncanbest
atedas
MRPTXY=PX/
PY

Themar
ginalr
ateoft
ransf
ormat
ionbet
weenanyt
wogoodsmustequalt
hecommon
mar
ginalr
ateofsubst
it
uti
onf
oral
lindi
vi
dual
s(ot
her
wiser
esour
cescanber
eal
l
ocat
edt
o
i
ncr
easet
hepr
oduct
ionofsomegoodsatt
heexpenseofot
her
stobr
ingt
hepr
oductmi
x
i
ntol
i
newi
thconsumerpr
efer
ence)
.Thent
hegener
alequi
l
ibr
ium oft
hesy
stem asawhol
e
r
equi
rest
hef
ulf
il
lmentoft
het
hir
dcondi
ti
on,
i.
e.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 179
ECON102MI
CROECONOMI
CSI
I

MRPTXY=MRSAXY=MRSBXY or
Forpr
efectmar
ketcase
MRSAXY=MRSBXY=PX/
PY

Fori
nst
ances,gener
alequi
l
ibr
ium f
ort
hesi
mpl
e2*
2*2modelcanbeat
tai
nedi
fthe
f
oll
owi
ngt
hreePar
etoopt
imum (
eff
ici
ency
)condi
ti
onsar
esat
isf
ied;
TheMRSXYmustbeequal
forbot
hconsumer
s(ef
fi
ciencyi
nexchange)
.
TheMRTSXYmustbeequal
foral
lfi
rms(
eff
ici
encyi
npr
oduct
ion)
.
TheMRSXYandMRPTXYmustbeequal
fort
wogoods(
eff
ici
encyi
npr
oductmi
x)
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
__
5.
[Link]
ivi
ty:
Expl
ainmar
ginal
condi
ti
onsofPar
etoopt
imal
i
tyi
npr
oduct
ion?
Expl
aint
hegener
alequi
l
ibr
ium oft
hesi
mpl
e2*
2*2model
?
Gi
vent
hef
oll
owi
ngsi
mpl
i
fiedgener
alequi
l
ibr
ium modeli
nfi
gur
e5.
9:bel
ow,expl
ainhow
t
hesy
stem camet
oequi
l
ibr
ium?

Y
T
14 J’

1
10 M’
(OB)
10 8 6 4 2
8

6
4 N’
2

2 4 6 8 10 11 12 14 X
(
OA)
Figur
e5.
9;Gener
alequi
l
ibr
ium ofpr
oduct
ionandexchange

5.
[Link]
Pr
evi
ouschapt
ershav
ebeenconcer
nedwi
thpar
ti
alequi
l
ibr
ium anal
ysi
s,i
nwhi
chi
tis
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 180
assumedt
hatchangesi
npr
icecanoccuri
nonemar
ketwi
thoutcausi
ngsi
gni
fi
cant
changes i
n pr
ices i
n ot
hermar
ket
s. Gener
alequi
l
ibr
ium anal
yses accountf
ort
he
i
nter
rel
ati
onshi
pamongpr
icesi
nvar
iousmar
ket
s.
Gener
alequi
l
ibr
ium anal
ysi
shasbeenusedt
ohel
pexami
net
hecondi
ti
onsunderwhi
chi
t
i
spossi
blef
orequi
l
ibr
ium t
ooccursi
mul
taneousl
yinal
lmar
ket
sinaper
fect
lycompet
it
ive
economy
.Moder
nwor
khasest
abl
i
shedt
hatagener
alequi
l
ibr
ium canbeachi
evedi
na
per
fect
lycompet
it
iveeconomyunderaf
air
lywi
desetofcondi
ti
ons.
Gener
alequi
l
ibr
ium anal
ysi
spr
ovi
desaf
ramewor
kwi
thi
nwhi
checonomi
stscanst
udyt
he
r
elat
ionshi
psbet
weenpr
icesandquant
it
iesf
orbot
hcommodi
ti
esandi
nput
sacr
osst
he
economyasawhol
e.I
tspur
posei
stoshowwhatt
heequi
l
ibr
ium conf
igur
ati
onofpr
ices,
out
put
s,andi
nput
swi
l
lbei
nvar
iousmar
ker
sgi
venacer
tai
nsetofconsumerpr
efer
ences,
asetofpr
oduct
ionf
unct
ions,
andasetofi
nputsuppl
yfunct
ion.
Thesi
mpl
estofgener
alequi
l
ibr
ium model
sinv
olv
est
hreeki
ndsofequat
ions-
onef
or
pr
oduct
s,onef
ori
nput
s,andonet
hatguar
ant
eet
hatt
hecondi
ti
onsofper
fectcompet
it
ion
ar
esat
isf
ied. Si
mpl
estmodelofal
lassumest
hatt
hesuppl
yofi
nput
sisgi
ven(
and
i
ndependentofpr
ices)andt
hatt
hecoef
fi
cient
sofpr
oduct
ionar
efi
xed.I
tnonet
hel
ess
i
l
lust
rat
est
henat
ureofgener
alequi
l
ibr
ium model
s.
Expandi
ngt
hescopeofanal
ysi
sbey
ondasi
ngl
emar
ketmakei
tpossi
blet
oconsi
der
manyi
nter
est
ingquest
ionsconcer
ningt
heef
fi
ciental
l
ocat
ionofr
esour
cesacr
ossmar
ket
.
The edge wor
th box di
agr
am can be empl
oyed t
o exami
ne ef
fi
ciental
l
ocat
ion of
commodi
tybet
weenconsumer
[Link]
ractcur
vesummar
izest
hoseal
l
ocat
[Link]
ar
eal
lchar
act
eri
zedbyequal
i
tyi
nthemar
ginal
rat
esofsubst
it
uti
onacr
ossal
lconsumer
s.
Theef
fi
ciental
l
ocat
ionofi
nput
sbet
weeni
ndust
ri
esal
sol
i
esonacont
ractcur
vedr
awni
n
anEdgewor
thboxwhosedi
mensi
onsdef
inet
hel
i
mit
sofi
nputempl
oyment
. Thi
s
cont
ractcur
vecaneusedt
oconst
ructapr
oduct
ionpossi
bil
i
tiescur
vef
oraneconomy
.
Ev
erypoi
ntont
hecont
ractcur
eischar
act
eri
zedbyequal
i
tyoft
hemar
ginalr
atesof
t
echni
cal
subst
it
uti
onacr
ossal
producer
s.
Ev
ensi
mpl
egener
alequi
l
ibr
ium model
scanaccommodat
ebot
hpr
oduct
ionandexchange.
Consumer sat
isf
act
ion cannot maxi
mize unl
ess t
he mar
ginal r
ate of pr
oduct
t
ransf
ormat
ionbet
ween(
any
)twogoodsi
sequalt
othemar
ginalr
ateofsubst
it
uti
on
bet
weent
hem f
orev
eryconsumer
.
Per
fect
ly compet
it
ive economi
es sat
isf
ythe t
hree set
s ofcondi
ti
ons f
oreconomi
c
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 181
ECON102MI
CROECONOMI
CSI
I

ef
fi
ciency
.Tot
heeconomi
ctheor
ist
,thi
sisoneoft
hebasi
car
gument
sinf
avorofa
per
fect
lycompet
it
iveeconomy
.

KEYTERMS
Gener
alequi
l
ibr
ium Par
ti
alequi
l
ibr
ium anal
ysi
s
Ef
fi
ciental
l
ocat
ion Pr
oduct
ion
Exchange Pr
oduct
ionpossi
bil
i
tycur
ve
Edgewor
thbox Consumersat
isf
act
ion
Par
etoopt
imum condi
ti
ons Mar
ginal
Rat
eofSubst
it
uti
on
Rev
iewQuest
ions
[Link]
out
hinkt
hegener
alequi
l
ibr
ium exi
sts?
[Link]
ti
onshoul
dbemetf
orsi
mul
taneousgener
alequi
l
ibr
ium t
ooccur
?
3.
Giv
ent hefol
l
owingEdgeworthboxshowni
nthef
igur
e5.
2bel
ow,expl
ainhow t
he
si
mpleeconomycomestoequi
l
ibr
ium?
L

12 1 10 9 8 7 6 5 4 3 2 1 OY
10
9 1
R
8
2
7 Y1 X3 K
3
6
X2 G 4
5
Y2
M
K)

4 5
t (
al

3
Capi

6
J
7
2 B3 X1

1 8

Ox 1 2 3 4 5 6 7 8 9 10 11 12

Labor(
L)

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 182
Fi
gur
e5.
10;
TheEdgewor
thboxdi
agr
am f
orpr
oduct
ion

Suggest
edr
eadi
ngs
Ni
chol
son,
w:Mi
croeconomi
ctheor
y;basi
cpr
inci
pleandext on.5thedi
ensi ti
on
Sal
vat
ore,
D(2003)
:Mi
croeconomi
cs;
theor
yandappl
icat
i 4thedi
ons. ti
on
Mansf
iel
d,[Link],
G(2000)
:Mi
croeconomi
cs,
theor
yandappl
icat
i 10thedi
ons. ti
on
Var
ian,
[Link]
l(1999)
:Int
ermedi
atemi
cr cs3rdedi
oeconomi ti
on
Pi
ndy
ck,
[Link]
nfel
d,D.
L.(
2003)
:Mi
cr cs.6thedi
oeconomi ti
on
Kout
soy
ianni
sA.(
1985)
:Moder
nmi
cr cs2ndedi
oeconomi ti
on.

7.
[Link]
far
eEconomi
cs:
AnI
ntr
oduct
ion
7.
[Link]
egat
ionofpr
efer
ences
7.
[Link]
il
it
yPossi
bil
i
tyFr
ont
ierandGr
andUt
il
it
yPossi
bil
i
tyFr
ont
ier
Soci
alWel
far
eFunct
ions
7.
[Link]
far
eMaxi
mizat
ion
7.
6Indi
vi
dual
i
sti
csoci
alWel
far
efunct
ions
7.
[Link]
rAl
l
ocat
ions
7.
[Link]
yandequi
ty
7.
[Link]
y

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 183
ECON102MI
CROECONOMI
CSI
I

5.
7WELFAREECONOMI
CS:ANI
NTRODUCTI
ON
Wel
far
e Economi
cs st
udi
es t
he condi
ti
ons underwhi
ch t
he sol
uti
on t
othe gener
al
equi
l
ibr
ium modeli
s sai
dto be opt
imal
.Itexami
nes t
he condi
ti
ons f
oreconomi
c
ef
fi
ciencyi
nthepr
oduct
ionofout
putandt
heex
changeofcommodi
tesandequi
i tyi
nthe
di
str
ibut
ionofi
[Link]
ethatt
heabov
edef
ini
ti
onpoi
ntsoutt
hatt
hemaxi
mizat
ionof
soci
ety
’swel
l
-bei
ngr
equi
resnotonl
yef
fi
ciencyi
npr
oduct
ionandexchangebutal
soequi
ty
i
nthedi
str
ibut
ionofi
ncome.

Themaxi
mizat
ionofsoci
ety
’swel
lbei
ngr
equi
rest
heopt
imalal
l
ocat
ionofi
nput
samong
commodi
ti
esand t
heopt
imalal
l
ocat
ion ofcommodi
ti
es(
i.
[Link]
str
ibut
ion ofi
ncome)
among consumer
[Link]
eader
s,t
hecondi
ti
onsf
ort
heopt
imalal
l
ocat
ion ofi
nput
s
amongcommodi
ti
esandexchangeofcommodi
ti
esamongconsumer
shav
eal
readybeen
di
[Link]
eobj
ect
ivecr
it
eri
adev
oidofet
hicalconnot
ati
onsorv
aluej
udgment
s.
I
not
herwor
d,i
tisi
mpossi
blet
oobj
ect
ivel
ydet
ermi
net
heopt
imaldi
str
ibut
ionofi
ncome.
Thi
snecessar
il
yrequi
resi
nter
per
sonalcompar
isonsofut
il
it
yandv
aluej
udgmentont
he
r
elat
ive“
deser
vingness”ormer
itofv
ari
ousmember
sofsoci
ety
,anddi
ff
erentpeopl
ewi
l
l
i
nev
itabl
yhav
edi
ff
erentopt
ions.

Thi
suni
twi
l
lspr
esent
scr
it
eri
aofsoci
alwel
far
[Link]
l
lconsi
dersomef
ourcr
it
eri
ali
ke,
cl
assi
calwel
far
ecr
it
eri
a,Neo–Cl
assi
calwel
far
eeconomi
cs,Par
etowel
far
eeconomi
cs
andpost
-Par
etocont
ri
but
iont
owel
far
eeconomi
cs.I
twi
l
lal
sopr
ovi
dey
ouwi
thabr
ief
accountondi
ff
erentcr
it
eri
aofsoci
alwel
far
e.

5.
8AGGREGATI
ONOFPREFERENCES

Soci
alwel
far
e depends on t
he r
efer
ences ofi
ndi
vi
dual
[Link] r
etur
nto ourear
ly
di
scussi
onofconsumerpr
efer
[Link]
,wewi
l
lassumet
hatt
hesepr
efer
encesar
e
t
ransi
ti
[Link]
igi
nal
l
y,wet
houghtofaconsumer
’spr
efer
encesasbei
ngdef
inedov
erhi
s
ownbundl
eofgoods,butnow wewantt
oexpandont
hatconceptandt
hinkofeach
consumer
s as hav
ing pr
efer
ences ov
ert
he ent
ir
e al
l
ocat
ion ofgoods among t
he
consumer
[Link]
se,t
hisi
ncl
udest
hepossi
bil
i
tyt
hatt
heconsumer
smi
ghtnotcar
e
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 184
aboutwhatot
herpeopl
ehav
e,j
ustaswehador
igi
nal
l
yassumed.

Letususet
hesy
mbolxt
odenot
eapar
ti
cul
aral
l
ocat
ionorwhatev
eryi
ndi
vi
dualget
sof
ev
[Link]
vent
woal
l
ocat
ion,
xandy
,eachi
ndi
vi
dualicansaywhet
herheorshe
pr
efer
sxt
[Link]
vent
hepr
efer
encesofal
ltheagent
s,wewoul
dli
ket
ohav
eawayt
o
“
aggr
egat
e”t
hem i
ntoonesoci
alpr
efer
[Link]
s,i
fweknow how al
lthei
ndi
vi
dual
s
r
ang v
ari
ous al
l
ocat
ions,how one mi
ghtgo aboutbr
ingi
ng t
oget
hert
he i
ndi
vi
dual
consumer
’spr
efer
encest
oconst
ructsomeki
ndof“
soci
alpr
efer
ences”
?

Twoappr
oachest
hatar
eofmaj
ori
nter
estar
e:
Maj
ori
tyv
oti
ngappr
oach
Rank–or
derv
oti
ngappr
oach

a)Maj
ori
tyv
oti
ngappr
oach(
MVA)

Maj
ori
tyv
oti
ngappr
oachi
sonewayt
oaggr
egat
eindi
vi
dualpr
efer
ences.I
nthi
sfor
m of
aggr
egat
ion,al
l
ocat
ionX i
ssai
dto bepr
efer
redt
o al
l
ocat
ionY i
famaj
ori
tyoft
he
i
ndi
vi
dual
spr
eferXt
[Link]
e,i
naneconomyconsi
sti
ngoft
hreei
ndi
vi
dual
s,i
ftwo
oft
hem pr
eferXt
oYandoneoft
hem pr
efer
sYt
oX,usi
ngmaj
ori
tyv
oti
ngappr
oachwe
concl
udet
hatt
hesoci
etypr
efer
sXt
oY.

Howev
er,
ther
eisapr
obl
em wi
tht
hismet
hodi
nthati
tmaynotgener
atet
ransi
ti
vesoci
al
pr
efer
enceor
der
[Link]
ethef
oll
owi
ngv
oti
ngr
esul
t.

Choi
ce Person Per
so Per
son
A n C
B
1st X Y Z
2nd
Y Z X
3r
d
Z X Y

Theranki
ngoft
hethreei
ndi
vi
dual
is
Per
sonsAandCpreferXtoYandper
sonBpr
efer
sYt
[Link]>Y.
Per
sonsAandBpr
eferYt
oZandper
sonCpr
efer
sZt
[Link]>Z.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 185
ECON102MI
CROECONOMI
CSI
I

I
fthi
ssoci
alpr
efer
enceor
der
ingwer
etr
ansi
ti
vewecoul
dconcl
udet
hatX>[Link]
er,
f
rom t
het
abl
eweknowt
hatper
sonsBandCpr
eferZt
oXi
mpl
yi
ngt
hatZ>[Link]
ncet
he
pr
efer
ences ar
e nott
ransi
ti
ve,t
her
e wi
l
lbe no “
best
”al
ter
nat
ivef
rom t
he setof
al
ter
nat
ives(
X,Y,Z)
.Whi
chout
comesoci
etychooseswi
l
ldependont
heor
deri
nwhi
ch
t
hev
otei
[Link]
s,f
orexampl
e,i
fthet
hreepeopl
evot
efi
rston:
Xv
ersusYandt
henv
oteont
hewi
nneroft
hiscont
estv
ersusZ,
thebestal
ter
nat
ivewi
l
lbe
Z.
Zv
ersusXandt
henv
oteont
hewi
nneroft
hiscont
estv
ersusY,
thebestal
ter
nat
ivewi
l
lbe
Y.
Yv
ersusZandt
henv
oteont
hewi
nneroft
hiscont
estv
ersusX,
thebestal
ter
nat
ivewi
l
lbe
X.
Ther
efor
e,maj
ori
tyv
otecanbemani
pul
atedbychangi
ngt
heor
deri
nwhi
cht
hingsar
e
v
otedsoast
oyi
eldt
hedesi
redout
come.

b)Rank–Or
derVot
ingAppr
oach(
RVA)

Her
eeachper
sonr
ankst
heal
l
ocat
ionsaccor
dingt
ohi
spr
efer
encesandassi
gnsa
numbert
hati
ndi
cat
esi
tsr
anki
nhi
sor
der
[Link]
dert
hef
oll
owi
ngt
abl
[Link]
e,
a1f
ort
hebestal
ter
nat
ive,
2fort
hesecondbest
,[Link] upt
hescor
es
ofeachal
ter
nat
iveacr
osst
hepeopl
etodet
ermi
neanaggr
egat
escor
edf
oreach
al
ter
nat
iveandsayt
hatoneout
comei
ssoci
all
ypr
efer
redt
oanot
heri
fithasal
owerscor
e.

Al
locat
ion Per
son Per
son Sum oft
he
s A B r
anks
X 1 2 3
Y 2 1 3

Si
ncet
hesum oft
her
anksi
sequal
forbot
hal
ter
nat
ives,
thesoci
etyi
sindi
ff
erentbet
ween
[Link]
derv
oti
nghasal
i
mit
ati
on.I
tcanbemani
pul
atedbyi
ntr
oduci
ngnew
al
ter
nat
ivest
hatchanget
hef
inal
ranksoft
her
elev
antal
ter
nat
[Link]
e,consi
der
t
hef
oll
owi
ngt
abl
eyy
.
Al
l
ocat
ions Per
son Per
son Sum oft
he
A B r
anks
X 1 3 4
Y 2 1 3
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 186
Z 3 2 5

Not
ethatt
hei
ntr
oduct
ionofanew al
ter
nat
ive(
i.
e.,al
ter
nat
iveZ)r
esul
tedi
nYbei
ng
pr
efer
redt
oXdespi
teourear
li
erconcl
usi
ont
hatt
hesoci
etyi
sindi
ff
erentbet
weenXandY
whenal
ter
nat
iveZwasnoti
ntr
oduced.

Tosummar
ize,bot
hmaj
ori
tyv
oti
ngandr
ank–or
derv
oti
nghav
eli
mit
ati
onsi
nthatt
hei
r
out
comescanbemani
pul
atedbyast
uteagent
[Link]
iont
hatnor
mal
l
yfol
l
owsi
s“Ar
e
t
her
eot
hersoci
aldeci
sionmechani
sms,apar
tfr
om maj
ori
tyv
oti
ngandr
ank– or
der
v
oti
ng,
thatar
eimmunet
othel
i
mit
ati
onsoft
heset
wov
oti
ngappr
oaches?
”Inot
herwor
ds,
ar
ether
eot
hersoci
aldeci
sionmechani
smst
hatsat
isf
ythef
oll
owi
ngpr
oper
ti
es?
Gi
venanysetofcompl
ete,r
efl
exi
ve,and t
ransi
ti
vei
ndi
vi
dualpr
efer
ences,t
hesoci
al
deci
si
onmechani
sm shoul
dresul
tinsoci
alpr
efer
encest
hatsat
isf
ythesamepr
oper
ti
es.
I
fev
ery
bodypr
efer
sal
ter
nat
iveXt
oal
ter
nat
iveY,t
hesoci
alpr
efer
encesshoul
drankX
aheadofY.
Thepr
efer
encesbet
weenXandYshoul
ddependonl
yonhowpeopl
erankXv
ersusY,
and
notonhowt
heyr
ankot
heral
ter
nat
ives.
I
tcanbequi
tedi
ff
icul
ttof
indamechani
sm t
hatsat
isf
iesal
ltheabov
epr
oper
ti
es.I
nfact
,
Kennet
hAr
row haspr
ovedt
hef
oll
owi
ngr
emar
kabl
eresul
twhi
chi
sknownasAr
row’
s
I
mpossi
bil
i
tyTheor
em.
“
Ifasoci
aldeci
si
onmechani
sm sat
isf
iespr
oper
ti
esa,bandc,t
heni
tmustbe
adi
ctat
orshi
p:al
lsoci
alr
anki
ngsar
ether
anki
ngsonei
ndi
vi
dual
s.”
Ar
row’
simpossi
bil
i
tyt
heor
em showst
hatt
hreev
erypl
ausi
bleanddesi
rabl
efeat
uresofa
soci
aldeci
sionmechani
sm ar
einconsi
stentwi
thdemocr
acy
.Thati
sunderdemocr
ati
c
sy
stem,t
her
eisnoper
fectwayt
o“aggr
egat
e”i
ndi
vi
dualpr
efer
encest
omakeonesoci
al
pr
efer
ence.I
fwewantt
ofi
ndawayt
o“aggr
egat
e”i
ndi
vi
dualpr
efer
encest
ofor
m soci
al
pr
efer
ences,
wewi
l
lhav
etogi
veuponeoft
hepr
oper
ti
esofasoci
aldeci
sionmechani
sm
descr
ibedi
nAr
row’
simpossi
bil
i
tyt
heor
em.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
Act
ivi
ty
Whatar
etheappr
oachesofsoci
aldeci
sionmechani
sm?
Expl
aint
hedi
ff
erencebet
weenmaj
ori
tyv
oti
ngandr
ankor
der
ingappr
oach?

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 187
ECON102MI
CROECONOMI
CSI
I

5.
9 UTI
LITYPOSSI
BILI
TYFRONTI
ER/
CURVE(
UPF/
UPC)AND GRAND UTI
LITY
POSSI
BILI
TYFRONTI
ER(
GUPF)
TheUt
il
it
yPossi
bil
i
tyFr
ont
ier(
UPFher
eaf
ter
)showst
hev
ari
ouscombi
nat
ionsofut
il
it
ies
r
ecei
vedbyi
ndi
vi
dual
sAandB(
i.
e.,UA andUB)whenoursi
mpl
eeconomyi
singener
al
equi
l
ibr
ium orPar
etoopt
imum i
nexchange;i
tist
hel
ocusofmaxi
mum ut
il
it
yforone
i
ndi
vi
dual
foranygi
venl
evel
ofut
il
it
yfort
heot
heri
ndi
vi
dual
.

UB UPF

UM’

UM’
Fi
gur
e 3.1. Ut
il
it
y Possi
bil
it
y UA
Fr
ont
ier

Not
ethatUPF i
s associ
ated wi
th Par
eto ef
fi
ciental
l
ocat
ions gi
ven equi
l
ibr
ium of
pr
oduct
ion
i
.e.
,gi
venapoi
ntonPPFwher
eMRPTX,Y=)
.Thi
smeanswehav
eanot
herUPFf
oranyot
her
poi
ntonPPF.I
ngener
alwecanhav
easmanyUPFsast
her
ear
epoi
[Link]
s
t
heenv
elopeoft
heseUPFsassoci
atedwi
thPar
etoopt
imum poi
ntsofpr
oduct
ionand
exchange.

UM’
UM’i
sUPFdr
awnwhent
heeconomyi
sinpr
oduct
ionequi
l
ibr
i ntE’asshown
um atpoi
abov
[Link]’
UN’i
sanot
herUPFdr
awnont
heassumpt
iont
hatt
heeconomyi
sinequi
l
ibr
ium
ofpr
oduct
i ntH’
onatpoi oni
[Link]
oini
ngpoi
ntsE’
,H’
,andot
herpoi
ntsofequi
l
ibr
ium
si
mil
arl
yobt
ained,
wecander
iveGUPFwhi
chi
scur
veGE’
H’Gi
ntheabov
edi
agr
am.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 188
TheGUPFi
ndi
cat
est
hatnor
eor
gani
zat
ionoft
hepr
oduct
ion– exchangepr
ocessi
s
possi
blet
hatmakessomeonebet
terof
fwi
thout
,att
hesamet
ime,maki
ngsomeoneel
se
wor
seof
[Link]
venGUPFoft
heabov
esor
t,i
nor
dert
odet
ermi
net
hePar
etoopt
imum poi
nti
n
pr
oduct
ionandexchangeatwhi
chsoci
alwel
far
eismaxi
mized,weneedasoci
alwel
far
e
f
unct
ion.

UPFUM’
UM’
showst
hev
ari
ouscombi
nat
ionsofut
il
it
iesr
ecei
vedbyi
ndi
vi
dual
sAandB(
i.
e.,
UAandUB)whent
heeconomycomposedofi
ndi
vi
dual
sAandBi
singener
alequi
l
ibr
ium or
Par
etoopt
imum i
[Link]
ront
ieri
sobt
ainedbymappi
ngconsumpt
ioncont
ract
(
OC)i
ntheEdgewor
thboxofconsumpt
ionf
rom out
putorcommodi
tyspacet
out
il
it
y
space.

