INTERMEDIATE MICROECONOMICS II : MARKET, GOVERNMENT AND WELFARE

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 Syllabus
Intermediate Microeconomics II: Market, Government and Welfare

Syllabus Mapping
UNIT I: Monopoly Lesson 1: Pricing under
Monopoly pricing, Inefficiency, Price discrimination, Regulation. Monopoly Markets
(Pages 3–25)
Lesson 2: Price
Discrimination and
Bundling in Monopoly
(Pages 26–42)
UNIT II: General equilibrium Lesson 3: General
Exchange economy, Robinson Crusoe economy, Pareto optimality, Welfare Equilibrium and Market
theorems, Welfare and social choice. Efficiency
(Pages 45–70)
UNIT III: Models of Monopolistic Competition Lesson 4: Monopolistic
Firms with differentiated products, mark-up, short-run and long-run Competition
equilibrium. (Pages 73–90)
UNIT IV: Externalities Lesson 5: Externalities
Market inefficiency under externalities, Pigou tax, Coase theorem, Market (Pages 93–111)
creation and other solutions.
UNIT V: Public Good Lesson 6: Public Good
Inefficiency of market equilibrium, Optimal public good provision, Free (Pages 115–135)
rider problem, Lindahl taxes.

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Intermediate Microeconomics II_Syllabus.indd 2 05-10-2024 [Link]
 Contents

PAGE

UNIT-I
Monopoly
Lesson 1: Pricing under Monopoly Markets 3–25
Lesson 2: Price Discrimination and Bundling in Monopoly 26–42

UNIT-II
General Equilibrium
Lesson 3: General Equilibrium and Market Efficiency45–70

UNIT-III
Model of Monopolistic
Lesson 4: Monopolistic Competition 73–90

UNIT-IV
Externalities
Lesson 5: Externalities93–111

UNIT-V
Public Good
Lesson 6: Public Good 115–135

Glossary137–142

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Intermediate Microeconomics II_Content.indd 2 05-10-2024 [Link]
 UNIT - I
Monopoly

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 L E S S O N

1
Pricing under Monopoly
Markets
Dr. Ruhee Mittal
Assistant Professor
Department of Economics
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Meaning and Kinds of Monopoly
1.4 Why do Monopolies Exist?
1.5 The Monopolist’s Profit Maximization Problem
1.6 Linear Demand Curve and Monopoly
1.7 Markup Pricing Under Monopoly
1.8 Lerner Index
1.9 Social Cost of Monopoly – Dead Weight Loss
1.10 Multiplant Monopoly
1.11 Summary
1.12 Answers to In-Text Questions
1.13 Self-Assessment Questions
1.14 Suggested Readings

1.1 Learning Objectives

‹ ‹Students will be able to define a monopoly and list its key characteristics.
‹ ‹Students will be able to explain the concept of a linear demand curve and how it
applies to monopoly pricing.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes ‹ ‹Students will be able to calculate the markup price using the price
elasticity of demand and marginal cost.
‹ ‹Studentswill be able to define the Lerner Index and calculate it to
measure the degree of monopoly power.
‹ ‹Students will be able to explain the concept of deadweight loss and
how it results from monopoly pricing.

1.2 Introduction
There exist various market structures within which firms operate. At one
extreme lies perfect competition, characterized by numerous buyers and
sellers offering identical products, with no barriers to entry or exit. Here,
prices are determined by the intersection of market demand and supply,
with all firms accepting the fixed price set by the industry, making them
price takers devoid of control over pricing, as the industry acts as the
price maker. On the other end of the spectrum is monopoly, where a single
seller dominates the market, often erecting barriers to entry for potential
competitors. In this scenario, the firm essentially encompasses the entire
industry, affording the monopolist the freedom to set prices and quanti-
ties that maximize profits, albeit constrained by the elasticity of demand.
Assessing the extent of a monopolist’s power is crucial, as it correlates
with the societal costs borne due to the monopoly’s presence, such as
deadweight loss incurred when high prices or reduced quantities diminish
market demand. Unregulated pure monopolies are typically restricted by
governments, as they may exploit their dominance to the detriment of
societal welfare, necessitating regulations to curb such exploitation.

1.3 Meaning and Kinds of Monopoly

The term “monopoly” originates from “Mono + Polein,” where “mono”
denotes single and “polein” means to sell, defining a market structure
wherein a lone seller offers a product without any close substitutes, cou-
pled with barriers to entry. The absence of competing firms underscores
the convergence of firm and industry in monopoly scenarios.
Features of Monopoly: Above definition of a monopoly reveals the
following characteristics of a monopolist:

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1. Single Seller: Monopoly entails a sole seller, blurring the distinction Notes
between firm and industry. The monopolist determines prices and
quantities to maximize profits, with the flexibility to prioritize either
variable—price or quantity—while the other is dictated by market
forces.
2. No Close Substitutes: A monopolist must offer a unique product to
maintain long-term dominance, lacking viable substitutes.
3. Barriers to Entry: Monopolies often yield supernormal profits due
to obstacles hindering new entrants, ensuring sustained profitability
unlike in perfect competition.
4. Goal of Profit Maximization: The primary objective of a monopolist
is profit maximization, guiding its pricing and production decisions.
5. Absence of Supply Curve: Unlike perfect competition’s direct
price-quantity relationship, monopoly’s supply depends on demand
elasticity and marginal cost shape, allowing for varied quantities
at identical prices or vice versa, negating the presence of a supply
curve.

1.4 Why do Monopolies Exist?

Monopolies typically establish prices higher than those in perfectly
competitive industries, consequently diminishing consumer welfare. It’s
natural to wonder: Why monopolies persist despite their negative societal
impact? Various barriers hinder new entrants from challenging established
firms in the market.
‹ ‹Structural Barriers: Structural barriers often provide incumbents
with cost or demand advantages that discourage potential competitors.
For instance, incumbent firms may benefit from superior technology
or a large base of loyal customers. Consider the water and natural
gas distribution sector, where significant fixed costs deter new
entrants, but servicing each additional customer incurs relatively
low costs. This scenario, characterized by decreasing average
costs with increased output, is termed a “natural monopoly” due
to the inherent economies of scale. Similarly, demand advantages
can fortify incumbents’ positions. For example, online giants like
Amazon or eBay attract a vast number of customers who default

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes to their platforms for purchases, posing challenges even for large
retailers like WalMart to compete effectively online.
‹ ‹Legal Barriers: Legal barriers also contribute to monopolistic
conditions, as some countries enact laws that protect monopolies.
Examples include restrictions on new telephone companies’ operations
or the granting of patents, preventing competitors from using
patented products or processes. Pharmaceutical firms, for instance,
may patent new drugs, enabling them to monopolize their sale for
a specific period, often resulting in exorbitant prices for patented
medications.
‹ ‹Strategic Barriers: Strategic barriers, independent of legal or
structural constraints, arise when incumbent firms employ tactics
to discourage new entrants, such as initiating price wars against
newcomers. By establishing a reputation as formidable competitors,
incumbents dissuade potential rivals from entering the market. An
illustration of this strategy occurred with the price war between
United Airlines and Frontier Airlines on the Billings, Montana to
Denver, Colorado route in 1994. After sustaining the conflict for a
year, Frontier Airlines withdrew, leaving United as the sole provider
on the route, allowing them to promptly increase prices thereafter.

1.5 The Monopolist’s Profit Maximization Problem

In a monopolized market, a single firm dictates the level of output, result-
ing in the alignment of individual and aggregate outputs (i.e., q = Q),
given the absence of other competitors. Consequently, fluctuations in out-
put q directly impact market prices, as indicated by the inverse demand
function p(q), which diminishes with increasing output q.
A typical illustration of this is the linear inverse demand equation p(q) =
a − bq, where a and b are positive constants. Visually, this inverse demand
curve originates at point a and slopes downwards at a rate determined
by b, intersecting the horizontal axis at ab.
Essentially, when the monopolist sells few units (low values of q), con-
sumers are willing to pay a relatively high price for the scarce good. As
the firm offers more units (larger values of q), consumers are willing to
pay less for the relatively abundant good.

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We express the monopolist PMP as follows: The monopolist chooses its Notes
output q to maximize its profits π:

(i)

Solving the monopolist problem: Differentiating the profit in the equation

(i) with respect to the monopolist’s output q, we obtain:

Or, rearranging,
Marginal revenue,

Marginal Cost, MC(q)

Hence, in order to optimize its profits, the monopolist expands its output
q until the marginal revenue from selling an extra unit aligns with the
marginal cost incurred in producing it. If, conversely, MR(q) > MC(q),
the monopolist remains motivated to increase output q as revenue growth
outpaces costs. Conversely, if MR(q) < MC(q), the monopolist is incen-
tivized to reduce output q.
From the above results the Marginal Revenue is calculated by:

Marginal revenue,

To understand this expression, consider that the monopolist increases its

output by 1 unit. This additional unit produces two effects on the firm’s
revenue (one positive and one negative), as indicated in the expression
for MR(q):
Positive Effect on MR(q): If the firm sells one more unit, it earns the
price p(q) for that unit. This is reflected in the first (positive) term in
MR(q), indicating an increase in the firm’s revenue.
Negative Effect on MR(q): However, to sell one more unit, the firm
must reduce the price of all units sold. This is represented by the second
term in MR(q), which is negative because ∂p(q)/∂q < 0. Intuitively, this
negative effect arises because the market becomes overloaded with new
products and the monopolist is forced to sell the new units at a lower
price. Because the firm sets a uniform price for all its units, the price

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Notes decrease required to sell an additional unit, indicated by ∂p(q)/∂q, must

be applied to all units sold, q. This price reduction results in a revenue
loss of ∂p(q)/∂q * q for the monopolist.
Thus, increasing output has both positive and negative effects on the
firm’s marginal revenue. The overall impact of these effects must balance
out the additional costs of producing one more unit, which means that
MR(q) must equal MC(q).

Numerical Question 1.1:

Consider a monopoly with an inverse demand function given by (q) =
10 − 3q. If the firm marginally increases its output, the marginal
revenue (MR) becomes:
MR(q) = (10 − 3q) + (−3)q = 10 − 6q
where p(q) = 10 − 3q and ∂p(q)∂q = −3. If the firm sells q = 2 units,
its total revenue (TR) is:

TR(2) = p(2) × 2 = (10 – 3 × 2) × 2 = 4 × 2 = Rs. 8

Evaluating the marginal revenue at q = 2q = 2 units yields:

MR(2) = p(2) + (−3) × 2 = 4 – 6 = −Rs. 2

Given the inverse demand function (q) = 10 − 3q, the price when the
monopolist sells 2 units is p(2) = 10 − (3 × 2) = Rs. 4. Intuitively,
M(2) = 4 − 6 indicates that the monopolist’s total revenue experiences
a positive effect of Rs. 4 from selling one additional unit at a price
of Rs. 4. However, there is also a negative effect, as selling one more
unit requires applying a price discount of Rs. 3 on all previous units.
Overall, these two effects result in a net decrease in total revenue of
Rs. 2.

1.6 Linear Demand Curve and Monopoly

Let’s consider a scenario where a monopolist is confronted with a linear
demand curve expressed as
p(y) = a − by.

This implies that as the quantity y increases, the price p(y) decreases linearly.
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 Pricing under Monopoly Markets

The corresponding revenue function can be derived by multiplying the Notes

price p(y) by the quantity y, yielding

r(y) = p(y)y = ay − by

The marginal revenue function, which signifies the change in revenue

resulting from a one-unit change in quantity, is then determined as

MR(y) = a – 2by.
It’s worth noting that the marginal revenue function shares the same
vertical intercept, a as the demand curve, but it’s twice as steep. This
simplifies the process of plotting the marginal revenue curve. By halving
the horizontal intercept of the demand curve and maintaining the vertical
intercept, we can easily sketch the marginal revenue curve by connecting
these two points with a straight line.
Understanding the relationship between the demand curve and the mar-
ginal revenue curve is crucial in analyzing the monopolist’s behavior and
pricing strategies in response to changes in quantity and price (Figure 1.1)

Figure 1.1: Monopoly with the Linear Demand Curve

(Source: H.L. Varian)

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Notes
1.7 Markup Pricing Under Monopoly
In a monopoly, the firm has significant control over the price of its
product because it is the sole producer in the market. This market power
allows the monopolist to use markup pricing to maximize profits. Markup
pricing refers to the practice of setting a price that includes a certain
percentage above the marginal cost of production. This is possible due
to the lack of competition, allowing the monopolist to influence market
prices to its advantage.

1.7.1 Determination of Markup Price

The monopolist sets its price based on the relationship between marginal
cost (MC) and the price elasticity of demand (ϵϵ). The price elasticity of
demand measures how responsive the quantity demanded is to changes in
price. The formula for the markup price in a monopoly is derived from
the profit-maximizing condition where marginal revenue (MR) equals
marginal cost:

MR = MC

Marginal revenue can be expressed in terms of price and elasticity as

follows:

Substituting MR into the profit-maximizing condition gives:

Solving for P (price), we get:

1.7.2 Interpretation of Markup Pricing

Elastic Demand (|ϵ| > 1): When the demand is elastic, consumers are
highly responsive to price changes. A small increase in price leads to a

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larger percentage drop in quantity demanded. Therefore, the monopolist Notes

sets a lower markup because increasing the price significantly would
cause a substantial reduction in sales volume.
Inelastic Demand (|ϵ| > 1): When the demand is inelastic, consumers
are less responsive to price changes. A price increase results in a smaller
percentage decrease in quantity demanded. In this case, the monopolist
can set a higher markup because the reduction in quantity demanded will
be relatively small, allowing for greater profit margins.

1.8 Lerner Index

When a monopolist operates in the elastic portion of the demand curve,
it can charge a higher margin if the demand is relatively inelastic (e.g.,
when consumers have no close substitutes) compared to when the demand
is relatively elastic (when close substitutes are available). To illustrate the
relationship between the margin (measured by the difference p − M(q)
and the price elasticity (ϵq, p), we start by recalling the profit-maximizing
condition for a monopolist, which is MR(q) = MC(q). Alternatively, this
can be expressed as:
The Lerner Index is a measure of market power used in monopolies. It
indicates the extent to which a monopolist can set prices above marginal
cost. The formula for the Lerner Index is: Lerner Index =

Interpretation of Lerner Index: If the Lerner Index is 0, it means that

the monopolist is pricing at marginal cost, indicating perfect competition.
‹ ‹If the Lerner Index is between 0 and 1, it signifies that the monopolist
is exercising market power by setting prices above marginal cost.
The higher the index, the greater the degree of market power.
‹ ‹If the Lerner Index is 1, it indicates that the monopolist is pricing
at twice the marginal cost, showing significant market power.
‹ ‹If the Lerner Index is greater than 1, it implies that the monopolist
is pricing at a level even further above marginal cost, reflecting
considerable market dominance.
The Lerner Index provides valuable insights into the pricing behavior of
monopolies and the level of competition in the market. It helps assess the
efficiency and fairness of pricing strategies in monopolistic industries.

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Notes Numerical Question 1.2: Consider a monopolist with a marginal cost

(MC) of $10 and a price elasticity of demand (e) of −2. Calculate price
and Lerner Index:
Price:

Lerner Index

Lerner Index

This indicates that the monopolist is able to set a price that is twice
the marginal cost, reflecting significant market power and a relatively
inelastic demand.
Inefficiency of Monopoly
In a competitive industry, equilibrium occurs where the price equals the
marginal cost of production. However, in a monopolized industry, the
price is typically set higher than the marginal cost. As a result, the price
is elevated, and the output is lower compared to a competitive market
structure. This discrepancy means that consumers often experience a
decrease in welfare in a monopoly compared to a competitive market.
Conversely, the monopolist benefits from this situation, experiencing
higher profits due to the ability to set prices above marginal cost. When
considering the welfare of both consumers and firms, it becomes ambig-
uous whether competition or monopoly is a preferable arrangement. This
ambiguity suggests that value judgments about the relative welfare of
consumers and firm owners are necessary.
However, from the perspective of efficiency alone, there are arguments
against monopoly. Consider a scenario where a monopolist is forced to
behave competitively, setting output at a level determined by market
price. Alternatively, the monopolist maximizes profits by considering its
influence on market price and adjusting output accordingly.
Comparing the competitive output level (y) and price (pc) with the monop-
oly output level (ym) and price (pm) we can assess Pareto efficiency.i
Pareto efficiency is achieved when there is no way to make anyone better
off without making somebody else worse off. In the case of a monopoly,

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the inverse demand curve (p(y)) indicates that people are willing to pay Notes
more for an additional unit of the good than it costs to produce it (p(y) >
MC(y)). This suggests a potential for Pareto improvement.
Pareto efficiency is achieved when there is no way to make anyone better
off without making somebody else worse off. In the case of a monop-
oly, the inverse demand curve (p(y)) indicates that people are willing to
pay more for an additional unit of the good than it costs to produce it
(p(y) > MC(y)). This suggests a potential for Pareto improvement.
For instance, at the monopoly output level (y) where p(ym) > MC(ym ),
there exists someone willing to pay more for an extra unit of output than
it costs to produce. By producing and selling this extra unit at a price
(p) where p(ym) > p > MC(y)p(ym) > p > MC(ym), both the consumer and
the monopolist benefit. The consumer gains surplus because they were
willing to pay more for the unit than its actual price, while the monopolist
earns additional profit by selling at a price higher than the marginal cost.
The inefficiency in monopoly arises from the monopolist’s consideration
of the revenue from inframarginal units when determining output levels.
In a competitive market, firms only compare the willingness to pay for an
additional unit with the cost of producing it. However, a monopolist also
considers the impact of increasing output on revenue from inframarginal
units, leading to output levels that deviate from the efficient outcome.

Figure 1.2: Inefficiency of Monopoly

(Source: Hall, 2010, 8th Edition)
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Notes
1.9 Social Cost of Monopoly – Dead Weight Loss
In perfect competition, a firm sells its product at the point where the
price (P) equals the marginal cost (MC), resulting in no cost to society.
However, a monopolist sells at a price higher than its marginal cost, as
illustrated in Figure 1.3. In perfect competition, the industry’s demand
curve is downward-sloping, and the supply curve, derived from the sum-
mation of individual marginal cost curves, is upward-sloping. The industry
reaches equilibrium where demand equals supply, yielding a quantity of
OQpc at a price of OPpc. In contrast, under monopoly, equilibrium occurs
where marginal revenue equals marginal cost, depicted by point A in the
figure, with the monopolist selling a quantity of OQm at a price of OPm.
It’s evident that a monopolist sells a smaller quantity compared to perfect
competition, and at a higher price, resulting in societal costs (Figure 1.3).

Figure 1.3
There are two costs that arise because of monopoly:
1. Dead Weight Loss
2. Rent Seeking
3. Price Regulation

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Dead Weight Loss: Deadweight loss refers to the overall loss incurred Notes
by society, encompassing both producers and consumers. Understanding
this concept requires an examination of consumer surplus and producer
surplus and how they are affected by the presence of monopoly power.
Consumer Surplus: This represents the disparity between the price con-
sumers are willing to pay and the price they actually pay for a good or
service. Graphically, it is depicted as the area between the demand curve
and the equilibrium price.
Producer Surplus: This denotes the discrepancy between the price
received by producers and the price at which they are willing and able
to sell their goods or services. Graphically, it is illustrated as the area
between the equilibrium price and the marginal cost (supply) curve.
To observe the changes in consumer and producer surplus resulting from
the transformation of a perfectly competitive industry into a monopoly,
assuming identical demand and cost conditions, we refer to Figure 1.4.

Table 1.1
Consumer Surplus Producer Surplus
Perfect Competition (Before) A + B + C + D + E F + G + H
Monopoly (After) A+ B C + D + F + G
Change (After – Before) – C – D – E C + D – H
Net Change = – C – D – E + C + D – H = – H – E = Dead weight loss

Figure 1.4
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Notes Initially we assume that there is perfect competition in the market.

