2

Words of inspiration
“Ours then are everything which we see, all
the homes, the fortresses, the cities, all the
buildings in the entire world which are so
many and such that they seem the work of
angels rather than of men. . . .Ours are the
pictures, ours the sciences, ours the
wisdom.”
Giannozzo Manetti1

For
"Economics is the study of people in the
ordinary business of life." my wife

Alfred Marshall2 Ammini

as always.
“. . . the beginner willhave difficulty in
finding a book that leads him straight to the
heart of the subject and give him the power
to apply it intelligently. He refuses to be
bored by diffuseness and general statements
which convey nothing to him, and will not
tolerate a pedantry which makes no
distinction between the essential and the
non-essential . . .”

Richard Courant3

1. On the Dignity and Excellence of Man (quote taken from Frederick Hart,
Art).
2. Principles of Economics
3. Differential and Integral Calculus.
3

Acknowledgements

My professional indebtedness is to my teachers, students and colleagues. Bibliography lists

all the scholarly publications I consulted as I was preparing this book.
Trained in India, Germany, and the United States, I pay my obeisance to all my teachers.
Special mention is due to Ryuzo Sato, my thesis adviser, mentor and my boss in the last eighteen
years of my academic career.
I was fortunate to start my academic career in the friendly environment of the Sanathana
Dharma College. In 1970, I came to Brown University for graduate education just as the
excitement over the New Curriculum was at its height. Involvement with undergraduate
education for three years as teaching assistant and one year as teaching associate showed me how
high one can aim in classroom instruction if it is properly motivated. In addition to carrying that
commitment to my courses at Southern Methodist University, I, as director of undergraduate
programs in economics, joined a few colleagues in a substantial upgrading and tightening of the
program. The enthusiastic support of our students made it a lasting success.
In 1987, I moved to Stern School of Business as Associate Director of the Center for Japan-
U.S. Business and Economic Studies. The School was then formulating a curriculum linking all
the core MBA courses. I approached colleagues in various departments asking what I could
possibly teach in the core course in microeconomics that would make the link to other core
courses explicit. Regrettably I do not have a complete record of all the conversations but there
are a few whose advice I sought repeatedly and some of them commented on various versions of
my lecture notes. They are: Kimberley Bates, Samuel Craig, Avijit Ghosh, Kose John, Robert
Shoemaker, Richard Sylla, and Lawrence White. Outside the Stern School, I am grateful to
Charles T. Horngren of Stanford University and late Peter L. Bernstein, author of several books
in economics and finance, for reading parts of the notes and giving constructive criticisms. Every
teacher is surprised by the ingenuity of the students in misinterpreting what was taught and I am
afraid that my colleagues will find me no less creative.
For the present book, I drew inspiration from three sources.
First is admiration of popular science books that began with reading Lancelot Hogben’s
Mathematics for the Million early in life. I am also fascinated by the increasing use of computer
graphics in recent science books. The one diagram in Dennis Robertson’s Lecturers on Economic
Principles and the success of Minoo Masani’s Our India were early indicators that graphic can
be effective in economics also.
Next is the recognition, even among mathematicians, of the pedagogic benefits of non-linear
presentation which, instead of following the logical order of deduction, brings out the connection
between topics and an overview of the whole structure. The “spiral method” used in this book is
adopted from Paul Bamberg and Shlomo Sternberg’s A course in mathematics for student of
physics.
Finally, in two succinct conversations on the teaching of game theory, Adam Brandenburger
suggested that I take the first chapter of John von Neumann and economist Oskar Morgenstern’s
4

Theory of Games and Economic Behavior seriously and I did. More than others before me, I
pursued their suggestion to begin with examination of a primitive economy and made it the
foundation of the spiral.
I used CorelDraw to prepare the graphics and am grateful to Lisbi Abraham for introducing
me to its power and flexibility.
I tested an earlier version of some chapters on three non-economists: Raghu Ramachandran,
Ashwin Shah, and Venu Venugopal. Their friendly but penetrating criticisms convinced me of
the enormity of the task ahead. I was lucky to work with Deborah Emin, publisher of Sullivan
Street Press, Inc.; she helped me break away from the academic style of writing though I am sure
she would have loved to make me rewrite the current version all over again.
Only a reader will know the errors and deficiencies and I appreciate comments and
corrections that you can e-mail to me at ramachandran@visualeconomicanaysis.info
My wife, Ammini, introduced me to the new trends in publishing industry as she self-
published her cookbook a few years earlier. I chose internet publishing through Scribd.
In 1964, I was leaving home to take my first faculty position, my father, Rama Varma Appan
Thampuran who was a professor before moving to educational administration, advised me of
goals I should have as a teacher. The rest of my career was a struggle to live up to it. My mother,
Padmam Varma, was better at making economic decisions than I ever will be. My nuclear
family, Ammini, Raghu, Rama and Jo Ann, who provided loving support through these years, is
the joy of my life.
5

Table of Contents

Chapter 1. Individuals in a liberal society. 1

Chapter 2. Consumer preferences and choices. 13

Chapter 3. From self-reliance to exchange. 27

Chapter 4. Choices involving time and uncertainty 45

Chapter 5. Let us go shopping. 59

Chapter 6. Firms: their role in supplying the market. 75

Chapter 7. Monopolist: the sole producer of a product. 89

Chapter 8. One product, many prices. 105

Chapter 9. Competing with differentiated products. 119

Chapter 10. Game theory: the analysis of strategy. 129

Chapter 11. The competitive markets. 139

Chapter 11: Intertemporal preferences, uncertainty and the financial markets. 157

Chapter 13. Firms: Islands of command. 181

Bibliography 223

Index 229
1

Chapter 1. Individuals in a liberal society.

We have no choice but to choose. Throughout the day, at home and at the office, we confront
situations where we have to select one of the options before us. Some choices have ephemeral
consequences while others leave a lasting impact on our future well-being.
Our education, our job, the place where we live, the way we furnish it, what we eat and our
leisure activities are choices we make about our personal lives. In some years, we borrow and
accumulate debt; in others, we save to increase our assets. Our current decisions affect our future
lifestyle.
Our responsibilities at work vary with our station in the corporate ladder. The Chief
Operating Officer (CEO) of a manufacturing organization sets the goals for the company.
Production is ratcheted up and new plants constructed or workers are laid off and plants closed
down to fulfill the goals he sets. The corporate office decides when to raise funds by issuing of
bonds and stocks to finance the operations of the company. These decisions are made public in
statutory filings and in corporate announcements.
The middle management ensures that the decisions made by the corporate office are
implemented by the operational units. Their involvement, though not publicized outside the firm,
is crucial to its success. At the factory floor, the worker appears to be doing purely repetitive
work. Within limits, she can work harder or slow down, and her choice depends on rewards for
her productivity. Beyond that, she has an intimate understanding of the operations in her area,
and can observe inefficiencies or potential for break-downs in the production process that are not
obvious to her superiors. Recognizing the value of the information, many firms offer incentives
to employees to alert the management about possible problems and for making suggestions to
increase productivity. In retailing, restaurants and airlines, the actions and attitude of the
employee who are responsible for delivering the service determine how satisfied the customers
are and how willing they are to make repeat purchases. Even those at the bottom level of the
corporate organization affect the fortunes of their companies.
In democratic nations, we elect the legislators and, in United States, also the President. The
budget they enact determines the levels of personal and corporate taxation and the expenditure
on public services. They pass laws promoting competition in the market and restricting pollution
of air and water. At election time, political parties announce their agenda and we vote for the
candidates based on our preferences for their policies.
The opportunities we have and our ability to execute our preferred actions depend on
decisions made by others. We are able to purchase goods only if firms produce and market them.
Decisions of our employers affect our job security and opportunities for advancement. The return
and risk on our investments depend on financial and real estate markets.
For each to achieve goals that partially depend on actions by others, there has to a
mechanism to coordinate the individual choices. One important goal of economic analysis is to
determine how well an economy achieves the coordination. Does the organization of economic
activity permit consumers to maximize their utility and firms to maximize their profit? Does the
2

economy maximize social welfare defined in terms of the welfare of the individuals? 1 The
general conclusion of modern economics is that a market economy, with caveats stated in later
chapters, is more efficient than alternate institutional arrangements.
Economic analysis has succeeded in convincing the general public and policy makers of
the rigor of its analysis and the relevance of its conclusions. Because of its influence, the trend in
western nations over the last two centuries and in developing countries more recently is to
increase the choices available to individuals and to allow them greater freedom in making
decisions. Deregulation also increased competition in the market and spurred firms to increase
their productivity. Economic growth leads to substantial improvement in the standards of living
around the world. Yet all is not well.
As consumers, investors, employees and executives we are inundated with advice and
offers by various groups; they are pushing their products and services. Political parties claim that
their programs are based on sound economic principles and beseech us to vote for them.
Increased opportunities and freedom to select has not always led to better choices. At individual
and national levels, we continue to make mistakes. Why are we not saving enough to sustain us
in our retirement? Why are so many of us purchasing houses we cannot afford? Financial
institutions, with highly qualified staff, have given out loans that they cannot recover or have
made investments that result in massive losses. Nations adopt policies that result in widespread
shortages of agricultural and industrial products, economic stagnation and discontent among its
citizens. Were those who made these decisions ignoring the lessons of economic analysis and if
so, why did they do so? Or is the discipline, in spite of its breadth and depth, lacking in effective
guidelines to help us to make proper choices in certain situations?
The goal of this book is to explain, in an intuitive manner, the core concepts in economic
analysis. Empirical literature is quoted to illustrate potential applications of economic analysis
but they are not intended to espouse any policy position.

The structures we build.

Our scientific knowledge can be compared to a campus with its many structures that differ
in style and functions but are dedicated to a common purpose. We have benefited from each of
them. Yet their magnificence does not hide the cracks in our knowledge. Consider how the
advances in three disciplines - medicine, and economics -- impacted our decisions.
The general public holds physical sciences in great reverence. In the seventeenth century
Isaac Newton stated the three laws that govern terrestrial and celestial motions. Newton's ability
to explain a broad range of phenomena by a few simple propositions fired public imagination
and became the model for all scientific endeavors. Technological development went hand in
hand with scientific progress. Steam engines developed as thermodynamics provided indices of
their efficiency. Internal combustion engines transformed the mode of transportation. Fascination
with static electricity branched into the study of currents, electromagnetic induction and radiation
and led to the birth of electrical, electronic and communication industries. The analysis of
cathode ray led to discovery of electron and then to radioactive decay. The nucleus of atoms was
shown to be made up of protons and neutrons. Better understanding of structure of atoms gave
1
Though much debated, there is no consensus on how indices of social welfare are to be constructed from those for
individual preferences.
3

birth to the nuclear industry. No wonder that other disciplines aspire to achieve the theoretical
elegance and experimental success of physics.
Classical physics precludes electrons within the atom having stable orbits and quantum
physics was developed to explain such anomalies. It was soon realized that protons and neutrons
are composites of many other fundamental particles. One of them is the neutrino, "the little one,"
postulated from theoretical considerations by Wolfgang Pauli in 1930. Its existence was
empirically verified in 1956 but even now some of its properties baffle physicists. What is
unique about neutrino is that tens of thousands of them originating in the Sun pass through our
bodies every second. We are not aware of it, anything we do will not affect their course and we
do not care about it. The general public can admire the achievements of physics without being
distracted by what is not yet known.
Contrast this with another discipline that has changed our lives, medicine. Bubonic plague
that wiped out a third to half the population in European cities in the fourteenth century is now
contained through public policy and medication. Two hundred years ago, Edward Jenner
developed vaccination against small pox, but it continued to be a threat in many parts of the
world until a sustained drive to vaccinate eradicated it recently. Making the public understand
the importance of hygiene has drastically limited contagions like cholera. Antibiotics were an
effective antidote to bacterial infections and many new vaccines were developed to provide
immunity against viruses.
Still newly identified viruses like HIV spread quickly and are infecting millions. Various
types of cancers that are known for a long time still lack definitive cures. New medications and
medical procedures that are announced as breakthroughs in treating some aliments are soon
found to have undesirable consequences. Some diseases show a new surge, but it is not known
whether it is due to aging of the population, hereditary factors, environmental changes or recent
behavioral patterns. We fear maladies without remedies and our concerns influence the funding
of medical research.
Given these uncertainties, the doctor and the patient have to agree on a course of treatment
when each alternative has some risk. Should the doctor, given his expertise, make the decision or
should he inform the patient of her choices and let her make the decision? Can the doctor be
depended to recommend the treatment that is best for the patient or will he be influenced by
personal or professional considerations to choose another? Many individuals are covered by
insurance offered by the private insurance companies or by the state. As the cost of medical
procedures increase, can the third parties paying for it -- the insurance companies or government
programs -- set criteria for deciding what treatments the patient can have or ask the patient to
take increasing share of the cost? Even though each choice has some undesirable consequences,
we have to decide on one of them.
In the beginning of eighteenth century, the European countries started constructing a new
structure in the campus of knowledge. In 1827, Prussia first established chairs to teach General
Householding (as economics was then referred to). 1 Those who discussed economic policy
whether they were in academics or in government positions were staunch nationalists. They, the
mercantilists, emphasized the "civilizing" nature of an authoritarian state and wanted it to be

1
The title is indicative of the prevailing view that national economy should be looked upon as the household of the
nation and managed as households are managed. Magnusson (1992), p.S249.
4

strong enough to take aggressive stand in international conflicts. 1 Economic growth enabled the
state to grow stronger and development of local industries under a protectionist trade policy was
necessary to assure supply of important industrial commodities in times of war. Nation as much
as individuals benefited from having a horde of precious metals (gold and silver) and considered
a balance-of-payment surplus that leads to their accumulation beneficial to the nation. This, in
spite of the recognition that inflows of gold and silver from South America in the sixteenth
century was the source of inflation in Europe and that the inflow of precious metals due to trade
surplus can lead to price increases in due course.
They did not have a clear conception of the interrelationship between various sectors of the
economy. They doubted that individual choices will lead to the development of the productive
sector and to the growth of a vibrant market economy. Even if it does, it would take a very long
time. "Why allow this to be achieved in a roundabout manner when it can be accomplished
directly?" asked the Swedish economist Johan Lastbohm. 2
It is against such views that Adam Smith launched a two pronged attack. He used the
philosophical arguments developed in the eighteenth century England and Scotland to argue for
the primacy of the individual's interests and rights. In addition he used the vast amount of data he
had collected about economic conditions from ancient times to the contemporary England and
France to expose in his Wealth of Nations the inequities and inefficiencies of the mercantilist
system.
Economic policy should promote the welfare of the individual. Instead of emphasizing the
role of production in strengthening the state, Smith held that consumption is the sole purpose of
production. Commerce and manufacturers will gradually introduce order and good government
and a free market would ensure the liberty and security of individuals. Introduction of machinery
became possible as the complex work of artisans was divided into many simple operations and
each of them was allocated to different workers. The division of work that increases productivity
of workers is limited by the size of the market. Smith argued that by eliminating restrictions to
internal and international trade, higher rate of economic growth and greater prosperity can be
achieved. Smith's stature grew slowly over the next century and he is now regarded as father of
modern economics.
While attacking specific regulations that hurt national prosperity, Adam Smith was
pragmatic than doctrinaire in drawing the boundary between public and private domains. He
accepted that the government should take beneficial responsibilities like maintaining law and
order, enforcing contracts and in maintaining public institutions. He opposed monopolies, like
East India Company, formed under a government charter but supported patent and copyright.
Even in international trade, he was willing to agree to restrictions like limiting export of corn
under certain conditions. He recommended taxing woolen to give domestic workers an
advantage.

1
Schumpeter attributes the aggressiveness of new native states to the breakup of the alliance between the Holy
Roman Empire and the Catholic Church. It used to be the only effective international authority in the Medieval
Europe. Schumpeter (1954), pp. 145-6.
2
Magnusson (1992), p.S251. This is a cry echoed in the twentieth century by leaders of the nations embarking on
rapid industrialization from Stalinist Soviet Union to democratic India. The belief persists as non-market economies
show short periods of high growth rates, generally at the beginning of the development program.
5

The market price of a product depends on demand and supply. If the price increases,
consumers will substitute other products for it and substitution will restrain price increases.
Smith went further and claimed that market price will fluctuate around a natural price that is
sufficient to cover the cost of production. Instead of building on the discussion of market
equilibrium based on consumer substitution and cost of production, the nineteenth century
economists followed David Ricardo in claiming that relative values of goods correspond to the
labor embodied in them. The labor theory of value was combined by Karl Marx with the
exploitive theory of profits to claim that capitalists extract value belonging to laborers.
In the middle of the nineteenth century, William Stanley Jevons, Carl Menger and Leon
Walras undermined the primacy of cost in determining relative prices or exchange value. They
claimed that utility from consumption is the source of value. Alfred Marshall shortly thereafter
argued that cost and demand are like the two blades of a scissor and that both are indispensible
for the determination of value.
The synthesis that Alfred Marshall made of classical economics and the evolving marginal
economics provides a bench-mark to measure subsequent progress. It began with the recognition
of the complimentary roles of cost and utility in determining relative prices of goods. Central to
this analysis is the idea that choice is substitution at the margin. The budget a consumer has is
limited and increasing consumption of one product requires a reduction of others. 1 When a
consumer values an incremental unit of a product no more than units of others he has to give up,
he has no inclination to change his consumption any further.
Marshall extended substitution at the margin to inputs in production. Firms choose more or
less labor intensive processes and use them with a mix of other inputs to minimize cost of
producing the output. The remunerations for inputs are determined by quantities demand and
supplied. This approach led him to the idea of the simultaneous equilibrium of all input and
output markets (the general equilibrium theory) but Marshall never developed the
interrelationship systematically as Leon Walras did.
Building on the works of Jevons, Menger and Walras, economic analysis emphasized
substitution at the margin as the means to maximize utility of individuals and profits of firms.
Antoine Cournot's seminal work in mathematical economics published in 1838 used calculus to
analyze individual optimization and market equilibrium. Going beyond market for one product,
Leon Walras in 1874 examined how the interactions among the many markets determine the
equilibrium of the economy. Both Walras and Vilfredo Pareto studied the efficiency of
competitive markets. Alfred Marshall was well trained in mathematics and was aware of
Cournot's work but he preferred to suppress the mathematical derivations and presented results
only verbally. Economic profession was slow in adopting mathematics as a tool. Even as late as
1940's less than three percent of the pages in American Economic Review, the journal of the
American Economic Association, had rudimentary mathematical expressions. 2

1
Jevons and Menger stated that marginal utility, incremental satisfaction from unit increase in consumption of a
commodity decreases as consumption increases. Because of the decrease, a consumer who achieved certain level of
consumption of a product will not be willing to incur the cost of purchasing additional units. This determines his
demand for the product. Utility analysis was subsequently refined, as discussed in the next chapter, to remove the
psychological assumptions in the nineteenth century formulation.
2
Debrue (1991), p.1
6

Calculus imposes limitations on the type of functions that can be used to model behavior
of individuals and firms. Since these restrictions do not always correspond to the opportunities
available in an economy, one trend in the economic analysis was to expand the scope and
generality of equilibrium analysis by adopting more sophisticated mathematical techniques. 1
Institutional changes and analytical developments influenced each other. The opening of the
market spurred organizational innovations. Deregulation of trade increased competition and, to
be profitable, firms had to reduce the cost of production by increasing the scale production. It
was no longer feasible for the owner to manage the operations and a managerial cadre was
created to enable separation of management from ownership. As cost of manufacturing
operations increased, pooling of savings by a few investors and loan from a local bank were not
enough to finance the plant and its operations. Financial markets developed to channel the saving
of different individuals to financial intermediaries and let them invest the funds in different
stocks and bonds. Limited liability protected personal assets of shareholders from the creditors of
the company in case the firm went bankrupt. Those who invested their savings needed
information on the returns they can expect. The firms periodically publish financial accounting
statements, and guidelines were set out by regulatory agencies to ensure that they accurately
reflect the financials flows of the firm. Finance theory showed how investors can reduce the risk
through diversification and hedging. Information technology was used to minimize inventory
without disrupting production and to develop cost effective supply chains.
Individual disciplines, like human resource and organizational management, finance,
accounting and supply chain management focused on specific aspects of the complex operations
of the firms. They all aim in guiding the firm to adopt practices that increase its profitability.
Shared goal and common methodologies like game theory (study of strategies used in interaction
among a small group of decision-makers) and dynamic optimization (optimization over time)
links them to economic analysis. Making explicit the links provides a better understanding of the
nature of decisions to be made.
The success of economics is that, over the two and half centuries, it has grown into a
rigorous discipline that uses mathematical and statistical reasoning to substantiate its
conclusions. Its belief in individual optimization placed on households and firms the
responsibility of making proper decisions. For some decisions, like savings to meet unexpected
expenses or for retirement, the individual has to look into the future. Many decisions, like
investment in stocks and undergoing some medical procedures, involve risks. Theories that deal
with intertemporal decisions and decisions under uncertainty invoke assumptions about the
behavior of individuals and firms that are much more complex than those about choice at one
point of time. When outcomes differ from what was expected, questions are raised about the
validity of these assumptions. Is the low savings rate in the United States due to myopic choices
by individuals? Do the current theories about choice under uncertainty underestimate the
probability of extreme outcomes? Adam Smith realized that markets may veer away from the
competitive ideal. There is a tension between freedom to transact in the market and instituting
regulations to ensure level playing field. This comes out in periodic debates about antitrust and
financial regulations.

1
New mathematical methods used include convex analysis, fixed point theorems, linear programming and activity
analysis, game theory and non-standard analysis.
7

When an individual or an economy faces a crisis, the question is whether those who made
bad decisions ignored the lessons of economic analysis or did economics fail to provide them
with clear guidelines? Whatever be the reason, the consequences are important to us and in this
economics is like medicine. Developments in both sciences have resulted in improvement over
time in the quality of life. 1 However, both have left challenges, some old and other new,
unanswered.

Public appreciation of sciences.

The scientific revolutions of the seventeenth century changed the public perception of the
world around them. The Copernican revolution, the calculations of Kepler and the observations
of Galileo revolutionized astronomy. William Harvey discovered the circulation of blood in the
body and the microscopes of Anton van Leeuwenhoek identified red blood cells and single cell
bacteria. The geographical explorations opened up access to new lands and people with strange
customs. The climax was the publication of Newton's Principia Mathematica in 1687.
The scientific breakthroughs and the controversies they created became part of social
discourse and popular science shaped the public opinion in France and England. 2 Even novels
and poems referred to them. Realizing the value of convincing a wider audience the validity of
various theories, the protagonists solicited public support for them as Voltaire did for Newtonian
physics. Louis XV created a post for professor of experimental physics at the College of Navarre
for Jean-Antoine Nollet and his lectures, which were free, were popular enough for hundreds to
attend them. He wrote books on scientific experiments for the general public. 3 Other scientists
gave lectures and demonstrated experiments in different parts of Paris and they were well
attended in spite of high entry fees.
In United Kingdom, interest in popular science was well established by the eighteenth
century. Royal Society was established in 1660 to promote scientific debate and lobby for
science. Till 1820 it admitted gentlemen interested in science as its members. At the end of
eighteenth century, the Royal Institution was established to promote science and to diffuse
scientific knowledge. Christmas lectures by Humphrey Davy and Michael Faraday at the
Institution were extremely popular. 4
Scotland, because of its location, had intellectual contacts with European universities and in
the seventeenth century many Scots attended Dutch universities. The Union with England in
1707 opened the economy for trade with the British Empire. By the middle of the eighteenth
century, Scotland became the tobacco capital of Europe, importing more tobacco from America
than even London. Linen industry also benefited from the wider market.
The economic prosperity created a cultural revival. A number of societies were organized
to propagate literature and the art of speaking. Noble families hired tutors to give lectures at their
homes. It is to this Scotland that Adam Smith returned after his six years at Oxford University.

1
In the common preface to Cambridge Economic Handbook, J.M.Keynes expresses that economics is not like
physical sciences. See preface in Robertson (1923).
2
Even novels and poems referred to them. Realizing the value of convincing a wider audience the validity of various
theories, the protagonists solicited public support for them as Voltaire did for Newtonian physics.
3
Lynn (2006), pp.56-57.
4
Gregory and Miller (1998), pp.20-21.
8

He was in need of financial support and his well-connected friends arranged for him to give a
series of lectures on "rhetoric and belle lettres."
He brought a new approach to the subjects, leading the students to develop a style that was
expressive but at the same time concise and precise. "Undoubtedly, Smith's lectures on rhetoric
and belle lettres delivered in Edinburg marked a clear transition from the earlier well-established
academic tradition of formal rhetoric. They were the first of the kind not only at the Edinburg
University but also in Great Briton giving to a more practical and creative attitude towards
rhetoric." 1 It is not surprising that he carried this style into his magnum opus, the Wealth of
Nations. Joseph Schumpeter comments on Adam Smith style: 2
"He never moved above the heads of even the dullest readers. He led them gently,
encouraging then with trivialities and homely observations, making them feel
comfortable all along. While the professional of his time found enough to command his
intellectual respect, the `educated reader' was able to assure himself that, yes, this was so,
he too always thought so; while Smith taxed the reader's patience with his masses of
historical and statistical material, he did not tax his reasoning power."
Many economists consider Schumpeter was condescending in his comments on Smith's
contributions. It may be true that individual building blocks of his system were developed earlier
by others but he weaved them together into a comprehensive thesis on economics. He never
hesitated in expressing his opposition to any institution or regulation that limited competition
with and across nations. But Schumpeter was correct is his ability to do all this without talking
down to the readers. Even today Smith's homely observations are quoted as of no other
economist.
Alfred Marshall took a different route. When he began study of economics in 1867, David
Ricardo and James Stewart Mill reigned supreme. Writing about the development of his thoughts
for a German publication, he said that he began by translating Ricardo's reasoning into
mathematics. 3 His first published work, Economics of Industry written with his wife, was meant
for the education of the working class. Later he began work on diagrammatic illustrations. His
goal was to focus on tools that have universal applicability. "Marshall's mathematic and
diagrammatic exercises in Economic Theory were of such character in their grasp,
comprehensiveness and scientific accuracy and went so far beyond the "bright ideas" of their
predecessors that we may justly claim him as the founder of modern diagrammatic economics." 4
Still he relegated diagrammatic analysis to footnotes, fearing businessmen who read his
Principles of Economics will be turned away by it. Even though his literary style had none of the
elegance of Smith's rhetoric, the book was received with wide acclaim.
The mathematization of economics enabled it to broaden its scope. It can now analyze
simultaneous equilibrium of many markets, choice of a diversified portfolio that balances risk
and return, strategic interaction among a few competitors and dynamic behavior over time. The
cost is that the profession is less committed to the Smith-Marshall tradition of making economic

1
Jermolowics (2004), p.204
2
Schumpeter (1954), p.185.
3
Keynes (1924), pp.328-329.
4
Keynes (1924), p.322.
9

analysis accessible to general readers. The one concession to non-mathematical readers is the use
of graphs but they tend to grow in complexity with the theories they depict and it requires skill to
decipher them.
Economics is not the only science that strived for mathematical rigor in the twentieth
century. Mathematics itself strengthened its foundations with set theory, analysis and topology.
There is a steep gradient in the mathematical structure of physical theories from Michael Faraday
to James Maxwell to Albert Einstein. Even so, there is a thriving market for popular science
books that explain these theories to readers with differing skills and perseverance.
In the seventy years since the publication of Lancelot Hogben's Mathematics for the
Million and Richard Courant and Herbert Robbin's What is Mathematics, dozens of books for
non-mathematicians were published. Some like Rueben Hersh's What is Mathematics Really and
Simon Singh's Fermat's Enigma have no or very few equations. Others, including John
Derbyshire's Prime Obsession and Mario Livio's The Equation that Couldn't Be Solved, have
many.
Popular science books in physics show even greater diversity. George Gamov, a nuclear
physicist, published sixteen popular science books between 1940 and 1970, including five in the
Mr. Tomkin series. Ian Stewart's What Shape is a Snowflake and Stephen Hawking's The
Universe in a Nutshell are profusely illustrated. Kip AS. Throne's Black Holes and Time Wraps
and Tony Hey and Patrick Walters's The New Quantum Universe require sustained attention
from the readers. Economic analysis, like all other disciplines, have many branches, some more
mathematical than others. However, there is no ground to believe that anyone of them is more
abstract and difficult to comprehend than cosmology, quantum physics or relativity.
Consider all the books on economic analysis for the general reader (excluding both
textbooks and those that do not explain concepts) and arrange them in the ascending order of
effort expected from the reader. How large is the pile? Partha Dasgupta's Economics: A Very
Short Introduction, Avinash Dixit and Barry Nalebuff's Thinking Strategically: The Competitive
Edge in Business, Politics, and Everyday Life and John Kay's Why Firms Succeed will be in most
lists. If the upper end is stretched, Paul Milgrom and John Robert's Economics, Organization
and Management can be added to the pile. As with sciences, the inclusion criteria are fuzzy and,
depending on how they are interpreted, different list can be complied. Still it fair to say that,
compared to the menu of popular science books, the choice of books on economic analysis for
the general reader is sparse.
In contrast, there are hundreds of books on economic policies, some proposing the very
policies others oppose. If principles of economic analysis have universal applicability,
differences in conclusions must be attributed to disagreement on objectives of the policies and
assumed differences in the responses of individuals. This is all the more the reason for those who
are affected by recommendations to have an understanding of tools used in forming them. It is
unfortunate that as choices open to individuals expanded in the second half of the twentieth
century, the general public have to, borrowing an analogy from Dennis Robertson, stand outside
and bow towards the temple of economic analysis. 1

The plan of this book.

1
Robertson (1958), p.42.
10

At the core of economic analysis is the study of markets. While there are a variety of
markets, it makes sense, as is usually done, to start with the market where we buy goods for daily
use. We have our budgets and, among what we can afford to buy, we select baskets of goods and
services based on our preferences. The goods are supplied to the market by the producers who,
based on their costs and technology, choose outputs that maximize their profits. Why should the
quantities they supply and what we want to buy be the same? If they are not, either there is a
shortage that prevents us from buying what we seek or a surplus that cuts into the profits of the
firm. For any economy to function without such perturbances, a mechanism to coordinate the
decisions of consumers and producers and to nudge the quantities demanded and supplied toward
equality, is needed. The thrust of modern economics is that price acting as a signal to consumers
and producers is, with caveats discussed in later chapters, the most efficient way to achieve
coordination.
The coordination problem does not exist or minimal in primitive economies where one or
two individuals live in isolation. Their efforts to make the best of their strained circumstances
bring out in a very intuitive way the conditions that must be satisfied to achieve efficient use of
resources in contemporary market economies. The next three chapters focus on study of isolated
societies but there are frequent digressions to consider the light they throw on the working of
modern economies.
Ability to substitute is what allowed mankind to prosper under varied natural conditions.
In modern economies substitution is what empowers consumers as they cut back or reject
products that have become expensive or of low quality. Chapter 2 discusses how willingness to
substitute is determined by the preferences of the consumers.
Chapter 3 starts with the discussion of a sailor stranded in a lush island. He has to direct
his efforts to gather food for dinner and he has to consume what he collected. He has to match
his ability to produce with his preferences for the consumption basket. His choices reveal how he
can achieve an efficient use of his time and resources.
Next exchange is introduced by considering two individuals living by themselves. Each of
them have in possession one food product - fish with the fisherman and vegetables with the
farmer - but they prefer to have both for dinner. They will agree to an exchange only if it benefits
both but the distribution of benefit will vary with the rate at which they exchange. This is true for
market economies too. Today we purchase many goods at fixed prices. Less frequently when we
buy a house or when we negotiate the terms of employment, we bargain the terms. The theory of
bargaining based on cooperative game theory is explained and its analysis is applied to
negotiations within affluent and subsistence level households. The chapter ends with an
examination of the transition from medieval economy with rural self-reliance to urban market
economies with retailing at fixed prices.
Chapter 4 braces both primitive and market economies. The first part discusses decisions
whose costs and benefits are spread over time. We decide on our education when young and,
while career changes are possible in the United States, it sets the direction for our professional
life. We save during working years as a buffer for unexpected expenses and for a comfortable
life after retirement. Future is uncertain and the second part discusses the concept of uncertainty
and how two farmers living on opposite sides of a mountain and facing different weather
patterns, can sign contracts (similar to derivative contracts in a modern economy) to limit the
fluctuations in their consumption.
11

The discussion of market economy begins with Chapter 5. Individuals with fixed budgets
go to shop in markets where prices are fixed. Among the baskets he can afford, an individual
chooses one that maximizes his utility. How a change in the price of one product or the income
of the consumer affects the chosen basket is examined. Given the income of consumers and
prices of other goods, there is only one price at which the quantities demanded equal that
supplied.
The internal organization of a firm is the topic of the next chapter. The relation between
inputs and outputs is considered. It leads to a discussion of how to account the cost and revenues
of the firm and how to measure profitability.
In modern economies, it is reasonable to assume that there are a large number of
consumers in any market. However, the number of firm producing a product differs from market
to market. Next five chapters discuss markets with one to many firms. The numbers affect the
output and pricing decisions made by each of the firms. In some markets, a product is sold to all
customers at one price while in others different groups of customers pay different prices.
Branding of products allows producers to differentiate their products from that of others and
charge different prices. Finally, the market where there are many producers and consumers with
none having any influence on the market price is discussed; it has a special place in economic
theory as it can be shown to achieve efficiency defined in a specific sense.
The next chapter develops on the discussion of time and uncertainty in Chapter 4 and
introduces financial economics.
The final chapter takes a look how the understanding of the functioning of the market
provides additional insights into decision making within a firm.

Summing up.
At least from the time of the Enlightenment movement in eighteenth century Europe, the
public has shown an interest in having the contributions of scientific disciplines explained in
non-technical language. Experimental sciences enthralled the public by holding demonstrations
in various institutions devoted to propagation of science but it was popular science books with
colorful graphics that reached a wider audience. To explain economic principles in a non-
technical language with help of computer graphics is the modest goal of this book. 1

Bibliographic Note:
Debreu (1991); Devine, Lee and Peden (2005); Gregory and Miller (1998); Jermolowics
(2004); Keynes (1924); Lamm (1989);Lothian (1963); Lynn (2006); Magnusson (1992);
Robertson (1923); Roberstson (1958); Schumpeter (1954); Stigler (1949); Stigler (1990); Viner
(1991).

1
This effort is not exempt from the mathematical proposition that one point cannot fill in a gap.
12
13

Chapter 2. Consumer preferences and choices.

"We hold these truths to be self-evident, that all men are created equal, that they are endowed
by their Creator with certain unalienable Rights, that among these are Life, Liberty and the
pursuit of Happiness--- That to secure these rights, Governments are instituted among Men,
deriving their just powers from the consent of the governed,..." In declaring that there is no
hierarchy among its citizens, that they have natural rights no government can restrict, that they
can pursue their worldly welfare and that it is the citizens that empowered the government, The
United States Declaration of Independence passed on July 4, 1776 set forth not only the
aspirations of a nation about to be born but of all liberal democracies around the globe.
At the time of the Declaration, most societies were hierarchical with the king at the top and
the serfs at the bottom. An individual's position in this hierarchy was determined at birth and the
right to choose one's lifestyle - where to live, what to wear, what to eat and the vocation to
follow - that we take for granted did not exist for him or her. The conviction in the Medieval Age
was that human beings, though endowed with rationality, were born with weakened will and
inclined to sinning. To prevent them from destabilizing the society, they have to be led by
divinely ordained rulers. According to an extreme formulation of this view, the theocratic theory,
rulers had absolute authority in temporal matters. He had a moral responsibility to care for their
subjects, but it was a one-sided obligation that did not allow subjects to judge or bring an action
against the ruler. In reality, the feudal system involved some devolution of power and the king's
power outside his own estate depended on his ability to form strategic alliances with barons, the
territorial magnates. In Europe this relationship began to change by sixteenth century as the
rulers expanded their jurisdiction at the expense of the barons and established modern states with
centralized administration. Individual rights under the feudalism and absolute monarchy, so far
as they existed, did so by the grace of the rulers and were subject to their whims. The
Declaration of Independence, in reversing this relation between the ruler and the ruled and by
conferring unalienable rights on the citizens and requiring the government to seek the consent of
the ruled, proposed a revolutionary agenda that was controversial then and continues to be
debated even now.
The English philosopher Thomas Hobbes (1588-1679) argued that political power comes
from the consent of the governed. The state of nature (society before the establishment of a
political authority) was poor, nasty and brutish and the struggle for survival led to violence. To
escape from the threat of constant turmoil, a civil society was formed by its members
surrendering their rights to a sovereign. The sovereign was vested with power not by divine
ordination but by a social contract made by the citizens.
John Locke (1632 - 1704) introduced an economic component into the political process
when he made hunger the main threat to survival in a state of nature. To alleviate their hunger,
individuals gathered food and even cultivated land. For making nature more abundant by his
labor, a person earned the right to the land he tills and the harvest he reaps. When individuals
came together and began to exchange what their produce using money as a measure of value,
two important changes occurred. First a society was created and second the right to property was
separated from labor that was embodied in it. Collective life was built on property and as
political authority was created by social contract, the authority cannot abridge the individual
right to property that pre-existed its formation. The role of justice was to guarantee property. The
14

need was to empower the political authority to enforce social contract without giving it too much
of power over individuals can be achieved only by creating a representative legislature. By the
end of the seventeenth century, the works of Hobbes and Locke brought an awareness of the
rights of individuals and the benefits of a democratic form of government.
Locke's claim that individuals were vested with natural rights was criticized by Jeremy
Bentham (1748-1832). Natural rights, he argued, were based on fictitious image of a primitive
society and a hypothetical social contract. It was political institutions that conferred rights on
individuals and the rights were justified only if they lead to "the greatest happiness" of the
citizens. Today the debate is whether public policies to promote "social justice" infringe on
individual rights. Modern welfare theory based on refinement of Bentham's utilitarian
philosophy supports redistribution if it raises social welfare, appropriately defined in terms of the
utilities of individuals. 1 According to entitlement theory, each household has the right to
consume what it produces and any redistribution is unjust. 2
Immanuel Kant (1724-1804) argued that state cannot impose any particular conception of
happiness on individuals. Society must treat humanity in each person as an end in itself and
freedom, defined as independence from being constrained by another's choice, was an absolute
right. Property right was essential for implementation of innate right to one's freedom. His strict
definition of property rights denied legitimacy to taxing one person to support another. This,
however, did not preclude him from arguing that the state should support the poor; since the state
had to raise resources to fund its effort, there is an ongoing debate, whether Kant's positions on
absolute property rights and the support of the poor are consistent or not.
Scientific breakthroughs culminating in the work of Newton led many intellectuals in the
eighteenth century Europe to believe that, through reasoning, the public can be made to reject the
superstitions of the medieval age and accept a social order based on reason. Beyond a belief in
rational order, there were ideological differences among protagonists; luminaries of Scottish
Enlightenment stressed more than their continental counterparts the economic, political and
religious freedoms of individuals. 3 Adam Smith was a prominent member of the Scottish circle.

1
The distinction between the two views of justice can be fudged by adding to rights over and beyond life and liberty
to the list that needs to be guaranteed. Critics argue that such addition makes the arguments for rights trivial as
anything can be defended. The debate continues.
2
The distinction between the two views of justice can be fudged by adding to rights over and beyond life and liberty
to the list that needs to be guaranteed. Critics argue that such addition makes the arguments for rights trivial as
anything can be defended. The debate continues.
3
Scottish Enlightenment influenced The Declaration of Independence. Among those associated with Enlightenment,
Francis Hutcheson, David Hume, Sir James Steuart and Adam Smith contributed to economic analysis and policy. A
comparison of their views brings out the diversity of opinion even within this group. Hutcheson, the teacher of
Adam Smith, was a critic of Hobbes views on morality. Hume discussed money, the rate of interest, balance of
trade, public finance and population but lacked a unified vision of the economic process. Steuart had a
comprehensive theory but it was one based on the earlier Mercantilist views that favored state intervention to
support industry. He is said to have influenced Alexander Hamilton in developing the infant-industry argument to
justify trade restrictions in newly independent United States. Adam Smith who began his career as a lecturer in
moral philosophy disagreed with his teacher Hutchinson. Later he wrote The Wealth of Nations, a systematic
exposition of free market economy. In the book, he never mentioned Steuart but opposition to his views are evident
in Smith's criticism of Mercantilist doctrines.
15

His early works were on rhetoric and moral philosophy but, after a trip to Europe during which
he had discussions with French economists, he turned his attention to economics.
The Wealth of Nations was the first comprehensive treatise on the economics. Smith
collected and analyzed information about agriculture, manufacturing, internal and international
trade, taxation and government regulations of commercial activities in British Isles and Europe.
He identified many regulations that were hindering the activities of individuals in these sectors
and argued for their elimination. Adam Smith went beyond recognizing the rights of individuals
and claimed that all activities in an economy must be directed to increase individual welfare.
"Consumption is the sole end and purpose of all production; and the interest of the producer
ought to be attended to, only so far as it may be necessary for promoting that of the consumer." 1
Relating the value of a product to its ability to meet the wants of consumers has a long
history. The Greek philosopher, Aristotle, wrote of the distinction between value-in-use and
value-in-exchange and Scholastic Philosophers of the sixteenth century had a theory of utility. 2
Individuals derived "utility" from the satisfaction of wants but relating utility to demand and
relative prices of products required refinements in utility analysis that was developed only in the
nineteenth century. Smith related price (at least in the long run) to the cost of production and
specifically to one component of it, the labor cost. While he was criticized for his focus on labor
cost, he did show awareness that consumers' willingness to substitute one product for another set
bounds for their relative prices. The price of wood, he noted, was capped by the possibility of
substituting cheaper coal, even though coal was judged inferior to wood by its users.
This chapter elaborates the concept of substitution in consumption and explains how it can
be quantified. Computer graphics, helpful to represent the substitution by consumers and
producers, is developed in next section.

Diagrammatic representation of consumer's choice as selection of a basket of goods.

A consumer, Emma, has received her weekly paycheck. Part of it she saves and the
balance spends on groceries, clothes, toiletries and gas. Her shopping takes her to different stores
even though the trend is for each store to broaden the selection of goods. Most of the purchases
are made in the weekend, but she does shop on weekdays. While she spreads her purchases over
the week, they are part of Emma's budgetary plan for the week. At the store, she places whatever
she selects in a basket as is usually done in grocery stores and warehouse clubs (like Costco or
Sam's Club). As part of her deliberation on what to purchase, she takes out some items that she
placed in the basket and adds others. 3 Each addition or substitution creates a new basket. The
choice she has to make in spending her budget wisely is to choose from the many baskets she can
afford, the one she prefers to all others.

1
Adam Smith (1937), p.62
2
Schumpeter (1954), pp.1053-1066.
3
The adding and subtracting can be a virtual substitution as she mentally plans her purchases, or she may physically
remove and add products to her basket at the store.
16

Figure 1. Constructing baskets by substitution of products.

Emma buys many goods but to facilitate a pictorial representation, the choice is restricted
to two goods. This outwardly absurd simplification does not affect the qualitative nature of the
conclusions discussed in this chapter. Using mathematics, the analysis can be extended to
purchase of any number of goods.
In Figure 1, quantities of the one product, a soft drink, is measured along the bottom or
horizontal line and quantities of the second product, milk, is measured along the vertical line.
The First Basket has two bottles of soft drink and four cartons of milk and the dot near the left
bottom corner of the basket represents the position of the basket. The quantities in the basket are
measured by distances of the dot from the vertical line and the horizontal one. By adding four
bottles of the soft drink and taking out two cartons of milk, a new basket with six bottles of soft
drink and two cartons of milk is created. The Second Basket is further away from the vertical
line but at a lower height than the First Basket. Emma can purchase these baskets only if they are
within her budget. If her budget for drinks is $15 and if the prices of soft drink and milk are
$1.50 and $3 respectively, then both baskets cost $15 and are just affordable. So is the Third,
Fourth and Fifth Baskets shown in Figure 2.
The points representing the baskets that cost as much as the budget lies along a straight
line appropriately known as the budget line. How many such points are there? Products are sold
in containers or packages of different sizes; milk can be had in a quart or half quart cartons and
gallon jugs; soft drinks are sold in big bottles and small cans. For analytical simplicity, diagrams
are drawn under the assumptions that products are divisible into such small quantities that they
can be viewed as varying continuously. Then every point on the budget line represents a basket
of milk and soft drink that costs $15.
17

Figure 2. Budget line.

Emma moves up the budget line as she buys more milk and less soft drink. The slope of a
curve is, in common usage and mathematics, the ratio of the increase in height to a forward
movement horizontally. 1 The economic significance of the slope of the budget line is that it
indicates how much more of one product can be purchased with the cost savings from reducing
one unit of the other product. Since the budget line is a straight line, its slope can be determined
by taking ratio of quantities in the end baskets. These are baskets Emma can purchase by
spending the entire budget on one of the products: Third Basket containing five cartons of milk
and Fifth Basket containing ten bottles of the soft drink. The ratio of quantities in the two baskets
is five-to-ten. Since the quantity of one product increases as the other decreases, the
mathematical convention is to making the slope of the line a negative number: (-5)/10 = -0.5.
Can Emma buy any basket that is not on the budget line? Sixth Basket with two bottles of
soft drink and two cartons of milk costs only $9 and is well within her budget. Any other basket
that lies below the budget line costs less than the budget, and Emma can afford baskets on or
below her budget line. Which one would she prefer?

1
Think of bicycling along a road. Slope for the road is how much you climb as you cycle a short distance. In
geometry, the slope of a curve at a point is the ratio of the vertical movement to the horizontal one as one traverses
along a curve. In general the slope varies along the curve and slope is calculated based on movement between two
close points. For a straight line, the slope is the same at all points, and it can be calculated by the ratio of the increase
in height to the horizontal distance travelled between its end points.
18

Figure 3.Choice reveals unobservable preferences of

consumer.
Individual preferences expressed by choice
Emma living in the United States does not have to fight for survival like those living in
primitive societies envisaged by Hobbes and Locke, but she gets hungry and thirsty periodically
and needs clothes to wear. In her purchases, she can choose from food products and apparels
available in the market. Her selection affects not only her but also the producers of goods and an
understanding of her decisions is a prerequisite for an analysis of the market mechanism.
Nineteenth century economists, building on the utilitarian philosophy, assumed that any basket
of goods provides the consumer, depending on her preferences and the composition of the
basket, a level of utility. In addition, they the level was measurable and its changes with
quantities of commodities indicated how her preferred basket changed with income and prices.
Their analysis was criticized in the beginning of twentieth century for assumptions about an
individual's preferences that cannot be verified by observation (Figure 3). A new approach to
consumer behavior, instead of claiming to explain choice in terms of utility, made utility a
numerical index that reflects the choice.
Economic analysis recognizes the diversity of preference among individuals. Two
individuals with the same income and paying same prices (in short, having the same budget line)
might choose different baskets and their choices demonstrate how their preferences differ.
However, consumers in different economies and at different times are observed reducing
consumption of products whose prices increased. Income increases lead to choices of bigger
baskets with larger quantities of almost all products.
Economic analysis has to explain both the diversity in choice among consumers and
similarity in their responses to changes in affordability. This is achieved by imposing minimal
restrictions on the preferences of all consumers. These restrictions are embodied in the axioms of
preference. 1
An axiom is defined in Oxford English Dictionary as "a self-evident proposition, requiring
no formal demonstration to prove its truth, but received and assented to as soon as mentioned."

1
The discussion in the text is based on revealed preference approach of Paul Samuelson and
Hendriks Houthakker.
19

Figure 4. Two axioms of preference.

The first axiom is that a consumer can express her preference; given any two baskets, she
ranks one basket as preferred to the other or ranks them equally (she is indifferent). If this is not
true, there is no rational choice.
The second axiom is that consumers, at least in the neighborhood of what they have, prefer
larger quantities to less of each of the goods. 1 The Basket One in Figure 4 (reproduced from
Figure 2), costs less than Emma's budget. If she adds two more bottles of the soft drink to the
basket, the cost increases from $9 to $12 and its cost is within her budget of $15. By this axiom
of non-satiation, she prefers Basket Two to Basket One. Her budget allows her to keep adding
two more bottles of the soft drink to the basket and she will prefer Basket Three (same as Fourth

1
The purchases are for a period, the week in the example of Emma. She may not want more milk in her cereal as
she sits for breakfast one morning, but she will be willing increase her consumption of milk over the week, if
changes in income and prices make it possible to consider such an increase. Consumption, in discussion of budget
allocation, should not be viewed as an act at one time but as what she would do over the period of allocation. It is in
this sense that consumers are assumed to have non-satiation. Though it is easier to visualize local non-satiation, in
the theory of consumer choice, it is common to assume non-satiation over the whole consumption set.
20

Basket in Figure 2) to Baskets one and two. By extension of this argument, there is a basket of
the budget line that is preferred to any basket below it.
Baskets on the budget line in Figure 2 differ in having more of one product and less of the
other. The third axiom imposes some order in the ranking of such baskets (Panel B of Figure 4).
She has to choose from three baskets, and she first considers a choice between Basket 2 to
Basket 3 and decides that she prefers Basket 2. Then she compares Basket 2 and Basket 1 and
chooses Basket 1. If she is to compare the third possible pair among the baskets, Basket 1 and
Basket 3, which one will she prefer? The third axiom states that she must prefer the Basket 1 to
the Basket 3.
Notice that ordinary numbers satisfy transitivity; 5 is greater than 3, 10 is greater than 5
and 10 is greater than 3. The axioms of preference make utilities reflecting the ranking of baskets
to have some of the properties of numbers but not all of them. A person chooses one basket to
another. Utility being only an index indicating choice, the preference for a basket over another
can be represented by assigning utilities 10 to the first basket and 2 to the second or 35 to the
first and 19 to the second. From choice of the baskets alone, it is impossible to decide which of
the utility assignments is valid. Much of the controversy in the beginning of twentieth century
economics was on this question but there is no need to get into this historic debate.
The fourth axiom can be interpreted as excluding what is known as "lexicographic
preferences." In a dictionary world are arranged by the first letter, and those words are then
ordered by the second letter and so on. "Azure" comes ahead of "baby" even though its second
and third letters "z and u" come much behind "a and b" in the ordering of alphabets. The axiom
requires that consumers should not rank baskets by the quantity of one product irrespective of the
quantities of other products. If enough of the second product is offered, he or she must be willing
to accept a reduction of the first. This axiom assures that preference for basket changes
continuously with quantities of the product and consumers are willing to substitute one product
for another.
The abstract formulation of preferences is necessitated by the recognition that only the
individual is privy to his or her preferences. Using the four axioms, a measure of the willingness
of an individual consumer to substitute is developed in the next section.

Consumers' preferences and willingness to substitute one product for another.

Innovation and substitution are two strategies vital to the survival of mankind through the
millenniums. Human intelligence enabled development of newer technologies to tame the
vagaries of nature and improve standard of living. However, shortages arise even today as crops
fail or industrial production is disrupted. When it happens, consumers have to adjust their
consumption and do it in a way that individual choices add up to the reduction in the availability
of the product. One solution is for a central authority to acquire command over the output and
apportion it among the consumers. Under rationing of "scare" goods as implemented in many
countries, the total output is divided equally among the consumers. 1 Allocation of predetermined

1
In times of food shortage, the state tries to avoid famines by rationing food. Less frequently, other items are also
rationed.
21

quantities results in consumers having to buy baskets that differ from the one they prefer. Some

Figure 5. Marginal rate of substitution.

are willing to exchange rationed goods for other products while other consumers prefer more of
the rationed goods. They circumvent the centralized allocation system by buying and selling in
the "black market." 1
The market economy relies on individual's willingness to substitute to achieve a reduction
in quantity demanded of the scarce product, and it leads to a better social outcome (in a sense to
be discussed in next chapter). Given a basket, the maximum amount of one product the consumer
willing to give up for one unit of another is a measure of his willingness to substitute.
A consumer, Allen, has to choose one of two baskets offered to him (Figure 5). Basket A has
six bottles of soft drink and two cartons of milk while Basket B has two bottles of soft drink and
four cartons of milk. If Allen chooses Basket B, he is revealing that having two additional
cartons of milk more than compensated him for the loss of four bottles of the soft drink.
How much extra milk will just compensate him for the loss soft drink? To determine that
amount, gradually reduce the quantity of milk in Basket B (here is where the assumption that
quantity changes continuously is needed). Allen will rank the new baskets lower than Basket B
but, at least for small reductions, he will continue to prefer them to Basket A. Further reduction
in quantities of milk will result in Basket D. It has less of both products than Basket A and must,
by axiom of non-satiation, be ranked in his preferences below Basket A.

1
Feasibility of such exchanges is explained in Chapter 3. Why could not the administrators adjust the baskets even
partially to make them closer to individual choices? Bureaucrats managing the rationing system will never be able to
obtain enough information about individual preferences to make such adjustments feasible.
22

In between Basket B and Basket D, there is a basket that Allen ranks equally as Basket A
(he is indifferent between the two). In Figure 5, it is Basket C. Allen's preferences are such that,
given Basket A, he is willing to accept one additional carton of milk for four bottles of the soft
drink. This rate of exchange is his marginal rate of substitution.
Graphically, it is measured by the ratio of the height CD to length of base AD of the
triangle ACD. 1
An individual's marginal rate of substitution varies with the baskets. An additional axiom of
preference, explained in detail in next chapter, indicates the way the rate changes. Given
identical baskets, the marginal rates of substitution will also differ among individuals. If Emma
had Basket A, her marginal rate of substitution will be different from that of Allen.
Willingness to substitute is important aspect of human behavior and plays a crucial role in
the functioning of the economy.

Relating preferences to product characteristics.

In the last section, consumer's preferences were defined by ranking of baskets of goods.
The role of products in the baskets in influencing the consumer was not made explicit.
Consumers purchase goods to satisfy wants: they rent or own housing for shelter, purchase food
to satisfy hunger and get drinks to quench their thirst. Different goods, in spite of their
differences satisfy each of these wants - an individual can alleviate his hunger with vegetables,
fish or meat. He can drink water, soft drinks or fruit juice when thirsty. Which one he will
choose depends on his preferences for the characteristics of these foods: their tastes and
nutritional values, for example. Can the preferences for goods be decomposed into preferences
for its characteristics?
Product changes in automobile industry provide an example. Shortly after Henry Ford
introduced mass production of T Model cars, customization based on a bare chassis began. Many
of the independent producers began putting a wooden frame with the interior extended to an
almost vertical back. The "station wagons" were used as taxis to transport passengers and their
luggage from railway stations to their destination. The idea of a minivan, positioned between the
station wagon and light truck, was first put forward at Ford but was shelved due to concern of
finance and sales departments that it will cannibalize sales of other models without increasing the
total.
Around this time, many Ford executives including Lee Iacocca left Ford and joined
Chrysler. 1

1
Reflecting the increase in one product as the other is decreasing, the ratio is negative. The marginal rate of
substitution is defined as the negative of a negative number, making the ratio a positive number. In the text, for
visual clarity, the marginal rate of substitution is expressed as the ratio of two discrete quantities while
mathematically it should be the ratio of two very small changes. If the two baskets, D and E, were brought closer to
each other, then the sides of the triangle will get smaller and a smaller and ultimately become infinitesimal
quantities. Another approach is to draw a curve through the points representing all baskets that the consumer ranks
equally with Basket D (called indifference curve in next chapter) and define the marginal rate of substitution as the
slope of the curve at Basket A.
23

Chrysler in the early eighties had only one distinctive product, the K-car, and it was marketed
in various versions. The Ford expatriates started pushing the idea of a minivan with front-wheel
drive. When introduced in 1983 (as 1984 model), the characteristics that made it so popular to
families and small businessmen were excellent visibility, seat height and pass through capability
from front seats to rear, height low enough to allow parking in home garages, easy entry through
sliding door on passenger side and capability to carry loads too wide for a station wagon. In the
1990s and early 2000s, the Sport Utility Vehicles (SUV), descendent of rough terrain vehicles,
became popular even among the urban population. With the increase in price of gasoline and the
recession of 2008-2009, these vehicles with low mileage became unpopular and hybrid-vehicles
that have both internal combustion engine and electric motors entered the market.
Consumers purchase products that are cost effective in providing the best combination of
characteristics to meet their wants. Preference for characteristics explains why product
differentiation - making products of the same class that differ slightly from each other - exists. It
provides insights into why new products succeed or fail. As long as products differ only in a few
characteristics, it is feasible to decompose the preference for the product into preference for the
characteristics. When they differ in many characteristics, the decomposition becomes too
complex to be instructive.

Changing consumption: what drives it?

Consumers add new products to their baskets and stop consuming that they used to. Some
of the changes are driven by availability; many customers dropped land phones when cell phones
became widely available and their reliability increased. However, all changes are not driven by
product innovations or even availability. What we are fed as a child is not what we want to eat as
grownups. Even during our adult life we make changes in our lifestyle. The shifts in the
consumption ripple through the economy and affect the fortunes of firms. The firms want to
understand and anticipate the shifts in demand for their products and to influence the direction of
the shift through advertisements and endorsement of actors and athletes. At the societal level,
policy makers and social scientists want to examine the impact of such changes on social well-
being.
What generates these changes? Is it information about a product that is new to the
consumer that made her change or did her friends and peers have an influence beyond providing
information to you?
You have walked past a Vietnamese restaurant many times but never gone in and are not
sure whether the food meets your established preferences for spicy, sour and sweet dishes. Your
colleagues at your new job go to the restaurant for lunch regularly and not wanting to be left out
of lunch outings, you agree to go with them. After eating a few times, you develop a liking for
Vietnamese food and started eating there on your own. Is your new found love of Vietnamese
cuisine the result of information that the cuisine meets your existing preferences for spicy food
or did you change your preferences under peer pressure?

1
Yates (1996), p.5.
24

Economics, in the liberal tradition, assume that preferences are specific to individual and
others can judge it only through observation of her choices (Figure 3). This limits the ability to
judge the sources of change in the observed selection. Firms spend heavily to influence
consumers to prefer their product to those of their competitor even as its competitors are doing
the same. How productive are these efforts?
In United States billions of dollars are spent in advertising. If advertising is providing
information to consumers, then the expenditure not only serves the interest of the producer but
benefits the consumers also. If advertising works by modifying the preferences of consumers,
then it is possible that consumers are influenced to make purchases over and beyond what is
socially desirable. Economist Phillip Nelson, in a number of research papers, argues that treating
advertisement as providing information not only by their contents but also through their
frequency and media choice, leads to conclusions that are consistent with data. 1
Those who focus on the psychological effects of advertising argue that, even if a mental
frame to rank preferences exists and satisfies all the axioms stated earlier, it can still be
influenced by persuasion by others. There are so many brands that are close to each other in
functionality - more than twenty models of midsize sedans available before 2008-2009
downsizing by automobile firms - that no amount of information in itself will convince a
customer to prefer one brand to another. Persuasion to change wants, belief and actions dominate
social life as individuals seek comfort in being accepted by peer groups.
While expressing preferences in terms of characteristics and considering the effect of
social factors in the choice are helpful in understanding specific aspects of consumer behavior,
rational choice as developed in the neoclassical tradition in economics with fixed preferences is
insightful and has generated many verifiable results. It will be the main focus of coming
chapters.

Summing up.
The individual has wants that need to be satisfied and, given the opportunity, will choose
the combination of goods among those affordable that he prefers most. The liberal tradition holds
that individuals have the right to property and liberty, and he should be able to make the choice
that maximizes his welfare without imposition from outside.
Any analytical framework to examine consumer choice must accept that individual
preferences are not directly observable, that they vary from a person to another and yet
individual response to price increases or income changes show a common trend. These
requirements have led to an abstract formulation in which those aspects of preferences shared by
all individuals are defined by the axioms of preference.
One common characteristic of individual preferences is the willingness to substitute. A
measure of this flexibility is the marginal rate of substitution, an increase of one product that just
compensates for a small decline in the other. The marginal rate of substitution differs from
individual to individual and, for each individual, it differs with the composition of the basket he
has. Substitution at the margin plays an important role in the functioning of an economy.