UB G

E’
UM’
GUPF
UN’

H’

UM’ UN’ G UA

Fi
gur
[Link]
andUni
tyPossi
bil
it
yFr
ont
ier

5.
10SOCI
ALWELFAREFUNCTI
ONS

I
fwewer
etodr
opanyoft
hedesi
redf
eat
uresofasoci
alf
unct
iondescr
ibedabov
e,i
t
woul
dpr
obabl
ybepr
oper
ty3-
thatt
hesoci
alpr
efer
encebet
weent
woal
ter
nat
ivesonl
y
dependsont
her
anki
ngoft
hoset
woal
ter
nat
ives.I
fwedot
hat
,cer
tai
nki
ndofr
ank–or
der
v
oti
ngbecomepossi
bil
i
ties.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 189
ECON102MI
CROECONOMI
CSI
I

Gi
vent
hepr
efer
encesofeachi
ndi
vi
dualIov
ert
heal
l
ocat
ions,wecanconst
ructut
il
it
y
f
unct
ions,
ui(
x),
thatsummar
izet
hei
ndi
vi
dual
s’v
aluej
udgment
s:per
sonipr
efer
sxt
oyi
f
andonl
yifui(
x)>ui(
y).Ofcour
se,t
hesear
ejustl
i
keal
lut
il
it
yfunct
ions-
theycanbescal
ed
i
nanywayt
hatpr
eser
vest
heunder
lyi
ngpr
efer
enceor
der
[Link]
eisnouni
queut
il
it
y
r
epr
esent
ati
on.

Ther
eisanamef
ort
hiski
ndofaggr
egat
ingf
unct
ions;
iti
scal
l
edasoci
alwel
far
efunct
ion.
A soci
alwel
far
efunct
ion i
sjustsome f
unct
ion oft
he i
ndi
vi
dualut
il
it
yfunct
ion:
W(
u1(
x)….
,
un(
x))
.Itgi
vesawayt
orankdi
ff
erental
l
ocat
ionst
hatdependsonl
yont
he
i
ndi
vi
dual
pref
erence,
andi
tisani
ncr
easi
ngf
unct
ionofeachi
ndi
vi
dual
’
sut
il
it
y.

Ther
e ar
e di
ff
erentway
s off
ormul
ati
ng soci
alwel
far
efunct
ion f
rom i
ndi
vi
dual
s’
pr
efer
ences,
somewhi
char
e:
Byaddi
ngt
hei
ndi
vi
dual
uti
l
iti
esanduset
her
esul
ti
ngnumberasaki
ndofsoci
alwel
far
e
f
unct
[Link]
s,
W(
U1(
X)…Un(
X))=.
Thi
sissomet
imesknownascl
assi
calut
il
it
ari
anorBent
hami
tewel
far
efunct
ion.I
nthi
s
f
orm ofsoci
alwel
far
efunct
ion,
wesayal
l
ocat
ionXi
ssoci
all
ypr
efer
redt
oal
l
ocat
ionYi
f
>
Asl
i
ghtgener
ali
zat
ionoft
heut
il
it
ari
anwel
far
efunct
ioni
sthewei
ght
edsum -of
-ut
il
it
ies
wel
far
efunct
ion.
W(
U1(
X)…Un(
X))=.
Wher
ethewei
ght
sa1,
…,an,
aresupposedt
obenumber
sindi
cat
inghowi
mpor
tanteach
agent
’si
stot
heov
eral
lsoci
alwel
far
e.

Anot
heri
nter
est
ingwel
far
efunct
ioni
sthemi
nimaxofRawl
siansoci
alwel
far
efunct
ion.
Consi
der
ingt
hewel
far
eoft
hewor
seof
fagentast
hataf
fect
sthesoci
alwel
far
eofan
al
l
ocat
[Link]
s:
W(
U1(
X),
…,Un(
X))=mi
n{U1(
X),
…,Un(
X)}

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 190
Thi
swel
far
efunct
ionsay
sthatt
hesoci
alwel
far
eofanal
l
ocat
iondependsonl
yont
he
wel
far
eoft
hewor
stofagent–t
heper
sonwi
tht
hemi
nimal
uti
l
ity
.

Eachoft
hesei
sapossi
blewayt
ocompar
eindi
vi
dualut
il
it
yfunct
ions. Eachoft
hem
r
epr
esent
sdi
ff
erentet
hicalj
udgment
saboutt
hecompar
isonbet
weendi
ff
erentagent
s’
wel
far
es. Aboutt
heonl
yrest
ri
cti
ont
hatwewi
l
lpl
aceont
hest
ruct
ureoft
hewel
far
e
f
unct
ionatt
hispoi
nti
sthati
tbei
ncr
easi
ngi
neachconsumer
’sut
il
it
y.

5.
11WELFAREMAXI
MIZATI
ON

Oncewehav
eawel
far
efunct
ionwecanexami
net
hepr
obl
em ofwel
far
emaxi
mizat
ion.
Letususet
henot
ati
onx1 t
oindi
cat
ehow muchi
ndi
vi
dualihasofgoodj
,andsuppose
t
hatt
her
ear
enconsumer
[Link]
heal
l
ocat
ionxconsi
stsoft
hel
i
stofhow
mucheachoft
heagent
shasofeachoft
hegood’
s.

I
fwehav
eat
otalamountX1,
….Xk ofgoods1,
, ….kt
odi
str
ibut
eamongt
heconsumer
swe
canposet
hewel
far
emaxi
mizat
ionpr
obl
em.
MaxW (
u1(
x),
…,un(
x))

Sucht
hat

Thuswear
etr
yingt
ofi
ndt
heal
l
ocat
iont
hatmaxi
mizessoci
alwel
far
[Link]
oper
ti
es
doessuchanal
l
ocat
ionhav
e?

Wecani
l
lust
rat
ethi
ssi
tuat
ioni
nFi
gur
ehh,wher
ethesetUi
ndi
cat
est
hesetofpossi
ble
ut
il
it
iesi
nthecaseoft
woi
ndi
vi
dual
.Thi
sseti
sknownast
heut
il
it
ypossi
bil
i
tiesset
.The
boundar
yoft
hisset
-theut
il
it
ypossi
bil
i
tiesf
ront
ier
-i
sthesetofut
il
it
ylev
elsassoci
ated
wi
th Par
eto ef
fi
ci
ental
l
ocat
ion. I
fan al
l
ocat
ion i
s on t
he boundar
y oft
he ut
il
it
y
possi
bil
i
tiesset
,thent
her
ear
eot
herf
easi
bleal
l
ocat
ionst
haty
iel
dhi
gherut
il
it
iesf
orbot
h
agent
s.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 191
ECON102MI
CROECONOMI
CSI
I

The“
indi
ff
erencecur
ves”i
nthi
sdi
agr
am ar
ecal
l
edi
swel
far
ecur
vessi
ncet
heydepi
ct
t
hosedi
str
ibut
ionsofut
il
it
ythathav
econst
antwel
far
e.I
sowel
far
ecur
vesshow t
hose
di
str
ibut
ionsofut
il
it
ythathav
econst
antwel
far
[Link]
l
ocat
iont
hatmaxi
mizessoci
al
wel
far
ecant
henbeobt
ainedbybr
ingi
ngt
oget
herourGUPFandt
hei
sowel
far
ecur
ves.

U2

U2* e

W2
W1

Fi
gur
e.3.
4. U1
U1*
I
nFi
gur
eyywehav
epi
ckedaPar
etoef
fi
ciental
l
ocat
ionandf
oundasetof i
sowel
far
e
cur
vesf
orwhi
chi
tyi
eldsmaxi
malwel
far
[Link]
,theopt
imalpoi
nti
schar
act
eri
zedby
at
angencycondi
ti
[Link]
alwel
far
eismaxi
miz
edwhenGUPFi
stangentt
othehi
ghest
possi
blei
sowel
far
e cur
[Link] economymax
imi
zessoci
alwel
far
e when i
tachi
eves
gener
alequi
l
ibr
ium atan al
l
ocat
ion whi
ch gener
atesU1*and U2*l
evel
sofut
il
it
yto
consumer1andconsumer2r
espect
ivel
[Link]
orourpur
poses,t
henot
abl
ethi
ngabout
t
hismaxi
mal
wel
far
epoi
nti
sthati
tisPar
etoef
fi
ci
ent
-i
tmustoccuront
heboundar
yoft
he
ut
il
it
ypossi
bil
i
tiesset
.

5.
12I
NDI
VIDUALI
STI
CSOCI
ALWELFAREFUNCTI
ONS

Upunt
ilnowwehav
ebeent
hinki
ngofi
ndi
vi
dualpr
efer
encesasbei
ngdef
inedov
erent
ir
e

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 192
al
l
ocat
ionsr
athert
hanov
ereachi
ndi
vi
dual
’
sbundl
[Link]
,aswer
emar
kedear
li
er,
i
ndi
vi
dualmi
ghtonl
ycar
eaboutt
hei
rownbundl
es.I
nthi
scase,wecanusexit
odenot
e
i
ndi
vi
dualt
;sconsumpt
ionbundl
e,andl
et,
ui(
xi)bei
ndi
vi
duali
’
sut
il
it
ylev
elusi
ngsome
f
ixedr
epr
esent
ati
onofut
il
it
[Link]
alwel
far
efunct
ionwi
l
lhav
ethef
orm
W=W(
u1(
x1)
….un(xn)
).

Thewel
far
efunct
ioni
sdi
rect
lyaf
unct
ionoft
hei
ndi
vi
dual
s’ut
il
it
ylev
els,
buti
tisi
ndi
rect
ly
af
unct
ionoft
hei
ndi
vi
dualagent
s’consumpt
ionbundl
[Link]
sspeci
alf
orm ofwel
far
e
f
unct
ioni
sknownasani
ndi
vi
dual
i
sti
cwel
far
efunct
ionoraBer
gson–Samuel
sonwel
far
e
f
unct
ion.

I
feachagent
’sut
il
it
ydependsonl
yonhi
sorherownconsumpt
ion,t
hent
her
ear
eno
consumpt
ion ext
ernal
i
ties. Thus we can hav
eint
imat
erel
ati
onshi
p bet
ween Par
eto
ef
fi
ciental
l
ocat
ionsandmar
ketequi
l
ibr
ia:al
lcompet
it
iveequi
l
ibr
aar
ePar
etoef
fi
cient
,
and ,underappr
opr
iat
e conv
exi
ty assumpt
ions,al
lPar
eto ef
fi
ciental
l
ocat
ions ar
e
compet
it
iveequi
l
ibr
ia.

7.
[Link]
RALLOCATI
ONS

Thewel
far
efunct
ionappr
oachi
sav
erygener
alwayt
odescr
ibesoci
alwel
far
e. But
becausei
tissogener
ali
tcanbeusedt
osummar
izet
hepr
oper
ti
esonmanyki
ndsof
mor
alj
udgment
[Link]
heot
herhand,i
tisn’
tmuchusei
ndeci
dingwhatki
ndsofet
hical
j
udgment
smi
ghtber
easonabl
eonce.

Anot
herappr
oachi
stost
artwi
thsomespeci
fi
cmor
alj
udgmentandt
henexami
net
hei
r
i
mpl
i
cat
ionsf
oreconomi
cdi
str
ibut
ion. Thi
sist
heappr
oacht
akeni
nthest
udyoff
air
al
l
ocat
[Link]
artwi
thadef
ini
ti
onofwhatmi
ghtbeconsi
der
edaf
airwaydi
vi
dea
bundl
eofgoods,andt
henuseourunder
standi
ngofeconomi
canal
ysi
stoi
nvest
igat
eit
s
i
mpl
i
cat
ions.

Supposet
haty
ouwer
egi
vensomegoodst
odi
vi
def
air
lyamong equal
l
ydeser
ving
peopl
[Link]
dyoudoi
t?I
tispr
obabl
ysaf
etosayt
hati
nthi
spr
obl
em mostpeopl
e
ADAMAUNI
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CS 193
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CROECONOMI
CSI
I

woul
ddi
vi
det
hegoodequal
l
yamongt
henagent
s. Gi
vent
hatt
heyar
ebyhy
pot
hesi
s
equal
l
ydeser
ving,
whatel
secoul
dyoudo?

Whati
sappeal
i
ngaboutt
hisi
deaofequaldi
vi
si
on? Oneappeal
i
ngf
eat
urei
sthati
tis
symmet
ri
[Link]
hesamebundl
eofgoods;noagentpr
efer
sanyot
heragent
’s
bundl
eofgoodst
ohi
sorherownsi
ncet
heyal
lhav
eexact
lyt
hesamet
hing.
Unf
ort
unat
ely
,anequaldi
vi
sionwi
l
lnotnecessar
il
ybePar
etoef
fi
cient
.Ifagent
shav
e
di
ff
erentt
ast
est
heywi
l
lgener
all
ydesi
ret
otr
adeawayf
rom equaldi
vi
sion. Letus
supposet
hatt
hist
radet
akespl
aceandt
hati
tmov
esust
oaPar
etoef
fi
ciental
l
ocat
ion.

Thequest
ionar
ise:i
sthi
sPar
etoef
fi
ciental
l
ocat
ionst
il
lfi
rinanysense?Doest
radef
rom
equal
div
isi
oni
nher
itanyoft
hesy
mmet
ryoft
hest
art
ingpoi
nt?

Theansweri
s:notnecessar
il
[Link]
dert
hef
oll
owi
ngexampl
[Link]
ethr
eepeopl
e.A,
B,
[Link]
ethesamet
ast
es,
andChasdi
ff
erentt
est
[Link]
artf
rom anequal
di
vi
sionandsupposet
hatAandCgett
oget
herandt
[Link]
heywi
l
lty
pical
l
ybot
hbe
madebet
terof
[Link],
whodi
dn’
thav
etheoppor
tuni
tyt
otr
adewi
thC,
wil
lA—t
hati
s,he
woul
dpr
eferA’
sbundl
etohi
[Link]
ent
houghtAandBst
art
edwi
tht
hesameal
l
ocat
ion.
Awasl
ucki
eri
nhert
radi
ng,
andt
hisdest
roy
edt
hesy
mmet
ryoft
heor
igi
nal
all
ocat
ion.

Thi
smeanst
hatar
bit
rar
ytr
adi
ngf
rom anequaldi
vi
sionwi
l
lnotnecessar
il
ypr
eser
vet
he
sy
mmet
ryoft
hest
art
ing poi
ntofequaldi
vi
[Link]
ghtwel
laski
fther
eisany
al
l
ocat
iont
hatpr
eser
vest
hissy
mmet
ry.I
sther
eanywayt
ogetanal
l
ocat
iont
hati
sbot
h
Par
etoef
fi
cientandequi
tabl
eatt
hesamet
ime?
5.
13ENVYANDEQUI
TY

Letusnow t
ofor
mal
i
zesomeoft
hesei
des. Whatdowemeanby“
symmet
ri
c”or
“
equi
tabl
e”any
way
? Onepossi
bleseti
fdef
ini
ti
onsusasf
oll
ows:

Wesayanal
l
ocat
ioni
sequi
tabl
eifnoagentpr
eferanyot
heragent
sbundl
eifgoodst
ohi
s
orherown.I
fsomeagenti
doespr
efersomeot
heragentj
’
sbundl
eifgoodswesayt
hat
Env
iesj
.Fi
nal
l
y,i
fanal
l
ocat
ioni
sbot
hequi
tabl
eandPar
etoef
fi
cient
,wewi
l
lsayt
hati
tis
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 194
af
airal
l
ocat
ion.I
nst
eadofj
ustanyar
bit
rar
ywayt
otr
ade,
ifweuset
hespeci
almechani
sm
oft
hecompet
it
ivemar
ket
,at
radeawayf
rom equaldi
vi
sionwi
l
lresul
tinaPar
etoef
fi
cient
al
l
ocat
ion.I
tisal
soi
mpossi
blef
orAt
oenv
yBi
ntheseci
rcumst
[Link]
it
ive
equi
l
ibr
ium f
rom equaldi
vi
sionmustbeaf
airal
l
ocat
[Link]
hemar
ketmechani
sm wi
l
l
pr
eser
vecer
tai
nki
ndsofequi
ty:i
ftheor
igi
nalal
l
ocat
ioni
sequal
l
ydi
vi
ded,t
hef
inal
al
l
ocat
ionmustbef
air
.
Act
ivi
ty
Whendowesayt
heal
l
ocat
ioni
sequi
tabl
e?

7.
[Link]
y

[Link]
row’
sImpossi
bil
i
tyTheor
em showst
hatt
her
eisnoi
deal
wayt
oaggr
egat
eindi
vi
dual
pr
efer
encei
ntosoci
alpr
efer
ence.
[Link]
ert
hel
ess,
economi
stsof
tenusewel
far
efunct
ionofonesor
toranot
hert
orepr
esent
di
str
ibut
ional
judgment
saboutal
l
ocat
ions.
[Link]
ongast
hewel
far
efunct
ioni
sincr
easi
ngi
neachi
ndi
vi
dual
’
sut
il
it
y,awel
far
e
maxi
mum wi
l
lbePar
etoef
fi
[Link]
ther
mor
e,ev
eryPar
etoef
fi
ciental
l
ocat
ioncan
bet
houghofasmaxi
mizi
ngsi
newel
far
efunct
ion.
[Link]
deaoff
airal
l
ocat
ionpr
ovi
desanal
ter
nat
ivewayt
omakedi
str
ibut
ional
judgment
s,
Thi
sideaemphasi
zest
hei
deaofsy
mmet
ri
ctr
eat
ment
.
[Link]
enwhent
hei
nit
ial
all
ocat
ioni
ssy
mmet
ri
c,ar
bit
rar
ymet
hodsort
radewi
l
lnot
Necessar
il
ypr
oduceaf
airal
l
ocat
[Link]
erm i
ttur
noutt
hatt
hemar
ketmechani
sm
wi
l
lpr
ovi
deaf
airal
l
ocat
ion.

KEYTERMS
Aggr
egat
ionofpr
efer
ences Ar
rowI
mpossi
bil
i
tyTheor
em
Env
yandEqui
tyAr
row’
s Gr
andUni
tyPossi
bil
i
tyFr
ont
ier
Maj
ori
tyv
oti
ngappr
oach(
MV Bent
hami
te
Wel
far
efunct
ion Ef
fi
ciency
Fai
rAl
l
ocat
ions Rank–Or
derVot
ingAppr
oach
Soci
alDeci
si
onMechani
sm Ut
il
it
yPossi
bil
i
tyFr
ont
ier
ADAMAUNI
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CS 195
ECON102MI
CROECONOMI
CSI
I

Wel
far
eeconomi
cs Wel
far
eMaxi
mizat
ion
Soci
alWel
far
efunct
ions

CHAPTERSI
X
MARKETFAI
LUREANDGOVERNMENTPOLI
CY
6.
1INRTODUCTI
ON
6.
[Link]
TY
6.
2.1TYPESOFEXTERNALI
TIES
6.
2.2.I
NEFFI
CIENCYOFMARKETWI
THEXTERNALI
TIES
6.
2.3REMEDI
ALMEASURESOFEXTRNALI
TIEI
S

6.
[Link]
TSTRAGEDY

6.
[Link]
COMMONPROPERTY ANDI
TS TRAGEDY
TRAGEDYOFCOMMONS
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 196
6.
3.2.
2SOLVI
NGTHECOMMONSPROBLEM
6.
[Link]
CGOODS
6.
4.1.
INEFFI
CIENCYOFPUBLI
CGOODSUNDERMARKETPROVI
SIONS
6.
4.2.
DEALI
NGWI
THPROBLEM PUBLI
CGOOD

6.
[Link]
CSOFI
NFORMATI
ON

6.
5.1.
INFORMATI
ONASECONOMI
CCOMMODI
TY

6.
5.2.
Inf
ormat
ionpr
obl
ems:Asy
mmet
ri
cinf
ormat
ion

6.
5.3.
MEASURESTOREDUCEI
NFORMATI
ONASYMMETRY
SUMMARY

CHAPTERSI
X
MARKETFAI
LUREANDGOVERNMENTPOLI
CY
6.
1INRTODUCTI
ON
I
nthepr
evi
ouschapt
ers,wehav
eseent
hef
unct
ionoft
hemar
ketandi
tsout
[Link]
i
nter
act
ionsamongeconomi
cagent
s(consumer
s,f
ir
ms,andgov
ernmentagenci
es)i
n
mar
kett
hroughi
nvi
sibl
ehandofAdam smi
thi
nfl
uencet
hei
rbehav
ior
.Mar
kett
hroughi
ts
i
ncent
ivesi
nthef
orm ofpr
ices,pr
ofi
ts,andcostdi
ff
erent
ial
shel
pseconomi
cagent
al
l
ocat
eresour
cesef
fi
cient
lyi
nthesoci
ety
'sbesti
nter
est
.Fori
nst
ances,pr
icer
educt
ions
can changeconsumer
sbuy
inghabi
ts(
incr
easest
heconsumpt
ionandhenceut
il
it
y)
wher
eas ani
ncr
ease i
npr
ices f
orm hi
ghpr
ofi
tmar
ginf
ort
hef
ir
mthatencour
ages
pr
oduct
ionsofdesi
redgoodsandser
vices…et
c.

But
,ther
ear
equi
teal
otofar
easwher
ethemar
ketout
comesar
enotassuchef
fi
cientf
or

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 197
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CROECONOMI
CSI
I

t
heeconomy
.Thati
s,t
hei
nvi
sibl
ehandpushesi
nsuchawayt
hati
ndi
vi
dualdeci
sionsdo
notl
eadt
osoci
all
ydesi
rabl
eout
[Link]
stscal
lthi
ssi
tuat
ionamar
ketf
ail
ure
wher
ethemar
ketout
comesl
ead t
oinef
fi
cientr
esour
cesal
l
ocat
[Link]
ear
ethr
ee
commonsour
cesofmar
ketf
ail
ure:
[Link]
ernal
i
ties
Publ
i
cgoods
I
mper
fecti
nfor
mat
ion

Anyt
imet
hemar
ketf
ail
sgov
ernmenti
nter
vent
ionsar
eamongt
hepossi
bler
emedi
al
measur
es.

I
nthi
sandt
hef
oll
owi
ngt
hischapt
erwewi
l
lseet
hesour
cesofmar
ketf
ail
ure,t
hei
r
consequencesandr
emedi
almeasur
esi
ndet
ail
.Fur
thermor
e,wewi
l
llookdi
ff
erentf
orms
ofi
nter
vent
ionasar
emedi
[Link]
hisend,
theobj
ect
ivesoft
hechapt
erar
e:
Toenabl
ethest
udent
swi
thsour
cesofmar
ketf
ail
ures
Toacquai
ntt
hest
udentwi
tht
heconsequencesofmar
ketf
ail
ure
Toseet
hepossi
bler
emedi
almeasur
eandpubl
i
cchoi
cepr
obl
ems

Obj
ect
ives:
Accor
dingl
y,att
heendoft
his,
thest
udent
swi
l
lbeabl
eto:
Expl
aindi
ff
erentf
ormsofext
ernal
i
ties.
Show t
hesoci
almar
ginalcosti
sdi
ff
erentf
rom t
hepr
ivat
emar
ginalcostwhent
her
eis
ext
ernal
i
ty.
Expl
aint
heopt
imal
sear
chr
ule.
Reasonoutwhyandhow r
esour
cei
nef
fi
ciencyi
nconsumpt
ionandpr
oduct
ionl
eadt
o
ov
eral
leconomi
cinef
fi
ciency
.
Ment
iondi
ff
erentf
ormsofi
nter
vent
ions

6.
[Link]
TY

Ther
" e’ssomuchpol
l
uti
oni
ntheai
rnowt
hati
fitwer
enotf
orourl
ungst
her
e’dbeno
pl
acebepl
acet
oputi
tal
l" Rober
tOr
ben
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 198
Hav
eyouev
erhear
dof
,facedwi
thorsee;
Anev
ilent
repr
eneurwhodumpsdeadl
ytoxi
nsi
nchi
l
dren'
spl
aygr
ounds,
Af
ir
m whosepr
oduct
ionpr
ocessl
etsof
ffumest
hathar
msi
tsnei
ghbor
s,
Gl
obal
war
mingasar
esul
toft
headv
ancedcount
ri
esi
ndust
ri
alemi
ssi
on….
etc.
Thesear
esomeexampl
eofext
ernal
i
[Link]
sext
ernal
i
ty?
.Whatdoy
out
hinkof
pol
l
uti
on?

Economi
csi
npar
thasanswert
otheseandot
herr
elat
edquest
[Link]
eryonewant
sa
cheaperandsaf
erenv
ironment
;act
ivi
ti
esf
reeofanyef
fectont
heot
her
’sdeci
sionst
hat
l
eadt
osel
f-
maxi
mizat
ionofobj
ect
ivef
unct
ionandt
hatoft
hesoci
ety
.Howev
er,many
act
ivi
ti
esgener
atecer
tai
nef
fectonpeopl
enotdi
rect
lyi
nact
[Link]
fect
sar
e
gener
all
yuni
ntendedandnott
akeni
ntoaccountbyt
hedoeroft
heact
ivi
ti
[Link]
e
speci
fi
cwhent
wopar
ti
es(
Peopl
e,gr
oupwhat
evert
ypeofeconomi
cagent
)pur
suet
hei
r
owni
nter
estand do someact
ivi
ty,t
hei
ract
ionmaypr
oducesuni
ntended ef
fect
sor
i
mpact
sonpeopl
enotdi
rect
lyengagedi
ntheact
ivi
ty(
ort
hir
dpar
ty)
.Economi
stscal
lthe
ef
fect
sont
het
hir
dpar
tynott
akeni
ntoaccountbyt
hedoeroft
heact
ionext
ernal
it
[Link]
abov
ear
esomeexampl
eofext
ernal
i
tiest
hataf
fect
sthet
hir
dpar
tynoti
nvol
vedi
nthe
act
ions.

Anext
ernal
i
tyoccur
swhenaper
son'
swel
lbei
ngoraf
ir
m’spr
oduct
ioncapabi
l
ityi
s
di
rect
lyaf
fect
edbyt
heact
ionsofot
her
sconsumer
sorf
ir
msr
athert
hani
ndi
rect
lyt
hrough
changesi
npr
icesascompar
edt
otheact
iondet
ermi
nedbyt
hemar
ketsy
stem.I
tist
he
ext
ernalef
fectont
het
hir
dpar
tynoti
nvol
vedi
ntheact
[Link]
sonsmoki
ngi
nthe
mi
ddl
eofmeet
ings,f
ori
nst
ance,af
fect
sthosepeopl
esi
nthemeet
ingwhomaynothav
e
i
nter
estf
orsmoki
ng.