Here demand curve is AR and supply curve is given by Mc, equilib-
rium is where demand and supply curve intersect which is given by
Epc. Equilibrium quantity is Qpc and price is Ppc. Here the consumer
surplus and producer surplus is given in the table below. Now if all
the firms under perfectly competitive industry are undertaken by a
monopolist assuming that demand and cost conditions remain same,
the equilibrium is obtained by intersection of MR and MC which is at
Em giving equilibrium quantity as Qm and price as Pm. It can be seen
that monopolist is selling a lesser quantity and that too at a higher
price. The new consumer surplus and producer surplus is shown in
Table 1.1. To find out whether consumers or producers are at loss or
gain we calculate the change in consumer and producer surplus. It is
seen that consumer surplus has reduced by C + D + E, the reduction of
C + D being because of a higher price that consumers now have to pay
while reduction in E is because of reduction in the quantity as now few
consumers have to do without the commodity. Producer surplus on the
other hand has increased by C + D but reduced by H. The increase of
C + D is because of higher price that producers get now; it is actually
just a transfer from consumers to producers (a zero sum game) and
loss in H is because of reduction in quantity that producers sell now.
To find out whether society as a whole is at gain or loss, we add the
change in consumer and producer surplus and find out that society at
large is at a loss of H + E, this being the dead weight loss or cost to
the society because of monopoly.
Rent Seeking: Rent-seeking behavior often leads to a social cost of
monopoly power that exceeds the deadweight loss shown in triangles E
and H of Figure 1.4. This is because firms spend substantial resources
on activities that are socially unproductive, aimed at obtaining, maintain-
ing, or exercising their monopoly power. These activities may include
lobbying efforts and campaign contributions to influence government
regulations that hinder the entry of new competitors. Rent-seeking also
involves advertising campaigns and legal strategies to avoid antitrust
actions. Additionally, firms might invest in excess production capacity
that remains unused, serving as a deterrent to potential competitors. The
economic justification for rent-seeking expenses is tied to the benefits of
monopoly power (represented by rectangle C + D – H). Therefore, the

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 Pricing under Monopoly Markets

larger the wealth transfer from consumers to the firm (shown by rectangle Notes
C + D), the higher the societal cost of monopoly power.
For example, in 1996, the Archer Daniels Midland Company (ADM)
successfully lobbied the Clinton administration to enforce regulations
requiring that ethanol in motor vehicle fuel be made from corn. Despite
ethanol being chemically identical regardless of its source—whether corn,
potatoes, or grains—the regulation favored corn-based production. This
benefited ADM, which nearly monopolized corn-based ethanol production,
thus increasing its monopolistic gains.
Price Regulation: To address the societal impact of monopolies, antitrust
laws aim to limit excessive monopoly power, a topic discussed later in
this chapter. Here, we examine an alternative government approach to
control monopoly power—price regulation. In a competitive market price
regulation typically results in a deadweight loss. However, with a monop-
olistic firm, price regulation can reduce the deadweight loss associated
with monopoly power.
Figure 1.5 illustrates price regulation. Without regulation, the market
equilibrium is at price Pm and quantity Qm​, where marginal revenue equals
marginal cost. Suppose the price is capped at P1P1. To determine the
firm’s profit-maximizing output under regulation, we examine the new
average and marginal revenue curves.
With the price cap, the firm can charge no more than P1​ for quantities
up to Q1​, creating a horizontal average revenue curve at P1​. Beyond Q1,
the original average revenue curve applies. The new marginal revenue
curve aligns with this new average revenue curve, as shown in Figure 1.5.
To maximize profit, the firm should produce at quantity Q1​, where the
new marginal revenue curve intersects the marginal cost curve, reducing
the deadweight loss from monopoly power.
As the price cap decreases, the quantity supplied increases, further reducing
the deadweight loss. When the price is set at Pc​, where average revenue
intersects marginal cost, output reaches the competitive level, eliminating
deadweight loss. If the price drops further, to P 3​ for instance, it causes
a quantity reduction similar to a price ceiling in a competitive market,
resulting in a shortage. If the price continues to fall below P4​, the firm
incurs losses and may exit the market.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes

Figure 1.5: Price Regulation under Monopoly

(Source: Pindyck and Rubinfeld, 8th Edition, 2013)

Numerical Question 1.3: Consider a monopolist who faces a linear

demand curve P = 100 − 2Q and a cost function C(Q) = 20Q, where
P is the price, Q is the quantity, 100 and 2 are constants from the
demand curve, and 20 is the constant marginal cost.
If the monopolist perfectly discriminates prices, then:
(a) How much output will the monopolist produce, and how much
profit will he generate?
(b) What is the total profit when he charges a single price?
(c) Calculate the deadweight loss when a single price is charged by
this monopoly.
(d) What is the deadweight loss under perfect price discrimination? Why?

Solution:
(a) Perfect Price Discrimination:
Under perfect price discrimination, the monopolist charges each con-
sumer their maximum willingness to pay. The monopolist will produce
the output where the price equals the marginal cost.

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 Pricing under Monopoly Markets

Demand curve: P = 100 − 2Q Notes

Marginal cost: MC = 20
Setting P = MC = 100 − 2Q = 20
Solving for Q: 2Q = 80, Q = 40
The monopolist produces 40 units.
The profit under perfect price discrimination is the area under the
demand curve minus the total cost.
Total revenue under perfect price discrimination is the integral of the
demand function from 0 to Q:

Total cost is: TC = 20Q = 20 × 40 = 800

Profit: Π = TR − TC = 2400 − 800 = 1600
(b) Single Price Monopoly: For a single price monopolist, marginal
revenue (MR) equals marginal cost (MC). The total revenue
TR = P × Q = (100 − 2Q)Q = 100Q − 2Q2
Marginal revenue is

Setting MR = MC: 100 − 4Q = 20

Solving for Q: 4Q = 80 = 20
The monopolist produces 20 units and charges a price P = 100 − 2Q:
P = 100 – 2 × 20 = 60
Total revenue: TR = P × Q = 60 × 20
TC = 20Q = 20 × 20 = 400
Profit: Π = TR − TC = 1200 − 400 = 800
(c) Deadweight Loss with Single Price Monopoly:
Deadweight loss (DWL) is the loss in total surplus compared to the
perfectly competitive outcome.
Perfect competition output: QPC where P = MC: 100 − 2Q = 20
QPC = 40

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes (d) DWL is the area of the triangle formed between the demand
curve and the MC curve from the single price monopoly quantity
to the perfectly competitive quantity:

(e) Deadweight Loss under Perfect Price Discrimination:

Under perfect price discrimination, there is no deadweight loss because
the monopolist produces the same output as in perfect competition,
Q = 40, capturing all consumer surplus as profit.
DWL = 0 under perfect price discrimination because the monopolist can
capture the entire area under the demand curve up to the competitive
quantity, ensuring no loss in total surplus.
In summary, the monopolist produces 40 units under perfect price dis-
crimination with a profit of 1600. Under single pricing, the monopolist
produces 20 units with a profit of 800, and the deadweight loss is 400.
Under perfect price discrimination, there is no deadweight loss.

Regulation in Practice:
In the competitive scenario (denoted as Pc in Figure 1.5), the market
equilibrium occurs where the firm’s marginal cost intersects the average
revenue (demand) curve. Similarly, in the case of a natural monopoly, the
minimum feasible price (represented as Pr in Figure 1.6) is determined
where the average cost intersects the demand curve. However, accurately
pinpointing these prices in practice is often challenging due to shifts in
the firm’s demand and cost curves as market conditions evolve.
Price

Pm

AC
Pr

Pc MC

MR AR

Qm Qr Qc Quantity

Figure 1.6
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 Pricing under Monopoly Markets

Consequently, the regulation of monopolies frequently resorts to evalu- Notes

ating the return on capital invested. Regulatory agencies set a maximum
allowable price to ensure a competitive or fair rate of return, a practice
known as rate-of-return regulation. This maximum price is based on the
expected rate of return the firm will achieve.
However, implementing rate-of-return regulation presents difficulties. Valuing
a firm’s capital stock accurately poses a challenge, and determining a “fair”
rate of return hinges on the actual cost of capital, which is influenced by
regulatory agency behavior and investor perceptions of future allowed rates
of return. Disputes over these calculations often result in delays in regulatory
responses to changes in costs and market conditions, leading to lengthy and
costly regulatory proceedings. Consequently, lawyers, accountants, and eco-
nomic consultants typically benefit from such delays, perpetuating regulatory
lag—significant delays, often exceeding a year, in adjusting regulated prices.
Alternatively, another regulatory approach involves setting price caps
based on various factors such as the firm’s variable costs, historical
prices, inflation rates, and productivity growth. Price caps offer more
flexibility than rate-of-return regulation. Under this system, firms are
typically allowed to adjust prices annually based on factors like actual
inflation rates minus expected productivity growth.
By the 1990s, the regulatory landscape in the United States underwent substan-
tial changes. Deregulation occurred in many parts of the telecommunications
industry and electric utilities in numerous states. With scale economies largely
exhausted and technological advancements facilitating easier entry by new
firms, the perception of these industries as natural monopolies diminished.

1.10 Multiplant Monopoly

A multiplant monopoly is one where the firm carries production at two
different plants with difference in the cost structure. Thus the monopolist
is faced with two questions: How much total output is to be produced
and secondly how to allocate this output amongst multiple plants. It can
be derived mathematically as:
Let there be two plants namely Plant 1 and Plant 2 with cost of production
being C1 and C2 respectively. Total profits can be calculated as:
Total Profit = Total Revenue – Total Cost
TP = P*QT – C1*Q1 – C2*Q2
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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Where P = Price at which output is sold

QT = T
 otal output being produced by the monopolist C1 = Average cost
of production at Plant 1.
C2 = A
 verage cost of production at Plant 2.
To maximize profits we take the first differentiation and put it equal to zero.
∆TP/∆Q1 = MR – MC1 = 0 (on differentiating w.r.t. Q1)
MR = MC1 (1)
Similarly
∆TP/∆Q2 = MR – MC2 = 0 (on differentiating w.r.t. Q2)
MR = MC2 (2)
From (1) and (2) we get
MR = MC1 = MC2
In Figure 1.7, AR and MR show the demand curve and marginal revenue
curve that the monopolist faces. MC1 and MC2 are the corresponding
marginal cost curves of Plant 1 and Plant 2. Total Marginal cost curve
is obtained by horizontal summation of the MC1 and MC2.

Figure 1.7
Equilibrium is obtained where MR and MCT intersect, it is at point E
where total output being sold by the monopolist is OQT at a price of
OP*. This total output is allocated to two plants by drawing a line from
E towards Y axis and where it intersects MC1 and MC2 from there we

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 Pricing under Monopoly Markets

draw perpendiculars to X axis to get the output to be produced at these Notes

plants respectively. Thus we get OQ1and OQ2 that would be produced at
plant 1 and plant 2 such that the equilibrium condition is being satisfied.

MR = MC1 = MC2

IN-TEXT QUESTIONS
1. In case of perfect competition there is no monopoly power. (True/
False)
2. Firms can easily enter in a monopoly market structure. (True/
False)
3. A monopoly firm always earns supernormal profits even in the
short run. (True/False)
4. A monopolist can determine the price at which it sells the
commodity as well as the number of units it wants to sell.
(True/False)
5. The objective of a monopolist is to maximize profits. (True/
False)
6. The higher is the elasticity of demand curve the more is the
monopoly power. (True/False)
7. There is no supply curve in case of monopoly. (True/False)
8. Lerner’s Index is a tool to measure ____________.
9. In case of perfect competition the gap between price and marginal
cost is ____________.
10. A monopolist firm is the price ____________.
11. There is ____________ of supply curve in case of monopoly.

1.11 Summary
This chapter delves into the intricacies of monopoly power and the regu-
latory mechanisms employed to mitigate its adverse effects. It begins by
elucidating the inefficiencies inherent in monopolistic markets, where firms
possess significant market power, leading to higher prices, reduced output,
and allocative inefficiency. The concept of deadweight loss is explored,

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes highlighting the loss in economic welfare resulting from monopolistic

pricing strategies.
Moreover, the chapter examines various regulatory approaches to curb
monopoly power. Rate-of-return regulation, based on ensuring a competitive
rate of return on capital, and price cap regulation, allowing flexibility in
pricing adjustments, are discussed. However, both approaches encounter
challenges, including difficulties in valuing capital stock and determining
fair rates of return, leading to regulatory delays and complexities.
The chapter also elucidates the evolving regulatory landscape, particu-
larly in the United States, where deregulation initiatives in sectors like
telecommunications and electric utilities have reshaped the perception
of natural monopolies. Technological advancements and the exhaustion
of scale economies have facilitated easier market entry, reducing the
necessity for stringent regulation in certain industries.
Overall, the chapter emphasizes the importance of balancing market effi-
ciency with regulatory intervention to foster competition, innovation, and
consumer welfare in monopolistic markets. It underscores the ongoing
evolution of regulatory frameworks to adapt to changing market dynamics
and promote economic efficiency.

1.12 Answers to In-Text Questions

1. True
2. False
3. False
4. False
5. True
6. False
7. True
8. Monopoly Power
9. Zero
10. Maker as well as taker
11. Absence

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 Pricing under Monopoly Markets

Notes
1.13 Self-Assessment Questions
1. Discuss the different types of monopolies and the barriers to entry
that contribute to their existence. Provide examples to illustrate
your points.
2. Explain the concept of markup pricing under monopoly. How does
the price elasticity of demand influence the markup price? Use
diagrams to support your explanation.
3. Analyze the social cost of monopoly, focusing on deadweight loss.
How does monopoly pricing lead to a reduction in consumer surplus
and overall economic welfare? Include a discussion of the Lerner
Index and its significance.

1.14 Suggested Readings

� Munoz-Garaia, Felix. (2017). Practice Exercises for Advanced
Microeconomics Theory. MIT Press.
� Dunaway, Eric; Strandholm, John C., Espinola-Arredondo, Ana and
Munoz-Garcia, Felix. (2020). Practice exercises for Intermediate
Microeconomic Theory. MIT Press.

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 L E S S O N

2
Price Discrimination and
Bundling in Monopoly
Dr. Ruhee Mittal
Assistant Professor
Department of Economics
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Price Discrimination
2.4 First Degree Price Discrimination
2.5 Second Degree Price Discrimination
2.6 Third Degree Price Discrimination
2.7 Peak Load Pricing
2.8 Inter-temporal Pricing
2.9 Bundling
2.10 Summary
2.11 Answers to In-Text Questions
2.12 Self-Assessment Questions
2.13 Suggested Readings

2.1 Learning Objectives

‹ ‹Understand the concept of price discrimination among monopolist firms.
‹ ‹Understand the concept of bundling among the monopolist firms.

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 Price Discrimination and Bundling in Monopoly

Notes
2.2 Introduction
This chapter explores how firms enhance their profits by charging varying
prices to different consumer groups based on their demand characteristics,
purchase timing, location, or quantities bought. The chapter delves into
three specific types of price discrimination. First-degree (or perfect) price
discrimination involves firms setting personalized prices for each con-
sumer, matching their maximum willingness-to-pay (WTP). Second-degree
price discrimination offers quantity discounts, while third-degree price
discrimination targets different consumer groups, such as students and
nonstudents, with distinct pricing.
All forms of price discrimination boost profits, with first-degree price
discrimination yielding the highest increase as it captures the entire
consumer surplus, converting it into profit for the firm. However, this
method is challenging to implement because it requires comprehensive
knowledge of each consumer’s WTP, unlike second- and third-degree
price discrimination which require less detailed information.
The chapter concludes with an examination of bundling strategies, a com-
mon practice where a combination of products is offered at a discounted
price compared to purchasing each item separately. For example, buying
a computer bundle including the monitor and CPU usually costs less than
buying each component individually. The analysis focuses on determining
when bundling is a profitable strategy for sellers various types of price
discrimination and bundling options that a monopolist can exercise.

2.3 Price Discrimination

Monopolists and firms with market power can achieve substantial profits. A
natural question arises: Can they do even better? The answer, as explored
in this chapter, is “Yes.” To illustrate, consider the monopolist’s decision
process shown in Figure 2.1. By selecting an output level where marginal
revenue equals marginal cost (MR = MC), the monopolist sets a single
price, pM, for all customers. This approach misses two profit opportunities:
1. Some customers are willing to pay more than pM​, as indicated by
the segment of the demand curve to the left of pM, where p > pM.
The monopolist could charge these customers higher prices, increasing
profit margins.
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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes 2. Other potential buyers are not willing to pay pM but would pay more
than the marginal cost (MC) of producing the good. By charging a
price between pM and MC, the monopolist could earn an additional
profit per unit (Figure 2.1).

Figure 2.1: Figure showing Room for Larger

Profits among Monopolists
These points reveal that a monopolist could boost profits by charging
different prices to different customers, known as price discrimination.
This section examines three types of price discrimination:
1. First-degree Price Discrimination: The monopolist charges each
customer their maximum willingness-to-pay (WTP).
2. Second-degree Price Discrimination (Non-linear Pricing): The
monopolist offers quantity discounts to buyers purchasing larger amounts.
3. Third-degree Price Discrimination: The monopolist charges different
prices to different customer groups, each with a distinct demand curve.
Conditions for price discrimination include:
‹ ‹No Arbitrage: The product cannot be resold by customers to others,
preventing low WTP customers from buying at a low price and
reselling to high WTP customers for a profit.
‹ ‹Information about WTP: The monopolist must have some information
about customers’ WTP. While firms rarely have detailed WTP
data for every customer, they often gather enough information to
distinguish between various customer groups.
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 Price Discrimination and Bundling in Monopoly

Notes
2.4 First Degree Price Discrimination
There are two types of first degree price discrimination:
(a) Perfect and (b) Imperfect
Perfect First Degree Price Discrimination: The monopolist charges each
consumer the maximum price that he is willing to give – known as the
reservation price thereby taking away all the consumer surplus of the con-
sumers. The demand curve here itself becomes the marginal revenue curve.
Impact of perfect first degree price discrimination is shown in Figure 2.2:

Figure 2.2: Monopolist under Perfect First Degree

Price Discrimination
A single price monopolist charges OPm and sells OQm units of the
commodity by equating marginal revenue with the marginal cost. The
consumer surplus here is shown by the area APmB. Now if the monop-
olist goes for price discrimination then he would charge the maximum
price that a consumer is willing to give which is shown by the demand
curve. Thus here MR curve becomes irrelevant as demand curve itself is
the MR curve for the discriminating monopolist. The consumer surplus is
reduced to zero as whatever price the consumer is willing to give the same
is charged by the monopolist. This is highest form of discrimination as
nothing is left for the consumers as surplus. To see how the monopolist is

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes benefited by the price discrimination we calculate incremental (variable)

profits before and after the discrimination. Variable profits are calculated
as the difference between Marginal revenue and marginal cost as it is
the incremental profit and not the total profits.
Incremental profit before price discrimination is shown by the area of
triangle ACEm Incremental profit after price discrimination is shown by
the area of triangle ACEpd
Thus increase in the incremental profit = ACEpd – ACEm = Area of
triangle AEmEpd. It is shown by the shaded area in the Figure above.
However there is a limitation of perfect first degree price discrimination
that is it is very difficult if not impossible to find out the reservation price
for each and every consumer. This type of price discrimination is thus not
found in real life, what we have is imperfect first degree price discrimination.
Imperfect First Degree Price Discrimination: Because of impractical
approach of perfect first degree price discrimination where monopolist
charges different price from each consumer depending on how much he
is willing to pay, there is an alternative that is to charge a few different
prices based on the reservation prices of different groups of consumers. So
here there are certain ranges for different consumers which a monopolist
can still identify. For example a doctor can charge different fees depending
upon the locality he is operating in. It is being explained in Figure 2.3.

Figure 2.3: Monopolist under Imperfect

First Degree Price Discrimination

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A single price monopolist would have sold OQ* units and charged a Notes
single price of OP3 from all the consumers. But in case of imperfect
first degree price discrimination, monopolist sets 5 different prices that
is P1, P2, P3, P4 and P5 which is being charged from different consum-
ers on the basis of the price that they are willing to pay. This type of
discrimination is called imperfect as there is still consumer surplus left
with the consumers unlike perfect first degree discrimination. The price
is set by identifying what the marginal (last) consumer of that particular
group is willing to pay. There can be various price bands and monopoly
equilibrium price can be one of them.

2.5 Second Degree Price Discrimination

A form of price discrimination where different prices are charged from
consumers on the basis of quantity being purchased. Thus more are the
units purchased lesser is the price. This type of discrimination is followed
in case of natural monopoly where it is beneficial for a firm to cater to
the whole market to have economies of scale. Block pricing is also an
example of second degree price discrimination where prices are different
for different blocks (Figure 2.4).
With a single price to be followed a monopolist would set its output
at OQm at a price of OPm. However with price discrimination on the
basis of quantity being purchased by the consumers there are three sets
of prices that is P1, Pm and P2 for Q1, Qm and Q2 quantities respectively.
Here cost curves are not U-shaped but downward sloping as it’s the case
of a natural monopoly. Thus the last block is at a point where demand is
equal to average cost and not where demand is equal to marginal cost as
at the latter point firm would be incurring losses. Here also consumers
are left with consumer surplus and all of it is not taken away by the
monopolist as price that the consumers have to pay is less than what
they are willing to pay which is shown by the demand curve.