1
The arguments for information approach are summarized in Chapter 13.
25

Marginal rate of substitution, a measure of flexibility in consumer's preferences is a core concept

in the economic analysis.
Taking a closer look at the role of products in fulfilling wants, preferences for goods can
be deduced from preferences for its characteristics, particularly when products differ in a few
characteristics. It is useful in examining how consumers respond to new goods.
When consumers change their choices even when prices and incomes have not changed, is
it due to new information that made them prefer a different product or is it a change in
preferences? Economists argue that advertisement convinces consumers by providing
information while others attribute it to the power of persuasion.
The next chapter considers how trade, instead of being exploitation of one by the other as
was widely feared through the ages, can benefit both parties.

Bibliographic note.
Bagwell (2007); Coleman (996); Finer (1997); Fleishchaker (2004); Manet (1994); Miller
and Dagger (2003); O'Shaughnessy & O'Shaughnessy (2004); Schumpeter (1954); Stigler
(1987);Waldon (1995); Wenar (2007); and Yates (1996).
26
27

Chapter 3. From self-reliance to exchange.

In subsistence economies in which families live mostly on food produced on their farms, the
coordination between production and consumption decisions poses less of a challenge than in
modern economies. An individual surviving alone in wilderness and producing what he
consumes faces no coordination problem at all but, to make the best of his lonely life, he needs to
align his preferences for consumption to his capabilities for production. He loves to eat
vegetables but is much better at hunting and fishing than in farming, and he has to decide how
much meat or fish he is willing to give up for additional vegetables. He maximizes his utility
when he produces the basket of meat and vegetables that he prefers to all others he can produce
and the choice identifies a relation between his capabilities and preferences. A market economy
must match the preferences of its many consumers and the capabilities of its producers if it is to
make best use of its resources and the condition necessary for efficiency of a market economy is
a direct generalization of the one for a single person economy. The irony is that our
understanding of a market economy is facilitated by first considering an economy where there is
none.

The saga of a stranded sailor.

The story of Alexander Selkirk's survival for four and a half years in a deserted island off
Chile was recorded by the captain of the ship that rescued him. Selkirk in interviews he gave
back at home in England embellished it and Daniel Defoe did even more so in his novel
Robinson Crusoe based on Selkirk.
After getting into trouble, Selkirk ran away from his home at the age of 19 and took to the
sea. In eight years, he will become the sailing master of a galley, and a year later joined a
privateer expedition to the Pacific Ocean. During the first decade of eighteenth century, Austria,
England and Netherlands were at war with France and Spain. War was a good excuse for English
buccaneers to raid, with the approval of British authorities, Spanish galleons as they were
transporting South American gold to Spain.
The 1703 expedition to the Pacific was put together by William Dampier, who had a
checkered career first as a buccaneer in South America and then as a captain of a Royal Navy
ship exploring Australia. Two ships set sail; Selkirk was on a ship commanded by Charles
Pickering but the captain died during the expedition and was replaced by Thomas Stradling. In
January 1704, the ships rounded Cape Horn at the southern tip of South America and entered the
Pacific Ocean. After many chases and battles the ship finally anchored in the only safe haven for
British buccaneers in that area, a deserted but hospitable island about 400 miles west of Chile
then known as Isla Más a Tierra. 1

1
In 1966 Isla Más a Tierra was renamed Isla Robinson Crusoe.
28

Figure 1. Changing production by shifting labor input.

Selkirk felt that the ship needed repairs before continuing the journey but the incompetent
Stradling disagreed. In a fit of temper, Selkirk asked to be set ashore with his baggage. He
assumed that others will join him in the protest as Stradling did not have good relation with his
crew. To his surprise, the ship sailed without him.1
He lived in the island from October 1704 to February 1709. Fortunately, the Island had a
flock of goats left over by Spanish settlers who were there for a short time and turnip and green
vegetables planted by pirates during their visits to the Island. The biggest problem was isolation,
and he diverted himself by reading the Bible and studying the navigation books that were among
his processions. He talked aloud to keep his faculty of speech, but even so, it was hard to
understand him when he returned to Scotland.

Choices for survival.

Being alone in the island, Selkirk had to feed himself. Those who saw him at the time of
rescue have commented on his ability to chase and catch goats bare-footed. He also set traps for
lobsters. Tulip and green vegetables in the plains and fruit from the trees in the mountainous
regions of the Island were there to be harvested. Even though he was lucky to be stranded in a

1
Souhami, ibid, pp.56-85; Severin, ibid, pp.35-42. The ship sank shortly after leaving the Island.
29

Figure 2. Selkirk's preference for baskets he can produce.

lush island, like all those living in primitive societies, survival was his first concern, and he spent
most of his time foraging for food and then cooking a balanced meal of meat and vegetables. 1
The choice before him, as shown in Figure 1 was to divide his time between gathering
vegetables and catching goats. The less time he spent gathering vegetables, more time was there
for catching goats and the dinner consisted of more meat and less greens. Ratio of the reduction
in vegetables he gathered in order to have another pound of meat was his marginal rate of
transformation. Economics does not believe in a mantra to recite, a wand to waive or a nose to
twitch that will change turnips into a goat. The transformation was not of outputs already
produced but outputs that can be produced.
In the time, it takes him to gather two pounds of green, he could procure (by catching goats
and butchering them) two pounds of mutton. 2 His marginal rate of transformation was 2/2 or 1
and, in the following discussion, the ratio is taken to be constant. 3 Will he prefer to produce and

1
Though he could have meat, lobsters, fruits and vegetables, his choices are, for sake of drawing diagram, reduced
to two: meat and vegetables.
2
Numerical examples in this section are constructed to illustrate economic concepts and are not based on historical
facts about Selkirk's life in the island. Using mathematics, it can be generalized to any number of goods instead of
two in the text and diagrams
3
To be mathematically accurate, the changes in quantities in Figure 2 should be very small (infinitesimal). Here, for
visual clarity, the liberty of drawing discreet changes is taken and the curves in Figures 2 are slightly distorted to
30

consume another basket with more meat and less vegetables to the earlier one? The willingness
of a consumer to substitute one product for another - the extra amount of the second product
needed to compensate for giving up a unit of the first - is measured by his marginal rate of
substitution (Figure 5, Chapter 2). Given Basket A in Panel A of Figure 2, Selkirk needs only 1.5
lbs. of meat to compensate him for the reduction in vegetables; his marginal rate of substitution
was 2/1.5 or 4/3. He ranks the two baskets, Basket A and the basket represented by the green dot,
equally in his preferences; he is indifferent between the two. 1 With the time saved in gathering 2
pounds less of vegetables, Selkirk can produce the red basket with two more pounds of meat. 2
Since the red basket contains more meat, Selkirk will prefer it to the green basket and Basket A. 3
What if he continues shifting his efforts to catching goats, he will end up with only meat
for dinner. He will not go to that extreme as it exposes him to risk of catching scurvy, the sailor's
disease, from deficiency of Vitamin C. In that he is like most consumers who are observed
preferring diversified baskets of goods.
The reason green basket is to the left of the red basket is that, at Basket A, Selkirk's
marginal rate of substitution, 4/3, is greater than the marginal rate of transformation, 1. He
needed less mutton to compensate him for a reduction of vegetables than what he can produce
through a shift in efforts. If the marginal rate of substitution declines as he consumes more
mutton and eventually equaled the marginal rate of transformation (as at Basket B in Panel A of
Figure 2), he will cease reducing consumption of vegetables.
Is there a reason to assume that marginal rate of substitution will decline? A possible
argument is that as a consumer has less and less of a product, he will be less willing to reduce it
further. This is too vague a statement as it suggests that marginal rates of any two baskets, one of
which contains more of a product and the other less of it - the red basket and Basket A, for
example - can be compared.
Preferences are personal to an individual and the liberal tradition in the economic analysis
is to assume the minimum about the consumer's preferences. The four axioms of preference
stated in the last chapter led to the definition of the marginal rate of transformation. An
additional axiom is needed to specify how the rate changes, but it should only impose minimum
restrictions on the preferences. The intuition about how a consumer responds to changes in the
baskets is made precise by an axiom: among baskets that any consumer ranks equally (between
which he is indifferent), the marginal rate of substitution decreases as the consumer has less and
less of a product along the vertical axis (as vegetable in Figure 2). As Selkirk moves from Basket
C to the green/red basket along the curve in Pane B of Figure 2, the reduction in meat just

accommodate discrete changes. To avoid clustering the diagram, the basket corresponding to the red dot (and some
others) are not drawn.
1
The basket is not drawn to avoid clustering the diagram and the green dot will be referred to as the green basket.
Other baskets are represented by dots of different color.
2
If marginal rate of transformation is a constant, all the baskets Selkirk can produce by shifting his efforts will lie
along a straight line, the production possibility frontier. If the rate varies with output, the frontier will be a curve.
Since increase in output leads to a decline in the other, the ratio of changes is negative but to enable comparison
with marginal rate of substitution, the sign is ignore (or formally only the absolute value is considered).
3
Notice that this reasoning used both the non-satiation and transitivity axioms stated in last chapter.
31

compensates him for the reduction of vegetables. Since he is indifferent between various baskets
on the curve, it is one of his indifference curves. 1
By the axiom of diminishing marginal rate of substitution, the slope of the curve which is
a measure of the marginal rate of substitution decreases as Selkirk's moves to the right and down
the curve and the curve becomes flatter at lower points. To establish that Selkirk will prefer one
of the baskets he can produce, it is necessary to show that the marginal rate of substitution and
the marginal rate of transformation will equal each other at the one and only one basket that
Selkirk can produce or at one point along the line in Panel A of Figure 2. If Panel B of Figure 2
is superimposed on Panel A, the indifference curve will touch the straight line at Basket B. 2The
level of utility from other feasible outputs (other points on the straight line) will be less as they
lie below the indifference curve. This follows from the shape of the curves.
The marginal rate of transformation between the two goods determined the flexibility that
nature allows Selkirk in producing meat and vegetables and the marginal rate of substitution
measures the flexibility his preference give him in substituting one item of food for another.
Equating the two enabled him to match his opportunities with his preferences. Though derived
for the case of one individual and two goods, the equality between the two rates is a necessary
condition for making the best use of resources, as judged by consumers' preferences, in a market
economy with many individuals and many goods.

Selkirk decides how long he wants to work.

Selkirk, instead of working all day, wants to take some time off to rest in his hut, to study the
bible and navigation books, to exercise his vocal codes by talking aloud and to go to the shore to
look out for any ship that possibly will come by and rescue him. He has to split his time between
these activities. Mathematically speaking, adding leisure as another choice requires only a
generalization of the discussion in the last section but for non-mathematical exposition it is
preferable to reduce choice back to two by treating mutton and vegetables as one compound
product. 3 4Baskets are now made up of two goods, food and leisure.

1
Other indifference curves will pass through the black and red baskets to the left and right of the indifference curve
shown in the diagram. Consumer's preference for various baskets is represented by a set of indifference curves.
2
It is not fortuitous that it did but the result of deliberate choice of the one indifference curve. Existence proof is
difficult and is not considered here. They are constructed to show that among the many indifference curves of the
individual whose preferences satisfy all the axioms, one and only one indifference curve will be tangent to the
budget line.
3
We unconsciously aggregate when we speak of expenditure on food though we spent it on many food products.
Economic analysis has derived the conditions under which individual goods can be aggregated to one. Skipping
niceties, we assume that they are satisfied in the one-person economy.
4
We unconsciously aggregate when we speak of expenditure on food though we spent it on many food products.
Economic analysis has derived the conditions under which individual goods can be aggregated to one. Skipping
niceties, we assume that they are satisfied in the one-person economy.
32

Figure 3. Selkirk chooses between gathering food and leisure.

The question is whether the extra leisure compensated him for the reduced meal. Treat
leisure as an activity that, like consumption of a product, increased his utility. As discussed in the
last section, the basket that equated his marginal rate of substitution between leisure and food to
the marginal rate of transformation between them maximizes his utility.

Choice between leisure and work in a modern economy.

Selkirk can decide for himself how long he wants to work. In a modern economy
employment is based on a contract between the employer and employee, and its terms depend on
the laws of the country, the structure of the industry and the conditions in the labor market. What
insight can Selkirk's choice provide on recent trends in working hours? An employee may not be
able to alter the hours of work from day to day but over time the employer and employee can
renegotiate the workweek. Governments, in response to public demands, introduced first laws
restricting child and women labor and then hours of work for male adults. The employers and
employees of a firm bargain within the framework of laws and come to an agreement; such
agreements, it will be shown in the section on Nash bargaining solution below, reflects the
preferences of the parties and the strength of their bargaining positions.
Angus Maddison estimates that in 1870 an employed person in the United States worked
for an average of 2,964 hours, a total that can be achieved only by working nine and a half hours
a day, six days a week, around the year. 1 The labor movement was clamoring for a reduction of
hours and many establishments agreed to forty hour workweek by the end of the Second World
War. In 1950, employed persons in the United States (including those not working full-time)
worked for an average of 1,867 hours while those in Europe worked slightly more hours. By the
end of the century further reductions in Western Europe led to an employed person there
working fewer hours than his or her counterpart in the United States.

1
Angus Maddison (2001), p.347. In Western Europe hours varied from country to country but were above or close
to 2,900 hours.
33

Figure 4. Benefits of exchange.

The shortening of the workweek resulted in a reduction of annual work-hours until 1970.
After 1970, the increases in participation rate (the percentage of population in labor force and the
average number of weeks worked) more than balanced the decline in working hours per week.
Availability of part-time work and removal of Blue Laws in the United States let those who are
not in the market for a fulltime job like students, housewives and retirees take part-time jobs.
Since then the growth in participation rate has leveled off but the annual hours worked continued
to increase. Among those who have a regular job, a higher percentage was taking a second job.
These trends reflect individual choices in working hours. There is no consensus on why work
hours in Europe continue to fall; some claim that it reflects the different preferences of European
workers for leisure while others argue that it is due to rigidity of labor laws and higher tax rates
which reduces the incremental after tax income from additional work.

Benefits from exchange.

The one-person economy lacks one important facet of market economies, the exchange of
goods and services between individuals. Today the percentage of a product consumed directly by
those who produce it is very small. Part of income from employment and assets is spent on
buying consumption goods produced by others and the rest saved. The simplest economy where
exchange can occur is one in which two individuals form an isolated community. In one such
economy, two individuals George and Robert, can fish or cultivate vegetables. Unlike Selkirk,
they need not necessarily consume what they produced as each can exchange some of his output
for that of the other. What advantages does the exchange provide over self-sufficiency?
Robert is a better farmer in the sense that by shifting time from fishing to farming, he can
harvest more vegetables than George can do with a similar shift. Their marginal rates of
transformation between fish and vegetables differ, with Robert having an advantage in farming
and George in fishing. The division of labor with Robert concentrating on cultivation and
34

Figure 5. Robert benefitted from exchange.

George on fishing allows them to produce collectively more vegetables and fish than if each tries
to produce both. Nevertheless, production by itself does not make them better off. Robert is not a
vegetarian and George does not want to eat fish all the time. Larger outputs benefits them only if
both George and Robert can obtain, through exchange, baskets they prefer to what they are can
produce themselves.
Having specialized in what they are good at, they meet to exchange (Figure 4). George, given
his catch, is willing to give up 3 pounds of fish for a pound of vegetables; his marginal rate of
substitution is 3. Robert, loaded with vegetables, is amenable to giving up six pounds of
vegetables for a pound of fish; his marginal rate of substitution is 1/6. After bargaining, they
agree to exchange 1.5 pound of fish for a pound of vegetables. 1 At that exchange rate Robert
who was willing to give nine pounds of vegetable for 1.5 pounds of fish had to give up only 1.5
pounds of vegetables and he became better off by the exchange (Figure 5). A similar diagram
can be drawn to show that George is better off as he had to exchange only 1.5 pounds of fish for
a pound of vegetables.
The crucial result is that exchange benefited both. What enabled mutually beneficial
exchange is that the rate of exchange, 1.5 to 1, lies between the marginal rates of substitution of
George (3/1) and Robert (1/6). If they had agreed on any other rate of exchange that lies in
between the two marginal rates of substitution, the exchange at that rate will also benefit both.
Having improved their welfare by one exchange, could they do even better with further
exchanges? If after the first exchange, the marginal rates of substitution are still different, there
are opportunities further exchanges. As they proceed with these exchanges, George has more
vegetables and fewer fish while Robert has more fish and fewer vegetables than at the start. As
fish in his basket depletes, George will be less willing to part with it and he will offer only
smaller amounts of fish for a pound of vegetable. Robert is depleting his vegetables and will
offer smaller amounts of it for a pound of fish. 2 The gap what each is willing to offer narrows as

1
Compare the bargaining George and Robert does to what is done now-a-days at a flea market or an oriental bazaar.
The bargaining process is not explicitly considered here but an example of it is discussed later in the chapter.
2
Marginal rate of substitution was defined in this example as (change in quantity of fish/change in quantity of
vegetable) as the consumer moves along an indifference curve or as he is as well off before as after. As George
becomes less willing to offer fish, his marginal rate of substitution declines from 3/1 to 2.5/1 and lower. As Robert
offers less vegetable, the ratio of exchange of fish to vegetables increase (notice the denominator is decreasing) and
35

exchange proceeds and when they become equal, opportunity for further trade that improves both
is exhausted. 1 Such an economy has achieved an efficient allocation of goods or Pareto
efficiency, so named after the Italian economist Vilfredo Pareto (1848-1923) who formulated
this definition.
The ability of a market to achieve efficient allocation of resources is at the core of the
arguments offered by economists to defend free trade. Careful analysis has shown that the
market economy must meet certain conditions for exchanges to lead to a Pareto efficient
allocation; the conditions pertain to the level of competition among producers and the extent of
information flow between consumers and producers. This allows critics of market economy to
argue that these conditions are seldom fulfilled in the real world.

Distribution of benefits from exchange.

Exchange is a game in which both parties win. Just as winners in sports stand on the victory
pedestals, winning by exchange can be represented by George and Robert standing on pedestals
(Figure 6). Move to a higher pedestal indicates that the new basket is preferred to the earlier one.
However, unlike in sports, the height of the pedestal in which George stands cannot be compared
to the one on which Robert stands. Robert preferring Basket F to Basket D (Figure 5) is an
indication that exchanges increased his utility, but it provides no indication the extent to which
his utility increased and whether it was more or less than the change in George's utility. To
reflect the limitations on ranking of utilities of different individuals, the red pedestals on which
George stands are placed in a row behind the blue pedestals of Robert. Pedestals in one row can
be compared with each other but not with those in the other row.
An allocation in this two person economy is the division of the total output among George
and Robert. Before trade, the allocation to each was he produced. How well they are under this
allocation is represented by the left-most pair of pedestals. They begin to trade starting with a
rate of 1.5 pounds of vegetables to 1 pound of fish and ends up with a set of baskets that is
another allocation. How well they were after trade is shown by the middle pair of pedestal. Both
became better as both the blue and the red pedestals in the center are higher than those to the
left. 2 But in judging the trading process, economists use a more demanding criterion. Is it
possible to have another allocation that will take Robert to a higher pedestal without reducing
George's pedestal? If there is one, then trade led to an inefficient allocation, inefficient in the
sense that one of the parties could be made better off by a reallocation. If not, then the trade has
resulted in a Pareto efficient allocation.

the two ratios converge. The indifference curve with quantity of fish on the vertical line and quantity of vegetables
on the horizontal axis becomes flatter as one move down on it due to the rule of diminishing marginal rate of
substitution. If Robert is moving down his indifference curve, George is moving up his and naturally slopes of their
indifference curves vary in opposite directions.
1
The rates at which the marginal rates of substitution change depend on individual preferences and differ from
person to person and basket to basket. Here for verbal exposition, they are visualized as making a sequence of
trades. They could bargain till they finally choose the basket at the end of the sequence. If they make a sequence of
trades, an additional assumption is necessary that the end baskets under the different trade regimes are the same; it is
assumed here.

2
It is clear if one of them become worse off (has to move to a lower pedestal), he will not agree to the trade.
36

Figure 6. Distribution of benefits.

Demanding as it looks, the criteria is weak in one sense. What if trade began at two pounds
of vegetables for a pound of fish? Robert is still better off but the rate moved in favor of George
who is receiving a larger amount of vegetables in exchange for the same amount of fish. If the
trade continues as they move to an efficient allocation were also better for George, at the end
George will have a basket that he would prefer to one under the earlier trade. 1This is represented
by the right-most pair of pedestals. George became better off from trade but less so than under
the earlier scheme.
These results generalize to economies with many individuals and products. An allocation
of all the goods produced in the economy among its consumers is Pareto efficient if there is no
shuffling of goods among baskets that result in one person having a higher level of utility (a
preferred basket) while all others have at least the same level.
Just as trade can take George and Robert to one of many allocations, trading among many
individuals in a market can be led to one of many Pareto efficient allocations. If the Pareto
efficient allocation reached makes one group in the population, the Georges, very poor and the
Roberts very rich relative to another Pareto efficient allocation with less disparity, should public
policy strive to shift to the second one?
Building on the works of Pareto, two important results were derived in the middle years of
twentieth century. The first theorem states that market transactions in a competitive economy
(the extent of competition to be defined precisely in Chapter 11) will lead to a Pareto efficient

1
Notice that they have to agree to trade and George cannot unilaterally push Robert to choose the trading favorable
to him. Though in the verbal description, the final outcome was presented as the result of a series of trades, George
and Robert may have agreed on final baskets before trade. If they make sequential trades, the process must be
explicitly modeled as is not done here.
37

allocation. The second one is about changing from one efficient allocation to another. It states
that any of the possible efficient allocations can be achieved by making appropriate changes in
the initial allocation of goods among individuals. In the two-person economy, the initial
allocation is the fish George caught and the vegetables Robert cultivated. In a monetary
economy, the initial endowments are the wealth of citizens. The impact of the second theorem is
that, by reallocating the wealth and letting the market operate without interference, any Pareto
efficient allocation can be achieved. If, on the other hand, the government tries to interfere in the
market in the interest of a "fair allocation"," then, as happened in the communist and other
regulated economies, inefficiencies will arise and black markets become common.
Even if it is feasible to shift from one efficient state to another, should public policy try to
redistribute wealth or income? Redistribution implies taking from Peter and giving it to Paul. 1
The entitlement theory, following the natural rights doctrines of Locke and Kant, claim that
individuals have an entitlement to the fruits of their labor, and the state should not deprive them
of it. Others use refinements of Jeremy Bentham's utilitarianism to argue that public policies
must seek to maximize social welfare (to be defined based on individual preferences) through
redistribution. Most public policies - income tax, sales tax, expenditures on education and health
and even regulations - involve some redistribution. From time to time, and in different countries,
heated debate breaks out on a public policy that is under consideration then and there; much of
the current debate is over environment and health. If, going beyond the slogans in which they are
presented for public consumption, the sources of disagreement are examined they turn out to be
over the distributional consequences of the policy. The debate is sometimes phrased as less
government versus more; less government is involved in making such policies, the less is the
threat of redistribution. Whether these disagreements are viewed as differences about
philosophical, political or economic doctrine, they will continue in the future as changing times
and circumstances bring new policy issues into the forefront.

Game theory: the logic of interaction among individuals.

Instead of bargaining as George and Robert were doing, we make most of our purchases at
fixed prices in stores. A customer is among the many in a store and, while the sales associates
may help her in finding the product she was looking for, the shop does not negotiate prices or
any other aspect of the sale with the shopper.
In other types of transactions, we interact with one other person or a small group and each
side makes choices based on their belief of how the other side will respond. Such interactions
can be classified into two: in the first type of interactions, gains to one party result in loss to the
other. Competitive sports like football and basketball are examples. Competition among firms for
market share is another example. Such interactions even outside sports are classified as non-
cooperative games.
There is another group of interactions in which both sides benefit if they can come to an
agreement on the outcome. George and Robert both benefited when they agreed to trade even
though each would like to get more out of the other. In negotiating a job offer, a prospective

1
Reallocation can affect the incentives of the Georges and Roberts. They may alter their efforts and the economy
can end up in an allocation that "trims both pedestals."
38

employee wants as high a salary as he can obtain but recognizes that his employer wants to keep
it low. The applicant who wants the job and the employer who need to fill a position benefit
when they agree on the terms of employment. When bidding on a house, a potential buyer has to
consider what is acceptable to the seller; it has to be better than other offers and yet one that he
prefers to pay than to walk away. Interactions among a small group of individuals where they
communicate with each other and come to a binding and mutually beneficial agreement are
cooperative games.
John von Neumann and Oskar Morgenstern's Theory of Games and Economic Behavior
(1944) was the first comprehensive thesis on game theory. 1 They defined a solution concept for
non-cooperative games that is independent of the specific nature of the game, its rules and its
rewards, as long as it is strictly competitive. The payoffs are in terms of "utility" to the players
and utility depends not only on the outcome but also on the risk the players have to take to
achieve it. This formulation is now standard in economics and finance.
George and Robert, on the other hand, benefited from co-operating. They will continue the
exchange until reaching one of many Pareto efficient allocations. John Nash in the 1950s
introduced a solution concept to a game where communication and binding agreements among
parties are possible and the result of the co-operative game was a specific Nash bargaining
solution. He did not consider the process by which the agreement is reached or the mechanism to
enforce it but assumed that the outcome of the process will satisfy a set of axioms he postulated.
He conjectured that the agreement could be the outcome of a non-cooperative game from
which the parties have no interest in diverging. Later developments in game theory showed that
Nash bargaining solution can be viewed as the limit of solutions of a non-cooperative game
when certain conditions are fulfilled.

An example of Nash bargaining solution.

George had a basket of fish and Robert a basket of vegetables when they met to trade.
They can always consume these baskets, and they will trade only if it procures them baskets,
they prefer to the ones they have. The pair of utility levels of baskets they had before trade is the
"disagreement point."
The first axiom of bargaining theory states that negotiations should lead in a Pareto efficient
allocation; it should not be possible to increase the utility of George or Robert without
decreasing that of the other. Another axiom goes by a fancy name, "Independence of Irrelevant
Alternatives." Just before trading, George and Robert saw some goats on a nearby mountain but
both knew that, unlike Selkirk, they do not have the ability to run up and catch them. Then the
presence of the goats should not affect their bargaining over fish and vegetables. 2
The increase in utility of any individual due to trade is measured by a difference between the
levels of utility indices of baskets before and after trade; call it excess utility. Pareto efficient
choices differ in the levels of excess utilities. The Nash Bargaining solution when both parties

1
Solution to a specific non-cooperative game in which two firms producing identical product compete in the market,
was developed in 19th century by Antoine Cournot.
2
This example is trivial but in many applications where the bargaining set (the set of Pareto efficient allocations
from which one is chosen as the solution) is complex, it is necessary to preclude choices that are not feasible from
affecting the agreement.
39

have equal bargaining power is the one among them that maximizes the product of excess
utilities. Bargaining power depends on the parties relative risk aversion (willingness to forgo
gains for reducing uncertainty) and impatience. If bargaining power differs, the solution is
obtained by raising excess utilities by appropriate indices to reflect the bargaining power of the
parties and then maximizing the product. This solution hides the bargaining process and assumes
that somehow it will lead to an agreement. The negotiation itself is a game where parties posture
to influence each other. Will the competition modeled as a non-cooperative game lead to the
Nash bargaining solution?
Consider two persons making offers to each other. Negotiations that lead to sale of a house
are of this format. The buyer makes an offer in the first period. In Period 2, the seller can either
accept it or reject it. If the offer is rejected, the seller makes a counteroffer. The buyer accepts or
rejects seller's revised offer in Period 3. The exchanges continue until, for houses that get sold,
one agrees to the offer made by the other. In the end, both parties find that dragging the
negotiations is costly; each time an offer is rejected, sometimes is lost in negotiations and there is
a cost to the delay. The seller has to pay the mortgage, and the buyer does not have the house he
wants.
In case of employment negotiations, the worker loses the wage for the period, and the
employer loses the incremental profit that can be earned by hiring an additional worker. In
commercial transactions, the interest that could be earned during the negotiating period is lost.
Such negotiations lead to a bargaining solution that is not necessarily the Nash bargaining
solution. However, if the time period between counteroffers becomes smaller and smaller, then
solution to the non-cooperative game approaches that of Nash bargaining solution. This validates
the insight Nash had in solving the bargaining problem.

Bargaining within a family

Everyone belongs to many social groups. There are groups of friends, work-groups,
political party units, committees, and family. The uniqueness of family is that members interact
over long periods in a wide set of issues. Its members who differ in age, sex and preferences
have to synchronize their goals and resolve their conflicts. This will require negotiations and
concessions, even if it is not as formal or as explicit as in making deal with outsiders. What is
being negotiated will depend on the circumstances of the family. The studies of affluent families
focus on who makes the decisions to save and to spend. Then the family has to agree on what
items the budget will be spent. In development economics the discussion covers the same topics
but the stress in on how resources hardly enough for survival are allocated among various
members. Concerns include the health of female and children in the family and the education of
younger generation.
Cooperative game theory provides one perspective to analyze these pressing social issues.
The Nash solution, as mentioned in last section, depends on the bargaining power of parties. If
the parties cannot come to an agreement, their utilities will depend on what other options they
have, the disagreement point. As old social structures break down, as accepted customs are found
to be anachronistic and as new opportunities empower the helpless, the bargaining powers of the
family members and the cost of disagreement changes. For a married couple, the outside option
is divorce. In societies where divorce is difficult or is looked down socially, the aggrieved
partner is struck in a dysfunctional marriage. In agrarian economies, children have to help
40

parents with the work in subsistence farms. When parents get old and infirm, the children have to
take care of them. Their future is tied to the farm. Economic development opens up opportunities
for the young to leave home and support themselves; the generations are less bound to each
other.
The conventional wisdom supported by marketing studies indicates that, in the case
groceries, cleaning items and other nondurable goods are the wife's domain. For expensive and
complex items like cars, historically men made the choice. When women become earning
members, they have more economic independence and, specifically if it is driven by them,
women get to choose the car. Manufacturers in designing the vehicle have to consider their
relative preferences of female drivers for reliability and safety over acceleration and speed.
Economic psychology argues that, instead of focusing on the outcome, the process of
arriving at it needs to be explicitly considered. Different members of the family can have more or
less an influence on choice that is finally made. One member of the family first recognizes the
need for purchase. The severity with which it is felt, the social and economic basis of the power
of that member and past bargaining experience all affect the outcome. Thus the one who cooks
knows what is needed in the kitchen. Contradictory results are found in the role of members in
next stage of gathering information about products and evaluation of alternatives. At the final
stage, the spouses jointly decide on the purchase. The husband decides what car to buy while the
wife chooses the color and some accessories. 1
In the impoverished families of Asian and African countries, the decision to allocate the
food and other collective resources can depend on sex and age with adult male members
receiving major shares. Women have fewer chances to work outside the family and earn cash
income; when they do work outside, they earn less than men. They also have less access to loans.
It has become an article of faith for World Bank and other international organizations that female
members tend to allocate more resources to the welfare of the children than men and that, for
improving the welfare of children, it is cost effective to direct financial aid to women. One study
based on Brazilian data showed that an increase in mother's unearned income increased child's
survival probabilities almost 20 times that of a similar increase provided to the father. 2 However,
economics warns that such efforts should not lead to even less support from the head of the
family.
Analysis of negotiations among members provided better understanding of decisions is
made within a family. In the western countries, it influenced the development and marketing of
goods while in poorer nations it has resulted in the formulation of welfare and development
policies.

The development of market economy.

George and Robert were both producers and consumers, and they traded directly with each
other. Today consumers depend on the market to supply most of their needs; wholesalers and
retailers separate the producer from the consumer. Trading in a market is more than an exchange
of goods (Figure 7). The buyer needs information on the nature of the product offered, its quality
and the time of delivery. The seller needs to be assured of the payments promised. The
1
Kircher (1988), pp.258-292; Phillip Kotler, p.165 -166.
2
Dasgupta (1993), p.471
41

transaction cost is the cost of obtaining information about possible exchanges, negotiating the
terms of exchange and enforcing the contract. It has to be added to the cost of producing the
good. Growth of demand for the products produced outside the household and lowering of
transaction costs leads to the development of market economies.
While trading existed in pre-historic times, early trade served a narrow clientele or a
government seeking command of the supply of staples. Ancient cities from Babylon onwards
relied on the agricultural hinterland and even distant colonies to feed the population in the cities.
Transporting over land was expensive and over time maritime trade became prominent.
Phoenicians and Greeks established colonies along the Mediterranean coast and actively traded
in the region. Romans first and Arabs later mastered the secret of the trade winds and used it to
establish trade routes to Asia. In addition to staples and slaves, exotic products from foreign
lands, like silk, ceramics and spices that the affluent demanded, were brought through the Silk
Road and sea routes. Meanwhile the rural population relied mostly on what they produced and
what they obtain by exchange from other villagers.
By third century, incursions along the border of the Roman Empire and strife within, led to
its economic decline and decay of its cities. The large percentage of the population was
impoverished and land was concentrated in few extensive estates. Those living on the land were
bound to the estate by law and obligations.
That this was true even as late as century is seen from the life of one Bodo as
reconstructed from well-preserved archival material of the Monastery of St. German de Press in
France. Hakan Lindgren describes it: "Despite his proximity to the city of Paris, Bodo and his
family had very little market contact. The network of economic contacts was both limited and
unchanging. The people who contributed to his annual consumption overwhelmingly were found
in his immediate proximity. More than one-half of Bodo's consumption originated in household
production by his wife Ermentrude and his three children, Windo, Gerbert and Hildegaurd. The
rest came largely from other households in the same village." 1
A typical peasant market in a village brought farmers and craftsman together. Country
fairs are held near churches on Sundays and festival days. 2 There were market squares in towns
to which artisans and farmers brought their products. In cities, those selling one product like
clothes set shops in one street so that customers can walk around and choose. Even in these
markets, most of the sales were by producers to consumers and as late as the sixteenth century

Figure 7. Three types of flows in a market.

1
Lindgren (1997), p.28.
2
Sawyer (1986), pp. 59-77
42

Italian Renaissance, retail trade where goods were brought by a third party for resale was viewed
with suspicion. 1
In the politically fragmented Europe, concern about security along the road, the cost of
transportation and the cost of enforcing the contract limited trade across regions. One solution is
for a local potentate to assure traders who come to a fair in his territory, safe passage and
enforceable contracts. The success of thirteenth century fairs in Champaign located in France is
due to the protection to traders and enforceability of contracts (like letters of credit) that the
Counts of Campaign offered. It became a premier market for textiles, leather, fur, and spices. At
their height, in the late twelfth and the thirteenth century, the fairs linked the cloth-producing
cities of the Low Countries (Netherlands and neighboring regions in Germany) with the Italian
dyeing and exporting centers.
In the sixteenth century, Portugal and Spain embarked on geographical exploration and
colonization. Portugal became masters of the Indian Ocean and wrested the spice trade from the
Arabs. Spanish colonized Mexico and parts of South America. Netherlands, British and French
also embarked on colonial expansion. An early impact of this process was in import of gold and
silver into Europe. Soon products like coffee, tea, cocoa, Indian cotton textiles, Chinese
porcelain and sugar were imported in larger quantities and became cheap enough to be within the
budget of ordinary Europeans.
Though by fourteenth century there were stores in most English towns selling products
from different regions, retailing in the modern sense began its slow but steady evolution in
London of the sixteenth century. London by then became the focal city for internal and
international commerce and needed outlets for the products that flowed into the city. In the
seventeenth century England, the average consumer began to demand products from foreign
countries like coffee and chocolates, and they began to eat out of pottery rather than wooden
flatware. This consumption revolution gave a boost to retail.
In the middle of the nineteenth century, some retailers selling textile fabrics to the less
affluent customers of London saw an opportunity to increase sales by cutting prices; larger
volume made up for the lower profit margin. They advertised by distributing handbills and
posted fixed price (price-tickets as it was then called) on their windows. 2 Evidently, the shops
were successful as the custom spread. After the first department store, Bon March opened in
Paris in 1860, the modern concept of shops with fixed prices and large body of salaried
personnel became well established.

Summing up.
The need to make choices on what to produce and what to consume exists in primitive as
well as modern economies. Increase in the output of one product can be achieved only diverting
resources from production of another. The ratio of the rates of changes of the two products is the
marginal rate of transformation.
Vilfredo Pareto defined an efficient allocation as one in which, by a reshuffling of goods
among consumers, it is impossible to increase the welfare of one person without reducing that of

1
Welch (2005), pp.34-41.
2
Davis (1966), pp.258- 261.
43

another. In the one person economy of Selkirk, it is achieved by equating the marginal rate of
substitution to the marginal rate of transformation. The equality of the two ratios is needed for
efficient allocation in a multi-person, multi-product economy.
The first theorem of welfare economics states that a competitive economy is Pareto efficient.
The second theorem states that, any efficient allocation can be achieved by a reallocation of
initial endowment and then let the competitive market function to choose the outputs and prices.
Redistribution is always controversial. Some consider it an infringement of property rights.
Even in a market economy, there are transactions like setting employment conditions that
are transacted between two or a few individuals. The cooperative game theory explains what all
influences the agreement. It is then applied to examine the allocation within families and to
develop public policies to help those who are impoverished.
Selkirk, George and Robert, like all who live in subsistence economies face the risk that
their survival can be threatened by forces beyond their control like by bad weather or other
natural disasters. They would like, if possible, limit the consequences to them from the worst
outcome. The next chapter considers making choices when the outcome is uncertain and
possibility of hedging to minimize the adverse consequences.

Bibliographical Note.
Binmore (2007); Cameron (1993); Dasgupta (1993); Davis (1996); Dimand and Dimand
(1996); Heap and Varoufakis (2004); Kotler (2000); Lindgren (1997); Lundberg and Pollack
(1996); Maddison (2001); Motley (1997); Osborne (2004); Schor (1991): Severin (2002);
Souhami (2001); Strauss and Thomas (1995); Turner (2002); Prescott (2004); Welch (2005).
44

Chapter 4. Choices involving time and uncertainty

The outcome of our decisions can be uncertain when it depends not only on our actions but
on events not in our control. It is beyond our resources and knowledge to foresee such events and
evaluate their impact. Selkirk looks at the sky, the seas and even the behavior of birds and
animals and uses his experience as a seaman to predict Island's weather. His vision is limited to
the horizon even though events beyond it will shortly affect the Island's weather. Today,
satellites and weather stations collect data around the world and are connected to massive
computers that analyze them. The weather forecasters distill the information and make
predictions about local weather in the evening news. Nevertheless, the jet stream shifts, fronts
stall and the weather surprise us. Are forecasts of weather three or four days ahead less reliable
than that for the next morning? It is not necessarily so but instinct and experience makes us
believe it is so. Time and uncertainty are intertwined and it is possible that opportunity for events
that are beyond our predictive power to occur increases with time lapse.
Selkirk when catching goats and keeping them in a pen near his hut was planning his future
consumption. Today we can shift consumption over time by adding to our asset through saving
or by running it down by outspending our income. Education is an investment in human capital.
Early in our lives we choose between continuing our education through college for higher
earnings later in life or going to work at a young age.
The benefit from postponing consumption is the opportunity it creates to consume a larger
basket in the future. However, individuals have time preference; a basket of goods received at a
later date is ranked below an identical basket available in the present. The section on
intertemporal choices examines this trade off. An individual will choose the time profiles of
consumption to maximize intertemporal utility just as each time period she chooses the basket
that maximizes her utility.
The next section, “Decision making when outcomes are uncertain,” turns to choice when
each decision could lead to one of many possible outcomes. The most promising educational
plans can disappoint as the job markets change; new technologies and outsourcing wipes out jobs
that looked attractive when we made our educational choices. House prices go up and down and
so do the stock market. Some of our investments appreciate in value while others lose theirs.
The section begins by describing how "states of nature" (broadly defined as events over
which we have no control) intervene to generate uncertainty about outcomes of our actions. We
fear that, in some states of nature, we suffer unexpected expenses or a loss of our property. Can
we make a deal with someone else to bear such losses, if it occurs, for a payment in advance? An
example of two farmers in an isolated community hedging their risk is developed. Each farmer
signs a contract that when the other has a poor harvest, he will consign a fixed quantity of his
output to the other. Trivial as this example is, the ideas it brings out are central to more complex
contracts like insurance and portfolio choice.

Intertemporal decisions and time value of money.

A high graduate can either start working or go to college. Higher education involves
paying tuition and board, and postponing fultime employment for four years.
45

Table 1. Calculation of the value of money

Panel A. Forward in time: compound interest.

Year 0 Year 1 Year 2.

Capital and $100 $ 110 =

interest (1 year $100(1+0.1)
investment)
Capital and $100 $110 = $121 = $100(1+
interest (2 year $100(1+0.1) .1)2
investment)

Panel B. Backward in time: present value

Year 0 Year 1 Year 2

Present value of $100/(1 + 0.1) = $100

cash flow one year
$90.90
from now.
Present value of $100[1/(1+0.1)]2 $100 [1/(1 + $100
cash flow to years
= $82.65 0.1)] = $90.91
from now
Why does anyone choose to go to college? At the end of twentieth century, the annual
earning of a college graduate in U.S. was, on the average, 1.8 times that of a high school
graduate. 1 At completion of high school, the student has to decide whether the extra earnings of
more than forty years of employment make it worthwhile for him to incur the expenses of
college education. 2
If a person goes to a bank and exchange dollars for euros, the exchange occurs
instantaneously, and he can compare the euros received to the dollars exchanged. In the case of
college education, the expenses are incurred early in life while the salary differences are spread
over the working years. Can he add up the extra income from different years and compare it to
the cost of education or should he make adjustments for the differences in time between
expenses and receipts? Will an individual's lower valuations of future receipts induce him to save
less than what is needed to meet unforeseen expenses or to maintain a reasonable standard of

1
The ratio cited is from a July 2002 report by Day and Newberger. The difference in earning between college and
high school graduates increased over the last quarter of twentieth century as changes in the job markets in the United
States and in most of the western nations reduced job opportunities for the less skilled workers.
2
The analysis assumes that the young high school graduates have funds to pay for the education or have access to
credit market to borrow the funds. Even if the student has the intelligence and motivation to go to college, cash
constraints can prevent him from doing so. A cash-constrained student is not able to maximize his life-time income.
46

living in his old age? Why is there such a striking decline in the personal savings rate in the
United States during the last two decades? This section extends the analytical framework of
utility maximization at one point of time to intertemporal choices.
If the interest rate on safe investments is 10 percent, $100 invested in Year 0 will earn an
interest of $10 by Year 1 (Panel A, Table 1). The initial fund is now $110 and if reinvested, earns
an interest of $11 in the next year. The fund grows to $121 by end Year 1. The relation between
the values of funds in different years can be expressed concisely using a multiplication factor: (1
+ interest rate expressed as a fraction). The capital and interest after a year are $100 (1+ 0.1) and
after two years $100(1+0.1)²
The reverse question plays an important role in subsequent discussions: What amount
would an individual be willing to pay now for receiving $100 in a year? Since she can earn an
interest by investing the amount at the current rate of interest, the most she will advance is an
amount if invested will yield $100 a year later Panel B, Table 1). Instead of multiplying by the
factor (1 + 0.1), the amount that is to be received in the future is divided by it. She will be willing
to advance $100[1/(1 + 0.1)] or $90.90 for receiving $100 a year henceforth. She will advance
$100[1/(1 + 0.1)]² or $82.65 for $100 two years from now. In general, the present value is found
by raising the discount factor, 1/(1 + interest rate expressed as a fraction), to an index equal to
the time interval until repayment. 1
Though Table1 considered only loaning and borrowing of funds, the rules for forward and
backward shifts over time have general validity. It applies to all comparisons of funds or utility
over time. Shifting forward in time requires the amount invested to be multiplied by a compound
interest factor and shifting backwards by division by the same factor. In case of utility from
consumption in future, the utility received at that date must be divided by, as explained in next
section, by a discount factor.
To apply it to investment in education take the average of differences in salaries of high
school and college graduates in all age cohorts; averaging is necessary due to idiosyncratic
variation among individuals. The averages are discounted to the year of high school graduation
and then compared to the cost of college education. The study by Barrow and Rose concludes
that, for college graduates in the United States, the present discounted value of the earning
differential for the first ten years after graduation, using prevailing interest rates, equals the cost
of education less any tuition grants they received. 2 Since the working life of a college graduate is
four times as long, the discounted value of higher salaries far exceeds the cost of education. Why
is it then that some go to college and others do not?

Choosing between consumption streams: time preference.

Educational choice, by shifting incomes and expenditures over time, affects consumption
patterns. Mia by going to college postponed earning for four years, but she earned more after
graduation than those who went to work after high school. Figure 1 shows a stylized
representation of the consumption streams (consumption over time) of a high school and a

1
The factor, (1+0.1) was raised is two for repayment two years after the advance. For later repayments, it should be
raised to an index equal to the number of years to repayment.
2
Burrow, Lisa and Cecelia Rouse (2005)
47

Figure 6. Time preference and intertemporal substitution

college graduate. 1 Treating consumption basket for each period as "an item for which the
individual has preferences," intertemporal consumption pattern can be viewed as a "super-
basket." Choice before Mia and her schoolmates is to choose one or the other of the super-
baskets.
Irving Fisher (1867-1947), writing in the 1930's, developed an analysis of intertemporal
choice that was similar to choice of baskets of goods at one point of time. He asserted that
individuals have time preferences for immediate consumption. Given a choice between a basket
of goods now and an identical basket next period, all consumers, irrespective of their other
differences in preferences, will choose the first. To compensate for time preference, increase the
basket for the second period until Mia is indifferent between the two baskets (Figure 2).
This suggests a measure of pure time preference: ratio of the quantity in Basket C to that in
Basket A = 1 + time preference. If Mia has to choose between any pair of baskets, one in Period
0 or another in Period 1, she will multiply the utility of "Period 1 basket" with discount factor
[1/(1+ time preference)] before comparing it to the utility of "Period 0 basket" and choose the
one with higher utility. 2

1
Compare this ratio with discounting future income by discount factor, [1/(1+interest rate)]. In spite of the similarity
of mathematical structure, there are serious conceptual differences. Interest rate is observable in the market while the
rate of time preference reflects the preferences of individuals. The composition of baskets is assumed not to change
over time, enabling each basket to be treated as one “commodity” in the superbasket.
2
Compare this ratio with discounting future income by discount factor, [1/(1+interest rate)]. In spite of the similarity
of mathematical structure, there are serious conceptual differences. Interest rate is observable in the market while the
rate of time preference reflects the preferences of individuals.
48

Figure 1.A measure of time preference.

While earlier chapters focused on choice of a consumption steam with no specific time
associated with it. Fisher's approach extends the logic to choice of the consumption stream over
two periods with recognition of the time and levels in the two periods. However, it is hard to
generalize his approach to many periods as is needed to take decisions about education or
savings. In 1937, Paul Samuelson proposed a generalization. He made two crucial assumptions.
First, the varied influences that go into intertemporal choice can be represented by a constant
discount factor. Second, utility from different periods can be added after discounting. The formal
structure is very similar to discounting future income to determine the present value as in Figure
1. The utility of the superbasket (income flow) is equal to the sum of utilities of the smaller
baskets (income in each year) discounted by dividing it by (1+time preference) raised to the
appropriate power. 1 Even though Samuelson expressed reservations about the intertemporal
discounting with constant discount factor, the approach became standard in economics analysis.
The differing choices Mia and schoolmates can be explained in terms of intertemporal
choices. The discount rate depends on preferences and will vary from individual to another. Even
if the income streams from educational choices are the same for two individuals, the one with a
higher discount rate will decide not go to college when the other does.

Decision making when outcomes are uncertain.

Up to now each action taken by an individual, whether acting as producer or consumer,
results in one specific outcome. From possible actions open to him, he will choose the one whose
outcome he prefers to those of others.
Frequently, the best laid plans fail and the outcome of a choice differs from what was
expected at the time of decision. Our purchases disappoint and production plans fail. We suffer
unexpected losses to our property through accidents, fire and flood. We fall sick and incur
unplanned medical costs. Financial losses arise as our assets depreciate. We respond to

1
Utility of superbasket = [U₀]+[U₁/(1+time preference)]+[U₂/(1+time preference)²]. . . .where U's are the utilities
of income in the year indicated by the subscript.
49

Figure 2. Decision making under certainty and uncertainty.

uncertainty by taking insurance or diversifying our portfolio of investments but we can never
eliminate it.
It is much more difficult to make a choice when the outcome is uncertain than when it is
certain, as each action has many consequences. In general the individual will not prefer all
possible outcomes of one's decision to those of the other and it is not known at the time of
decision which outcome will occur, what rule should the individual follow in making the choice?

Nature of uncertainty.
Figure 3 illustrates how choice under uncertainty differs from that under certainty. Each
begins with a decision to take an action that leads to an outcome. Under certainty, there is only
one consequence to that action. When Chloe is in a store, she selects a few goods; her challenge
is in deciding what basket of goods she prefers to all others that she can afford. She is sure that
she can buy the chosen basket at the counter. (Panel A of Figure 3).
Uncertainty arises when each action has more than one outcome. The outcome is
determined, in Panel B, not only by Chloe's decision but also by the slot in the roulette wheel
into which a ball falls (for the sake of latter diagrams, the slots are grouped into two). The
possible outcomes are represented by a super-basket containing one basket for each group of
slots (just as a consumption stream over working years was represented by baskets within a
super-basket in Figure 1). The individual will, in contrast to intertemporal consumption, obtain
only one of the baskets.
Chloe is planning to go to a beach for sunbathing. The outcome of a trip depends on the
weather; she will get a good tan if it is sunny all day but not if summer showers in the afternoon
50

force her to leave early. The weather is the state of nature whose randomness is represented by
the roulette wheel in Panel B of Figure 3. Using this analogy, nature is said to intervene between
the decision-maker and the outcomes in every situation where uncertainty arises. The states of
nature are so enumerated that they are mutually exclusive and exhaustive; any possible outcome
is associated with one and only one state of nature. The action together with the state of nature
determines an outcome; for Chloe the outcomes contingent on the state of nature are good tan or
light tan.
Chloe, if she is going to the sea shore, has to leave in the morning; her other choice is to
stay at home and watch TV. How can she decide whether to go to beach or not without knowing
the afternoon weather? What makes the choice difficult is that her ranking of choice switches
with state of nature. In State 1, good weather, she prefers going to a beach but with rain
threatening in State 2, she prefers to stay at home.
Since the publication of von Neumann and Morgenstern's Theory of Games and Economic
Behavior in 1944, economists have developed three approaches to analyze choices under
uncertainty. Each involves a reexamination of the elements -- baskets of goods, preference and
decision rules -- involved in the choice. Though the three approaches have much in common, this
chapter will focus on one developed by Kenneth Arrow and Gerald Debreu. The other two
approaches are discussed in Chapter 11.

State-contingent commodities and individual choice.

Commodities are most obviously distinguished by their physical characteristics. At a
grocery store, a shopper has no problem in distinguishing between tomatoes and cabbage. As he
gets to the tomato counter, additional distinctions come into focus. Some tomatoes are plucked
unripe and ripened in storage while others are vine-ripened. Some are grown using chemical
fertilizers and pesticides while others are grown organically. Tomatoes are tagged by the
processes used in cultivation and ripening, and these tags are important to some consumers.
A product that is currently available should be differentiated from the same product that is
available at a later date. A farmer may need wheat now even though he is expecting a bountiful
harvest within months. He will seek to exchange wheat available at different dates and even pay
premium for immediate delivery.
The experience of drinking a cup of hot coffee after being out in the cold is different from
that of drinking it on a hot afternoon. Products are tagged by the state of nature in which they are
available and each of the tagged commodities is a state-contingent commodity. Individuals have
preferences that lead them to exchange one state-contingent commodity for another and, because
of such preferences, prices of state-contingent commodities differ even though they are physical
identical.
When an individual makes a consumption or production decision, the outcome can depend
on the state of nature. In Figure 3, each decision has two possible outcomes corresponding to two
baskets of state-contingent commodities (for Chloe planning a trip to the beach, the state-
contingent commodities are good tan or a light one). The super-basket of state-contingent
commodities is more like a magician's hat than a grocery basket: sometimes you pull out one and
other occasions another product. The difference is that decision maker, unlike the magician, has
no control over the contents. It depends on the state of nature.
51

Figure 4.Choice of a superbasket of contingent commodities.

Consider an Indian farmer dependent on monsoon making a decision to plant. If he plants
early and rains arrive ahead of schedule, he has a good harvest; if the rains come late, the plants
whither in the field, and he has a poor harvest. Planting early leads to a super-basket of state-
contingent commodities, (good harvest, poor harvest). If he postpones the planting, his harvest
will again depend on the onset of rains; if the rains come early, the growing season missed part
of the monsoon and the harvest will be poor; if it is late, the harvest will be bountiful. The
decision to plant late led to another super-basket of state-contingent commodities (poor harvest,
good harvest). He can choose in-between dates but each date to plant corresponds to a super-
basket.
Another example is an individual investing her savings in bonds and stocks. Bonds offer a
fixed interest rate while return on stocks varies with the state of the economy. Consider two
states of the economy, a period of expansion and one of recession. When the economy is
buoyant, the returns on stocks are higher than that of bonds; in a recession, stocks lose value and
returns are low or even negative; on the average, return on stocks is greater than that of bonds.
Each allocation of her assets among the two corresponds to a superbasket of returns on assets. 1
In general, the choices open to an individual are limited, and in Figure 4 they are taken to lie
along a straight line.
Individuals have a preference that ranks the super-baskets off state-contingent
commodities. Those that are ranked equally lie on an indifference curve. The marginal rate of
substitution is, as in the case of indifference curves of consumption goods, the slope of the
indifference curve.
Figure 4 shows the indifference curve which is tangent (touches at one point) to the line at
the red point. All other available super-baskets lie below the indifference curve and are ranked
lower in preference relatively to the red basket. Comparison with Figure 3 of Chapter 3 shows
how Arrow-Debreu contingent commodity formulation extended the decision process under
certainty to decision making under uncertainty.

1
Portfolio choice is discussed in Chapter 12.
52

So far the discussion proceeded with referring to the probability of events but it is common
to associate probability with random events.

What is the probability of an event?

Probability is an amorphous concept that appears in everyday discussions and in all the
sciences. It underlies statistical analysis used in social sciences for verification of results. There
is no single system of axioms about probability that is universally accepted and applied in all
contexts in which probabilistic judgments are involved. Whatever the interpretation, it should
have the property that more probable events should occur more frequently. 1
The concept of probability has its root in gambling. In repeated throws of a fair coin, head
tends to appear roughly half the times, and the law of large numbers states that the ratio of heads
to total throws tends to 0.5 as the number of throws increases. If a dice is thrown repeatedly, any
face will appear on the average one-sixth of the time. From such examples, an intuitive notion of
relating probability to relative frequency arose.
Once outside the casino halls, the definition of probability as relative frequency raises the
question: relative to what? The probability of rain is, by this definition, the percentage of times it
rained in the past when similar weather patterns existed. The problem is in defining "similar
weather patterns." The more detailed the description of weather patterns the less frequent is their
occurrence; if the definition is made less precise, there is no assurance that the events are really
repetitive. Without repeated occurrences, probability cannot be defined as limiting value of the
ratio of preferred events to the total.
Even bigger problem is the critique of induction by the eighteenth century Scottish
philosopher, David Hume. What guarantee is that the patterns of the past will be a reliable guide
to the future? The problem with inductive interference is that it claims to generalize from a finite
number of observations to a general conclusion. The difficulty of going from the specific to the
general is not confined to estimation of probability but challenges the very foundation of
empirical knowledge. In spite of much debate it has created, there is no convincing resolution of
this critique.
A common approach to valuation of financial assets is based on the probability of various
returns and the extent of their variation around the mean return. Implicit in the estimates are
assumptions about the probability of the asset-returns taking values in the range of its variation.
Low probability is assigned to extreme values of returns and if and when they occur the analysts
and policy makers are taken by surprise. On Black Monday, October 19, 1987, the U.S. stock
market crashed. Dow Jones lost 22.6 per cent and S & P 500 lost 20.4 per cent. Jackwerth and
Rubinstein have calculated that, using a probability distribution of stock prices that is widely
used in financial analysis, the probability of the crash once in 20 billion years, the life of the
universe, is extremely low! 2 Measures of probability, imperfect though they may be, provide a
guide to making decisions in economics and finance.

1
Kolmogrov axioms are the ones that have wide acceptance but not all interpretations of probability are consistent
with it.
2
Jackwerth and Berstein (1996), p.1611.
53

Uncertainty and hedging.

Figure 5. Fluctuations of output of Tim's farm

Outcomes of many decisions an individual has to make are uncertain. Some of them like
inclement weather on an outing to the beach have a transient impact on the individual while
others like a loss of assets have serious consequences. Individuals desire to minimize an
unpleasant outcome or to mitigate it. Their preferences show risk aversion or a willingness to
take a lower expected income or wealth to avoid large losses. An example is purchase of
insurance. The individual pays a premium in all periods and states, reducing his budget for other
expenses; in return he is compensated, at least partly, for a loss in one state of nature (as when
his car is damaged in an accident or his house by fire or flood).
Agreement by one individual, Natalie, to exchange some of her assets for a claim on
Pablo's assets in case she suffers a loss is an example of risk sharing that mimics insurance.
Pablo, in agreeing to such a contract, will balance the benefits of receiving payments from
Natalie with the cost of compensating her loss. The best that the two can do is to come to an
agreement, as George and Robert did, that is Pareto efficient in the sense that neither has another
choice that benefits him or her without forcing the other to choose one ranked lower.
Adam Smith had an idea that markets where many individuals perusing his or her interests
will lead to an allocation that is efficient. Two instances of economic activity were considered in
Chapter 3. Selkirk was both a producer and a consumer but not involved in trade while George
and Robert traded goods in their possession. Adam Smith explicitly included both consumers and
producers among those trading in the market. The development of an analytical framework for
treating both production and consumption decisions by individuals trading in many markets
began with Leon Walras in the third quarter of the nineteenth century and culminated in a
rigorous formulation by Kenneth Arrow and Gerald Debreu in the middle of twentieth century.
Later Arrow and Debreu extended the analysis to include trade in contingent claims (like
Natalie's claim on Pablo's assets if she suffers a loss). The advantage of tagging commodities by
time and state of nature is that the analysis of trade at one instant of time, like that between
George and Robert, can be extended to trade over time and states of nature. A simple example
below shows how trading in contingent claims can be used to hedge against losses.
54

Figure 6. Contingent claims.

Hedging using contingent claims in an isolated economy.