6.
2.1TYPESOFEXTERNALI
TIES
Ext
ernal
i
tycanbeoft
wot
ypesbasedt
heef
fect
sthati
thasonot
hereconomi
cagent
s.I
t
mayei
therhel
porhar
m ot
her
[Link]
dingl
y,i
tisoft
wot
ype:
Posi
ti
veext
ernal
i
ty
Negat
iveext
ernal
i
ty.
ADAMAUNI
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CS 199
ECON102MI
CROECONOMI
CSI
I

Posi
ti
veext
ernal
it
y:i
tisabenef
itofanact
ivi
tyr
ecei
vedbypeopl
esot
hert
hant
hosewho
pur
suet
heact
ivi
[Link]
e,honeybeeswher
esomeoneear
nshi
sli
vi
ngaskeeperof
honeybeeandhi
snei
ghbor
sonal
lsi
desgr
owappl
[Link]
l
inat
eappl
est
rees
ast
heyf
oragef
ornect
[Link]
ehi
veshekeeps,t
hel
argert
hehar
vestwi
l
lbei
nthe
sur
roundi
ngor
char
[Link]
atesext
ernalbenef
it
stot
heot
herpar
ti
es.
Byi
nst
all
i
ngat
tract
iveshr
ubsandout
doorscul
ptur
ear
oundi
tspl
ant
s,af
ir
m pr
ovi
des
ext
ernal
i
tiest
oit
snei
ghbor
[Link]
son(
par
ty)t
hatcr
eat
esi
tisnotpai
dforf
ort
hese
benef
it
s(ext
ernal
).

Negat
iveext
ernal
it
y:Theext
ernal
i
tieshar
m [Link]
ehar
medi
fyournei
ghbor
keepsy
ouawakebyscr
eami
ngateachot
herl
ateatni
ght
.Iti
sthenegat
iveef
fectofan
act
ivi
tyt
hatf
all
sonpeopl
eot
hert
hant
hosewhopur
suet
heact
ivi
[Link]
ivi
tyi
nvol
ves
costont
hosenotdi
rect
lyi
nvol
[Link]
iveext
ernal
i
tiesgener
ateext
racostont
he
t
hir
dpar
tyf
orwhi
cht
heyhav
enotcompensat
edf
ort
heef
fect
[Link]
ionqui
tea
l
otoft
hist
ypeofext
ernal
i
ties,butt
hemostcommon negat
iveext
ernal
i
tyar
iseduet
o
di
ff
erentt
ype ofpol
l
uti
[Link]
nst
ance,ai
rpol
l
uti
onandaci
drai
nasar
esul
tofbur
ning
hi
ghsul
furf
uel
s(coal
s)i
nindust
ri
alpl
ant
sandel
ect
ri
cut
il
it
iest
hatdest
roy
sveget
ati
on
andf
orest
s.

Not
ethat
:Asi
ngl
eact
ionmayconf
erposi
ti
veext
ernal
i
tiesonsomepeopl
eandnegat
ive
ext
ernal
i
tiesonot
her
[Link]
lofpi
pesmokepl
easessomepeopl
eandannoy
sot
her
s.
Somepeopl
ethi
nkt
hatt
hei
rwi
ndchi
mespl
easet
hei
rnei
ghbor
s,wher
easany
onewi
than
ounceofsensewoul
dreal
i
zet
hatt
hosechi
mesmakeuswantt
ost
rangl
ethem.I
twas
r
epor
tedt
hatef
for
tst
ocl
eanupt
heai
rinLos-
Angel
es,whi
l
ehel
pingpeopl
ebr
eat
hmor
e
easi
l
y,causedr
adi
ati
onl
evel
stoi
ncr
easef
armor
erapi
dlyt
hani
fai
rhadr
emai
neddi
rt
y.
_
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___
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___
___
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___
___
___
___
6.
[Link]
ivi
ty:
Doy
out
hinkeducat
ionhav
eanyext
ernal
i
ty?Supposesomeoneeducat
eher
sel
f/hi
msel
f,
howdoheorshebenef
it
shi
msel
fandhi
ssoci
ety
?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 200
Ont
heot
herhand,wehav
esai
dthatal
leconomi
cact
ivi
ti
esofeconomi
cagent
sar
e
r
elat
ed t
o pr
oduct
ion and consumpt
ion act
ivi
ti
esbased on t
hei
rrespect
iveobj
ect
ive
f
unct
ion i
n pr
evi
ous chapt
ers. We di
scussed t
he condi
ti
ons f
orobj
ect
ivef
unct
ion
opt
imi
zat
ionbyi
mpl
i
cit
lyassumi
ngt
heact
ionsofeconomi
cagenthav
enoext
ernalef
fect
ont
heot
her
[Link]
er,someact
ivi
ti
eshav
espi
l
lov
eref
fectornei
ghbor
hoodef
fect
s.
Thesear
etwocommoneconomi
cact
ivi
ti
esordeci
sionsofeconomi
cagentt
hatar
e
sour
cesofext
ernal
i
ties.I
not
herwor
d,ext
ernal
i
tiesar
ebypr
oduct
sofconsumpt
ionand
pr
oduct
iont
hatmaybebenef
it
sorhar
m ot
herpeopl
es.

I
.CONSUMPTI
ONEXTERNALI
TIES

I
tri
sesi
foneconsumerdoesnotcar
edi
rect
lyaboutanot
heragent
'spr
oduct
ionor
consumpt
[Link]
eoft
wot
ypesaccor
dingt
othei
ref
fect
:
[Link]
ernaleconomi
esofconsumpt
ion(
posi
ti
veext
ernal
i
ty)t
hatoccur
swhenanact
ion
t
akenbyaconsumer
,rat
hert
hanapr
oducer
sresul
tsi
nanuncompensat
edbenef
it
sto
ot
her
[Link]
es,
pleasur
ethatonegetf
rom obser
vingone'
sbeaut
if
ulf
lowergar
den.
[Link]
ernaldi
seconomi
esofconsumpt
ions(
negat
iveext
ernal
i
ty)t
hatoccurwhenact
ion
t
akenbyaconsumerr
esul
tsi
nanuncompensat
edcostt
oot
her
[Link]
es,my
nei
ghborpl
ayi
ngl
oudmusi
cat3houri
nthemor
ningori
ntheev
enwhent
henei
ghborgo
t
osl
eepi
ngorper
sonnextt
omei
nar
est
aur
antsmoki
ngacheepci
gar
ett
e.

I
[Link]
ONEXTERNALI
TIES

These t
ypes ofext
ernal
i
ty ar
ise when t
he pr
oduct
ion possi
bil
i
ties ofone f
ir
m ar
e
i
nfl
uencedbyt
hechoi
ceofot
herf
ir
[Link]
ket
hatofconsumpt
ioni
tisei
therhar
m or
benef
itt
het
hir
dpar
ty.

[Link]
ernaleconomi
esofpr
oduct
ionoccurwhenf
ir
m’spr
oduct
ionmaybenef
it
stheot
her
notdi
rect
lyi
nvol
vedi
ntheact
[Link]
e,t
rai
ningwor
ker
swhoev
ent
ual
l
ygot
o
wor
kforot
herf
ir
mswhodonotpayt
rai
ningcost
sbutl
eadt
oincr
easedout
put
.

[Link]
ernaldi
seconomi
esofpr
oduct
iont
hatar
isewhent
heact
iont
akenbyaconsumer
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 201
ECON102MI
CROECONOMI
CSI
I

r
esul
tsi
nanuncompensat
edcost
stoot
her
[Link]
nst
ance,af
ir
m ont
heupst
ream mi
ght
pol
l
utemanypar
ti
essuchasf
isher
manandi
rr
igat
ional
ongdownst
ream usedbydumpi
ng
outwast
emat
eri
als.
_
___
___
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___
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___
___
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___
___
___
__
6.
[Link]
ivi
ty:

Whatt
ypeofext
ernal
i
tyar
evacci
nat
ions?(
Nott
hathel
psnotonl
ytheper
sonv
acci
nat
ed
butal
sot
heent
ir
enei
ghborhoodt
hatt
heper
sonl
i
vesi
nbypr
event
ingt
hespr
eadof
cont
agi
ousdi
seases)

Supposecer
tai
ntext
il
eindust
ryi
sconst
ruct
edi
nEt
hiopi
aandi
tincr
easet
heempl
oyment
s,
cr
eat
edemandf
ori
nputpr
oducer
[Link]
ypeofext
ernal
i
tyi
sit
?

6.
2.2.I
NEFFI
CIENCYOFMARKETWI
THEXTERNALI
TIES
Wehav
edi
scussedt
hecondi
ti
onsf
oref
fi
ciencyi
nconsumpt
ionandpr
oduct
ionand
ov
eral
leconomi
cef
fi
ci
encyunderPar
eto-
opt
imal
i
[Link]
ti
onsi
nvol
vedmar
ginal
r
atesofsubst
it
uti
on(
MRS)andmar
ginalr
atesoft
ransf
ormat
ion(
MRT)
.Thecondi
ti
ons
wer
eder
ivedont
heassumpt
iont
hatpr
oduct
ioncost
sar
ebor
nonl
ybyt
hepr
oducer
sof
t
hepr
oductandt
heut
il
it
yder
ivedf
rom consumpt
ionenj
oyedonl
ybyt
hepur
chaser
s.
Ther
eisnodi
ff
erencebet
weenpr
ivat
eandsoci
albenef
it
sorbet
weenpr
ivat
eandsoci
al
cost
sasal
lther
elev
antcost
sandbenef
it
sofanact
ivi
tyaccr
uedi
rect
lyt
otheper
sonwho
car
ri
esi
toutt
heact
ivi
ty.

I
nmanyi
nst
anceswher
ether
eisext
ernal
i
ty(
posi
ti
veornegat
iveext
ernal
i
tyofpr
oduct
ion
orconsumpt
ion)t
heseassumpt
iondonothol
d.I
ndi
vi
dual
sfol
l
ow t
hei
rsel
fint
erestt
hat
maynotpr
oducet
hebestal
l
ocat
ionofr
esour
[Link]
ndi
vi
dual
sconsi
deronl
ythei
r
owncost
sandbenef
it
sandt
endt
oengagemuchi
nact
ivi
ti
est
hatgener
atenegat
ive
ext
ernalcost
stot
hesoci
etyandt
ool
i
ttl
einact
ivi
ti
eswi
thposi
ti
veext
ernal
i
tiest
othe
soci
etyandv
icev
[Link],
ext
ernal
i
tiescr
eat
edi
ver
gencesbet
weenpr
ivat
eandsoci
al
cost
sandbenef
it
sthatchangeeconomi
cpat
ter
nsofpr
oduct
ionandconsumpt
ion.

Hence,
ifext
ernal
i
tiesex
ist
,ourear
li
ermodel
breaksdownf
ort
wor
easons:
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 202
Pr
icest
hatpl
ayscr
uci
alr
olei
ndet
ermi
ningt
heequi
l
ibr
ium,
lossesi
tssi
gni
fi
canceast
hey
donotr
efl
ectal
lcost
sandbenef
it
s
ThePar
eto-
opt
imal
i
tycondi
ti
onsnol
ongerwor
kaspr
icespr
ovi
demi
sleadi
ngsi
gnal
sfor
opt
imum al
l
ocat
ionofr
esour
ces.

Thef
amouseconomi
stA.
[Link]
gouwast
hef
ir
stt
opr
esentt
hisi
nsy
stemat
icwayi
nhi
s
bookent
it
led“
Weal
thandWel
far
e"i
[Link]
guedt
hati
nthepr
esenceofext
ernal
i
ties,
ev
eni
fwehav
eper
fectcompet
it
ionwedonoachi
evePar
eto-ef
fi
ciency
.Thesoci
al
benef
itorcosti
sacombi
nat
ionofpr
ivat
eandext
ernalbenef
it
sorcost
[Link]
l
luset
he
f
oll
owi
ngnot
ati
ont
odenot
ethesecost
sandbenef
it
s
MPC=mar
ginal
pri
vat
ecost Si
mil
arl
y MPB=mar
ginal
pri
vat
ebenef
it
MEC=mar
ginal
ext
ernal
cost MEB=Mar
ginal
ext
ernal
benef
it
MSC=Mar
ginal
soci
alcost MSB=Mar
ginal
soci
albenef
it
Hence;
MSB=MPB+MEB Hence;
MSC=MPC+MEC

Theov
eral
leconomi
cef
fi
ciencyr
equi
rest
hatMSC=MSBf
oreachpr
oduct
.Ther
easoni
s
t
hatasl
ongasMSB>MSC,pr
oduct
ionshoul
dbeexpandedbecauseaddi
ti
onalbenef
it
exceedsaddi
ti
onalcost
.Si
mil
ari
ty,i
fMSB<MSC,t
henpr
oduct
ionshoul
dbedecr
eased
si
nceonl
ypr
ivat
ecostand benef
iti
scov
ered byt
hepr
oducer
sofext
ernal
i
ties,t
he
economywi
l
lnotr
eacheconomi
cef
fi
ciency
.Foreconomi
cef
fi
ciencyconsumer
sand
pr
oducer
smustwei
ght
hef
ull
soci
albenef
it
sofconsumpt
ionorpr
oduct
[Link]
fect
sof
ext
ernal
i
tiesonr
esour
cesal
l
ocat
ioncanbepor
tray
edgr
aphi
cal
l
yundereachcaset
hatwe
hav
eseenabov
e.

EXTERNALI
TIESI
NCONSUMPTI
ONS

Recal
lthatunderut
il
it
ychapt
erwehav
eassumedt
hatt
heut
il
it
y(sat
isf
act
ion)ofone
consumeri
sindependentofaconsumpt
ionpat
ter
noft
heot
her
.Theeconomi
cef
fi
ciency
i
nconsumpt
ioni
sat
tai
nedwhenmar
ginal
rat
eofsubst
it
uti
onofcommodi
ti
esmustbet
he
samef
oranyoft
woconsumer
s.I
fweassumet
her
ear
enoext
ernal
i
tiesi
nconsumpt
ion
t
hemar
ginalsoci
alcostandmar
ginalpr
ivat
ecost
sar
eequal
,andt
hecompet
it
ivesuppl
y
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 203
ECON102MI
CROECONOMI
CSI
I

cur
vesr
efl
ectt
hecommonmar
ginalcost
.Si
mil
arl
y,mar
ginalsoci
albenef
itandmar
ginal
pr
ivat
ebenef
it
sar
eequal
,andt
hedemandcur
ver
efl
ect
sthebenef
it
s.

Howev
er,
incaseofext
ernal
i
tyt
het
wogr
aphsdi
ff
er.I
nthecaseofconsumpt
ion,
wehav
e
expl
ainedabov
ethatt
her
ear
etwof
orms/
typesofconsumpt
ionext
ernal
i
ties(
negat
ive
andposi
ti
ve)
.Ifweassumet
her
ear
enoext
ernal
i
tiesi
nconsumpt
ioni
smar
ginalsoci
al
costandmar
ginalpr
ivat
ecost
sar
eequal
,andt
hecompet
it
ivesuppl
ycur
vesr
efl
ectt
he
commonmar
ginalcost
.Howev
er,
ont
hedemandsi
de,
thedemandcur
ver
efl
ect
sonl
ythe
mar
ginalpr
ivat
ebenef
it(
MPB)i
nwhi
cht
heeconomi
cagentdoesnott
akei
ntoaccount
t
heext
ernal
i
[Link]
hemar
ginal
soci
albenef
it(
MSB)di
ff
ersf
rom MPB.

Ext
ernal
benef
it
s=soci
albenef
it
s-pr
ivat
ebenef
it
sor
Wewi
l
llookatt
hei
mpactoft
hedi
ff
erencebet
weenMPBandMSBonr
esour
ceal
l
ocat
ion
undert
woscenar
ios.

NEGATI
VEEXTERNALI
TYOFCONSUMPTI
ON.

Recal
lthatt
hemar
ginalpr
ivat
ebenef
iti
sthedemandcur
vef
ort
hef
ir
m andt
hemar
ginal
costi
sthesuppl
ycur
veoft
hef
ir
m aswel
last
hesoci
ety
.Int
hiscaset
hemar
ginalsoci
al
benef
it(
MSB)i
sbel
ow t
hatofmar
ginalpr
ivat
ebenef
it(
MPB)ascanbeseenf
rom t
he
f
igur
e6.
1-Abel
[Link]
easoni
sthatt
heeconomi
cagentconsumesomet
hingt
hatr
esul
t
i
nlowerbenef
itt
othesoci
etyt
hant
othepr
ivat
eashe/
shepur
suehi
ssel
f-
int
erest
.Ther
e
i
sanov
erpr
oduct
ionoft
hecommodi
tyast
hei
ndi
vi
duali
snott
akei
ntoaccountal
lthe
costandbenef
it
.Accor
dingl
y,t
heamountofgoodsandser
vicesaneconomi
cagentwant
t
oconsumei
satpoi
ntwher
eMPB=MPCwhi
chi
spoi
ntQ1 atpr
icei
sP1 i
sthemar
ket
equi
l
ibr
ium wher
east
heopt
imalquant
it
yfort
hesoci
etyi
sQo(
wher
eMSB=MSC)wi
tht
he
cor
respondi
ngC0.

MC
MC
D
MSC=MP
MS MSC=MP
P0 D

P1 ADAMAUNIVERSITY,DEPARTMENTOFECONOMICS C0 204
C0 P1
Att
hesoci
all
yopt
imum poi
ntt
heMSB=MPB+MEBt
hati
sPo=Co+CoPoov
ert
heent
ir
e
pr
ivat
edemandcur
ve;t
heext
ernalsoci
alcosti
sXCatal
llev
elofpr
oduct
[Link]
tis
notatt
hesoci
all
yopt
imall
evelofpr
oduct
ionasi
tleadst
oov
erpr
oduct
ionont
hepar
tof
pr
ivat
e.

B.
POSI
TIVEEXTERNALI
TIESOFCONSUMPTI
ON

Agai
n,t
heMSC(
equalt
oMPC)cur
vei
sthesuppl
ycur
[Link]
veDi
sthe
mar
ginal
pri
vat
ebenef
itt
hati
sdi
ff
erentf
rom t
hatoft
hesoci
ety
’sasshownbyf
igur
e6.
1-B
abov
[Link]
ncet
her
ear
eext
ernalbenef
it
s,MSB>MPB,andt
heMSBcur
vewasabov
ethe
demandcur
[Link]
all
yopt
imal
quant
it
yisgi
venbyQowher
eMSB=[Link]
er,
for
t
hepr
ivat
eeconomi
cagentpoi
ntofv
iew t
heequi
l
ibr
ium at
tai
nedwhenQ1 i
spr
oduced
wi
thcor
respondi
ngpr
icesi
sP1whi
chi
ssmal
l
ert
hant
hesoci
all
yopt
imall
evel
.Hence,
t
her
eisunder
product
ionascompar
edt
othesoci
all
yopt
imall
evel
.Thesoci
all
yopt
imal
,
Qoi
stheout
putl
evelatwhi
chMSC=MSBi
sobt
ainedbyaddi
ngt
heext
ernalbenef
it
,XB,
t
oev
eryv
alueal
ongpr
ivat
edemandcur
[Link]
s,t
opr
oduceatsoci
ali
tyopt
imum (
Qo)
t
heconsumerneedt
obecompensat
ed(
subsi
dized)byt
heamountequalt
oCo-
Po.(
Thi
s
wi
l
lbecov
eredunderl
egal
remedi
est
opi
c).

Thus,i
nbot
hcasespr
ivat
eequi
l
ibr
ium undercondi
ti
onext
ernal
i
tiesf
ail
stoexhaustal
l
possi
blegai
nsf
rom consumpt
ionsi
nsuchawayt
hatt
hesoci
eti
esr
eachi
tsequi
l
ibr
ium
(
Soci
all
yopt
imal
quant
it
y).
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 205
ECON102MI
CROECONOMI
CSI
I

EXTERNLI
TIESI
NPRODCUTI
ONS

Underi
dealci
rcumst
ancespr
oducer
’spr
ivat
ecostorbenef
itwi
l
lencompassesal
lthe
at
tendantsoci
alcost
s and soci
albenef
it
[Link],t
he pr
oduct
ion deci
sion wi
l
lbe
consi
stentwi
thoursoci
alwel
far
[Link]
ort
unat
ely
,thi
shappyi
dent
it
ydoesnotal
way
sexi
st
associ
alcostdi
ff
erf
rom pr
ivat
ecost
sbycer
tai
namountt
ermedasext
ernal
soci
alcost
s.

Ext
ernal
cost
=soci
alcost
s-pr
ivat
ecost
s.

I
nthi
scaset
hepr
icesi
gnalconf
ront
ingpr
oducer
sisf
lawedbynotconv
eyi
ngt
hef
ull
(
soci
al)costofscar
cer
esour
ces,t
hemar
ketencour
agesexcesspol
l
uti
onandweendup
wi
thnonopt
imalmi
xofout
putandwr
ongpr
oduct
ionpr
[Link]
derf
ir
stt
he
caseofnegat
ivepr
oduct
ionext
ernal
i
tiesandt
henposi
ti
vepr
oduct
ionext
ernal
i
ties.

A.
NEGATI
VEEXTERNALI
TYI
NPRODUCTI
ON

Fi
gur
e6.
2(A)i
l
lust
rat
ethecaseofnegat
iveext
ernal
i
tyi
npr
oduct
[Link]
her
ear
eno
ext
ernal
i
tyi
nconsumpt
ion,t
hedemandcur
veDshowst
hemar
ginalpr
ivat
eandsoci
al
benef
it
s(MPB=MSB)asi
dent
ical
.Thecompet
it
ivesuppl
ycur
ve,
howev
er,
ref
lect
sonl
ythe
mar
ginalpr
ivat
ecost
s(MPB)butt
heMSC cur
vel
i
eabov
ethecompet
it
ivecur
veasi
t
i
ncl
udesmar
ginalext
ernalcost
stoev
eryv
olumeal
ongpr
ivat
eMCby‘
’
XC.
"Theopt
imal
out
puti
sQo wi
thapr
[Link]
hisl
evelal
lpossi
bil
i
tiesf
rom exchangei
sexhaust
[Link]
t
hecompet
it
ivemar
ket
,ifi
tlef
tal
one,wi
l
lpr
oduceQ1,wi
thapr
[Link],t
her
eisa
t
endencyt
oov
erpr
oducebyXCamount
.

MC
MC
DNIVERSITY,DEPARTMENTOFECONOMICS
ADAMAU 206
MP
MS MSC=MPC
D
[Link]
TIVEEXTERNALI
TIESI
NPRODUCTI
ON
Thi
scasei
sil
l
ust
rat
edi
nFi
gur
e6.
2–Babov
[Link]
ver
epr
esenti
dent
icalt
he
mar
ginalsoci
alandpr
ivat
ebenef
itcur
ve,
butsuppl
ycur
vedi
ff
ersi
nthatt
heMSCcur
vei
s
bel
ow t
heMPCcur
ve(
MSC<MPC)
.Thesoci
all
yopt
imall
evelofout
puti
sgi
venbyt
he
i
nter
sect
ionoft
hedemandcur
vewi
tht
heMSCcur
veasshownbypoi
nt‘
e’wi
th Qoout
put
andPo pr
[Link]
er,i
flef
tal
onet
hecompet
it
ivemar
ketwi
l
lpr
oduceQ1 wi
thpr
iceP1
wher
ethedemandcur
vei
nter
sectt
heMPCcur
ve,
Thus,
tool
i
ttl
ewi
l
lbepr
oducedf
rom t
he
soci
alpoi
ntofv
[Link]
putl
evelQo,pr
oducer
srecei
vedapr
icesorPo,butt
her
e
mar
ginalcosti
sCot
hedi
ff
erencebet
weent
het
woi
stheamountBXi
stheext
ernal
benef
itgener
atesf
rom t
heact
ionofeconomi
cagenti
npr
oduct
ion.

I
n gener
al,no mat
terwhet
herext
ernal
i
ties ar
e posi
ti
ve ornegat
ivet
heydi
stor
tthe
al
l
ocat
ionofr
esour
cesi
not
her
wisei
nef
fi
cientmar
ket
[Link]
ernal
i
tiesar
epr
esent
,
t
hei
ndi
vi
dualpur
sui
tofsel
fint
erestwi
l
lnotr
esul
tint
hel
argestpossi
bleeconomi
c
sur
plusf
ort
hesoci
ety
.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 207
ECON102MI
CROECONOMI
CSI
I

6.
2.3REMEDI
ALMEASURESOFEXTRNALI
TIEI
S

Wehav
eseent
hatext
ernal
i
tiesl
eadt
oinef
fi
ciental
l
ocat
ionofr
esour
[Link]
ethe
measur
est
obet
akent
oreducet
hei
nef
fi
cienci
esgener
atedbyext
ernal
i
ties?Whatar
e
gov
ernmentpol
i
ciesorconcer
nedbodi
esact
iont
oreducei
tsef
fect
?

Underi
dealcondi
ti
onsaf
ir
m oraneconomi
cagentt
hatgener
ateext
ernalact
ivi
ti
esmust
i
ncl
udeext
ernalcost
sorbenef
it
sini
tscal
cul
ati
onsofpr
ivat
egai
nsandcost
s. The
i
nter
nal
i
zat
ioncanbet
hroughpr
ivat
epr
icet
agspl
acedonext
ernalcost
s(orbenef
it
s)so
t
hatpr
ivat
eandsoci
alcost
s(orbenef
it
s)coi
nci
[Link]
herpossi
blewayi
sthr
oughquant
it
y
ofpr
oductadj
ust
menti
nwhi
chonecani
ncr
easeordecr
easedependi
ngont
het
ypeof
ext
ernal
i
[Link]
nst
ances,pol
l
uti
oncanber
educedei
therbyr
educi
ngt
heact
ivi
tyoft
he
pol
l
uti
ngagent
sorpay
ingt
hecostofpol
l
uti
onabat
ement
.Whati
stheopt
imall
evelof
ext
ernal
i
ty?Whati
stheopt
imal
lev
elofpol
l
uti
onabat
ement
?