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Notes

Figure 2.4: Second Degree Price Discrimination

2.6 Third Degree Price Discrimination

A discrimination that charges different prices from different sub-groups
of the market for the same product with different elasticities thereby
charging a higher price in the sub-group that lower elasticity and lower
price in the sub-group having higher elasticity. It is the most common
type of price discrimination. For the firm to successfully follow third
degree price discrimination following conditions should be satisfied:
1. Firm should have some degree of monopoly power.
2. The whole market should be divisible into sub-groups that are
homogeneous amongst themselves.
3. Elasticity should be different in the different sub-groups.
4. Markets should be kept separate that is it should not be possible
for the consumers to shift themselves from one sub-market to the
other.
5. It should not be possible to transfer goods from one sub-market to
other otherwise arbitrage opportunities would eliminate the price
differential thereby making price discrimination infeasible.
Third degree price discrimination is explained with Figure 2.5 where
there are two demand curves (AR curves) and corresponding marginal
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revenue (MR) curves, AR1 is the demand curve of a subgroup which has Notes
lesser elasticity the demand curve is therefore steeper showing that this
sub group is not that responsive towards prices. MR1 is the correspond-
ing marginal revenue curve. AR2 is the demand curve of the subgroup
that has greater price elasticity and is therefore flatter showing higher
responsiveness of the group towards price changes. MR2 is the corre-
sponding marginal revenue curve. To get the equilibrium following two
mathematical conditions need to be satisfied:

Figure 2.5: Third Degree Price Discrimination

Determining Equilibrium Condition

Total Profits of the monopolist =
Total Revenue from first sub group + Total Profits from second subgroup –
Total cost TP = TR1 + TR2 – TC
To maximize profits we take the first differentiation and put it equal
to zero. Differentiation is done first with respect to Q1 and then Q2 as
follows:
∂TP/∂Q1 = ∂TR1/∂Q1 + ∂TR2/∂Q1 – ∂TC/∂Q1 = 0
= MR1 – MC = 0
= MR1 = MC (1)

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Notes Similarly w.r.t Q2

∂TP/∂Q2 = ∂TR2/∂Q2 + ∂TR2/∂Q2 – ∂TC/∂Q2 = 0

= MR2 – MC = 0
= MR2 = MC (2)

From Equations (1) and (2) we get

MR1 = MR2 = MC (Equilibrium Condition)

Thus to get the equilibrium the two marginal revenue curves are summed
up to get total marginal revenue i.e. MR Total which is a kinked curve
because of the difference in the slopes of two marginal curves. The point
where MR Total and Marginal cost (MC) curves intersect from there a
line towards Y axis is drawn and the point of intersection of this line and
marginal revenue curves (MR1 and MR2) are taken to be the equilibrium
points for the two sub-groups. In the Figure it is shown by points A and
B. To get the corresponding price and quantity of the two sub-groups we
go down to the quantity axis to get the quantities that would be sold in
each of the sub-group and up to the demand curve to get the price that
would be charged in the sub-groups. P1 is the price that would be charged
from sub-group 1 and OQ1 would be the quantity that would be sold
whereas P2 is the price to be charged from sub-group 2 and OQ2 would
be the units sold. It is also seen that P1 > P2 shows that a relatively
elastic demand curve commands a lower price as compared to relatively
inelastic one. It is shown mathematically as follows:

Determining Relative Prices

The relation between Average Revenue (AR), Marginal Revenue (MR)
and Elasticity of demand is:

MR = P(1 + 1/Ed)
Using above equation for the two sub-groups with different marginal
revenue curves and different elasticities we get:

MR1 = P1(1 + 1/Ed1) (1)

MR2 = P2(1 + 1/Ed2) (2)

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In the equilibrium MR1 = MR2, thus equating equations (1) and (2) we Notes
get: MR1 = MR2

P1(1 + 1/ Ed1) = P2(1 + 1/Ed2)

P1/P2 = (1 + 1/Ed2 )/(1 + 1/Ed1) (3)
From Equation (3) there can be two cases:

(a) If Ed1 = Ed2, then P1 = P2

(b) │Ed1 │ < │Ed2│, P1 > P2

2.7 Peak Load Pricing

Peak load pricing is a kind of discrimination where different prices are
charged at different points of time on the basis of peak period or off
peak period. It can be shown using the Figure 2.6:

Figure 2.6: Peak-load Pricing

AR1 is the demand curve for the peak period which is farther from the
origin showing a higher demand. MR1 is the corresponding marginal
revenue curve. AR2 shows demand curve for off peak period with MR2
being corresponding marginal curve. Marginal cost (MC) curve is upward
sloping showing higher cost during peak period and lower cost during
off peak period because of capacity constraints. Equilibrium is set sepa-
rately in peak period and off peak period by equating marginal revenue
with marginal cost. It gives OQ1 units in peak period at price of OP1
and OQ2 units at price of OP2. Price is more in peak period because of

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Notes higher demand. Peak load is different from third degree as here MR1 is
not equal to MR2 unlike third degree price discrimination.
Peak load pricing can also be used to bring efficiency by reducing the
demand in peak period and shifting it to off peak period. This can be
shown by comparing it with uniform pricing in Figure 2.7:

Figure 2.7

Figure above compares differential pricing (P1 in peak period and P2 in

off peak) with a uniform pricing (Pr). A pricing is efficient if it transfers
demand from peak period to off period. If there is uniform pricing which
is the average of P1 and P2 then demand in the peak period would be Q1ʹ
and in off peak period it would be OQ2. Now if there is a higher price
in peak period P1 then quantity demanded reduces to OQ1 from OQ1ʹ.
Also if price is reduced to OP2 in off peak period then demand increases
to OQ2ʹ. Net gain/loss can be calculated to see if differential pricing is
better than the uniform pricing. On an increase in the price in peak period
with reduction in quantity costs fall by the area under marginal cost curve
and benefits fall by the area under demand curve. Costs are reduced by
more than the reduction in benefits thus it is beneficial to have a higher
price rather than to have a uniform price. Similarly in off peak period
with increase in quantity, benefits increase by area below the demand
curve and costs increase by area below the MC curve. The net gains are
shown by the shaded areas showing that uniform pricing is not suitable.
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 Price Discrimination and Bundling in Monopoly

Notes
2.8 Inter-temporal Pricing
A price discrimination where the consumers are divided on the basis of
high demand and low demand by charging different prices at different
points in time. Initially the demand is only by those consumers who
are not that price sensitive and cannot or do not want to postpone the
consumption of a commodity, the demand curve is therefore relatively
inelastic. As the time passes new consumers join the demand those who
were initially not willing to buy the commodity at a higher price, the
demand curve thus becomes flatter showing relatively elastic demand.
Marginal cost is assumed to be constant showing that cost remains same
at different points of time. It is being explained in Figure 2.8:

Figure 2.8

D1 is the demand curve when the commodity is new and its price is rel-
atively high, at this point only those consumers demand the commodity
who have relatively inelastic demand. MR1 is the corresponding marginal
revenue curve. Equilibrium is at point E1 where MR1 = MC, monopolist
sells OQ1 units at a price of OP1. D2 is the demand curve at a later
point of time when even those consumers demand the commodity who are
price sensitive and have relatively elastic demand curve. Equilibrium is
at E2 where MR2 and MC intersect. Monopolist is selling OQ2 units at

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Notes a price of OP2. It can be seen that OP1 > OP2 showing that commodity
is expensive earlier and its price is reduced over a period of time. Thus
it is known as inter temporal price discrimination.

2.9 Bundling
Consider the classic 1939 film “Gone with the Wind,” which remains
popular even today. In contrast, you might not have heard of “Getting
Gertie’s Garter,” a lesser-known flop distributed by the same company, MGM
(a division of Loews). Interestingly, both films were priced in an unusual
and innovative way at the time. Movie theaters that wanted to lease “Gone
with the Wind” were also required to lease “Getting Gertie’s Garter.” This
practice, known as bundling, involved selling the two films as a package.
You might assume that the rationale behind this bundling was simply to
force theaters to lease the unpopular “Gertie” by pairing it with the highly
desirable “Gone with the Wind.” However, this explanation doesn’t fully
capture the economic reasoning. For instance, if a theater’s maximum
willingness to pay (reservation price) is $12,000 per week for “Gone with
the Wind” and $3,000 per week for “Gertie,” the most it would pay for
both films together would still be $15,000, regardless of whether they
are sold individually or as a package.
Bundling makes economic sense when customers have varying demands
and when the firm cannot price discriminate. Different movie theaters
cater to different demographics, leading to varying demand for films.
For example, theaters that attract different age groups may have patrons
with distinct film preferences.
To illustrate how a film company can leverage customer heterogeneity,
imagine there are two movie theaters with the following reservation prices
for the two films:
Theater A:
‹ ‹“Gone with the Wind”: $12,000 per week
‹ ‹“Getting Gertie’s Garter”: $2,000 per week
Theater B:
‹ ‹“Gone with the Wind”: $10,000 per week
‹ ‹“Getting Gertie’s Garter”: $4,000 per week

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 Price Discrimination and Bundling in Monopoly

If the films were sold separately, Theater A might only lease “Gone with Notes
the Wind” and Theater B might lease both but at a lower combined price.
However, by bundling, the film company ensures that both theaters lease both
films, potentially maximizing overall revenue. This approach capitalizes on the
different valuation each theater places on the films, allowing the distributor
to capture a larger total payment than if the films were sold individually.
Another example of bundling can be seen in the technology sector. Consider
how software companies often bundle different applications together in a
suite. For instance, Microsoft Office includes Word, Excel, PowerPoint,
and Outlook. Customers might have varying preferences and demands for
these individual applications, but by bundling them, Microsoft can maximize
revenue from users who value the entire suite differently. Some users might
primarily need Word and Excel but will still pay for the entire package,
thus increasing overall sales compared to selling each application separately.
Similarly, telecommunications companies often bundle services like inter-
net, phone, and television. Customers might value each service differ-
ently, but bundling allows the company to offer a package that appeals
to a broader customer base, optimizing revenue by addressing diverse
consumer preferences.
Bundling is commonly seen in various industries, such as electronics and
entertainment. For example, you can purchase a desktop computer as a
complete package (including a monitor, CPU, keyboard, and mouse) or
buy each component separately. Similarly, at water parks, you can buy
an entry ticket that includes access to all rides or an entry ticket without
ride access, where you pay for each ride individually. This practice can
be categorized into three types of bundling:
‹ ‹No Bundling: The firm does not bundle any products, allowing
the buyer to purchase each item individually. For instance, each
component of a computer is sold separately.
‹ ‹Pure Bundling: The firm offers only the bundle, meaning the buyer
can purchase the entire package (such as the whole computer) or
nothing at all.
‹ ‹Mixed Bundling: The firm provides prices for both individual
items and the bundle, giving the buyer the option to purchase items
separately or as a package. For example, a buyer can choose to
buy the complete computer set or just the components they need.
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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes In summary, bundling is an effective strategy for firms when dealing with
heterogeneous customer demands and an inability to price discriminate,
allowing them to capture more revenue by leveraging the varied valua-
tions different customers have for the products.

IN-TEXT QUESTIONS
1. In monopoly there is no dead weight loss. (True/False)
2. Second degree price discrimination is applicable in case of
Natural monopoly. (True/False)
3. There is no loss to the producer surplus in conversion of perfect
competition to monopoly. (True/False)
4. Perfect First degree price discrimination is the most common
form of discrimination by the monopolist. (True/False)
5. In third degree price discrimination elasticity of two sub-markets
should be different. (True/False)
6. Peak load pricing and inter temporal pricing are one and the
same thing. (True/False)
7. Perfect first degree price discrimination uses ____________ to
differentiate between different types of consumers.
8. The net loss to the society because of monopoly is called
____________.
9. A simple monopoly charges ____________ price for its product
from all consumers.
10. Producer surplus is the difference between equilibrium price
and ____________.

2.10 Summary
Monopoly is a market structure characterized by a single seller possess-
ing monopoly power that it can exploit to take away the surplus from
the consumers. For this the monopolist goes for various kinds of price
discrimination that includes first degree price discrimination which is not
that common as it involves knowledge of reservation price of the custom-
ers that is not easy to know. It is the worst form of discrimination as it

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 Price Discrimination and Bundling in Monopoly

takes away the entire surplus from the consumers. Then there is second Notes
degree price discrimination which is suitable in case of natural monopoly
where different prices are charged for different blocks of commodities.
There is also third degree price discrimination which is the most common
form of discrimination that divides the whole market into sub-groups with
different elasticities such that each group is homogeneous amongst itself.
There are two more types of discrimination namely inter-temporal and
peak load pricing where discrimination is based on the time lag and usage
respectively. In inter temporal pricing a higher price is charged initially
when a product is new in the market and with time its price also reduces.
In peak load pricing different prices are charged for usage during peak
period and off peak period. Thus the various types of discrimination are
used by a monopolist to earn higher profits and this is one of the reasons
why the society has to bear a cost because of the monopoly power that
a monopolist possesses.

2.11 Answers to In-Text Questions

1. False
2. True
3. False
4. False
5. True
6. False
7. Reservation Price
8. Deadweight loss
9. Same
10. Marginal cost curve

2.12 Self-Assessment Questions

1. Explain the differences between perfect competition and monopoly.
2. What is multiplant monopoly?
3. Explain third degree price discrimination. When is it successful?

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes 4. What is the cost that society has to bear because of monopoly?
5. What is the difference between Peak load pricing and Intertemporal
price discrimination?
6. What is Rent seeking? How it is a cost that society has to bear
because of monopoly?

2.13 Suggested Readings

� Pindyck and Rubinfeld. Micro Economics, Prentice Hall of India.
Salvatore, Micro Economics Theory, Schaum’s Outline Series.
� Browning and Browning. Microeconomics Theory and Applications.
Kalyani Publishers.

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 UNIT - II
General Equilibrium

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Intermediate Microeconomics [Link] 44 08-10-2024 [Link]
 L E S S O N

3
General Equilibrium and
Market Efficiency
Dr. Ruhee Mittal
Assistant Professor
Department of Economics
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 General Equilibrium Model 2 × 2 × 2
3.4 Pareto Optimality/Efficiency
3.5 The Robinson Crusoe’s Production Economy
3.6 The Pareto Efficiency within a Production Economy
3.7 The Two Fundamental Welfare Theorems of Pure Exchange Economy
3.8 First Welfare Theorem
3.9 Second Welfare Theorem
3.10 Social Choice Theory
3.11 Summary
3.12 Answers to In-Text Questions
3.13 Self-Assessment Questions
3.14 Suggested Readings

3.1 Learning Objectives

‹ ‹Understand the concept of Partial and General Equilibrium.
‹ ‹Compute General Equilibrium in Consumption.
‹ ‹Compute General Equilibrium in Production.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes ‹ ‹Compute Simultaneous Equilibrium in Consumption and Production.

‹ ‹Analyze situation of equilibrium in perfect competition.
‹ ‹Understand the concept of Robinson Crusoe economy.

3.2 Introduction
In this chapter, we start with a very simple model of an exchange econ-
omy. An exchange economy, or pure exchange economy, is a model
where no production takes place—goods are given and the primary focus
is on how these goods should be distributed and consumed among indi-
viduals. Despite its simplicity, this model raises critical questions about
the efficiency of allocations and provides significant insights into the
distribution of resources.
Next, we will discuss Pareto optimality or Pareto efficiency, which is
a criterion used to evaluate the efficiency of different allocations of
goods among consumers. An allocation is Pareto optimal if no one can
be made better off without making someone else worse off. This concept
is fundamental in understanding the potential for welfare improvements
within an economy.
Following the discussion on Pareto efficiency, we turn our attention to
the role of markets in an exchange economy. We will explore market or
competitive equilibrium allocations, examining how markets facilitate the
distribution of goods and the conditions under which these allocations
occur.
Finally, we will delve into the crucial connections between markets and
efficiency. These connections are encapsulated in the fundamental theorems
of welfare economics, which articulate the conditions under which market
outcomes are efficient and the relationship between market equilibria and
social welfare. These theorems form some of the most important results in
economic theory, highlighting the interplay between market mechanisms
and the efficient allocation of resources. Through this chapter, students
will gain a comprehensive understanding of the foundational concepts in
welfare economics, the role of markets in resource allocation, and the
theoretical underpinnings of economic efficiency.

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 General Equilibrium and Market Efficiency

Notes
3.3 General Equilibrium Model 2 × 2 × 2

The 2 × 2 × 2 model assumes that there are 2 factors of production that

is land and labour that are being used to produce 2 commodities and
distributed among 2 consumers A and B. It is based on the following
assumptions:
1. There are only two factors of production that is labour and capital
(L and K) being used for production, their quantity available being
fixed and all the units are homogeneous and perfectly divisible.
2. These two factors of production are being used to produce just two
commodities X and Y in the market space assuming that these are
the only two commodities that are being demanded.
3. There are only two consumers A and B who allocate amongst
themselves all the quantities of goods X and Y that are being
produced on the basis of maximum satisfaction.
4. There is perfect competition in the product as well as factor
market.

3.3.1 General Equilibrium of Exchange or Consumption

Assuming a simple economy with only two consumers that is A and B
and given level of output or production now it has to be decided how
the given output would be allocated amongst the two consumers where
Edgeworth Box of Consumption or Exchange would be used. Edgeworth
box is a common tool in general equilibrium analysis that allows for the
study of interaction of two individuals trading two different commodities.
Here the origin of one consumer is on the left bottom comer and origin
of another consumer is taken on right top comer. The axis represents
two different commodities that would be fully allocated amongst two
consumers in a manner that maximizes their satisfaction. It is explained
below using Figure 3.1:
Here there are two consumers A and B whose consumption of commodity
X and Y is shown together with origin of consumer A being at OA and
that of consumer B at OB. The total production is already decided and
is shown by the X and Y axis.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes

Figure 3.1: Edgeworth Box of Consumption Equilibrium

Let us assume that the consumers A and B are initially at point R which
is the initial endowment basket. Here the slopes of the indifference curves
are not equal as they are intersecting and not tangent to each other. Out
of total production of good X, Consumer A is consuming OX I and OY1,
the remaining being consumed by the other consumer B. This is however
not the optimum allocation, as it is possible for either one or both the
consumers to move to a higher indifference curve without reducing the
satisfaction of the other. For example from point R, the consumers can
move to either point S, where satisfaction of A is same but that of B
increases as he moves to a higher indifference curve B3. Similarly at point
U, consumer B has same satisfaction and consumer A moves to a higher
indifference curve that is A3. Other alternative where both the consumers
move to a higher indifference curve is point T. At all these three points
the two indifference curves are tangent to each other that is the slopes
are same. OASTUOB is the contract curve of exchange which is the loci
of tangency points of the indifference curves. Any point on the contract
curve is pareto optimum as it is not possible for any consumer to move
to any other point once both are on the contract curve without reducing
the satisfaction of either one or both. Thus the equilibrium for exchange
is on the contract curve. The condition for equilibrium is:

MRSxvA = MRSxvB

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 General Equilibrium and Market Efficiency

MRS represents marginal rate of substitution which is the slope of the Notes
indifference curve that shows how many units of commodity Y the con-
sumer is willing to forego for one additional unit of commodity X so
that he remains on the same indifference curve such that the satisfaction
is same for the consumer. Here the MRS for both the consumers is same
on the contract curve that is the units of commodity Y that consumer is
willing to forego for an additional unit of X is exactly equal to the units
of X that consumer B is willing to forego for an additional unit of Y. This
is because one consumer can get additional unit of one commodity only
if the other consumer is willing to give it to the consumer because of
limited quantity of the two commodities that are available in the economy.

3.3.2 General Equilibrium of Production

Assuming a simple economy with only two commodities being produced
that is X and Y using only two factors of production that is labour and
capital. Given the factors of production it has to be decided how the
given inputs would be allocated amongst the production of two commod-
ities where Edgeworth Box of Production would be used. It is explained
below using Figure 3.2:

Figure 3.2: Edgeworth Box of Production Equilibrium

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Notes Here there are two factors of production L and K whose units available
are given, using these the two commodities have to be produced X and
Y. Production of commodity X is shown with origin OX and isoquants
X1, X2 and X3 while that of commodity Y is shown with origin OY and
isoquants Y1, Y2 and Y3. Let us assume that at present the economy is
at point D where X1 units of commodity X and Y1 units of commodity
Y are being produced. For production of commodity X1, OL1 units of
labour and OK1 units of capital are being employed; the remaining fac-
tors of production are being used for production of commodity Y. Here
the slopes of the isoquants are not equal as they are intersecting and not
tangent to each other. This is however not the optimum allocation, as it
is possible to increase the production of either one or both the commod-
ities and to move to a higher isoquant without reducing the production
of the other. For example from point D, the production can move to
either point E, where production of commodity X is same but that of Y
increases as economy moves to a higher isoquant Y3. Similarly at point
G, production of commodity Y is same and that of X increases moving
to a higher isoquant that is X3. Other alternative where production of
both the commodities increases is at point F. At all these three points
the two isoquant curves are tangent to each other that is the slopes are
same. OxEFGOy is the contract curve of production which is the loci
of tangency points of the isoquants. Any point on the contract curve is
pareto optimum as it is not possible to increase the production of any
commodity on the contract curve without reducing the production of
either one or both. Thus the equilibrium for production is on the contract
curve. The condition for equilibrium is:

MRTS1kx = MRS1ky

Where MRTS is the marginal rate of technical substitution that is the

slope of the isoquant curve that shows how many units of capital the
producer has to give up for an additional unit of labour so that the pro-
duction of the output is same and there is same isoquant. To attain the
simultaneous equilibrium of production the slopes of both the isoquants
that is for production of commodity X and Y both should be same as there
is fixed amount of both factors of production available in the economy.

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 General Equilibrium and Market Efficiency

Notes
3.3.3 General Equilibrium of Production and Exchange
The economy is simultaneously in equilibrium when both the consump-
tion and production are in equilibrium. For this the production possibility
frontier (PPF) and the contract curve for exchange is required. PPF can
be derived as Figure 3.3:

Figure 3.3: Production Possibility Frontier (PPF)

Here the general equilibrium of production is converted from input space

to output space where E’ corresponds to point E on the contract curve
producing X1 units of commodity X and Y3 units of commodity Y.
Fʹ corresponds to point F on the contract curve producing X2 units of
commodity X and Y2 units of commodity Y. Gʹ corresponds to point G
on the contract curve producing X3 units of commodity X and Y1 units
of commodity Y. Production Possibility Frontier thus shows the different
combinations of two commodities that an economy can produce by fully
utilizing the two factors of production. The points inside the PPF are
not optimum as more output can be obtained by using the same units
of factors available. Point D is thus a point not lying on the contract
curve of production and shows non-optimum utilization of resources.
The points outside PPF are not attainable as they require more resources
and resources are limited. Thus only the points on the PPF that in fact

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Notes correspond to the points on the contract curve are optimum and econ-
omy to be in the equilibrium has to lie on the PPF. Slope of the PPF is
measured by Marginal Rate of Transformation of X for Y (MRTxy). It
can be defined as the number of units of commodity Y that the economy
has to give up to release enough factors of production to produce one
extra unit of commodity X. PPF being concave to the origin, its slope
increases as we move down.
Now how PPF can be used to derive simultaneous equilibrium is shown
in Figure 3.4:

Figure 3.4: Simultaneous Equilibrium

For the simultaneous equilibrium the combination of commodities being

produced in the economy should be in conformity with the demand of
commodities by the consumers. Thus at the equilibrium the slopes of the
indifference curves and the PPF should be same which happens at A2
and B1 indifference curves. This is because of the fact that MRS shows
the rate at which the consumer is willing to exchange one good for
another and MRT shows the rate at which one good can be transformed
into another, the economy will be in equilibrium when the two ratios
are equal that is:

MRTxv = MRSxvA = MRSxvB

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 General Equilibrium and Market Efficiency

Above was the case when there are two consumers; however there is a Notes
special case when the economy consists of only one consumer and it is
known as Robinson Crusoe Economy where the simultaneous equilibrium
is obtained where the highest possible indifference curve is tangent to
the production possibility frontier as shown in Figure 3.5:

Figure 3.5: Production Possibility Frontier

Reflecting Simultaneous Equilibrium

3.4 Pareto Optimality/Efficiency

A change in the economic state is termed Pareto optimal or efficient
if making one individual better off requires making another individual
worse off. In other words, resources are allocated in the most efficient
way possible. This concept signifies an optimal state where resources are
allocated in the most efficient way possible. Any further reallocation would
necessarily harm someone, making it impossible to improve one individ-
ual’s situation without worsening another’s. It comes under 2 × 2 × 2
model. (2 consumer, 2 producer, 2 factor of production)

Example: Consider a situation where reallocating resources from one

individual (A) to another (B) would make B better off, but A worse off.
If no further reallocation can occur without harming someone, the current
state is Pareto optimal.

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Notes Pareto Improvement: A change in the economic state is considered a

Pareto improvement if it makes at least one individual better off without
making anyone else worse off.
Example: Imagine two individuals, A and B, in an economy. If a change
occurs, say an increase in the production of a good, and both A and B
benefit without any negative impact on either, it is a Pareto improvement.