Tim, a subsistence farmer living in isolation, is planting wheat in his farm; for simplicity,
it is assumed that he has no choice in what he plants and how he farms. The harvest in good
weather is 40 bushels while in bad weather it is only 10 bushels (Figure 5). Since good and bad
weather are equally frequent, his average output is 25 bushels. Still he faces periods of famine
and feast. Tim, like so many other consumers, prefers lesser fluctuation in his consumption. How
can he achieve it? To make a deal, he has to find another party, a wheat farmer Harold, willing to
exchange wheat based on states of nature. The two farms are identical except in location and the
weather in Tim's farm located on one side of a mountain range is opposite of that in Harold's
farm located on the other side. When one produces 40 bushels, the other produces 10 bushels,
and this occurs equally often. The average output of each farm is 25 bushels.
Unlike George in Chapter 3, exchanging fish for Robert’s vegetables, Tim in lean years
has nothing at hand to exchange for the wheat he is seeking. The most he can do is to promise to
return the wheat next time the harvest is good. What Tim and Harold can do is to trade promises
that the one with the good harvest will provide the other with bushels of wheat. The
commitments need to be documented. They agree to exchange slips of paper each of which
promises to deliver 1 bushel of wheat to the other party if the harvest is low. Tim's green slips
are contingent claims that offer one bushel of wheat if the weather is good in his farm while
Harold's red slips offer one bushel if weather is good in his (Figure 6). If they can exchange 15
contingent claims both have 25 bushels irrespective of the weather. If both farmers prefer a
steady level of consumption to fluctuations, then they have increased their utility levels by this
deal.
There are two special features of hedging by Harold and Tim that enable them to avoid
uncertainty altogether. Why was it possible? Tim and Harold were lucky to have the fluctuation
in their harvests cancel each other perfectly. In general it will not occur. If Harold's output in
good weather is only 30 bushels with other outputs are as in Figure 6, then the total output of the
two farms will fluctuate between 40 (30 in Harold's farm and 10 in Tim's) and 50 (= 10 + 40)
55

Figure 7. Ratio of prices of contingent claims and probabilities

of states of nature.
bushels. There is "systemic risk" (risk of the economy as a whole) and someone has to bear it.
One possibility is for one of them to absorb the change in total output. If the agreement is for
Harold to trade 10 bushels of his good harvest in return for 10 bushels when his output is low,
then his consumption is 20 bushels in both states while Tim's will fluctuate between 20 and 30
bushels. Exchange of contingent claims allowed them to move to a preferred consumption
pattern but uncertainty cannot be completely eliminated.
In a contemporary world, wage contracts provide examples of arrangements to share
systemic risk. A firm has to meet its expenses from its sales revenue and what is left belongs to
the owners. Consider the residual after paying all expenses other than wages. What is left is to be
divided between workers and owners. This residual amount fluctuates with variations in sales
revenue and cost of inputs, and the firm has to agree on an arrangement to share the risk between
the workers and the owners. One common arrangement is for workers to get fixed wages while
letting owner's income fluctuate. The other is for both to share some risk; bonuses are structured
to make the employee remuneration move with profits of the firm.

Prices of contingent claims and hedging.

Individuals have limited budget and they allocate some of it for risk management. They
buy contingent claims to compensate for loses in adverse situations. Those who sell the claims
charge a price just as insurance industry changes a premium. The cost of these claims determines
the amount and type of claims that an individual can purchase with his budget. Assuming that
there are only two types of claims and their prices are fixed, the packets an individual with a
budget for hedging can afford are points on a straight line that slopes downward to the right in
Figure 7 (which is a reproduction of Figure 4). The slope, how much more one contingent claim
can be added by reducing a unit of the other, depends on the ratio of prices.
One basket on the line has equal quantities of the two claims. If the indifference curve is
tangent to the line at that point, the individual, like Harold or Tim, avoids any fluctuation in their
consumption. When will that occur?
56

With reinterpretations of the indifference curve as set of (equally ranked) super-baskets of

contingent commodities suggests a new definition of the marginal rate of substitution. It differs
from the definition in Chapter 2 in that an increase in contingent claims to wheat does not
necessarily increase the consumption of the wheat. The change in consumption is contingent
upon the state of nature occurring. The potential increase in utility basket must be weighted by
the probability of the state occurring. The expected increase in utility is a product of three
factors: the increase in quantity of contingent commodity, the increase in utility per unit increase
in the commodity (marginal utility) and the probability of the state occurring. This product must
equal a similar product for the other commodity for a movement to keep the level of utility
remains unchanged. The slope of the indifference curve, marginal rate of substitution, is the ratio
of the change in quantities along the curve. If it equals the ratio of the probabilities, then as
shown in the footnote, the individual will a super-basket with equal quantities in both states. 1
Harold and Tim were exchanging contingent claims at a ratio of one and the ratio of
probabilities of the two states (0.5/0.5) is also one. They choose an exchange that provided them
with 25 bushels of wheat in each state. Given another price ratio for contingent claims, they
would not have done so. In contemporary world, most individuals do not fully insure their losses
from car accidents or fire, agreeing to take part of the loss as deductible in the insurance policy.

Efficiency of trade in contingent claims.

One justification of market economy is that it allows the economy to reach an efficient
state in the sense that no one can move to higher level of utility without decreasing the utility of
another. If all those trading in contingent claims paid the same price, every individual sets the
marginal rate of substitution of contingent claims to a common price ratio. In the example of
Figure 7, there were two states of nature and two contingent claims; the market is said to be
complete when the number of contingent claims equals that of the states of nature. The
completeness allows the individuals to achieve Pareto efficiency, even if there is uncertainty.
Since there are so many sources of uncertainty in a modern economy -- health of
individuals, stock prices of companies, weather affecting agricultural output - and each has many
states of nature, it looks unrealistic to expect that the number of contingent claims available in
the economy equal that of the states of nature. Can such an economy achieve efficiency? Each of
the long lived securities -- securities like share that provide returns in different states of nature in
different periods -- are equivalent to packet of many contingent claims and they can possibly
bridge the difference between number of states and claims. It is an empirical question and
depends on the market conditions.

1
(Probability of state 1)(change in quantity of contingent commodity 1)( marginal utility of the commodity) =
(probability of state 2) (change in quantity of contingent commodity 2)(its marginal utility). Hence (change in
quantity of contingent commodity 2)/(change in quantity of contingent commodity1) = slope of indifference curve =
[(probability of state1)(marginal utility of contingent commodity1)]/[(probability of state 2)(marginal utility of state
2)]. At point of tangency, this equals the ratio of price of contingent commodity 1 to price of contingent commodity
2. If the price ratio equals the ratio of probabilities, then the ratio of marginal utilities must be 1.This will happen
only if quantities of wheat are the same or the chosen point, the state of nature does not affect the level of
consumption.
57

Summing up.
Many of the decisions we make in the present affect us in the future. Economic science
from the time of Adam Smith on recognized the role of time but the tools to analyze
intertemporal decisions when outcomes are uncertain were developed only in the twentieth
century. Time preference in one form or another can be traced back to nineteenth century writers
had but the precise formulation stated here is from Irving Fisher's Theory of Interest published in
1907.
Introduction of uncertainty complicates the decision process as outcomes depend not only
on the choice by the decision maker but also on states of nature (defined as a source of
randomness). Given his inability to control the outcome, an individual resigns to making choices
that maximize the expected utility.
Individuals are risk averse and want to avoid losses, even if, on the average the asset has
high value; this is shown by purchase of various types of insurance that require payments of
premiums even if there is no loss. A rudimentary arrangement to shift risk is by transacting in
contingent claims.
States of nature intervene between the choice made by the decision maker and the
outcome. Incorporating trading in dated commodities and contingent claims into the general
equilibrium has provided insights into what is needed to achieve optimal allocations in such
economies. Incomplete markets with fewer numbers of contingent claims than states of nature
can prevent the economy attaining efficient allocations. Institutional arrangements to cope with
trade over time and states of nature reflect the response incompleteness of markets and
asymmetric information.
Except for the short description of general equilibrium above, analysis of choice was
mostly confined to rather primitive and isolated economies. It allowed the core concept in
economics to be developed in an intuitive manner. Next chapter explains how the consumption
choices of individual consumers lead to market demand for a commodity and how quantity
demanded is responsive to changes in the prices of commodities. Producers also respond to price
changes. The responses of consumers and producers result in a market moving to a price at
which quantity demanded to equal quantity supplied.

Bibliographical note.
Day and Newberger (2002); Frederick, Loewenstein and Donoghue (2002); Huang and
Litzenberger (1998); Herschleifer and Riley (1992); Fisher (1930); Lengwiler (2004),Jackwerth
and Rubinstein (1996); Lutz (1967).
58
59

Chapter 5. Let us go shopping.

In modern societies, we rely on others to supply us with goods and service needed to meet
our wants. Nothing is more frustrating than not getting a product when we need it. Irritation turns
to anxiety, if the unavailable products - grains, milk, or gasoline, for example - are essential for
our daily life. In North America and Europe such shortages are rare and transitory but in many
parts of the world millions live a life of quiet desperation.
Those who supply us rely on sales for their income. If they produce less than what we
demand, lost sales cut into their profits. Excess production results in unsold inventory and an
inability to recover the cost incurred in their production. Every society - primitive or modern,
autocratic or liberal - needs to coordinate production and consumption decisions.
Our instincts lead us to believe that such coordination requires conscious efforts by
individuals with an oversight over the process. Air traffic controllers use radar to keep our planes
flying safely and FedEx and UPS use bar codes and tracking systems to deliver millions of
packages to customers across the world on time. Producers use logistic systems to ensure timely
delivery of goods to stores. Why not establish a system of controls to manage the economy?
Production in anticipation of demand by consumers is intrinsically much harder task than
delivering what is ordered. Output of each firm is purchased by thousands of consumers, and
stores want to stock their shelves in expectation of sales. Each firm has to decide, without direct
information about choices of individual consumers, the quantity of its product that they will
collectively demand. Production and pricing strategies of competitors will affect the sales of the
firm. When political leaders, either out of idealism or of selfish interest, try to intervene in the
market by establishing controls, they end up creating either excess demand or excess supply.
Thwarted buyer and sellers try to circumvent the system by dealing in "black markets."
Adam Smith is renowned for his exposition of the benefits of free market economy, but it is
Frederick von Hayek who emphasized the informational problems in achieving coordination
among independent decision makers. 1 He argues that the central problem in economics is not the
logistics of implementing what we know needs to be done but knowing what has to be done.
Even if those who devise and implement controls have the best of intentions, they are hindered
from being effective by the lack of knowledge about quantities demanded and supplied. In
addition to the information problem, we now know that there is an incentive problem. Shortages
give administrators the power to decide who receives what and experiences of many economies
that implemented controls show that administrators resist attempts to deprive them of that power.
The market system, Hayek claimed, minimizes the informational requirements. Both
consumers and producers observe one signal in the market, the price, and make their decisions
independently. Shortage of gasoline leads to an increase in its price and each consumer decides
how to respond. Susan is a sales agent whose work involves travel and cutting back on driving
will hurt her business. Wong is retired and can substitute sightseeing trips with other leisure
activities. As the price of gasoline goes up both Susan and Wong reduce their purchases but by
different amounts. No one other than the consumer needs to know how pressing their wants are

1
Hayek (1945), pp.519-530.
60

and how willing he or she is to reduce consumption. The price continues to increase until the
reductions balance quantities demanded and supplied.
The next section considers how a consumer sets his budget for consumption expenditure.
Subsequent sections discuss how his purchases depend on the budget and prices. Given the
budget, he chooses a basket of goods that he prefers to others that cost as much. Understanding
his choice permits examination of how the composition of the basket changes with his income
and the prices of goods. An individual demand curve is derived to reflect his responses to price
changes. The quantities demanded by individuals at various prices are added to draw the market
demand curve.
Producers also respond to changes in price. Pending discussion in later chapters on how the
production plans of firms depend on their cost structures and the extent of competition in the
market, the quantity of a product collectively supplied by all firms is assumed to increase with its
price. The market clearing price is the one that equates the quantity demanded to the quantity
supplied.

Setting the budget.

The budget for our shopping depends on our income and our assets. We receive income
from our employment, returns from our investments in bonds and stocks, and rents from the
properties we own. Some households receive transfer payments include pensions, social security,
welfare payments or remittances from family members. 1 Part of the income is spent on
consumption and the rest is saved. The Consumer Expenditure Survey conducted by the U.S.
Bureau of Labor Statistics reports that of the average-after-tax income of households in 2008 was
$61,774 of which they spent $50,486. 2
Some of the consumption expenditure is on goods that last a long time while others are on
those meant for immediate use. Among the durable goods that we buy are houses, furniture, cars
and computers. We spent on education early in life (and occasionally for short periods later) and
enjoy its benefits for the rest of our lives. Purchase of durable goods and services that last a long
time should be viewed as investments. 3
Other products like food, toiletries, cleaning supplies are used up quickly as we consume
them. We anticipate our need for these products in the near future and, in each of our shopping
trips, make purchases for the days ahead. Still the time interval between purchase and use is so
short that we can, as an approximation, ignore it.

1
Transfer payments differ from wages in that no service is done in return for the payment. Pensions and social
security are based on work done in the past. Family members support each other. Some welfare payments are made
conditional to working but the payments as such is not related to the amount or quality of work.
2
Bureau of Labor Statistics, Consumer Expenditure Survey (2008), Table 2.
3
A house is considered an investment. Education should be viewed as investment in human capital.
61

Figure 1. A consumer's income, expenditure and assets.

We save to make provisions for our retirement and for uncertain contingencies like illness
or period of unemployment. We look into the future and timing of our wants enters our decision
process in an essential way. The assets that we accumulate through our savings can be compared
to water in a tub. Our income is the inflow into it, and our expenses are the outflows (Fig. 1). In
the years we earn most, we spent less than our income and add the difference to our assets. In
some periods, anticipating higher income in the future or facing unexpected expenses, we borrow
and run down our assets. 1 In addition to changes due to savings or borrowings, our wealth can
increase or decrease if specific assets appreciate or depreciate in value. If an individual has an
income of $50,000 and her house and stocks appreciated from $100,000 to $120,000, then she
can consume $70,000 without reducing her wealth from the previous level. 2
In the last decades of twentieth century, there was significant appreciation of the value of
stocks and houses. In the ten years to 1999, the wealth of U.S. households, adjusted for inflation,
increased by $15 trillion or slightly in excess of 50 per cent. More than 60 per cent of asset
growth was due to increases in the value of stock holding; the prices of stocks increased five
folds in this period. 3 The stock market began to decline in 2000 but house prices continued to
increase. Housing prices peaked in 2007. Between April 2007 and February 2008, OFHEO
pricing index put out by the Federal Housing Finance Agency fell by 10 percent. Between May
2007 and May 2009, the S&P500 stock price index fell by 40 percent. Estimates indicate that
between the second quarter of 2007 and last quarter of 2008, the total household net worth
declined by $12.9 billion (about 20 percent of net worth). 4
When asset prices were increasing, consumers feel less need to save for future and this is
offered as an explanation for the decline in the household savings rate in US from around 14
percent from mid- 1980s to zero in 2000. More recently it is increasing, but it is too early to say
at what level it will settle. Once the individual chooses the budget for consumption expenditures,
the baskets she can afford to buy will depend on the prices of products.

1
Chapter 11 considers how savings in the present is determined by intertemporal utility maximization.
2
General inflation is assumed to be negligible.
3
Poterba (2000),p.99
4
Cashell (2009), pp.5-8.
62

Figure 2. Budget line.

Baskets that are within a consumer's budget.

Julia, a consumer with a budget of $300, spends it on buying two products. The price of
Product 1 is $4 and of Product 2, $6. Baskets that cost $300 - Baskets A, B and C in the Figure 2
- lie on the budget line. 1
The slope of the budget line at a point is the ratio of the vertical distance to the horizontal
distance between two neighboring points on it. Since the budget line is a straight line, the slope is
the same at all points on it, and it can be measured by the ratio of the height of the left end of the
budget line (the length of the blue arrow) to the distance of its right end from the corner (length
of red arrow). The slope, -50/75, has a negative sign indicating that height decreases to the right.
It is possible, and in fact helpful, to express the slope as the ratio of two prices. The
maximum amount of Product 2 Julia can purchase is (budget/price of Product 2) = $300/$6 = 50.
Similarly, the maximum amount of Product 1 she can purchase is (budget/price of Product 1).
The ratio of the two with a negative sign added is - (price of Product 1/price of Product 2).
While budgets of consumers in a market differ, all of them pay the same prices and budget
lines of all consumers have the same slope. Expressing the slope of the budget line in terms of
prices enables deriving many important results.

Julia chooses a basket.

What basket on the budget line will Julia choose? In the case of Selkirk, the loner who had to
produce his own dinner, the best he could do was to match his willingness to substitute products
in his consumption (his marginal rate of substitution) with his ability to shift production from

1
It is a straight line as long as prices do not vary with quantities; price discounts with quantity purchased, for
example, will put a kick in the line.
63

Figure 3. The budget that maximizes utility.

one to the other (his marginal rate of transformation). Julia purchases what she consumes and
she must equate her marginal rate of substitution to her ability to buy more of one product by
reducing the other or to the slope of the budget line.
The reasoning to determine Julia's utility maximizing budget is similar to that used to
determine Selkirk's choice. Will Julia choose Basket A on the left panel of Figure 3? Starting
from that basket she reduces Product 2 by a small amount. The position of the green basket
shows how much more of Product 1 is needed for her to feel indifferent to the reduction in
Product 2. 1 But the savings on expenditure on Product 2 allows her to buy the red basket on the
budget line which she prefers as it contains additional amount of Product 1 and the same amount
of Product 2.
As she shifts down the budget line, she has less of Product 2, and she will become reluctant
to reduce it even more. She needs larger amounts of Product 1 to compensate for further
reductions of Product 2. When Julia reaches Basket B, she has no incentive to move down the
budget line as the additional quantity of Product 1 that can be purchased just compensates the
decrease in Product 2 (the green and red baskets coincide and is shown by the half-green half-red
circle).
Panel B shows baskets that Julie ranks equally as Basket B; its shape is determined by the
axiom of diminishing marginal rate of substitution. If Panel B is superimposed on Panel A, the
indifference curve will touch the budget line at Basket B with the rest of the curve will lie above
the line. Basket B is the utility maximizing basket that Julie can afford. The discrete changes in
quantities in Figure 3 make explicit the substitution process but it takes liberties with the
analytical derivation of the results. In a rigorous derivation of the equality between marginal rate
of substitution and price ratios, the changes in quantities of goods are made smaller and smaller -
the limiting process in mathematics makes quantities infinitesimal - until the black and green
baskets are almost indistinguishable. Then the indifference curve will be tangent to the budget
line as shown in the inset at the upper right hand of Figure 3.

1
Baskets are represented by dots of the same color.
64

Figure 4.Choices of different individuals.

Though only one indifference curve is drawn in Panel B, other curves lie above and below it
(Basket A lies on one such curve). Irrespective of the position and slope of the budget line, one
indifference curve of Julie that will be tangent to it. This is an important result as it enables
comparing baskets Julie will choose as her budget line shifts either due to changes in her income
or in the prices she pays.

Why individuals choose different baskets?

Scott is another individual with the same income as Julie and shops in the same market.
Since both are also paying the same prices, their budget lines are identical. Still differences in
tastes lead them to choose different combinations of the two goods as they maximize their
utilities (Figure 4). Since both equate their marginal rates of substitution to the common price
ratio, they end up having the same marginal rates of substitution.
The equality of marginal rates holds for all the consumers in a market, irrespective of their
incomes, as long as they pay the same prices. Once the purchases were made, they have no
incentive to make further transactions just as George and Robert exhausted possibilities of
trading when their marginal rates of substitution became equal. 1
The equality of marginal rates of substitution is one of the conditions for the economy to
achieve an efficient allocation of resources.

1
Trade between George and Robert was discussed in Chapter 3.
65

Consumption changes with increasing affluence.

Figure 5. Proportional increase in expenses on all commodities.

Scott had an increase in his income and that leads him to increase his budget for consumption
by 20 per cent to $360. He can afford larger baskets and the axiom of non-satiation (preferring
more to less) guarantees that he will choose one on his new budget line. One possibility is to
increase consumption of all products by 20 percent; the new basket will be Basket B of Figures
5. Other possibilities shown in Figure 6 include spending the additional $60 on one of the goods
and ending up with Basket C or Basket D.
Scott will choose a basket along the new budget line that equates his marginal rate of
substitution to the price ratio. As long as the chosen basket is in the segment between Baskets D
and C, he has increased consumption of both products. Other consumers faced with similar
budget increases will make their own choices and the aggregate change in quantity demanded of
each product will be the sum of the changes in individual demand.
The income elasticity of demand of any product is the ratio of the percentage change in the

Figure 6. Shift in budget line.

quantity demanded to the percentage change in income. Ernst Engel, a nineteenth century
German statistician, observed that the proportion of income spent on food in Germany decreased
66

Figure 7. Cost savings from decrease in price of one commodity.

as income of average consumer increased. This relation implies, assuming prices are constant,
that the demand for food product does not increase in proportion to income or the income
elasticity of food products is less than one.
The percentage of income spent on food in United States has declined during the last
century. 1 In 1900, the typical American household spent 36 per cent of the income on food but
by 1950 it came down to 24 per cent. By 2001 it was 13.5 per cent and of this 5.7 per cent was
on food consumed away from home (restaurants and fast food places). In contrast to food, the
expense on all types of transportation in United States increased from 4 per cent in 1900 to 13
percent in 1950 to 19.3 percent in 2001. The automobile and airplane made travel easier and
Americans are now traveling longer distances and more often than ever before.

Effects of change in a price.

The effect of a price change on affordable baskets depends on the quantity of the product
in the basket. Andrew with a budget of $300 is buying 15 units of Product 1 priced $4 and 40
units of Product 2 priced $6 (Upper basket in Figure 7). As the price of Product 1 falls to $3, the
cost of the basket goes down by $15. In contrast, the cost of the lower basket with 30 units of
Product 1 goes down by $30. More he consumes the product that has become less expensive the
greater is the cost savings.
Cost savings indicate how the budget line changes with a reduction in price. If Andrew was
spending the entire budget on Product 2, there is no cost savings and top end of the budget line is
not affected (Figure 8). If he buys only Product 1, he can buy 100 units instead of 75 and the
lower right-hand end of the line moves to the right. The budget line swings outwards.

1
Bureau of Labor Statistics, "100 years of U.S. Consumer Spending: Data for the Nation, New York City and
Boston," http://www.bls.gov/oub/uscs/. The decline reflects both the relative change in quantities and prices of food
and other items in the basket of a typical consumer.
67

Figure 8. Shift in budget line as price of

Product 1 decreases.
Both before and after the price change, Andrew buys baskets that equate his marginal rates
of substitution to the price ratios. He will shift from the basket corresponding to the black dot on
the lower budget line to one on the new budget line. It may sound reasonable that consumers will
alter their budget allocations to buy more of the cheaper product and less of the other; one such
allocation is the red basket on new budget line. However, one of the core assumptions of
economics is that individuals differ in their preferences. For general validity, the increase in
consumption with price decline must be established, not by vague conjecture, but by deriving it
using minimal assumptions about preferences.
To simplify the analysis without affecting the core of the reasoning, add another
assumption to the axioms of preference: a proportional change in all commodities, as when he

Figure 9.The effect of price decline of Product 1.

68

Figure 10. Market demand curve.

buys the yellow basket instead of the black, will not affect Andrew's marginal rate of
substitution.
Andrew will buy a basket on the new budget line and let the one that maximizes his utility
be the red basket on Panel B of Figure 9. Consider the indifference curve passing through that
basket. Given the assumptions about consumer preference, the curve must lie above the new
budget line except at the chosen basket (Curve 2 of Panel B, Figure 9).
To determine the relative position of the black and red baskets, increase the quantities in
the black basket proportionately to get green basket on Curve 2. By the newly added assumption,
the marginal rate of substitution at green basket remains the same. But the budget line has lower
slope as see in Figure 8; the lower end has moved out making it flatter. To reduce the rate to
equal the lower slope, Andrew must move down the curve or increase quantity of Product 1; this
follows from the axiom of diminishing marginal rate of substitution.
Andrew's move from the black basket to red basket can be decomposed into two separate
ones: proportional expansion to reach the green basket and a slide down the indifference curve to
the red basket. The first move increases quantities of both products, and the second move
increases the quantity of Product 1 while decreasing that of the other. The two moves jointly
increase in the consumption of Product 1 whose price has decreased.

Market: the price at which the market clears.

Nineteenth century French economist, Antoine Cournot defined market as "the whole of any
region in which buyers and sellers are in such free intercourse with one another that the prices of
the same good tend to equality easily and quickly." Given that all consumers are paying the same
price, the quantities they demand at that price can be added up to equal the quantity demanded in
this market. As price decreases, each of them will buy more and the quantity demanded in the
market will increase.
This is illustrated in Figure 10 for a product.
69

Figure 11. Supply curve.

As price is reduced from $3 to $2.50 each individual in the market will increase his or her
purchases and the total quantity demanded increases from 1,000 bottles to 2,000 bottles. At a still
lower price of $2, the quantity demanded will be 3,000 bottles.
A demand curve graphically illustrates the relation between prices and the quantities
demanded for any product, and it slopes downwards to the right to reflect the increase in quantity
demanded at lower prices. Each point on the curve corresponds to one price measured along the
vertical line to the left and to one quantity as measured along the horizontal line at the bottom. At
any point of time, only one price prevails in the market.
The consumers are able to purchase the products only if the producers supply them to the
market. The output each producer is willing to produce depends on his costs, the price in the
market and the competition he faces from other producers. As price increases, more revenue is
generated per unit sold and the firm has an incentive to consider increasing its output. Pending
detailed analysis of how incremental cost and revenues determine each firm's response to price
changes, the collective output of all firms producing a homogenous product is assumed to
increase as its price increases. This is shown in Figure 11; the firms produce 1000 units when
price is $2, 2000 units when it is $2.50 and 3000 units when price is $3.00.
The table in Figure 12 juxtapositions the quantities demanded by consumers and that
supplied by producers at various prices. What stands out is that there is only one price, $2.50, at
which the quantity demanded to equal the quantity supplied. The output brought to the market is

Figure 12. Market clearing price.

70

sold and shelves in stores are cleared at this market-clearing price. The demand curve of Figure 9
and the supply curve of Figure 10 are drawn together in Figure 12 and they intersect at the
market-clearing price.
It show that if the price is above the market-clearing price, producers supply more than what
consumers are willing to buy. Every fall automobile companies introduce new models. As 2007
models were introduced in the fall of 2006, dealers in the United States could not display the new
vehicles as their lots were full of leftovers. The worst hit was Chrysler Corporation. Beginning of
November 2006, only half the vehicles in Chrysler dealerships were new models as compared to
more than 75 percent in General Motors and Ford dealerships. Chrysler announced an incentive
program to move the unsold vehicles. Irrespective of how the program is structured, it is a
reduction in what consumers have to pay for their purchase and was intended to increase sales. 1
If the price is below the market clearing price, the quantity demanded will exceeded that
supplied and shortage will lead to an increase in price. The periodic increases in price of food
product as storms and freezes disrupt the supply of vegetables and fruits are examples of market
response to shortages. The price observed in the market at any moment need not be the market
clearing price but the surpluses and shortages will move it towards the market clearing level.

Prices we see in stores.

In the nineteenth century stores in London selling textiles began to post prices instead of
bargaining on every item sold. The arrangement was found profitable and soon spread to other
stores. Today most of the purchases by individuals in Europe and North America are in stores
that sell at "fixed prices." Are they the same as the market clearing prices of Figure 12? If not,
will they tend to move towards each other?
"Like most marketing decisions," writes Thomas Nagle and Reed Holden, "pricing is an art.
It depends as much on good judgment as on precise calculation.... Good judgment requires
understanding. One must comprehend the factors that make pricing strategies succeed and others
fail" 2There are many consumers in a market and drawing the demand curve requires an estimate
not only the quantities they will buy at the current posted price but for a range of prices around it.
The supply curve depends on the responses of all producers. It is hard for the marketing officers
of a corporation, be it a retailer or the manufacturer, to anticipate correctly the market clearing
price of a product and set the price at that level.
Consider the experience of the retailer, K-Mart. To attract customers to their stores, they
would announce a sale on a Sunday in 2002 but the firm underestimated the demand at the
lowered prices. When customers rush to buy, the store had run out of stock on the very day the
sale was announced. The frustration of missing the sales turned customers off, and it is
considered to be one of the reasons K-mart had to go into Chapter 11 bankruptcy reorganization
in 2002. 3

1
New York Times, November 2, 2006. C.3
2
Nagel and Holden (1995), p.9
3
The Wall Street Journal, October 15, 2002. B1& 3
71

Absence of precise information leads manufacturers and retailers to seek for guidelines to
determine the posted prices. One approach is cost-plus pricing. Internal accounting provides unit
cost of the product and the price is set above it to generate targeted profits. The problem with this
approach is that it sets price without considering the consumers. They may not be willing to
purchase the quantity that maximizes producer's profits at that price. If production is reduced to
match the quantity demanded, the unit cost to the manufacturer increase as its plants operate at
less than capacity; if price is increased to equal the higher costs, then the sale decreases even
more, generating a spiral of increasing costs and decreasing sales.
Over time retailers and manufacturers developed sophisticated pricing strategies to assess
demand and control inventories at stores but the central issue of understanding the consumer is
still there.

Changes in quantity demanded as price changes: price elasticity.

We are faced with frequent changes in prices as a market adjusts to fluctuations in the
quantity supplied. Weather changes lead to bountiful harvest or a crop failure. Shortage of raw
materials, breakdown at a major plant, disruption of transportation or political instability affect
the supply of industrial products. In 2005, supply disruptions due to Hurricane Katrina that hit
the Gulf Coast initially took out 25 per cent of the crude oil production in the United States and
10 to 15 percent of its refining capacity. It created a shortage of gasoline in the country and the
shortage together with the increasing crude oil prices in international markets resulted in the
gasoline prices rising from $1.78 per gallon on January 3ed to $3.07 on September . 1
Shortages lead to price increase but how much should it increase to balance the market?
If demand is elastic - elasticity in the usual sense implies a response to any pressure - then
a slight increase in price will lead to a substantial reduction in quantity demanded. Only a small
price change is needed to rebalance demand and supply. Demand for gasoline is relatively
inelastic in the short run as users cannot reduce their driving or shift to a fuel efficient vehicles
with every fluctuation in gasoline prices. The inelasticity resulted in the increase in gasoline
prices in 2005. If higher prices persisted over time, the demand for automobiles will shift from
gas guzzlers to fuel efficient cars and the demand for gasoline will decrease. Gasoline price
begins to fall.
The consumer is choosing a utility maximizing basket. If the price of a product changes,
he will shift to another basket with different quantities of both goods (as seen by the move the
black basket to the red basket in Figure 9). The effect of the change in price of one product on
quantity demanded of another is measured by the cross-elasticity of demand. As price of gasoline
increased, the demand for new cars declined.

Who buys and sells in a market?

The English economist William Jevons points out that the institution of markets evolved
over time while maintaining their basic function of bringing buyers and seller together:
"Originally a market was a public place in a town where provisions and other object were

1
Energy Information Administration, U.S.A
72

exposed for sale; but the word has been generalized, so as to mean any body of persons who are
in intimate business relations and carry on extensive transactions in any commodity." 1 It is up to
the individuals to decide which "body of persons" to join. The decision will be based on the
prices in various markets and the convenience of accessing the market.
Consumers in medieval villages buy farm products from farmers come to sell their products.
To attract the largest number of buyers, village markets of the Medieval Europe were always
held near churches, especially on festival days. As communication and transportation improved
and as retailing developed individuals were no more restricted to buying locally produced goods
or shopping at a local store. They can go to a neighborhood grocery store, a superstore or
wholesale food club, or they can order it over the internet for home delivery. Each consumer will
go to the market where prices are lowest, given the effort involved in making the purchase.
On the supply side, farmers consider the markets where they want to sell their harvest. If
their ability to transport the products is limited, they are confined to the nearest one. As
packaging, preserving and transportation developed, farmers ship products to distant markets.
Today Australian lamb is sold in London and South Asian shrimp in United States. The cost of
transportation and price differential between markets determine the choices of the producers.
As long as consumers and suppliers brought and sold in the nearest market, it was separated
from markets elsewhere. Each commodity has its own demand and supply relations in every
market, and they will determine the market-clearing prices. If producers and consumers have the
opportunity to switch markets, buyers will move to a market where prices are lower and
producers go to the one where it is higher. The shifts in demand and supply will make the prices
converge. In spite of geographical separation, there is only one body of persons transacting in the
two localities and, from an economic point of view, those who face one price for a product are in
one market.
This logic was used by George Stigler and Robert Sherwin to examine the wholesale market
for flour in Midwest. Analyzing the prices of wheat from 1971 to 1981 in Minneapolis and
Kansas City, Missouri, two cities 300 miles apart, they concluded that the differences were not,
in a statistical sense, significant. The reason was that the same national bakeries are buyers in
both markets. On the supply side, Stigler and Sherwin found that 28 per cent of the flour was
being shipped more than 500 miles. Many mills supplying Minneapolis and Kansas City are
located in between the two centers, making the distance to the two markets much less than 300
miles. All these factors made the prices in two cities move quickly and easily to equality, making
them one market in the sense Jevons. They also examined the co-movement of the prices of
flours in Portland, Oregon and Buffalo, New York with those in Minneapolis and Kansas City,
Missouri. Their conclusion was: "The direct and reasonable answer is that flour prices in these
widely separated cities have a significant measure of independence, but they share all major
movements in prices." 2
The geographical extent of a market can be quite large, depending on the price of the
product and cost of transportation.

1
Jevons (1871), p.84
2
Stigler and Sherwin (1985), p.564.
73

Summing up.
The separation of consumption decisions made at the household from production decisions
taken by the firms necessitated an institutional arrangement for their coordination. The
commodity market that allows each participant to take decisions based on a common price signal
has, it was argued, many advantages over alternate institutional arrangement.
Complementing the separation between production and consumption, two other
separations developed in modern industrial economies: separation of ownership from
management and savings from investment. As the production activities in pre-industrial
households shifted to firms, labor market emerged to match workers with the firms emerged.
Labor market directs the service provided by workers to their employers. Selkirk chose
how much he works and implicitly how intensively he worked. An employer wants his workers
to maximize their effort while workers like to work at a less demanding pace. The conflict
between the interest of employer and employees is an example of the agency problem. The price
that equates the labor market is wages. The wages has to be related to productivity to induce
workers to put their best effort and various forms of incentive pay schemes were developed.
Given the size of modern firms, the owners are not able to supervise the workers. They
created a cadre, middle management, to ensure that the directives of owners and senior
management are implemented by their subordinates. Neither supervision nor the incentive pay
can totally eliminate the agency problem as informational limitations and uncertainty limit their
effectiveness.
It was a common in the past for generations in a family to work at the same plant in their
locality. Mobility of workers and pressure on firms facing rapid technological change and
foreign competition made frequent turnovers in employment common. Workers had to enter the
labor market more than once in their lifetimes.
The construction of a plant requires financial resources. Well into the nineteenth century,
factories were small enough that a group of entrepreneurs, their friends and local bank could
fund it. It was public works like railways and canals that needed massive investments and
depended on raising funds by issuing bonds and shares. Development in technologies led to
increases in size of factories and the needed funds could only be raised by tapping into the
savings of a large number of households. Those who provide the funds do not have control over
the operations but they lose their savings if the firm fails. The financial market developed a
number of institutions to absorb the savings from households and provide them with a return
while reducing their exposure to risk. Banks accept deposits at fixed interest and provide mostly
short term loans to firms. Diversification, spreading the savings over many investments, reduces
the risk to the investors. Mutual funds have made it easier for individuals to achieve a higher
level of diversification than possible if they directly in stocks.
The information requirements of modern economies created new activities like marketing
to match producers and consumers, and accounting to inform outsiders of the financial
conditions of the operations. Inventory control and supply chain management were developed to
ensure a smooth flow of inputs into the firm and output from it.
Various markets in an economy are interlinked. A reduction of sales leads to cut in
employment. The labor market response is increase in unemployment and downward pressure on
wages. The reduction in wage income of households forces them to cut consumption
74

expenditures and trim savings, sending another shock through commodity, financial and labor
markets.
The next chapter looks at the inside of a factory as it converts inputs into output. It brings
out the involvement of the firm in the three markets.

Bibliographical note.
Bureau of Labor Statistics (2006); Cashell (2009), pp.5-8; Consumer Expenditure Survey
(2008); Energy Administration (2005); Hayek (1945); Jevons (1871); Nagel and Holden (1995),
p.9; New York Times, November 2, 2006. p. C3; Stigler and Sherwin, (1985) p.564; The Wall
Street Journal, October 15, 2002. B1& 3.
75

Chapter 6. Firms: their role in supplying the market.

Even though a few factories existed in the early modern Europe, the shift of manufacturing
from households to factories became widespread only in the eighteenth century. Concentration of
production in factories enabled introduction of complex machines. In the beginning of industrial
revolution, machines were driven by windmills, waterwheels and steam engines; later they were
replaced by those relying for energy on internal combustion engines and electricity. Each worker
in the factory specialized in one operation and the division of labor increased productivity. Henry
Ford introduced assembly line production in his automobile plant. Its adoption in other industries
is followed by increased use of automation and robotics.
While we tend to associate modern industry with large plants, smaller ones are still
common and, indeed, some recent technologies like electric furnaces in steel industry are making
smaller plants competitive. About half of the US non-farm output is produced by firms that
employ less than 500 persons. Among these firms about half employ 1 to 4 employees. 1 One
common factor is that whether the technology is complex or simple and the plants large or small,
the underlying economics of these operations - converting some products into others that users
value more - is common to all of them.
Shifting production away from households created a separation between consumption
decisions and production decisions and the coordination between the two was achieved through
the commodity market. As firms grew in size and as technology grew in complexity, the capital
required for establishing and operating a manufacturing operation exceeded what an individual
was able to provide. Financial institutions pooled the savings of individual households and lent
parts of the pool to different firms and the growth of financial markets led to separation of
savings and investment decisions. Innovations in business organizations, like types of
partnerships and joint-stock companies, made it feasible for those not involved directly in the
management of the firm to contribute to the equity of a firm without concern that financial
problems of the firm will push time to bankruptcy. The management of the firm shifted to the
professionals hired by the owners, creating a separation of ownership from management evolved.
The three separations have economic consequences that will be discussed in different contexts in
following chapters. This chapter introduces the basic structure of firms.

Organizing the production.

Even now each household is involved to a limited extent in production, preparation of food
being an example, for its own consumption. Considering what we do in the kitchen is helpful in
understanding of the complex operations of a firm. At the start of the cooking we check that we
have the ingredients needed for the dinner. Perishables like meat, milk and vegetables are in the
refrigerator and others we store in the pantry. A variety of appliances like food processors,
mixers, stoves, ovens and microwaves are in the kitchen to assist us in the preparation of a meal.
There are many appliances that are meant for specific uses, like rice cooker, and we had to

1
SBA Office of Advocacy (1998)
76

Figure 1. The firm: an external look.

decide which ones to buy, taking into consideration their costs and the space they take in the
kitchen-counter.
The meat and vegetables we purchase are cleaned, cut and even packaged. Some of it is
even precooked, reducing the time and effort needed to incorporate them into the dishes we want
to serve. We can avoid cooking altogether by buying pre-cooked dinners or ordering delivery
from restaurants. Such outsourcing is not without cost. The preparation may not be to our tastes
and the food may not be as fresh as the one we prepare from scratch.
In setting up as plant the firm must choose the technology it uses. Is it worth incurring
additional investment in complex machinery to save labor cost? How much of the product should
be fabricated within the plant and what parts or operations are to be outsourced? Henry Ford
chose the vision of an integrated firm. The Rouge River Plant at its peak in the 1920s had the
furnaces to produce steel and glass for the cars, a plant to process rubber and produce the tires
and even an electricity plant. The raw materials came from forests, mines, and limestone queries
the Ford Motor Company owned. Ford even sought to establish rubber plantations in Brazil.1
After the Second World War, the Ford Motor Company shifted its strategy to decentralization
and globalization. Today a typical manufacturing firm purchases finished and semi-finished
products from suppliers. Some companies, like PC makers, outsource all the production and
focus on assembly and marketing of their branded product. 2
At one time or other, we have passed by plants that look from outside like the one in
Figure 1. An imposing physical structure is enclosed in to restrict entry. Raw materials and semi-
finished goods are delivered to the plant by road or rail. We observe workers going in at the
beginning of a shift and leaving at the end of it. Output is shipped out to various locations. This
external view that excludes all internal operations highlights the core economic function of a
firm: converting inputs into output. Modern economics use this view as the starting point for the
analysis of the firm.
The building and machinery installed in the plant are fixed inputs that cannot be altered in
a short period of time. Other inputs like labor hours (number of laborers times hours worked) and
quantity of raw materials can be changed much more quickly; they are variable inputs. 3

1
http://media.ford.com/article_display.cfm?article_id=13884
2
The distinction between outsourcing and subcontracting for which there is no consensus is ignored.
3
For exposition using graphs, the number of inputs need is restricted to two. The inputs are then grouped into two:
fixed and variable.
77

Figure 2. Flow of inputs and output.

The firm in Figure 2 is producing four boxes of output using eight boxes of variable inputs.
If the firm increased the number of inputs baskets without altering the machinery installed
within the plant, will it change its output and by how much? The outcome will depend on the
installed technology but there are technologies where some increase in output is to be expected.
The output increases per unit increase in the basket of inputs is defined the marginal product of
the basket. For the firm in Figure 2, it is half a unit.
The marginal product can increase or decrease as the firm keeps increasing the variable
inputs. One possibility is that the installed machinery determines the capacity of the plant and
until it is reached every basket of variable inputs has a fixed marginal product. Firms with such
technology provide a simple framework to derive many results that are valid even if the marginal
product is not constant. Some results that crucially depend on an alternate technology are
developed in Chapter 11.
The use of inputs to produce output sets up a relation between sales revenue and cost of
inputs (Figure 3). The difference between the two flows is "the operating income." The "profit
of a firm," defined later in the chapter, equals the operating income less cost of funds raised to
finance construction and maintenance of the plant. These costs are fixed in the short run. Given
variation in cost of production and sales revenues with output, the interest of owners is served by
choosing the output that maximizes operating income.

Figure 3. Flow of products and funds.

78

Figure 4. Marginal revenue and marginal cost.

To get insights into how cost changes with production, consider once again home production.
You invited six of your friends to a home-cooked dinner. You have set a budget and purchased
the meat, vegetable and wine. Then you learn that a friend you always wanted to invite is in town
and you decided to include him. How does it affect the planning and preparation of the meal?
You have to spend more time preparing the meal, in setting places and washing dishes but it is a
labor of love. All the same the expenses for the dinner will go over your original budget as you
need to buy more meat and wine and maybe larger amounts of vegetables. The extra cost you
had to incur is the marginal cost of having one more person for dinner; the benefit to you is the
fun of visiting with an out-of-town friend.
A firm focused on its profitability compares the monetary cost and benefits of increasing
its output by a unit. Whether operating income increases or not depends on the relative size of
the changes in sales revenue and cost of inputs. The change in input is the reciprocal of the
marginal product; if one basket produces 0.5 units, then it takes two baskets to produce a unit.
The cost incurred in producing that unit is the cost of purchasing two additional baskets of input:
$200 if each basket costs $100. The increase in total cost per unit increase in production is the
marginal cost of the product (height of red box in Panel A of Figure 4). If the firm now
increases the output by another unit, will the increase in operating expenses for second unit be
the same as that for the first unit or will it be different? For this firm that pays fixed price for
inputs and has constant marginal product, the marginal cost is a constant.
Kalnins provides data on the marginal cost of renting a room (difference in cost to the
hotel of having an occupied and an unoccupied room). For economy motels it is $20 per night
and for luxury hotels $75 per night. 1
Sales revenue increases as more units are sold in the market. 2 The increase in revenue per
unit increase in sales is marginal revenue (height of green box in Panel A of Figure 4). How

1
Kalnins (2006), p.214.
2
There are circumstances where sales revenue can decrease with output. Then the firm will not increase the output
but instead decrease it. The reasoning in the text should be reversed.
79

Figure 5. Gross profit at capacity.

marginal revenue changes with output will depend on the extent of competition in the market for
the product. Pending detailed analysis of competition in following chapters, it is fixed at the level
in Figure 4 in this chapter.
For this firm with fixed marginal cost and marginal revenue, an additional unit increases
its sales revenue more than by its costs and the difference adds to the operating revenue. Can the
firm keep increasing net income by increasing output? It will ultimately run into one or more of
three barriers: capacity limit, decreasing marginal revenue and increasing marginal cost. Next
few chapters will deal with markets where marginal revenue decrease with output and Chapter
11 will consider firms with increasing marginal cost. In this chapter marginal cost and marginal
revenue are taken to be constant at the level in Figure 4 and the firm will keep expanding output
until capacity is reached. The sum of differences between marginal revenue and marginal cost,
represented by the area of the blue box, is the firm's gross profit (Figure 5). 1
Sales revenue, cost of inputs, and gross profit of public companies are published in their
income statements.

Economics and financial accounting.

Many groups of individuals, within and outside the firm have to make decisions based on
financial data like costs, sales revenue, assets and liabilities of the firm. Investors have to choose
how much shares of the firm they want to hold in their portfolios. Financial institutions like
banks, insurance companies and pension funds provide funds to the firm by loans or through
purchases of its bonds and they use accounting information to evaluate the firm's financial
condition. Suppliers who sold the company products on trade credit need assurance that they will
receive the payment as per schedule. Customers who purchase durables like cars and computers
have concerns about after sales service. The allocation of resources in an economy is guided by

1
Fixed cost, like the cost of financing existing plant and paying salaries to employees at the management level, do
not change with output and do not enter into marginal cost. The plant has the capacity to produce so many units and
dashes are to indicate that marginal cost and marginal revenues of in-between units. The height of the rectangles
being the difference between marginal revenue and marginal cost, and the length of the side the number of units
sold, their product measures the excess of revenue over cost for capacity output.
80

Figure 6. Flow of information, funds and products.

accounting data. The demand for financial information by these groups creates a supply. Firms
generate financial accounting statements to stakeholders about the performance of its operations.
Figure 6 shows the flow of information funds and products. The nature and amount of data
supplied to outsiders will depend on the cost of generating and making public the information
relative to the benefit from their publication like enhanced credibility with financial institutions
and customers. Costs include expenses for collection, collation and distribution of the data.
Competitors can use information about the firm to develop strategies that benefit them.
Firms want to emphasize favorable information and gloss over unfavorable aspects of their
performance. United States and most developed nations have financial agencies that promulgate
regulations to ensure that the financial statements meet certain minimum standards. One of the
challenges facing financial regulators in this age of global integrations is to make the national
reporting requirements consistent with each other. The conventions and rules that are to be
followed in the United States are known as Generally Accepted Accounting Principles (GAAP).
Though quite elaborate to ensure that financial statements reflect the economic conditions and
performance of the companies, GAAP leaves enough discretion to the firms in choosing
accounting techniques and procedures that statements should be read with a critical mind.
Among financial information released by publically owned companies, the income statement
indicates how well the entity performed during a period. Part of the "2005 Income Statement" of
the Model Corporation is reproduced in Table 1. 1

1
Table is constructed by simplifying the "Consolidated Statement of Income" of an American technology
company. It illustrates the general format of such statements but specifics will vary among corporations.
81

Operating Income of Model Corporation In millions

for year ending in December 2005

Net Revenue $39,000

Cost of goods sold $16,000
Depreciation* $4,300
Gross profit $23,000
Marketing, general and administrative $5,700
Research and development $5,000
Amortization of intangibles $100
Operating expenses $10,800
Operating income $12,200
Table 1. Model Corporation, “Consolidated Statement of Income,” 2005 Annual Report.
* Depreciation is from “Consolidated Statements of Cash Flows.”

The first entry is net revenue defined as total sales revenue less returns by customers. Most
sales are not for cash; the sales may occur in December 2005 but the buyer has 30 days to pay
and settle the account in January 2006. The sales will be included the Income Statement under
net revenues as it was earned in the year; cash will be recorded in the statement of cash flows
when it is received. The buyer is allowed to return the product within a period and even if the
product is returned in January 2006, it will be recorded as sales the income statement. Every now
and then, a firm (or sales employees of the firm without the knowledge of its upper management)
will bolster the bottom line in income statements by pushing customers (using their ongoing
relations or offering incentives) to purchase more of the product at the end of an accounting
period than they would otherwise do, knowing well that a portion of what is sold will be returned
soon. By then the accounting period has ended and the sales figures for the past period are
inflated by these tactics.
Cost of goods sold is the sum of material, labor and overhead costs. The firms are unwilling
to reveal detailed breakup of costs as it provides useful information to competitors and the
income statement groups them together as cost of goods sold.
Some technologies permit substitution of one input for another. In those cases, the firm has
the opportunity to minimize costs. This result is examined in Chapter 11; here the technology is
assumed to require fixed combination of inputs.
Capital equipment wears out with use and becomes obsolete with time. Consider the case
of an entrepreneur running a business from home. He purchases a car costing $35,000 for
business purposes only. As he drives around to meet his clients, the car gets worn out and he
realizes that after five years the car will not meet his needs. If he does not subtract from his
revenues an amount to reflect the depreciation of the car, he is underestimating the cost of doing
business and overestimating his income. Alternatively, he can estimate that the car will last five
years and the end it can be sold for $10,000. The depreciation in the value of the car over five
years is $25,000 and he accounts for it by setting aside $5,000 each year and treating
depreciation as a cost of doing business. Accounting for depreciation requires a judgment.
Instead of depreciating by the same amount per annum he can take a larger depreciation in the
first year as cars lose value as soon as they are driven out of the dealership. Depreciation (and
82

Net Income of Model Corporation

December 2005
In millions
of dollars
Operating income 12,200
Interest and other, net 600
Income before taxes 11,600
Provision for taxes 4,000
Net Income 7,600
Table 2. Model Corporation, “Consolidated
Statement of Income,” 2005 Annual Report.

obsolescence) is an estimate and US accounting rules permit the firm to choose from one of four
schedules. Because of the special nature of this cost, it is listed separately.
A technology oriented firm has to invest heavily in research and development to remain in
the forefront; the income statement of the Model Corporation shows that its expense on research
and development is one third of the cost-of-goods sold. Patents acquired through its research lose
value over time; industrial patents have limited life and new ones makes earlier patents less
valuable. Amortization of intangibles is the write down of values of intangibles like patents. All
these items add up to operating expenses.
The difference between gross profits and operating expenses measure the revenue
generated by the operation of the firm and is listed as operating income (also referred to as net
operating income). Out of this, the firm must meet the interest cost on loans, payment to bond
holders and taxes.
The next section considers the different concept of profitability.

Measures of profitability.
The firm has assets like the plant, inventory of finished and semi-finished products and
offices. There is a cost involved in acquiring these assets and it has to be financed either equity
of the owners or debt. Those who provided the funds expect payments in return (like interest on
loans) and these payments should be treated as cost to the firm.
Some assets are financed by debt. In borrowing the firm undertakes a legal obligation to pay
fixed amounts at agreed times. Debt includes loans from banks and outstanding bills, notes and
bonds issued by the firm and sold in financial markets. These payments take precedence over
payments to equity holders. The Model Corporation had a net interest expense of $600 million in
2005 and this was paid out of the operating income (Table 2). On the income after paying
interest, a corporation with limited liability like Model Corporation has to pay corporate taxes.
The justification for the tax (at least when it was introduced) is that incorporated firms enjoy
privileges like being recognized a legal entity separate from its owners and limited liabilities.
Since this privilege conferred on it by the state, it should contribute to the state revenue and the
Model Corporation has set aside $4,000 million for paying taxes. The balance is net income or
accounting profits (as it is referred in economics) and is available for distribution to the owners.
Because of the deductions of costs administrative costs and interest, the net income can be
83

negative even if gross profit is positive. In that case the output that maximizes gross profit will
minimize the loss after these deductions.
Economists argue that accounting costs, calculated by deducting the cost of debt but not
that of equity, do not reflect the true competitive position of the firm. Those who provided the
equity to the firm will consider whether the return they receive from the firm (their share of the
distribution of net income) matches what they can earn by investing their funds elsewhere. If the
return equaled or exceeds that from other firms, then the investors will maintain their investment
or even increase it. If it is lower, they will withdraw their funds; how quickly or easily they can
do it depends on the organization of the firm. If the shares of the firm are traded in the stock
market, they can sell them and prices of the shares will fluctuate with purchases and sales in the
stock market. In a fully rational market, the share price should equal the discounted value of
future dividends from the firm. Investor of a privately held firm will find it harder to dispose of
the assets but they will seek to exit. Just as interest costs were reduced from operating income,
economic analysis suggests that the return funds invested in the firm can earn elsewhere should
be treated as a cost and deducted from net income. The difference, economic profit, is what
enters into the decisions of the equity holders.
In practice, comparison of returns among firms poses many problems. Unlike the interest
on debt, return on equity fluctuates due to the conditions the firm faces in the output and input
markets. Moreover, returns of some firms fluctuate more than that of others. Investment in them
is considered risky. Investors demand a higher return for riskier investments than for those less
so and the returns must be adjusted for differences in risk. If accounting numbers are to be
interpreted with some caution, measures of economic profit should be viewed even more
critically. Still investors have to take decisions about allocating their funds and some measure of
economic profit is needed. Professional firms are adjusting accounting data and offering
estimates of returns that are comparable. Economic Value Added, developed by a consulting
group Stern Stewart & Co has achieved wide recognition.

Relating profitability to output.

The economic profit is calculated by deducting interest cost and what equity holder can
earn elsewhere from the operating income. Even if a firm has a positive operating income, the
firm can be functioning at a loss. Operating income and economic profit (or loss) varies with
output. Four additional concepts - average revenue, average variable cost, average fixed cost and
average cost -- are helpful in bringing out the relation between output and profitability.
The total sales divided by units sold is the average revenue at that output; if changes in its
output does not affect the price at which the product is sold, average revenue equals price. Cost
of inputs like employment and raw materials that varies are with production is the variable cost;
variable cost per unit of output is average variable cost. If marginal cost is constant as was for
the technology of firms considered in this chapter, then the average variable cost is a constant
(Figure 7).
Expenses that are not variable with output including interest on debt and competitive
return on equity are treated as fixed costs. Average fixed cost, fixed cost divided by output,
decreases as output increases; same fixed costs are divided by larger output. The sum of average
variable cost and average fixed costs is the average cost. If average revenue is less than the
84

Figure 7.Variation of average cost with output

average cost, each unit produced is bringing in less sales revenue than the cost of producing it;
the firm is running at a loss. Still it may not want to close down production as long as average
revenue is greater than the average variable cost; the firm is earning a positive operating income
it can use to offset partially the fixed costs like debt payments and plant maintenance that cannot
be avoided in short run.
A 2006 article in FORTUNE analyzing the problems faced by Ford Motors illustrates how
variation of the average cost with output determines profitability. 1 The average variable cost of a
Ford vehicle is $15,000. The fixed cost is $57 billion and Ford was selling 6.6 million units. The
average fixed cost, given the sales, is $8,636 making average cost $23,636. Price, average
revenue, must exceed the average cost if Ford is to make a profit on vehicle sales. Consider what
happens if the sales increase to 7 million units, a number close to Ford's output a few years
earlier. The average fixed cost declines to $8,125 and reduces the average cost by $500. On sales
of 7 million units, it amounts to an increase net income by $3.5 billion dollars. Facing declining
sales in the first decade of twenty-first century, Chrysler, Ford and General Motors competed
with each other by offering discounts, effectively reducing the average revenue. Since a shift in
consumers' preferences resulted in a reduction of sales in spite of incentives, Ford and other
automobile companies found themselves in a spiral of increasing average cost (as output
decreased) and decreasing average revenue. Is it a wonder that the three companies ran up
losses? The solution that was finally adopted was to reduce fixed costs by closing down plants
and reducing capacity.

Changing capacity
If marginal revenue exceeds the marginal cost, the firm will produce at installed capacity
as every additional unit adds to its gross profit. If the average revenue exceeds the average cost,
then the firm is making an economic profit at capacity output. Why not increase the capacity and
1
FORTUNE (2006), pp.96-100.
85

increase even more the profits of the firm? The firm adding to its capacity incurs the cost in the
present and the benefit, increases in cash flow after meeting cost of production, is received in the
future. Before comparison, the two cash flows must be discounted to the same period. Cash
received next year is discounted to the present by multiplying it by the discount factor, 1/ (1 +
interest rate expressed as a fraction); if cash is received two years from now, it is multiplied by
the square of the discount factor. 1 In general, the discount factor is raised by the number of years
before the receipt of the cash. Adding all the discounted cash flow gives the present value of
future income flows.
If the present value is greater than the cost of investment, then the owners benefit by
expanding the firm. To make the calculation, the firm needs estimates of the cash receipts in the
future and future cash flow is uncertain. One possibility is to ascertain the expected value for
each year and discount it but it involves not only estimating the possible values of cash receipts
each year but their probabilities as well. Decision makers frequently use an alternate approach of
looking at stock prices of firms that face the same market condition. If the firm used for
comparison has a dividend pattern that is similar to the cash flow from the capacity expansion,
the price of the stock of the comparison firm will equal the present value of the cash flow of the
investment. It can then be compared to the cost of capacity expansion.
This assumes that capacity expansion is strictly based on market conditions that are not
affected by actions of competitors. If two firms are competing intensively like Boeing and
Airbus or Intel and AMD, each firm will respond to expansion by the other by expanding its
capacity. Such a situation can be examined using game theory and is discussed in Chapter 12.

The organization of the firm.