Theopt
imi
zat
ionofext
ernal
i
tyi
sjustl
i
ket
hepr
oduct
ionandconsumpt
ioni
ssueswehav
e
di
scussedsof
arempl
oyt
heconceptofmar
ginal
i
tyanal
ysi
s.I
ndeal
i
ngwi
thanyf
orm of
ext
ernal
i
tiest
hecostandbenef
it
smat
ter
sandopt
imall
evelofpr
oduct
iondependsont
he
mar
ginalcostandbenef
it
sofpr
oduci
ngaddi
ti
onalgood. I
tisunt
ilt
hemar
ginalext
ernal
soci
albenef
itofext
ernal
i
tyi
sequal
tot
hemar
ginal
ext
ernal
soci
alcost
.

Thi
scanbei
l
lust
rat
edwi
thourpol
l
uti
onexampl
[Link]
gur
e6.
3 showst
hemar
ginalsoci
al
cost
sandmar
ginalsoci
albenef
it
sofdi
ff
erentamountofpol
l
uti
onabat
ement– t
he
numberofgal
l
onsofwat
erpur
if
iedt
houghtf
il
tr
ati
onandhow i
tisdet
ermi
[Link]
mar
ginalsoci
alcostofeachsuccessi
veuni
tofabet
menti
ncr
easesasmor
eandmor
e
wat
eri
spur
if
ied.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 208
ar
l
dol
ment(
onabet

Mar
ginal
soci
alcostof
gi ut
l
pol
nal i

Mar
ginal
soci
albenef
itof
Mar

a b
Opti
mal Quanti
tyofpoll
uti
on
abat
ement abatement
(gal
l
onofwat erpuri
fi
edby
Fi
gur
e6.
3:Opt
imal
pol
l
uti
on

Themar
ginal
soci
albenef
itcur
vei
sdownwar
dsl
opi
ngwher
east
hemar
ginal
soci
alcostof
pol
l
uti
on i
sassumed t
o beconst
ant
. Themar
ginalsoci
albenef
it
sdecl
i
nesast
he
abet
menti
ntensi
fi
esbecausewev
aluet
hef
ir
stuni
tofabat
ementmor
ehi
ghl
ythan
subsequentuni
[Link]
imall
evelofabet
mentoccur
swhent
hemar
ginalsoci
alcostof
ext
rauni
tsofabet
mentequal
sit
smar
ginalsoci
albenef
it
s.I
ftheabat
ementi
sunder
taken
bey
ondt
hisopt
imall
evel
,theext
rabenef
it
sfal
lshor
tsoft
heext
raoppor
tuni
tycost
s. On
t
hecont
rar
y,i
ftheabat
ementi
sunder
takenbel
ow t
hisopt
imall
evel
,theext
racost
sfal
l
shor
tsoft
heext
raoppor
tuni
tybenef
it
s.

Fr
om ouranal
ysi
sonemayt
hinkwhet
hert
heopt
imall
evelofpol
l
uti
onshoul
dbegr
eat
er
t
hanzer
[Link]
imalext
ernal
i
tyi
sgr
eat
ert
hanzer
odoesnotmeananyposi
ti
vel
evelof
negat
iveext
ernal
i
ty(
pol
l
uti
on)i
sgood.I
tismer
elyt
orecogni
zet
hatsoci
etyhasan
i
nter
esti
ncl
eani
ngupt
heenv
ironment
,butonl
yupt
othecer
tai
npoi
nt.I
fyouai
mfort
he
t
otalel
i
minat
ionofpol
l
uti
onwewoul
dhav
etodev
otemor
eandmor
escar
cer
esour
cest
o
abet
ment
,unt
ilt
hemar
ginalsoci
albenef
it
sar
ezer
o. Hence,t
hel
astdol
l
arsspenton
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 209
ECON102MI
CROECONOMI
CSI
I

pol
l
uti
onabat
ementwi
l
lyi
eldzer
obenef
it
sandwi
l
lhav
eahi
ghmar
ginal
cost
.

Thei
deacanbeseenf
rom di
rti
nanapar
tmentev
eni
fyouspentt
hewhol
eday
,ev
eryday
,
v
acuumi
ngy
ourapar
tment
,ther
ewoul
dbesomedi
rtt
hatl
efti
nit
.Youpr
obabl
ytol
erat
e
subst
ant
ial
l
ymor
ethant
hemi
nimalamountofdi
rt
.Fur
thermor
e,t
hesoci
etywi
l
lincur
costt
hatex
ceedt
hebenef
itbyt
ryi
ngt
omakei
tzer
[Link]
er,t
heef
fi
cientl
evelof
pol
l
uti
onwoul
dbezer
oift
hepol
l
utantwer
esodamagi
ngt
hatt
hemar
ginalcostofev
en
t
hef
ir
stuni
trel
easedi
ntot
heenv
ironmentexceededt
hemar
ginalcostofnotal
l
owi
ng
r
eleases.

Theabov
eopt
imum l
evelofext
ernal
i
tycanbeat
tai
nedt
houghti
nter
nal
i
zat
ionoft
hecost
andbenef
it
saswei
ndi
cat
edabov
[Link]
nter
nal
i
zat
ioncanbeaccompl
i
shedbyt
he
Redef
ini
ti
onofpr
oper
tyr
ight
s
Vol
unt
aryagr
eement
s
[Link]
ernmentact
ion

[Link]
NITI
ONSOFPROPERTYRI
GHTS

Poordef
ini
ti
onofpr
oper
tyr
ighti
sapr
omi
nentsour
ceofext
ernal
i
[Link]
oper
tyr
ight
sar
e
soci
alar
rangement
sthatgov
ernt
heowner
shi
p,use,
anddi
sposalofr
esour
ces,
goodsand
ser
vicesi
nmoder
nsoci
ety
.Iti
sal
egal
l
yest
abl
i
shedt
it
let
hati
senf
orceabl
eint
hecour
ts.
I
fwedonotknowwhoownst
hepr
oper
tyr
ightt
other
iver
,ther
eisnoonet
oli
mit
sit
suse
andr
esour
ceswi
l
lli
kel
ybeexpl
oit
[Link]
nst
ances,f
ishi
ngbusi
nesswi
l
lbe
ov
erf
ishi
ngoceanwat
er,
fact
orswi
l
lpol
l
utemor
e…et
c.

Howev
er,i
fpr
ivat
epr
oper
tyr
ightcanbecl
ear
lydef
ined,t
hepr
ivat
eownerwi
l
lmakesur
e
t
hatt
her
esour
cei
sef
fi
cient
lyusedas(
theassi
gni
ngpr
oper
tyr
ight
s)gi
veanexcl
usi
ve
pr
ivi
l
egedt
ouseasset
[Link]
nst
ances,byowni
ngt
hist
estbook(
modul
e),y
ouhav
ea
pr
oper
tyr
ightt
oreadi
tandt
ost
opot
her
sfr
om r
eadi
ngort
aki
ngi
t.I
fyouhadapr
oper
ty
r
ightt
hatassur
edy
ouoft
her
ightt
obef
reef
rom noi
sepol
l
uti
on,
youcoul
dgett
hecour
ts
t
ost
opy
ournei
ghbort
opl
ayt
hemusi
c. Theownerofhunt
ingl
andcansetf
eeshi
gh
enought
opr
eventgamesf
rom bei
ngdepl
[Link]
gnmentofmaynotmat
teron
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 210
i
ndi
vi
dual
pref
erences.

B.
VOLUNTARYAGREEMENT
Vol
unt
aryagr
eement
sar
eanot
hermeansofi
nter
nal
i
zingext
ernal
i
[Link]
oper
ty
r
ight
s ar
e wel
ldef
ined,v
olunt
ary agr
eement
s can i
nter
nal
i
ze ext
ernalcost
[Link]
pr
oposi
ti
ont
hatv
olunt
aryagr
eement
scansol
veext
ernal
i
typr
obl
emswasf
ir
sti
ntr
oduced
byR.
H. Coase and t
ermed as Coase t
heor
em. He pr
ofoundl
ychanged t
he way
economi
sts,l
egalschol
ars,pol
i
tici
ans,phi
l
osopher
sandot
her
sthi
nkaboutext
ernal
i
ties
andt
hel
egalandsoci
ali
nst
it
uti
onst
hathav
eev
olv
edt
odealwi
tht
[Link]
t
heor
em st
ates t
hatext
ernal
i
ties (
cost
s/benef
it
s)can be i
nter
nal
i
zed bynegot
iat
ion
amongt
heaf
fect
edpar
ti
esasl
ongast
hecostofbar
gai
ningi
sver
ysmal
lornul
landt
he
number
sofpar
ti
esar
esmal
l
.

Toi
l
lust
rat
etheCoaset
heor
em,weconsi
derourst
eelmi
l
landf
isher
[Link]
nger6.
4show
suchext
ernal
i
ty. Fi
rmsuni
tofwast
edi
sposedi
sgi
venal
ongt
hehor
izont
alaxi
[Link]
mar
ginalbenef
it
s(MB)t
othef
ir
m ofpr
oduci
ngt
hiswast
ear
egi
veni
ndol
l
art
ermsont
he
v
ert
icalaxi
[Link]
hesakeoft
hisanal
ysi
s,mar
ginalbenef
itcanbet
houghtofast
henet
pr
ofi
tofpr
oduci
ngaddi
ti
onaluni
tofwast
e(i
nter
msoft
hest
eelpr
oduced)andhencei
tis
demandcur
[Link]
ether
efor
edecl
i
neswi
thi
ncr
easesi
nout
putbecauset
he
r
ateofr
etur
nonaddi
ti
onpr
oduct
iongener
all
ydecl
i
[Link]
vet
ell
suswhatt
hef
act
ory
i
swi
l
li
ngt
opayf
ordumpi
ngt
her
espect
iveamount
.

Themar
ginalext
ernalcost(
MC)cur
ver
epr
esent
stheext
ernal
i
tycausedbyt
hef
ir
m’s
pr
oduct
ionandi
sgiveni
Andol
l
art
erm al
ongt
hev
ert
ical
axi
s.
200
e
sofwast

150
MS
ones)
Costandbeneft
i

E
spert

100

5
ar

MB
( l
dol

O
2 Qxx= 6 8 Quant
it
yofwast
ein
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 211

Fi
gur
e6.
4:opt
imal
wast
ebasedonv
olunt
ary
ECON102MI
CROECONOMI
CSI
I

Nowweappl
yCoase’
sanal
ysi
[Link]
iment
,wegi
vet
heowner
shi
pri
ghtt
ofi
sher
y.
Assumi
ngt
hatbar
gai
ningcosti
snot
hing,wecanpr
edi
ctwhatwi
l
lhappenwi
tht
hehel
pof
f
igur
[Link]
heamountofwast
eupt
o,weobser
vet
hatMB>[Link]
ir
m’spr
ofi
ton
addi
ti
onaluni
ts ofwast
e ar
e gr
eat
ert
han t
he addi
ti
onalpol
l
uti
on costbor
n byt
he
nei
ghbor
hood(
fi
sher
)woul
dbewi
l
li
ngt
osel
lther
ightofusi
ngt
hewat
ert
opr
oducet
hese
uni
[Link]
ncet
het
otalcostoft
heext
ernal
i
tycausedbyt
hisout
puti
srepr
esent
edbyt
hear
ea
undert
heMSCcur
ve,abar
gai
ncanbet
ruckl
ebet
weent
hef
ir
m andt
hef
isher
ytopr
oduce
byagr
eementonhowt
odi
vi
det
hesur
plusmar
ginalbenef
it
[Link]
act
orcanpayt
he
f
isher
yandhencebot
hcangai
nfr
om v
olunt
aryagr
eementupt
o=4wast
edi
sposal
.

Bey
ond MSC>MB,abar
gai
ntopr
oducet
heseuni
tscannotber
eachedbet
weent
hef
ir
m
andf
isher
yasf
ir
m woul
dnotbewi
l
li
ngt
obi
denought
oobt
aint
her
ightt
opr
oducet
hese
uni
tshence,t
hef
isher
ywoul
dnotsel
lther
ight
.SoQ,wher
eMB=MSCi
stheequi
l
ibr
ium
out
comewhent
henei
ghbor
hoodi
sgi
vent
het
ransf
erabl
eri
ghtt
ouseofr
iver
.
Supposet
hataj
udgedeci
dedi
nst
eadt
oawar
dthef
ir
mther
ightt
ouset
heai
rasi
tchoose.
Whathappens?Wegot
hrought
hesameanal
ysi
s,butnowweseet
hatt
hef
isher
ymustpay
t
hef
ir
mtopr
oducel
esswast
[Link]
ouni
tsofout
put(
wast
e)MB>MC,i
mpl
yi
ngt
he
f
isher
ycannotof
feral
argesum ofmoneyt
oinducet
hef
ir
mtor
educei
[Link]
ondQ,
fir
m
woul
dbewi
l
li
ngt
oacceptanyof
ferbutt
hef
isher
yisnotwi
l
li
ngt
omakei
tasi
tcost
shi
m
mor
e.I
tiswor
thwhi
l
eforf
ir
mtor
educepol
l
uti
onupt
o wher
eMSC=[Link]
esul
tshows
t
hatnomat
terwhohast
hel
egalr
ightt
ouse,t
heamountofpol
l
uti
oni
[Link]
sis
t
hecent
ral
insi
ghtof
fer
edbyt
heCoaset
heor
em.

[Link]
ONS

Manyr
ealwor
ldext
ernal
i
typr
obl
emscanbeanal
yzedwi
thCoaset
heor
em,asl
ongast
he
bar
gai
ningandt
ransact
ioncost
sar
elow. Nev
ert
hel
ess,t
hepar
ti
esmaynotbeabl
eto
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 212
bar
gai
nsuccessf
ull
yforatl
eastt
hreei
mpor
tantr
[Link]
rst
,tr
ansact
ioncosti
snotv
ery
smal
l
,ift
henumber
sofpl
ant
sar
enumer
ous,i
tisdi
ff
icul
ttoor
gani
zeandr
eachont
he
sol
uti
on.I
magi
net
het
ransact
ioncost
sif50f
act
ori
esand10f
isher
sascompar
edt
othe
onewehav
eseensof
[Link],i
ffi
rmsengagei
nst
rat
egi
cbar
gai
ningbehav
ior
,an
agr
eementmaynotber
[Link]
rd,i
fei
thersi
del
acksi
nfor
mat
ionaboutt
hecost
sor
benef
it
sofr
educi
ngpol
l
uti
on,
anonef
fi
cientout
comemayoccur
.Iti
sdi
ff
icul
ttoknowhow
mucht
oof
fert
heot
herpar
tyandt
oreachanagr
eementi
fyoudonotknow how t
he
pol
l
uti
ngact
ivi
tyaf
fect
stheot
herpar
[Link]
heser
easons,
Coasi
anbar
gai
ningi
sunl
i
kel
yto
occuri
nrel
ati
vel
yfew si
tuat
ions. Sot
hecostofdef
ini
ngandenf
orci
ngasy
stem of
owner
shi
pcanbesohi
ght
hatsomesy
stem coul
dbeadopt
ed.

Undert
hesescondi
ti
ongov
ernmenti
nter
vent
ioni
soneoft
heopt
ionf
orsol
uti
[Link]
gov
ernmentcancopewi
tht
hepr
obl
emsi
ntwoway
s/appr
oaches.

[Link]
ator
yappr
oach
B.I
ncent
ivebasedappr
oach

Regul
ator
yappr
oach

Thegov
ernmentr
equi
resext
ernal
i
typr
oduci
ngagent(
pol
l
uti
onagent
)tol
i
mitt
hel
evelof
ext
ernal
i
tyt
oacer
tai
nlev
[Link]
l
ythel
i
mit
sar
esett
otheopt
imall
evelbasedont
he
mar
ginalort
hecost-
benef
itcal
cul
ati
onanal
ysi
[Link]
ear
etwomaj
orappr
oacht
hrough
whi
cht
hegov
ernmentcancopewi
thext
ernal
i
tiespr
obl
emsundert
[Link]
e:
I
.Li
mit
ingt
hel
evel
ofext
ernal
i
ties
I
ncent
ivebasedappr
oach

I.
Limi
ti
ngt
hel
evel
ofext
ernal
it
ies
Undert
his case t
he gov
ernmentl
i
mit
sthe amountofext
ernal
i
tygener
ated byeach
economi
cagent
.Eachf
act
ory
,fori
nst
ances,woul
dhav
eal
i
mitont
heamountofpol
l
utant
al
l
owedt
odi
schar
[Link]
’ssubst
ant
iat
eouranal
ysi
swi
thourspeci
fi
cexampl
esment
ion
abov
eusi
nggr
[Link]
gur
e:6.
5bel
owshowt
het
otalsoci
alcostofeachl
evelofdi
schar
geof
ani
ndust
ry’
swast
[Link]
e,t
hei
ndust
rycutdownont
heamountofwast
eitdi
schar
ges,
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 213
ECON102MI
CROECONOMI
CSI
I

t
hehi
gherar
eit
scost
sofpol
l
uti
oncont
rol
ateachl
owofdi
schar
geoft
hei
ndust
ry’
swast
es.

Speci
fi
cal
l
y,t
heef
fi
ci
entl
eveloft
hepol
l
uti
oni
nthei
ndust
ryi
sR. Becausei
ncr
easi
ng
pol
l
uti
onf
rom al
evell
owert
henRwoul
dimpr
ovesoci
alwel
far
[Link]
schar
gingonemor
euni
t
ofpol
l
uti
onwoul
dincr
easet
hecostofpol
l
uti
on,buti
twoul
dreducet
hecostofpol
l
uti
on
cont
rol
bymor
[Link],
theopt
imal
lev
elofpol
l
uti
oni
sR.

Poll
uti
oncost
cos contr
ol
t

Poll
uti
on
cost

O
R Quant
it
yofpol
l
uti
on

Fi
gure6.
5:opt
imal
pol
l
uti
on
di
schar
ge

I
ntheUni
tedst
ate,v
ari
ousst
ate,l
ocal
s,andf
eder
alagenci
esar
eresponsi
blef
orpol
l
uti
on
cont
rol
.Theagenci
esder
ivei
tsl
egi
slat
ivesaut
hor
it
yfr
om anumberofCongr
essi
onalAct
s,
i
ncl
udi
ngt
heCl
earAi
rAct
,theWat
erPol
l
uti
onCont
rolAct
s,t
heNat
ionalEnv
ironment
al
pol
i
cy….
etc.I
nenf
orci
ngFeder
alEnv
ironment
all
aws,t
heEnv
ironment
alPr
otect
ionAgency
(
EPA)has usual
l
yfol
l
owed t
he r
egul
ator
yappr
oach.I
tspeci
fi
es st
andar
dforwast
es
di
schar
gewi
thr
espectt
oai
r,wat
er,andnoi
sespol
l
uti
ons.I
tissuesper
mit
sset
ti
ngcei
l
ing
ont
heamountofpol
l
uti
ondi
schar
ged.

_
___
___
___
___
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___
___
___
___
___
___
___
___
___
___
___
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___
___
___
___
_
6.
[Link]
ivi
ty:
I
sther
esucht
ypeofappr
oachi
nourcount
ry?I
fther
eiswhatdoy
out
hinkt
hepol
i
cies?
_
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___
___
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___
___
___
___
___
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___
___
___
___
_
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 214
I
I.I
ncent
ivebasedappr
oach

Thi
sist
hecasewher
egov
ernment
suseseconomi
cincent
ivesorpenal
ti
es(
sucht
axor
subsi
des)t
oencour
agepol
l
uti
ngagent
stor
est
ri
ctemi
ssi
onst
oef
fi
cientl
evel
s.
Someoft
hesear
e:
Emi
ssi
onchar
ges
Taxandsubsi
dies

Emi
ssi
onchanges
Thegov
ernment(
ther
egul
ator
yagencyest
abl
i
shedbyt
hegov
ernment
)set
stheemi
ssi
on
char
ges,
whi
char
einef
fect
,apr
iceperuni
tofpol
l
uti
[Link]
epol
l
uti
onaf
ir
m cr
eat
es,
t
hemor
eitpay
sinemi
ssi
onchar
[Link] wor
koutt
heemi
ssi
onchar
get
hatachi
eve
ef
fi
ciency
,ther
egul
atormustdet
ermi
net
hemar
ginal
soci
alcostandmar
ginal
soci
albenef
it
ofpol
l
uti
[Link]
imum l
eveli
swher
epr
iceperuni
tofpol
l
uti
onmustbesett
omaket
he
mar
ginal
soci
alcostoft
hepol
l
uti
onequal
toi
tsmar
ginal
soci
albenef
it
.

I
npr
act
ice,
iti
shar
dtodet
ermi
net
hemar
ginal
benef
itofpol
l
uti
on,
andpeopl
ewhoar
ebest
i
nfor
med aboutt
he mar
ginalbenef
it
,the pol
l
uter
s,hav
e an i
ncent
ivet
o mi
slead t
he
r
egul
ator
[Link]
esul
t,i
fapol
l
uti
onchar
gei
sused,
themostl
i
kel
yout
comei
sfort
hepr
ice
t
obesett
ool
ow.

Gov
ernmentt
axes:Ef
fi
cientf
ee

Ef
fl
uentf
eei
scer
tai
nmoneyt
hatapol
l
utermustpayt
othegov
ernmentf
ordi
schar
ging
wast
[Link]
axsy
stem i
samechani
sm t
hroughwhi
cht
heamountofext
ernalcost
s(t
he
dev
iat
ionbet
weenpr
ivat
eandsoci
ety
)isi
mposedonpr
ivat
ethatcr
eat
eext
ernal
i
[Link]
pr
ovi
dei
ncent
ivest
opr
oducer
sorconsumer
stocutbackonact
ivi
ti
espr
ovi
det
hatcr
eat
e
ext
ernalcost
. Anappr
opr
iat
etaxwi
thext
ernal
i
tywi
l
lfor
cet
hebusi
nessf
ir
mtot
akei
nto
accountt
hecost
simposedonot
her
[Link]
dingl
y,r
educest
heamountofpr
oduct
iont
othe
ef
fi
cientl
evel
wher
emar
ginal
soci
alcost
sequal
mar
ginal
soci
albenef
it
s.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 215
ECON102MI
CROECONOMI
CSI
I

6.
[Link]
TSTRAGEDY

6.
[Link]

Ther
ear
edi
ff
erentt
ypesofgoodsandser
vicest
hatcanbepr
oducedandconsumedby
economi
cagent
[Link]
hesegoodsand ser
vicesar
eter
med aspr
ivat
egoods,
commongoods,col
l
ect
ivegoodsandpubl
i
[Link]
ecl
assi
fi
edassuchbasedon
t
hei
rpr
oper
ty:v
ary
ingdegr
eeofexcl
usi
onandr
ival
[Link]
val
rymeanst
hatonl
yoneper
son
canconsumet
hegoods:t
hegoodi
susedupi
nconsumpt
ion-
iti
sdepl
etabl
e.I
fan
i
ndi
vi
dualconsumesapar
ti
cul
arquant
it
yofagood,suchasappl
es,t
hesesameappl
es
ar
enol
ongerav
ail
abl
efort
heot
her
[Link]
usi
onmeanst
hatot
her
scanbe
pr
event
edf
rom consumi
ngt
[Link]
ytheper
sonwhoownst
hecandybarmayeati
t.
Fori
nst
ances,wheny
oueatacheesebur
ger
,iti
snol
ongerav
ail
abl
eforanyoneel
se.
Mor
eov
er,peopl
ecan beeasi
l
ypr
event
ed f
rom consumi
ng cheesebur
ger
sthatt
he
i
ndi
vi
dual
donotpayf
or.

The cl
assi
fi
cat
ion scheme def
ined byt
he non r
ivaland non excl
udabl
e pr
oper
tyi
s
summar
izedont
abl
[Link]
eexpl
ainedbel
ow i
nfourcl
assi
fi
cat
ionswi
thr
elev
ant
exampl
[Link] col
umns oft
he t
abl
eindi
cat
ethe ext
entt
o whi
ch one per
son'
s
consumpt
ionofagoodf
il
lst
odi
mini
shi
tsav
ail
abi
l
ityf
orot
her
[Link]
nther
ightcol
umn
ar
enon-
ri
val
sandt
hosei
nthel
eftcol
umnsar
enot
.Li
kewi
se,goodsont
het
opar
ehi
ghl
y
nonexcl
udabl
eascompar
edt
othebot
tom [Link]
wohy
bri
dcat
egor
iesar
ecommon
goodswhi
char
eri
valbutnonexcl
udabl
eandcol
l
ect
ivegoodswhi
char
eexcl
udabl
ebut
nont
ri
vi
al.
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 216
Thef
ir
stt
ypeofgoodi
spr
ivat
[Link]
ivat
egoodshav
ethepr
oper
ti
esoft
her
ival
ryand
excl
usi
[Link]
ivat
egoodsar
eont
heupper-l
eftcol
[Link],t
her
ear
eresour
ceswi
th
r
ival
rybutwi
thoutexcl
usi
[Link]
emostoft
hecal
l
edcommongoodorcommon
pr
oper
tyr
esour
[Link](
pur
e)i
sonef
orwhi
chnonpay
erscannoteasi
l
ybe
excl
udedandf
orwhi
cheachuni
tconsumedbyoneper
sonmeansonel
essuni
tav
ail
abl
e
f
ort
heot
her
s.I
nanopenaccessoceanwi
thf
isher
y,anyonef
ish(
noexcl
usi
on)
,butonce
af
ishi
scaught
,nooneel
secancat
chi
t(r
ival
ry)
.