3.4.1 Assumption of Marginal Condition

‹ ‹Individual Preferences: Everyone likes different things, and they
each have a certain amount of stuff.
‹ ‹Producer Cost Efficiency: Producers try to use resources in the
smartest way to save money.
‹ ‹Constant Technology: The way things are made doesn’t change.
‹ ‹Universal Purchases: Everyone buys at least a bit of everything.
‹ ‹Perfectly Divisible Goods: We can have as much or as little of a
product as you want.
‹ ‹Individual Satisfaction: Everyone wants to be as happy as possible
with what they have.
‹ ‹Mobile Factors of Production: Resources can move around easily
to where they’re needed.
The marginal conditions are outlined as follows; Efficiency of consumer,
Efficiency in production and Efficiency of product mix. The detailed
discussion is given as follows:

3.4.2 Efficiency of Consumer

Optimizing the allocation of goods among consumers for increased effi-
ciency in the exchange process. The first condition is about making sure
that goods are shared among people in a society in the best way possible.
It says that the rate at which someone is willing to give up one thing
for another (called the marginal rate of substitution) should be the same
for everyone who uses that thing.

MRSxy of A = MRSxy of B

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 General Equilibrium and Market Efficiency

The marginal rate of substitution (MRS) is about how many units of Notes
one thing you’re willing to give up to get a little more of something
else, while keeping your happiness level the same. When two people
are trading goods, they’ll only reach the best deal if their MRS values
are the same. If they’re different, there’s room for a better exchange.
Imagine connecting all the best deals from different scenarios, and
you’ll get a curve known as the contract curve. Every point on this
curve represents a win-win situation, where both people are as happy
as they can be.
The box diagram, Figure 3.6, illustrates the best way for two people,
A and B, to exchange two goods, X and Y. The vertical sides of the
diagram represent good Y, while the horizontal sides represent good X.
Each person has their own indifference curves (A1, A2, A3 for A and
B1, B2, B3 for B).
Points within the box represent possible distributions of goods between
A and B. Point E, where A’s A1 curve intersects with B’s B1 curve, is
not the best exchange point because the curves have different slopes.

Figure 3.6
Source: [Link]

To find a better point, let’s consider point R, where A and B move

to higher indifference curves. A gets more X by giving up some Y,
and B gets more Y by giving up some X. This benefits A without
harming B.

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Notes Point P is where A and B move to higher curves, but only B benefits
significantly. Point Q is where both benefit on higher curves. These
points form the contract curve (CC), showing optimal exchanges where
marginal rates of substitution for X and Y are equal.
Moving along the contract curve improves one person at the expense
of the other. Each point on the contract curve represents optimal social
welfare in the Paretian sense.

3.4.3 Efficiency in Production

The second condition deals with how we allocate resources like labor
and capital among different businesses. If one company can increase
its production without hurting other companies, that’s called a Pareto
improvement. But if one company’s gain comes at the expense of anoth-
er’s loss, it’s called Pareto optimality. To achieve this, the rate at which
we exchange different factors of production must be the same for all
companies making the same product.
MRTS LK of firm A = MRTS LK of Firm B he marginal rate of substi-
tution represents the exchange of units of one factor of production for a
certain number of units of another factor, while keeping the output level
constant. When we connect the optimal points from various isoquant
curves, we form a curve known as the contract curve. Each point on the
contract curve signifies a Pareto optimal point.
The marginal condition for achieving Pareto efficiency in production is
illustrated through the use of the Edgeworth box diagram, as depicted
in Figure 3.7. The dimensions of the rectangle in the diagram represent
the total available quantities (x01 and x02) of inputs X1 and X2, which
are utilized in the production of consumer goods Q1 and Q2.
Within the box, each point signifies a specific allocation of inputs for
the production of both goods. For example, at point B, the coordinates
relative to the origin O represent the quantities of X1 and X2 used in
producing Q1, while the coordinates relative to the origin O’ represent
the quantities used for Q2.
The diagram includes Isoquant (IQ) maps for Q1 and Q2 referenced to
origins O and O’, respectively.

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Notes

Figure 3.7
Source: [Link]

To achieve Pareto efficiency in production, the goal is to maximize the

output of Q1 while maintaining a given output level of Q2. This maxi-
mization occurs at the point where the isoquants for the two goods are
tangent. For instance, maximizing Q1 output with the quantity of Q2
given by IQ3 results in tangency at point S, and similarly for maximizing
Q2 output with Q1 quantity given by IQ3, tangency occurs at point R.
At the tangency point between isoquants, the numerical slope of the IQ for
Q1 equals the numerical slope of the IQ for Q2, expressed as MRTSX1,
X2(Q1) = MRTSX1, X2(Q2). This equation signifies that the marginal
rate of technical substitution (MRTS) between the two inputs should be
the same in the production of both goods.
The Pareto efficiency point in production must be a point of tangency
between the isoquants for the two goods. Connecting all points of tan-
gency forms the Edgeworth contract curve for production (CCP), denoted
as CCP, which runs from point O to point Oʹ in Figure 3.7.
All points on the CCP are Pareto-efficient in production, indicating that
no change in input allocation can increase the output of one good without
reducing the quantity of the other. Points not on the CCP, such as B in
Figure 3.7, are Pareto-non-optimal. Reallocation of resources to a point
on the CCP between R and S results in larger quantities of both goods,
while reaching point R or S individually increases the quantity of one
good while keeping the other constant.

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Notes Although all CCP points are Pareto-optimal, comparing two points (e.g.,
R and S) is challenging due to the inability to compare interpersonal
utility. Moving from S to R may advantage some individuals while dis-
advantaging others, making a direct comparison unfeasible.

3.4.4 Efficiency of Product Mix

The third condition pertains to the production pattern, guiding the opti-
mal quantities of various commodities based on the available factors of
production. This condition posits that the marginal rate of substitution
between two goods should be equivalent to the marginal rate of trans-
formation between them.
In a scenario of perfect competition, where price ratios for two products
are uniform among consumers and firms, the Marginal Rate of Substitu-
tion (MRS) for individuals equals the Marginal Rate of Transformation
(MRT) for firms. This implies that the production and exchange of the
two products are efficient. Symbolically, if MRSXY represents the ratio
of the prices of goods X and Y (MRSXY = PX/PY), and MRTxy rep-
resents the ratio of the input prices for producing X and Y (MRTxy =
Px/Py), then it follows that MRSXY equals MRTxy (MRSXY = MRTxy).

Figure 3.8
(Source: [Link]

Figure 3.8 illustrates the overarching concept of Pareto optimality, encom-

passing both consumption and production. The curve PP1 delineates
the production possibility frontier for goods X and Y, showcasing their

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inherent trade-off. Any point on this curve signifies the marginal rate of Notes
transformation (MRT) between X and Y, denoting the relative opportunity
costs of producing each, expressed as the ratio MCx/MCy.
Indifference curves I1 and I2 depict consumer preferences for the two
goods. The slope of an indifference curve at any point mirrors the mar-
ginal rate of substitution (MRS) between X and Y. At point E, where
the slopes of transformation curve PP1 and indifference curve I2 align,
Pareto optimality is realized. This equilibrium is highlighted by the price
line cc, indicating that at point E, MRSxy = MRTxy = Px/Py or Mux.

3.5 The Robinson Crusoe’s Production Economy

Robinson Crusoe is now alone on the island, as Friday has not yet arrived.
Robinson spends his days working and resting. The time he spends working
each day (or any other time unit) is denoted by l, representing his labor.
The time he spends resting is referred to as leisure, denoted by L. Since
there are only 24 hours in a day, labor and leisure are interconnected:
l + L = 24. This analysis is similar to the consumer’s choice between
consumption and leisure discussed in the previous chapter.
We assume for now that Robinson produces bread when he works. The
quantity of bread produced per day is represented by x. Towards the end
of the chapter, we will introduce another good, rum, denoted by y. For
now, Robinson’s production is limited to bread.
As a consumer, Robinson has preferences for leisure and bread. Although
he cares about the time spent working (l), it is primarily because it limits
his leisure time, as l = 24 − L. His preferences regarding leisure and bread
can be represented by a utility function (L, x). The indifference curves
for this utility function are downward sloping and convex. However, our
analysis will be simpler if we replace leisure (L) in the utility function
with labor (l). Leisure is considered a positive good (Robinson prefers
more of it), while labor is a negative good (Robinson prefers less of it
because it reduces his leisure).
Let (l, x) represent Robinson’s utility from labor and bread. For this util-
ity function, the marginal utility of bread (MUx = ∂(l, x)/∂x) is positive,
and the marginal utility of labor (MUl = ∂u(l, x)/∂l is negative. Robinson
prefers more bread and less work. Therefore, the indifference curves for

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Notes the utility function u(l, x) will be upward sloping and convex, in contrast
to the downward sloping and convex indifference curves for v(L, x).
Figure 3.9 illustrates two graphs of indifference curves: the top graph
corresponds to the (L, x) utility function with standard downward-sloping
curves, while the bottom graph corresponds to the u(l, x) utility function
with upward-sloping curves.

Figure 3.9: Robinson as a Consumer

The top graph displays indifference curves for leisure and bread, while
the bottom graph shows indifference curves for labor and bread. Arrows
indicate the directions of increasing utility.

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 General Equilibrium and Market Efficiency

Next, we consider Robinson as a producer of bread. His production func- Notes

tion is x = f (l), which indicates the maximum quantity of bread he can
produce given a certain amount of labor. Graphing the production func-
tion provides a visual representation of the optimal output levels (bread)
Robinson can achieve for given inputs (labor). Points on the production
function itself are considered technologically efficient.
The production function is depicted in Figure 3.10. Points below the graph
of the production function are feasible but technologically inefficient; they
represent possible combinations of labor and bread that are not optimal.
In contrast, points above the production function graph are nonfeasible,
as they are impossible to achieve given Robinson’s production technology.

Figure 3.10: Robinson as the Producer

3.6 The Pareto Efficiency within a Production Economy

Let’s revisit the concept of Pareto efficiency within a production econ-
omy. To be considered optimal or efficient, an alternative must first be
feasible. Additionally, it must not be Pareto dominated by any other alter-
native. In an economy with multiple individuals, if we have two feasible
alternatives, A and B, A is said to Pareto dominate B if everyone prefers
A at least as much as B, and at least one person prefers A more.

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Notes In a single-person economy like Robinson Crusoe’s, A Pareto domi-

nates B if both alternatives are feasible and Robinson prefers A over
B. An alternative is Pareto optimal or efficient if it is feasible and no
other feasible alternatives are preferred by Robinson. Essentially, in a
one-person economy, Pareto optimal outcomes are those feasible options
that Robinson likes the most. Figure 3.11 illustrates this by showing the
unique efficient alternative in such a simple economy. This is the point
on the production function that maximizes Robinson’s utility, where the
production function curve is tangent to the highest indifference curve,
denoted as (l*, x*) in Figure 3.11.
For an interior Pareto optimal point (l*,* > 0) in this simple economy,
certain conditions must be met. Firstly, (l*,*) must be technologically
efficient, meaning it lies on the production function, adhering to the
equation x = f (l). Points below this curve are feasible but inefficient,
and points above it are non-feasible.
Secondly, this point must be where the production function and an indifference
curve are tangent. The slope of an indifference curve represents the marginal
rate of substitution (MRS) of bread for labor. Since labor is considered a
negative good (or a bad), the MRS in this model has an unconventional sign.
In the context of two goods, the MRS of the second good for the first good
is the amount of the second good needed to compensate for consuming one
less unit of the first good. For two goods x1 and x2, the MRS is defined as
MU1/MU2, which is positive. However, since labor is a bad, the MRS of bread
for labor, or MRSl, = MU1/MUx​, is negative. To compensate Robinson for one
less hour of work, we would need to provide a negative quantity of bread.

Figure 3.11: The Pareto Efficient Production

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 General Equilibrium and Market Efficiency

In Figure 3.11, Robinson’s indifference curves slope positively. The slope Notes
of an indifference curve at any given point is −MRS at that point.

Indifference curve slope

The slope of the production function is

The optimal point (l*,*) must satisfy: −MRSl,x = MP(l)

If a social welfare optimizer were overseeing Robinson Crusoe’s
production economy, their goal would be to achieve the allocation
(l*,*) that maximizes Robinson’s utility, given his technological
constraints.

3.7 The Two Fundamental Welfare Theorems of Pure

Exchange Economy
The connection between free markets and efficiency, along with the
impact of market incentives on national wealth, has been a topic of
discussion since the days of Adam Smith (1723–1790), notably in
his seminal work “The Wealth of Nations” published in 1776. While
Smith’s arguments lacked formal mathematical analysis, it wasn’t until
the late 19th and mid-20th centuries that such analyses emerged, lead-
ing to the establishment of the first and second fundamental theorems
of welfare economics. The first theorem, demonstrated in Figure 3.12
using a basic exchange model with two individuals and goods, shows
that a competitive equilibrium allocation achieves Pareto optimality.
This principle extends to various exchange and production models,
contingent upon assumptions like competitive markets, price-taking
behavior by agents, and utility being solely determined by an indi-
vidual’s consumption bundle. Formally stated, the first fundamental
theorem asserts the optimality of competitive equilibrium allocations
under these conditions.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes

Figure 3.12: The Walrasian or Competitive Equilibrium

reflecting First Welfare Theorem

3.8 First Welfare Theorem

The First Fundamental Theorem of Welfare Economics asserts that compet-
itive equilibrium allocations, under conditions such as competitive markets
with individuals acting as price takers and utility being solely dependent
on one’s own consumption bundle, are Pareto optimal. In simpler terms,
this theorem suggests that societies relying on competitive markets tend
to achieve Pareto optimality, where no individual can be made better off
without making someone else worse off. However, this efficiency comes
with a caveat: the outcome heavily hinges on the initial allocation. If the
initial distribution is highly skewed, the resulting competitive equilibrium
will mirror this inequality.
To tackle this limitation, the Second Fundamental Theorem of Welfare
Economics adds convexity to the assumptions of the first theorem. This
theorem proposes that with convex indifference curves, which represent
preferences, a society can transition from an initial, potentially unfair
allocation to a more equitable Pareto optimal allocation using the market
mechanism with slight modifications. The theorem introduces the concept
of a numeraire good and employs lump-sum taxes and transfers to adjust
individuals’ budget constraints.

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 General Equilibrium and Market Efficiency

Referring to Figure 3.13 which illustrates this process, we observe two Notes
key points labeled “Laissez-faire” and “Target.” The former represents
the outcome of an unshackled free market, which, while Pareto opti-
mal, can be highly unfair. The latter depicts the desired Pareto optimal
allocation. The market mechanism can be adapted to move society from
the initial “Laissez-faire” allocation to the “Target” allocation through
careful adjustments.

Figure 3.13: A Very Unfair Laissez-faire Competitive Equilibrium,

and a more Equitable, and Pareto Optimal, Target.

To elaborate on the procedure:

‹ ‹The society identifies the desired Pareto optimal allocation, represented
by the point labeled “Target.”
‹ ‹By analyzing the tangency point of traders’ indifference curves, the
necessary price ratio for achieving this allocation is determined.
‹ ‹The government implements lump-sum taxes and transfers on
individuals, ensuring wealth neutrality. These are represented by
equations such as: TR + TF = 0
‹ ‹Individuals then adjust their consumption bundles based on revised
budget constraints, represented by equations like:

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Notes ‹ ‹With proper taxation and transfers, society can transition from
any initial allocation to a more desirable Pareto optimal allocation
without forsaking the market mechanism.
In summary, the Second Fundamental Theorem illustrates that through
judicious manipulation of taxes and transfers, a society can navigate from
an initially inequitable state to a more preferable Pareto optimal outcome,
all while leveraging the efficiency of market dynamics.

3.9 Second Welfare Theorem

Imagine a scenario where markets exist for all goods, individuals act as
competitive price takers, and each person’s satisfaction depends solely
on their own bundle of goods. Now, suppose further that traders possess
convex indifference curves, and consider any Pareto optimal allocation
labeled as “Target.” Under these conditions, there exist competitive
equilibrium prices for goods and a set of lump-sum taxes and transfers
for individuals, totaling zero. When these taxes and transfers modify
the budget constraints based on these prices, the resulting competitive
equilibrium allocation converges to the Target allocation.
In essence, the first fundamental theorem of welfare economics posits that
any competitive equilibrium is Pareto optimal, while the second asserts
that any Pareto optimal point can be achieved as a competitive equilibrium
with appropriate adjustments to traders’ budget constraints, assuming con-
vexity. Although the second theorem necessitates an additional assumption
and relies heavily on budget constraint modifications, its existence allows
economists to generally agree that the market mechanism leads to Pareto
optimality. This debate between conservative and liberal economists regard-
ing the market’s efficacy and the role of taxes and transfers in addressing
inequalities adds an intriguing dimension to economic discourse, making
life intellectually stimulating for economists and others alike.

3.10 Social Choice Theory

Social choice theory is an economic idea that explores if we can organize
a society to mirror what individuals prefer. This theory was introduced
by economist Kenneth Arrow in 1951 in his book “Social Choice and
Individual Values.” Rather than just focusing on majority rule, Arrow

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expanded social choice theory in the 20th century to look into whether we Notes
can create a rule that combines individual preferences, judgments, votes,
and decisions while meeting certain criteria for what makes a good rule.
Arrow’s social choice theory goes beyond political decisions and examines
various individual choices and potential rules for making group decisions
beyond a simple majority vote. To make society reflect diverse individual
preferences is challenging. Arrow outlined five conditions that a society’s
choices must satisfy to genuinely represent the choices of its individuals.
This theory plays a significant role in understanding how we can make
fair and effective decisions in different aspects of life, not just in politics.
Using these conditions, Arrow developed his Impossibility Theorem.
Arrow’s Impossibility Theorem states that it is impossible to order
society in a way that reflects individual preferences without violating
one of the five conditions. The theorem highlights inherent challenges
in collective decision-making, emphasizing that no voting method can
satisfy all desirable criteria simultaneously. Whether in democracies or
other decision-making processes, trade-offs and compromises are inevi-
table. Arrow’s Impossibility Theorem remains a foundational concept in
social choice theory, shaping our understanding of the complexity and
limitations in designing fair and effective systems for aggregating diverse
individual preferences.
Therefore, selecting a social choice rule will always involve sacrificing
or compromising among Arrow’s five axiomatic conditions. They are:
Universality: Everyone’s Opinions: The rule for making decisions should
provide a complete ranking of everyone’s preferences and do so consis-
tently in the same situations.
Responsiveness: Responding to Changes: If someone likes something
more, the overall group preference for that thing should also increase or
at least stay the same, never decrease.
Independence of Irrelevant Alternatives: Options Shouldn’t Change
Things: Adding or removing choices shouldn’t change how other options
are ranked relative to each other.
Non-imposition: The set of aggregate social preferences must be a product
of one or more combinations of individual preferences.
Non-dictatorship: No Single Boss: The rule shouldn’t favor the prefer-
ences of one person; it should consider the opinions of multiple people.
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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Let’s look at a political example to understand social choice theory. In a

dictatorship, one person makes all decisions about how society is organized.
On the other hand, in an open and democratic society, each person has their
own ideas on how things should be. However, both of these systems have
problems according to Arrow’s Impossibility Theorem. This theorem says that
it’s impossible to create a system that truly represents everyone’s preferences.
So, in real life, even in a democracy, the final decision from a majority
vote might not really show what everyone truly prefers. This happens
because the choices available for voting can affect the result, and it may
not always match what people really want. This shows that finding a
perfect way for everyone to express their preferences in a group decision
is tricky, and there are often compromises or issues in the process.

IN-TEXT QUESTIONS
1. Partial equilibrium works under assumption of ceteris paribus.
(True/False)
2. General Equilibrium does not consider spillover effect to other
sub-markets. (True/False)
3. Contract curve of exchange is where different indifference curves
of two consumers intersect. (True/False)
4. An economy where there is only one individual is known as
Robinson Crusoe Economy. (True/False)
5. Production possibility frontier is concave to the origin. (True/
False)
6. Slope of Production possibility frontier is called ____________.
7. Production Possibility Curve is ____________ to the origin.
8. Contract curve of exchange is the loci of equilibrium points
of ____________.
9. Simultaneous equilibrium is where marginal rate of transformation
is equal to ____________.

3.11 Summary
The equilibrium analysis can be studied in two cases—under the assump-
tions of ceteris paribus that is where the price and quantity of only the
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 General Equilibrium and Market Efficiency

market segment under study is considered and its impact on the other Notes
sub markets are assumed to be constant, however there is another situa-
tion where we do away with the assumption of ceteris paribus as all the
markets impacted because of changes in the initial sub-market is consid-
ered. Here we take into effect the spillover effect as well as the feedback
effect unlike the partial equilibrium. The attainment of equilibrium under
general equilibrium is complex as compared to partial equilibrium as here
there are three conditions that has to be satisfied—the available factors
of production should be optimally allocated for the production of two
commodities which should be optimally distributed between two consumers
and finally simultaneously both the production and exchange should be
in equilibrium. It was given by Leon Walras and is known as 2 × 2 × 2
model as there are two factors of production, two consumers and only
two commodities. Here Edgeworth Box is used to obtain contract curve of
exchange and production that helps in determining the general equilibrium
situation with the help of production possibility frontier. These ideas help
us understand how people make decisions, how markets work, and the
challenges of creating fair systems. They explore why we make certain
choices, how groups decide things, and if markets distribute resources
well. They also look at creating systems that are both fair and effective,
considering what’s right and good for everyone. Overall, these concepts
give us a good grasp of how economies and societies function, helping
us make better and fairer decisions.