Three considerations determine the organization of the firm: need for funds, ability to sell
its products and managing the resources used in production.
Organization of industrial activity in years leading up to the eighteenth century industrial
revolution can be classified into four categories. 2 In the beginning, there were the tiny family
workshops like that of the village blacksmith with the master and three or four others to assist
him. Each shared the work without any clear differentiation of responsibilities and they had
direct contact with the customers. In the second group are industries, most notably in textiles,
individual workshops were liked by a supply chain managed by a merchant entrepreneur. He
supplied the raw cotton or wool to the spinner. The spinner supplied yarn to weaver, and the
weaver supplied clothes to the merchant-entrepreneur who pocketed the profit from selling the
final product.
The third group of industries, like in breweries, glass works and tanneries, the
manufacturing was localized, in one building. Workers specialized on specific tasks and worked
under supervision of owners. There were even small factories like paper-mills and saw-mills
where grindstones and bellows were operated mechanically. The fourth group consists of

1
Discounting future cash flows was discussed in Chapter 4.
2
Brudel, (2002), pp.298-302; 433-442.
86

Figure 8. Liability under partnership and incorporation.

manufacturing that uses machinery driven by running water and later by steam engines. They
grew into the factories that became widespread in the nineteenth century onwards.
In the process of production, costs are incurred and revenues generated. The organization
of production should assign the responsibility for its liabilities and the rights to its revenues.
From prehistoric times, family members shared the work in the farm and, after giving local
barons the share of the harvest those were their due by law and customs, survived on what was
left. Small workshops of the village blacksmith, cobbler or lace-maker were run as family
enterprises with the family retaining the profits. Merchants involved in maritime trade that was
both costly and risky, minimized the burden to each by forming partnerships. The partners
contributed fund to host a single voyage in the Mediterranean and later to ports further away.
Another innovation by trading companies was that the partnership was structured as
unincorporated joint-stock companies in which members had shares in the joint or common
stock. Partners could sell or buy the stocks. Manufacturing firms adopted this approach as
production became increasingly mechanized and the cost of starting a business increased with
the complexity of the technology and size of operations. Well into the nineteenth century most
businesses were organized as partnerships; unlike partnership for voyages, it was not time bound.
Partners are able to contribute more funds than individual entrepreneurs and the firm in many
cases can benefit from the diverse expertise of partners - one good at overseeing manufacturing
and other sales. One disadvantage is that the firm has no independent existence and the departure
of one partner requires its dissolution and if its operations are to continue, reconstitution as
another partnership.
Another limitation is unlimited liability is that it puts the entire wealth of all partners at risk.
Adrian and Neville are two individuals of unequal wealth who formed a partnership. In Figure 8,
the size of their assets is represented by bundles of dollars; part invested in the firm is shaded
red. Adrian invested two-thirds of his wealth in the firm. Neville invested only one-fifth of this
87

wealth and, in spite of being wealthier, his investment is less than that of Adrian. If the firm is
organized as a partnership and runs into financial distress, the creditors can seek to reclaim the
losses from the assets of any of the partners. Neville's assets will be the preferred target as it is
larger and less impaired by the loss of investment in the firm. He can end of losing his wealth
altogether.
The experiences of those who subscribed to the syndicates of Lloyd's of London are
poignant reminders of the dangers of unlimited liability. Lloyd's is not a firm in the traditional
sense; rather it serves as a meeting place where underwriters from syndicates for specific
insurance contracts. Individual members known as "Names" commit to back the syndicate with
their assets. To be a name was considered both prestigious and profitable and Names did not take
the downside risk was not taken seriously. In the 1980s, Lloyd's ran into massive debts ($3.3
billion in 1989), putting the personal wealth of 50,000 names at risk. Many of them ended up in
personal bankruptcy or close to it.
Individuals will be reluctant to join partnerships for the risk of losing their assets. One
solution to the conundrum is to separate the liabilities of the directors from that of other
investors. Continental Europe recognized limited partnerships in which some partners were
allowed to limit their exposure (to the liabilities of the firm) to the amount they subscribed to its
capital, as long as they did not participate in the management of the firm; English law, however,
did not recognize limited partnerships.
The time was right for the fusion of the corporation and joint-stock company forms of
business organizations to achieve first, the transferability of shares, next a separate identity for
the business unit, and finally limited liability. In England, the Acts of 1844 made the
incorporation of unlimited companies possible by registration, while the Act of 1856 permitted
the formation of limited companies. During the nineteenth century other European nations
enacted legislation enabling limited liability joint-stock companies. In 1811, New York adopted
a general law of incorporation and the competition among states led to its general adoption by
other states by the middle of the century.
As long as manufacturing firms remained small, the owner or few partners directed and
supervised its operation. The development of railways and steamships enlarged the geographical
extent of markets and firms located in different cities began to compete with each other.
Manufacturing operations grew in size and marketing became more sophisticated. The need for
professional management led to the development of the hierarchy shown in Figure 6. Ever since
the organizational structure has gone through cycles with the layers increasing some periods and
being trimmed down in others

Conclusion.
Manufacturing plant has installed machinery that it uses to convert baskets of variable
inputs like labor hours, energy and raw material into products that it sells. An increase in output
for unit increase in a basket of inputs is the marginal product of the basket.
Reversing the perspective, consider the increase in the input required to produce an extra
unit of output. The cost of that basket of inputs is the marginal cost of the product. When the
firm sells the product, the additional revenue it generates is the marginal revenue. As long as
marginal revenue is greater than marginal cost, the firm has incentive to increase output. The
88

tendency to expand output will be limited by capacity of the plant or by shrinkage of the
difference between marginal revenue and marginal cost. In this chapter, marginal revenue and
marginal cost will be taken as constants and the capacity is the binding factor in limiting output.
Management, investors, financial institutions, suppliers and customers depend on data
about the firm to make their decisions. The firm responds to the need by generating and
publishing data; the type of data produced and published is determined by cost-benefit
considerations. Cost arises from the resources devoted to generating it and from the data
revealing the strategies of the firm to its competitors. Benefits arise from convincing the
investors and financial institutions to provide funds at attractive rates and by assuring suppliers
and customers of the continued solvency of the firm.
Financial accounting provides information about the cost of inputs used in production,
administrative and marketing expenses, expenses on research, interest payments and provision
for corporate income tax. The sales revenue net of these expenses is net income or accounting
profit.
Those who subscribed to the equity of the firm needs a return that at least equals what they
could earn elsewhere. In economics but not in accounting, this return is treated as a cost and
economic profit is accounting profit less the required return to equity holders. The difficulty is
that the return equity owners expect is not easy to ascertain as they also take into consideration
the riskiness of the investment. Some companies are adjusting accounting information to provide
investors returns that are comparable across companies.
Profitability can be expressed in terms of average revenue and average cost. Average cost
includes average variable cost and average fixed cost. If marginal cost is a constant, so will
average variable cost but average fixed cost will decline with output. Companies with large fixed
cost will run into loss even if their operating income is positive.
Partnership provided advantage over individual ownership in being able to pool the
financial resources and to benefit from the expertise of different partners. The limitation is that
the total assets of each partner are exposed to the liabilities of the firm. Limited partnership
limited liability of each partner to the amount subscribed to the capital of the firm. Joint stock
companies with limited liability allowed individuals to invest in a firm going strictly by
accounting and market information. In subsistence economies, production was within the family
and for consumption. Development of factory system led to a separation between production and
consumption. The joint stock companies created a separation between management and
ownership. In addition to separation between and production, these companies created a
separation between management and ownership.

Selected Bibliography.
Braudel (2002); Ford Corporation; The Economist (1993); Hongren et al (2006); Kalnins
(2006): FORTUNE (2006); SBA Office of Advocacy (1998 ); The Wall Street Journal (1995).
89

Chapter 7. Monopolist: the sole producer of a product.

The market is defined as an area where buyers and sellers are in such close contact that
price of the same product trends quickly to equality. The size of the market (the number of
buyers and sellers in it) increased with the improvements in transportation and development in
communication technology. Today millions of households in United States who eat cereals at
breakfast buy it from three producers: Kellogs, General Mills and Quaker. Does this imbalance
in numbers (monopoly is an extreme case with one producer) put the consumers at a
disadvantage by tilting the market process towards higher prices for products and higher profits
for the producers? What norm is to be used in judging prices as high or low? Does the cost of
production provide a benchmark for evaluating fairness of prices in a market? Should the
government interfere in the market if prices are judged too high? Should promotion of
competition be a goal in itself or are there circumstances that justify creation of monopolies?
This chapter considers a market with one producer of a product and many consumers; subsequent
chapters will consider those with more producers.
Monopoly can prevail only if the firm is able to exclude competitors from the market.
Governments through decrees or laws can create a monopoly and government owned or
sponsored monopolies were quite common in the past. Among them state monopolies of salt
achieved particular notoriety. Daily consumption of salt is a biological necessity and, before
modern refrigeration, salting of meat and fish was the only means to preserve them. Since there
are no known substitutes for salt, individuals have minimal flexibility in reducing its
consumption as the price increases. Governments from France to China were quick to realize that
they can exploit the dependence on salt to raise revenues by monopolizing either its production
or trade and charging high prices. 1
The price of salt in France in 1630 was 14 times its cost of production; in 1710 it was 140
times the cost! 2 Many of the salt monopolies including those in France and Japan lasted well into
the twentieth century but governments having developed other sources of revenue ceased
inflating the price of salt to fill their budgetary gaps.

Figure 1. Consumers vs monopolist: the choices they have.

1
Kurlansky (2002), pp.11-12, 31-35; Laszlo (2001), pp.74-79.
2
Laszlo (2001), p.77.
90

Figure 2. Monopolist chooses his profit maximizing output.

A market with a monopolist producer and many customers is illustrated in Figure 1. On one
side of the market, the supply side, there is only one producer. The lack of competition, it is
alleged, prompts him to charge a higher price than he would if he had competitors. While he can
set a price, customers decide how much they will buy. It constrains him as his profit depend both
on the price and the quantity sold.
Each consumer chooses the basket that he prefers among all those he can afford to buy and
the amount of a product in it will depend on its price relative to that of other goods. Consumers
reduce the amount of a product when it price increases either by reducing its consumption or by
substituting other goods that can satisfy the same needs. The sum-totals of the quantities
demanded by individuals at various prices generate the market demand curve. The monopolist
can choose either the price or the quantity he wants to sell and the demand curve will determine
the other variable.
He will make the choice that maximizes his profits. While in public discussions it is
traditional to focus on the price monopolists charges, in economic analysis it is more intuitive to
think of him as choosing the output. Next section analyzes his choice of the price-output
combination that maximizes his profit. How it affects the welfare of the consumers and what
policies public authorities should adopt in a market with one producer will be discussed in
following sections.

The choice of the monopolist.

The relative levels of marginal revenue and marginal cost will determine the contribution
an additional unit of output makes to the profit of the firm. The marginal cost, increase in total
cost per unit increase in output, depends on the firm's technology and input prices and here, as in
previous chapter, marginal cost is taken to be a constant. Marginal revenue is the increase in
sales revenue per unit increase in output and its variation has to be analyzed (Figure 2).
91

A decision to increase sales has a two-fold effect of total sales revenue of a monopolist.
Additional units sold increases his sales revenue. But to achieve the sales, he has to slide down
the demand curve and cut the price on all unit sold and it reduces the sales revenue.
A simple example will bring out the principle which is valid in general. A monopolist is
selling two bottles when price is $4. The firm, if it wants to increase the sales to three units has to
reduce the price to $3.50. While the third bottle brought additional sales revenue of $3.50, the
firm received $0.50 less from the sale of the other two. Marginal revenue, the increase in sales
revenue, is 3.50 - 1 = $2.50. The price at which he can sell 4 units is $3 and the marginal revenue
is $1.50. In Figure 2, Panel A, the heights of the green boxes measure the marginal revenue as
output changes in discrete units. The height decreases with output, reflecting the decline in
marginal revenue. 1 For continuous variation in output, Panel B shows the marginal revenue
curve lying below the demand curve. The shape and position of the marginal revenue curve
depend on that of the demand curve; if demand curve is a straight line as in Panel B, then the
marginal revenue curve will also be a straight line that is twice as steep.
The challenge for the monopolist is to choose the point on demand curve where his gross
profit is a maximum. Economists noticed that for analytical purpose it is easier to visualize the
monopolist's decision as one of choosing the output. As marginal revenue is decreasing with
output, it will ultimately slide below the constant marginal cost and increasing output any further
will reduce gross profit. Profit maximizing output for this firm is determined not by plant
capacity but by declining marginal revenue. In case of continuous variation as in Panel B, the
output is where the marginal revenue curve intersects the marginal cost curve.

Normal profit or excess profit?

To determine whether the monopolist is earning "excess profit," the distinction between
gross profit and economic profit has to be reintroduced. Costs the firm has to incur other than
that of inputs include administrative costs and the cost of obtaining funds either as debt or equity.
If these costs exceed the gross profit, the firm is having a loss in spite of the surplus from its
manufacturing operations.
The size of the gross profit depends on the gap between constant marginal cost and price.
To ascertain the influence of the demand for the product on this gap, consider the monopolist
setting the price equal the marginal cost (zero gross profit); the price and output corresponds to
the blue dot in Figure 2. As output exceeds the one that maximizes profit, he will want to reduce
sales by increasing the price. The extent of the price increase depends on how sensitive
consumers are to its change. 2 The more responsive the consumers are, the smaller will be the gap
between price and marginal cost at the profit maximizing output; the gap expressed as a fraction
of the price, Lerner's Index, is a measure of monopoly power.
1
Since marginal revenues at various outputs are less than the price at which they are sold, they must all lie below the
downward sloping demand curve. This is possible only if they decline in general as output increases, though
additional assumptions are needed to ensure that they decrease smoothly at all outputs.
2
The quantitative measure, elasticity (discussed in next section) relates infinitesimal changes in quantity and to
infinitesimal changes in prices. Elasticity normally varies along the demand curve. To focus on monopolist's ability
to charge a price higher than the marginal cost, it is assumed that elasticity is constant along the marginal revenue
curve.
92

Eurotunnel has a monopoly in linking British Isles to the Continent by a rail line. The idea
of constructing a tunnel under the English Channel was floated more than 200 years ago. Yet
concern that it might undermine the security of the United Kingdom held it up until the British
and French governments signed an agreement in 1986 to build a 30 mile tunnel from Folkestone,
England and Calais, France. The British Government insisted in not providing public funding for
the project and a private British-French consortium, Channel Tunnel Group, won the bid to build
the tunnel.
As an engineering project, it was a major success and was awarded, according to
Eurotunnel, the first prize among top ten construction projects of twentieth century. Like so
many mega-projects around the world, its capital cost exceeded the original estimate and with it
the cost of financing went up with it. 1 More than the cost increase, it was the unexpected low
demand for rail transportation that hurt Eurotunnel. The ferries that linked the Island and the
Continent cut their fares, shippers who had invested in moving goods through them were
unwilling to change and consumers valued other benefits of taking the ferry like availability of
duty-free liquor. Rail traffic when operations started in 1994 was half of what was projected and
Eurotunnel's profitability was hurt by a shortfall in projected revenue. The resistance of potential
customer drove Eurotunnel close to bankruptcy more than once as it was not able to meet its
interest obligations much less provide a return to investors.
If the firm succeeds in charging a price that ensures it high rate of return on its capital,
others will try to enter the market by developing substitutes. Monopoly will last only as long as
the firm is able to prevent entry by legal or strategic actions. Historically public policy has
swung back and forth from supporting monopolies to restricting them. Governments have used
monopolies to raise revenues or provide services that competitive firms will not be able to do.
Examples of state conferring such privileges are: (1) the 1670 British Royal Charter to the
Hudson Bay Company to explore vast areas of Canada; (2) utility laws that give a utility
company monopoly to provide gas and electricity in a city; and (3) patent and copyright laws that
confers temporary monopoly to innovators and authors. Periodically governments have
responded to public concerns that monopolies are gorging the consumers and have enacted laws
against monopolization.
Recognizing the value of public policies, firms lobby legislators (in the old days ingratiate
themselves to the monarchs) to enacting laws and regulations that protect them from
competition. Recent efforts to extend intellectual property rights by allowing patenting of
software and genetically engineered organisms are examples of such efforts.
Lobbying is not limited to one side. Potential entrants lobby the legislature about the
harmful effects of the monopoly enjoyed by the incumbent. Though there is no competition in
the product market, there develops a competition in "influence market." In the end when the

1
Cost overruns are common for big infrastructure projects. An international comparison shows that the cost of
bridges and tunnels exceed estimates by 34 per cent. Given the challenging nature of constructing Eurotunnel, the
cost overurn of 80 per cent is not out of line. Anyway, it is much less than the other Anglo-French undertaking, the
supersonic Concorde. "The cost of borrowing: why do big projects such as Eurotunnel find it difficult to make the
numbers add up?" Financial Times, April 10, 1994 and "Eurotunnel shows us how big plans get derailed,: Financial
Times, July 27, 2005.
93

profits are dissipated though lobbying, neither the consumers nor the producer has benefited by
the continuation of the monopoly.
The English economist, John Hicks, commented that the best of all monopoly profits is
quite life. He is not living every moment wondering what the competitors are planning and
fearing that they will wipe out his profits. However the quite life can be for a short period if
consumers are able to resist high prices and innovators are able to come with new products that
circumvent the barriers to entry. The development of digital photography eroded the monopoly
of Polaroid in instant photography.

Quantitative measure of consumer responsiveness to price changes.

The ability of the monopolist to increase price above the marginal cost depends on how
sensitive consumers are to price increases. Given its role, a quantitative measure of consumer
response is needed to derive analytical results and to develop appropriate policies.
The rate of change of quantity demanded to a change in price suffers from the defect that it
depends on units in which the product or price is measured. Consider a product sold in packages
of two units. If rate of decrease in sales is 5 unit per dollar increase in price, the rate changes to
0.05 per cent if price is measured in pennies. To avoid the dependence of the response rate on
units, both price and quantity changes are measured in percentages and price responsiveness
measured as ratio of the proportional change in quantity to percentage change in price. 1 This
ratio is known as the price elasticity of demand.
Since the quantity demanded changes in the opposite direction to change in price, the ratio
will be always negative. A negative sign creates a problem in relating the magnitude of elasticity
with the sensitivity of consumers. If elasticity changes from -2 to -3, algebraically it has
decreased as (-3) minus (-2) is -1. The consumers though are more sensitive to price increase
when elasticity is -3 than when it is -2. Alfred Marshall suggested that the ratio of percentage
changes be multiplied by - 1 to make the numbers positive; then higher elasticity indicates
greater sensitivity to price. In this book, the Marshallian tradition will be followed though in
United States more and more economists keep the negative sign.
If price elasticity is greater than 1, the demand is said to be elastic; a reduction in price
increases the sales by a higher percentage and the sales revenue will increase. Marginal revenue,
the increase in sales revenue per unit increase in sales, is positive. 2
If the elasticity is less than one, the relationship between price change and change in sales
revenue is reversed; it is an increase in price that leads to an increase in sales revenue. Though
the price elasticity of demand for salt in nineteenth century France is not known, estimates of
price elasticities for basic food products, in different countries and at different times, are all well

1
The demand for a product in the market increases from 2,000 units to 3,000 units when price decreases form
$4 to $3. The percentage change in price is 100(3000-2000)/2000 or 50 per cent. The percentage change in price is -
25. The ratio is 50/-25 or -2 and elasticity as defined by Marshall is 2.
2
When the monopolist was increasing price above the marginal cost, his sales revenue was decreasing. His cost
was decreasing faster (marginal cost was greater than marginal revenue) and his profits increased.
94

Figure 3. Consumer surplus.

below one. The low elasticity of demand is what allowed salt monopolies to raise revenue by
increasing the price.

Consumer surplus: a measure of benefits to consumer from exchange.

When George the fisherman met Robert the farmer, he was surprised that Robert was
willing to exchange more vegetables for a pound of fish than the minimum he would have
demanded. 1 He was valuing the first pound of vegetables more than what it costs him to get it.
The difference is "a surplus" that he obtained from the opportunity to exchange.
In a market economy, the consumer exchanges dollars for what she purchases. A
consumer, Madison, goes to the store and is surprised by the price of chicken: "Hey that is a
bargain and I am going to buy it." The difference between what she was willing to pay and what
she paid is a monetary measure of her "surplus." The price is fixed but as she buys more, her
valuation of the additional purchases decreases. Still she benefitted from opportunity to trade as
she moved to a preferred position.
Madison purchases the basket along her budget line at which her marginal rate of
substitution (the ratio at which she is willing to exchange one product for the other without
affecting the level of her utility) equals the ratio of prices. As the price ratio decreases with a fall
in the price of one product, she moves along the new budget line and purchases more of the
product to reestablish the equality of the two ratios.
Her downward sloping demand curve is shown in Figure 3. Consider discrete changes first.
The price in the market was $6 and Madison will not buy the product as her valuation of the first
unit is slightly below $6. She makes her first purchase of one unit when price comes down to $5.
Though she paid only $5, her marginal valuation of the first unit is close to $6 and the difference
is a gain from the trade. A monetary measure of the gain, consumer surplus is $1 times the
quantity purchased (the light blue rectangle in Figure 3 on the left). Her marginal valuation of the
second unit is slightly less than $5 and it takes another price reduction to $4 to make her buy
another unit. Her surplus from the second unit is $1 and her surplus from the first unit increases

1
Chapter 3, Figure 4.
95

Figure 4. Deadweight loss under monopoly.

by another dollar. Her total surplus is now 2+ 1 = $3 and equals the area of the three blue
rectangles.
In case of continuous variation, Madison's marginal valuation changes continuously along
the demand curve (as with the discrete case, the price at which she buys the last "incremental"
quantity is taken as the marginal valuation). To find the total surplus, divide the total quantity
purchased at the price shown in Figure 3 into small segments (as between the white lines) and
take the area of the strip - the product of the height of the demand curve over price and the
incremental quantity - as a measure of the surplus from that incremental change in quantity. Add
up the area of all such strips and the area of the blue triangle is a measure of the consumer
surplus.
The market demand curve is obtained by adding the quantities individual consumers
purchase at each of the prices. Does it imply that the surplus under the individual demand curves
can be added to measure the consumer surplus generated by the market? There are serious
objections to it as each individual surplus is dependent on his or her preferences. The liberal
belief is that preferences being specific to individuals, interpersonal comparisons and
aggregation across individuals are not admissible. Those involved in policy analysis, like cost-
benefit analysis of public projects, argue that consumer surplus can be used as an approximation.
One application in industrial organization is to evaluate the welfare cost of monopoly.

Deadweight loss: cost of monopoly and certain public policies.

A monopolist sells the profit maximizing output at a price higher than the marginal cost
(Panel B of Figures 2 and 4). The higher price relative to marginal cost has two-fold effect on
consumer surplus: it leads consumers to reduce their purchases and the height differences
between the price line and demand curve at various levels of output are narrowed.
96

This is brought the numerical example of Panel A of Figure 4. If marginal cost to the
producer is $4 and price equals marginal cost, Madison will purchase 2 units and the consumer
surplus is, as calculated in Figure 3, is $3. If the monopolist increases the price above marginal
cost to $5, Madison will reduce her consumption to 1 unit and consumer surplus is only $1. The
monopolist will have a gross profit (yellow square) of $1. The reduction of consumer surplus by
$2 is not matched by increase in monopolist's profit and the difference (grey square) is a
deadweight loss to the society.
Continuous variation in price and quantity is shown in Panel B. The monopolist will set
the output at the level where marginal revenue equals marginal cost and the price at which he
sells it will be higher than marginal cost. The reduction in output is shown in Figure 4 as the
distance between sales at marginal cost and at monopoly price. The loss in consumer surplus not
matched with increase in monopolist's profit, the deadweight loss, is as in the discrete case is the
grey area (a triangle if the demand curve is a straight line).
Redistribution from consumers to the producer to be considered unfair on equity grounds
but it cannot be approved or condoned on efficiency grounds. A departure from efficiency
requires that some are worse off without others being made better off. In the case of monopoly,
the increase in profits of the firm is less than the decreases in consumer surplus by the grey
triangle. That the difference is a deadweight loss can be made clear by considering a hypothetical
negotiation between producer and consumers. Let the monopolist agree to reduce the price to
marginal cost on the understanding that consumers will voluntarily transfer the amount equal to
the yellow rectangle back to him. Producing a larger output increases his cost of production but it
is matched by an increase in sales revenue. The reduction in profits because of lower price is
made up by the transfer from consumers. The proposed arrangement neither benefits nor hurts
him while consumers find their surplus increasing by the grey area. The cost of monopoly to the
society, its deadweight cost, is the grey triangle.
Monopoly is not the only source of deadweight loss. The taxes can create a deadweight
loss by making consumers pay a higher price than what the producer receives. If a product is sold
at the marginal cost of $10 and a tax of 10 per cent is imposed on it, the price consumers have to
pay is $11. It reduces their consumer's surplus. The producers are selling less and their profits are
reduced. The government raises tax revenue and, even if it is used in most efficient way to
promote the welfare of the citizens, there is a deadweight loss due to higher price paid by
consumers.
This is true when tariffs increases the price consumers have to pay for foreign goods that
are imported and leads them to substitute home goods that are more expensive. In the past, the
need for income and the belief that the economic and strategic interests of a nation requires
protecting its industries were explanations offered as reasons for imposing tariff duties. After the
Second World War, the Allied nations did not want to repeat the competitive tariff increases of
the interwar years and all industrial economies of Europe and in the United States agreed to
reduce tariff under the 1947 General Agreement on Tariffs and Trade. Subsequently the World
Trade Organization took the role of making nations agreeing to reduction of barriers to
international trade.
The calculation of deadweight loss due to tariffs on different goods is complicated as it
requires the elasticities of demand for various imported goods. For the United States with its
97

large internal economy, the estimates for the economy as a whole are rather low at around 0.1
per cent of the total value of all goods produced (gross national product) in United States. 1
When specific sectors - automobile, computers and textiles are examples - faced severe
competition from foreign producers, owners and workers of firms in these industries exerted
political pressure on the administration and congress to protect them either through tariffs or
quantitative restrictions. The benefits to owners and worker should be balanced against cost to
consumers.
After the Oil Shock of 1973, consumers started shifting to the smaller Japanese cars with
higher mileage. American producers had to cut production, creating excess capacity in the plants
and unemployment. Detroit and neighboring areas took the blunt of this downturn. Fear that
political pressure is building to impose trade restriction led the Japanese government in March
1981 to announce a voluntary quota on exports of Japanese automobiles to the United States. The
quota amounted to a 7.7 per cent reduction over previous levels. The estimated cost to consumers
based on various elasticities and on the initial level of demand ranged from $1 to $6 billion.
More revealing is that the cost per job saved ranged from $95,000 to $220,000, well above the
average income of an American. 2
Those who are hurt by international trade are concentrated in a few industries and regions
and they are able to form action groups to pressure politicians to act. Consumers though more
numerous are too spread out, have no contact with each other and are not able to organize.
Economists argue that cost to consumers should be considered before adopting policy measures
that increase price or restrict availability. In United States, the Council of Economic Advisors
has acted as a counterweight to pressure groups and has consistently supported freer trade.
Instead of conferring such privileges, should the government, given its mandate to promote the
welfare of the citizens, enact laws and regulations to prohibit anti-competitive strategies of
firms?

Patent: monopoly as incentive for innovation.

From the dawn of civilization, rulers recognized the value of patronizing arts and sciences.
Literature and visual arts were mostly devoted to glorifying them. Success in war required
developing new military technology. Agriculture being the main source of income, rules brought
new land under agriculture through irrigation system like the one that watered the river valleys of
Euphrates-Tigris and Nile. Construction technology developed as state and religion were
committed to monumental architecture from pyramids to temples and palace. European courts
became even more active in patronage as the pace of innovations increased around the
Renaissance. Today universities and research institutes receive grants to undertake research.
Another way of rewarding individual innovators is to offer prizes. In 1714, the British
Parliament established a prize for one who can devise a way to determine of a ship's longitude
with great precision. It was awarded to John Harrison though not without some reluctance as his
method differed from what conventional wisdom considered appropriate. 3

1
Irwin (2010), p.113.
2
Nelson (1996), p.38.
3
Sobel (1995)
98

Initially patents were bestowed as special favors by the monarch but criticism that such
awards were based on favoritism than on merits led to establishing a formal process for patenting
beginning with the Venetian statute of 1474 and the English Statute of Monopolies of 1623. The
advantage of patent system over grants and prizes to innovators is that the reward is determined
by competition in the market and not by an administrative process. The reward he receives - the
profits from exploiting the innovation which he alone is authorized to do - is a cost to the users
of the invention and not to the general taxpayer.
The reason for bestowing a monopoly on the innovator is that he has to meet the cost of
development upfront. Once a new product or manufacturing technique is developed and made
public, others can quickly mimic it. The resulting competition brings the price of the product or
output of the innovative process down to its cost of production and the investor who incurred the
developmental cost has no opportunity to recover it. This happened to two of the eighteenth
century pioneers in industrial revolution.
Industrial revolution in England began with gradual mechanization of the cotton textile
manufacturing. Handlooms needed the weaver to reach for the tread on both sides of the loom
and that limited the width of the cloth. In 1733 John Kay invented "the flying shuttle" allowing
weaving broader cloths by freeing the weaver from using both hands to pass the tread and more
than doubled the productivity of weavers. Though Kay took a patent, the weavers refused to pay
him the royalties and the cost of litigation to recover them actually ruined him. He petitioned the
British Parliament for an Act to let him recoup his royalties but failing to get the response he
expected, went to France where the government awarded him a pension.
Faster weaving increased the demand for yarn and there was an urgency to mechanize
spinning. Who made the breakthrough is still debated. The accepted version is that John
Hargreaves discovered "spinning jenny" which allowed many looms to be worked by one person.
The counterclaim is that Thomas High had developed it two years earlier but could not afford to
patent it. The introduction of "water frame" by Richard Arkwright, a barber and wigmaker, in
1769 was decisive step in the mechanization of the textile industry. Arkwright's patent was
rescinded in 1785 but he was a successful businessman, built many mills and, unlike the earlier
inventors, accumulated a fortune. The next major innovation was by Samuel Crompton when he
combined elements of the jenny and the frame in his "mule." Crompton was born in a poor
family and had to contribute to the support of his family at the age of 15 by working on the
spinning jenny. Recognizing that he can improve on it, he worked secretly for five years during
which time he financed his experiments by playing violin at a local bar. He was too poor to take
out a patent on the machine and even if he had attempted the broad patent that Arkwright had
would have involved him in a costly litigation. He tried to raise subscription from those who
used the mule but the first effort was a failure though later some Manchester merchants raised
£500. He submitted a petition to the British Parliament showing that more than eighty per cent of
spindles then in use were based on his mule. The Parliament awarded him a grant of £5,000. His
effort to get into business failed and he survived on an annuity his friends brought him without
his knowledge. Together the four innovations - flying shuttle, spinning jenny, water frame and
the mule - increased the productivity of a labor 25 times. Yet two of the innovators died in
penury.
The expenditures firms have to incur to remain in the forefront of technological race are
increasing over time. The Model Corporation spent $5,000 million on research and development
in 2005 and similar expenditure are incurred in other years. In pharmaceutical industry, one
99

study estimates the cost of development of a new drug as $403 million (2000 dollars). If the
interest cost accumulated on the funds invested during the long interval of time from the early
stages of development to approval of a drug is included, it can be as high as $802 million.1
Patent gives the innovator property rights to his innovation. If there is sufficient demand
for the new product, the innovator can be either earn monopoly profit as the sole produce or
receive royalty by licensing the innovation to others. 2 The higher profit stream last as long as the
patent lasts or until newer technologies make the innovation redundant.
What is the benefit to the society in creating a temporary monopoly as a matter of public
policy? When a new product comes into the market, the consumers who switch to it values it
more than the existing products and they are choosing a basket that is preferred to what they had
before. This benefit must be balanced against the cost of creating a monopoly.
The state must also decide on the "length and breadth" of the patent and consider how the
decisions affect future innovations too. In the ending decades of the twentieth century, the United
States, concerned with falling behind other nations in technological race, strengthened patent
protection. In 1994, it joined other members of the World Trade Organization in signing the
"Trade Related Aspects of Intellectual Property Rights" (TRIPS) that set the life of a patent at 20
years. The Hatch-Waxman Act added five year lost in premarket testing and Food and Drug
Administration approval process and eliminated duplicative testing of generic drugs.
In addition, through court judgments, patents for genetically engineered bacteria and
business practices like Amazon's one-click Internet ordering were declared patentable. The
United States set up a Court of Appeals of the Federal Circuit to bring specialized expertise and
expedite cases about patent validity or infringement.
Looking forward, the effect of patent on further innovations must be judged. A broad
patent can inhibit others from developing products or processes that are improvements of the
current one.
A monopolist has the privilege of being the one and only. Yet in a society that promotes
technological innovation and economic growth, the peace of mind from monopoly can be
fleeting. His life is akin to that of a dictator of a small island who is fighting the erosion of his
shores. Competitors are ever threatening him new products and customers take every opportunity
to switch to products that offer value.

Public resentment of monopoly and antitrust laws.

Public policies have supported and opposed monopolies. Having considered the arguments
for permitting monopolies, consider the one for limiting them. Opposition to monopolies has a
long history. In 81 B.C. the Chinese emperor called on 60 nobles to debate on appropriateness of
state owned iron and salt monopolies. The nobles split into two opposing groups. The
Confucians argued that charging monopoly prices were not befitting a just state while the
1
Cost of new medicines, DiMasi, Hansen and Grabowski (2003). The data on Model Corporation is from Table 1 on
page 81.
2
It is the consumer preference for the product that is the source of profit. In 1975 Sony introduced Betamax, the first
home video cassette recorder. Within a year, JVC introduced the VHS format and consumer preference for the
longer playing VHS tapes resulted in it becoming the standard in spite of Sony's early introduction, superior
technology and patent rights. Licensing is common in some industries like semiconductor and biotechnology.
100

legalists considered them necessary for raising revenues needed to maintain a strong state. In the
end the monopolies were continued. 1 In his 483 A.D. edict, Zeno, the Emperor of Eastern Roman
Empire, banned monopolies even if an Emperor had authorized them in the past. This prohibition
Adam Smith was opposed to large state chartered corporations like British East India
Company and Hudson's Bay Company that dominated international trade during his time. He
made an impassioned plea for freedom in commerce. 2
"A monopoly granted to either an individual or to a trading company has the same effect
as a secret in trade or manufactures. The monopolists, by keeping the market constantly
under-stocked, by never fully supplying the effectual demand, sell their commodities much
above the natural price, and raise the emoluments, whether they consist of wages or profits,
greatly above their natural rate.
The price of monopoly is every occasion the highest which can be got. The natural price,
or the price of free competition, on the contrary, is the lowest which can be taken, not upon
every occasion, but for any considerable period."
A sympathetic reading of this passage in a pioneering work written more than 200 years
ago would make natural price equal to cost of production including competitive return to equity
investors. The output of the monopolist is less than what would be sold at marginal cost and in
that sense he keeps "the market constantly under-stocked." But the claim that monopoly charges
the highest price is refuted by Figures 1 and 2.
Monopoly is an extreme example of a market with one supplier and many consumers.
Even if there are a few producers, the fear is that the imbalance in numbers and ability of a few
to form alliances to their benefit will hurt the consumers. Such concerns reached a critical level
in the United States at the end of nineteenth century.
Around that time, the United States economy was going through a transformation. The
development in transportation and telecommunication merged local markets into one large
national market. The capital market became capable of raising the required capital to acquire the
stocks of other firms while technological changes gave a cost advantage for large scale
production. The same factors created price instability. Firms well entrenched in local markets
were now exposed to competition from firms far away. Firms around the nation were increasing
their installed capacities to make use of the economies of new technologies. Jointly they led to
periods of boom and burst in the markets.
In railways and oil industry, firms formed cartels - association among firms to maximize
their collective profits - to stabilize prices but at the cost to sectors like farmers that use their
products and services. Public resentment against cartels become strong enough for the Congress
to enact Sherman Act of 1890 and the United States became pioneer in policies to promote
competition.
The Act prohibits contracts combinations and conspiracies to restrain trade and prohibits
monopolization, or attempts to monopolize. A legal nicety that has economic significance is that

1
Kurlansky (2002), pp.28-35.
2
Smith (1937), p.61.
101

having a monopoly position in itself is not illegal. In the first major decision under this act, the
Supreme Court in 1987 ruled the price agreement among 18 railway companies illegal. In 1911,
the Court ruled against manufactures requiring sellers to sell above a minimum price. The
Standard Oil Trust formed by John D. Rockefeller controlled at the end of nineteenth century 80
per cent of the refining and 90 per cent of the oil pipelines in the United States. 1
There was public hue and cry that it was not only a monopoly but that it was formed by
destroying competitors through ruinous price cutting (predatory price cutting) and other
unethical business practices. In 1911 Supreme Court issued a decree dissolving the Trust into 38
companies.
The Sherman Act did not prohibit companies from merging into a single firm and many
cartels circumvented the act by merging. Clayton Act of 1914 was the first of few acts that
extended the scope of the laws restricting anti-competitive practices. It prohibited mergers to
reduce competition. Subsequently antitrust policies restricted other practices like price
discrimination. If a firm discriminates by offering different prices, then there has to be an
economic justification like low costs for large orders. Finally it allowed firms hurt by illegal
practices to sue for triple damages (three times actual damages plus attorney fees). The Federal
Trade Commission established in 1914 by an act of the Congress and the Commission and the
Antitrust Division of the Department of Justice are empowered to enforce the antitrust laws. The
level of enforcement has varied over time responding to economic and political climates.
Developments in economic analysis have refined the understanding of what constitutes anti-
competitive practices.
In contrast Germany at during the turn of twentieth century was favoring cartels as a way
to control instability. The first restrictions were introduced after the hyperinflation following the
First World War. It did not limit cartel but only policies that use market power to increase prices.
After the Great Depression cartels were made compulsory for firms in many industries and Nazi
regime used it as a tool to control nations industries. After the Second World War, the Allies
wanted to impose laws against cartels but their enthusiasm faded as a strong Germany was
considered a necessary bulwark against the Soviet Union. In 1957, after long debate Germany
finally passed a competition law.
The Treaty of Paris that created the European Coal and Steel Community in 1951 included
a number of pro-competitive measures. The dominant motivation was to diminish German power
by making available essential iron and coal to other European nations. The other motivation was
recognition that competition is the way to attain efficiency in market allocation of resources. The
competition policy of the European Union is built on the same principles. It calls for a system
that does not distort internal markets and prohibits discrimination on national grounds. But it
exempts cartels formed to eliminate excess capacity in a permanent way. The competition policy
gives a favorable treatment to small and medium firms. The subsidies they receive from the state
are not considered to affect trade and competition in the Common Market.
The early case laws under the Sherman and Clayton tended to judge mergers or pricing
policies like volume discount on the intent of the law and not their impact on the welfare of
consumers and producers. If merger creates efficiencies by reducing fixed or marginal costs,
would it justify the merger? There are two difficulties in using welfare criteria. The first is that

1
Miller (2003), p.267.
102

the companies will always claim large efficiencies but they are hard to measure and will only be
realized, if at all, only long after the action was approved. Next there is a distributional question
whether the gains for producers should be given equal weight as to consumers. If a merger
reduces fixed cost by eliminating excess capacity but do not change marginal cost or price, is the
increase in profits of the firm a justification for the merger? Two or more firms were competing
and pricing their product at marginal cost. Their merger leads to a reduction in marginal cost but
it creates a monopoly and price now not only exceeds the new marginal cost but even the old
marginal cost (and price), should the merger be approved as increase in profits outweigh the
decrease in consumer surplus? Since Williamson (1968) raised these questions they are being
debated.
Since 1980, the level of economic sophistication in the guidelines issued by Department of
Justice and the Federal Trade Commission has increased dramatically. Yet the issues are so
complex that the guidelines had to adopt intuitive measures to guide decisions. The European
Union guidelines resemble that of U.S. in many respects. Given its origin in fear that a firm or
firms will dominate the market, the European Union guidelines place greater emphasize on the
market of the merged firm than U.S. guidelines.
The cost of challenging the decision by Department of Justice or Federal Trade
Commission in U.S. or Competition Director General of European Union in court is so high that
few firms pursue it.

Summing up.
A monopolist, as the sole producer, is constrained by the market demand curve. He can set
the price and sell what consumers demand at that price or decide on what he wants to produce
and sell and let the market demand curve determine the price. His technology is assumed to be
such that the marginal cost is a constant. He has to reduce the price to sell a larger quantity and
the marginal revenue lies below the demand curve and, at each output, it is less than the price.
He will maximize his profit when he produces an output at which marginal cost equals
marginal revenue. The price will exceed marginal cost and the difference will depend on how
sensitive consumers are to price increases. A measure, price elasticity of demand is constructed
to measure consumer sensitivity to price changes.
Consumer surplus is a measure of the benefit from being able to purchase goods. As price
increases reduce the quantity purchased, it decreases more than the increase in profits of the
producers. The difference is a measure of the deadweight loss due to monopoly.
Currently laws allow the innovator to have a monopoly of his product or process. The
higher profit is an incentive to innovators. The length and breadth of the patent should balance
the cost to the consumer with the benefits of providing incentive to innovators.
The public resentment against monopoly has led even ancient monarchs to adopt policies
to limit them. Today the antitrust policies in the United States and competition policies of
European Union set the model for limiting ability of firms to form monopolies.
103

Selected bibliography.
Carlton and Perloff (2000); DiMasi, Hansen and Grabowski(2003); Irwin (2010); Kalnins
(2006); Kurlansky (2002); Laszlo (2001); McGee (1958); Miller (2003); Motto (2004); Mund
(1933); Nelson (1966); Sobel (1995); Smith (1937); Whinston (2007); and Williamson (1968)
104
105

Chapter 8. One product, many prices.

Nothing is more exasperating than to find out that we paid more than others for the same
goods. Yet selling a product at different prices is endemic in modern economies. Prices of
groceries vary among neighboring stores. When we drive up to gas stations, we find stations
within a block charging different prices. Airline fare depends on the time of purchase, the time of
travel and the length of the trip and it is not uncommon for passengers sitting next to each other
in commercial flights paying very different fares. 1
The 43 million Americans without health insurance and many more whose insurance do not
cover drugs try to save by purchasing generic version of drugs but variation in prices from one
drug store to the other makes it hard to get the best prices. A Wall Street Journal survey shows
that price of 30 tablets of 20 mg Simvastatin, the generic equivalent of the widely prescribed
cholesterol reducing medication Zocor, is as high as $89.99 at a drug store and as low as $6.99 at
a pharmacy within a wholesale club. 2
Another example is the grey market in electronic goods; products sold at lower price abroad
are re-exported to the United States and sold at stores specializing in such goods at prices lower
than the same goods directly exported to the United States by authorized retailers.
A market, by definition, brings buyers and sellers together and moves the prices of same
goods easily and quickly to equality. Why is it that process not working in cases of price
discrimination? How can producers segment the market and prevent the price of the same
product equalizing across segments? How do producers determine the segmentation of the
market? Since producers adopt different strategies to segment the market, depending on the
preferences of the consumers and the information they are able to obtain about consumers, a
number of specific forms of market segmenting and segment pricing have to be considered
separately.

Segmenting markets by characteristics of consumers.

Consumers make their decisions based on their preferences, their incomes and the prices of
goods. Preferences of a consumer are known only to him or her. Firms depend on consumers for
their revenue and not knowing price sensitivity is a limitation in planning production and
choosing pricing schedules. To obtain additional information on the preferences of consumers,
firms adopt one of two strategies. Firms stratify consumers using information about
demographics, family status and income obtained from sources like the U.S. Census Bureau and
hope that this stratification corresponds to consumers' ability and willingness to pay. The other

1
The question, "What is a commodity?" has to be addressed. Is a trip between two airports purchased just before the
flight the same commodity as one purchased two weeks in advance? Tagging commodities by different
characteristics is useful in many contexts but, by common usage and economic analysis, trips in the same class in
one plane are not differentiated.
2
The Journal reports that stores were changing prices even as they were being asked about them while denying that
the survey prompted the change.
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Figure 1. Observable and unobservable characteristics of consumers.

strategy is to develop a schedule of prices that would make consumers with low price sensitivity
self-select into groups that pay higher prices.
Airlines, in addition to using weekend stay as an observable criterion to distinguish
business and leisure travelers, also use how advance of travel booking are made as another
observable criterion. Business trips, unlike vacations, are snap decisions made as opportunities
arise. Accordingly airlines charge higher fares to those who do not make advance reservations.
Following English economist Joan Robinson, the market - group of sellers and buyers - with a
higher price is referred to as the strong market and the one with a lower price as the weak
market.
Firms use a different strategy when they offer a schedule with two or more prices that are
so structured as to induce consumers with different price sensitivities to choose one of the price-
quantity combinations. One scheme is to charge a lower price for the second unit if purchased
together. Another schedule charges a lump-sum charge for every consumer upfront and then a
per-unit price; as the lump-sum charge is spread over more units, the average price per-unit price
vary with quantities purchased.
Under uniform pricing, the monopolist will produce the output at which marginal cost
equals marginal revenue and the demand curve will determine the price. If he decides to adopt
price discrimination, he has to determine the output in different segments given the demand by
consumers in the segments. If more than one firm competes in the segment, each firm has to
consider the strategies of its competitors.
Each of the sections below will consider one form of price discrimination under monopoly
and then examine how it is modified by the existence of competition among firms.
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Price discrimination by observable characteristics of consumers.

The demand curve of the monopolist is the demand curve for the product in the market and
slopes downwards to the right. The marginal revenue curve lies below it. The technology of the
firm is such that the marginal cost, as shown by the height of the horizontal marginal cost curve,
is constant for all levels of output.
Price is given by the height of the demand curve right above the intersection of marginal
revenue and marginal cost curves. Monopoly price, as shown in last chapter, exceeds the
marginal cost. The difference between price and marginal cost depends on the sensitivity of
consumers to price changes as measured price elasticity (ratio of the percentage change in
quantity demanded to percentage change in price). 1 Less responsive the customers are to price
increase, the higher is the price that the monopolist finds it profitable to change for his product.
Price discrimination based on price responsiveness of consumers.
The firm examines the possibility of increasing its profits by dividing the market into two
and charging different prices. The first step is to identify the subset of its consumers with low
elasticity of demand that can be charged a higher price relative to the constant marginal cost. In
this section we will consider firms using observable characteristics of consumers to segment the
market. Stores, in giving discounts to students and senior citizens, are assuming that those who
are not working and earning an income are more sensitive to price increases. They use student
IDs and driver licenses to identify those who are in the "weak market" and prevent those in "the
strong market" from crossing over.
Having segregated the market, the monopolist has two markets to supply. It must make
two interrelated decisions: choose its output and decide how the output is partitioned between the
markets. 2
These decisions together with the demand curves in the two markets will determine the
prices. Taking division of output first, consider the monopolist shifting one unit of a given output
from Market 2 to Market 1. The sales revenue from Market 1 will increase and sales revenue
from Market 2 will decrease by the marginal revenues in these markets. If marginal revenues
differ, the firm can increases sales revenue by shifting sales to the one with higher marginal
revenue. These transfers make the firm slide down the marginal revenue curve in the market to
which it transfers the product and up the curve in the other (Figure 2).

1
Defining price elasticity as the negative of the ratio of proportionate change in quantity to proportionate change in
price, the relation between the excess of price over marginal cost is given by the Lerner index: (price - marginal
cost)/price = (1/price elasticity).
2
The college student, the pensioner and the employed are all in the same locality. Geographical distance between
markets is considered in a later section.
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Figure 2. Segmenting markets for price discrimination.

Ultimately the two marginal revenues will equal each other, exhausting possibilities for
further profitable transfers. Once common marginal revenue is established by the allocation
process, choice of output becomes clearer. If the common marginal revenue is greater than the
marginal cost, the firm can increase profit by increasing output and allocating the extra output
between the markets. The two decision processes together determine the total output and how
much of it is sold in each of the two markets.
Since the monopolist has the option of charging the same price, it is obvious that he will
introduce price discrimination only if it increases his profits. The welfare of consumers may
increase or decrease depending on changes in output. Utility maximization leads to consumers
equating marginal rate of substitution between any two goods to the ratio of their prices. Take
any product other than that of the monopolist that consumers buy. Since the monopolist has
divided consumers into two markets and is charging different prices, consumers in each market
will equate their marginal rate of substitution to the ratio of the monopolist's price in that market
to the price of the other product. The marginal rate of substitution in strong market will be
different from that in the weak market. An economy is efficient in the sense formulated by
Vilfredo Pareto if two consumers are not able to make an exchange that improves both or at least
improve one without hurting the other. Since price ratios between the monopoly product and the
other product differ by the segments, there are exchanges that can benefit both. 1
However without the ability to charge higher price in one market, the monopolist may not be
willing to serve the weak market; without a higher price for hard bound volumes, publishers will
not be able to sell paperbacks. As he withdraws from the weak market, consumers in that market
are not able to buy the product. Price discrimination reverses this condition and opens new
markets and increases output. Then welfare may increase depending on the specific
circumstances prevailing in the markets.

1
If the marginal rates of substitution of consumers are not the same, Consumer 1 who has Product 1 is willing
to give up more of it for a unit of Product 2 than what Consumer 2 demands. They can agree to an exchange that
benefits at least one and possibly both.
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Segmenting markets by geographical distance from plant.

Figure 3. Delivered price: mill price plus freight.

When an individual order goods over the phone or internet, he is billed for the product and
for shipping and freight. Many of the products brought in stores are manufactured at plants far
away and have to be transported to the stores. In each of these cases, the consumers are buying
not only the product but the transportation service to where the customer is. It is intuitive to think
of the delivered price paid by the customer as the sum of two prices: the price of the product and
the price of transportation services (Figure 3).
Consider a monopolist who has decided on a fixed price at his plant - fob price - and
expects the consumer to pay the freight to the place of delivery. In the example, customers are
clustered in two locations, the Near Market and Distant Market. In this section, the distance from
the plant provides a natural segmentation of consumers. Under the pricing scheme in Figure 3,
the firm charges a fixed fob price at the plant and adds the transportation cost to determine
delivered price to customers in the two markets. If the firm chooses the price at the plant, then
the quantities sold in the two markets are determined by their demand curve and the price the
customers have to pay. The customers in Distant Market will have to pay a higher delivered price
than those in the Near Market
The pricing scheme does not take into consideration the differences in the demand
conditions in the two markets. Will smoothen out the price difference, by charging more in the
Near Market and less in the Distant Market increase his profits? To reduce costs to the customers
in the Distant Market, the firm charges a lower fob price to the shipments there and a higher fob
price to the Near Market. Depending on the price sensitivity of the customers in the two markets,
the profitability from increased sales in Distant Market can make up for the reduction in the Near
Market (Figure 4)
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Figure 4. Price discrimination between geographically separated markets.

Assuming demand curves are identical in both markets and that they are linear, the
difference between the delivered prices in the two markets will be half of the additional
transportation cost between the two markets. Analysis of efficiency is complicated by the freight
charges. Consumers in the two markets adjust the quantity demanded to the delivered prices they
have to pay. Equality of marginal rates of substitution among all consumers is not feasible as
prices differ with distance from the plant. One conclusion drawn in the literature is that price
discrimination by charging different fob prices to different markets is not efficient.
Plasterboard in United Kingdom and cement in Belgium are delivered to customers at
fixed prices irrespective of how far they are from the plant. Both products have high
transportation costs; for plasterboard it is about 13 per cent of the price and for cement it ranges,
depending on distance, from 10 to 40 percent of price. The London Brick Company is a
monopoly and follows zonal pricing; they charge a uniform prize within zones 5 miles wide. In
all the three cases, those close to the plant are subsidizing those further away. 1
Figure 4 made two specific assumptions: consumers are charged freight from the point of
production and there is only one firm. When there are more firms, they may agree on pricing
scheme that no one benefits from nearness to customers. Under the "Pittsburg plus" pricing that
U.S. steel industry, irrespective of where the steel plant serving a customer is located, the price
included freight from Pittsburg; a Chicago customer purchasing steel from a local plant was
changed "phantom" freight from Pittsburg. The pricing scheme was abandoned in 1924, when
U.S. courts ruled against it. The European Coal and Steel Community use multiple base point
pricing and the resulting price schedule is very complex.

1
Phlips (1981), pp.23-30.
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Price discrimination under competition.

Figure 5. Price discrimination in competitive markets.

When there is competition, the firms segmenting the market have not only to consider the
elasticities in these markets but also the pricing adopted by their competitors. If Firm A and Firm
B consider one market to be the strong market the other to be the weak market, both will charge
high prices in the first market and low price in the second. Both firms agree that students and
senior citizens are in the weak market and those in working years are in the strong market and
both offer discounts to the first group of customers. Even though it is not necessarily true, price
discrimination can lead to an increase profits.
However the strong market for one firm may be the weak market for the other. One
possibility is that the location of a firm gives it an advantage in one market. If, in Figure 4, a
second firm is located in the right side of Distant Market, then it has an advantage in that market
compared to the firm at the left end. The distance, instead of being in geometrical space, can be
in characteristic space. American automobile companies dominated the market for large sedans
and SUVs preferred by certain buyers; it was their strong market. They were weak in the market
for energy-efficient smaller cars where Japanese and other foreign automobile companies had an
advantage. But some customers will switch to the small cars if the U.S. car manufactures charge
a high price in the strong market. Competition exerts a downward pull on the prices in the strong
market. In contrast to price discrimination under monopoly, the competition between the two
firms will, if it is intense, lower prices of both products below the uniform prices the two firms
would have charged. Profits may be less than under uniform pricing.

II. Price discrimination based on unobserved characteristics of consumers.

Over and beyond the observable characteristics like age, employment and distance from
the plant, consumers have other characteristics that cannot be observed by producers. Yet they
provide opportunities for profit-enhancing price discrimination. A firm, even though it cannot
observe the price sensitivity of its customers can induce them to self-select into groups according
to their price elasticities and charge a higher price to those with relatively inelastic demand.
112

Letting consumers who are deal-prone self-select.

Manufacturers and stores distribute coupons that offer a discount at time of purchase. They
are in advertisements in newspapers; leaflets of coupons are inserted into Sunday newspapers;
and they stick out between pages of magazines. An envelope of several coupons appears
periodically in mailboxes. Some products purchased in stores have coupons inside the packages
while others have it inside; some of them can be used to discount current purchase and others
future ones. Stores hand out coupons in their in-house newspapers or have coupon dispensing
machines. Customers with loyalty cards receive discounts.
Paradoxically, while almost everyone redeems some coupons, most of coupons are thrown
away. In 1996, manufacturers of consumer packaged goods distributed 268.5 billion coupons of
which 5.3 billion or 2 per cent were redeemed. The average value of coupons redeemed was 69
cents. 1 Why are consumers redeeming only two percent of coupons and discarding the rest?
What is the benefit to producers in incurring the cost of printing and in distributing the coupons
so few of which are redeemed?
Using a coupon requires an effort by the consumer. They have to be cut out, sorted by
product categories - breakfast cereals, cooking oil etc - and stored till the next shopping trip.
Coupons have expiration dates which could force the consumer to choose between letting them
expire or by accelerating purchases. If a coupon is for a different brand in the same product
category, a decision has to be made whether to substitute the favored band with the new one or
not.
Against these costs, the customer benefits from reduction in price and, as with bargaining
in a flea market, from the satisfaction of being a smart buyer. Consumers differ in their attitude
to seeking lower prices, to changing purchase timing or shifting to a new brand; these
preferences cannot directly observed by the producer. The ideal situation for the producer would
be for coupons to be redeemed only by those who consider the effort worth the savings. Then the
firm has succeeded in making the consumer reveal how elastic their demand is and price their
product accordingly.
In reality such a clear segmentation of price sensitive and insensitive consumers is not
achieved as firms, instead of focusing on one single goal, seek many at the same time. They want
to induce consumer to try newly introduced products or brands, make them switch from one
existing brand to another, increase sales to meet corporate goals, encourage loyalty to the brand,
and defend market share. In view of such variations, overarching conclusions, valid for all
consumers and markets, on the effect of issuing coupons are not to be expected.
Some results stand out in empirical studies and they are mostly in line with what is to be
expected from analysis of consumer behavior. The households that use coupons have, in the
aggregate, a higher price elasticity of demand than nonusers. However a loyal consumer who
receives a coupon for his favorite brand through one of the channels of distribution will redeem it
even if he or she would have purchased the product without the coupon. Studies also indicate
that coupons provide a strong inducement to those who do switch, to do so.

1
Nevo and Wolfram (2007), p.319. The average value of non-redeemed coupons need not be the same as that
of redeemed coupons but given the low rate of redeeming coupons, recipients ignore much of the potential savings.
113

Ready-to-eat breakfast cereal industry is one of the major issuers of coupons. It is an

industry dominated by a few firms which compete with each other by selling many brands.
Various studies of the industry validate the results stated in the previous paragraph. Among
additional results observed is the tendency for a larger percentage of consumers to use coupons
for brands with higher prices. Producers of brands facing intense competition from lower-priced
generic store brands issue coupons more frequently and conversely producers of generics find
that their market shares are lower when brands-name manufactures issue coupons often.
Firms use coupons to meet sales goals through a short term boost in sales; between 10 and
15 percent more coupons are issued in the last quarter of the fiscal year of the corporation than in
its first. It is not clear that the short spurt in sales increases the firm's profit as much as enabling
the employees of the companies to claim that they have met corporate goals. The lack of
alignment between the interests of the corporation and of its employees is known as "agency
problem."

Using pricing to acquire and retain consumers.

Thousands of new products are introduced each year. 1 Most of them will not be of interest
to any one customer but each time she tries to make a purchase, she finds that some new ones are
viable alternatives to what she was buying. For customers the choice arises anytime they have to
make a purchase. Some goods like the food are purchased quite often as they are used up in one
act of consumption. Others like cars, SUVs, computers or kitchen equipments are durable goods
and last longer but still need to be replaced regularly. Producers of existing products want to
retain the past customers while innovators offer inducements to switch. A U.S. firm on the
average loses annually ten percent of its customers and replacing them is essential for survival.
Various studies show that only 10 to 20 per cent of new products survive.
The tension between acquisition and retention is seen in pricing policies. Given that only a
small percentage of customers on the average switch, its current customers are its strong market
and potential customers are weak market. The firm should offer a low introductory price to those
who are willing to switch and then start increasing it; such a price schedule is standard in phone
and cable industries that offer low prices for a limited period. Some firms post a low price for the
basic unit like ink-jet printer or razor and then set a high markup on "follow-on" products like
ink and blades that have to be purchased from the firm to assure compatibility. Coupons and
inducements for repurchase are used to counter these inducements; airlines offer frequent flyers
to accumulate mileages for future upgrades or few tickets.
Knowledge of how long the consumer was purchasing the product or how long she was
shopping in the store is valuable information for producers and retailers. Developments in
information technology have made gathering the information feasible and cost- effective.
Loyalty card allow stores to keep track of their purchases. In addition stores can purchase from
third parties data bases with purchase history of large groups of customers. Before assuming that
the information on purchase history allows sellers to use highly profitable pricing strategies, two
limitations of the data must be noted. Consumers make a selection, based on their preferences,

1
By the end of twentieth century, roughly 25,000 new Uniform Product Code (UPC) or barcodes are issued each
year. New UPCs are issued for new sizes and slightest variation in characteristics of the product that is sold
separately. Distinct new products (however defined) are fewer in number but still run into thousands.
114

from what is available to them. Just to know that a consumer purchased a product does not allow
any deduction of her preferences without information of what else she could have purchased.
The first limitation of purchase histories is that such data is not included in it. The second
limitation is that consumers are mobile and available data on each consumer will be valid for a
limited period only. In spite of these limitations, one study shows the value of purchase history.
Issuing coupons to consumers who had made just one purchase increase the net coupon revenue
by 50% over blanketing consumers with coupons and focusing on those with a short history
increases it to 250%. 1
So far the discussion has been on charging different prices to different customers. Another
pricing strategy is offer discounts for purchasing larger quantities and a customer will end up
paying different prices for the different units purchased.

Price that varies with consumption - two-part tariff.

Amusement parks have an entrance fee and some add additional charges for rides. As soon
as a passenger engage a taxi, the meter registers an initial charge to which is added a fare based
on distance traveled. In all these cases, the initial fixed charge gets divided among larger number
of units as consumption increases and the average cost per unit to the buyer keeps deceasing.
The analytical tools developed in last chapter on monopoly enables consideration of how
the "two-part tariff" affects the profitability of firms and the welfare of consumers.
The individual demand curve of a consumer, Jayden, is also downward sloping. His
valuation of marginal units decreases as his consumption of the product increases. In the
numerical example of Figure 7, the relation between quantity demanded and price is: price = 16 -
quantity. Jayden values the first unit in dollar terms at $15, the second at $14 and following units
even less until the sixth unit is valued at $10. Consumer's surplus for each unit is its valuation
less price and equals the height of the shaded rectangle for that unit. It is $5 for the first unit and
$0 for the sixth unit. Adding them all up, the total consumer's surplus is $15.
The production technology is such that marginal cost is a constant at $4. The monopolist
maximizes his profit by setting marginal revenue (not shown in the figure) equal to marginal
cost. For this demand curve and marginal cost, the profit maximizing output is 6 units.2 The
product is sold at a uniform price of $10. Gross profits (excess of sales revenue over cost of
inputs and labor) is 6 x (10 - 4) = $36. 3

1
Rossi, McCulloch and Allenby (1996), p.322.
2
The discussion in the text is based on discrete changes and it can differ from calculations based on continuous
variations. Under discrete changes, the firm finds its marginal revenue of 7th unit, $3, to be less than the marginal
cost.
3
Average variable cost equals constant marginal cost.
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Figure 7. Two part tariff

In addition to the cost of production, the firm has to incur a fixed cost that includes the cost
of funds raised to construct plant. The firm will be profitable only if gross profits exceed fixed
cost. If the fixed cost is $45, the firm is not profitable under uniform pricing and will go out of
business. Is there a two-part tariff that makes the firm profitable and consumers better off?
Let the fixed charge under two-part tariff be $10. Then the firms gross profits, assuming
that the expenditure on this product is a small part of the consumer's budget and the fixed charge
will not change his demand curve, will increase to $46 and the operation has become profitable.
But consumer's surplus is reduced from $15 to $5.
It is even possible to increase the fixed charge and reduce the price per unit and increase
the total surplus total surplus (consumer's surplus and profits together). Then the possibility
arises that producers and consumers can both be made better off.
If the monopolist reduces the price to $6, he will sell 10 units and his gross profit is 10 x (6
- 4) or $20. Increase the fixed charge to $27 and the monopolist is now profitable as operating
income of $47 exceeds the fixed cost. The consumers surplus for the first unit is now 15 - 6 = $9.
The sum of individual surpluses for the ten units sold is $45; after paying the tariff of $27 the
surplus of $18 exceeds the one under uniform pricing showing that consumers benefited from the
shift. The two-part tariff enabled the firm to reduce the discrepancy between price and marginal
cost and both consumer surplus and profits increased. Such a change is an improvement in the
sense Pareto defined efficiency and the new outcome is said to be Pareto Superior.
The numerical example only shows the possibility of a two-part tariff being Pareto Superior
to monopoly pricing; it is not necessarily so. If customers are divided into weak and strong
markets, those in the weak market may not be willing to willing to pay the fixed charge and will
drop out. Public utilities like electricity, gas and telephone companies which have large fixed
cost do not want to exclude many residents in its area of service (it may even be against public
utility regulations) from connecting to it by charging a high connecting charge. They charge a
116

non-linear tariff where the cost of additional units -- additional kilowatt hours of electricity for
example - decreases as more units are consumed. Compared to a uniform price greater than
marginal cost, a non-linear tariff can be devised that, by making consumers self-select into
groups by choice of their consumption, is Pareto Superior.