Tabl
e6.
1:Pr
ivat
e,publ
i
candhy
bri
dgoodsnonr
ival

Excl
usi
on Noexcl
usi
on
Ri
val
ry Pr
ivat
egoods Commonsgoods
-wheat -fi
shery
-candybar -hunti
ng
-hi
ghway

NoRi
val
ry Coll
ecti
vegoods Publi
cgoods
-Pay-per-vi
ewTV -
nati
onaldef
ense
-Cl ub goods(concer
t,t
enni
s -aer
ialspr
ayi
ngpest
ici
de,
cl
ub) -cl
eanair

Thet
hir
dty
peofgoodi
scol
l
ect
[Link]
egoodswi
thst
rongnon-
excl
usi
veand
non-
ri
val
[Link]
ubgoods(
concer
t,t
enni
scl
ub)ar
ety
picalexampl
eoft
heset
[Link]
i
nst
ances,cl
ub-
goods,secur
it
yguar
dspr
eventpeopl
e who don'
thav
eat
icketf
rom
ent
eri
ngaconcer
thal
l
.Unt
ilt
heconcer
thal
lisf
il
led,t
hecost(
mar
ginal
)ofpr
ovi
dingt
he
concer
ttooneext
raper
soni
szer
[Link]
nganot
herper
soncr
eat
escongest
ionorot
her
ext
ernal
i
tiest
hathar
m concer
tgoer
soncet
heconcer
thal
lisf
il
[Link]
mil
arl
y,al
l
owi
ng
mor
epeopl
etoj
oinaswi
m cl
ubdoesnoti
nfl
i
ctext
racost
sunt
ilmember
sst
artget
ti
ngi
n
eachot
her
'sway
.Thesear
egoodswi
thbot
hpr
ivat
e(excl
usi
on)andpubl
i
cpr
oper
ty(
non-
r
ival
ry)
.Thesear
ecol
l
ect
ivegoods.
Thati
sgoodsorser
vicest
hatatl
eastsomedegr
eei
s
non r
ivalbutexcl
udabl
e(excl
ude non pay
ers)
.They ar
e pr
ovi
ded somet
imes by
gov
ernment
,somet
imesbypr
ivat
ecompani
es

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 217
ECON102MI
CROECONOMI
CSI
I

Thef
our
tht
ypesofr
esour
cesar
epubl
i
cgoods.
Publ
i
cgoodsar
ethosegoodsorser
vices
t
hatar
einv
ary
ingdegr
ees,
non-
ri
val
ryandnon–excl
udabl
[Link]
hatar
ehi
ghl
ynon-
excl
udabl
eandnon-
ri
valar
eof
tencal
l
edpur
epubl
i
[Link]
rst
,somepubl
i
cgoodsar
e
excl
usi
vebutl
ackr
ival
ryi
nconsumpt
[Link]
ionbyoneper
sondoesnot
di
mini
shi
tsav
ail
abi
l
ityf
orot
her
[Link]
s,oncet
hegoodi
spr
ovi
dedf
orsomeoneot
her
canal
soconsumei
tatnoext
racost(
themar
ginalcostofpr
ovi
dingt
hegoodt
othe
addi
ti
onalconsumeri
szer
o).Andi
tist
echni
cal
l
ydi
ff
icul
torext
remel
ycost
lyt
oexcl
ude
nonpay
ersf
rom consumi
ngi
[Link]
e,t
henat
ionaldef
ense,Law enf
orcement
,fi
re
andpol
i
cepr
otect
ion,andf
loodcont
rol
,theEt
hiopi
anRadi
obr
oadcast
ing…et
[Link]
act
t
hati
tisapubl
i
cgooddoesnotnecessar
il
ymeant
hatgov
ernmentoughtt
opr
ovi
dei
t.
Somet
imes,pr
ivat
ecompani
escanf
indi
tpr
ofi
tabl
ewayofpr
oduci
nggoodswi
thbot
h
char
act
eri
sti
cs.

Somegoodsev
enchangeschar
act
eri
sti
csov
ert
imeandsomev
arybackandf
ort
h.
Consi
der
,forexampl
e,anuncr
ownedbr
idge.I
fyoucr
ossedanuncr
ownedbr
idge,
itwoul
d
noti
nter
facewi
thmycr
ossi
ng,sot
heuseoft
hisbr
idgecoul
dbel
abel
ed"
nor
ival
".I
tis,
howev
er,notanonexcl
usi
vegoodbecausei
tisper
fect
lyf
easi
blet
ochar
geaf
eef
or
cr
ossi
ngt
hebr
idgeandt
opr
eventpeopl
ewhodonotpayf
rom cr
ossi
ngi
[Link]
hepeak
t
imesdur
ingt
heday
,iti
snotev
ennonr
ival
;becausey
ourcr
ossi
ngdur
ingacongest
ed
t
imecoul
deasi
l
yint
erf
erewi
thmycr
ossi
[Link]
ket
sforpubl
i
cgoodsexi
stonl
yifnon
pur
chaser
scanbeexcl
udedf
rom consumi
ngi
t.

Ot
hergoodsl
ackr
ival
ryorexcl
usi
onorbot
[Link]
ther
mor
e,manygoodsdi
ff
ersi
nthe
degr
eet
owhi
cht
hehav
enon-
ri
val
ryornon-excl
usi
veandhencet
hei
[Link]
ar
ehy
bri
ds,wi
thpr
oper
ti
esofbot
hpr
ivat
eandpubl
i
cgoodsnotal
lnon-
tr
ivi
algoodsar
e
non-excl
usi
ve,
andnotal
lnonexcl
usi
vegoodsar
enonr
ival
[Link]
hem ar
eexcl
usi
ve
butl
ackr
ival
ryi
nconsumpt
ion.
_
___
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___
6.
[Link]
ivi
ty
Di
scusest
heabov
ety
peofpr
oper
tyr
esour
ceswi
thexampl
est
haty
out
hinki
nyour
env
ironment
s?
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 218
Whatt
ypeofi
sfi
shi
ngi
nlakeZewayi
fyouassumeev
erybodyhasf
reeaccesst
o
r
esour
ces?

_
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___
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___
___
___
___

COMMONPROPERTY ANDI
TS TRAGEDY
6.
3.2.
[Link]

So f
arwe hav
e exami
ned ext
ernal
i
tiest
hatar
ise asbypr
oductofa pr
oduct
ion or
consumpt
ion act
ivi
ti
es mai
nlyr
elat
ed t
o ef
fecton i
ndi
vi
dualeconomi
c agentbe i
t
pr
oducerorconsumer(
thi
rdpar
it
y).Ot
heri
mpor
tantext
ernal
i
tiesar
isewi
thcommon
pr
oper
ty-r
esour
cest
owhi
chev
ery
onehasf
[Link]
i
kepr
ivat
epr
oper
ty,f
orwhi
ch
t
heownercanexcl
udeot
her
sfr
om usi
ngt
hepr
oper
tyr
ight
,commonpr
oper
tyi
snot
subj
ectt
osuchexcl
usi
[Link]
spr
inci
pleappl
i
esbot
htot
her
enewabl
eresour
ces,
suchas
f
ish,
andnonr
enewabl
eresour
cessuchasoi
l
.Someot
herexampl
esofcommonpr
oper
ty
r
esour
cesar
ecommonpool
s,I
nter
net
,road,
&fi
sher
ies.

Commonpool
:commonpar
king,pet
rol
eum andot
herf
lui
dandgasesar
eof
tenext
ract
ed
f
rom acommonpool
.Thosei
ndi
vi
dualusi
ngt
her
esour
ces(
commonpool
)compet
eto
r
emov
ethe subst
ances mostr
api
dlyt
her
e by goi
ng owner
shi
p oft
he [Link]
s
compet
it
ioncr
eat
esext
ernal
i
tybyl
ower
ingf
lui
dandot
herr
esour
cest
hroughopposi
ng
pr
essur
[Link]
eecommonpar
kingwher
eev
eryonecanf
reel
yent
erandenj
oyur
banpar
ks
suchasacent
ral
par
kinci
[Link]
kswi
thf
eeent
ryof
tenbecomecr
owded,
anout
comet
hat
r
educesev
eryone'
senj
oyment
. Themostcommon r
esour
ceswi
tht
hispr
oper
tyi
n
dev
elopi
ngcount
ri
esl
i
keour
sar
e:hunt
ing,gr
azi
ngl
andonwhi
ch t
heeconomi
cagent
ov
erut
il
izet
her
esour
ces.

TheI
nter
net
:Ther
eisov
ercr
owdi
ngont
heI
nter
netf
oraf
latf
reet
hatdoesnotv
erywi
th
t
henumberofhour
[Link]
sAbabaUni
ver
sit
ywher
est
udent
sar
eusi
ngf
or
manyhour
scanbeci
ted.

Roads:i
fyouownacar
,youhav
eapr
oper
tyr
ightt
odr
ivet
hatcar
,buty
oul
ackapr
oper
ty
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 219
ECON102MI
CROECONOMI
CSI
I

r
ightt
othehi
ghwayonwhi
chy
oudr
ive,y
oucannotexcl
udeot
her
sfr
om der
ivi
ngont
he
hi
ghwayandmustshar
eitwi
tht
[Link]
iver
,howev
er,cl
aimst
empor
arypr
oper
ty
r
ighti
napor
ti
onoft
hehi
ghwaybyoccupy
ingi
[Link]
it
ionf
orspaceont
hehi
ghway
l
eadsf
orcongest
ionsanegat
iveext
ernal
i
ty)
,whi
chsl
ow ev
erydr
iver
sspeedandhence,
l
otofemi
ssi
onofcar
bon.

Fi
sher
ies:manyf
isher
iesmenhav
ecommonaccesst
ooceansuchpl
atev
ery
onecanf
ish
andnoonehasapr
oper
tyr
ightt
oaf
ishunt
ili
tcaught
.Eachf
ishermanwant
stol
anda
f
ishbef
oreot
herdosot
ogai
npr
oper
tyr
ightt
othatf
[Link]
isher
manhasanegl
i
gibl
e
i
mpactont
het
otalst
ockoff
ish,butt
hecumul
ati
veef
for
tsoft
housandsoff
isher
man
r
esul
tsi
n ser
ious depl
eti
[Link]
stendency t
o ov
erf
ish has di
mini
shed many f
ish
popul
ati
ondr
amat
ical
l
yast
her
ateatwhi
chf
ishar
ebei
ngbor
nisl
owert
hem t
her
ateat
whi
cht
heyar
ebei
ngcaught
.Thi
sisoneoft
ypi
calpr
obl
em wi
thEt
hiopi
anl
akes(
exampl
e
Zewayl
akes)
.

I
neachoft
hesecasesnooneownst
her
esour
ce,
noonehasanyi
ncent
ivet
oinv
estoni
t
i
nthepr
oduct
ivewayort
aket
heoppor
tuni
tycostofusi
ngi
tint
oaccount
.Indi
vi
dual
negl
ect
sher
/hi
sef
fect
sont
her
esour
ce’
spr
oduct
ivi
tyandhenceexpl
oiti
[Link],
peopl
ewi
l
ltendt
ousei
tunt
ili
tsmar
ginalbenef
iti
szer
[Link]
spr
oper
tyoft
hegoods
makest
hegoodar
ivalgoodandal
sonon-
excl
udabl
ethatal
way
sresul
tsi
ntr
agedyoft
he
[Link]
obl
ems,andot
hersi
mil
art
oit
,ar
eknownasTr
agedyofcommons.
Ther
ear
etendencyf
orar
esour
cest
hathasnopr
icet
obeusedunt
ili
tsmar
ginalbenef
it
f
all
stozer
o.

Theessent
ialcauseoft
het
ragedyoft
hecommonsi
sthatoneper
son'
suseofcommonl
y
hel
dpr
oper
tyi
mposesanext
racostonot
herbymaki
ngt
hepr
oper
tyl
essv
aluabl
[Link]
out
comesofeconomi
cint
eract
ion wi
tht
he t
ragedyofcommonsar
einef
fi
ciencyi
n
r
esour
cesal
l
ocat
[Link]
l
lposet
hispr
obl
em i
ntheor
igi
nalcont
entofacommon
gr
azi
ngl
and,al
thought
her
ear
emanyot
herpossi
blei
l
lust
rat
[Link]
derapeasant
economyi
nwhi
cht
hev
il
lager
sgr
azet
hei
rcow ont
hepr
ivat
eandcommonf
iel
dunder
di
ff
erentscenar
ios.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 220
Wewi
l
lseeal
l
ocat
ionofr
esour
cesunderpr
ivat
eowner
shi
pandcommongr
azi
ngl
and.
Fi
rst
,assumet
hegr
azi
ngl
andi
sownedbypr
ivat
e(pr
ivat
eowner
shi
p)whor
ear
scows
wi
tht
hemai
nint
ent
ionofdai
rypr
oduct
[Link]
hati
tcost
s‘a’dol
l
art
obuyacow.
How manycowsshoul
dtheper
sondeci
det
ogr
aze?How muchmi
l
kcow pr
oduceswi
l
l
dependonhow manyot
hercowsar
egr
azi
ngont
hegr
azi
ngl
[Link]
l
lletf
(c)bet
he
v
alueoft
hemi
l
kpr
oducedi
fther
ear
e'c'
cowsgr
azedont
[Link]
hev
alueof
t
hemi
l
kpercow i
sjustt
heav
eragepr
oduct
,f(
c)/
[Link]
sthenumberofcowst
hat
maxi
mizet
het
otalweal
th?I
nor
dert
omaxi
mizet
het
otalamountofweal
th,
wesetupt
he
f
oll
owi
ngpr
obl
em:
Maxf
(c)-ac

Ourcondi
ti
onf
ormaxi
mizat
ionofpr
oduct
ionwi
l
loccurwhent
hemar
ginalpr
oductofcow
equal
sit
scost
,a,MP(
C)=a whi
chi
sthecompet
it
iveequi
l
ibr
[Link],t
hecommon
gr
azi
nggr
oundwer
eownedbysomeonewhocoul
drest
ri
ctassesst
oit
,thesol
uti
oni
t
woul
dbeopt
[Link]
il
lagerhasachoi
ceofacowornotgr
azi
ngone,andi
twi
l
lbe
pr
ofi
tabl
etogr
azeacowasl
ongast
heout
putgener
atedbyt
hecowi
sgr
eat
ert
hant
he
costofacow.

I
fther
ear
ec'
cowsar
ecur
rent
lybei
nggr
azedsot
hecur
rentout
putpercowi
sf(
c)/[Link]
addacowt
hev
il
lager
slooksatt
het
otalout
putf
(c+1)
,andt
het
otalcownumberofcow
(
k+1)
.Thus,
tot
alav
erager
evenuepercowi
[Link]
erev
enuewi
thcostoft
hecow,
a.
I
f >a,
iti
spr
ofi
tabl
etoaddt
hecowsi
ncet
hev
alueoft
heoutputexceedst
hecost
.Then
eachv
il
lagechoosest
hepoi
nt.

Oncont
rar
y,t
hegr
azi
ngl
andi
sownedcommunal
l
yandt
hecosti
sthesameast
hatoft
he
abov
[Link]
ery
bodyi
sfr
eet
oent
er(
nonexcl
usi
on)asl
ongasi
tispr
ofi
tabl
etogr
azeacow
ont
hecommonf
iel
d,v
il
lagerwi
l
lpur
[Link]
l
lst
opaddi
ngcow t
othe
commononl
ywhent
hepr
ofi
ts hav
ebeendr
ivent
ozer
o.

_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
__
6.
[Link]
ivi
ty
I
sther
e anycommon pr
oper
tyi
nyoursur
roundi
ng?I
fso,whatar
ethey
?How do
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 221
ECON102MI
CROECONOMI
CSI
I

i
ndi
vi
dual
sar
eusi
ngt
her
esour
ces?

6.
3.2.
2SOLVI
NGTHECOMMONSPROBLEM

Ther
ear
etwoappr
oachest
oamel
i
orat
ecommonpr
obl
[Link]
e;
[Link]
rectgov
ernmentr
egul
ati
ont
hrought
axat
ionorr
est
ri
cti
onofaccess
[Link]
oper
tyr
ight

[Link]
ON
Ov
eruseofcommonr
esour
cesoccur
sbecausei
ndi
vi
dual
sdonotbeart
hef
ullsoci
alcost
.
Howev
er,
byappl
yi
ngt
axesorf
eesequalt
otheext
ernalhar
mthateachi
ndi
vi
duali
mpose
onot
her
s,agov
ernmentf
orceseachper
sonst
oint
ernal
i
zet
heext
ernal
i
[Link]
pr
act
icalexper
iencet
hatcanbeci
tedasexampl
emaybe;gov
ernmentof
tenchar
gesan
ent
rancef
eet
oaAr
[Link]
herexampl
eisr
elat
edt
ocongest
[Link]
anci
sco
-Oakl
andBayBr
idgei
nCal
i
for
niaamongt
hemostcongest
edbr
idgei
nthewor
ld.I
tis
about8.
5mi
l
elongandoutof275,
000v
ehi
clest
hatdr
iveacr
osst
hebr
idgei
naday
100,
000cr
osst
hebr
idgei
nonedi
rect
ioni
nthemor
[Link]
hebr
idgecanhandl
eonl
y10,
000
commut
ersperhour
sinonedi
rect
ionwi
thoutcongest
[Link]
idge’
smor
ningt
raf
fi
cjam
i
scost
lyi
nter
msoft
ime,moneyandpol
l
uti
[Link]
mel
osti
sappr
oxi
mat
ely20mi
nut
e
cr
awl
i
ngacr
ossacr
osst
hebr
idgeatl
[Link]
i
nei
swast
ed,
andt
ailpi
pepol
l
uti
on
i
s250%gr
eat
erundercongest
edcondi
ti
ont
hanwhencar
sdr
iveatt
hespeedl
i
mit
.

Theopt
imall
eveloft
olli
sest
imat
edt
obe$3.
6atpeakhour
.Al
though,
pol
i
tici
andoes
noti
mposedi
tbecauseofi
tswel
far
eef
fectont
hepoori
nthati
thel
pweal
thi
ercommut
er
att
heexpenseofhar
mingpoor
er,st
art
ingf
rom 1980,$1t
ollwascol
l
ect
edatal
lhouri
n
onedi
rect
ion.I
mposi
ngal
i
ght
ert
ollt
ocr
osst
hebr
idgedur
ingr
ushhourwoul
dreduce
congest
ionbydi
scour
agi
ngsomecur
rentder
iver
s.

Al
ter
nat
ivel
ythegov
ernmentcanr
est
ri
ctaccesst
[Link]
ypi
calappr
oachi
s
t
ogr
antaccessofaf
ir
st-come-f
ir
st-ser
vedbasi
sonwhi
chpeopl
ewhoar
ri
veear
lyget
access.I
nthi
sregar
dasTheNew Yor
kTi
mesr
epor
tedov
erusi
nghasdeci
mat
edt
he
st
ocksofcod,handdockandf
loundert
hathav
elacksust
[Link]
esul
tTheNew
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 222
Engl
andFi
sher
iesManagementCounci
lisat
tempt
ingt
oal
l
evi
atet
hepr
obl
em bybanni
ng
newent
ryt
othei
ndust
ryr
equi
ri
ngf
isher
ment
oli
mitt
hei
rday
satseaandi
ncr
easi
ngt
he
meshsi
zeoft
hei
rnet
s.

[Link]
oper
tyr
ight

Theot
hersol
uti
onmaybeassi
gni
ngpr
oper
tyr
ightt
opr
ivat
ethatr
emov
est
hei
ncent
ives
t
oov
eruset
her
esour
[Link]
sconv
ert
ingt
hecommonaccesspr
oper
tyt
othepr
ivat
e
pr
oper
ty.I
n many dev
elopi
ng count
ri
es ov
ert
he pastcent
ury hav
ethe common
agr
icul
tur
all
andhasbeenbr
okendowni
ntosmal
l
erpr
ivat
efar
ms. Asar
esul
tthe
ov
erexpl
oit
ati
onpr
obl
emshav
ebeenr
educed.

I
nsum,
wehav
eseent
hati
fev
eryt
hingt
hatpeopl
ecar
eabouti
sownedbysomeonewho
cancont
roli
tuseand,i
npar
ti
cul
ar,canexcl
udeot
herf
rom ov
erusi
ngi
tPar
etoef
fi
cient
out
comecoul
dber
eact
[Link]
er,i
fagov
ernmentsetat
axorf
eet
hati
slesst
hant
he
mar
ginal
ext
ernal
i
tyhar
m,i
treducesbutdoesnotel
i
minat
etheext
ernal
i
typr
obl
em.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
__
6.
[Link]
ivi
ty
[Link]
hesoci
eti
essol
vet
hepr
obl
em?Howdoy
our
elat
ethesoci
etalsol
uti
onwi
th
what
wehav
elear
nt?
[Link]
her
eiscommonpool
ofwat
err
esour
cescal
l
ed‘
Bir
ka’
int
hecer
tai
nvi
l
lageand
hecostperm3i
t s50cent
[Link]
other
esour
cewhent
her
eisnor
est
ri
cti
ont
o
access bey
ondt
hel
i
mit
?Ift
heabov
eamountofchar
gei
simposedonani
ndi
vi
dual
whatdoy
out
hinkhappent
heut
il
izat
ionoft
her
esour
ces?

6.
[Link]
CGOODS

I
nthepr
evi
oust
opi
cwehav
eseenpr
oduct
iongoodconsumpt
ionext
ernal
i
tiesandt
ragedy
[Link]
esmoker
’sf
isher
sandchemi
calf
act
ory
,pr
obl
em ofgr
azi
ng
commonl
and,andt
hewayt
odealwi
tht
hem suchas assi
gni
ngpr
oper
tyr
ight
,vol
unt
ary
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 223
ECON102MI
CROECONOMI
CSI
I

agr
eementandsoon.

Unf
ort
unat
ely
,notal
lext
ernal
i
tiesonl
yli
mit
edt
othem andcanbehandl
edi
nthatmanner
.
Asl
ongt
henumber
sofeconomi
cagenti
ncr
eases(
mor
ethant
woeconomi
cagent
s
i
nvol
ved)t
hingsbecomemuchmor
edi
ff
icul
[Link],i
nst
eadofonef
act
ory(
steelmi
l
l)
andonef
isher
y,t
henumberoff
act
ori
espr
oduci
ngchemi
cali
ncr
easest
oabout50or100
andf
[Link]
heext
ernal
i
tiest
hatr
esul
tast
henumberpr
oducer
sincr
ease
becomecommonf
ort
hecount
ry,cer
tai
npor
ti
onoft
hesoci
ety
.Theyar
epar
ti
cul
arl
y
t
roubl
esomeki
ndofext
ernal
i
ty,f
ort
hedecent
ral
i
zedmar
ketsol
uti
onandcost
lyev
enf
or
nonmar
ketsol
uti
ont
hatwehav
edi
scussedsof
arwi
tht
heot
herf
ormsofext
ernal
i
ties.
Thi
sisanexampl
eofagoodwi
tht
hechar
act
eri
sti
csofpubl
i
cgood.

Hav
ingsai
dthesei
tisappr
opr
iat
etoaskquest
ionr
elat
edt
opubl
i
cgoods.
Someoft
hesear
e:
Whatar
epubl
i
cgoods?
Howdowei
dent
if
ypubl
i
cgoodsf
rom pr
ivat
egoods?
Whatar
etheopt
imal
i
tycondi
ti
onsf
ort
hepr
ovi
sionofpubl
i
cgoods?
Whoi
sresponsi
blef
ort
hesuppl
yofpubl
i
cgoodandhow?

Asi
tisexpl
ainedabov
epubl
i
cgoodsar
ethosegoodsorser
vicest
hatar
einv
ary
ing
degr
ees,non-
ri
val
ryand non –excl
udabl
[Link]
dert
he case ofnat
ionaldef
ense.A
speci
fi
cci
ti
zen’
sint
eresti
nthenat
ioncanbepr
otect
ionbyt
henat
ion’
smi
l
itar
ywi
thout
r
educi
ngt
hepr
otect
iont
hati
tof
fer
edt
oanyot
herEt
hiopi
anci
ti
[Link]
thermor
e,oncea
count
ryhascr
eat
edmi
l
itar
yest
abl
i
shment
,al
lofi
tsci
ti
zensenj
oyi
tspr
otect
ionatt
he
somet
[Link]
ncet
her
eisno pr
act
icalwayofexcl
udi
ng ci
ti
zensf
rom i
tspr
otect
ion,
nat
ional
def
ensei
snonexcl
usi
vegood.

6.
4.1.
INEFFI
CIENCYOFPUBLI
CGOODSUNDERMARKETPROVI
SIONS

Mar
ket
sfort
he publ
i
c goods exi
stonl
yifnon pur
chaser
s can be excl
uded f
rom
consumi
ngt
[Link]
ket
sdonotexi
stf
ornonexcl
usi
vepubl
i
[Link]
ket
t
endt
opr
oducet
ool
i
ttl
eofanexcl
usi
vepubl
i
cgoodbecauseoft
hel
ackofr
ival
ry.I
nthe
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 224
absenceofr
ival
ry,t
hemar
ginalcostofpr
ovi
dingpubl
i
cgoodt
ooneext
raper
soni
szer
o.
Fi
rmshav
enoi
ncent
ivet
opr
oduceatazer
opr
ices,i
ffi
rmssetapr
iceabov
ezer
o,
consumer
sbuyt
ool
i
ttl
eoft
hispubl
i
c.
Thi
sisacompl
i
cat
edi
ssuewhoseansweri
sbestexpl
oredi
nit
ial
l
ywi
thi
nthecont
extof
par
ti
alequi
l
ibr
ium anal
ysi
[Link]
er,
wecani
l
lust
rat
ewi
thsi
mpl
edi
agr
am.

Wehav
econst
ant
lyar
guedt
hatt
hecompet
it
ivemar
ketwi
l
lpr
ovi
deopt
imalquant
it
yof
pr
ivat
egoodsbecauseout
putwi
l
lbeexpandedj
ustt
othepoi
ntwher
eD=S.
Andt
he
demandcur
ver
epr
esent
sthesoci
albenef
it
sofaddi
ti
onaluni
tsMSBandt
hesuppl
ycur
ve
r
efl
ectt
hemar
ginal
soci
alcostofpr
oduct
ionMSC.

Suppose,t
othi
sandf
orsi
mpl
i
cit
y,t
hatt
her
ewer
eonl
ytwoconsumer
s,t
heAbabef
ami
l
y
andBekel
efami
l
[Link] i
nfi
gur
e6.
6bet
heAbebe'
sfami
l
ydemandcur
vef
orsomegoods,
DB bet
heBekel
'
sdemandcur
vef
ort
[Link]
ycur
ve,S,i
sal
sonot
ed.I
f
weassumet
hegoodi
nquest
ioni
spr
ivat
egoodwef
oll
owanor
dinar
yef
fi
ciencycr
it
eri
aof
compet
it
ivemar
ket
.Theopt
imum quant
it
yofapr
ivat
egoodi
satpoi
ntwhenmar
ket
demandf
ort
hepr
oductequal
sthemar
ketsuppl
yfort
hepr
oduct
.