3.12 Answers to In-Text Questions

1. True
2. False
3. False
4. True
5. True
6. Marginal Rate of Transformation
7. Concave
8. Indifference curves of the two consumers
9. Marginal rate of substitution for the two consumers

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes
3.13 Self-Assessment Questions
1. What are the three conditions needed for obtaining equilibrium
according to Leon Walras?
2. What is general equilibrium and how it is different from partial
equilibrium?.
3. Explain the concept of Edgeworth box of production.
4. Explain why production possibility frontier is downward sloping.
5. What is the difference between contract curve of exchange and
contract curve of production?
6. How simultaneous equilibrium is attained in case of a single
individual economy?
7. How does Robinson Crusoe use his smarts and adapt to survive on
the deserted island?
8. Can you share an example that shows how things get better for at
least one person without making others worse off, which is called
a Pareto improvement?
9. What role does the price mechanism play in achieving a Pareto-
efficient allocation of resources, according to the First Welfare
Theorem?
10. How does Arrow’s Impossibility Theorem question the possibility
of arranging society to match individual preferences?

3.14 Suggested Readings

� Gould and Lazear. Micro Economic Theory, AITBS. Salvatore, Micro
Economics Theory, Schaum’s Outline Series.
� Browning and Browning. Microeconomics Theory and Applications,
Kalyani Publisher.
� Maddala GS and Miller E. Microeconomics Theory and Applications,
McGraw Hill International.
� Lipsey and Chrystal. Principles of Economics, Oxford.

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 UNIT - III
Model of Monopolistic

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 L E S S O N

4
Monopolistic Competition
Dr. Ruhee Mittal
Assistant Professor
Department of Economics
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Demand Curve for Monopolistic Firms
4.4 Price Output Determination by Monopolistic: Short-Run
4.5 Monopolistic in Long Run: Competitors and their Entry
4.6 Product Differentiation under Monopolistic Competition: Market Outcomes and
Efficiency
4.7 Markup under Monopolistic Competition
4.8 Summary
4.9 Answers to In-Text Questions
4.10 Self-Assessment Questions
4.11 Suggested Readings

4.1 Learning Objectives

‹ ‹Distinguish between monopolistic competition and other market structures such as
perfect competition, monopoly, and oligopoly.
‹ ‹Describe the shape and position of the demand curve faced by a monopolistically
competitive firm.
‹ ‹Explain how the demand curve for a monopolistically competitive firm is different
from that of a perfectly competitive firm and a monopolist.
‹ ‹Illustrate how a monopolistically competitive firm determines its profit-maximizing
price and output in the short-run.
‹ ‹Define and explain the concept of markup in the context of monopolistic competition.
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Notes
4.2 Introduction
Monopolistic competition is a market structure that combines features
of both monopoly and perfect competition. Let’s break down its key
characteristics:
1. Product Differentiation: In monopolistic competition, firms believe
they can distinguish their products from competitors. This differentiation
can be based on quality, branding, features, design, or other factors
that create perceived differences in consumers’ eyes.
2. Many Firms: Despite having unique products or brands, there are
numerous firms operating within the market. This variety ensures
that consumers have choices when making purchasing decisions.
3. Independent Action: Unlike in an oligopoly (where firms are
interdependent), firms in monopolistic competition act independently.
They assume their actions—such as pricing or marketing strategies—
do not significantly impact other firms’ decisions.
4. Ease of Entry and Exit: Firms can enter or exit the market relatively
easily. This assumption affects long-term profitability, as new firms
can enter when existing ones earn supernormal profits, eventually
driving down profits.
5. Perfect Information (with a caveat): The assumption is that
consumers have access to all relevant information about products,
prices, and features. However, in reality, information may not be
perfect, leading to differences in perceived product value among
consumers.
6. Profit Maximization: Like other market structures, firms aim to
earn maximum profits. Achieving this involves balancing pricing,
production costs and making differentiated goods for sustainable
long-term success.

4.3 Demand Curve for Monopolistic Firms

A firm in a monopolistically competitive market faces a demand for its
goods that lies between the extremes of monopoly and perfect competition.
As shown in Figure 4.1, the demand curve for a perfectly competitive
firm is perfectly elastic, indicating that the firm can sell any quantity
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 Monopolistic Competition

at the prevailing market price. In contrast, a monopolist’s demand curve Notes

represents the overall market demand, which slopes downward since the
monopolist is the only supplier in the market.

Figure 4.1: Demand Curve for Monopolistic

Competitor vs Perfect and Monopoly

For a monopolistic competitor, the demand curve slopes downward,

showing that the firm can raise prices without losing all its customers
or lower prices to gain more customers. However, because there are
close substitutes available, the demand curve is more elastic than that
of a monopoly. If a monopolist raises its price, consumers must switch
to entirely different products, while a price increase by a monopolistic
competitor causes consumers to purchase similar products from other
firms. Thus, a monopolistic competitor will lose more customers than
a monopolist if it raises prices, but not as many as a perfectly compet-
itive firm would in the same situation. Although the demand curves of
a monopoly and a monopolistic competitor both slope downward, their
economic implications differ significantly. A monopolist faces the entire
market demand curve, while a monopolistic firm does not.

4.4 Price Output Determination by Monopolistic: Short-Run

To understand monopolistic competition, consider Amazon Prime as an
example. Amazon Prime operates in a market with a downward-sloping
demand curve and faces Average Total Cost (ATC) and Marginal Cost
(MC) curves similar to those of a monopolistic competitor. A firm like
Amazon Prime determines its profit-maximizing quantity and price sim-
ilarly to a monopolist. Given its downward-sloping demand curve, the

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Notes firm maximizes profits where Marginal Revenue (MR) equals Marginal
Cost (MC), ensuring the price (P) is greater than MR.
Step 1: Determining the Profit-Maximizing Level of Output
Amazon Prime identifies its profit-maximizing output where MR equals
MC. There are two scenarios:
If MR exceeds MC at a given quantity, the firm should expand production
because each additional unit adds to profit by generating more revenue
than cost. Production continues until MR equals MC.
If MC exceeds MR at a given quantity, each additional unit costs more
than the revenue it generates. The firm will increase profits by reducing
output until MR equals MC. For instance, suppose MR and MC intersect
when Amazon Prime has 3.6 million subscribers.

Figure 4.2: Monopolistic Competition in Short Run

(Source: [Link]
8-3-monopolistic-competition/)

Step 2: Setting the Price

After determining the profit-maximizing output, Amazon Prime sets the
price based on the highest price the market will bear at that quantity.
This is shown graphically as a vertical line from the profit-maximizing
quantity to the demand curve. For Amazon Prime, this might be a price
of $70 per month. Although the process for setting quantity and price is
similar for both a monopolistic competitor and a monopolist, there are
key differences:
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‹ ‹Demand Curve Differences: Both face downward-sloping demand Notes

curves, but a monopolist’s demand curve represents the entire market
demand, while a monopolistic competitor’s demand curve is shaped
by product differentiation and the number of competitors.
‹ ‹Market Entry: A monopolist is protected by barriers to entry,
preventing new competitors. In contrast, a monopolistic competitor
must consider the potential entry of new firms offering similar but
differentiated products if it earns profits.
Therefore, Amazon Prime, as a monopolistically competitive firm, max-
imizes profits where MR equals MC and sets prices accordingly, while
also taking into account product differentiation and potential competition.

4.5 Monopolistic in Long Run: Competitors and their Entry

To extend the analysis of Amazon Prime’s monopolistic competition
into the long run. At the equilibrium quantity of 3.6 million subscribers,
Amazon Prime charges $70 per month, while the ATC is $60 per month. This
results in a profit of $10 per subscriber, totalling $36 million in profits.
However, this market creates a deadweight loss represented by the pink area
in the graph (Figure 4.3) as the equilibrium quantity is lower than what
would occur in a perfectly competitive market (5 million subscriptions).

Figure 4.3: Monopolistic Competition leading to Deadweight Loss

in Short-run
(Source: [Link]
8-3-monopolistic-competition/)
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Notes Market Entry and Its Impact: In monopolistic competition, barriers to

entry are low. The positive economic profits earned by Amazon Prime
attract new firms into the market. As new firms enter, the demand curve
faced by Amazon Prime shifts leftward because the quantity demanded at
any given price declines. Consequently, the firm’s perceived demand curve
and its marginal revenue (MR) curve both shift to the left (Figure 4.4):

Figure 4.4: Monopolistic Competition in the Long-run

(Source: [Link]
8-3-monopolistic-competition/)

Adjustments and Zero Economic Profits: The entry of new firms con-
tinues until Amazon Prime’s economic profits are driven to zero. This
happens when the price (P) equals the ATC. As firms enter, demand
continues to shift inward until P equals ATC and MR equals MC at a
lower quantity of output. This is illustrated in Figure 4.4, where the
demand curve is tangent to the ATC curve. This tangency point occurs
because ATC is downward-sloping, and the MC curve intersects ATC at
its minimum point, which is at a higher quantity than the monopolistically
competitive firm’s production level.
Long-Run Equilibrium and Deadweight Loss: In the long run, the
market reaches a point where P equals ATC and MR equals MC, elim-
inating economic profits. Despite zero economic profits, deadweight
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 Monopolistic Competition

loss persists. This is due to the fact that in monopolistic competition, P Notes
exceeds MR, and thus P exceeds MC. As a result, consumers’ willingness
to pay is higher than the firm’s marginal cost, leading to market failure.
The inability to charge different prices to different consumers prevents
the market from achieving perfect efficiency.
Moreover, ATC is not minimized in this scenario. This inefficiency is
the price paid for product variety. Slight differentiation among products
means the aggregate market does not ensure the most efficient produc-
tion levels, reflecting the inherent trade-off in monopolistic competition
between variety and efficiency.
Therefore, in the long-run equilibrium of a monopolistically competitive
market, experiences zero economic profits as new firms enter and shift
the demand curve leftward. This leads to a tangency between the demand
and ATC curves, eliminating profits but maintaining deadweight loss
due to the discrepancy between price and marginal cost. The market’s
inability to minimize ATC reflects the trade-off for offering a variety of
differentiated products, illustrating the nuanced inefficiencies in monop-
olistic competition.

4.6 Product Differentiation under Monopolistic Competition:

Market Outcomes and Efficiency
Product differentiation is a key strategy for firms aiming to increase
profits in monopolistically competitive markets. This differentiation can
stem from various factors such as patents, trademarks, and copyrights
that prevent direct imitation of competitors’ products. The fundamental
reason behind differentiation is the potential for higher profits. In a per-
fectly competitive market, new firms might enter due to short-term profit
opportunities, even though long-term profits will eventually decrease to
zero. Similarly, in monopolistic competition, firms can freely enter and
exit, leading to zero profits in the long-run equilibrium. Unlike perfect
competition, firms with differentiated products always price above mar-
ginal cost, resulting in less than the socially optimal production level.
While monopolistic competition does not achieve Pareto efficiency, it
does offer consumer benefits by providing a variety of products compared
to a single homogenous product. Quantifying these consumer benefits is

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Notes challenging, as it’s difficult to measure how much consumers value the
diversity of differentiated products. These benefits must be weighed against
the inefficiencies caused by the market power of differentiated firms and
potential inefficiencies from monopolistic practices, such as advertising.
Moreover, there is no market mechanism ensuring the optimal number
of firms in a differentiated product industry, as firms do not consider
the positive and negative externalities of their entry and exit decisions
on consumers and competitors.
One complex issue is determining whether there are “too many” firms
in the long-run equilibrium of a monopolistically competitive industry.
Fewer firms could lead to outward shifts in the demand curves for the
remaining firms, potentially reducing allocative inefficiency by allowing
each firm to produce closer to its minimum average cost (AC). However,
this would also likely make the demand curves less elastic, increasing
market power and thus allocative inefficiency, unless price controls were
implemented, which introduce their own issues. The U-shaped AC curve
indicates a fixed production cost for each firm. Fewer firms can save on
these fixed costs, allowing each to produce closer to its minimum AC.
However, eliminating a product reduces consumer surplus, as consumers
lose the utility of that differentiated good, despite any outward demand
shift for other products. It’s difficult to determine from theory alone
whether overall consumer surplus would increase or decrease.
In markets with differentiated products, each firm faces a downward-sloping
demand curve. Raising prices does not lead to a total loss of customers
because some consumers are willing to pay more for specific product fea-
tures. However, because the products are close substitutes, changes by one
firm significantly impact the demand curves of other firms. For instance, a
price reduction by a competitor shifts a firm’s demand curve inward, and
making products more similar increases the demand curve’s elasticity. New
firms entering the market also cause an inward shift and increase elasticity,
as they add more substitutes and spread consumer demand thinner.
Monopolistic competition differs from oligopoly in that firms do not
behave strategically. Each firm treats other firms’ actions as fixed, not
considering how changes in their own prices affect competitors’ prices
and subsequently their own demand. This simplification holds because,
in industries with many firms, the strategic impact of any single firm is
minimal.
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In monopolistic competition, a firm maximizes profit where marginal Notes

revenue equals marginal cost, creating allocative inefficiency similar to
that of a monopolist. Despite zero long-term profits due to free entry and
exit, firms still charge a price higher than marginal cost. This results in
a deadweight loss, as firms charge more than the socially optimal price
and produce less than the socially optimal quantity. Figure 4.5 shows the
smaller shaded region is the Dead Weight Loss (DWL) caused by the fact
that the firm is charging optimal price pʹ and optimal p* and producing
output qʹ instead of optimal quantity q*. To achieve efficient pricing,
the government would need to subsidize firms to produce beyond their
profit-maximizing output, but the costs of raising taxes for subsidies and
potential inefficiencies from reduced incentives for cost reduction make
this policy impractical. Therefore, accepting some allocative inefficiency
in exchange for greater product variety is often considered a preferable
trade-off.

Figure 4.5

Advertising plays a significant role in monopolistically competitive

markets and can lead to productive inefficiencies by inflating costs.
However, advertising can be socially beneficial if it informs consumers
about genuinely useful new product features. Conversely, misleading or
manipulative advertising can reduce consumer surplus and create pro-
duction inefficiencies. Therefore, government regulation of advertising
standards is important to ensure that monopolistic competition provides
genuine consumer choice and variety.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Therefore, product differentiation complicates economic modeling of

market outcomes and firm behavior. The clear efficiency result of perfect
competition does not hold, and assessing market efficiency involves more
nuance. However, with proper government regulation ensuring compet-
itive behavior and honest advertising, allowing consumers access to a
variety of substitutes likely offers overall benefits. Historical experiences
of planned economies support this conclusion, emphasizing the value of
consumer choice in a market economy.

Numerical Questions on Monopolistic:

Question 1: Firms with Differentiated Products: Given the demand
function 𝑃 = 200 − 4𝑄 and the TC function 𝑇𝐶 = 50 + 20𝑄, calculate
the profit-maximizing quantity and price. Determine the markup and
the firm’s profit.
‹ ‹Demand function: P = 200 − 4Q
‹ ‹TC (TC): TC = 50 + 20Q
‹ ‹Marginal Cost (MC): 20
‹ ‹Marginal Revenue (MR): 𝑀𝑅 = 200 − 8𝑄
Set 𝑀𝑅 = 𝑀𝐶 : 200 − 8𝑄 = 20 : 180 = 8𝑄: 𝑄 = 22.5
Find the price using the demand function: 𝑃 = 200 − 4(22.5) 𝑃 = 200 − 90
𝑃 = 110
Markup = 𝑃 – 𝑀𝐶 = 110 – 20 = 90
Total Revenue (TR): 𝑇𝑅 = 𝑃 × 𝑄 = 110 × 22.5 = 2475
Total Cost (TC): 𝑇𝐶 = 50 + 20 × 22.5 = 50 + 450 = 500
Profit: 𝜋 = 𝑇𝑅 – 𝑇𝐶 = 2475 – 500 = 1975
Question 2: Short-Run and Long-Run Equilibrium: Suppose a firm’s
short-run demand function is 𝑃 = 150 − 5𝑄 and the cost function is 𝑇𝐶 =
100 + 10𝑄. Calculate the short-run equilibrium price and quantity.
Explain the adjustment process to the long-run equilibrium.
‹ ‹Demand function: 𝑃 = 150 − 5𝑄
‹ ‹Total Cost (TC): 𝑇𝐶 = 100 + 10𝑄

‹ ‹Marginal Cost (MC): 10

‹ ‹Marginal Revenue (MR): 𝑀𝑅 = 150 − 10Q

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 Monopolistic Competition

Set 𝑀𝑅 = 𝑀𝐶 :150 − 10𝑄 = 10 : 140 = 10𝑄 : 𝑄 = 14 Notes

Find the price using the demand function: 𝑃 = 150 − 5(14): 𝑃 = 150 −
70: 𝑃 = 80
Short-run profit:
‹ ‹Total Revenue (TR): 𝑇𝑅 = 80 × 14 = 1120
𝑇𝐶 = 100 + 10 × 14 = 100 + 140 = 240
‹ ‹Profit: 𝜋 = 𝑇𝑅 – 𝑇𝐶 = 1120 – 240 = 880
Adjustment to Long-Run Equilibrium: In the long run, new firms
enter the market due to positive economic profits, which shifts the
demand curve leftward for existing firms. This entry continues until
economic profits are zero. In long-run equilibrium, firms produce where
price equals ATC, and each firm’s demand curve is tangent to its ATC
curve, leading to zero economic profit. The firm still charges a price
above marginal cost, resulting in positive markup and excess capacity.
Question 3: Excess Capacity: Given the cost function 𝑇𝐶 = 100 + 15𝑄 +
𝑄2, determine the output level where the firm achieves minimum ATC.
Compare this with the profit-maximizing output level found using the
demand function 𝑃 = 120 − 3𝑄
Cost function: 𝑇𝐶 = 100 + 15𝑄 + 𝑄

Marginal Cost (MC):

‹‹

Find the output level that minimizes ATC by setting the derivative of
ATC to zero:
Q = 10
Compare this with the profit-maximizing output using the demand
function:
‹ ‹Demand function: 𝑃 = 120 − 3Q
‹ ‹Marginal Revenue (MR): 𝑀𝑅 = 120 − 6Q
Set 𝑀𝑅 = 𝑀C : 120 − 6𝑄 = 15 + 2𝑄 : 105 = 8𝑄 : 𝑄 = 13.125

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Comparison
‹ ‹Minimum ATC output: 𝑄 = 10
‹ ‹Profit-maximizing output: 𝑄 = 13.125
The firm operates with excess capacity, as the profit-maximizing output
(13.125) is less than the output that minimizes ATC (10), illustrating
the typical characteristic of monopolistic competition where firms do
not produce at the lowest possible cost.

4.7 Markup under Monopolistic Competition

Markup refers to the difference between the cost of producing a good and
its selling price. In monopolistic competition, firms have some power in
the market due to product differentiation, which allows them to set prices
above their marginal costs. This pricing behavior leads to a positive markup.

4.7.1 Key Concepts of Markup in Monopolistic Competition

1. Product Differentiation: Each firm offers a product that, while
similar to others in the market, has unique characteristics that set
it apart. These differences can be in quality, branding, features, or
customer service. Because of these distinctions, each firm has a
demand curve which is downward-sloping for its product.
2. Downward-Sloping Demand Curve: Unlike in perfect competition
where firms are price takers, firms in monopolistic competition face
a downward-sloping demand curve. This means that if a firm raises
its price, its all customers will not be lost because some consumers
are ready to pay more for its differentiated product. Conversely, if
it lowers its price, it can attract more customers, but it also needs
to balance this against lower revenue per unit sold.
3. Price Setting and Marginal Cost (MC): Firms in monopolistic
competition set their prices above MC. The optimal pricing strategy
involves MR = MC. Because the average revenue/demand curve
is downward sloping, MR is less than the price, leading firms to
set prices above MC to maximize profits. The markup is thus the
difference between the price (P) and the marginal cost (MC):
Markup = P − MC
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 Monopolistic Competition

4. Elasticity of Demand: The level of markup a firm can charge is Notes

influenced by the price elasticity of demand for its product. When
demand is relatively inelastic, consumers are less responsive to
price changes, enabling the firm to impose a higher markup. On
the other hand, if demand is elastic, the firm has less ability to
increase prices, resulting in a lower markup. The Lerner Index, a
measure of a firm’s market power, is defined as:

Where e is the price elasticity of demand. A higher Lerner Index indicates

greater market power and a higher markup.
Zero Economic Profits: Despite positive markups in the short run, the
free entry and exit of firms in monopolistic competition ensure that eco-
nomic profits are zero in the long run. When existing firms earn economic
profits, new firms are attracted to the market, increasing both product
variety and competition. This process continues until economic profits are
eliminated, which happens when the price equals ATC. In this long-run
equilibrium, firms still charge prices above marginal cost, maintaining a
positive markup, but they do not earn any economic profits.
Allocative Inefficiency: Because firms price above marginal cost,
monopolistic competition leads to allocative inefficiency. The price
consumers pay exceeds the cost of producing the last unit, meaning that
some mutually beneficial trades do not occur. This results in a dead-
weight loss, where the total surplus (consumer and producer surplus)
is not maximized.

4.7.2 Implications of Markup in Monopolistic Competition

‹ ‹Consumer Choice: Consumers benefit from a variety of products,
but they pay a higher price than in perfect competition.
‹ ‹Firm Profitability: Firms can achieve short-term profits due to
their market power, but these are eroded in the long run due to
new entrants.
‹ ‹Market Efficiency: The market does not achieve allocative efficiency
due to the positive markup, resulting in a deadweight loss.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Numerical Question on Mark-up and Excess Capacity:

Consider a monopolistic firm, Rogers, which sets its profit-maximizing
price at $70 per subscription, with a corresponding profit-maximizing
quantity of 3.6 million subscribers. Given that the marginal cost of
providing the 3.6 millionth subscription is $40, what is the markup and
minimum efficient scale output at this profit-maximizing quantity? How
is this markup and excess capacity represented graphically?
Solution:
Markup Price: This difference between the price and the marginal
cost at the profit maximizing quantity is called markup. The mark up
in the graph is $70 – $40 = $30.
Excess Capacity: About 4.8 million subscriptions. If Rogers has pro-
vided subscriptions to 4.9 m customers, it would be operating efficiently
because at that quantity the ATC reaches a minimum. However, we see
Rogers’ profit maximizing quantity of subscriptions is 3.6 m customers.
This difference between profit maximizing quantity of output and the
minimum efficient scale is the excess capacity. In the above figure,
that is about 4.9 – 3.6 = 1.3 million subscriptions.