Bundling: selling two products as a package.

It is common for a producer to package two goods together and to sell it at one price.
Common examples include fixed price menus at restaurants and vacation packages that include
travel, hotel and sight-seeing. Receivers, video players, TVs and speakers are sold separately or
packaged into a music system. Computer manufacturers sell PCs as a system and most customers
purchase it as such though it is made of components and the customers are allowed to select each
component from a menu. 1
Going back to a monopolist, the advantage for bundling comes from the differences in
customers' preferences for the products. One vacationer likes to travel in comfort and willing to
pay up to $250 while a hotel is for him just as place to sleep that is not worth more than $125.
Another customer sees travel as a necessary nuisance and looks for the best bargain. She is not
willing to pay more than $200 for air fare but likes nice accommodation that costs as much as
$200. If travel agency (with a monopoly in selling trips to this resort) is selling travel
arrangements and hotels rooms separately and wants both customers to buy, it can charge only
the lowest prices at which both will purchase; $200 for airfare and $125 for hotel and his revenue
from a customer is $325. If however he offers a package of comfortable travel and hotel
accommodation for $350, both customers will take it. The first customer who would have paid
up to $375 earns a consumer surplus of $25 from the package. The second consumer was willing
to pay up to $400 and obtains a consumer surplus of $75. The higher revenue adds to the profit
of the firm. Bundling can be thought of as a form of non-linear pricing with first element of the
bundle charged the same price as if it was brought separately and the second at a discount.
Bundling can be either pure bundling or mixed bundling. Under pure bundling, the
consumer has no choice but to buy the products together as a bundle. Under mixed bundling, the
customers are allowed to purchase the components individually or buy the bundle. Restaurants
are offering mixed bundling when they put on the menu fixed price and a la carte meals.

Summing up.
Every market transaction has two parties, a buyer and a seller. Does the market benefit
both of them or are sellers able to exploit the consumers' dependence on them for the products
and charge "unfair prices?" Adam Smith writing in the eighteenth century argued that it is the
self-interest of the producer to supply the market and their actions not only benefit them but also
the consumers. Since then economic analysis has refined this argument and, as in the text, today

1
Computers are sold with pre-installed "trialware," security software, internet services and other utilities not
requested by the buyer. These softwares keep prompting him or her to subscribe to them. Financial Times (2007)
reports that commission paid by software vendor to PC manufacturers when customer subscribes is between $10 and
$20 per machine, a significant amount in an industry with very narrow profit margin.
117

apply the yardstick of Pareto efficiency to evaluate on the welfare implications of market
systems.
In spite of the development and refinement since Adam Smith's time, a consensus on
whether the market needs regulation to enforce a level playing ground has eluded us to this day.
Pareto criterion is not definitive because of two limitations. From an inefficient position, there is
more one movement or change that would improve all parties; these moves differ in that some
changes will benefit one party more than the other and no guidance is offered in choosing one
over the other. Next, the market system will lead to an efficient allocation of the resources and
product (one from which there are no Pareto Superior moves) only if the market satisfies a
number of conditions. In policy debates focused on whether that conditions are met by a specific
market.
One of such conditions is that producers should not be able to set or influence prices and
another is that the marginal rate of substitution between two products should be the same for all
consumers. In the markets discussed in this chapter neither conditions are satisfied. Should
public policy limit price discrimination and enforce conditions on the market that enhances its
efficiency? How much would such policies affect the individual freedom to engage in
commerce? The anti-trust or competition policies of various nations seek a balance between
presumed increases in efficiency of markets and the limitations and distortions to its operations
that regulations introduce.
The development of transportation systems and the legal environment led to consolidation
among manufacturing and transportation companies at the beginning of twentieth century.
Concern that these firms were monopolizing segments of industry and trade led to the passing of
Sherman Act of 1890 which prohibited such practices. However courts interpreted it as not so
much prohibiting monopoly but certain acts by them. The uncertainties created by this
interpretation let the passing of Clayton Act of 1914. It prohibited four practices, one of which
was use of price discrimination to reduce competition. Section 2 of Clayton Act of 1914 reads:
It shall be unlawful for any person engaged in commerce, in the course of such
commerce, either directly or indirectly, to discriminate in price between different
purchasers of commodities of like grade and quality, . . .and where the effect of such
discrimination may be substantially to lessen competition or tend to create a monopoly in
any line of commerce, or to injure, destroy, or prevent competition with any person who
either grants or knowingly receives the benefit of such discrimination, or with customers
of either of them: Provided, That nothing herein contained shall prevent differentials
which make only due allowance for differences in the cost of manufacture, sale, or
delivery resulting from the differing methods or quantities in which such commodities are
to such purchasers sold or delivered:
The first sentence declares price discrimination unlawful while the second sentence
conditions it by stating that differentials are allowable as long as it reflects underlying
differences in costs. Practitioners of price discrimination can claim that differences indeed reflect
differences in cost of production or distribution.
The Great Depression together the spread of grocery chains in the 1930s created the
suspicion that the buying power of large corporations could allow them to negotiate price
concessions that are not extended to small stores and that the cost difference would put
independent stores at a competitive disadvantage. The Robinson-Patman Act of 1936 prohibited
118

any one engaged in commerce from discriminating in price between different purchasers of
commodities of similar grade and quality. As the Supreme Court stated in one of the judgments:
"…the Robinson-Patman Act condemns price discrimination only to the extent that it threatens to
injure competition . . . Congress did not intend to outlaw prices differences that result from or
further the forces of competition."
There were much litigation under the Act and it is a provision that creates concerns among
manufacturers and distributors to this day. The contentious issue is not whether there is price
discrimination but whether it injures competition. However the firms that are receiving price
breaks maybe passing it on to consumers benefiting them. Is Wall Mart that using its purchasing
power to get low prices from its suppliers and passing it on to consumers benefiting the
consumers or hurting the market by pushing out competitors? The controversy that frequently
surrounds opening of new stores by Wall Mart indicate that the issue is still very emotional. The
discussion in this chapter brought out the complexity in analyzing various forms of price
discrimination and determining its effects on consumers and producers. The analysis in this
chapter shows that a blanket condemnation of price discrimination is not justified as under
certain circumstance it can benefit consumers. Since these conditions may not hold in specific
instances, it is necessary to be vigilant.
This chapter showed that while a market brings together buyers and sellers and establishes
a price, the producers may be able to influence who are the buyers in one market. The customers
for a product are separated into different markets based on their willingness to pay and charged
different prices. In the next chapter, a closer look is made of what a product is and how close it is
to other products. Today each of our wants is satisfied by many products; competition in the
breakfast cereal market was discussed earlier. What are the differences between the various
brands? Are consumers benefiting from the greater choice or is this another way for producers to
fragment the market and charge higher prices?
Bibliographic note:
Acquisti and Varian (2005); Amstrong (2006); Blattberg, Getz and Thomas (2001); Kotler
(2000); Blattberg and Neslin (1990); Brown and Sisley, (1986); Carlton and Perloff (2000),
pp.274-331; Clark, (1995); Financial Times (July 11, 2007); Hogan and Nagel(1995); Hogan and
Nagel (2006); Holmes (1998); Narasimhan (1984); Nevo and Wolfram (2002); Philips (1981);
Rossi, McCulloch, Allenby (1996); Stole (2007); Varian (1989); and The Wall Street Journal
(March 13, 2007).
119

Chapter 9. Competing with differentiated products.

Figure 8. Consumers' preferences for differentiated products.

Depending on the context, commodities are defined broadly or narrowly. We speak of eating
cereals for breakfast. When we go to buy them at the grocery store we find not "one cereal" but a
whole aisle of breakfast foods with close to one hundred ready-to-eat cereals. The milk we
choose can be whole, 2 per cent or one per cent.
In general equilibrium analysis -- considering the simultaneous equilibrium of all markets --
the refinement of commodities was carried to the extreme with same products tagged not only by
characteristics but even by date and state of nature. In spite of the elegance of this approach, a
coarser classification is useful in bringing out aspects of competition in the market
In the derivation of the demand, consumers were assumed to have preferences for baskets of
goods without consideration of the nature of the goods in the basket. Analyses of competition in
a market where products are branded require making explicit how consumers differentiate one
brand from another. Consumers’ responses to product differentiation suggest two approaches. In
the first, consumers rank brands by levels of specific characteristics. In the case of cereals, the
characteristics that influence preference include sweetness, the amount of fiber and the extent to
which one serving meet the daily minimum requirement. In automobiles, buyers are interested in
acceleration, number of passengers that can be seated comfortably and leg space. Panel A of
Figure 1 shows different brands arranged according to one characteristic. Each consumer has one
preferred level of the characteristic and will choose the brand that is closest to his preferred
position (assuming price differences among similar brands are minimal); among close to forty
brands of toothpaste for sale at the grocery store, the consumer chooses the one brand. Since
arranging products in a characteristic spectrum has similarity to arranging them in space, this
approach is referred to as spatial model of product differentiation. If a new brand is introduced in
the market, consumers whose preferred position in the spectrum is closer to it will switch to the
new one.
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Figure 2. Customers in geographical space.

In the other approach, consumers group products with those belonging to one group viewed as
closer substitutes to each other than products in other groups (Panel B of Figure 1). Consumers
love variety; in earlier discussion of consumer choosing one of the baskets along his budget line,
he preferred a basket with two goods and not one at the end of the budget line. In choice among
differentiated goods, consumers allocate their budgets among groups of commodities and, then
from each group, choose a combination of brands.
Preference to a brand translates to limited substitutability between brands and the low
elasticity of demand allows producers to charge a price higher than the marginal cost. Whether it
increases his profit will depend on the cost side; fragmentation of demand results in lower output
of each brand and it increases average fixed costs of each brands. However the prevalence
branding in almost all industries indicates that branding is in general is profitable.
Next sections elaborate the model of competition for consumers spread out in space. It
provides the intuition to analyze to competition in characteristic space.

Competition in geographical space.

A plant located as in Figure 2 supplies customers located at equal intervals along a road. The
firm sets the price at the plant (fob or mill price) and then adds the transportation costs to
determine the "delivered price" to the consumers at different locations. The delivered price
increases at uniform rate over distance from the plant as cost per unit distance is a constant. Each
consumer buys one unit of the product provided its delivered price is below the "reservation
price," the maximum price she is willing to pay for it. 1
In Figure 2, the firm sells to eight customers (blue figures) closest to the plant. The ninth and
tenth consumers (red figures) find the delivered price exceeding reservation price.

1
Here the consumer, instead of changing quantities continuously with price, is assumed to either
buy it or not depending on whether the price is below or above the reservation price. It focuses
on the role of distance related cost in a very simple framework.
121

Figure 3. Firm location and sales region.

A second firm, producing an identical product, has its plant located at other end of a road and
is charging the same mill price. The length of the road is thrice the distance to the eight
consumer. Because of symmetry in price and cost of transportation, eight consumers in its
neighborhood will now purchase from it (Figure 3). Each firm has a monopoly in the market in
its neighborhood with the cost of transportation preventing each from competing in the sales
region of the other. There is a region in the center with eight potential customers who will not
buy from either firm.
This configuration encourages a new firm to enter the market and locate at the very center. At
worst, it captures the eight customers who were not buying from the other two firms. Given the
location of the third firm, some customers of Firm 1 and 2 (seventh and eight from either end)
will find that they are closer to Firm 3 and will switch to it. Foreseeing this threat, Firms 1 and 2
will, instead of choosing the two ends of the road, locate closer to each other. Whether that will
preclude another firm entering or not depend on the cost structure of the firms; if no firms enter,
the established firms were able to use their positioning to limit competition. The central result of
this simple model, that firms have choose their locations with consideration to their competitive
advantage in potential sales regions, is valid in general.
Potential customers instead of being spread out uniformly along a straight road cluster around
neighborhoods. Retailers using census and other data try to identify the economic status and
tastes of consumers in each neighborhood and locate stores where their goods are most in
demand. Customers, for instance, are unwilling to travel a distance to eat at a fast food
restaurant. Such restaurants will succeed only if they are located where patrons tend to
congregate. Within cities, they choose locations near offices, urban shopping areas and schools;
another common location is near highway exists. In contrast shopping malls attract customers
even if located away from residential areas as they offer the opportunity to visiting many stores,
check out different brands of goods and buy them all at one place. Mall owners provide varied
inducements to attract the crowd like having nationally known anchor stores, attractive food
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Figure 4. Product in characteristic space.

courts, convenient parking facilities, play area for children and movie theatres. The flow of
customers that this aggregation of facilities generates will determine the mall's success.

Locating in the characteristic space.

Within each commodity group, there are many brands that differ in characteristics. Orange juice
in a grocery store is classified as with lot of pulp, with some pulp and no pulp; cars are ranked by
their acceleration measured by the time to attain a speed of 30 miles per hour from start.
Consumers, based on their preference for the amount of the characteristics, are spread out
uniformly in the characteristic space and any consumer further away from the location of the
brand bears a "psychic cost" in having to buy a product with characteristics that differs from her
preferred combination. The total cost to the consumer, "cost at delivery," of buying a product is
the sum of its price and psychic cost. With this interpretation, competition in characteristic space
can be related to spatial competition. Firms can compete by positioning brands in different
location in the characteristic space. Instead of developing a general analysis of product
positioning the rest of the section focuses brand proliferation in the ready-to-eat breakfast cereal
industry.
Kellogg, General Mills, General Foods and Quaker Oats, the top four of the six firms that
practically formed the supply side of the market, accounted for approximately 90 per cent of the
sales in the 1960.1 They had a higher rate of profit than other manufacturing industries. Between
1958 and 1970, accounting profits for the four firms and Ralston was 19.8 per cent of assets
while the comparable figure for all manufacturing in United States is 8.7 per cent. Still there was
no entry of new firms into the industry. In 1972, the U.S. Federal Trade Commission charged the

1
Scherer (1979), pp.113-114. The other two were Nabisco and Ralston-Purina.
123

four largest U.S. manufacturers with creating high barriers to entry through brand proliferation,
differentiating similar products and promoting trademarks through intensive advertising.
In the two decades after World War II, demographic growth and increase in weight for a
standard serving of cereal due to sweetening accounted for as much as 57 per cent of the
aggregate growth in ready-to-eat cereals. In turn it implies that the sales of new brands came
mostly from consumers switching from others. 1 Between 1957 and 197, the six firms introduced
51 new brands of cereals into distribution beyond regional test marketing while withdrawing 22.
A total of 67 brands were in distribution in December 1970; few succeeded in reaching a market
share of 2 per cent or more. Since the older brands showed considerable staying power, the new
brands were being used to cover small niches and to exclude other brands from locating there.
No new firms entered the market in this period.
The antitrust litigation failed and the industry in the United States continued to be dominated
by few firms. The four firms originally listed in the litigation have a market share (by volume
sold) of 79 per cent in the last quarter of 1992. The cost of material and labor for the industry is
34.7 per cent as contrasted to 72.2 per cent for all manufacturing firms. The advertising to sales
ratio for the industry is high at 13 per cent while for other food industries it is between 2 and 4
per cent. 2
Competition, in so far it exists, is from other forms of breakfast foods.

Product characteristics and market power of producers.

Just as consumers are clustered in some neighborhoods, products are clustered in characteristic
space. In Panel B of Figure 1, consumers consider brands in one group as good substitutes for
each other while those in other groups are poor substitutes. The importance of group is brought
by the antitrust litigation against Gillette.
If the price of a brand increases, consumers will, given the preference for products in the
group, substitute another one in it. The producer of the brand has to consider profit reduction
from the loss of sales but if he owns other brands in the group, his combined profits suffers less
than if consumers shifted to that of another manufacturer. If one producer owns many brands in a
group, the only recourse for the consumer against price increases of these brands is to use
products outside the group but it forces her to move to a less preferred product group.
How should group defined or what brands are to be included in one group? Will a consumer
consider only cereals in the breakfast group or will he consider other European and Spanish
breakfast foods as potential substitutes. If a group is defined too narrowly, any merger will give
appear to give the merged firm a large share of the sales in that group. The antitrust regulations
prohibit monopolization and definition of the group influences the judgment whether a firm has
gained monopoly power or not. This is brought out by the attempt of the Antitrust Division of the
Department of Justice to block Gillette that owned Waterman pen from acquiring Parker Pen.
In 1993 Gillette that owned Waterman posted a tender to buy the stocks and options of the
Parker Pen Holding Company. The Antitrust Division requested the United States District Court
of District of Columbia to issue a preliminary injunction against the acquisition. It was claimed

1
Scherer (1979), p.122.
2
Nevo (2001), p.319.
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that consumers would be unwilling to substitute Parker or Waterman for any other pen and the
merger would allow Gillette to increase prices.
Fountain pens are classified as base, premium or jewelry model. The characteristics that
distinguish a premium pen from a base pen are its sold gold nib, gold trim, superior ink filling
system and superior resistance to leak. 1 It gives the owner a feeling of status and affluence. The
Antitrust Division claimed that choice is dictated by another characteristic: the national origin.
Waterman and Parker are quintessential American pens since 1888 and consumers differentiate it
even from European premium pen, Schaffer and Montblanc. Gillette Company argued that the
Antitrust Department was defining the group narrowly. Those who own premium pens also own
base pens, ball point pens, pencils and other writing instruments. A proper definition of market
includes all writing instruments and that most customers buy not one of them but a combination.
In short, the relevant group of brands is not American premium pens but all writing instruments.
Even if Waterman and Parker pens merge, merged companies will face competition from
producers of other writing instruments. The Court agreed with this argument and denied
injunction.
Next section considers markets where consumers purchase a portfolio of differentiated
products.

Monopolistic competition: between monopoly and competition.

As standards of living improved over the last three centuries, consumer purchases reflect
ongoing changes in their lifestyle. Instead of consuming what is essential for survival, wearing
the roughest garments and confining their activities to their immediate neighborhood, the public
wants to try out different cuisines, follow recent fashion in what they wear and travel further and
further away. Restaurants offering ethnic foods from various regions of the world are striving
and bookstores have a collection of cookbooks that promote exotic, healthy or easy-to make
recipes. In cloths, men buy button-down shirts, casual wear of different styles and colors, many
ties and belts and a variety of footwear; woman's wardrobe has many dresses, hats and a
collection of shoes. The preference for variety is obvious.
When consumers buy a portfolio of products, the demand for the individual product has to be
distinguished from that of the group. Each firm has a monopoly in its brand and seeks to
maximize its profit, recognizing that the demand for its brand is affected by the price and
quantity of other products in consumer's portfolios. Edward Chamberlain in 1933 analyzed the
price and output of a firm under monopolistic competition and the equilibrium of the market. A
rigorous formulation of competition among differentiated products was provided by Avinash
Dixit and Joseph Stiglitz in 1977.
Differentiation produces a preference for a particular brand and consumers will not be willing to
abandon the brand for a slight price difference. The demand curve for the brand is downward
sloping and marginal revenue curve lies below the demand curve and is downward sloping
(Figure 5). The technology of the firm is such that its marginal cost is constant. An increase in
output will increase gross profit (sales revenue minus cost-of goods produced) as long as

1
Jewelry pens are made with lacquer polish and are used more as jewelry than as a writing instrument.
125

marginal cost exceeds marginal cost. The firm has to pay the fixed costs (administrative
expenses and interest on its debt) out of the gross profit; the residue is the accounting profit
reported in income-expenditure statements of companies. 1
The average variable cost equals constant marginal cost. As the fixed cost is spread over larger
and larger number of units, the average fixed cost will decrease. Figure 5 shows the average
variable cost (AVC) and average fixed cost (AFC) for three outputs. Average cost, being sum of
average variable cost and average fixed cost, decreases with output.

Price, output and profits of a brand.

The firm maximizes its profit by choosing the output at which marginal cost equals marginal
revenue and the demand curve for the brand determines the price. Price and average cost
determines the profit of the firm. Figure 4 shows revenues and cost of one brand. Given the
position of the demand curve before entry, "Output before entry" is such that price exceeds the
average cost. 2
The firm earns "excess profit" as it has funds left after paying the market rate of interest to the
financial institutions. Since there are no barriers to industry, new firms will enter the product
group. Each firm finds that he quantity demanded of its product at any price is decreasing and,

Figure 5. Profit maximization under monopolistic competition.

1
The assumption is that the firm is fully financed by debt, accounting profit is also economic profit. It assumes that
the assumptions of the Modigliani-Miller theorem hold in the financial market. The importance of capital structure
will be discussed in Chapter 12.

2
The marginal revenue curve of the demand curve before entry is not drawn in Figure 4. It intersects marginal cost
curve at the "Output before entry."
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after enough firms have entered, the demand curve will shift down to the lower curve in Figure
5. Price at the new profit maximizing output will equal average cost; there is no excess profit and
new firms have no incentive to enter the industry. Both the firm and the industry are in
equilibrium.
The analysis of entry depends crucially on comparison of price with a proper measure of
average cost. Given the difficulty in estimating it, one possibility is to compare the rate of
accounting profit per dollar invested in the firm with the average for the industry or economy. In
discussion of ready-to-eat breakfast cereals in last section, the profit rate for four firms in the
industry between 1958 and 1970 was 19.8 per cent while that for all manufacturing in United
States is 8.7 per cent. There was no entry in spite of the difference in rates of return. One
explanation is that the investment in cereal industry is risky and there are other hidden costs. The
other possibility is that there are barriers to entry as Federal Trade Commission claimed but the
court did not accept it.

Is there excess entry?

Under monopolistic competition, each firm faces a downward sloping demand curve and price
exceeds marginal cost. But there is entry and the demand curve for each brand is pushed down
till price is equals average cost. However entry, by fragmenting the market among producers,
increases the average cost of a firm. Does brand proliferation that increases cost of product
benefit or hurt consumers?
Market for many consumer goods show a proliferation of brands. Is there excessive brand
proliferation in the sense that reduction improves efficiency in the sense that it benefits some
without hurting others? If the preference for variety is ignored, the conclusion of too many
differentiated goods than is valid. If consumers do have a preference for variety, Dixit and
Stiglitz showed that the outcome is efficient allocation subject to the additional condition that
firms recover the fixed and variable costs of production.

Conclusion.
The concern about monopoly is that the producer has market power to charge a very high price
and earn a profit in excess of what is needed to attract investment to the industry. Will entry of
competitors with differentiated product limit the power to set prices and reduce the excess profit?
How will a producer in such an industry react to entry? The effect of entry depends on (i) the
preference of consumers; (ii) how it affects existing producers; and (iii) how affected producers
respond. So many are the possible combinations of consumer preferences, cost conditions and
manufacturers responses that one framework cannot analyze all of them. The chapter laid out
two models that have been found useful in analyzing markets with differentiated products.
The location model focuses on one aspect of our preferences. Whenever an individual is
shopping for a product, she examines different products for some specific characteristics. If the
spatial model, each firm has a lock on consumers whose preferred combination is closest to its
product. If the distance between two firms in one-dimensional characteristic space is large
enough, a third will enter in the middle. Anticipating challenge by new firms, those in the market
will locate close enough to preclude entry.
127

The monopolistic competition focuses on another aspect of our preferences: the love for
variety. Product fall into groups and, in each group, there are many brands. The brands in a
product group are viewed by consumers as close substitutes but not identical. The demand curve
for each brand is downward sloping. Each producer sets his output to equate marginal cost with
marginal revenue. If the price exceeds average cost, the firm earns a profit is excess of what the
resources can earn other investments. It attracts other firms to enter the group and the
competition pushes back the demand curve of each firm till price equals average cost.
At a social level, the question is whether the monopoly power leads to a proliferation of
brands. If consumer prefer variety, the allocation is efficient with the side condition that each
firm just covers its variable and fixed costs.
Bibliographic note:

Dixit and Stiglitz (1977); Freeman and Dungey (1981); Martin(2002); Mazze and Michman
(1998); Nevo (2001); Phlips and Thisse (1982); and Scherer (1979).
128
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Chapter 10. Game theory: the analysis of strategy.

In fall of 1704, after almost one year of sailing around South America, the ship Cinque Ports
anchored in a Chilean island Isla Más a Tierra (now renamed Isla Robinson Crusoe). Alexander
Selkirk, sailing master, felt that the ship needed repair before proceeding further but the captain,
Thomas Stradling, disagreed. Hoping to force captain's hand Selkirk asked to be set ashore but to
his dismay the ship sailed without him.1
Both Stradling and Selkirk had two choices: Stradling could agree to repair the ship before
sailing or refuse to do so. Selkirk could remain on the ship or stay at the Island. Since they were
making decisions independently, there are four possible combinations. Among them, the
combination chosen was for Selkirk to stay on the Island and for Stradling to sail without
repairing the ship. The outcomes of their choices were that Selkirk was stranded in the Island for
more than four years while the ship sank shortly after it set off. Stradling and the sailors who
survived were taken prisoners. As the story is told, the choices seem to be based not on rational
calculation of outcomes but on the hatred the two had for each other.
To survive alone in the Island, Selkirk built a hut in a meadow less than two miles uphill from
the Cumberland Bay, the bay that provided best anchorage of ships visiting the Island. 2 In the
thick woodlands to be east of the hut, he also built a hideout on a tree. Selkirk was hoping that
one of the many ships that sail by will rescue him. In the spare time he had after gathering food,
he would go to a lookout up the hill to watch for ships and, if he saw one, he would try to get its
attention by dragging branch of a tree to the sea shore and setting it on fire.
One dawn he went to the shore and found a Spanish ship anchored there. Sailors from the ship
were rowing to come ashore. Since British buccaneers were praying on Spanish galleons
transporting gold, Selkirk was sure that he will be taken prisoner and condemned to the galleys.
To escape, he ran towards the protecting trees with the sailors chasing him and firing at him.
Difficult as it was, he managed to evade them and climb to the hideout on the tree. The sailors
came up to its bottom of the tree but did not notice him. They gave up the chase and went to his
hut, butchered and eat the goats there, destroyed the sea chest, the kettle, bedding, books and
tools he had forged from items that earlier visitors had left behind. The Spanish sailors stayed for
two days during which Selkirk remained in hiding. As they sailed away, they left behind a rusty
anchor, a piece of sailcloth, a short length of chain, a coil of worn rope and discarded timber.
With them he rebuilt his hut and went on with his life on the Island until his eventual rescue by
British ships that anchored in the Bay. 3
Selkirk had two choices: to run to his hut where there is a good chance of being found or to
hide in the forest even if it involves hardship. The Spanish sailors could continue to search the
forest till Selkirk was captured or they can go to the hut and enjoy the fresh food (vegetables and
1
"The saga of the stranded sailor" in Chapter 3 has details of his life in the Island. Before the ship sailed, Selkirk
begged Stradling to take him back on board but was refused. It indicates that Selkirk did not really prefer the option
he took. He assumed that his strategy will force Stradling to rethink his decision to sail without repairing it. In this
Selkirk misjudged even though the outcome was much worse for Stradling and other sailors than living in isolation.
2
National Geographic (2004). The National Geographic Society led an expedition to find the spot where Selkirk
built the hut. The spot was confirmed when the dug up a navigational divider.
3
Souhami (2001), pp.115-117.
130

mutton from goats in the pen). Both parties made rational choices as Selkirk will have a
miserable life as a prisoner and fresh food is a premium for sailors sailing in ships without
refrigeration. Non-cooperative game theory provides the rationale for analyzing strategic
interactions and their outcomes. 1
In a modern society, a monopolist as the sole producer does not have to consider the strategies
of any competitor. It is in his interest to make entry into the industry as difficult as possible.
Patenting and brand proliferation examined in previous chapters are strategies to extend his
position in the market. Depending on cost and market considerations, one or more firms may
break though the barrier and, if they did, the incumbent must reconcile to competing with the
entrants.
Two aircraft manufacturers, Boeing and EADS (producers of Airbus) compete in the market
for wide-bodied passenger planes; two semiconductor firms, Intel and Advanced Micro
Processors (AMD), compete in computer processors market. Each of them has to consider not
only cost of production and market demand but the output and pricing strategies of their
competitor.
The output of individual firms and the market clearing price will be different when two firms
compete in the market (duopoly) from that under monopoly. They can compete by adjusting
output, changing prices or establishing capacities. The strategies that they adopt are themselves
their choices. Competition on quantities and prices were analyzed even before the development
of game theory. As seen from the experiences of Selkirk, different strategies can lead to different
outcomes. In the case of duopoly, output and price competition leads to dramatically different
results, resulting in much discussion whether one is more relevant than the other. Recent studies
consider firms using both strategies in competition. Following sections consider all three cases.

The quantum jump from one to two.

Two firms managed by Murphy and Zvi are competing in the market. Any action
contemplated by a firm to increase its profits will affect the profits of the other firm. The second
responds by altering its decisions to make the best of the new situation. Each has to make plans
on the basis of his inference of the other's action. There is no more a unique output that
maximizes a firm's profit but one for each of the anticipated action of the other.
Each firm knows that its price and profits depends on the total output. Since a firm can only
choose its output, it has to make a choice of its output based on its anticipation of the output of
the other firm.
Murphy determines the profit maximizing output for his firm to be 200,000 units, given his
conjecture that Zvi will produce 200,000 and the market price is set to clear the market (equate
quantity demanded to 400,000 units produced).

1
Games are classified into cooperative and non-cooperative games. In cooperative game theory, the players
communicate with each other and make binding agreements. The theory of negotiations based on cooperative game
theory was discussed in Chapter 3. In non-cooperative game theory, players consider that they are competitors. They
make independent decisions and do not communicate with each other.
131

Figure 1. Nash equilibrium: each chooses the best response to the

strategy of the other player.
Notice that Murphy is not observing or reacting to a decision by Zvi; he is considering his best
response given what he believes Zvi would do. What is Zvi doing as Murphy is forming his
conjecture and output decision? He has to make a decision based on his conjecture of what
Murphy will do. Consider one possible conjecture and choice:
Zvi determines that the profit maximizing output for his firm to be 200,000 units, given his
conjecture that Murphy will produce 200,000 units and the market price clears 400,000 units
produced.
Both made the decisions simultaneously, not in the sense that they were made in the same
nanosecond, but did so without any knowledge of the other's choice. In this particular case, their
decisions turned out to be felicitous. Each made conjectures that turned out to be accurate neither
Murphy nor Zvi has any incentive to change their decisions (Figure 1). When no firm can
unilaterally make a change that improves its profit, the strategies of the firms constitute Nash
equilibrium, named John Nash.
It is great if both firms end up in the Nash equilibrium and coexisted in that blissful state
forever. But the analysis as an explanation of business behavior has no credibility if the outcome
is not related to demand and cost considerations. Then the mangers understand why there their
decisions were consistent optimal decisions and to develop an algorithm to determine achieve it.
In retrospect the second turned out to be the harder of the two to achieve.

Cournot's model of duopoly.

In 1838 monograph, Augustin Cournot analyzed one solution for competition of two firms in a
market. The demand for the product is determined by the consumers and the firms take the
market demand curve as given to them (prices and quantities that we cite below are from a
numerical example given footnote). 1 They have identical cost conditions; the constant marginal
1
The numerical example is based on a market demand curve,q=680,000-10,000pwhere q is the sum of outputs of
the two firms and p is the price at which that output is sold. If one firm has monopoly, the marginal revenue curve
will be mr=68-0.0002q and setting it equal to marginal cost of $8, the output of monopolist is seen to be 300,000.
The price in the market will then by $38. With two firms, Murphy's marginal revenue is 68-0.0002qM -0.000qZ. If
132

cost is $8. They make decisions independently of each other and these decisions determine the
output and market clearing price.
Given the demand curve and a marginal cost, Murphy will produce 200,000 units if he expects
Zvi to produce 200,000 units. Given symmetry in costs, Zvi will produce 200,000 units if he
expects Murphy to produce 200,000 units. Their assumption match the actual outputs as in
Figure 1 but the choice is shown to be the outcome of profit maximization by the two firms,
given their expectations of the other firm.
Calculation in Footnote 1 of previous page shows that the output if there was only one firm
will be 300,000 units and the price $38. Competition increased output and reduced price but the
price is still higher than the marginal cost. The downward marginal revenue curve lies below the
demand curve of each firm and intersects the constant marginal cost at a lower output. The
output has to be reduced from one at which the demand curve and marginal cost intersects to
achieve profit maximization and that results in higher price than marginal cost.
Murphy's output is based on his conjecture of the output produced by Zvi. Why should
Murphy and Zvi have consistent expectations as shown in Figure 1? If Murphy expects Zvi to
produce a larger output, he will reduce his output while if the expectation is that Zvi's output is
lower, he will produce a higher output. Various outputs will lie along a curve (a straight line for
the example) that Cournot called Murphy's reaction curve. Similarly Zvi will have a reaction
curve. Cournot argued, under some naïve assumptions about their expectations, that the two
curves will intersect at the outputs that are consistent. Further, if any firm chooses another
output, profit considerations will make it move towards the point of intersection. While
Cournot's pioneering work is to be admired, the assumptions are too restrictive to be accepted as
realistic.

Competing on price - Bertrand's Model.

In the case of a monopolist, it does not matter whether the firm chooses the output or the price;
one will determine the other along the market demand curve. When there are few firms
competing in the market, the choice of the decision variable affects the results. This was brought
out by Joseph Bertrand, a French mathematician, in a critical review of Cournot's work. Consider
as in the last section, two firms producing a homogeneous product under constant and identical
marginal cost. Firms choose prices simultaneously and consumers, who see the output of the two
firms as perfect substitutes, choose to buy from the firm that posts the lowest price. If they offer
it at the same price, then consumers would split evenly between the two.
The two firms have the same marginal cost of $8 and the market demand curve was as in
Figure 2. 1 Suppose Firm 1 sets a price of $15. If the other firm also sets the price at $15, they
will split quantity demanded at that price, 530,000, evenly. Each unit sold $7 over its marginal
cost and the surplus over operating cost of each firm is 0.5 x 530,000 x7 = $1,855,000.
Now look what happens if Murphy decides to undercut Zvi by setting the price at $14.50. Since
Firm 1 offers a lower price, consumers would buy 535,000 units from it (larger quantity because

Murphy expects Zvi to produce 200,000 units, his profit maximizing output will be 200,000 units. The combined
output of 400,000 will be sold at a price of $28.
1
Under the assumptions, average cost equals marginal cost
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of lower price) and, assuming it has the capacity to supply that output, the operating profit of
Firm 1 would increase to 535,000 x 6.5 = $3,477,500. Firm 1 has an incentive to act by itself to
cut its price below $15 and the pair of prices (15, 15) by the two firms cannot be Nash
equilibrium.
Firm 2 will respond to Firm 1's action by setting its price even lower. What made unilateral
price cutting profitable is that price was above the marginal cost and as long as that is true one
firm or the other will cut the price to draw consumers to it. Only the pair of prices ($8, $8) is the
Nash equilibrium for the two firms engaged in price competition.
The works of Cournot and Bertrand laid the foundation for study of interactions among a few
firms. Still the differing results create a dilemma. Do firms use quantity or price competition?
Why should a firm confine to one strategy? Why not use both quantity and price strategies in
tandem?
The result that, under price competition, consumers will switch from one firm to the other at
the slightest price reduction is valid only if the two products are considered perfect substitutes. If
they are viewed as slightly different - Coke and Dr. Pepsi - the change in the quantity demanded
will depend on the marginal rates of substitution of various consumers. The prices will not
plunge to the marginal cost.
If the reduction in price shifts the demand to one of the two firms, it can profit from it only if it
has the capacity to produce the extra output at the same marginal cost. Its output may be
constrained not by the demand curve but plant capacity. This suggests that firms compete by
both adjusting installed capacity and by the price they charge for the product.

Choosing the capacity and setting the price.

Capacity takes time to install and is expensive to create. A new part of a town is bringing in
businesses and hoteliers anticipate demand for accommodation. Like all constructions, building a
hotel involves cost and takes time and, once constructed, it is not easy to change the number of
rooms. Its capacity is limited and rigid. But the prices charged for a room per night can changed
from day to day. How would hoteliers compete in this market?
David Krep and Jose Scheinkman constructed a two-period model to examine competition in
capacity and price. In the first period the firms choose, independently and simultaneously, the
capacity to produce a homogeneous good. At the beginning of second period, each firm knows
the capacity and has to choose the price they are going to charge (Figure 2). Arguing backwards,
guess an answer and then see why it can be justified. If the capacity established in first period is
what would be produced under one-period Cournot competition, what will be the prices charged
in the next period if firms compete on price? The claim is that the common price chosen by both
firms will be Cournot prices and not marginal cost as in single-period Bertrand competition. It is
obvious that Cournot prices, by definition, will clear the quantities demanded when output equals
combined Cournot capacities. Yet the firms setting prices independently could choose another
price, if it more profitable. It needs to be shown that there is no such price.
First consider one of them choosing a lower price. If it did, consumers who consider the
products to be perfect substitutes will want to buy from it. Since its capacity is limited, it cannot
increase output and ends up selling the same output at the new lower price. No firm wanting to
maximize its profits will do so.
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Figure 2. Sequential decisions: setting

capacity and price.
The next step is to show that there is no incentive for a firm to increase the price. If Zvi
increases his price, all consumers try to shift to Murphy's firm. But Murphy's capacity is limited
and he cannot meet the market demand at the price he had set. Zvi's customers who wanted to
buy from Murphy but could not, will go back Zvi. Even if the net result is that Zvi sells a smaller
quantity, he is selling at a higher price and the possibility exists that the he earns a higher profit.
Kreps and Schenkman using some intricate reasoning showed that, if the firms had established
Cournot capacities in the first period, then both firms would not depart from the Cournot (market
clearing) price. In the first period, firms realize that the prices that both firms will choose next
period are the Cournot prices and so they will establish Cournot capacities. In spite of following
Bertrand type competition in the second period, the equilibrium that firms find optimal for two
periods together coincides, in Krep-Scheinkman model, with the Cournot outcome.
Who are the consumers who could not get what they want from Murphy if Zvi charges a
higher price? Murphy can "ration" his output in two ways. Knowing that he cannot satisfy each,
he could give each the same fraction of demand. 1 According to the numerical example, each firm
has a capacity of 200,000. If everyone tries to buy from Murphy, he could sell each half of what
they want. The other possibility, "Beckmann rationing," is for Murphy to sell whoever comes
first; it is like a sale that last as long as the product is in stock. It has been shown that Kreps-
Scheinkman result holds only if Murphy uses the first type of rationing.

Can pursuit of individual betterment be self-defeating?

Cournot, Bertrand and two-period games discussed show that the outcome of the strategy one
player adopts depends not on the strategy of his competitor.

1
Governments rationing essential goods in times of scarcity use this type of rationing as they consider it to be “fair.”
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Figure 3. Persuing individual interests lead to a bad choice for all.

Bertrand model with two firms producing identical product showed the possibility that prices
can spiral down to marginal cost with firms ending in losses. Airline fares are easy to find out
from various websites and price cuts can be easily confirmed. There are periods when one major
airline in the United States will cut the fare and then other major lines will match it though all
airlines. Then one airline will increase it but others will not match and the airline that increased
the fare will have to cancel the fare increase. The competitive cuts in fares end all airlines in
losses. The average fare increases by 18.3 per cent from $292 in 1995 to $346 in 2008. The
increase was much less than the increase in general price level. When adjusted for inflation, fares
actually decreased by 16.2 percent in this period. Due to economizing in travel following the
recession of 2007-2008, the airfare fell to $309 in 2009. 1
Consider a duopoly shown in Figure 3. Each firm has two possible strategies: choose a high
price or a low price. The profit of each firm is shown by the height of the box of appropriate
color. Suppose Firm 1 decides to charge a high price. Firm 2 can charge a high or low price
(Panel A) and finds that its profit is higher when it charges a lower price. If Firm 1 selects the
lower price for its product, Firm 2 is better off charging a lower price (Panel B). Whatever price
Firm 1 charges, Firm 2 is better off charging a low price. When a player in a game has a strategy
which it prefer irrespective of what the other player does, it is said to have a dominant strategy.
Firm 1 considers how it will respond to strategies of Firm 2. If Firm 2 chooses a high price,
then consider the left column in Figure 3, Firm 1's profit is higher if it chooses a lower price. If
Firm 2 chooses lower price, the right column shows that Firm 1 is better off by choosing a lower

1
U.S. Bureau of Transportation.
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price. It has a dominant strategy, to charge a lower price. Both firms follow their dominant
strategies and end up with profits shown on the lower right side of Figure 3. Comparison of the
left top pair of boxes shows that the both firms will have higher profits if they had chosen the
higher price. But if one charged the higher price, the other earns a higher profit by charging a
lower price and forces the first to move to a lower price. Individual decisions led collectively to a
bad choice.
If this is just one example of firms choosing price, it could be dismissed as an aberration. But
it can arise in any context where individuals interact strategically. A well-known example is of a
prosecutor negotiating plea bargaining.
John and Matthews are suspected to be partners in a crime. The prosecutor knows that he does
not have enough evidence to get a conviction. So he negotiates with them independently. He tells
Matthews that if he confesses, he will ask the judge to give him a lenient sentence but if he
refuses and John confesses, he will get a very harsh one. Matthews knows that if neither agrees
to plea bargain, both of them will go free but he cannot trust John to reject a similar deal that the
prosecutor will be offering him. The net outcome is that both confesses and has to do time in jail.
From this widely discussed example, self-defeating behavior due to lack of coordination and
enforcement of agreements is known as "Prisoner's Dilemma."
Thomas Hobbes argued that the "state of nature," or societies without a government are nasty
and brutal. Mutual respect of life and property benefits all but each one is tempted to encroach on
another for immediate benefit. The result is mayhem. Hobbes made such behavior a justification
for a strong government to enforce law and order.
One of the contemporary issues is controlling pollution. Equipment to clean effluents adds to
the cost of production. Car owners have to pay more for cars with catalytic converters while
electric cars are have only limited range. If everyone other than you adopts these measures, you
can enjoy the benefits without incurring the costs. Yet if everyone uses that logic, the
environment will be polluted and no one benefits.
How prevalent is Prisoner's Dilemma? Is it possible that the players will develop enforceable
coordination mechanism without it being forced on them? In 2008, airlines in the United States
started charging for fee for luggage and no airline tried to undercut the other by abandoning the
fees. 1 When players have to interact repeatedly, they will be willing to abide by an
understanding, explicit or implicit, to choose what is mutually beneficial.
A large number of experiments were conducted to test how people will respond to situations
where Prisoner's Dilemma can arise. The results indicate that cooperation is more than what one
would expect if everyone was strictly maximizing their utility. On the other hand, a sizable
percentage of players depart from the cooperative solution. Whether utility maximization is
bound by a commitment for higher morality - as citizens we have to give to charities or blood
drives and even agree for tax increase to improve schools even if we have no kids - continues to
be debated.

1
This is true of airlines that introduced the fees. SouthWest Airlines never charged the luggage fees.
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Nash equilibrium.
Not every interactive situation has dominant strategies for each player that results in a unique
solution. Sometimes one player has a dominant strategy and more commonly none have
dominant strategies.
In the conflict between Alexander Selkirk and Thomas Stradling on whether Cinque Ports
should be repaired before sailing or not, Selkirk did not have a dominant strategy. If the ship was
repaired, he had no reason not to sail with it but if it is not repaired and was in danger of sinking
(which it did), he was better off being stranded in the lush Island. Whether Selkirk agreed to
continue or not, Stradling (as far as the situation can be reconstructed from narratives that are
available) was better off repairing the ship than sailing on a worn-eaten one. 1 If Stradling had
acted rationally and chosen the dominant strategy, then Selkirk would have gone abroad and the
game has a unique solution.
In many games, no player has a dominant strategy. Can such games have a solution and will it
be unique? John Nash in 1950s extended the concept of solution to many games that could not be
solved otherwise. Nash equilibrium is a set of strategies for each player such that it yields him at
least as high a reward (in dollars or utility) as any other that he can choose provided all others
remain with the strategies they choose.
The Cournot and Bertrand equilibrium are the Nash equilibriums of two games. Even if they
are the same firms producing the same product, the two equilibriums should be viewed as that of
two separate games as the strategies used by firms in competing are different.
Many games in which players choose one of many strategies may have no equilibrium
solution. A simple example is where two players playing head or tails. If both announce head or
tail the second player has to pay the first player a penny (traditionally this game is described for
such a small bet). If one player announces head and the other tail, irrespective who announces
which, the first player must pay the second a penny. If the first player suspects that the second
player will make a call that does not match with his, he will change as he prefers not to lose a
penny. If the second player suspects that the first player will match his call, he will change to
gain a penny. But the game has equilibrium if each calls head or tail with probability 0.5. In that
case, half the time they will match and half the time they will not and each has an expected gain
of zero penny but neither has an incentive to change the strategies they have adopted.
The contribution of Nash was in showing that any game with finite number of strategies has at
least one equilibrium solution if the players switch between strategies with appropriate
probabilities. This result considerably expanded the number of games with solutions and made
wide use of game theory in economic analysis feasible. The problem is that Nash equilibrium is
not unique for many games and subsequent research game theory is to develop criteria to reduce
the set of Nash equilibriums for a game.
Summing up.
The interactions among individuals in a society can take many forms. In some cases, they
communicate with each other and arrive at binding agreements. Cooperative game theory

1
The claim that repairing the ship was a dominant strategy implies that Stradling did not act rationally. It is quite
possible that Stradling infuriated with a shipmate challenging him acted irrationally. Economic analysis of games
assumes that players act rationally
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provides a framework to analyze decisions within a family, negotiations for sale of a house or
salary negotiations.
In other type of interactions, the parties are competitors. Firms that produce the same product
for a market, even if they are willing to communicate, are prevented by antitrust laws from doing
so. They have to decide on what output or price will maximize their profit based on what they
expect their competitors will do. Cournot considered two firms competing by changing their
output and showed that in the duopoly market output will be greater than under monopoly and
for prices less, given identical demand curve. Bertrand considered the firms competing by price
cutting and concluded that they will cut the prices till both are equal to the common marginal
cost. In Kreps-Schenkman model, firms choose the capacities first and then compete on prices.
The price that clears the market is the Cournot price.
There are circumstances where individuals competing ends up in making a choice that is
worse for all than one they could have achieved by coordination. The wide applicability of
Prisoner's Dilemma to economic and social decisions has led to extensive debate its logical
foundations and for many experiments to test whether players really behave as postulated in the
game.
There are many games without dominant strategies and, without a method of finding
equilibrium strategies, applicability of game theory was limited. John Nash proved that a set of
strategies from which no player will unilaterally deviate exists for a wide class of games.
Assumptions of rationality includes the question that the outcomes of the game are evaluated
on purely what it does to the individual or whether he accepts a moral code that requires
consideration of some social benefits.
Bibliographic note:
Binmore (2007); Kreps and Scheinkman (1983); National Geographic Magazine (2004);
Osborne (2004); Shy (1995); Souhami (2001); Triole (1990).
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Chapter 11. The competitive markets.

We join the crowds at open markets, stores or malls to choose from array of products offered
for sale there. Each one chooses a few products and each product is brought by many. No one
buys a sizable percentage of a product and no customer has the leverage to affect the prices.
Can a producer influence price? When we go to a farmer’s market, we see different sellers
selling bushels of corn, tomatoes or potatoes. None can set a higher price on any product than
others as all we have to do is to move to the next stall to get an identical product cheaper. When
we buy manufactured products at a department store, we do not see different producers selling
homogenous products. Products are branded and each band is produced by one producer. Since
branding differentiates products, can producers of different brands charge different prices?
Discussion of monopolistic competition showed that high prices and profits induce new firms
to enter the market and that entry reduces the demand for each of the existing brands at the
current prices. Firms adjust output and price to respond to the shift. In this chapter, we consider a
case where many producers sell a homogenous product and the competition for consumers is so
great that the producers have to accept, like those in the farmer’s market, the prices that prevail
in the market.
How common is such conditions? Even though each brand is produced by only one firm, we
find in any store many brands of electronic goods of comparable quality. It is different in
automobile industry. Showrooms have only car or trucks of one division of General Motors or
Ford or Toyota. While side by side comparison of different brands is not possible, a buyer can
consult Consumer Report or automobile magazines for comparison. Interned is another source of
information. Before the reductions in automobile industry following the 2008- 2009 crisis, there
were around twenty models competing in market for family sedans. If the price of one brand was
significantly above the average of other brands, consumers will switch and the producer will find
that he has to cut prices to regain market share.
When a firm introduces an innovative product, it can charge more than products in its group.
Responding to this competition, other producers will introduce brands of comparable quality - a
process that results in what is known as commodification or commoditization of the product –
and prices begins to fall. In service industry, airlines in spite of brand names found that their
influence in fares is limited; through the last decades of twentieth century, if an airline increases
its fares and others did not then the airline is forced to reverse the fare increase. A competitive
market is one in which neither individual producers or consumers can affect the price through
their decisions.
Vilfredo Pareto considered a market to be efficient if the allocation of resources is “beyond
improvement” in a specific sense that none can be bettered while others. It is always possible to
rob Peter to pay Paul but if Peter can be made better off without hurting anyone else, why not do
so? Pareto’s argument is that a use of the resources in the economy that does not exploit such an
opportunity is inefficient. By exclusion, an efficient economy is one in which such inefficiencies
do not exist. One of the achievements of twentieth century mathematical economics is show that
an economy in which all markets are perfectly competitive will have a Pareto efficient allocation
of its resources. This is reason enough for considering competitive markets.
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Figure 1. Variation of marginal revenue with price.

Marginal revenue and marginal costs: guide-posts to profit maximization.

The variation of the marginal revenue and marginal cost with output is decisive in
determining the profit maximizing output. In earlier chapters on monopoly and monopolistic
competition, the technology of the firm was assumed to be such that the marginal cost was a
constant. The firm can increase its sales only by reducing the price and the marginal revenue
decreases as output increasing. The decreasing marginal revenue provided the constraint as the
output where it equals marginal cost is the profit maximizing output.
Under perfect competition, each product is produced by many firms. Each firm is so small
relative to the market that it can increase its sales without affecting the market price for the
product and marginal revenue, as shown below, is constant. If both marginal revenue and
marginal cost are constant, they were never (except by accident) be equal to each other. If
marginal revenue is greater than marginal cost, the firm can keep expanding as it never reached
the profit maximizing output. If it does, it ceases to be one of many firms in the market but more
significantly such expansions are not observed in the economy. The constraint has to be come
from the cost side. The increasing marginal cost must be forcing the firm to limit output.
Marginal revenue. An increase in output by one firm does not lead to a reduction in the
price of the product. If thousand units of a product are sold at $3 each, total sales revenue is
$3,000. If sales increase to 1,100 units, its sales revenue is now $3,300. Each additional unit
increased sales revenue by $3; marginal revenue (increase in total revenue per unit increase in
sales) equals price as shown in Figure 1.
Even though marginal revenue does not change with output, it will increase or decrease if the
market conditions lead to a change in the price of the product. If price increases to $3.50, then
the marginal revenue will also increase with it to $3.50. Given the cost structure, every shift in
marginal revenue increases or decreases the profit maximizing output.
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Figure 2.Drag and thrust needed to counter it.

Marginal cost. Changing the manufacturing facility requires planning ahead, raising finance
and ordering capital equipment. The firm cannot change it in the short run. If output is very low,
the fixed cost associated with the financing and maintenance of this facility has to be spread over
a few units. If, on the other hand, the output is increased beyond a level, the fixed input is
strained as it is combined with many units of variable input to increase production. In short, the
marginal cost (and average cost) are not constant any more. The justification of variable costs
when all inputs are variable is more complex and controversial. Instead of beginning with an
abstract discussion of variable costs, the next section summarizes a management accounting
study of the cost of flying a plane at various cruising speeds. It brings out how technology
determines cost variations and provides an introduction to U-shaped average cost curves.
Cost management of aircraft operation
A study by Burrows et al focuses on three specific costs - the cost of fuel; salaries of pilots
and cabin crews; and cost of maintenance directly related to flight time vary with cruising speed.
The following discussion focuses on fuel costs.
Isaac Newton’s law of motion can be used to analyze the flight dynamics of a plane. There
are two forces that impede the flight of steady flight of a plane at fixed altitude. The first one is
the drag of the air. When we walk or even run in calm weather, our speed is not enough to make
us notice the resistance of air. However if the wind is blowing in our direction, then we have to
strain to walk against it. When cycling, the resistance offered the flow of air around us is
noticeable.
Airplanes flying at great speed have to move large quantities of air around it and it creates a
drag that retards the flight (Panel A, Figure 2). There is also friction between air and the surface
of the plane. The drag depends on the shape of the plane, its surface, the speed and the properties
of air around it and it increases with the speed of the plane. The engines have to generate power,
thrust, to push the plane against the drag and the power needed increases quickly with the speed
of the plane (Panel B, Figure 2).
The second force acting on the plane is gravity which pulls objects towards the earth. Kites
were the first heavier-than-air object designed and built to fly and it does so by the using the
steady wind above the ground level to counter its weight and the tension of the string that the kite
flyer holds. A commercial plane weighs tons and needs more than the lift of the natural air
stream. Instead, the forward flight of the plane creates airflow over its wings that provide the lift
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Figure 3. Lift and power required to generate it.

(Figure 3). At any speed, the lift depends on area of the shape of the wing, the angle by which
the air stream is tuned down, the relative speeds of air above and below the wing (sue to the
shape of the wing) and the density of air. When plane flies faster, the airflow increases leading to
an increase in the lift. Engines have to strain less against gravity and this leads to saving of the
power needed to generate lift.
The total power that engines have to generate to keep the plane flying at a constant speed and
altitude is the sum of power for thrust and lift and this is obtained in Figure 4 by adding up the
two curves in the right hand panels of Figures 3 and 4. As plane accelerates from low speeds, the
reduction of power for lift will exceed the increase for thrust and the sum will decrease. At
higher speeds the drag of air increases more than the decline needed to generate lift. The total

Figure 4. Total power that engines have to

generate at different cursing speeds.
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power that engines of the plane need to generate decreases as speed increases from low level and
then increases; this is shown by a U-shaped curve in Figure 4.
The total fuel cost of a flight depends on fuel consumption per hour and the time of flight.
Calculations using flight management systems show that total fuel cost of a flight by commercial
plane as cruising speed is varied has a U-shape. When cruising speed increases from 0.76 Mach
(ratio of the speed of plane of to that of sound in the air) to 0.78 Mach, total fuel cost for a flight
of 7000 nautical miles of a commercial plane decreases from $25,250 to $25,000. But further
increase in speed to 0.8 Mach leads to higher the fuel cost of $25,275. 1 The average cost or cost
per mile will also be U-shaped. 2
The airline example is interesting in that cost variation can be explicitly related to the
dynamics of flight. In manufacturing firms, the multiplicity of processes and complexities of
each prohibit such direct derivation. The current view of the shape of cost curves evolved over
hundred and fifty years following the publication of the Wealth of Nations as economists sought
to understand the nature of costs.
Variable proportion: Explanation for variations in marginal and average costs.
It is pressure of population on cultivable lands that led economist to conclude that marginal
product (increase in output per unit increase in an input) can vary with output. In any region, the
most fertile land will be cultivated first and then, as demand for food increases, the cultivation is
extended to less fertile plains. The output per acre will fall. Another possibility to increase output
is to cultivate each acre more intensively. This requires application of additional labor (to plow,
to weed, to fertilize) and again incremental labor has lower marginal product.
Robert Malthus (1766-1834), an English clergyman and writer in economics, claimed that
population will periodically outstrip agricultural supply leading to famines and pestilence.
Improvements in irrigation, new and better fertilizers and the green revolution have increased
agricultural output beyond what could be imagined in the end of eighteenth century.
Adam Smith argued that the division of labor in industry will increase the productivity of
workers. Marginal product increases with specialization made possible by higher outputs. Alfred
Marshall combined the two arguments and attributed both increases and decreases of marginal
product to variation in the proportion between inputs.
Marginal product and marginal cost. There are inputs like installed machinery that takes
time to change while others like employment can be increased much more rapidly. An increase
in variable input increases its ratio to fixed input. In the beginning, “the better utilization of the
fixed input” will lead to quick increases in incremental output or marginal product of the variable
input. After a limit, the flexibility of the fixed input to combine with ever increasing quantities of
the variable input is strained and the growth in output slows down.

1
The calculation made by Burrows et al is for a hypothetical flight of 370 seat BB-400 plane for 7,000 nautical
miles. The price of fuel was set as $0.25 per kilogram. The article notes that while the cost changes look modest, a
$150 savings per sector for an airline that serves 20 similar sectors daily will produce an annual savings of $1.5
million. It is a significant number given the razor-thin profit margins in the industry.
2
In the familiar case of driving a car, the miles per gallon decreases with speed and increases gasoline consumption
for a trip.
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Figure 5. Changes in output as employment increases.