P
Pr
ice
D
P
Suppl DB Suppl
y=MSC
H DA
E G T M

N
L

O C F Q O
F Q Q Quant
it
R

Fi
gur
ADAMAUNI
e6.
[Link]
i
VERSI
vat
TYDEPARTMENTOFECONOMI
egood
CS
Fi
gur
e6.
[Link]
i
c 225
ECON102MI
CROECONOMI
CSI
I

Wewoul
dthander
ivet
hemar
ketdemandcur
veDbysummi
nghor
izont
all
ythedemand
cur
vesoft
het
woconsumer
[Link]
thermor
e,t
hesoci
almar
ginalbenef
itofapr
ivat
egood
i
sthesameast
hemar
ginalbenef
itt
othei
ndi
vi
dualwhoconsumest
[Link],
the
demandcur
ver
epr
esent
sthef
ullsoci
albenef
it
sofaddi
ti
onaluni
tsMSBandt
hesuppl
y
cur
ver
efl
ectt
hemar
ginalsoci
alcostofpr
oduct
[Link]
fi
cientout
putcoul
dbeQ,
wher
emar
ketdemand mar
keti
nter
sect
sthemar
ketsuppl
ycur
[Link]
hispoi
ntt
he
mar
ginalbenef
itt
hateachconsumerwoul
dobt
ainf
rom anext
rauni
toft
hegoodwoul
d
equal
itmar
ginal
cost
.

I
font
heot
herhand,
thegoodwer
epubl
i
cgoods,
thought
heef
fi
ciency/
opt
imal
i
tycr
it
eri
a
ar
ethe same,t
her
eismodi
fi
cat
ion oft
he suppl
y/demand [Link] keyt
o
under
standi
ngt
hedi
ff
erencei
stor
ecogni
zet
hatonceapur
epubl
i
cgoodi
ssuppl
i
edby
onei
ndi
vi
dual
,i
tissi
mul
taneousl
ysuppl
i
edt
oal
l
,andwher
easapr
ivat
egoodi
ssuppl
i
ed
onl
ytoi
ndi
vi
dualwhopur
chasedi
t.I
ncont
rastwi
tht
hecaseofpr
ivat
egood,wher
ethe
soci
almar
ginalbenef
itofapubl
i
cgoodi
sthesum oft
hemar
ginalbenef
itt
oeachper
son
whoconsumest
hegood,
i
tismar
ginalsoci
albenef
itofonei
ndi
vi
dual
.Becauseapubl
i
c
goodl
ackr
ival
ry,manypeopl
ecangetpl
easur
efr
om t
hesameuni
tofout
put
.Asa
consequence,t
hesoci
aldemandcur
veorwi
l
li
ngnesst
opaycur
vef
orapubl
i
cgoodi
sa
v
ert
ical
sum oft
hedemandcur
vesofeachi
ndi
vi
dual

I
nthi
scase,t
hemar
ketdemandcur
vewoul
dbeobt
ainedbysummi
ngt
hei
ndi
vi
dual
demandcur
vesv
ert
ical
l
yas agi
venamountofpubl
i
cgoodcanbeconsumedbybot
hof
ourconsumer
s(i
nourexampl
e)att
hesamet
[Link]
nedpr
icest
hati
ndi
cat
e
wi
l
li
ngl
ypai
dbyt
het
woconsumer
sfort
hepr
ovi
sionofgoodshoul
dbet
hesum oft
he
pr
icest
hateachwoul
dpayi
ndi
vi
dual
l
y.

Thus,aggr
egat
edemandcur
vef
orpr
oductX,(
D)i
sobt
ainedbyv
ert
icalsummat
ionofDA
[Link]
vent
hemar
ketsuppl
ycur
ve(
SX)f
orpr
oductX,
theopt
imalamountofXi
sRuni
t
perper
iodatpoi
[Link]
hispoi
ntmor
epr
eci
sel
y,r
ecal
lthemar
ginalbenef
itofeach
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 226
consumerf
rom t
hegoodyi
sref
lect
edbyt
hei
ndi
vi
dualdemandcur
ve.I
fout
puti
sR,t
hen
t
hemar
ginalsoci
albenef
itf
rom anext
rauni
tofout
putwoul
dbev
ert
icalsum ofL(
the
mar
ginalbenef
itt
oAbebe)andN(
themar
ginalbenef
itt
oBekel
);t
hati
sL+N=T,
Itf
oll
ows
t
hatR mustbeef
fi
ci
entout
put
,si
ncemar
ginalsoci
albenef
it
satR (
OT)equal
sthe
mar
ginal
soci
alcostatR(
RM)
.

Theabov
eanal
ysi
sremi
ndsust
hateconomi
cef
fi
ciencyf
orapr
ivat
egoodr
equi
rest
hat
eachconsumer
smar
ginalbenef
itequal
smar
ginalcost
.Asshowni
[Link]
rast
,
panelB,
showst
hateconomi
cef
fi
ciencyf
orpubl
i
cgoodr
equi
rest
hatt
hesum ofmar
ginal
benef
it
sofal
lconsumer
smustequal
mar
ginal
cost
.
MBA+MBB=MC
Thus,
not
eonceagai
nthemar
ginal
pri
nci
plei
satwor
[Link]
obl
em i
sthati
ngener
al,
less
t
hant
heopt
imalamountofpubl
i
cgoodwi
l
lbesuppl
i
edunderper
fectcompet
it
ion,and
t
hispr
event
stheat
tai
nmentofmaxi
mum ef
fi
ciencyandPar
eto-opt
imum.

Whi
tpubl
i
cgoodsout
putshoul
dbeexpandedt
othepoi
ntwher
etheMSB=MSC,butt
he
mar
ketdemandcur
vewhi
chi
sder
ivedbyv
ert
icalhor
izont
alsummat
ionofi
ndi
vi
dual
s
demandcur
vei
snol
ongerr
efl
ectt
heMSB.I
naddi
ti
on,
eveni
fpeopl
ecoul
dbesel
ect
ivel
y
excl
udedf
rom consumi
ngi
t,t
henonr
ival
ryi
nconsumpt
ionmeanst
hati
tisi
nef
fi
cientt
o
excl
[Link]
tcost
snot
ingt
opr
ovi
det
hegoodt
oeachaddi
ti
onalconsumer
af
tert
hef
ir
stsoci
alwel
far
eismaxi
mizedbygi
vi
ngawayt
hegoodf
[Link]
simpl
i
est
hat
onceagoodi
spr
oduced,t
hemar
ginalcostofpr
ovi
sionoft
hegoodt
oanyaddi
ti
onal
i
ndi
vi
duali
szer
[Link]
eat
eani
ncent
ivef
ort
heeconomi
cagentnott
opayf
ort
he
good t
hatl
eadt
ofr
eer
iderpr
obl
[Link]
smanypeopl
esar
eunwi
l
li
ngt
opayf
ort
hei
r
shar
eofpubl
i
[Link]
ryt
ogetot
her
stopayf
ori
t,sot
hatt
heygetbenef
itf
rom t
he
act
ionsoft
heot
herwi
thoutpay
ing.I
nthi
scase,
indi
vi
dual
sknowt
hati
tispossi
blet
oget
i
tfr
eeonceassomeoneal
sopay
sfori
tspr
ovi
sion,t
hisi
ssi
mil
arbutnoti
dent
icalt
othe
pr
isoner
'sdi
l
emmaweexami
nedsof
ar.

Letusconst
ructanumer
ical
exampl
eonTVpr
obl
emswher
etwor
oommat
es(
pay
er-
Aand
Pl
ayer–B)t
ryt
odeci
dewhet
herornott
opur
[Link]
vent
hesmal
lsi
zeoft
hir
d
apar
tment
,theTVwi
l
lnecessar
ygot
hel
i
vingr
oom andbot
hroommat
eswi
l
lbeabl
eto
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 227
ECON102MI
CROECONOMI
CSI
I

wat
chi
tandt
her
eisnowayt
oexcl
udet
heot
herf
rom wat
chi
[Link]
tchar
act
eri
zes
publ
i
[Link]
hateachper
sonhasaweal
thof$500,
thateachper
sonv
aluest
he
TVat$100andt
hecostofTV$[Link]
ncet
hesum oft
her
eser
vat
ionpr
ice(
themoney
t
heyar
ewat
chi
ngt
opayi
ndi
vi
dualt
oacqui
re)ex
ceedst
hecost
,it
'sPar
etoef
fi
cientt
obuy
t
[Link]
dert
hedeci
sionofoner
oommat
e,pl
ayeri
fhebuy
stheTV,
heget
sbenef
it
s
of$100andpay
sacostof$150,
leav
inghi
mthenetbenef
it
sof$[Link]
er,
ifpl
ayer
-A
buy
stheTV,pl
ayerBget
stowat
chi
tforf
ree,whi
chgi
vehi
m benef
itof$[Link]
ayerB’
s
i
nter
esti
stof
reer
ide:t
owat
cht
heTVbutnotcont
ri
but
[Link]
reer
idi
nggamepay
off
mat
ri
xisdepi
ctedi
ntabl
exx.

Pl
ayerB
Pl
ayer
- (
-50,
-
50) (
-50,
100) (
100 -(
0,0)
A 50)

Thesamel
ogi
chol
difpl
ayer
'Bbuyt
[Link]
nantst
rat
egyequi
l
ibr
ium i
sfor
nei
therpl
ayert
obuyt
[Link]
sissi
mil
art
opr
isoner
’sdi
l
emma,
butnotexact
lyt
hesame.
I
npr
isoner
’sdi
l
emma,t
hest
rat
egyt
hatmaxi
miz
est
hesum ofpl
ayer
’sut
il
it
iesi
sforeach
pl
ayer
’st
omaket
hesamechoi
[Link]
ethest
rat
egyt
hatmaxi
mizest
hesum oft
he
ut
il
it
iesi
sforj
ustoneoft
hepl
ayer
stobuyt
heTV.

I
fpl
ayer-
Abuyt
heTVandbot
hpl
ayer
swat
chi
t,wecanconst
ructaPar
etoi
mpr
ovement
si
mpl
ybyhav
ingpl
ayer
-Bmakea"
sidepay
ment
"topl
ayer
-[Link]
e,i
fpl
ayer
-B
gi
vespl
ayer
-A$51,
thenbot
hpl
ayer
swi
l
lbemadebet
terof
fwhenpl
ayer-
Abuyt
heTV.I
n
f
act
,thi
sispr
obabl
ywhathappensi
npr
act
ice;
eachpl
ayerwoul
dcont
ri
but
esomef
ract
ion
oft
hecostoft
heTV.

Thus,
afr
eer
iderpr
obl
em ar
isesbecauseeachconsumerbel
i
evest
hatt
hepubl
i
cgoodwi
l
l
bepr
ovi
deanyway
,whet
herheorshecont
ri
but
etoi
tspay
mentornot
.Thepr
obl
em i
s
t
hatasmanyi
ndi
vi
dual
sbehav
ethi
sway
,lesst
hanopt
imalamounti
spr
[Link]
venal
l
t
hesecompl
i
cat
ions,i
tisper
hapsnotsur
pri
singt
olear
nthatt
hemar
ketmechani
sm i
s
gener
all
yil
l-equi
ppedt
opr
ovi
depubl
i
cgoodsi
nther
ightamount
[Link]
ket
soper
ate
ont
hepr
inci
plet
hatt
hosewhodonotpayf
oragoodcannotconsumei
t,buti
tis
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 228
i
mpossi
blet
opr
eventpeopl
efr
om consumi
ngapubl
i
cgoodi
ftheydonotpayf
ori
t.
_
___
___
___
___
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___
___
___
___
6.
[Link]
ivi
ty

Suppose cer
tai
n Mi
crosof
tcomput
ersof
twar
e pr
ogr
am speci
fi
cal
l
y‘Mi
crosof
tof
fi
ce’
wi
thoutpr
otect
ionbyt
hecompanyofnotusi
ngt
[Link]
out
hinkt
heser
esour
ces
hav
ethepubl
i
cgoodchar
act
eri
sti
cs?I
fsowhyandhow?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
6.
4.2.
DEALI
NGWI
THPROBLEM PUBLI
CGOOD

Wehav
eseent
hatmar
ketmechani
sm ofdeal
i
ngwi
thPubl
i
cleadt
oinef
fi
ciental
l
ocat
ion
oft
hepubi
[Link]
ear
edi
ff
erentmechani
smst
ohandl
ethepr
obl
em dependi
ng
upont
hesi
tuat
[Link]
almeasur
esar
emor
eorl
esssi
mil
arwi
thwhatwe
di
scussedunderext
ernal
i
tiesandt
ragedyofcommonsandhenceonecanappl
ythose
meansofsol
vi
ngt
hepr
obl
[Link]
er,
amongt
hemechani
sm t
hef
oll
owi
ngf
ourar
ethe
mostcommonl
yway
sofdongwi
tht
hepr
obl
[Link]
e:
A Soci
alpr
essur
e
[Link]
ger
s
[Link]
sionand
D. Pr
ivat
izat
ion
Soci
alpr
essur
eist
heact
iont
hroughwhi
cht
hel
ocalpeopl
efor
cest
heper
sont
oacti
n
appr
opr
iat
e manner
.Somet
ime,especi
all
ywhen t
he gr
oup i
s smal
l
,soci
alpr
essur
e
el
i
minat
efr
eer
idi
[Link]
alpr
essur
eresul
tsi
natl
eastmi
nimalpr
ovi
sionofsomepubl
i
c
[Link]
essur
emancausemostf
ir
msatausi
ngpubl
i
ctocont
ri
but
e"v
olunt
ari
l
y"t
o
af
undf
orpr
otect
ionsandopt
imal
prov
isi
ons.

A di
rectwayt
oel
i
minat
efr
eer
idi
ngi
sbymer
gingf
ir
msandt
her
ebyi
nter
nal
i
zingt
he
posi
ti
veext
ernal
i
[Link]
ivat
izat
ion(
excl
usi
on)t
hatr
est
ri
ctedt
heaccesst
other
esour
ces

Compul
sion,some out
side ent
it
ysuch as gov
ernmentmaydi
ctat
e a sol
uti
[Link]
gov
ernment
sint
erv
enei
nthef
unct
ionoft
hemar
kert
hroughaser
iesofr
egul
ati
[Link]
exampl
esar
e:
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 229
ECON102MI
CROECONOMI
CSI
I

-
ant
it
rustl
awsai
medatpr
eser
vingcompet
it
ioni
ntheeconomy
-mi
nimum wagel
aws
-agr
icul
tur
alpr
oductpr
icessuppor
tpr
ogr
am
-mot
orv
ehi
cl
epol
l
uti
oncont
rol
act
-
ahostofr
egul
ati
ononconsumerpr
otect
ions
-
regul
ati
onr
egar
dingl
i
censi
ngofoccupat
ions

Fur
thermor
e,t
hegov
ernmentaf
fectt
heal
l
ocat
ionr
esour
cest
hroughi
mposi
ngt
axes
r
easonabl
eforcompensat
ionaswel
lasr
etar
dingaf
fectt
hem .
topay"
taxes"t
hatar
e
assessedt
hrought
enant
s"v
otes"
.Ift
hemaj
ori
tyv
otest
ohi
reguar
s,al
lmustshar
ethe
cost
sorgov
ernmentmayi
mposecer
tai
namountoft
axes.
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
6.
[Link]
ivi
ty
Whatmechani
sm ofsol
uti
onsf
ort
hepr
obl
emsofpubl
i
cgoodswehav
eseenunder
act
ivi
tyabov
einy
oursur
roundi
ng?
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

6.
[Link]
CSOFI
NFORMATI
ON

I
nfor
mat
ioni
svi
tal
l
yimpor
tancet
ofi
rms,consumer
s,andi
nputowner
[Link]
ilnowwe
hav
egener
all
yassumedt
hateconomi
cagent
shav
ecompl
etei
nfor
mat
ionaboutt
he
mat
ter
sthati
nfl
uencet
hei
reconomi
cchoi
cesordeci
sion–f
ulli
nfor
mat
[Link]
nst
ance,
wehav
esai
dthatwhenaf
ir
mismaki
ngpr
oduct
iondeci
sionsi
sabsol
utel
ycer
tai
nabout
t
hepr
icesi
twi
l
lbepay
ingf
ort
hei
nput
sandt
hepr
icesi
twi
l
lbesel
l
ingt
heout
put
.Under
t
hissi
tuat
iont
hemar
ketal
l
ocat
ionl
eadt
oef
fi
cientassoci
ati
onofr
esour
ces.

Howev
er,i
nrealwor
ld,t
hei
nfor
mat
iononcer
tai
nissuesf
luct
uat
eov
ert
imeandi
snot
per
fect
,somepar
ti
est
oagi
vent
ransact
ionmi
ghthav
emor
eorbet
teri
nfor
mat
iont
han
t
heot
her
[Link],mar
ketf
ew i
stoachi
eveef
fi
ciental
l
ocat
ionofeconomi
cresour
ces.
Ther
ear
etwomaj
orpr
obl
ems:uncer
tai
ntyandi
mper
fecti
nfor
mat
[Link]
obl
ems
f
orm anar
eacal
l
ed“
Economi
csofi
nfor
mat
ion”
.Ini
nfor
mat
ioneconomi
csi
nfor
mat
ion
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 230
i
tsel
fisacommodi
ty,
whi
checonomi
cagent
scanacqui
reonl
yatsomecost
.Inf
ormat
ion
pr
ovi
dedbyt
hosei
nbusi
nessf
ori
nst
ancesspecul
ator
s,r
etai
l
ers,agent
s,st
ockbr
oker
s,
andot
her
sar
eval
uabl
ecommodi
tyf
ort
heot
herpar
ti
es.

Thegener
alobj
ect
iveoft
hischapt
eri
stoi
ntr
oducet
heconceptofi
nfor
mat
ioneconomi
cs
t
oseet
hepr
obl
em r
elat
edt
oinf
ormat
ions,andt
hemechani
sm t
oreducei
nfor
mat
ion
pr
obl
ems.
Accor
dingl
y,af
tercompl
eti
ngt
hischapt
er,
youwi
l
lbeabl
eto;
Expl
aint
hecausesofi
nfor
mat
ionpr
obl
ems.
Ment
iont
her
emedi
almeasur
es.
Descr
ibehow i
nfor
mat
ion cost
saf
fectt
hecont
ract
sbet
ween par
ti
est
o a busi
ness
cont
ract
.
Under
standhowoppor
tuni
sti
cbehav
ioraf
fect
sbusi
nesscont
ract
swor
ks?

6.
5.1.
INFORMATIONASECONOMI CCOMMODI TYANDOPTI
MALSEARCHRULE
Manypeoplessuchasspecul
ator
s,i
nter
medi
ari
es,
andot
her
sint
hei
nfor
mat
ionbusi
ness
ar
eof
tenunpopul
[Link]
het
imepeopl
essuchaspr
oduct
ionwor
ker
s,v
iewst
hem as
mor
emi
ddl
emanwhi
char
epar
asi
tesont
heef
fect
sofot
her
swhodot
her
ealwor
k.
Somet
imesf
armer
scompl
ainaboutt
hespecul
ator
swhobuyf
ormt
hem whent
hepr
icei
s
l
ow andr
esal
elat
eratahi
gherpr
[Link]
scompl
ainaboutr
isi
nggr
ocer
ypr
ices,
whi
cht
heyat
tri
but
etogr
eedygr
ocer
y’s.

Buton cl
oserexami
nat
ion,we can see t
hatt
he economi
crol
e ofsal
es agent
sis
essent
ial
l
ythesameast
hatofpr
oduct
ionwor
ker
[Link]
saddgenui
neeconomi
c
v
alue byi
ncr
easi
ng t
he ext
entt
o whi
ch goods and ser
vices f
ind t
hei
rwayt
othe
consumer
swhov
aluet
hem most
.Fori
nst
ances,oneoft
hemostcommonpr
obl
ems
consumerconf
ronti
stheneedt
ochooseamongdi
ff
erentv
ersi
onsofapr
oductwi
thmany
compl
exf
eat
uret
hatt
heydonotf
ull
yunder
[Link]
ddl
emenassi
stt
hem i
ngi
vi
ng
i
nfor
mat
ionaboutt
hequal
i
[Link]
tedt
hef
actt
hatmanypeopl
egot
ogr
eat
l
engt
hst
oav
oidpay
ingf
ort
heser
vicesofsal
esagent
[Link]
act
urer
scat
ert
o
t
hem byof
fer
ing consumera chance t
o buydi
rectand si
de st
ep t
he mi
ddl
eman’
s
commi
ssi
on

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 231
ECON102MI
CROECONOMI
CSI
I

Theseeconomi
cagent
sal
soassi
stmanuf
act
uresorpr
oducer
sint
hei
rsal
epr
oduct
.
Hence,t
hei
nfor
mat
ionpr
ovi
dedbyt
hosei
nthe“
inf
ormat
ionbusi
ness”(
specul
ator
s,
r
eal
tor
s,agent
s,i
nter
medi
ari
es,
stockbr
oker
sandot
her
s)i
sav
aluabl
ecommodi
ty.

Becauseoft
heabov
ereasonsandot
her
s,whi
chwi
l
lbement
ionedi
ndet
ailshor
tl
y,
economi
cagent
sspentahugequant
it
yofscar
cer
esour
cesoneconomi
csofi
nfor
mat
ion.
Peopl
eandbusi
nessesv
olunt
ari
l
ypaybi
l
li
onsofdol
l
arst
oacqui
rei
nfor
mat
iononpr
ices,
l
ocat
ionsandquant
it
[Link]
sinf
ormat
ioni
ncl
udesdat
aont
hepr
ices,
quant
it
yandqual
i
ty
ofgood,
locat
ion,
andpr
oductper
for
mance.

I
ncont
rastwi
thmodel
sofper
fect
lycompet
it
ive,monopol
yandot
hermar
ketst
ruct
ure
wher
einf
ormat
ioni
sfr
ee,i
nrealwor
ldmostoft
het
imei
tisscar
ce.I
fitwer
enot
,we
woul
d notneed,t
he Wal
lSt
reetJour
nal
,CNN,The Repor
ter
s,t
he Et
hiopi
an Her
ald,
Et
hiopi
anTVandRadi
o…et
[Link]
dnotneedt
oshopar
oundf
orbar
gai
nsorspend
t
imel
ooki
ngf
orj
[Link]
heri
nfor
mat
ionar
edi
str
ibut
edov
ert
hepopul
ati
oni
n
bi
tsandpi
ecesandev
erymar
ketpar
ti
cipanthav
enoequal
assesst
othem.
Becauseofi
tsscar
cit
y,i
nfor
mat
ionacqui
ri
ngt
ypi
cal
l
ydoeshav
eit
scost
s.I
nfor
mat
ion
gat
her
ingi
sanact
ivi
tyl
i
keanyot
her
.Peopl
eval
ueal
lthet
ime,ef
for
t,moneyorf
inanci
al
cost
sandr
elat
edbenef
it
sofgat
her
ingi
nfor
mat
[Link]
s,t
hecostbenef
itpr
inci
ple
pr
ovi
desast
rongconcept
ual
framewor
kforl
ooki
ngatt
hewayt
oopt
imi
zet
hei
nfor
mat
ion
cost
.These i
nfor
mat
ion cost
sincl
ude t
he costoft
elephoni
ng,shoppi
ng,checki
ng
cr
edent
ial
s,i
nspect
inggoods,moni
tor
ingt
hehonest
yofwor
ker
sorcust
omer
s,pl
aci
ng
Adsandr
eadi
ngAds…et
[Link]
nst
ances,consumeri
ncur
ssear
chcostwhi
l
eshoppi
ng,
r
eadi
ngorconsul
ti
ngexper
tsi
nor
dert
oacqui
repr
ici
ngandqual
i
tyi
nfor
mat
[Link]
s
i
nfor
mat
ioni
scost
ly,aswehav
eli
mit
edcapaci
tyt
oacqui
re,pr
ocess,st
ore,andr
etr
iev
e
f
act
sandf
igur
esaboutt
her
equi
redi
ssueev
ent
houghsomet
echnol
ogi
calchangesuch
asI
nter
nethasr
educedi
t.

I
nfor
mat
ioncosthassubst
ant
ialef
fectonr
eal
-wor
ldmar
ket
s.I
tisoneoft
hecr
uci
alcost
s
t
hataf
fectt
het
ransact
ioncost
[Link]
ersandsel
l
ersmustf
ir
stf
indeachot
herand
t
heyagr
eeont
hepr
icesandot
hert
ermsoft
hecont
ract
.Knowl
edgeofexi
stencesand
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 232
l
ocat
ionofwi
l
li
ngbuy
eri
sval
uabl
einf
ormat
iont
osel
l
ersj
ustasknowl
edgeofawi
l
li
ng
sel
l
eri
sval
uabl
einf
ormat
iont
othebuy
ers.

Pr
icei
sthecent
ral
var
iabl
efort
hemar
ketadj
ust
mentandhassi
gnal
impl
i
cat
ioni
nmar
ket
f
orgoodsandser
[Link]
thr
egar
dtoi
nfor
mat
ionwehav
esai
dthati
tisscar
ceand
v
aluabl
ecommodi
[Link]
mil
aranal
ogyt
hepr
icesy
stem ofi
nfor
mat
ioneconomi
zeson
t
hecommodi
tycer
tai
n(cost
s)byal
l
owi
ngpeopl
etopayf
ort
hesear
chi
nfor
mat
[Link]
model
sdi
scussedabov
ewehav
eseensof
arassumeper
fecti
nfor
mat
ionwher
eit
scost
i
szer
[Link]
actt
hateconomi
cmodel
signor
einf
ormat
ioncostdoesnotmaket
hismodel
usel
[Link]
vei
nsi
ghtt
othef
orce-
gener
ati
ngt
rendi
npr
icesandquant
it
iesoccur
al
ongper
iodwher
einf
ormat
ionl
i
mit
snott
obei
mpor
tant
.Nowwer
elaxedourassumpt
ion
i
nthati
nfor
mat
ioni
snotf
ree.I
tisappr
opr
iat
etoaskandunder
standhowmar
ket
swor
kin
shor
[Link]
s,howeconomi
cagentopt
imi
zesi
nfor
mat
ionwheni
tincl
udescost
.