(Source: [Link]
nomicscdn/chapter/10-4-markup-excess-capacity/)

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 Monopolistic Competition

IN-TEXT QUESTIONS Notes

1. In monopolistic competition, firms:

(a) Produce homogeneous products
(b) Have no market power
(c) Produce differentiated products
(d) Always make economic profits
2. In the long run, firms in monopolistic competition:
(a) Earn positive economic profits
(b) Earn zero economic profits
(c) Produce at the lowest point on their ATC curve
(d) Face a perfectly elastic demand curve
3. Markup in monopolistic competition is the difference between:
(a) TC and total revenue
(b) Price and marginal cost
(c) ATC and marginal cost
(d) Fixed cost and variable cost
4. Which of the following is a characteristic of monopolistic
competition?
(a) Single seller
(b) No barriers to entry or exit
(c) Perfect knowledge
(d) Homogeneous product
5. Given the demand function P = 150 − 3Q and the TC function
TC = 50 + 12Q what is the profit-maximizing quantity (Q)?
(a) 10 (b) 14
(c) 18 (d) 20
6. For a firm with the demand function P = 200 − 4Q and marginal
cost MC = 40 what is the markup?
(a) 40 (b) 60
(c) 80 (d) 120

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes 7. Suppose a firm’s demand function is P = 180 − 2Q and the TC

function is TC = 100 + 20Q. What is the profit-maximizing price?
(a) 90 (b) 100
(c) 140 (d) 160
8. If a firm in the short run produces 15 units at a price of $120
per unit with the TC function TC = 200 + 10Q, what is the
firm’s total profit in the short run?
(a) 200 (b) 400
(c) 600 (d) 800
9. Given the cost function TC = 50 + 10Q + Q2 and the demand
function P = 130 − 3Q, what is the output level where the firm
achieves minimum ATC?
(a) 5 (b) 10
(c) 15 (d) 20

4.8 Summary
Monopolistic competition is a market structure characterized by many
firms offering differentiated products, which allows them to have some
degree of market power. Firms set prices above marginal cost, leading
to positive markups and some allocative inefficiency. In the short run,
firms can earn economic profits due to product differentiation. However,
in the long run, free entry and exit drive economic profits to zero, though
firms still operate with excess capacity and positive markups. This results
in higher average costs and allocative inefficiency compared to perfect
competition. Despite these inefficiencies, monopolistic competition pro-
vides consumers with a variety of products, enhancing consumer welfare
through increased choice and product differentiation.

4.9 Answers to In-Text Questions

1. (c) Produce differentiated products
2. (b) Earn zero economic profits
3. (b) Price and marginal cost

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 Monopolistic Competition

Notes
4. (b) No barriers to entry or exit
5. (b) 14
6. (c) 80
7. (d) 160
8. (c) 600
9. (b) 10

4.10 Self-Assessment Questions

1. Given the demand function P = 250 − 5Q and the TC function TC =
100 + 30Q calculate the profit-maximizing quantity and price.
Determine the markup and the firm’s profit. Explain the implications
of the positive markup on allocative efficiency.
2. Suppose a firm’s short-run demand function is P = 180 − 6Q
and the cost function is TC = 150 + 20Q. Calculate the short-run
equilibrium price and quantity. Discuss how the entry of new firms
affects the market in the long run and the adjustment process to
long-run equilibrium.
3. Given the cost function TC = 200 + 20Q + 2Q2, determine the output
level where the firm achieves minimum average TC. Compare this
with the profit-maximizing output level using the demand function
P = 140 − 4Q. Discuss the concept of excess capacity and its
implications for productive efficiency in monopolistic competition.
4. Assume a firm’s demand function is P = 160 − 8Q and the TC
function is TC = 80 + 12Q. Calculate the profit-maximizing output
and price in the short run. Explain what happens to the firm’s
economic profits in the long run and how market entry influences
these profits.
5. Given a firm’s demand function P = 100 − 2Q and TC function
TC = 50 + 25Q calculate the profit-maximizing quantity and price.
Assuming the firm spends a fixed cost on advertising that shifts its
demand curve to P = 120 − 2Q, recalculate the profit-maximizing
quantity and price. Discuss the role of advertising in monopolistic
competition and its impact on firm profitability and market efficiency.
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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes
4.11 Suggested Readings
� Munoz-Garaia, Felix. (2017). Practice Exercises for Advanced
Microeconomics Theory, MIT Press.
� Dunaway, Eric; Strandholm, John C., Espinola-Arredondo, Ana and
Munoz-Garcia, Felix. (2020). Practice exercises for Intermediate
Microeconomic Theory, MIT Press.

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 UNIT - IV
Externalities

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 L E S S O N

5
Externalities
Dr. Ruhee Mittal
Mukesh Kumar
Assistant Professor
Department of Economics
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Externalities
5.4 Positive Externalities
5.5 Negative Externalities
5.6 Externality Theory: Market Outcome is Inefficient
5.7 Market Creations Solutions to Externalities
5.8 Externality and Pigouvian Tax
5.9 Externality and Coase Theorem
5.10 Summary
5.11 Answers to In-Text Questions
5.12 Self-Assessment Questions
5.13 References
5.14 Suggested Readings

5.1 Learning Objectives

‹ ‹Define positive and negative externalities.
‹ ‹Identify real-world examples across industries.
‹ ‹Evaluate solutions like government intervention or market-based mechanisms.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes
5.2 Introduction
In the realm of economics, market inefficiency arises when the allocation
of goods and services within an economy is not optimal. This inefficiency
can result from various factors, with one significant contributor being
externalities. The choices made by individuals, households, and firms
in consumption, production, and investment often have repercussions
that extend beyond the involved parties. While some indirect effects
may be minor, larger ones can pose challenges, termed as externali-
ties in economics. These externalities serve as a primary reason for
government involvement in the economy. Most of these externalities
are classified as technical externalities, where the secondary impacts
influence the opportunities for others in consumption and production,
yet the product’s price doesn’t consider these effects. Consequently,
there exists a disparity between private returns or costs and the overall
returns or costs to society. Externalities can indeed be both negative
and positive, depending on their impact on parties not directly involved
in a transaction or activity.
Neoclassical economics focuses predominantly on the efficient allocation
of resources using market mechanisms. Within the production process,
alongside the creation of private or public goods, there also emerges
what is termed as a public ‘bad,’ often seen in the form of pollutants like
solid, liquid, gas, or noise. For instance, in cement production, emissions
of dust and harmful chemicals into the atmosphere occur, a facet not
typically addressed by neoclassical theory, which predominantly concerns
itself with the market-driven production of cement but overlooks the
management of resultant air pollution. These ‘public bads’ aren’t solely
generated during production but also manifest during consumption; for
example, discarding non-biodegradable packaging from consumed goods
leads to land pollution. These instances exemplify negative externalities,
a topic to be explored further in this unit. Managing externalities proves
challenging due to issues involving accurately valuing these public
‘bads’ and defining clear property rights. Addressing these concerns
requires understanding the divergence between social and private costs

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 Externalities

resulting from externalities and exploring mechanisms, as discussed Notes

by economists like A.C. Pigou and Ronald Coase, to internalize these
externalities. This unit primarily delves into these concepts, exploring
policy measures adopted by governmental and non-state actors to mit-
igate these issues.

5.3 Externalities
Externality is an economic activity where the results in social cost that
is not borne by either the producer or the consumers. Externalities can
result from either production or consumption. Consumption (production)
externalities occur when a second person is affected by your consumption
(production) of a good or service, either positively or negatively, even
though that person (or often, many persons) is not a party to the trans-
action leading to your consumption (production). The following major
costs are associated with the externalities:
Private Marginal Cost (PMC): PMC refers to the immediate expenses
borne by producers when generating an extra unit of a commodity.
Marginal Damage (MD): MD signifies supplementary costs linked to
the production of the commodity, which are enforced on others but are
not covered by the producers.
Social Marginal Cost (SMC): SMC combines the private marginal cost
to producers with the additional costs inflicted on others, encapsulating
both the producer’s immediate expenses and the external costs imposed
on society. It is calculated as follows:

SMC = PMC + MD

Private Marginal Benefit (PMB): PMB signifies the specific advan-

tage gained by consumers when they consume an extra unit of a
commodity.
Social Marginal Benefit (SMB): SMB combines the private marginal
benefit enjoyed by consumers with any expenses linked to the consump-
tion of the commodity that are passed on to others.

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Notes Table 5.1: Weak Rivalry and High Rivalry Goods

Weak Rivalry
Club goods/Local Public Goods Public Goods
‹ ‹Outdoor concerts ‹ ‹Lighthouse,

‹ ‹Public buildings and parking space ‹ ‹Street lights

‹ ‹Theatre, Public parks recreational facilities ‹ ‹Defence

‹ ‹Libraries ‹ ‹Lake, rivers

‹ ‹Limited access highways ‹ ‹Television

‹ ‹Beaches

‹ ‹Police
and fire protection
High Excludability Low Excludability
‹ ‹Houses, cars ‹ ‹Education

‹ ‹Tennis courts, swimming pools ‹ ‹Garbage Pickup

‹ ‹Food, clothing ‹ ‹Sewer Service
‹ ‹Personal services (haircuts, medical care) ‹ ‹Technological

Private Goods Advancements

Goods with Externalities
High Rivalry

5.4 Positive Externalities

In cases of positive externalities arising from consumption or produc-
tion, it becomes challenging to prevent non-participants from benefiting.
These externalities are placed within the quadrant of high rivalry and
low excludability in Figure 5.1. These externalities commonly stem from
activities considered private, yet with side-effects (costs or benefits) that
unavoidably affect others and are difficult to contain.
Positive externalities often have spillover effects generated by economic
activities, extending beyond the immediate parties involved in a transaction.
These externalities often bring unaccounted advantages to society at large.
For instance, investments in education not only enhance an individual’s
skills and employability but also contribute to the overall knowledge
base and innovation within a society, leading to increased productivity

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 Externalities

and societal advancement. Similarly, advancements in technology and Notes

research not only benefit the inventors or companies involved but also
offer widespread advantages to other industries and the population as a
whole, fostering progress and improving living standards beyond what
the market transactions may indicate. The underestimation of these pos-
itive externalities often results in underinvestment by private entities,
highlighting the discrepancy between private and societal gains.

5.4.1 Positive Externalities in Production

When a firms production increases the welfare of others but the firm
does not receive compensation from those beneficiaries. For example:
When a tech company invests in research and development to create a
new technology, the knowledge and innovations generated often spill
over to benefit other companies or industries. These advancements can
enhance productivity and create new opportunities, serving as a positive
externality for the broader economy beyond the original firm’s immediate
gains. Let’s understand this with the help of a diagram:

Figure 5.1: Positive Production Externalities

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Notes Figure 5.1 essentially illustrates how market forces might lead to a quan-
tity of production (Q1) that falls short of what would be best for society
(Q2) due to unaccounted positive externalities. The explanation of this
scenario is given below:
‹ ‹MPB and MSB (Marginal Private Benefit and Marginal Social
Benefit): MPB and MSB are equal (D = MPB = MSB) when
there are no consumption externalities. This means that individuals
consuming a good receive benefits equal to the overall benefits to
society from the consumption of that good.
‹ ‹MPC and MSC (Marginal Private Cost and Marginal Social
Cost): When MPC (Marginal Private Cost) is greater than MSC
(Marginal Social Cost), it implies that the cost to an individual
producer exceeds the cost to society as a whole. There might be
negative externalities or costs not accounted for by the producer.
‹ ‹Equilibrium Quantity (Q1) vs. Socially Optimal Quantity (Q2):
Q1 is the quantity where the supply and demand curves intersect in
a free market, establishing an equilibrium. However, Q2, the socially
optimal quantity, exceeds Q1 due to positive externalities associated
with the production of a certain good. This means society would benefit
from a higher quantity than what the free market equilibrium offers.
‹ ‹Under-allocation of Resources: The difference between Q2 and
Q1 signifies that resources are not efficiently allocated in the free
market. There’s an under-allocation toward goods with positive
externalities because the market fails to consider the broader social
benefits.
‹ ‹Potential Welfare Gain: Society can benefit from producing at the
socially optimal level (Q2). This represents an increase in overall
welfare due to the positive impact on society from producing more
of the good with positive externalities.
‹ ‹Government Intervention: To address the under-allocation and move
production closer to the socially optimal quantity, the government
can intervene. Subsidies or incentives given to producers could
encourage them to increase their output of goods with positive
externalities. For instance, supporting medical research or incentivizing
tree planting are interventions to enhance positive externalities and
move production closer to Q2.
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A positive consumption externality occurs when the consumption of a Notes

good or service by an individual creates an additional benefit for others
in society, beyond what the consumer pays for. This externality leads to
an underestimation of the true social benefit of the good.
For instance, education often generates positive consumption externalities.
When an individual receives education, not only do they benefit person-
ally in terms of improved skills and income, but society benefits from
a more educated populace contributing to economic growth, innovation,
and a more informed citizenry.
These positive externalities tend to result in under consumption of such
goods/services in the free market because the private benefit captured by
the consumer does not account for the broader societal gains. Address-
ing positive consumption externalities often involves interventions like
subsidies, public funding, or policies aimed at incentivizing increased
consumption to align private and social benefits, ultimately promoting
societal welfare.

Figure 5.2: Positive Consumption Externalities

Figure 5.2 illustrating positive consumption externalities showcases a typical

demand curve representing private benefit (DD), sloping downward with
quantity on the horizontal axis and benefit or price on the vertical axis.
Alongside it lies the social benefit curve, running parallel but situated

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Notes above the demand curve, highlighting the additional benefits to society i.e.
Social Marginal Benefits (SMB). The gap between these curves indicates
the positive externality associated with consumption i.e. the Marginal
Benefits. The market equilibrium, where supply meets demand, leads to
a quantity lower than the socially optimal level. Interventions aimed at
aligning private and social benefits, such as subsidies, public provision,
or incentives, seek to bridge this gap, allowing for increased consumption
to reach a level that better reflects the broader societal benefits, thus
enhancing overall welfare.

5.5 Negative Externalities

The negative externalities refer to management of ‘public bads,’ typically
involves utilizing natural environmental resources such as air, water and
land as natural sinks. However, when this disposal surpasses the natural
capacity to absorb, it disrupts ecological balance. Therefore, the primary
concern lies in mitigating pollution levels to remain within safe limits,
enabling sustainable development to persist.

5.5.1 Externalities in Production

When a product’s manufacturing generates negative additional expenses
imposed on society, such as environmental or health-related costs, it leads
to spillover costs. Let’s understand this graphically. Figure 5.3 presents
the example of a steel plant that pollutes a river but does not face any
pollution regulation (and hence ignores pollution when deciding how much
to produce). In the figure, PMC represents the direct monetary expenses
for firms in producing steel, including raw materials and wages. On the
other hand, SMC encompasses the overall costs of production incurred
by society, encompassing PMC and all external costs like pollution and
health-related expenses. The socially optimal quantity of production, Q2,
reflects the ideal level considering all costs, both private and external.
P1 indicates the gas price if all expenses were factored in. Deadweight
loss signifies the decline in overall welfare due to excessive production
that exceeds the socially optimal quantity.

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Notes

Figure 5.3: Negative Externalities in Production

5.5.2 Negative Externalities in Consumption

When one person’s consumption negatively affects others without compen-
sation, it leads to externalities. Private Marginal Benefit (PMB) represents
the direct benefit to consumers when consuming an extra unit of a good.
Social Marginal Cost (SMC) includes the private marginal benefit to con-
sumers and any costs imposed on others due to the consumption of that
good. For instance, driving a car and emitting carbon, which contributes
to global warming, is an example of such an externality (Figure 5.4).

Figure 5.4: Negative Externalities in Consumption

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Notes
5.6 Externality Theory: Market Outcome is Inefficient
In a free market, the quantity and price align when PMB (Private
Marginal Benefit) equals PMC (Private Marginal Cost). However, the
social optimum occurs when SMB (Social Marginal Benefit) equals SMC
(Social Marginal Cost). As a result, the private market fails to achieve
an efficient outcome, indicating that the 1st welfare theorem does not
hold. The following market outcome arises:

With a free market, quantity and price are such that PMB = PMC
Social optimum is such that SMB = SMC
Negative production externalities lead to Over-production
Positive production externalities lead to Under-production
Negative consumption externalities lead to Over-consumption
Positive consumption externalities lead to Under-consumption

5.7 Market Creations Solutions to Externalities

Addressing externalities involves employing inventive solutions. Deter-
mining the optimal level of public good production and fairly distributing
the associated costs among users presents a challenge to public officials.
Moreover, measuring externalities and implementing effective interventions
to align output with the appropriate level and allocate costs to beneficiaries
pose complexities. In the past, addressing market failure due to exter-
nalities involved strategies like government production of public goods
or items with significant positive externalities. Conversely, responses to
negative externalities included regulation, prohibition, or restriction of
their production. This could involve directly curbing discharges into the
environment or imposing limitations on goods causing adverse externalities
(such as safety regulations or alcohol access restrictions). In recent times,
considerable emphasis has been placed on identifying existing methods
and developing new strategies to rectify externalities. These encompass
several techniques, such as:
‹ ‹Assigning property rights (following the Coase theorem).
‹ ‹Implementing tax incentives and vouchers (Pigouvian Tax)

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 Externalities

‹ ‹Launching educational or informational programs to encourage or Notes

discourage specific types of production.
‹ ‹Establishing markets for emission permits.
‹ ‹Transferring production responsibilities to a lower level of government
or a non-profit provider.

5.8 Externality and Pigouvian Tax

Externality presents itself as the unintended and unremunerated impact
that an individual’s or a company’s actions have on others. To elaborate
formally, externalities emerge when the decisions made by a person or a
firm in consumption or production intrude upon the utility or production
of another entity without their acknowledgment or compensation. Con-
sider, for instance, air pollution caused by cement production, a classic
example of an externality. Externalities aren’t confined solely to actions
taken by private individuals; they often seep into various government
policies, causing cascading effects. For example, providing farmers with
free electricity for irrigation leads to excessive extraction of groundwater,
which leads to a decline in the water table. While the farmer bears the
cost of lift irrigation, the broader social cost surfaces in reduced water
availability for others. This discrepancy between ‘private marginal cost’
and ‘social marginal cost’ is evident in activities with negative exter-
nalities, where the social cost consistently outweighs the private cost.
Consequently, producers of goods with negative externalities tend to
oversupply, focusing on private costs without considering broader social
consequences.
As far back as the 1920s, the prominent British economist Arthur C.
Pigou devised an economic remedy to this issue known as the Pigouvian
tax or pollution tax. Pigou suggested that the societal harm caused by a
firm’s polluting activities could be offset by levying a tax on pollution.
In his proposal, the tax rate would align with the environmental cost or
social damage incurred per unit of pollution caused by the firm, thereby
aiming to neutralize these negative effects on society. This tax is also
known as corrective tax or Pigouvian tax. Corrective tax is also known
as sin tax when the commodity involved is causing pollution.

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Notes Case 1: In Case of Increasing Burden on the Society: Figure 5.5 illus-
trates the scenario with MSC representing the marginal social cost and MPC
denoting the marginal private cost of producing a good (displayed in the
diagram as the upward sloping segment of the MC curves). As production
increases, the overall pollution burden on the environment grows, evident in
the widening gap between MPC and MSC. The demand for this polluting
good is indicated by the DD/ curve (representing the marginal revenue, MR).

Figure 5.5: Pigouvian Taxes

In line with market mechanisms, the equilibrium output occurs at q1 with

a price of P1 where MCp equals MR. However, the socially optimal output
stands at q2 for price P1 where MCs aligns with MR. If the producer were
held accountable for the social costs, the equilibrium output would ideally be
at q*. Therefore, in Figure 5.5, the disparity between MSC and MPC at the
socially optimal output level is denoted by ‘ac.’ To internalize these exter-
nalities, Pigou proposes the imposition of a tax ‘t’ per unit of output, where
t equals ac, signifying the difference between MCp and MCs at the socially
optimal level. This approach operates under the assumption that pollution
emitted per unit of output remains constant despite changes in output levels.

5.9 Externality and Coase Theorem

Coase Theorem
The Coase Theorem, developed by economist Ronald Coase, discusses
how individuals can independently address issues arising from external

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factors, known as externalities. Externalities occur when someone’s actions Notes

affect others and create a problem.
Coase’s idea is that if people have clear property rights, meaning they
know who owns what, they can find solutions without government
intervention. The theorem suggests that when individuals have a good
understanding of their property rights, they can communicate and negoti-
ate to resolve problems caused by one person’s actions affecting another
person’s property.
For instance, consider a situation where a noisy factory is bothering a
neighbor. If property rights are well-defined, the neighbor and the fac-
tory owner can have a conversation and reach an agreement. This might
involve the factory owner compensating the neighbor for the disturbance
or finding ways to reduce the noise.
In essence, the Coase Theorem emphasizes that with clear property
rights, people can independently handle problems caused by externalities
through communication and negotiation, without relying on government
interference.
Coase Theorem’s Basic Assumptions:
1. Clear Ownership Rights:
‹ ‹This means everyone should be clear about who owns what. If you
have a phone, and it’s yours, that’s a clear ownership right. The
Coase Theorem thinks that for things to go well, everyone needs
to know what belongs to them.
2. Limited Government Involvement:
‹ ‹The Coase Theorem prefers it when the government doesn’t get
involved too much. It’s like saying, “Let people figure things out
without too many rules from the government.” If there’s too much
government in the mix, it might make it harder for people to find
solutions on their own.
3. Expressing Pollution in Money Terms:
‹ ‹The Coase Theorem suggests that the harm caused by pollution
can be measured in money. For instance, if a factory is polluting
a river, we can calculate the damage by looking at how much it
costs to clean up the pollution or how it affects people’s health.