Confining for ease of discussion to the case of two inputs and one output, consider the
increase in output of a small workshop as more laborers are hired ( Figure 5). With the hiring of
the first employee, the firm produces 5 units. When the second employee is added, the output
increases to 12, making the incremental output after hiring the second employee or marginal
product of second employee, 7. Marginal product is measured by changes in total output as
production is the result of cooperative action by the fixed and variable inputs in the plant. The
second employee did not produce 7 units; rather the two employees together produced 7 more
units than the first employee. Still the marginal product defined as increase in total output for
unit increase in input increased from 5 to 7. The output when three employees work in the plant
is 16; the marginal product of labor declined to 4.
The switch from increasing returns to diminishing returns was attributed to the ratio of
variable input to fixed input exceeding a limit and the two cases were subsumed under what
came to be known as law of variable proportions.
The cost of production will depend on the price and productivity of inputs. The costs incurred
in financing maintaining the fixed input is the fixed cost and that from variable inputs is variable
cost.
Marginal cost is calculated from the variable costs. Take a wage rate of $14 per hour or $112
for an eight hour day for the laborers in Figure 6. The first employee produced 5 units or the
marginal cost of producing any one of the five units is 112/5 = $22.40. After hiring the second
employee total wages doubled to $224. For an additional cost of $112, the firm was producing 7
more units and the marginal cost fell to $16. The third employee increased wages by another
$112 and output by 4. The marginal cost is now $28. Marginal cost decreased when marginal
product of labor increased and it increased when productivity decreased.
The average variable cost will also vary with output and its variation can be related to
marginal cost. When only one person was employed, average variable and marginal cost were
both $22.40. With an additional employee, marginal cost declined to $16 and average variable
cost to 224/12 = $18.67; notice, for contrast with next change in output, that marginal cost at the
new output is less than average variable cost. When one more employee was added, marginal
cost increased to $28 and average variable cost went up to $21; marginal cost is now greater than
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Figure 6. Marginal and average variable cost

average variable cost. For simplicity in calculations, these examples considered discrete changes
in variable input and output. The relation between the two costs can be precisely stated when
variable input and output are changing continuously. Average variable cost will decline with
increases in output if marginal cost is less than the average and increase when marginal cost
exceeds average variable cost. The intuition is that new unit costs less than the average cost of
earlier ones and addition pulls down the average. This result can hold only if marginal cost curve
intersect average variable cost at its lowest point; outputs for which marginal cost is less than
average variable cost lies to one side and those for which average variable cost exceeds marginal
cost to the other (Figure 6). 1
Output of a competitive firm in the short run: Profit maximization requires marginal
revenue to equal marginal cost. The marginal revenue of the firm is the price and as price
changes, the firm will change its output till marginal cost is equal to the new marginal revenue
(Figure 7). This relation permits drawing the individual supply curve of the firm which relates
quantities supplied by the firm at various prices. At the price , the firm will produce an output
determined by the intersection of price line and the marginal cost curve. As price declines to ,
the price line shifts down and the new and lower output is given by its intersection with the
marginal cost curve. In general, as price varies, the output corresponds to points along the
marginal cost curve making it the individual supply curve of the firm with one caveat. The
supply curve (not marginal cost) is truncated at the lowest point of the average variable cost. If
the price is below the minimum average variable cost, then the revenue from any unit sold is less
than the cost of variable inputs like labor used to produce it. The firm is better off by not
incurring these costs. Firing all the laborers, the firm will shut down the plant. The individual
supply curve is the marginal cost curve above the average variable cost.

1
While U-shape of the average variable cost curve and its relation to its marginal cost curve are derived from
increasing and decreasing returns, the specific shape and position of the curve will depend on the technology used
and input prices.
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Figure 7. Individual supply curve of a competitive firm.

In the market, there are many firms. The output of each firm at any price is determined by its
individual supply curve. The total quantity supplied to the market at any price is the sum of the
outputs of individual firms at that price. Figure 8 shows adding up of the outputs of two firms for
two prices. At price the quantity supplied by the first firm is Q and that of second firm is Q’.
The total output is Q + . At the lower price, the output of first firm is q and that of second is q’,
making total output q + . The market supply curve can be obtained by following this procedure
to add up the individual supply curves of all firms in the market.
Market supply curve and market clearing price.
In the market, the quantities demanded by consumers at different prices are represented by
the market demand curve reproduced in Figure 9. 1 Matching this with quantities supplied as
represented by the market supply curve of Figure 8, the relative quantities of the product
demanded and supplied at various prices can be compared. As shown in Figure 8, at high price
the firms supply a quantity in excess of what is demanded and there is excess supply. The unsold
inventory leads to price cutting.
At low price, there is shortage as quantity demanded exceeds quantity supplied. The price

Figure 8. Market supply curve with two individual

supply curves.
1
The market demand curve was discussed in detail in Chapter 5.
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Figure 9. Market clearing price in a competitive

market.
begins to increase. Given smooth demand and supply curves, there is only one price at which the
quantity supplied equals the quantity demanded. Whatever the producers bring to the market is
cleared. Another perspective is that if this price prevails in the market, no producer or consumer
will have any incentive to change the production or consumption decision and, in this sense, it is
the market equilibrium price.
The buildup of inventory when price is high or shortages when price is low does not imply
that the market will not move instantaneously to the market clearing price. The adjustment
process depends on behavioral and institutional factors. Any time, the price prevailing in the
market may differ from the equilibrium price for any number of reasons. Either the demand or
the supply curve could have shifted in the recent past. Such shifts occur as changes in tastes and
income of consumers shifted the demand curve or as entry or exit of sellers shifted the supply
curve. Depending on the market response, the price instead of moving quickly to a market
clearing price instantaneously frequently fluctuates around it.
Producers devote considerable resources and efforts to make more realistic estimate of
demand for future. Products can be stored in inventories and firms can test the market by starting
with a high price and then discounting. Still it is not possible to correctly predict prices and
quantities demanded. In recent years, there have been frequent shortages of electronic goods as
demand was underestimated. Prices of agricultural crops go up as soon as crop damage due to
climatic conditions is predicted only to fall back when the loss estimate was found to be too
large. The fluctuations continue even as more sophisticated methods are developed to predict
future demand.
Long run: marginal cost when all inputs are variable.
The increase in marginal cost as output increases was attributed to the variation in the ratio of
the fixed and variable inputs. Given enough time fixed inputs like manufacturing plants can be
changed, adding capacity if there is demand for the output and downsizing or closing if demand
is decreasing. If all inputs are doubled, will not output double? If the input market is competitive
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and demand by one firm do not affect prices, the doubling of the quantities of all inputs will
double the cost but average cost will remain constant and marginal cost will equal it. What limits
the output of a firm in the long run?
One possibility is that as firms become large, the constraint comes not from production
technology but from ability of the management to supervise the firm. How small or large the
firm, it has only one chief executive officer (CEO) and his time and capabilities are stretched as
the operations within the firm becomes extensive. He can delegate some of the responsibilities
and the development of middle management in large corporations is a sign of it. It however
increases the coordination problem among decision makers. American industries go through the
cycles. In one phase, the firms go on an acquisition binge claiming that it will reduce costs
through synergy among the merged firms. It is followed by another phase where the firms sell
off many divisions to concentrate on core competence. Managerial ability seems to be as binding
a factor as technological ones.
Over time technological changes increases productivity of inputs and reduces cost. Adam
Smith argued that factory operations that breaking manufacturing into small repetitive operations
that are supported by machinery increases workers’ productivity. In recent years computers and
robotics are at the forefront of enhancing productivity and reducing costs.
The discussion shows many possibilities in the long run when firms have wider choice of
technologies but there are no clear indications that one of these factors has a dominant influence.
Entry and exit of firms into a competitive industry.
In a competitive market, by definition, firms are free to enter or exit; any market where it is
not so is not a competitive market. Differing for a moment why firms enter, consider the effect
on market supply curve as new firms enter. The output of the new firms at various prices must
now be added to the output of firms; instead of two firms in Figure 8, now there are three firms
and the individual supply curve of the entrant should be added to those of the market demand
curve obtained by adding the other two (Figure 10). It shifts the supply curve to the right and, if
there are no changes in the demand for the product, the new market clearing price will be lower
but the market clearing quantity will be greater as shown in the diagram.
The motivation for entry or exit is the profitability of firms in the industry. The profit is sales

Figure 10 . Entry of new firm and effect on market clearing price and
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revenue minus total cost. The total cost incurred by the firm has two components: (i) the fixed
cost are cost that do not vary with output and includes administrative overheads and the
providing a competitive return for the finance provided to construct and maintain the plant and
its operations; and (ii) the cost of purchasing variable input like labor and raw materials.
Dividing these costs by output, the average cost can be written as sum of average fixed cost and
average variable cost. Comparing price with average cost at the profit maximizing output, there
are three possibilities each of which need consideration: (i) average cost is less than price; (ii)
average cost is less than price; and (iii) price equals at average cost. If average cost is less than
price, then the owners or shareholders of the firm is earning a return in excess of the what they
could have earned in alternate investment (as the cost of obtaining the financing for the firm is
already included in the fixed cost); they are making an above normal returns. This will motivate
others to enter the industry and as shown in Figure 10, price will fall. If price is below average
cost, the owners are making a return less than that in other industries or even making a loss. They
will get out of the industry and the dropping of each firm shifts the market supply curve to the
left (reversing the process in Figure 10) and prices will increase. Entry or exit will cease when
the price equals average cost. 1
A quick note on the efficiency of competitive economies: Two results under perfect
competition stands in direct contrast to those of monopoly or monopolistic competition. First
entry and exit ensures that price equals average cost and that the owners or investors of the plant
are not earning a return on their investment that exceeds that they could have earned elsewhere.
Second price equals marginal cost; the cost to consumer of an additional unit is the cost to
producer of producing that unit. If this relation did not hold, there is a reallocation that makes
consumers and producers better off. To get an intuitive idea of the reasoning, consider the firm
selling another unit at a price between marginal cost and the current price without changing the
price of other units (like airlines discounting the fare on an empty seat closer to the flying time).
Firm is better off as its operating income increased by the difference between the discounted
price and marginal cost. The consumers are better off as one consumer who was not buying it is
consumes it (the price now is not greater than what she is willing to pay for it).
However this is a very partial view of changes that affect the welfare of individuals.
Increasing the output of one product requires the firms to use resource that could have been used
to produce other outputs. This changes the composition of outputs and the use of inputs that are
provided by household to firms. They earn their income by providing labor services to firms and
letting firms use their assets like their savings. Both firms and households transact in two sets of
markets, in one as buyers and in another as sellers. This double interaction has important
consequences to the economy.
Pareto efficiency requires that the multi-person economy is allocating resources so efficiently
that no further improvement is possible; there is no reallocation that can make one better off
without hurting another. Looking beyond changes in one output to the economy as a whole, an
allocation is Pareto efficient only if the answers to the following three questions are all negative:
(1) Can a reallocation of existing products among different consumers make some consumers

1
Over the long run, firms can change plant, adding or reducing capital. This changes the shape and location of
average cost curves. The complex reasoning is avoided in this presentation. The bottom line remains that price will
tend to minimum average cost showing that the product is produced in the most cost effective manner.
150

better off without hurting anyone else? (2) Can a reallocation of inputs among firms producing
the same product increase the output of one firm without reducing that of another? and (3) Is it
possible to increase the output of one industry by diverting inputs to it from other industries and
allocating the changed outputs of industries among consumers make some consumers better off
without hurting anyone else? These questions suggest that the condition for attaining Pareto
efficiency is very difficult to achieve. One of the achievements of modern economics is in
showing that if all markets - input and output - are perfectly competitive, the resulting allocation
in Pareto efficient. This result sets a benchmark to evaluate the markets that prevail in different
economies at different times. As a prelude to discussion the efficiency of an economy, the next
section takes a look at the structure of input markets.
Review of input markets.
For bringing out the central characteristics of input markets without too much complexity,
they are grouped into two: labor market and capital market.
Labor markets. The most striking characteristic of labor market is that what are sold are the
services of individuals whose welfare is the goal of liberal societies. The diversity of individual
preferences that influence the purchases of products also influences the sale of services in the
labor market. A bag of potatoes does not care whether it is baked or boiled or where it is
transported. We have preferences for the work we do; we have invested in the education and
training that qualified us for the work and our skills improve with practice. We expect salaries
that are commensurate with our skills and the difficulties of the work we do. We care for
environment in the work place; we are very responsive to incentives and sensitive to how we are
treated by our colleagues and superiors. We also reluctant to move from the community we are
living as breaking social connections impose a personal cost on us. In the end, the goal of a
liberal and democratic society is to maximize the welfare of individuals and economic
institutions and social policies have to accommodate our work preferences as much as our
consumption preferences.
While these considerations are true at individual level, we see economic opportunities direct
individuals to industries where there is a demand for labor. Adam Smith wrote: “If in the same
neighborhood, there are any employment more or less advantages than the rest, so many people
will crowd into it in the one case, and so many others would desert it in the others, that its
advantage would soon return to the level of other employments.” 1 (Wealth of Nations, p.111). As
an industry whether information technology, oil or real estate becomes profitable and expand,
there is a rush to be trained in the professions that provide entry into them. The extent of
international migration shows that individuals are willing to move to areas where opportunities
exist. In the beginning of twenty-first century, United Nations estimates that 175 million people
are living in countries other than where they were born. 2 Shortages will bring about an increase
in labor force, though the adjustment may be more painful than in the commodity market. This
provides a justification for assuming that firms can hire employees at the current wages.
Capital markets. We finance the purchase of a house partly with our savings and the rest
(generally the larger fraction) with a mortgage loan. To establish manufacturing plants, retails
stores, centers that provide services - health care centers and telecommunication facilities, for
example - firms need to invest in physical capital. This is financed by past profits retained by the
1
Wealth of Nations, p.111.
2
United Nations (2002), p.1
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Figure 11. Financial intermediation.

firms, additional loans from financial institutions or through issue of new equity; the percentage
of funds from different sources varies with industries, with countries and over time.
Considerations that go into the choice of the mix between loans and equity will be discussed in
Chapter 11; till then it is assumed for simplicity that firms raise all the needed funds through
loans.
What is the source of funds for the mortgage company that gives us the loan to buy the
house? It may have issued complex securities to other financial companies but these companies
need to generate funds to purchase the securities. Going down the chain, however long that is, it
ends in the households who have savings to lend or invest. 1 Through deposits in banks or mutual
funds and through purchase of securities, household savings get transmitted through the financial
system to make investments in physical capital. This process is known as financial
intermediation. In short mortgage industry is fully financed by our savings though our
individual house is financed mostly by savings others.
Just as laborers are attracted to industries with higher wages until the difference evaporates,
so funds will flow into industries that earn an above-normal profit; here normal profit is defined
as what investors could earn in alternate investments. The funds that flow into the industry can
be used either to finance expansion of existing firms or start new ones. Either way the industry
increases the absorption of inputs and adds to its output.
As inputs, labor and capital, moves from one industry to another, it changes the outputs of
those industries. It could also have an effect on wages and returns to equity.
Interactive equilibrium of the three markets.
We set explicitly or implicitly budget for our purchases for the coming week or month and
we make our purchases in the commodity market. Our budget for purchases is closely related to
our earning which is based on our income from employment and our earnings from our assets. In
any period, our expenses though it may be less or more than our earnings. If our expenses are
less than our income, the savings are invested in the financial markets though banks and other
financial institutions; if expenses exceed income, then we borrow to bridge the gap. Every one of
us is to a greater or less extent transacting in product, labor and capital markets.

1
Technically retained earnings of a company belong to its shareholders. Because of separation of ownership and
management, the decision not to distribute the profits but plough it back is generally made by the upper
management.
152

Figure 12. The flow of goods and funds between sectors.

Starting from the bottom of the figure, we see two types of flow through the commodity
market. The black arrow from the factories to the commodity market indicates the goods and
services producers supply the market. 1 The black arrow emanating from the commodity markets
to the left indicate what is sold to the households. The payments by households for their
purchases are shown by a green arrow directed to the commodity market. The funds are
transmitted to the suppliers who record it as their sales revenue. This pattern will be repeated in
the other two markets also: there is a flow of services or assets in one direction and a reverse
flow of payments for them.

1
The commodity market groups together all the markets for individual products that are bought and sold in this
economy. This is an expedient to show the interrelationship between the three groups of markets. While only
production of goods by the factories is visually represented in the diagram. The symbol for factories should be
interpreted to stand for institutions like universities, theatres and hospitals that provide services that consumers want
to purchase.
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Each market has characteristics that separate it from others. Commodity market was
discussed in detail in earlier chapters and labor market and financial market will be discussed in
in coming chapters.
Even though all flows into the market and from the market are funds measured in dollars, the
flow from the households to financial institutions and from them to the firms are shown as
orange arrows while the interest and dividends that firms pay are shown as green arrows.
Figure 12 shows that though there are different markets and there are many flows thorough
each of them, they all begin or end at two foci: the household and firms. Any change in any one
of the flows will bring about responses from household and firms and that will affect other
markets. If firms hire more laborers, then the income of household from offering labor services
increases. Part of the increased income would be spent on buying goods and services, part on
savings; the split will depend on individual preferences. The increased demand for goods and
services in turn leads to a higher level of sales, higher sales revenue and increased profits. Part of
the increased income of households that is saved increases the flow of funds into financial
institutions which are then willing to lend more to other households and firms. The Japanese
economy suffered a long recession partly due to lack of consumer demand around the same time
when consumer demand was a source of strength for the U.S. economy; the crisis in mortgage
lending in 2007 brought with it the treat of recession.
Consideration of the interaction among markets, known as general equilibrium analysis,
contrasts with the partial equilibrium analysis of earlier chapters which focused on one product.
The analysis was developed in the third quarter of the nineteenth century by Leon Walras and
refined by Kenneth Arrow and Gerald Debrue in the twentieth century. Still partial equilibrium
approach continued to be the dominant paradigm in economics due to its ability to derive results
like the ones in early chapters. The two approaches are consistent if the effect of changes in one
market on others can be neglected or if the price ratio between any two other products is not
affected by changes in the market.
The first theorem of welfare economics states that if all the markets in the economy (markets
for different products, for different types of labor services and loans of different maturities and
risks) are all perfectly competitive, then the market system brings about an allocation of
resources in the economy that is Pareto efficient.
Efficiency of competitive equilibrium.
In Chapter 3, the exchanges between Robert the farmer and George the fisherman, living by
themselves, was considered. Robert and George exchanged at a price ration that lies between
their marginal rates of substitution. As exchange continues their marginal rates of substitution
will converge due to the rule of diminishing marginal rate of substitution. When the two are
equal, there is no further opportunity to exchange that benefits both of them. However, given the
initial difference in the marginal rate of substitution, there are many possible exchanges that will
equate the marginal rates of substitution of the two but at different values.
Modern general equilibrium analysis establishes the efficiency of competitive economy
without any restrictions on the number of types of individuals or the number of goods. Can the
reasoning about George and Robert be extended to exchanges involving many consumers and
many products? In a competitive economy, no individual has influence on the prices of goods as
his or her demand is an infinitesimal part of the total output of each product. When the consumer
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Figure13. Condition for cost minimization in a competitive market.

chooses the preferred basket, she equates the marginal rate of substation between any two goods
to their price ratios. Since all consumers pay the same prices for goods in the market, the
marginal rate of substitution between the two goods for all consumers will equal the common
price ratio. The equality of marginal rates of substitution between any two goods among the
many consumers assures that there is no possibility of additional exchanges that are mutually
beneficial.
The analysis assumed that the products to be reallocated were already produced. In an
economy, the firms can change output and even if they are producing the same output, they can
change the input basket used to produce it. Because of the interdependence depicted in Figure
12, any change in one sector affects others. Selkirk the stranded sailor changes what he has for
dinner by shifting time spent gathering vegetables and meat. Any change in the output in a
modern economy also requires a reallocation of inputs among firms. An efficient allocation in an
economy requires not only allocation of outputs among consumers but allocation of inputs within
a firm and among firms. If the choice of inputs like labor and capital do not minimize the cost of
production of an output, then a reallocation will increase the profit of the firm or leads to a
reduction in the price of the product. The reallocation made either the owners of the firm or the
consumers of the product better off and the original allocation is inefficient. If shifting inputs
from one industry to another, the economy can produce an output basket that consumers prefer to
the earlier one (reminiscent of Selkirk reallocating his labor), then the earlier allocation is
inefficient.
Given the complexity of the process, an indirect approach that provides intuition to the
conditions for efficiency is adopted. Two types of changes in inputs that jointly represent all
possible changes are taken one by one and the condition first efficiency identified. Finally it will
be shown that all the conditions are satisfied in a competitive economy.
First, consider one firm purchasing two inputs in competitive input markets where input
prices are not affected by its actions. To focus on inputs, assume that the firm is considering
changes in input baskets that produce the same output. 1 If there is a change in input basket of the
firm that reduces the cost, the cost reduction can benefit the owners by increasing profits or the
firms competitively reduce prices and it benefits the consumers. In either case someone benefits.
What basket of inputs among those that produce an output will minimize costs? A numerical
example brings out the condition needed to minimize costs. The marginal product of capital - the
increase in total output as one additional capital is employed - in an industry is 60 and the cost of
capital for it is $120. One unit of labor costs $40 and its marginal product is 10. If the firm fires

1
Just as in discussion of consumption, baskets of goods between which the consumer is indifferent were considered
in determining the marginal rate of substitution.
155

six employees, then output is reduced by 60 units and cost by $240. By hiring another unit of
capital at the cost of $120, it can restore the output to the previous level while reducing cost by
$12. An economy is efficient only if all such shifts are precluded; either the price of the input or
the marginal product should adjust. The ratio of marginal product is the ratio at which inputs
need to be changed to keep output the same; it is the marginal rate of transformation. Selkirk has
to equate his marginal rate of substitution to the marginal rate of transformation to make the best
use of his resources. Firms in markets where they can purchase inputs at fixed prices in the input
market will minimize their costs for producing an output (necessary for maximize their profits)
when the ration of marginal products equal the ratio of input prices (Figure 13). 1 For another
industry, the product is different and the increase in output as a unit of input is increased is
different. However the ratio of marginal product of capital to that of labor will equal, under cost
minimization, to the price ratio of inputs.
Next consider changes in output of two industries as an input is shifted from one to the other.
Consumption baskets must reflect the change in output. Will consumers prefer the new baskets
to the old? Competitive firms produce an output that equates price to marginal cost (Figure 7).
One laborer moves from Industry 2 to Industry 1. In Industry 2, the marginal product of labor is
15 units; the loss of laborer reduces output by 15 units. The marginal product of labor in Industry
1 is 10 units and, with the addition of a laborer output increases by 10 units. The ratio of output
changes, the marginal rate of transformation, in 1.5 and the original allocation is efficient if
consumers prefer 1 unit of Product 1 to 1.5 units of Product 2.
The wage of the laborer is $40 and, the marginal cost in Industry 1 is 40/15 or $2.66 and that
in Industry 2 is 40/10 or $4. Under perfect competition, marginal costs are equal marginal costs
and the ratio of prices will be the same as ratio of marginal costs, 1.5. Consumers equate their
marginal rate of substitution (how much they are willing to give up one product for another and
still prefer the baskets before and after change equally) to the price ratio. As a result all
consumers in the economy will equate their marginal rates of substitution to the price ratio of
products and consumers are neither made better off nor worse off by a small change in outputs
through reallocation of inputs (Chapter 3). In the section, “A quick note on the efficiency of
competitive economies,” it was argued that three questions must be answered in the negative if
the economy is to achieve Pareto efficiency. The section showed that it is indeed so for a
competitive economy and provides an intuitive understanding of the first theorem of welfare
economics.
Summing up.
The first theorem of welfare economics provides a vindication to Adam Smith’s claims that
self-interest will lead to an efficient allocation of resources in an economy. It also brings out that
many restrictive conditions must be satisfied if the economy if the theorem is to hold. The output
of any firm is such a small fraction of the total market demand that a change made by one
producer should not the price of the product. The marginal revenue of the firm equals the price
and is a constant as long as market conditions keep the price at the current level.
For the firm to achieve profit maximization at an output, either reduction in marginal revenue
or increase in marginal cost must make it unprofitable to expand beyond that output. In previous

1
The reasoning behind this relation is given in Chapter 13.
156

chapters where the firm had market power, the reduction in marginal revenue limited the
expansion of output. In competitive economies, the constraint has to come from the cost side.
The study of cost fuel at various speeds of flight of an airplane showed that the average
variable cost can be U-shaped with marginal cost rising to intersect the average variable cost at
its minimum point. In manufacturing industries, the existence of some inputs that cannot be
varied in the short run is offered as an explanation for rising marginal cost. When all inputs are
variable in the long run, the deciding factor is the ability of the management.
The firm maximizes its profit when the rising marginal cost equals the marginal revenue. As
price and marginal revenue varies, the outputs of an individual firm at different prices are given
by the marginal cost curve. The marginal cost curve is the individual supply curve and the
market supply curve is the sum of individual supply curves.
The intersection of market clearing price and demand curve determines the equilibrium price
and quantity as the market participants have no incentive to change once it is attained. But the
price at any time can differ from the equilibrium price due shocks on the supply side or
unexpected changes in demand. The convergence to equilibrium can involve fluctuations over
time.
Just as for output, there are markets for inputs. Individuals invest in education to provide
them with skills that are in demand. Firms hire laborers are long as the remuneration is less than
the sale of their marginal product. The savings of households are transferred to financial
institutions that then lend to firms and individuals who are in need to borrow funds. Funds flow
to firms that has a profit rate in excess of other uses of funds with equal risk attracts funds and
they expand. Entry of new firms and expansion of existing firms shift the supply curve to the
right and that affects the equilibrium price.
The input and output markets are interlinked. The general equilibrium theory examines the
simultaneous equilibrium of all markets. One of the achievements of the general equilibrium
approach is the formulation and derivation of the first theorem of welfare economics. It shows
that a competitive economy achieves Pareto efficiency.
Bibliographical note:
Burrows et al (2001); Stigler (1987); Tremblay and Tremblay (2005); United Nations (2002);
Yntema (1941).
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Chapter 11: Intertemporal preferences, uncertainty and the financial

markets.

In choosing between decisions that generate different inflows and outflows of cash,
comparisons should be made only after discounting the flows to the same period using interest
rate (Chapter 4). In comparing alternate steams of consumption, utilities must also be discounted
using time preference; utility from a basket of goods received in future is less than one received
in the present. The incentive to save in spite of this temporal preference is the return to our
investments; it allows us to buy a lager basket in the future than what an individual gave up in
the present. If the sum of discounted values of future utilities exceeds the reduction in that from
present consumption, then savings lead to a net gain in utility. Paul Samuelson proposed a rule
for discounting of utilities over many periods that closely followed the rule for discounting future
cash flows.
The challenge is to explain the sudden decline in savings rate in United States starting in the
1990s. While aware of long term need to save, individuals seem to fall for the temptations to
consume in the present. This creates an inconsistency in each period between what they planned
to do and what they do. New Year resolutions seldom last a quarter. Recent researches model
explain such behavior by assuming that time preference for immediate future to be greater than
for later periods. In addition institutional changes, like second and reverse mortgage, have made
it easier to spend out of past savings or take more credit. The next section examines these
arguments.
Choice when outcome is certain involves selecting one that maximizes utility. When
uncertainty is involved, the outcome is not known when the decision is being made. Preferences
and the decision rule need to be redefined. In Chapter 4, commodities were tagged by the state of
nature and each decision lead to a basket of state-contingent commodities. The decision rule is to
choose the basket that maximizes utility. Another approach examined in this chapter views
choice as selecting from lotteries each of which promise a specific outcome in each state of
nature. A preference over lotteries is defined and the individual chooses the lottery that
maximizes expected utility. The analysis is then used to understand the peculiarities of insurance
market.
Well-known results in financial analysis are derived by assuming that preferences take a
special form; individual ranks financial assets in terms of their expected return (sum of returns
weighted by their probability) and a measure, variance, of how much the actual return vary
around the mean. Variation of returns is a risk that investors prefer to minimize and by
diversification they can create portfolios with lower variance than individual assets. Many
individuals with different preferences trade in the financial market and, for the market to be in
equilibrium, the demand for individual assets should equal their supply. Capital asset pricing
model examines the market equilibrium and derives a relation between expected return of an
asset and its riskiness relative to a market portfolio (a diversified portfolio of all assets), given
yield of a riskless asset like treasury bill.
The chapter concludes with an introduction to market for derivative securities, securities
whose value depends on the price of some underlying assets. An intuitive explanation of Fisher
Black and Myron Scholes derivation of the price of options (right to purchase or sell at a fixed
price on or before an agreed date) follows. Options provide buyers new opportunities to hedge
158

Figure 1.Discounting of utilities from future consumption.

against risk and from 1970s option trading grew at an astonishing rate. Unfortunately, in a less
regulated market than insurance, riskiness of some positions in the derivative markets was
ignored and the market achieved notoriety for their presumed role in financial market crisis of
2008.
Intertemporal decisions

Choosing between consumption streams.

The principle of utility maximization under certainty requires the marginal rate of
substitution between the two goods to be set equal to the price ratio. Irving Fisher in the
beginning of twentieth century extended the analysis to savings decisions of an individual. The
decrease in consumption necessary for saving in Year 0 reduces Mia’s utility. The savings earns
interest and next year she has (1 + interest rate) to spend for every dollar saved this year. The
relative price of dollar next year to one this year (what is needed to receive one dollar next year)
is [1/(1+interest rate)] and this should equal the marginal rate of substitution between
consumption in present and one in future. Because of time preference, the marginal rate of
substitution between consumption today and an equal quantity next year is not 1 but the discount
factor, [1/(1+time preference)]. Utility is maximized when relative price equals marginal rate of
substitution or interest rate equals time preference.
Paul Samuelson extended the analysis to many periods assuming that the discount factor is a
constant and discounted utilities in different periods can be added up. If the level of utility of
current basket is indexed as 100 and taking the discount factor as 0.944 as in Panel A of Figure
159

1, , the level of utility of next year’s basket (identical to one this year) is 94.4. 1 The level of
utility of a basket received 9 years from now is 59.3.
This can be graphically depicted using a technique from painting. Euclid’s Optics used
purely geometrical arguments to prove that, if we look at two objects of equal size, the one
further away from the viewer will seem to be smaller as the rays from its edges to his eyes will
make a smaller angle than the one from nearby object of equal size. Beginning with century, this
principle was used to depict depth in paintings. 2
The investment Andrei was making in Year 0 yields a constant return for 11 years as
represented by baskets in Figure 1. Even though they are of equal, the discounted utilities of
baskets decreases with time. The left side shows the utilities when discount factor is a constant.
Andrei will save now and invest if the sum of discounted utility is greater than the reduction in
utility in Year 0. The assumption of constant discount factor has the advantage dynamic
consistency; plans made in Year 0 for the tenth year will not be changed when Andrei is in Year
9. In spite of its analytical convenience, even Samuelson had doubts about the descriptive
realism of this model.
Under present-based discounting, the Andrei is even more relectant to forego consumption in
the present though he values future consumption. His discount factor, instead of being constant,
decreases over his time horizon; for simplicity, the discussion here assumes a high discount
factor in the present and a constant discount factor for all future years. If change reduces the
valuation of future benefits and Andrei and other like him will save less. The decline in personal
savings rate around 7 per cent during early 1990 to around 0.4 percent by 2006 has serious
consequences for individuals as the savings is a buffer to meet unexpected expenses or shortfalls
in income. It has consequences for the economy as it is an accounting identity that investments
equal savings.
Short falls in savings either require borrowings from abroad or reduction in investments that
hurt the economy in future. An understanding of the reasons for the fall in personal savings rate

Table 1. Personal savings as percentage of U.S. personal disposable income.

Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Savings 7.3 7.2 7.0 7.3 7.7 5.8 4.8 4.6 4.0 3.6
rate

Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Savings 4.3 2.4 2.3 1.8 2.4 2.1 2.1 0.5 0.4 0.4
rate
Source: U.S. Department of Commerce, Bureau of Economic Statistics, Personal
Income and Its Disposition. March 27, 2008.

1
The discount factor is from Angelletos et al ((2001).
2
In Byzantine painting, the sizes of figures were based on their theological or social importance. It is Florentine
architect and sculptor Filippo Brunelleschi (1377-1446) who developed the rule of perspectives but the first formal
thesis on perspectives was written by Leon Battista Alberti (1404-1472). Field (1997), pp.20-42.
160

is a necessary to develop policies to restore savings rate to its historic levels.

The disappearing personal savings: Even though Table 1 indicates a decline in personal
savings rate, the numbers require careful analysis as there are many conceptual issues in
estimating savings rate. National income is compiled from administrative data collected from
different sources and they differ in degrees of precision. Should expenses for purchasing of
durable goods be accounted as a current expense or as an investment to be depreciated over years
of use? Should an increase in value of assets due to increase in prices of stocks or of houses be
added to savings or excluded as they arise not from disposition of current income?
Is downward drift in personal savings rate an illusion generated by the measurement
problems? After many studies reworked the data, the consensus is that the decline in real. Is this
decline compensated by changes in business savings and government savings? Private savings
rate - the sum of personal and business savings rate - used to be 11 per cent for a long period but
declined to 4 percent by 2000. The third component of national savings is government savings
but in a modern democracy, governments cannot be expected to have substantial savings over
long periods of time; the politicians will feel the pressure either to increase social expenditure or
cut taxes. In U.S., after many years of deficit, the budget was in surplus during the last few years
of the twentieth century and then turned negative again. Neither business nor government
savings increased to compensate for decline in personal savings rate. Since savings by an
accounting identity should equal investment in the economy, United States investment is
sustained by foreign savings. 1
Partially yielding to temptation: present-based discounting. One explanation for the low
savings rate is temporal inconsistency in our preferences. There are obvious instances of such
behavior. It is common to make New Year resolutions to quit smoking and cut credit card debts,
yet most find the temptation to light another cigarette and to splurge at the next sales irresistible.
The same shortsighted can lead to inadequate savings. After looking ahead, Andrei sets a goal to
save during our working years and build a targeted level of assets before retirement. But he fails
to put aside what he planned to save this year, promising to begin next year. When that year
comes, it is the new first year and he and so many others like him procrastinate once more. The
temptation for immediate gratification is modeled by replacing constant time preference in
exponential discounting with declining time preference; the name “present-based” discounting
for it comes from it favoring gratification in the present.
The Angeletos et al (2001) models declining discount factors in an analytically tractable way
by setting the discount factor for first year equal to 0.6699 and for subsequent years at 0.957 and
presents simulation of the intertemporal decisions of high school graduates in the United States. 2
They provide evidence that their simulations fit the data better than the constant discount model
though the fit is far from perfect.

1
U.S. Department of Commerce, Bureau of Economic Analysis, “National Income Accounts,” provides statistics on
income and savings.
2
Simulations are a way of making computer models to make predictions about a physical or social system and are
used when the system is too complex to be solved by analytically. The inputs are chosen as closely as possible to
reflect realistic values, some randomness in the process is admitted and the outcomes, the values of variables that are
being studied, are made to depend on both the deterministic and random variables. The computer is used to simulate
the model many times to generate different values of the outcomes and their values are averaged to make a possible
prediction of the variables.
161

Institutional explanations. Another set of explanations attribute the trend in savings rate to
institutional changes. Two of them that gained currency in public discussion, aging of population
and growth in financial and real estate wealth, looked credible but careful statistical analysis
brought out facts that contradicted them. As the population ages, it is argued, older persons save
less or even use up their savings and national savings rate will decline. If this is true then the
savings of those in lower age groups should have remained the same during these years but data
shows that all age groups are saving less in the last two decades. Further the savings rate must
change slowly with the age structure of the population while there is a perceptible break in the
1990s.
Another claim is that the feeling of increased wealth due to stock market boom and housing
bubble motivated the consumers to increase their consumption and reduce savings. If this is true,
then the fall in savings rate should be only among those who benefited from the prices of assets.
Only half the population holds stocks and slightly more owns houses but all cohorts of
households showed a decline in savings. Also why did the savings rate fall even after the stock
market burst of 2001-2002 when billions of dollars of unrealized gains were lost?
Another explanation focuses on financial innovation that allowed consumers to gain credit
easily and to convert illiquid assets like house equity into cash by taking second mortgages.
Coincidently the household debt doubled during the last two decades. Once households have
easy access to liquid assets, it was used to finance current consumption above the level that
would not otherwise be possible. This explanation for the trend in savings has found support in
many studies.
The fourth explanation focuses on the nature of individual risks in the society. Part of the
savings of households is to tide over unforeseen contingencies. Government transfer programs
like Social Security and Medicare generated a confidence that less reliance need to be placed on
personal savings to meet age related disabilities. Risks to individuals from general economic
trends like inflation and depression became less common when macroeconomic policies were
able to achieve what is known as “the Great Moderation;” before 2008, business cycles were
believed to be damped and both inflation and unemployment rates were steady at low levels.
Collectively they created in individuals a lower preference for savings or a lower discount factor.
Statistical studies show that the explanation is consistent with observed changes not only of
savings rate but also of interest rate.
How far do the new theories explain the decline in savings rate? At the social level,
trends arise from the confluence of individual actions and the outcome is influenced by income
patterns among individuals, attitudes to risk, institutional constraints and the costs and benefits of
holding various classes of assets. Given that they are all changing as economy evolves, the time
span of data available for statistical analysis is limited and short time span affects the reliability
of results. A review of recent empirical studies suggests that, in spite of the progress in analysis
of intertemporal decisions, the decline remains a puzzle.1

Decision making when outcomes are uncertain.

Individual choosing a basket of consumption goods will, knowing that he can buy it with
certainty, will choose the combination that maximizes his utility. If there is uncertainty in

1
Guidolin and La Jeunesse (2007), p.512.
162

Figure 2. Choice of portfolios.

outcome, it seems natural to assume that his goal to be maximization of expected utility?
Intuitive as such an extension is, the claim has to be justified by reexamining and justifying the
decision process (Figure 2). John von Neumann and Oskar Morgenstern in their book Theory of
Games and Economic Behavior assumes that choices are over lotteries with each lottery
delivering a “prize” - a basket of the commodities or returns for financial securities- in each state
of nature. Preferences for lotteries are based on the prizes they offer. The individual whose
preferences satisfy the axioms of choice they formulated will choose the lottery that maximizes
his expected utility.
Expected utility maximization.
Chloe wants to invest her savings in an asset or assets that earn a good return. Returns on her
portfolio (even if it has only one asset) vary with the profitability of the industries and state of
the economy. Every portfolio is “a lottery” offering a “prize” in each state of nature. She cannot
choose a return but must confine herself to choosing one of the portfolios costing $1,000.
Panel A of Figure 2 shows a portfolio with two states of nature. An investment of $1,000 in
the portfolio earns a return of $100 if State 1 occurs and $30 if State 2 occurs; the probabilities of
these states occurring are 0.7 and 0.3 respectively. She expected return is [(0.7 x 100) + (0.3 x
30)] = $79. 1 Other portfolios that require same investment will provide different returns in the
two states (states of nature and their probabilities of remain same as they are not affected by
portfolio choice). How should Chloe decide which portfolio to choose? One rule that she can

1
The states of nature are limited to two only to make to simplify the diagram; in a mathematical formulation, the
analysis can be extended to any number of states. Taking a frequency interpretation of probability, Chloe over a
period of time receives $100 seventy percent of the time and $30, thirty per cent of the time.
163

Figure 3. Example of compound lottery.

use is to compare expected returns of different portfolios and choose the lottery with highest
expected return. She prefers for good reasons not to do so.
Consider a portfolio she could choose that yields $0 in State 1 and $300 in State 2. Even
though the expected return is $90 is greater, it has no return in the state with high probability and
Chloe prefer a less skewed distribution of prizes. She may decide to consider the worst outcomes
($30 and $0) and choose the lottery for which it is higher. Among these and other possible rules,
the one proposed by von Neumann and Morgenstern is considered by economists to provide a
better understanding of individual choices involving uncertainty. 1
It makes a distinction between preferences for prizes and preference for lotteries. The ranking
of prizes is represented by a utility function that satisifes the axioms of preference stated in
Chapter 2. Tese rules are not enough to rank lottery. An individual can prefer a low prize with a
high probability to a large prize with low probability even if the expected values are the same.
von Neumann and Morgenstern developed a set of axioms according to which lotteries are
ranked by expected utilities; expected utility of an asset is the sum of utilities of prizes weighted
by probabilites of their occurance.
A conceptual difficulty in defining expected utility is that the prize for a lottery may itself be
another lottery. The challenge facing a farmer provides an example (Figure 3). Kevin, a
commercial farmer in Iowa, chooses his planting of corn knowing that the crop will depend on
temperature and rainfall during the season. Assuming two states of nature, he will have a good or
bad harvest. Being a commercial farmer, he is not interested in the quantity of corn harvested
but the income from its sales. The income depends not only on the harvest but the prices at
which it can be sold. So his desired outcome depends on a compound lottery with the prize of
the first, the harvest, being another lottery whose prizes are prices. Each choice he makes at
planting leads to one compound lottery. Kevin whose preferences satisfy the von Neumann-
Morgenstern axioms will rank compound lotteries by their expected utilities and chose the one
that maximizes it.

1
Experiments offering a set of individuals (students are often used in experiments) choices show a sizable minority
breaking von Neumann-Morgenstern axioms. Choices that are identical but posed differently resulted in different
selections. This suggests that the selections they made were sensitive to how the choices were presented to them.
164

Figure 4. Utilities of returns and of lotteries.

Going back to Chloe’s choice of portfolios, the distinction between return and utility of
return is brought out in Figure 4. Panel A shows utility from the return on the portfolio; it is her
level of utility when she has realized a particular return on her portfolio. If the return was $30,
the utility is marked as U($30). As the return increases to $100, the utility increases along the
curve to U(100). Of interest is the shape of the curve which reflects Chloe’s preferences. She
values an additional dollar more when the return is less and the curve of utilities has a steeper
slope at lower returns than at higher ones.
Panel B shows the expected utilities of three lotteries chosen specifically to analyze Chloe’s
preferences. The first corresponds to a portfolio, a time deposit with a 3%, interest that pays the
same return of $30 in each state (black dot). Since it offers the return do not vary with state of
nature, its expected utility equal utility of $300 in Panel A. Another portfolio pays $100 in each
state (grey dot). The lotteries corresponding to these portfolios (black and grey lotteries) are
degenerate in that they pay the same prize in each state of nature and there is no uncertainty. The
portfolio in Figure 2 can be viewed as a compound lottery that offers black lottery as prize with
probability 0.3 and grey lottery with probability 0.7. Its expected utility (red dot) is the weighted
average of the expected utilities of the black and blue lotteries with weight 0.3 and 0.7 and lies
along a straight line joining the expected utilities of the other two lotteries.
Figure 5 by superimposing Panel B of Figure 4 on Panel A brings out one important
consequence of Chloe’s preferences. The utility of a portfolio with a constant return of $79
(green point) is greater than the expected utility of a lottery with expected return of $79 (red
point) and Chloe will prefer the first portfolio over the second. Individuals who like Chloe prefer
the fixed income over equal expected income are risk averse. Risk aversion induces individuals
to seek ways to reduce fluctuations in their income and wealth and the financial market has
responded by developing many products like insurance and financial derivatives to facilitate
individuals to transfer risk.
Risk premium. The horizontal line from the red point to the utility curve shows that the
expected utility of the lottery in Figure 2 equals utility of a fixed return of $60. The risk premium
is the maximum difference between expected return of a lottery and return of a riskless asset that
leaves an individual indifferent between the two. For Chloe and for this lottery, it is $19.
165

Figure 5. Risk aversion and risk premium.

If she is able to exchange the lottery for a portfolio with a fixed return greater than $60, she is
better off. Why should another person or institution want to accept the lottery in such an
exchange? The preferences of individuals differ and the utility curve of another individual can
have a different curvature, even if U($30) and U($100) are the same. A special case is where the
utility curve of an individual, Ennio, is a straight line. For him, the red and green spots coincide
and the expected utility of the lottery equals the utility of $79. An individual or institution with
straight-line utility curve has no risk-premium and is risk-neutral. If he purchases the lottery
from Chloe for a price between $60 and $75, like $68, Chloe’s is better off as she values a sure
payment of $68 over the lottery while the risk-neutral buyer is also better off as he is getting a
lottery that he values as $75 for $68.
Insurance industry. Insurance industry exploits the mutual benefit of shifting risk between
those with differing risk premiums. For an individual, the damage to his house from fire, claims
from a car accident or illness requiring expensive treatment can result in a substantial loss to the
value of his assets and being risk-averse, is willing to pay a premium to an insurance company to
hedge against such losses. 1 Insurance firms with a wide and diversified portfolios are risk neutral
or substantially less risk averse than individuals.
Within a small group of drivers, the percentage of drivers involved in accident can vary from
1 to 100 per cent, but within a large group of drivers, all making independent trips, the
percentage involved in accidents tends to be stable. Many drivers make no accident and the loss
per accident also averages out to a stable number.

1
Insurance premiums refers to amounts one is willing to pay insurance companies to insure against loss and is
distinct from risk premium which is a reduction over expected wealth that the consumer is willing to accept to avoid
uncertainty. Figure 5 gives a graphical measure of risk premium and Figure 6 compares it to the insurance premium.
166

Figure 6. Principle of setting insurance premium

The estimate of loss per person is crucial for determining the insurance premium. The
insured pays the premium whether she had a loss or not and a numerical example can be
constructed to bring out the principle in setting a premium. The probability that Ashanti, owner
of a car worth $30,000, having an accident that results in damage of $5,000 is 0.02; her assets are
either $30,000 or $25,000. The expected value of car is $29,900 and the expected loss is $100
(Panel A, Figure 6). Ashanti is risk averse and to her the utility of even $29,500 with certainty is
greater the expected utility of having the uncertain value of car. To avoid the risk of loss, she is
willing to pay an insurance company a premium higher than the expected loss, as long as the
excess is less than her risk premium (Panel B, Figure 6). 1 The insurance company will not be
willing to insure the car for a premium less than the expected loss. A higher premium will let it
earn an operating profit. A premium greater than expected loss and expected loss plus risk
premium benefits both of them.
Going beyond one individual, the differences in preferences of individuals buying insurance
and competition of insurers restrict even more the bounds for insurance premium. Risk
premiums of individuals differ with their risk aversion and those with low risk premiums will not
be willing to pay the insurance premium acceptable to others.
There are two additional considerations in designing the insurance contract. The individual
driver or household taking insurance has limited ability to control losses to his assets. This has a
two-fold effect on the insurance industry. Driving at low speeds is safer but increases commuting
time; the driver is impatient and tries to overtake others on the road and his weaving through
traffic increases the probability of accident. In principle such drivers should be charged a higher
premium but the insurance company cannot keep track of how each of the insured drivers acts on
the road. He avoids the incremental cost of driving defensively but is able pass the cost of the

1
Panel B magnifies the right end of Panel A.
167

accident to the insurance company. The temptation to exploit informational asymmetry to act in
manner that differs what was explicitly or implicitly assumed when the insurance was purchased
is known as moral hazard.
The insurance industry counters it by setting a deductible; the insurer has to pay part of the
cost of accident. The industry divides the insured into groups that have different expected loss
and charge different rates; rates differ by age as young drivers are, in a statistical sense, more
accident prone. Insurance companies refuse to cover drivers with bad record.
The insurance company depends on customers buying insurance. Since a premium has to be
paid even when there is no loss, those who know that they have low probability of loss will avoid
it while those prone to losses will have an incentive to seek more insurance. The young and the
healthy do not want to pay the health insurance premiums that they suspect is subsidizing those
who are sick and elderly. If each individual is allowed to take insurance, the insurance company
will find that they are stuck with a pool of insured prone to running up medical bills. This is an
example of adverse selection, adverse for the insurance company as it losses increases. 1 To
compensate for adverse selection, the company can increase premium for those who are insured
but then high premiums will make those with lower risk within the group drop the insurance,
making the pool even smaller and expected loss possibly even larger. Offering health insurance
collectively to employees of a large organization with young and old employees avoids adverse
selection.
The burning issue in health reform is whether the society has an interest and obligation to
offer health insurance to all citizens and how the cost is to be covered and adverse selection
avoided. Some countries have national health insurance programs where Unites States insurance
is mostly through employers. While major employers are able to negotiate insurance premiums
that they can agree to pay themselves or more often share with the employees, small companies
and self-employed face very high premium. Many millions are left without insurance. Any
choice whether to leave the system as is or to modify it to create insurance pools to those who
are currently left out involves decisions about distribution about cost and benefits among the
population and, as noted in earlier discussions of Pareto efficiency, it involves moral, social and
political values that are beyond what can be discussed in terms of economic analysis. 2
The expected loss is only an estimate and actual losses can differ from year to year.
Insurance is only a transfer of risk from the insured to the insurer and while aggregation over
individuals smoothens out the fluctuations in payouts, there is always a risk that in one period it
will spike. This is particularly true for property insurance. Hurricane in Golf Coast, tornadoes in
Mid-West and flooding in any part of the country can be financial disaster for the insurance
companies. The financial institutions that provide loans to the insurance companies and the
individuals who purchase the stocks of the company are concerned about the solvency of the
company and its future dividends. If they feel that the company can be under financial stress due
to the risks it insured, they will demand a higher return. The company has to consider the risk it
is facing and its cost of funds in pricing its products. It charges a premium more than the
1
This has become a controversial issue in the health reform passed in United States in 2009.
2
John Locke and Immanuel Kant (sixteenth and eighteenth century philosophers) stressed the rights of individuals
to the fruits of their work and argued against the society depriving him or her of any part of it to meet social goals.
Jeremy Bentham in eighteenth century stressed the welfare of the society as a whole. (Chapter 2 has a short
description of their positions). There are a group of economists, Amartya Sen being prominent among them, who
argue that criteria beyond those used in defining Pareto efficiency is needed to address social issues.
168

Figure 7. Judging portfolios by their mean and variance.

expected loss but as it increases premium, more and more buyers of insurance will find that it
exceeds the maximum premium many they are willing to pay. Other insurance companies will
come up with rate structures to attract dissatisfied customers of their competitors. An insurance
company has to balance between its financial need and the desirability of having a large pool of
insured.
Financial Economics.
In the analysis in the last section, the individual’s response to variations of returns with states
of nature determined the shape of her utility curve. A person is risk averse if utility of prizes
increase less than proportionately with the value of the prize. It created a gap between utility of
expected return and expected utility and gives rise to a measure of risk aversion, the risk
premium.
Irving Fisher in 1906 proposed using variance, a statistical measure of fluctuations around
the mean (expected value), as a measure of risk. Harry Markowitz in 1952 paper quantified the
reduction of risk from diversification of investments and developed the idea that investors want
to maximize expected portfolio return while minimizing its variance. James Tobin (1958)
derived an important result that reduced the combination of assets that individuals need to
consider in choosing the preferred one. He showed that, if there is one riskless asset and many
risky assets, risk-averse individuals restrict their choices to combinations of the risk-less asset
and one specific portfolio of all the risky assets. What varies among individuals is the proportion
of the two in their portfolios. Still determining the benefit of diversification remained difficult as
it required knowing the covariance of returns (intuitively the extent to which returns of stocks
vary together) of every pair of stocks. 1 The Capital Asset Pricing developed by William Sharpe
and John Lintner showed that, instead of knowing covariance of returns among all stocks, all that
is needed to determine the return of any risky asset like a share of a company is its covariance
with the market portfolio (a portfolio in which the stock are held in the same ratio as their market
value to the total value of all shares sold in the market). 2

1
Stocks and shares both refer to certificates that provide ownership of a fraction of the equity of a firm but shares
usually refers to certificates of a firm while stocks refers to such certificates in general. Covariance is positive if
both shares have higher return in the same state. It is negative if one has a higher return in the state where the other
has low return and the reverse in the other state. In a portfolio of the two stocks, the high return of one will balance
the low return of the other and the portfolio will have lower variation that individual returns.
2
Jack Treynor and Jan Mossin are now listed as co-founders in light of the papers they published around the same
time.
169

Figure 8. Calculation of variance of the share of High Risk Company.

Mean and variance of shares and portfolios. Elijah could invest his assets in a bond or
Treasury bill. They provided a fixed return and have no variance. 1
If Elijah invests in shares of companies, he has the right to receive “a share of the profits,”
the fraction being proportional to the ratio of shares he has to number of shares of the company
that are outstanding with other investors. Profit of a company fluctuates with changes in
consumers’ taste, their purchasing power and with the extent of competition in the market.

Table 2. Mean, standard deviation and covariance of two shares.

High Risk Mundane Portfolio
Company Corporation (50%
invested in
each share)

Return in state of 16% 3% 9.5%

nature (probability = 0.5)

Return in state of 4% 10% 7%

nature (probability = 0.5)

Mean return 10% 6.5% 8.25%

12.2 1.5625
Variance 36
(SD = 3.5%) (SD = 1.25%)
(SD = 6%)

Covariance -20.5

1
Uncertainty about inflation is a problem and the rate has to be adjusted for expected rate of inflation. Inflation
depends on monetary policy and state of the economy and, to exclude economy level issues, all returns are assumed
adjusted for inflation.
170

To simplify the discussion, the profit in examples of portfolio choice is made to depend on
two states of nature only. If Elijah purchases for $100 a share of the High Risk Corporation at the
beginning of the period and at the end it is worth either $116 or $104 with probabilities 0.5.
Since no dividends are paid on this stock in this period, the return is 16% or 4%. The mean or the
expected return is 0.5 x 16 + 0.5 x 4 =10%. Since actual returns in both states differ from the
mean, a measure of the variation is needed to determine how risky the stock is. One measure is
be to add up the differences between mean and return in each state of nature. The difference is
+6% in one state and -6% in the other and they will cancel each other and the measure suggests
that there was no fluctuation! This paradox can be avoided by squaring the differences,
multiplying them with probabilities of the states and adding then up (as done in the last line of
Figure 8). 1 The sum, variance, is a measure of risk in holding a stock or a portfolio and Table 2
gives the variance for shares of two companies and a portfolio. The positive square root of
variance, standard deviation, also is a measure of variation and is used in in graphic
presentation of the relation between return and risk. In Table 2 standard deviations (SD) are
given in parenthesis.
If in one state of nature the return of one stock is above its mean and that of the other below
its mean, then the differences offset each other at least partially. While it is in line with the old
sayings, “do not put all your eggs in one basket,” Markowitz showed that, while variance of
portfolios can only be minimized for each level of return or mean return maximized for each
level of variance, risk cannot be completely eliminated. This is brought out by estimates by
Andre` Perold of variances of portfolios of stocks in various financial markets. 2
Taking data from 1994 to 2003, Pernold compared the standard deviations of 24 stock
markets round the world. Each market can be thought of as a portfolio consisting of all stocks
traded there and the aggregate of them as an international portfolio. The capitalization (value of
stocks outstanding) of all stock markets was $29,870 billion dollars and standard deviation 15.3
per cent. U.S. stock market with half the total capitalization has a standard deviation of 16.1
percent; standard deviation of the next largest, Japan with about 10 per cent of total
capitalization, is 22.3 per cent. United Kingdom, third in capitalization, has a lowest standard
deviation at 14.3 per cent while Russia with a capitalization 0.7 per cent has a standard deviation
of 76.9 per cent. The standard deviation of the international portfolio of all stocks is lower than
that of portfolios of stocks in any of the markets except United Kingdom but still significantly
different from zero.
Elijah has three securities to choose from: a risk free bond and shares of two corporations. He
examines investing his assets in a portfolio consisting only of the bond and shares of the
Mundane Corporation. If he invests all the assets in bond, the return will be the risk free interest
rate, 3 per cent and standard deviation will be zero. As he shifts his investment to the shares of
High Risk Company, the return will increase in proportion to the percentage of shares in the
portfolio; if Elijah holds 50 per cent of his assets as shares, the expected return will be 6.5 per
cent. The variance will also increase in proportion to the share in the portfolio, as bond has no
variance.

1
It is accident of numbers chosen that the two factors, (16 – 10)2 and (4 – 10)2 in calculation of variance are the
same. Variance has some nice statistical properties that make it the preferred measure of fluctuations around the
mean.
2
Perold (2004) pp.3-24. Table on market capitalization and historic risk estimates is on page 8.
171

Figure 9. Mean and variance of portfolios.

Compare choices Elijah makes as an investor with that as a consumer. As a consumer, he has
a budget which determines the baskets he can afford. The budget line slopes downwards to the
right; any increase in the purchase of one product requires a reduction in the other to remain
within the budget. He will pick a basket on the budget line where his marginal rate of
substitution equals the slope of the budget line; the indifference curve is tangent (touches at one
point) to the budget line at that basket. As an investor in a bond and a stock, the combinations of
mean and standard deviation that Elijah can attain is determined by mean-variance frontier, a
straight line in Panel A of Figure 9. It slopes up as higher expected return can be attained only by
portfolios with greater risk. Turning to his preferences, Elijah sees a tradeoff between risk and
return. The combination between which he is indifferent is shown by the curve marked I-I. It
slopes upwards to the right as he is willing to take greater risk only if rewarded with higher
expected return. Among the combinations that lie along the straight line frontier, he will choose
the one that equates his marginal rate of substitution between return and risk to the slope of the
line or where one of his indifferences curve for return and risk is tangent to the line.
The portfolio chosen will depend on Elijah’s preferences. If he is very risk averse, the point
of tangency will be to the left and he will hold most of his assets as bonds; if his preferences are
to take risk for higher expected returns, he will move up the line and may even go to the dashed
part where he invests more than his assets in stocks by borrowing in the financial market.
If Elijah invests his assets in shares of the two companies, expected return will increase as
the proportion of shares of High Risk Company (the one with a higher expected return)
increases. The variance of portfolio will also increase as the variance of returns of High Risk
172

Figure 100. Risk and return for portfolios with many shares and a bond.

Company is greater than that of Mundane Corporation but, due to negative covariance, the
increase will be less than proportional to the change in share ratios. 1
Risk and return with many shares and bonds. Having appreciated the advantages of
adding the share of a second share to his portfolio, Elijah can diversify even further by investing
in more of shares traded in the stock market. Increasing diversification allows him to attain
higher returns at the same level of risk. Confine to shares only, the curve relating risk to return in
Panel B of Figure 9 opens up to the tilted U-shape of the red curve in Figure 10. The portfolios
that achieve the highest return for a given level of standard deviation are “efficient” and they
form the efficiency frontier (the upward sloping part of the cure in Figure 10). The shape and
position of the curve depends only on the means, standard deviations and covariances of the
shares and is independent of the preferences or assets of the investors; this property is important
in establishing market equilibrium.
In addition to stocks, Elijah has a choice of investing part of his assets in a risk free asset and
it offers portfolios that offer better trade-off than the shares-only portfolios. If he invests his
assets in the risk free asset and the shares of Mundane Corporation, they will lie along the
straight line of Panel A of Figure 9. It will intersect the red curve as the portfolio has less
diversification than those on the curve. Elijah can form a portfolio with more shares which has
higher return for any given level of variance. As more stocks are added, the line from risk-free
return has swung up (Portfolio P is one of them). Diversification reduces the relative price of risk
and return and the line swings upwards. 2

1
Negative covariance implies that when one has low return, the other has a high return and the returns of the
portfolio varies less that of individual stocks.
2
As relative price decreases, the budget line of a consumer swings outwards. The objects of choice are different and
the derivation of results needs to be done afresh. Elijah’s choice of a portfolio of investments involves choosing the
preferred “basket’ given the constraints imposed by his resources and opportunities in the market.
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Figure 11.Efficiency frontiers in capital asset pricing model.