Weknowt
hati
naper
fectcompet
it
ivemar
ketal
lbuy
erspayt
hesamepr
icef
ort
hesame
pr
oduct
.Inmanyr
ealwor
ldmar
ket
s,howev
er,t
hepr
icesofev
ent
hesehomogenous
goodsdi
ff
erf
rom st
oret
ost
ore,
andshopst
[Link]
sorbuy
ersf
eel
dif
fer
ence
i
npr
icesandwantt
ofi
ndexpl
ainwhyhomogenouspr
oductsel
lfordi
ff
erentpr
icesi
n
di
ff
erentl
ocat
ionast
hecostofgoi
ngt
othecheapestst
oremayoutwei
ght
headv
ant
ages
oft
hel
owerpr
ices.

Becauseoft
heser
ati
onal
economi
cagent
s(buy
er)uset
heopt
imal
sear
chr
ulet
oopt
imi
ze
hi
str
ansact
[Link]
imal– sear
chr
ulest
atest
hatpeopl
ewi
l
lcont
inuet
oacqui
re
economi
cinf
ormat
ionasl
ongast
hemar
ginalbenef
it
sofgat
her
ingi
nfor
mat
ionexceed
t
hemar
ginalcostThati
s,t
hebuy
ermustbal
ancest
heexpect
edgai
nfr
om f
urt
hersear
ch
agai
nstt
hecostoff
urt
hersear
chorsear
chf
orl
owerpr
iceunt
ilt
heexpect
edmar
ginal
benef
itofaddi
ti
onal
sear
chequal
sthemar
ginal
costofsear
ch.

Exampl
e,whenaper
sondeci
dest
obuyanewcar
,themor
einf
ormat
iont
hatper
sonhas
ont
hepr
icesandont
echni
calqual
i
tiesofv
ari
ousaut
omobi
l
es,t
hebet
tert
heev
ent
ual
choi
cei
sli
kel
[Link]
tiscost
lyt
odr
iveal
lov
ert
ownt
othev
ari
ousdeal
ers,
taket
ime
of
ffr
om wor
korf
rom l
eisur
eact
ivi
ti
est
ocompar
epr
ices,acqui
reandmast
ert
echni
cal
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 233
ECON102MI
CROECONOMI
CSI
I

i
nfor
mat
iononnew car
.Becauseoft
hese,pr
ospect
ivebuy
ermustdr
aw t
hel
i
neatt
he
poi
ntwher
ethemar
ginal
benef
it
sfr
om acqui
ri
ngi
nfor
mat
ionequal
wit
hmar
ginal
cost
.

Thi
sopt
imalsear
chr
ulecanbei
l
lust
rat
edusi
ngdi
agr
[Link]
ust
mov
edt
oanew t
ownandi
slooki
ngf
ort
hebestpl
acet
obuyapar
ti
cul
arpr
oduct
.The
consumermi
ghtv
isi
tsev
eralst
orest
ocol
l
ectv
ari
edpr
icei
nfor
mat
[Link],af
tersome
compar
isonshoppi
ng,
theconsumerwi
l
lhav
easampl
eoft
hev
ari
ouspr
iceschar
gedsay
t
hepr
oducti
sBM car
.

Letv
ert
icalaxi
smeasur
est
hebenef
it
sandcost
sofsear
chperv
isi
[Link]
izont
alaxi
s
measur
est
hel
owestknownpr
ice(
s)t
hatt
heconsumerhascol
l
ect
edt
hroughsear
ch.
Yourmar
ginalcostofsear
chi
s$C (
$5f
orcase)perdeal
erv
isi
tedandi
sshownby
hor
izont
all
i
nei
nthef
igur
[Link]
sincl
udet
imecostand t
heamountspenton
t
ranspor
tat
ionandadv
[Link]
edmar
ginalbenef
itofv
isi
ti
ngonemor
edeal
er
dependsont
hel
owestpr
icet
haty
ouhav
[Link]
ginalbenef
it
sdi
ff
erwi
thpr
ices.
Thel
owert
hepr
icey
ouhav
eal
readyf
ound,
thel
oweri
syourexpect
edmar
ginalbenef
itof
v
isi
ti
ngonemor
edeal
er,
asshownbyt
hecur
ve

Unt
ilpoi
nt‘
e’wher
ethepr
iceatwhi
cht
hemar
ginalcostofsear
chequalt
hemar
ginal
benef
itofsear
ch(t
heconsumer
’sr
eser
vat
ionpr
ice)
,thebuy
ermar
ginalbenef
iti
sgr
eat
er
t
hant
hecostandhencet
heysear
chf
ort
hel
owestpr
icepossi
[Link]
eser
vat
ionpr
ices
ar
ethehi
ghestpr
iceatwhi
cht
heconsumerwi
l
[Link]
l
ltosear
chf
or
l
owestpr
icesi
fthel
owestpr
icessof
arf
oundexceedst
her
eser
vat
ionpr
iesbutwi
l
lst
op
sear
chi
ngandbuyi
tift
hel
owestpr
icef
oundi
slesst
hanorequal
tot
her
eser
vat
ionpr
ices.

Ther
eser
vat
ionpr
icei
s$5i
nfi
gur
exx.I
fthel
owestpr
icesampl
edi
s$6,t
heconsumer
shoul
dst
il
lsear
chbecauset
hemar
ginalbenef
itofsear
chexceedst
hemar
ginalcostof
sear
ch.I
fthel
owestpr
icei
sbel
ow $5say$4t
heConsumerwi
l
lpur
chaset
hegood
becauset
hemar
ginalcostofsear
chexceedst
hemar
ginalbenef
itofsear
[Link]
owest
pr
icesampl
edi
s$5,
because$5i
nthehi
ghestpr
icet
heconsumerwi
l
lpayf
ort
hepr
oduct
.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 234
ch per
tandcostofsear

Mar
ginal
benef
itof

5 e
Mar
ginal
costof
i
Benef
l
dolar

O Lowestpr
icesampl
edi
n
4 $=C= 6 dol
lar

Fi
gur
e6.
7; Opt
imal
–Sear
ch

Wecanappl
ythet
heor
ythatconsumer
suseasear
ch-
rul
ewher
emar
ginalbenef
it
sequal
mar
ginalcost
stopr
edi
ctt
heext
entofpr
icedesper
ati
onondi
ff
erentpr
oduct
[Link]
e
r
esour
cesdev
otedt
osear
chi
ng,
thecl
oserwi
l
lbet
hepr
icesofhomogeneouspr
oductsol
d
atdi
ff
erentst
ores.I
nfor
mat
ion’
scostcanbemi
nimi
zedf
orconsumer
sbyor
gani
zat
ions
suchast
heconsumer
suni
on,whi
cht
est
spr
oduct
sand sel
lther
esul
tsi
nmont
hly
magazi
[Link]
thermor
e,gov
ernmentcan al
so r
educe t
he costbyset
ti
ng mi
nimum
st
andar
d and car
ing outi
nspect
ions t
o ensur
ethatst
andar
dis bei
ng obser
ved.
Adv
ert
isi
ngandot
heri
nfor
mat
ionsour
cescanr
educet
hecost
.Itcanr
educepr
icef
ort
wo
r
easons,f
ir
stl
y,i
tcani
ncr
easecompet
it
ionbyt
ell
i
ngpot
ent
ialbuy
eraboutal
ter
nat
ive
sour
cesofsuppl
[Link],i
tenabl
esf
ir
mst
oincr
easet
hei
routputandr
eapeconomi
cs
ofscal
e.

_
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_
6.
8Act
ivi
ty:
Doy
out
hinkhouser
entorsal
ebr
oker
siny
ousur
roundi
nghasanyeconomi
crol
efort
he
t
ransact
ionact
ivi
tyundert
akenbyt
het
womaj
orpar
ti
es:buy
erandsel
l
er?Howandwhat
dot
heydo?
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 235
ECON102MI
CROECONOMI
CSI
I

Supposey
ouwantt
obuyTaper
ecor
derascompet
it
ivemar
ketwher
eisdi
ff
erencei
ncost
oft
hepr
oducti
ndi
ff
[Link] doy
oudeci
det
obyt
hegoodusi
ngt
heopt
imal
-
sear
chr
ulecr
it
eri
a?

6.
5.2.
Inf
ormat
ionpr
obl
ems:Asy
mmet
ri
cinf
ormat
ion

Sof
arwehav
elookedatsi
tuat
ionsi
nwhi
chi
nfor
mat
ioni
sav
ail
abl
etoev
eryoneandcan
beobt
ainedwi
thanex
pendi
tur
eofr
esour
[Link]
lsi
tuat
ionsar
eli
ket
[Link]
exampl
e,someone mi
ghthav
e pr
ivat
einf
ormat
ion t
hatmayaf
fectmanyeconomi
c
t
ransact
ionsaswhati
sav
ail
abl
etooneper
soni
stoocost
lyf
orany
oneel
set
oobt
ain.
Ty
picalexampl
emaybey
ourknowl
edgeabouty
ourdr
ivi
[Link] muchmor
ethan
y
ouraut
oinsur
ance companydoes abouthow car
eful
l
yand def
ensi
vel
yyou dr
ive.
Anot
heri
syourknowl
edgeabouty
ourwor
kef
for
[Link]
armor
ethany
ourempl
oyer
abouthowhar
dyouwor
k.

Economi
cdeal
i
ngsbet
weeneconomi
cagent
s(i
ndi
vi
dual
soror
gani
zat
ion)ar
egov
erned
bycont
ract
.Onepar
tyt
oat
ransact
ionmayknowamat
eri
alf
actt
hatt
heot
herpar
tydoes
notknowaboutt
[Link]
e,t
hesel
l
erknowst
hequal
i
tyofhi
spr
oductwher
eas
t
hebuy
erdoesnot
.Whenagoodi
spur
chased,
thesel
l
erexpl
i
cit
lyori
mpl
i
cit
lyguar
ant
ees
t
hatt
hegood wi
l
lwor
kaccor
ding t
o an expect
ed per
for
mancest
andar
[Link]
e
i
nfor
medpar
tymanyexpl
oitt
hel
essi
nfor
medpar
ty.

Economi
stsuset
het
erm asy
mmet
ri
cinf
ormat
iont
odescr
ibesi
tuat
ionsi
nwhi
chbuy
ers
andsel
l
ersar
enotequal
l
ywel
linf
ormedaboutt
hechar
act
eri
sti
csofpr
oductorser
vices.
I
nthesesi
tuat
ions,sel
l
ersar
ety
pical
l
ymuchbet
teri
nfor
medt
hanbuy
ers,butsomet
imes
t
her
ever
seswi
l
lbet
[Link]
sasy
mmet
ri
cinf
ormat
ionaf
fect
sthebehav
iorofmar
ket
par
ti
cipant
sandexpl
ainsawi
dev
ari
etyofphenomenoni
nmoder
neconomyl
eadt
o
oppor
tuni
sti
cbehav
ior
swhi
chi
ntur
nleadt
omar
ketf
ail
ure,dest
roy
ingmanydesi
rabl
e
pr
oper
ti
esofcompet
it
ivemar
ket
s.

UsedCar
es:
Anexampl
eofasy
mmet
ri
cinf
ormat
ion
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 236
Thecl
assi
cexampl
eofasy
mmet
ri
cinf
ormat
ioni
sthemar
ketf
orusedcar
s-l
emonsWhyi
s
t
hisnotasur
pri
se?Cl
ear
ly,t
hesel
l
erofausedcargener
all
yknowsagr
eatdealmor
e
abouti
tsper
for
manceanddef
ici
enci
est
hant
hepot
ent
ialbuy
er. Thi
sasy
mmet
ryof
i
nfor
mat
ionwi
l
linf
luencehow t
hemar
ketwor
[Link]?Supposet
hatal
lnew car
sar
e
ei
thergoodordef
ect
iveandt
hatbuy
ersf
indoutwhi
chaf
tert
heyhav
epur
chasedacar
.If
t
heownert
hent
urnsar
oundandof
fer
sthecarf
orsal
e,t
henapot
ent
ialbuy
erofwhati
s
now ausedcarwi
l
lnotbeabl
etodet
ermi
ne(
bef
orebuy
ingi
t)whet
heri
tisgoodor
def
ect
ive,
butt
hesel
l
erwi
l
lknow.

Undert
heseci
rcumst
ances,t
heequi
l
ibr
ium pr
iceofausedcarwoul
dbel
esst
hant
he
pr
iceofanew car
.Not
efi
rstt
hatgoodandbadusedcar
sshoul
dbot
hsel
latt
hesame
pr
icesbecauset
hepot
ent
ialbuy
ercannott
ellt
hedi
ff
erencepr
iort
othesal
[Link]
his
commonpr
icemustbel
esst
hant
hepr
iceofanewcar
.Ift
hepr
icesofausedcarwer
e
notl
esst
hant
hepr
icefanewone,
ther
ewoul
dbenodemandf
orusedcar
speopl
es buy
anewcar
,andhencedet
ermi
newhet
heri
tisdef
ect
ive,and(
ifi
tpr
ovest
obedef
ect
ive)
sel
li
tandbuyanot
hernewcar
.

“
Lemons”(
def
ect
ivecar
s)woul
dli
kel
yconst
it
uteapor
ti
onoft
heusedcar
sof
fer
edf
or
sal
[Link]
sofgoodusedcar
scoul
deasi
l
yfi
ndt
heequi
l
ibr
ium pr
icesofasusedcart
o
besol
ow t
hatt
heywoul
dnotbemot
ivat
edt
oof
fermanyoft
hei
rcar
sforsal
[Link]
he
ot
herhand,owner
sofdef
ect
iveusedcar
swoul
dnotf
eelsi
mil
arl
yrest
rai
[Link]
his
i
nsi
ghtwoul
dmakepot
ent
ialbuy
ersev
enmor
eincl
i
nedt
obewor
ryofent
eri
ngt
hemar
ket
f
orusedcar
sandt
oof
ferr
elat
ivel
ylowpr
icesf
orusedcar
sift
heydi
d

Thebuy
erofausedcarwoul
dbewi
l
li
ngt
opaymor
ethant
heequi
l
ibr
ium pr
icei
fheorshe
wer
esur
eofget
ti
ngagoodoneandt
hesel
l
erofagoodusedcarwoul
dbedel
i
ght
edt
o
agr
eet
osuchat
ransact
[Link]
heasy
mmet
ryofi
nfor
mat
ionacr
osst
hemar
ketandt
he
f
actt
hatonl
ythesel
l
erknowswhet
hert
heusedcari
sgoodordef
ect
ivemakesi
tdi
ff
icul
t
f
ort
hesesor
tsoft
ransact
ionst
ooccur
.Facedwi
tht
hissi
tuat
ion,sel
l
ersofusedcar
str
y
i
nvar
ious way
sto si
gnalbuy
erst
hatt
hei
rcar
s ar
e [Link]
ter
elev
antf
act
s
concer
ningt
hei
rcar
[Link]
aget
hebuy
ert
ohav
ehi
sorherexper
tsi
nspectt
hecar
s
bef
orepur
chase.
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 237
ECON102MI
CROECONOMI
CSI
I

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6.
[Link]
ivi
ty
I
sther
esomet
hingsi
mil
art
otheusedcarpr
obl
em doy
ouknow?I
fsowhati
sthat
,and
howdi
dithappen?
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Wehav
esai
dthateconomi
cdeal
i
ngbet
weeni
ndi
vi
dual
sisgov
ernedbycont
ractei
ther
i
mpl
i
cit
lyorexpl
i
cit
[Link]
hpar
ti
est
oacont
ract(
transact
ion)hav
enoequal
l
y
i
nfor
mat
ion,t
ransact
ioni
snotef
fi
cientasi
nfor
mat
ionadv
ant
agel
eadst
opr
obl
emsof
oppor
tuni
sm,wher
ebyt
hei
nfor
medpar
tyorper
sonbenef
itatt
heexpenseoft
heper
son
wi
thl
essi
nfor
mat
[Link]
tuni
sti
cbehav
iororasy
mmet
ri
cinf
ormat
ioncr
eat
est
wo
pr
obl
ems:
Mor
alHazar
d
Adv
ersesel
ect
ion
[Link]
alhazar
dpr
obl
em

Themor
alhazar
dpr
obl
em occur
swhenonepar
tyt
oacont
ractengagesi
noppor
tuni
sti
c
behav
ioraf
tert
hecont
racti
smade.A Mor
alhazar
dpr
obl
em exi
stswhenoneoft
he
par
ti
est
ocont
racthasani
ncent
ivet
oal
terhi
sorherbehav
ioraf
tert
hecont
racti
smade
att
heexpensesoft
hesecondpar
tyt
ogetbenef
it
.Itar
isesasi
tist
oocost
lyf
ort
he
secondpar
tyt
oobt
aini
nfor
mat
ionaboutt
hef
ir
stpar
ty’
spostcont
ract
ualbehav
iorand
hi
ddenact
[Link]
ati
ngdi
ff
erent
lyi
tisoppor
tuni
sm char
act
eri
zedbyani
nfor
medper
son’
s
t
aki
ngadv
ant
ageofal
essi
nfor
medper
sont
hroughanunobser
vedact
ion.

Someexampl
esar
e
I
fMr
.-
Xhi
resMr
.-
Yasasal
esper
sonandpay
shi
m af
ixedwager
egar
dlessofhi
ssal
es.
Mr
.–Yhasani
ncent
ivet
oputi
nthel
eastpossi
bleef
for
t,benef
it
inghi
msel
fandl
ower
ing
pr
ofi
tsofMr
.ast
hepayi
snotbasedont
hev
olumeofsal
es.
Ani
nsur
edpeopl
efi
ndt
otakeunobser
vedact
ion(
engagei
nri
skybehav
iorort
akel
esser
pr
ecaut
ion)t
hati
ncr
easet
hepr
obabi
l
ityofl
argecl
aimsagai
nsti
nsur
ancecompani
es.
I
ndi
vi
duali
swi
l
lspendl
essonpr
event
iveheal
thcar
eandt
hust
hepr
obabi
l
ityorget
ti
ngi
n
t
ori
skr
ises

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 238
Buti
faconsumercanpur
chasecari
nsur
anceont
hef
t,t
hent
hecosti
nfl
i
ctedont
he
i
ndi
vi
dualofhav
inghi
scarst
oleni
slessashe/
shecanr
epor
ttot
hecompani
esandget
i
nsur
edi
fthecari
sst
[Link]
mil
aranal
ogy
,appl
i
est
ocardamage/col
l
usi
[Link]
thoughi
t
i
sunl
i
kel
ythati
nsur
edder
iverwoul
ddel
i
ber
atel
yhav
ecol
l
usi
on,suchani
nsur
ancepol
i
cy
mi
ghtgi
vet
heder
iverani
ncent
ivet
oal
terder
ivi
ngbehav
ior
.Theder
ivermi
ghtbel
ess
caut
iousi
npar
kingl
otsandmi
ghtgener
all
ydr
ivel
essdef
ensi
vel
ythannor
mal
.

Suchact
ivi
ti
esasf
ail
uret
otakecar
eandr
eckl
essbehav
iorr
educeout
putori
ncr
ease
acci
dent
s,whi
chshow whymar
ketf
ail
uresandhencehar
m soci
ety
.Thesear
emor
al
hazar
dinwhi
chi
ndi
vi
dual
shav
eani
ncent
ivet
odoopposi
tet
ogetadv
ant
ageatt
he
expenseofcont
ract
ingpar
ti
[Link]
alhazar
doccur
sinal
leconomi
cact
ivi
ti
eswher
e
economi
cagent
sdonotbeart
hef
ullconsequencesoft
hei
ract
ion.I
nsuchi
nst
ancest
he
economi
cagent
smaxi
mizest
hei
rownut
il
it
ytodet
ermi
nantofot
her
s.

Asopposedt
ocompet
it
ivemar
ketwher
ethet
ransact
ioni
sdet
ermi
nedbyt
hecondi
ti
on
t
hatdemandequal
ssuppl
ythemar
ginal
wil
l
ingnesst
opayequal
sthemar
ginal
wil
l
ingness
t
osel
lher
eisnosmoot
htr
ansact
ionupt
otheequi
l
ibr
ium i
ncaseofmor
ehaz
ard,hence
nomar
ketequi
l
ibr
ium.

I
nouri
nsur
ancecase,f
ori
nst
ances,hast
hepr
oper
tyt
hateachconsumerwoul
dli
ket
o
buymor
einsur
ance,andt
hei
nsur
ancecompani
eswoul
dbewi
l
li
ngt
opr
ovi
demor
e
i
nsur
ancei
ftheconsumer
scont
inuedt
otaket
hesameamountofcar
[Link]
hist
rade
won’
toccurbecausei
ftheconsumer
swer
eabl
etopur
chasemor
einsur
ancet
heywoul
d
r
ati
onal
chooset
othel
esscar
e.

Despi
tet
hepej
orat
ivename,notal
lmor
alhaz
ard,ar
eent
ir
elyhar
mful
.Fori
nst
ances,
pr
egnantwomenwi
thheal
thi
nsur
ancemakemor
epr
enat
aldoct
orv
isi
[Link]
thought
he
ext
racostf
rom t
hesev
isi
tsi
samor
alhazar
dtoi
nsur
ancecompani
es,soci
etybenef
it
s
f
rom heal
thi
ermot
her
sorbabi
es.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 239
ECON102MI
CROECONOMI
CSI
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6.
10Act
ivi
ty

Someone,whosecari
sinsur
ed,mayt
akel
esscar
etopr
eventf
rom bei
ngst
olen
par
kingor
/anddamagewhi
l
eder
ivi
ngascompar
edsomeonewi
thnoi
nsur
[Link]
?
Whatki
ndofpr
obl
em i
sit
?Ist
her
eanysi
mil
arpr
obl
em i
nyousur
roundi
ng?

[Link]
ON

Theadv
ersesel
ect
ioni
sot
herpr
obl
em whi
char
isespr
iort
othemaki
ngoft
hecont
ract
t
ransact
ionsbet
weenpar
ti
es.I
tist
het
endencyf
orpeopl
etoent
eri
ntoagr
eement
sin
whi
ch t
hey can use t
hei
rpr
ivat
einf
ormat
ion t
othei
rown adv
ant
age and t
othe
di
sadv
ant
ageoft
hel
essi
nfor
medpar
ty.I
toccur
sast
hecostofobt
aini
ngt
her
elev
ant
i
nfor
mat
ionmakesi
tdi
ff
icul
ttodet
ermi
newhet
hert
her
eal
isagoodoneorabadone.

Some exampl
emaybe:
I
nashoporsuper
mar
ketcont
ractbet
weent
hebusi
nessmansayMr
.Xandsal
esper
son
Mr
.Y,i
fMr
.Xof
fer
ssal
espeopl
eaf
ixedwage,shewi
l
lat
tr
actl
azysal
espeopl
e,har
d
wor
kingsal
espeopl
ewi
l
lpr
efernott
owor
kforMr
.Xbecauset
heycanear
nmor
eby
wor
kingf
orsomeonewhopay
sbyr
esul
[Link]
ixedwagecont
ractadv
ersel
ysel
ect
s
t
hosewi
thpr
ivat
einf
ormat
ion(
knowl
edgeaboutt
hei
rwor
khabi
ts)whocanuset
hat
i
nfor
mat
ion/knowl
edget
othei
rownadv
ant
ageandt
odi
sadv
ant
ageoft
heot
herpar
ty.

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 240
Supposet
her
ear
emanypr
oducerofumbr
ell
ainwhi
chsomepr
oducehi
gh-qual
i
ty
pr
oductatwi
thPH pr
icesandt
heot
her
spr
oducesl
ow-qual
i
typr
oductatPL.I
fthemar
ket
i
scompet
it
ive,
ithasani
ncent
ivet
opr
oduceonl
ylow–qual
i
tyumbr
ell
asaseachpr
oducer
hasnegl
i
gibl
eef
fectonot
her
[Link]–qual
i
tyumbr
ell
apr
oduct
ionhasdest
roy
edt
he
mar
ket
,forbot
hqual
i
[Link]
s,l
owqual
i
tyi
tem cr
owdedouthi
ghqual
i
tyi
tems
becauseoft
hehi
ghcostofacqui
ri
ngi
nfor
mat
ion.

Theseadv
ersesel
ect
ionpr
obl
emsar
emor
epr
eval
enti
ninsur
ancei
ndust
ry.I
nsur
ance
compani
esf
aceadi
ff
erentwor
ld;
fori
nst
ancegoodandbadcarorder
iver
s.I
fweassume
Mr
.Gagooddr
iver
slowr
ateacci
dentandMr
.Fbaddr
iverwi
thhi
ghr
ateacci
dent
,unl
ess
t
hecompani
esev
aluat
ewhent
heyder
ive,
itcannotdi
ff
erent
iat
ebet
weent
wodr
iver
[Link]
t
ohi
ghcostofgat
her
ingi
nfor
mat
ion,
thei
nsur
ancecompanysel
l
saut
omobi
l
einsur
ances
t
obot
hpar
tyatt
hesamer
ate,ev
ent
hroughi
ndi
vi
dual
swi
thi
nthegr
oupof
tendi
ff
er
shar
plyi
nter
msoft
hei
rli
kel
i
hoodoff
il
ingcl
[Link],buy
ingi
nsur
ancei
sat
tr
act
ivet
o
t
hosei
ndi
vi
dual
wit
hthehi
ghestl
i
kel
i
hoodofacci
dent
sthem gooddr
iver
.