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Notes 4. Low Costs for Making Deals:

‹ ‹Transaction costs are like obstacles that make it tricky for people
to make agreements. The Coase Theorem works better when these
obstacles are low. It’s easier for people to work things out if there
aren’t too many complications or if it’s not too expensive for them
to make deals.
In simple terms, the Coase Theorem likes it when everyone knows what
they own, the government doesn’t get too involved, we can put a money
value on pollution harm, and it’s not too tough or costly for people to
make agreements.
Imagine there’s a river where Rakesh, who runs a factory, is putting dirty
stuff into the water. This is making the river dirty, and sadly, it’s causing
the fish in the river to die. Now, there’s a guy named Manish who makes
a living by catching those fish. So, because of what Rakesh is doing,
Manish is having a hard time catching enough fish to support himself.
In simpler words, Rakesh’s factory is making the river dirty, and that’s
making life difficult for Manish, the fisherman.
Now it is explained with the help of a diagram.
In the diagram, we’re using the X-axis to show the output and the Y-axis
to represent the price. On the graph, AB stands for the marginal benefit,
MD stands for marginal damage, PMC represents private marginal cost,
and MSC represents Social marginal cost.

Figure 5.6: Bargaining and Coase Theorem

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 Externalities

Case I: The industrialist Rakesh possesses the right of ownership to the Notes
river.
Here, Rakesh won’t produce at a certain level (OX1) until he gets paid
more than what he gains (RSV) from making that amount. Manish is
willing to pay as long as it’s less than the harm caused (PQTU) by that
extra production. So, the compensation needed is:
RSV < actual payment < PQTU.
This leaves room for negotiation. Therefore, Manish pays Rakesh to
reduce the output to a level (Oxp) that’s good for everyone.
Case II: Manish, the fisherman possesses the property right to the river
Now, Rakesh is in the process of paying Manish for permission to pollute
the river. Top of Form Manish is open to tolerating a certain amount of
pollution as long as the payment he receives exceeds the harm it causes
to his business, known as marginal damage (PQTU). Rakesh is ready to
pay an amount that is lower than the gain (RSV) he earns from producing
that unit of output.
Under such circumstances, Rakesh and Manish would come to an agree-
ment where Rakesh produces at the OX1 level.
In conclusion, regardless of whether the property right is granted to
Rakesh or Manish, the outcome remains the same: the production level
settles at OX1, which is considered socially efficient. This means that the
agreed-upon arrangement, whether favoring Rakesh or Manish in terms of
property rights, results in a level of output (OX1) that is deemed optimal
for the overall well-being of the community or society. It’s not always
easy to figure out who owns what, especially when it comes to things like
air pollution. To solve the problem and get rid of pollution, we need to
clearly say what the issue is, understand how much it might cost, come
up with a plan to fix it, and then agree on how to make it happen.
Application of Coase Theorem: Using the Coase Theorem to solve
environmental problems, Scotland and England prevented overfishing
and controlled water pollution by giving private ownership of rivers and
waterways. In Zimbabwe, wildlife preservation benefited from assigning
property rights to landowners. This led to the elephant population growing
from 40,000 to 68,000.

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Notes Criticism: Finding out who’s responsible for things like air pollution
isn’t always easy, like the Coase theory suggests. It’s hard to say who
owns the problem and where it’s coming from. To fix pollution, we need
to say exactly what the problem is, figure out how much it might cost,
come up with a plan to solve it, and agree on how to make it happen.

IN-TEXT QUESTIONS
1. What often causes markets to work less well in economics?
(a) Not enough supply and demand balance
(b) Externalities – unintended effects of people’s actions
(c) Government interference
(d) What consumers like
2. What is an example of a ‘public bad’ in the form of pollutants
mentioned in the passage?
(a) Renewable energy
(b) Noise pollution
(c) Education programs
(d) Economic growth
3. What does the Coase Theorem suggest about dealing with
externalities?
(a) The government must intervene
(b) Making property rights clear allows people to negotiate
and solve externalities privately
(c) Externalities are inevitable in any economic system
(d) Private property rights don’t matter in addressing externalities
4. What happens when public goods are underprovided in the
market?
(a) Overconsumption
(b) The tragedy of the commons
(c) Free-rider problem
(d) Market failure

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 Externalities

5. What poses challenges in managing externalities, as mentioned Notes

in the passage?
(a) Lack of neoclassical theories
(b) Valuation issues and unclear property rights
(c) Efficient market mechanisms
(d) Government intervention
6. What is a common example of a positive externality?
(a) Air pollution
(b) Education benefits spilling over to society
(c) Noise pollution
(d) Discarding non-biodegradable packaging

5.10 Summary
Market inefficiency in economics arises when the allocation of goods
and services is suboptimal, often due to externalities—unintended conse-
quences of individual, household, or firm choices affecting others. These
technical externalities create a gap between private and societal costs
or returns. Despite neoclassical economics’ emphasis on market mech-
anisms for resource allocation, negative externalities such as pollution
in production and consumption processes are often overlooked. ‘Public
bads,’ like air and land pollution, result from economic activities without
being factored into market prices. Managing externalities is challenging
due to valuation issues and unclear property rights. This unit explores
the concepts of externalities, delving into the works of economists like
A.C. Pigou and Ronald Coase. It investigates policy measures adopted
by governments and non-state actors to address these challenges, aiming
to internalize externalities and optimize resource allocation for societal
well-being.

5.11 Answers to In-Text Questions

1. (b) Externalities – unintended effects of people’s actions
2. (b) Noise pollution

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Notes
3. (b) M
 aking property rights clear allows people to negotiate and
solve externalities privately
4. (d) Market failure
5. (b) Valuation issues and unclear property rights
6. (b) Education benefits spilling over to society

5.12 Self-Assessment Questions

1. What is market inefficiency in economics, and what can contribute
to its occurrence?
2. How do externalities play a significant role in creating market
inefficiencies?
3. Why do externalities often lead to government involvement in the
economy?
4. Give an example of land pollution resulting from the consumption
of goods and the generation of negative externalities.
5. In what ways do externalities impact societal well-being, and why
is the optimization of resource allocation crucial in addressing these
impacts?
6. What are the basic assumptions of the Coase Theorem, and why
are they important for its application?
7. According to the Coase Theorem, how can the harm caused by
pollution be expressed, and why is this important in the resolution
of externalities?

5.13 References
� Serrano, Roberto and Feldman, Alan. (2012). A short course in
intermediate Microeconomics with Calculus, Cambridge University
Press.
� Espinola-Arredondo, Ana ad Munoz-Garaia, Felix. (2020). Intermediate
Microeconomic Theory, MIT Press.

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 Externalities

Notes
5.14 Suggested Readings
� Munoz-Garaia, Felix. (2017). Practice Exercises for Advanced
Microeconomics Theory, MIT Press.
� Dunaway, Eric; Strandholm, John C., Espinola-Arredondo, Ana and
Munoz-Garcia, Felix. (2020). Practice exercises for Intermediate
Microeconomic Theory, MIT Press.

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 UNIT - V
Public Good

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 L E S S O N

6
Public Good
Dr. Ruhee Mittal
Assistant Professor
Department of Economics
School of Open Learning
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Examples of Public Goods
6.4 The Efficiency and Inefficiency of the Market Equilibrium
6.5 The Samuelson Optimality Condition
6.6 Public Good and the Free Rider Problem
6.7 Cost and Benefit Analysis
6.8 Lindahl Taxes
6.9 Summary
6.10 Answers to In-Text Questions
6.11 Self-Assessment Questions
6.12 References
6.13 Suggested Readings

6.1 Learning Objectives

‹ ‹What are public goods?
‹ ‹Characteristic of public good.
‹ ‹Pure public goods versus private goods.
‹ ‹Common resources and club goods.
‹ ‹Free rider problem and tragedy of commons.

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Notes
6.2 Introduction
A public good is defined by two key characteristics: it is nonrival and
non-excludable. Non-rivalry means that one person’s use of the good does
not diminish its availability to others. Non-excludability means that it
is difficult or impossible to prevent anyone from using the good. These
features result in public goods creating significant externalities, where
the benefits extend beyond the individual consumer. An example of a
public good is a judicial system. If the laws, courts, and police protect
one person, they simultaneously protect everyone else. Similarly, national
defense and clean air are public goods; my consumption of these goods
does not reduce their availability to you, and it is impractical to exclude
anyone from their benefits.
In contrast, private goods are both rival and excludable. For instance, a pair
of socks or an apple can be consumed by only one person at a time, and
those who do not pay for these items can be excluded from using them.
Markets typically provide efficient quantities of private goods, as their
consumption is straightforwardly managed through supply and demand.
The presence of public goods introduces market inefficiencies. Due to
their nonexcludable nature, individuals may exhibit free-rider behavior,
benefiting from the good without contributing to its cost. This results in
under-provision of public goods by the market (Table 6.1):
Table 6.1: Public Goods
Excludable Nonexcludable
Rival Private Goods (Ex: fruits, C o m m o n - p o o l r e s o u r c e s
vegetables, clothes, ice-creams). (Example: fishing grounds,
forests, rivers, grazing lands).
Non-rival Club goods (Ex: private Public goods (Ex: Street
schools and universities, gated lights).
communities.
Goods can be categorized based on their excludability and rivalry:
‹ ‹Public Goods (Non-rival and Non-excludable): Examples include
national defense, clean air, and the judicial system.
‹ ‹Private Goods (Rival and Excludable): Examples include apples
and socks.
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‹ ‹Club Goods (Non-rival but Excludable): Examples include gym Notes

memberships, where multiple members can use the facilities without
diminishing each other’s benefits, but non-members can be excluded.
‹ ‹Common-pool Resources (Rival but Non-excludable): Examples
include forests and fisheries, where use by one person reduces
availability for others, but it is difficult to prevent anyone from
accessing them.
Understanding these categories helps illustrate the challenges in providing
and managing different types of goods, particularly the inefficiencies in
public goods and common-pool resources, necessitating regulatory or
collective action for optimal management.

6.3 Examples of Public Goods

Some examples of public goods in India, reflecting the non-rival and
non-excludable nature of these resources:
‹ ‹National Defense: India’s national defense protects all citizens
from external threats. If the Indian Armed Forces safeguard one
individual, they provide security for the entire population. This
protection is nonexclusive within the country but does not extend
to individuals outside India.
‹ ‹Public Street Lighting: In many Indian cities, street lighting is
provided to enhance safety and security at night. If a street is lit, it
benefits all residents and passersby equally. For instance, streetlights
in Mumbai or Delhi serve everyone in those areas without exclusion.
‹ ‹Fire Services: Municipal fire departments in cities like Mumbai,
Delhi, and Bangalore provide fire protection services to all properties
within their jurisdiction. If a fire breaks out, the fire department
will respond regardless of who owns the property, offering equal
protection to all.
‹ ‹Public Broadcasting (Doordarshan): Doordarshan, India’s public
broadcasting service, is available to everyone with a television.
The signal is nonexclusive, and anyone within range can access
the broadcast. This service is funded by the government and does
not charge viewers directly.

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Notes ‹ ‹Public Parks and Monuments: Examples include India Gate in

Delhi, Marine Drive in Mumbai, and Lalbagh Botanical Garden in
Bangalore. These public spaces are accessible to everyone. Although
entry to some parks and monuments might require a nominal fee,
their use remains largely nonexclusive and benefits the general public.
‹ ‹Public Education: Government schools in India provide free or
low-cost education to children. This service is available to all
students within the catchment area of the school, ensuring access
to education for everyone, regardless of their financial status. The
Right to Education Act (RTE) further emphasizes the nonexclusive
nature of public education in India.
‹ ‹Public Health Services: Government hospitals and clinics, such as
AIIMS in New Delhi and PGIMER in Chandigarh, offer healthcare
services to the public. These institutions provide medical care to
all individuals, reflecting the nonexclusive nature of public health
services.
‹ ‹Scientific Research and Knowledge: Institutions like the Indian
Space Research Organisation (ISRO) and the Council of Scientific
and Industrial Research (CSIR) produce scientific knowledge that
benefits the entire nation. The research findings and technological
advancements made by these institutions are generally accessible
to all and contribute to the public domain.
These examples illustrate the concept of public goods in the Indian con-
text, showcasing how they are provided and the challenges related to
their efficient distribution and management.

6.4 The Efficiency and Inefficiency of the Market

Equilibrium

6.4.1 Homogenous Good and Efficiency in Public Goods

Graphically, the concept of non-rivalry in public goods provision is
depicted by the vertical summation of individual demand curves to form
the aggregate demand curve (Figure 6.1). This contrasts with the process
for determining the aggregate demand for private goods, where individual
demands are summed horizontally (Figure 6.2).
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 Public Good

Notes

Figure 6.1: Public Goods

Figure 6.2: Aggregate Demand for Private Goods

The rationale behind horizontal summation for private goods lies in their
characteristics:
Exclusivity: Upon purchase, ownership allows unrestricted consumption.
Rivalry: Consumption diminishes availability for others.
Horizontal summation is effective because private goods are subject to
rivalry in consumption. This feature underpins the efficiency of market
pricing and the functioning of the invisible hand hypothesis. Market
prices reflect per unit charges, ensuring equilibrium through adjustments

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes in response to supply and demand imbalances. Shortages prompt price

increases as consumers compete for limited goods, while surpluses drive
prices down until equilibrium is reached.
In contrast, public goods pose challenges for efficient pricing. Their
non-rivalrous nature means that consumption by one individual does not
diminish availability for others, making it impractical to apply traditional
market pricing mechanisms.
The aggregate demand for a public good in the economy is determined
by vertically summing individual demand curves. This vertical summation
is appropriate because all individuals can benefit from the same unit of
the good. Consequently, for each marginal unit of the public good, the
aggregate demand equals the sum of the individual values for that unit.
It’s important to note that almost no good or service is entirely non-rival.
Conversely, many goods exhibit varying degrees of rivalry. Therefore,
the characteristic of non-rivalry in a public good is relative rather than
absolute. However, for the sake of discussion, we often conceptualize
public goods in terms of a pure form.
Several environmental amenities exemplify public good characteristics.
For instance, we will explore the socially optimal level of provision for
regional air quality, which is considered a relatively pure public good.
Additionally, we’ll delve into non-use values, which represent environ-
mental benefits that also exhibit public good attributes.
Many environmental challenges can be framed in the context of public
goods. Consider the Coase Theorem’s limitations, which can be attributed
to public goods dynamics. If air and water resources were treated as
private goods, they could potentially be efficiently traded in a market.
However, we’ll illustrate how inefficiencies can arise in the provision
of public goods.

6.4.2 Heterogeneity, Non-rivalry and Market Failure

Let’s examine two goods sharing identical aggregate demand:
G1: The first item represents a private good, exemplified by Chicken
Sandwiches.
G2: The second one embodies a public good, illustrated by Water Quality
at Mono Lake.
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 Public Good

Private Good: The market price serves as an efficient mechanism. The Notes
equilibrium price of a chicken sandwich, denoted as P = MC, ensures each
sandwich costs $P. Consumers compete for sandwich consumption and, at
a price of $P, opt for socially optimal quantities. Consumer 1 consumes
Q1* sandwiches, Consumer 2 consumes Q2* sandwiches, resulting in
Q1* + Q2* = Q*, the aggregate efficient level. Shaded regions depict
the total payment by each individual.

Public Good: In contrast, the market price loses efficiency due to the
non-depletion nature of public goods. The equilibrium price of water
quality cannot align with P = MC because Consumer 1 would abstain
from paying for any quality improvements, while Consumer 2 would
only pay for Q2. Consequently, if Q2 < Q*, the efficient quality level
wouldn’t be reached. Analogous to private goods, the socially optimal
solution would entail providing Q* and charging each consumer a unit
price equal to their marginal value at Q*, represented by P1* and P2*.
However, achieving such a solution may prove challenging.

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Notes

Inefficiency in public goods provision stems from the inadequacy of

quantity as a market mechanism: Given a specific quantity, individuals
won’t naturally select their optimal price but would prefer paying the
lowest possible price when exclusion from consuming the good isn’t
feasible.

6.5 The Samuelson Optimality Condition

In our public goods economy, suppose there are nn individuals with
quasilinear preferences. They collectively choose allocations denoted as
(x1, y2, …, yn) , ensuring that the total cost of these allocations doesn’t
exceed their combined initial funds M1 + M2 + … + Mn.
Thus, we can aggregate the utilities of all n consumers, much like we did
with consumers’ surplus. An allocation (x1, y2, …, yn) is Pareto optimal
if it maximizes:
v1(x) + v2(x) + … + vn(x) + y1 + y2 + … + yn​
subject to the budget constraint:
x + y1 + y2 + … + yn = M1 + M2 + … + Mn​

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 Public Good

By replacing the inequality with an equality sign, Pareto optimality Notes

necessitates maximizing:
v1​(x) + v2(x) + … + vn(x) − x
This function represents the total net benefit from the public good, fac-
toring in its benefits to all consumers and subtracting its cost. In essence,
in our public goods model, optimality translates to maximizing this total
net benefit.
This leads us to the Samuelson optimality condition, named after econo-
mist Paul Samuelson. Maximizing the total net benefit function implies:
v1(x) + v2(x) + … + vn(x) = 1
or, in terms of marginal benefits:
MB1(x) + MB2(x) + … + MBn(x) =
This condition stipulates that the sum of the marginal benefits from the
public good must equal the marginal cost. In essence, the benefits derived
from consuming one more unit of the public good across all individuals
should match the cost of producing that additional unit.
For instance, if an extra unit of the public good costs $1 and every person
benefits by 2 cents from it, producing more is socially beneficial because
the total benefit to society exceeds its cost.
The inefficiency of the previous market equilibrium underscores the
importance of the Samuelson optimality condition. Market provision of
public goods differs from private goods because the benefits extend to all
individuals, necessitating special considerations for efficient allocation.

6.6 Public Good and the Free Rider Problem

Fre e rider is a person who enjoys benefit from good but avoids any
pay ment for the use of the good. Example: When we want to have a
security guard for our society which will benefit every person in society
but there are very less persons who are willing to pay for the security
service. This situation is called as free rider problem in economics. If
we take a numerical example: - Let total cost for security service be
Rs. 1000 and there are 120 houses in society and each benefit Rs. 10
from security service. So total benefit to society will be Rs. 1200 from

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes security service but everyone will try to skip payment in hope that other
individual will pay which will create the problem of free rider so security
service will not be provided.
The problem of free rider arises due to positive externality, if society
develops mechanism in which each person is mandatory to pay Rs. 10
then the problem of free rider will be solved.
Positive Externality: When action of an agent creates positive benefit
to another agent without any payment from benefiting agent.
Classical example of public good:
(i) National Defence: Countries spend huge amount to protect their
borders and create influence in world geo-political space. Even
though there is vast debate regarding huge amount of money spent
on defence given other more productive use of money in developing
countries, but everyone agrees that government should spend money
to create common defence from enemies’ aggression due to public
good nature of defence.
(ii) Basic Research: There are two types of knowledge, one is specific
which is patentable like vaccine and new battery type which lasts
longer than our traditional battery and second type is basic research
like a mission sent to Mars for detection of water by Indian Space
and Research Organisation (ISRO) or by National Aeronautics and
Space Administration (NASA), which produce basis knowledge
which can be utilised by other organisations for further research.

CASE STUDY

Is lighthouse public good or private good?

There are many goods which can be provided as public good or can
be provided through market mechanism. One of the most discussed
cases is lighthouse which was extremely useful in earlier times to
warn about any hazard under the water. It was the duty of state to
provide lighthouse, so lighthouse was a public good in earlier times.
Once lighthouse was installed anyone passing near lighthouse gets
benefited and if government tried to collect any fee for lighthouse,

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 Public Good

then it was extremely hard to collect any fee because the use of Notes
lighthouse is non-rival and non-excludable in consumption. Due to
market innovations now, lighthouse is getting provided through market
mechanism where private firms install lighthouse and collect money
from port so if any port denies the payment, then firm can turn off
light for passing ships. So, when deciding any good as private and
public good we need to consider every economic alternative to exclude
the non-paying agent. There is possibility that some goods can be
public and private good at the same time. Another example can be
public road, they are public goods until there is no congestion and
no toll on road but after introduction of toll public roads become
private good with properties of rival and excludable in nature.

6.7 Cost and Benefit Analysis

In our above analysis we define what is public good and due to non-
rival and non-excludable in nature we concluded that public goods should
be provided by government. If we leave the supply of public good on
market, then public good will be provided in inefficient quantity. Above
analysis helps in determining what government should provide the
public, to determine which goods should be provided and which not,
the government considers the cost and benefit analysis which helps to
determine provision of public good. Example: Construction of a water
tanker in remote area. Cost and benefit analysis is extremely useful tool
to determine worthiness of any good. It is not just helpful in provision of
public good, but we use to take many decisions in our real life. Example:
When we decide about going for a movie we think of total cost (like
transportation, movie ticket etc.) to see a movie and total happiness we
will get from watching any movie. If our benefits from seeing movie
exceed benefits in terms of total cost, we will choose to go for movie.
The analysis of cost and benefit is a handy rule to evaluate any project,
but it has one big drawback when the benefit and cost are not in same
unit then we cannot use cost and benefit analysis. Example: When cost
of a person’s life is compared with safety cost to protect a life.

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Notes Numerical Questions

Q1: Numerical Problem for Private Good (Chicken Sandwiches)
Consider a market for chicken sandwiches. The cost of producing each
sandwich is $3. The demand for chicken sandwiches in this market can
be represented by the equation:
Qd = 10 − P
Qd is the quantity demanded and P is the price per sandwich.
(a) Determine the equilibrium price and quantity of chicken sandwiches.
(b) C
 alculate the total revenue received by the sandwich producer at
equilibrium.

Solution: Cost of producing each sandwich, C = $3

Demand Function: Qd = 10 − P
(a) T
 o find the equilibrium price and quantity of chicken sandwiches,
we set the quantity demanded equal to the quantity supplied:
Qd = QS
10 − P = QS
Given that the cost of producing each sandwich is $3, the supply
curve is determined by the equation:
P = MC = $3
Setting
QS = 10 − P and P = $3, we get:
QS = 10 − 3 = 7
Therefore, at equilibrium, the price of a chicken sandwich is $3 and
the quantity supplied is 7.