Ultimately the line will touch the red curve (frontier for portfolios only shares) at the point
M. Combinations along the blue line provides a higher return for a given level of risk than any
other portfolio available to Elijah.
Marginal risk of a stock for Elijah: The riskiness of a share is measured by its variance or its
square root, the standard deviation. Investors expect to be compensated for higher risks of their
investment by a higher return. Going back to the case of a share and a bond (Panel A of Figure
9), as the share is added to the portfolio, the standard deviation of returns and excess return
(mean of portfolio over that of bond) increased in proportion to the share of the stock. Yet as a
share with high standard deviation is added to a portfolio with less risky shares, the incremental
risk to a portfolio from the stock purchase depends not on stock’s variance but covariance with
the portfolio. Realizing this, an investor like Elijah considering purchasing a share is not judging
its riskiness by its variance but with its covariance with his portfolio. This suggests a distinction
between average risk and marginal risk parallel to the distinction between average and marginal
cost in the market for goods. Under competition the price of a product equals the marginal cost,
not average cost. The excess return (difference between expected return and return on risk-free
asset) he expects for adding a stock depends on its covariance and not variance. When market
equilibrium is examined in next section, the portfolio against which the riskiness of individual
stock is judged is the market portfolio.
Market equilibrium: capital asset pricing model. The discussion of individual decision to
invest in a portfolio assumed that the expected return and variance of various assets are known to
the decision maker. The returns in the one-period model depend on the end-of-the-period price
of the assets (Figure 8) which an individual observer takes as determined in the financial
markets. The prices of financial, like all prices, are determined by the demand and supply for
them. The Capital Asset Pricing Model (CAPM) developed in the 1960s uses parsimonious
assumptions to develop an explanation of financial market equilibrium. It establishes a relation
between riskiness of individual assets and their expected returns.
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The model adds two assumptions to the mean-variance analysis of last section. First, it
assumes that the mean and variance of all the assets are known publically and agreed upon by all
those who are in the market. Mean and variance are the properties of the stocks but investors
obtain their estimates from statistical analysis of stock market data. Statistical estimates can
differ depending on data used and estimating techniques. This assumption assumes unanimity.
Second, capital asset pricing mode assumes that there is a risk free asset and further the
borrowing and lending rate of that asset is same for all individuals and is independent of the
amount borrowed or loaned. This also is a strong assumption as rates differ and there are limits
to borrowing. Simplifying assumptions can get to the core of a complex problem and the
judgment on the model has to be based on how well it describes real-world stock markets.
The benefit of diversification is that it provides a better tradeoff between risk and return.
Consider all the portfolios that can be formed with the shares traded in the stock market and the
ones that provide the best return will lie along the red curve in Figure 11. If there is a risk free
asset as assumed in Capital Asset Pricing Model, it is possible to form combinations of the risk
free and a portfolio on the frontier of portfolio with shares only (red curve). These portfolios fall
on straight lines from the risk free asset to points on the red curve and one of them will be
tangent (touch at one point) the red curve.
A particular portfolio plays a special role in the Capital Asset Pricing model. To identify it,
first define the value of any share as the number of shares outstanding (and held by various
individuals and institutions) times the current price of the share. The ratio of the value of a share
to the value of all shares in the market is the weight of each share in the market capitalization. A
market portfolio includes all risky assets in proportion to their weights. First important
conclusion of the Capital Asset Pricing Model is that the market portfolio, M of Figure 11, is on
the efficiency frontier of all risky assets. This is a condition for market equilibrium as otherwise
there is a change which will benefit the investors. The market will clear - or the quantity
demanded of each asset will equal the quantity supplied - only if the market portfolio is on the
efficiency frontier.
The next important result is that the straight line efficiency frontier with bond and stocks is
tangent to the efficiency frontier for stocks at M. All investors will choose portfolios on the line
where their marginal rates of substitution between risk and return equal the slope of this line.
Relatively more risk-averse investors will choose portfolios that have a higher fraction of the
risk-free assets like bonds and earn a lower mean return while less risk-averse investors will
choose one further out on the line that has higher risk and higher return.
Relation between return and riskiness of assets. Risk-averse individuals will hold risky assets
in their portfolios only if the expected return is greater than that of risk free assets.
Diversification can reduce the riskiness of portfolios but, as Markowitz showed, cannot eliminate
it. Even a portfolio of all shares traded in 24 major stock markets around the world has a
standard deviation of 15.3 per cent. 1 The return on market portfolio in a financial market also
must exceed the return on risk free asset to compensate for the risk. There are three returns to be
considered: risk free return, the expected return on market portfolio and the expected return on
individual assets. The capital asset pricing model establishes a relation between the three by
deriving a relation between two differences among the three returns. Excess return of any share
or market portfolio is the excess of its expected return over that of risk free asset. The difference

1
Perold (2004), p.8.
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between expected return of market portfolio and return of risk free asset is one component of the
relation.
An investor can avoid part of the risk of holding an individual stock by adding it to the
portfolio and knowing that it can be diversified, the market will not reward the investor for
bearing the variance of that stock; the return in a competitive financial market is for the risk that
cannot be diversified. The expected return of a stock over that of market portfolio depends on its
riskiness relative to that of market portfolio and that is measured by covariance between the two.
In the capital asset pricing model, the covariance is divided by the variance of market portfolio
and the ratio is known as beta. Since the denominator of beta is common to all stocks, the
differences in betas of different stocks are due to differences in covariance. The beta of the
riskless asset as it does not vary and covariance is zero. The beta of the market portfolio is one as
covariance with itself is its variance. Other stocks can have higher or lower beta depending on
their covariance with market portfolio.
The capital asset pricing model is expressed by the relation:
The excess return of any asset = (beta of the asset) times (the excess return of the market
portfolio).
The model has many intuitive conclusions. The expected return of an asset depends not on its
total variance but on that part of its variance that cannot be diversified away. Holding assets in
any two shares will not lead to reduction of riskiness. Only if they have negative covariance will
there be a reduction in risk. This has important implications for company policies. Every now
and then there is a merger mania; company executive claim synergy and go on an acquisition
spree. The market is skeptical that riskiness is reduced and stocks of the acquiring company
frequently falls.
An individual’s assets include human capital and real estate but in practice data availability
has forced users to take a portfolio of stocks as a proxy for market portfolio. One of the
assumptions of the model is that market prices the stocks using all the information available to
those trading in it and critics argue that there are episodes of mispricing. Additional variables
like book-to-market ratio (the ratio of the firm’s historical cost to the valuation of the firm in
stock market) and size of the firm are included to increase the explanatory power of the model
but there is resistance to addition of variables without theoretical underpinning. Beta of stocks is
still widely uses as a practical measure in making financial decisions. 1
The uncertain future
As we make decision about the future, we have to consider both the lapse of time till we reap
the benefits and the uncertainty of the outcome. Previous sections considered them separately.
Time preference explains our unwillingness to postpone gratification and the greater is our time
preference, more inclined we are to prefer the present gratification over the future. The one-
period models of uncertainty provide us an understanding of the financial markets. Today there
is a class of financial - forward and futures contracts, and options - that are extensively used to
hedge against risk that arise over time. They are collectively known as derivatives as their prices
are based on, derived from, that of other assets. The next subsection examines one of them, the
options and the principle of pricing options.
1
The empirical evidence for Capital Asset Pricing Model is not very strong but it is valued as a framework for
thinking about risk, return and diversification.
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Options.
Price of crude oil rose from $52 a barrel in January 2007 to $80 per barrel in October 2007
and then to about $147 in July 2008. 1 Southwest Airlines had options to purchase oil at $51 per
barrel for most of its oil and price difference between market price and the option price made the
option contract worth $2 billion for the Airline. For whatever reasons, other airlines did not take
options on aviation fuel. Meanwhile for American Airline, the price difference amounted to
annual cost increase of $3 billion. As the price of derivatives of crude oil responded to the price
increase, users of oil or its products suffered a cost shock. Next year as prices increased to $147,
Southwest Airlines pinned its cost to $62 per barrel. The airline industry was in utter turmoil but
Southwest Airlines used options to cushion its costs and continued to be profitable.
Option in its simplest form is a right to purchase (call option) or sell (put option) a specified
asset at a fixed price by a certain date; the buyer of an option can but is not obliged to exercise
the option. 2 The call option is exercised only if the one who holds it finds it beneficial to do so.
If an individual or institution has a call option for aviation oil at a price of $61 per barrel
when the price in the market is it is selling in the market for $126, the buyer saved $65 per barrel
while the one who sold the option suffers loss of $65. 3 Option like insurance shifted the risk
from one party to the other. To purchase this privilege, the buyer of the option must pay a price
to the one who writes the option. If the price in the market at the time the call option has to be
exercised is less than the option price, the buyer will forgo the option and purchase oil in the
open market. The price he paid to buy the option is a loss.
This example illustrates that derivatives like option only transfers risk; someone has to bear
the risk that price of the underlying asset like oil or stocks in open market differs from the price
in the option contract The option premium, the price that the one who transfers the risk by
purchasing the option, must compensate the writer for the risk. If risks are underpriced, it will be
like low insurance premiums and create serious financial problems for those who wrote it.
Finally, option premiums are much less than the price of the assets, options give the buyer
potential command over quantities of assets at low cost; the fear is that it gives opportunities for
manipulating the market for the underlying asset.
Evolution of option trading. Trade in futures on rice in Japan and options on tulip bulbs in
Holland go back to seventeenth century. These contracts were individually negotiated and the
one who sells it practically draws up the contract and the term writer is still used to one who sells
an option. Negotiations of a contract are time consuming, negotiated prices are not public
information and cannot be compared with prices of similar options traded. Finally there is no
secondary market where one who has a position in the option market can unwind it. Due to lack
of transparency there was widespread concern that options were being used to manipulate the
market and studies indicate that there was an element of truth to the allegation.

1
“An Airline Shrugs at Oil Prices,” New York Times, November 29, 2007; “Southwest boosted by clever fuel
hedges” Financial Times, July 24, 2008.
2
The subsequent discussion of option pricing is restricted to call options; the price of put options is related to it by
the call-put parity.
3
Writers of option hedge against such losses. Hedging which is integral to option pricing will be discussed later in
this section.
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In the early decades of the twentieth century, option pools were formed in Unites States to
obtain from major shareholders call options on up to 20 percent of outstanding stocks of
companies. There was concern that the options were used to manipulate prices. In 1973, the
Chicago Board Option Exchange began trading in standardized stock options and the
transparency inspired confidence in the working of the market. In the same year, Fisher Black
and Myron Scholes published a paper that analytically derived the price of the option based on
the strike price (price of the stock for one who exercises the option), expiry date and volatility of
the stock. Now traders in the option market could decide whether the option is mispriced or not.
The benchmark inspired confidence in the market and there was explosive growth in options
market.
Pricing of a call option on a stock. The price of a call option on a stock depends on the
movement of stock prices, the profitability to the holder of the option if he exercises it, the
hedging by the writer of the option to protect against loses and an appropriate rate of interest to
discount to the present. An intuitive understanding of the option price formula can be obtained
by considering components separately and then linking them together in the Black-Scholes
formula.
Pricing just before the expiration date. Consider an option that gives you the right to
purchase a stock price at $100 on May 30, 2008. The price is known as expiration price or strike
price. The date on which the option can be exercised is the expiration date, exercise date or
maturity. American options, allow the holder to exercise it any time up to and including the
expiration date while European options can be exercised only on the expiration date. Most
options traded are American option but European options are easier to analyze and once
European options are understood, the analysis can be generalized to include American options.
The discussion below is confined to European call option.
Consider a time just before the expiry of the option. Albert has an option to purchase a stock
at $100 on a specific expiration date. The price of the stock in the market at that expiration date
is $102 and if Albert exercises the option he can then sell it in stock market and make a profit of
$2. Recognizing it others will be willing to buy the option from Albert near the expiration date
and the price of option will be bid up to $2. If the price of stock was $103, the option price will
be $3. This leads to the first of the results needed to build a general theory of option pricing: if
stock price is above the strike price, option price close to the expiration date will increase dollar
per dollar for every increase in stock price.
On the contrary if the stock price just before expiry was $95, the option to buy it at $100 is
worthless and price of option will be $0. Even if price of stock changes marginally from that
price, it has no effect on the price of option. The jump in option prices complicates the relation
between the two.
The fluctuations of stock price. The price of High Risk Company in Figure 8 was assumed to
fluctuate between $116 and $104 with equal probability. In stock markets, stock prices change
by smaller amounts and over a wider range.
The return on the stock held for a period of time depends on how the price changed. When
the stock of High Risk Corporation increased from $100 to $110, the return was 10 per cent. If
the price was $104, the return will be 4 per cent. In stock markets, the stocks take many prices
and there is one rate of return for each price (relative to the price in previous period). The
assumption used in option theory is that rates of return vary according to a distribution, Normal
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Distribution that occurs frequently in statistical analysis. It places highest probability at the mean
value and probability tapers off symmetrically in either direction. The probability of any other
return depends on the distance from the mean and the standard deviation of the distribution.
Reversing the calculation of returns from prices earlier, the distribution of stock prices can be
calculated from the distribution of returns.
In addition to distribution of stock prices at an instant of time, how this distribution moves
over time must also be defined. This can be illustrated by assuming discrete changes in prices
and, for minimizing computation, assuming mean to be constant. Assume that the stock price
was $100 at Period 0. The price in Period 1 depends on one of two states of nature; in one state it
is $101 with a probability of 0.5 and in the other it is $99, each with probability 0.5. The mean
price is $100 (to keep the numerical example simple, the drift of the mean is ignored). The
variance is 1 percent. Next period the price moves from the previous position, moving up or
down by 1 percent with equal probability. If the price in Period 1 was $101, then the price next
period is $102.01 or $99.99. Since the probability of price in Period 1 being $101 is 0.5, the
probability of it being $102.01 or $99.99 will be 0.25. If price was $99 in Period 1, the next
period it will be $99.99 or $98.01 with probability 0.25. There are three possible prices, $102.01,
$99.99 and $98.01 with probabilities 0.25, 0.5 and 0.25. The mean is $100 and variance 2 per
cent and variance increases over time. Given the assumed distribution of returns, the movement
of stock price follows Brownian motion which, because of its frequent occurrences in physical
sciences, is well understood. Modeling stock price movement as Brownian motion and deriving
option prices involved many conceptual challenges that were solved by Fisher Black and Myron
Scholes.
Option pricing. The four variables that influence the option pricing are current stock price,
the strike price of option, the variance of the stock under Brownian motion and time to expiration
date. Because of the complexity of the process the equation relating these variables to the option
price is very involved. Still it has a simple structure and consists of the sum of two factors. The
first one is current price of stock multiplied by a probability that depends on a function of the
four variables. Second one is the discounted value of strike price multiplied by probability that
depends on another function of the four variables. 1
Hedging: Southwest Airlines brought options to purchase aviation fuel at $52 per barrel
when the current price of fuel was $51 per barrel. It was betting that price will increase. If price
increased as it did $80 by October 2007, those who wrote the options will suffer a loss of $28 per
barrel. The same will happen to those who write options on stocks. If the price of stock at the
expiry date exceeds the strike price, the difference is a loss to the writer who has to give the
stock at a lower price to the one who holds the option. The writer of option, faced with this risk,
can hedge against possible loss by using a strategy of buying the stock on which the option is
written and financing it with the price of option and selling a bond short. 2 The writer did not
have to commit any of his other funds to form this portfolio.

1
The strike price is the price at which option can be exercised at the time of expiry option. It presents value at any
time before the time of expiry is obtained by discounting it for the time difference.
2
Selling short is selling an asset that the individual do not own. Sometimes the person shorting the asset borrows it
from another individual to whom he has to return it at the specified date. If price of the asset has fallen in between,
the person who shorts it makes a profit. Such transactions are common in markets where seller is sure that he can
purchase the financial asset in the market if he has to deliver it to the buyer. Hedging is the defraying the cost of one
investment by another.
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The terms in the brackets will change with stock prices, time to expiration and variance.
Another part of the complex proof of option pricing is to show that on the net the changes in the
value of stocks and bonds will cancel each other and the writer will have no cost in maintaining
the hedge during the life of the option; in the terminology of option price is a self-replicating. At
the time of expiration, the writer following this ever changing hedge portfolio will be left with
enough stock to meet the demand by those who brought the option if price of stock exceeds
strike price. Since the buyer will exercise the option, the writer can pass the stock to him without
additional costs. If the stock price is less than the strike price, the hedging would end up with no
stock but then the holder of option is not exercising it. The hedge eliminates the risk of loss to
the writer but he makes no profit from it; it is like an insurer who offers a fair gamble to the
insured. The buyer of the option has to pay the price of the option and it could be viewed as a
premium for avoiding purchasing the stock at a higher price than the strike price.
Though the hedging explained after stating the Black-Scholes option pricing formula was
stated, the ability of the writer to use dynamic hedging to protect himself from any loss from the
option was used in deriving the formula. Mathematically all the arguments in different sections
in which options were discussed are interconnected.
Assessment of option pricing. The Black-Scholes pricing rule was instrumental in the growth
of option markets and still widely used in pricing options. It is a rational pricing formula if the
assumptions underlying it are valid. Yet they are frequently violated.
The model assumes that the writer can hedge by buying stocks and selling bonds at current
prices. If the market is thin relative to the trade by option dealers, the price will change as trade
occurs. The model also assumes that there is no transaction cost for these trades which is not true
and these costs limit the ability of the writer to trade hedge continuously as required by the
formula. The interest rate will not remain constant during the life of the option. Finally the
probability distribution of stock prices may differ from what is assumed in the formula.
Option pricing formula is another example of how simplification leads to a fundamental
insight but once it is obtained, it is necessary to strive to adjust for complexities excluded. Much
of the work in option pricing is directed at this goal.
Conclusion.
Many of the decisions we make in the present affect us in the future. Economic science from
the time of Adam Smith on recognized the role of time but the tools to analyze intertemporal
decisions when outcomes are uncertain were developed only in the twentieth century. Time
preference in one form or other can be traced to nineteenth century writers but the precise
formulation by Irving Fisher stated here is from his Theory of Interest published in 1906. Von
Neumann and Morgenstern’s work on utility maximization under uncertainty was published in
1944 and Leonard Savage work on subjective utility in 1954. The mean-variance theory was
developed in the fifties by Harry Markowitz and James Tobin. The rest of the analysis of
financial markets in this chapter was developed in the last half century.
The impact these theories had in their short lives is evident from the dramatic development of
the financial markets. Theoretical developments were crucial for the broadening of the market.
Until mean-variance theory and capital asset pricing model were developed the concept of risk
was not well understood and the cost of equity capital was related to growth rate of the firm
which is very subjective. New theories enabled innovation in portfolio management and
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corporate finance. The derivative market, though traced back to seventeenth century, came into
its own only after the option price formula was developed.
The theories clear were based on simplifying assumptions that were necessary to bring out
the role of risk and reward. The result was an analytical foundation that is well understood and a
host of empirical results that provide general support to its conclusions. But the fit has not been
perfect and ongoing research while questioning and extending the models has not led to a new
and widely accepted analytical framework.
The assumption of stock prices are rational in the sense that it incorporates all the
information about the firm as of that moment is one of the hotly contested assumptions.
Behavioral finance argues that the internet bubble, the 1987 stock market crash, the large
variance of stock indices and the tendency of stock prices to follow a trend set in past indicate
that the assumption of rational expectation need to be modified. The 2008 financial crisis is
bound to add to this debate.

Bibliographic note: Akerlof (1991); Bailey (2005); Bosworth (2005); Burrow and Rouse
(2005); Browning and Lusanrdi (1996); Chabis, Laibson, Schuldt (?); Chriss (1997); Danthine
and Donaldson (2002); Day and Newberger (2002); Eichenberger and Harper (1997); Fama and
French (2004); Field (1997), Financial Times (July 24, 2008); Fisher (2006); Shane,
Loewenstein and O’Donoghue (2002); Grinblatt and Titman (1998); Herschleifer and Riley
(1992); Huanf and Litzenberger (1998); Hull (1993); Laibson (1997); Lentwiler (2004); Lutz
(1967); Machina (1987); Mass Colell, Whinston and Green (1995); Option Insitute (1999);
Parker (200); Perold (2004); Shiller (2003).
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Chapter 13. Firms: Islands of command.

The English economist Dennis Robertson described firms in a market economy as “islands of
conscious power in this ocean of unconscious cooperation, likes lumps of butter coagulating in a
pail of buttermilk.” 1 The ocean is the competitive market where firms compete with each other
for sales to customers. The islands are the firms in which employees are required to take
directions from their administrative superiors. Instead of pursuing their individual interests,
employees are expected to take actions judged to be in the best interest of the organization. The
paradox is that these “islands of conscious power” were not imposed on the economy - as
planning was imposed on the Russian economy after the Soviet Revolution - but arose out of the
churning of the competitive markets.
Each one of us, even when swimming in the markets, has to interact with the command
structures as consumers, investors of our savings, and as employees. Decisions made within it
has affects us. Yet there is aura of mystery as the firms are guarded in what they reveal. Even if
we are working in the firm, what we know is restricted to what we have to do. Yet actions within
the firm affect us by affecting our career opportunities, the value of our savings and the choices
in the product market. In the interrelationship in an economy, the two foci are the consumer and
the producer. All other institutions play a supporting role in the relations between the two. This
chapter takes a peek at the mysterious islands.
The shifting of production from cottages to factories occurred when new technologies gave a
competitive advantage to mass production using of machines driven by water or steam power.
Adam Smith in his Wealth of Nations uses the process of producing pins to illustrate the
enhanced productivity from ‘division of labor.” 2 A single craftsman, if he tries to make pins by
himself, can at most produce ten pins per day. In the factories he visited, Adam Smith noted that
the production of pins was broken down into eighteen distinct operations and ten persons manage
them (with some doing more than one of the operations). The output of the plant is forty-eight
thousand pins or four thousand and eighty pins per worker per day.
The boundaries between its internal operations and the markets where they transact are
changes over time. The Rouge River Complex of Ford Motor Company grew over time to
include almost all stages in the manufacturing of a car; it had its own blast furnace and steel mill,
glass manufacturing, tire plant and assembly line to put it all together. Today it is common for a
firm to purchase many components of its products from other firms; a computer manufacture
purchases semiconductors, plastic cover of the central processing unit and even the keyboard
from other firms. Instead of producing something internally while buying rest from outside, why
not carry the breakup the manufacturing process to the level of individual operation and let a
market transaction intervene between them? In pin making, let each of the eighteen operations be
done by different firms with the firm that did the first operation selling the semi-finished good in
the market to the one doing the second and so go on till at the end of eighteen operations, are
done and the finished product can be sold in the consumer goods market. This limit of
fragmentation is never reached and firms that internalize production coexist with markets for
parts and semi-finished goods.

1
Robertson (1923), p.85
2
Adam Smith (1904), p.5
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Figure 1. The organizational chart of a firm.

The rise of the industrial corporation.

Till the middle of nineteenth century, manufacturing except in armories and textiles, were
conducted at the smallest level. Most American firms relied on human, water or animal power to
run the simple machines made out of wood; many were put together locally but some were
imported from England. “The overwhelming majority of enterprises listed in McLane Report has
assets only of a few thousand dollars and employed at the most ten or dozen people.” 1 Given
their sizes and organization, the need for capital was limited and met from the savings of the
owner, his partners and the local bank.
In the transition from household production to factories, consumer industries in England
went through an intermediate stage of proto-industrialization or putting-out system. An urban
entrepreneur provided workers at home with raw materials and then took back the processed
good and sold them in the market. In United Sates, a few industries - cotton (for a short period),
textile, shoes, chairs - used the putting-out system but it never became widespread here as in
England. Since the most common primary production units of production are a small factory,
there was no need for complex organizational structure. The owners relied on direct supervision
to manage the laborers and their activities. This delayed use of accounting system to assess the

1
McLane Report is a 1932 survey of American manufacturing authorized by the Secretary of the Treasury. Alfred
D. Chandler (1977), p.60.
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efficiency of operations; later double-entry bookkeeping was used to record of financial

transactions. 1
As the size of firms grew with technological change, with improvements in transportation
opening distant markets and with mergers of firms in the same industry (horizontal mergers), the
owners had to delegate decisions to others. In United States, the railways faced the challenge of
coordinating movement of goods and passengers over long distances. In the case of
manufacturing industries, technological innovations increased the size and output of firms and
they had to develop capabilities to sell the output over a wide geographical region. Firms created
a middle management staffed with professionals specialized in management, accounting, sales to
supervise the operations (Figure 1). 2 In England, the early industrialization and smaller
geographical area with more concentrated population had the opposite effect as opening of
markets in the United States; the management continued to be in the hands of entrepreneur or his
family and professional management structure as in the United States did not develop till the
twentieth century.
In the entrepreneurial firms, the top management consisted of the founder/owner or his
partners. With the growth of firms, decentralization even at the top level became imperative. The
firms that raised funds in capital market had to provide representation to those who provided it
with funds. The shareholders of firms (that have issued stocks in financial markets) are the
nominal owners of the firms but diffused ownership of stocks makes it impractical for them to
participate actively in the management. This responsibility is delegated to the board of directors
who are elected by the shareholders. The board appoints the chief executive officer (CEO). The
chief executive office is assisted by the chief financial officer and executive vice presidents for
operations, marketing and personnel in developing competitive strategy and policies of the firm.
They evaluate how well the policies set by them are implemented by the middle management
and operating units.

Decisions relating to operating unit.

Operating unit’s position at the bottom of the command structure (Figure 1) belies its
economic significance. The profitability of the firms is determined mostly by the cost of inputs
into its processes and by the sales revenue of its output. The economic justification for the
superstructure is its role in directing the operating unit to meet the goal of maximizing profits.
Management that fails to meet this goal come in for criticism and is under threat of being
replaced.
The operating unit is only one segment of a longer supply chain that begins with consumers
at one end and ends with producers of the most basic inputs at the other. Its operations must be
tuned to the demand for the firm’s output which depends on the needs of the consumers and the
extent of competition in the market. For any level of output, the management must minimize the
cost of production by choosing a basket of inputs that is appropriate for its technology and the
current cost of inputs. While the production process differs from industry to industry, in general
it can be depicted, as in Figure 2, as the transformation of raw materials into finished product.
1
Accounting systems were introduced earlier in England due to prevalence of putting-out system there.
2
The distinction between line and staff positions was carried over from the railways. The line positions, from
general manager to foreman, form the hierarchy for the control of the product or service while staff positions are
provide advisory and support responsibilities like accounting, finance and research.
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Figure 2. Cross-section of a firm

The profit maximizing output will vary with the changing conditions in the product market
and the operating unit must respond by changing the input basket to achieve cost minimization at
the new level of production. The adjustments will depend on the technology and the speed with
quantities of inputs can be changed. From outside, a modern factory is an imposing structure and
the management, out of concern that information about its operations will give away its
competitive advantages, limits access to its plants. One familiar exception to this inaccessibility
is small restaurants where as diners we can observe the meals being prepared. Viewed in abstract
as a transformation of raw food products into a meal their operations parallel that of other
industrial units. In addition a restaurant is a retailer and its choices throw light on how it links
food preparation to marketing.
Choices made by a restaurant. The physical space of the restaurant includes dining area,
the bar, kitchen and storage area. The dining area has its chairs, tables, lightning and music
system. The bar is stocked with beer, wine and liquor. The kitchen is equipped with appliances,
cutlery and crockery to prepare and serve food. The two common sources of energy are
electricity and gas. The restaurant employees cooks, assistants in the kitchen, bartender and the
waiters.
If it is an up-scale restaurant that only serves dinner from 6:00 p.m. to 10 p.m., the food
preparation starts around noon and the last employee leaves around midnight. The limited hours
of operation creates an asymmetry in its cost structure. The employees are paid for the hours they
work and the electricity and gas charges depend on usage. Whether it is used or not, the physical
capital - space and equipment - is there all the time and the owners have to pay interest on the
cost of the capital even though it is used only half the time. 1 .
The capacity of the restaurant is based on an expectation how many customers will come for
dinner on an average day but the number fluctuates from day to day. If unexpectedly large
number of customers comes on a day, the restaurant needs extra tables and chairs to sit the guests
and the kitchen has to be equipped to prepare additional dinners. The restaurant must have at

1
Most firms use a mix of equity and loans to fiancé their investment in physical capital. The implication of using
the mix will be discussed later in the chapter but here, for simplicity, the investment is assumed to be financed by
loans only.
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hand enough groceries to prepare the extra meals. Each choice has its costs. If the restaurant
maintains a capacity well above what it uses in general, it adds to the cost of capital of the firm.
Some food items become stale quickly and if purchased in excess will have to be thrown out. If
some guests are denied seating, he or she will most likely go to another restaurant. Not only has
the firm lost revenue from the sale of dinners on that day, those who went away may not return
in future. In choosing capacity, the restaurant seeks a balance between the fixed cost of capital
and the loss of profits from lost sales.
The owners can increase utilization of the physical capital by serving lunch. The wage cost
will increase in proportion to hours employees worked and the energy bill will go up. Additional
grocery need to be purchased. In terminology used in earlier chapters, these are the variable
costs. The cost of capital that does not change with increased utilization - ignoring additional tare
and ware - is the fixed cost. The decision to serve lunch is economical if the additional sales
revenue exceeds incremental variable cost.
If one evening more than normal diners are served, would the rushed preparation to use more
of the ingredients per additional meal? Will extra activities in the kitchen create distract kitchen
staff and add to the labor time needed to prepare each additional meal? If so, the cost of
additional meal, the marginal cost goes up with the number of meals. If the prices of entries in
the menu are fixed, then it is also the marginal revenue and there is a level of service at which
marginal revenue equals marginal cost. As discussed in earlier chapters, this is the level at which
restaurant maximizes its profit.
The decision whether to serve lunch or not is an example of the choice the owners have to
make about the strategic fit of the restaurant in the supply chain. It must decide on: the quality of
the product, the price, the level of service, the speed of delivery and addition of new items in the
menu. Some diners go to fast food restaurant seeking quick service and low prices but are willing
to give up the service in an upscale restaurant. Others choose chain restaurants with sit-down
service, bar serving beer and wine, and better choice of foods; the prices exceed those of fast
food restaurants. Still others seek upscale restaurant with full bar, a gourmet meal served with
individualized attention that takes more time and cost more. The strategic fit requires that the
production end - the chef who prepares the food, the waiting staff if any and the setup of the
kitchen - should match the marketing strategies like the ambiance of the restaurant, the speed of
service and the pricing.
The next section considers how the quantitative relation between inputs and output is
determined by the technology.

Input choices and production management.

The production process in a plant being a transformation of inputs into output, the quantity
of output can be related to the quantities of inputs and production function is an expression of
this relationship: quantity of output = a function of the quantities of (machine hours, labor hours,
raw material and energy). 1

1
The relation between the speed of plane and use of fuel is an example of such quantitative relation between inputs
and outputs (See Chapter 11).
186

Certain technologies require that the inputs be combined in fixed proportion. Such is the case
of an industry that requires a fixed amount of steel, so many hours of machining, labor hours and
a given quantity of energy. 1 If the capacity of the plant is not fully utilized, then a proportional
increase in the other (variable) inputs will increase the output in the same proportion. The cost of
variable inputs, given fixed prices, will also increase in the same proportion, making marginal
cost, the cost of an incremental unit of output, constant till capacity. This is one justification for
the constant marginal cost assumption in Chapters 6 to 10.
If the technology permits combining inputs in different proportions, then output can be
increased by increasing anyone of the inputs. Can the production process have such flexibility? It
is widely accepted that in agriculture the proportion of inputs can be varied. Without changing
the amount of seeds, a farmer can increase the output through better irrigation, use of fertilizer or
careful tending of crops. Does such flexibility exist in industries? Possibly there are workers in a
plant who have to switch from one job to the other and the switching time was reducing their
productivity. If new workers are added, the jobs can be separated and together they can produce
a larger output.
Examples apart, whether individual inputs can be varied depends on the technology and this
was debated at length in the second half of nineteenth century. Now it is widely accepted that
such variation, at least within limits, is feasible. Once the variation of input proportions is
admitted, certain “marginal” concepts that are useful in analysis of firm and of the input markets
can be developed. 2
Changing output through change in variable inputs.
Based on their marketing studies, the upper management asks you, the production manager
of a plant, to increase the output. What are your choices and how should you go about doing it?
If inputs can be varied individually, you can increase one of the inputs; let it be energy. For unit
increase in the energy, the output of the firm will increase by the marginal product of energy.
The marginal product is a derived concept from the increase in total output for unit increase in
the quantity of the input; the temptation to think of marginal product as the output produced by
“the last unit of the input” should be resisted as all units of inputs are identical and there is no
identification of any unit of output with anyone unit of input.
Your decision affects both the cost and the revenue of the firm. An additional unit of energy
hour increases the cost by cost of energy but the sales revenue also increases as the additional
output is sold. If the price is 10 cents for kilowatt hour and the marginal product is 0.05, then
producing an extra unit would cost the firm $2 and that is the marginal cost. In general marginal
cost is (price of input)/marginal product. If the increase in sales revenue, marginal revenue, is
greater than the marginal cost, the profit of the firm has increased. You will then be justified in
hiring more of the input.

1
Another way of stating this relation is that the ratio of any one of the inputs to the output, the coefficient of
production for that input, is a constant.
2
George Stigler, an eminent economist and historian of economic thought, succinctly summarizes the debate: “By
1900 most economists used universal variable production coefficients. In recent years there has been a revival of
fixed coefficients, in connection with so called input-output and linear programming analysis.”
“The question is mostly one of fact, and of a kind of fact not easily enumerated in a census. Moreover, while it is
easy (I conjecture) to show that every important production coefficient has varied since 1925, only those variations
that occurred in the absence of technological progress are in question, and they do not carry separate labels.” Theory
of Price p.124.
187

Figure 3. The marginal rate of technical substitution.

When will increasing energy cease to be profitable? The answer is jointly determined by the
manufacturing technology and the market for the product. The output of a firm is constrained by
one of the three conditions: the firm reaches capacity, marginal revenue decreases to the level of
constant marginal cost, or marginal cost increases to the level of marginal revenue. Once
marginal cost exceeds marginal revenue, the firm cannot add to profit by increasing output.
Should you have increased another variable input than energy? The increase in profit for one
additional unit of output will be the difference between the marginal revenue and marginal cost.
Since marginal revenue is determined by the output market, it will be the same irrespective of the
input used to increase output. The differences in profit from using different inputs depend only
on marginal product of an input and its price. If you are asked to increase the output, your
responsibility as the production manager is to choose the input that adds most to the profit of the
firm.
When will a substitution of inputs reduce the cost and increase the profits of the firm? What
basket of inputs will produce the current output at minimal cost? What is the condition for cost
minimization?
How to choose the basket of inputs that minimize cost. The firm in Figure 2 is considering
substituting some of its labor intensive operation with one that uses more energy without
changing in output. The contribution to output by additional energy must match the decline due
to reduced labor hours. It suggests that that the rate of substitution will depend their marginal
products. The conditions that neither output nor cost be affected by small changes imply that
ratio of marginal products of the two inputs, defined as the marginal rate of technical
substitution, equals the ratio of their prices (Figure 3). 1 If the change in input basket had
1
The output is constant if (marginal product of labor) times (change in labor) equal (marginal product of energy)
times (change in energy). Hence (marginal product of energy)/(marginal product of labor) = (change in
labor)/(change in energy). Since the changes in the quantities of inputs are such as to keep output constant, it is
defined as the marginal rate of technical substitution (along the lines of defining change in quantities of consumer
goods that keep level of utility constant as the marginal rate of substitution). Constancy of cost requires (change in
188

reduced costs, then the firm was not minimizing cost. This condition is reminiscent of the rule in
consumer choice that marginal rate of substitution should equal the price ratio.
Is there a combination of inputs that minimize cost and if so is there only one such
combination? The condition necessary is that as more and more labor is added, the reduction in
energy input needed to keep output constant must decrease; the marginal rate of substitution
must decrease as more energy is substituted for labor.
Marginal product and marginal cost curve. Going back to input use in agriculture, an
increase in fertilizer (or irrigation) increases the yield from the land. In those regions of the
world where cultivation was primitive, applying fertilizers led to a substantial increase in the
output of the farm. The first dose of fertilizer has a high marginal product. But experience
suggests that as more and more fertilizer is added, the land gets saturated and output ceases to
increase; the law of diminishing marginal product is a formal statement of the principle that
output cannot be increased indefinitely by adding one input while others are constant. As
marginal product decreases, the cost of producing an additional unit with additional employment
of this input whose price is constant increases.
The technology of an industrial unit determines whether output changes with one input and
also how the marginal product varies. In marginal product is constant, marginal cost will be
constant (assuming input price is constant). In the complex environment in which a plant
operates, it is not generally feasible to change one input alone. Given the absence of
experimental verification, one approach is to statistically analyze the cost data of the firm and
derive the cost curve. Another approach is to interview managers and obtain estimates. Such
studies suggest that marginal cost is constant up to an output which was defined as the capacity
of the plant and it is assumed to be so in discussions in many models of industrial organization,
management accounting and operations research. Most discussions of ‘price theory” - the branch
of economics that discusses how prices are determined - still favors the assumption that marginal
cost is increasing.
Perturbations in the supply chain.
Changing output. The fluctuations in the demand force every producer to face choices
similar to that of the restaurateur in responding to them. Too much of capacity leads to
redundancy and the high fixed costs can result in loss as happened to the U.S. automobile
industry in 2008. Compared to the previous year, the sales of the “Big Three” automobile
companies, GM, Ford and Chrysler, saw their sales decline by 22.6 per cent, 20.1 per cent and 30
per cent respectively. 1 In mid-December GM announced that it will idle 30 per cent of its North
American assembly plant volume. 2
In contrast any firm that underestimates demand will lose sales. Though publishers and
booksellers suffered a decline in sales in 2008, Amazon faced a shortage in one of its products.
In November 2007, Amazon introduced Kindle, a paperback sized wireless portable reading

labor) times (wage rate) = (change in energy) times (price of energy) and this leads to the condition that (price of
energy)/(wage rate) = (change in labor)/(change in energy). The right hand side of the two equalities are the same
and so (marginal product of energy)/(marginal product of labor) = (price of energy)/(wage rate). The left hand side
of this equality is defined as the marginal rate of technical substitution, leading to a relation that at profit
maximization, it must equal the ratio of input price.
1
Los Angeles Times, January 6, 2009.
2
The Wall Street Journal, January 5, 2009
189

device into which a large number of e-books could be downloaded. The sudden surge in sales
after it was featured in a popular TV in October 2008 resulted in it being out of stock by end of
the year and was expected to remain so till the next February. It allowed competitor Sony to
promote its Reader device during the gift-buying Christmas season. 1
The ideal is for a firm to adjust its output with sales but such close tracking may be too costly
to be profitable. A study of the automobile industry in US by Timothy Bresnahan and Valerie
Ramey identifies different ways of adjusting output in the short run. 2 The industry pioneered use
of assembly line for mass production; it reduces average cost by spreading the fixed cost of the
plant among large number of units and by increasing productivity of workers who repeat the
same operation. The output can be varied in response to demand changes by altering the hours of
operation of the line and the labor input measured in the work hours will change with it. Labor
hours can be increased by making workers on a shift do overtime, by increasing the line speed
and by adding more shifts. 3 Overtime achieved by adding an hour or two per day or, more
commonly, by an eight hour shift on Saturday requires that the workers be paid a premium of 50
per cent for hours worked in excess of 40 hours a week. Increasing the speed from 70 cars to 80
cars require requires hiring more laborers per shift as it involves reorganizing the assembly line
and redefining jobs. If a second shift is added, the workers in that shift receive 5 percent wage
premium. The marginal cost of the product depends on how the labor hours were increased.
Output reductions are achieved by shutting the plant for at least a day, shut-down for a week,
reducing the number of shifts and reducing the line speed. Looking at the reasons plants were
closed down, Bresnahan and Ramey notes that 35 per cent of the days the plants are shutdown is
for model changeover, 25 per cent for reducing inventory and 7 per cent due to supply
disruptions including strikes.
The different methods of changing output have different costs due to overtime pay. If higher
sales are expected for long time, the firm increases capacity leading to higher fixed cost but not
much change in marginal cost. For the duration of the change in output is longer, it will prefer a
change in work schedule with larger fixed cost but lower increase in marginal cost; in case when
duration is expected to be shorter, it will prefer the change in operations with a smaller increase
in fixed cost and high marginal cost. In any case, the nature of costs make the changes in
production rate vary, as measured by variance, more than the fluctuations in sales.
An inventory of final products permits the firm to meet fluctuating demand by drawing on it
when demand exceeds output and adding to it in times of slack sales. Inventories however can be
costly. The firm has incurred costs in producing the items in inventory and they were finances
from the working capital for which the firm must pay an interest. The cost of the storage facility
and the salaries of personnel that manage it are other expenses. Over time part of the inventory

1
The New York Times, December 24, 2008. A1.
2
Bresnahan and Ramey (1994) pp. 593-624.
3
The data for this study is from 50 automobile plants over 626 weeks from 1972 to 1983. The wage rates and work
rules are those that prevailed during this period. Among these plants, 6 produced only one model and that enabled
identifying work hours with the specific output.
190

Figure 4.Multi-stage processing and flow of inputs through the plant.

gets spoiled and parts become redundant as new products produced either by the firm or its
competitors. 1 Today firms strive to minimize inventory.
Managing the flow of inputs. In most manufacturing operations, the inputs that are brought
into the firm (Figure 1) are transformed into the output by a multistage production process;
Figure 4 shows a simple two-stage process. The modern automobile has many parts made out of
different materials. Its production involves fabrication of many parts and then assembling them
together. Some are produced in the plant itself while others are provided by its suppliers. In a
sequential multi-stage process, output of one process is input to a subsequent process in the
operation and demand for it depends on the production schedule of the latter. It would be ideal if
inputs can be produced just when there is a demand for it but it is not practical for many reasons.
The time involved in production of components differs and machinery at one station in the plant
may have to be used for fabrication of different parts. All plants, in spite of differences of in their
outputs and technologies, face the problem of ensuring a smooth flow of work-in- process
through the manufacturing process.
There is a fundamental difference between meeting internal demand for work-in-process and
meeting the demand for the product in the market. The buyers makes decisions based on their
wants and the producer can provide incentives like price discounts but have no quantitative
control. Within a plant both the units producing the components and the ones using them are
within the command structure of the firm. The firm can choose how workers operating each unit
are informed and motivated to produce the parts in quantities as needed while minimizing cost of
production and cost of holding inventory. Should the operating units have freedom to
communicate directly with each other and schedule the production or should they be asked to
follow a master plan made by the management? The two paradigms for production planning that
were widely adopted in the later decades of twentieth century differed substantially in the degree
of decentralization.

1
Thread separation in the tires made by Firestone for Ford SUVs at the Decatur plant resulted in death in early
1990s due to rollovers of the vehicles. One alleged quality control problem that led the separation was that rubber
used in manufacture of tires was allowed to sit too long. New York Times, September 15, 2000.
191

Just-in-time production. The first approach, developed by Toyota Motor Corporation,

focused on inventory reduction by producing what is used just as it is needed. As this paradigm
was emulated by other firms, it came to be known as just-in-time production system. “Lean
production,” popularized by MIT’s International Motor Vehicle Program can be viewed as a
refinement and broadening of just-in-time approach. 1
The decision process under just-in-time production hinges on communication between
operating units. Consider a processing unit producing a component in small batches and placing
it in bins with green cards bearing the identification number of the part. The next processing unit
takes them out of the bin when needed and, as each unit is taken out, replaces a green card with a
red card. When most of the green cards are replaced by the red ones, the first unit produces
another batch of the part. 2 Once a part is placed in the bins, it remains there till the next stage
withdraws it: the supervisor has to take responsibility for it and not hide overproduction by
shifting the inventory to other units. The just-in-time production is characterized as a pull system
as signals from the next stage of production, “the pull,” determines the operations of each unit.
Elementary as the process is, its efficiency derives in localizing and simplifying decision-
making.
For the system to succeed, some complementary changes in the operations of the plant are
needed. A processing unit that manufactures any part in small batches will have to switch to
production of other parts if its equipments are not to remain idle for long periods of time.
Minimizing the labor cost and minimizing the downtime of the machinery are essential if the
process is to be economic. Toyota separated the operations for the change-over into those that
can be done when the unit is still producing from those that requires shutting down the unit and
used the separation to reduce change over time. This is embodied in its philosophy of ‘single
minute exchange of dies.” The lean production system allowed Toyota to respond to the
consumers by offering more choices in any model of the vehicle and even from shifting from
production of one model to another than American automobile companies that remained with
mass production systems.
Toyota developed two other programs - “total quality management” in 1960s and “total
productive maintenance” in 1970s - that complemented the just-in-time production developed in
1950s and enhanced the competiveness of the company in terms of quality, cost and delivery.
Total productive maintenance program seeks to achieve greater customer satisfaction by
involving the employees at various stages in the development and production of the product. Its
philosophy is that quality of the product is built in the process and any problems should be
detected in the process and corrected than after the production of the defective product. The total
productive maintenance focuses on the involvement of employees in maximizing the overall
effectiveness of the equipments through reduction of downtimes due to repair, resetting or work-
related to losses.
Though the goals of these programs are commendable and the evidence of success of
companies that have effectively implemented them is convincing, any firm that tries to introduce
them must consider the cost of the complex organizational changes they require, including
investment in retraining of employees and schemes to motivate them to follow its demanding

1
Enkawa and Schvandeveldt (2001) pp. 551-555.
2
This is a simplified representation of signaling the use of parts known as kanban system, kanban being Japanese
for cards. The green cards are production kanbans and the red ones are withdrawal kanbans.
192

requirements. Experience shows that it is advisable not to introduce the system simultaneously as
the cost involved will have no return in the immediate future.
Managing flows of inputs from suppliers. Most manufacturing plants purchase many
finished, semi-finished and raw materials from other suppliers. In placing orders with suppliers,
the firm had to ensure sure that they are capable of producing the product in quantities required
to the specifications given and on schedule. The time and effort the firm spends on comparing
potential suppliers and choosing between them imposes a cost on it, the transaction cost. If their
flow does not match with their use internally, either excess inventory will accumulate at the input
end (Bin 1 of Figure 4) or production will be disrupted by shortages. Any bilateral relation is
open to opportunistic behavior; the supplier can ask for price increases price beyond that
warranted by cost changes as it knows that the firm will have difficulty in changing over to
another one. The manufacturing firm can also be opportunistic in pressuring the suppliers as they
would suffer serious loss from the redundancy of the investment to produce the part. 1
The Japanese manufacturers minimized such costs and risks by maintaining a close link with
a limited number of suppliers and getting them involved in the model design and manufacture.
John McMillan argues that the long-term relationship between the firm and its supplier can be
viewed as a repeated game which reduces the incentives to take opportunistic action.2
Manufacturers in other industries and other countries have adopted just-in-time production and
supplier relations developed by Toyota. McMillan points to the example of Xerox which cut the
pool of suppliers from 5,000 to 400. Recent growth of e-commerce reduces the transaction cost
of searching and placing an order for parts and how it affects the balance between long-term
contracting and market transactions is to be seen.
Limitations: In spite of the contribution of the just-in-time programs to efficiency of the
production process, it has the limitation that it is reactive than proactive to changes in market
conditions. The demand schedule is liable to change with seasons and over the life of a product.
Just-in-time production is best suited to high volume and repetitive manufacturing processes. As
market trends pressures firms to produce a larger variety of products in smaller quantities, the
kanban system loses its ability to minimize inventory. On low volume items, Toyota itself has
gone to schedule-initiated production.
An alternative system: material requirements planning. Another approach to planning the
operations that was extensively used in the second half of twentieth century begins by
forecasting demand for the product during a pre-determined planning period. Once the
projections are made, a production schedule of each component is prepared. As first developed in
the 1960’s, material requirement planning (MRP) was found to be too narrow in its scope and
newer programs, manufacturing resource planning (MRP II) and Enterprise Resource Planning
(ERP), addressed the deficiencies of material requirement planning, by encompassing all
operations of the firm, from processing of materials to distribution of the final product.
In contrast to the localization of decisions under just-in-time production, these complex
computerized systems centralized the information in large data bases and used them to check
inventories and order deliver of parts. It is a push system that manufactures parts to a centralized
schedule than based on the pull from the next processing systems.

1
Game theory discussed in previous chapter provides the logic and the possible solution to such behavior.
2
Mcmillan (1990).
193

These push systems require expensive computer systems and once established takes too
much of computer time to run the schedule once. It assumes that “lead time”, time taken to
produce a product from time of order is fixed and provides no incentive to workers in the plant
to reduce it as exists under just-in-time systems. Being data intensive, it is sensitive to the
accuracy of the data and workers have to go through extensive training in inputting shop-floor
data into the computer. Also the program cannot respond to frequent changes in data as it is not
economic to run the program frequently.
Uday Karmarkar points out that the planning system should be tailored to the nature of
production process. 1 Instead of viewing pull and push programs as substitutes, they should be
used complimentarily with the first promoting shop floor efficiency and the other responsiveness
to market conditions.
How does your employer treat you?
About seventy percent of the aggregate income of individuals in western economies is
employment compensation. Each one of us spent the better part of the day during our working
years at the job and how enthusiastic we are and how much effort we put into it depends on how
the employer and coworkers treat us and how your efforts are recognized and rewarded.
For the employer, the compensation paid as wages, bonus or benefits is a cost to be recovered
from the sales revenue generated by the efforts of the employee. If the outcome of his effort can
be identified either by direct supervision of his work or if the firm can identify what part of the
output is due to his effort , then the compensation – as with a piece rate or commission for sales
for example - can be related to his productivity. Output can depend on group activity or may vary
with random factors and the employee can claim that they do not measure his effort well. Close
supervision is not possible if the employees have to work are geographically dispersed; it is not
practical to closely supervise a sales person is travelling in his region or an airline attendants
flying around the country. Knowing that the employer cannot ascertain how diligent he is in his
work, the employee, preferring less effort to more, will shirk his responsibilities. Most of us have
met at stores, restaurants, in planes or in public offices, employees who seem indifferent to
providing you the service that they are supposed to do. We are upset at the employer for not
supervising or motivating the employee and even if we do not walk out, we promise never to
return. Losing a customer costs the firm current or future profits. The challenge for an employer
is to devise a compensation scheme and other human resource policies that motivates the
employees to increase their effort at job.
Hiring of employees.
The crux of recruiting is matching the skills of a recruit with the needs of the employer. The
matching is facilitated if the qualifications required of the expected recruit are fairly standard and
there are a large number of applicants with identical qualifications; this situation is discussed
below. If each vacancy can be filled only by individuals with specific skills and it is not obvious
who has it, the matching of the applicant and the job becomes a challenge.
Functioning of a labor market where a large number of identical individuals (as far as job
qualifications are concerned) compete for many jobs is similar to that of a commodity market in
which many consumers purchase identical products from many firms. The market clearing wage
is determined by equality of the number of offers to the number of job seekers.
1
Karmarkar (1989).
194

Figure 511. Labor market: market clearing wage rate and employment.
In contrast to the commodity market, buyers in labor market are the firms while sellers of
labor service are the individuals who seek work as a source of income. This reversal necessitates
fresh explanation of the response of the buyers and sellers to changes in the price.
An individual in a modern economy, like Alexander Selkirk in a deserted island off Chile,
has a choice between work and leisure. It is true that the hours of work are standard in many jobs
but even so an individual can choose to work more or less. In factories and stores, she can work
overtime or take a second job. At managerial level, there are choices between jobs that require
long hours and pay more and those that provide more leisure. Her preference is reflected in her
marginal rate of substitution between work and leisure. As the work hours lengthen, the
individual will be reluctant to give up additional hours of leisure or the marginal rate of
substitution will decrease. To induce the employee to give up more leisure, real wages (wages
adjusted for price changes of commodities purchased with it) must increase. This leads to the
upward slope of the supply curve Figure 5. 1
The cost of hiring worker for an additional hour is the wage rate. Increase in labor hours
increase output by the marginal product of labor. This output is sold at a fixed price (in a
competitive market for the product) and the extra income for the firm from one additional hour
of work is marginal product of labor times the price. As long as the incremental sales revenue
exceeds wages, the firm can increase profits by increasing labor input. If production is subject to
diminishing returns, increases in labor input without a change in the plant leads to a reduction in
the marginal product labor. Assuming the latter, the firm ceases hiring more employees when the
extra sales revenue (marginal product times price of product) equals wages. Only a reduction in
wages will induce the firms to add more employees. The demand curve for labor slopes

1
To focus on the labor market, this section assumes that the prices of products are constant and real wages change
with money wages. Changes in labor input can be either through employees working longer hours or through new
hires. The substitution between leisure and work was used to justify rising supply curve in the text but a similar
reasoning shows that offer of higher wages is required to attract those not willing to work at the current wages (a
housewife who finds cost of child care makes it unprofitable to work at current wages would be an example).
195

downwards to the right. Where the two curves intersect is a point on both curves showing that, at
the corresponding wage (showing on the vertical line on the right), the quantity of labor supplied
equals what is demanded. At this wage, the labor market clears.
The demand-and-supply diagram provides insights into the wage-price spiral and
unemployment. Firms produce is to sell and it is the demand for the product that generates the
demand for labor input; the demand not only for labor but for any input is a “derived demand”.
Another way of expressing the condition for clearing the labor market is that marginal product of
labor must equal (wage rate/ price of product). If money wages increase, profits and employment
are not affected if price of the product increases proportionately. In times of wage-price spirals,
employees demand higher wages and firms pass it on to the customers.
In contrast, in recessionary times like 2008-2009, the firms will cut down the employment at
any given wage level. This corresponds to a shift of the demand curve to the down and left;
though not drawn in Figure 5, it is clear that such a shift will move the point of intersection to the
left along the supply curve of labor and employment will fall. If those willing to work have not
changed in the short run, the reduction will lead to an increase in unemployment. 1
If individuals differ in skills and if the job for which the firm is recruiting has specific
requirements, the recruiting process must be match the candidate with the job. The manager who
is making the selection process has to content with the problem of asymmetric information. The
individual knows more about his abilities and skills than he does. Recruit wants to “signal” the
employer how suitable he is for the job. One signal is his level of education. According to one
view of education, the human capital approach, individuals learn skills in the process of
education and the recruiter considers the level of education of the applicant. Another theory
argues that it is the innate skills of the individual that matters and that education does not add to
it. But one with better abilities will find education less demanding that another with less ability
and so the former will have a higher level of education. In this view education is a signal that
tells you about his innate abilities. Either way, a good education is asset to a job seeker.

Motivation and retention of employees.

In the United States, employment is on at will basis which either the employer or the
employee can terminate without notice or cause; employment will last only as long as both
parties feel that the benefits of continuation exceeds that of termination. An employee will
remain with his present employer only as long as his remuneration exceeds what other
companies are willing to offer him. The firm desires to keep the employee as long as his
productivity earns them a profit. The problem for the employee and the employer is to make the
judgment whether it is worth continuing the present contract.
An employee’ productivity varies with her effort. The employer wants her to exert maximum
effort at work while she, for physical and psychological reasons, prefers less effort to more. The
agency problem arises as when the interests of the employer and employee are not aligned.
Given the difficulties in estimating individual productivity mentioned earlier, it is as if she works
behind a screen that allows her, at least to an extent, to pursue her interest than that of the firm

1
A full explanation of when wage-price spiral or unemployment can occur and how they can be rectified is in the
realm of macroeconomics and is not considered here.
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Figure 6. Agency problem in employer-employee relation.

(Figure 6). The firm tries to develop compensation scheme that encourages the employee to align
her interests with that of the firm.
One method that has a long history is to pay workers a fixed rate per piece produced.
Agricultural workers get paid by the amount harvested. Before the development of factories,
master craftsman assigned his juniors work they have to finish at home; later garment workers
worked at workshops set up for them. They were all paid “piece rate” for work done. In spite of
the opportunity to earn more by increasing their income by producing more, workers on piece
rate system were seen to hold back fearing that higher output in one period will lead to
employers’ reducing the rate in future. To eliminate this perverse incentive and to spare the
workers from the idiosyncrasies of the supervisor, Frederick Taylor, in the end of nineteenth
century, proposed setting up piece rate on a “scientific basis.” Each task was broken into
component part and carefully analyzed to determine the time required to complete it in the most
efficient way. These time-motion studies were used to determine the norm that the employees
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have to meet. To encourage employees to produce as much as they can the piece rate for output
in excess of norm was set higher. 1
Lincoln Electric, a successful manufacturer of arc welding equipment, is known for its
commitment to Taylor’s scientific management. Piece rates were determined on the basis of
time-motion studies and a worker who produced the norm will earn competitive wages. The
norm was revised only when new machinery or methods are introduced and workers are allowed
to ask for new studies to adjust the rates. Commitment to fix rates till a change in production
process assures workers that such opportunistic policy to decrease piece-rate whenever output
increases will not be adopted.
Do monetary incentives induce employees to increase their productivity? If so, do firms
devise compensations schemes to align their interest in higher productivity with that of workers?
To identify the response to incentive pay, it is necessary observe the productivity of the same
workers under the hourly rates and piece rate. In 1994 Safelite Glass Corporation, the largest
installer of automobile glass in the United States changed over from hourly rate to piece rate.
They had a sophisticate computerized information system that kept the number of units installed
by each worker. Edward Lazear used the data to examine the productivity of workers before and
after the change over and concludes that output per worker increased in the range of 40 per cent. 2
Incentive pay draws skilled workers to the company and made them work hard; those who are
less productive find their wages falling behind what their colleagues are earning and tend to
leave. Lazear estimates that half the increase in productivity at Safelite was due to workers
responding to the incentive system and the rest to retention of more productive workers. The
gains from increase in productivity were split between firm and the employees; workers
compensation increased by 10 per cent.
Whether following Taylor nor not, the system of enforcing strict targets on workers who are
assigned narrowly defined job was widely adopted in the United States in and around the First
World War. Federal Government’s procurement policies during the Second World War
accelerated its diffusion in the US industries.
By 1980, the trend reversed. Considering the success of Japanese firms like Toyota Motors in
the 1970s, American companies moved away from the rigid management to innovative systems
that empowered the workers on the shop floor.
In many activities the difficulty in introducing incentive pay is in developing appropriate
measures of output. Profitability depends not just on the quantity of output but on bundle of
characteristics associated with production and delivery of the product. Lincoln Electric found
that paying crane operators by the number of loads moved created safety problems. A sales
person who seeks quick sales by pressuring customers to buy or misrepresents the product will
antagonize them and lose the opportunity to repeat sales.
Incentives and risk sharing. In devising incentive pay schemes, the differing attitude of
employers and the employees to risk needs to be considered. Since output is affected by random
shocks, her employment income will fluctuate even if she maintains the same level of effort. The
employee whose main source of income is company compensation is risk averse and even

1
Some recent studies claim that there was nothing scientific in Taylor’s work as many parameters were set
arbitrarily.
2
Lazear (2000), pp. 1341-1361.
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though he has an opportunity to earn higher income though his efforts, he will shun it unless he
is offered a risk premium in the form of higher average salary and bonus. 1
The owners of the firm are assumed to be risk neutral; one justification for it is that part of
the income is from assets. His budget is not subject to pressures from one source of income.
Given the preferences of the employer and the employee, an efficient allocation of risk is for the
employer to absorb all the fluctuations of income from the operation and offer the employee a
fixed wage. It destroys the incentive to work harder. A contract that reverses the roles in risk
sharing is common in the taxi industry in New York City. The owner of the taxi charges the
driver a fixed rent and let him collect as many fares as he can get. He hustles for passengers but
he takes the risk that the fares collected differ from day to day.
Most compensation schemes try to balance between the need to create incentives to
employees and to share the risk; they also consider other goals of the firm like maintaining the
reputation for quality and for good consumer relations. Those who fail repeatedly to meet the
norm that includes quality are liable to be terminated. When Lincoln Electrics shifted to piece
rate, they offered $20 per unit installed with a guarantee that they can earn approximately $11
per hour; to prevent employees from doing shoddy work, as they strive to install more
windshields, the company tracks who installed each one and if one cracks, the employee has to
fix it at his own time.
More than seventy per cent of those involved in sales of industrial products, industrial
services, office products and office services are on salary and commission. Interestingly the
highest percentages of those on either fixed salary (27 per cent) or commission only (17 per cent)
are in consumer services industry. 2
Involving employees in decisions. The management system that evolved with the birth of
modern corporations at the end of nineteenth century stressed the command structure. The
organizational structure prescribed the responsibilities of each individual within the organization
and they were expected to follow rigid rules made by the management. Those in the lower ranks,
the blue color workers in the operating unit specifically, were placed under strict supervision,
tight quotas and were given no voice in the decision making. Scientific management devised by
Frederick Taylor refined this approach by redesigning work and using time-motion study to set
production goals.
The decline productivity growth in the 1970s and competition from foreign firms led to a
rethinking of the management practices of US firms. The success of Japanese firms created
interest not only on their inventory management but about their human resources policies.
Japanese firms were viewed as encouraging worker participation; joint consultation between
management and labor which takes place at many levels and with varying degrees of formality.
At the corporate level it is a formal meeting between management and labor union leaders. 3 At
the other end are discussions taking place at workshop level about the day-to-day operations and
issues about worker concerns. In addition the life-time employment system of major corporations

1
Consider an employment that offers $40,000 with probability 0.5 and $30,000 with probability 0.5. The expected
income from this employment is $35,000. An individual is risk-neutral if he is indifferent between this wage offer
and one that offers a fixed income of $35,000. He is risk averse if he rejects the offer for a job that pays a lower
fixed wage. The reduction that he is willing to accept depends on his degree of risk-aversion.
2
Johsnton and Marshall (2006), p.337.
3
Japanese labor unions are mostly company unions.
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guaranteed the worker the job. The seniority based salary is a form of deferred payment and the
incentive effects were cited in previous section.
Whether out of deference to the Japanese system or as a result of internal evolution,
managements in United Sates started encouraging employee involvement. At the same time it
was recognized that the agency problem will not go away just through consultation and what was
efficient was a policy that incorporated supervision, incentives and participation.
Paul Milgrom and John Roberts argue that not just the piece-rate but a set of complementary
policies that made the system succeed. Workers at Lincoln are guaranteed that they will be able
to work for 30 hours and there were no general layoffs since the company was started. 80 percent
of the company is owned by direct stock holding and employee stock ownership plans. The
bonuses offered are very important part of the total compensation of employees and is decided
by supervisors based on employees quality of work and cooperation. The recession of 2008
tested their policy. They left go 50 temporary workers and a number of employees with poor
performance and less than three years of service. 1
The role of complementarily is brought out by the problems the company had when it started
plants abroad. Beginning in 1987 it rapidly established plants in as many as 15 foreign countries
and even though it had planned to establish the Lincoln system abroad, the company had to
accept that it underestimated the problem of transplanting the culture and the company ran into
losses.
Casey Ichniowski, Kathryn Shaw and Giovanna Pernnushi did a study of 36 steel finishing
lines owned by 17 companies. 2 The sample consisted of high and low performers and a wide
range of human resources environments. The choice of specific process, engineering information
about it and data collected from visits made allowed the evaluation of the effects of the effect of
complementarities on productivity.
From the literature on human resources they identified 13 policies like incentive pay, high
screening at recruiting, job security and teamwork. The human resources practices of the
companies were classified into four systems based on which combinations of the 13
characteristics they had. System 1 was the most innovative and companies that adopted
incentives pay based on evaluation of employee contribution in many dimensions including job
duties covering wide range of tasks and high level of employee involvement in problem-solving
teams. System 2 has most of the practices but miss a few like job rotation or extensive evaluation
of employee’s efforts. System 3 has even fewer of the practices while System 4 is the typical
hierarchical management system. Data showed that not only were companies using more
innovative human resources system has higher productivity, changing over to System 1 or 2 from
System 3 increased productivity. The study supports the view that more than individual
innovative practices, it is complementarity among the various measures that increases
productivity.