Si
mil
arpr
obl
em ar
iseswi
thheal
thi
nsur
ancesi
nwhi
chcaset
hosepeopl
ewi
thhi
gh
i
nci
dencesofheal
thpr
obl
emst
endt
obuyheal
thi
nsur
ancesatsamer
atewi
tht
hatof
peopl
ewi
thl
owi
nci
[Link]
ghr
iskpeopl
ear
ebet
terof
fbecauset
heycanpur
chase
i
nsur
ancesatr
atest
hatar
elowert
hant
heact
ualr
iskt
heyf
aceandt
hel
owerpeopl
ecan
pur
chasei
nsur
ances.
Adv
ersesel
ect
ion f
orcesi
nsur
ancecompani
est
orai
set
hei
rpr
emi
um,whi
ch makes
buy
ingi
nsur
anceev
enl
essat
tract
ivet
olow-
ri
ski
ndi
vi
dual
s,whi
chr
aisesst
il
lfur
thert
he
av
erager
iskoft
hosewhor
emai
ninsur
ed.I
ncomecasesonl
ythosei
ndi
vi
dual
sfacedwi
th
ext
remer
iskmaycont
inuet
ofi
ndi
nsur
anceanat
tr
act
ivepur
[Link]
ersesel
ect
ion
cr
eat
eamar
ketf
ail
urebyr
educi
ngt
hesi
zeofmar
ketordomi
nat
ingi
t,t
her
ebypr
event
ing
desi
rabl
etr
ansact
ionsi
nsur
ancecompani
eshav
etochangehi
gherr
atesf
ori
nsur
ancedue
t
oadv
ersesel
ect
ionorchoosenott
oof
feri
nsur
anceatal
l
.
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6.
11.
Act
ivi
ty
Supposet
her
ear
etwoi
ndi
vi
dual
sAbebewhi
thi
ghl
evelheal
thpr
obl
em andKebedewi
th
l
owl
evelofheal
thpr
obl
em andeachper
sonknowshi
msel
fbutt
heot
her
sdonot
.Fur
ther
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 241
ECON102MI
CROECONOMI
CSI
I

mor
e,t
heyhav
eaccesst
oheal
thi
nsur
ancesatt
hesamer
atepay
ment
s$[Link] does
eachoft
hesebehav
e?Whatt
ypeofpr
obl
emsmayar
ise?
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6.
5.3.
MEASURESTOREDUCEI
NFORMATI
ONASYMMETRY
Upunt
ilknow wehav
eseent
hatasy
mmet
ri
cinf
ormat
ionr
esul
tini
nef
fi
cienci
esduet
o
mor
alhazar
daswel
lasadv
ersesel
ect
ion pr
obl
[Link] dot
hesepr
obl
emscanbe
sol
vedwi
thoutshi
ft
ingr
iskt
opeopl
ewhohat
ebear
ingi
torcont
ract
satl
eastr
eacha
goodcompr
omi
sebet
weent
het
wogoal
s.I
nsur
ancecompani
es,
fori
nst
ances,
facet
rade-
of
fbet
weenr
educi
ngmor
alhazar
dsandt
her
iskofi
nsur
ancebuy
ersast
hecompanyhas
apool
sri
sk.I
tact
sast
hroughi
tisr
iskneut
ral
.Si
mil
art
rade-
offmayar
iseunderadv
erse
sel
ect
[Link],
howt
osol
vet
hesepr
obl
ems?

Ther
ear
etwomai
nmet
hodsofsol
vi
ngadv
ersesel
ect
ionandmor
alhazar
[Link]
e:
A.r
est
ri
cti
onsoppor
tuni
sti
cbehav
iororcont
rol
l
ingoppor
tuni
sti
cbehav
ior
and
[Link]
i
zingi
nfor
mat
ion

A.
CONTROLLI
NGOPPORTUNI
STI
CBEHAVI
OR

Adv
erse sel
ect
ion can be pr
event
ed i
finf
ormed hav
e no choi
[Link]
e,a
gov
ernmentcanav
oid/
reduceasy
mmet
ri
cinf
ormat
ionbypr
ovi
dingi
nsur
ancet
oev
ery
one
orbymandat
ingt
hatev
ery
onebuyi
nsur
[Link]
atesr
equi
ret
hatev
erydr
ivercar
ry
aut
oinsur
ances t
her
e byr
educe adv
erse sel
ect
ion t
hatwoul
d ar
ise f
rom hav
ing a
di
spr
opor
ti
onat
enumberofbaddr
iver
sbuyi
nsur
[Link]
mil
arl
y,f
ir
msof
tenpr
ovi
de
heal
thi
nsur
ancet
oal
lempl
oyeesasabenef
itr
athert
hatpay
ingahi
gherwageandl
ett
ing
empl
oyeesdeci
deswhet
hert
obuysuchi
nsur
anceont
hei
[Link]
ngso,f
ir
mreduce
adv
ersesel
ect
ionpr
obl
emsf
ort
hei
rinsur
ancecar
ri
[Link]
hheal
thyandunheal
thywi
l
lbe
cov
eredasar
esul
tfi
rmscanbuymedi
cali
nsur
ancef
ort
hei
rwor
ker
satal
owercostper
per
sont
hanwor
ker
scoul
dobt
ainont
hei
rown.I
nsur
ancecompani
eshav
erespondedt
o
t
hispr
obl
em byi
mposi
ngl
i
mit
sont
heamountt
obei
nsur
[Link]
ti
cul
arpol
i
ciesmany
,for
exampl
e,payf
ornomor
ethan8day
sint
hehospi
talf
oraper
sonunder
goi
ngagal
l
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 242
bl
adderoper
ati
on.

Fur
thermor
e,manyi
nsur
ancepol
i
cieshav
eaf
eat
ureofco-
insur
ancesi
nwhi
cht
he
compani
escov
ersomepar
tsot
hatt
hepol
i
cyhol
deri
sobl
i
gedt
opayt
hebal
anceheal
th
i
nsur
ancepol
i
[Link]
tenhav
ea20%co-
insur
ancer
ate,whi
chi
mpl
i
est
hatt
hei
nsur
ance
companypay
s80%andpol
i
cyhol
der
spay
s20%ofanybi
l
[Link]
tha$500medi
cal
bi
l
lwoul
dthenpay0.
20x500or
$[Link]
s560–i
nsur
ancei
stogi
vet
hepol
i
cyhol
der
mor
eincent
ivet
ohol
ddownmedi
cal
bil
l
sandt
otakeper
vasi
vecar
e.

I
nsur
ancecompani
esal
sor
espondt
omor
alhazar
dbyi
nser
ti
ngdeduct
ibl
esi
ntot
he
pol
i
ciest
hatt
heywr
it
[Link]
thadeduct
ibl
e,apol
i
cymakerhast
obearpar
toft
hei
nsur
ed
l
ossupt
osomel
i
mit
.Forexampl
e,amedi
cali
nsur
ancepol
i
cymayst
imul
atet
hatt
he
pat
ientmustpayt
hef
ir
st$200,
ofmedi
cal
expensest
hatheorshei
ncur
s..

I
nsomemar
keti
tispossi
blet
oav
oidf
rom consumeri
gnor
ancet
hroughl
awsmi
ght
pr
ovi
depr
otect
ionagai
nstbei
ngsel
l
ingl
[Link]
smi
ghtscr
eenbycol
l
ect
ingt
he
i
nfor
mat
ion t
hemsel
ves,t
he gov
ernmentorot
her
sthi
rd par
tymi
ghtsuppl
yrel
i
abl
e
i
nfor
mat
[Link]
nst
ance,pr
oductl
i
abi
l
ityl
awspr
otectconsumer
sfr
om bei
ngst
uckwi
th
non f
unct
ionalordanger
ous pr
oduct
[Link]
e ov
er,many st
ates supercour
ts hav
e
concl
udedt
hatt
hepr
oduct
sar
esol
dwi
thoni
mpl
i
citunder
standi
ngt
hatt
heywi
l
lsaf
ely
per
for
mthei
rint
endedf
unct
ion.I
ftheydonot
,consumer
scanduet
hesel
l
ersev
eni
nthe
absenceofpr
oductl
i
abi
l
ityl
aws.
_
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6.
12.
Act
ivi
ty
Whatar
e si
mil
arpol
i
ciesorr
emedi
almeasur
esi
n ourcount
ryaboutt
he i
nsur
ance
i
ndust
ri
esr
elat
edt
ocari
nsur
ancesandheal
thi
nsur
ances?
_
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__
[Link]
ZATI
ONI
NFORMATI
ON
Ei
theri
nfor
medoruni
for
medpar
ti
escanel
i
minat
einf
ormat
ionpr
obl
emst
hrough:
Scr
eeni
ng
Si
gnal
i
ng
Scr
eeni
ng i
s an act
ion t
aken bya uni
for
med per
son t
o det
ermi
ne t
he i
nfor
mat
ion
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 243
ECON102MI
CROECONOMI
CSI
I

possessedbyi
nfor
medpeopl
[Link]
ermayt
est–dr
ive(
scr
een)sev
eralusedcar
sto
det
ermi
newhi
chonest
art
sandhandl
est
hebest
.Whent
heor
igi
nal
l
yuni
nfor
medpeopl
e
obt
ainbet
teri
nfor
mat
ion,t
heymayr
efuset
osi
gnacont
ractori
nsi
stsonchangesi
n
cont
ractcl
ausesoront
hepr
icesofagood.I
nsur
ancecompani
es,f
orexampl
e,t
ryt
o
r
educe adv
erse sel
ect
ion pr
obl
ems byl
ear
ning t
he heal
th hi
stor
yoft
hei
rpot
ent
ial
cust
omer
s;i
nfor
mat
iononageandgener
alheal
th,
indi
vi
dual
sdanger
oushabi
t(dr
inki
ngor
smoki
ng)
…et
c.

Consumercanav
oidt
hel
emonspr
obl
emsi
ftheycanobt
ainr
eli
abl
einf
ormat
ionabout
qual
i
[Link]
scanbuyi
nfor
mat
ionf
rom ex
per
tsori
nferpr
oductqual
i
tyf
rom sel
l
er’
s
r
eput
ati
onasi
tiseasyt
oest
abl
i
shr
eput
ati
oni
namar
keti
nwhi
cht
hesameconsumer
s
andf
ir
mst
rader
egul
arl
y.I
nsomemar
ket
,consumer
slear
nofaf
ir
m’sr
eput
ati
onf
rom
ot
herconsumer
sorf
rom obser
vat
ion.I
fthemechani
ccanr
eli
abl
edet
ermi
net
hewhet
her
t
hecari
slemon,
thei
nfor
mat
ionasy
mmet
ryi
sli
mit
ed.

Si
gnal
ingi
sanact
iont
akenbyani
nfor
medper
sont
osendi
nfor
mat
iont
oal
essi
nfor
med
per
[Link]
ir
m maysendasi
gnalsuchaswi
del
ydi
str
ibut
ingaf
avor
abl
erepor
toni
ts
pr
oductbyani
ndependentt
est
ingagencyt
otr
ytoconv
incebuy
erst
hati
tspr
oducti
shi
gh
qual
i
ty.I
n some mar
ket
s gov
ernmentagenci
es on non-
prof
itor
gani
zat
ion such as
cust
omer
suni
onsal
sopr
ovi
deconsumer
swi
thi
nfor
mat
ion.

Fi
rm and i
ndi
vi
dual
s bot
h engage i
n an act
ivi
tycal
l
ed ‘
mar
ketsi
gnal
i
ng’t
o conv
ey
i
nfor
mat
ionaboutt
hequal
i
tyoft
hepr
oduct
sorser
vicest
hatt
heyar
eof
fer
[Link]
es
usual
l
y,f
orexampl
e,ar
eint
erv
iewi
ngandgi
vi
ngexam t
osel
ectr
elat
ivel
ybet
terwor
ker
s
f
rom t
hel
abormar
ket
.Fi
rm usual
l
yuseeducat
ionasani
mpor
tanti
ndi
cat
orsorsi
gnalof
per
son’
spr
oduct
ivi
tywhent
heyar
emakehi
ri
ngdeci
sionsast
hemor
eeducat
edpeopl
e,
t
hemor
ethepr
oduct
ivi
tyoft
hewor
ker
.

Si
mil
arl
y,t
hepr
oducer
ssi
gnalpr
oductqual
i
tyt
hrough di
ff
erentmechani
sm such as
i
ssui
ngguar
ant
eeandwar
rant
iesf
orcust
omer
simpl
yi
ngt
hei
rpr
oducti
sofhi
ghqual
i
ty.
Thehi
ghqual
i
typr
oducti
sal
sosi
gnal
edt
hroughhi
ghpr
icesf
ort
hei
[Link]
thermor
e,
adv
ert
isi
ngandot
hermar
keti
nfor
mat
iongi
vev
aluabl
eresul
tint
hisr
egar
dev
ent
hroughi
s
ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 244
per
suade i
ndi
vi
dual
tobuyapr
oductorser
vices.

Mor
eov
er,i
tanout
sideor
gani
zat
iont
opr
ovi
debel
i
evabl
einf
ormat
ion,i
tmustconv
ince
consumer
sint
hati
tist
rust
wor
thy
.Somenonpr
ofi
tor
gani
zat
ion,suchasconsumer
s
gr
oups,andnon-
prof
itor
gani
zat
ionpubl
i
shexper
tcompar
isonsofbr
[Link]
hedegr
ee
t
hatt
hisi
nfor
mat
ioni
scr
edi
ble,
itmayr
educeadv
ersesel
ect
ionbyenabl
i
ngconsumer
sto
av
oid buy
ing l
ow-
qual
i
ty goods.I
n some case t
her
eis al
so st
andar
dizat
ion and
cer
ti
fi
cat
ion i
n whi
ch t
he gov
ernment,consumergr
oups,I
ndust
rygr
oup and ot
her
pr
ovi
desi
nfor
mat
ionbasedonst
andar
d:amet
ri
corscal
eforev
aluat
ingqual
i
tyofa
par
ti
cul
arpr
oduct
.Consumer
slear
nofabr
and’
squal
i
tyt
hroughcer
ti
fi
cat
ion:ar
epor
tthat
apar
ti
cul
armeet
sorexceedsagi
venst
andar
dlev
els.

_
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___
6.
13.
Act
ivi
ty
Expl
ainwhymor
eisspentont
headv
ert
isi
ngofdeodor
ant
sthanont
headv
ert
isi
ngoff
arm
ofmachi
ner
y?
Doy
out
hinkt
hecer
ti
fi
cat
ionandst
andar
dizat
ionofpr
oductespeci
all
yfoodi
temsbyThe
Et
hiopi
anQual
i
tyandSt
andar
dAut
hor
it
yhel
psconsumeri
nsel
ect
ingr
elat
ivel
ygood
pr
oduct
?How?
_
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___
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___
___
SUMMARY
Ther
ear
equi
tal
otofar
easi
nwhi
cht
hemar
ketcannotal
l
ocat
eofr
esour
cesef
fi
cient
ly.
Thepr
esenceofext
ernal
i
tyi
soneoft
hemai
nreasons.I
tar
iseswhent
heact
ionofan
economi
cagentt
heot
herpar
tynoti
nvol
vedi
ntheact
ionandnotcompsat
edf
ort
hat
.
Ther
ear
etwomaj
ort
ypeofext
ernal
i
tybasedont
hesour
ces.
Thesear
econsumpt
ionandpr
oduct
ionext
ernal
i
tywhi
chmaybeei
therhel
porhar
mtot
he
t
hir
dagent
.Theseact
ionscanber
esol
vedt
houghti
nter
nal
i
zat
ionofext
ernal
i
tybyt
he
par
tygener
ated t
heact
[Link]
ear
ethr
eemaj
orway
sofi
nter
nal
i
zing:r
edef
ini
ti
onof
pr
oper
tyr
ight
,vol
unt
aryagr
eement
,andgov
ernmentact
ion.
Ext
ernal
i
tyoccur
swhenaconsumer
’swel
l
-bei
ngoraf
ir
mspr
oduct
ioncapabi
l
ityar
e
ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 245
ECON102MI
CROECONOMI
CSI
I

di
rect
lyaf
fect
edbyt
heact
ionsofot
herconsumer
sorf
ir
msr
athert
hani
ndi
rect
lyaf
fect
t
hroughchangei
npr
ices.
Ext
ernal
i
tiesar
emai
nlybypr
oductofconsumpt
ionorpr
oduct
ionwhi
chei
therhar
m or
hel
pthet
hir
dpar
tynoti
nvol
vedi
ntheact
[Link]
stencesofext
ernal
i
tyl
eadt
omar
ket
f
ail
ureast
hosewhopr
oducesomet
hingdonoti
ncl
udet
hef
ull
costoft
hei
ract
ions.
Commonpr
oper
tyi
sot
hersour
cesofext
ernal
i
tieswher
ether
esour
cest
owhi
chev
ery
one
hasf
[Link]
oper
tyr
esour
cesar
eov
erexpl
oit
edasev
ery
onewant
sget
benef
itbef
orehi
sfel
l
owmenmakeshi
sorherpr
ivat
epr
oper
ty.
Publ
i
cgoodsar
egoodsf
orwhi
chev
ery
onemustconsumeonest
hegoodi
ssuppl
i
[Link]
pr
ivat
emar
keteconomydoesnotdowel
latpr
ovi
dingpubl
i
cgoods.I
fnoonecanbe
excl
udedf
rom consumpt
iont
her
eisnowayt
ochar
geapr
icef
ort
hegoodand,t
her
efor
e
noi
ncent
ivesf
orpr
ivat
eent
repr
eneur
stopr
oducesandsel
laspr
ivat
ecompani
eswoul
d
hav
eobv
iousdi
ff
icul
tyr
ecov
eri
ngt
hei
rcostofpr
oduct
ion.
Manypeopl
emi
ghtbewi
l
li
ngt
opayenought
ocov
ert
hecostofpr
oduci
ngt
hegood,but
asi
tisnonexcl
udabl
e,t
hecompanycannoteasi
l
ychar
gef
ori
t.I
nthepr
ovi
sionofpubl
i
c
goodl
eadst
ofr
eer
iderpr
obl
[Link],t
her
ear
emanypeopl
eshar
ingt
hecostof
pr
ovi
dingt
hepubl
i
cgood,eachi
ndi
vi
dualf
eel
sthatwi
thdr
awi
nghi
sandherf
inanci
al
suppor
twi
l
lpr
act
ical
l
ygounnot
icedbyot
her
sandwi
l
lhav
eli
tt
leornoef
fectont
he
pr
ovi
si
onoft
[Link]
ketpr
ovi
sionsofpubl
i
cgoodsl
eadunderopt
imalsuppl
yoft
he
r
esour
[Link]
cagent
shav
econst
ant
lyf
aceswi
thpr
obl
em ofhi
ddeni
nfor
mat
ion
t
hatr
esul
tinmor
alhaz
ardandadv
ersesel
ect
[Link]
obl
emsofmor
alhazar
dar
ise
becauset
hosewhohav
einf
ormat
ionadv
ant
ageshav
eincent
ivest
ochanget
hei
rbehav
ior
.
Theequi
l
ibr
ium outcomesi
nthesemar
ket
swher
ehi
ddeni
nfor
mat
ionpr
obl
em t
her
e
appeart
obei
nef
fi
ci
ent
,butonehast
obecar
efuli
nmaki
ngsuchacl
[Link]
l
ibr
ium
i
nthi
scasewi
l
lal
way
sbei
nef
fi
cientr
elat
ivet
otheequi
l
ibr
ium wi
thf
ull
inf
ormat
ion.
Ther
ear
etwomai
nmet
hodsofsol
vi
ngadv
ersesel
ect
ionandmor
alhazar
[Link]
e:
r
est
ri
cti
onsoppor
tuni
sti
cbehav
iororcont
rol
l
ingoppor
tuni
sti
cbehav
iorandequal
i
zing
i
nfor
mat
ion.I
nthef
ir
stcaset
hegov
ernmentort
heconcer
nedbodyr
est
ri
ctt
hisbehav
ior
byl
aw oruse di
ff
erentmechani
smssuch asst
andar
dizat
ion,cer
ti
fi
cat
ions…et
c. I
n
r
elat
iont
othesecondei
theri
nfor
medoruni
for
medpar
ti
escanel
i
minat
einf
ormat
ion
pr
obl
emst
hroughscr
eeni
ngandsi
gnal
i
ng

ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 246
Economi
cagent
shav
econst
ant
lyf
aceswi
thpr
obl
em ofhi
ddeni
nfor
mat
iont
hatr
esul
tin
mor
alhazar
dandadv
ersesel
ect
[Link]
obl
emsofmor
alhazar
dar
isebecauset
hose
whohav
einf
ormat
ionadv
ant
ageshav
eincent
ivest
ochanget
hei
rbehav
ior
.

Theequi
l
ibr
ium outcomesi
nthesemar
ket
swher
ehi
ddeni
nfor
mat
ionpr
obl
em t
her
e
appeart
obei
nef
fi
ci
ent
,butonehast
obecar
efuli
nmaki
ngsuchacl
[Link]
l
ibr
ium
i
nthi
scasewi
l
lal
way
sbei
nef
fi
cientr
elat
ivet
otheequi
l
ibr
ium wi
thf
ull
inf
ormat
ion.

Ther
ear
etwomai
nmet
hodsofsol
vi
ngadv
ersesel
ect
ionandmor
alhazar
[Link]
e:
r
est
ri
cti
onsoppor
tuni
sti
cbehav
iororcont
rol
l
ingoppor
tuni
sti
cbehav
iorandequal
i
zing
i
nfor
mat
ion.I
nthef
ir
stcaset
hegov
ernmentort
heconcer
nedbodyr
est
ri
ctt
hisbehav
ior
byl
aw oruse di
ff
erentmechani
smssuch asst
andar
dizat
ion,cer
ti
fi
cat
ions…et
c. I
n
r
elat
iont
othesecondei
theri
nfor
medoruni
for
medpar
ti
escanel
i
minat
einf
ormat
ion
pr
obl
emst
hroughscr
eeni
ngandsi
gnal
i
ng

KEYTERMS
Ext
ernal
i
ties Ef
fl
uentf
ee Subsi
dies Regul
ator
yappr
oach
Pol
l
uti
on Pr
oduct
ionext
ernal
i
ties Consumpt
ionext
ernal
i
ties
Coaset
heor
em mar
ginal
pri
vat
ecostandbenef
it
s pol
l
uti
on
Gov
ernmenti
nter
vent
ion mar
ginal
soci
alcostandbenef
it
s posi
ti
veext
ernal
i
ties

Pr
oduct
ionext
ernal
i
ties consumpt
ionext
ernal
i
ties Negat
iveext
ernal
i
ties

Publ
i
cgoods t
ragedyofcommons pr
ivat
epr
oper
ty

Soci
all
yopt
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evel
ofpr
oducti
on freer
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oblem
Adver
sesel
ecti
on Economicsofi
nfor
mation Opt
imal
–sear
chr
ule
I
nfor
mat
ion asy
mmet
ry Mor
alhazar
d Scr
eeni
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gnal
i
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Pr
inci
pal
-Agentpr
obl
em Lemon’
s deduct
ibl
es co-
insur
ances

REVI
EW QUESTI
ONSREVI
EW QUESTI
ONS
Whati
sext
ernal
i
ty?
Whatar
ether
emedi
almeasur
esf
orext
ernal
i
ties?

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 247
ECON102MI
CROECONOMI
CSI
I

Whyzer
opol
l
uti
onnott
hebestsol
uti
onf
orsoci
ety
?Cant
her
ebet
ool
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ttl
epol
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uti
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orwhynot
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Anal
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oll
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tract
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ti
veornegat
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ernal
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ty?Whyi
smar
ket
sol
uti
onpr
act
ical
her
e?
Gar
bagei
nPhi
l
adel
phi
aisundesi
rabl
eofcour
[Link]
ncet
het
urnoft
he
cent
aur
y,howev
er,hogf
armer
sinNew Jer
seyhav
ebeenf
eedi
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sav
es3$mi
l
li
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l
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NewJer
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oodscr
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ort
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ecy
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ont
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her
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t
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dhav
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fect
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eont
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Expl
ainwhyi
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cientt
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udeany
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rom consumi
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oduced?
Whent
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benef
it
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dizi
ngt
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pr
oducer
sbr
ingaboutt
hesoci
all
yopt
imal
output
?Whyorwhynot
?
Whyi
sfr
ee-
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derpr
obl
em mor
eli
kel
ytooccurwhenal
argenumberofpeopl
esar
einv
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ed?
Whyi
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opol
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uti
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uti
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orsoci
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her
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i
ttl
epol
l
uti
on?
Whyorwhynot
?
Assumi
ngt
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ear
etwof
ir
msi
ntheeconomy
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cal
fact
oryt
hatemi
twast
eont
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upperst
ream andf
isher
menont
hedownst
ream oft
hesamer
iver
,showt
hatt
hemar
ket
mechani
sm l
eadt
oinef
fi
cientout
come?
Whatar
ether
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almeasur
esf
orext
ernal
i
tiesi
npr
oduct
ionorconsumpt
ion?
Expl
aini
ng t
he si
gni
fi
cancesoft
he ‘
fr
ee r
ider
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obl
em?expl
aint
he meani
ng oft
he
f
oll
owi
ngt
ermsandt
hei
rimpl
i
cat
ionsf
oreconomi
cpol
i
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adv
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mor
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si
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i
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scr
eeni
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Whati
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ances?Supposet
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thi
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[Link] dot
hel
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ADAMAUNI
VERSI
TY,
DEPARTMENTOFECONOMI
CS 248
of
fi
cesmi
ti
gat
ethepr
obl
em ofmor
alhazar
d?
Howt
headv
ersesel
ect
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em i
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fect
edbyI
nter
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I
fthesear
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scompet
it
ivel
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pr
edi
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oumakeaboutpr
icesi
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smar
ket
?
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sopt
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chr
ulesay
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heut
il
izat
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esour
ces?
Doi
nter
medi
ari
eshav
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opl
ayi
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cact
ivi
ti
esi
nmar
keteconomy
?What
ar
ethei
ract
ivi
ti
es?
Suggest
edr
eadi
ngs
Ni
chol
son,
w:Mi
croeconomi
ctheor
y;basi
cpr
inci
pleandext on.5thedi
ensi ti
on
Sal
vat
ore,
D(2003)
:Mi
croeconomi
cs;
theor
yandappl
icat
i 4thedi
ons. ti
on
Mansf
iel
d,[Link],
G(2000)
:Mi
croeconomi
cs,
theor
yandappl
icat
i 10thedi
ons. ti
on
Var
ian,
[Link]
l(1999)
:Int
ermedi
atemi
cr cs3rdedi
oeconomi ti
on
Pi
ndy
ck,
[Link]
nfel
d,D.
L.(
2003)
:Mi
cr cs.6thedi
oeconomi ti
on
Kout
soy
ianni
sA.(
1985)
:Moder
nmi
cr cs2ndedi
oeconomi ti
on.

ADAMAUNI
VERSI
TYDEPARTMENTOFECONOMI
CS 249

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