Q2: Numerical Problem for Public Good (Water Quality)

Imagine a scenario where a local government is responsible for main-
taining the water quality of a lake. The government can invest in water
treatment measures to improve the lake’s quality, which benefits all
residents in the area. The total cost of implementing these measures
is $10,000, while the total benefit to the community is given by the
equation: B(Q) = 200Q − 0.05Q2

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 Public Good

where Q represents the level of water quality improvement measured Notes

in units.
(a) C
 alculate the optimal level of water quality improvement that max-
imizes the total benefit to the community.
(b) D
 etermine the marginal benefit of the last unit of water quality
improvement.
(c) D
 iscuss whether the government should proceed with implementing
the water treatment measures based on the calculated results.

Solution:
(a) To determine the optimal level of water quality improvement that
maximizes total benefit to the community, we need to find the level
of quality, Q* that maximizes the benefit function, B(Q). We do
this by taking the derivative of B(Q) with respect to Q and setting
it equal to zero:

Therefore, the optimal level of water quality improvement is

Q* = 2000 units.
(b) To find the marginal benefit of the last unit of water quality
improvement, we take the derivative of the total benefit function
with respect to Q at Q*:
Putting value of Q* in

Marginal Benefit = 200 − 0.1(2000) = 200 − 200 = 0

The government should proceed with implementing the water treatment
measures if the total benefit exceeds the total cost. In this case, since
the marginal benefit of the last unit of water quality improvement is
zero, it suggests that the optimal level of improvement has been reached,
and further investment may not be warranted.

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Notes
6.8 Lindahl Taxes
The Benefit Principle, conceived by Swedish economists Johan Gustaf
Knut Wicksell and Erik Lindahl, is a foundational concept in taxation
theory, positing that individuals should be taxed in proportion to the
benefits they derive from public goods and services. It asserts that those
who enjoy greater advantages from government activities should con-
tribute more through taxes. This principle operates on the premise that
taxpayers express their willingness to pay for received benefits through
a politically-revealed mechanism, aligning with the broader goal of tax-
ation to fund government services. An exemplification of this principle
is evident in road tax, where those who utilize and benefit from roads
contribute to their maintenance and construction.
The justification for employing the Benefit Principle lies in its recognition
of the primary purpose of taxation: financing government services with
contributions directly proportional to benefits received. Furthermore, it is
argued that the principle promotes economic efficiency, akin to private
transactions where prices guide resource allocation. This implies that under
the Benefit Principle, public sector resource allocation would align more
closely with consumer preferences. Additionally, the principle facilitates
the measurement of specific benefits in the case of certain taxes, such
as those on petrol and betterment.
However, the Benefit Principle faces criticism on multiple fronts. Critics
argue that taxation is fundamentally a compulsory contribution, and the
direct connection it introduces between benefits conferred and derived
contradicts this essential aspect of taxation. The practical application of
the principle raises concerns about its potential impact on the poor, as
heavier tax burdens may be imposed on them, undermining principles
of fairness and justice. Furthermore, challenges arise when dealing with
pure public goods, where benefits cannot be precisely measured. The
existence of “Free Riders” poses a practical challenge, particularly in
instances involving public goods like street lighting.
In summary, while the Benefit Principle provides a conceptual frame-
work for aligning tax contributions with received benefits, its application
encounters practical challenges and ethical considerations. These include
issues of justice in taxation and difficulties in measuring benefits for

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certain types of goods and services, especially those characterized as Notes

pure public goods.
Lindahl tries to solve the following three problems:
‹ ‹Extent of state activity
‹ ‹Allocation of the total expenditure among various goods & services
‹ ‹Allocation of tax burden

In the Lindahl model, we look at how public goods are produced and
paid for. Imagine there’s a supply curve for public goods horizontal to X
axis. We assume that making these goods follows a simple and consistent
process. Taxpayer X has a demand for these goods (DDx), and taxpayer
Y has their demand curve (DDy). When we add up both demands, we
get the community’s total demand for public goods. Now, X and Y don’t
pay the same share of the cost for these services.
Let’s say TI is the amount of public goods produced. X pays IC, and Y
pays IB, making the total cost IA. Since the government doesn’t aim to
make a profit, it increases the supply to TJ. At this level, X pays JH,
and Y pays JG, covering the whole cost of supply. We reach a balance,
or equilibrium, at a point called P. This happens voluntarily, meaning
everyone agrees on this arrangement.
The Lindahl tax, which is a way to figure out how much each person
should pay for public goods, has some problems when we try to use it
in the real world.

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Notes 1. People Don’t Know Everything: The Lindahl model assumes that
everyone knows exactly how much they benefit from public goods.
In reality, people might not have all the information they need to
know this, making it hard to decide how much each person should
pay in taxes.
2. Preferences are Complicated: People’s likes and dislikes for public
goods can be really complicated, and these feelings might change
over time. The Lindahl model makes things simpler by using a
basic representation of preferences, but this might not capture the
full complexity of what people actually want.
3. Tricky Free Rider Problem: The Lindahl model relies on people
honestly saying how much they’re willing to pay in taxes. But some
might want to pay less to save money. This creates a problem where
some people benefit from public goods without paying their fair share.
4. Hard to Put into Action: Trying to make Lindahl taxation work in
real life can be really complicated and a lot of work. You’d need
a good system to collect and process everyone’s preferences, and
that’s not easy to set up and maintain.
5. Fairness Issues: Lindahl taxation might not be fair for everyone.
People with more money might have to pay a lot more, which
could make income inequality worse. It’s also tough to account for
differences in how much people can afford to pay.
6. Preferences Change Over Time: What people want from public
goods can change as time goes on. The Lindahl model doesn’t
handle these changes well, so it might not be suitable for dealing
with shifts in what people value.
7. Problems with Public Goods for Everyone: Lindahl taxation can
struggle when it comes to public goods that benefit everyone, and
you can’t stop someone from benefiting. In these cases, some people
might not want to pay their fair share because they know they’ll
still benefit even if they don’t.
To sum it up, while the Lindahl tax gives us a way to think about how
much people should pay for public goods based on what they want,
actually making it work in real life is tough because of issues with
information, people trying to avoid paying, how complicated it is to set
up, and fairness concerns.
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IN-TEXT QUESTIONS Notes

1. Which of the following is a key characteristic of a public good?

(a) It is rival in consumption
(b) It is excludable
(c) It is non-rival and non-excludable
(d) It is provided only by private entities
2. Which of the following is an example of a public good in
India?
(a) National defense provided by the Indian Armed Forces
(b) Internet services by JioFiber
(c) Private hospitals in metropolitan areas
(d) Subscription-based television channels
3. Why is clean air considered a public good?
(a) Because it is rival in consumption
(b) Because it is non-excludable and non-rival
(c) Because it can be privatized easily
(d) Because it is provided by private companies
4. Which of the following scenarios best illustrates the free-rider
problem associated with public goods?
(a) People paying for their own internet service
(b) Citizens enjoying national defense without directly paying
for it
(c) Students paying tuition for private education
(d) Members of a gym paying a monthly fee for access
5. Which of the following is NOT a public good?
(a) Street lighting in urban areas
(b) A fire department serving a city
(c) Broadcast television signals
(d) Bottled water sold in stores

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Notes 6. Which of the following best describes Lindahl taxes?

(a) Taxes levied equally on all individuals regardless of their
income levels
(b) Taxes that vary based on an individual’s ability to pay and
the amount of the public good they consume
(c) Taxes imposed only on low-income individual to fund
public goods
(d) Taxes designed to incentivize private investment in public
goods
7. What is Samuelson optimality conditions for public goods?
(a) The sum of the marginal benefits from the public goods
must equal the MC
(b) The total cost of the public good must be minimized
(c) The Govt. should provide public goods until the marginal
benefit equals the AC
(d) Each individual should pay taxes proportional to their
income to fund public goods
8. Which of the following statements is true regarding efficiency
and inefficiency in public goods provision?
(a) Efficiency occurs when public goods are provided up to
the point where the MC equals to average benefit
(b) Inefficiency arises when public goods are overprovided
relative to the level that maximizes social welfare
(c) An efficient allocation of public goods ensures that all
individuals receive an equal share of the benefits
(d) Inefficient provision of public goods can lead to dead
weight loss in social welfare
9. What is the free rider problem in the context of public goods?
(a) It refers to individuals who are unable to contribute
towards the provision of public goods due to financial
constraints
(b) It occurs when individuals benefit from public goods without
contributing to their provision
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 Public Good

(c) It is a situation where the government fails to allocate Notes

resources efficiently to provide public goods
(d) It describes the tendency of individuals to overconsume
public goods, leading to market failure
10. Which of the following is a characteristic of public goods
provision?
(a) Public goods are provided by private firms in a competitive
market
(b) The quantity of public goods provided is determined solely
by individual demand
(c) Public goods are non-excludable and non-rivalrous in
consumption
(d) Governments have no role in the provision of public goods

6.9 Summary
Good can be differentiated based on their properties of excludability and
rivalry. If a good satisfy both properties, non-rivalry, and non-excludability
then we call this good as pure public good. When some goods satisfy
one property only then we call them common resources and club goods.
Some goods do not satisfy both properties they are called private goods.
The problem of commons arises due to non-excludability property of
good which can be solved through defining property rights of goods. So,
property rights play very important role in dealing public goods especially
common resources.

6.10 Answers to In-Text Questions

1. (c) It is non-rival and non-excludable
2. (a) National defense provided by the Indian Armed Forces
3. (b) Because it is non-excludable and non-rival
4. (b) C
 itizens enjoying national defense without directly paying
for it

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Notes
5. (d) Bottled water sold in stores
6. (b) T
 axes that vary based on an individual’s ability to pay and the
amount of the public good they consume
7. (a) T
 he sum of the marginal benefits from the public goods must
equal the MC
8. (d) Inefficient provision of public goods can lead to dead weight
loss in social welfare
9. (b) It occurs when individuals benefit from public goods without
contributing to their provision
10. (c) Public goods are non-excludable and non-rivalrous in consumption

6.11 Self-Assessment Questions

1. Identify goods which are non-pure public goods and explain in each
case why some excludability and diminishability are possible.
2. Why are health and education not considered as pure public goods?
3. Wireless, high-speed Internet is provided for free in the airport of
a city. At first, only a few people used the service.
(a) What type of a good is this and why?
(b) Eventually, as more people find out about the service and start
using it, the speed of the connection begins to fall. Now what
type of a good is the wireless Internet service?
(c) What problem might result and why? What is one possible way
to correct this problem?

6.12 References
� Mankiw, N. G. (2016). Principles of Microeconomics. United States:
Cengage Learning.
� Laibson, D., List, J. A., Acemoglu, D. (2018). Microeconomics:
Global Edition. United Kingdom: Pearson.

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 Public Good

Notes
6.13 Suggested Readings
� Batina, R. G., Ihori, T. (2006). Public Goods: Theories and Evidence.
Germany: Springer Berlin Heidelberg.
� Laudal, T. (2019). A New Approach to the Economics of Public
Goods. United Kingdom: Taylor & Francis.
� Young, H. Peyton. Equity: in theory and practice. Princeton: Princeton
University Press, 1994.
� Fried, Barbara. “Chapter 6: Why Proportionate Taxation?,” Tax justice:
the ongoing debate. Eds. Joseph Thorndike and Dennis J. Ventry.
Washington DC: The Urban Institute Press, 2002.
� Feldman, Allan M and Roberto Serrano. Welfare Economic and Social
Choice Theory, second edition. Springer/Birkhauser, 2006.

i
Pareto Efficiency: Pareto efficiency is an economic concept that represents an optimal
allocation of resources where no one can be made better off without making someone
else worse off. In simpler terms, it’s a situation where resources are allocated in the
most efficient way possible, maximizing overall welfare without causing harm to anyone.
Achieving Pareto efficiency is a key goal in economic theory, indicating a state where
no further improvements can be made without negatively impacting someone else’s
well-being.

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 Glossary

Allocative Efficiency: An economic concept signifying the optimal allocation of resources

in a market, where the marginal benefit to society of one more unit of a good equals the
marginal cost of production, ensuring maximum societal welfare.
Allocative Inefficiency: A situation where the price of a good is above the marginal cost,
leading to less than optimal production and consumption from a societal perspective.
Bundling: Bundling is the practice of selling multiple products or services together as a
single combined unit. This strategy can maximize profits by leveraging the combined value
of complementary products. Bundling can be used to segment the market, increase sales, and
reduce competition by creating product offerings that are difficult for competitors to match.
Club Goods: Which has at least excludability property.
Common Goods: Where property rights are not clearly defined.
Consumer Surplus: Consumer surplus is the difference between what consumers are will-
ing to pay for a good or service and what they actually pay. It represents the extra utility
or satisfaction that consumers receive from paying less than their maximum willingness
to pay. In a monopoly with price discrimination, the aim is often to capture as much of
this surplus as possible.
Deadweight Loss: Deadweight loss refers to the loss of economic efficiency that occurs
when the equilibrium outcome is not achieved. In the context of monopoly pricing and price
discrimination, it represents the lost welfare due to prices being set above marginal cost,
which reduces the quantity of goods traded compared to a perfectly competitive market.
Deregulation: The process of reducing or eliminating government regulations and controls
in a particular industry or sector, often aimed at promoting competition, innovation, and
efficiency by allowing market forces to operate more freely.
Economic Profits: Profits above the normal rate of return, typically existing in the short run
in monopolistic competition but driven to zero in the long run due to free entry and exit.
Efficiency in Production: Production efficiency is achieved when goods are produced
at the lowest possible cost and inputs are allocated among firms in a way that no real-
location can reduce the overall cost of production. This ensures that resources are used
in the most cost-effective manner. Concepts related to this include cost minimization and
optimal input allocation.

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Efficiency of Consumer: Consumer efficiency occurs when consumers

allocate their resources to maximize their utility given their budget con-
straints. This involves making choices that optimize their satisfaction or
happiness based on their preferences and available resources. Key concepts
include utility maximization and budget constraints.
Efficiency of Product Mix: The efficiency of the product mix refers
to the allocation of resources that ensures the mix of goods produced
matches consumer preferences, achieving an optimal combination of goods
and services. This concept emphasizes producing the right quantities of
different goods to best satisfy consumer demands.
Excess Capacity: When firms produce below the level that minimizes
average TCs, resulting in higher costs than necessary.
Externalities: Unintended effects from what people, households, or busi-
nesses do in buying, making, or investing that impact others who aren’t
part of the deal, making markets work less well.
First Welfare Theorem: The first welfare theorem asserts that any
competitive equilibrium will result in a Pareto efficient allocation of
resources, provided there are no externalities and markets are perfectly
competitive. This theorem highlights the efficiency of market outcomes
under ideal conditions.
First-Degree Price Discrimination: Also known as perfect price dis-
crimination, this occurs when a monopolist charges each consumer the
maximum price they are willing to pay. This strategy allows the monop-
olist to capture the entire consumer surplus, effectively extracting all the
economic value that consumers would have gained from the transaction.
In practice, this requires perfect information about each consumer’s will-
ingness to pay, which is rarely achievable.
General Equilibrium of Exchange or Consumption: The general equi-
librium of exchange or consumption refers to a state in which the alloca-
tion of goods among consumers is such that no individual can be made
better off without making someone else worse off. This balance between
supply and demand ensures that consumers’ utility is maximized, given
their preferences and budget constraints. Key concepts include utility
maximization, indifference curves, and market clearing.
General Equilibrium of Production and Exchange: This concept encom-
passes the simultaneous equilibrium in both the production and exchange
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 Glossary

of goods. It signifies that both consumers and producers are optimizing Notes
their behavior, resulting in an overall efficient allocation of resources
within the economy. The equilibrium is characterized by the Walrasian
equilibrium, competitive markets, and the price mechanism, ensuring that
markets clear and resources are allocated efficiently.
General Equilibrium of Production: The general equilibrium of produc-
tion occurs when the distribution of goods among producers is optimal,
meaning that no reallocation can improve production efficiency. This
condition ensures that firms are maximizing their profits within their
production constraints, and resources are utilized in the most efficient
manner. Important concepts here are the production possibility frontier,
isocost lines, and profit maximization.
Long-Run Equilibrium: A situation in which no firm earns economic
profits, and all firms produce at a level where price equals average TC.
Marginal Cost (MC): Marginal cost is the additional cost incurred by
producing one more unit of a good or service. In a monopoly, the mar-
ginal cost is a crucial factor in determining the profit-maximizing output
level. Price discrimination strategies often involve setting prices above
marginal cost to maximize profits.
Marginal Revenue (MR): Marginal revenue is the additional revenue gen-
erated from selling one more unit of a good or service. For a monopolist,
the marginal revenue is less than the price due to the downward-sloping
demand curve. Understanding the relationship between marginal revenue
and marginal cost is essential for determining the optimal pricing strategy.
Market Inefficiency: It occurs when goods and services aren’t distributed
in the best way, resulting in less-than-optimal outcomes.
Markup: The difference between the price a firm charges for its product
and the marginal cost of producing it.
Mixed Bundling: Mixed bundling allows consumers to purchase either
the bundle or the individual products separately. This strategy provides
flexibility to consumers and can capture more consumer surplus by
appealing to different segments of the market. Mixed bundling can also
mitigate the risk of cannibalization, where the sale of the bundle reduces
the sales of individual products.
Monopolistic Competition: A market structure with many firms selling
differentiated products, allowing for some degree of market power.
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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes Monopoly: A market structure characterized by a single seller dominating

the industry, exerting significant control over prices and output levels.
Natural Monopoly: A market situation where economies of scale result
in a single firm being able to produce the entire industry’s output at a
lower average cost than multiple smaller firms, leading to monopolistic
market structures.
Negative Externalities: Unintended adverse consequences of economic
activities, such as pollution, causing harm to parties not directly involved
in the transaction.
Pareto Efficiency within a Production Economy: Pareto efficiency
within a production economy is a state in which resources are allocated
in such a way that it is impossible to make any individual better off with-
out making at least one individual worse off. This concept is crucial for
understanding how production can be optimized to ensure that resources
are used most effectively, with no waste.
Positive Externalities: Unintended beneficial consequences of
economic activities that positively impact parties not directly involved
in the transaction.
Price Cap Regulation: A regulatory mechanism that allows firms to
adjust prices within a specified cap, often based on factors such as vari-
able costs, historical prices, and inflation rates, providing more flexibility
compared to other regulatory methods.
Price Regulation: Government intervention aimed at controlling prices
in a market, often employed to mitigate the adverse effects of monopoly
power by setting maximum or minimum price levels.
Price Sensitivity: Price sensitivity refers to the degree to which the price
of a product affects consumers’ purchasing behaviors. Consumers who
are highly price-sensitive will significantly alter their buying habits in
response to price changes. Understanding price sensitivity is crucial for
effective price discrimination and bundling strategies.
Product Differentiation: Product differentiation is the process of
distinguishing a product from others in the market. This can involve
differences in quality, features, branding, or other attributes. In bundling,
product differentiation can be leveraged to create unique combinations
of products that appeal to different consumer segments.

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 Glossary

Profit Maximization: Profit maximization is the process by which a Notes

monopolist determines the price and output level that returns the greatest
profit. This involves setting prices where marginal revenue equals marginal
cost. Price discrimination and bundling strategies are often employed to
achieve this goal by capturing more consumer surplus and increasing sales.
Public ‘Bads’: Undesirable outcomes such as pollution that emerge as
unintended consequences of economic activities, particularly in the pro-
duction process, not typically addressed by neoclassical economic theories.
Public Good: Goods having property of non-rival and non-excludability.
Pure Bundling: Pure bundling occurs when only the bundle is offered for
sale, and the individual products are not available separately. This strategy
forces consumers to purchase the entire bundle, which can increase total
sales if the combined value of the products in the bundle is higher than
the individual willingness to pay for each product separately.
Rate-of-Return Regulation: A regulatory approach where maximum
prices are set to ensure a competitive rate of return on capital invested
by a firm, typically used to regulate monopolistic industries.
Regulatory Lag: Delays in regulatory responses to changes in costs and
market conditions, often caused by disputes over pricing calculations
and regulatory proceedings, resulting in inefficiencies and complexities
in regulatory frameworks.
Robinson Crusoe’s Production Economy: This model is a simplified
economic framework where a single individual (Robinson Crusoe) makes
decisions about production and consumption, illustrating basic economic
principles in a closed economy. It highlights how an individual allocates
resources between different uses to maximize their well-being, providing
insights into autarky, production decisions, and self-sufficiency.
Second Welfare Theorem: The second welfare theorem states that any
Pareto efficient allocation can be achieved through a competitive equilib-
rium, given appropriate redistribution of initial endowments. This theorem
underscores the role of initial distribution in achieving efficient market
outcomes and suggests that policy interventions can achieve desired
redistributions without sacrificing efficiency.
Second-Degree Price Discrimination: Also referred to as menu pricing,
this type involves varying prices based on the quantity consumed or

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 INTERMEDIATE MICROECONOMICS II: MARKET, GOVERNMENT AND WELFARE

Notes the version of the product purchased. For example, bulk discounts and
different versions of software (basic, premium) are common forms of
second-degree price discrimination. This strategy is designed to segment
the market based on consumers’ preferences and their willingness to pay
for different quantities or qualities of a product.
Social Choice Theory: Social choice theory is a framework for analyzing
collective decision-making processes and the aggregation of individual
preferences into a social welfare function. It examines how societies can
make collective decisions that reflect individual preferences, considering
challenges such as Arrow’s impossibility theorem and the design of voting
systems. This theory is fundamental for understanding how to achieve
fair and efficient outcomes in collective decision-making.
Third-Degree Price Discrimination: In third-degree price discrimination,
the monopolist charges different prices to different identifiable groups
of consumers. These groups can be based on age, location, occupation,
or other identifiable characteristics. Examples include student discounts,
senior citizen discounts, and geographic pricing. This strategy relies on
the ability to segment the market and effectively prevent reselling between
different consumer groups.
Two Fundamental Welfare Theorems of Pure Exchange Economy:
These theorems describe the conditions under which market equilibria
lead to Pareto efficient allocations and the conditions under which any
Pareto efficient allocation can be achieved through competitive markets.
The first welfare theorem states that any competitive equilibrium leads
to a Pareto efficient allocation of resources, while the second welfare
theorem states that any Pareto efficient allocation can be achieved by
some competitive equilibrium given appropriate redistribution of initial
endowments.

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