1
Milgrom and Roberts (1995);199-205.
2
Ichniowski, Shaw, Prennushi (1997), pp. 291-313.
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Wage distribution in the economy.

So far the focus was on how an employee can be motivated and how the agency problem
influences the compensation scheme. Going beyond one employer and employee, consider the
income from employment of the working population. Three facts stand out: average
compensation increases with education; with experience and seniority; and if employees are
divided by ethnicity or sex, certain segments of employees who have outwardly similar
characteristics as others are earning less.
Education and wages. The increase in earning with educational attainment is dramatic.
Average salary of a high school graduate in 2007 was $26,894; in the same year a college
graduate earned 75 percent more and one with advanced degree, 30 percent more than the
college graduate or 127 percent more than high school graduate. 1
Distribution of earning with age and experience. Whether the employee is a high school
graduate, a college graduate or a postgraduate, the annual income from employment increases
roughly up to the age of 50, then flattens out and finally starts declining around the age of 60.
One explanation for this trend is that human capital that is acquired through education and
training, depreciates over time. In the early years, the individual and the employer invests on
improving skills as the higher productivity over a long working life provides a high return on the
investment. As the employee approaches the end of working years, the return for further
investment decreases and depreciation of human capital leads to a decline in wages. Another
explanation is that employers “defer payments.” Given that the employer cannot verify whether
the employee is shirking, the employer offers a wage that increases with seniority. It provides the
employee an incentive to work hard and be retained by the firm. This is beneficial to the
employer as it increases the output and reduces turnover. Another reason for avoiding turnover is
that the cost of replacement is about 27 percent of the annual salary. 2
Discrimination at workplace. Competition in the labor market, it was claimed in earlier,
sets wages equal to the revenue generated by the employee. Competition among firms in the
labor market will result in the wages of employees with the same skills and productivity being
the same in all industries. Perfect competition in commodity and labor markets together provide
precise relation between wages and productivity.
Now consider the converse question. The employees are divided into different groups based
on ethnicity or sex. The average income of one group exceeds that of the other. Are the observed
differences between the groups due to individual choices of the employees or are they due to
discrimination preventing them from making choices that would have increased their earnings? It
is a historic fact that the opportunities to people of color and women were limited. Social norms
put additional constraints on all minorities and women. Recently the laws are leaning towards
affirmative action in labor market and competition in product market. How can discrimination be
defined in such a society? Are the current differences due to discrimination social factors or to
individual choices about education and training? An economic definition of discrimination is
employees with the same productivity receiving different wages. The rest of the section focuses
on the analytical implications of this definition and a way of measuring the sources of variation
in wages.
1
The data is median earning of workers aged 25 or over from Current Population Reports of US Census Bureau
(2009)
2
Don Hellriegel et al, p.448.
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Figure 7. Explaining the gap between average male and female

Gary Becker argues in his The Economics of Discrimination (1957) that discrimination
cannot prevail for a long run in a competitive economy as the firm that discriminates will be at a
cost disadvantage. Non-discriminating employers can employees in the discriminated group,
women for example, at lower wages and reduce the cost of production. The resulting competition
in the product market will reduce demand for higher paid employees and bring down their
wages.
However such frictionless adjustment may not occur. Workers may refuse to work with those
belonging to another ethnic group or sex; technically an employer can get around only
employees who are in the shunned groups. Then competition will reduce demand for higher paid
workers.
Consumers can be the source of discrimination if they refuse products made by minority
workers. There is record of firms in meat industry not employing blacks fearing that consumers
would object to meat processed by persons of color. Hiring higher paid workers increases the
cost of production. Discrimination will continue as long as consumers are willing to pay the
higher price.
If the competition in the labor market is less than perfect, firms hiring minority employees
will not be able to break into the product market and the discriminating firms can continue to
operate for a long time. Today the United States laws promote equal opportunity in the labor
market and competition in the commodity market. Why then the gaps in the incomes of different
groups of workers persist even in the twenty-first century?
In 2007, the average earning of white employees, $43,732 exceeds that of black employee
by 26 percent and of Hispanics by 46 percent. 1 As shown in Figure 7, female employees earn 31

1
The average used in the study is the median income, which as the name suggests lies in the middle. Half the
employees earn more and the other half earns less. It is one of the averages used in statistical studies.
Source: “Median Earnings for Full-time, Year-Round Worker (in 2007 Inflation -Adjusted Dollars,” Current
Population Reports, US Census Bureau, January 2009.
202

percent less than their male counterparts. Are the differences in average earning due to
discrimination or productivity differences?
Unfortunately, for reasons discussed earlier, employers are not able to observe the effort
made by employees and even what they know it, they consider it as proprietary information and
an analysis by third party the reasons for wage difference is not possible. An indirect approach
begins by identifying attributes like education that are known to affect the productivity of
employees and measuring the differences in these attributes among the groups. One among the
many measures of education is the percentage with college degrees. 29.6 percent of US born
white workers have college degrees as compared to 16.2 percent of the blacks and 15.9 percent
of the Hispanics.
There are other attributes that also affect compensation levels. Salaries levels differ among
professions and, if those in different groups cluster in industries, their income levels will reflect
the industry differences. Until recently women showed preferences for being teachers, clerical
workers or librarians and the low level of salary in these professions reduced their average
salary. The level of unionization reduces the spread of salaries. If a person temporarily drops out
of the labor market for personal reasons, as when a female employee takes a break when children
are small, it is possible that the salary levels on reentry will be less than that of other workers in
the same age group or years of work experience. Statistical analysis is used to decompose the
income gap into components that are attributable to different characteristics. The residue can
then be taken as a measure of discrimination (Figure 7). Various studies have explained only
one-third of their earning differential and the debate continues whether there is persistence of
discrimination against women.
Employment compensation is on the average close to 70 percent of the income of individuals
and for those in the minorities, it is close to 100 percent. Low relative earning hurts the self-
respect of the employee at work. The economic importance and social significance jointly has to
a lively and even passionate argument on the sources of discrimination and their continuance.
Connecting with the consumer
In the end of all activities in a firm there has to be sales. Only through sales can a firm
recover the costs incurred in purchase of raw materials and energy, payment of salary to
employees and the interest on its loans. Sales depend on the choice of consumers who select the
basket of goods and services that they prefer among those within their budgets. A firm has to
understand the preferences of the consumers and choices that are available to them and position
its product - its characteristics and price – so as to meet its revenue goals.
An artisan in the medieval village sells to customers he knows for most of his life. They
come to him for repeated purchases and he makes the products to order or he produces what his
customers have purchased so many times in the past. His direct contract with customers
facilitates the marketing of his products. Mass production that came into existence after the
Industrial Revolution of late eighteenth century necessitated creating an extensive customer base.
Understanding the consumers is a challenge that the firm has to meet if it is to be successful in
the market.
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The creation of a sales or marketing group within manufacturing corporation coincided with
development of middle management. 1 James Buchanan Duke pioneered the manufacturing and
marketing of cigarettes. His success led other cigarette manufactures to join with him in 1890 to
form the American Tobacco Company. Cigarettes used to be hand rolled till Duke introduced the
continuous-rolling Bonsack machine that could produce about 70,000 cigarettes a day. He
established selling and distribution offices in all major commercial centers; each had a salaried
manager, a salesman for the city, another to travel to outlying areas and clerical staff. Matching
production with distribution and sales was important as cigarettes, before wrapping in cellophane
was introduced, tends to become dry and bitter in a few days. This coordination was managed a
central office in New York City which controlled the flow 3 to 5 billion cigarettes. The company
had leaf department to purchase, dry and cure the tobacco leaf gave it control of the other end of
the supply chain and the firm became an integrated manufacturing enterprise.
Issac Singer introduced the first commercially successful sewing machine and with his
partner Edward Clark form I. M. Singer & Co (today Singer Corporation). Clark took initiative
in replacing the independent distributors with internally managed sales operation. Customers
were willing to buy the machine if credit was offered and if they could get the machines
serviced. Singer innovated in making them the function of sales division.
Both American Tobacco and Singer divided their sales operation on a regional basis. Armour
was selling meat, hog, poultry, laboratory byproducts, fertilizers and consumer products like glue
and soaps. It organized itself on product lines with a general manager for each division. Each
division had a sales manager. Today corporations produce many products and sell then nationally
and internationally and the sales organization is structured on regional or product line or on a
hybrid of the two depending on their assessment of marketing needs.
Functions of marketing and sales divisions.
The marketing group in the firm has the responsibility of connecting with the consumer and
making choices that satisfies the goals of the consumers and firms. The broad responsibilities of
marketing group includes identifying the wants of the consumers, working with the research and
production divisions to make marketable products, pricing them, and marketing them through
advertisements and promotions. The corporate organization sets up a sales group either within
the marketing department or as a separate entity focuses on selling the product; its responsibility
is in helping an individual consumer choose a product of his firm.
Marketing. A marketing manager of a manufacturing firm or a retailer needs to know the
consumers and has to let them know of firm’s products.
Choices made by consumers, given the options, provide explicit indications of their
preferences. This limited information is not adequate for developing firm’s marketing strategy as
it needs to know not just how they respond to the current environment but to changes in their
incomes, in the price of your product (the price elasticity of demand) and how changes in prices
of other products will affect their decisions. Product innovations will change the characteristics
of products and marketing manager is concerned how they affect demand for his products.
Corporations suffer severe economic losses if they either overestimate or underestimate demand
for their products.

1
Chandler (1977), pp.381-414.
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Figure 8. Facing the competition.

In addition to selling to your existing customers, the firm wants to extend its geographical
reach by introduce it in a new region of the home country (introducing a product popular in New
England to the South-West region of US) or in new countries (extend marketing to developing
economies of South and Southeast Asia). The marketing manager has to evaluate the income and
tastes of the potential customers in markets that the firm wants to enter and estimate the demand
at various prices. The task becomes even more challenging if the product is new. Customers do
not ask for them; the demand for very successful products from Sony’s cassette recorder to
Apple’s I-phones arose from the vision of the firm that saw the technological possibilities and
marketing opportunities. The head of sales division must judge how enthused customers will be
of a product that is new to them.
The firm obtains information about consumers from two types of sources: secondary data
that is already collected and collated by someone else and primary data it collects. Secondary
data, in spite of the diminutive name, is cost effective provided that they have the needed
information.
The Bureau of Census is the largest source of secondary data in the United States. The
Census of Population is conducted once every ten years. One of the innovations of 1990 Census
that is of great value to the marketing is TIGER (Topographically Integrated Encoding and
Referencing). It provided detailed information about clusters as small as 100 individuals. In
addition, the Bureau provides Census of Manufactures, Census of Wholesale Sales and Census
of Retail Sales and Census of Retail Sales. Other sources of information are trade magazines like
Advertising Age and Sales and Marketing Management. Data are collected and sold by private
information companies; Scantrack has information on products and brands sold through retail
outlets.
In addition the marketing department has the choice of collecting information on its own. It
can organize focus groups where a small group is invited to discuss either an existing product or
one the firm is planning to produce. The discussion in the group is discretely monitored. The
firm gathers information from those who brought the product by filling up information as they
register their product.
Turning to informing the customer of the product, the firm can use different channels. It can
establish a direct marketing group that contacts customers over mail, contact through social
groups (Mary Kay and Tupperware) or internet. It can arrange for news items or articles to be
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Figure 9. Nature of product and how it

determines the type of advertisements.
published; while they are inexpensive, but the firm has no control on what gets written up.
Personal selling is another form of marketing that provides feedbacks but it is very expensive.
With the development of modern technology, there is a proliferation of commercial message
sent out. Each consumer receiving on the average 1,600 commercial messages, of which 12
provokes some reaction. 1 The goal is to maximize the response as the firm is incurring cost in
sending out these messages. Advertising allows the firm to control the message and at the same
time reach a large audience. It can even choose the placement to advertisement to target specific
groups; an advertisement placed in a magazine or TV show that is popular with the teenage
crowd is focused on that group. Advertising is costly but because of the ability to reach a large
audience is cost effective and widely used.
Advertising campaigns must consider what consumers know of the goods and how much
they rely on advertising and other sources for additional information before making a choice
(Figure 9). In the 1970s, Phillip Nelson introduced the distinction between search and
experience goods and argued that type and frequency of advertisements will depend on whether
consumers can determine the quality and other characteristics before purchase or not.
For a product like clothing, a buyer can feel the fabric and check whether it fits him before
purchase, advertisements provide information about the characteristics of the product -
percentage of natural and synthetic fibers, color and cut - and about the stores where it is sold
and the price. Advertisements interest consumers by being informative. By comparing
information about competitive products, consumers can deliberate decision on what stores to
visit and what dresses or suites to try on.
When considering new soft drinks that have come to the market, a consumer can decide
which one he or she likes only by tasting them; some factual information about calorie contents
or main ingredients can be published but there is no way to communicate to the consumer the

1
Kotler (2000)p.551
206

taste sensation he or she would have when drinking it. Producers resort to persuasive
advertisements - relating it to lifestyles, endorsements by film or sports stars - to catch the
attention of potential consumers. The consumers, he argues, look to persuasive advertisements
not for factual information but some signals about the quality of the product. How they interpret
and respond to the advertisements determine how worthwhile it is for the producers to spend on
placing them in various media.
Consumers cannot be sure of a product till they make their first purchases but their
experiences will decide whether they buy again. The power of consumers in the market comes
from their control of the repeat purchases. A producer of quality product expects a higher
proportion of their first-time customers to buy again and they will increase the volume of
advertising to bring in more first time buyers. The customers sense this rationale and will relate
quality to volume of advertising. Experience goods are advertised more on national media than
local and more of the advertisements are on TV than on newspapers.
Producers who have better information about the product than the consumers know that their
product matches with the tastes of a segment of the population. They target their advertisement at
the group that will provide the best yield and the customers take the channel as an indication on
they should try the product.
Recent studies using scanner data from stores and various measures of exposure to
advertising bring out the interplay between persuasion and experience in consume choice. These
studies concentrate on convenience goods of low unit prices that are frequently purchased
(Figure 9). A consumer who has purchased a brand of a product (one brand of cereal or coffee)
knows its characteristics while potential customers lack such information. The general
conclusion of these studies is that repeat purchases are determined by prior experience of the
product and current price. Customers tend to be risk averse and prefer to stick with the satisfying
experience provided by a familiar brand. Consumers looking for a new brand are more
responsive to advertisements.
Pricing the product. Most of the products that we buy are sold at fixed prices at stores, or
on internet. Who determined these prices? Why did they choose these prices? Economic analysis
of the market gives a simple and precise answer as to what the price should be. Take the demand
curve for your product and determine at each level output, marginal revenue or the increase in
sales revenue for unit increase in quantity sold. For the same level of output, determine the
marginal cost or the increase in total cost for unit increase in output. Compare the marginal costs
and marginal revenues for various levels of output and choose the one at which they are equal.
Then find from the demand curve, the price at which the profits of the firm will be a maximum,
given cost and demand conditions. Fine as the advice is, those who make the decisions within the
firm do not have adequate information about the demand curve to implement it.
Compared to demand conditions which depends on its customers choices, the firm has better
information from its internal reports about its cost of production. The temptation is to use the
cost as the base for determining the price. Taking the marginal cost of the product (if taken to be
constant, it is also the average variable cost) and adding a markup to provide a return on its
capital seems the sensible approach to determining price and cost-plus pricing is historically the
most common approach. The excess of sales revenue over costs, “net income” in the income-
statement of firm, will them be mark-up times unit sold. This gives the illusion that by increasing
the mark-up the firm can earn a higher profit and finance division in management will press for
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it. The fallacy in the argument is in ignoring the demand side. When mark-up is increased, the
price will increase, leading to a reduction in the sales. The effect of reduced sales can, in specific
instances, overwhelm the increase in margin and profits of the firm can decrease.
The marketing department will push for price reduction and increase in sales. In this case, it
is the reduction of margin on each unit sold that can, in specific circumstances, lead to a
reduction in profits. It sounds paradoxical to claim that both increase and decrease in margin can
lead to reduction of profits. The resolution for this paradox is in comparing current price to profit
maximizing level. Any movement of the price whether it be an increase or a decrease to price at
which profit is maximized, will increase profit and any movement away from the latter will
decrease it. In short, no rule can ignores demand however difficult it is to estimate it.
This is seen from the experience of Wang Laboratories. 1 It introduced the first word
processors in 1976 with great success. By 1980s, the competition from personal computers with
word processing software cut into its sales. Instead of competing on price, Wang Laboratories
took a cost based approach and decided to recover its fixed cost from lower volume of
production by increasing the markup. Higher markup led to higher prices that cut into sales even
more and soon Wang discontinue the product. In retrospect Wang seems to have adopted an
inane policy but such errors in subtler versions were subsequently committed by many other
firms with equally disastrous results.
As marketing manager has to convince the customers that the product is suits their needs
better than that of its competitors and that it is competitively priced. He has to work with the
engineering department to avoid engineers and product designers adding features that are
technologically interesting even though customers are not willing to pay for. He has to assure the
treasurer of the company that the sales plan will yield desired returns on capital invested. All this
require that pricing should not be seen in isolation but should be an integral part of the
competitive strategy of the firm and success in marketing depends on whether the upper
management has the necessary vision.
Financing the operations of the firm
When we purchase a house, we finance it through a mortgage. We take a loan to buy a car
and change many items we buy in stores to our credit cards that give the flexibility of paying it
off over months.
The firm incurs upfront expenses in constructing a plant, months before it starts operating.
The firm has inventories of raw materials and semi- finished products that cost the firm to
acquire and store. There is one difference between individual and the firm. While we make our
purchases of a house or a car for the satisfaction from its use, the firm incurs costs in advance to
make profits in the future. The costs have to be judged in terms of the profits that it generates.
The chief financial officer is responsible for cash management, raising funds through equity
and loans and preparing financial statements and tax documents. Based on these records, he
reports regularly to the Chief Executive Office and the Board of Directors on the financial health
of the company and alert them about potential problems. He has to get involved in determining
whether the company benefits by discontinuing some operations or adding others. His financial
evaluations bring him into conflict with those in charge of production, marketing or human
resources who will be promoting other goals. He has to be in contact with the bankers and with
1
Nagel and Holden (1995), p.3.
208

investment banks to explore the possibility reducing the cost of funds and adding to the profits of
the firm. The flexibility that financial innovations since deregulation have given added to the
power and influence of chief financial officer. Some of them have taken risks under optimistic
assumptions about future or even hidden the consequences from the shareholders and regulators
and have ended in seriously undermining the financial stability of their institutions.1
Investing in new projects. To exploit the opportunities offered by the market, the firm must
periodically consider whether to increase its output beyond existing capacity or establish plants
to produce new line of products. To create that capacity, the firm incurs now the cost of
establishing it while the income it generates is in the future. Because of the lag in receipt of
revenues, the firm has to take into account the time value of money.
Compound interest rate and discounting. Table 1 from Chapter 4 summarizes the discussion

Table 1. Calculation of the value of money

Panel A. Forward in time: compound interest.

Year O Year 1 Year 2.

Capital and interest $100 $ 110 = $100(1 + 0.1)
(1year investment)
Capital and interest $100 $110 = $100(1 + 0.1) $121 = $100
(2 year investment)
x(1 + 0.1)2

Panel B. Backward in time: present value

Year 0 Year 1 Year 2
Present value of cash $100/(1 + 0.1) = $90.90 Cash flow in Year 1 = None
flow one year from $100
now.
Present value of cash Present value in Year 0 = Present value in Year Cash flow in
flow to years from now $100[1/(1+0.1)]2 = $82.65 1 = $100 [1/(1 + 0.1)] Year 2 =
= $90.91 $100

on compound interest and discounting. The familiar rule of compound interest rate Table 1:
Panel A).

1
An individual’s opportunity to finance his house purchase used to be restricted to 30-year fixed interest mortgages
with a minimum of five or ten percent down payment. With financial innovations, he can get loans with interest rate
base on LIBOR (London Interbank Offer rates at which banks lend to each other) or with minimal monthly
payments followed by a balloon payment later. This has induced some take mortgages beyond their ability to pay
and have got themselves and mortgage banks into financial trouble as during the subprime crisis of 2007-2008.
209

Figure 10. Net present value of an investment

Going backward in time, how much should an individual loan at 10% interest rate now to get
back $100 one year later? Not $100 as previous calculation shows that it will grow to $110. To
find this amount, reverse the calculation. The end payment is divided (1 + interest rate expressed
as a fraction) or multiplied by (1/(1+interst rate) raised to the time interval(Table 1: Panel B).
The calculation determines the present value of future income.
Cash flows of the project. Establishing the additional capacity envisaged under the project
requires an outflow of cash in Year 0. Over the life of the project, it produces an output that
generates revenue from the sales and incurs cost for inputs used in production. The difference
between the two is the free cash flow that the project generates and it is what must be
discounted. 1
Present value = [First year cash flow/ (1 + interest rate)] +
+ [Second year cash flow/(1 + interest rate)2] + - -

1
The concept of cash flow is in principle simple: cash in minus cash out. Accountants start with this number but
make many changes to fit the reports they generate to be according to prevalent accounting principles. While these
rules have their justification, it clouds the economic and financial significance of cash flows. It is assumed, for
simplicity, in Figure 10 and subsequent discussion that construction of the project took only one year and that the
firm started generating cash flows (even if it is negative) from next year onwards.
210

Figure 11. Will shareholders with diverse preferences agree on a project

with positive net present value?
+ [Last year cash flow / (1 + interest rate)Life of the project].
Under discounting, the cost of investment and the cash flow are both valued in the year the
project was started and it makes it feasible to compare the two. The difference between the two is
the net present value of the investment (Figure 10). It is the net gain to the investor from
investing in this project over the prevailing rate of interest.
Project finance when interest rate and profits are known with certainty. There is one
difference between any of us investing in our education and a chief financial officer investing for
the company. When we are young we decide on the level of education and incur the cost of
acquiring it knowing the type of career that we can have with that education. The cost and the
benefits come to the same person.
The shareholders are the owners of a modern corporation and they benefit or loss from
changes in its value. They have, in law if not in practice, the right to approve or reject the project
chosen by the management. When the chief financial officer recommends an investment
decision, he is doing it for hundreds or even thousands of shareholders. Given the differences in
individual preferences, how can she be sure that shareholders agree with his decision?
From the production point of view, the project is an increment to the productive capacity of
the firm. From a financial point of view, the firm is a hub of cash flows - inflows and outflows -
and a value can be assigned for the firm based on these flows. The project makes incremental
changes to these flows. What Figure 10 shows is that, if the net present value is positive, the
investment had earned the shareholders a return in excess of the market rate of interest and has
increased the value assigned to the firm. What is their alternative if the shareholders overrule the
recommendation to invest in the project and force the management to distribute the amount as
dividends? They can invest the distributed funds themselves in the market and earn the market
rate of interest but the present value of the earnings will be less than that from the project by its
net present value. Since increased resources benefits any shareholder irrespective of his or her
preferences, each of the shareholders will implicitly support the chief finance officer’s
recommendation. There is unanimity among shareholders in spite of their differing preferences
(Figure 11)!
211

The uncertain future and choice of projects. Future is never known with certainty and the
uncertainty in the future cash flows has a two-fold effect on the calculation of net present value
of a project. The cash flows in Figure 10 are replaced by their expected values for each of the
years. Next the discount factor should not be risk free interest rate but adjusted to compensate the
individuals for the risk they are taking in choosing the cash flow from the project. The rate used
for should have a premium over riskless rate. Ideally the discount rate should be the return of a
portfolio of traded securities that has the same risk as the project. In reality, chief financial
officer will be hard pressed to come up with such a portfolio as the project has many unique
features.
The mean-variance approach in finance measures the riskiness of an asset by the variance of
its rate of return; variance is a statistical measure of how much the observed rates fluctuate
around its mean, taking into consideration the probability of each value occurring. The project is
adding to the existing assets of the firm and the riskiness of the project is reduced as the
fluctuation the return of firm assets is less than that of individual projects. Competition among
buyers will reduce the premium to reflect only the riskiness of asset that is not diversified away.
This is the principle underlying Capital Asset Pricing Model which is widely used in determining
the discount rate applicable to project financing.
The Chief Financial Officer has to use his judgment in determining the appropriate discount
rate. Some guidance is given by: (1) the cost of equity for the firm or a similar group of firms;
(2) overall cost of capital to these firms when some of the funds are not raised as equity but as
debt (bonds and other sources of finance); and (3) the riskiness of the project relative to the
overall riskiness of the firm or firms.
Ways the firm finances its assets. Once a decision is made to go with the project, chief
financial officer has to choose between financing it by issuing shares or bonds. 1 The company
has outstanding mix of equity and debt from financing of its existing assets and the new project
is an opportunity for management to determine not only how it is financed but also whether the
current mix should be changed.
The firm is at the nexus of different cash flows. The inflow of cash arises from sales and
some of the outflow from purchase of inputs. Their difference, the free cash flow, is what is
available to distribute to those to bonds or shareholders. Free cash flow differs from net
operating income (profits in accounting sense); one distinction is that depreciation which is
treated as a cost in calculation of profits as assets suffer wear and tear but is included in free cash
flow as unlike wages or other payments to inputs, it is not paid out in any specific time to an
outside party.
The value of the free cash flow is obtained by discounting the future payments and it is the
value of the firm. The total value of bonds and shares is equal to the discounted values of the free
cash flow. It is also the value of the firm. However those who purchased the bonds or equity
have made funds available to the company in return for future payments. But bondholders and
shareholders do not have the same rights to future cash flows.
Characteristics of debt and equity. In issuing a bond, the firm commits to repay the
principal with interest by a series of fixed payments up to the expiration date of the bond. The

1
In modern financial literature, stocks and shares are used interchangeably to refer to certificates testifying to
ownership share in a corporation. Equity is the total investment in a business by its owners.
212

schedule of payments is announced as the bonds are offered to the public and they take
precedence over any payments to the shareholders; if the free cash flow in any period is not
enough for payouts to bondholders, the firm is in bankruptcy and will have to be either liquidated
or the payment schedule restructured with the consent of the bondholders. In contrast to these
benefits, the bondholders, unlike shareholders, do not have the right to participate in the
management of the company or to benefit financially from the growth of the firm.
A shareholder has an ownership interest in the firm, in proportion to the fraction of shares he
or she owns. As part owner, the shareholder can vote in the election of the board of directors and
require them, at least in principle, to promote the shareholder interest by maximizing the value of
the firm. 1 The shareholders have a right to residual of the free cash flow over and above what is
owned to bondholders. This amount may be distributed as dividends or a part held within the
firm as retained earnings for future investments. Since shareholders have legal right to the
retained earnings, the price of the share will, in a well-functioning financial market, reflect this
right. If the firm falters, the share prices will fall and dividends will be reduced or even
eliminated.
Capital structure of a firm is the ratio of debt to equity and equals the ratio of the value of
company bonds to that of company stocks in the financial market. The firm can change its
structure by issuing bonds to finance purchase of stocks, issuing stocks to purchase the bonds or
financing the new project by issuing bonds and stocks in a different proportion to current capital
structure. Will changing the ratio affect the value of the firm which was defined as the sum of the
values of bonds and stocks? One reads in newspapers of how share purchases or other changes
resulted in spectacular increases in the value of a company. Finance textbooks up to the middle
of twentieth century sought to prescribe desirable debt-equity ratios for various industries.
The conventional wisdom about capital structure was challenged by Franco Modigliani and
Merton Miller in 1958. They claimed that value of a firm is unaffected by changes in capital
structure. What made this very surprising is that the cost of debt, the return needed to induce
individuals to own debt, was much lower than that of equity. In 1950s, the interest rate on
corporate debt was between 3 and 5 percent while the cost of equity was between 15 and 20
percent. Why can’t a firm reduce the cost of financing its assets by substituting debt for equity?
Modigliani and Miller used an argument to show that firms with the same free flow of cash
should have the same value, irrespective of how it is divided between shareholders and
bondholders. They showed that any difference in values will induce arbitrage: some profit
seekers will buy more shares and debt of the firm with lower value and sell that of the other until
the two values are equal.
Consider two firms generating the same free cash flow that is fully distributed (no increments
to retained earnings). The first firm is financed by equity alone and the second by half equity and
half debt. An outside individual can replicate 10 percent of the capital structure of the second
firm by buying 10 percent of the stocks of the first firm and borrowing to the extent of 10 percent
of the outstanding bonds of the second firm; though he gets 10 percent of the free cash flow of
the first he has to pay interest on the funds he borrowed to buy the bonds and the difference will
equal the dividends from investing in 10 percent of the second firm. 2 If the values of the firm are
not the same, then speculators will invest in the cheaper one and earn the same income as
1
Corporate governance is discussed in next section.
2
This follows from the fact that both firms have the same free cash flow.
213

investing in the other and the demand will push up the value of the firm till it equals that of the
other.
This proposition can then be used to explain the difference between the cost of equity and
debt. Since bond holders of a firm has to be paid in full before dividends to shareholders are
declared, any fluctuation in free cash flow of the firm must be absorbed as changes in the
dividends. The shares of firm with higher debt-equity ratio are riskier than that of one with lower
ratio and a premium has to be paid to the owners of these shares. The lower cost of using cheaper
debt is negated by the higher cost of equity. Modigliani and Miller showed the average cost of
the two will be the same across firms. That is consistent with the conclusion that the firms with
the same free cash flow (with the same risk of fluctuations) will have the same value.
To emphasize the role of assets in determining the value of a firm, Modigliani and Miller
simplified the financial environment in which the firm operates. They assumed that the firm does
not pay corporate taxes, its bonds have no risk, the interest rate is risk free rate and individuals
also can borrow at that rate. Subsequent work by them and others explore the effect of replacing
these assumptions with others that are better approximations to the market conditions. As Miller
wrote in an article commemorating the anniversary of the Merton-Miller propositions: “showing
what doesn’t matter can also show, by implication, what does.” 1
First taxation of income from bonds differ from taxation of dividend from shares. For the
privilege of incorporating as a limited liability corporation, the state charges a corporate income
tax on such corporations. But the rules have a twist that the interest on debt can be deducted from
the income of the corporation to determine the taxable income. The bond holders then pay taxes
on their income some of which comes from interest on bonds and the rest from other sources.
Those who own stocks have first to pay corporate tax out of their share of corporation’s taxable
income and then pay taxes on their individual income which includes the dividends. The net
result is that dividends are taxed at corporate and individual levels while interest on debt is taxed
only at individual level. This difference is partly compensated by lower tax rate on capital gains.
Since most corporations retain a sizable part of the free cash flow as retained earnings,
shareholders do not have to pay income tax on them as they are accrued. The growth in retained
earnings result in growth in share but the shareholders have to pay only capital gains tax on it. It
moderates the cost of double taxation.
Next, the firm has a legal obligation to pay interest on debt. If free flow of income is not
enough to pay it, the firm is in default and is in danger of bankruptcy. Dividends are rights to
profit and if profits is low or there is none, the shareholders have no right to claim payments,
Higher debt by making a larger commitment on cash flow increases the probability of
bankruptcy during a downturn and this ought to be a consideration in limiting the debt/equity
ratio.
The managers have information about the firm that outsiders do not have. When in need of
new funds, they will choose the method where the difference is information matters least.
Investors fear that managers issue new stocks only when they feel that stocks are overvalued and
are unloading them. Those who buy debt tend to be better informed about value of the firm and
this belief lead to smaller change in stock prices when new debt is issued.

1
Miller (1988), p.100
214

The Modigliani-Miller theory proposed a challenge but a single alternative explanation of

capital structure is not yet known and the search for one, given the differences among firms
arising from market opportunities they have, the uncertainties they have to consider and the scale
of operations, may be futile.
[
Corporate office and corporate governance
When one individual entrepreneur owns and manages a firm, he controls its operations and
directs them to fulfill his goals. However, even when firms were small as most were till the
middle of nineteenth century, few entrepreneurs could provide the entire equity of their firm
from their own savings. He chose his friends as partners and took loans from the local bank. The
small number of partners from the same neighborhood enabled, though not always, achieving
agreement on the decisions. The equity of a modern corporation is provided by many
shareholders while the management is in the hands of professionals who may own some shares.
In law the shareholders are the legal owners of the firm but their interests in the use of funds and
in the risks firm takes can differ from that of the management. The goal of corporate governance
is to develop a set of procedures and rules to resolve this conflict.
Whenever a group of individuals, principals, hires others, agents, to undertake some actions,
there is the possibility that the self-interest of agents will make them take actions that differ from
those most beneficial to the principals. An employee may not work as hard as the employer was
expecting him or her to do. Human resources policies of firms provide a combination of in-house
supervision and productivity incentives to motivate the employee. What makes corporate
governance different from other instances of agency problem in firm?
The principals in this case are shareholders who are numerous and, unlike factory
supervisors, have no direct participation in the decision making of the firm. The chief executive
officer (CEO) knows that he is responsible to the shareholders to maximize their value but they
have no voice in the day-to-day decisions that he make. He to report periodically to the Board of
Directors but the Board is composed of those who are friendly with the CEO; he may even be the
chairman of the Board. In principle the Board is elected by shareholders at the annual meetings
but the management presents a slate and shareholders and the rules are such that it is difficult to
elect dissident members to the Board. Chief executive officer’s compensation is determined by
the Compensation Committee but he influence who is on it. When profit is high, it is the glory of
the management; when low it is due to forces beyond their control. Chief Operating Officer is
like an agent without a principal.
The companies are competing in the market and firms with efficient corporate governance
should be able to out-compete those with inefficient governance. A serious discussion of
corporate governance should examine why an outwardly inefficient system continue to exist,
why different corporate governance systems coexist across the world and what the instruments
there are to alleviate the agency problem. In addition it must be asked why the agency problem
came into focus in public policy debate in the last two decades.
Growth of interest in corporate governance. Public awareness of the importance of
corporate governance was triggered by (1) a series of losses incurred by major corporations due
to poor internal controls, outright manipulation by management or failure of management to take
215

appropriate decisions; (2) the rise of pension and mutual funds as vehicles for channeling of
private savings; and (3) deregulation and globalization of economies.
Financial institutions have shown vulnerability to employees taking risks beyond what they
are authorized to do and running up large loses. The rogues gallery includes Nick Leeson at
Baring Bank whose attempts to hide small mistakes he made in trades led to a loss of ₤827
million and bankrupted his firm that was in operation for 233 years; Yasuo Hamanaka whose
manipulations of copper market resulted in a loss of $2.6 billion for his employer, Sumitomo
Corporation; and Jerome Kerviel whose unauthorized positions at the trading desk of Soicete
Generale resulted in a loss of €4.9 billion. 1
Loses at Enron and WorldCom were due to fraud committed by management. Enron had two
set of operations. One was selling electricity and natural gas. Enron used the sophisticated
techniques involving unconventional interpretation of its income from trade in energy futures
and shifting of losses to offshore units. 2 From early 1999 to middle of 2002 WorldCom
understated its costs and overstated its income by much more obvious process of treating some
current expenses as non-recurring expenses. Executive compensations in both companies were
set to their hypothetical profits.
The problems of General Motors and Chrysler in manufacturing and Citicorp and Bank of
America in 2008/2009 are not due to fraud but bad judgment. The automobile companies were
way off in their estimate of demand for various models of vehicles and did not control their costs
to make them competitive with foreign car makers. 3 Deal making and acquisitions by the Chief
Executive Officer, Sanford I. Weil to make Citigroup a global supermarket for financial services
left it with an unwieldy structure and with many dodgy assets that threatened its solvency during
the recession of 2008/2009. Bank of America acquired a real estate lender, CountryWide
Financial, in 2008 and an investment bank, Merrill Lynch, in 2009 and their losses forced Bank
of America to rely on the rescue package offered by the U.S. government. 4
The question is why the governance system of these companies failed to protect their
shareholders.
Institutional investors like insurance companies, mutual funds, pension funds, and hedge
funds pool together savings of individuals and invest it in a diversified portfolio of stocks and
bonds. The individual saver benefits from the expertise of the institutional investor and obtains a
better return for the level of risk than through individual investment. Institutional investors in
U.S. have slightly more than 50 percent of the assets under management of which a significant
portion is pension funds. Pension funds are obliged by the Employee Retirement Income
Security Act of 1974 (ERISA) to vote their shares responsibly and though they limit the amount
of shares of a corporation they hold, still their holdings is large enough to have an impact. Their
focus on corporate governance is another reason why it is now much discussed researched topic.

1
, Financial Times ( 2009), pp.1-2.
2
Dharan and Bufkins, (2004), pp.97-112.
3
Labor cost, due to union contract and unfunded pension commitment, was way above that of foreign producers.
Some aspects of the wage structure in automobile industry in the seventies was discussed in p.189-190
4
The purchase of Merrill Lynch was part of the rescue effort of distressed financial institutions under Federal
Reserve and Treasury program and there is a question whether the Bank was steamrolled into it.
216

Figure 12. Firm as a nexus of contractual obligations

Globalization and integration of financial markets allowed companies to raise funds in
international markets and increased awareness of the comparative strengths and weaknesses of
various corporate governance regulations.
Vigorous discussion by policy makers and research by scholars have identified what could
contribute to better governance but each of them could also create conditions that go against the
interests of the shareholders. A better understanding has not led to identifying one superior
system of corporate governance. Given the broad sweep of the subject, covering corporations of
various sizes and organizations in different economies, lack of unanimity should not be
surprising.
Governance mechanisms to reduce misalignment of interests. International comparison
of practices shows that some institutional arrangements contribute to the management being
more responsive to the interests of the shareholders. An individual or an institutional investor
217

who owns a large block of shares of corporation has an interest in monitoring the management
and using the voting power that the block gives to put pressure on management if it takes actions
not in the interests of the shareholders (Figure 12). Executive compensation schemes can be
designed to reward the management when they promote the interest of the investors. Corporate
raiders have interest in taking over firms with inefficient management. Each of these
arrangements unfortunately has the potential of introducing misalignments of their own.
Monitoring by shareholders. Monitoring of a corporation is time consuming and expensive.
If a shareholder owns only a few shares tries to monitor the management, he bears all the costs
while he gains a very small share of the benefits of better management. A large shareholder
captures a larger share of benefits from monitoring and will have more inclined to do monitoring
on an ongoing basis. Stocks of American companies are generally dispersed and there is no
dominant shareholder while a study of companies in France, Germany Italy and Sweden showed
that more than half of them had one controlling owner. 1
Monitoring will not affect corporate policies unless those monitoring have control. An
individual or institution that holds 10 to 20 percent of the shares may be able to convince other
shareholders to join in influencing the policies and, if the management is not amenable, to host a
proxy fight. The ability to do so depends on the cost of communication and coalition building.
Proxy fights are important in the United States but not in European countries and Japan.
A large shareholder may have no interest in monitoring if it is possible for her to exist. This
occurs when there is an active market for shares as in United States and United Kingdom. A
measure of the relevance of stock market is its capitalization (the number of shares outstanding
times their prices) relative to the size of the economy (measured by gross national product, the
value of all goods and services produced in an economy). The capitalization of stock markets in
the two countries have about the same value as their respective national incomes while many
continental European countries it is around 50 percent of gross national product.
The depth of the stock market can contribute to the dispersal of ownership. When a large
shareholder is able to sell the shares at current prices, she has less interest in monitoring. If she is
not satisfied by the performance, it is cost effective to exit. This suggests that international
differences in stock ownership and between equity and debt financing may be the result of
differences in costs of monitoring, cost of displacing management by takeovers and of selling off
the stocks.
Having a large shareholder need not result in better performance. She is able to appoint her
nominees to the Board of Directors and through them induce the management to take actions that
beneficial to her but not to others. Instead of value maximization that creates unanimity, the large
shareholder appropriates some of the gains at the cost to others. Out of this concern, corporate
law and securities regulation imposes restrictions on the right of a large shareholder. The
limitations imposed vary among jurisdictions.
Monitoring by the board of directors. In principle, the corporate chapters envision a
democracy with shareholders electing the board of directors, the board acting as legislative
branch appointing and monitoring the chief executive officer (CEO). The responsibilities of the
board include approving issue or purchase of stocks, mergers and acquisitions and setting the
compensation of the chief executive officer. In the reality the Board fails in its monitoring of the

1
Jean Triole (2006) pp.39-40.
218

management. The shareholders are, by rules, forced to elect a board from a panel submitted to
the shareholders at the annual meeting and substitution is very difficult if not impossible. In
United States, chief executive officer is commonly the chairman of the board. Many members
have links with the company other than being a member of the board; they either are employees
or past employees or suppliers to the firm. They feel obliged to the chief executive officer and
will not be inclined to critically examine his decisions. The independent members - those who
have no other relation with the company - even if they are willing to be critical, are handicapped
as they are not familiar with the industry and have less information about the corporation than
inside members; when financial firms like Bank of America and Royal Bank of Scotland became
financially distressed in 1009 and questions were raised about the decisions of their chief
operating officers, it was found that the boards that approved these decision had few independent
members knowledgeable about banking. Most members of the board prefer to be reappointed and
are unwilling to confront the chief executive officer who de facto makes that decision.
One criticism is that the board has managerial and supervisory responsibilities and it is
desirable to separate the two functions as is done with the two-tier boards of German
corporations. The management board (its members are appointed by the supervisory board) has
functions similar to that of the upper management of an American corporation. In addition to
managing the corporation and setting policies like risk management, they represent the
corporation to third parties. The members of the supervisory board are elected; half the members
are elected by the shareholders while the other half is elected by the workers. The chairperson is
appointed by the representatives of the shareholders, giving the shareholders a marginal
advantage in the Board. German companies have two boards: supervisory board and
management board. The supervisory board members are elected by shareholders and workers
and the board then elects the members of the supervisory board. The method of co-determination
which was considered to be a major strength of the German corporate governance is now
criticized for promoting gloating over differences among board members rather than undertake a
critical review even when a decision has serious consequences for the corporation. Another
problem is that the supervisory board is dependent on the management board for information and
when management feels that the workers representatives in the supervisory board could object to
a proposal, they tend to hold it back till the last minute. The two-board system is not exempt
from informational limitations of unitary boards.
Proposals for reform of the boards of Anglo-American corporation seek to separate the
offices of the chief executive officer and the chairman of the board and to appoint
knowledgeable and to appoint more independent or non-executive directors to the board.
Unfortunately no robust relation between the composition of the board and the company’s
performance is seen in the empirical studies.
Setting executive compensation to align the interests of shareholders and management. The
chief executive officer and senior management are agents expected to promote the interest of the
shareholders (with due consideration, in some governance systems, to the interest of other
stakeholders). Their self-interest will not match with that of the shareholders and the agency
problem arises. In early 1990s, many studies argued that the chief executive officer is not offered
compensation that is responsive to the effort he put in increasing the value of the company and it
creates serious agency problem. Stock options were promoted as a way to correct the lack of
incentives.
219

A stock option allows an employee to purchase the stock of the company within a period, the
life of the option, at a price specified “exercise price” when the option is granted. The exercise
price is the price of the stock on the day of the option is granted. The option can be exercised
only after a specified time; at that time the option is said to be vested. If the exercise price is $10
and the price of the stock increases to $15 at the time of vesting, the employee gains $5 by
exercising the option and selling the stock in the market; the option is said to be in money. If the
stock price falls to $8, there is no sense in exercising the option which is said to be “out of
money.” While the employee does not benefit from having received the stock option, he does not
lose either while if he had owned the stock, as under the du Pont plan, he would have lost $2 per
stock.
The stock options offered to chief executive officers of S& P 500 firms increased nine-fold
from an average $800,000 in 1992 to &7.2 million in 2000. The compensation to chief executive
officers increased in inflation adjusted dollars from $3.5 million in 1992 to $14.7 million in
2000. 1 In 1970, the compensation of an average chief executive officer of S&P 500 was 30
times the pay of an average production worker; by 2002 the ratio of compensations was 90. 2 The
sensitivity of executive pay to performance was 2 to 10 times higher in 1994 than in 1980. 3
The differential growth in compensation was criticized both on grounds of equity and
efficiency. Focusing on efficiency arguments, the criticism is that stock options created
distortions of their own. An efficient scheme of compensation should be based on outcomes that
arise from the efforts of the employee. Much of the returns from stock options is due to the stock
market boom of 1990s and unrelated to the efforts made by the management.
A compensation scheme is efficient only if the cost of the stock option to the corporation
equals the value of the option to the recipient. The cost to the corporation is equated to what it
would have to pay the outside investor to accept the liabilities (commitment for payments) under
the option and this can be determined by the Black-Scholes formula for options.
The employees are receiving an uncertain cash flow. Being risk averse, his preference is for
cash or diversified portfolio and the stock option based on stock will be valued lower by the
compensating differential for bearing risk. The efficiency condition is not met.
The two main arguments for stock options, that it alleviates agency problem and that is it an
efficient form of compensation, have limitations. Another claim is that it allows companies,
particularly those like Silicone Valley startups, to offer attractive compensation packages without
straining their cash balances. The evidence is inconclusive as statistics indicate that stock options
were more add-ons than substitute for salary and companies that cash rich like Microsoft and
Intel are generous with stock options.
There are many incentives that the firm can offer to induce employees to remain with the
company. A salaries profile that starts below marginal product and then rise over years to above
the marginal product is one of them. The problem with options that become vested some years
later is that the employee has incentive only if stock prices are above the exercise price.
A serious criticism is that when stock prices fall below the exercise price companies are
resetting the strike price and, in some cases, changing the dates on which the option was granted

1
Hall and Murphy (2003), p.51
2
ibid. p.63
3
Becht, Bolton, and Roell (2003). p.75.
220

to make it more favorable. While stock options have made executive compensation sensitive to
the stock performance, it creates its own distortions.
Takeovers. When internal controls fail to discipline the management, outside groups move to
displace the management and gain control of the firm and its cash flows. This sets up a market
for managerial services, with those who claim that they can increase its value of a firm
challenging current management. The economic benefit of the takeover is measured by the
increase in the sum of values of the acquired and acquiring firm. If the sum increased after the
hostile takeover, what is the source of the increase? How is the incremental value divided among
the shareholders of the two firms? The management reacts to the threat of a hostile takeover by
either finding a friendly group to take-over the firm or by introducing measures that make its
harder for the outside group to get the control. How do these measures affect the shareholders?
In addition to hostile takeovers, managements arrange for merger or acquisitions of other
firms. Are they in the interest of the shareholders or are the managements increasing the sizes of
firms expecting that such increases will also increase their compensation and benefits?
Changing technologies and market conditions require major restructuring of an industry with
closure of facilities, changing product lines, and developing new marketing strategies.
Managements that spent years developing and implementing the current strategies will have
difficulty in abandoning them and make arguments for their continuation even when they are not
viable any more.
An interesting example is oil industry since the oil crisis of 1970s. The oil price increases
increased the cash flow of major oil companies; in 1984 cash flow of ten largest oil companies
was 28 percent of the cash flow of 200 firms in Dunn’s Business Month. 1 An opportunities for
investment in exploration and expansion of refineries were dying up. Instead of returning the free
cash flow to the shareholders and letting them invest it, the management tried to acquire
unrelated businesses. Mobile purchased retailer Montgomery Ward, Exxon purchased a
manufacture of electric motors, Reliance Electric and an office equipment company Vydec, BP
entered animal food by purchase of U.S. Purnia Mills and Gulf Purchased Ringling Brothers.
With the then shocking attempt by T. Boone Pickens of Mesa Petroleum, a small oil company,
for a hostile takeover of a major oil company, the Gulf, the downsizing and reorganization of the
oil industry began.
The economic environment was favorable for takeovers. Under Regan Administration many
industries were deregulated and antitrust enforcement relaxed. A financial innovation,
introduction of junk bonds enabled the acquiring companies to raise funds quickly. 2 A striking
fact is that for the first time, small companies made hostile offers for larger corporations.
Takeovers are not as widespread as the publicity that hostile takeovers generated in 1980s
would suggest. Even at its peak takeover rates rarely exceeded 1.5 percent and it declined
thereafter before reaching a new peak in 1998-2001. While classifying takeovers as friendly or

1
Andrei Shleifer and Robert W. Vishny (1988 p.33.
2
Junk bonds can be thought of as commercial loans resold in financial market and rated below investment grade by
rating agencies. While such bonds were issued earlier, the bonds issues up to the early years of twentieth century, it
gradually dried up. The first issue in many decades was in 1977 when Bear Sterns underwrote an issue; Michael
Millikan of Drexel Burnham became the leader in underwriting junk bonds. He financed deals like T. Boone Pickens
attempt at hostile takeover of Gulf Oil.
221

hostile poses many problems, only 40 of the 3336 transactions in 1986 can be considered hostile;
with the takeover defenses introduced in the late 1980, hostile takeovers died out. 1
Does takeover creates increases in the value of the firms? Various event studies show that
target shareholders of hostile takeovers in U.S. receive a sizable premium of 24 per cent. When
all takeovers are considered, the shareholders of bidder companies have collectively not received
any observable gain. Studies in U.S. and U.K fail to substantiate that hostile takeovers are
targeting firms with poor performance relative to their peers. 2
Then where does the value increase arise? It could be due to transfer of wealth from
employees (tougher wage negotiations or reduction of health benefits and pensions) or
bondholders. Whether such transfers are a rectification of inefficient allocation or not depends on
the initial position. If the stakeholders had bargained unjustifiable terms from the pre-takeover
management, takeover is a mechanism to correct the misallocation. 3
While event studies show that stock market responds favorably to the announcement, event
studies focus on short run. Studies considering value change over longer period show that it is
negative. The creation of conglomerates in the 1960 and 1970s were well received then but later
were recognized as failures and were undone by divestiture.
The effect of introducing takeover defense depends on what the management does with it.
Some boards use to entrench the management while others have used it to negotiate
Summimg up.
Consumers and producers are the two foci of the economic system. The liberal society
recognized the individuality of each consumer and claimed that he or she has the right to
maximize utility based on preferences known only to the individual. The consumers make public
their preferences when they make choices in the market. In contrast to the consumers, the
preference of producers was taken to be known and it is to maximize the profits. Achieving it
requires that many individuals that participate in the production process. This is achieved in
principle by a command process in which the top management fixes the goal and then directs all
others to act to fulfill them. In reality, corporations are a nexus of contracts and each of them the
contracting party has incentives to take opportunistic actions. The challenge for the firm is to
develop policies to minimize if not eliminate such actions. Such policies were discussed in this
chapter.
Bibliographic Note:
Becker (1957); Becht (2003); Blinder (1973); Brealey and Myers (2003); Chandler (1997);
Breshnahan and Ramsey (1994); Copeland and Weston (1992); Enkawa and Schvaneveldt
(2001); Hall, and Murphy (2003); Holden (2005); Ichniowski et al (1997); Financial Times
(2009); Holden (2005); Karmarkar (1989); Los Angles Times (2009); Lazear (2000); McMillan
(1994); Milgrom and Roberts (1995); Nagel and Holden (1995); New York Times (2000); New
York Times (2008);Scherer (1988); Shleifer and Vishny (1988); Smith (1937); Sterndhal and
Craig (1982); Stigler (1987); Triole (2006); US Census Bureau (2009); Wall Street Journal
(2009).

1
M. Becht et al (2003), pp.50-51; Triole (2006), pp.43-44.
2
M. Becht et al (2003), pp. 53-54.
3
F. M.Scherer (1988),pp.70-71.
222
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229

Index

Aging population 161

Discrimination at workplace 202
Adverse selection 167
Dixit, Avinash 9, 124, 126
Advertising, 24
Delivered price 120
Agency problem 197
Deadweight loss 95, 96
Asset boom 161
Deal prone consumer 112
Arrow, Kenneth 51, 54, 153
Derivative securities 157
Average cost 83
Debreu, Gerard 5, 51, 54, 153
Average fixed cost 83
Declaration of Independence 13
Average revenue 83
Declining savings rate 159ff
Average variable cost 83
Defoe, Daniel 27
Axioms of preference 18ff, 31
Delivered price 109
Becker, Gary 202
Discount factor 47ff, 158ff
Bentham, Jeremy 14
Division of labor 33
Bertrand, Joseph 132ff
Dixit, Avinash 9
Beta 175 Duke James Buchanan 204
Black, Fisher 157, 178 Duopoly 130ff
Breshnahan, Timothy F. 189 Economic profit 83
Budget line 16, 17, 37, 60ff Economic value added 83
Bundling 116 Enron 216
Capacity of a firm 133 Engle, Ernest 66
Capital Asset Pricing model (CAPM) 168, 173ff Enlightenment, Europe 11
Cartels 101 Enterprise resource planning 193
Chief executive officer 208 Entitlement theory 14
Clayton Act 101, 117 Exchange, benefits 33
Competitive markets 139ff Expected utility maximization 162
Compound lottery 163 European Union Antitrust policies, 101
Contingent claims 55, 157 Eurotunnel 92
Consumer surplus 94ff Experience good 206
Coordination 10, 27 f.o.b. 109
Coupons 112ff Fixed cost 185
Cournot, Antoine 68, 131ff Fisher, Irving 48, 58, 158, 168
Covariance 168 Ford, Henry 76
Customer retention 113 GAAP 80
Dasgupta, Partha 9 Game theory, cooperative 11
230

Gillette Company 123, 124 Market, strong and weak 106

German supervisory board 218 Market clearing price 69, 70
Gross profit 79, 91 Markowitz, Harry 168, 179
Hatch-Waxman Act 99 Marshall, Alfred 5, 8, 9, 93
Hedging 55ff Mean-variance analysis 157
Hicks, John 93 McLane Report 182
Hobbes, Thomas 13, 18, 136 Menger, Carl 5
Holden, Reed 70 Milgrom, Paul 9, 199
Houthakker, Hendriks 18 Mill price 109
Hume, David 53 Monopolist 89ff
Ichniowski, Casey 199 Moral hazard 167
Income elasticity of demand 66 Morgenstern, Oskar 38, 51, 179
Income statement 81 Nagle, Thomas 70
Indifference curve 31ff Nalebuff', Barry 9
Jermolowics, 8 Nash, John 38, 131
Jevons, William 5 Nash equilibrium 137
Just–in-time production 191 Nash bargaining solution 38ff
Kalnins, Arthur 76 Nelson, Phillip 24, 206
Kant, Immanuel, 14, 37 Net income 82
Kay, John, 9 Net present value 209
Keynes, John 8 Newton, Issac 7, 142
Kreps, David 133 Normal distribution 178
Lastbohm, John 4 Operating income 77
Lazear, Edward P. 198 Options 176ff
Leisure, choice of, 32ff Outsourcing 76
Lincoln Electric 197ff Pareto, Vilfredo 34ff, 108
Locke, John 13, 18, 37 Pareto efficient 35, 54
Maddison, Angus 32 Parker Pen Holding Company 123, 124
Magnusson 3 Patent 97ff
Malthus 143 Pernnushi, Giovanna 199
Marginal cost 78, 91 Portfolio diversification 157
Marginal rate of substitution 22, 52, 63ff Preference 18ff
Marginal rate of transformation 28ff Present Based discounting 160
Marginal product 77 Price discrimination 106
Marginal rate of technical substitution 187 Price elasticity 71
Marginal revenue 78, 90, 140ff, 185ff Probability 53
Marginal risk of stock 173 Production function 185
231

Proto-industrialization 182 Stiglitz, Joseph 124, 126

Prisoner’s dilemma 135ff Stock option 219
Product characteristics 22ff Stradling, Thomas 27ff, 129, 130
Product group 119ff Strike price 177
Property rights 14 Super-baskets 48
Psychic cost 122 Transaction cost 4, 192
Ramsey, Valeriw A. 189 Time preference 45, 48
Repeat purchase, 207 Tobin, James 168, 179
Reservation price 120ff Two-part tariff 114ff
Ricardo, David 5 TRIPS 99
Roberts, John 9, 199 Utilitarianism 14 , 18
Robertson, Dennis 9, 181 Utility 15
Robertson – Patman Act Variable proportion 143, 185
Robinson, Joan 106 Variance 170ff
Safelite Glass Corporation 197 Von Hayek, John 59
Salt tax 89 von Neumann, John 38, 51, 179
Sales region 121 Walras, Leon 5, 54, 153
Search goods 206 Wang Laboratories 208
Self-replicating portfolios 179 Williamson, Oliver 102
Samuelson, Paul 18, 49, 157,158,159 Welfare economics, theorems 37
Scholes, Myron 157, 158, 177
Schumpeter, Joseph 8, 15
Segmenting of markets 105
Selkirk, Alexander, 27ff, 129, 130
Scheinkman, Jose 133, 134
Shaw, Kathryn 198
Sherman Act 101
Sherwin, Robert 73
Singer, Issac 204
Smith, Adam 4, 8, 9, 14, 15, 54, 59, 100, 117, 140,
150, 155, 181
Spatial model of price discrimination 109ff
Sport utility vehicle (SUV) 23
Standard deviation 170
State of nature 45
State contingent commodities, 51ff
Stigler, George 73, 186